Weekly Lecture: Week 06
Chaps 12 –Monopoly
CHAPTER ROADMAP

What
’
sNe
wi
nt
hi
sEdi
t
i
o
n?
The material in Chapter 12 is largely unchanged from the fifth edition, though the Eye
applications have been updated and slightly rewritten.

Where We Are
In this chapter, we examine another market structure: monopoly. We discuss how
monopoly arises and how a monopoly (single-price or price-discriminating) chooses its
profit-maximizing output and price. Recognizing that monopoly creates a deadweight loss,
we discuss whether monopoly is efficient and fair. The concept of rent seeking is examined
and reveals that rent seeking is likely to extract all of the economic profit made by a
monopoly. Finally, regulation of natural of monopoly is covered.

Whe
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revenue curves. We combined them with the cost curve analysis in Chapter 14 to
determine perf
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of
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-maximizing output and price
decisions.

Whe
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eWe
’
r
eGoi
ng
After this chapter we examine two more market structures: monopolistic
competition and oligopoly in Chapter 13.
CHAPTER LECTURE
12.1
Monopoly and How It Arises
A monopoly has two key features:
 No Close Substitutes: There are no close substitutes for the good or service.
 Barriers to Entry: Legal or natural constraints that protect a firm from
potential competition are called barriers to entry. Monopolies are protected
by barriers to entry.
 Natural barriers to entry create a natural monopoly, which is an industry
in which one firm can supply the entire market at a lower price than two or
more firms can.
 When one firm owns all (or most) of a natural resource, it creates an
ownership barrier to entry.
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 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).
Monopoly Price-Setting Strategies
 A single-price monopoly is a firm that must sell 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.
 12.2 Single-Price Monopoly
Price and Marginal Revenue
 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.
Price
$4
Quantity
Total
Marginal
demanded
revenue
revenue
0
$0
$3
$3
2
$6
$1
$2
4
$8
$1
$1
6
$6
 A key feature of a single-price
monopoly is that MR < P at each quantity so, as illustrated in the figure below,
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
 When demand is inelastic, fall in price decreases total revenue. A monopoly
never profitably produces along the inelastic range of its demand curve
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because it could increase total revenue
by raising the price and selling a smaller
quantity.
Output and Price Decisions
 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
maximum possible 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 200 units
of output and sets a price of $160 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 the 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).
12.3 Monopoly and Competition Compared
Output and Price
 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 horizontals
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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, which in the figure above is 250 units of output and a price of $140
per unit.
 Monopoly: The monopoly produces where MR = MC and sets its price using
its demand curve. In the figure, the monopoly produces 200 units of output
and sets a price of $160 per unit.
 Compared to a perfectly competitive industry, a single-price monopoly
produces less output and sets a higher price.
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Is Monopoly Efficient?
 A perfectly competitive industry produces the efficient quantity of output.
Because a single-price monopoly produces less output, it creates a deadweight
loss.
 Though the monopoly creates a deadweight loss, the monopoly benefits its
owners because it makes an economic profit. A monopoly benefits the owner
because it redistributes some of the consumer surplus away from the consumer
and to the monopoly producer.
Is Monopoly Fair?
 A monopoly redistributes gains from consumers to producers. According to
the fair results standard, this is fair if the consumers are richer than the
monopoly. According to the fair rules standard, this is fair if everyone is free
to acquire the monopoly.
Rent Seeking
 The social cost of monopoly might exceed the deadweight loss it creates
because of rent seeking, which is any attempt to capture consumer surplus,
producer surplus, or economic profit. Rent seeking can occur when someone
uses resources seeking the opportunity to buy a monopoly for a price less than
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king also can occur when someone
uses resources lobbying the government to restrict the competition faced by
the lobbyist.
 The resources used up in rent seeking are a cost to society that adds to the
monopol
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potential economic profit.
 A person can become the owner of a monopoly in two ways:
 Buy a monopoly: A person can buy a firm (or a right) that is protected by
a barrier to entry. Competition to buy a monopoly will drive up the price to
the point at which they make zero economic profit.
 Create a Monopoly by Rent Seeking: A person can try to influence the
political process to get laws that create legal barriers to entry. Rent-seeking
equilibrium: Competition among rent seekers pushes up the cost of rent
seeking until it leaves the monopoly making zero economic profit after
paying rent-seeking costs. Rent seeking leaves consumer surplus
unaffected but converts producer surplus into deadweight loss.
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12.4 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.
Price Discrimination and Consumer Surplus
 Price discrimination occurs because of differences in willingness 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 average
willingness to pay are charged a higher price and groups with a lower
average willingness to pay are charged a lower price. An example is airline
travel, where business travelers who have a high average willingness to
pay and often make last-minute reservations are charged a higher price
than leisure travelers, who have a low average 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.
Profiting by Price Discriminating
 By pushing the price closer to what groups of buyers are willing to pay,
price discrimination converts consumer surplus into economic profit.
Perfect Price Discrimination
 Perfect price discrimination occurs when a firm is able to sell each unit of
output for the highest price that consumers are willing to pay for each unit.
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s(
downward sloping) demand curve becomes the
same as its marginal revenue curve. Output increases to the point where
the marginal revenue (demand) curve intersects the marginal cost and the
efficient quantity is produced. The deadweight loss is eliminated. The
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helargest possible. The firm captures the entire
consumer surplus, however, so consumer surplus equals zero.
Price Discrimination and Efficiency
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 With perfect price discrimination, the monopoly produces the identical output
of perfect competition - an efficient outcome. In contrast to perfect
competition, consumer surplus is zero and the total surplus is all producer
surplus. However, these large producer gains encourage rent seeking, which
can use up all of the producer surplus.
12.5 Monopoly Regulation
 Regulation consists of rules administered by a government agency to
influence prices, quantities, entry, and other aspects of economic activity
in a firm or industry. Conversely, deregulation is the process of removing
regulation of prices, quantities, entry, and other aspects of economic
activity in a firm or industry.
 The social interest theory of regulation is that the political and regulatory
process relentlessly seeks out inefficiency and introduces regulation that
eliminates deadweight loss and allocates resources efficiently.
 The capture theory of regulation is that the political and regulatory
process gets captured by the regulated firm and ends up serving its
self-interest, with maximum economic profit, underproduction, and
deadweight loss.
 A natural monopoly is an industry in which one firm can supply the entire
market at a lower price than two or more firms can. The figure below
shows a natural monopoly. The definition of a natural monopoly means
t
ha
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sATC curve falls throughout the relevant range of production.
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sMC curve is below its ATC curve when the MC
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.

Efficient Regulation of a Natural Monopoly
 A marginal cost pricing rule sets
price equal to marginal cost, P = MC.
In the figure, the firm sets a price of
Pmc and produces Qmc.
 The rule leads to the efficient
level of production in the
industry, so it maximizes the
total surplus in the industry. It is
in the public interest. But the
firm incurs an economic loss
because P < ATC.
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 A government subsidy can be used to make a direct payment to the firm
equal to its economic loss, though the government must use a tax to raise
the revenue to pay the subsidy.
Second-Best Regulation of a Natural Monopoly
 An average cost pricing rule sets price equal to average total cost, P = ATC.
In the figure, the firm sets a price of Patc and produces Qatc.
 The rule leads to an inefficient level of production so there is a deadweight
loss so this type of regulation is second-best. But the firm makes a normal
profit because P = ATC.
 Implementing pricing rules is difficult because the regulator does not know the
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:
 Rate of return regulation is regulation that sets the price at a level that
allows the regulated firm to make 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.
 A price-cap regulation is a regulation that specifies the highest price that
a firm is permitted to set—a price ceiling. Price cap regulation gives
managers an incentive to minimize costs because if the firm decreases its
costs and makes 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
bes
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ustomers.
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