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Chapter 13: Monopoly

Monopoly

· A monopoly is a market with a single firm that is protected by barriers to entry.

· A monopoly maximizes its profit by producing where MR = MC and then using its demand curve to set its price.

· Price-discriminating monopolies charge a higher price to customers with a higher willingness to pay.

· Compared to a competitive market, a monopoly sets a higher price, produces a smaller quantity, and converts consumer surplus into economic profit.

· Natural monopolies can be regulated by the government.

I. Monopoly and How It Arises

A monopoly is a firm that produces a good or service for which no close substitute exists and which is protected by a barrier that prevents other firms from selling that good or service. A monopoly has two key features:

· No Close Substitutes: There are no close substitutes for the good or service.

· Barriers to Entry: A constraint that protects a firm from potential competition is called a barrier to entry. Monopolies are protected by barriers to entry.

· Natural barriers to entry create a natural monopoly, which is an industry in which economies of scale enable one firm to supply the entire market at the lowest possible cost.

· An ownership barrier to entry occurs if one firm owns a significant portion of a key resource.

· Legal barriers to entry create a legal monopoly, which is a market in which competition and entry are restricted by the granting of a public franchise (an exclusive right is granted to a firm to supply a good or service—the U.S. Postal Service has a public franchise to deliver first-class mail), a government license (when the government controls entry into particular occupations, professions and industries—a license is required to practice law), a patent (an exclusive right granted to the inventor of a product or service) or a copyright (exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work).

onopoly Price-Setting Strategies

· A single-price monopoly is a firm that sells each unit of its output for the same price to all its customers.

· Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.

II. A Single-Price Monopoly’s Output and Price Decision

Price and Marginal Revenue

Price	Quantity demanded	Total revenue	Marginal revenue
$4	0	$0
			$3
$3	20	$60
			$1
$2	40	$80
			($1
$1	60	$60

· The demand curve facing a monopoly firm is the market demand curve. Total revenue (TR) is the price (P) multiplied by the quantity sold (Q). Marginal revenue (MR) is the change in total revenue resulting from a one-unit increase in the quantity sold.

· The table shows the calculation of TR and MR.

· A key feature of a single-price monopoly is that MR < P at each quantity so the MR curve lies below the demand curve. MR < P because a single–price monopoly must lower its price on all units sold to sell an additional unit of output.

Marginal Revenue and Elasticity

· If demand is elastic, the MR is positive. A decrease in the price will result in a proportionately greater increase in quantity, generating an increase in revenue.

· If demand is unit elastic (as it is at the midpoint of a linear demand curve), the MR equals zero. A change in the price will result in a proportionate change in quantity, generating no change in revenue. If further increase in revenue is not possible from changing price, this is also the point where revenue is maximized.

· If demand is inelastic, MR is negative. A decrease in price will result in a proportionately smaller increase in quantity, generating a decrease in revenue.

· A single-price monopoly never produces in the inelastic part of its demand because if it did, the firm could increase its total profit by decreasing its output, which would raise its total revenue and decrease its total cost.

Price and Output Decision

· To maximize its profit, a monopoly produces the level of output where MR = MC. The monopoly then uses its demand curve to set the price at the highest price for which it will be able to sell the quantity it produces. In the figure, which uses the demand and MR schedules from the table above, the firm produces 20 units of output and sets a price of $3 per unit.

· The firm makes an economic profit if P > ATC, which is the case for the firm in the figure. The monopoly can make an economic profit even in the long run because the barriers to entry protect the firm from competition. However, a monopoly firm is not guaranteed an economic profit. In the short run and/or long run, it might make zero economic profit, (P = ATC) or in the short run, it might incur an economic loss (P < ATC).

III. Single-Price Monopoly and Competition Compared

Comparing Price and Output

· Perfect Competition: The market demand curve (D) in perfect competition is the same demand curve that the firm faces in monopoly. The market supply curve (S) in perfect competition is the horizontal sum of the individual firm’s marginal cost curves. This supply curve also is the monopoly’s marginal cost curve, so in the figure above the supply curve is labeled MC. In a competitive market, equilibrium occurs where the quantity demanded equals the quantity supplied. In the figure above, the competitive equilibrium quantity is 30 units and the competitive equilibrium price is $2.50 per unit.

· Monopoly: The monopoly produces where MR = MC and sets its price using its demand curve. In the figure, the monopoly produces 20 units of output and sets a price of $3.00 per unit.

· Compared to a perfectly competitive industry, a single-price monopoly produces less output and sets a higher price.

Efficiency Comparison and Redistribution of Surpluses

· A perfectly competitive industry produces the efficient quantity of output, where MSB = MSC. Because a single-price monopoly produces less output (where MSB > MR = MC = MSC), it underproduces and creates a deadweight loss.

· Consumer surplus is smaller with a monopoly than with perfect competition. In the figure above, the consumer surplus under perfect competition is the area under the demand curve and above the competitive equilibrium price of $2.50 per unit. Under monopoly the consumer surplus is the area under the demand curve and above the monopoly price of $3.00.

· Though the monopoly creates a deadweight loss, the monopoly’s owners benefit because it earns an economic profit. A monopoly’s owners benefits because the monopoly redistributes some of the consumer surplus away from the consumer and to the monopoly.

Rent Seeking

· Any surplus—consumer surplus, producer surplus, and economic profit—is called economic rent. Rent seeking is the pursuit of wealth by capturing economic rent.

· Rent seeking can occur when someone uses resources seeking the opportunity to buy a monopoly for a price less than the monopoly’s economic profit.

· Rent seeking also can occur when someone uses resources lobbying the government to create a monopoly. Because of rent seeking, the social cost of monopoly exceeds the deadweight loss it creates.

· The resources used in rent seeking are a cost to society that adds to the monopoly’s deadweight loss. Because there are no barriers to entry in the activity of rent seeking, the resources used up can equal the monopoly’s potential economic profit, reducing monopoly profit.

IV. Price Discrimination

Price discrimination is the practice of selling different units of a good or service for different prices. Price discrimination converts consumer surplus into economic profit. To be able to price discriminate, a firm must:

· Identify and separate different buyer types.

· Sell a product that cannot be resold

Capturing Consumer Surplus

· Price discrimination occurs because of different willingnesses to pay for the good. A firm can charge the same buyer different prices for different units of a good or a firm can charge different prices to different groups of buyers.

· Discriminating Among Groups of Buyers: A firm can charge different customers different prices for the product. Groups with a higher willingness to pay are charged a higher price and groups with a lower willingness to pay are charged a lower price. For example, business airline travelers who have a high willingness to pay and often make last-minute reservations are charged a higher price than leisure travelers, who have a low willingness to pay and often make advance reservations.

· Discriminating Among Units of a Good: A firm can charge a higher price for the first units purchased and a lower price for later units purchased. An example is pizza delivery, where the second pizza is generally cheaper than the first.

· Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price anyone is willing to pay for it. In this case, the price of each unit is the same as the unit’s marginal revenue, so the firm’s (downward sloping) demand curve becomes the same as its marginal revenue curve. Output increases to the point where the demand (= marginal revenue) curve intersects the marginal cost and the efficient quantity is produced. The deadweight loss is eliminated. The firm’s economic profit is the greatest possible. But consumer surplus equals zero because the firm captures the entire consumer surplus.

· The more perfectly a monopoly can price discriminate, the greater the amount of its output and the more efficient the outcome.

· Because the producer grabs the entire surplus in perfect price discrimination, rent seeking becomes profitable, and the long-run equilibrium outcome is that rent seekers use up the entire producer surplus.

V. Monopoly Regulation

· A natural monopoly is an industry in which one firm can supply the entire market at a lower cost than can two or more firms. The definition of a natural monopoly means that the firm’s LRAC curve falls throughout the relevant range of production. As a result, the firm’s MC curve is below its LRAC curve when the MC curve crosses the firm’s demand curve.

· The figure shows a natural monopoly with constant marginal costs. A natural monopoly has large economies of scale so that one firm can supply the entire market at lower cost than two firms because the LRAC curve is falling even when the entire market is supplied.

· A natural monopoly produces at the lowest possible cost, but as an unregulated monopoly it will raise the price above the competitive price and produce less than the efficient quantity. To try to reap the benefits of the lower costs while avoiding the drawback of a monopoly, natural monopolies are typically given a public franchise (so they are given the right to be a monopoly) but are regulated by a government agency.

Efficient Regulation of a Natural Monopoly

· An unregulated natural monopoly will produce where MR = MC and use its demand curve to set the highest price for which this quantity is demanded. In the figure, when unregulated, the firm produces Qm and sets a price of Pm. There is a deadweight loss.

· A marginal cost pricing rule sets price equal to marginal cost. In the figure, the firm produces Qmc and sets a price of Pmc. This regulation results in an efficient use of resources but the firm’s price is less than its average cost, so the monopoly incurs an economic loss.

· If firms are regulated with a marginal cost pricing rule, they incur an economic loss because the price is less than the average cost. They will have to be paid a subsidy by the government or allowed to price discriminate in order to avoid the economic loss.

· An average cost pricing rule sets price equal to average total cost. In the figure, the firm produces Qac and sets a price of Pac. Because a normal profit is part of the firm’s costs, the firm earns a normal profit. The amount of output, however, is inefficient, though it is closer to the efficient quantity than when the monopoly is unregulated.

· Because regulators cannot determine a firm’s exact costs, rate of return regulation is often used.

· Rate of return regulation requires a firm to justify its price by showing that the price enables it to earn a specified target percent return on its capital. When this policy is used, the managers of the regulated firm have the incentive to inflate its costs for beneficial amenities that do not promote efficiency but instead give the managers more amenities.

· Because rate of return regulation does not give the firm the incentive to operate efficiently, price-cap regulation is now used more frequently.

· A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set. Price cap regulation gives managers an incentive to minimize costs: if the firm decreases its costs and earns an economic profit, the firm will be allowed to keep all (or part) of the profit. Typically price cap regulation also requires earnings sharing regulation, under which profits that rise above a target level must be shared with the firm’s customers.