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Chapter 12

Pure Monopoly

This chapter is divided into seven learning objectives: the characteristics of pure monopoly, the barriers to entry that create and protect monopolies, how demand is viewed by a monopolist, price and output determination under monopoly, the economic effects of monopoly, price discrimination, and the regulation of monopolies.

The discussion of barriers to entry asserts at the outset that these barriers may occur to some extent in any form of imperfect competition, not just in a pure monopoly. The concept of a natural monopoly is addressed in this section.

Building on the analysis of the preceding chapter, the discussion of the price‑output decision-making by monopoly firms points out that the marginal-revenue=marginal-cost rule still applies. Emphasis here is on the major difference between the determination of marginal revenue in pure competition and in pure monopoly. The misconceptions about monopoly pricing behavior are presented, as well as a comparison of efficiency in pure competition and pure monopoly. The case of price discrimination and its effects are discussed along with the conditions necessary for it to occur. This section ends with a discussion of the effects of monopoly power in the U.S. economy and some policy alternatives. Some basic issues involved in the regulation of public service monopolies are reviewed.

The Last Word examines how some Internet companies have achieved near monopoly power due to network effects and economies of scale.

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Introduction to Pure Monopoly

Pure monopoly

Single seller – a sole producer
No close substitutes – unique product
Price maker – control over price
Blocked entry – strong barriers to entry
Non-price competition – mostly PR but can engage in advertising to increase demand

LO1

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Barriers to Entry

Barriers to entry are factors that prevent firms from entering the industry

Economies of scale
Legal barriers to entry like patents and licenses
Ownership or control of essential resources
Pricing and other strategic barriers

LO2

12-3

Economies of scale constitute one major barrier. This occurs where the lowest unit costs and, therefore, lowest unit prices for consumers depend on the existence of a small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale. Google and Amazon both enjoy economies of scale in their respective markets. 1. Public utilities are often natural monopolies because they have economies of scale in the extreme case where one firm is most efficient in satisfying the entire demand. 2. Government usually gives one firm the right to operate a public utility industry in exchange for government regulation of its power.

Legal barriers to entry into a monopolistic industry also exist in the form of patents and licenses. 1. Patents grant the inventor the exclusive right to produce or license a product for twenty years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits. 2. Licenses are another form of entry barrier. Radio and TV stations and taxi companies are examples of government granting licenses where only one or a few firms are allowed to offer the service.

Ownership or control of essential resources is another barrier to entry. 1. International Nickel Co. of Canada (now called Inco) used to control about 90 percent of the world’s nickel reserves and DeBeers of South Africa controls most of the world’s diamond supply (see Last Word). 2. Professional sports leagues control player contracts and leases on major city stadiums.

Monopolists may use pricing or other strategic barriers such as selective price-cutting and advertising. 1. Dentsply, manufacturer of false teeth, controlled about 70 percent of the market. In 2005 Dentsply was found to have illegally prevented distributors from carrying competing brands. 2. Microsoft charged higher prices for its Windows operating system to computer manufacturers featuring Netscape Navigator instead of Microsoft’s Internet Explorer. U.S. courts ruled this action illegal.

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Economies of Scale

10

15

$20

50

100

200

ATC

LO2

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Monopoly Demand

The pure monopolist is the industry
Monopolistic demand curve is the market demand curve
Demand curve is downsloping

LO3

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Monopoly Demand

Marginal revenue will be less than price
Monopolist is a price maker
Monopolist sets price in the elastic region of the demand curve

LO3

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Demand, Marginal Revenue, and Total Revenue

Elastic

Inelastic

Total-revenue curve

D

MR

TR

LO3

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Output and Price Determination

Steps for Graphically Determining the Profit-Maximizing Output, Profit-Maximizing Price, and Economic Profit (if Any) in Pure Monopoly
Step 1	Determine the profit-maximizing output by finding where MR=MC.
Step 2	Determine the profit-maximizing price by extending a vertical line upward from the output determined in step 1 to the pure monopolist’s demand curve.
Step 3	Determine the pure monopolist’s economic profit by using one of two methods:
	Method 1. Find profit per unit by subtracting the average total cost of the profit-maximizing output from the profit-maximizing price. Then multiply the difference by the profit-maximizing output to determine economic profit (if any).
	Method 2. Find total cost by multiplying the average total cost of the profit-maximizing output by that output. Find total revenue by multiplying the profit-maximizing output by the profit-maximizing price. Then subtract total cost from total revenue to determine the economic profit (if any).

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Misconceptions Concerning Monopoly Pricing

Not the highest price
Total profit
Possibility of losses

LO4

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Economic Effects of Monopoly

Income transfer
Cost complications

Economies of scale
Simultaneous consumption
Network effects
X-inefficiency
Rent-seeking behavior
Technological advance

LO5

12-11

Total revenue (TR) increases at a decreasing rate, reaches a maximum, and then declines. Note that in the elastic region, TR is increasing and hence MR is positive. When TR reaches its maximum, MR is zero. This graph reflects the demand, marginal revenue, and total revenue for a pure monopolist. Because it must lower price on all units sold in order to increase its sales, an imperfectly competitive firm’s marginal-revenue curve (MR) lies below its downsloping demand curve (D). The elastic and inelastic regions of demand are highlighted. Note that in the elastic region, TR is increasing and hence, MR is positive. When TR reaches its maximum, MR is zero. In the inelastic region of demand, TR is declining, so MR is negative.

Notice there is no supply curve for the monopolist. There is no unique relationship between price and quantity supplied for the monopolist.

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X-Inefficiency

ATC₂

ATC₁

ATC_x

Q₁

Q₂

Average

total cost

X

X'

ATC_x'

LO5

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Assessment and Policy Options

Antitrust laws

Break up the firm

Regulate it

Government determines price and quantity

Ignore it

Let time and markets get rid of monopoly

LO5

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Price Discrimination

Price discrimination

Charging different buyers different prices
Different prices are not based on cost differences

Conditions for success

Monopoly power
Market segregation
No resale

LO6

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Graphical Analysis

MC = ATC

Q_b

Q_s

P_s

P_b

P

MR_b

MR_s

D_b

D_s

(a) Small businesses

(b) Students

Economic profit

LO6

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Regulated Monopoly

Natural monopolies
Socially optimal price

Set price equal to marginal cost

Fair return price

Set price equal to average total cost

LO7

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Monopoly Power in the Internet Age

Google dominates search
Facebook dominates social media
Amazon dominates as an online retailer
Barriers of entry

Network effects of being large attract more users
Economies of scale

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Income distribution is more unequal than it would be under a more competitive situation. The effect of the monopoly power is to transfer income from the consumers to the business owners. This will result in a redistribution of income in favor of higher-income business owners, unless the buyers of monopoly products are wealthier than the monopoly owners.

Costs complications: Costs for monopolies may not be the same as for more competitive firms. Following are 4 reasons why costs may differ:

Economies of scale may result in one or two firms operating in an industry experiencing lower ATC than many competitive firms. These economies of scale may be the result of spreading large initial capital cost over a large number of units of output (natural monopoly) or, more recently, spreading product development costs over units of output, and a greater specialization of inputs. Some firms have been able to achieve extensive economies of scale due to the ability to produce a single product that many consumers can simultaneously enjoy like products that once produced can be downloaded over the Internet. Also, network effects can be factor that gives rise to monopoly power. Network effects occur when the value of a product rises as the total number of users rise. An example would be computer software or Facebook. The more people that use it, the more benefits of the product to each person using it. People tend to use products that everyone else is using.

X‑inefficiency may occur in monopoly since there is no competitive pressure to produce at the minimum possible costs. (see next slide for graph)

Rent‑seeking behavior often occurs as monopolies seek to acquire or maintain government‑granted monopoly privileges at someone else’s expense. Such rent‑seeking may entail substantial costs (lobbying, legal fees, public relations advertising, etc.), which are inefficient.

Technological progress and dynamic efficiency may occur in some monopolistic industries but not in others. The evidence is mixed. Some monopolies have shown little interest in technological progress. On the other hand, research can lead to lower unit costs, which help monopolies as much as any other type of firm. Also, research can help the monopoly maintain its barriers to entry against new firms.