Chapter 15 Monopoly © 2002 by Nelson, a division of Thomson Canada Limited

In this chapter you will… Learn why some markets have only one seller. Analyze how monopoly determines the quantity to produce and the price to charge. See how monopoly’s decisions affect economic well-being. Consider the various public policies aimed at solving the monopoly problem. See why monopolies try to charge different prices to different customers. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

MONOPOLY While a competitive firm is a price taker, a monopoly firm is a price maker. A firm is considered a monopoly if . . . it is the sole seller of its product. its product does not have close substitutes. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

The fundamental cause of monopoly is barriers to entry. Why Monopolies Arise The fundamental cause of monopoly is barriers to entry. Barriers to entry have three sources: Ownership of a key resource. The government gives a single firm the exclusive right to produce some good. Costs of production make a single producer more efficient than a large number of producers. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Why Monopolies Arise Monopoly resources Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason. Government created monopolies Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets. Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Why Monopolies Arise Natural Monopolies An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-1: Economies of Scale as a Cause of Monopoly Cost Average total cost Quantity of Output Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Pricing and Production Decisions Monopoly versus Competition Monopoly Is the sole producer Faces a downward-sloping demand curve Is a price maker Reduces price to increase sales Competitive Firm Is one of many producers Faces a horizontal demand curve Is a price taker Sells as much or as little at same price Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-2: Demand Curves for Competitive and Monopoly Firms (a) Competitive Firm (b) Monopoly Price Price Demand Demand Quantity of Output Quantity of Output Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

A Monopoly’s Revenue Total Revenue P  Q = TR Average Revenue TR/Q = AR = P Marginal Revenue TR/Q = MR Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Table 15-1: A Monopoly’s Total, Average, and Marginal Revenue. Quantity of Water Price Total Revenue Average Revenue Marginal Revenue (Q) (P) (TR = P x Q) (AR = P x Q) (MR = ∆TR/∆Q) ------ $ 0 $ 11 $ 10 10 1 8 9 18 2 - 4 3 24 8 - 2 4 28 7 5 30 6 2 Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

A Monopoly’s Revenue A Monopoly’s Marginal Revenue A monopolist’s marginal revenue is always less than the price of its good. The demand curve is downward sloping. When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

A Monopoly’s Revenue A Monopoly’s Marginal Revenue When a monopoly increases the amount it sells, it has two effects on total revenue (P  Q). The output effect—more output is sold, so Q is higher. The price effect—price falls, so P is lower. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-3: The Demand and Marginal Revenue Curves for a Monopoly Price 11 Marginal revenue Demand (average revenue) 10 9 8 7 6 5 4 3 2 1 –1 1 2 3 4 5 6 7 8 –2 –3 –4 Quantity of Water Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Profit Maximization A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. It then uses the demand curve to find the price that will induce consumers to buy that quantity. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-4: Profit Maximization for a Monopoly Costs and Revenue 2. … and then the demand curve shows the price consistent with this quantity. Monopoly price B Marginal revenue Demand Average total cost Marginal cost A 1. The intersection of the MR curve and the MC curve determines the profit maximizing quantity… QMAX Q1 Q2 Quantity Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Profit Maximization Comparing Monopoly and Competition For a competitive firm, price equals marginal cost. P = MR = MC For a monopoly firm, price exceeds marginal cost. P > MR = MC Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

A Monopoly’s Profit Profit equals total revenue minus total costs. Profit = TR - TC Profit = (TR/Q - TC/Q)  Q Profit = (P - ATC)  Q The monopolist will receive economic profits as long as price is greater than average total cost. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-5: The Monopoly’s Profit Costs and Revenue Marginal cost Marginal revenue Demand Average total cost Monopoly price E B Monopoly profit C Average total cost D QMAX Quantity Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

CASE STUDY: The Market for Drugs A new drug discovery gives rise to a patent and gives the firm a monopoly on the sale of that drug. When the patent expires and any company can make or sell the drug. The market switches from being monopolistic to being competitive. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-6: The Market for Drugs Costs and Revenue Price during patent life Monopoly quantity Marginal cost Price after patent expires Competitive quantity Demand Marginal revenue Quantity Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

THE WELFARE COST OF MONOPOLY In contrast to a competitive firm, the monopoly charges a price above the marginal cost. From the standpoint of consumers, this high price makes monopoly undesirable. However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-7: The Efficiency Level of Output Price Marginal cost Cost to monopolist Value to buyers Value to buyers Cost to monopolist Demand (Value to buyers) Efficient quantity Quantity Value to buyers is greater than cost to sellers Value to buyers is less than cost to sellers Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Deadweight Loss Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost. This wedge causes the quantity sold to fall short of the social optimum. The Inefficiency of Monopoly The monopolist produces less than the socially efficient quantity of output. The “economic pie” shrinks. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-8: The Inefficiency of Monopoly Price Marginal cost Deadweight loss Monopoly price Monopoly quantity Efficiency quantity Demand Marginal revenue Quantity Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Deadweight Loss The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax. The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PUBLIC POLICY TOWARD MONOPOLIES Government responds to the problem of monopoly in one of four ways. Making monopolized industries more competitive. Regulating the behaviour of monopolies. Turning some private monopolies into public enterprises. Doing nothing at all. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Competition Law Legislation designed to encourage competition and discourage the use of monopoly practices can curb the inefficiencies resulting from market power in general and monopoly in particular. Competition law has a long history in Canada: 1889: The Act for the Prevention and Suppression of Combinations Formed in Restraint of Trade. 1910: Combines Investigation Act 1986: Competition Act and the Competition Tribunal Act Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Competition Law The Competition Act: “… maintain and encourage competition in Canada in order to promote the efficiency and adaptability of the Canadian economy… …. and in order to provide consumers with competitive prices and product choices.” Competition law in Canada is enforced by the Commissioner of Competition of the Competition Bureau, a unit within the Federal government’s Industry Canada. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Competition Law Competition laws have costs and benefits. Sometimes companies merge not to reduce competition but to lower costs through joint production. The benefits of greater efficiencies through mergers are called synergies. If the competition laws are to raise social welfare, the government must determine which mergers are desirable and which are not. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Regulation Government may regulate the prices that the monopoly charges. This is often the case with natural monopolies where governments regulate the price. The allocation of resources will be efficient and total surplus maximized if price is set to equal marginal cost. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Regulation Two practical problems associated with marginal-cost pricing. Natural monopolies often have declining average total cost. (See Figure 15-9) The price is less than ATC thus creating losses. No incentive for monopolist to reduce costs. Reducing costs will reduce prices. In practice, regulators will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-9: Marginal Cost Pricing Price Demand Average total cost Average total cost Loss Marginal cost Regulated price Quantity Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Public Ownership Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself. Crown Corporations Canada Post CBC Hydro-Québec Saskatchewan Tel and B.C. Tel. Ontario Hydro. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Doing Nothing Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies. Government intervention such as regulation can cause average costs to inflate (Political failure), increasing the deadweight loss above its “do nothing” level. (See Figure 15-10) Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-10: Political Failure and Average Costs Curves Price ATCinflated ATCtrue G F Pinflated Qinflated A P0 B Q0 E Ptrue D Qtrue Marginal cost C Demand Marginal revenue Quantity Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PRICE DISCRIMINATION Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PRICE DISCRIMINATION Perfect Price Discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price. Three important effects of price discrimination: It can increase the monopolist’s profits. Need to separate customers according to their ability to pay. No arbitrage, the process of buying a good in one market at a low price and selling it in another market at a higher price. It can reduce deadweight loss. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Figure 15-11: Welfare with and without Price Discrimination (a) Single price monopolist (b) Perfectly discriminating monopolist Price Price Consumer surplus D MC Profit Monopoly price Quantity sold Deadweight loss Profit MC Quantity sold D MR Quantity Quantity Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

PRICE DISCRIMINATION Examples of Price Discrimination Movie tickets Airline prices Discount coupons Financial aid Quantity discounts Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Conclusion How prevalent are the problems of monopolies? Monopolies are common. Most firms have some control over their prices because of differentiated products. Firms with substantial monopoly power are rare. Few goods are truly unique. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Summary A monopoly is a firm that is the sole seller in its market. It faces a downward-sloping demand curve for its product. A monopoly’s marginal revenue is always below the price of its good. Like a competitive firm, a monopoly maximizes profit by producing the quantity at which marginal cost and marginal revenue are equal. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Summary Unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost. A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus. A monopoly causes deadweight losses similar to the deadweight losses caused by taxes. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Summary Policymakers can respond to the inefficiencies of monopoly behaviour with competition laws, regulation of prices, or by turning the monopoly into a government-run enterprise. If the market failure is deemed small, policymakers may decide to do nothing at all. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

Summary Monopolists can raise their profits by charging different prices to different buyers based on their willingness to pay. Price discrimination can raise economic welfare and lessen deadweight losses. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

The End Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition