Monopoly
Monopoly Structure
• The essence of market power is the
ability to alter the price of a product.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Monopoly Structure
• A monopoly firm is one that produces
the entire market supply of a particular
good or service.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Monopoly = Industry
• Because a monopoly industry consists
of only one firm, the firm is the industry.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Monopoly = Industry
• The firm’s demand curve is identical to
the market demand curve for the
product.
Market demand is the total quantities of a good or service
people are willing and able to buy at alternative prices in a
given time period.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Price vs. Marginal Revenue
• Marginal revenue (MR) is the change in
total revenue that results from a oneunit increase in quantity sold.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Price vs. Marginal Revenue
• Price equal marginal revenue only for
perfectly competitive firms.
A monopolist can sell additional output only if it reduces
prices.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Price vs. Marginal Revenue
• Marginal revenue is always less than
price for a monopolist.
The MR curve lies below the demand (price) curve at every
point but the first.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Price vs. Marginal Revenue
• Total revenue before price reduction
= 1 ton X $6,000/ton = $6,000
Total revenue after price reduction
= 2 tons X $5,000/ton = $10,000
Marginal revenue
= $10,000 – $6,000 = $4,000
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Price and Marginal Revenue
Quantity
1
2
3
4
5
6
7
McGraw-Hill/Irwin
Price
$13
12
11
10
9
8
7
Total
Revenue
$13
24
33
40
45
48
49
Marginal
Revenue
—
$11
9
7
5
3
1
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
PRICE (per basket)
Price and Marginal Revenue
$14
13
12
11
10
9
8
7
6
5
4
3
2
1
A
0
1
McGraw-Hill/Irwin
B
C
D
b
E
c
F
G
d
Demand (= price)
e
f
Marginal revenue
g
2
3
4
5
6
7
QUANTITY (baskets per hour)
8
9
10
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Monopoly Behavior
• A monopolist must make a pricing
decision that perfectly competitive firms
never make.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Profit Maximization
• The monopolist uses the profitmaximization rule to determine its rate
of output.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Profit Maximization
• According to the rule, a monopolists will
produce at rate of output where
marginal revenue equals marginal cost.
(MR = MC)
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Profit Maximization
• The profit maximization rule applies to
all firms.
Perfectly competitive firms produce the quantity where
MC = MR (= p).
The monopolist produces the quantity where MC = MR
(<P).
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Production Decision
• Choosing a rate of output is a firm’s
production decision.
• It is the selection of the short-term rate
of output with existing plant and
equipment.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Production Decision
• A monopolist finds the quantity where
marginal revenue and marginal cost
curves intersect.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
PRICE OR COST (per basket)
Profit Maximization
$14
13
12
11
10
9
8
7
6
5
4
3
2
1
Average
total cost
D
Total Profit
0
McGraw-Hill/Irwin
d
Demand
Marginal
cost
1
2
3
4
5
6
QUANTITY (baskets per hour)
Marginal
revenue
7
8
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
9
The Monopoly Price
• The intersection of the marginal
revenue and marginal cost curves
establishes the profit-maximizing rate of
output.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Monopoly Price
• The demand curve tells us the highest
price consumers are willing to pay for
that specific quantity of output.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Monopoly Price
• Only one price is compatible with profitmaximization rate of output.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Monopoly Profits
• Total profit equals profit per unit times
the number of units produced.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Monopoly Profits
• Profit per unit = price minus average
total cost
Profit per unit = p – ATC
Total profits = profit per unit times quantity
Total profits = (p – ATC) X q
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Monopoly vs. Competitive
Outcomes
• A monopolist produces less and
charges a higher price than a
competitive industry.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
PRICE OR COST (per basket)
Monopoly vs. Competitive
Outcomes
$14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
McGraw-Hill/Irwin
Average
total cost
D
E
d
Demand
Marginal
cost
1
2
3
4
5
6
QUANTITY (baskets per hour)
Marginal
revenue
7
8
9
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Barriers to Entry
• A monopoly attains higher prices and
profits by restricting output.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Threat of Entry
• The threat of entry does not affect
monopolist due to high barriers to entry.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Threat of Entry
• Barriers to entry are obstacles that
make it difficult or impossible for wouldbe producers to enter a particular
market.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Barriers to Entry
•
•
•
•
•
Patent protection
Legal harassment
Exclusive licensing
Bundled products
Government franchises
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Patent Protection
• A patent is a government grant of
exclusive ownership of an innovation.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Patent Protection
• A patent is a source of monopoly power.
Polaroid’s patents forced Kodak out of the instantphotography business.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Legal Harassment
• Suing potential new entrants can deter
entry into an industry.
– Lengthy legal battles are so expensive that
the threat of legal action may deter entry
into a monopolized market.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Exclusive Licensing
• Lack of a license makes it difficult for
potential competitors to acquire the
factors of production they need.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bundled Products
• Forcing consumers to purchase
complementary products thwarts
competition.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bundled Products
• Bundling products makes it difficult for
competitors to sell their products
profitably.
For example, Microsoft bundles software applications
with its Windows operating systems.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Government Franchises
• A monopoly granted by a government
license.
– Examples include local power, telephone
and cable TV companies.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Comparative Outcome
• A monopoly’s market power allows it to
change the way its market respond to
consumer demands.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Competition vs. Monopoly
• In competition, high prices and profits
signal consumers’ demand for more
output.
• In monopoly, the same.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Competition vs. Monopoly
• In competition, the high profits attract
new suppliers.
In monopoly, barriers to entry are erected to exclude potential
competition.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Competition vs. Monopoly
• In competition, production and supplies
expand.
In monopoly, production and supplies are constrained.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Competition vs. Monopoly
• In competition, prices slide down the
market demand curve.
In monopoly, prices do not move down the market demand
curve.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Competition vs. Monopoly
• In competition, a new equilibrium is
established.
In monopoly, no new equilibrium is established.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Competition vs. Monopoly
• In competition, average costs of
production approach their minimum.
In monopoly, average costs are not necessarily at or near a
minimum.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Competition vs. Monopoly
• In competition, economic profits
approach zero.
In monopoly, economic profits are at a maximum.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Competition vs. Monopoly
• In competition, price equals marginal
cost throughout the process.
In monopoly, price exceeds marginal cost at all times.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Competition vs. Monopoly
• In competition, the profit squeeze
pressures firms to reduce cost or
improve product quality.
In monopoly, there is no profit squeeze to pressure the firm to
reduce costs.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Near Monopolies
• Two or more firms may rig the market to
replicate monopoly outcomes and
profits.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Near Monopolies
• In duopoly two firms together produce
the industry output.
In oligopoly several firms dominate the market.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Near Monopolies
• In monopolistic competition many firms
each have monopolies on their own
brand name but must compete against
other brand names.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
WHAT Gets Produced
• There is a basic tendency for
monopolies to inhibit economic growth.
• There is no pressure to produce at
minimum average cost.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
WHAT Gets Produced
• Monopolies do not engage in marginal
cost pricing.
Marginal cost pricing means firms offer (supply) goods at
prices equal to their marginal cost.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
WHAT Gets Produced
• Monopolies do not deliver the most
utility with available resources.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
FOR WHOM
• Higher prices charged by monopolists
favor purchases by higher-income
consumers.
• Monopolists get fat profits and thus
access to more goods and services.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
HOW
• Monopolists have less of an incentive to
innovate.
– They can continue to make profits with
existing equipment
– There is a tendency to inhibit technological
improvement by keeping out competition.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Any Redeeming Qualities?
• Despite the strong and general case to
be made against monopoly, monopolies
could also benefit society.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Research and Development
• In principle, monopolies have a greater
ability to pursue research and
development.
– They have the resources available to
invest in expensive R&D functions.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Research and Development
• Monopolies have no clear incentive for
invention and innovation.
They can continue to make profits by maintaining market
power.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Entrepreneurial Incentives
• Promise of even greater profits is a
strong incentive for monopolies to
innovate.
• Innovators in perfect competition also
have the ability to earn large profits.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Economies of Scale
• Economies of scale are present if
average costs fall as the size (scale) of
plant and equipment increases.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Economies of Scale
• A large firm can produce goods at a
lower unit cost than a small firm
because of economies of scale.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Natural Monopoly
• A natural monopoly is an industry in
which one firm can achieve economies
of scale over the entire range of market
supply.
– Examples include telephone, cable, and
other utility services.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Natural Monopoly
• Economies of scale are a natural barrier
to entry.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Natural Monopoly
• There exists a potential for abuse in
natural monopoly.
Government regulation may be necessary to ensure that
benefits of increased efficiency are shared with
consumers.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Contestable Markets
• Potential competition is a threat even to
monopolies.
• May cause them to behave more
competitively.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Contestable Markets
• How contestable a market is depends
not on structure but on entry barriers.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Structure vs. Behavior
• If potential rivals force a monopolist to
behave like a competitive firm, then
monopoly imposes no cost on
consumers or on society at large.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Structure vs. Behavior
• The experience with the Model T
suggest that potential competition can
force a monopoly to change its ways.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Structure vs. Behavior
• Critics argue that even if markets are
contestable, there will always exist a
gap between a monopoly and a
competitive outcome.
This gap can be very costly to consumers.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Flying Monopoly Air
• Market structure explains why it is
cheap to fly to one place and expensive
to fly somewhere else of equal distance.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Industry Structure
• From a national perspective, the airline
industry looks pretty competitive.
• However, all of these companies do not
fly to the same place.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Industry Structure
• In many markets, there is only one or
two air carriers, thus, the firms in this
market act like duopolies or monopolies.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Industry Structure
• The number of airlines serving a
particular route is a far better measure
of market power than the number of
airlines flying anywhere.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Industry Behavior
• Air fares from airports dominated by one
or two carriers are 45-85 percent higher
than at more competitive airports.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Entry Effects
• Another way to assess the impact of
market structure on prices is to observe
how airline fares change when airlines
enter or exit a specific market.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Predatory Pricing
• Temporary price reductions designed to
drive out competition.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Predatory Pricing
• The Justice Department says American
Airlines cut its fares when low-cost
carriers arrived – then raised them
when they left.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Predatory Pricing
• A monopoly carrier may use a sharp but
temporary cut in fares to drive a new
entrant out of the market.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Barriers to Entry
• One of the most formidable entry
barriers to the airline industry is the
ownership of landing rights and gates.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Barriers to Entry
• At Washington, D.C.’s National Airport,
the six largest carriers owned 97percent
of available takeoff/landing slots in
2000.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Barriers to Entry
• To offer service from that airport, a new
entrant would have to buy or lease a
slot from one of these firms.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Barriers to Entry
• If existing firms are unwilling to sell or
lease their slots, then competition is
thwarted.
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.
Monopoly
End of Chapter 7
McGraw-Hill/Irwin
© 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.