244
WHAT’S NEW IN THE EIGHTH EDITION:
A new
Ask the Experts
feature on “Airline Mergers” has been added and there are two new questions in
the Problems and Applications section.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ why some markets have only one seller.
➢ how a monopoly determines the quantity to produce and the price to charge.
➢ how the monopoly’s decisions affect economic well-being.
➢ why monopolies try to charge different prices to different customers.
➢ the various public policies aimed at solving the problem of monopoly.
CONTEXT AND PURPOSE:
Chapter 15 is the third chapter in a five-chapter sequence dealing with firm behavior and the organization
of industry. Chapter 13 developed the cost curves on which firm behavior is based. These cost curves
were employed in Chapter 14 to show how a competitive firm responds to changes in market conditions.
In Chapter 15, these cost curves are again employed, this time to show how a monopolistic firm chooses
the quantity to produce and the price to charge. Chapters 16 and 17 will address the decisions made by
KEY POINTS:
• A monopoly is a firm that is the sole seller in its market. A monopoly arises when a single firm owns a
key resource, when the government gives a firm the exclusive right to produce a good, or when a
single firm can supply the entire market at a lower cost than many firms could.
MONOPOLY
15
Chapter 15/Monopoly ❖ 245
• Because a monopoly is the sole producer in its market, it faces a downward-sloping demand curve for
its product. When a monopoly increases production by one unit, it causes the price of its good to fall,
which reduces the amount of revenue earned on all units produced. As a result, a monopoly’s
marginal revenue is always below the price of its good.
• Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which
marginal revenue equals marginal cost. The monopoly then sets the price at which that quantity is
demanded. Unlike a competitive firm, a monopoly firm’s price exceeds its marginal revenue, so its
price exceeds marginal cost.
• A monopolist can often increase profit by charging different prices for the same good based on a
buyer’s willingness to pay. This practice of price discrimination can raise economic welfare by getting
the good to some consumers who would otherwise not buy it. In the extreme case of perfect price
discrimination, the deadweight loss of monopoly is completely eliminated, and the entire surplus in
the market goes to the monopoly producer. More generally, when price discrimination is imperfect, it
can either raise or lower welfare compared to the outcome with a single monopoly price.
• Policymakers can respond to the inefficiency of monopoly behavior in four ways. They can use the
antitrust laws to try to make the industry more competitive. They can regulate the prices that the
monopoly charges. They can turn the monopolist into a government-run enterprise. Or, if the market
failure is deemed small compared to the inevitable imperfections of policies, they can do nothing at
all.
CHAPTER OUTLINE:
I. A competitive firm is a price taker; a monopoly firm is a price maker.
II. Why Monopolies Arise
B. The fundamental cause of monopoly is barriers to entry.
1. Monopoly Resources
a. A monopoly could have sole ownership or control of a key resource that is used in the
production of the good.
b. A key example is DeBeers, which has at times controlled about 80% of the diamonds in
the world.
2. Government-Created Monopolies
246 ❖ Chapter 15/Monopoly
b. Patents are issued by the government to give firms the exclusive right to produce a
product for 20 years.
c. Patents involve trade-offs; they restrict competition but encourage research and
development.
3. Natural Monopolies
a. Definition of 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.
b. A natural monopoly occurs when there are economies of scale, implying that average
total cost falls as the firm’s scale becomes larger.
III. How Monopolies Make Production and Pricing Decisions
A. Monopoly versus Competition
2. The demand curves that each of these types of firms faces is different as well.
a. A competitive firm faces a perfectly elastic demand at the market price. The firm can sell
all that it wants to at this price.
b. A monopoly faces the market demand curve because it is the only seller in the market. If
a monopoly wants to sell more output, it must lower the price of its product.
B. A Monopoly’s Revenue
1. Example: sole producer of water in a town.
(1)
Quantity
(2)
Price
(3)
Total Revenue
(4)
Average Revenue
(5)
Marginal Revenue
0
$11
$0
—-
—-
1
10
10
$10
$10
2
9
18
9
8
3
24
Chapter 15/Monopoly ❖ 247
2. A monopoly’s marginal revenue is less than the price of the good (other than at the first unit
sold).
c. Note that, for a competitive firm, there is no price effect.
Students often have trouble with this. Go through the table making sure that they
understand the calculation of both total revenue and marginal revenue as output
increases. Emphasize that the monopolist is selling all units at the same price.
ALTERNATIVE CLASSROOM EXAMPLE:
The Whatsa Widget Company has a monopoly in the sale of widgets. The demand the firm
faces can be shown by the following schedule:
Quantity
Price
Total Revenue
Marginal Revenue
0
$15
$0
—-
1
14
14
$14
2
13
26
12
3
12
36
10
4
11
44
8
5
10
50
6
248 ❖ Chapter 15/Monopoly
3. When graphing the firm’s demand and marginal revenue curve, they always start at the same
point (because
P
=
MR
for the first unit sold); for every other level of output, marginal
revenue lies below the demand curve (because
MR
<
P
).
C. Profit Maximization
1. The monopolist’s profit-maximizing quantity of output occurs where marginal revenue is
equal to marginal cost.
a. If marginal revenue is greater than marginal cost, profit can be increased by raising the
firm’s level of output.
2. Even though
MR
=
MC
is the profit-maximizing rule for both competitive firms and
monopolies, there is one important difference.
a. In competitive firms,
P
=
MR
; at the profit-maximizing level of output,
P
=
MC
.
3. The monopolist’s price is determined by the demand curve (which shows us how much
buyers are willing to pay for the product).
3
26
10
4
39
13
5
57
18
At this point, you may want to discuss the price elasticity of demand again. Remind
students that demand tends to be elastic along the upper left portion of the demand
curve. Thus, a decrease in price causes total revenue to increase (so that marginal
ALTERNATIVE CLASSROOM EXAMPLE:
The costs for the Whatsa Widget Company can be represented by the following schedule:
Quantity
Total Cost
Marginal Cost
0
$8
—-
1
11
$3
2
16
5
Chapter 15/Monopoly ❖ 249
D.
FYI: Why a Monopoly Does Not Have a Supply Curve
1. A supply curve tells us the quantity that a firm chooses to supply at any given price.
2. But a monopoly firm is a price maker; the firm sets the price at the same time it chooses the
quantity to supply.
E. A Monopoly’s Profit
1. We can find profit using the following equation:
Profit =
TR
–
TC
.
2. Because
TR
=
P
×
Q
and
TC
=
ATC
×
Q
, we can rewrite this equation:
Profit = (
P
–
ATC
) ×
Q
.
After having seen profit-maximization for a perfectly competitive firm, students
generally do not have difficulty understanding that a monopolist will maximize profit
where marginal revenue equals marginal cost. However, students do have trouble
remembering to use the demand curve to find the monopolist’s price. Be careful to
review this point several times.
250 ❖ Chapter 15/Monopoly
F.
Case Study: Monopoly Drugs versus Generic Drugs
1. The market for pharmaceutical drugs takes on both monopoly characteristics and competitive
characteristics.
2. When a firm discovers a new drug, patent laws give the firm a monopoly on the sale of that
drug. However, the patent eventually expires and any firm can make the drug, which causes
the market to become competitive.
IV. The Welfare Cost of Monopolies
A. The Deadweight Loss
1. The demand curve represents the value that buyers place on each additional unit of a good
or service. The marginal-cost curve represents the additional cost of producing each unit of a
good or service.
3. Because the monopolist sets marginal revenue equal to marginal cost to determine its output
level, it will produce less than the socially efficient quantity of output.
Remind students that total surplus is the area between the demand curve and the
marginal cost curve. It should be clear that surplus is not realized for quantities of
output between the monopoly output and the socially efficient output.
Chapter 15/Monopoly ❖ 251
4. The price that a monopolist charges is also above marginal cost. Although some potential
customers value the good at more than its marginal cost but less than the monopolist’s price,
they do not purchase the good even though that is inefficient because total surplus is not
maximized.
5. The deadweight loss can be seen on the graph as the area between the demand and
marginal cost curves for the units between the monopoly quantity and the efficient quantity.
B. The Monopoly’s Profit: A Social Cost?
1. Welfare in a market includes the welfare of both consumers and producers.
2. The transfer of surplus from consumers to producers is therefore not a social loss.
V. Price Discrimination
A. Definition of price discrimination: the business practice of selling the same good at
different prices to different customers.
B. A Parable about Pricing
1. Example: Readalot Publishing Company
Point out to students that this is similar to the analysis of taxes in Chapter 8. Here,
the monopolist places a wedge between price and marginal cost and the quantity
sold ends up being short of the optimum level.
252 ❖ Chapter 15/Monopoly
2. The firm pays an author $2 million for the right to publish a book. (Assume that the cost of
printing the book is zero.)
3. The firm knows that there are two types of readers.
a. There are 100,000 die-hard fans (living in Australia) of the author willing to pay up to
4. How should the firm set its price?
a. If the firm sets its price equal to $30, it will sell 100,000 copies of the book, receive total
revenue of $3 million, and earn $1 million in profit.
b. If the firm sets its price equal to $5, it will sell 500,000 copies, receive total revenue of
$2.5 million, and earn only $500,000 in profit.
5. Since it would be difficult for Australian readers to buy a copy of the book in the United
States, the company could make even more profit by selling 100,000 copies to the die-hard
fans at $30 each, and then selling 400,000 copies to the other readers for $5 each.
a. The total revenue from selling 100,000 copies at $30 each is $3 million.
b. The total revenue from selling 400,000 copies at $5 each is $2 million.
c. Because the firm’s costs are $2 million, profit will be $3 million.
Activity 1—Price Discrimination and Time Travel
Type: In-class demonstration
Topics: Price discrimination, consumer surplus
Materials needed: None
Time: 10 minutes
Class limitations: Works in any size class
Purpose:
This example illustrates how a price-discriminating monopolist can earn even higher profits
than a monopolist charging a single price. The example uses an imaginary time machine to
look at monopoly profits. The cases of competition, monopoly, and price discriminating
monopoly are examined.
Instructions:
Use student names in the demand for travel time below.
Chapter 15/Monopoly ❖ 253
C. The Moral of the Story
1. By charging different prices to different customers, a monopoly firm can increase its profit.
3. Arbitrage (the process of buying a good in one market at a low price and then selling it in
another market at a higher price) will limit a monopolist’s ability to price discriminate.
4. Price discrimination can increase economic welfare. Producer surplus rises (because price
exceeds marginal cost for all of the units sold) while consumer surplus is unchanged
(because price is equal to the consumers’ willingness to pay).
D. The Analytics of Price Discrimination
• “Chip” can’t wait for the semester to end; he is willing to pay up to $125 to use the
time machine.
• “Dawn” just wants to get through this class period; she is willing to pay up to $100 to
use the time machine.
The demand curve for time travel is:
Price Quantity
$200 1
150 2
125 3
100 4
(TC = ATC x Q = $100 x 4) $400, so profit would be zero.
If time travel were a monopoly, the quantity of trips would be determined where marginal
revenue equals marginal cost, so 2 trips would be sold. Total revenue would be $300 and
total cost would be $200, so profit would be $100.
Price Quantity Total Revenue Marginal Revenue
$200 1 $200 $200
150 2 $300 $100
125 3 $375 $75
100 4 $400 $25
Both profit and quantity are highest with price discrimination.
254 ❖ Chapter 15/Monopoly
1. Perfect price discrimination describes a situation where a monopolist knows exactly the
willingness to pay of each customer and can charge each customer a different price.
2. Without price discrimination, a firm produces an output level that is lower than the socially
efficient level.
3. If a firm perfectly price discriminates, each customer who values the good at more than its
marginal cost will purchase the good and be charged his or her willingness to pay.
E. Examples of Price Discrimination
1. Movie Tickets
2. Airline Prices
F.
In the News: Price Discrimination in Higher Education
1. While there is a common belief that the cost of a college education has risen sharply in
recent years, the real price has risen for high income families and fallen for low income
families.
2. This article from
Bloomberg.com
describes the price discrimination that occurs in this market.
VI. Public Policy toward Monopolies
A. Increasing Competition with Antitrust Laws
1. Antitrust laws are a collection of statutes that give the government the authority to control
markets and promote competition.
2. Antitrust laws allow the government to prevent mergers and break up large, dominating
companies.
Figure 9
Chapter 15/Monopoly ❖ 255
B.
Ask the Experts:
Airline Mergers
1. Economic experts are divided on whether air travelers would be better off today if regulators
had not approved mergers in the past decade between major airlines, with 29 percent
agreeing, 26 percent disagreeing, and 45 percent uncertain.
C. Regulation
1. Regulation is often used when the government is dealing with a natural monopoly.
2. Most often, regulation involves government limits on the price of the product.
3. While we might believe that the government can eliminate the deadweight loss from
monopoly by setting the monopolist’s price equal to its marginal cost, this is often difficult to
do.
a. If the firm is a natural monopoly, its average total cost curve will be declining because of
its economies of scale.
4. Therefore, governments may choose to set the price of the monopolist’s product equal to its
average total cost. This gives the monopoly zero profit, but assures that it will remain in the
market.
a. There is still a deadweight loss in this situation because the level of output will be lower
than the socially efficient level of output.
b. Average-cost pricing also provides no incentive for the monopolist to reduce costs.
D. Public Ownership
1. Rather than regulating a monopoly run by a private firm, the government can run the
monopoly itself.
2. However, economists generally prefer private ownership of natural monopolies.
Local phone and electric companies are good examples of regulated monopoly firms.
256 ❖ Chapter 15/Monopoly
b. If government bureaucrats do a bad job running a monopoly, the political system is the
taxpayers’ only recourse.
E. Doing Nothing
2. Therefore, some economists believe that it is best for the government to leave monopolies
alone.
VII. Conclusion: The Prevalence of Monopolies
A. Monopoly firms behave very differently from competitive firms.
B. Table 2 summarizes the key similarities and differences between monopoly and competitive
markets.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. A market might have a monopoly because: (1) a key resource is owned by a single firm; (2)
2. A monopolist chooses the amount of output to produce by finding the quantity at which
3. A monopolist produces a quantity of output that is less than the quantity of output that
4. Examples of price discrimination include: (1) movie tickets, for which children and senior
citizens get lower prices; (2) airline prices, which are different for business and leisure
travelers; (3) discount coupons, which lead to different prices for people who value their time