Monopoly Structure: Monopoly

Monopoly

Chapter 7Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

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Monopoly Structure: Monopoly

• Market power is the ability to alter the price of a good or service.

• A monopoly is one firm that produces the entire market supply of a particular good or service.

• Since there is only one firm in a monopoly industry, the firm is the industry.

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Monopoly = Industry

• The firm’s demand curve is identical to the market demand curve for the product.– Market demand is the total quantity of a

good or service people are willing and able to buy at alternative prices in a given time period.

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Price versus Marginal Revenue

• Marginal revenue (MR) is the change in total revenue that results from a one-unit increase in quantity sold.

• Price equals marginal revenue only for perfectly competitive firms.

• Marginal revenue is always less than price for a monopolist.

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• A monopolist can sell additional output only if it reduces prices.

• The MR curve lies below the demand curve at every point but the first.

Price versus Marginal Revenue

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Figure 7.1

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Profit Maximization

• The monopolist uses the profit-maximization rule to determine its rate of output.

• According to the rule, a monopolist maximizes profit at the rate of output where MR = MC.

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• The profit maximization rule applies to all firms:– A perfectly competitive firm produces the

quantity where MC = MR (= p)– A monopolist produces the quantity

where MC = MR (< p)

Profit Maximization

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Figure 7.2

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The Production Decision

• Choosing a rate of output is a firm’s production decision.

• It is the selection of the short-term rate of output (with existing plant and equipment).

• A monopolist finds the rate of output where the marginal revenue and marginal cost curves intersect.

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The Monopoly Price

• The intersection of the marginal revenue and marginal cost curves establishes the profit-maximizing rate of output.

• The demand curve tells us the highest price consumers are willing to pay for that specific quantity of output.

• Only one price is compatible with the profit-maximizing rate of output.

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Monopoly Profits

• Total profit equals profit per unit times the number of units produced.

• Profit per unit = price minus average total cost

Profit per unit = p – ATC

• Total profit = profit per unit times quantity

Total profit = (p – ATC) x qLO-3

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• Profit can also be calculated by subtracting total cost from total revenue:

Total profit = TR – TC

Monopoly Profits

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Monopoly versus Competitive Outcomes

• A monopolist produces less and charges a higher price than would a competitive industry.

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Figure 7.3

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Barriers to Entry

• Obstacles that make it difficult or impossible for would-be producers to enter a particular market.

• Examples include patents, legal harassment, exclusive licensing, bundled products, and government franchises.

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Patent Protection

• A patent is a government grant of exclusive ownership of an innovation.

• A patent is a source of monopoly power.– Polaroid’s patents forced Kodak out of the

instant-photography business.

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Legal Harassment

• Suing potential new entrants can deter entry into an industry.

• Lengthy legal battles are so expensive that the threat of legal action may deter entry into a monopolized market.

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Exclusive Licensing

• Lack of a license makes it difficult for potential competitors to acquire the factors of production they need.

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Bundled Products

• Forcing consumers to purchase complementary products thwarts competition.

• Bundling products makes it difficult for competitors to sell their products profitably.– Microsoft bundles software applications

with its Windows operating systems (although the European Union required Microsoft to offer alternatives to consumers). LO-4

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Government Franchises

• A monopoly granted by a government license.– These include local power, telephone, and

cable TV companies. – Another example is the U.S. Postal

Service, which has a monopoly in providing first-class mail.

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Comparative Outcomes

• A monopoly’s market power allows it to change the way the market responds to consumer demands.

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Competition versus Monopoly

• In competition, as well as in monopoly, high prices and profits signal consumers’ demand for more output.

• In competition, the high profits attract new suppliers.

• In monopoly, barriers to entry are erected to exclude potential competition.

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• In competition, production and supplies expand, and prices slide down the market demand curve.

• In monopoly, production and supplies are constrained, and prices don’t move down the market demand curve.

Competition versus Monopoly

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• In competition, a new equilibrium is established, and average costs of production approach their minimum.

• In monopoly, no new equilibrium is established, and average costs are not necessarily at or near a minimum.

Competition versus Monopoly

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• In competition, economic profits approach zero, and price equals marginal cost throughout the process.

• In monopoly, economic profits are at a maximum, and price exceeds marginal cost at all times.

Competition versus Monopoly

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• In competition, the profit squeeze pressures firms to reduce costs or improve product quality.

• In monopoly, there is no profit squeeze to pressure the firm to reduce costs or improve product quality.

Competition versus Monopoly

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Competition versus Monopoly

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Near Monopolies

• Two or more firms may rig the market to replicate monopoly outcomes and profits.

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• In duopoly two firms together produce the industry output.

• In oligopoly several firms dominate the market.

• In monopolistic competition many firms each have a monopoly on their own brand image but must still contend with competing brands.

Near Monopolies

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Redeeming Qualities of Monopolies?

Monopolies could also benefit society. We must consider:

• Research and Development

• Entrepreneurial Incentives

• Economies of Scale

• Natural Monopolies

• Contestable Markets

• Structure versus behavior LO-5

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Research and Development

• In principle, monopolies have a greater ability to pursue research and development. – They have the resources available to

invest in expensive R&D functions.

• However, they have no clear incentive for invention and innovation, and can continue to make profits by maintaining market power.

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Entrepreneurial Incentives

• The promise of even greater profits is a strong incentive for monopolies to innovate.

• Innovators in perfect competition also have the ability to earn large profits.

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Economies of Scale

• Economies of scale are present if average costs fall as the size (scale) of plant and equipment increases.

• A large firm can produce goods at a lower unit cost than can a small firm because of economies of scale.

• Consumers may not benefit from the lower costs if the monopolist doesn’t lower its prices.

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Natural Monopoly

• A natural monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply. – Examples include local telephone, cable,

and utility services.

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Contestable Markets

• A contestable market is an imperfectly competitive industry subject to potential entry if prices or profits increase.

• How contestable a market is depends not so much on its structure as it does on its barriers to entry.

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Structure versus Behavior

• If potential rivals force a monopolist to behave like a competitive firm, then monopoly imposes no cost on consumers or on society at large.

• The experience with the Model T suggests that potential competition can force a monopoly to change its ways.

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Flying Monopoly Air

• Market structure explains why it can be cheap to fly to one place and expensive to fly somewhere else of equal distance.

• From a national perspective, the airline industry looks pretty competitive.

• However, all of these companies do not fly to the same places.

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Industry Behavior

• Air fares from airports dominated by one or two carriers are 45 – 85% higher than at more competitive airports.

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Entry Effects

• How fares change when airlines enter or exit a specific market can be used to assess the impact of market structure on prices.

• American Airlines cut its fares when low-cost carriers entered a market it dominated—then raised them when the low-cost carriers left.

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• Predatory pricing – temporary price reductions designed to drive out competition.

Entry Effects

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Barriers to Entry

• One of the most formidable entry barriers to the airline industry is the ownership of landing rights and gates.

• At Washington, D.C.’s National Airport, the six largest carriers owned 97 percent of available takeoff/landing slots in 2000.

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• To offer service from that airport, a new entrant would have to buy or lease a slot from one of these firms.

• If existing firms are unwilling to sell or lease their slots, then competition is thwarted.

Barriers to Entry

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End of Chapter 7