Business Economics

Lecture 6
Types of markets and firms part 2
Monopoly and oligopoly

1
 Monopoly
• A competitive firm is a price taker, a monopoly
firm is a price maker.
• A firm is considered a monopoly
1) it is the sole seller of its product
2) No close substitutes for its product
• A monopoly firm has strong barriers to
entry

2
 Reasons for Monopoly
Barriers to entry have three sources:
• Ownership of a key resource.
• The government gives a single firm the
exclusive right to produce the goods.
• Costs of production make a single producer
more efficient than a large number of
producers. (eg. Town gas supplier)

3
 Monopoly firm in control of limited resources

• Exclusive ownership of a key resource is a

potential source of monopoly, in practice
monopolies rarely arise for this reason.
(exception: oil fields in Mid East countries)

4
 Government created monopoly
• Governments may restrict entry by giving a
single firm the exclusive right to sell a
particular good in certain markets.
• Patent and copyright laws are two important
examples of how government creates a
monopoly to serve the public interest.

5
 Natural Monopoly
• An industry is a natural monopoly when a
single firm can supply a good or service to an
entire market at a smaller cost than could two
or more firms.
• A natural monopoly arises when there are
economies of scale for the output.

6
 Economies of Scale for Monopoly...
Cost

Average
total
cost

0 Quantity of Output 7
 Monopoly vs. Competitive Firm
Monopoly
 Is the sole producer
 Has a downward-sloping demand curve
 Is a price maker
 Reduces price to increase sales

8
 Competitive Firm vs. Monopoly
Competitive Firm
 Is one of many producers
 Has a horizontal demand curve
 Is a price taker
 Sells at same price if there is a demand

9
 Demand Curves for Competitive and
Monopoly Firms...

(a) A Competitive Firm’s (b) A Monopolist’s

Demand Curve Demand Curve
Price Price

Demand

Demand

0 Quantity of 0 Quantity of Output

Output
10
 A Monopoly’s Revenue

• Total Revenue
P x Q = TR
• Average Revenue
TR/Q = AR = P
• Marginal Revenue
DTR/DQ = MR

11
 A Monopoly’s Total, Average, and Marginal
Revenue

Average
Quantity Price Total Revenue Revenue Marginal Revenue
(Q) (P) (TR=PxQ) (AR=TR/Q) (MR= DTR / D Q )
0 $11.00 $0.00
1 $10.00 $10.00 $10.00 $10.00
2 $9.00 $18.00 $9.00 $8.00
3 $8.00 $24.00 $8.00 $6.00
4 $7.00 $28.00 $7.00 $4.00
5 $6.00 $30.00 $6.00 $2.00
6 $5.00 $30.00 $5.00 $0.00
7 $4.00 $28.00 $4.00 -$2.00
8 $3.00 $24.00 $3.00 -$4.00

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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.
 When a monopoly drops the price to sell one more
unit, the revenue received from previously sold units
also decreases.
• When a monopoly increases the amount it sells,
it has two effects on total revenue (P x Q).
 The output effect—more output is sold, so Q is higher.
 The price effect—price falls, so P is lower.

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Demand and Marginal Revenue Curves for a
Monopoly...
Price
$11
10
9
8
7
6
5
4
3 Demand
2 Marginal (average revenue)
1 revenue
0
-1 1 2 3 4 5 6 7 8 Quantity of Water
-2
-3
14
-4
Profit Maximization of a monopoly
• A monopoly maximizes profit by producing
the quantity at which marginal revenue equals
marginal cost.
• It then uses the demand curve to find the
price that will induce consumers to buy that
quantity.
• The monopolist will receive economic profits
as long as price is greater than average total
cost.

15
 Profit-Maximization for a Monopoly...
2. ...and then the demand
Costs and curve shows the price 1. The intersection of
Revenue consistent with this the marginal-revenue
quantity. curve and the marginal-
cost curve determines
B the profit-maximizing
Monopoly
price quantity...

Average total cost

A

Demand
Marginal
cost

Marginal revenue
16
0 QMAX Quantity
 Monopoly firms’ profits
• For a competitive firm, price equals marginal cost.
P = MR = MC
• For a monopoly firm, price exceeds marginal cost.
P > MR = MC
• 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...
Costs and
Revenue
Marginal cost

Monopoly E
B
price
Average total cost

Average
total cost D C
Demand

Marginal revenue
18
0 QMAX Quantity
 The Market for Medicine

Costs and
Revenue

Price
during
patent life

Price after Marginal

patent cost
expires Marginal
revenue Demand

0 Monopoly Competitive Quantity

quantity quantity
19
 The welfare cost of monopoly
 In contrast to a competitive firm, the monopoly
charges a price above the marginal cost.
 From the standpoint of consumers, such higher price
makes monopoly undesirable.
 However, from the standpoint of the owners of the
firm, such higher price makes monopoly very
desirable.

20
 The Efficient Level of Output...
Price
Marginal cost

Value Cost to
to monopolist
buyers

Value
to Demand
Cost to
monopolist buyers (value to buyers)

0 Efficient Quantity
quantity

Value to buyers is greater Value to buyers is less

than cost to seller. than cost to seller. 21
 Deadweight Losses
• Because a monopoly sets its price above
marginal cost, it places a wedge between the
consumer’s willingness to pay and the
producer’s cost.
 This wedge causes the quantity sold to fall
short of the social optimum.
 The monopolist produces less than the socially
efficient quantity of output.

22
 The Inefficiency of Monopoly...
Price
Deadweight Marginal cost
loss

Monopoly
price

Marginal
revenue Demand

0 Monopoly Efficient Quantity 23

quantity quantity
Government policy towards monopoly
Government responds to the problem of
monopoly as follows:
• Making monopolized industries more
competitive.
• Regulating the behavior of monopolies.
• Turning some private monopolies into public
enterprises.
• Doing nothing at all.

24
 Antitrust Laws
• Antitrust laws are a collection of statutes aimed
at curbing monopoly power.
• Antitrust laws give government various ways to
promote competition.
 They allow government to prevent mergers.
 They allow government to break up companies.
 They prevent companies from performing
activities which make markets less competitive.

25
 Regulation on prices
• Government may regulate the prices that
the monopoly charges.
 The allocation of resources will be efficient
if price is set to equal marginal cost.

26
 Marginal-Cost Pricing for a Natural
Monopoly...
Price

Average
total cost Average total cost
Loss
Regulated
price Marginal cost

Demand

0 Quantity 27
 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.
• Two important effects of price discrimination:
 It can increase the monopolist’s profits.
 It can reduce deadweight loss.

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 Welfare Without Price Discrimination...

Price (a) Monopolist with Single Price

Consumer
surplus

Monopoly Deadweight
loss
price
Profit
Marginal cost

Marginal Demand
revenue

0 Quantity sold Quantity 29

Welfare With Price Discrimination...

Price (b) Monopolist with Perfect Price Discrimination

Profit
Marginal cost

Demand

0 Quantity sold Quantity 30

Examples of Price Discrimination

• Movie tickets
• Airline prices
• Fees on different types
of bank accounts
• Quantity discounts
• Early bird discounts

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 Monopoly summary
• A monopoly is a firm that is the sole seller in its market.
• It faces a downward-sloping demand curve for its
product.
• A monopoly’s marginal revenue is always below the
price of its good.
• Like a competitive firm, a monopoly maximizes profit
by producing the quantity at which marginal cost and
marginal revenue are equal.
• Unlike a competitive firm, its price exceeds its marginal
revenue, so its price exceeds marginal cost.

32
 Monopoly summary
• A monopolist’s profit-maximizing level of
output is below the level that maximizes the
sum of consumer and producer surplus.
• A monopoly causes deadweight losses.
• Policymakers can respond to the inefficiencies
of monopoly behavior with antitrust laws,
regulation of prices, or by turning the
monopoly into a government-run enterprise.

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 Monopoly summary
• Monopolists can raise their profits by charging
different prices to different buyers based on
their willingness to pay.
• Price setters can use price discrimination to
raise economic welfare and lessen deadweight
losses.

34
 Oligopoly
 Oligopoly
 Only a few sellers, each offering a similar or
identical product to the others. (eg. soft
drinks, petroleum, cars)
 Monopolistic Competition
 Many firms selling products that are similar
but not identical. (eg. restaurants, hair
salon, clothing)
35
 Oligopoly
• The key feature of oligopoly is the tension
between co-operation and self-interest.
 Few sellers offering similar or identical products
 Interdependent firms
 Co-operating and acting like a monopolist by
producing a small quantity of output and
charging a price above marginal cost
 A duopoly is an oligopoly with only two members.
It is the simplest type of oligopoly.

36
 A Duopoly Example: Demand
Schedule for water drinks
Quantity Price Total Revenue
0 $120 $ 0
10 110 1,100
20 100 2,000
30 90 2,700
40 80 3,200
50 70 3,500
60 60 3,600
70 50 3,500
80 40 3,200
90 30 2,700
100 20 2,000
110 10 1,100
120 0 0
 A Duopoly Example: Price and
Quantity Supplied

 The price of water in a perfectly competitive

market would be driven to where the marginal
cost is zero:
P = MC = $0
Q = 120 gallons
 The price and quantity in a monopoly market
would be where total profit is maximized:
P = $60
Q = 60 gallons
38
 Duopoly example
 The socially efficient quantity of water is 120 gallons,
but a monopolist would produce only 60 gallons of
water.
 So what outcome then could be expected from
duopolists?
 The duopolists may agree on a monopoly
outcome.
 Collusion
 The two firms may agree on the quantity to produce
and the price to charge.
 Cartel
 The two firms may join together and act in unison.
39
 Equilibrium for oligopoly
• A Nash equilibrium is a situation in which
economic actors interacting with one another
each choose their best strategy given the
strategies that all the others have chosen.
• When firms in an oligopoly individually choose
production to maximize profit, they produce
quantity of output greater than the level
produced by monopoly and less than the level
produced by competition

40
 Outcomes of oligopoly
 Possible outcome if oligopoly firms pursue
their own self-interests:
 Joint output is greater than the monopoly
quantity but less than the competitive industry
quantity.
 Market prices are lower than monopoly price but
greater than competitive price.
 Total profits are less than the monopoly profit.

41
 Effects on Oligopoly
 How increasing the number of sellers affects the
price and quantity:
 The output effect: Because price is above marginal
cost, selling more at the going price raises profits.
 The price effect: Raising production lowers the price
and the profit per unit on all units sold.
 An oligopolistic market looks more and more like
a competitive market for increasing sellers.
 The price approaches marginal cost, and the
quantity produced approaches the socially
efficient level.

42
 Game Theory
Game theory is the study of how people behave
in strategic situations.
Strategic decisions are those in which each
person, in deciding what actions to take, must
consider how others might respond to that action.
 Because the number of firms in an oligopolistic
market is small, each firm must act strategically.
 Each firm knows that its profit depends not only
on how much it produced but also on how much
the other firms produce.
43
 Prisoners’ dilemma
• The prisoners’ dilemma provides insight into
the difficulty in maintaining cooperation.
• Often people (firms) fail to cooperate with one
another even when cooperation would make
them better off.

44
 The Prisoners’ Dilemma
Peter’s Decision

Confess Remain Silent

Peter gets Peter gets
8 years 20 years
Confess Ricky gets Ricky goes
Ricky’s 8 years free
Decision
Peter goes Peter gets
Remain free 1 year
Silent Ricky gets Ricky gets
20 years 1 year

45
 Prisoners’ Dilemma
• The dominant strategy is the best strategy for
a player to follow regardless of the strategies
pursued by other players.
• Cooperation is difficult to maintain, because
cooperation is not in the best interest of the
individual player.

46
 Oligopolies as a
Prisoners’ Dilemma OPEC+
Saudi Arabia’s Decision
High Production Low Production
SA gets SA gets
High $80 billion $50 billion
Production Iran gets Iran gets
Iran’s $80 billion $100 billion
Decision
SA gets $80 SA gets
Low billion $70 billion
Production Iran gets Iran gets
$50 billion $70 billion

47
 Oligopolies as a Prisoners’ Dilemma
• Self-interest makes it difficult for the oligopoly to
maintain a cooperative outcome with low
production, high prices, and monopoly profits.
• Firms that care about future profits will
cooperate in repeated games rather than
cheating in a single game to achieve a one-time
gain.
• Cooperation among oligopolists is undesirable
from the standpoint of society as a whole
because it leads to production that is too low and
prices that are too high.

48
 An Advertising Game
Coke’s Decision
Advertise Don’t Advertise
Coke gets $5 Coke gets $4
billion profit billion profit
Advertise
Pepsi gets Pepsi gets
$5 billion $7 billion
Pepsi’s profit profit
Decision
Coke gets $7
Coke gets $6
billion profit
billion profit
Don’t Pepsi gets
Pepsi gets
Advertise $4 billion $6 billion
profit profit
49
 Competition Law
• Antitrust laws make it illegal to restrain trade or
attempt to monopolize a market.
• In Hong Kong, the Competition Law was launched
on 14th Dec, 2015. http://www.compcomm.hk

 Antitrust policies sometimes may not allow

business practices that have potentially positive
effects:
 Resale price maintenance (episode 6)
 Predatory pricing (episode 8)
 Tying (episode 9)

50
 Competition Law
• Resale price maintenance (or fair trade) occurs
when suppliers (like wholesalers) require the
retailers that they sell to, to charge customers a
specific amount.
• Predatory pricing occurs when a large firm begins
to cut the price of its product(s) with the intent of
driving its competitor(s) out of the market.
• Tying refers to when a firm offers two (or more)
of its products together at a single price, rather
than separately.
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 Oligopoly summary
 Oligopolists maximize their total profits by
forming a cartel and acting like a monopolist.
 Oligopolists resulted in a greater quantity and a
lower price than under the monopoly outcome
based on their own production level.
 The prisoners’ dilemma shows that self-interest
can prevent oligopolies from maintaining
cooperation.
 Policymakers use the antitrust laws to prevent
oligopolies from engaging in behavior that
reduces competition.
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