Chapter 7 Section 2
Describe characteristics and give
examples of monopolies.
Describe how monopolies are formed
including government monopolies.
Explain how a firm with a monopoly sets
output and price, and why companies
practice price discrimination.
You go to the emergency room with a high fever
and a sharp pain in your leg. The doctor
diagnoses it as a rare infection. He prescribes a
new medication (10 pills). You go to CVS and
find out that the medicine costs $ 97.35
($10.00/pill). The pharmacists tell you that only
one company has the right to produce this
medicine and it charges a high price because its
scientists worked for years to develop this
The market for prescription medicines is
one of many markets in which monopolies
A Monopoly forms when barriers prevent
firms from entering a market that has a
Monopolies have ONE seller.
Any number of buyers.
Barriers to entry are the principal condition
that allows monopolies to exist.
Monopolies can take advantage of their
market power and charge high prices.
This means that the quantity of goods sold
is lower than in a market with more than
For this reason, the United States has
outlawed some monopolistic practices.
All monopolies have one common trait – a
single seller in a market.
Different market conditions can create
different types of monopolies.
If a firm’s start-up costs are high, and its average costs
fall for each additional unit it produces, then it enjoys
what economists call economies of scale.
Economies of Scale – characteristics that cause a
producer’s average cost to drop as production
Companies without economies of scale – as output
increases from zero, the average cost of each good
drops, and the curve initially sloes downward. Eventually
the average cost of production begins to rise as output
increases because it has a rising cost per unit.
i.e. Hydroelectric Plant
It has a high expense to build.
Once the dam is built, the plant can produce
energy at a very low additional cost by letting
water flow though the dam.
As output increases, the fixed costs of the dam
can be spread over more units of electricity, so
the average cost drops.
A market that runs efficiently when one large
firm provides all of the output
If a second firms enters the market, competition
will drive down the market price charged to
customers and decrease the quantity each firm
can sell. One or both of the firms will not be
able to cover their costs and will go out of
Example of a natural monopoly is public
In a competitive market, different water
companies would have to dig their own
well, run their own water pipes throughout
town (city), and have their own pumping
Lead to a big mess in town & confusion
In a case like this, the government steps in
and allows just one firm in each
geographic area to provide these
The government ensures that we don’t
waste resources building additional plants
when only one is needed.
A firm with a natural monopoly agrees to
let the government control the price it can
charge and what services it must provide.
Technology & Change
Sometimes the development of new technology can
destroy a natural monopoly.
A new innovation can cut fixed costs and make small
companies as efficient as one large firm.
i.e. Used to be that no one wanted to put up all the
wiring and all the poles to connect people by use of the
telephone. Copper wire, etc. Than in the 1980s –
consumers began using Cell Phones – changed
A monopoly created by the government.
Barriers created by the government limit the
entries into the market.
One way to give a company monopoly power is
by issuing a Patent – a license that gives the
inventor of a new product the exclusive right to
sell it for a certain period of time.
If Leland Pharmaceuticals develops a new asthma
medication called Breathe-Deep. If the researchers can
prove to the government that they had invented this
product, the Food & Drug Administration (FDA) would
give Leland the exclusive right to sell this product for 20
Patents guarantee that companies can
profit from their own research without
This is the reason that companies are
encouraged to research and develop new
products that benefit society.
Costs are very high, but the patent allows
firms to set prices that maximize their
opportunity to make a profit.
Franchises and Licenses
Franchises – is a contract issued by a
local authority that gives a single firm the
right to sell its goods within an exclusive
National Park Services – pick one single
firm to provide food and other goods at all
national parks in the US.
License – the government grants firms the
right to operate a business.
i.e. – Radio and television broadcast
frequencies. Issued by the Federal
Communications Commission (FCC).
Sometimes the government lets companies in
an industry restrict the number of firms in a
Major League Baseball and other sports restrict
the number and location of their teams.
Baseball can choose new cities for their teams
and is not charged with violating the laws that
prevent competitors from working together.
Major League Baseball is exempt from
these laws – antitrust laws – they were
passed to break up an illegal form of
monopoly known as a trust.
Baseball owners are able to control a lot of
what goes on in their sport (as well owners
in other sports).
Price Discrimination – division of
customers into groups based on how
much they will pay for a good.
Price Discrimination is based on the idea that each
customer has his or her own maximum price that they
will pay for a good.
If monopolists set the price of that good at the highest
maximum price of all buyers in the market, the
monopolist will only sell to the few customers will to pay
If the monopolist sets a low price, the
monopolist will gain a lot of customers, but
the monopolist will lose the profits he
could have made.
Price discrimination is practiced by
companies who have market power – the
ability of a company to change prices and
output like a monopolist.
Companies divide customers into large groups
and design pricing policies for each group.
Examples of Price Discrimination
Discounted airline fares
• Airlines offer discounts to travelers who buy tickets
several weeks in advance or are willing to spend a
Saturday night at their destination.
Business travelers would not prefer to spend a
Saturday night at their destination, but these
tickets are appealing to vacationers who
wouldn’t otherwise pay to fly and don’t mind the
Manufacturers’ rebate offers
Television, car, refrigerator, and other
manufacturers will refund a small part of the
purchase price to buyers who fill out a form and
mail it back. People who take time to fulfill the
rebate requirements are likely more price-
conscious than those who don’t and may be
paying full price.
Senior citizens or student associations
Many senior citizens or students have
lower incomes than people who work full
time. Zoos, theaters, and restaurants often
offer discounts to these people because
they are unlikely to be able to pay full price
for what some consider luxuries.
Children fly or stay for free promotions
Families with young children spend more
of their income on food, clothing, and
school expenses. As a result, they have
less to spend on vacations. Firms would
rather have their business and earn lower
profits than earn no profits at all, so they
offer these discounts.
Limits of Price Discrimination
For price discrimination to work, a market has
to meet three conditions.
Firms that use price discrimination must have some
market power, customers must be divided into
distinct groups, and buyers must not be in a position
in which they can easily resell the good or service.
a. Some market power – have some control
b. Distinct customer groups – be able to
divide groups into distinct groups based on
their sensitivity to price.
c. Difficult resale – it does not work if people
can resell the goods for a profit.
Usually, it will be for theme park admission, restaurants,
Sometime firms use price discrimination to
drive other firms out of business.
This is illegal – called predatory pricing