1. Chapter 15
Monopoly
© 2002 by Nelson, a division of Thomson Canada Limited

2. In this chapter you will…
Learn why some markets have only one seller.
Analyze how monopoly determines the quantity to produce and the price to charge.
See how monopoly’s decisions affect economic well-being.
Consider the various public policies aimed at solving the monopoly problem.
See why monopolies try to charge different prices to different customers.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

3. MONOPOLY
While a competitive firm is a price taker, a monopoly firm is a price maker.
A firm is considered a monopoly if . . .
it is the sole seller of its product.
its product does not have close substitutes.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

4. The fundamental cause of monopoly is barriers to entry.
Why Monopolies Arise
The fundamental cause of monopoly is barriers to entry.
Barriers to entry have three sources:
Ownership of a key resource.
The government gives a single firm the exclusive right to produce some good.
Costs of production make a single producer more efficient than a large number of producers.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

5. Why Monopolies Arise Monopoly resources
Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason.
Government created monopolies
Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets.
Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

6. Why Monopolies Arise Natural Monopolies
An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.
A natural monopoly arises when there are economies of scale over the relevant range of output.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

7. Figure 15-1: Economies of Scale as a Cause of Monopoly
Cost
Average
total
cost
Quantity of Output
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

8. Pricing and Production Decisions
Monopoly versus Competition
Monopoly
Is the sole producer
Faces a downward-sloping demand curve
Is a price maker
Reduces price to increase sales
Competitive Firm
Is one of many producers
Faces a horizontal demand curve
Is a price taker
Sells as much or as little at same price
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

9. Figure 15-2: Demand Curves for Competitive and Monopoly Firms
(a) Competitive Firm
(b) Monopoly
Price
Price
Demand
Demand
Quantity of Output
Quantity of Output
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

10. A Monopoly’s Revenue Total Revenue P  Q = TR Average Revenue
TR/Q = AR = P
Marginal Revenue
TR/Q = MR
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

11. Table 15-1: A Monopoly’s Total, Average, and Marginal Revenue.
Quantity of Water
Price
Total Revenue
Average Revenue
Marginal Revenue
(Q)
(P)
(TR = P x Q)
(AR = P x Q)
(MR = ∆TR/∆Q)
------
$ 0
$ 11
$ 10 10 1 8 9 18 2
- 4 3 24 8
- 2 4 28 7 5 30 6 2
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

12. A Monopoly’s Revenue A Monopoly’s Marginal Revenue
A monopolist’s marginal revenue is always less than the price of its good.
The demand curve is downward sloping.
When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

13. A Monopoly’s Revenue A Monopoly’s Marginal Revenue
When a monopoly increases the amount it sells, it has two effects on total revenue (P  Q).
The output effect—more output is sold, so Q is higher.
The price effect—price falls, so P is lower.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

14. Figure 15-3: The Demand and Marginal Revenue Curves for a Monopoly
Price 11
Marginal revenue
Demand (average revenue) 10 9 8 7 6 5 4 3 2 1 –1 1 2 3 4 5 6 7 8 –2 –3 –4
Quantity of Water
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

15. Profit Maximization
A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.
It then uses the demand curve to find the price that will induce consumers to buy that quantity.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

16. Figure 15-4: Profit Maximization for a Monopoly
Costs and Revenue
2. … and then the demand curve shows the price consistent with this quantity.
Monopoly price B
Marginal revenue
Demand
Average total cost
Marginal cost A
1. The intersection of the MR curve and the MC curve determines the profit maximizing quantity…
QMAX Q1 Q2
Quantity
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

17. Profit Maximization Comparing Monopoly and Competition
For a competitive firm, price equals marginal cost.
P = MR = MC
For a monopoly firm, price exceeds marginal cost.
P > MR = MC
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

18. A Monopoly’s Profit Profit equals total revenue minus total costs.
Profit = TR - TC
Profit = (TR/Q - TC/Q)  Q
Profit = (P - ATC)  Q
The monopolist will receive economic profits as long as price is greater than average total cost.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

19. Figure 15-5: The Monopoly’s Profit
Costs and Revenue
Marginal cost
Marginal revenue
Demand
Average total cost
Monopoly price E B
Monopoly
profit C
Average total cost D
QMAX
Quantity
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

20. CASE STUDY: The Market for Drugs
A new drug discovery gives rise to a patent and gives the firm a monopoly on the sale of that drug.
When the patent expires and any company can make or sell the drug.
The market switches from being monopolistic to being competitive.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

21. Figure 15-6: The Market for Drugs
Costs and Revenue
Price during patent life
Monopoly quantity
Marginal cost
Price after patent expires
Competitive quantity
Demand
Marginal revenue
Quantity
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

22. THE WELFARE COST OF MONOPOLY
In contrast to a competitive firm, the monopoly charges a price above the marginal cost.
From the standpoint of consumers, this high price makes monopoly undesirable.
However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

23. Figure 15-7: The Efficiency Level of Output
Price
Marginal cost
Cost to monopolist
Value to buyers
Value to buyers
Cost to monopolist
Demand (Value to buyers)
Efficient quantity
Quantity
Value to buyers is greater than cost to sellers
Value to buyers is less than cost to sellers
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

24. Deadweight Loss
Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost.
This wedge causes the quantity sold to fall short of the social optimum.
The Inefficiency of Monopoly
The monopolist produces less than the socially efficient quantity of output.
The “economic pie” shrinks.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

25. Figure 15-8: The Inefficiency of Monopoly
Price
Marginal cost
Deadweight
loss
Monopoly price
Monopoly quantity
Efficiency quantity
Demand
Marginal revenue
Quantity
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

26. Deadweight Loss
The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax.
The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

27. PUBLIC POLICY TOWARD MONOPOLIES
Government responds to the problem of monopoly in one of four ways.
Making monopolized industries more competitive.
Regulating the behaviour of monopolies.
Turning some private monopolies into public enterprises.
Doing nothing at all.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

28. Competition Law
Legislation designed to encourage competition and discourage the use of monopoly practices can curb the inefficiencies resulting from market power in general and monopoly in particular.
Competition law has a long history in Canada:
1889: The Act for the Prevention and Suppression of Combinations Formed in Restraint of Trade.
1910: Combines Investigation Act
1986: Competition Act and the Competition Tribunal Act
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

29. Competition Law The Competition Act:
“… maintain and encourage competition in Canada in order to promote the efficiency and adaptability of the Canadian economy… …. and in order to provide consumers with competitive prices and product choices.”
Competition law in Canada is enforced by the Commissioner of Competition of the Competition Bureau, a unit within the Federal government’s Industry Canada.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

30. Competition Law Competition laws have costs and benefits.
Sometimes companies merge not to reduce competition but to lower costs through joint production.
The benefits of greater efficiencies through mergers are called synergies.
If the competition laws are to raise social welfare, the government must determine which mergers are desirable and which are not.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

31. Regulation
Government may regulate the prices that the monopoly charges. This is often the case with natural monopolies where governments regulate the price.
The allocation of resources will be efficient and total surplus maximized if price is set to equal marginal cost.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

32. Regulation
Two practical problems associated with marginal-cost pricing.
Natural monopolies often have declining average total cost. (See Figure 15-9)
The price is less than ATC thus creating losses.
No incentive for monopolist to reduce costs.
Reducing costs will reduce prices.
In practice, regulators will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

33. Figure 15-9: Marginal Cost Pricing
Price
Demand
Average total cost
Average total cost
Loss
Marginal cost
Regulated price
Quantity
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

34. Public Ownership
Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself.
Crown Corporations
Canada Post
CBC
Hydro-Québec
Saskatchewan Tel and B.C. Tel.
Ontario Hydro.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

35. Doing Nothing
Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies.
Government intervention such as regulation can cause average costs to inflate (Political failure), increasing the deadweight loss above its “do nothing” level. (See Figure 15-10)
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

36. Figure 15-10: Political Failure and Average Costs Curves
Price
ATCinflated
ATCtrue G F
Pinflated
Qinflated A P0 B Q0 E
Ptrue D
Qtrue
Marginal cost C
Demand
Marginal revenue
Quantity
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

37. PRICE DISCRIMINATION
Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.
Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

38. PRICE DISCRIMINATION
Perfect Price Discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.
Three important effects of price discrimination:
It can increase the monopolist’s profits.
Need to separate customers according to their ability to pay.
No arbitrage, the process of buying a good in one market at a low price and selling it in another market at a higher price.
It can reduce deadweight loss.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

39. Figure 15-11: Welfare with and without Price Discrimination
(a) Single price monopolist
(b) Perfectly discriminating monopolist
Price
Price
Consumer surplus D MC
Profit
Monopoly price
Quantity sold
Deadweight loss
Profit MC
Quantity sold D MR
Quantity
Quantity
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

40. PRICE DISCRIMINATION Examples of Price Discrimination Movie tickets
Airline prices
Discount coupons
Financial aid
Quantity discounts
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

41. Conclusion How prevalent are the problems of monopolies?
Monopolies are common.
Most firms have some control over their prices because of differentiated products.
Firms with substantial monopoly power are rare.
Few goods are truly unique.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

42. Summary A monopoly is a firm that is the sole seller in its market.
It faces a downward-sloping demand curve for its product.
A monopoly’s marginal revenue is always below the price of its good.
Like a competitive firm, a monopoly maximizes profit by producing the quantity at which marginal cost and marginal revenue are equal.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

43. Summary
Unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost.
A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus.
A monopoly causes deadweight losses similar to the deadweight losses caused by taxes.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

44. Summary
Policymakers can respond to the inefficiencies of monopoly behaviour with competition laws, regulation of prices, or by turning the monopoly into a government-run enterprise.
If the market failure is deemed small, policymakers may decide to do nothing at all.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

45. Summary
Monopolists can raise their profits by charging different prices to different buyers based on their willingness to pay.
Price discrimination can raise economic welfare and lessen deadweight losses.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition

46. The End
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition