CHAPTER

6
Monopoly
Prepared by: Jamal Husein

2005 Prentice Hall Business Publishing

Survey of Economics, 2/e

OSullivan & Sheffrin

Monopoly
A

monopoly is a market served by a single firm.

monopoly occurs when there is only one firm and a barrier preventing other firms from entering the market.
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

Barriers to Entry
Possible barriers to entry include:

A patent, granted by the government, gives an inventor the exclusive right to

sell a new product for some period of time

A franchise, or licensing scheme, in

which the government designates a single firm to sell a particular product

A natural monopoly, in which large

economies of scale in production allow only one firm to be profitable

2005 Prentice Hall Business Publishing

Survey of Economics, 2/e

OSullivan & Sheffrin

The Monopolists Output Decision

Like other firms, the monopolys objective is to produce the output level that will maximize profit.

The firm faces the same laws of production and cost in the short run, associated with diminishing returns.
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

The Monopolists Demand Curve

Since the monopoly is the only firm in the market, it faces the entire market demand for its product. A downwardsloping demand curve is associated with particular revenue characteristics for the monopoly firm.
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

TR and MR for the Monopolist

In order to increase the quantity sold, the monopolist must decrease price for all units sold. When the monopolist decreases price in order to increase quantity sold, there is good news and bad news regarding additional revenue.
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

Demand, TR and MR for the Monopolist

Marginal revenue is defined as the change in TR that results from selling one more unit of output The good news is that the firm sells more output, so it collects more revenue from new customers. The bad news is that the firm loses revenue from selling at a lower price to all customers combined.
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

Demand and MR for the Monopolist

The combined good and bad news yields the value of marginal revenue for the monopolist. When the bad news outweighs the good news, marginal revenue becomes negative.

2005 Prentice Hall Business Publishing

Survey of Economics, 2/e

OSullivan & Sheffrin

TR and MR for the Monopolist

Information from the demand curve (price and quantity sold) can be used to derive the total and marginal revenue curves.
Price ($)
P

Total Revenue

32

C o s t in $

24 16 8 0 0 1 2 3 Quantity sold 4 5 6

Quantity Sold
Q

P rice an d m arg in al reven u e

Total Revenue ($)

TR (PxQ) 0 14 24 30 32 30 24

Marginal Revenue ($)

TR Q

Demand and Marginal Revenue

14 12 10 8 6 4 2 0 -2 -4 -6 0 1 2 3 4 5 6

MR

16 14 12 10 8 6 4

0 1 2 3 4 5 6

14 10 6 2 -2 -6

Quantity sold

Demand
OSullivan & Sheffrin

Marginal Revenue

2005 Prentice Hall Business Publishing

Survey of Economics, 2/e

The Marginal Principle and the Output Decision

To decide how much output to produce and what price to charge, the monopolist can use the marginal principle.

Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.
2005 Prentice Hall Business Publishing Survey of Economics, 2/e OSullivan & Sheffrin

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The Marginal Rule for Profit Maximization

A firm maximizes profit by following the marginal principleby setting marginal revenue equal to marginal cost;

MR = MC
2005 Prentice Hall Business Publishing Survey of Economics, 2/e OSullivan & Sheffrin

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Computing Maximum Profit

Price
$18 17 16

Q
600 700 800

MR
$12 $11 $9

TR
$10,800 $11,900 $12,800

Revenue per Unit $18 $17 $16

TC
$5,710 $6,140 $6,635

MC
$4 $4 $5

ATC
$9.52 $8.77 $8.29

Profit (Total Approach $5,090 $5,760 $6,165

Profit Per Unit $8 $8 $8

Profit Per Unit Approach $5,090 $5,760 $6,165

15
14 13 12

900
1000 1100 1200

$7
$5 $3 $1

$13,500
$14,000 $14,300 $14,400

$15
$14 $13 $12

$7,20
$7,835 $8,560 $9,400

$6
$6 $7 $8

$8.00
$7.84 $7.78 $7.83

$6,300
$6,165 $5,740 $5,000

$7
$6 $5 $4

$6,300
$6,165 $5,740 $5,000

Marginal revenue is closest to marginal cost at 900 units of output.

Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

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The Output Decision

When the gap between total revenue and total cost is greatest, marginal revenue is roughly equal to marginal cost. The monopolist maximizes profit when it produces 900 units of output.
2005 Prentice Hall Business Publishing

MC
15 m

AC
8 6 c

n D
900 MR
13

Doses of Drug per hour

Survey of Economics, 2/e OSullivan & Sheffrin

The Costs of Monopoly

What are the trade-offs? The costs & benefits of monopoly to society as a whole? In many cases monopoly results from government policy;
If

the costs exceed the benefits , it may be sensible to remove barriers to entry; The benefits to consumers are measured by Consumer Surplus.
2005 Prentice Hall Business Publishing Survey of Economics, 2/e OSullivan & Sheffrin

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The demand Curve & Consumer Surplus

Consumer Surplus: The difference

between the maximum amount a consumer is willing to pay for a product and the price that he/she actually pays.

The consumer surplus is the area under the demand curve and above the market price. It is what consumers gain from their Purchases after deducting the cost.
2005 Prentice Hall Business Publishing Survey of Economics, 2/e OSullivan & Sheffrin

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The demand Curve & Consumer Surplus

Juan is willing to pay $22, so if the actual price is $10, his consumer surplus is $12

$25
Price ($ per lawn) $22 $19 $16 $13 $10 $7 Juan

Forest is willing to pay $13,his consumer surplus is $12

Tupak
Thurl Forest Fivola
Fivola is willing to pay $10,her consumer surplus is $0

Price Siggy

D
4 1 2 3 Number of Lawns cut per week 5 6

Siggy is willing to pay $7,he doesnt get his lawn cut

Total market Consumer surplus = $12+$9+$6+$3+$0=$30

OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

Survey of Economics, 2/e

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The Costs of Monopoly

To examine the social costs of monopoly, we start with a perfectly competitive market and then switch to a monopoly

2005 Prentice Hall Business Publishing

Survey of Economics, 2/e

OSullivan & Sheffrin

17

Monopoly Versus perfect Competition

Monopoly price is $18 and consumer surplus associated with this price is shown by triangle C. Switching from perfect competition to monopoly decreases consumer surplus by the areas R and D.

$
C
$18

Perfectly competitive price is $8, so the consumer surplus is shown by triangles C and D and rectangle R

R
$8

Only part of consumers loss is LRAC recovered by producers (Rectangle Demand R). The net loss to consumers &
400

200

Doses of Drug per hour

2005 Prentice Hall Business Publishing Survey of Economics, 2/e

society is triangle D (deadweight loss)

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18

Rent Seeking

Rent seeking is a term used to describe the efforts by a monopoly to persuade government to erect barriers to entry. If rent seeking exists, the monopoly may spend some of its potential profit on rent-seeking activity, and the net loss to society would be areas R and D, not just area D.

2005 Prentice Hall Business Publishing

Survey of Economics, 2/e

OSullivan & Sheffrin

19

The Costs and Benefits of Monopoly

Costs: a monopoly produces less output than a perfectly competitive market, and people waste resources trying to get and keep monopoly power. Benefits: a patent or license increases the payoff from research and development, thus encourages innovation.
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

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Natural Monopoly

A natural monopoly is a firm that serves the entire market at a lower cost than two or more firms can.

Examples of natural monopolies:

Public utilities (sewerage, water, and electricity generation) Transportation services (railroad freight and mass transit)
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

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Natural Monopoly

The long-run average cost of electricity generation is negatively sloped, reflecting large economies of scale. As long as the longrun average cost decreases, the longrun marginal cost must lie below it.
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

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Natural Monopoly

Given the structure of demand and marginal revenue, the monopoly maximizes profit by generating 3 thousand kilowatt hours.
Left alone, the monopoly will charge $8.20 and earn a profit of ($8.20-$6.20) = $2 per kilowatt hour (distance between points c and m).
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

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Natural Monopoly

Total profit equals (price average cost) x quantity produced and sold (the green area). Profit is possible only if there is one firm, unregulated, serving the entire market demand.

2005 Prentice Hall Business Publishing

Survey of Economics, 2/e

OSullivan & Sheffrin

24

Natural Monopoly

Suppose that the monopoly shared the market demand and output sold with a second firm, and that each firm produced half of the market output (1.5 kw/h). The cost of producing 1.5 kw/h would exceed the price the firms can receive, thus they would suffer losses.
Survey of Economics, 2/e OSullivan & Sheffrin

2005 Prentice Hall Business Publishing

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Price Controls for a Natural Monopoly

Under an average-cost pricing policy, the government picks a price equal to the average cost of production, or $5.20. But regulation gives the utility no incentive to control costs, so costs rise. Price after regulation decreases by less than anticipated.

2005 Prentice Hall Business Publishing

Survey of Economics, 2/e

OSullivan & Sheffrin

26