13 MONOPOLY After studying this chapter you will be able to Explain how monopoly arises Explain how a single price monopoly determines its output and price Compare the performance and efficiency of single price monopoly and competition Explain how price discrimination increases profit Explain how monopoly regulation influences output price economic profit and efficiency 2014 Pearson Addison Wesley Google and Microsoft are dominant players in the markets for Web search and advertising and for computer operating systems These firms are not like the firms in perfect competition How do firms that dominate their markets behave Do they charge prices that are too high and that damage the interest of consumers Students get lots of price breaks at the movie theater and the hairdresser and on busses and trains Why How can it be profit maximizing to offer lower prices to some customers 2014 Pearson Addison Wesley Monopoly and How It Arises A monopoly is a market That produces a good or service for which no close substitute exists In which there is one supplier that is protected from competition by a barrier preventing the entry of new firms 2014 Pearson Addison Wesley Monopoly and How It Arises How Monopoly Arises A monopoly has two key features No close substitute Barriers to entry No Close Substitutes If a good has a close substitute even if it is produced by only one firm that firm effectively faces competition from the producers of the substitute A monopoly sells a good that has no close substitutes 2014 Pearson Addison Wesley Monopoly and How It Arises Barriers to Entry A constraint that protects a firm from potential competitors is called a barrier to entry Three types of barriers to entry are Natural Ownership Legal 2014 Pearson Addison Wesley Monopoly and How It Arises Natural Barriers to Entry Natural barriers to entry create natural monopoly A natural monopoly is a market in which economies of scale enable one firm to supply the entire market at the lowest possible cost Figure 13 1 illustrates a natural monopoly 2014 Pearson Addison Wesley Monopoly and How It Arises One firm can produce 4 million units of output at 5 cents per unit Two firms can produce 4 million units 2 units each at 10 cents per unit 2014 Pearson Addison Wesley Monopoly and How It Arises In a natural monopoly economies of scale are so powerful that they are still being achieved even when the entire market demand is met The LRAC curve is still sloping downward when it meets the demand curve 2014 Pearson Addison Wesley Monopoly and How It Arises Ownership Barriers to Entry An ownership barrier to entry occurs if one firm owns a significant portion of a key resource During the last century De Beers owned 90 percent of the world s diamonds 2014 Pearson Addison Wesley Monopoly and How It Arises Legal Barriers to Entry Legal barriers to entry create a legal monopoly A legal monopoly is a market in which competition and entry are restricted by the granting of a Public franchise like the U S Postal Service a public franchise to deliver first class mail Government license like a license to practice law or medicine Patent or copyright 2014 Pearson Addison Wesley Monopoly and How It Arises Monopoly Price Setting Strategies For a monopoly firm to determine the quantity it sells it must choose the appropriate price There are two types of monopoly price setting strategies A single price monopoly is a firm that must sell each unit of its output for the same price to all its customers Price discrimination is the practice of selling different units of a good or service for different prices Many firms price discriminate but not all of them are monopoly firms 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision Price and Marginal Revenue A monopoly is a price setter not a price taker like a firm in perfect competition The reason is that the demand for the monopoly s output is the market demand To sell a larger output a monopoly must set a lower price 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision Total revenue TR is the price P multiplied by the quantity sold Q Marginal revenue MR is the change in total revenue that results from a one unit increase in the quantity sold For a single price monopoly marginal revenue is less than price at each level of output That is MR P 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision Figure 13 2 illustrates the relationship between price and marginal revenue and derives the marginal revenue curve Suppose the monopoly sets a price of 16 and sells 2 units 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision Now suppose the firm cuts the price to 14 to sell 3 units It loses 4 of total revenue on the 2 units it was selling at 16 each And it gains 14 of total revenue on the 3rd unit So total revenue increases by 10 which is marginal revenue 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision The marginal revenue curve MR passes through the red dot midway between 2 and 3 units and at 10 You can see that MR P at each quantity 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision Marginal Revenue and Elasticity A single price monopoly s marginal revenue is related to the elasticity of demand for its good If demand is elastic a fall in price brings an increase in total revenue 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision The increase in revenue from the greater quantity sold outweighs the decrease in revenue from the lower price per unit and MR is positive As the price falls total revenue increases 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision If demand is inelastic a fall in price brings a decrease in total revenue The rise in revenue from the increase in quantity sold is outweighed by the fall in revenue from the lower price per unit and MR is negative 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision As the price falls total revenue decreases 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision If demand is unit elastic a fall in price does not change total revenue The rise in revenue from the greater quantity sold equals the fall in revenue from the lower price per unit and MR 0 Total revenue is maximized when MR 0 2014 Pearson Addison Wesley A Single Price Monopoly s Output and Price Decision In Monopoly