ECON 201: Principles of Microeconomics Chapter 9 of McEachern: Monopoly What is Monopoly? A Single Seller is the Sole Supplier in a Market where the Product has no Substitutes 1

2 Chapter 9: Monopoly Major Themes for this Chapter: What are Barriers to Entry, and what are their relationships to monopolies? What are examples of Monopolies in real world markets? What is the Theory of Pure Monopoly? What does it predict?

3 Chapter 9: Monopoly What are Barriers to Entry, and what are their relationships to monopolies?  Barriers to Entry prevent new firms from becoming viable competitors within a profitable market.  Contrast this situation to the “Free Entry-Free Exit” Conditions in Perfect Competition.  “Entry and Exit” Conditions are a key factor in determining the competitiveness and the level of long-run profit of a firm within a market.

4 What are typical examples of Barriers to Entry? Legal Restrictions Patents – 20-year incentive for inventors Licenses – e.g., broadcast radio and TV signals Economies of Scale – reduce average total cost by increasing # of units produced. e.g., electric power utility firms Control of Essential Resources – e.g., China as a monopoly supplier of Pandas to zoos Customer Loyalty – consumers who will only purchase specific brands. e.g., Harley Davidson motorcycle riders High Cost of Start-up – e.g., in the aircraft industry, the very high cost of designing and producing airliners. Chapter 9: Monopoly

5 What are examples of Monopolies in real world markets? The US Post Office has the exclusive right to deliver first-class mail to your mailbox. Many local public utilities are the exclusive providers of water supply and electric power to individual households within their service areas. DeBeers Consolidated Mines, for many years, was practically the sole source of the world’s supply of rough diamonds.

6 Chapter 9: Monopoly Economist’s vocabulary: How does a “Natural Monopoly” differ from an “Artificial Monopoly”? What are Natural Monopolies? Technological or Production-Related Factors create a Downward-Sloping long-run Average Total Cost Curve known as “Economies of Scale” Public Utilities (such as electric power and water supply) are typical examples of natural monopolies. Many Natural Monopolies are regulated by Public Utility Commissions See below for an illustration of "Economies of Scale” $TC/Q Quantity of Output Average Total Cost Curve

7 Chapter 9: Monopoly Economist’s vocabulary: How does a “Natural Monopoly” differ from an “Artificial Monopoly”? (Continued) What are Artificial Monopolies? Collusion or cooperation among sellers in the same industry create a “Cartel” Instead of competition, the industry's firms unite their production and pricing strategies into a unified cartel policy – effectively becoming a single seller.

8 Chapter 9: Monopoly Economist’s vocabulary: How does a “Natural Monopoly” differ from an “Artificial Monopoly”? (Continued) What are Artificial Monopolies? (Continued) OPEC (Organization of the Petroleum Exporting Countries) is an example of a cartel. In the US, if firms in the same industry secretly conspire to create a cartel to fix prices or otherwise control the market, they can be investigated by the Federal Trade Commission and prosecuted by the US Justice Department under the US Antitrust Laws.

9 Chapter 9: Monopoly What is the Theory of Pure Monopoly? What does it predict? Important Observation about Pure Monopoly: A Monopolist is a “Price Maker” who faces a downward-sloping demand curve. Contrast the Monopolist with a Perfectly Competitive Firm $Price Quantity Monopolist’s Demand Perfectly Competitive Firm’s Demand

10 Chapter 9: Monopoly The importance of calculating “Marginal Revenue” for a monopolist (or any imperfect competitor): Marginal Revenue (MR) = Change in $Total Revenue  Change in Total Output Sold MR =  $TR/  Q Marginal Revenue – Answers the entrepreneur’s question, “What is the extra gain in revenue by producing and selling another product unit?”

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14 Chapter 9: Monopoly Next Question: In microeconomic theory, what is the primary goal of managing any firm? Answer: Maximize Total Profit Result: Assume that a pure monopoly is managed to earn maximum total profit.

15 Chapter 9: Monopoly Follow-up Question: How will the manager of the monopoly assure that maximum total profit is achieved? Answer: To maximize total profit, a monopolist will monitor the extra revenue (Marginal Revenue = MR) and extra cost (Marginal Cost = MC) of each production unit. As long as a positive (+) profit margin is generated by producing another unit, then expand production by another unit.

16 Chapter 9: Monopoly Production will increase, as long as: Marginal Revenue (MR) > Marginal Cost (MC) The monopolist’s production will only stop when no additional (+) profit margin exists. When “marginal profit” = $0, then Total Profit has hit a maximum. Logically, the goal of Maximum Total Profit means that production is taken to the output level where: $Marginal Revenue (MR) = $Marginal Cost(MC) The above result (MR=MC) can be graphically illustrated. See the next slide.

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18 Chapter 9: Monopoly Question: What are the long run impacts on the entire economy when a monopoly sets MR=MC to maximize total profit? Multi-faceted Answer: Monopolists earn an above-normal profit in the long run, if entry barriers remain high. Monopolists produce Q where $P > $MC, because they maximize total profit where $MR=$MC. Monopolists restrict market output Q compared to the results of Perfect Competition.

19 Chapter 9: Monopoly Question: What are the long run impacts on the entire economy when a monopoly sets MR=MC to maximize total profit? Answer: Continued, in more detail. Production and Price Results in Monopoly: Produce the level of Q such that: $MR = $MC However, we also know that*: $MR < $Product Price *Note: ($P > $MR) by definition, because of negatively-sloped demand. Therefore, by logical deduction, we conclude: $MC < $Product Price

20 Chapter 9: Monopoly Question: What are the long run impacts on the entire economy when a monopoly sets MR=MC to maximize total profit? Answer: Continued, in more detail. In Pure Monopoly, produce the Q level where: $Price > $Marginal Cost What does $P > $MC mean? It means that consumers value the last unit of the product more than it costs to produce that last unit. The $P > $MC outcome of monopoly is not economically efficient.

21 Chapter 9: Monopoly Question: What are the long run impacts on the entire economy when a monopoly sets MR=MC to maximize total profit? Answer: Continued, in more detail. The $P > $MC outcome of monopoly is not economically efficient: Product Price does NOT measure the product’s true scarcity. The economy no longer has any guarantee that it will be allocatively efficient. Monopolists restrict the output level (Q) compared to the output volume produced in perfect competition. If entry of new firms into the industry never occurs, then a monopoly can permanently earn above-normal (economic) profit.