Eco 6351Economics for Managers

Chapter 7. Monopoly

Prof. Vera Adamchik

Monopoly

• How monopoly arises

• Price discrimination

• Price discrimination and total revenue

• Price and Output Decision

• Comparing Monopoly and Competition

• A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

Barriers to Entry

• Barriers to entry are legal or natural constraints that protect a firm from potential competitors.

• Most monopolies arise from two types of barriers: legal barriers and natural barriers. In addition, a firm can sometimes create its own barrier to entry by acquiring a significant portion of a key resource (DeBeers).

Legal Barriers to Entry

• Legal barriers to entry create legal monopoly. A legal monopoly is a market in which competition and entry are restricted by the granting of a public franchise, government license, patent, or copyright.

• A public franchise is an exclusive right granted to a firm to supply a good or service.

• A government license controls entry into particular occupations, professions, and industries.

• A patent is an exclusive right granted to the inventor of a product or service.

• A copyright is an exclusive right to the author or composer of a literary, musical, dramatic, or artistic work.

Natural Barriers to Entry

• Natural barriers to entry create natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can.

A major difference between monopoly and competition is that a monopoly sets its own price. But it faces a market constraint. All monopolies face a tradeoff between price and the quantity sold. But there are two broad monopoly situations that create different tradeoffs. They are:

• Price discrimination

• Single price

Price Discrimination

• Price discrimination is the practice of charging some customers a higher price than others for an identical good or charging an individual customer a higher price on a small purchase than on a large one.

Price Discrimination

• Examples of price discrimination– Children and students pay a lower price

than other people to see a movie.– Magazine subscribers pay a lower price

than buyers at a news stand.– Vacation travelers pay lower air fares than

business travelers.– Fashion conscious people pay more for

their clothes.

Price differences vs.Price discrimination

• Not all price differences are examples of price discrimination

• If differences in cost lead to differences in price, there is no price discrimination

Price Discrimination

• Why would a firm price discriminate?

• It turns out that price discrimination is profitable.

• To see why, we first look at the connection between price discrimination and total revenue.

Price Discrimination and Total Revenue

• For example, if Mary has 3 customers per hour, she may charge $14 for each haircut and her total revenue is $42 an hour

3 x $14 = $42

Price Discrimination and Total Revenue

• But suppose she can sell 1 haircut for $18 (a female customer), one for $16 (a male customer), and one for $14 (a child)

16

18

Price Discrimination and Total Revenue

• Mary’s total revenue increases

• It is now $18 + $16 + $14 = $48

16

18

$18 + $16 + $14

= $48

Price Discrimination and Total Revenue

• The greater the degree of price discrimination, the greater is the total revenue

Limits to Price Discrimination

• No resale must be possible

• Must be possible to identify groups with different demand elasticities

Single Price Monopoly

• A single-price monopoly is a firm that must sell each unit of its output for the same price. All the firm’s customers pay the same price for each unit they buy.

Price and Marginal Revenue

• For a single-price monopoly, marginal revenue is always less than the price.

• Thus, the marginal revenue curve will always lie below the demand curve.

Price and Output Decision

• A monopoly maximizes profit by producing an output at which MR=MC.

• At the profit-maximizing output, the monopoly charges the highest price that consumers are willing to pay, which is determined by the demand curve.

• Because in monopoly, price exceeds MR, price also exceeds MC.

Price and Output Decision

• The single price monopoly

• Mary maximizes profit by selling 3 haircuts an hour

Price and Output Decision

• The price per haircut is $14 and Mary’s economic profit is $12 an hour

• Does a monopoly produce the same quantity and charge the same price as firms in perfect competition?

• Let’s look at an example.

• The firms in a perfectly competitive industry are bought up by a single firm -a monopoly.

• What happens to price and quantity?

Comparing Monopoly and Competition

Comparing Monopoly and Competition

• We begin with a perfectly competitive industry

• The demand curve is D and the supply curve is S

Comparing Monopoly and Competition

• The industry produces the quantity QC and sells it for the price PC

• Now the industry becomes a monopoly

Comparing Monopoly and Competition

• The supply curve of the competitive industry becomes the marginal cost curve of the monopoly

Comparing Monopoly and Competition

• The demand curve of the competitive industry becomes the monopoly’s demand curve

Comparing Monopoly and Competition

• The monopoly also faces the marginal revenue curve MR

Comparing Monopoly and Competition

• The monopoly maximizes profit by producing the quantity QM, which it sells for a price of PM

Comparing Monopoly and Competition

• Compared to perfectly competitive firms, a single-price monopoly restricts output and charges a higher price

To summarize:

• A single-price monopoly charges a higher price and produces a smaller quantity than a perfectly competitive industry does.

Comparing Monopoly and Competition

Gains from Monopoly ?

• The main reasons why monopoly might have some advantages are:– Economies of scale– Incentive to innovate

Gains from Monopoly

• Here, the competitive outcome is a price of PC and a quantity of QC

Gains from Monopoly

• Because of economies of scale, a monopoly can produce more efficiently than many small firms.

Gains from Monopoly

• The monopoly’s marginal cost curve is MCM

• The monopoly’s produces QM

which it sells for PM

Gains from Monopoly

• The price is lower and the quantity is larger with monopoly than with competition

• Some industries fit this case

Varieties of Market Structure

Many real-world industries lie somewhere between the extremes of perfect competition and monopoly, and two other market models are used to study the behavior of these industries:

• Monopolistic competition

• Oligopoly

Monopolistic Competition

• A large number of firms compete.

• Each firm produces a differentiated product which is a close but not a perfect substitute for the products of the other firms. (Each firm faces a downward-sloping demand curve.)

• Firms are free to enter and exit.

Monopolistic Competition

• Economic profit in the short run stimulates entry in the long run.

• In long-run equilibrium, price equals average total cost (economic profit is zero) and price exceeds marginal cost.

Oligopoly

• In oligopoly, a small number of producers compete. The quantity sold by any one producer depends on that producer’s price and on the other producers’ prices and quantities sold.

Oligopoly

• Several models have been developed to explain the prices and quantities in oligopoly markets. But no one theory has been found that can explain all the different types of behavior that we observe in such markets. The models fall into two broad groups: traditional models and game theory models.