MonopolyCHAPTER 11

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A monopoly is a market structure in which there is a single supplier of a product.

The monopoly firm (monopolist):◦ May be small or large.◦ Must be the ONLY supplier of the product.◦ Sells a product for which there are NO close substitutes.

Monopolies are fairly common: U.S. Postal Service, local utility companies, local cable providers, etc.

What is a Monopoly?

The Creation of Monopolies

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Monopolies often arise as a result of barriers to entry.

Barrier to entry: anything that impedes the ability of firms to begin a new business in an industry in which existing firms are earning positive economic profits.

There are three general classes of barriers to entry:◦ Natural barriers, the most common being economies of scale◦ Actions by firms to keep other firms out◦ Government created barriers

Economies of Scale

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In some industries, the larger the scale of production, the lower the costs of production.

Entrants are not usually able to enter the market assured of or capable of a very large volume of production and sales.

This gives incumbent firms a significant advantage.

Examples are electric power companies and other similar utility providers.

Economies of Scale

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Actions by Firms

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Entry is barred when one firm owns an essential resource.

Examples are inventions, discoveries, recipes, and specific materials.◦ Microsoft owns Windows, and has been challenged by the U.S. Dept. of

Justice as a monopolist.

Government

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Governments often provide barriers, creating monopolies.

As incentives to innovation, governments often grant patents, providing firms with legal monopolies on their products or the use of their inventions or discoveries for a period of 20 years.

Types of Monopolies

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Natural monopoly: A monopoly that arises from economies of scale. The economies of scale arise from natural supply and demand conditions, and not from government actions.

Local monopoly: a monopoly that exists in a limited geographic area.

Regulated monopoly: a monopoly firm whose behavior is overseen by a government entity.

Monopoly power: market power, the power to set prices.

Monopolization: an attempt by a firm to dominate a market or become a monopoly.

The Demand Curve Facing a Monopoly Firm

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In any market, the industry demand curve is downward-sloping. This is the result of the law of demand.

Critical to understanding the profit maximization of the monopolist is remembering that the monopolist IS the industry because it is the sole producer.

Therefore the monopolist confronts a downward-sloping demand curve. The industry demand curve is the firm’s demand curve.

Marginal Revenue

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Recall that marginal revenue (MR) is:

MR is less than price for a monopoly firm.

The MR is less than price and declines as output increases because the monopolist must lower the price in order to sell more units (because the demand curve slopes downward).

QTR

MR

Demand Curve for a Monopoly Firm

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Average Revenue

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Whenever MR is greater than AR, AR rises.

Whenever MR is less than AR, AR falls.

Average revenue is:

Note that the AR is the same as price. In fact, the AR curve is the demand curve.

With a downward-sloping demand curve, prices fall as output increases. This means that AR falls.

MR must always be less than AR.

PQQP

AR

Demand and Revenue for the Monopolist

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Profit Maximization

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The monopoly firm will not set the price arbitrarily high. The profit-maximizing price still corresponds to the point where MR=MC.

The monopoly firm’s market power will allow the firm to achieve above-normal profits.

Profit Maximization

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Monopoly Profit and Loss

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A monopolist will suspend operations in the short run if its price does not exceed the average variable cost at the quantity the firm produces.

A monopolist will shut down permanently if revenue is not likely to equal or exceed all costs in the long run.

In contrast, however, if a monopolist makes a profit, barriers to entry will keep other firms out of the industry.

Monopoly Myths

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A monopolist can charge any price it wants and will reap unseemly profits by continually increasing the price.

A monopolist is not sensitive to customers.

A monopolist cannot make a loss.

Price Discrimination

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Under certain conditions, a firm with market power is able to charge different customers different prices. This is called price discrimination.

Necessary Conditions for Price Discrimination

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For price discrimination to work, the firm cannot be a price taker.

The firm must be able to “segment the market” That is, the firm must be able to:

◦ Separate the customers◦ Prevent resale of the product

Price Discrimination in Action

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The Early Bird Gets a Lower Price

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Early Bird Specials—Restaurants charge special, lower prices for early diners.

Matinees—Theaters charge less for earlier shows.

Air Fares—Airlines charge less for flyers willing to fly “off peak,” i.e. early morning and late night.

Perfect Price Discrimination

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By discriminating, a monopoly firm makes greater profits than it would make by charging both groups the same price.

A firm with market power could collect the entire consumer surplus if it could charge each customer exactly the price that that customer was willing and able to pay. This is called perfect price discrimination.

Monopoly and Perfect Competition: Comparison

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