These are my notes and thoughts on monopoly market structures in Economics.
A company with market power behaves quite differently from the way that a competitive firm behaves. Compared to competitive firms, monopolists produce less and charge more. They make themselves better off, with the potential of earning economic profits in both the short run and the long run. But their gain will come at the cost of making consumers worse off and decreasing social surplus.
Monopoly represents an extreme market structure with a single seller. Monopolies arise both naturally and through government protection. Monopolists are price-makers and produce at the point where marginal revenue equals marginal cost. The monopolist profits by producing a lower quantity and charging a higher price than perfectly competitive sellers. The result is a deadweight loss. Efficiency can be established in a monopoly through first-degree price discrimination or government intervention.
Studying perfectly competitive markets provided important insights into how agents interact in markets and how markets equilibrate. But it proves to be a special type of market. A more common market situation is one in which a firm is not simply a price-taker, but a price-maker, a seller that sets the price of a good. Such a firm has the ability to set the price of the good because it has market power. The most extreme form of market power is a monopoly.
A monopoly is an industry structure in which only one seller provides a good or service that has no close substitutes. In this way, a monopolist is not concerned with the behavior of other sellers. The price chosen by the monopolist is the one that makes the company the highest profit.
The ability of a company to control a market, to gain market power, relies on barriers to entry. Barriers to entry are obstacles that prevent potential competitors from entering the market. As such, they provide the seller protection against competition. Barriers to entry range from complete exclusion of market entrants to prevention of a new firm from entering and competing on an equal footing with the incumbent firm.
Two types of market power arise from barriers to entry, legal market power and natural market power.
A firm has legal market power when it obtains market power through barriers to entry created not by the firm itself but by the government. These barriers can take the form of patents and copyrights that are issued to innovative companies. With a patent, the government grants an individual or company the sole right to produce and sell a good or service. With a copyright, the government grants an individual or company an exclusive right to intellectual property.
A second common source of barriers to entry occur naturally rather than by design. Natural market power occurs when a firm obtains market power through barriers to entry created by the firm itself. There are two main types:
- The monopolist owns or controls a key resource for production
- There are economies of scale in production over the relevant range of output
Key resources are those materials that are essential for the production of a good or service. The most basic way for a firm to develop market power naturally is to control the entire supply of such resources.
Another key resource is individual expertise. Network externalities occur when a product;s value increases as more consumers begin to use it. Monopolies also form because it is practical for both producers and consumers. Natural monopolies are characterized by substantial fixed costs and economies of scale.
For goods and services that have economies of scale over the relevant range of output, it is efficient for a single firm to serve the entire market, because it can do so at a lower cost than any larger number of firms could. We denote such cases as natural monopolies, because they arise naturally. A natural monopoly arises because the economies of scale of a single firm make it efficient to have only one provider of a good or service. Often such firms are the first suppliers in a given market, and the cost advantages they achieve through producing a large number of goods preclude would-be competitors from entering the market. Examples of natural monopolies include providers of clean drinking water, natural gas, and electricity.
In contrast to monopolies that arise through legal means, natural monopolies emerge when unique cost conditions characterize their industry. Because of these conditions, natural monopolists worry less about potential market entrants than do monopolies that arise through legal means.
The monopolist’s problem shares two important similarities with the perfectly competitive seller’s problem. First, the monopolist must understand how inputs combine to make outputs. Second, the monopolist must know the costs of production.
We do find one important difference between the perfectly competitive seller’s decision problem and the monopolist’s decision problem. To maximize profits, the perfectly competitive firm expands production until marginal cost equals price, where price is determined by the intersection of the market demand and market supply curves.
This situation represents the major difference between the perfectly competitive firm’s decision problem and the monopolist’s decision problem. Because the monopolist is the sole market supplier, it faces the market demand curve, which is downward-sloping. Unlike the perfectly competitive firm, the monopolist can increase price and not lose all of its business. In fact, the market demand curve tells us exactly the trade-off the monopolist faces when it changes its price.
High fixed costs are typical for industries that spend large amounts of money on researching and developing products, such as pharmaceutical companies. In such instances, it is not uncommon for marginal cost to be constant over large ranges of output, because mass production of the product leads to each additional unit of production to have a constant additional cost per unit.
A perfectly competitive firm must consider both marginal cost and marginal revenue when making its production decision. A monopolist is no different. This reasoning shows that your profit-maximizing level of output produced is given by the intersection of the marginal revenue and marginal cost curves.
Your pricing decision as a monopolist is critically linked to the nature of the market demand curve. Price is set at a level higher than marginal costs for a monopolist, whereas price is equal to marginal cost for a perfectly competitive firm.
In perfectly competitive markets, entry causes long-run economic profits to be zero. For a monopoly, economic profits remain. This is because there is no threat of entry from competitors because of barriers to entry. Therefore, no new entrants threaten to increase supply and push the price down to eliminate economic profits.
Monopolists, unlike sellers in competitive markets, do not have a supply curve. To create a supply curve under perfect competition, it is necessary for firms to be price-takers, whose production is based on the given market price. Under this assumption, we simply determine the quantity at which the marginal cost of producing the last unit of a good is equal to the market price. Thus, in a competitive market, a supply curve shows all price and quantity combinations at which firms will produce.
Monopolists, as price-makers, do not vary their production based on market price because they set the price. It makes no sense to ask how much of a good a monopolist will produce at a given price. Like sellers in competitive markets, monopolists will produce at the point where their marginal revenue is equal to their marginal cost. Marginal revenue depends on the negatively sloped demand curve that the monopolist faces. Because a monopolist’s production decision is based on demand, it cannot be depicted as an independent supply curve.
Previously, we learned that the invisible hand creates harmony between individual and social interests. A firm that exercises market power causes a reallocation of resources toward itself, thereby sacrificing social surplus.
Price discrimination occurs when firms charge different consumers different prices for the same good or service. First-degree price discrimination is where consumers are charged the maximum price they are willing to pay. Second-degree price discrimination is where consumers are charged different prices based on characteristics of their purchase, such as the quantity they purchase. Third-degree price discrimination is when different groups are charged different prices based on their own attributes, such as age, gender, or location.
In practice, perfect price discrimination is difficult to achieve for two reasons. First, it is hard to charge every consumer a unique price. Second, it is challenging to know every consumer’s willingness to pay. Therefore, other forms of price discrimination are more prevalent in practice.
A monopoly is an industry structure in which only one firm provides a good or service that has no close substitutes. Monopolies arise because of barriers to entry, which take two forms: legal and natural. In the legal form, the government creates the barrier, as with a patent or copyright. In the natural form, control of key resources or achieving economies of scale can result in a natural monopoly.
Barriers to entry permit the monopolist to exercise market power when making quantity and pricing decisions. The optimal action of the monopolist is to set price > marginal revenue = marginal cost. This differs from a competitive industry, where price=marginal cost=marginal revenue.
In equilibrium, monopoly leads to less quantity and higher prices compared to a perfectly competitive market equilibrium. In this way, because consumers are standing by ready to purchase from the monopolist for a price greater than marginal cost, social surplus is not maximized, leading to a deadweight loss.
Monopolies may sometimes be appropriate, and understanding whether a firm is occupying a monopoly status appropriately is a major concern of US lawmakers. Even though there are costs to allowing firms to have monopoly power, the extra profit might translate into better and more productive research and development for new products, medicines, and technologies.
Which of the following are properties of a monopoly?
- There are high barriers to entry
- There is only one seller
Natural monopolies are characterized by substantial fixed costs and economies of scale. To see this, at a low quantity level the average total cost is very high, and as quantities increases the average total cost decreases, approaching marginal cost.
All firms, regardless of market structure, must consider their average total cost when determining profitability. Show the average total cost curve for a natural monopoly.
- Draw line starting from top left and curving down towards bottom right
When comparing the graph of your average total cost curve for a natural monopoly with that of a firm in perfect competition, we see that?
- A natural monopoly has a downward-sloping average total cost curve, while a firm in perfect competition has a u-shaped curve
Which of the following is not one of the sources of natural market power?
- Production of a luxury good
Which of the following best describes network externalities?
- They occur when a product’s value increases as more customers begin to use it
The graph on the right shows the average total cost curve for a firm.
How would the cost differ if the market consisted of only one large firm compared to a market with many small firms?
- Draw points at the units asked for on the atc line
Using the graph, a firm with that type of cost curve is best suited to be:
- A natural monopoly, since it faces economies of scale and can produce at a lower cost if done by one firm
Which of the following best describes the relationship between price, marginal revenue, and total revenue for a monopolist?
Is it always true that when marginal revenue is falling, total revenue is falling? If the revenue from the last unit sold is positive, it will still add to total revenue. So, whether marginal revenue is rising or falling, as long as it is positive, it should add to total revenue.
The marginal revenue curve for a monopolist is downward-sloping. If the revenue from the last unit sold is positive, it will still add to total revenue. Similarly, if the revenue from the last unit sold is negative, it will lower total revenue.
- When marginal revenue is positive, total revenue is rising, and when marginal revenue is negative, total revenue is falling
Given the following demand and marginal revenue curves for a monopolist, graph the resulting total revenue curve on the graph to the right.
- Draw inverse U shape, starting at 0,0 vertex at 5=mr quantity and ending at 10 quantity
The graph on the right shows the market demand curve for a good. Use the graph to find total revenue and marginal revenue at the given output levels.
If the price is 4, then total revenue is:
Price * quantity
- 8 thousand
If the price is 3, then total revenue is:
- 9 thousand
If the price is lowered from 4 to 3, then the change in total revenue is:
- 1 thousand
Suppose a monopolist faces the linear demand curve P=a-bq
Where a is the point where the demand curve touches the y-axis and b represents the slope of the demand curve.
Given this equation, which of the following represents the monopolist’s marginal revenue?
Given the linear demand curve for a monopoly on the graph to the right, find this monopolist’s marginal revenue curve?
- Draw line that starts at same point on y-xis as demand curve, end on x-axis halfway of total quantity on x-axis.
Suppose as creative college students you and your friends develop software that for a small fee helps students choose courses based on professor’s ratings and grade distributions, and it becomes an instant hit around campus. You decide to patent your software and license its use to a large tech firm who agrees to pay you 5 percent of all revenue earned. For example, if the tech firm sells 200 subscriptions at 1- each, it will have revenue of 2000, meaning you will earn 5 percent of that total or 100.
The tech firm’s goal is to maximize profits, while your goal as a license holder is to maximize total revenue. Given this information, what do we know about the price of the good?
- You prefer P1, but the tech firm prefers P2
You are a monopolist facing the demand schedule below. You produce a good at a constant marginal cost of 4 per unit. Fill the marginal revenue column:
The total revenue of a firm is calculated by multiplying the quantity of goods sold by the price of the goods. Marginal revenue is the change in total revenue associated with producing and selling one additional unit of output.
1 14 14
2 12 10
3 10 6
4 8 2
The profit-maximizing output for you is:
A monopolist should continue production as long as marginal revenue is greater than marginal cost.
- 3 units because at 3, marginal revenue is 6, which is more than the marginal cost of 4
Suppose there is a fixed cost of 10. The maximum profit you can earn is:
A monopolist should continue production as long as marginal revenue is greater than marginal cost.
- The maximum profit the monopolist can earn is at the profit-maximizing output of 3 units. The profit earned at this output is 30-(3*4)=8
Which of the following equations calculates economic profits for a monopoly?
The graph on the right illustrates the demand, marginal revenue, marginal cost, and average total cost curves for a monopoly.
Use these curves to show a firm’s profits.
A monopolist finds its profit-maximizing quantity where marginal revenue equals marginal cost and then sets its price for that quantity to the maximum amount that consumers would be willing to pay.
The graph on the right shows the demand, marginal revenue, and marginal cost curves in a monopoly market.
Suppose you are a monopolist and you have two customers, A and B. Each will buy either zero or one unit of the good you produce. A is willing to pay up to 55 for your product, B is willing to pay up to 20. You produce this good at a constant average and marginal cost of 8. If you could not engage in third-degree discrimination, what price would you charge?
If you could practice third-degree price discrimination, you will earn a profit of:
- $59 (55-8) + (20-8)
In recent years, some online firms have offered different consumers different prices for the same good. These firms use the consumer’s IP address to find what city they are in and then charge a higher price to people in wealthier cities. This type of pricing behavior is:
- Third-degree price discrimination
Consider the standard monopoly graph on the right that illustrates a monopoly’s demand, marginal revenue, and marginal cost curves. If this monopoly is able to engage in perfect price discrimination, what area would be considered producer surplus?
With perfect price discrimination, a monopoly is able to charge each consumer up to their willingness to pay. The monopoly will want to do this for as many consumers as possible, and will keep producing until the last consumer’s willingness to pay matches the firm’s cost of making that unit.
Compared to a monopoly that does not price discriminate, a monopolist who engages in perfect price discrimination will produce:
- More output and have no deadweight loss
As this chapter explains, a monopoly is an industry structure where only one firm provides a good or service that has no close substitutes. This question explores the last part of this definition further. In 1947, the US government charged the DuPont company with a violation of the Sherman Act. The government argued that DuPont was monopolizing the cellophane market. At trial, the government showed that DuPont produced nearly 75 percent of all of the cellophane sold in the US each year. Nonetheless, the US supreme court ruled in favor of DuPont and dismissed the case.
Which of the following is a likely argument used by DuPont to convince the supreme court that it did not violate the Sherman Act?
- There are many close substitutes for cellophane such as aluminum foil and waxed paper, so DuPont did not have significant market power
Sirius XM Satellite Radio and XM Satellite radio were the only two satellite radio providers in the US. The DOJ and the FCC approved the merger of the two companies in 2008 even though Sirius-XM would then control 100 percent of the satellite radio market.
Which of the following arguments do you think Sirius and XM used to convince the DOJ and the FCC to allow the merger to proceed?
- There are many close substitutes for satellite radio, therefore, the Sirius-XM would not exercise market power.