Module 28 Monopoly in Practice

What You Will Learn How a monopolist determines the profit-maximizing output and price How to determine whether a monopoly is earning a profit or a loss 1 2

The Monopolist’s Demand Curve and Marginal Revenue The price-taking firm’s optimal output rule is to produce at the level whose marginal cost of the last unit produced is equal to the market price. A monopolist, in contrast, is the sole supplier of its good. So its demand curve is simply the market demand curve, which is downward-sloping.

The Monopolist’s Demand Curve and Marginal Revenue This downward slope creates a wedge between the price of the good and the marginal revenue of the good—the change in revenue generated by producing one more unit.

Comparing the Demand Curves of a Perfectly Competitive Producer and a Monopolist (a) Demand Curve of an Individual Perfectly Competitive Producer (b) Demand Curve of a Monopolist Price Price Market price DC Figure 28-1: Comparing the Demand Curves of a Perfectly Competitive Producer and a Monopolist Because an individual perfectly competitive producer cannot affect the market price of the good, it faces a horizontal demand curve, DC, as shown in panel (a). A monopolist, on the other hand, can affect the price. Because it is the sole supplier in the industry, its demand curve is the market demand curve DM, as shown in panel (b). To sell more output, it must lower the price; by reducing output, it raises the price. DM Quantity Quantity An individual perfectly competitive firm cannot affect the market price of the good; therefore, it faces the horizontal demand curve DC as shown in panel (a). A monopolist can affect the price (sole supplier in the industry); therefore, its demand curve is the market demand curve DM as shown in panel (b).

The Monopolist’s Demand Curve and Marginal Revenue An increase in production by a monopolist has two opposing effects on revenue: A quantity effect. One more unit is sold, increasing total revenue by the price at which the unit is sold. A price effect. To sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue.

The Monopolist’s Demand Curve and Marginal Revenue The quantity effect and the price effect are illustrated by the two shaded areas in panel (a) of Figure 28-2 based on the numbers in the table on the next slide.

The Monopolist’s Demand Curve and Marginal Revenue

A Monopolist’s Demand, Total Revenue, and Marginal Revenue Curves Price, cost, marginal revenue of demand (a) Demand and Marginal Revenue $1,000 Quantity effect = +$500 A 550 B 500 Price effect = –$450 C 50 D 9 10 20 Quantity of diamonds –200 Marginal revenue = $50 MR –400 (b) Total Revenue Quantity effect dominates price effect. Total Revenue Price effect dominates quantity effect. Figure 28-2: A Monopolist’s Demand, Total Revenue, and Marginal Revenue Curves Panel (a) shows the monopolist’s demand and marginal revenue curves for diamonds from Table 25-1. The marginal revenue curve lies below the demand curve. To see why, consider point A on the demand curve, where 9 diamonds are sold at $550 each, generating total revenue of $4,950. To sell a tenth diamond, the price on all 10 diamonds must be cut to $500, as shown by point B. As a result, total revenue increases by the green area (the quantity effect: +$500) but decreases by the orange area (the price effect: −$450). So the marginal revenue from the tenth diamond is $50 (the difference between the green and orange areas), which is much lower than its price, $500. Panel (b) shows the monopolist’s total revenue curve for diamonds. As output goes from 0 to 10 diamonds, total revenue increases. It reaches its maximum at 10 diamonds—the level at which marginal revenue is equal to 0—and declines thereafter. The quantity effect dominates the price effect when total revenue is rising; the price price effect dominates the quantity effect when total revenue is falling. $5,000 4,000 3,000 2,000 1,000 TR 10 Quantity of diamonds 20

The Monopolist’s Demand Curve and Marginal Revenue Because of the price effect of an increase in output, the marginal revenue curve of a firm with market power always lies below its demand curve. A profit-maximizing monopolist chooses the output level at which marginal cost is equal to marginal revenue—not to price.

The Monopolist’s Demand Curve and Marginal Revenue As a result, the monopolist produces less and sells its output at a higher price than a perfectly competitive industry would. It earns a profit in the short run and the long run.

The Monopolist’s Demand Curve and Marginal Revenue At low levels of output, the quantity effect is stronger than the price effect: as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small. At high levels of output, the price effect is stronger than the quantity effect: as the monopolist sells more, it has to lower the price on many units of output, making the price effect very large.

The Monopolist’s Profit-Maximizing Output and Price To maximize profit, the monopolist compares marginal cost with marginal revenue. If marginal revenue exceeds marginal cost, De Beers increases profit by producing more; if marginal revenue is less than marginal cost, De Beers increases profit by producing less.

The Monopolist’s Profit-Maximizing Output and Price At the monopolist’s profit-maximizing quantity of output: MR = MC

The Monopolist’s Profit-Maximizing Output and Price Price, cost, marginal revenue of demand The optimal output rule: the profit maximizing level of output for the monopolist is at MR = MC, shown by point A, where the MC and MR curves cross at an output of 8 diamonds. $1,000 Monopolist’s optimal point B PM 600 Perfectly competitive industry’s optimal point Monopoly profit PC Figure 28-3: The Monopolist’s Profit-Maximizing Output and Price This figure shows demand, marginal revenue, and marginal cost curves. Marginal cost per diamond is constant at $200, so the marginal cost curve is horizontal at $200. According to the optimal output rule, the profit-maximizing quantity of output for the monopolist is at MR = MC, shown by point A, where the marginal cost and marginal revenue curves cross at an output of 8 diamonds. The price De Beers can charge per diamond is found by going to the point on the demand curve directly above point A, which is point B here—a price of $600 per diamond. It makes a profit of $400 × 8 =$3,200. A perfectly competitive industry produces the output level at which P = MC, given by point C, where the demand curve and marginal cost curves cross. So a competitive industry produces 16 diamonds, sells at a price of $200, and makes zero profit. 200 MC = ATC A C D 8 10 16 20 Quantity of diamonds –200 QM QC MR –400

Monopoly Versus Perfect Competition P = MC at the perfectly competitive firm’s profit-maximizing quantity of output. P > MR = MC at the monopolist’s profit-maximizing quantity of output.

Monopoly Versus Perfect Competition Compared with a competitive industry, a monopolist does the following: Produces a smaller quantity: QM < QC. Charges a higher price: PM > PC. Earns a profit.

The Monopolist’s Profit Price, cost, marginal revenue Profit = TR − TC = (PM × QM) − (ATCM × QM) = (PM − ATCM) × QM MC ATM B The average total cost of QM is shown by point C. Profit is given by the area of the shaded rectangle. PM Monopoly profit A D ATCM C Figure 28-4: The Monopolist’s Profit In this case, the marginal cost curve has a “swoosh” shape and the average total cost curve is U-shaped. The monopolist maximizes profit by producing the level of output at which MR = MC, given by point A, generating quantity QM. It finds its monopoly price, PM, from the point on the demand curve directly above point A, point B here. The average total cost of QM is shown by point C. Profit is given by the area of the shaded rectangle. MR QM Quantity The monopolist maximizes profit by producing the level of output at which MR = MC, given by point A, generating quantity QM. It finds its monopoly price, PM, from the point on the demand curve directly above point A, point B here.

Economics in Action Electric utilities were recognized as natural monopolies with a defined area. They owned the plants and the transmission lines. In the late 1990s, there was a move toward deregulation. Power generation entails large up-front costs. Lack of competition after deregulation enabled power generators to engage in market manipulation. From 2002 to 2006 average electricity prices rose 21% in regulated states versus 36% in fully deregulated states.

Summary The key difference between a monopoly and a perfectly competitive industry is that a perfectly competitive firm faces a horizontal demand curve but a monopolist faces a downward-sloping demand curve. This gives the monopolist market power, the ability to raise the price by reducing output. The marginal revenue of a monopolist is composed of a quantity effect (the price received from the additional unit) and a price effect (the reduction in the price at which all units are sold). Because of the price effect, a monopolist’s marginal revenue is always less than the market price, and the marginal revenue curve lies below the demand curve.

Summary At the monopolist’s profit-maximizing output level, marginal cost equals marginal revenue, which is less than market price. At the perfectly competitive firm’s profit-maximizing output level, marginal cost equals the market price. So in comparison to perfectly competitive industries, monopolies produce less, charge higher prices, and earn profits in both the short run and the long run.