S121 ECO504 BUSINESS ECONOMICS
roy robin 
Session-07-handouts.pdf
1
Market structures
Why Monopolies Arise
• Market power
– Alters the relationship between a firm’s
costs and the selling price
• Monopoly
– Charges a price that exceeds marginal
cost
– A high price reduces the quantity
purchased
– Outcome: often not the best for society
Why Monopolies Arise
• Monopoly resources
– A key resource required for production is
owned by a single firm
– Higher price
“Rather than a monopoly,
we like to consider
ourselves ‘the only game
in town.’”
2
Why Monopolies Arise
• Government regulation
– Government gives a single firm the
exclusive right to produce some good or
service
– Government-created monopolies
• Patent and copyright laws
• Higher prices
• Higher profits
Why Monopolies Arise
• Natural monopoly
– A single firm can supply a good or service
to an entire market
• At a smaller cost than could two or more firms
– Economies of scale over the relevant
range of output
– Club goods
• Excludable but not rival in consumption
Economies of Scale as a Cause of Monopoly
Costs
When a firm’s average-total-cost curve continually declines, the firm has what is
called a natural monopoly. In this case, when production is divided among more
firms, each firm produces less, and average total cost rises. As a result, a single firm
can produce any given amount at the least cost
Quantity of output 0
Average total cost
3
Why Monopolies Arise
External Growth
- Acquisition, mergers and takeovers
- Big four banks
Production and Pricing Decisions
• Monopoly
– Price maker
– Sole producer
– Downward sloping demand: the market
demand curve
• Competitive firm
– Price taker
– One producer of many
– Demand is a horizontal line (Price)
Demand Curves for Competitive and Monopoly Firms
Price
Because competitive firms are price takers, they in effect face horizontal demand
curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it
faces the downward-sloping market demand curve, as in panel (b). As a result, the
monopoly has to accept a lower price if it wants to sell more output.
Quantity of output 0
(a) A Competitive Firm’s Demand Curve
Price
Quantity of output 0
(b) A Monopolist’s Demand Curve
Demand
Demand
4
Production and Pricing Decisions
• A monopoly’s total revenue
– Total revenue = price times quantity
• A monopoly’s average revenue
– Revenue per unit sold
– Total revenue divided by quantity
– Always equals the price
Production and Pricing Decisions
• A monopoly’s marginal revenue
– Revenue per each additional unit of output
• Change in total revenue when output
increases by 1 unit
– MR < P
• Downward-sloping demand
• To increase the amount sold, a monopoly firm
must lower the price it charges to all
customers
– Can be negative
A Monopoly’s Total, Average, and Marginal Revenue
5
Demand and Marginal-Revenue Curves for a Monopoly
Price
2 1
-1 -2 -3
5 4 3
6 7 8 9
10 $11
-4
The demand curve shows how the quantity affects the price of the good. The marginal-revenue
curve shows how the firm’s revenue changes when the quantity increases by 1 unit. Because
the price on all units sold must fall if the monopoly increases production, marginal revenue is
always less than the price.
Quantity
of water
0 1 2 3 4 5 6 7 8
Demand
(average revenue)
Marginal revenue
Marginal Revenue Like a Monopolist
Q Q
P TR
100
0 0 10 20 30 40 50 10 20 30 40 50
800
60 1200
40
20
•Inelastic
•Elastic
•Elastic •Inelastic
•Unit elastic
•Unit elastic
•MR
Production and Pricing Decisions
• Profit maximization
– If MR > MC: increase production
– If MC > MR: produce less
– Maximize profit
• Produce quantity where MR=MC
• Intersection of the marginal-revenue curve
and the marginal-cost curve
• Price: on the demand curve
6
Profit Maximization for a Monopoly
Costs
and
Revenue
A monopoly maximizes profit by choosing the quantity at which marginal revenue equals
marginal cost (point A). It then uses the demand curve to find the price that will induce
consumers to buy that quantity (point B).
Quantity 0
Average total cost
Demand
Marginal revenue
Marginal cost
QMAX
B Monopoly
price
A
1. The intersection of the marginal-revenue
curve and the marginal-cost curve
determines the profit-maximizing quantity . . .
2. . . . and then the demand
curve shows the price consistent
with this quantity.
Q1 Q2
Production and Pricing Decisions
• Profit maximization
– Perfect competition: P=MR=MC
• Price equals marginal cost
– Monopoly: P>MR=MC
• Price exceeds marginal cost
• A monopoly’s profit
– Profit = TR – TC = (P – ATC) ˣ Q
The Monopolist’s Profit
Costs
and
Revenue
The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is
price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the
number of units sold.
Quantity 0
Demand
B E
D
Marginal revenue
QMAX
Average total cost
Marginal cost
Monopoly
price
C
Monopoly
profit
Average
total
cost
7
Monopoly Drugs versus Generic Drugs
• Market for pharmaceutical drugs
– New drug, patent laws, monopoly
• Produce Q where MR=MC
• P>MC
– Generic drugs: competitive market
• Produce Q where MR=MC
• And P=MC
• Price of the competitively produced
generic drug
– Below the monopolist’s price
The Market for Drugs
Costs
and
Revenue
When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly
price, which is well above the marginal cost of making the drug. When the patent on a drug runs
out, new firms enter the market, making it more competitive. As a result, the price falls from the
monopoly price to marginal cost.
Quantity 0
Demand Marginal revenue
Monopoly
quantity
Price
during
patent life
Marginal cost Price after
patent
expires
Competitive
quantity
The Welfare Cost of Monopolies
• Total surplus
– Economic well-being of buyers and sellers
in a market
– Sum of consumer surplus and producer
surplus
• Consumer surplus
– Consumers’ willingness to pay for a good
– Minus the amount they actually pay for it
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The Welfare Cost of Monopolies
• Producer surplus
– Amount producers receive for a good
– Minus their costs of producing it
• Benevolent planner: maximize total
surplus
– Socially efficient outcome
– Produce quantity where
• Marginal cost curve intersects demand curve
– Charge P=MC
The Efficient Level of Output Costs
and
Revenue
A benevolent social planner maximizes total surplus in the market by choosing the level of output where
the demand curve and marginal-cost curve intersect. Below this level, the value of the good to the
marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good.
Above this level, the value to the marginal buyer is less than marginal cost.
Quantity 0
Demand
(value to buyers)
Efficient
quantity
Marginal cost
Value
to
buyers
Value
to
buyers
Cost to
monopolist
Cost to
monopolist
Value to buyers is greater
than cost to sellers
Value to buyers is less
than cost to sellers
The Welfare Cost of Monopolies
• Monopoly
– Produces less than the socially efficient
quantity of output
– Charge P > MC
– Deadweight loss
• Triangle between the demand curve and MC
curve
9
The Inefficiency of Monopoly Costs and
Revenue
Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than
its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The
deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value
of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer).
Quantity 0
Demand
Marginal revenue
Monopoly
quantity
Marginal cost
Monopoly
price
Efficient
quantity
Deadweight loss
The Welfare Cost of Monopolies
• The monopoly’s profit: a social cost?
– Monopoly - higher profit
• Not a reduction of economic welfare
– Bigger producer surplus
– Smaller consumer surplus
• Not a social problem
– Social loss = Deadweight loss
• From the inefficiently low quantity of output
Price Discrimination
• Price discrimination
– Business practice
– Sell the same good at different prices to
different customers
– Rational strategy to increase profit
– Requires the ability to separate customers
according to their willingness to pay
– Can raise economic welfare
10
Price Discrimination
• Perfect price discrimination
– Charge each customer a different price
• Exactly his or her willingness to pay
– Monopoly firm gets the entire surplus
(Profit)
– No deadweight loss
Welfare with and without Price Discrimination
Price
Panel (a) shows a monopoly that charges the same price to all customers. Total surplus in this
market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a
monopoly that can perfectly price discriminate. Because consumer surplus equals zero, total
surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect price
discrimination raises profit, raises total surplus, and lowers consumer surplus.
Quantity 0
(a) Monopolist with Single Price
Price
Quantity 0
(b) Monopolist with Perfect Price Discrimination
Profit
Consumer
surplus
Deadweight
loss Monopoly
price
Quantity
sold
Marginal
revenue Demand
Marginal cost
Quantity
sold
Profit
Demand
Marginal cost
Price Discrimination
• Examples of price discrimination
– Movie tickets
• Lower price for children and seniors
11
Public Policy Toward Monopolies
• Increasing competition with
antitrust laws
– Prevent mergers
– Break up companies
– Prevent companies from
coordinating their activities
to make markets less
competitive
“But if we do merge
with Amalgamated,
we’ll have enough
resources to fight the
anti-trust violation
caused by the merger.”
Public Policy Toward Monopolies
• Regulation
– Regulate the behavior of monopolists
• Price
– Common in case of natural monopolies
– Marginal-cost pricing
• May be less than ATC
• No incentive to reduce costs
Marginal-Cost Pricing for a Natural Monopoly
Price
Because a natural monopoly has declining average total cost, marginal cost is less
than average total cost. Therefore, if regulators require a natural monopoly to charge
a price equal to marginal cost, price will be below average total cost, and the
monopoly will lose money.
Quantity 0
Average total cost
Loss
Average
total cost
Demand
Marginal cost Regulated
price
12
Public Policy Toward Monopolies
• 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
