1. Monopoly, Oligopoly, and Monopolistic Competition
Chapter 8
©McGraw-Hill Education. All rights reserved.

2. Learning Objectives
Distinguish among three types of imperfectly competitive industries and describe how imperfect competition differs from perfect competition
Identify the five sources of monopoly power and describe why economies of scale are the most enduring of the various sources of market power
Apply the concepts of marginal cost and marginal revenue to find the output and price that maximizes a monopolist's profits
Explain why the profit-maximizing output level for a monopolist is too small from society's perspective
Discuss why firms offer discounts to buyers who are willing to jump a hurdle
Discuss public policies that are often applied to natural monopolies
©McGraw-Hill Education. All rights reserved.
7-2

3. Imperfect Competition
Imperfectly competitive firms have some ability to set their own price: they are price setters
Long-run economic profits possible
Reduce economic surplus
Three types:
Monopoly has only one seller, no close substitutes
Monopolistic competition has many firms producing slightly differentiated products that are reasonably close substitutes
Oligopoly has a small number of large firms producing products that are close substitutes
©McGraw-Hill Education. All rights reserved.
7-3

4. Monopolistic Competition
Number of Firms
Many firms
Price
Limited flexibility
Entry and Exit
Free
Product
Differentiated
Economic Profits
Zero in long run
Decisions
P, Q, product differentiation
Perfect Competition
Many firms
Price taker
Free
Standardized
Zero in long run
Q only
©McGraw-Hill Education. All rights reserved.
7-4

5. Oligopoly Oligopoly Number of Firms Few firms, each is large Price
Some flexibility
Entry and Exit
Difficult
Product
Differentiated or standardized
Economic Profits
Possible
Decisions
P, Q, differentiation, advertising
Perfect Competition
Many firms
Price taker
Free
Standardized
Zero in the long run
Q only
©McGraw-Hill Education. All rights reserved.
7-5

6. Imperfect Competition
Examples of monopoly
Electricity and Magic Cards
Examples of monopolistic competition
Retail gas stations
Convenience stores
Examples of oligopoly
Wireless phone service
Cement
Automobiles and tobacco
©McGraw-Hill Education. All rights reserved.
7-6

7. The Essential Difference
Market power is the firm's ability to raise its price without losing all its sales
Any firm facing a downward sloping demand curve
Firm picks P and Q on the demand curve
Market power comes from factors that limit competition
Quantity
Price
Imperfectly Competitive Firm
Quantity
Price
Perfectly Competitive Firm D D
©McGraw-Hill Education. All rights reserved.
7-7

8. Five Sources of Market Power
Exclusive control over inputs
Patents and copyrights
Government licenses or franchises
Economies of scale (natural monopolies)
Network economies
©McGraw-Hill Education. All rights reserved.
7-8

9. Market Power: Economies of Scale
Returns to scale refers to the percentage change in output from a given percentage change in ALL inputs
Long-run idea
Constant returns to scale: doubling all inputs doubles output
Increasing returns to scale: output increases by a greater percentage than the increase in inputs
Average costs decrease as output increases
Natural monopoly: a monopoly that results from economies of scale
©McGraw-Hill Education. All rights reserved.
7-9

10. Economies of Scale Increasing returns to scale (economies of scale):
Constant returns to scale (economies of scale):
Diminishing returns to scale (economies of scale):

11. Economies of Scale Increasing returns to scale (economies of scale):
Constant returns to scale (economies of scale):
Diminishing returns to scale (economies of scale):

12. Economies of Scale and the Importance of Fixed Costs
Firms with large fixed costs and low variable costs
Have low marginal costs
Average total cost declines sharply as output increases
Economies of scale will exist

13. Total and Average Total Costs for a Production Process with Economies of ScaleQ0
F + Q0
TC = F + MQ
Total cost rises at a constant
rate as output rises
ATC = F/Q + M M
Average costs decline and is
always higher than marginal cost
Average cost ($/unit)
Total cost ($/year)
Quantity
Quantity

14. Market Power: Network Economies
Network economies occur when the value of the product increases as the number of users increases
VHS format for video tapes, Blu-ray for DVDs
Telephones
Windows operating system
eBay
Facebook and MySpace
©McGraw-Hill Education. All rights reserved.
7-14

15. Economies of Scale and Start-Up Costs
New products can have a large fixed development cost
Variable cost: sum of payments made to the variable factors, such as labor
Fixed cost: sum of payments made to the fixed factors, such as capital
Start-up costs can be thought of as a fixed cost
Average total cost (ATC): total cost divided by output
A good whose production has a large start-up cost and low variable cost is subject to economies of scale
ATC declines sharply as output increases
©McGraw-Hill Education. All rights reserved.
7-15

16. Economies of Scale and Start-Up Costs
Consider an example:
Assume marginal cost (M) is constant
Variable cost is M*Q
Total cost is fixed cost (F) plus variable cost
TC = F + M*Q
Total cost increases as output increases
Average total cost is
ATC = F / Q + M
Average total cost decreases as output increases
Average fixed cost = F/Q
©McGraw-Hill Education. All rights reserved.
7-16

17. Economies of Scale TC = F + M Q ATC = F/Q + M Average cost ($/unit)
Quantity F
TC = F + M Q
ATC = F/Q + M
Total cost ($/year) M
Quantity
©McGraw-Hill Education. All rights reserved.
7-17

18. Example: Video Game Producers – Different Volumes
Nintendo
Sony
Annual Production (000s)
1,000
1,200
Fixed Cost ($000s)
$200
Variable Cost ($000s)
$800
$960
Total Cost ($000s)
$1,000
$1,160
ATC per game
$1.00
$0.97
©McGraw-Hill Education. All rights reserved.
7-18

19. Example: Video Game Producers – Lower Marginal Costs
Nintendo
Sony
Annual Production (000s)
1,000
1,200
Fixed Cost ($000s)
$200
Variable Cost ($000s)
$240
Total Cost ($000s)
$400
$440
ATC per game
$0.40
$0.37
©McGraw-Hill Education. All rights reserved.
7-19

20. Example: Video Game Producers – Higher Fixed Cost
Nintendo
Sony
Annual Production (000s)
1,000
1,200
Fixed Cost ($000s)
$10,000
Variable Cost ($000s)
$200
$240
Total Cost ($000s)
$10,200
$10,240
ATC per game
$10.20
$8.53
©McGraw-Hill Education. All rights reserved.
7-20

21. Example: Video Game Producers – Different Production Levels
Nintendo
Sony
Annual Production (000s)
500
1,700
Fixed Cost ($000s)
$10,000
Variable Cost ($000s)
$100
$340
Total Cost ($000s)
$10,100
$10,240
ATC per game
$20.20
$6.08
©McGraw-Hill Education. All rights reserved.
7-21

22. Intel's Advantage Development cost of a new chip …………$2 billion
Marginal cost of making a chip
Dominating the market
Intel supplies more than 80% of the processors for PCs
…………$2 billion
………….Pennies
………...Priceless
©McGraw-Hill Education. All rights reserved.
7-22

23. Profit Maximization for the Monopolist
Like all other firms, a monopolist:
Maximizes profits
Applies the Cost-Benefit Principle:
Increase output if marginal benefit > marginal cost
Decrease output is marginal benefit < marginal cost
Marginal benefit is called marginal revenue:
Change in total revenue from a one-unit change in output
Equal to price for the perfectly competitive firm
Less than price for the monopolist
©McGraw-Hill Education. All rights reserved.
7-23

24. Profit Maximization for the Monopolist
To sell another unit the monopolist must lower price
Total revenue from 2 units = $12
Total revenue from 3 units = $15
Marginal revenue = $3
Price ($/unit)
Quantity (units/week) D 2 6 3 5
©McGraw-Hill Education. All rights reserved.
7-24

25. Monopolist's Marginal Revenue
Price & marginal revenue ($/unit) 8 D
Quantity (units/week) MR 3 2 1 4 -1 5
Price
Quantity $6 2 $5 3 $4 4 $3 5
Total Revenue
$12
$15
$16
Marginal Revenue 3 1 -1
©McGraw-Hill Education. All rights reserved.
7-25

26. Monopoly Demand and Marginal Revenue
The monopolist's marginal revenue curve:
Has the same intercept as the straight-line demand curve
Has twice the slope of the demand curve
Lies below the demand curve
Price
Quantity a D Q0
Q0/2
a/2 MR
©McGraw-Hill Education. All rights reserved.
7-26

27. Marginal Revenue of, and Price Charged by the Monopolist
MR changes with price and with quantity
The monopoly’s price will be on the elastic part of the inverse demand curve (P = a – bQ)
Pmax = a
Qmax
P* =a/2
Q* =Qmax/2

28. Deciding Quantity
Profit is maximized at the level of output where marginal cost equals marginal revenue
At P = $3 and Q = 12,
MC > MR
Decrease output
At Q = 8, MC = MR = 2
The demand curve sets the price at P = $4
At any output below 8, MC < MR
Price ($/unit of output)
Quantity (units/week) 3 MC 2 6 D 12 MR 4 8
©McGraw-Hill Education. All rights reserved.
7-28

29. Monopoly Profit Profit = Total revenue – total cost
Total cost = ATC x Q
Profit = P x Q – ATC x Q
Profit = (P-ATC) x Q
If P > ATC then the firm earns a profit
If P < ATC then the firm suffers a loss
This can be graphically illustrated
©McGraw-Hill Education. All rights reserved.
7-29

30. Monopoly Losses and Profits
Price ($/minute)
Minutes (millions/day) 20
0.12
0.10
ATC
Economic loss
= $400,000/day D
0.05 MC MR 24
0.08
Economic profit
©McGraw-Hill Education. All rights reserved.
7-30

31. The Invisible Hand Fails
The monopolist's optimal
amount occurs where
MC = MR, Q = 8 units and P = $4 24 D 3 12 6
Marginal Cost 2 MR 8 4
Deadweight loss from monopoly = $4
Price ($/unit of output)
The socially optimal
amount occurs where
MC = MB, Q = 12 units and P = $3
Quantity (units/week)
©McGraw-Hill Education. All rights reserved.
7-31

32. Monopoly and Perfect Competition
MC = MR
MC = MR
P >MR
P > MC
P = MR
P = MC
No Deadweight Loss
Deadweight Loss
©McGraw-Hill Education. All rights reserved.
7-32

33. Managing Monopoly: The Breakdown of the Invisible Hand
Monopolies exist for economic reasons
Patents, copyrights, and innovation
Economies of scale
Network economies
Anti-trust laws attempt to limit deadweight loss
Limiting monopoly has costs
Patents encourage innovation
Economies of scale minimize ATC
Network economies increase benefits
©McGraw-Hill Education. All rights reserved.
7-33

34. Price Discrimination
Price discrimination means charging different buyers different prices for essentially the same good or service
Separate the groups
No side trades among buyers
Many forms of price discrimination
Hurdle method: discounts for identifiable groups (e. g., students, AARP)
Perfect discrimination: negotiate separate deals with each customer
©McGraw-Hill Education. All rights reserved.
7-34

35. Carla the Editor: Social Optimum
What is the social optimum?
6 papers with an economic profit of $6 per person, total profit = $36
Opportunity cost of Carla's time is $29
Student
Reservation Price A
$40 B 38 C 36 D 34 E 32 F 30 G 28
Total Revenue
$40
$76
$108
$136
$160
$180
$196
What if Carla is a profit maximizer? What is Carla's total revenue?
©McGraw-Hill Education. All rights reserved.
7-35

36. Carla the Editor: Marginal Revenue
What is Carla's marginal revenue?
3 papers with a total
economic profit of $21
Opportunity cost of Carla's time is $29
Student
Reservation Price A
$40 B 38 C 36 D 34 E 32 F 30 G 28
Total Revenue
$40
$76
$108
$136
$160
$180
$196 MR
$40
$36
$32
$28
$24
$20
$16
©McGraw-Hill Education. All rights reserved.
7-36

37. Carla the Editor: Price Discriminator
Opportunity cost of Carla's time is $29
Student
Reservation Price A
$40 B 38 C 36 D 34 E 32 F 30 G 28
Total Revenue
$40
$78
$114
$148
$180
$210
$238
What if Carla is a perfect price discriminator?
What is Carla's total revenue?
6 papers with
an economic
profit of $36
©McGraw-Hill Education. All rights reserved.
7-37

38. Hurdle Method of Price Discrimination
The hurdle method of price discrimination is the practice of offering a discount to all buyers who overcome some obstacle.
Temporary sales
Hard cover and paperback books
Multiple car models from one manufacturer
Commercial air carriers
Movie producers and phased releases
Scratch and Dent appliance sales
©McGraw-Hill Education. All rights reserved.
7-38

39. Carla Offers a Rebate
If reservation price < $36, student will mail in rebate
Student
Reservation Price
Total Revenue A
$40 B 38 76 C 36
108 MR
$40 36 32
5 papers, price $36, rebate $4, economic profit $27
Discounted Price Submarket D
$34 E 32 64 F 30 90
$34 30 26
©McGraw-Hill Education. All rights reserved.
7-39

40. Perfect Discriminator
Carla's Choices
Program
Social Optimum
Papers Edited 6
Price
$30
Total Revenue
$180
Carla's Time 
 $174
Economic Profit $6
Total Surplus
$26
Single Price 3
$36
$108
$87
$21
$27
Perfect Discriminator 6
Reservation
$210
$174 
$36
Hurdle
5 = (3 + 2)
$36, $4 rebate
$172
$145 
$27
$35
©McGraw-Hill Education. All rights reserved.
7-40

41. Monopoly and Public Policy
Challenge: create the greatest increase in total surplus
Policy options
Government ownership and operation
Regulation
Competitive bids for natural monopoly services
Break up
©McGraw-Hill Education. All rights reserved.
7-41 41

42. State-Owned Natural Monopoly
Marginal cost is always less than average cost
Marginal cost pricing produces losses
Options
Fund losses from tax revenues
Fixed monthly fee plus usage fee
Fixed fee covers losses
Limited incentives to innovate and cut costs
Commonly used for water, Post Office, and some electricity
©McGraw-Hill Education. All rights reserved.
7-42 42

43. Regulated Monopolies
Cost-plus regulation sets price at per unit explicit costs plus a mark-up for implicit costs
Used for electricity, telephone, and cable TV
Policies vary by state
Disadvantages
High administrative cost
Reduced incentive for cost-saving innovation
Price is greater than marginal cost
©McGraw-Hill Education. All rights reserved.
7-43 43

44. Exclusive Contracting for Natural Monopolies
Government awards contract to low bidder for natural monopoly services
Garbage collection, fire protection, road construction, Department of Defense
Could achieve marginal cost pricing IF government pays the resulting losses
Asset transfer for large fixed investment is complex
©McGraw-Hill Education. All rights reserved.
7-44 44

45. Enforcement of Anti-Trust Laws
Two landmark laws
Sherman Act of 1890
Declared conspiracy to create a monopoly illegal
Clayton Act of 1914
Outlawed transactions that would "substantially lessen competition"
Applies to mergers and acquisitions today
IBM avoided break-up; AT&T did not
Microsoft survived
©McGraw-Hill Education. All rights reserved.
7-45 45

46. Another Policy Option: Ignore Monopoly
Two objections to monopolies
Restrict output, decrease total surplus
Raise price, earn economic profits
Analysis
Discount offers allow some customers to pay less than average cost, though more than marginal cost
Economic profits generated by customers who pay list price – their choice
About two-thirds of economic profits are taxed away
Remainder accrues to shareholders
©McGraw-Hill Education. All rights reserved.
7-46 46

47. Imperfect Competition
Monopolistic Competition and Oligopoly
Sources of Market Power
Monopoly
Public Policy
©McGraw-Hill Education. All rights reserved.
7-47

48. The Algebra of Monopoly Maximization
Chapter 8 Appendix
The Algebra of Monopoly Maximization
©McGraw-Hill Education. All rights reserved.
7-48

49. From Demand to Marginal Revenue
Given a demand curve such as
P = 15 – 2 Q
We can write the marginal revenue curve as
MR = 15 – 4 Q
Suppose marginal cost is a line with zero intercept and a slope of 1
MC = Q
The remaining step is to set marginal revenue equal to marginal cost
©McGraw-Hill Education. All rights reserved.
7-49

50. MR = MC To find P, substitute Q = 3 into the demand equation
Let Q* be the profit maximizing level of output
MC = MR
Q* = 15 – 4 Q*
5 Q* = 15
Q* = 3
To find P, substitute Q = 3 into the demand equation
P = 15 – 4 Q*
P = 15 – 4 (3)
P = 3
©McGraw-Hill Education. All rights reserved.
7-50