Chapter

15

Chapter 15: Monopoly

Lecturer: Dr. Tran Ky Han

 CONTENT
1

Why Monopolies Arise

2
How Monopolies Make Production&
Pricing Decisions
3

The Welfare Cost of Monopolies

2
 1 - Why Monopolies Arise
• Monopoly
– Firm that is the sole seller of a product without close
substitutes Price maker
– Barriers to entry
1. Monopoly resources
2. Government regulation
3. The production process

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 1 - Why Monopolies Arise
• Monopoly resources
– A key resource required for production is owned by a single
firm
– Higher price
• Government regulation
– Government gives a single firm the exclusive right to produce
some good or service
– Government - created monopolies
• Patent and copyright laws
• Higher prices; Higher profits
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 1 - Why Monopolies Arise
• The production process
– A single firm can produce output at a lower cost than can a
larger number of producers.
• Natural monopoly
– Arises because a single firm can supply a good or service to an
entire market
• At a smaller cost than could two or more firms
– Economies of scale over the relevant range of output

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Figure 1
Economies of scale as a cause of monopoly
Costs

Average total cost

0 Quantity of output

When a firm’s average-total-cost curve continually declines, the firm has what is called a natural
monopoly. In this case, when production is divided among more firms, each firm produces less, and
average total cost rises. As a result, a single firm can produce any given amount at the smallest cost
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 2 - How Monopolies Make Production& Pricing Decisions

Monopoly versus Competition

Monopoly Competitive firm

Price maker Price taker
Sole producer One producer of many

Downward sloping demand

Market demand curve (There is no perfect Demand – horizontal line (Price)
substitute)

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Figure 2
Demand curves for competitive and monopoly firms
(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve
Price Price

Demand

Demand

0 Quantity of output 0 Quantity of output

Because competitive firms are price takers, they in effect face horizontal demand curves, as in
panel (a). Because a monopoly firm is the sole producer in its market, it faces the downward-
sloping market demand curve, as in panel (b). As a result, the monopoly has to accept a lower
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price if it wants to sell more output.
 2 - How Monopolies Make Production& Pricing Decisions

• A monopoly’s revenue
– Total revenue = price times quantity (TR = P x Q)
– Average revenue
• Revenue per unit sold
– Total revenue divided by quantity
– Marginal revenue
• Revenue per each additional unit of output
– Change in total revenue when output increases by 1 unit
• Can be negative
• Always: MR < P
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Table 1
A monopoly’s total, average, and marginal revenue
Quantity of Price Total Average Marginal
water (P) revenue revenue revenue
(Q) (TR=P ˣ Q) (AR=TR/Q) (MR=ΔTR/ΔQ)
0 gallons $11 $0 -
1 10 10 $10 $10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2
8 3 24 3 -4

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 How Monopolies Make Production& Pricing Decisions

• Increase in quantity sold

– Output effect
• Q is higher
• Increase total revenue
– Price effect
• P is lower
• Decrease total revenue
• Because MR < P
– MR curve is BELOW the demand curve

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Figure 3
Demand and marginal - revenue curves for a monopoly
Price
$11
10
9
8
7
6
5
4
3
Demand
2 (average revenue)
1
0
-1 1 2 3 4 5 6 7 8 Quantity
of water
-2
-3
Marginal revenue
-4

The demand curve shows how the quantity affects the price of the good. The marginal-revenue curve
shows how the firm’s revenue changes when the quantity increases by 1 unit. Because the price on all
units sold must fall if the monopoly increases production, marginal revenue is always less than the price.
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 How Monopolies Make Production& Pricing Decisions

• Profit maximization
– If MR > MC – increase production
– If MC > MR – produce less
– Maximize profit
• Produce quantity where MR=MC
• Intersection of the MR curve and the MC curve

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Figure 4
Profit maximization for a monopoly
Costs 2. . . . and then the demand curve shows the
price consistent with this quantity.
and
Revenue Marginal cost

1. The intersection of the marginal-revenue

curve and the marginal-cost curve
Monopoly B determines the profit-maximizing
price quantity . . .
Average total cost
A

Demand Đường giá của cty độc quyền

Marginal revenue

0 Q1 QMAX Q2 Quantity

A monopoly maximizes profit by choosing the quantity at which marginal revenue

equals marginal cost (point A). It then uses the demand curve to find the price that will
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induce consumers to buy that quantity (point B).
 How Monopolies Make Production& Pricing Decisions

• Profit maximization
– Perfect competition: P=MR=MC
• Price equals marginal cost
– Monopoly: P>MR=MC
• Price exceeds marginal cost
• A monopoly’s profit
– Profit = TR – TC = (P x Q) – (ATC x Q) = (P – ATC) ˣ Q

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Figure 5
The monopolist’s profit
Costs
and
Revenue Marginal cost

Monopoly E B
Average total cost
price

Monopoly
profit
Average Demand
total
cost D C

Marginal revenue

0 QMAX Quantity

The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus
average total cost, which equals profit per unit sold. The width of the box (DC) is the number of units sold.
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 Monopoly drugs versus generic drugs

• Market for pharmaceutical drugs

– New drug, patent laws – monopoly
• Produce Q where MR=MC
• P>MC
– Generic drugs – competitive market
• Produce Q where MR=MC
• And P=MC
• Price (competitively produced generic drug)
– Below the price(monopolist)

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Figure 6
The market for drugs
Costs
and
Revenue

Price
during
patent life

Price after Marginal cost

patent
expires

Demand
Marginal revenue

0 Monopoly Competitive Quantity

quantity quantity

When a patent gives a firm a monopoly over the sale of a drug, the firm charges the
monopoly price, which is well above the marginal cost of making the drug. When the patent
on a drug runs out, new firms enter the market, making it more competitive. As a result, the
price falls from the monopoly price to marginal cost. 18
 3 - The Welfare Cost of Monopolies
• Total surplus
– Economic well-being of buyers & sellers in a market
– Sum of consumer surplus & producer surplus
• Consumer surplus
– Consumers’ willingness to pay for a good
– Minus the amount they actually pay for it
• Producer surplus
– Amount producers receive for a good
– Minus their costs of producing it

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 The Welfare Cost of Monopolies
The deadweight loss
• Benevolent planner – maximize total surplus
– Produce quantity where
• Marginal cost curve intersects demand curve
– Charge P=MC

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Figure 7
The efficient level of output
Costs
and
Revenue
Marginal cost

Value Cost to
to monopolist
buyers

Value
to Demand
Cost to
buyers (value to buyers)
monopolist
0 Quantity
Value to buyers is greater Efficient Value to buyers is less
than cost to sellers quantity than cost to sellers

A benevolent social planner who wanted to maximize total surplus in the market would choose the
level of output where the demand curve and marginal-cost curve intersect. Below this level, the value
of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of
making the good. Above this level, the value to the marginal buyer is less than marginal cost. 21
 The Welfare Cost of Monopolies
The deadweight loss
• Monopoly
– Produce quantity where
• MC = MR
– Produces less than the socially efficient quantity of output
– Charge P > MC
– Deadweight loss
• Triangle between: demand curve and MC curve

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Figure 8
The inefficiency of monopoly
Costs
and
Revenue
Marginal cost
Deadweight
loss
Monopoly
price

Demand

Marginal revenue

0 Monopoly Efficient Quantity

quantity quantity
Because a monopoly charges a price above marginal cost, not all consumers who value the good at more
than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level.
The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the
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value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly
 The Welfare Cost of Monopolies

The monopoly’s profit: a social cost?

• Monopoly
– Higher profit
– Not a reduction of economic welfare
• Bigger producer surplus
• Smaller consumer surplus
• Monopoly profit
– Not a social problem

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 Price Discrimination

• Price discrimination
– the business practice of selling the same good at different
prices to different customers
– Increase profit

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Price Discrimination

26
Price Discrimination

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 Price Discrimination
• Lessons from price discrimination
1. Rational strategy
• Increase profit
• Charges each customer a price closer to his or her
willingness to pay
• Sell more than is possible with a single price

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 Price Discrimination
• Lessons from price discrimination
2. Requires the ability to separate customers according to
their willingness to pay
• Certain market forces can prevent firms from price discriminating
– Arbitrage – buy a good in one market, sell it in other market at a higher
price
3. Can raise economic welfare
• Can eliminate the inefficiency of monopoly pricing
– More consumers get the good
– Higher producer surplus (higher profit)

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 Price Discrimination
The analytics of price discrimination
• Perfect price discrimination
• Charge each customer a different price
– Exactly his or her willingness to pay
• Monopolist - gets the entire surplus (Profit)
• No deadweight loss
• Without price discrimination
• Single price > MC
• Consumer surplus
• Producer surplus (Profit)
• Deadweight loss
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Figure 9
Welfare with and without price discrimination
(a) Monopolist with Single Price (b) Monopolist with Perfect Price Discrimination

Price Price
Consumer
surplus

Deadweight
Monopoly
loss
price
Profit
Profit
Marginal cost Marginal cost

Marginal Demand Demand

revenue

0 Quantity Quantity 0 Quantity Quantity

sold sold

Panel (a) shows a monopolist that charges the same price to all customers. Total surplus in this market equals
the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly
price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit.
Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus,
and lowers consumer surplus. 31
 Price Discrimination
• Examples of price discrimination
– Movie tickets
– Airline prices
– Discount coupons
– Financial aid
– Quantity discounts

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Table 2 Competition versus monopoly: A summary
comparison Competition Monopoly
Similarities
Goal of firms Maximize profits Maximize profits
Rule for maximizing MR=MC MR=MC
Can earn economic profits
in short run? Yes Yes
Differences
Number of firms Many One
Marginal revenue MR=P MR<P
Price P=MC P>MC
Produces welfare-maximizing
level of output? Yes No
Entry in long run? Yes No
Can earn economic profits
in long run? No Yes
Price discrimination possible? No Yes

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