CH 15: MonopolyLecture

Characteristics of Monopolies

• A monopoly is a market structure in which one firm makes up the entire market

• Firm=Industry

Characteristics of Monopolies

• The monopolist is a price maker

• There are no close substitutes for the good the monopolist produces

• Barriers to entry exist and prevent competition

• If there were no barriers to entry, profit-maximizing firms would always compete away profits

Barriers to Entry

• 1. Geography

• Location or control of resources limits competition and leads to one supplier

• 2. Government

• Government allows monopolies for public benefits or to stimulate innovation

• Think water/sewer system

Barriers to Entry

• 3. Technology or Common Use

• Patents and widespread availability of certain products lead to only one major firm controlling a market

• Example: Medicine

• 4. Mass Production and Low Costs

• If there were three competing electric companies they would have higher costs

• Having only one electric company keeps prices low

Profit Maximizing Level of Output

• The goal of the monopolistic firm is to maximize profits (difference between total revenue and total cost)

• The profit-maximizing condition of a monopolistic firm is: MC = MR

Profit Maximizing Level of Output

• For a monopolistic firm, MR < P (ALWAYS)

• This is because to sell more units a monopolist has to lowerits price

• A monopoly maximizes total profit, not profit per unit

• When marginal revenue is zero, a monopolist has maximized total revenue

Profit Maximizing Level of Output

• If MR > MC,

• The monopoly can increase profit by increasingoutput

• If MR < MC,

• The monopoly can increase profit by decreasing its output

Q

$15

10

5

$64

40

20

TR

D

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18Q

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

MR

Demand and Marginal Revenue Curves

What happens to TR when MR hits zero?

Total Revenue is at its peak when MR

hits zero

P

TR

Drawing the Monopoly Graph

• The demand curve is always downward sloping and represents the market demand curve

• Draw your MC curve

• The MR curve starts at the same point on the price axis as does P

• The MR curve bisects the demand curve

Drawing the Monopoly Graph

• The output (Q) the monopolist will produce is where MC=MR

• Put a dot where MC=MR and take the point down to the Q axis

Drawing the Monopoly Graph

• Determine the price the monopolist will charge

• Take the point where MC=MR and draw a dotted line up to the demand curve

• Draw a dotted line to the price axis (price is always derived from the demand curve)

Drawing the Monopoly Graph

• Determine profit or loss

• Subtract ATC from price at that level of output and multiply by the output

• (P-ATC)*Q

Drawing the Monopoly Graph

• If price is greater than ATC (P>ATC) at this output, the monopolist will make a profit

• If price equals ATC (P=ATC), the monopolist will not make a profit (zero profit/loss)

• If price is less than ATC (P

Graph: Monopolist Earning a Profit

• Find the output where MC = MR (profit maximizing quantity)

• Find how much consumers will pay; this is where the profit max Q intersects demand and is the monopolists’ price

• Find profit per unit where the profit max Q intersects ATC

Graph: Monopolist Earning a Profit

• Extend the lines from where the quantity line intersects the demand curve and the ATC to the price axis

• This rectangle is the monopolists’ profit

• Since P>ATC at the profit maximizing quantity, this firm is earning a profit

Draw the Graph: A Monopoly Earning a Profit

Since P>ATC at the profit maximizing quantity, this firm is earning profits

Find output where MC = MR, this is the profit

maximizing Q

Find profit per unit where the profit max Q

intersects ATC

Find how much consumers will pay where the profit max Q intersects demand, this is

the monopolist price Profit

Q

P

ATC

Qprofit max

P1

MC

DMR

Graph: A Monopoly with a Loss

• Find output where MC = MR (profit maximizing Q)

• Find how much consumers will pay; this is where the profit max Q intersects demand and is the monopolists’ price

• Find profit per unit where the profit max Q intersects ATC

• Since P

Draw the Graph: A Monopoly with a Loss

Find output where MC = MR, this is the profit

maximizing Q

Find profit per unit where the profit max Q

intersects ATC

Find how much consumers will pay where the profit max Q intersects demand, this is

the monopolist price

Since P

Price

Quantity

Demand

Marginal Revenue

Inelastic range

Elastic Range

Price

Quantity

Total Revenue

Note that in the inelastic range of the demand curve, MR is negative and TR falls as Q increases.

A monopoly will only produce in the

elastic range

Total Revenue TestIf price falls and TR

increases, then demand is elastic.

If price falls and TR falls, then demand is inelastic.

So, when MR is zero, demand is unit elastic

Monopoly: Elastic and Inelastic Range

Are Monopolies Efficient?

• No, they are inefficient by nature

• They charge a higher price

• They under produce and are not allocatively efficiency

• They produce at higher costs and are not productively efficiency

Socially Optimal Level (Allocatively Efficient) for a Monopoly

•Socially optimal (allocatively efficient) is where MC=D

•This is where CS and PS is maximized

Q

P

ATC

Q1

P1

MC

DMR

SO/AEPSO

QSO

Socially Optimal Level (Allocatively Efficient) for a Monopoly

• The government could institute a price ceiling here to force the monopolist to produce at SO/AE: this would create a lossfor the monopolist

• The government would have to offer a subsidy to the monopolist to produce at SO

Fair Return Level for a Monopoly

•Fair return is when the government regulates price with a price ceiling

•This is where D=ATC and where TR=TC (no economic profit)

Q

P

ATC

Q1

P1

MC

DMR

FRPFR

QFR

Monopolies Compared to Perfect Competition

• A monopolistic firm’s MR is not its price

• MR is always below its price

• To sell more units, a monopolist has to decrease its price—this makes the MR curve less than demand

• Monopolies create DWL

Monopoly and Perfect Competition

Let’s compare where perfect competitors produce and where monopolists produce

Profit

Q

P

ATC

Qprofit max

P1

MC

DMR

MC

Q

P

ATC

P = D = MR = AR

Qprofit max

P1 Profit

Monopoly Graph Compared to Perfect Competition Graph

Result: Monopoly output is lower, and price is higher, than perfect

competition

• In a monopoly, P>MR, • In perfect competition, P=MR=D• MR=MC is the profit max rule for

both

First find the monopoly Q and P

Then find the perfectly competitive Q and P

MC

Q

P

DM

QM

PM

MRM

PPC

QPC

DPC= MRPC

Why does a monopoly have DWL?

• Because a monopoly charges a higher price and produces a lower quantity than a perfect competitor

• Monopolies are allocatively inefficient

• The welfare loss (DWL) from a monopoly is represented by the blue triangles

• To maximize CS and PS, a monopolist would have to produce where MC=D

CS, PS, and DWL for a Monopoly

MC

Q

P

D

QM

PM

MR

DWL

CS

PS

Lump-sum vs. Per-unit Subsidies and Taxes

• A lump-sum tax (or subsidy) occurs one time

• It affects fixed costs: AFC and ATC

• A per-unit tax (or subsidy) is added to every unit produced

• It affects variable costs: AVC, ATC, and MC

(Learn and know these!)

Lump-sum vs. Per-unit Tax

• If a monopoly is earning a profit, the government could institute a lump-sum or per-unit tax

• A lump-sum tax would affect fixed costs (AFC and ATC) and not MC, so it would not alter the profit maximizing P and Q

• It would decrease profit

Lump-sum vs. Per-unit Tax

• A per-unit tax would affect variable costs (AVC, ATC, and MC), so it would alter the profit maximizing P and Q

• It would shift MC up (to the left)

• Q would decrease and P would increase

• It would decrease profit

Lump-sum vs. Per-unit Subsidy

• If a monopoly is earning a loss, the government could institute a lump-sum or per-unit subsidy

• A lump-sum subsidy would affect fixed costs (AFC and ATC) but not MC, so it would not alter the profit maximizing P and Q

• It would not impact DWL

Lump-sum vs. Per-unit Subsidy

• A per-unit subsidy would affect variable costs (AVC, ATC, and MC), so it would alter the profit maximizing P and Q

• Q would increase and P would decrease

• MC would shift down (to the right) and would allow the firm to produce where MC=D (where a perfect competitor would produce)

The Price-Discriminating Monopolist

• All of the graphs you just learned are for unregulatedmonopolies

• When a monopolist price discriminates, it charges different prices to different individuals (or groups of individuals)

The Price-Discriminating Monopolist

• Consumers with less elastic demands are charged higher prices

• Consumers with more elastic demands are charged lower prices

• Price discrimination increases output and profits

Graph: The Price-Discriminating Monopolist

•D and MR are the same

•Q is where it would be for a perfect competitor, where MC=MR

•P, is anywhere on the demand curve because those willing to pay a higher price will

•There is no CS

MC

Q

P

D=MR

QM

ATCProfit

Natural Monopoly

• Natural monopoly is when a single firm can produce at a lower cost than can two or more firms

• Significant economies of scale exist —more than one firm would prevent the monopolist from taking advantage of economies of scale

• There is no DWL

Natural Monopoly

• If demand intersects ATC while demand is downward sloping, we can conclude the industry is a natural monopoly

• If a firm charges at its profit maximizing point, where MC=MR, it is charging much higher than the socially optimalprice (where MC=D)

• It also restricts its output (or under produces)

Natural Monopoly

• How can society achieve a socially optimal level with a natural monopoly?

• The government can intervene with price controls and subsidies

Natural Monopoly

• A price control instituted at the socially optimal price would cause the firm to earn economic losses and shutdown

• A monopolist needs a per-unit subsidy to be able to produce the socially optimal level

• The natural monopoly is then referred to as a regulatedmonopoly

A Natural Monopoly Graph, Profit and Regulation

• A natural monopolist produces QM and charges PM, therefore earning a profit

• If there is government regulation and a competitive solution where P = MC is required, the monopolist produces QC and charges PC, therefore earning a loss

Q

Average Cost

CC

QCQM

CM

ATC

DMR MC

PM

PC

Profits

Losses

Natural Monopoly

Q

QSOQ profit max

ATC

D

MR

MC

P profit max

PSO

P

Natural Monopoly

Q

QSOQ profit max

ATC

D

MR

MC

P profit max

PG

The government would institute a price control at PG (a price ceiling) and then subsidize the firm to reduce MC

Natural Monopoly

• What happens is this: MC and ATC shift down into the negative revenue range of the graph and the government subsidizes the firm to produce at the socially optimal level

• See next graph: I don’t think you will ever see this on the AP exam, but this is what the graph would look like

Natural Monopoly Graph

QQSO

Q

profit max

ATC

DMR

MC

P profit max

PG

MC2 with subsidyATC2

Chapter Summary

• Monopoly is a market structure, protected by barriers to entry, in which a

single firm produces a product for which there are no close substitutes

• A monopolist maximizes profit or minimizes losses where MR=MC

• To determine a monopolist’s profit or loss:

• Find output where MR=MC

• Determine price and ATC at that output

• Profit or loss = (P – ATC) * Q

Chapter Summary

• Monopoly output is lower and price is higher than in competitive markets

• Because monopolies reduce output and charge P > MC, monopolies create a

welfare loss for society

• A price-discriminating monopolist earns more profit than a normal monopolist

by charging a higher price to those with less elastic demand and a lower price

to those with more elastic demand

• Natural monopolies exist in industries with strong economies of scale, so it is more efficient for one firm to produce the entire output

• In a natural monopoly the competitive outcome where P=MC results in losses