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Monopoly

Survey of ECON

Robert L. Sexton

Chapter 8

Chapter 8 Sections

– Monopoly: The Price Maker

– Demand and Marginal Revenue in Monopoly

– The Monopolist’s Equilibrium

– Monopoly and Welfare Loss

– Monopoly Policy

– Price Discrimination

Monopoly:
The Price Maker

Section 1

SECTION 1 QUESTIONS

Monopoly

A true or pure monopoly exists when there is only one seller of a product for which no close substitute is available.
The firm and “the industry” are one and the same.

Because a monopoly firm faces the industry demand curve, it can pick the most profitable point on that demand curve.
Monopolists are price makers (rather than takers) that try to pick the price that will maximize their profits.

Monopoly: Price Makers

Pure Monopoly is a Rarity

Pure monopolies are a rarity because few goods and services truly have only one producer.
Near-monopoly conditions may exist, such as many public utilities, but absolute total monopoly is rather unusual.
However, the number of situations in which monopoly conditions are fairly closely approximated are numerous enough to make the study of monopoly useful.

Barriers to Entry

For a monopoly to persist, it must be virtually impossible for other firms to overcome barriers to entry.
Barriers to entry
legal barriers
economies of scale
control of important inputs

Legal Barriers

Legal barriers include franchising (the postal service), licensing to ensure quality (trade industries), and patents.

The situation in which one large firm can provide the output of the market at a lower cost than two or more smaller firms is called a natural monopoly. With a natural monopoly, it is more efficient to have one firm produce the good. The reason for the cost advantage is economies of scale throughout the relevant output range.

Economies of Scale

Exhibit 8.1: Economies of Scale

Another barrier to entry is control over an important input.
Alcoa’s control over aluminum in the 1940s
De Beers’ control over much of the world’s output of diamonds

Control of Important Inputs

Section 1

Demand and Marginal Revenue in Monopoly

Section 2

SECTION 2 QUESTIONS

Demand and Marginal Revenue in Monopoly

In monopoly, the market demand curve may be regarded as the demand curve for the firm’s product because the monopoly firm is the market for that particular product.
Unlike in perfect competition, monopolists (and all other firms that are price makers) face a downward-sloping demand curve.
If the monopolist raises its price, it will lose some, but not all of its customers.

Exhibit 8.2: Comparing Demand Curves: Perfect Competition versus Monopoly

Exhibit 8.3: Total, Marginal, and Average Revenue

Because a monopolist’s marginal revenue is always less than the price, the marginal revenue curve will always lie below the demand curve.
If the seller wants to expand output, it will have to lower the price on all units.

Demand and Marginal Revenue in Monopoly

The monopolist receives additional revenue from the new unit sold (the output effect), but will receive less revenue on all the units it was previously selling (the price effect).
So when the monopolist cuts prices to attract new customers, the old customers benefit.

Demand and Marginal Revenue in Monopoly

Exhibit 8.4: Demand and Marginal Revenue for the Monopolist

In Exhibit 8.5, we can compare marginal revenue for the competing firm with the marginal revenue for the monopolist.

Marginal Revenue: The Competing Firm and the Monopolist

Exhibit 8.5: Marginal Revenue—Competitive Firm versus Monopolist

The Monopolist’s Price in the
Elastic Portion of the Demand Curve

The relationship between the elasticity of demand and marginal and total revenue are shown in Exhibit 8.6.
In the elastic portion of the curve, when the price falls, total revenue rises, so that marginal revenue is positive.
In the inelastic portion of the curve, when the price falls, total revenue falls, so that marginal revenue is negative.

Exhibit 8.6: The Relationship between the Elasticity of Demand and Total and Marginal Revenue

A monopolist will never knowingly operate in the inelastic portion of its demand curve.
Increased output will lead to lower total revenue and higher total cost in that region.

The Monopolist’s Price in the
Elastic Portion of the Demand Curve

Beyond the Book: The Cable Car

Cable cars in San Francisco are one of the main tourist attractions. Consider a cable car company that decided to increase prices from $3 to $5. Consequently, the number of users would fall, as locals would substitute into buses and other forms of transportation. The demand by tourists for cable car rides, however, would be relatively inelastic. So as cable car fares rose, so would total revenue; so the firm must have been operating in the inelastic portion of its demand curve.

Of course, as we just learned, this is clearly not the profit-maximizing part of the demand curve; monopolists can improve their profits by operating on the elastic portion of their demand curve.
However, one might argue that there are positive externalities from keeping cable car fares low. Lower fares could attract more visitors and help local businesses.

Beyond the Book: The Cable Car

Section 2

The Monopolist’s Equilibrium

Section 3

SECTION 3 QUESTIONS

The Monopolist‘s Equilibrium

The monopolist, like the perfect competitor, will maximize profits at that output where MR = MC. Profits continue to grow until that output is reached.
Therefore, the equilibrium output is where MR = MC.

Exhibit 8.7: Equilibrium Output and Price for a Monopolist

Three-Step Method for Monopolists

The three-step method for determining economic profits, economic losses, or zero economic profits:
Find where MR equals MC, which is the profit-maximizing output level.
Go straight up to the demand curve, then left to find the corresponding market price.
Find TC as ATC times the quantity produced.

TC = ATC  Q

If TR > TC (the price exceeds average total cost), the monopolist is generating economic profits.
If TR < TC (the price is less than average total cost), the monopolist is generating economic losses.

Profits for a Monopolist

Exhibit 8.8: A Monopolist’s Profits

In perfect competition, profits in an economic sense will persist only in the short run because in the long run,
new firms will enter the industry,
increasing industry supply,
and thus driving down the price of the good.
Thus, profits are eliminated.

Profits for a Monopolist

In monopoly, profits are not eliminated because barriers to entry exist.
Other firms cannot enter, so economic profits can persist in the long run.

Profits for a Monopolist

Being a sole supplier does not guarantee that consumers will demand your product.
A monopolist will incur a loss if there is insufficient demand to cover average total costs at any price and output combination along the demand curve.

Losses for the Monopolist

Exhibit 8.9: A Monopolist’s Losses

Patents

Patents and copyrights
examples of monopoly power
designed to provide an incentive to develop new products
The fall in the price of a patented good when the patent expires illustrates the effect of introducing competition.

Exhibit 8.10: Impact of Patent Protection on Equilibrium Price and Quantity

Section 3

Monopoly and
Welfare Loss

Section 4

SECTION 4 QUESTIONS

Does Monopoly Promote Inefficiency?

The major objections to monopoly:
Not “fair” for monopoly owners to have persistent economic profits
Monopoly leads to lower output and higher prices than would exist under perfect competition

Does Monopoly Promote Inefficiency?

Efficiency objection: monopolists charge higher prices and produce less output.
monopolist produces an output where the price is greater than its cost,
so that the value to society from the last unit produced is greater than its cost,
so the monopoly is not producing enough of the good from society’s perspective, creating a welfare loss.

Exhibit 8.11: Perfect Competition versus Monopoly

The actual amount of the welfare loss in monopoly is of considerable debate among economists.
Estimates vary from 0.1 percent to 6 percent of national income.

Welfare Loss in Monopoly

Does Monopoly Retard Innovation?

Some argue that a lack of competition retards technological advance.
Already reaping monopolistic profits, firms do not work at:
product improvement
technical advances designed to promote efficiency
Notion that monopoly retards innovation can be disputed.
Many near‑monopolists are important innovators.

Indeed, innovation helps firms initially obtain a degree of monopoly status.
Even monopolists want more profits, and any innovation that lowers costs or expands revenues creates profits for a monopolist.
Therefore, the incentive to innovate may well exist in monopolistic market structures.

Does Monopoly Retard Innovation?

Section 4

Monopoly Policy

Section 5

SECTION 5 QUESTIONS

Monopoly Policy

Two major approaches to dealing with the monopoly problem:
antitrust policies
regulation

Antitrust Policies

By imposing monetary and nonmonetary costs on monopolists, antitrust policies reduce the profitability of monopoly.
The fear of lawsuits
Jail sentences

Antitrust Laws

The first important law regulating monopoly was the Sherman Antitrust Act.
The Sherman Act prohibited “restraint of trade”—price fixing and collusion—but narrow court interpretation of the legislation led to a number of large mergers, such as U.S. Steel.

Antitrust efforts were strengthened by subsequent legislation, the most important of which was the Clayton Act in 1914.
Additional legislation in the same year created the Federal Trade Commission (FTC), which became the second government agency concerned with antitrust actions.

Antitrust Acts Strengthened

The Clayton Act made it illegal to engage in predatory pricing—setting prices to drive out competitors or deter potential entrants in order to ensure higher prices in the future.
The Clayton Act also prohibited mergers if it led to weakened competition.

The Clayton Act

Not all of the later legislation actually served to enhance competition.
The Robinson-Patman Act of 1936 (forbade most forms of price discrimination)
The Cellar-Kefauver Act in 1950, (toughened restrictions on mergers that reduced competition)

Further Antitrust Legislation

Many professional associations restrict the promotion of price competition by prohibiting advertising among their members.
Both the FTC and the Justice Department successfully attacked these types of restrictions on the grounds that they violate the antitrust laws.

Promoting More Price Competition

Have Antitrust Policies Been Successful?

The success of antitrust policies can be debated.
It is very likely that at least some anticompetitive practices have been prevented simply by the very existence of laws prohibiting monopoly‑like practices.

Although the laws were probably enforced in an imperfect fashion, on balance they impeded monopoly influences to at least some degree.

Have Antitrust Policies Been Successful?

Government Regulation

Government regulation is an alternative approach to dealing with monopolies.
The goal is to achieve the efficiency
of large-scale production without permitting the high monopoly prices and low output that can promote allocative inefficiency.

Regulators often face a basic policy dilemma.
Without regulation, profit-maximizing monopolists will produce where
MR = MC.
At that output, the price exceeds average total cost, so economic profits exist.

Government Regulation

The monopolist is
producing relatively little output
charging a relatively high price
producing at a point where price is above marginal cost

Government Regulation

Exhibit 8.12: Marginal Cost Pricing versus Average Cost Pricing

Socially allocative efficiency
where P = MC
With natural monopoly,
where P = MC, the ATC > P
The optimal output, then, is an output that produces losses for the producer.

Allocative Efficiency

Any regulated business that produced for long at this “optimal” output would go bankrupt; it would be impossible to attract new capital to the industry.
Therefore, the “optimal” output from a welfare perspective really is not viable.

Allocative Efficiency

A compromise between unregulated monopoly and marginal cost pricing is average cost pricing, where price equals average total cost.
The monopolist is permitted to price the product where economic profits are zero, meaning that a normal return is being permitted, like firms experience in perfect competition in the long run.

Average Cost Pricing

Difficulties in Average Cost Pricing

The actual implementation of a rate (price) that permits a “fair and reasonable” return is more difficult than the graphical analysis suggests.
The calculations of costs and values is very difficult, often forcing regulatory agencies to use profits as a guide instead.

Another problem is that average cost pricing gives the monopolist no incentive to reduce costs (which regulators have tackled by letting the firm keep some of the profits that come from lower costs).

Difficulties in Average Cost Pricing

Exhibit 8.13: Changes in Average Costs

Also, consumer groups are constantly battling for lower rates, while the utilities themselves are lobbying for higher rates so that they can achieve some monopoly profits.
The temptation is great for the commissioners to be generous to the utilities.
On the other hand, there may be a tendency for regulators to bow to pressure from consumer groups.

Difficulties in Average Cost Pricing

Section 5

Price Discrimination

Section 6

SECTION 6 QUESTIONS

Price Discrimination

Under certain conditions, the monopolist finds it profitable to discriminate among various buyers, charging higher prices to those that are more willing to pay and lower prices to those less willing to pay.

PRICE DISCRIMINATION

the practice of charging different consumers different prices for the same good or service

Conditions for Price Discrimination

Three conditions are necessary for the monopolist to practice price discrimination:
Monopoly Power
Market Segregation
No Resale

Monopoly Power

Price discrimination is possible only with monopoly or where members of a small group of firms follow identical pricing policies.
When there are a number of competing firms, discrimination is less likely because competitors tend to undercut higher prices charged by the firms engaging in price discrimination.

Price discrimination can only occur if the demand curve for markets, groups, or individuals are different. If the demand curves are not different, a profit-maximizing monopolist would charge the same price in both markets.
In short, price discrimination requires the ability to separate customers according to their willingness to pay.

Market Segregation

For price discrimination to work, the purchaser buying the product at a discount must have difficulty in reselling the product to customers being charged more. Otherwise, consumers would buy extra product at the discounted price and sell it at a profit to others, reducing the number of customers paying the higher price.

No Resale

Why Does Price Discrimination Exist?

Price discrimination results from the profit-maximization motive.
Different groups of people have different demand curves and therefore react differently to price changes.
A producer can make more money by charging these different buyers different prices.

Exhibit 8.14: Price Discrimination in Movie Ticket Prices

Price Discrimination Examples: Airline Tickets

Seats on airlines usually go for different prices.
The airlines can discriminate against business travelers who usually have little advance warning and often travel on weekdays—preferring to be home on the weekends.
Because the business traveler has a high willingness to pay (a relatively inelastic demand curve) the airlines can charge them a higher price.

The coupon cutter, who spends an hour looking through the Sunday paper for coupons, will probably have a relatively more elastic demand curve than, say, a busy and wealthy physician or executive.
Consequently, firms charge a lower price to customers with a lower willingness to pay (more elastic demand)—the coupon cutter—and a higher price to those who don’t use coupons (less elastic demand).

Price Discrimination Examples: Coupons

Students who are well off financially tend to pay more for their education than do students who are less well off because of different financial aid packages.

Price Discrimination Examples: College and University Tuition

The seller charges a higher price for the first unit than for later units, allowing the producer to extract some consumer surplus.
A six-pack of soda might be less expensive than buying each separately. Or you might be able to buy a baker’s dozen of donuts—13 for the price of 12.
With this type of price discrimination, you are charging more for the first units than, say, for the 20th unit.

Price Discrimination Examples: Quantity Discounts

Section 6