Lecture 9

Monopoly
I. Why Monopolies Arise
- Monopoly: a firm that is the sole seller of a product without close substitutes

- The fundamental cause of monopoly is barriers to entry: A monopoly remains the

only seller in its market because other firms cannot enter the market and compete with
it. Barriers to entry, in turn, have three main sources:
 Monopoly resources: A key resource required for production is owned by a
single firm.
 Government regulation: The government gives a single firm the exclusive right
to produce some good or service
 The production process: A single firm can produce output at a lower cost than
can a larger number of producers.

1. Monopoly Resources
- The simplest way for a monopoly to arise is for a single firm to own a key resource.

- The monopolist has much greater market power than any single firm in a
competitive market => Monopolist could command quite a high price => More benefit

2. Government regulation
- In many cases, monopolies arise because the government has given one person or
firm the exclusive right to sell some good or service

- Government-created monopolies
 Patent and copyright law: The copyright is a government guarantee that no one
can print and sell the work without the author’s permission.
 Ex: The copyright makes the novelist a monopolist in the sale of her novel.
  Allowing these monopoly producers to charge higher prices -> earn higher
profits
 The laws governing patents and copyrights have benefits and costs. The
benefits of the patent and copyright laws are the increased incentives for
creative activity. These benefits are offset, to some extent, by the costs of
monopoly pricing

3. The production process

- An industry is a natural monopoly when a single firm can supply a good or service
to an entire market at a lower cost than could two or more firms.

- A natural monopoly arises when there are economies of scale over the relevant
range of output.

 Ex: To provide water to residents of a town, a firm must build a network of pipes
throughout the town. If two or more firms were to compete in the provision of
this service, each firm would have to pay the fixed cost of building a network.
Thus, the average total cost of water is lowest if a single firm serves the entire
market.
II. How Monopolies Make Production& Pricing Decisions
1. Monopoly versus Competition
- The key difference between a competitive firm and a monopoly is the monopoly’s
ability to influence the price of its output:
 A competitive firm: small relative to the market in which it operates => has no
power to influence the price of its output => takes the price as given by market
conditions -> Price taker
 Monopoly: the sole producer in its market => can alter the price of its good by
adjusting the quantity it supplies to the market-> Price maker

2. A monopoly’s revenue
- Total revenue = price x quantity (3th column of the table)

- Average revenue = total revenue/ units sold (4th column of the table) <= the
amount of revenue the firm receives per unit sold
 Note: Average revenue always equals the price of the good. This is true for monopolists as well
as for competitive firms

- Marginal revenue = the change in total revenue when output increases by 1 unit,
can be negative (last column) <= the amount of revenue that the firm receives for each
additional unit of output

- For example, when the firm is producing 3 gallons of water, it receives total
revenue of $24. Raising production to 4 gallons increases total revenue to $28. Thus,
marginal revenue from the sale of the fourth gallon is $28 minus $24, or $4

=> A monopolist’s marginal revenue is always less than the price of its good: MR < P

- Marginal revenue for monopolies is very different from marginal revenue for
competitive firms. When a monopoly increases the amount it sells, this action has two
effects on total revenue (P × Q):
 The output effect: More output is sold, so Q is higher, which tends to increase
total revenue.
 The price effect: The price falls, so P is lower, which tends to decrease total
revenue
 When a monopoly increases production by 1 unit, it reduce the price it charges for
every unit it sells, and this cut in price reduces revenue on the units it was already
selling
 A monopoly’s marginal revenue is less than its price (MR curve is below the D
curve)

3. Profit Maximization

- Suppose:
TH1: The firm produces at a low level of output - Q1.
- Marginal cost < marginal revenue.
- The firm increased production by 1 unit -> the additional revenue would exceed
the additional costs -> profit would rise.
  Marginal cost < marginal revenue, the firm can increase profit by producing
more units.
TH2: The firm produce at high levels of output - Q2
- Marginal cost > marginal revenue.
- The firm reduced production by 1 unit -> the costs saved would exceed the
revenue lost.
 Marginal cost > marginal revenue, the firm can raise profit by reducing
production

- The firm adjusts its level of production until the quantity reaches Q MAX, at which
marginal revenue equals marginal cost
 The monopolist’s profit maximizing quantity of output is determined by the
intersection of the marginal-revenue curve and the marginal-cost curve
(point A figure 4)

- Rule for profit maximization:

 For a competitive firm: P = MR = MC.
 For a monopoly firm: P > MR = MC
- A key difference between markets with competitive firms and markets with a
monopoly firm: In competitive markets, price equals marginal cost. In monopolized
markets, price exceeds marginal cost.

4. A Monopoly’s Profit
- Profit = (TR/Q – TC/Q) × Q.
- TR/Q is average revenue, which equals the price, P, and TC/Q is average total
cost, ATC. Therefore:
Profit = (P – ATC) × Q
CASE STUDY: Monopoly Drugs vs Generic Drugs
A firm discovers a new drug, patent laws give the firm a monopoly on the sale of that
drug. But eventually, the firm’s patent runs out, and any company can make and sell the
drug. At that time, the market switches from being monopolistic to being competitive

- During the life of the patent: the monopoly firm maximizes profit by producing
the quantity at which marginal revenue equals marginal cost and charging a price
well above marginal cost.
 - When the patent runs out, the profit from making the drug should encourage
new firms to enter the market. As the market becomes more competitive, the
price should fall to equal marginal cost.
- The price of the competitively produced generic drug is well below the price that
the monopolist was charging. The expiration of a patent, however, does not cause
the monopolist to lose all its market power. Some consumers remain loyal to the
brand-name drug, perhaps out of fear that the new generic drugs are not actually
the same as the drug they have been using for years. As a result, the former
monopolist can continue to charge a price above the price charged by its new
competitors.

III. The Welfare Cost of Monopolies

- Total surplus is the sum of consumer surplus and producer. Consumer surplus is
consumers’ willingness to pay for a good minus the amount they actually pay for it.
Producer surplus is the amount producers receive for a good minus their costs of
producing it. In this case, there is a single producer—the monopolist.

1. The Deadweight Loss

- If the monopoly firm were run by a benevolent social planner:
 The social planner cares about: the profit earned by the firm’s owners + the
benefits received by the firm’s consumers
 The planner tries to maximize total surplus, which equals producer surplus
(profit) plus consumer surplus (total surplus equals the value of the good to
consumers minus the costs of making the good incurred by the monopoly
producer)

- Figure 7 analyzes how a benevolent social planner would choose the monopoly’s level
of output.
 Demand curve -> the value of the good to consumers, as measured by their
willingness to pay
 Marginal-cost curve -> the costs of the monopolist.
 The socially efficient quantity is found where the demand curve and the
marginal-cost curve intersect
  Below this quantity: the value of an extra unit to consumers > the cost of
providing it -> increasing output would raise the total surplus.
 Above this quantity: the cost of producing an extra unit > the value of that unit
to consumers -> decreasing output would raise total surplus.

 At the efficient quantity, the value of an extra unit to consumers exactly

equals the marginal cost of production.

 If the social planner were running the monopoly, the firm could achieve this
efficient outcome by charging the price found at the intersection of the
demand and marginal-cost curves. Thus, like a competitive firm and unlike
a profit-maximizing monopoly, a social planner would charge a price equal
to marginal cost. Because this price would give consumers an accurate
signal about the cost of producing the good, consumers would buy the
efficient quantity.

- Figure 8 shows the comparison of output that the monopolist chooses to the level of
output that a social planner would choose
  Monopolist chooses to produce and sell the quantity of output at which the
marginal-revenue and marginal-cost curves intersect
 Social planner chooses the quantity at which the demand and marginal-cost
curves intersect
 The monopolist produces less than the socially efficient quantity of
output

- The market demand curve describes a negative relationship between the price and
quantity of the good, a quantity that is inefficiently low is equivalent to a price that is
inefficiently high.
- When a monopolist charges a price above marginal cost -> some potential consumers
value the good at more than its marginal cost but less than the monopolist’s price ->
they don’t buy the good because the value they place on the good > the cost of providing
it to them, this result is inefficient.
 Monopoly pricing prevents some mutually beneficial trades from taking place.
- The inefficiency of monopoly can be measured with a deadweight loss triangle (figure
8).
 Demand curve = the value to consumers
 Marginal-cost curve = the costs to the monopoly producer
  The area of the deadweight loss triangle between the demand curve and the
marginal-cost curve (= the total surplus lost because of monopoly pricing)

2. The Monopoly’s Profit: A Social Cost?

- A monopoly firm does earn a higher profit by virtue of its market power.
- Welfare in a monopolized market, like all markets, includes the welfare of both
consumers and producers.
- Whenever a consumer pays an extra dollar to a producer because of a monopoly
price, the consumer is worse off by a dollar, and the producer is better off by the same
amount.
- This transfer from the consumers of the good to the owners of the monopoly does
not affect the market’s total surplus—the sum of consumer and producer surplus.
- The monopoly profit is not a social problem.

IV. Price Discrimination

- Price discrimination: the business practice that firms sell the same good to
different customers for different prices, even though the costs of producing for the two
customers are the same => Increase profit.
- Not possible in a competitive market because many firms are selling the same good
at the market price, no firm is willing to charge a lower price to any customer because
the firm can sell all it wants at the market price. If any firm tried to charge a higher price
to a customer, that customer would buy from another firm
=> For a firm to price discriminate, it must have some market power

1. A Parable about Pricing

To understand why a monopolist would price discriminate, let’s consider an
example. Imagine that you are the president of Readalot Publishing Company.
Readalot’s best-selling author has just written a new novel. To keep things
simple, let’s imagine that you pay the author a flat $2 million for the exclusive
rights to publish the book. Let’s also assume that the cost of printing the book is
zero. Readalot’s profit, therefore, is the revenue from selling the book minus the
$2 million it has paid to the author. Given these assumptions, how would you, as
Readalot’s president, decide the book’s price?
Your first step is to estimate the demand for the book. Readalot’s marketing
department tells you that the book will attract two types of readers. The book will
appeal to the author’s 100,000 die-hard fans who are willing to pay as much as
$30. In addition, the book will appeal to about 400,000 less enthusiastic readers
who will pay up to $5.
If Readalot charges a single price to all customers, what price maximizes
profit? There are two natural prices to consider: $30 is the highest price Readalot
can charge and still get the 100,000 die-hard fans, and $5 is the highest price it
can charge and still get the entire market of 500,000 potential readers. Solving
Readalot’s problem is a matter of simple arithmetic. At a price of $30, Readalot
sells 100,000 copies, has revenue of $3 million, and makes profit of $1 million. At
a price of $5, it sells 500,000 copies, has revenue of $2.5 million, and makes profit
of $500,000. Thus, Readalot maximizes profit by charging $30 and forgoing the
opportunity to sell to the 400,000 less enthusiastic readers.
Notice that Readalot’s decision causes a deadweight loss. There are 400,000
readers willing to pay $5 for the book, and the marginal cost of providing it
to them is zero. Thus, $2 million of total surplus is lost when Readalot charges
the higher price. This deadweight loss is the inefficiency that arises whenever a
monopolist charges a price above marginal cost.
Now suppose that Readalot’s marketing department makes a discovery: These
two groups of readers are in separate markets. The die-hard fans live in Australia,
and the other readers live in the United States. Moreover, it is hard for readers in
one country to buy books in the other.
In response to this discovery, Readalot can change its marketing strategy and
increase profits. To the 100,000 Australian readers, it can charge $30 for the book.
To the 400,000 American readers, it can charge $5 for the book. In this case,
revenue is $3 million in Australia and $2 million in the United States, for a total of
$5 million. Profit is then $3 million, which is substantially greater than the $1
million the company could earn charging the same $30 price to all customers.
Not surprisingly, Readalot chooses to follow this strategy of price discrimination.
The story of Readalot Publishing is hypothetical, but it describes accurately
 the business practice of many publishing companies. Textbooks, for example, are
often sold at a lower price in Europe than in the United States. Even more
important is the price differential between hardcover books and paperbacks. When
a publisher has a new novel, it initially releases an expensive hardcover edition and
later releases a cheaper paperback edition. The difference in price between these
two editions far exceeds the difference in printing costs. The publisher’s goal is just
as in our example. By selling the hardcover to die-hard fans and the paperback to
less enthusiastic readers, the publisher price discriminates and raises its profit.

2. The Moral of the Story

Price discrimination give us 3 lessons:
- Rational strategy (most clear):
 Increase profit
 Charges each customer a price closer to his or her willingness to pay
 Sell more than is possible with a single price

- Requires the ability to separate customers according to their willingness to pay:

 Because certain market forces can prevent firms from price discriminating
 In particular is arbitrage, the process of buying a good in one market at a low
price and selling it in another market at a higher price to profit.
 Ex: Australian bookstores buy the book in the US and resell it to Australian
readers, the arbitrage would prevent Readalot from price discriminating,
because no Australian would buy the book at the higher price

- Price discrimination can raise economic welfare:

Price discrimination can eliminate the inefficiency (deadweight loss) inherent in
monopoly pricing.
Ex: A deadweight loss arises when Readalot charges a single $30 price because
the 400,000 less enthusiastic readers do not end up with the book, even
though they value it at more than its marginal cost of production. By contrast,
when Readalot price discriminates, all readers get the book, and the outcome
is efficient.
 In this example the increase in welfare from price discrimination shows up
as a higher producer surplus rather than higher consumer surplus.
 Consumers are no better off for having bought the book: The price they pay
exactly equals the value they place on the book, so they receive no
consumer surplus. The entire increase in the total surplus from price
discrimination accrues to Readalot Publishing in the form of higher profit.

3. The Analytics of Price Discrimination

- Perfect price discrimination: describes a situation in which the monopolist knows
exactly each customer’s willingness to pay and can charge each customer exactly his or
her willingness to pay=> monopolist gets the entire surplus in every transaction => no
DWL

- Figure 9 illustrates producer and consumer surplus with and without price
discrimination

- This figure is drawn assuming constant per unit costs—that is, marginal cost and
average total cost are constant and equal
- (a) without price discrimination:
Some potential customers who value the good at more than marginal cost don’t
buy it at this high price => the monopoly causes a DWL.
- (b) perfectly price discriminate
All mutually beneficial trades take place
No deadweight loss occurs
The entire surplus derived from the market goes to the monopoly producer in
the form of profit.

4. Examples of Price Discrimination

– Movie tickets –Discount coupons –Quantity discounts
– Airline prices – Financial aid

V. Public Policy Toward Monopolies

- We have seen that monopolies, in contrast to competitive markets, fail to allocate
resources efficiently. Monopolies produce less than the socially desirable quantity of
output and, as a result, charge prices above marginal cost. Policymakers in the
government can respond to the problem of monopoly in one of four ways:
 By trying to make monopolized industries more competitive.
 By regulating the behavior of the monopolies.
 By turning some private monopolies into public enterprises.
 By doing nothing at all

1. Increasing Competition with Antitrust Laws

- Sherman Antitrust Act, 1890: reduce the market power of the large and powerful
“trusts”

- Clayton Antitrust Act, 1914: strengthened the government’s powers and authorized
private lawsuits

- The antitrust laws give the government various ways to promote competition. They
allow the government to prevent mergers, such as the assumption of merge between
Coca-Cola and PepsiCo. They also allow the government to break up companies. For
example, in 1984, the government split up AT&T, the large telecommunications
company, into eight smaller companies. Finally, the antitrust laws prevent companies
from coordinating their activities in ways that make markets less competitive.

- Antitrust laws have costs as well as benefits. Sometimes companies merge not to
reduce competition but to lower costs through more efficient joint production.

2. Regulation
- Another way the government deals with the problem of monopoly is by regulating
the behavior of monopolists.

- This solution is common in the case of natural monopolies, such as water and
electric companies. These companies are not allowed to charge any price they want.
Instead, government agencies regulate their prices.

3. Public Ownership
How the ownership of the firm affects the costs of production:
- Private owners
• Incentive to minimize costs

- Public owners (government)

• If it does a bad job => Losers are the customers and taxpayers