1. Chapter 13
Monopoly

2. Outline Market Power How a Firm Uses Market Power to Maximize Profit
The Costs of Monopoly: Deadweight Loss
The Costs of Monopoly: Corruption and Inefficiency
The Benefits of Monopoly: Incentives for Research and Development
Economies of Scale and the Regulation of Monopoly
Other Sources of Market Power

3. Introduction Since 1981 AIDS has killed over 36 million people.
In the U.S., deaths from AIDS dropped 50% due to drugs like Combivir.
INGRAM PUBLISHING/VETTA/GETTY IMAGES
A Combivir pill costs $0.50 to produce, but sells for 25 times higher - $ Why? 3

4. Definition Market power: Monopoly:
The power to raise price above marginal cost without fear that other firms will enter the market.
Monopoly:
A firm with market power. Normally thought of as a single seller in a market

5. Market Power GlaxoSmithKline owns the patent on Combivir.
A patent gives exclusive rights to make, use, or sell the product, i.e. a monopoly
GSK’s patent prevents competition.
This gives GSK market power.
India does not recognize the Combivir patent.
In India, an equivalent drug sells for $0.50, or the marginal cost.
Market Power = “lack of substitutes”

6. Definition Marginal revenue (MR): Marginal cost (MC):
the change in total revenue from selling an additional unit.
Marginal cost (MC):
the change in total cost from selling an additional unit.

7. Self-Check Market power allows a firm to raise price:
Above average cost.
Above marginal cost.
Above marginal revenue.
Answer: b – market power allows a firm to raise price above marginal cost, without fear that other firms will enter the market.

8. Market Power MC = MR MR < P
To maximize profit, firms produce at the level of output where:
A firm with market power faces a downward sloping demand curve.
It must lower price to sell an additional unit.
The additional revenue per unit < current price, or:
MC = MR
MR < P

9. Marginal Revenue
When price ↓ from $16 to $14, quantity ↑ from 2 to 3 units
Total revenue ↑ from $32 to $42.
MR, or the change in total revenue, is $10.
Figure 13-1 (13-1): Marginal Revenue

10. Marginal Revenue Price $20 Revenue loss $2 x 2 = $4 18 16
Price ↓ $16 to $14 14 12 10
MR =
$10
Revenue gain
14 x $1 = $14 8 6
Demand 4 2
Quantity 1 2 3 4 5 6 7 MR

11. Short-Cut for Finding MR
MR begins at same point on the vertical axis as demand.
MR has twice the slope (assuming linear demand curve).
Price a
Demand: P = a – b x Q 2b 1 b 1
MR = a – 2b x Q
Quantity
a/2b
a/b

12. Self-Check For a firm with market power, marginal revenue is:
Higher than price.
Equal to price.
Lower than price.
Answer: c – A firm with market power must drop its price to sell more units, so the marginal (additional) revenue is lower than price.

13. Profit Maximization for Monopoly
Just like for firms in a competitive industry:
Profit maximization consists of two steps:
Choosing a Quantity
Rule: choose Q where MR = MC
Choosing a Price
Choose the highest price you can get away with… which is the highest price consumers will pay for that Quantity
Rule: once you’ve picked your Quantity, then follow the graph to the Demand curve, which shows you how much consumers will pay (price).

14. Using Market Power to Maximize Profit
Price
($/pill)
Profit maximizing output: MR = MC at 80 million pills
Profit maximizing price = $12.50
Profit per pill = $10.00
Total profit = $10 x 80 = $800 m
Demand
$12.50
Profit
2.50 AC //
0.50 MC
Quantity
(millions of pills) 80 MR

15. Elasticity of Demand and Markup
Two effects make demand for pharmaceuticals inelastic:
The “you can’t take it with you” effect:
People with serious illnesses are relatively insensitive to the price of life saving drugs.
The “other people’s money” effect:
If third parties are paying for the medicine, people are less sensitive to price.
The more inelastic the demand curve, the more a monopolist will raise price above MC.

16. Elasticity of Demand and Markup
Price
Price
Relatively elastic demand
→ small markup
Relatively inelastic demand
→ big markup P P
Demand MC MC
Demand QE
Quantity Q
Quantity MR MR

17. Costs of Monopoly: Deadweight Loss
Monopolies charge a higher price and produce less than competitive firms.
Monopolies reduce total surplus (consumer surplus + producer surplus).
This implies a deadweight loss - sales that do not occur because the monopoly price is above the competitive price.
The real cost to society of monopoly is the lost gains from trade or DWL.

18. Costs of Monopoly: Deadweight Loss
Consumers get this
Consumers get this
Monopolist gets this PM
No one gets this
(deadweight loss) PC
Supply
MC = AC
Demand
Demand MR Q Q QC QM QC
Competition: P = MC
Monopoly: P > MR

19. Self-Check A monopolist’s price is: Lower than a competitive firm’s.
Higher than a competitive firm’s.
The same as a competitive firm’s.
Answer: b – a monopolist’s price is higher than a competitive firm’s.

20. Costs of Monopoly: Corruption and Inefficiency
Many monopolies are the result of government corruption.
Tommy Suharto, the Indonesian president’s son, was given the clove monopoly.
He bought the Lamborghini company with the monopoly profits.
In these cases, self-interest is channeled toward social destruction through poor institutions, instead of towards social prosperity through good institutions.

21. Costs of Monopoly: Corruption and Inefficiency
Monopolies are especially harmful if they control a good that is used to produce other goods.
In Algeria a dozen or so army generals each control a key good
People refer to these men as General wheat, General tire….
Each general tries to get a larger share of the economic pie.
The result is greater deadweight loss, and the “pie” shrinks.

22. Benefits of Monopoly: Incentives for R&D
Drug prices are lower in India and Canada.
India does not offer strong patent protection.
Canada’s government controls drug prices.
It costs $1 billion to develop a new drug.
Patents are one way of rewarding research and development (R&D).
Without patents firms would not spend on R&D, fewer new drugs would be developed.

23. Benefits of Monopoly: Incentives for R&D
Prizes can reward research and development without creating monopolies.
Patent Buyouts
If the government were to compensate patent holders the value of their patents (and then allow competition), prices could be driven down - eliminating the deadweight loss without eliminating the incentive to innovate.
Reduce price without reducing R&D.
Must raise taxes to pay for the patent.
May be difficult to determine a price.

24. Sources of Monopoly Power
Economies of scale
Barriers to entry
Network effects
Innovation

25. Definition Economies of Scale: Natural Monopoly:
the advantages of large-scale production that reduce average cost as quantity increases.
Natural Monopoly:
when a single firm can supply the entire market at a lower cost than two or more firms.

26. Natural Monopoly
Monopolies can arise naturally when economies of scale allow a single firm to produce at lower cost than many small firm.
Utilities such as water, natural gas, and cable television are often natural monopolies.
The largest firm will be able to produce its goods at a lower per unit cost than smaller firms, so only one firm tends to exist.
If economies of scale are large enough, price can be lower under natural monopoly than under competition.

27. Natural Monopoly P Average costs for small firms
It is possible for PM < PC
If economies of scale are large enough
Competitive
price PC
Monopoly
price PM AC MC
Demand Q
Monopoly
Quantity QM
Competitive
Quantity QC MR

28. Self-Check
Which of the following is most likely to be a natural monopoly:
A home builder.
A restaurant.
A railroad company.
Answer: c – a railroad company is most likely to be a natural monopoly, due to economies of scale and the high cost of duplicating tracks.

29. Definition Barriers to Entry
Factors that increase the cost to new firms of entering an industry

30. Self-Check
A monopolist will have normal profit when its price is set equal to:
Marginal cost.
Average cost.
Total cost.
Answer: a – a monopolist will have normal profit when P = AC.

31. Definition Barriers to entry:
factors that increase the cost to new firms of entering an industry.

32. Barriers to Entry Barriers to entry can include:
Ownership of an input that is difficult to duplicate.
Brands and trademarks.
Development of a relationship with the market (for example, the TI-84 graphing calculator).

33. Network Effects
Network effects make a product or service more valuable the more users there are
Facebook has few competitors because everybody wants to use the site their friends use.
There are only a few credit card companies.
Customers want cards that are widely accepted.
Firms want to accept cards that are widely used.

34. Innovation
Innovation can lead to products that other firms can’t immediately duplicate.
Involves a trade-off:
iPhones are priced higher than if there were stronger competitors.
But Apple would have less incentive to innovate if it didn’t expect monopoly profits.

35. Other Sources of Monopoly Power
Table 13-1 (13-1): Some Sources of Market Power

36. The government has many tools to regulate monopolies.
Regulating Monopoly
The government has many tools to regulate monopolies.
Price controls.
Government ownership.
Antitrust law.
Table 13-1 (13-1): Some Sources of Market Power

37. Price Controls
A price control on a monopoly can increase output.

38. Price Controls A price control can increase output.
Price = MC is the optimal level of output.
At P = MC, P < AC.
The firm is operating at a loss and will exit the industry.
Price = AC is the lowest price the firm will accept.
Firm is earning zero (normal) profit.
Output is higher than at monopoly price.

39. Price Controls Loss (P < AC) Price PM and QM are set where MR = MC
Optimal quantity is where P = MC
At optimal Q, firm suffers a loss
Monopoly
price PM AC
Loss (P < AC)
P = MC MC
Demand
Quantity QM
Optimal
quantity
Monopoly
quantity MR

40. Price Control and Natural Monopoly
At P = AC, firm has normal profit
Results in some deadweight loss
Monopoly
price PM
Deadweight Loss
P = AC AC
P = MC MC
Demand
Quantity QM
Optimal
quantity
Monopoly
quantity MR

41. Government Ownership & Regulation
Government ownership and regulation of electricity provided the United States with cheap power for decades.
Without competition or a profit motive, there is a tendency to become inefficient.

42. Government Ownership & Regulation
Government Regulation or ownership can solve the Natural Monopoly problem.
California deregulated electricity prices with disastrous results.
High demand pushed generators to capacity
Utilities’ demand for electricity is inelastic when supply is critically low.
System was designed for regulation, not competition
Social cost of an outage – at least $10,000/Mwh if not higher
“Electricity is damn useful stuff”

43. Natural Monopoly - Regulation
Firms that generated electricity found a way to increase profit by shutting down some of their generators “for maintenance and repair.”
When supply decreased, the price rose rapidly.
Enron and others “gamed” the system for their benefit
California put wholesale price controls in place
Deregulation, ultimately caused PG&E to file for bankruptcy, and added $50,000,000,000 to total power costs in the region
Other Western States would up charging as much as $5000/Mwh (normal - $40/Mwh)

44. More On Regulation
Many assume that market failure can be corrected via regulation
Implicitly presume that regulation is done competently if not perfectly
“Nirvana” fallacy - the fallacy of comparing actual things with unrealistic, idealized alternatives. It can also refer to the tendency to assume that there is a perfect solution to a particular problem.
Example: using political, not economic criteria

45. More On Regulation
Sometimes regulatory actions are hardly “solutions” (i.e. Calif electric “deregulation”)
Many believe Dodd-Frank Financial Regulation bill has made things worse
What matters is the effectiveness of the regulation in terms of costs/benefits, including potential opportunity costs
i.e. over-regulation can stifle market forces for cost reduction and/or innovation
“Power does not equate to wisdom”

46. Antitrust Law Antitrust laws are antimonopoly laws.
Two important U.S. antitrust laws are the Sherman Act (1890) and the Clayton Act (1914).
The laws give the federal government legal authority to prosecute monopolies or firms’ attempts to monopolize.
Can break up a monopoly.
Can prohibit a merger.
Can prevent acts that reduce competition.

47. Antitrust Law
Mergers
Prices, technology, and market conditions are constantly changing.
Firms grow, shrink, split, and merge.
Mergers lead to efficiencies of scale but more market power.
Authorities must try to balance lower costs with higher prices.

48. Numerical Example - Monopoly
MC = 5, MR = 50 – Q, FC = 0
MC = MR is profit max Quantity
so 50 – Q so Q = 45, Q = 45
Solve for P using demand equation: Q = P
45 = P (solve for P)
5/.5 yields P = 10
Profit = TR – TC
(45)*(10) – ($5)*45 =
Profit = $225

49. Takeaway
For a monopolist, marginal revenue is less than market price (MR < P).
Monopolies:
Charge a higher price than competitive firms.
Reduce total.
Create a deadweight loss.
Use market power to earn above normal profits.
The markup of price over marginal cost is larger the more inelastic the demand.

50. Takeaway
Patent monopolies involve a trade-off between deadweight loss and innovation,
Natural monopolies involve a trade-off between deadweight loss and economies of scale.
Outcomes can be improved by:
Opening the industry up to competition.
Regulating the monopolist.