EconomicsCombined Version

Edwin G. DolanBest Value Textbooks

4th edition

Chapter 10Theory of Monopoly

What is a Monopoly?

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A monopoly is a market structure in which there is a single supplier of a product.

The monopolist:May be small or large.Must be the ONLY supplier of the product.Sells a product for which there are NO close

substitutes. (The greater the number of close substitutes for a firm’s products, the less likely it is that the firm can exercise monopoly power.

Monopolies are fairly common: U.S. Postal Service, local utility companies, local cable providers, etc.

The Creation of Monopolies

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Monopolies often arise as a result of barriers to entry.

Barrier to entry: anything that impedes the ability of firms to begin a new business in an industry in which existing firms are earning positive economic profits. There are three general classes of barriers to entry:Natural barriers, the most common being

economies of scaleNetwork effectsActions by firms to keep other firms outGovernment (legal) barriers

Economies of Scale

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In some industries, the larger the scale of production, the lower the costs of production.

Entrants are not usually able to enter the market assured of or capable of a very large volume of production and sales.

This gives incumbent firms a significant advantage.

Examples are electric power companies and other similar utility providers.

Monopoly based on Economies of Scale

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Actions by Firms

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Entry is barred when one firm owns an essential resource.

Examples are inventions, discoveries, recipes, and specific materials.Microsoft owns Windows, and has been challenged by the U.S. Dept. of Justice as a monopolist.

Government

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Governments often provide barriers, creating monopolies.

As incentives to innovation, governments often grant patents, providing firms with legal monopolies on their products or the use of their inventions or discoveries for a period of 17 years.

Types of Monopolies (Alt. Text)

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Natural monopoly: A monopoly that arises from economies of scale. The economies of scale arise from natural supply and demand conditions, and not from government actions.Local monopoly: a monopoly that exists in a limited

geographic area.Regulated monopoly: a monopoly firm whose

behavior is overseen by a government entity.

Monopoly power: market power, the power to set prices.

Monopolization: an attempt by a firm to dominate a market or become a monopoly.

Kinds of Monopoly (Dolan Text) A closed monopoly is protected by legal

restrictions on competition. For example, state law in Washington prevents anyone from offering competing car ferry service to islands served by the Washington State Ferry System.

A natural monopoly is an industry in which long-run average cost is minimized when just one firm serves the entire market. Distribution of natural gas to residential customers is an example.

3. An open monopoly is a case in which a firm becomes, at least for a time, the sole supplier of a product without having the special protections against competition that is enjoyed by a closed or natural monopoly. An example is Sony’s first home video cassette recorder.

Washington State Ferry at Lopez Island

Picture by E. Dolan

The Demand Curve Facing a Monopoly Firm

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In any market, the industry demand curve is downward-sloping. This is the result of the law of demand.

In Monopoly the monopolist IS the industry because it is the sole producer.

Therefore the monopolist faces a downward-sloping demand curve. The industry demand curve is the firm’s demand curve.

Marginal Revenue

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Marginal Revenue (MR) is:

MR is less than price for a monopoly firm.

The MR is less than price and declines as output increases because the monopolist must lower the price in order to sell more units (because the demand curve slopes downward).

QTR

MR

Demand Curve for a Monopolist

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Q Price TR MR

1 $1,700 $ 1,700 $1,700

2 $1,650 $ 3,300 $1,600

3 $1,600 $ 4,800 $1,500

4 $1,550 $ 6,200 $1,400

5 $1,500 $ 7,500 $1,300

6 $1,450 $ 8,700 $1,200

7 $1,400 $ 9,800 $1,100

8 $1,350 $10,800 $1,000

9 $1,300 $11,700 $ 900

Average Revenue

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Whenever MR is greater than AR, AR rises.Whenever MR is less than AR, AR falls.Average revenue is:

Note that the AR is the same as price. In fact, the AR curve is the demand curve.

With a downward-sloping demand curve, prices fall as output increases. This means that AR falls.

MR must always be less than AR.

PQQP

AR

From the text but not very useful

For A Monopolist: Marginal Revenue IS NOT Price

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The MR Curve for a downward sloping, linear demand curve:

Is always below the demand curve

Sits half-way between the demand curve and the Y axis

In other words it is half-way between the quantity on the Demand curve and a quantity of Zero

Demand and Revenue for the

Monopolist

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Monopoly firms NEVER chose to produce in the inelastic range of their demand curve.

Monopoly firms will always withhold product to keep their sales in the Elastic or Unit Elastic range of their demand curve.

Profit Maximization

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The monopolist will not set the price arbitrarily high.

For the monopolist, the profit-maximizing price still corresponds to the point where MR=MC.

The monopolist’s market power will allow the firm to achieve above-normal profits.

Unlike Perfect Competition, in Monopoly:

MR < Price & MR < Demand Curve

Profit Maximizing Monopoly

Monopoly Firms pick their profit maximizing quantity where:

MR=MC

The price is determined by the Demand Curve at that Quantity

D

Monopoly Profit Solution

Price is the intersection of the Monopoly Quantity with the Demand Curve

Cost is found at the intersection of the quantity with the firm’s Average Total Cost Curve at the selected quantity

Cost

Profit Maximization

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Price is the intersection of the Monopoly Quantity with the Demand Curve

Cost is found at the intersection of the quantity with the firm’s Average Total Cost Curve at the selected quantity

Price Discrimination

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Under certain conditions, a firm with market power is able to charge different customers different prices. This is called price discrimination.

Necessary Conditions for Price Discrimination

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For price discrimination to work, the firm must be able to set the price.The firm cannot be a price taker.

The firm must be able to “segment the market”. That is, the firm must be able to:Separate the customersPrevent resale of the product

Price Discrimination in Action

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Monopoly and Perfect Competition: Comparison

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