Introduction to Microeconomics ECO1104
14. Monopoly
Cristina Blanco-Perez
Faculté des sciences sociales | Faculty of Social Sciences
uOttawa.ca
Outline
• Monopoly:
– Barriers of Entry
– Monopoly Characteristics
– Problems with Monopoly
– Market power and Price Discrimination
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14.1 Monopoly
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Monopoly
• A monopoly refers to a firm that is the only producer of a
good or service with no close substitutes.
– A firm is a perfect monopoly if it controls the entire
market.
– A firm has monopoly power if it can manipulate the
price.
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Monopoly
• Why do monopolies exist?
• Monopolies exist because of barriers to entry that prevent
other firms from entering the market:
– Scarce Resources
– Economies of Scale
– Governmental intervention
– Aggressive business tactics
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14.1.1 Barriers of Entry
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Monopoly: scarce resources
• Not possible to enter the market because there is
scarcity resources or input of the production process
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Monopoly: economies of scale
• High fixed costs, better to produce at larger scale to
take advantage of economies of scale
• New firms are prevented to enter the market because of
this
• E.g.: railway, water-supply, fix phone lines, electricity
• A natural monopoly refers to a market where a single
firm can produce the entire market quantity demanded
at a lower cost than multiple firms.
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Monopoly: government intervention
• Monopoly created or sustained by governments where
they would not otherwise exist:
– To protect consumers
– For state-owned firms
– To protect intellectual property rights (patents,
copyrights, trademarks, …)
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Monopoly: Aggressive business tactics
• Incumbent firm prevent new entries:
– Acquiring competitors
– Predatory Pricing
– Threating them
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Active Learning: Identify the barrier to entry
• For each of the following, identify which barrier to
entry permits monopoly power.
– H2O Company owns all of the water rights to a
town’s drinking water supply.
– XYZ Pharmaceuticals is awarded a patent for
their new asthma drug.
– National Brewing Company buys a successful,
local microbrewery.
– ABC Motor Company produces cars at a lower
cost than smaller firms could.
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14.1.2 Monopoly characteristics
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Monopoly characteristics
• Monopolies are also rational economic agents: maximize
their profits
• But they have different characteristics than perfect
competition firms:
– Monopoly is not price taker!!!
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Monopolists and the demand curve
• Monopoly markets differ from perfectly competitive markets with
regard to their demand curves.
Perfectly competitive firm’s demand curve Monopolist’s demand curve
Price ($) Price ($)
Competitive Monopolists face
firms face a a downward-
horizontal sloping demand
demand curve. 5,00 0 curve.
2,500 D 2,50 0
D
0
0 3 8
Quantity of diamonds
Quantity of diamonds
Firms cannot affect the market Monopolists can affect the market price,
price through their production
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but are constrained by the market
decisions. demand curve.
Monopoly revenue
• When a monopolist produces more of a good, the market
price is driven down.
• Therefore, producing an additional unit of output has two
effects on total revenue:
1. Quantity effect: Total revenue increases.
2. Price effect: Total revenue decreases.
• Total revenue might increase or decrease, depending on
which effect is larger.
• In perfectly competitive markets, a firm can sell as much as it wants
at the market price.
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Monopoly revenue
• Total revenue is maximized when marginal revenue equals $0.
• Average revenue equals price and is greater than or equal to marginal
revenue.
Ma rg i na l Avera g e
Pri ce Qua nti ty s ol d Tota l revenue
revenue Revenue
( $/di a m ond) ( V i ol et di a m onds ) ( $) ( $) ( $/di a m ond)
6,500 0 0 0
6,000
6,000 1 6,000 6,000
5,000
5,500 2 11,000 5,500
4,000
5,000 3 15,000 5,000
3,000
4,500 4 18,000 4,500
2,000
4,000 5 20,000 4,000
1,000
3,500 6 21,000 3,500
0
3,000 7 21,000 3,000
- 1,000
2,500 8 20,000 2,500
- 2,000
2,000 9 18,000 2,000
- 3,000
1,500 10 15,000 1,500
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Monopoly revenue
• The total revenue maximizing point is identified where MR = $0.
TR, AR, MR ($)
25,000 1. A monopolist's
total revenue first
increases. 2. then decreases.
20,000
15,000
The MR curve intersects the x-
axis at the revenue-maximizing
TR quantity.
10,000
5,000
The average revenue equals the
AR price at any quantity sold.
0 1 2 3 4 5 6 7 8 9 1 0 11 12
MR
25,000 Quantity of violet diamonds
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Active Learning: Determine revenue-maximizing quantity
• Fill in the following table and identify the monopolist’s revenue-
maximizing level of production.
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Active Learning: Determine revenue-maximizing quantity
• Fill in the following table and identify the monopolist’s revenue-
maximizing level of production.
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Monopoly profit-maximizing quantity
• While revenue is important, firms maximize profits.
• The profit-maximizing quantity of output for a monopoly is
found where marginal revenue equals marginal cost.
– This is the same marginal decision-making analysis used
in perfectly competitive markets.
MR= MC
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Monopoly profit maximization
• A monopolist’s profit maximizing price and quantity can be found graphically:
MC, MR, ATC ($)
8,000 • The profit-maximizing
7,000 MC quantity is identified
where MR = MC, point B.
6,000
ATC • The price is determined
5,000
A by the point on the
4,500
4,000 demand curve that
3,000 B corresponds to the
2,000 profit-maximizing
D
quantity, point A.
1,000
MR • Price is set higher than
0
1 2 3 4 5 6 7 8 9 10 the marginal revenue.
Quantity of violet diamonds
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Monopoly profit maximization
• A monopolist’s profits can be found graphically:
MC, MR, ATC ($)
Monopolist’s • Profit per unit =
8,000
profit P – ATC.
7,000 MC
Profit per unit • Vertical distance
6,000 between A and B.
ATC
5,000 • Profit = (P – ATC)
A
4,500 × Q.
4,000
• Since P > MC and
3,000 B barriers to entry
exist, monopolists
2,000
D earn positive
1,000 economic profits in
0
MR the long-run.
1 2 3 4 5 6 7 8 9 10
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Quantity of violet diamonds
Active Learning: Determine
profit-maximizing price and quantity and profit
• Use the following graph to determine a coffee-producing monopolist’s
profit-maximizing price and quantity.
P
12
MC =
11
10
9
8
7
6
5
4
3
2
1 MR D
0
0 1 2 3 4 5 6 7 8 9 10 Q
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Active Learning: Determine
profit-maximizing price and quantity and profit
• Use the following graph to determine a coffee-producing monopolist’s
profit-maximizing price and quantity.
P
12
MC =
11
10
9
8
7
6
5
4
3
2
1 MR D
0
Q
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14.1.3 Problems with Monopoly
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Problems with monopoly
• Monopoly power benefits monopolists but causes social
welfare losses.
• In a competitive market, the equilibrium price and quantity
maximize total surplus.
• Monopolists produce at a lower quantity than the efficient
level.
– Total surplus is not maximized.
– Producer surplus (monopolist profit) increases.
– Consumer surplus decreases.
– The loss of total surplus is a deadweight loss equal to the
total surplus under perfect competition minus the total
surplus under a monopoly.
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The welfare costs of monopoly
Efficient market Inefficient monopoly
MC, MR ($)equilibrium MC, MR ($)market
Consumer surplus Consumer surplus
Producer surplus Producer surplus
Deadweight loss
MC A MC
4,500
C
3,500
B
2,250
D D
MR MR
0 6 0 4
Quantity of violet diamonds Quantity of violet diamonds
• Consumer surplus decreases because of
• Total surplus is maximized and there is the lower quantity and higher price.
no deadweight loss. • Monopolists earn positive economic
profits.
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• Society suffers a deadweight loss.
The welfare costs of monopoly
• The welfare costs associated with monopolies is a positive
statement.
• Many voters and policy-makers make normative
statements concerning monopolies:
– Extra profits to monopolies.
– Benefits of maintaining a particular monopoly outweigh
the social welfare costs.
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Public policy responses
• Pressure from both the government and consumers can lead
to a decrease in monopoly power.
• Policy responses are often imperfect and controversial.
• The goals of policy responses are typically:
– Break up existing monopolies.
– Prevent new monopolies from forming.
– Ease the effect of monopoly power on consumers.
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Public policy responses
• How?
– Antitrust laws
– Public Ownership
– Regulation
– Vertical Splits
– No response
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Public policy responses: Antitrust laws
• One public policy response is to enact antitrust laws that
investigate and prosecute corporations that engage in
anti-competitive practices.
– Competition Act.
– Administered by the Competition Bureau.
• Critics of antitrust laws argue that they:
– Are typically politically motivated.
– Cause more inefficiency than they create.
– E.g.: https://www.wsj.com/articles/the-antitrust-case-
against-facebook-google-amazon-and-apple-
1516121561
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Public policy responses: Public ownership
• Natural monopolies occur when one firm can achieve lower
costs of production than multiple firms.
• A public policy response to natural monopolies is to allow the
government to run them.
Benefits Costs
• Provide broader services. • Political pressure.
• Set prices lower than
• Loss of profit incentive
unregulated monopolies.
potentially leading to
inefficiencies.
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Public policy responses: Public ownership
• Below provide the effect of price regulation of a natural
monopolist.
Price (cents per kilowatt hour) Price (cents per kilowatt hour)
Monopoly profit Monopoly loss
Deadweight loss
Efficient price:
(P = MC)
20 Ceiling
ATC ATC
MC 14 MC
D D
MR MR
0 5,600 0 6,350
Millions of kilowatt hours of electricity Millions of kilowatt hours of electricity
• Price ceiling set above the • Price regulated to marginal
monopolist’s ATC. cost.
• Monopolist produces where price • Monopoly is producing at a
intersects average revenue loss because P < ATC.
(identical to demand).
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competitive market price.
Public policy responses: Regulation
• If policymakers do not want public ownership, one common
intermediate step is to regulate the behavior of natural
monopolies.
– Takes the form of price controls.
• Firms have an incentive to avoid releasing information
about their true production costs.
– This makes it difficult for regulators to determine the
appropriate price.
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Public policy responses: Vertical splits
• Another policy response is to vertically split an
industry to introduce competition.
– Different firms now operate at different points in the
production process.
• In a horizontal split, a monopolist is separated into
several firms that compete with each other to sell the
same product.
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Public policy responses: No response
• Cost-benefit analysis might suggest that the best response
is to do nothing.
• This might be preferable if regulation is difficult and/or
ineffective to establish and manage.
• Common when government interventions are subject to
corruption or political mishandling.
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14.1.4 Market power and Price
discrimination
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Market power and price discrimination
• Some consumers are willing to pay more for a good than the
prevailing market price.
• Price discrimination is the practice of charging customers
different prices for the same good (to increase monopoly
profits)
– Firms with monopoly power can charge higher prices to
consumers with a higher willingness to pay.
– The more monopoly power a firm has, the more it is able to
price discriminate.
– E.g.: by age (students, elderly, children), be the first of
doing something (choosing a plane sit, or ticket), different
quality (the first edition or the pocket format)…Assuming
different willingness to pay among these different groups
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Market power and price discrimination
Suppose Microsoft has the following potential customers for MS Office:
• 1 million ‘business owner’ customers willing to pay $225.
• 1 million ‘standard user’ customers willing to pay $150.
• 1 million ‘student’ customers willing to pay $75.
Microsoft also has fixed costs of $50 million.
• The demand curve for
Only business Microsoft Office is a step
Price ($) owners buy function.
Business owners • At $225 per copy, only
225 and standard
business owners will buy
users buy
Office.
150 All customers • At $150 per copy, both
buy business owners and standard
users will buy Office.
75 • At $75 per copy, all
customers, including
Demand students, will buy Office.
0 1 2 3
uOttawa.caMillions of copies of Office
Market power and price discrimination
• What price should Microsoft charge for Office to maximize
profits without price discrimination?
Price ($) Number of copies Total Revenue ($) Fixed Costs ($) Profits ($)
75 3,000,000 225,000,000 50,000,000 175,000,000
150 2,000,000 300,000,000 50,000,000 250,000,000
225 1,000,000 225,000,000 50,000,000 175,000,000
‒ A price of $150 maximizes profits.
‒ Note that by charging $150, Microsoft loses the business of
students.
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Price discrimination
• What are Microsoft’s profits with price discrimination?
No price discrimination Imperfect price Perfect price
Price ($) Price ($) discrimination Price ($) discrimination
Consumer surplus
300 Producer surplus 30 0 30 0
Deadweight loss Business price = $225
22 5
Standard price = $150
150 15 0
Student price = $75
75
D D D
0 2 4 0 1 2 3 4 0
Millions of copies of Office
Millions of copies of Office Millions of copies of Office
• Sets price equal to each
• One price of $150 to • Sets price per each
customer’s willingness to
all customers. group of customers.
pay.
• Loses student • Earns profits from
• Earns profits from all
customers. all customers.
customers.
• Results in a
uOttawa.ca • Results in smaller
• Zero deadweight loss and
deadweight loss deadweight loss.
consumer surplus.
Price discrimination
• Price discrimination requires firms to accurately know
how much each customer (or group of customers) are
willing to pay.
– Requires some sort of verification.
• The ability to resell products creates problems for firms
trying to price discriminate.
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Summary
• Monopoly markets have barriers that prevent firms other
than the monopolist from entering the market.
• Monopolists are constrained by the market demand curve.
• Monopolists choose their profit-maximizing quantity the
same way that firms in competitive markets do.
– Produce where MR = MC.
• However, monopolists earn positive economic profits.
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Summary
• Monopolists produce less than the competitive market
quantity, causing a deadweight loss.
• Public policy exists to break up, prevent entry, and
mitigate the effect of monopolies.
• Monopolies can use price discrimination strategies to
maximize profits.
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References
• Karlan, D., Morduch, J., Startz. M.L., Wong, A., (2017).
Microeconomics. Chapter 14. McGraw-Hill.
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