Monopoly

This Chapter

Last time, we have introduced the most competitive market – perfect competition.
Today, we will introduce another extreme – the least competitive market,
monopoly
• There is only one firm on the market

• The firm has a huge “market power”

• Other potential competitors cannot enter the market

How does the firm make profit-maximizing decisions?

What are the consequences of such a market?

Monopoly and How It Arises

A monopoly is a market:
• That produces a good or service for which no close substitute exists
• In which there is one supplier that is protected from competition by a barrier
preventing the entry of new firms.

How Monopoly Arises

A monopoly has two key features:
• No close substitutes
• Barriers to entry
Monopoly and How It Arises

No Close Substitutes
• If a good has a close substitute, even if it is produced by only one firm, that firm
effectively faces competition from the producers of the substitute.
• A monopoly sells a good that has no close substitutes.

Barriers to Entry
Barrier to entry is a constraint that protects a firm from potential competitors.
Three types of barriers to entry are
• Natural
• Ownership
• Legal
Monopoly and How It Arises
Natural Barriers to Entry
• Natural barriers to entry create a natural
monopoly, a market in which
economies of scale enable one firm to
supply the entire market at the lowest
possible cost.
• In a natural monopoly, economies of
scale are so powerful that they are still
being achieved even when the entire
market demand is met.
• The LRAC curve is still sloping
downward when it meets the demand
curve.
Monopoly and How It Arises
An Example of Natural Monopoly
A classic example of natural
monopoly: Telecommunication
• The LRAC is sloping downward at large
scales because the entry cost and fixed
cost are high (building up and
maintaining base stations, etc.) but the
variable cost (service provision) is low.
• AT&T Inc., founded by Alexander
Graham Bell, was once the monopoly of
phone service in the U.S. and Canada.
• The U.S. regulators forced it to break up
in 1982.
Monopoly and How It Arises

Ownership Barriers to Entry

An ownership barrier to entry occurs if one firm owns a significant portion
of a key resource.
• During the last century, De Beers owned 90 percent of the world’s diamonds.
Monopoly and How It Arises

Legal Barriers to Entry

Legal barriers to entry create a legal monopoly.
A legal monopoly is a market in which competition and entry are restricted
by the granting of a:
• Public franchise (like the U.S. Postal Service, a public franchise to deliver mail)
• Government license (like a license to practice law or medicine)
• Patent or copyright
Monopoly and How It Arises

Example: Two Information-Age Monopolies

Information-age technologies have created some big
natural monopolies—firms with large plant costs but
almost zero marginal cost, so they experience
economies of scale.
Two of these firms are Microsoft and Google. The
figures show their market shares. Microsoft provides
88% of the market for personal computer operating
systems, and Google provides 70% of internet search.
Monopoly and How It Arises

Monopoly Price-Setting Strategies

For a monopoly firm to determine the quantity it sells, it must choose the
appropriate price.
There are two types of 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.
A Single-Price Monopoly’s
Output and Price Decision
Price and Marginal Revenue
A monopoly is a price setter, not a price taker like a firm in perfect competition.
The reason is that the demand for the monopoly’s output is the market demand.
To sell a larger output, a monopoly must set a lower price.
A Single-Price Monopoly’s
Output and Price Decision
Total revenue, 𝑇𝑅, is the price, 𝑃, multiplied by the quantity sold, 𝑄.
Marginal revenue, 𝑀𝑅, is the change in total revenue that results from a one-
unit increase in the quantity sold.
For a single-price monopoly, marginal revenue is less than price at each level
of output. That is,
𝑀𝑅 < 𝑃
A Single-Price Monopoly’s
Output and Price Decision
The figure illustrates the relationship
between the price and marginal
revenue and derives the marginal
revenue curve.
Suppose the monopoly sets a price of
$16 and sells 2 units.
A Single-Price Monopoly’s
Output and Price Decision
Now suppose the firm cuts the price
to $14 to sell 3 units.
It loses $4 of total revenue on the 2
units it was selling at $16 each.
And it gains $14 of total revenue on
the 3rd unit.
So total revenue increases by $10,
which is marginal revenue.
A Single-Price Monopoly’s
Output and Price Decision
The marginal revenue curve, 𝑀𝑅,
passes through the red dot midway
between 2 and 3 units and at $10.
For a monopoly, 𝑀𝑅 < 𝑃 at each
quantity.

If the demand curve is linear, what is the

slope of the MR curve?
A Single-Price Monopoly’s
Output and Price Decision
Marginal Revenue and Elasticity
A single-price monopoly’s marginal
revenue is related to the elasticity of
demand for the good.
If demand is elastic, a fall in the price
brings an increase in total revenue.
• MR is positive.
A Single-Price Monopoly’s
Output and Price Decision
The increase in revenue from the
greater quantity sold outweighs the
decrease in revenue from the lower
price per unit.
So MR is positive.
• As the price falls, total revenue increases.
A Single-Price Monopoly’s
Output and Price Decision
If demand is inelastic, a fall in the
price brings a decrease in total
revenue.
The rise in revenue from the increase
in quantity sold is outweighed by the
fall in revenue from the lower price
per unit.
• MR is negative.
A Single-Price Monopoly’s
Output and Price Decision
As the price falls, total revenue
decreases.
If demand is unit elastic, a fall in the
price does not change total revenue.
The rise in revenue from the greater
quantity sold equals the fall in revenue
from the lower price per unit.
𝑀𝑅 = 0.
• Total revenue is maximized when 𝑀𝑅 = 0.
A Single-Price Monopoly’s
Output and Price Decision
In Monopoly, Demand Is Always Elastic
A single-price monopoly never produces an output at which demand is inelastic.
If it did produce such an output, the firm could increase total revenue, decrease
total cost, and increase economic profit by decreasing output.
A Single-Price Monopoly’s
Output and Price Decision
Price and Output Decision
The monopoly faces the same types of technology constraints as the
competitive firm, but the monopoly faces a different market constraint.
The monopoly produces the profit-maximizing quantity, where 𝑀𝑅 = 𝑀𝐶.
The monopoly sets its price at the highest level at which it can sell the profit-
maximizing quantity.
A Single-Price Monopoly’s
Output and Price Decision
In Figure (a), the monopoly produces
the quantity that maximizes total
revenue minus total cost.
A Single-Price Monopoly’s
Output and Price Decision
In figure (b), the firm produces the
quantity at which 𝑀𝑅 = 𝑀𝐶 and sets
the price at which it can sell that
quantity.
The ATC curve tells us the average
total cost.
Economic profit is the profit per unit
multiplied by the quantity
produced—the blue rectangle.
A Single-Price Monopoly’s
Output and Price Decision
The monopoly might make an economic profit, even in the long run, because
barriers to entry protect the firm from market entry by competitor firms.
But a monopoly that incurs an economic loss might shut down temporarily
in the short run or exit the market in the long run.
Single-Price Monopoly and
Competition Compared
Comparing Price and Output
The market demand curve, D, in
perfect competition is also the
demand curve that the firm in
monopoly faces.
The market supply curve in perfect
competition is the horizontal sum of
the individual firms’ marginal cost
curves, 𝑆 = 𝑀𝐶.
This curve is the monopoly’s
marginal cost curve.
Single-Price Monopoly and
Competition Compared
Perfect Competition
Equilibrium occurs where the
quantity demanded equals the
quantity supplied at quantity 𝑄𝐶 and
price 𝑃𝐶 .
Single-Price Monopoly and
Competition Compared
Monopoly
Equilibrium output, 𝑄𝑀 , occurs
where marginal revenue equals
marginal cost, 𝑀𝑅 = 𝑀𝐶.
Equilibrium price, 𝑃𝑀 , occurs on the
demand curve at the profit-
maximizing quantity.
Compared to perfect competition,
monopoly produces a smaller output
and charges a higher price.
Single-Price Monopoly and
Competition Compared
Efficiency Comparison
The market demand curve is the marginal
social benefit curve, 𝑀𝑆𝐵.
The market supply curve is the marginal
social cost curve, 𝑀𝑆𝐶.
So competitive equilibrium is efficient:
𝑀𝑆𝐵 = 𝑀𝑆𝐶.
Total surplus, the sum of consumer
surplus and producer surplus, is
maximized.
The quantity produced in perfect
competition is efficient.
Single-Price Monopoly and
Competition Compared
Under monopoly…
Because price exceeds marginal social cost,
marginal social benefit exceeds marginal
social cost, …
and a deadweight loss arises.

Redistribution of surpluses
Some of the lost consumer surplus goes to
the monopoly as producer surplus.
Price Discrimination

Price discrimination is the practice of selling different units of a good or

service for different prices.
To be able to price discriminate, a monopoly must:
• Identify and separate different buyer types.
• Sell a product that cannot be resold.
Price differences that arise from cost differences are not price discrimination.
Price Discrimination

Ways of Price Discriminating

A monopoly can discriminate
• (First-degree) based on each consumer’s willingness to pay.
• For example, biddings on EBay.

• (Second-degree) among units of a good.

• For example, quantity discounts in the supermarket.
• However, quantity discounts that reflect lower costs at higher volumes (increasing
returns to scale) are not price discrimination
• (Third-degree) among groups of buyers.
• For example: advance purchase and other restrictions on airline tickets.
Price Discrimination

Increasing Profit and Producer Surplus

By price discriminating, a monopoly captures consumer surplus and
converts it into producer surplus.
More producer surplus means more economic profit. Why?
Economic profit = Total revenue – Total cost
Producer surplus is total revenue minus the area under the marginal cost
curve, which is total variable cost.
Producer surplus = Total revenue – Total variable cost
Economic profit = Producer surplus – Total fixed cost
Price Discrimination
A Price-Discriminating Airline
The figure shows the market demand
and the airline’s marginal cost of $40
a trip.
Price Discrimination
Single-Price Profit Maximization
The airline sells 8,000 trips a week at
$120 a trip.
Travelers enjoy a consumer surplus.
The airline has a producer surplus of
$640,000.
Can the airline increase its producer
surplus by price discriminating?
Price Discrimination

Discriminating Between Two Types of Travelers

Figure (a) shows the market for business travel. The airline expands into the
leisure market in figure (b).
Price Discrimination

Leisure travelers will not pay $120 a trip, so the demand for leisure travel is the
curve 𝐷𝐿 .
The airline sells 4,000 leisure trips at $80 a trip.
Price Discrimination

The airline increases its output to 12,000 trips a week.

Consumer surplus increases and the airline’s producer surplus increases.
Price Discrimination
Perfect Price Discrimination
Perfect price discrimination occurs if
a firm is able to sell each unit of
output for the highest price someone
is willing to pay.
Marginal revenue now equals the
price, so …
the demand curve is also the
marginal revenue curve.
Price Discrimination
The perfect price discriminating
monopoly …
increases its output until the price of
the last trip equals marginal cost.
Producer surplus is maximized when
the lowest fare is $40 and 16,000 trips
are bought.
The monopoly makes the maximum
possible profit.
Monopoly Regulation

Efficient Regulation of a Natural Monopoly

When demand and cost conditions create natural monopoly, the quantity
produced is less than the efficient quantity.
How can government regulate natural monopoly so that it produces the
efficient quantity?
• Marginal cost pricing rule is a regulation that sets the price equal to the monopoly’s
marginal cost.
• Average cost pricing rule is a regulation that sets the price equal to the monopoly’s
average total cost.
The Story of AT&T

• AT&T was founded as a subsidiary of the American Bell Telephone Company in 1985.
• AT&T acquired its parent company in 1899

• Throughout most of the 20 th century, AT&T led a group of subsidiaries to form a

monopoly on telephone services (the “Bell System”)
• AT&T’s local telephone monopolies accounted for 80-85% of access lines in 1982

• In 1982, AT&T's local telephone service was broken up into 7 individual companies (the
“Baby Bells”).
• It was a result of an anti-trust lawsuit against AT&T by the U.S. Justice Department
in 1974
• One of the spinoffs is Verizon, nowadays the second largest telecom company in the
world
The Story of AT&T

• Why, in the first place, should a monopoly like AT&T be allowed?

• Is AT&T a natural monopoly or a legal monopoly?
• Why would the U.S. government breakup AT&T?
• What are the economic consequences, in theory and practice?