Monopoly decisions

©2001Claudia Garcia-Szekely 1

Imperfect Competition Occurs when firms in a market or

industry have some control over the price of their output

Monopoly, Oligopoly, and Monopolistic Competition


Pure MonopolyAn industry with a single firm that produces a product for which there are no close substitutes, andin which significant barriers to entry prevent other firms from entering the industry to compete for profits.


Barriers to EntryGovernment franchises

Patents and Copyright laws

Economies of scale and other cost advantages

Natural Monopoly (Water, electricity)

Ownership of a scarce factor of productionThe De Beers Diamond Company


Firms in a Perfectly Competitive Market Take the market price as a given and decide:

How much output to produceHow to produce output (what combination of labor and capital to use)How much to demand in each input market (How many workers to hire)


Monopolists must decide:

How much output to produceHow to produce outputHow much to demand in each input marketWhat price to charge for output


Price and Output Decisions in Pure Monopoly MarketsBasic assumptions:

Entry to the market is strictly blocked.Firms act to maximize profits.The monopolistic firm cannot price discriminate.

Charge only ONE price.

The monopoly faces a known demand curve.


Consider this hypothetical data for a monopolist’s demand curve:

Quantity Price Total Revenue Marginal Revenue

0 11

P x QTR /Q

1 10

2 9

3 8

4 7

5 6

6 5

7 4

8 3

9 2

10 1

Can youcalculate totaland marginalrevenue for

the firm?


X

X

Quantity Price Total Revenue Marginal Revenue

0 11 0

1 10 10 10/1 = 10

2 9 18 8/1= 8

3 8 24 6/1= 6

4 7 28 4/1= 4

5 6 30 2/1= 2

6 5 30 0/1= 0

7 4 28 -2/1= - 2

8 3 24 -4/1= - 4

9 2 18 -6/1= - 6

10 1 10 -8/1= - 8

Sell more units by reducing

price

MR decreases when Q increases

X ===

TR/Q

As Price decreases,

TR increase, reach a

maximum (30) and

then decrease

Price > MR

In Perfect Competition

P = MR


We can plot demand and marginal revenue as follows:

-8

-6

-4

0

2

4

6

8

10

12

-2 0 1 2 3 4 5 6 7 8 9 10

Pric

e pe

r uni

t ($)

MR<Price

Market Demand

Marginal Revenue


Adding the total revenue curve:

Units of output Q-10

-5

0

5

10

15

20

25

30

0 1 2 3 4 5 6 7 8 9 10

Demand

MR

TR

TR MaxMR = zero


The monopolist’s profit-maximizing output and price:

D

MR

$

ATCMC

Choose Q such that MR = MC

Go up to the demand curve to set the price

Q*

P

The maximum price this monopolist can charge for Q units is P.

Q


The monopolist’s profit-maximizing output and price

D

MR

Q

ATCMC

Pm

Qm

TC = ATC x Q

ATC

TC

TR = P x QProfit

Profit = TR - TC

TR


Monopolist Sets Price Above MC

D

MRQ

$

ATCMC

$P

Qm

$ATC

$MC

Price > MC

This is the “mark-up” above cost resulting

from monopoly’s market power

This markup over MC is the signature of a

monopolistTo find a firm that has market power: Look for firms that charge a price that is higher than their MC of production

To find a firm that has market power: Look for firms that charge a price that is higher than their MC of production


In Monopoly...The monopolist has no supply curve; there is no unique relationship between price and quantity supplied.Since entry is blocked, the monopolist can earn economic profits in the long run.Monopolists can have losses in the short run if demand is not sufficient or if costs are too high.


Comparison of Monopoly and Perfect Competition

D

Units of output, Q

$

Pm=$4

2000Qm

Ppc=$2

4000Qpc

Sum of MC above AVC for all firms in a Perfectly Competitive

industry = Market Supply

Monopolist restricts output and charges a higher price than under Perfect Competition

MC

MR

These are the Price and Quantity under Perfect Competition


Natural MonopolyAn industry where the technological

advantages of large-scale production allow a single firm to produce at a lower

cost than many smaller companies.


D10,000 500,000

5

3

ATC1

MC

400,000

ATC5MC

S

D

Or Demand can be supplied by ONE firm with a large plant of

size ATC5

This Demand can be supplied by many perfectly competitive firms each with a small plant of

size ATC1

40 Firms selling 400,000 units at $5/unit

ONE firm selling 500,000 units at

$3/unit


Government MonopoliesSince a large firm can supply the entire

market at a lower cost, governments have two choices:Allow a private monopoly to exist under government regulation orGovernment ownership of the industry.

Most public services are state owned monopolies in most countries.


Regulating a Natural MonopolySeveral alternatives:

The government sets the price as it would occur under perfect competition.The government sets a price ceiling equal to marginal cost, and subsidizes production.The government sets the monopoly price to cover average cost per unit.


The government forces the perfectly competitive solution

P = MC

Q = 600,000

Pm

Qm

Profit Monopoly profits

decreaseProfit after regulation


The government sets a price ceiling equal to marginal cost, and subsidizes production.

P = MC

Pm

Qm

LossSubsidy

Q = 500,000


The government sets a monopoly’s price to cover average cost.

P = ATC

Pm

QmQ = 500,000

No Loss, No Profit.

No Subsidy

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Monopoly decisions