- What is monopoly?
- What are the differences between legal monopoly and natural
- How does a monopoly determine price and output?
- How does the performance of a monopoly compare with perfect
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
- 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
- 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
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.
- 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
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
- 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
- In this chapter, we study unregulated monopoly.
- A single-price monopoly is a monopoly that charges
the same price to all buyers for each and every unit of output
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.
Price Elasticity of Demand
The elasticity of demand is the absolute value of the percentage
change in the quantity demanded divided by the percentage change
- 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 will be positive on the elastic part of a
- Marginal revenue will be negative on the inelastic part of
the demand curve.
- Marginal revenue will be zero where demand is unit 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.
Price and Output Decisions
- 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.
- 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
- 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
- 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
Price Discrimination and Consumer Surplus
- When all units consumed can be bought for a single price,
- This benefit is called consumer surplus.
- Price discrimination is an attempt by a monopoly to capture
the consumer surplus for its revenue.
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
By charging a higher price to individuals who place a higher value
on the good, the producer can obtain some of the consumer surplus.
Price discrimination discriminates between consumers on the basis
of age, employment status, or some other easily distinguished
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
- 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
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.
- 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
- 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 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 measures allocative inefficiency as the
reduction in consumer and producer surplus caused by monopoly
restrictions on output.
- A monopoly always redistributes surplus from consumers to
- 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 behavior is activity directed toward acquiring
- 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
- 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
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.
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.
- Empirical evidence on innovation in large and small firms
- 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.