Monopoly

• What is monopoly?
• What are the differences between legal monopoly and natural monopoly?
• How does a monopoly determine price and output?
• How does the performance of a monopoly compare with perfect competition?

Monopoly

A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

Examples of Monopoly

• Examples of monopolies include:
  • Local telephone service
  • Water service
  • Cable television
  • The U.S. Postal Service

No Close Substitutes

• If there are close substitutes for a good or service, that means there is competition in the market.
• Competition in the market means the market cannot be a monopoly by definition.
• Example of monopoly: water supplied by a local public utility.

Innovation, Technological Change, and Substitutes

• Innovation and technological change create new products, some of which are substitutes for existing products.
• Example: FedEx, UPS and fax machines are substitutes for the services of the U.S. Postal Service, weakening their monopoly.

Barriers to Entry

• Barriers to entry are legal or natural impediments protecting a firm from competition from potential new entrants.
• Barriers to entry include:
  • Legal barriers
  • Natural barriers

Legal Barriers to Entry

• Legal barriers to entry create legal monopoly.

A legal monopoly is a market in which competition and entry are restricted by the granting of a public franchise, license, patent or copyright, or in which a firm has acquired ownership of a significant portion of a key resource.

Legal Barriers: Public Franchises and Licenses

• A public franchise is an exclusive right granted to a firm to supply a good or service.
  • Example: U.S. Postal Service
• A government license controls entry into particular occupations, professions and industries.
  • Example: licensing of medical doctors.

Legal Barriers: Patents
and Copyrights

• A patent is an exclusive right granted to the inventor of a product or service.
• A copyright is an exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work.

Ownership of a
Key Resource

If a single firm acquires ownership of the supply of a key resource, the firm will be a monopoly since no other firm can produce that output without the key input.

• Examples:
  • Alcoa (aluminum production, 1930's)
  • DeBeers (diamonds, today)

Natural Barriers to Entry

• Natural barriers to entry give rise to natural monopoly.
• Natural monopoly occurs when one firm can supply the entire market at a lower price than two or more firms.
• Demand must limit sales to a quantity at which economies of scale exist.

Natural Monopoly, Demand and Average Total Cost

• The demand curve must intersect the industry ATC curve on a part of the ATC curve that is sloping downward.

If two or more firms supply the market, the per unit cost will be higher than will be the case if a single firm supplies the entire market.

Examples of
Natural Monopoly

• Examples of natural monopoly usually involve economies of scale in distribution:
  • Natural gas distribution systems
  • Electric power distribution
  • Trash collection

Monopolies are Regulated

• Most monopolies are regulated in some way by one or more government agencies.
• In this chapter, we study unregulated monopoly.

Single-Price Monopoly

• A single-price monopoly is a monopoly that charges the same price to all buyers for each and every unit of output produced.

By contrast, some monopolies charge different prices to different consumers. We will study price discrimination later in this chapter.

Demand and Revenue

• Since only one firm supplies all the output, the firm and industry demand curves are the same.
• The firm clearly has control over the price it charges.

Consumers and Monopoly

• Consumers can only choose the quantity of output they will purchase from the monopoly.

However, the demand curve for a monopoly's output still slopes downward. Consumers can still choose to purchase less output at a higher price.

Marginal Revenue and Price

• For any firm facing a downward sloping demand curve, marginal revenue will be less than price.
• In order to sell more units, the firm must lower price.
• They must lower price on all units they sell, including those they were formerly selling at the higher price.

The elasticity of demand is the absolute value of the percentage change in the quantity demanded divided by the percentage change in price.

• The demand for a good can be:
  • Elastic (elasticity > 1.0)
  • Inelastic (elasticity < 1.0)
  • Unit elastic (elasticity = 1.0)

Revenue and Elasticity

• Recall that price and total revenue move in opposite directions when demand is elastic.
• This implies output and revenue move in the same direction (since price and output always move in opposite directions).

Marginal Revenue
and Elasticity

• Marginal revenue will be positive on the elastic part of a demand curve.
• Marginal revenue will be negative on the inelastic part of the demand curve.
• Marginal revenue will be zero where demand is unit elastic.

Monopoly Demand
Always Elastic

• The profit maximizing monopoly will sell the quantity of output that makes MR = MC.
• MC must be positive so MR must also be positive. This is on the elastic part of the demand curve.
• A profit maximizing monopoly will always set price on the elastic part of the demand curve.

• Profit is the difference between total revenue and total cost.

An unregulated, single-price, profit-maximizing monopoly will produce and sell the quantity of output that makes marginal revenue equal to marginal cost.

Monopoly Profits

• A positive profit is still not guaranteed, even for a monopoly.
  • Total profit depends on the position of the ATC curve relative to the demand curve.
• However, we don't see many unprofitable monopolies.
  • If you're the sole supplier of a good and still can't make a profit, how long will you stay in the business?

Price discrimination is the practice of charging some customers a lower price than others for an identical good or service. Examples:

• Senior citizen discounts for banking services.
• Lower prices for afternoon showings of movies
• Discounts for children at baseball games.

Perfect Price Discrimination

Perfect price discrimination occurs when a firm charges each consumer the maximum price he or she is willing to pay. Under perfect price discrimination, consumer surplus will be zero.

• Firms in the real world do not practice perfect price discrimination because it would cost too much.

Price Differences and
Price Discrimination

• Not all price differences are caused by price discrimination.
• Price discrimination requires that the price differences not be based on cost differences.
• As long as price differences reflect cost differences, price discrimination does not exist.

Price Discrimination and Profit Maximization

• On the face of it, offering a discount to students or senior citizens appears to contradict the goal of profit maximization.

Actually, this can increase profits. By charging a higher price to groups with lower demand elasticity, a monopoly can increase its profit.

Price Discrimination and Consumer Surplus

• When all units consumed can be bought for a single price, consumers benefit.
• This benefit is called consumer surplus.
• Price discrimination is an attempt by a monopoly to capture the consumer surplus for its revenue.

Discriminating Among
Units of a Good

• Units price discrimination occurs when price differences are based on the number of units purchased.
• Quantity discounts are a good example of this technique.
• If the quantity discounts reflect lower average costs, it is not price discrimination.

Discriminating Among Individuals

Individual price discrimination occurs when price differences are based on an estimate of the group to which an individual customer belongs.

By charging a higher price to individuals who place a higher value on the good, the producer can obtain some of the consumer surplus.

Discriminating
Between Groups

Price discrimination discriminates between consumers on the basis of age, employment status, or some other easily distinguished characteristic.

Conditions for Successful Price Discrimination

• Each group must have a different demand elasticity.
• It must be possible to figure out which group an individual customer belongs to at low cost.
• The consumer must be unable to resell the good or service in question.

Comparing Monopoly
and Competition

• How do the quantities produced, prices, and profits of a monopoly compare with those of a perfectly competitive industry?
• Consider a hypothetical example of a perfectly competitive industry which suddenly becomes a monopoly.

Price and Output

A perfectly competitive industry will produce the quantity of output and charge the price at the equilibrium point where the industry MC curve intersects the demand curve.

A monopoly will produce the quantity of output dictated by the intersection of the MR and MC curves, charging a price set by the demand curve.

Comparison of Monopoly and Perfect Competition

• Compared to a perfectly competitive market, a single-price monopoly restricts its output and charges a higher price.
• The more perfectly a monopoly can price discriminate, the closer its output gets to the competitive output.

Allocative Efficiency

• A single-price monopoly is inefficient.
• A perfect-price discriminating monopoly is efficient.

Allocative Inefficiency of a Single-Price Monopoly

• The difference between the value of a good and its price is consumer surplus.
• A single-price monopoly restricts output and charges a higher price, reducing consumer surplus.
• While the monopoly gets part of this reduction, another part is simply lost.

Producer Surplus

• Producer surplus is the difference between a producer's revenue and the opportunity cost of production.
• Part of producer surplus is lost when a monopoly restricts output to less than its competitive level.

Deadweight Loss

Deadweight loss measures allocative inefficiency as the reduction in consumer and producer surplus caused by monopoly restrictions on output.

Redistribution:
Single-Price Monopoly

• A monopoly always redistributes surplus from consumers to itself.
• There will always be a net gain for the monopoly and a net loss for the consumer. There will also be a deadweight loss.

Redistribution: Price Discriminating Monopoly

In the case of a perfect price-discriminating monopoly, there is no deadweight loss, but there is an even larger redistribution from consumers to producers.

• It is the deadweight loss that makes monopoly inefficient since that is a loss to society.

Rent Seeking

• Rent seeking behavior is activity directed toward acquiring monopoly power.
• Rent seeking is profitable and widely pursued.
• Rent seeking is a complete loss to society since it uses resources but does not produce any output.

Rent Seeking and
Social Cost

• Since only monopoly power can yield rent seeking behavior, this is an additional cost associated with monopoly.

The social cost is the sum of the deadweight loss and the value of the resources used in rent seeking. This sum is equal to the monopoly's profit.

Gains from Monopoly

• Monopolies may achieve economies of scale and economics of scope not available to more competitive firms.
• Monopolies may also have an incentive to innovate in order to maintain their monopoly position.

Economies of Scale

A firm experiences economies of scale when an increase in its production of a good or service causes a decrease in the average total cost of producing it.

Economies of Scope

• Economies of scope are decreases in average total cost made possible by increasing the number of different goods produced.
• This often results from using highly specialized (and expensive) technical inputs to produce several different products.

Incentives to Innovate

• Innovation is the first-time application of new knowledge in the production process.
• Economists disagree about whether large firms with monopoly power or small competitive firms are the most innovative.
• An innovation gives the firm temporary monopoly power.

Innovation:
The Case of a Patent

• A patent gives a firm a 20 year monopoly on a new product.
• Does this increase the pace of innovation?
  • Yes because it increases profits.
  • No because monopolies can afford to be lazy while competitive firms must innovate and cuts costs.

Innovation:
Empirical Evidence

• Empirical evidence on innovation in large and small firms is mixed.
• Large firms do much more research and development. However, this is measuring inputs.
• Using output measures (number of patents, productivity growth), the evidence is ambiguous.