CHAPTER 2 MONOPOLY

PART I
GOVERNMENT AND
ECONOMIC EFFICIENCY

MARKET FAILURE

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CHAPTER 1

MONOPOLY: A MARKET
FAILURE

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Introduction
Free Market

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Competitive
Forces

Market
Efficiency

Market
Failure

Regulation

Regulation

Equitable
Distribution

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Introduction


Market failure occurs when freely functioning
markets, operating without government
intervention, fail to deliver an efficient or
optimal allocation of resources



Therefore economic and social welfare may
not be maximized



This leads to a loss of economic efficiency

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Monopoly

1. Definition of monopoly

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1. Definition

While a competitive firm is a price taker,
a monopoly firm is a price maker.

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Monopoly


A firm is considered a monopolist if . . .



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

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Monopoly power occurs when the seller of a
product can influence prices





it is the sole seller of its product.

its product does not have close substitutes.

A single seller is a monopolist
There is oligopoly if there are several sellers

Monopsony power occurs when the buyer of
a product can influence price


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A single buyer is a monopsonist

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Monopoly

2. Causes of monopoly

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Why Monopoly??

The fundamental cause of monopoly is
barriers to entry.

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Barriers to Entry




The reason a monopoly exists is that other
firms find it unprofitable or impossible to
enter the market
Barriers to entry are the source of all
monopoly power


there are two general types of barriers to entry



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technical barriers

legal barriers

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Technical Barriers to Entry


The production of a good may exhibit
decreasing marginal and average costs
over a wide range of output levels


in this situation, relatively large-scale firms are
low-cost producers





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firms may find it profitable to drive others out of the
industry by cutting prices
this situation is known as natural monopoly
once the monopoly is established, entry of new firms
will be difficult
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Technical Barriers to Entry


Another technical basis of monopoly is
special knowledge of a low-cost productive
technique




it may be difficult to keep this knowledge out of
the hands of other firms

Ownership of unique resources may also
be a lasting basis for maintaining a
monopoly

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Legal Barriers to Entry


Many pure monopolies are created as a
matter of law




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with a patent, the basic technology for a
product is assigned to one firm
the government may also award a firm an
exclusive franchise to serve a market

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Creation of Barriers to Entry


Some barriers to entry result from actions
taken by the firm







research and development of new products or
technologies
purchase of unique resources
lobbying efforts to gain monopoly power

The attempt by a monopolist to erect
barriers to entry may involve real resource
costs

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Economies of Scale as a Cause of Monopoly...
Cost

Average
total
cost
0
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Quantity of Output

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Monopoly

3. Recap about monopoly

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a, Monopoly versus Competition
Monopoly
 Is the sole producer
 Has a downwardsloping demand
curve
 Is a price maker
 Reduces price to
increase sales

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Competitive Firm
Is one of many
producers
Has a horizontal
demand curve
Is a price taker
Sells as much or as

little at same price

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Comparing Monopoly and Competition


For a competitive firm, price equals marginal
cost.

P = MR = MC


For a monopoly firm, price exceeds marginal
cost.

P > MR = MC

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b, A Monopoly’s Revenue



Total Revenue

P x Q = TR


Average Revenue



Marginal Revenue

TR/Q = AR = P
TR/Q = MR

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Monopoly’s Marginal Revenue
A monopolist’s marginal revenue is always
less than the price of its good.
The

demand curve is downward sloping.
a monopoly drops the price to sell one
more unit, the revenue received from

previously sold units also decreases.

When

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A Monopoly’s Total, Average, and
Marginal Revenue

Quantity
(Q)
0
1
2
3
4
5
6
7
8

Price
(P)

$11.00
$10.00
$9.00
$8.00
$7.00
$6.00
$5.00
$4.00
$3.00

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Total Revenue
(TR=PxQ)
$0.00
$10.00
$18.00
$24.00
$28.00
$30.00
$30.00
$28.00
$24.00

Average
Revenue
(AR=TR/Q)

Marginal Revenue
(MR= TR / Q )

$10.00
$9.00
$8.00
$7.00
$6.00
$5.00
$4.00
$3.00

$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
-$2.00
-$4.00

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Demand and Marginal Revenue Curves for
a Monopoly...
Price
$11
10
9
8

7
6
5
4
3
2
1
0
-1
-2
-3
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Demand
(average revenue)

Marginal
revenue
1

2

3

4

5

6

7

8

Quantity of Water

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Profit-Maximization for a Monopoly...
2. ...and then the demand
curve shows the price
consistent with this
quantity.

Costs and
Revenue

B

Monopoly
price

1. The intersection of
the marginal-revenue
curve and the marginalcost curve determines
the profit-maximizing
quantity...

Average total cost

A
Demand

Marginal
cost

Marginal revenue
0
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QMAX

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Quantity
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c, The Monopoly’s Profit
Profit equals total revenue minus total costs.

Profit = TR - TC
Profit = (TR/Q - TC/Q) x Q
Profit = (P - ATC) x Q

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The Monopolist’s Profit
The monopolist will receive economic
profits as long as price is greater than
average total cost.

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The Monopolist’s Profit...
Costs and
Revenue
Marginal cost

Average
total cost D

B

y
ol
op it
on f

M pro

Monopoly E
price

Average total cost

C
Demand

Marginal revenue
0
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QMAX

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Quantity
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Monopoly = market failure

4. Deadweight welfare loss under
monopoly

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£

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A monopolist producing less than the
social optimum
MC

P1

MC1

AR
MR
O

£

Q

Q1

Monopoly output

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A monopolist producing less than the
social optimum MC = MSC

P1
P2 = MSB
= MSC

MC1

AR = MSB
MR
O

Monopoly output

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Q1

Q

Q2

30
Perfectly competitive output

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£

Deadweight loss under
monopoly

MC

(= S under perfect competition)

Consumer
surplus

Ppc

a
Producer
surplus

AR = D
O

Qpc
Q
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(a) Industry equilibrium

under perfect competition

£

Pm
Ppc

Deadweight loss under
MC
(= S under perfect competition)
monopoly
Deadweight
welfare loss

Consumer
surplus

b
a

Producer
surplus

AR = D

MR
O
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£

31

Qpc

Qpc

Q

Economics - Hoang Phu LY - FTU
(b) Industry Public
equilibrium
under monopoly

Deadweight loss under monopoly

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MC

(= S under perfect competition)

Perfect
competition

Consumer
surplus

Ppc

a
Producer
surplus

AR = D
O

Qpc
Q
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(a) Industry equilibrium
under perfect competition

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Deadweight loss under monopoly

MC

£

(= S under perfect competition)

Monopoly

Consumer

surplus

Pm
Ppc

Deadweight
welfare loss

b
a

Producer
surplus

AR = D

MR
O
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Qpc

Qpc

Q

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(b) Industry Public
equilibrium
under monopoly

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Monopoly

5. Public Policy Toward Monopolies

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5.1. Public Policy Toward Monopoly
Government responds to the problem of
monopoly in one of four ways.






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Making monopolized industries more competitive.
Regulating the behavior of monopolists.
Turning some private monopolies into public
enterprises.
Doing nothing at all.

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Regulation of Monopoly



The natural policy is to encourage competition
This can be done directly by enforcing division of
monopolists
US antitrust legislation applied to Standard Oil (1911) and
Bell System (1984) => division into separate competing
firms






It can be done indirectly by reducing barriers to entry
Legal barriers can be removed by changing the law
But why were they imposed initially?



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Regulation of Monopoly


Technological barriers can be reduced insistence on
knowledge sharing
US insists Microsoft provides information





Patents are also a barrier to entry
Optimum length trades reward for innovation against stifling
of competition





Advertising and excess capacity can be part of an
entry deterrence strategy
Advertising expenditure can be limited (e.g. tobacco)
Proving excess capacity is held to deter entry is difficult





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5.2. Regulation of a Natural Monopoly


Natural monopolies such as the utility,
communications, and transportation
industries are highly regulated in many
countries

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Regulation of a Natural Monopoly




Many economists believe that it is
important for the prices of regulated
monopolies to reflect marginal costs of
production accurately
An enforced policy of marginal cost pricing
will cause a natural monopoly to operate at
a loss


natural monopolies exhibit declining average
costs over a wide range of output

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Regulation of a Natural Monopoly
Because natural monopolies exhibit
decreasing costs, MC falls below AC

Price

An unregulated monopoly will
maximize profit at Q1 and P1
If regulators force the
monopoly to charge a
price of P2, the firm will
suffer a loss because

P2 < C2

P1
C1
C2
AC
MR

P2

MC

Q1

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Q2 D

Quantity

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a, Marginal-Cost Pricing for a Natural
Monopoly...
Price

Average
total cost

Regulated
price

Average total cost

Loss

Marginal cost

Demand
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0

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b, Pricing for a Natural Monopoly as AC
Price

Price as AC

Average
total cost

Average total cost

Marginal cost

MR

0
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Demand

Q1 Q2 Q0

Quantity

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c, Price Discrimination
Price discrimination is the practice of selling the
same good at different prices to different customers,
even though the costs for producing for the two
customers are the same. In order to do this, the firm
must have market power.

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Price Discrimination
 Two

important effects of price
discrimination:
 It

can increase the monopolist’s profits.
 It can reduce deadweight loss.


But in order to price discriminate, the firm must
 Be able to separate the customers on the
basis of willingness to pay.
 Prevent the customers from reselling the
product.

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Regulation of Monopoly
Suppose that the regulatory commission allows the
monopoly to charge a price of P1 to some users

Price

Other users are offered the lower price
of P2
The profits on the sales to highprice customers are enough to
cover the losses on the sales to
low-price customers

P1

C1

C2
AC
MC

P2
Q1

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Q2 D

Quantity

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Regulation of Monopoly



Another approach followed in many
regulatory situations is to allow the
monopoly to charge a price above
marginal cost that is sufficient to earn a
“fair” rate of return on investment
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if this rate of return is greater than that which
would occur in a competitive market, there is
an incentive to use relatively more capital than
would truly minimize costs
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Regulation of Oligopoly



Collusion among firms allowed price to rise and
profit to increase
Tacit collusion may be difficult for a regulator to
detect




Does a high price represent lack of substitutes or price
collusion?

This question is answered by calculating price
elasticities and using these to construct Lerner index
with and without collusion




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Breakfast cereal: collusion implies Lerner of 65-75%
Competition implies Lerner of 40-44%
Actual index about 45%, implying no collusion

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Regulation of Oligopoly









Mergers can damage economic efficiency by
increasing monopoly power
Mergers are regulated by governments
A merger is not permitted if it is judged to harm the
public interest
Estimated demand elasticities can be used to
predict the outcome of a merger
The predicted price changes favor the merger

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Monopsony


A monopsonist is a single buyer










Such as the only firm using a specialized form of labor

Monopsony results in price (or wage) being below
the competitive level
The monopsonist takes account of the fact that a
higher price (or wage) must be paid to all units
purchased
This provides a disincentive to raising the wage to
the competitive level
Monopsony causes a deadweight loss

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Monopsony







Labor demand is given by
the marginal revenue of

labor (MRL)
The competitive wage is wc
The marginal cost for the
monopsonist is w plus
additional payment to
existing workers
Monopsony wage is wm

Wage
Marginal
Cost
Labor Supply
w(L)
wc
wm

Labor Demand
MRL

Lm

Lc

Quantity
of Labor

Monopsony in the
labor market

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Next CHAPTER…


EXTERNALITIES

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