2. Monopoly and How It Arises
A monopoly is a market:
That produces a good or service for which no close substitute exists
In which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

3. Monopoly and How It Arises
HOW MONOPOLY ARISES
A monopoly has two key features:
No close substitutes
Barriers to entry
No Close Substitutes
If a good has a close substitute, even if it is produced by only one firm, that firm effectively faces competition from the producers of the substitute.
A monopoly sells a good that has no close substitutes.

4. Monopoly and How It Arises
Barriers to Entry
A constraint that protects a firm from potential competitors are called barriers to entry.
Three types of barriers to entry are
Natural barrier to entry
Ownership barrier to entry
Legal barrier to entry

5. Monopoly and How It Arises
Natural Barrier to Entry
A natural barrier to entry creates natural monopoly.
A natural monopoly is an industry in which economies of scale enable one firm to supply the entire market at the lowest possible cost.
Figure 10.1(a) illustrates a natural monopoly.

6. Monopoly and How It Arises
Ownership Barrier to Entry
An ownership barrier to entry occurs if one firm owns a significant portion of a key resource.
During the last century, De Beers owner 90 percent of the world’s diamonds.

7. Monopoly and How It Arises
Legal Barrier to Entry
A legal barrier to entry creates a legal monopoly.
A legal monopoly is a market in which competition and entry are restricted by the granting of a
Public franchise (like the Australia Post, a public franchise to deliver mail)
Government licence controls entry in professions such as law, medicine, and dentistry
Patent or copyright

8. Monopoly and How It Arises
A MONOPOLY’S GOAL AND CONSTRAINTS
A monopoly’s goal is to maximise economic profit.
A firm’s economic profit is equal to total revenue minus total cost.
Total revenue is the amount received from selling the firm’s product.
Total cost is the opportunity cost of the firm’s production, which includes the cost of the labour, capital, land (raw materials), and entrepreneurship used by the firm.

9. Monopoly and How It Arises
A monopoly faces two sets of constraints in the pursuit of maximum profit. They are
Market demand
Technology and cost
Market Demand
Because a monopoly is the only seller in a market, the demand curve that it faces is the market demand curve.
A monopoly sells a good or service that has no close substitute, so the demand curve for the firm’s good or service slopes downward.

10. Monopoly and How It Arises
Technology and Cost
To produce its good or service, a monopoly must set up its production plant and equipment and hire the labour and other resources needed.
Because a monopoly experiences economies of scale, it has a high fixed cost of its plant and a low marginal cost.
The greater the quantity produced, the more units over which the monopoly spreads its high fixed cost, so the lower is its average total cost of production.

11. Monopoly and How It Arises
Figure 10.1(a) shows the demand curve, D, facing a monopoly electricity producer.
The ATC curve shows the average total cost of producing a kilowatt hour of electricity, which is the total cost of operating the plant, divided by the number of units produced.

12. Monopoly and How It Arises
Figure 10.1(b) shows the monopoly’s economic profit.
Economic profit equals total revenue minus total cost.
The blue rectangle shows the monopoly’s profit if it produces 2 megawatt hours.
The price charged by a monopoly exceeds the average total cost of producing the good.

13. Monopoly and How It Arises
Figure 10.1(c) shows the producer surplus made by a monopoly electricity producer.
The monopoly’s profit is shown by the blue rectangle.
The monopoly sells for a price that exceeds average total cost.

14. Monopoly and How It Arises
ECONOMIC RENT AND RENT SEEKING
A monopoly’s economic profit and producer surplus are called economic rents.
An economic rent is any surplus—economic profit, producer surplus, or consumer surplus.
The activity of trying to increase an economic rent by taking the economic rent of someone else is called rent seeking.

15. Monopoly and How It Arises
Rent Seeking in the Political Marketplace
Most legal monopolies either exist, or are as effective as they are, as a result of rent seeking.
They result from lobbying activities and financial contributions to politicians and political parties.
Legal barriers to entry are valuable to those protected by them.
It is profitable for a legal monopoly to use resources in the political marketplace to create new barriers to entry or to raise the height of the existing barrier.

16. Monopoly and How It Arises
A monopoly is better off if it can resist regulation in the social interest.
So monopolies work hard to capture the regulator and ensure that the producer’s self-interest prevails over the social interest.

17. Monopoly and How It Arises
Rent Seeking by Price Discrimination
A firm practises price discrimination when it sells different units of a good or service for different prices or when it sells to different buyers at different prices.
When a firm price discriminates, it is rent seeking—transferring consumer surplus to the monopoly and converting it to producer surplus.
Not all monopolies can price discriminate.
Some monopolies must operate as a single-price monopoly, which is a firm that sells each unit of its output for the same price to all its customers.

18. A Single-Price Monopoly’s Output and Price
Total revenue, TR, is the price, P, multiplied by the quantity sold, Q.
Marginal revenue, MR, is the change in total revenue that results from a one-unit increase in the quantity sold.
For a single-price monopoly, marginal revenue is less than price at each level of output. That is,
MR < P.

19. A Single-Price Monopoly’s Output and Price
Figure 10.2 illustrates the relationship between price and marginal revenue and derives the marginal revenue curve.
Suppose the hairdresser in Augathella has a monopoly sets a price of $16 and sells 2 units.
Marginal revenue curve
Students don’t find the concept of marginal revenue difficult, but they do need to be clear on the intuition of the MR curve and the reason why MR < P for a single-price monopoly. This fact is the central source of the monopoly predictions.

20. A Single-Price Monopoly’s Output and Price
Now suppose the firm cuts the price to $14 to sell 3 units.
It loses $4 of total revenue on the 2 units it was selling at $16 each.
And it gains $14 of total revenue on the 3rd unit.
So total revenue increases by $10, which is marginal revenue.

21. A Single-Price Monopoly’s Output and Price
The marginal revenue curve, MR, passes through the red dot midway between 2 and 3 units and at $10.
You can see that MR < P at each quantity.

22. A Single-Price Monopoly’s Output and Price
Maximising Economic Profit
Table 10.1 (on the next slide) provides information about Paula’s costs, revenues, and economic profit.
Economic profit equals total revenue (TR) minus total cost (TC).
As output increase, economic profit increases at small output levels, reaches a maximum, and then decreases.

23. A Single-Price Monopoly’s Output and Price

24. A Single-Price Monopoly’s Output and Price
Marginal Revenue Equals Marginal Cost
Table 10.1 also shows Paula’s marginal revenue (MR) and marginal cost (MC).
When Paula’s increases output from 2 to 3 haircuts, MR is $10 and MC is $8. MR exceeds MC by $2 and Paula’s economic profit increases by that amount.
If Paula’s increases output from 3 to 4 haircuts, MR is $6 and MC is $8. MC exceeds MR by $2, so economic profit decreases by that amount.
The monopoly produces the profit-maximising quantity, where MR = MC.

25. A Single-Price Monopoly’s Output and Price
The monopoly produces the output at which MR equals MC and sets the price at which it can sell that quantity.
The ATC curve tells us the average total cost.
Economic profit is the profit per unit multiplied by the quantity produced—the blue rectangle.
The classic monopoly diagram
The classic monopoly diagram, Figure 10.4(b) provides a good opportunity to tell your students about the contribution of one of the most brilliant economists of the 20th century, Joan Robinson. This diagram first appeared in her book, The Economics of Imperfect Competition, published in 1933 when she was just 30 years old.
You can learn more about Joan Robinson at (or use the link on the Economics Place Web site).
Women are still not attracted to economics on the scale that they’re attracted to most other disciplines, so the opportunity to talk about an outstanding female economist shouldn’t be lost. Joan Robinson was a formidable debater and reveled in verbal battles, a notable one of which was with Paul Samuelson on one of her visits to MIT. Anxious to make and illustrate a point, Samuelson asked Robinson for the chalk. Monopolising the chalk and the blackboard, the unyielding Robinson snapped, “Say it in words young man.” Samuelson meekly obeyed. This story illustrates Joan Robinson’s approach to economics: work out the answers to economic problems using the appropriate techniques of math and logic, but then “say it in words.” Don’t be satisfied with formal argument if you don’t understand it. Your students will benefit from this story if you can work it into your class time.

26. A Single-Price Monopoly’s Output and Price
MONOPOLY AND COMPETITION COMPARED
Comparing Price and Output
Figure 10.4 shows that a competitive equilibrium.
A single-price monopoly produces 3,000 haircuts an hour and sells them at $14 a haircut.
Compared with competition, monopoly produces a smaller output and charges a higher price.

27. A Single-Price Monopoly’s Output and Price
Efficiency Comparison
Figure 10.5(a) shows the efficiency of perfect competition.
The market demand curve is the marginal social benefit curve, MSB, and the market supply curve is the marginal social cost curve, MSC.
So competitive equilibrium is efficient: MSB = MSC.

28. A Single-Price Monopoly’s Output and Price
Consumer surplus is the area below the demand curve and above the price.
Total surplus is maximised and the quantity produced is efficient.

29. A Single-Price Monopoly’s Output and Price
Figure 10.5(b) shows the inefficiency of monopoly.
Because price exceeds marginal social cost, marginal social benefit exceeds marginal social cost.
A deadweight loss arises.
Monopoly is inefficient. The inefficiency of monopoly is one of the key propositions in this chapter.
Because P > MR, and because MR = MC, P > MC—single-price monopoly under-produces and creates deadweight loss.
Rent seeking uses further resources so potentially the social cost of monopoly is the sum of the deadweight loss and the economic profit that a monopoly might earn.
Adam Smith described the situation thus: “People in the same trade seldom meet together, even for merriment and diversion, but the conversation ends in some contrivance to raise prices.”

30. A Single-Price Monopoly’s Output and Price
Redistribution of Surpluses
Some of the lost consumer surplus (blue rectangle) goes to the monopoly as producer surplus.
This portion of the loss of consumer surplus is not a loss to society. It is a redistribution from consumers to the monopoly producer.

31. Price Discrimination
Price discrimination is the practice of selling different units of a good or service for different prices.
To be able to price discriminate, a monopoly must:
1 Identify and separate different buyer types.
2 Sell a product that cannot be resold.
Price differences that arise from cost differences are not price discrimination.
Price discrimination may not be fair, but it is efficient
Be sure that the students understand that aside from equity considerations, resources will be allocated more efficiently in a monopoly market under any price discrimination scenario than under a single-price scenario.

32. Price Discrimination PROFITING BY PRICE DISCRIMINATING
Figures 10.8 and show the same market with a single price and price discrimination.
As a single-price monopoly, this firm maximises profit by producing 8 trips a year and selling them for $600 each.

33. Price Discrimination
By price discriminating, the firm can increase its profit.
In doing so, it converts consumer surplus into economic profit.

34. Price Discrimination PERFECT PRICE DISCRIMINATION
Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price anyone is willing to pay.
Marginal revenue now equals price and the demand curve is also the marginal revenue curve.

35. Price Discrimination With perfect price discrimination:
The profit-maximising output increases to the quantity at which price equals marginal cost.
Producer surplus is maximised and consumer surplus is zero.
Deadweight loss is eliminated.

36. Price Discrimination
EFFICIENCY, EQUITY, AND RENT SEEKING WITH PRICE DISCRIMINATION
The more perfectly a monopoly can price discriminate, the closer its output is to the competitive output (P = MC) and the more efficient is the outcome.
But this outcome differs from the outcome of perfect competition in two ways:
1 The monopoly captures the entire consumer surplus.
2 The increase in economic profit attracts even more rent-seeking activity that leads to inefficiency.

37. Monopoly Policy Issues
GAINS FROM MONOPOLY
The main reason why monopoly exists is that it has potential advantages over a competitive market.
These advantages arise from
Incentives to innovation
Economies of scale and economies of scope
A quick introduction
The treatment of monopoly policy here is brief and designed for the instructor who wants to cover the topic briefly and at this point in the course. Chapter 14 provides a more extensive treatment of regulation and antitrust law. You can cover that chapter, in whole or part, right now if you want to do more on the topic.

38. Monopoly Policy Issues
NATURAL MONOPOLY REGULATION
Regulation: rules administrated by a government agency to influence prices, quantities, entry, and other aspects of economic activity.
Two theories about how regulation works are
Social interest theory: the political and regulatory process relentlessly seeks out inefficiency and regulates to eliminate deadweight loss.
Capture theory: regulation serves the self-interest of the producer, who captures the regulator.
A quick introduction
The treatment of monopoly policy here is brief and designed for the instructor who wants to cover the topic briefly and at this point in the course. Chapter 14 provides a more extensive treatment of regulation and antitrust law. You can cover that chapter, in whole or part, right now if you want to do more on the topic.

39. Monopoly Policy Issues
Efficient Regulation of a Natural Monopoly
When demand and cost conditions create natural monopoly, the quantity produced is less than the efficient quantity.
How can government regulate natural monopoly so that it produces the efficient quantity.
Marginal cost pricing rule is a regulation that sets the price equal to the monopoly’s marginal cost.
The quantity demanded at a price equal to marginal cost is the efficient quantity.

40. Monopoly Policy Issues
Figure illustrates the marginal cost pricing rule.
Unregulated the natural monopoly maximises economic profit by producing the quantity at which marginal revenue equals marginal cost …
and charging the highest price at which that quantity will be bought.

41. Monopoly Policy Issues
Regulating a natural monopoly in the social interest sets the quantity where MSB = MSC.
The demand curve is the MSB curve.
The marginal cost curve is the MSC curve.
Efficient regulation sets the price equal to marginal cost.

42. Monopoly Policy Issues
With marginal cost pricing rule, the quantity produced is efficient,
but the average cost exceeds price, so the firm incurs an economic loss.
How can the firm cover its costs and at the same time obey the marginal cost pricing rule?

43. Monopoly Policy Issues
Where possible, a regulated natural monopoly might be permitted to price discriminate to cover the loss from marginal cost pricing.
Or the natural monopoly might charge a one-time fee to cover its fixed costs and then charge a price equal to marginal cost.

44. Monopoly Policy Issues
Second-Best Regulation of a Natural Monopoly
A natural monopoly cannot always be regulated to achieve an efficient outcome.
Two possible ways of enabling a regulated monopoly to avoid an economic loss are
Average cost pricing
Government subsidy

45. Monopoly Policy Issues
Average Cost Pricing
The average cost pricing rule sets the price equals average total cost.
The monopoly produces the quantity at which the ATC curve cuts the demand curve.
The monopoly makes zero economic profit—breaks even

46. Monopoly Policy Issues
Government Subsidy
A government subsidy is a direct payment to a firm equal to its economic loss.
To pay a subsidy, the government must raise the revenue by taxing some other activity.
But taxes themselves generate deadweight loss.

47. Monopoly Policy Issues
And the Second Best Is …
Which is the better option, average cost pricing or marginal cost pricing with a government subsidy?
The answer depends on the relative magnitudes of the two deadweight losses.
The smaller deadweight loss is the second-best solution to regulating a natural monopoly.
Implementing either pricing rule presents the regulator with a challenge because it can only estimate the firm’s costs.

48. Monopoly Policy Issues
The practical regulation that economists favour today is price cap regulation.
Price Cap Regulation
A price cap regulation is a price ceiling.
The rule specifies the highest price that the firm is permitted to charge.
This type of regulation gives the firm an incentive to operate efficiently and keep costs under control.

49. Monopoly Policy Issues
Unregulated, a natural monopoly profit-maximises.
A price cap sets the maximum price.
The firm has an incentive to minimise cost and produce the quantity on the demand curve at the price cap.
The price cap regulation lowers the price and increases the quantity.