Chapter 12 Colander
The characteristics of the monopoly are introduced. The fact that a
monopoly is a single seller and there are very strong barriers to entry is
central to this market structure. The barriers to entry may include
ownership of an essential resource, government restrictions, legal barriers,
and economies of scale. A natural monopoly arises because of extensive
economies of scale.
Because the monopoly is a single seller it is a price maker--it sets the
price in the market by producing that output level which maximizes its
profits, thereby effectively determining market supply, which in turn sets
the market price. The monopolist is faced with the market demand curve.
Therefore, the monopolist's marginal revenue curve lies below the market
demand curve it faces. The profit-maximizing quantity to produce is the
same for any other firm. Long-run economic profits are likely for a
monopolist because of the strong barriers to entry which limit others from
entering and competing in the market.
Monopolies may price discriminate in order to increase their profits if
they are able to do so. Price discrimination means the firm is charging
different prices to different people where those price differences are not a
reflection of cost differences.
This chapter concludes with a critique of monopolies from society's
Characteristics of Monopoly –
1. One seller – thus monopolists are price makers
2. Highly differentiated, even unique product
3. No entry and no fear of entry
General Comments –
1. There is nearly always some competition – pure monopoly is extremely
5 to 6% of national output is produced by monopolies
2. Many monopolies are based on location -- Ex – drug store in remote town
3. Famous monopolies – De Beers, GM locomotives, International Nickel
4. Declining monopolies – Western Electric, Dow chemical, Xerox, Apple
Barriers to entry –
1. Large economies of scale in relation to market demand
Retail outlets in small towns
Bricks in local markets
Public utilities -- natural monopolies – exist where one firm can
achieve much lower production costs than if industry output where
divided among several firms.
When a single industry standard owned by one firm is more efficient
than multiple standards. Example ????? ______________
2. Ownership of essential raw materials
Alcoa – bauxite
3. Government granted monopolies – patents, copyrights, licenses
4. Economies of being established
P Q TR MR
15 2 Graph the demand curve to the left
14 3 on graph paper
Graphing the Monopoly -
MR = MC is still the profit maximizing rule (264)
Fig. 12-1 263
Fig. 12-2 266
Like pure competition, monopoly must cover AVC to stay in business in the
In the LR a monopoly must earn at least a normal profit to stay in
In the LR a monopoly can earn substantial economic profit because no
entry is possible
Common misconceptions about monopoly –
1. Monopolies charge the highest possible price
2. Monopolies charge the price that will yield the highest profit per unit
3. Monopoly guarantees a profit
4. Monopoly will NOT pass on a decrease in cost by decreasing its prices
Why monopolies will not always maximize profits.
1. They fear loss of goodwill in the community if they gouge too much
2. They fear possible government intervention if they push too hard
3. They do not want to attract competition
The Welfare loss from Monopoly --
Fig. 12-5 269
Additional problems with monopoly – blending normative and positive
1. Monopoly profits increase income inequality
2. There is slower technological advance in industries that are monopolized
due to the lack of competitive pressures
3. X–inefficiency – there is no real push to fully lower costs due to the lack
4. Rent seeking expenditures increase costs and product prices.
Monopolists will go to great lengths to gain and keep monopoly position
5. Monopolies reduce economic freedom by cutting off the possibility of
Price Discrimination – a special case of monopoly 269
Price discrimination exists when a product is sold at more than one price
and these differences are not justified by cost differences.
Necessary conditions for price discrimination to exist –
1. Seller must be able to set either quantity or price
2. Seller must be able to segregate buyers into separate classes
based upon their different elasticities of demand.
3. Buyers must not able to resell the product or service.
Examples – transportation, legal services, medical services, telephone
rates, utility rates, movies, golf, senior discounts
Example – Graph the following.
Price Quantity TR MR
o Now on the same graph, graph the same demand curve assuming the
firm is a non-discriminating monopolist.
o Find the profit maximizing level of output and price
o Now look at your graph and note:
1. Both firms produce where MR = MC but in doing so the
discriminating monopolist produces more output.
2. Not only that, discriminating producer earns extra economic profits
as a result of its ability to discriminate. It finds it profitable to allow
some people to consume at prices well below what the non-
discriminator would find profitable.
3. As a result of PD, some consumers (the rich, the willing) end up
subsidizing other consumers (the poor, the less willing).
Public Utilities are usually natural monopolies.
Natural Monopolies – exist when large economies scale can only be
realized if one firm produces the vast majority of the product. In this case,
if output is divided between a number of firms to avoid monopoly, these
firms will produce at significantly higher costs per unit than would a
In the case of a public utility, D cuts ATC at a point where ATC is still
falling. This is because of heavy fixed cost due to high peak demand.
Fig. 12-6 272
The problem with a letting a natural monopoly like a public utility produce
without government intervention is that they will earn huge economic profits
due to the highly inelastic demand for their product.
Possible solutions – (see graph in class)
1. Private ownership but with government regulation through a public utility
commission -- firms would be required to produce where P = ATC (i.e.
normal profits are achieved). This is called the “fair return price.”
Problems with this solution –
a. firm has no incentive to cut costs for it will only be allowed only a
normal profit even if they reduce costs.
b. fair return price is difficult to calculate – is it on sales or on
invested capital? In the case of sales, do we want public utilities
to promote wasteful consumption of energy? In the case of using
invested capital as a yardstick, we giving utilities the incentive to
over invest in unneeded capital equipment.
2. Government Ownership – make firms produce to the point where P = MC.
Problem – this price (called the “socially optimum price”) causes the
firm to lose money
How do we make the socially optimum price work?
a. have government subsidize the private firm to cover its losses.
b. nationalize the firm and pay for its losses out of taxes
c. let it remain private but condone price discrimination
Can Price Controls Increase Monopoly Output and Lower Market
Problems with price controls in this case -- 271
The Problem of Monopoly and the AIDS vaccine. 274-5
Problem – Price of the drug is much greater than MC.
How do we get life saving drugs to people at a reasonable cost?
Solution #1 – make firms charge a price that equals MC.
Problem with this is that it would diminish profits and perhaps
reduce R&D on other important drugs.
Solution #2 – Government would buy the patents from the
pharmaceutical firms and license all firms to manufacture the drugs.
Problems -- Who would decide the price? Which drugs should
government buy? How does government pay for them?
Solution #3 - Dramatically reduce the length of time a patent would
give a firm a monopoly on the sale of the drug – some economists say 2
or 3 years would be about right as opposed to the 20+ years that are
In the end, the key question is what rate of profit does the
pharmaceutical industry need to maintain strong R&D efforts?
For years they have been making the highest percentage profit
on invested capital of any industry in the U.S. (32%). How much