Monopoly

Prof. John M. Abowd

Themes of Today's Lecture

Different Market Structures
Monopoly in a Single Market
How Monopolies are Created and Destroyed
Are There "Good" Monopolies?
Should the Government Regulate Monopolies?

Constant Cost, External Economies, External Diseconomies in an Industry

Long Run Supply in the Telecommunications Industry (Example)

Long Run Competitive Supply Reviewed

The firms in a market are in long run equilibrium when
- Long run quantity supplied = long run quantity demanded at the current market price.
- Price = marginal cost for all firms in the market.
- Price = minimum average total cost for all firms in the market.
- No firm with a lower minimum average total cost wants to enter the market.
- No firm currently in the market wants to exit.

Why are there zero economic profits in the long run?

Zero economic profits means that all factors used in production make exactly their opportunity cost.
Purchased factors receive their market price, which is equal to their opportunity cost.
Owned factors receive the same compensation that they would receive in their next best use, which is also equal to their opportunity cost.
Thus, no firm wants to enter the market because it cannot make any more money than it is currently making.
Similarly, no firm wants to leave the market because it cannot make any more money in any other business.

Market Structures

Competitive: many firms, identical products
Monopoly: single firm, no close substitutes
Oligopoly: several firms, similar products, degree of product differentiation varies depending upon the market
Monopolistic competition: many firms, similar products, slightly differentiated products

Competitive Market

This is the classic "textbook" market structure.
Firms in a competitive market all make a product that is perfectly substitutable: all demanders are equally satisfied with any supplier's product.

Monopoly

The single seller makes a product that has no good substitute.
Other firms may be able to produce the good or service but choose not to enter the market or are barred from it.

Oligopoly

A few sellers make products that are good, but not perfect, substitutes.
Consumers can be induced to change suppliers but have only a limited number of choices.

Monopolistic Competition

The market has many firms but each supplier's product is differentiated.
Consumers can be induced to change brands but they have brand preferences.

Question

What is the market structure for each of these products or firms: competitive, monopoly, oligopoly, monopolistic competition?
- The Campus Store
- Kinko's
- Pepperidge Farm's Whole Wheat Bread
- PowerMac computer and clones
- Windows computer
- NYSEG (electricity utility)
- Morton salt
- AT&T long distance

Answer

The Classic Monopoly

A single seller supplies the entire market with a product for which there is no good substitute.
A monopolist has no "supply curve."
A monopolist faces the declining market demand curve for its product and simultaneously chooses price and quantity.

Question

For the monopolist shown in your handout, which of the following price and quantity combinations is optimal?
Price = $25, Quantity = 150
Price = $30, Quantity = 140
Price = $55, Quantity = 90
Price = $70, Quantity = 60
You can solve the problem from first principles: maximize profits.

Quantity	Market Demand Price	Total Costs	Marginal Cost	Average Total Cost
0	100.00	800
10	95.00	1,500	82.50	150.00
20	90.00	2,450	65.00	122.50
30	85.00	2,800	42.50	93.33
40	80.00	3,300	32.50	82.50
50	75.00	3,450	20.50	69.00
60	70.00	3,710	18.50	61.83
70	65.00	3,820	9.50	54.57
80	60.00	3,900	9.00	48.75
90	55.00	4,000	10.00	44.44
100	50.00	4,100	12.50	41.00
110	45.00	4,250	17.50	38.64
120	40.00	4,450	20.00	37.08
130	35.00	4,650	25.00	35.77
140	30.00	4,950	30.00	35.36
150	25.00	5,250	35.00	35.00
160	20.00	5,650	45.00	35.31
170	15.00	6,150	60.00	36.18
180	10.00	6,850	75.00	38.06
190	5.00	7,650	100.00	40.26
200	0.00	8,850		44.25

Answer

Classic Monopoly

Monopoly Selling in a Single Market at a Single Price
Quantity	Market Demand Price	Total Costs	Marginal Cost	Average Total Cost	Total Revenue	Marginal Revenue	Economic Profits
0	100.00	800			0.00		-800
10	95.00	1,500	82.50	150.00	950.00	90.00	-550
20	90.00	2,450	65.00	122.50	1,800.00	80.00	-650
30	85.00	2,800	42.50	93.33	2,550.00	70.00	-250
40	80.00	3,300	32.50	82.50	3,200.00	60.00	-100
50	75.00	3,450	20.50	69.00	3,750.00	50.00	300
60	70.00	3,710	18.50	61.83	4,200.00	40.00	490
70	65.00	3,820	9.50	54.57	4,550.00	30.00	730
80	60.00	3,900	9.00	48.75	4,800.00	20.00	900
90	55.00	4,000	10.00	44.44	4,950.00	10.00	950
100	50.00	4,100	12.50	41.00	5,000.00	0.00	900
110	45.00	4,250	17.50	38.64	4,950.00	-10.00	700
120	40.00	4,450	20.00	37.08	4,800.00	-20.00	350
130	35.00	4,650	25.00	35.77	4,550.00	-30.00	-100
140	30.00	4,950	30.00	35.36	4,200.00	-40.00	-750
150	25.00	5,250	35.00	35.00	3,750.00	-50.00	-1,500
160	20.00	5,650	45.00	35.31	3,200.00	-60.00	-2,450
170	15.00	6,150	60.00	36.18	2,550.00	-70.00	-3,600
180	10.00	6,850	75.00	38.06	1,800.00	-80.00	-5,050
190	5.00	7,650	100.00	40.26	950.00	-90.00	-6,700
200	0.00	8,850		44.25	0.00		-8,850

Economic profits equal total revenue minus total costs.
Marginal revenue is the rate of change of total revenue (just like marginal cost is the rate of change of total cost) as quantity increases.
Economic profits are maximized when marginal revenue equals marginal costs

Derivation of Monopolist's Optimal Price and Quantity

For both the monopolist and the competitor, profits are the difference between total revenues and total costs (TR - TC).
A maximum occurs where the rate of change of total revenues equals that of total costs.
For the competitor, when quantity produced changes there is no change in the market price, so marginal revenue equals the market price equals marginal cost.
For a monopolist, every time quantity increases, the market price received for each unit sold falls, so marginal revenue equals the price plus the (old) quantity times the slope of the demand curve (negative).
Marginal revenue equals marginal cost for both competitors and monopolists but the monopolist charges a price that exceeds marginal cost.

Implications of the Monopolist's Profit Maximum

Price will exceed the competitive price.
Quantity will be less than the competitive quantity.
The monopolist sells the output at a price greater than marginal costs but the monopoly price can be above or below average total costs. Thus, the monopolist need not always make a profit. In the long run, of course, unprofitable monopolists will either stop production or raise the price further above marginal cost until it covers average total costs.
The monopolist will always try to operate on the elastic portion of the demand curve because when the elasticity of demand is greater than -1 (inelastic, between 0 and 1 in absolute value), marginal revenue is negative and, necessarily, less than marginal cost.

Graphical display of Monopolist's Solution

The monopolist sets marginal revenue equal to marginal cost at MR=MC=$10.
The optimal quantity is thus 90 units, which implies a market price of $55/unit.
The monopoly profits (light blue in the graph) are the difference between price ($55) and average total cost ($44.44) times the number of units sold.
Notice that our monopolist is a “natural monopoly” the average total costs decline over the entire relevant range of production and the minimum efficient scale (150) is bigger than the entire market.
Notice that if our monopolist operated at the competitive equilibrium (Price=MC=$30, Quantity=140), the firm would make a loss (ATC>Price).

Price Discriminating Monopolists

A monopolist doesn’t have to charge the same price to all customers.
When there are ways to divide a market into parts with different demand curves, the monopolist can benefit from charging different prices to different customers.
This is called price discrimination.

Question

The data on your handout show the demand curves for movie tickets of adults and seniors. The market described has only one movie theatre.
- Find the best single price.
- If the movie theater can charge separate prices for adults and seniors, what are the best two prices?

Two Prices Are Better Than One for Movie Tickets

Types of Monopolies

Natural monopoly: the most efficient scale is so large that a single firm dominates the market.
Patents, copyrights, licenses: government protection of a firm's right to produce a unique product.
Entry barriers: economic and legal restrictions that make entry more difficult for new competitors than for the existing monopoly firm.

Natural Monopolies

Goods and services whose delivery requires the construction of a physical network (wires, pipes, etc..)
In such industries (local phone service, water, sewage removal, electricity, gas) the physical networks display decreasing marginal cost over essentially all quantities.
Thus, average total cost is always declining and the minimum efficient scale is much larger than the size of the market.
Natural monopolies are often regulated: they cannot charge a higher price without government approval.

What Happens When Technology Changes?

When wire-based networks became technologically obsolete for the provision of long distance telephone service, AT&T lost its natural monopoly on this service (early 1980s).
MCI, and others, were able to compete by combining the local telephone network (wire-based) with long distance transmitters (micro-wave and satellite) to provide long distance telephone services that had a much smaller minimum efficient scale and increasing marginal costs at normal operating quantities.
Thus, a natural monopoly can be eliminated by technological advances that change the minimum efficient scale.
Local telephone service is losing its natural monopoly because of the advance of cellular systems.
When natural monopolies disappear, deregulation often follows.

Are There "Good" Monopolies?

Consider the protease inhibitor Crixivan from Merck.
The most effective AIDS therapy developed to date.
Development costs were more than one billion dollars.
Annual revenue now from treating around 90,000 patients is $500,000,000.

What is a "Good" Monopoly?

Why is Merck given a monopoly?
The granting of a patent on the drug Crixivan guarantees that Merck can earn monopoly profits on its sale.
These monopoly profits provide the incentive to invest in the research and development required to create the new drug.

"Good" Monopolies

The granting of patent protection (legal monopoly) gives firms a strong incentive to invest in new product development.
Would a firm that could not protect its technology have produced Crixivan?
Probably not.

Should the Government Regulate Monopolies.

Essentially all monopolies are regulated.
Natural monopolies are regulated by price commissions that determine the rates the monopolies may charge.
Patent, copyright and license protections are a form of ex ante regulation: firms that follow the rules for establishing the validity of their innovations receive the protection of the patent, copyright or license.

Summary of Lecture

Monopolists set marginal revenue equal to marginal cost but, because the demand curve for the monopolist's product slopes downward, price is greater than marginal cost.
The monopoly price exceeds the competitive price for markets with the same cost and demand structure.
The monopoly quantity is less than the competitive quantity for markets with the same cost and demand structure.
Some monopolies are created to give competitive firms an incentive to innovate.

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