Principles of Microeconomics Chapter 15 A monopoly firm is a price maker A monopoly firm charges a price that exceeds marginal cost A monopoly can set a price high but because a high price reduces the quantity its customers buy the monopoly s profits are not unlimited Monopoly firms are unchecked by competition Monopoly a firm that is the sole seller of a product without close substitutes E g Microsoft A monopoly remains the only seller in its market because other firms cannot enter the market and compete with it 3 main sources of barriers to entry Monopoly resources a key resource required for production is owned by a single firm Government regulation the government gives a single firm the exclusive right to produce some good or service The production process a single firm can produce output at a lower cost than can a larger number of producers Government Created Monopolies Patent and copyright laws if the government deems a product to be truly original it will approve a patent giving a firm the exclusive right to manufacture and sell the drug for 20 years For copyrights no one can print and sell someone else s product without the author s permission Because these laws give one producer a monopoly over one product they lead to higher prices than would occur under competition but by allowing these monopolistic things to happen the laws also encourage increased incentives for creative activity Natural Monopolies Natural monopoly a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms arises when there are economies of scale over the relevant range of output In this case a single firm can produce any amount of output at least cost Monopolist s profit attracts entrants into the market making it more competitive But entering a market in which another firm has a natural monopoly is unattractive because entrants know that they cannot achieve the same low costs that the monopolists enjoy as more firms enter each firm would have a smaller piece of the market As a market expands one firm might not be able to produce enough to meet demand allowing the market to evolve into competition Monopoly vs Competition A competitive firm is small relative to the market in which it operates and has no power to manipulate market price A monopoly is the sole producer in its market it can alter the price of its good by adjusting the quantity it supplies to the market Because a competitive firm can sell as much or as little as it wants at a price it faces a horizontal demand curve perfectly elastic because its product has many perfect substitutes A monopoly s demand curve is the market demand curve because it is the sole producer of its product Its demand curve will slope downward as usual if price rises qD will diminish market demand curve is a constraint on monopoly s ability to profit from market power if the monopoly sets a very high price for its good qD will fall A Monopoly s Revenue Average revenue price of the good for a monopoly A monopolist s revenue is always less than the price of its good due to the downward sloping demand curve to increase q sold a monopoly firm must lower the price it charges to all customers To sell another unit of output the monopolist will get x less revenue for each of the previous units When a monopoly increases the amount it sells remember revenue P x Q the output effect more output is sold so Q is higher which tends to increase total revenue the price effect the price falls so P is lower which tends to decrease total revenue For competitive firms they can sell all they want at market price with no price effect because they are price takers marginal revenue price For monopolies they must reduce the price they charge for every unit they sell reducing revenue on the units they were already selling This makes a monopoly s marginal revenue less than price The demand and marginal revenue curves of a monopoly start off at the same point on the y axis because the marginal revenue of the first unit sold will equal the unit s price As units sold increases the curves diverge and marginal revenue will always be under demand Profit Maximization When marginal cost is less than marginal revenue a firm can increase production and profit because the extra revenue would exceed the extra costs When marginal cost is greater than marginal revenue a firm can decrease production because the costs saved would exceed the revenue lost In order to maximize profit a firm will adjust qS until it reaches a point at which marginal revenue equals marginal cost or the intersection of the two lines Competitive firm P MR MC Monopoly firm P MR MC A Monopoly s Profit Profit TR TC OR Profit P ATC x Q The Welfare Cost of Monopolies The DWL The socially efficient quantity is found where the demand curve and the marginal cost curve intersect The value of an extra unit to consumers is equal to the marginal cost of production below this quantity an extra unit to consumers exceeds the cost of providing it so increasing output would raise total surplus and vice versa when above qEfficient Since monopolies choose to produce the quantity at which the marginal cost curve and marginal revenue curve intersect it is lower than qEfficient This results in a DWL from the efficient point to the qMonopoly equaling the total surplus lost Monopoly profit in terms of total surplus is not a social problem total surplus will not change But when the firm produces and sells a quantity that is below qEfficient total surplus will shrink Price Discrimination Price discrimination the business practice of selling the same good at different prices to different customers For a firm to price discriminate it must have some market power Price discrimination is a rational strategy for a profit maximizing monopolist charge each customer a price closer to his her willingness to pay than is possible with a single price Price discrimination requires ability to separate customers according to their willingness to pay Certain maker forces can prevent firms from price discriminating e g arbitrage process of buyers a good in one market at a low price and then selling it in a different market for a higher price Price discrimination can raise economic welfare An increase in total surplus is entirely on the side of producers consumers buy goods at their willingness to pay Perfect price discrimination the monopolist knows exactly each customer s willingness to pay