Chapter 15 Monopoly

Outline of Topics
T1 Why monopolies arise
T2 How monopolies make production and pricing
decisions
T3 The Welfare cost of monopoly
T4 Public policy toward monopolies
T5 Price discrimination
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T1 Why monopolies arise

Monopoly: a firm that is the sole seller of a product without
close substitutes
The fundamental cause of monopoly is barrier to entry.
Barrier to entry have three main sources:
1, A key resource is owned by a single firm:
Although exclusive ownership of a of a key resource is a
potential cause of monopoly, in practice monopolies
rarely arise from this reason.
2, Government created monopolies: the government
gives a single firm the exclusive right to produce some
good or service
In many cases, monopolies arise because the government
has given one person or firm the exclusive right to sell
some good or service.
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 The patent and copyright laws are two important

examples of how the government creates a monopoly to
serve the public interest.
Because these laws give one producer a monopoly, they
lead to higher prices than would occur under
competition. By allowing these monopoly producers to
charge higher prices and earn higher profits, the laws also
encourage some desirable behaviour such as
pharmaceutical research for new drugs.
Thus, the laws governing patents and copyrights have
benefits and costs. The benefit of the patent and
copyright laws is the increased incentive for creative
activity. This benefit is offset to some extent by the costs
of monopoly pricing.
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3, Natural monopolies: the costs of production make a

single producer more efficient than a large number of

producers
See Figure 15-1 on page 321
When a firms ATC curve continually declines, the firm
has what is called a natural monopoly
When a firm is a natural monopoly, it is less concerned
about new entrants eroding its monopoly power.
Normally, a firm has trouble maintaining a monopoly
position without ownership of a key resource or
protection from the government. The monopolists profit
attracts entrants into the market, and these entrants make
the market more competitive. By contrast, entering a
market in which another firm has a natural monopoly is
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unattractive.

T2 How monopolies make production and pricing

decisions
The key difference between a competitive firm and a
monopoly is the monopolys ability to influence the price of
its output. A competitive firm is small relative to the market
in which it operates and therefore, takes the price of its
output as given by market condition. By contrast, because a
monopoly is the sole producer in its market, it can alter the
price of its good by adjusting the quantity it supplies to the
market.
One way to view this difference between a competitive firm
and a monopoly is to consider the demand curve that each
firm faces.
See Figure 15-2 on page 323.
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 Competitive firms are price takers, they in effect face

horizontal demand curves.
A monopoly firm is the sole producer in its market, it
faces the downward-sloping market demand curve. As a
result, the monopoly has to accept a lower price if it
wants to sell more output.
A monopolys revenue
Consider a town with a single producer of water.
See Table 15-1 on page 324.
Total Revenue (TR) =P*Q
Average Revenue (AR) = TR/Q
Marginal Revenue (MR) = TR/ Q
Table 15-1 shows a result that is important for
understanding monopoly behaviour: a monopolists MR is
always less than the price of its good.
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 For a monopoly, MR is lower than price because a

monopoly faces a downward-sloping demand curve. To
increase the amount sold, a monopoly firm must lower the
price of its good. For example, to sell the fourth litre of
water, the monopolist must get less revenue for each of the
first three litres.
When a monopoly increases the amount it sells, there are
two effects on total revenue (P*Q)
The output effect: more output is sold, so Q is higher
The price effect: the price falls, so P is lower
Because a competitive firm can sell all it wants at the
market price, there is no price effect. When it increases
production by one unit, it receives the market price for that
unit, and it does not receive any less for the amount it was
already selling. Since the competitive firm is a price taker,
its MR equals the price of its good.
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 See Figure 15-3 on page 325.

These two curves always start at the same point on the
vertical axis because the MR of the first unit sold equals the
price of the good.
MR can even become negative. MR is negative when the
price effect on revenue is greater than the output effect.
In this case, when the firm produces an extra unit of output,
the price falls by enough to cause the firms TR to decline,
even though the firm is selling more units.
Profit Maximization
See Figure 15-4 on page 326.
The monopolists profit maximizing quantity of output is
determined by the intersection of the MR and the MC.
That is the Qmax in the Figure 15-4. Q1? Q2?
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 In following this rule, MR=MC, for profit maximization,

competitive firms and monopolies are alike. However, there
is an important difference between these types of firm:
For a competitive firm: p= MR=MC ( P =MC)
For a monopoly firm: P > MR = MC ( P > MC)
How does the monopoly find the profit-maximizing price
for this product?
The demand curve answers this question, because the
demand curve relates the amount that customers are
willing to pay to the quantity sold. Thus, after the
monopoly firm chooses the quantity of output that
equates MR and MC, it uses the demand curve to find the
price consistent with that quantity. In Figure 15-4, the
profit-maximizing price is found at point B.
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A monopolys profit
Profit = TR-TC
= (TR/Q TC/Q)*Q = (AR ATC)*Q = (P-ATC)*Q
See Figure 15-5 on page 328.
Case study: Monopoly Drugs Vs. Generic Drugs
Monopoly drugs (Brand-name drugs): when a firm
discovers a new drug, patent laws give the firm a
monopoly on the sale of that drug.
Generic drugs are chemically identical to the former
monopolists brand-name product.
But eventually the firms patent runs out, and any
company can make and sell the drug. At that time, the
market switches from being monopolistic to being
competitive.
See Figure 15-6 on page 329.
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T3 The welfare cost of monopoly

Is monopoly a good way to organize a market?
From the standpoint of consumers, this high price
makes monopoly undesirable.
From the standpoint of owners of the firm, the high
price makes monopoly very desirable because owners
have a good earning profit from charging this high
price.
Is it possible that the benefits to the firms owners exceed
the costs imposed on consumers, making monopoly
desirable form the standpoint of society as a whole?
We can use total surplus as our measure of economic wellbeing.
See Figure 15-7 on page 331. It shows what level of
output a benevolent social planner would choose.
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 The demand curve reflects the value of the good to

consumers, as measured by their willingness to pay for it.
The marginal cost curve reflects the costs of the monopolist.
Thus, the socially efficient quantity is found where the
demand curve and the marginal-cost curve intersect.
Below this quantity, the value to consumers exceeds the
marginal cost of providing the good, so increasing output
would raise total surplus.
Above this quantity, the marginal cost exceeds the value to
consumers, so decreasing output would raise total surplus.
If the social planner were running the monopoly, the firm
could achieve this efficient outcome by charging the price
found at the intersection of the demand and MC curves.
Thus, a social planner would charge a price equals MC.
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 As we have seen on slide 8, the monopolist chooses to

produce and sell the quantity of output at which MR=MC;
the social planner would choose the quantity at which the
demand and MC intersect.
See Figure 15-8 on page 332. It shows the above
comparison.
The monopolist produces less than the socially efficient
quantity of output.
When a monopolist charges a price above marginal cost,
some potential consumers value the good at more than its
marginal cost but less than the monopolists price. These
consumers do not end up buying the good. Because the
value these consumers place on the good is greater than
the cost of providing it to them, this result is inefficient.
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 Thus, the area of the deadweight-loss triangle between the

demand curve and the marginal-cost curve equals the total
surplus loss because of monopoly pricing.
The monopolys profit: a social cost?
A monopoly firm does earn a higher profit by virtue of its
market power. However, the firms profit is not in itself
necessarily a problem for society.
Whenever a consumer pays an extra dollar to a producer
because of a monopoly price, the consumer is worse off by a
dollar, and the producer is better off by the same amount.
This transfer from the consumers of the good to the owners
of the monopoly does not affect the markets total surplusthe sum of consumer and producer surplus. In other words,
the monopoly profit itself does not represent a shrinkage in
the size of economic pie; it merely represents a bigger14

 slice for producers and a smaller slice for consumers. Unless

consumers are for some reason more deserving than
producers-a judgment that goes beyond the realm of
economic efficiency-the monopoly profit is not a social
problem.
The problem in a monopolized market arise because the
firm produces and sells a quantity of output below the level
that maximizes total surplus. The inefficiently low quantity
of output is caused by the monopolys high price. The
deadweight loss can measure how the economic pie shrinks
as a result.
If the high monopoly price did not discourage some
consumers from buying the good, it would raise producer
surplus by exactly the amount it reduced consumer surplus,
leaving total surplus the same as could be achieved by a
benevolent social planner.
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A possible exception to the above conclusion.

Suppose that a monopoly firm has to incur additional costs
to maintain its monopoly position. For example, firm need
to hire lobbyists to convince lawmakers to continue its
monopoly.Firms that devote resources to protecting or

obtaining a monopoly are said to be engaging in rent

seeking ( rent is another word for economic
profits).
A firm that engages in rent seeking may use up some of
its monopoly profits paying for these additional
resources.
The costs associated with rent seeking are a real cost
imposed on society because the resources could have
been used in some other productive activity.
The social cost of monopoly thus includes both the costs
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associated with rent seeking and the deadweight loss.

T4 Public policy toward monopolies

Monopolies fail to allocate resources efficiently because
monopolies produce less than the socially desirable quantity
of output and as a result charge prices above marginal cost.
Policy makers in the government can respond to the
problem of monopoly in one of four ways:
By trying to make monopolized industries more
competitive (Competition Law)
By regulating the behaviour of the monopolies
(Regulation)
By turning some private monopolies into public
enterprises (Public ownership)
By doing nothing at all (Doing nothing)
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Competition Law
The Competition Act recognize that competition is a means
to an end (or several ends) and firmly places competition
policy in Canada in a global context. In its preamble, the act
states that its purpose is to maintain and encourage
competition
in order to promote the efficiency and adaptability of the
Canadian economy,
in order to expand opportunities for Canadian
participation in world markets while at the same time
recognizing the role of foreign competition in Canada,
in order to ensure that small and medium-size enterprises
have an equitable opportunity to participate in the
Canadian economy, and
in order to provide consumers with competitive prices
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and product choices.

Regulation
This solution is common in the case of natural monopolies,
such as water and electric companies. These companies are
not allowed to charge any price they want. Instead,
government agencies regulate their prices.
What price should the government set for a natural
monopoly? Setting price = MC ? If price equals MC,
customers will buy the quantity of monopolists output that
maximizes total surplus, and the allocation of resources will
be efficient.
However, there are two practical problems with marginal
cost pricing as a regulatory system.
The first is illustrated in Figure 15-9 on page 337. Because a
natural monopoly has declining ATC, MC is less than ATC.
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 Therefore, if regulators requires a natural monopoly to

charge a price equal to MC, price will be below ATC and
the monopoly will lose money.
Regulator can respond to this problem by subsiding the
monopolist or allowing the monopolist to charge a price
higher than MC.
The second problem is that it gives the monopolist no
incentive to reduce costs.
Each firm in a competitive market tries to reduce its costs
because lower costs mean higher profits.
But if a regulated monopolist knows that regulators will
reduce prices whenever costs fall, the monopolist will not
benefit from lower costs.
Regulators deal with this problem by allowing
monopolists to keep some of the benefits from lower
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costs in the form of higher profit.

Public Ownership
That is, rather than regulating a natural monopoly that is run
by a private firm, the government can run the monopoly
itself. In Canada, government ownership occurs at both the
federal and the provincial levels. Government-owned firms
are known as Crown corporation.
Federal Crown corporations include Canada Post, the
Canadian Broadcasting Corporation and Atomic Energy of
Canada Limited.
In the past decade the federal government has privatized
some of its Crown corporations, including Petro-Canada,
Air Canada and the Canadian National Railway.
At the provincial level, Crown corporations exist in
insurance, hydroelectricity and telecommunications. Gas
and water utilities are also public owned in most provinces.
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 Economist usually prefer private to public ownership of

natural monopolies. The key issue is how the ownership of
the firm affects the costs of production. Private owners have
an incentive to minimize costs as long as they reap part of
the benefit in the form of higher profit. If the firms
managers are doing a bad job of keeping costs down, the
firms owner will fire them. By contrast, if the government
bureaucrats who run a monopoly do a bad job, the losers are
the customers and taxpayers, whose only resource is the
political system.
As a way of ensuring that firms are well run, the voting
booth is less reliable than the profit motive.

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Doing Nothing
Each of the foregoing policies aimed at reducing the
problem of monopoly has drawbacks. As a result, some
economists argue that it is often best for the government not
to try to remedy the inefficiencies of monopoly pricing.
George Stigler, who won Nobel Prize for his work in
Industrial Organization wrote:
A famous theorem in economics states that a competitive
enterprise economy will produce the largest possible income
from a given stock of resource. No real economy meets the
exact conditions of the theorem, and all real economies will
fall short of the ideal economy-a difference called market
failure. In my view, however, the degree of market failure
for the American economy is much smaller than the political
failure arising from the imperfections of economic policies
found in real political systems.
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 As this quotation makes clear, determining the proper role

of the government in the economy requires making
judgments about politics as well as economics.
See Figure 15-10 on page 339
Consider government regulation or ownership as inflating
the costs of production above the true costs.
Without G intervention, the profit maximizing monopolist
will produce output Q0 and charge a price of P0. This
generates a deadweight loss given by the area of the triangle
ABC.
With G intervention- setting P=ATC. If this price is based
on the monopolists ATCtrue, then the price is Ptrue and
quantity is Qtrue and the deadweight loss is the triangle DEC.
However, if the government regulation causes the
monopolists ATC to inflate to ATCinflated and the resulting
regulated price is set to Pinflated and quantity is Qinflated24

 and the deadweight loss would increase to the area given by

the triangle FGC.
In this case, society would be better off if the government
did nothing.
T5 Price Discrimination
Price discrimination: the business practice of selling the
same good at different prices to different customers.
For a firm to price discriminate, it must have some market
power.
Price discrimination is a rational strategy for a profitmaximizing monopolist because by charging different prices
to different customers, a monopolist can increase its profit.
In essence, a price-discriminating monopolist charges each
customer a price closer to his or her willingness to pay than
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is possible with a single price.

 Price discrimination requires the ability to separate

customers according to their willingness to pay. (arbitrage
or resell issue)
Price discrimination can raise economic welfare
See Figure 15-11 on page 342
Comparing these two panels, you can see that perfect price
discrimination raises profit, raise total surplus and lowers
consumer surplus.
This is the case of First-degree price discrimination. It
occurs when the seller is able to extract the entire consumer
surplus

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 Second-degree price discrimination is like first-degree

price discrimination. The seller knows that there are buyers
of different types; but the seller is not able to identify the
different types.
Example: Quantity discounts.
Third-degree price discrimination: Consumers differ by
some observable characteristic(s)
A uniform price is charged to all consumers in a particular
group; but different uniform prices are charged to different
groups
kids are free
Airlines prices
early-bird specials
Movie Tickets
Discount coupons
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