econ210 ch06

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Prepared by: Jamal Husein

C H A P T E R

6

2005 Prentice Hall Business Publishing Survey of Economics, 2/e OSullivan & Sheffrin

Monopoly

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2 2005 Prentice Hall Business Publishing Survey of Economics, 2/e OSullivan & Sheffrin

Monopoly

A monopoly occurs whenthere is only one firm and a

barrier preventing otherfirms from entering themarket.

Amonopolyis a market servedby a single firm.

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Barriers to Entry

A patent, granted by the government,gives an inventor the exclusive right to

sell a new product for some period of time A franchise, or licensing scheme, in

which the government designates a singlefirm to sell a particular product

A natural monopoly, in which largeeconomies of scale in production allow onlyone firm to be profitable

Possible barriers to entry include:

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The Monopolists Output Decision

The firm faces the same laws ofproduction and cost in the short

run, associated with diminishingreturns.

Like other firms, the monopolysobjective is to produce the output

level that willmaximize profit

.

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The Monopolists Demand Curve

Since the monopoly

is the only firm in themarket, it faces theentire marketdemand for its

product.

A downward-

sloping demand

curve is associated

with particularrevenue

characteristics for

the monopoly firm.

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TR and MR for the Monopolist

In order to increase

the quantity sold,the monopolist mustdecrease price for allunits sold.

When the monopolist

decreases price in

order to increase

quantity sold, there isgood news and bad

news regarding

additional revenue.

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Demand, TR and MR for the Monopolist

Marginal revenue is

defined as thechange in TR thatresults from sellingone more unit of

output

The bad news is that the firm loses revenue from

selling at a lower price to all customers combined.

The good news isthat the firm sellsmore output, so itcollects morerevenue from newcustomers.

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Demand and MR for the Monopolist

When the bad newsoutweighs the good

news, marginalrevenue becomesnegative.

The combined goodand bad newsyields the value ofmarginal revenue

for the monopolist.

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TR and MR for the Monopolist

Information from the

demand curve (price andquantity sold) can be used toderive the total and marginalrevenue curves.

($)

Revenue

Marginal

($)

Revenue

Total

Sold

Quantity

($)

Price

MRTRQP

(PxQ)

0016

1414114

1024212

630310

23248

-23056

-62464

TR

Q

0

8

16

24

32

C

o

s

t

in

$

0 1 2 3 4 5 6Quantity sold

Total Revenue

-6

-4

-2

0

2

4

6

8

10

12

14

Priceand

m

arginalrevenue

0 1 2 3 4 5 6

Quantity sold

Demand Marginal Revenue

Demand and Marginal Revenue

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The Marginal Principle and the Output Decision

To decide how much output to produceand what price to charge, the monopolistcan use the marginal principle.

Marginal PRINCIPLEIncrease the level of an activity if itsmarginal benefit exceeds its marginal cost,

but reduce the level if the marginal cost

exceeds the marginal benefit. If possible,

pick the level at which the marginal benefit

equals the marginal cost.

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The Marginal Rule for Profit Maximization

A firm maximizes profit byfollowing the marginal

principleby settingmarginal revenue equal tomarginal cost;

MR = MC

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Computing Maximum Profit

Price Q MR TRRevenueper Unit

TC MC ATCProfit(Total

Approach

ProfitPerUnit

Profit PerUnit

Approach

$18 600 $12 $10,800 $18 $5,710 $4 $9.52 $5,090 $8 $5,090

17 700 $11 $11,900 $17 $6,140 $4 $8.77 $5,760 $8 $5,760

16 800 $9 $12,800 $16 $6,635 $5 $8.29 $6,165 $8 $6,165

15 900 $7 $13,500 $15 $7,20 $6 $8.00 $6,300 $7 $6,300

14 1000 $5 $14,000 $14 $7,835 $6 $7.84 $6,165 $6 $6,165

13 1100 $3 $14,300 $13 $8,560 $7 $7.78 $5,740 $5 $5,740

12 1200 $1 $14,400 $12 $9,400 $8 $7.83 $5,000 $4 $5,000

Marginal revenue is closest to marginal

cost at 900 units of output.

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The Output Decision

When the gapbetween total

revenue and total

cost is greatest,

marginal revenueis roughly equal

to marginal cost.

The monopolist

maximizes profitwhen it produces

900 units of

output.

$

n

m

c

MC

AC

D

MR900

8

6

15

Doses of Drug per hour

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The Costs of Monopoly

What are the trade-offs? The costs& benefits of monopoly to society asa whole?

In many cases monopoly resultsfrom government policy;

If the costs exceed the benefits , it may

be sensible to remove barriers toentry;

The benefits to consumers are

measured by Consumer Surplus.

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The demand Curve & Consumer Surplus

Consumer Surplus: The differencebetween the maximum amount aconsumer is willing to pay for a productand the price that he/she actually pays.

The consumer surplus is the area under the

demand curve and above the market price.

It is what consumers gain from their

Purchases after deducting the cost.

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The demand Curve & Consumer Surplus

1 2 3

Price($perlawn)

$10

Number of Lawns cut per week

$25

$22

Price

54 6

Juan

Tupak

ThurlForest

Fivola

Siggy

$19

$16

$13

$7

Juan is willing to pay $22, so if the

actual price is $10, his consumersurplus is $12

Forest is willing to pay $13,his consumer

surplus is $12

Total market Consumer surplus =

$12+$9+$6+$3+$0=$30

Fivola is willing to pay $10,herconsumer surplus is $0

D

Siggy is willing to

pay $7,he doesntget his lawn cut

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Monopoly Versus perfect Competition

Perfectly competitive price is

$8, so the consumer surplus is

shown by triangles C and D

and rectangle R

Monopoly price is $18 and consumer surplus associated with

this price is shown by triangle C. Switching from perfectcompetition to monopoly decreases consumer surplus by the

areasR andD.

200 400

$18

$8

$

Doses of Drug per hour

LRACDemand

C

RD

Only part of consumers loss isrecovered by producers (Rectangle

R). The net loss to consumers &society is triangle D (deadweight

loss)

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Rent Seeking

Rent seeking is a term used to describe the efforts by amonopoly to persuade government to erect barriers toentry.

If rent seeking exists,the monopoly may

spend some of itspotential profit onrent-seeking activity,and the net loss tosociety would be areasR and D, not just areaD.

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The Costs and Benefits of Monopoly

Costs: a monopoly produces lessoutput than a perfectly competitivemarket, and people waste resources

trying to get and keep monopolypower.

Benefits: a patent or license

increases the payoff from researchand development, thus encouragesinnovation.

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Natural Monopoly

Examples of natural monopolies:

Public utilities (sewerage, water, and

electricity generation) Transportation services (railroad

freight and mass transit)

A natural monopoly is a firm thatserves the entire market at a lower cost

than two or more firms can.

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Natural Monopoly

The long-runaverage cost ofelectricitygeneration is

negatively sloped,reflecting largeeconomies of scale.

As long as the long-

run average costdecreases, the long-run marginal costmust lie below it.

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Natural Monopoly

Given the structure of

demand and marginalrevenue, themonopoly maximizesprofit by generating 3

thousand kilowatthours.

Left alone, themonopoly will charge

$8.20 and earn a profitof ($8.20-$6.20) = $2per kilowatt hour(distance between

pointsc andm).

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Natural Monopoly

Profit is possibleonly if there is onefirm, unregulated,serving the entiremarket demand.

Total profit equals(priceaveragecost) x quantityproduced and sold

(the green area).

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Natural Monopoly

Suppose that themonopoly shared themarket demand andoutput sold with asecond firm, and that

each firm producedhalf of the marketoutput (1.5 kw/h).

The cost of producing1.5 kw/h would exceedthe price the firms canreceive, thus theywould suffer losses.

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26 2005 P ti H ll B i P bli hi S f E i 2/ OS lli & Sh ff i

Price Controls for a Natural Monopoly

Under an average-costpricing policy, thegovernment picks aprice equal to theaverage cost of

production, or $5.20.

But regulation gives theutility no incentive tocontrol costs, so costsrise. Price afterregulation decreases byless than anticipated.

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