Chapter 10 Monopoly

What is a pure monopoly?

What are the 5 characteristics of a pure monopoly?

Often monopolies are formed because the particular industry requires such large amounts of capital that one firm can gain tremendous economies of scale and actually supply the entire market at a price cheaper than if more than one firm entered the industry.

What are economies of scale?

Because of the large economies of scale long run average costs are always falling as the output level increases. (Remember when we talked about the shape of the long run supply curve) The monopolist can satisfy the entire market demand while it long run average cost declines. Thus it produces an output level great enough and cheaper than anyone else can. This is called a Natural monopoly. Economies of scale act as a barrier of entry because no other firm can sell enough output that will allow them to get a cost less than what the monopolist is charging. When a natural monopoly exists the government l often regulate it.

How does the government create other barriers of entry in some industries?

Some monopolies reduce price of their product so much that other firms do not enter the market because they know that the monopolist will cut its price and drive them out of business.

Notice how in the computer industry for software companies cut there price to zero by giving away their products.

The monopolist like all firms are motivated by trying to maximize profits. The main difference between a monopoly and a perfectly competitive firm is the demand side of the market.

In perfect competition what does the demand curve look like?

Remember how we derived the demand curve for a perfectly competitive firm. The negatively sloped market demand curve intersected the supply curve and established the market price which the individual firm uses as the price they charge.

The question is, what does the monopolist demand curve look like?

Why is the monopolist demand curve negatively sloped?

There are three implications of the downward sloping demand curve.

The first is that Marginal revenue is less than price.

(Insert Table 10-1)

Since the demand curve is negatively sloped, in order for the firm to sell more it must lower the price. Look at table 10-1 notice for each level of output that the firms sells MR<P. For example if it sells 2 units of output the price is \$152 per unit and total revenue is \$304. MR=\$122. Notice MR<P. (122<152) If you do this for every level of output we see MR<P . The only exception is the first unit of output sold. There MR has to be the same as price.

The question is why is MR<P?

In order for the firm to sell one more unit of output it must lower the price (because demand is negatively sloped) but if it lowers price to sell one more unit it must lower the price of all the previous units also. These previous units of output could have been sold at a higher price if the extra output was not produced. So when the firm sells extra output total revenue goes up by the price of the extra unit but it also falls by the price cut of all the previous units.

For example: If the firm sells 2 units of output each unit is sold for \$152. Now if the firm sells the 3rd unit it must lower the price to \$142. But it not only lowers the price of the 3rd unit to \$142 it lowers the price of the 1st and 2nd units to \$142. (Remember that the book assumes there is no price discrimination thus the monopolist has to charge each customer the same price.) Thus it could have sold the 2nd unit for \$152 (\$10 more than the 3rd unit) and it could have sold the first unit for \$162 (\$20 more than the 3rd unit) Thus when it sells the 3rd unit it must charge all the customers \$142. When it charges all 3 customers \$142 it losses that extra \$20 it could have sold to only one customer plus the \$10 to the second customer. Thus when it lowers the price, it lowers it to all their customers not just the additional one. Consequently MR will be less than price.

(Insert Figure 10-3)

Notice in this figure that the MR curve is always below the demand curve. Suppose output was 4 units. Go up to the MR curve and notice that MR=\$82, then continue to go up to the demand curve to get the price of \$132. Notice MR<P. Note also that when MR>0 (a positive number) TR is rising.

Why must this be the case?

When we discussed  elasticity we showed that when the price is above the midpoint of the demand curve elasticity is greater than one. Thus When TR is rising and price falls we are in the elastic range of the demand curve. Also note that when  MR<0, TR is falling. This corresponds to the inelastic range of the demand curve because when price falls,  TR is also falling thus it must be inelastic.

Since the monopolist is the only supplier of the output it is said to be a price maker. Thus if it wants to sell 9 units of output it makes the price \$82, if it wants to sell 10 units of output it makes the price \$72. Thus it makes the price. Unlike in perfect competition the firm takes the price established in the market place.

The monopolist will always operate in the elastic range of the demand curve or where TR is rising or where MR>0. Remember when the monopolist wants to sell more (the only reason to sell more is to make more profit) it must lower the price. If it is in the inelastic range when it lowers price TR falls. Why would it produce in this range? It wouldn't because if TR falls when it produces more (TC must go up as output rises) then profit would fall.

Look at table 10-1, when estimating a monopolists costs note that the costs will be the same as if the industry was perfectly competitive.

Why are the costs of a monopolist the same as those in a perfectly competitive industry?

This occurs because although the monopolist is the only firm producing a particular product it is buying inputs in a market with every other firm in all the other industries, thus it is just a small buyer of inputs. The input market is perfectly competitive.

The monopolist, like any other firm, wants to maximize profit. It will maximize profit when MR=MC

Everyone should be able to explain why profit is maximized when MR=MC. Unlike perfect competition we can't say P=MR because we already showed that MR<P in monopoly. Thus in monopoly we must use MR=MC as the profit rule we can't use P=MC like we did in perfect competition.

If you go back to Table 10-1 you will see MR=MC at the 5th unit of output. MR =\$82. Notice the 5th unit is the last unit of output where MR>MC after the 6th unit we see MC (80) > MR(62). (hint remember MR is between the units of output sold, so the MR between 0 and 1 unit of output is \$162, the first unit must be produced before you get the MR. This is why the MR and MC is between the units produced and not exactly on the same line)

(Insert figure 10-4)

This figure shows the cost curves (which are exactly the same as if this was a perfectly competitive industry) and the demand and MR curve for the monopolist. Profit is maximized where MR=MC which occurs at 5 units of output. (where MR=MC) From the point where MR=MC go up to the demand curve (draw a vertical line up to the demand curve if you like) and then go over to the price to see what price will be charged.  Repeating what to do, follow the point where MR=MC straight up until you hit the demand curve. The price is \$122. Now the question is what kind of profit is this firm making?

The analysis is just like we did before when we were talking about a perfectly competitive industry. The price of \$122 is greater than the average cost (\$94) of producing 5 unit of output. Since a normal profit is built into average cost we see that when the price is above average total cost there is excess profit. (Also notice we are in the elastic range of the demand curve).

Suppose this was a perfectly competitive market and one firm was making excess profit what would happen to price and excess profit? Why?

But this is not a perfectly competitive market, what happens when the monopolist is making economic (excess) profit?

We now see the real reason why a firm would want to be a monopolist. If it makes an excess profit it keeps it. Unlike in perfect competition.

Is it possible for the monopolist to operate at a loss? What must the relationship between price and average total cost be?

It is important to remember that just because you are a monopolist it does not mean you will earn excess profit. If the demand for your product is to low then you can't charge a price high enough to make an excess profit. Or management, of the monopolist, might be so bad that it's average costs are very high. Just because a firm is a monopolist  it is still possible to lose money.

How do we know whether a monopolist will stay in business or close down if it is operating at a loss?

(Figure 10-5 to explains this)

Another fallacy about monopoly is that the monopolist will always charge the highest price it can. This is not so. The monopolist will charge that price which allows it to maximize profit. Thus in our example the price is \$122. It could charge \$152 and only sell 2 units of output, but then it is not maximizing its profit.

If you remember from perfect competition we said the MC curve above the minimum AVC was the firms supply curve. The reason was that for each level of output there was a unique price associated with it. (Remember how we derived the supply curve we showed when there was one price the firm would supply a certain amount to maximize profit, when the price fell the firm would supply another amount to maximize profit at that price. Notice in each situation every output level had a single, unique price associated with it.) But that is not the case in monopoly. Go back to diagram 11-4. Draw another MR curve that goes through the same point on the MC curve that the one on the book goes through. Then draw the corresponding demand curve. Notice the price is different than \$122. Thus we see there are different prices associated with the same output of 5. Thus there is not a unique relationship between price and quantity supplied. Without this unique relationship there can't be a supply curve in monopoly.

Differences between Monopoly and Perfect Competition

When we compare these two market structures what are the variables we want to compare? (Hint in a two dimensional diagram we are only looking at two things what are those two things)

prices and quantity

(Insert figure 10-6)

If you look at the two pictures in this diagram (one is for perfect competition and one is for monopoly) you will notice that the Demand curve is exactly the same.

Why are these demand curves the same?

Also remember that both a perfectly competitive firm and a monopoly face the same cost structures because inputs are bought in a competitive input market place.

In diagram (a) we see that the interaction of supply and demand determines the perfectly competitive market price Pc and quantity Qc. Remember from chapter 9 this occurred at the minimum point of the long run average total cost curve where P=MC=min ATC. We said there was both productive and allocative efficiency.

If this industry was a monopoly (book says one firm buys all the others)

Then the market demand curve is the same and the costs are the same. Thus the MC and D curves are the same. But since it's monopoly the MC is not equal to the supply curve.

When this was perfect competition the demand for one firm was perfectly elastic (horizontal). Each firm maximized profit by equating P=MC . Now in monopoly market demand is the same as individual demand thus the negatively sloped demand curve is the firms demand curve and MR<P. The MR curve lies below the demand curve. The monopolist maximizes profit where MR=MC.

Compare the price and quantity between the two market structures, which one produces more and charges less?

This is the reason why monopoly is not good. The monopolist charges a higher price and produces fewer units of the output than a perfectly competitive firm. Wouldn't society rather have more people getting more goods at a lower price than fewer people get less goods at a higher price?

Remember in perfect competition, we had productive efficiency when P= min ATC. In monopoly P>min ATC. (Remember in perfect competition P=min ATC when Qc was produced. Since Qm is less than Qc then that means enough output is not produced in monopoly to reach the minimum ATC. Thus P>min ATC and productive efficiency does not take place. Also allocative efficiency occurs when P= MC, but we see that in monopoly P>MC thus not allocative efficient.

Explain why monopoly leads to inequality in income distribution?

the cost in monopoly and perfect competition may not be the same even though when we compared Price and output of the two markets we assumed they would be.  The cost of monopoly may in fact be less or more than a perfectly competitive firms costs.
One reason is Due to Economies of Scale Explain.

Another reason is due to X-Inefficieny.

Explain why monopoly leads to x-Inefficiency?

(insert figure 10-7 to explain your answer)

This will occur because a monopolist knows they will make excess profit thus does not try very hard to lower cost, in fact sometimes a monopolist has much higher cost. Without competition nipping at your heal the monopolist is not afraid and thus does not pay a great deal of attention to reducing cost.

Since a monopolist earns excess profit it may pay for them to do what ever they have to in order to maintain their excess profit. Thus they lobby the government to get a patent or license and pay a lot of money to maintain their excess profit. This is called Rent seeking expenditures.

A third reason costs may differ is due to rent seeking expenditures, explain

A fourth reason is Technological Advances explain.

Price Discrimination

Remember up until now we said that the monopolist will charge each customer the same price. Let forget this assumption. Now we say the monopolist will charge different consumers different prices for the same good. For example, airlines charge different prices, phone company charge different prices, senior discounts is a form of price discrimination.

List the 3 conditions necessary for price discrimination?

1.Seller must have some monopoly power, i.e. some control of price and quantity

2.Seller can segregate buyers into distinct classes of people who will pay different prices for same good. Usually based on demand elasticity.

3.can't buy in one group and sell to another, no arbitrage.

Go back to figure 10-4. Notice the price charged was \$122.

But note that the first four people were willing to pay a higher price than \$122. (Especially if this meant not buying the product altogether.) If the monopolist can segment (put the buyers into different groups) the buyers then they can charge each group a different price. Suppose they can break the market into each individual buyer.

Table 10-1                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  shows that the first buyer was willing to pay \$162 for the product. If the monopolist charges this person \$162 rather than \$122 profit is \$40 more. The second person was willing to pay \$152 rather than getting it for \$122. Thus profit can be increased by \$30. The third person was willing to pay \$142 thus profit can increase by another \$20 and the fourth person was willing to pay \$132 thus profit increased by another \$10. Thus by engaging in price discrimination the firm increases profit by an extra \$100. So price discrimination pays for the monopolist. In fact the perfectly discriminating monopolist (i.e. charging each individual the price associated with that one output level) will produce more output than the monopolist who does not discriminate.

This occurs because it does not have to lower price to everyone when it wants to sell more it just lowers the price to the additional customer. Price and revenue are equal for each unit of output.

Figure out why the perfectly discriminating monopolist will produce 7 units of output, the same amount as perfect competition. P=MC which is allocative efficiency. But it still makes excess profit.

A natural monopoly is usually regulated by the government. Remember what a natural monopoly is. The natural monopoly satisfy all demand for the market in the range where the ATC curve is still falling. Thus no one could enter the market and sell the product cheaper.

If the regulatory commission wants allocative efficiency what should it do?

Sometimes if p is set equal to MC it is to low for the monopolist to pay its ATC. When this occurs the regulatory agency will allow the monopolist to charge a price equal to ATC. This sometimes provides incentives for the monopolist not to be efficient because they tend to keep cost high knowing they can pass those costs on to the consumer.