Monopoly
12 c h a p t e r
WHAT IS A MONOPOLY?
A true or pure monopoly exists when there is only one seller of a product with no close substitute and there are natural or legal barriers to entry that prevent competition. In monopoly, the firm and “the industry” are one and the same. Consequently, the firm sets the price of the good because the firm faces the industry demand curve and can pick the most profitable point on that demand curve. Monopolists are price makers (rather than price takers) that try to pick the price that will maximize their profits.
PURE MONOPOLY IS A RARITY
Few goods and services truly have only one producer.
One might think of a small community with a single bank, a single newspaper, or even a single grocery store. Even in these situations, however, most people can bank out of town, use a substitute financial institution, buy out-of-town newspapers or read them on the Web, go to a nearby town to buy groceries, and so on. Near-monopoly conditions exist, but absolutely pure monopoly is unusual.
One area where there is typically only one producer of goods and services within a market area is public utilities. In any given market, usually only one company provides natural gas or supplies water.
Moreover, governments themselves provide many services for which they are often the sole providers—sewer services, fire and police protection, and military protection. Most of these situations resemble a pure monopoly. Again, however, for most of these goods and services, substitute goods and services are available. People heating their homes with natural gas can switch to electric heat (or vice versa). In some areas, residents can even substitute home-collected rainwater or well water for what the local water company provides.
While the purist might correctly deny the existence of monopoly, the number of situations where monopoly conditions are closely approximated are numerous enough to make the study of monopoly more than a theoretical abstraction; moreover, the study of monopoly is useful in clarifying certain desirable aspects of perfect competition.
BARRIERS TO ENTRY
There are several ways that a monopolist can make it virtually impossible for other firms to overcome barriers to entry. For example, a monopolist might prevent potential rivals from entering the market by establishing legal barriers, taking advantage of economies of scale, or controlling important inputs.
Legal Barriers
In the case of legal barriers, the government might franchise only one firm to operate an industry, as is the case for postal services in most countries. The government can also provide licensing designed to ensure a certain level of quality and competence.
Workers in many trade industries must obtain government licensing—hair stylists, bartenders, contractors, electricians, and plumbers, for instance.
Also, the government could award patents that encourage inventive activity. It can cost millions of dollars to develop a new drug or computer chip, for instance, and without a patent to recoup some of the costs, there would certainly be less inventive activity.
As long as the patent is in effect, the company has the potential to enjoy monopoly profits for many years. After all, why would a firm engage in costly research if any company could free ride off their discovery and produce and sell the new drug or computer chip?
Economies of Scale
The situation in which one large firm can provide the output of the market at a lower cost than two or more smaller firms is called a natural monopoly.
With a natural monopoly, it is more efficient to have one firm produce the good. The reason for the cost advantage is economies of scale; that is, ATC
Monopoly: The Price Maker
s e c t i o n
12.1
_ What is a monopoly?
_ Why is pure monopoly rare?
_ What are the sources of monopoly power?
_ What is a natural monopoly?
226 CHAPTER TWELVE | Monopoly
falls as output expands throughout the relevant output range, as seen in Exhibit 1. Public utilities, like water, gas, and electricity, are often given exclusive monopoly rights because the government believes they are natural monopolies.
Control over an Important Input
Another barrier to entry could occur if a firm had control over an important input. For example, from the late 19th century to the early 1940s, the Aluminum Company of America (Alcoa) had a monopoly in the production of aluminum. Its monopoly power was guaranteed because of its control over an important ingredient in the production of aluminum —bauxite. Similarly, the De Beers diamond company of South Africa has monopoly power because it controls roughly 75 percent of the world’s output of diamonds.
In monopoly, the market demand curve may be regarded as the demand curve for the firm’s product because the monopoly firm is the market for that particular product. The demand curve indicates the quantities that the firm can sell at various possible prices. In monopoly, the demand curve for
Demand and Marginal Revenue in Monopoly 227
Demand and Marginal Revenue in Monopoly
12.2
_ How does the demand curve for a monopolist differ from that of a perfectly competitive firm?
_ Why is marginal revenue less than price in monopoly?
Cost Quantity of Output
0 ATC QSMALL FIRM QLARGE FIRM
SECTION 12.1
EXHIBIT 1
The firm has economies of scale over the relevant range of output with declining average total costs. When one firm can produce the total output at a lower cost than several small firms, it is called a natural monopoly.
1. A pure monopoly exists where there is only one seller of a product for which no close substitute is available.
2. Pure monopolies are rare because there are few goods and services where only one producer exists.
3. Sources of monopoly power include legal barriers, economies of scale, and control over important inputs.
4. A natural monopoly occurs when one firm can provide the good or service at a lower cost than two or more smaller firms.
1. Why does monopoly depend on the existence of barriers to entry?
2. Why is a pure monopoly a rarity?
3. Why does the government grant some companies, like public utilities, monopoly power?
s e c t i o n c h e c k
the firm’s product declines as additional units are placed on the market—the demand curve is downward sloping. In monopoly, the firm cannot set both its price and the quantity it sells. That is, a monopolist would love to sell a larger quan-tity at a high price, but it can’t. If the monopolist raises the price, the amount sold will fall; if the monopolist lowers the price, the amount sold will rise.
Recall that in perfect competition, because there are many buyers and sellers of homogeneous goods (resulting in a perfectly elastic demand curve), competitive firms can sell all they want at the market price. They face a horizontal demand curve. The firm takes the price of its output as determined by the market forces of supply and demand. Monopolists, on the other hand, face a downward-sloping demand curve, and if the monopolist wants to expand output, it must accept a lower price. The two demand curves are displayed side by side in Exhibit 1.
In Exhibit 2, we see the price of the good, the quantity of the good, the total revenue (TR 5 P 3
Q), and the average revenue, the amount of revenue the firm receives per unit sold (AR 5 TR 4 Q). The average revenue is just the price per unit sold, which is exactly equal to the market demand curve and the marginal revenue—the amount of revenue the firm receives from selling an additional unit—is (MR 5 DTR 4 DQ).
In Exhibit 3, we see that the marginal revenue curve for a monopolist lies below the demand curve.
Why is this the case? Suppose the firm initially sets its price at $5. It only sells one unit a day, so its total rev-
228 CHAPTER TWELVE | Monopoly
a. Perfectly Competitive Firm’s Demand Curve b. A Monopolist’s Demand Curve
Price Quantity of Output
Demand 0
Comparing Demand Curves: Perfect Competition versus Monopoly
SECTION 12.2
The demand curve for a perfectly competitive firm is perfectly elastic; competitive firms can sell all they want at the market price. The firm is a price taker. The demand curve for a monopolist is downward sloping; if the monopolist wants to expand output, it must accept a lower price.
The monopolist is a price maker. Because a monopoly has no close competitors, it can change the product price by adjusting its output.
Total Marginal Average Revenues Revenue Revenue Price Quantity (TR _ P _ Q) (MR _ _TR/_Q) (AR _ TR/Q)
$6 0 — — — 5 1 $5 $5 4 2 8 $3 4 3 3 9 1 3 2 4 8 –1 2 1 5 5 –3 1
Total, Marginal, and Average Revenue SECTION 12.2
EXHIBIT 2
enue is $5. To increase sales, it decides to drop the price to $4. Sales increase to two units a day, and total revenue increases to $8. The firm’s marginal revenue is only $3. Why? When the firm cuts the price to induce the second customer to buy, it gains only $4 from the first customer even though she is willing to pay $5. That is, because both customers are now paying $4, the company is receiving $4 more from customer two but is earning $1 less from customer one for a total of $8. Remember, the first customer was willing to pay $5. Thus, to get revenue from marginal customers, the firm has to lower the price.
To induce a third daily customer to purchase the good, the firm must cut its prices to $3. In doing so, it gains $3 in revenue from the new, third customer, but it loses $2 in revenue because each of the first two customers are now paying $1 less than previously. The marginal revenue is $1 ($3 3 $2), less than the price of the good ($3).
Finally, to get a fourth customer, the firm has to cut the price to $2. The firm finds that in doing so, it actually loses additional revenue: The new revenue received from the fourth customer ($2) is more than offset by losses in revenues from the first three customers, $3, because each customer pays $1 less than before.
Hence, a monopolist’s marginal revenue is always less than the price—that is, the marginal revenue curve will always lie below the demand curve, as shown in Exhibit 3. Recall that in perfect competition, the firm could sell all it wanted at the market price and the price was equal to marginal revenue.
However, in monopoly, if the seller wants to expand output it will have to lower the price on all units.
This means that the monopolist receives additional revenue from the new unit sold, but it will receive less revenue on all the units it was previously selling.
Thus, when the monopolist cuts the price to attract new customers, the old customers benefit.
In Exhibit 4, we can compare marginal revenue for the competitive firm with the marginal revenue for the monopolist. The firm in perfect competition can sell another unit of output without lowering its price; hence, the marginal revenue from selling its last unit of output is the market price. However, the monopolists has a downward-sloping demand curve. This means that to sell an extra unit of output, the price falls from P1 to P2, and the monopolist loses area c in Exhibit 4(b).
It is important to note that while a monopolist can set its price anywhere it wants, it will not set its price as high as possible—be careful not to confuse ability with incentive. As we will see in the next section, some prices along the demand curve will not be profitable for a firm. In other words, the monopolist can enhance profits by either lowering the price or raising it.
THE MONOPOLIST’S PRICE IN THE ELASTIC PORTION OF THE DEMAND CURVE
The relationship between the elasticity of demand and marginal and total revenue are shown in Exhibit 5. In Exhibit 5(a), elasticity varies along a linear demand curve. Recall from Chapter 6 that above the midpoint, the demand curve is elastic (ED
> 1); below the midpoint, it is inelastic (ED < 1); and at the midpoint, it is unit elastic (ED 5 1). How does elasticity relate to total and marginal revenue?
In the elastic portion of the curve shown in Exhibit 5(b), when the price falls, total revenue rises and marginal revenue is positive. In the inelastic region of the demand curve, when the price falls, total revenue falls and marginal revenue is negative. At the midpoint of the linear demand curve in Exhibit 5(b), the total revenue curve reaches its highest point and MR 5 0.
For example, suppose the price falls on the top half of the demand curve in Exhibit 5(a) from $90 to $80; total revenue increases from $90 ($90 3 1) to $160 ($80 3 2), and marginal revenue is positive
Demand and Marginal Revenue in Monopoly 229
6 $7 5
Marginal Revenue Demand (Average Revenue)
4 3 2 1 1 0 2 3 4 5 6
Demand and Marginal Revenue for the Monopolist
EXHIBIT 3
To sell more output, the monopolist must accept a lower price on all units sold. This means that the monopolist receives additional revenue from the new unit sold but less revenue on all the units it was previously selling. Thus, the marginal revenue curve for the monopolist always lies below the demand curve.
230 CHAPTER TWELVE | Monopoly
a. The Perfect Competitive Firm’s Demand Curve b. A Monopolist’s Demand Curve
Price Quantity
0 b a q q +1 P1 Demand
0 Demand Q P1
P2
b a c Q +1
Marginal Revenue—Competitive Firm versus Monopolist SECTION 12.2
EXHIBIT 4
Area b in (a) represents the marginal revenue from an extra unit of output (q 1 1) for the firm in perfect competition. The competitive firm’s marginal revenue (area b) is equal to the market price, P1 (P1 3 1). In (b), we see that the monopolist’s marginal revenue from an extra unit (Q 1 1) is less than the price by area c because the monopolist must lower its price to sell another unit of output.
60 70 80 90 $100 50
Total Revenue Curve MR 5 0 MR . 0 MR , 0 Marginal Revenue Demand Inelastic Unit Elastic Elastic
Price Quantity Total Revenue
40 30 20 10 0 1 $250 0 2 3 4 5
Quantity
6 7 8 9 10 1 2 3 4 6 7 8 9 10 5
The Relationship between the Elasticity of Demand and Total and Marginal Revenue
EXHIBIT 5
In (a), we see that along a linear demand curve, the elastic segment lies above the midpoint, the inelastic segment lies below the midpoint, and at the midpoint the demand is unit elastic. When demand is elastic, a decline in price will increase total revenue; when demand is inelastic, a decline in price will lead to a decrease in total revenue. In (b), we see that over the range from 0 to 5 units, total revenue is rising, so marginal revenue is positive. Over the range from 5 units to 10 units, total revenue is falling, so marginal revenue is negative. At 5 units of output, total revenue is maximized at $250 ($50 3 5), so marginal revenue is zero.
at $70. Because a reduction in price leads to an increase in total revenue, the demand curve is elastic in this region. Now suppose the price falls from $20 to $10 on the lower portion of the demand curve; total revenue falls from $160 ($20 3 8) to $90 ($10 3 9), and marginal revenue is negative at
2$70. Because a reduction in price leads to a decrease in total revenue, the demand curve is inelastic in this region.
A monopolist will never knowingly operate in the inelastic portion of its demand curve because increased output will lead to lower total revenue in this region. Not only are total revenues falling, but total costs will rise as the monopolist produces
a. Demand and Marginal Revenue b. Total Revenue
more output. Similarly, if the monopolist was to lower its output, it could increase its total revenue and lower its total costs (because it costs less to produce fewer units), leading to greater economic profits.
Demand and Marginal Revenue in Monopoly 231
Using the concepts of total revenue and marginal revenue, show why marginal revenue is less than price in a monopoly situation. Suppose a monopolist wants to expand output from one unit to two units. To sell two units rather than one, the monopolist must lower its price from $10 to $8, as shown in Exhibit 6. Will the marginal revenue be less than the price?
In Exhibit 6, we see that to sell units, the monopolist will have to lower the price on both units to $8. That is, the seller doesn’t receive $10 for unit one and $8 for unit two but receives $8 for both units. Therefore, what happens to marginal revenue? There are two parts to this answer. First, there is a loss in revenue, $2, from selling the first unit at $8 instead of $10. Second, there is a gain in revenue from the additional output—the second unit at $8. Thus, the marginal revenue is $6 ($8 – $2), which is less than the price of the good, $8. The monopolist’s marginal revenue will always be less than the price of the downward-slopping demand curve.
DEMAND AND MARGINAL REVENUE
USING WHAT YOU’VE LEARNED
A Q
Total Marginal Price Quanity Revenue Revenue
$10 1 $10 $6 $8 2 $16 $2 $6 3 $18
Demand and Marginal Revenue
EXHIBIT 6
12 10 8 6 4 2 0
MR D Total Revenue Loss $2 Total Revenue Gain $8 Marginal Revenue $6
1 2 3 4 5
A B
1. The monopolist’s demand curve is downward sloping because it is the market demand curve. To produce and sell another unit of output, the firm must lower its price on all units. As a result, the marginal revenue curve lies below the demand curve.
2. The monopolist cannot set both price and the quantity it sells. If the monopolist reduces output, the price will rise, and if the monopolist expands output, the price will fall.
3. The monopolist’s marginal revenue will always be less than price because there is a downward-sloping demand curve.
In order to sell more output, the monopolist must accept a lower price on all units sold. This means that the monopolist receives additional revenue from the new unit sold but it will receive less revenue on all of the units it was previously selling.
4. The monopolist will operate in the elastic portion of its demand curve.
1. Why are the market and the firm demand curves the same for a monopoly?
2. Why is a monopoly a price maker but a perfectly competitive firm a price taker?
3. Why is marginal revenue less than price for a profit-maximizing monopolist?
4. Why would a monopolist never knowingly operate on the inelastic portion of its demand curve?
HOW DOES THE MONOPOLIST DETERMINE THE PROFIT-MAXIMIZING OUTPUT?
In the last section, we saw how a monopolist could choose any point along a demand curve. However, the monopolist’s decision on what level of output to produce depends on more than the marginal revenue derived at various outputs. The firm faces production costs, and the monopolist, like the perfect competitor, will maximize profits at that output where MR 5 MC. This point is demonstrated graphically in Exhibit 1.
As you can see in Exhibit 1, at output level Q1, the marginal revenue exceeds the marginal cost of that production, so it is profitable for the monopolist to expand output. Profits continue to grow until output Q* is reached. Beyond that output, say at Q2, the marginal cost of production exceeds the marginal revenue from production, so profits decline. The monopolists should cut production back to Q*. Therefore, the equilibrium output is Q*. At this output, marginal cost and marginal revenue are equal.
THREE-STEP METHOD FOR MONOPOLISTS
Let’s return to the three-step method we used in Chapter 11. Determining whether a firm is generating economic profits, economic losses, or zero economic profits at the profit-maximizing level of output,
Q*, can be done in three easy steps.
1. Find where marginal revenue equals marginal cost and proceed straight down to the horizontal quantity axis to find Q*, the profitmaximizing output level.
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