1. Monopoly
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2. Drawing on Chapter 12
Graphics copyright © The McGraw-Hill Companies, Inc. All rights reserved.

3. Overview Monopoly Setting a Single Price and Output
Definition
Sources
Profit Maximization
Setting a Single Price and Output
The Short Run
Adjustments In The Long Run
Price Discrimination
The Social Perspective
Efficiency and Consumer Surplus Losses
Public Policy Toward Natural Monopoly
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4. What is a Monopoly? Single seller Product with no close substitutes
Monopolist has significant control over the price(s) it charges
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5. Five Sources Of Monopoly
Exclusive control over important inputs
Economies of scale (natural monopoly)
Patents & copyrights
Network economies
Government licenses or franchises
These are all types of barriers to the entry of other firms.
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6. Input Control Minerals Expertise: nuclear reactor vessels
Diamonds: DeBeers cartel and beyond
Rare earths
China: before and after cutoff of exports
Beryllium & Brush Wellman/Materion
Expertise: nuclear reactor vessels
Some of these are not complete monopolies, but come close enough to discuss in this context.
The DeBeers link is to a mining information website article about the DeBeers cartel that long dominated the international diamond market. The “beyond” link is to an Economist article reporting more details of the end of the DeBeers cartel.
The first China article is a more comprehensive economic analysis by Ed Dolan (in Seeking Alpha) about the 2010 cutoff of exports that drove up international prices, which misuses the term “natural monopoly.” The second, from Extreme Tech, reports a WTO complaint against China.
The “Beryllium” link is to an article, “Beryllium – Where the USA Dominates” that emphasizes national-level market control, but does refer specifically to the sources of mineral supply and Materion (“the 800-lb. gorilla”). The “Materion” link is to its page about its big beryllium mine, referred to as the world’s largest source of the ore, with a photo.
The “nuclear reactor vessels” link is to a description of the process for making them in the only company (in Japan) that can do it.
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7. Figure 12.1: Natural Monopoly
Frank’s example is a natural monopoly. Is the second example a natural monopoly, or not?
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8. Other Sources Patents & copyrights Network economies
Pharmaceuticals
Publishing
Movies
Network economies
Windows & Android?
Government licenses
India’s “License Raj”
The “patents and copyrights” link is to the US Trade Representative’s page on increasing these through the Trans-Pacific Partnership.
The “Windows” link is to a page with a chart comparing market shares over time of desktop PC operating systems.
The “Android” link is to a chart of mobile “phone” OS market shares in various countries and a time series graph that shows Android’s share as growing at the expense of everyone else except Apple.
The exclusive charter to trade in India of the British East India Company was the predecessor of the post-independence “license Raj”, which was nicknamed after the colonial power’s system of control. The link is to a 4-min. video critique of it from the “Commanding Heights” series, with examples of mediocre unchanging products, bureaucratic offices, and talking heads.
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9. Profit-Maximization by Monopolists
Economic profit,  = TR - TC
Maintain the assumption that the firm’s goal is to maximize economic profit
With barriers to entry, evolutionary justification is weaker, but still exists
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10. Figure 12.2: The Total Revenue Curve for a Perfect Competitor
For firms facing fixed P, TR is linear in Q.
The TR curve from the exercise we recently did about perfect competition illustrates this.
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11. Monopoly Pricing Monopolist faces market demand Monopolist may charge
P varies inversely with Q
Monopolist may charge
One price to all buyers (single price)
Different prices to different buyers (price discriminate) – if possible
Start analysis with single price
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12. Figure 12.3: Demand, Total Revenue, and Elasticity
For a monopolist facing full market demand (and P that varies with Q), TR is not linear.
For linear demand, as price falls, total revenue instead reaches a maximum value at the quantity corresponding to the midpoint of the demand curve after which it again begins to fall. Total revenue reaches its maximum value when the price elasticity of demand is unity.
This just repeats what we already studied for total expenditure in the context of Frank’s chapter 4, without worrying about whether all of that expenditure was paid to one firm.
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13. Figure 12.4: Total Cost, Revenue, and Profit Curves for a Monopolist
A monopolist facing this linear demand and a typical cost function will choose Q (and corresponding P) that maximizes economic profit (pi) in the way shown.
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14. Marginal Analysis Profit is maximized at Q where MR = MC
For a perfectly competitive firm, MR = P (given)
For a monopolist, MR depends on Q (chosen)
Knowing the total economic profit for every Q is a demanding information problem. It is mathematically equivalent to find the Q where MR = MC, and more realistic to have enough information to consider small changes.
As with a firm in perfect competition, MR is the marginal benefit to the firm of additional output. If output is not perfectly divisible, a profit-maximizing firm would choose the last unit of output for which MR>MC.
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15. Figure 12.5: Changes in Total Revenue Resulting from a Price Cut
We’ve been through this before in relation to our review of the price elasticity of demand. The total expenditure identified there for any number of suppliers is the total revenue for a single (monopoly) supplier.
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16. Figure 12.6: Marginal Revenue and Position on the Demand Curve
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17. Figure 12.7: The Demand Curve and Corresponding Marginal Revenue Curve
Apply the point-slope method of calculating the price elasticity of demand:  = (P/Q)(1/slope).
For || < 1, MR < 0
For || > 1, MR > 0
The less elastic demand is with respect to price, the more price will exceed marginal revenue.
[Go back to Figure 12.3, point to where MR would be on the D graph, and how its levels are reflected in the slope of the TR curve.]
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18. Figure 12.8: A Specific Linear Demand Curve and the Corresponding Marginal Revenue Curve
For a linear demand curve, here are two short cuts to MR. MR has the same vertical axis intercept, and:
MR has twice the slope of D
MR’s horizontal axis intercept is half that of D
[Optional calc-based derivation: D: P=a-bQ, TR = PQ = (a-bQ)Q = aQ-bQ2, dTR/dQ = MR = a-2bQ.]
Students: write MR function and draw D and MR “curves” for D: P=200-6Q.
[D’s Q-intercept is 33.3…, MR=200-12Q, with Q-intercept 16.6…]
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19. Figure 12.9: The Profit-Maximizing Price and Quantity for a Monopolist
A profit-maximizing single-price monopolist, then, will choose Q* where MR=MC, charging the P* matching Q* given D, and earn profit of (P*-ATC*)Q*.
What source of monopoly is probably in action here?
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20. Figure 12.10: The Profit-Maximizing Price and Quantity for Specific Cost and Demand Functions
For the specific simplified case with D of P=100-2Q, FC = 640, and MC = 20, here is the single-price profit-maximizing choice.
[MR = 100 – 4Q = 20 = MC. Solve for Q.
Also ATC = (FC + MC Q)/Q = FC/Q + MC.
Let’s work through another example: D of P=60-4Q, FC = 120, MC = 2Q. [After individual work outside of class and small-group work in class, review with spreadsheet table and graph, as well as algebra.]
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21. Profit-maximizing Monopoly Pricing
The profit-maximizing level of output must lie on the elastic portion of the demand curve.
This is one of the simplest rules we can infer about monopolies’ behavior.
Why? Think about why not to produce on the inelastic part of the demand curve.
[The P increase causes such small Q decrease that TR rises. As Q drops, TC drops, so profit rises. Go back to Figure 12.6]
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22. Profit-maximizing Monopoly Pricing
We can be more specific, however, in relating pricing to costs and the price elasticity of demand. We can rearrange the definition (formula) of marginal revenue into a form based on elasticity.
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23. Profit-maximizing Monopoly Pricing
Choosing the profit-maximizing output level brings in marginal cost, and we can rearrange the expression into the markup of (profit-maximizing) price over marginal cost, which is inversely proportional to elasticity.
So a monopolist facing more elastic demand (bigger epsilon, due to closer substitutes, etc.) will charge a lower markup over marginal cost, and the opposite for less elastic demand.
For example, if a monopolist has constant MC=10 and constant elasticity=-0.5, what price (P*) will it charge to maximize profit?
We’ll see later that this has implications for profit-maximizing price discrimination.
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24. Figure 12.11: A Monopolist who Should Shut Down in the Short-Run
The general prediction based on Fig presumed that the monopolist would benefit from producing some positive level of output. However, this is not always true. A monopolist should shut down production whenever average revenue is less than average variable cost at every level of output.
Note the parallel to the shutdown price for a firm in perfect competition (P=AR). The difference is that because P varies for a monopolist over different Qs, the comparison must be made at every Q, not just at the Q where AVC is minimized.
A minor note: Q1 would be the loss-minimizing (profit-maximizing) level of output if the monopolist did not shut down production. At level Q0, MR=SMC, but profit is only maximized where they intersect with MR decreasing faster. Consider why.
The link is to an article about the fate of Hummer. There were substitutes for Hummers, but its vehicles were relatively unique in the automotive market, so closer to monopoly products than most other automobiles. Initially the shutdown was not considered permanent (an exit from the market), but GM did not want to try to rebuild it after auto demand rises, and a buyer could not be found.
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25. A Monopolist Has No Supply Curve
The monopolist is a price maker.
When demand shifts, elasticity at a given price may either increase or decrease, and vice-versa.
So there is no unique correspondence between the monopolist’s price and quantity produced.
Monopoly has a supply rule, which is to equate marginal revenue and marginal cost.
Notice that the “inverse elasticity pricing rule” implicitly includes the output level among supply side factors, but also includes elasticity on the demand side.
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26. Figure 12.12: Long-Run Equilibrium for a Profit-Maximizing Monopolist
In the long run, a profit-maximizing monopolist still sets Q=Q* where MR=MC, but taking into account adjustments in all inputs, not just short run variable inputs, along LMC. At Q* that coincides with SMC for the corresponding level of FC that minimizes ATC (at ATC*Q*= LACQ*) given Q=Q*.
Note that there is still positive economic profit.
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27. Price Discrimination
Charging different prices to different buyers and/or for different units bought.
Examples
Volume discounts
Senior citizen discounts
Coupons ?
General definition applies to several types.
The links are to:
Vanguard share classes (with cost rates for Admiral vs. Investor shares)
AARP’s member discount advertising page (follow links to specific types to see %s)
A column by a woman reporting in detail about how time-consuming coupon use can be, and her opportunity costs given work alternatives.
[in ?, to Marcus Theaters’ student discount page.]
What other examples can you come up with? [such as student discounts]
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28. Price Discrimination
Third-degree: prices differ only across buyers in separate markets
Second-degree: each buyer chooses from the same structure of multiple prices across different numbers of units
First-degree: different price for every unit bought
Distinction between types in order of degree to which not only prices differ across units, but also to which monopolist captures consumer surplus.
Some authors use the term market segments for the different groups of buyers charged different prices.
Let’s examine them more closely, starting with third-degree.
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29. Figure 12.13: The Profit-Maximizing Monopolist Who Sells in Two Markets
Markets can be separated in a variety of ways. The key is that buyers in each market cannot resell their units to buyers in other markets – otherwise the “law of one price” would apply. For which of our previous examples is this true? [Senior citizen discounts]
Ask: who has bought international editions of textbooks? Why? Why cheaper?
The link in Two Markets is to an article about international textbook pricing. It first outlines some legal restrictions on international resales, though weak. The first paragraph under “Why are international editions cheaper?” talks about charging “what the market will bear.”
With a single price charged in each market, the inverse-elasticity pricing rule rules. Since there is only a single cost function for production for the two markets, we add the MR curves horizontally (adding Qs as functions of MR) to find a combined MR curve. This tracks the answers to the question: for each additional unit produced, in which market should this be sold, for a higher MR? Then find the Q=Q* at which combined MR = MC. The corresponding individual Qi*’s give us the Pi* in each market.
Write point-slope formula for elasticity: e = (P/Q)(1/slope). Which market has higher e at a given MC? [Market 1 has lower Q and slope, so larger e. Then charge smaller markup over MC.]
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30. Figure 12.14: A Monopolist with a Perfectly Elastic Foreign Market
Especially a few decades ago, when there were greater government-created barriers to international trade, it was fairly common for small economies to have a monopoly producer of a good with a government license or economies of scale, as well as a strongly protected national market. (Say, auto makers in Europe before the EU, or in S. Korea before WTO entry.) In a few cases, those monopolists also exported to foreign markets which were large and integrated enough to have a high degree of competition. Even today, with freer international trade, this story applies to a significant degree to producers in relatively protected markets.
Again (pointing to the graph for elements of the horizontal sum of MRH and MRF.)
Form the horizontal sum of MRs, asking the question: for each additional unit produced, in which market should this be sold, for a higher MR?
Find Q* where combined MR=MC.
Find corresponding Qi* and Pi*
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31. Figure 12.15: Perfect Price Discrimination
Next, first-degree, or perfect, price discrimination: every unit is sold at a different price, the maximum price the corresponding buyer is willing to pay, leaving no consumer surplus. It’s an ideal (from the perspective of the monopolist) that is never attained, just presented for comparison, as we do with many extremes/ideals.
When Radiohead (as reported in the article linked to Perfect) being idealists when asking fans to pay whatever they wanted for “In Rainbows”? Or good marketers of their brand of music?
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32. Figure 12.16: The Perfectly Discriminating Monopolist
Doesn’t the shaded area plus the ATC curve look like a smiling cartoon face? You’d be happy, too, if you wanted profit and got all the consumer surplus!
It illustrates the idea common to second-degree that the monopolist can charge some buyers with higher willingness to pay more without losing the buyers that aren’t willing to pay that much, and continue to serve the lower willingness-to-pay buyers without “undercharging” the higher willingness-to-pay buyers.
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33. Figure 12.17: Second-Degree Price Discrimination
Charging a finite number of different prices in the same market is second-degree.
[Only if lots of extra time, use Besanko-Breutigam example of optimal block tariff.]
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34. Figure 12.18: A Perfect Hurdle
A common example of this is creating a “hurdle” over which some, but not all, buyers will be willing to jump in order to get a lower price. The hurdle creates costs for buyers which are either not the same for all buyers or which some buyers are more willing to pay than others. To which of our previous examples does this apply? [Coupons.]
It’s sort of 3rd-degree price discrimination, but with a twist (the hurdle) that separates buyers based on behavior, not something more fixed (age, location, …).
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35. The Efficiency Loss From Monopoly
Deadweight loss from monopoly: the loss of efficiency (consumer surplus + producer surplus) due to the presence of a monopoly.
None if price discriminating perfectly.
Now let’s take the perspective of society as a whole, rather than the profit-seeking monopolist. First we’ll evaluate its effects. Then we’ll think about how to respond through government action.
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36. Figure 12.19: The Welfare Loss from a Single-Price Monopoly
S1 is DWL, S2 is remaining CS. This example has no fixed cost.
Now let’s go back to our previous example, with FC and rising MC.
In both cases, not only is there a welfare loss, but the monopolist is taking surplus away from consumers. As a result, there have historically been calls for government intervention to try to improve on these results.
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37. Public Policy Toward Natural Monopoly
State ownership and management
State regulation
Exclusive contracting
Vigorous enforcement of antitrust laws
A laissez-faire policy
The intervention – or lack thereof – can take several different forms.
Where monopoly is “natural” –
Where monopoly is not “natural” --
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38. Figure 12.20: A Natural Monopoly
An example with a FC.
Q* is the laissez faire outcome, with DWL of S and profit of pi.
Q** is efficient, with no DWL. What about profit?
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39. State Ownership And Management
Subsidization for greater allocative efficiency?
X-inefficiency? Or less than private?
Better quality assurance, or not?
For efficient regulation of natural monopoly, subsidization may be necessary to cover the difference between ATC and M.
Let’s return to the next two points when discussing articles next time.
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40. State Regulation Of Private Monopolies
Public Utilities
Usually rate of return guaranteed
Erring on the high side,
Incentives to overinvest
Possible cross-subsidization
If you get an above-normal rate of return on capital invested in a regulated public utility, what do you have an incentive to do?
[Cross-subsidization is illustrated graphically on the next slide.]
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41. Figure 12.21: Cross-Subsidization to Boost Total Output
Allowing a regulated rate of return (in accounting profit) above normal (the “cost of capital”)  an incentive to sell:
Below cost in the more elastic market, cross-subsidizing the resulting losses by selling
Above cost in the less elastic market
Given the differences in elasticity of demand, this increases total output, correspondingly necessary capital (the key part), and the above-normal profit obtained on that per unit.
[Draw copy of Market 2 graph and modify by adding a MR line and its profit-maximizing single price in the absence of cross-subsidization.]
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42. Exclusive Contracting for Natural Monopoly
Detailed contracts, competitive bidding?
Theory
Evidence
Hard to specify every detail of quality
Theory:
Even if one supplier, could not competition to be that supplier be enough to  more efficiency?
Evidence:
Successful in some areas and services, but not in others.
Among other potential problems, hard to specify …
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43. Antitrust and Laissez Faire
Sherman (1890) and Clayton (1914) Acts
HHI or other index, specification of market
Economies of scale vs. competition
Innovation and entry
The idea is to prevent “unnatural” monopolies that are not (due to lack of cost savings due to economies of scale that regulation may force companies to share with consumers) in the public interest.
Follow the link in HHI = Herfindahl-Herschman index to the Justice Department’s discussion of it, then follow the link to the Horizontal Merger guidelines description (section 5.3) that discusses (a bit down the page) the ranges of its value that are considered (at various labeled degrees of concentration) grounds for opposing a merger.
If extra time, go back up to the table of contents, and select
“Hypothetical monopolist test” (4.1.1) of whether there are close substitutes in the specified market,
6.4 Innovation and product variety (possibly discouraged when competition is lacking),
9. Entry (potential, and suggestive history of)
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44. Figure 12.22: The Efficiency Losses from Single-Price and Two-Price Monopoly
Less efficiency loss, the more differentiated prices are charged, but that comes with more loss of consumer surplus to monopolist’s profit.
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45. Figure 12.23: Does Monopoly Suppress Innovation?
Although, as the DOJ page indicates, there is commonly suspicion that monopolists will have less incentive to innovate, this is not necessarily true.
For example, in Frank’s example 12.4, a lightbulb-producing monopolist has a patent on a new energy-efficient technology – CFLs or LEDs – that saves the consumer electricity costs that more than compensate for the higher equipment cost. By lowering MC from 1 to 0.1, the technology could allow the firm to earn higher profits (area FGHK > area ABCE), and an incentive to introduce the innovation that also benefits consumers.
Would firms in perfect competition have the same incentive to introduce such an innovation? [Not the same incentive, but a different one: cut costs or others will undercut you and eliminate you.]
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