Copyright 2008 The McGraw-Hill Companies 22-1 10 Pure Monopoly.

Copyright 2008 The McGraw-Hill Companies22-1

10

Pure Monopoly


Learning objectivesLearning objectives • In this chapter students will learn:In this chapter students will learn:

A.A. The characteristics of pure monopoly.The characteristics of pure monopoly.B.B. How a pure monopoly sets its profit-maximizing How a pure monopoly sets its profit-maximizing output and price.output and price.C.C. About the economic effects of monopoly.About the economic effects of monopoly.D.D. Why a monopolist might prefer to charge different Why a monopolist might prefer to charge different prices in different marketsprices in different markets.


Pure Monopoly: An IntroductionPure Monopoly: An IntroductionDefinitionDefinition: Pure monopoly exists when a single firm is the : Pure monopoly exists when a single firm is the sole sole

producerproducer of a product for which there are of a product for which there are no close substitutesno close substitutes..• There are a number of products where the producers have a There are a number of products where the producers have a

substantial amount of monopoly power and are called “substantial amount of monopoly power and are called “nearnear” ” monopoliesmonopolies..

• There are several characteristics that distinguish pure There are several characteristics that distinguish pure monopoly:monopoly:

1.1. There is a There is a single sellersingle seller so the firm and industry are so the firm and industry are synonymous (the same).synonymous (the same).

2.2. There are There are no close substitutesno close substitutes for the firm’s product. for the firm’s product.3.3. The firm is a “The firm is a “price makerprice maker” that is, the firm has considerable ” that is, the firm has considerable

control over the price because it can control the quantity control over the price because it can control the quantity supplied.supplied.

4.4. Entry into the industry by other firms is Entry into the industry by other firms is blockedblocked..5.5. A monopolist may or may not engage in A monopolist may or may not engage in nonprice competitionnonprice competition. .

Depending on the nature of its product, a monopolist may Depending on the nature of its product, a monopolist may advertise to increase demand.advertise to increase demand.


Barriers to Entry Limiting Competition:Barriers to Entry Limiting Competition:

1.1. Economies of scaleEconomies of scale constitute one major barrier. This constitute one major barrier. This occurs where the lowest unit costs and, therefore, lowest occurs where the lowest unit costs and, therefore, lowest unit prices for consumers depend on the existence of a unit prices for consumers depend on the existence of a small number of large firms or, in the case of a pure small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm with a monopoly, only one firm. Because a very large firm with a large market share is large market share is most efficientmost efficient, new firms cannot , new firms cannot afford to start up in industries with economies of scaleafford to start up in industries with economies of scale

2.2. Public utilitiesPublic utilities are often natural monopolies because they are often natural monopolies because they have economies of scale in the extreme case where one have economies of scale in the extreme case where one firm is firm is most efficientmost efficient in satisfying existing demand (two or in satisfying existing demand (two or more firms will lead to higher ATC).more firms will lead to higher ATC).

• Government usually gives one firm the right to operate a Government usually gives one firm the right to operate a public utility industry in exchange for public utility industry in exchange for government regulationgovernment regulation of its power.of its power.


Ave

rage

Tot

al C

ost

Quantity

$20

15

10

0 50 100 200

ATCIf ATC declines over extended output, least-cost production is realized only if there is one producer - a natural monopoly

THE NATURAL MONOPOLY CASE


• The explanation of why more than one firm would be The explanation of why more than one firm would be inefficient involves the description of the inefficient involves the description of the maze of pipesmaze of pipes or or wireswires that would result if there were competition among that would result if there were competition among water companies, electric utility companies, etc.water companies, electric utility companies, etc.

3.3. Legal barriersLegal barriers to entry into a monopolistic industry also to entry into a monopolistic industry also exist in the form of patents and licenses.exist in the form of patents and licenses.

a)a) PatentsPatents grant the inventor the exclusive right to produce or grant the inventor the exclusive right to produce or license a product for twenty years; this exclusive right can license a product for twenty years; this exclusive right can earn profits for future research, which results in more earn profits for future research, which results in more patents and monopoly profits.patents and monopoly profits.

b)b) LicensesLicenses are another form of entry barrier. Radio and TV are another form of entry barrier. Radio and TV stations are examples of government granting licenses stations are examples of government granting licenses where only one or a few firms are allowed to offer the where only one or a few firms are allowed to offer the service.service.


c)c) Ownership or controlOwnership or control of essential resources is another of essential resources is another barrier to entry.barrier to entry.

• International Nickel Co. of Canada (now called Inco) International Nickel Co. of Canada (now called Inco) controlled about 90 percent of the world’s nickel reserves, controlled about 90 percent of the world’s nickel reserves, and DeBeers of South Africa controls most of the world’s and DeBeers of South Africa controls most of the world’s diamond supplies.diamond supplies.

• Aluminum Co. of America (Alcoa) once controlled all basic Aluminum Co. of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication.sources of bauxite, the ore used in aluminum fabrication.

• Monopolists may use pricingMonopolists may use pricing or other or other strategic barriersstrategic barriers such as selective price-cutting and advertising.such as selective price-cutting and advertising.

• Dentsply, manufacturer of false teeth, controlled about 70 Dentsply, manufacturer of false teeth, controlled about 70 percent of the market. In 2005 Dentsply was found to have percent of the market. In 2005 Dentsply was found to have illegally prevented distributors from carrying competing illegally prevented distributors from carrying competing brands.brands.

• Microsoft charged higher prices for its Windows operating Microsoft charged higher prices for its Windows operating system to computer manufacturers featuring Netscape system to computer manufacturers featuring Netscape Navigator instead of Microsoft’s Internet Explorer. U.S. Navigator instead of Microsoft’s Internet Explorer. U.S. courts ruled this action illegal.courts ruled this action illegal.


• Monopoly demandMonopoly demand is the industry (market) demand and is is the industry (market) demand and is therefore therefore downward slopingdownward sloping..

• Our analysis of monopoly demand makes three Our analysis of monopoly demand makes three assumptions:assumptions:

1.1. The monopoly is The monopoly is securedsecured by patents, economies of scale, by patents, economies of scale, or resource ownership.or resource ownership.

2.2. The firm is The firm is not regulatednot regulated by any unit of government. by any unit of government.3.3. The firm is a The firm is a single‑pricesingle‑price monopolist; it charges the same monopolist; it charges the same

price for all units of output.price for all units of output.

• Price will exceed marginal revenuePrice will exceed marginal revenue because the because the monopolist monopolist must lowermust lower the price to sell the additional unit. the price to sell the additional unit. The added revenue (MR) will be the The added revenue (MR) will be the priceprice of the last unit of the last unit less the sum of the less the sum of the price cutsprice cuts which must be taken on all which must be taken on all prior units of output.prior units of output.

• The marginal-revenue curve is The marginal-revenue curve is below below the demand curve, the demand curve, and when it becomes negative, the total-revenue curve and when it becomes negative, the total-revenue curve turns downward as total-revenue falls.turns downward as total-revenue falls.


0 1 2 3 4 5 6

$142

132

122

112

102

92

82

Price and Marginal RevenueMarginal Revenue is Less Than Price

D

• A Monopolist isSelling 3 Units at$142

• To Sell More (4), Price Must BeLowered to $132

• All Customers Must Pay the SamePrice

• TR Increases $132 Minus $30 (3x$10)

Gain = $132

Loss = $30


0 1 2 3 4 5 6

$142

132

122

112

102

92

82

Price and Marginal RevenueMarginal Revenue is Less Than Price

D

• A Monopolist isSelling 3 Units at$142

• To Sell More (4), Price Must BeLowered to $132

• All Customers Must Pay the SamePrice

• TR Increases $132 Minus $30 (3x$10)

• $102 Becomes a Point on the MR Curve

• Try Other Prices toDetermine Other MR Points

Gain = $132

Loss = $30

The Constructed Marginal Revenue CurveMust Always Be Less Than the Price

MR


• The monopolist is a price makerThe monopolist is a price maker. The firm controls output . The firm controls output and price but and price but is not free of market forcesis not free of market forces, since the , since the combination of output and price that can be sold depends combination of output and price that can be sold depends on on demanddemand. For example, Table 22.1 shows that at $162 . For example, Table 22.1 shows that at $162 only 1 unit will be sold, at $152 only 2 units will be sold, etc.only 1 unit will be sold, at $152 only 2 units will be sold, etc.

• Price elasticityPrice elasticity also plays a role in monopoly price setting. also plays a role in monopoly price setting. The total revenue test shows that the monopolist The total revenue test shows that the monopolist will avoidwill avoid the inelasticthe inelastic segment of its demand schedule. As long as segment of its demand schedule. As long as demand is elastic, total revenue will rise when the monopoly demand is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true when demand lowers its price, but this will not be true when demand becomes inelastic. At this point, total revenue falls as becomes inelastic. At this point, total revenue falls as output expands, and since total costs rise with output, output expands, and since total costs rise with output, profits will decline as demand becomes inelastic. Therefore, profits will decline as demand becomes inelastic. Therefore, the monopolist will expand output only in the the monopolist will expand output only in the elastic portionelastic portion of its demand curve. of its demand curve.


• Output and Price DeterminationOutput and Price Determination

• Cost data is based on hiring resources in competitive Cost data is based on hiring resources in competitive markets, so the cost data of Chapters 20 and 21 can be markets, so the cost data of Chapters 20 and 21 can be used in this chapter as well. used in this chapter as well.

• The MR = MC ruleThe MR = MC rule will tell the monopolist where to find its will tell the monopolist where to find its profit‑maximizing outputprofit‑maximizing output level. The same result can be found level. The same result can be found by comparing total revenue and total costs incurred at each by comparing total revenue and total costs incurred at each level of production.level of production.

• The pure monopolist The pure monopolist has no supplyhas no supply curve because there is curve because there is no unique relationship between price and quantity supplied. no unique relationship between price and quantity supplied. The price and quantity supplied will always depend on The price and quantity supplied will always depend on location of the demand curve.location of the demand curve.


Monopoly Revenue and CostsRevenue and Cost Data of a Pure Monopolist

(1)Quantity

Of Output

(2)Price

(AverageRevenue)

(3)Total

Revenue(1) X (2)

(4)MarginalRevenue

(5)Average

Total Cost

(6)Total Cost

(1) X (5)

(7)Marginal

Cost

(8)Profit (+)

or Loss (-)

0123456789

10

$172162152142132122112102928272

$0162304426528610672714736738720

$16214212210282624222

2-18

$190.00135.00113.33100.0094.0091.6791.4393.7597.78

103.00

$100190270340400470550640750880

1030

$90807060708090

110130150

$-100-28+34+86

+128+140+122

+74-14

-142-310

Revenue Data Cost Data

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Can you See Profit Maximization?


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Monopoly Revenue and CostsDemand, Marginal Revenue, and Total Revenue for a Pure

MonopolistElastic Inelastic

Demand and Marginal Revenue Curves

Total-Revenue Curve

DMR

TR


Profit Maximization

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ATC

MC

MR=MC

Pm=$122

A=$94

EconomicProfit


Loss Minimization

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MR=MC

Loss

AVCPm

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A


• There are several There are several misconceptionsmisconceptions about monopoly about monopoly prices.prices.

1.1. Monopolist cannot charge the highest priceMonopolist cannot charge the highest price it can get, it can get, because it will maximize profits where total revenue minus because it will maximize profits where total revenue minus total cost is greatest. This depends on quantity sold as total cost is greatest. This depends on quantity sold as well as on price and will never be the highest price well as on price and will never be the highest price possible.possible.

2.2. Total, not unit, profitsTotal, not unit, profits is the goal of the monopolist. Once is the goal of the monopolist. Once again, quantity must be considered as well as again, quantity must be considered as well as unit profitunit profit..

3.3. Unlike the purely competitive firm, the pure monopolist Unlike the purely competitive firm, the pure monopolist can can continue to receive economic profits in the long runcontinue to receive economic profits in the long run. . Although losses can occur in a pure monopoly in the short Although losses can occur in a pure monopoly in the short run (P>AVC), the less-than-profitable monopolist will run (P>AVC), the less-than-profitable monopolist will shutdownshutdown in the long run (P>ATC). in the long run (P>ATC).


Evaluation of the Economic Effects of a MonopolyEvaluation of the Economic Effects of a Monopoly• Price, output, and efficiency of resource allocation should be Price, output, and efficiency of resource allocation should be

considered.considered.• Monopolies will sell a smaller outputMonopolies will sell a smaller output and charge a and charge a higher higher

priceprice than would competitive producers selling in the same than would competitive producers selling in the same market, i.e., assuming similar costs.market, i.e., assuming similar costs.

• Monopoly Monopoly price will exceed marginal costprice will exceed marginal cost, because it , because it exceeds marginal revenue and the monopolist produces exceeds marginal revenue and the monopolist produces where marginal revenue and marginal cost are equal. The where marginal revenue and marginal cost are equal. The monopolist charges the price that consumers will pay for that monopolist charges the price that consumers will pay for that output level.output level.

• Allocative efficiency is not achievedAllocative efficiency is not achieved because price (what because price (what product is worth to consumers) is above marginal cost product is worth to consumers) is above marginal cost (opportunity cost of product). Ideally, output should expand (opportunity cost of product). Ideally, output should expand to a level where price = marginal revenue = marginal cost, to a level where price = marginal revenue = marginal cost, but this will occur only under pure competitive conditions but this will occur only under pure competitive conditions where price = marginal revenue. (See Figure 22.6)where price = marginal revenue. (See Figure 22.6)


Economic Effects of MonopolyPrice, Output, and Efficiency

PurelyCompetitive

Market

PureMonopoly

D D

S=MC MC

P=MC=Minimum

ATC

MR

Pc

Qc

Pc

Pm

QcQm

Pure Competition is Efficient. Monopoly Price is Greater Than MC And Is Therefore Inefficient

a

b

c

P = MC P > MC


• Productive efficiency is not achievedProductive efficiency is not achieved because the because the monopolist’s output is less than the output at which average monopolist’s output is less than the output at which average total cost is minimum.total cost is minimum.

• The efficiency (or deadweight) lossThe efficiency (or deadweight) loss is also reflected in the is also reflected in the sum of consumer and producer surplus equaling sum of consumer and producer surplus equaling less than less than the maximum possible valuethe maximum possible value..

• Income distribution is more unequalIncome distribution is more unequal than it would be under a than it would be under a more competitive situation. The effect of the monopoly more competitive situation. The effect of the monopoly power is to power is to transfer income from the consumers to the transfer income from the consumers to the business ownersbusiness owners. This will result in a redistribution of income . This will result in a redistribution of income in favor of higher-income business owners, unless the in favor of higher-income business owners, unless the buyers of monopoly products are wealthier than the buyers of monopoly products are wealthier than the monopoly owners.monopoly owners.


Assessment and policy options:Assessment and policy options:• Although there are legitimate concerns of the effects of Although there are legitimate concerns of the effects of

monopoly power on the economy, monopoly power on the economy, monopoly power is not monopoly power is not widespreadwidespread. While . While research and technologyresearch and technology may strengthen may strengthen monopoly power, overtime it is monopoly power, overtime it is likely to destroylikely to destroy monopoly monopoly position.position.

• When monopoly power is resulting in an adverse effect upon When monopoly power is resulting in an adverse effect upon the economy, the government may choose to the economy, the government may choose to interveneintervene on a on a case-by-case basiscase-by-case basis

Price discriminationPrice discrimination • occurs when a given product is sold at more than one price occurs when a given product is sold at more than one price

and the price differences are not based on and the price differences are not based on cost differencescost differences. . Price discrimination can take three forms:Price discrimination can take three forms:

1.1. Charging each customer in a Charging each customer in a singlesingle market the market the maximum pricemaximum price he or she is willing to pay.he or she is willing to pay.

2.2. Charging each customer Charging each customer one priceone price for the for the first setfirst set of units of units purchased, and a purchased, and a lower pricelower price for subsequent units. for subsequent units.

3.3. Charging one Charging one groupgroup of customers of customers one priceone price, and another , and another group a different price.group a different price.


Conditions needed for successful price discrimination:Conditions needed for successful price discrimination:1.1. Monopoly powerMonopoly power is needed with the ability to control output is needed with the ability to control output

and price.and price.2.2. The firm must have the The firm must have the ability to segregateability to segregate the market, to the market, to

divide buyers into separate classes that have a different divide buyers into separate classes that have a different willingness or ability to pay for the product (usually based on willingness or ability to pay for the product (usually based on differing elasticities of demand).differing elasticities of demand).

3.3. Buyers must be Buyers must be unable to resellunable to resell the original product or the original product or service.service.

Examples of price discriminationExamples of price discrimination::1.1. Airlines charge high fares to Airlines charge high fares to executive travelersexecutive travelers (inelastic (inelastic

demand) than demand) than vacation travelersvacation travelers (elastic demand). (elastic demand).2.2. Electric utilities frequently segment their markets by end uses, Electric utilities frequently segment their markets by end uses,

such as such as lighting and heatinglighting and heating. (Lack of substitutes for lighting . (Lack of substitutes for lighting makes this demand inelastic).makes this demand inelastic).

3.3. Long‑distance phoneLong‑distance phone service has higher rates during the day, service has higher rates during the day, when businesses must make their calls (inelastic demand), when businesses must make their calls (inelastic demand), and lower rates at night and on week‑ends, when less and lower rates at night and on week‑ends, when less important calls are made.important calls are made.


4.4. Discount couponsDiscount coupons are a form of price discrimination, are a form of price discrimination, allowing firms to offer a discount to allowing firms to offer a discount to price-sensitiveprice-sensitive customers.customers.

5.5. International tradeInternational trade has examples of firms selling at different has examples of firms selling at different prices to customers in different countries.prices to customers in different countries.

Regulated MonopolyRegulated Monopoly• This occurs where a natural monopoly or economies of This occurs where a natural monopoly or economies of

scale make scale make one firm desirableone firm desirable..• As a result of changes in technology and deregulation in the As a result of changes in technology and deregulation in the

local telephone and the electricity-providers industry, some local telephone and the electricity-providers industry, some states are allowing new entrants to compete in previously states are allowing new entrants to compete in previously regulated markets.regulated markets.

• In those markets that are still regulated, a regulatory In those markets that are still regulated, a regulatory commission may attempt to establish the commission may attempt to establish the legal pricelegal price for the for the monopolist that is equal to marginal cost at the quantity of monopolist that is equal to marginal cost at the quantity of output chosen. This is called the “socially optimal price.output chosen. This is called the “socially optimal price.


0

Pric

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(Dol

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)

Quantity

Regulated MonopolyDilemma of Regulation

MonopolyPrice

Fair-ReturnPrice

SociallyOptimal

Price

Pr

Dr

f

b

aPf

Pm

Qm Qf Qr

MR

MC

ATC


• However, setting price equal to marginal cost may However, setting price equal to marginal cost may causecause losseslosses, because public utilities must invest in enough fixed , because public utilities must invest in enough fixed plant to handle peak loads. Much of this fixed plant goes plant to handle peak loads. Much of this fixed plant goes unused most of the timeunused most of the time, and a price = marginal cost would , and a price = marginal cost would be below average total cost. Regulators often choose a be below average total cost. Regulators often choose a price equal to average costprice equal to average cost rather than marginal cost, so that rather than marginal cost, so that the monopoly firm can achieve a “the monopoly firm can achieve a “fair returnfair return” and avoid ” and avoid losses. (Recall that average-total cost includes an losses. (Recall that average-total cost includes an allowance for a normal or “fair” profit)allowance for a normal or “fair” profit)

• The dilemma for regulators is whether to choose a socially The dilemma for regulators is whether to choose a socially optimal price, where P = MC, or a fair‑return price, where P optimal price, where P = MC, or a fair‑return price, where P = AC. P = MC is = AC. P = MC is most efficientmost efficient but may but may result in lossesresult in losses for for the monopoly firm, and government then would have to the monopoly firm, and government then would have to subsidizesubsidize the firm for it to survive. P = AC does not achieve the firm for it to survive. P = AC does not achieve allocative efficiencyallocative efficiency, but does insure a fair return (normal , but does insure a fair return (normal profit) for the firm. profit) for the firm.


• LAST WORD:LAST WORD: De Beers’ Diamonds: Are Monopolies De Beers’ Diamonds: Are Monopolies Forever?Forever?

• De Beers Consolidated Mines of South Africa has been one De Beers Consolidated Mines of South Africa has been one of the world’s strongest and most enduring monopolies. It of the world’s strongest and most enduring monopolies. It produces about 45 percent of all rough-cut diamonds in the produces about 45 percent of all rough-cut diamonds in the world and buys for resale many of the diamonds produced world and buys for resale many of the diamonds produced elsewhere, for a total of about 55 percent of the world’s elsewhere, for a total of about 55 percent of the world’s diamonds.diamonds.

• Its behavior and results fit the monopoly model portrayed in Its behavior and results fit the monopoly model portrayed in Figure 22.4. It sells a limited quantity of diamonds that will Figure 22.4. It sells a limited quantity of diamonds that will yield an “appropriate” monopoly price.yield an “appropriate” monopoly price.

• The “appropriate” price is well over production costs and has The “appropriate” price is well over production costs and has earned substantial economic profits.earned substantial economic profits.

• How has De Beers controlled the production of mines it How has De Beers controlled the production of mines it doesn’t own?doesn’t own?

1.1. It convinces producers that “single-channel” monopoly It convinces producers that “single-channel” monopoly marketing is in their best interestsmarketing is in their best interests


2.2. Mines that don’t use De Beers may find the market flooded Mines that don’t use De Beers may find the market flooded from De Beers stockpiles of the particular kind of diamond from De Beers stockpiles of the particular kind of diamond they produce, which causes price declines and loss of they produce, which causes price declines and loss of profits.profits.

3.3. Finally, De Beers purchases and stockpiles diamonds Finally, De Beers purchases and stockpiles diamonds produced by independentsproduced by independents

Threats and problems face De Beers’ monopoly power.Threats and problems face De Beers’ monopoly power.1.1. New diamond discoveries have resulted in more diamonds New diamond discoveries have resulted in more diamonds

outside their control.outside their control.2.2. Russia, which has been a part of De Beers’ monopoly, has Russia, which has been a part of De Beers’ monopoly, has

agreed to sell progressively larger quantities directly to the agreed to sell progressively larger quantities directly to the world market rather than through De Beers.world market rather than through De Beers.

• In mid-2000, De Beers abandoned its attempt to control the In mid-2000, De Beers abandoned its attempt to control the supply of diamonds.supply of diamonds.

• The company is transforming itself into a company that sells The company is transforming itself into a company that sells “premium” diamonds and luxury goods under the De Beers “premium” diamonds and luxury goods under the De Beers label.label.

• De Beers plans to reduce its stockpile of diamonds and De Beers plans to reduce its stockpile of diamonds and increase the demand for diamonds through advertisingincrease the demand for diamonds through advertising.

Copyright 2008 The McGraw-Hill Companies 22-1 10 Pure Monopoly.

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