Monopoly

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Four Basic Market Structures
 Perfectly Competitive: many firms, identical
products, free entry and exit, full and symmetric info
 Monopoly: single firm, no close substitutes, barriers
to entry, full and symmetric info
 Oligopoly: several firms, similar products, degree of
product differentiation varies depending upon the
market, might be barriers, full and symmetric info
 Monopolistic competition: many firms, similar
products, slightly differentiated products, free entry
and exit, full and symmetric info

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 Competitive Market
 This is the classic
“textbook” market structure.
 Firms in a competitive
market all make a product
that is perfectly
substitutable: all
demanders are equally
satisfied with any supplier’s
product.

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 Monopoly
 The single seller makes
a product that has no
“good” substitute.
 Other firms may be able
to produce the good or
service but choose not to
enter the market or are
barred from it.

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Oligopoly
 A few sellers make
products that are good,
but not perfect,
substitutes.
 Consumers can be
induced to change
suppliers but have only
a limited number of
choices.

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Monopolistic Competition
 The market has
many firms but each
supplier’s product is
differentiated.
 Consumers can be
induced to change
brands but they
have brand
preferences.

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Question
 What is the market structure for each of
these products or firms: competitive,
monopoly, oligopoly, monopolistic
competition?
– The Campus Store
– Kinko’s
– Pepperidge Farm’s Whole Wheat Bread
– PowerMac computer
– Windows computer
– NYSEG (electricity utility)
– Morton salt
– AT&T long distance

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Answer
 The Campus Store: most products competitive, textbooks
oligopoly, but location is very important.
 Kinko’s: monopolistic competition (differentiated service)
 Pepperidge Farm’s Whole Wheat Bread: competition or
monopolistic competition (slightly differentiated recipes)
 PowerMac computer and clones: monopoly, under license.
 Windows computer: monopolistic competition (differentiated
features)
 NYSEG (electricity utility): monopoly
 Morton salt: competitive
 AT&T long distance: oligopoly

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Monopoly
 single firm
 no close substitutes
 barriers to entry
 full and symmetric
information

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Sources of Monopoly Entry
Barriers
 Natural monopoly: the most efficient scale of
production is so large, relative to market demand, that
a single firm dominates the market.
 Patents, copyrights, licenses, franchises: government
protection of a firm’s right to produce a unique product.
 Economic and/or legal restrictions, strategies or
situations that make entry more difficult for new
competitors than for the existing monopoly firm.

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Natural Monopolies
 Goods and services whose delivery requires the
construction of a physical network (wires, pipes, etc..)
 In such industries (local phone service, water,
sewage removal, electricity, gas) the physical
networks display decreasing marginal cost over
essentially all quantities.
 Thus, average total cost is always declining and the
minimum efficient scale is much larger than the size
of the market.
 Natural monopolies are often regulated: they cannot
charge a higher price without government approval.

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Patents: Are There “Good”
Monopolies?
 Consider the protease inhibitor Crixivan from
Merck.
 A very effective AIDS therapy.
 Development costs were more than one
billion dollars.
 Annual revenue now from treating around
90,000 patients is $500,000,000.

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What is a “Good” Monopoly?
 Why is Merck given a monopoly?
 The granting of a patent on the drug
Crixivan guarantees that Merck can earn
monopoly profits on its sale.
 These monopoly profits provide the
incentive to invest in the research and
development required to create the new
drug.

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“Good” Monopolies
 The granting of patent protection (legal
monopoly) gives firms a strong incentive to
invest in new product development.
 Would firms make the R&D investments if
they could not protect them through patents
and trade secrets?
 Probably not because competitors could steal
the design at a fraction of the cost after the
product is brought to market.

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“Other” Monopolies - Good?
Bad?
 Input Ownership
– DeBeer’s and diamonds
 Industry Secret or Know-how
– IBM and mainframes?
 Strategic Behavior
– buy ‘em up
– blow’ em up
– let’s make a deal
– Microsoft and operating systems?

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Caveats
 monopoly does not => big
 big does not => monopoly
 monopoly does not => absolute and unlimited
control over price
 monopoly does not => must have economic
profit
 short run profit does not => monopoly power
 monopoly does not => badly behaved firm

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Classic Simple Monopoly
 Polar extreme from perfect competition.
 Monopolist is a “price maker.”
 Cost curves are pretty much the same
(except in the case of natural
monopoly).
 The big change from before is in the
demand side of the profit function.

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The Simple Monopolist
 The simple monopolist abides by the “law of one
price.” Everyone pays the same market price for all
units purchased.
 A monopolist faces the declining market demand
curve for its product and simultaneously chooses
price and quantity.
 Now P>MR (before P=MR) because the simple
monopolist must lower the price on all preceding
units to sell an additional unit.
 A monopolist has no “supply curve.”

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The Simple Monopolist: Rules
for Profit Maximization
 Suppose we are in the short run.
 Rules for profit maximization are the same as
before.
 If XSM maximizes profit, then
– MR(XSM ) = MC(XSM )
» very important note: for a simple monopolist
P>MR at all positive levels of X.
– XSM is a max and not a min.
– at XSM it’s worth operating.

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 Simple Monopoly
Monopoly Selling in a Single Market at a Single Price
Marginal Marginal
 Economic profits equal total Market Cost Average Revenue
Demand Total (midpoint Total Total (midpoint Economic
revenue minus total costs. Quantity Price Costs formula) Cost Revenue formula) Profits
0 100.00 800 0.00 -800
 Marginal revenue is the rate 10 95.00 1,500 82.50 150.00 950.00 90.00 -550
of change of total revenue 20
30
90.00
85.00
2,450
2,800
65.00 122.50 1,800.00
42.50 93.33 2,550.00
80.00
70.00
-650
-250
(just like marginal cost is 40 80.00 3,300 32.50 82.50 3,200.00 60.00 -100
50 75.00 3,450 20.50 69.00 3,750.00 50.00 300
the rate of change of total 60 70.00 3,710 18.50 61.83 4,200.00 40.00 490
cost) as quantity increases. 70
80
65.00
60.00
3,820
3,900
9.50
9.00
54.57 4,550.00
48.75 4,800.00
30.00
20.00
730
900
 Economic profits are 90
100
55.00
50.00
4,000
4,100
10.00
12.50
44.44 4,950.00
41.00 5,000.00
10.00
0.00
950
900
maximized when marginal 110 45.00 4,250 17.50 38.64 4,950.00 -10.00 700
120 40.00 4,450 20.00 37.08 4,800.00 -20.00 350
revenue equals marginal 130 35.00 4,650 25.00 35.77 4,550.00 -30.00 -100
costs 140
150
30.00
25.00
4,950
5,250
30.00
35.00
35.36 4,200.00
35.00 3,750.00
-40.00
-50.00
-750
-1,500
160 20.00 5,650 45.00 35.31 3,200.00 -60.00 -2,450
170 15.00 6,150 60.00 36.18 2,550.00 -70.00 -3,600
180 10.00 6,850 75.00 38.06 1,800.00 -80.00 -5,050
190 5.00 7,650 100.00 40.26 950.00 -90.00 -6,700
200 0.00 8,850 44.25 0.00 -8,850

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 Graphical Display of
Monopolist’s Solution
 The monopolist sets marginal revenue
Natural Monopolist's Market
equal to marginal cost at MR=MC=$10.
100.00
 The optimal quantity is thus 90 units, 90.00
Market Demand Price
which implies a market price of $55/unit. Exact Marginal Revenue
80.00
Marginal Cost
 The monopoly profits (light blue in the Average Total Cost
70.00
graph) are the difference between price
60.00
($55) and average total cost ($44.44)
Monopoly Profits
times the number of units sold. 50.00

40.00
Notice that our monopolist is a “natural

Dollars/unit

monopoly” the average total costs decline 30.00

over the entire relevant range of 20.00

production and the minimum efficient 10.00

scale (150) is bigger than the entire 0.00
market. 0
10
20
30
40
50
60
70
80
90
100

120
130
140
150
160
170
180
190
200
110
-10.00
 Notice that if our monopolist operated at -20.00
the competitive equilibrium
-30.00
(Price=MC=$30, Quantity=140), the firm
-40.00
would make a loss (ATC>Price).
Quantity

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Implications of the
Monopolist’s Profit Maximum
 Price will exceed the competitive price.
 Quantity will be less than the competitive quantity.
 The monopolist sells the output at a price greater than marginal
costs but the monopoly price can be above or below average total
costs. Thus, the monopolist need not always make a profit. In the
long run, of course, unprofitable monopolists will either stop
production or raise the price further above marginal cost until it
covers average total costs.
 The monopolist will always try to operate on the elastic portion of the
demand curve because when the elasticity of demand is greater than
-1 (inelastic, between 0 and 1 in absolute value), marginal revenue is
negative and, necessarily, less than marginal cost.
 Since there is no entry to consider monopolists can have persistent
long run economic profit.

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Simple Monopoly-
Performance
 Efficiency:
– Is the monopoly equilibrium Pareto Efficient?
That is, at XSM is net social surplus maximized?
Does $MB=$MC at XSM?
– Is the monopolist productively efficient? Does the
monopolist operate at minimum efficient scale?
 Equity:
– Is the outcome of monopoly fair? Equitable?
Just?

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Simple Monopoly-
Performance Answers
 The simple monopoly equilibrium is not Pareto
Efficient.
– The simple monopolist creates “dead-weight-loss.”
– At XSM, $MB>$MC . Recall: $MR=$MC at XSM while
$PSM>$MR at all X. So $PSM>$MC. Since $P=$MB,
then $MB>$MC.
 The simple monopolist may or may not be
productively efficient.
 Compared to the competitive equilibrium, there is a
transfer of surplus from consumers to producers.

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 Price Discriminating
Monopolists
 A monopolist might be able to charge different prices
for different units sold and enhance its profits.
– charge different people different prices
– charge the same person different prices for different units
 price discrimination
– charging different prices for different units with no cost basis
– charging the same price for different units when there are
cost differences

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Requirements for Price
Discrimination
 Some amount of monopoly power.
 An ability to prevent resale.
 Detailed information about who is buying
what unit and what demanders are
willing to pay.

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Believe It Or Not
 What would you do to prevent resale???
 when: 1940’s
 market: plastic molding powder
– industrial users: .85/pound
– denture manufacturers: $22/pound
 firm: Rohm and Haas
 problem: resale from industrial users to denture
manufacturers
 solution: rumor you are mixing arsenic in the
powder sold to industrial users!

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Two classic forms of Price
Discrimination
 Perfect or First Degree Price Discrimination
– charge a different price for each unit sold
– the most extreme form of price discrimination
 Third Degree Price Discrimination
– segment market and then charge a different price in each
market
– exploit the observation that at the simple monopoly price the
own price elasticity of demand differs across the defined
segmented markets
 Price discrimination comes in many other “flavors”

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Question
 The data on your handout show the
demand curves for movie tickets of
adults and seniors. The market
described has only one movie theatre.
– Find the best single price.
– If the movie theater can charge separate
prices for adults and seniors, what are the
best two prices?

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 Two Prices are Better than
One for Movie Tickets
Price Discrimination in the Movie Theatre Market
Quantity Quantity Total Single Adult Senior Single
adult senior Demand Single Price Adult Price Price Price
Price per movie movie for Price Total Marginal Total Marginal Senior Total Marginal Marginal Economic
ticket tickets tickets Tickets Revenue Revenue Revenue Revenue Revenue Revenue Cost Profits
12.00 200 0 200 2,400 2,400 0 1.00 2,200
11.50 225 25 250 2,875 9.00 2,588 7.00 288 11.00 1.00 2,625
11.00 250 50 300 3,300 8.00 2,750 6.00 550 10.00 1.00 3,000
10.50 275 75 350 3,675 7.00 2,888 5.00 788 9.00 1.00 3,325
10.00 300 100 400 4,000 6.00 3,000 4.00 1,000 8.00 1.00 3,600
9.50 325 125 450 4,275 5.00 3,088 3.00 1,188 7.00 1.00 3,825
9.00 350 150 500 4,500 4.00 3,150 2.00 1,350 6.00 1.00 4,000
8.50 375 175 550 4,675 3.00 3,188 1.00 1,488 5.00 1.00 4,125
8.00 400 200 600 4,800 2.00 3,200 0.00 1,600 4.00 1.00 4,200
7.50 425 225 650 4,875 1.00 3,188 -1.00 1,688 3.00 1.00 4,225
7.00 450 250 700 4,900 0.00 3,150 -2.00 1,750 2.00 1.00 4,200
6.50 475 275 750 4,875 -1.00 3,088 -3.00 1,788 1.00 1.00 4,125
6.00 500 300 800 4,800 -2.00 3,000 -4.00 1,800 0.00 1.00 4,000
5.50 525 325 850 4,675 -3.00 2,888 -5.00 1,788 -1.00 1.00 3,825
5.00 550 350 900 4,500 -4.00 2,750 -6.00 1,750 -2.00 1.00 3,600
4.50 575 375 950 4,275 -5.00 2,588 -7.00 1,688 -3.00 1.00 3,325
4.00 600 400 1,000 4,000 -6.00 2,400 -8.00 1,600 -4.00 1.00 3,000
3.50 625 425 1,050 3,675 -7.00 2,188 -9.00 1,488 -5.00 1.00 2,625
3.00 650 450 1,100 3,300 -8.00 1,950 -10.00 1,350 -6.00 1.00 2,200
2.50 675 475 1,150 2,875 -9.00 1,688 -11.00 1,188 -7.00 1.00 1,725
2.00 700 500 1,200 2,400 1,400 1,000 1.00 1,200

 The best single price in this market is $7.50/ticket, which makes economic profits of $4,225
(blue entries). Set marginal cost = marginal revenue with the single price.
 The price discriminating monopolist can make more economic profits by charging adults $8.50
(yellow entries) and seniors $6.50 (green entries). Set marginal cost = marginal revenue
separately for each market.

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Summary of Price
Discrimination Example
Profit Maximum with 2 Prices
Economic profits adult market 2,813
Economic profits senior market 1,513
Total with price discrimination 4,325
Total without price discrimination 4,225
 Calculating economic profits separately for the
two markets (adult and senior) shows that the
total is greater than with the best single price.
 Taking advantage of different elasticities of
demand.

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Believe It Or Not
 when: early 1990’s
 market: contact lenses
 firm: Bausch & Lomb
 Lenses:
– Optima @ $70/pair - wash and keep 1 year
– Medalist @ $15/pair - wash and keep 2 months
– SeeQuence 2 @ $8/pair - wash and keep 2 weeks
– Occasions @ $3/pair - daily and disposable each day
 Guess what?

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Believe It Or Not
 They were all the same lenses!
 Just packaged differently!
 What would you pay for a year?
– Optima = $70/pair - wash and keep 1 year
– Medalist = $15x6=$90 (last 2 months)
– SeeQuence 2 = $8x26=$208 (last 2 weeks)
– Occasions = $3x365 = $1095
 What would I do? Buy the Occasions and wash and
wear until my eyes hurt.
 Class action suits were eventually settled.

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First Degree Price
Discrimination
 The monopolist charges the demand price for each
unit sold.
 In this case the market demand curve becomes the
monopolist’s marginal revenue curve.
 The monopolist sets MR=MC to get XFDPD.
 The monopolist charges a different price for each
unit according to the demand curve.
 Performance: XFDPD is Pareto Efficient and all the net
social surplus goes to the monopolist as producer
surplus. Consumer surplus = $0!

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Should the Government
Regulate Monopolies?
 Essentially all monopolies are regulated.
 Natural monopolies are regulated by price
commissions that determine the rates the
monopolies may charge.
 Patent, copyright and license protections are a form
of ex ante regulation: firms that follow the rules for
establishing the validity of their innovations receive
the protection of the patent, copyright or license.
 Should the government do more? Good question.

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