Lecture 18

Monopoly
Industrial Organization Characterized by:
• only one seller  the firm is the industry
• firm faces the market demand curve and is a
price-maker
• demand is inelastic because no substitutes are
available  firm has significant market power
• entry into industry is blocked by barriers
– economies of scale  natural monopoly
– patents
– ownership of key resources
– legal restriction on entry 1
Short run decision making for the a monopoly:
1. produce if P > AVC
2. if 1., produce where MR = MC
3. determine P based on demand

P
MC

P*

D
MR

Q* Q 2
 Case 2: break even
π = 0  TR = TC  P = ATC

MC

P2 = ATC
ATC

D
MR
Q2 Q
3
 Case 3: min. losses by producing
π < 0  TVC < TR < TC  AVC < P < ATC

P
MC

ATC ATC
P3
AVC
AVC

D
MR

Q3 Q 4
 Case 4: min. losses by shut down
π = 0  TR < TVC < TC  P < AVC < ATC

P
MC
ATC ATC
AVC
AVC
P

D
MR
Q Q
5
 SR equilibrium conditions for monopoly:
1. produce if P > AVC
2. if 1., produce where MR = MC
3. π >=< 0

Long Run Considerations for Monopoly

1. SR π < 0  monopoly exits from industry
2. SR π > 0  new firms can not enter because entry is
blocked by barriers

6
 Long Run Equilibrium for Monopoly

P
LRAC
MC ATC

PM

min ATC

min LRAC

D
MR

QM Q
1. P > MC
2. MR = MC
3. normally P > ATC  π > 0
4. P > min. ATC
5. P > min. LRAC 7
Welfare Analysis: Comparing Perfect Competition and Monopoly
1. Compare Production and Prices: What happens to the levels of
production and price if a competitive industry is monopolized?

Perfect Competition Monopoly

P P

MC MC
PM
PM


PC

D D
MR MR
QM
 QC Q QM Q

Monopoly produces too little output and charges too

high a price. 8
2. Compare Benefits and Costs: How do benefits and costs change
if a perfectly competitive industry is monopolized?
change in benefits P change in costs
P MC

?TB
?TC
D = MB

QM QC Q QM QC Q
P
MC

DWL

QM QC Q

Monopoly causes a dead weight loss (DWL) of benefits that would

9
otherwise be enjoyed if the market were perfectly competitive.
 3. Compare the long run equilibrium conditions of Perfect
Competition and Monopoly
Perfect Competition Monopoly
1. P = MC: value output equals
1. P > MC: too little output at too
value of resources used to
high of price  misallocation
produce it.
of resources.
2. MR = MC: all firms are
2. MR = MC: monopolist
maximizing profits.
maximizes profits.
3. P = ATC: all firms earn a
normal profit  all resources 3. P > ATC: monopolist earns
earn exactly their opportunity positive profits  earns in
cost. excess of its opportunity cost.

4. P = min. ATC: all firms are 4. P > min. ATC: monopolist

fully utilizing their plant under utilizes its plant
capacity capacity.
5. P > min. LRAC: monopolist
5. P = min. LRAC: all firms build
the optimal plant size. does not build the optimal 10
plant size.
 Alternative View of Monopoly

Monopolies tend to be more technically progressive

because they have a:
1. greater incentive to be innovative
• desire to earn higher profits
• desire to protect monopoly position
1. greater ability to innovate because profits provide
the resources needed for research and
development.

11
 The Problems in Dealing with Natural Monopoly
1. Because of economies of scale, costs are lower if only
one firm produces all output LRAC decline over entire
range of production.
2. MC < LRAC because of average-marginal rule.
P

LRAC
MC
Q 12
3. Given adequate demand a natural monopolist earns a
profit.

PM

LRAC
MC
QM
D
Q
MR

13
4. Since P > MC  too little output at too high of price 
misallocation of resources.

PM

LRAC

PC MC

QM QC
D
Q
MR
14
 5. Since antitrust action won’t work, the policy is to regulate
natural monopoly.
Marginal Cost Pricing: regulate so that P = MC

LRAC
LRAC
losses MC
PMC

QC
D
Q
MC pricing fails because firm earns losses and exits industry in the
long run. 15
Average Cost Pricing: regulate so that firm earns a normal profit 
P = LRAC

PAC LRAC

MC MC

QAC Q
D

AC pricing fails because P > MC means a misallocation of resources.

16
 Declining Block Pricing: regulate so that
• different blocks of output are sold at different prices
• firm breaks even because the profits from the 1st block of sales
offsets losses from the 2nd block of sales
P

PB1
profits
LRACB1

LRAC
LRACB2
losses MC
PB2
QB1 QC D
Q
Declining block pricing encourages consumption because the consumer's
average cost falls as consumption increases. 17
 Price Discrimination: charging different prices to the same or
different customers

Perfect Price Discrimination: firm charges the demand price

for each unit sold.

No Price Discrimination Perfect Price Discrimination

P P

P1

P2
P3

P4
PM P5

D = MB D = MB

QM Q Q1 Q2 Q3 Q4 Q5 Q
18
 Price discriminating firm collects more total revenue

No Price Discrimination Perfect Price Discrimination

P P

PM

TR = TE
TR = TE
D = MB D = MB

QM Q QPPD Q

19
 Extra total revenue is earned because the price
discriminating firm is able to capture the consumers’ surplus

consumers’ surplus (CS): benefits consumers receive from a

good that are over and above the expenditures they must make
to purchase the good

Benefits Received Expenditures Made

P P

CS
P
TB
TE
D = MB D = MB

Q Q Q Q20
P Other Forms of Price Discrimination
Declining Block Pricing

P1

CS
P2
CS CS

P3

TE
D = MB

Q1 Q2 Q3 Q
21
 Other Forms of Price Discrimination
Price Discrimination by Elasticity of Demand

P
P P

MC
P2

P1

D1 D2 CMR
MR1 MR2

Q Q Q
Q1 Q2 QT

22