	Prepare For Class
Use these documents and activities to introduce yourself to concepts and topics from this chapter.

Chapter 10: Monopoly

Economists classify industries into four different types, based on the number of firms that produce and sell the product, the ease of entry into and exit from the industry, and the degree of product differentiation, which refers to how similar or different are the products that the firms sell. We have already considered one type of market, the competitive industry, in which there are many firms selling the same product and free entry and exit of firms.
A monopoly occurs when there is only one firm in an industry selling a product for which there are no close substitutes, and other firms are not free to enter the industry. Whatever prevents other firms from entering the industry is called a barrier to entry.
To the economist, the difference between a monopoly and a competitive firm is not in the firm’s goals. Both are assumed to maximize profit. Instead, the difference lies in how the firm can achieve that goal. The competitive firm is a price-taker; it can choose how much to sell at the market price, but its output is so small compared to the total in the market that its decision concerning how much to sell has no perceptible effect on the price. The monopoly, on the other hand, has market power; it can set the market price without reducing its sales to zero. Or, put somewhat differently, the monopoly can choose the price at which it wishes to sell, and is therefore a price-maker. The monopoly takes into account the effect of its sales on the price it receives for its output, something the competitive firm doesn’t need to do because there is no such effect for a competitive firm.
The monopoly can control the amount it sells or the price at which it sells its output, but not both independently. If the monopoly chooses to set the price, consumers’ demand will determine how much gets purchased, and if the monopoly chooses a quantity to supply, consumers’ demand will determine what price it can charge in order to sell that quantity. But, unlike the competitive firm, the monopoly can raise the price of its product without losing all of its customers because there are no other sellers for customers to switch to and no close substitutes for the product. Similarly, unlike the competitive firm, whose sales are only a tiny fraction of the total market supply, the monopoly’s decision to restrict the quantity it offers for sale by a considerable amount has a considerable effect on the total quantity available to consumers because its output is all the output available.
One way to see that the monopoly can choose price or quantity, but not both independently, is to look at the demand curves for their output that the competitive firm and the monopoly see. The demand curve for its output that the competitive firm sees is horizontal (perfectly elastic) at the market price. Customers are willing to buy any amount the competitive firm wishes to sell at that price, but if it tries to sell at even a slightly higher price, it loses all its customers to other firms in the market. The monopoly, on the other hand, faces a demand curve for its output that is the same as the downward-sloping market demand curve for the product, because it is the only supplier in the market. If the monopoly chooses higher prices, then consumers won’t want to buy as much, but because there are no other suppliers and limited substitutes for the product, quantity demanded will not drop to zero.
As we saw in Chapter 6, each additional unit the competitive firm sells is sold for the same price, so that revenue increases by the price when one more unit is sold. In other words, for the competitive firm, the marginal revenue (remember that from Chapter 6) equals the price. But for the monopoly, which faces a downward-sloping demand curve, things are different. In order to sell another unit, the monopoly has to charge a lower price. Thus, selling another unit has two effects on the monopoly’s revenues. First, revenue is increased by the sale of the additional unit at the slightly lower price. Second, revenue is decreased because in order to sell the additional unit, the monopoly has to charge a lower price for all its output, not just the last unit. As a result of these two effects, we know that for a monopoly marginal revenue must be less than the price at which it is selling its output. That is, if the monopoly is currently selling output for P per unit, then if it lowers the price enough to sell one more unit, its total revenue will increase by less than P. In fact, if the second effect is large enough, total revenue can actually fall when the monopoly sells one more unit, although, as we will see shortly, no profit-maximizing monopoly will choose to produce an output so large that marginal revenue is negative.
Since price declines as the monopoly’s output rises, and since marginal revenue for a monopoly is lower than price, marginal revenue must also decline as output increases.
The effect that selling one more unit has on total revenue depends on how much the price has to be reduced in order to sell that unit. In Chapter 4, we measured the effect of a change in price on the quantity demanded using the price elasticity of demand, and in fact, there is a relationship between the marginal revenue for a monopoly and the elasticity of demand that it faces for its output. Marginal revenue is negative when the demand for the product is inelastic, or in other words has a price elasticity less than 1. A monopolist will never produce a quantity in the inelastic portion of its demand curve; since increasing output lowers revenue in that portion, reducing output increases revenue and lowers cost, and therefore clearly makes profit go up.
Another way to see that marginal revenue is less than the price at every quantity (except the first unit of output) is to recognize that the price the firm charges is also the firm’s average revenue. This is easy to see; since total revenue is price times quantity, average revenue, which is total revenue divided by quantity, equals price. Recall that any time an average is falling as additional units are added, the marginal contribution of those additional units must be less than the average. So if average revenue, which is price, is falling (downward-sloping demand), then marginal revenue must be below average revenue.
We can now put together the revenue that the monopoly receives from its sales with the costs that the monopoly incurs to produce its output. Monopolies have to acquire inputs in order to produce their products just as competitive firms do, and so we can use the same cost measurements (average cost, marginal cost) that we discussed in Chapters 6 and 8 to describe the monopoly’s costs. Like that for a competitive firm, the monopoly’s total cost curve is rising as output rises, and marginal cost also increases as output increases.
To find the monopoly’s profit-maximizing level of output, we can look at a table of total revenue and total costs for different levels of output and find the one that gives the largest difference between revenue and cost. We can also do this graphically by plotting total revenue and total costs at different levels of output and looking for the output that gives the greatest vertical distance between the two curves.
We can also apply the logic that we developed in Chapter 6 to find the profit-maximizing output level for a monopoly. Remember, in order to maximize profit, a firm should sell any unit that adds more to revenue than it adds to cost. We stated that rule as produce that quantity for which marginal revenue equals marginal cost, and we said that in the case of the price-taking firm, marginal revenue is equal to price. This logic and rule still hold for a monopoly; the only difference is that the monopoly is not a price-taking firm and so marginal revenue for the monopoly is below price. But the monopoly can still find its profit-maximizing output level by producing up to the level of output where marginal cost equals marginal revenue (MR = MC).
We can combine the demand and marginal revenue curves facing a monopoly with the cost curves facing the monopoly in the same way that we combined the demand curve and cost curves facing a competitive firm in Chapter 8. Figure 10.1 shows this information in one diagram.

Figure 10.1
From Figure 10.1, we can find the monopoly’s profit-maximizing output. First, find the point where the marginal revenue curve and the marginal cost curve cross. Draw a vertical line down from this point to the horizontal axis. The quantity at which this line hits the axis (QM) is the quantity for which marginal cost equals marginal revenue, so it is the profit-maximizing quantity.
To find the price at which the monopoly sells, extend the vertical line above the monopoly quantity up to the demand curve, and then go horizontally to the left to the vertical axis. Since the demand curve tells us how much will be demanded at each price, this price (PM) is the price that the monopoly must charge if it wants to sell the profit-maximizing quantity.
To measure the profits that the monopoly makes by selling the monopoly quantity at the monopoly price, we need to find the monopoly’s total revenue and total costs. Total revenue is simply price times quantity, so it appears on the diagram as the area of the rectangle with a height equal to the monopoly price and a base equal to the monopoly quantity. Total costs can be calculated by multiplying average total costs (that is, total costs divided by output) by the number of units produced. Total costs are thus equal to the area of a rectangle with a base equal to the monopoly quantity and a height equal to the average total cost associated with producing that quantity (labeled “ATC at QM” in Figure 10.1). The difference between these rectangles in the diagram is the shaded rectangle with a base equal to the monopoly quantity and a height equal to monopoly price minus average total cost at the monopoly quantity. The area of this rectangle measures the monopoly’s profits. It is the amount by which each unit sells above average cost times the number of units sold.
If there are barriers to the entry of new firms, the monopoly can earn these profits year after year. Remember that total costs (and therefore average total cost) already include the opportunity cost of capital, so these profits are economic profits; that is, they are above and beyond the ordinary return that investors can get by investing their capital in the next best alternative. If costs other than the costs of production, such as research and development costs or license fees that have to be paid to the government, are not included in total costs, they have to be subtracted from the profits computed in Figure 10.1 to get true profits.
When the monopoly finds the quantity at which marginal revenue equals marginal cost, it may find that the price needed to sell that quantity is below average cost. This happens if the average cost curve is above the demand curve at that quantity. In that case, total revenue at the profit-maximizing quantity is below total costs, and the firm makes a negative profit. In that case, the firm will shut down in the short run, if the monopoly price is less than the average variable cost, and will exit the market if negative profits are expected to persist.
In Chapter 7, we saw that competitive markets were efficient and maximized the sum of producer and consumer surplus. How does a market supplied by a monopoly compare with a competitive market in terms of equilibrium price, quantity, and consumer and producer surplus? We can evaluate the monopoly outcome by looking at Figure 10.2, which shows the monopoly’s demand, marginal revenue, and marginal cost curves (we leave out the average total cost curve to avoid cluttering up the diagram too much). The monopoly quantity and price are found in the usual way: Find the point at which marginal revenue and marginal cost cross; then go down to the quantity axis and up to the demand curve and over to the price axis.

Figure 10.2
Now suppose the monopoly were broken up into many small, price-taking firms. This would mean creating many new firms, each with its own marginal cost curve. These marginal cost curves would have to add up to the former monopoly’s marginal cost curve, since that was what was broken up in the first place, and we know from Chapter 6 that the sum of the competitive firms’ marginal cost curves is the market supply curve. So the monopolist’s marginal cost curve in Figure 10.2 is also the competitive market’s supply curve. We can find the equilibrium price (PC) and quantity (QC) in the competitive industry in the usual way, by finding the intersection of the supply and demand curves. Compare the monopoly price (PM) and quantity (QM) with the competitive equilibrium price and quantity. The monopoly sells less output and charges a higher price than the competitive industry would.
In Chapter 7, we saw that a competitive market maximized the sum of producer and consumer surplus, which was a measure of the benefits to producers and consumers from the good. The competitive market produces every unit that provides a marginal benefit to consumers that is greater than the marginal cost of producing that unit. We have just seen that the monopoly doesn’t produce as much as the competitive market does, so there must be some units that the monopoly chooses not to produce that would add to consumer plus producer surplus if they were produced. This reduction in consumer plus producer surplus is called the deadweight loss due to monopoly. We can see how much it is, in dollar terms, by looking at Figure 10.3.

Figure 10.3

Recall that the sum of consumer and producer surplus is the area under the demand curve and above the marginal cost curve from the vertical axis out to the quantity that is sold. In a competitive market, the quantity sold is QC, and the sum of producer and consumer surplus is all of the shaded area, both lightly shaded and darkly shaded. A monopoly will sell only QM units, and the sum of consumer and producer surplus is only the lightly shaded area. The darkly shaded area is the amount of producer and consumer surplus that is lost as a result of the monopoly, or the deadweight loss.
Another thing that can be seen in Figure 10.3 is how the monopoly results in some consumer surplus being converted into producer surplus. The consumer surplus part of the total of producer and consumer surplus is the area under the demand curve and above the price that consumers are paying (PC in the case of competition, PM in the case of monopoly). Some part of the surplus that would be received by consumers if the market were competitive is lost in the deadweight loss, but another part is transferred to the monopoly. This is measured by the area of the rectangle between PM and PC vertically and out to QM horizontally. This isn’t a loss to society, since the monopolist is a member of society too, but it is a change in the distribution of income.
Remember that it makes sense to compare monopoly provision of a good with competitive provision of that good only if competition really is a viable alternative. In some industries, the costs would be much higher if the firms were small, so it wouldn’t be desirable to break up the monopoly. And sometimes a monopoly in a more technologically advanced product is better than a competitive market in an obsolete one.
Another way to think about the harm done by a monopoly is to think about the fact that in the monopoly equilibrium, price is greater than marginal cost. Recall from Chapter 5 that consumers buy up to the point where the marginal benefit of another unit equals the price they have to pay for it; this is true whether the market is competitive or a monopoly. In a competitive market, price also equals marginal cost, so consumers buy up to the point where the additional benefit they get from the last unit they consume just equals the cost of producing it. In a monopoly, however, price is above marginal cost, so when consumers purchase up to the point where the marginal benefit equals the price, the marginal benefit is above the marginal cost. As a result, the next unit would bring more additional benefit to the person who would consume it than it would cost society to produce it, which is inefficient.
Economists often measure the difference between price and marginal cost by looking at the price-cost margin. This is given by

The difference between price and marginal cost is divided by price because a $1 difference is a lot on a $5 paperback book, but virtually nothing on a $10,000 car. If the price-cost margin is 0.25, that means that 25 percent of the price is a markup over marginal cost. For a competitive firm, price equals marginal cost and the price-cost margin is zero. The size of the price-cost margin depends on the elasticity of demand that the firm faces, because that determines how much the price has to be lowered to sell another unit and therefore by how much marginal revenue falls below the price. In fact, there is an inverse relationship between the price-cost margin and the price elasticity of demand facing the firm:

A perfectly competitive firm faces a perfectly elastic demand curve (infinitely large elasticity) and therefore has a price-cost margin of zero. A monopoly facing a demand curve with an elasticity of 3 would have a price-cost margin of 0.33, meaning that 33 percent of the price was markup over marginal cost.
There are several reasons why monopolies might exist. A key issue is the extent of economies of scale. As we saw in Chapter 8, when there are economies of scale, there is a minimum size that firms have to attain if they are to have average costs as low as possible; that size is called the minimum efficient scale. If the minimum efficient scale is so large that one firm of that size can serve the entire market, there will probably be a monopoly in the market. Any smaller firm would not be able to survive alongside the larger firm. A natural monopoly occurs when average total cost is declining at every level of demand and the minimum efficient scale is larger than the size of the market.
Markets may be monopolized by firms that have patents or copyrights. A patent is a legally recognized monopoly in the production of a good or the use of a technology that is granted to the inventor by the government for a limited length of time (17 years) in order to encourage innovation. A patent prohibits others from selling that good or using that process without permission from (and often payment to) the holder of the patent. A copyright is a legally recognized monopoly for the author on the use of books, pictures, computer programs, movies, songs, and so on that is also granted by the government. It makes it illegal to reproduce and sell those writings without permission from the copyright holder. Copyrights and patents do not guarantee a profitable monopoly; there may be similar but different products that satisfy the same needs or other ways to accomplish the same task.
The government can also create a monopoly by giving one firm a license to produce some good or service and excluding other firms from producing that good or service. Again, there is no guarantee that a monopoly created by a license will be profitable, as there may be substitutes available to consumers.
Firms may also attempt to create their own monopolies by merging into a single firm or by driving their rivals out of business and then erecting barriers to entry to prevent other firms from entering the market. However, simply observing that there is only a single firm providing a good or service does not mean that the firm is a monopolist secure behind a barrier to entry. In fact, if entry is very easy, the mere threat of entry by other firms may be sufficient to induce the sole producer of a product to produce the competitive quantity and sell it at the competitive price. If the firm were to raise its price above cost, new entrants would jump into the market to steal the firm’s customers and drive the price back down to the competitive level. When entry into a market is very easy, economists refer to it as a contestable market, and they are less concerned about the power of a single seller to raise the price.
So far, we have been talking about a monopoly that can only charge a single price for all the units of output that it sells. In that case, when the monopoly lowers the price a little to increase sales by another unit, it has to lower the price on all the units sold, not merely on the last one. But some monopolies are able to charge different prices for the same item. This is called price discrimination. Price discrimination can take several forms: selling the same product at different prices in different locations (so long as the difference in price doesn’t reflect different shipping costs), charging different prices to customers who buy different amounts, or charging different prices to different types of buyers.
If a monopoly can distinguish between consumers with more elastic demand and those with less elastic demand, and if it can keep those customers separate, it will be profitable to charge them different prices. Consumers with relatively inelastic demands won’t reduce their consumption as much in the face of a price increase, and they can be charged a higher price. But if customers with relatively elastic demand are charged that higher price, it will lead more of them to stop consuming. Hence, it is more profitable to charge them a somewhat lower price. In order to price-discriminate successfully according to customers’ demand elasticities, the monopoly must be able to distinguish those customers with relatively inelastic demand from those with relatively elastic demand and then prevent the latter from buying output and reselling it to the former.
Another way for monopolies to price-discriminate is to charge different prices depending on how much is purchased. The monopoly can do this by offering customers the first units they buy, for which their marginal benefit is higher, at a high price, and the remaining units, which have a lower marginal benefit, at a lower price. To do this successfully again requires that consumers not be able to easily resell the item; otherwise, consumers would get together and have one of the group do all the purchasing to take advantage of the lower price. Price discrimination of this sort can lead to additional sales being made; after selling the monopoly quantity at the monopoly price, the monopoly can sell some additional units at a lower price without lowering the price on the first units sold. In this case, the total output sold moves closer to the competitive quantity, so deadweight loss is reduced, but more of the consumer surplus is transferred to the monopoly’s profits. Price discrimination isn’t always bad from an efficiency standpoint (at least compared to a monopoly that cannot price-discriminate).