I. Learning Objectives In this chapter students should learn: A. The characteristics of pure monopoly. B. How a pure monopoly sets its profit-maximizing output and price. C. The economic effects of monopoly. D. Why a monopolist might prefer to charge different prices in different markets. E. The difference between the monopoly price, the socially optimal price, and the fairreturn price of a government-regulated monopoly. II. Pure Monopoly: An Introduction A. Definition: Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. B. Characteristics of a Pure Monopoly 1. A single firm is the sole producer, so the firm and industry are synonymous. 2. There are no close substitutes for the firm s product. 3. The firm is a price maker; that is, the firm has considerable control over the price because it can control the quantity supplied. 4. Entry into the industry by other firms is completely blocked. 5. A monopolist may or may not engage in nonprice competition. Depending on the nature of its product, a monopolist may advertise to increase demand. C. A number of producers have a substantial amount of monopoly power and are called near monopolies. D. Examples of Pure Monopolies and Near Monopolies 1. Public utilities gas, electric, water, cable TV, and local telephone service companies are pure monopolies. 2. Intel (computer microprocessors), First Data Resources (Western Union), Wham-O (Frisbees), and the DeBeers diamond syndicate are examples of near monopolies (Last Word). 3. Professional sports leagues grant team monopolies to cities. 4. Monopolies are virtually nonexistent in nationwide manufacturing industries, but monopolies may be geographic; a small town may have only one airline, bank, or grocery store. E. Analysis of monopolies yields insights concerning monopolistic competition and oligopolies, the more common types of market structures (Chapter 11). III. Barriers to Entry Limiting Competition A. The strength of the barriers preventing entry of new firms helps to define a market structure. 1. Pure monopoly strong barriers effectively block all potential competition. 2. Oligopoly weaker barriers allow a few firms to dominate the market. 3. Monopolistic competition weak barriers permit many firms to enter the industry.
4. Pure competition a lack of effective barriers allows the large number of firms in the industry. B. Economies of Scale 1. As the firm grows in size, long-run average total cost continues to fall over a wide range of output. This occurs where the lowest unit costs (and, therefore, lowest unit prices for consumers) depend on the existence of a small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm is most efficient, new firms cannot afford to start up in industries with economies of scale (Figure 10.1). 2. Public utilities are often natural monopolies because they have economies of scale, so one firm is most efficient in satisfying existing demand; laying additional mazes of water pipes or electric lines, in the name of competition for utilities, would be very inefficient. 3. Government usually gives one firm the right to operate a public utility in exchange for government regulation of its power. C. Legal Barriers to Entry: Patents and Licenses 1. Patents grant the inventor the exclusive right to produce or license a product for twenty years. This exclusive right can earn profits for future research, which results in more patents and monopoly profits. 2. Licenses for radio and TV stations, taxi companies, and liquor stores are means by which government limits the number of producers to only one or a few firms. D. Ownership or Control of Essential Resources 1. International Nickel Company of Canada (now called Inco) controlled about 90 percent of the world s nickel reserves, and DeBeers of South Africa controls most of the world s diamond supplies (Last Word). 2. Aluminum Company of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication.
3. Professional sports leagues control player contracts and leases on major city stadiums. E. Pricing and Other Strategic Barriers 1. Dentsply, a manufacturer of false teeth that controlled about 70 percent of the market, illegally prevented distributors from carrying competing brands. 2. Microsoft illegally charged higher prices for its Windows operating system to computer manufacturers featuring Netscape Navigator instead of Microsoft s Internet Explorer. IV. Monopoly Demand A. Analysis of monopoly demand makes three assumptions: 1. The monopoly is secured by patents, economies of scale, or resource ownership. 2. The firm is not regulated by any unit of government. 3. The firm is a single-price monopolist; it charges the same price for all units of output. B. While the purely competitive firm faced a horizontal demand curve as a price taker, the pure monopolist faces a downward sloping market demand curve, because it is the only firm in the industry. The firm is the industry. In order to sell more products, the firm must lower the price of all of the products it sells. C. Price will exceed marginal revenue because the monopolist must lower the price to sell each additional unit. The added revenue will be the price of the last unit less the sum of the price cuts which must be taken on all prior units of output (Table 10.1 and Figure 10.2). See next page for Figure 10.2
1. Figure 10.3 shows the relationship between the demand, marginal-revenue, and total-revenue curves. 2. The marginal-revenue curve is below the demand curve, and when it becomes negative, the total-revenue curve turns downward as total revenue falls. D. The monopolist is a price maker. The firm controls output and price but is not free of market forces, since the combination of output and price depends on demand. For example, Table 10.1 shows that at $162 only 1 unit will be sold, and at $152 only 2 units will be sold.
E. The monopolist sets prices in the elastic region of the demand curve. The totalrevenue test shows that a monopolist will avoid the inelastic segment of its demand schedule. As long as demand is elastic, total revenue rises when the monopoly lowers its price. But when demand becomes inelastic, total revenue falls as output expands. Because total costs rise with output, profits will decline as demand becomes inelastic. Therefore, the monopolist will expand output only in the elastic portion of its demand curve. V. Output and Price Determination A. Cost data is based on hiring resources in competitive markets, so the cost data of Chapter 7, used in the price and output determination of the purely competitive firm in Chapters 8 and 9, can be used in this chapter, as well. The costs in Table 10.1 restate the data of Table 7.2. B. The monopolist, like the pure competitor, uses the MR = MC rule to find its profitmaximizing output level (Table 10.1 and Figure 10.4). The same result can be found by comparing total revenue and total costs incurred at each level of production. Figure 10.4 C. Price is determined by extending a vertical line from the MR = MC output up to the demand curve. Be careful to ensure students do not set the price at the MR = MC point. D. The monopolist s profit or loss is the difference between the price and the average total cost. Price minus ATC is the profit per unit, and the profit per unit times the quantity is the firm s total profit. Profit can also be determined by subtracting total cost from total revenue. Be careful to ensure students illustrate the area of profit by
only showing the vertical distance between price and ATC, not the distance between price and the MR = MC point. E. The pure monopolist has no supply curve because there is no unique relationship between price and quantity supplied. The price and quantity supplied will always depend on the location of the demand curve. F. Misconceptions about Monopoly Pricing 1. A monopolist cannot charge the highest possible price, because it will maximize profit where total revenue minus total cost is greatest. This depends on quantity sold as well as on price, and it will never be the highest price possible. 2. Total profit, not unit profit, is the goal of the monopolist. Table 10.1 shows perunit profit is $32 at 4 units of output, compared with $28 at the profitmaximizing output of 5 units. Once again, quantity must be considered as well as per-unit profit. G. Unlike the pure competitor, the pure monopolist can continue to receive economic profit in the long run because of barriers to entry. H. Although losses can occur in a pure monopoly in the short run (P<ATC), the lessthan-profitable monopolist will shut down in the long run (Figure 10.5).
VI. Economic Effects of a Monopoly AP Microeconomics Chapter 11 A. Price, output, and efficiency of resource allocation should be considered. 1. Monopolies will sell a smaller output and charge a higher price than would competitive producers selling in the same market, assuming the same costs. 2. Monopoly price will exceed marginal cost, because it exceeds marginal revenue and the monopolist produces where MR=MC. The monopolist charges the price that consumers will pay for that output level. 3. Productive efficiency is not achieved, because the monopolist s output is less than the output at which average total cost is minimized. 3. Allocative efficiency is not achieved because price (what the product is worth to consumers) is above marginal cost (opportunity cost of the product). Ideally, output should expand to a level where price = marginal revenue = marginal cost, but this will occur only under pure competitive conditions where price = marginal revenue. The efficiency (or deadweight) loss is also reflected in the sum of consumer and producer surplus lost because the firm produces at a lower output (Figure 10.6). B. Income distribution is more unequal than it would be under a more competitive situation. The effect of the monopoly power is to transfer income from consumers to business owners in the form of a private tax. C. Cost complications may lead to other conclusions. 1. Economies of scale may result in one or two firms operating in an industry experiencing lower ATC than many competitive firms. These economies of scale may be the result of spreading large initial capital costs or product development costs over a large number of units of output (natural monopoly). 2. X-inefficiency (bad management) may occur in a monopoly because there is no competitive pressure to produce at the minimum possible cost. (See x- inefficiency figure at beginning of next page)
X-inefficiency 3. Rent-seeking behavior (designed to transfer income or wealth to the firm at someone else s, or society s, expense) often occurs as monopolies seek to acquire or maintain government-granted monopoly privileges. Such rent-seeking may entail substantial costs (lobbying, legal fees, public relations advertising), which are inefficient. 4. Technological progress may occur in some monopolies, but not others; evidence is mixed. a. Some monopolies have shown little interest in technological progress. b. Other monopolies engage in research to reduce per-unit costs. Research can also help the monopoly maintain its barriers to entry against new firms. D. Assessment and Policy Options 1. Although there are legitimate concerns about the effects of monopoly power on the economy, monopoly power is not widespread. While research and technology may strengthen monopoly power, over time it is likely to destroy monopolies. 2. When monopoly power results in an adverse effect on the economy, the government may choose to intervene on a case-by-case basis. VII. Price Discrimination A. Price discrimination occurs when a given product is sold at more than one price, and the price differences are not based on cost differences. B. Price discrimination can take three forms. 1. Charging each customer in a single market the maximum price he or she is willing to pay. 2. Charging each customer one price for the first set of units purchased and a lower price for subsequent units. 3. Charging some customers one price and other customers a different price. C. Conditions Necessary for Successful Price Discrimination 1. Monopoly power to control output and price.
2. The ability to segregate buyers into separate classes with different levels of willingness or ability to pay for the product (usually based on differing elasticities of demand). 3. Buyers must be unable to resell the original product. D. Examples of Price Discrimination 1. Airlines charge high fares to executive travelers (inelastic demand) and lower fares to vacation travelers (elastic demand). 2. Electric utilities frequently segment their markets by end uses, such as lighting and heating; demand for lighting is inelastic due a lack of substitutes, while demand for heating is more elastic due to alternatives such as natural gas. 3. Movie theaters and golf courses vary their charges on the basis of time and age. 4. Discount coupons are a form of price discrimination, allowing firms to offer a discount to price-sensitive customers. 5. In international trade, firms sell at different prices to customers in different countries. 6. CONSIDER THIS Price Discrimination at the Ballpark a. Ballparks can successfully discriminate in offering lower prices to children because all three criteria for price discrimination are met. b. Concession stands at the ballparks cannot engage in successful price discrimination because it is possible for children to resell their lower-priced snacks to adults, reducing the park s profit. E. Graphical Analysis 1. Most price discrimination separates the market into two (sometimes more) groups of customers (Figure 10.8). 2. Because the demand curves for software differ for students and small businesses, so will the MR curves and the profit-maximizing prices and output for each group. 3. For each segment of the market, the monopolist will set output and price according to the MR = MC rule.
4. Firms realize greater profits, and students benefit from lower prices. Small businesses face higher prices and consume less. F. Price discrimination is common and only illegal when the firm uses it to lessen or eliminate competition. VIII. Regulated Monopoly A. A natural monopoly occurs if the market-demand curve intersects the ATC curve at any point where average total costs are declining. In such cases, economies of scale make one firm desirable. B. As a result of changes in technology and deregulation, new entrants are competing in some previously regulated long-distance telephone, natural gas, wireless communications, cable, and long-distance electricity transmission markets. C. In markets that are still regulated, a regulatory commission may attempt to establish the legal price for the monopolist where the marginal cost equals demand. This is called the socially optimal price and represents allocatively efficient output (Figure 10.9). D. However, setting price equal to marginal cost may cause losses, because public utilities must invest in enough fixed plant to handle peak loads. Much of this fixed plant goes unused most of the time, and a price equal to the marginal cost would be below average total cost, leading to losses in the short run and firms exiting the industry in the long run. Regulators often choose a price where demand = average total cost rather than marginal cost, so that the monopoly can achieve a fair return and avoid losses. Recall that average total cost includes an allowance for a normal profit (Figure 10.9). E. The dilemma for regulators is whether to choose a socially optimal price, where P = MC, or a fair-return price, where P = ATC. P = MC is most efficient, but may result in
losses for the monopoly firm, so government would have to subsidize the firm for it to survive. P = ATC does not achieve allocative efficiency, but does insure a fair return (normal profit) for the firm. IX. LAST WORD: De Beers s Diamonds: Are Monopolies Forever? A. De Beers has been one of the world s strongest and most enduring monopolies. It produces about 45 percent of all rough-cut diamonds in the world and buys for resale many of the diamonds produced elsewhere, for a total of about 55 percent of the world s diamonds. B. Its behavior and results fit the monopoly model portrayed in Figure 10.4. It sells a limited quantity of diamonds that will yield an appropriate monopoly price much higher than production cost, allowing the firm to earn substantial economic profit. C. How did De Beers control the production of mines it didn t own? 1. It convinced producers that single-channel monopoly marketing through De Beers would maximize their profits. 2. Mines that didn t use De Beers found the market flooded with similar diamonds from De Beers s stockpiles, which caused price declines and loss of profits. 3. De Beers purchased and stockpiled diamonds produced by independent producers. D. Threats and problems eroded De Beers s monopoly power. 1. New diamond discoveries resulted in more diamonds outside their control. 2. Technological improvements allowed chemical firms to manufacture flawless artificial diamonds. 3. Australian diamond producer Argyle withdrew from the De Beers monopoly. 4. International media coverage of the story of conflict diamonds led De Beers to stop dealing in diamonds in some African markets. E. In 2000, De Beers abandoned its attempt to control the supply of diamonds. It transformed itself into a company selling premium diamonds and luxury goods under the De Beers label, reducing its stockpile of diamonds and increasing demand for diamonds through advertising.