Monopoly, Oligopoly

and Monopolistic
Competition

MB

MC

MB MC

Learning Objectives
1.

2.

3.

4.

5.

6.

Define imperfect competition and compare it to perfect

competition
Define market power and explain how it affects the demand
curve facing the firm
Understand and use marginal cost and marginal revenue to
maximize monopolist's profit
Explain how start-up costs affect economies of scale and
market power
Show how monopoly alters economic surplus compared to
perfect competition
Describe price discrimination and its effects

Copyright c 2007 by The McGraw-Hill

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MB MC

Market Structures

We know that in reality, perfect competition, in its

ideal text-book form, is rare.
What is far more common are firms with some
degree of market power (power to set prices). Market
Power is a measure of a firms ability to raise the
price of a good without losing all its sales.
In economics we define market structures based
mainly on the following two dimensions:
Number

of producers in the market (one, few, or, many)

Whether goods produced are homogeneous or
differentiated
Copyright c 2007 by The McGraw-Hill
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 3

MB MC

Market Structures

Homogeneous - Identical
Differentiated the goods are similar but are
not perfect substitutes in the consumers mind
(differentiated by quality, packaging,
advertising, etc)
Whether a market sells differentiated goods or
homogeneous goods depends on the nature
of the good and consumers preferences
Breakfast

Copyright c 2007 by The McGraw-Hill

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cereals versus hammers!

Chapter 10: Monopoly and Other Forms
of Imperfect Competition

Slide 4

MB MC

Market Structures

Thus we have one perfectly competitive and

three Imperfectly competitive market forms:
Perfect Competition (homogeneous, many)
Imperfect Competition
Monopolistic

Competition (differentiated, many)

Oligopoly (differentiated/homogeneous, few)
Pure Monopoly (one firm)

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 5

MB MC

Different Forms of Competition

From Krugman and Wells
Are Products Differentiated?
No

One

How Many
Producers?

Few

Many

Copyright c 2007 by The McGraw-Hill

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Yes

Monopoly

Not Applicable

Oligopoly

Perfect Competition

Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Monopolistic
Competition

Slide 6

MB MC

Different Forms of Imperfect

Competition

Pure Monopoly (most inefficient)

The only supplier of a unique product with no
close substitutes
Monopolistic Competition (closest to perfect
competition)
A large number of firms that produce slightly
differentiated products that are reasonably close
substitutes for one another
Long-run adjustment to zero economic profits
because of free entry and exit
Importance of product differentiation

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 7

MB MC

Different Forms of Imperfect

Competition

Oligopoly (typically more efficient than a

monopoly)
Industry

structure in which a small number of

large firms produce products that are either
close or perfect substitutes
Homogeneous (wireless phone service, cement)
and differentiated (automobile, cigarettes,
detergents) products.

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 8

MB MC

Imperfect Competition Vs.

Perfect Competition

With perfect competition:

If

the firm raises its price, sales will be zero.

No incentive to charge a lower price because it can sell
as many units as it wants at the current price.
The firms demand curve is the horizontal line at the
market price. It is a price taker.

With imperfect competition:

The

firm has some control over price or market power.

If it raises market price, it will not lose all its customers.
If it reduces price, it will add customers.
The firm faces a downward sloping demand curve. It is a
price maker.
Copyright c 2007 by The McGraw-Hill
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 9

MB MC

The Demand Curves Facing Perfectly

and Imperfectly Competitive Firms

Market
price

Imperfectly competitive firm

Price

$/unit of output

Perfectly competitive firm

d
Quantity

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Quantity

Slide 10

MB MC

Sources of Market Power

1. Exclusive control of a scarce resource or input

De

Beers of South Africa a near monopoly; Are

diamonds rare? Gem quality diamonds are more
common than other gem quality colored stones.

2. Government Licenses or Franchises

lodging

and concession operation at National Parks

3. Patents and Copyrights (Drug companies,

Authors)

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 11

MB MC

More Enduring Sources of

Market Power

4. Economies of Scale - Natural Monopolies

Production of electricity, natural gas, etc. When natural

gas companies initially started there was competition.

But large fixed costs gave the firm that sold the most the
lowest ATC.

Network Economies (a products quality increases

as the number of users increase i.e., sales volume
increase) another form of economies of scale
Microsoft,

Copyright c 2007 by The McGraw-Hill

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ebay, Facebook, etc.

Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 12

Returns to Scale

Returns to scale is a long run phenomenon. All

inputs are changed in the same proportion.
If output more (less) than doubles when all
inputs are doubled, the production function is
said to exhibit Increasing (Decreasing) returns
to scale.
If output doubles when all inputs are doubled,
the production function is said to exhibit
Constant returns to scale.
Sudeshna C.
Bandyopadhy
ay

07/02/15

13

Returns to Scale and LRATC

W=$50 and r=$100

Units of
Labor (L)

Units of
Capital
(K)

Total
Cost
(TC)

Output
under
IRS

Output
under
DRS

Output
under
CRS

$150

10

10

10

$300

30

15

20

LRATC

Quantity of Output

Constant returns
to scale

LRATC

Quantity of Output

Adapted from Baumol and Blinder

Long-Run Average Cost

Increasing
returns
to scale

Long-Run Average Cost

Long-Run Average Cost

Returns to Scale and Shapes of LRATC

Decreasing LRATC
returns
to scale

Quantity of Output

Why Economies of Scale?

Specialization and Division of labor yields

efficiency.
Mass production reduces average costs since
the large set up costs are spread over a large
amount of output. Once production is
established, MC is very low.
Experience leads to learning by doing and
leads to improvements in efficiency.
Sudeshna C.
Bandyopadhy

07/02/15

16

Why Dis-economies of Scale?

Is there anything called too large in terms of

factory size or size of operations?
Yes. Beyond a certain point bureaucratic and
managerial inefficiencies creep in. Cook book
procedures replace managerial brilliance.
Coordinating a large labor force becomes
prohibitively expensive.

Sudeshna C.
Bandyopadhy
ay

17
07/02/15

MB MC

Economies of Scale and the

Importance of Start-Up Costs

Firms with large fixed costs and low variable costs

any production process that entails large preinvestments in research and development are
characterized by:
Large start up costs
Low marginal costs
Average total cost declines sharply as output
increases
Economies of scale Increasing returns to scale.

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 18

MB MC

Economies of Scale and Start-Up

Costs

New products can have a large fixed development

costs
If marginal cost is constant, Marginal cost (M) =
Average variable cost
Total cost is fixed cost (F) plus variable cost
TC = F + (M) (Q)
Total cost increases as output increases
Average total cost is
ATC = F / Q + M
Average total cost decreases as output increases

Copyright c 2007 by The McGraw-Hill

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MB MC

Total and Average Total Costs for a

Production Process with Economies of Scale
M is Marginal Cost,
assumed constant

Average cost ($/unit)

Total cost ($/year)

TC = F + MQ

F + MQ0

ATC = F/Q + M
M

Q0

Quantity

Total cost rises at a constant

rate as output rises
Copyright c 2007 by The McGraw-Hill
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Quantity

Average costs decline and at very

high levels of output ATC is
infinitely close to MC.

Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 20

MB MC

Economies of Scale and the

Importance of Start-Up Costs

Cost advantages from economies of scale

depends on how large the fixed cost is in
relation to marginal cost.
Example 1:
Nintendo

and Playstation each have fixed costs of

$200,000 and constant MC= $0.80 per game.
Nintendo produces 20% fewer copies of the video
game compared to Playstation
3 cent difference in ATC because TFC/TC is
small.
Copyright c 2007 by The McGraw-Hill
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 21

MB MC

Economies of Scale and the

Importance of Start-Up Costs

Example 2:
Nintendo

and Playstation each have fixed costs

of $10,000,000 and constant MC= $0.20 per
game.
Nintendo produces 20% fewer copies of the
video game compared to Playstation
$1.67 difference in ATC because TFC/TC is high.

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 22

Costs for Two Computer Game Producers

(1) Small TFC/TC

MB MC

Constant MC = $0.80
Nintendo

Playstation

Annual production

1,000,000

1,200,000

Fixed cost

$200,000

$200,000

Variable cost

$800,000

$960,000

$1,000,000

$1,160,000

$1.00

$0.97

Total cost
Average total cost per game

Observations
Fixed costs are a relatively small share of total cost
Cost/game is nearly the same
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 23

MB MC

Costs for Two Computer Game Producers

(2) Large TFC/TC
Constant MC = $0.20

Annual production
Fixed cost
Variable cost
Total cost
Average total cost per game

Nintendo

Playstation

1,000,000

1,200,000

$10,000,000

$10,000,000

$200,000

$240,000

$10,200,000

$10,240,000

$10.20

$8.53

Fixed costs are a relatively large share of total cost

Playstation has a $1.67 average cost advantage
Playstation can lower prices, cover cost, and attract
customers
Copyright c 2007 by The McGraw-Hill
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 24

MB MC

Economies of Scale and the

Importance of Start-Up Costs

Example 3:
With

a $1.67 advantage in ATC, Playstation is

able to get a larger market share.
Cost advantage to Playstation becomes larger.

Explains why you would expect to see just a

few firms survive in markets characterized by
large fixed start up costs and low variable
costs.

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 25

MB MC

Costs for Two Computer Game Producers

(3) Self Reinforcing Cost Advantage

Annual production
Fixed cost
Variable cost
Total cost
Average total cost per game

Nintendo

Playstation

500,000

1,700,000

$10,000,000

$10,000,000

$100,000

$340,000

$10,100,000

$10,340,000

$20.20

$6.08

Shift of 500,000 units to Playstation

Nintendos average cost increases to $20.20/unit
Playstation average cost falls to $6.08
A large number of firms cannot survive when the cost
differential is high
Copyright c 2007 by The McGraw-Hill
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 26

MB MC

Economic Naturalist

Why does Intel sell the overwhelming

majority of all microprocessors used in
personal computers?
The fixed investment needed to produce a
new leading edge micro-processor is
upwards of $2 billion while the marginal cost
is just pennies.
Huge start up costs and initial advantage
translating to insurmountable cost
advantages for Intel

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 27

MB MC

Profit Maximization for the Monopolist

A monopolist maximizes profits by setting

MR=MC
The AR is falling; so MR<AR
This implies P>MR=MC in equilibrium.
Equilibrium is inefficient.

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 28

MB MC

The Marginal Revenue Curve for a

Monopolist with a Straight-Line Demand Curve

Price

1
1

a/2

1
MR

D
Q0

Q0/2
Quantity

The vertical intercept, a, is the same for MR and D

The horizontal intercept for MR, Q0/2, is one half the
demand intercept, Q0.
Copyright c 2007 by The McGraw-Hill
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 29

The Monopolists Profit-Maximizing Output

Level

MB MC

Price ($/unit of output)

Marginal Cost
4
3
2

MR
8

12

Observations
If P = $3 & Q = 12 MR <
MC and output should
be reduced
Profits are maximized
at 8 units where MR =
MC
P = $4 where quantity
demanded = quantity
supplied
D
24

Quantity (units/week)

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 30

MB MC

Elasticity of Demand and Monopoly

A monopolists MR is less than the price

this is the essential source of the
monopolists power. How much less?
Depends

on the price elasticity of demand.

A monopolist that faces a highly elastic

demand curve will behave a lot like a
perfectly competitive industry.
Amtrak

has a monopoly in intercity passenger service in

the North-east corridor and yet is not able to raise prices
by restricting service very effectively. Good substitutes
cars, planes

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 31

MB MC

Even a Monopolist May

Suffer an Economic Loss

Being a monopolist doesnt guarantee an economic profit

0.12
0.10

ATC

MC

0.05

Economic profit
= $400,000/day
Price ($/minute)

Price ($/minute)

Economic loss
= $400,000/day
0.10
0.08

ATC
MC

0.05

D
20
MR
Minutes (millions/day)

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

D
20
24
MR
Minutes (millions/day)

Slide 32

MB MC

The Demand and Marginal Cost

Curves for a Monopolist
Why the Invisible Hand Breaks Down Under Monopoly

Price ($/unit of output)

Marginal cost

The socially optimal

amount occurs where
MC = D (MB) @ 12 units

D
12

24

Quantity (units/week)

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 33

MB MC

Price ($/unit of output)

The Demand and Marginal Cost

Curves for a Monopolist
Why the Invisible Hand Breaks Down Under Monopoly
The profit
maximizing level
6
of output of 8
Marginal cost
units, where MR
= MC, is less
4
than the socially
3
optimal output of
12
2
Between 8 and
D
12, MB to society
> MC to society
MR
Cannot increase
8
12
24
output because
Quantity (units/week)
MR to the firms
is less than MC

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 34

MB MC

The Demand and Marginal Cost

Curves for a Monopolist
Why the Invisible Hand Breaks Down Under Monopoly
Because MR < P,
the monopoly
Deadweight loss
produces less than
the socially optimal
Marginal cost
amount
The deadweight
loss of the
monopoly to
society = (1/2)
($2/unit)(4units/wk)
D = $4/wk.
MR

Price ($/unit of output)

4
3
2

12

24

Quantity (units/week)

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 35

MB MC

Using Discounts to Expand the

Market

If the monopolist could reduce the price

below $4 for output sold beyond 8 units, it
would want to expand output closer to the
efficient level of 12 units and would have
increased its profits by doing so.
Sometimes monopolists do that through
Price Discrimination
The

practice of charging different buyers different

prices for essentially the same good or service

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 36

MB MC

Price discrimination under

monopoly

We have price discrimination when a monopolist:

charges

a different price to different consumers even

when the cost of supplying each consumer is the same.
Example discount airfares, discounts on movie tickets
for students and seniors, rebate coupons.

Charges

the same price when the cost of supplying

different consumers is different. Example mailing
letters to Boston vs. Chicago say from St Louis.

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07/02/15

37
Sudeshna C.
Bandyopadhy

MB MC

Economic Naturalist

Why do many movie theaters offer discount tickets

to students?
The goal is to get buyers who would not buy
without the discount. Students have a lower RP
compared to older working adults. Theater owners
expand their clientele by offering tickets to students
at a discount. There is also no risk (because of
verifiable IDs) that a student would buy the ticket
for a low price and re-sell it to a non-student for a
higher price and pocket the difference.

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 38

MB MC

Price Discrimination

Carla supplements her income as a TA by

editing term papers for undergrads. There
are 8 students for whom she might edit and
her reservation prices are given on the next
table.
Carla is a profit maximizer. The OC of her
time to edit each paper is $29.
Assume that Carla must charge the same
price to every buyer.

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 39

Total and Marginal

Revenue from Editing

MB MC

Student

Reservation Price
($ per paper)

40

40

40

38

76

36

36

108

32

34

136

28

32

160

24

30

180

20

28

196

16

26

208

12

Copyright c 2007 by The McGraw-Hill

Companies, Inc. All rights reserved.

Total Revenue
($ per week)

Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Marginal revenue
($ per paper)

Slide 40

MB MC

Using Discounts
to Expand the Market

If Carla maximizes profits, how many

manuscripts should Carla edit?
Compare

MR with OC of $29.
Carla will edit 3 papers.
TR = 3 x $36 = $108/wk
TC = 3 x $29 = $87/wk
Economic profit = $21/wk
Accounting profit = $108/wk as Carlas explicit
cost = 0.
Copyright c 2007 by The McGraw-Hill
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 41

MB MC

Using Discounts
to Expand the Market

What is the socially efficient number of manuscripts

for Carla to edit, if she must still charge the same
price to every buyer?
Opportunity cost = $29
Reservation price > opportunity cost for A to F
Socially efficient number is 6
TR = 6 x $30 = $180
TC = 6 x $29 = $174
Economic profit = $180 - $174 = $6
Accounting profit = $180

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 42

MB MC

Using Discounts
to Expand the Market

If Carla can price discriminate, how many papers

should she edit if she wants to maximize her
profits?
Again Reservation Price > OC for A to F
Profit maximizing quantity is 6
TR = $40 + $38 + 36 + 34 + 32 + 30 = $210/wk
TC = $29 x 6 = $174
Economic profit = $36/wk, $30 more than the
socially efficient equilibrium and $9 more than
her private profit maximizing equilibrium but w/o
price discrimination.

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 43

MB MC

Perfect Price Discrimination

A monopolist that charges each buyer exactly

his/her RP is called a Perfectly Discriminating
Monopolist.
Under

perfect price discrimination, the private

profit maximizing equilibrium is exactly the
socially efficient equilibrium. So, economic
surplus is maximized.
All consumers willing to pay a price high enough
to cover MC will be served.
Consumer surplus is zero; Economic surplus =
producer surplus.
Copyright c 2007 by The McGraw-Hill
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 44

MB MC

Limitations to Price Discrimination

In reality, perfect price discrimination can never

occur because
Seller will not know each buyers reservation
price.
Even if buyers RP is public knowledge, low price
buyers could always resell to other buyers at a
higher price and capture a part of the producers
surplus.
Imperfect price discrimination is widespread.
The hurdle method of PD is aimed at solving these
problems

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 45

MB MC

Hurdle Method of Price Discrimination

The hurdle method of price discrimination is

the practice of offering a discount to all
buyers who overcome some obstacle.
Rebate

coupons
Temporary Sales
Commercial airline tickets
Hard cover and paperback books
Cars with optional add-ons
Scratch and Dent appliance sales
Movies with phased releases
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 46

MB MC

Using Discounts
to Expand the Market

A Perfect Hurdle
Separates

buyers precisely according to

their reservation prices

They dont exist in reality.

How much should Carla charge for
editing if she uses a perfect hurdle?

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 47

MB MC

Using Discounts
to Expand the Market

Assume
Carla

must charge the same price to everyone

Carla offers a mail in rebate coupon
Students with at least a $36 reservation price
never use the coupon
Students with a reservation price below $36
always use the coupon
Opportunity cost = $29

Copyright c 2007 by The McGraw-Hill

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 48

Price Discrimination
with a Perfect Hurdle

MB MC

Student

Reservation Price
($ per paper)

Total Revenue
($ per week)

Marginal revenue
($ per paper)

List Price Submarket

40

40

40

38

76

36

36

108

32

Discount Price Submarket

34

34

34

32

64

30

30

90

26

28

112

22

26

130

18

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 49

MB MC

Using Discounts
to Expand the Market

List price submarket

Carla

will service all three students as the MR is

greater than the MC of $29. Equilibrium price
=$36 (lowest AR of group)

Discount price submarket

Carla

will only serve students D and E. For

everyone else MC is greater than MR.
Equilibrium price is $32
So, charge $36 and allow a rebate coupon for
$4
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 50

MB MC

Using Discounts
to Expand the Market

With Price Discrimination:

TR

= (3)(36) + (2)(32) = $172

TC = ($5)($29) = $145
Economic Profit = $27/wk; This is $6 more than

Without Price Discrimination

Serve

students A, B and C only.

TR = (3)(36) = $108
TC = ($3)($29) = $87
Economic Profit = $21/wk
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 51

MB MC

Is Price Discrimination Bad?

The hurdle method raised economic surplus

(consumers and producers surplus).
CS and PS are both greater under the hurdle
method of price discrimination than when
there is no price discrimination.

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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 52

MB MC

Using Discounts
to Expand the Market

Hurdle Price Discrimination:

A,

B and C pay $36; D and E pay $32.

CS = A: (40-36) + B: (38 36) + C: (36 36) + D: (34
32) + E: (32 32) = $8
PS = 3x(36 - 29) + 2(32 29) = $21 + $6 = $27
Economic Surplus = $8 + $27 = 35/wk

Without Price Discrimination

Serve

students A, B and C only.

CS = A: (4036) + B: (38-36) + C: (3636) = $6
PS = 3x(36-29) = $21
Economic Surplus = $6 + $21 = 27/wk
Copyright c 2007 by The McGraw-Hill
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Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 53

MB MC

Carla's Choices
Program

Social
Optimum

Papers Edited

Price

Single
Perfect
Price
Discriminator
Monopoly

Hurdle

5 = (3 + 2)

$30

$36

Reservation

$36, $4
rebate

Total Revenue

$180

$108

$210

$172

Total Cost

$174

$87

$174

$145

Economic Profit

$6

$21

$36

$27

Economic Surplus

$36

$27

$36

$35

Copyright c 2007 by The McGraw-Hill

Companies, Inc. All rights reserved.

MB MC

Using Discounts
to Expand the Market

Summary
Single

price monopolies are inefficient because

P > MC (=MR).
The hurdle method of price discrimination
reduces the inefficiency.
The more finely the seller can discriminate, the
smaller the efficiency loss.
Hurdles are not perfect, therefore, there will be
some efficiency loss.

Copyright c 2007 by The McGraw-Hill

Companies, Inc. All rights reserved.

Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 55

MB MC

Economic Naturalist

Why might an appliance retailer instruct

its clerks to hammer dents into the
sides of its stoves and refrigerators?

Copyright c 2007 by The McGraw-Hill

Companies, Inc. All rights reserved.

Chapter 10: Monopoly and Other Forms

of Imperfect Competition

Slide 56

End of
Chapter
MB

MC