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Lesson 10


Characteristics of a Monopoly

Pure monopoly - a firm is sole producer / supplier of a product in the market
  • Characteristics
    1. Single seller of a product
      • The demand for the monopolist's product is the market demand curve
      • A one firm industry
    2. No close substitutes for the product
      • You either buy the product from him or you don't
    3. A monopolist can exert control over the price
      • He decreases production level and market price increases
    4. Other firms are prevented from entering the market, because of high barriers
      • No competition
Market Entry Barriers - Prevent entry of competitors into the market

1. Economies of scale - also called a natural monopoly - monopoly has to be large to obtain low per-unit cost.

  • Firm has very large fixed costs
  • A new firm entering this market would need substantial amounts of capital to reach this low-cost production level
    • Monopoly usually supplies the whole market.
    • Examples: Local phone service, electricity, and natural gas.
      • Requires large amount of equipment & infrastructure
      • More convenient - imagine 12 electric power stations competing in Arkadelphia. Each has its own power lines, power substations, etc. This would be a mess.
    • Economies of scale are shown below
      • Output is the whole market before a monopoly hits the constant economies of scale
Economies of Scale
Per-unit costs
Economies of Scale

2. Legal Barriers - government's rules or regulations create an entry barrier

  • Licenses - oldest form of protection - government grants permission to engage in an activity
    • Protects businesses from competition
      • Doctors
      • Legal services
      • Taxicabs
      • Funeral homes, etc.
    • Sometimes the license has little costs, while other cases, they are expensive.
      • Example: Taxicabs in New York City.
        • The number of taxi licenses are fixed.
        • Licenses can be sold or traded.
        • Market price of license exceeds $100,000.
  • Patents - government protects a new invention, drug, device, etc.
    • U.S. - gives the exclusive right to produce product for 17 years
      • Most countries have them
    • Benefits - encourages costly scientific research
    • Costs - higher prices to consumers until patent expires
      • Firms have come up with ways to renew patents
        • Pharmaceutical companies invent similar medications, obtain a patent on them, and phase out production of old medications as their patents expire

3. A firm controls an essential resource

  • Example: Before World War II
    • Aluminum Company of America (Alcoa) controlled the supply of bauxite
    • Other firms could not produce aluminum cheaply without bauxite
  • Example: DeBeers Corporation of South Africa.
    • Controlled 80 to 85% of the world's supply of diamonds
      • Currently controls approximately 55% of market
    • "Diamond is forever."

4. Unfair competition:

  • Example: Standard Oil - John Rockefeller.
    • Came into a small town and charge a price below cost.
    • Drove competitors out of business.
    • Standard Oil would buy these businesses for cents on the dollar and consolidate them into Standard Oil.
    • With no competition, Standard Oil charged monopoly prices.
    • Controlled 90% of U.S. oil market.
Blue arrow Given enough time, technology allows new firms to circumvent the high barriers and drive economic profits to zero.
  Intel and AMD both compete for microprocessors. VIA is trying to break into the market with its 64-bit microprocessor Nano. The Nano can beat the Intel's Atom processor.

The Case of Monopoly

1. Price and output under monopoly

  • Profits are maximized at MR = MC
    • Monopolists expand output when MR > MC
    • Monopolists contract output when MC > MR
  • Unregulated monopolist: Market price, P* and production level, Q*
    • P* > C*, therefore monopolist earns economic profits
    • High entry barriers prevent competition
    • Monopolist earns long-run profits
      • Market barriers prevents competition
  • Monopolist does not have a supply function
    • Monopolist produces at MC =MR, which is one point
    • Monopolist has lower social welfare than a competitive market
      • Monopolistic market has higher price and lower quantity
      • Consumers' surplus is transferred from consumers to monopolist as profits
A Monopolist
Price, Per-unit costs
A monopolist is earning profit

2. Other information about monopolies

  1. Price gouging
    • Monopolist charges the price, where MR = MC
    • He does not raise price further, because profits will fall
    • A monopolist does not price gouge
  2. Investing in a monopolist's stock may not be profitable, because the monopoly value is already captured in the stock price.
    • Early bird - unless you are the first person to buy the stock before economic profits began
    • Investing in monopolists may not be a good investment.
  3. Monopolies may not earn long-run economic profits.
    • Patents for products that consumers do not want.
  4. The monopolists do not know the MR and MC curves.
    • They approximate the rule MR = MC by max. revenue, min. costs, and changing production levels.


Why Monopolies are Bad?

Not only does this list apply to monopolies in the private market, but also includes government that has monopolies over certain services.
  1. Little competition limits the options to consumers
    • You either buy the product from the monopolist or you go without
  2. Reduced competition results in allocative inefficiency
    • Consumers value the products more highly than what it costs to produce them
      • P* > MC
      • Firms are earning economic profits
  3. Consumers are not able to direct monopolies to serve their interests
    • Bad service
    • No incentive to improve products, etc.
  4. X-Inefficiency - firms or agencies may not produce at low cost
      • lack of competition
      • no incentive to minimize costs
      • mismanagement
      • poorly motivated workers
    • X-Inefficiency - may be worse with government organizations because they can be much larger
  5. Monopoly power may encourage rent seeking behavior
    • Rent seeking behavior - government officials take cash & assets from private companies & people
    • Russia:
      • Companies bribe public officials, then officials grant licenses to those businesses, restricting competition.
    • U.S.
      • Corporations funnel campaign money to Congressmen
      • Congress passes laws favorable to corporations

Price Discrimination

Price discrimination - a firm sells products/services at different prices to different buyers.
  • Firms, who price discriminate, capture some of the consumers' surplus as additional revenue.
  • Examples:
    • Senior citizen discounts for dinners, etc.
    • Student discounts on movies, software, etc.
    • Coupons, rebates, family specials, etc.
  • Three conditions:
    1. Identify different groups of customers
      • Price elasticities of demand is different for each group
    2. Prevent customers who buy at the low price and sell to customers at higher prices
      • Senior citizen selling her "discounted" medication to another customer
    3. Firm has some monopoly power.
  • Example: College Financial Aid
    • First case, college does not price discriminate.
      • Total Revenue = P q* = $10,000 q*
    • Second case, college divides students into 3 groups
      • "Rich students" are charged $20,000
        • Number of students: q1 - 0
        • Revenue = $20,000 q1
      • "Middle-class students" are charged $15,000
        • Number of students: q2 - q1
        • Revenue = $15,000 (q2 - q1)
      • "Poor students" are charged $10,000
        • Number of students: q* - q2
        • Revenue = $10,000 (q* - q2)
    • Total revenue increases.
No Price Discrimination Price Discrimination
Tuition Tuition
A firm does not use price discrimination A firm uses price discrimination
Students Students
  • Firms maximize profits by expanding output until:
    • MRrich = MC
    • MRmiddle class = MC
    • MRpoor = MC
  • Rich students are less sensitive to price changes.
    • Inelastic demand.
  • Poor students are very sensitive to price changes.
    • Elastic demand.


Government Policy Alternatives

Policies are ranked from the economically best to the worse.

1. Government reduces market barrier:.

  • Reduce licensing requirements.
  • Reduce trade barriers that exposes monopoly to international competition

2. Government can "ideally" regulate natural monopolies. Unregulated monopolist produces at MC = MR, so the market price is P* and output is Q*.

     1. Average Cost Pricing - the government sets the price where the demand curve intersects the long-run ATC.

  • The price is lower ( P~< P*)
  • The quantity produced is higher (Q~ > Q*)
  • The firm earns zero economic profit in long run
  • Social welfare improves
  • Allocative inefficient
    • Price> MC
A Monopolist - Average Cost Pricing
Price, Per-Unit Costs
Average Cost Pricing for a monopolist

Unregulated monopolist produces  at MC = MR, so the market price is P* and output is Q*.

     2. Marginal Cost Pricing - the government sets the price where the demand curve intersects the MC.

  • The price is the lowest (P~ < P*)
  • The quantity produced is the highest (Q~ > Q*)
  • The same social welfare as a competitive market
  • Allocative efficient
    • P = MC
  • The firm earns a loss in long run
    • May need to be subsidized
    • Red area shows the loss

     3. Ramsey Pricing - regulated monopolist charges two prices

  • Two prices
    • Rate charge is the price, P~, where price equals marginal costs
    • Fixed charge - monopolist take loss and charges the loss to consumers as fixed fees
  • Allocative efficient and does not need to be subsidized by government
A Monopolist - Marginal Cost Pricing
Price, Per-Unit Costs
Marginal Cost Pricing for a monopolist

3. Antitrust policies - increase the number of firms in a market.

  • Government can break up monopolies.
    • Ex: Microsoft
    • Prevent companies from merging that may reduce competition.
    • Prosecute firms engaging in collusive behavior.
    • Do not breakup natural monopolies!
      • Per-unit costs will be higher with more firms.
      • In 1984, AT&T was broken down into five baby bells.
      • A large monopoly broken down into 5 smaller regional monopolies.

4. Government can take over monopoly.

  • Maybe worse than a private firm monopoly
    • No profit motive
    • No incentives to minimize costs and satisfy consumers
    • Taxpayers could end up subsidizing it


  • pure monopoly
  • market entry barriers
  • economies of scale
  • natural monopoly
  • licenses
  • patents
  • price gouging
  • early bird
  • X-inefficiency
  • rent-seeking behavior
  • price discrimination
  • average cost pricing
  • marginal cost pricing
  • Ramsey pricing

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