C HA P T

E R 1
5
Monopoly

Economics
P R IN C I P L E S O
F

N. Gregory
Mankiw
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by Ron Cronovich
© 2009 South-Western, a part of Cengage Learning,
In this chapter,
look for the answers to these questions:

 Why do monopolies arise?

 Why is MR < P for a monopolist?
 How do monopolies choose their P and Q?
 How do monopolies affect society’s well-being?
 What can the government do about monopolies?
 What is price discrimination?

2
 Introduction
 A monopoly is a firm that is the sole seller of a
product without close substitutes.
 In this chapter, we study monopoly and contrast
it with perfect competition.
 The key difference:
A monopoly firm has market power, the ability to
influence the market price of the product it sells.
A competitive firm has no market power.

MONOPOLY 3
 Why Monopolies Arise
The main cause of monopolies is barriers
to entry – other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws

MONOPOLY 4
 Why Monopolies Arise
3. Natural monopoly: a single firm can produce
the entire market Q at lower cost than could
several firms.
Example: 1000 homes
need electricity Cost Electricity
ATC slopes
ATC is lower if downward due
one firm services to huge FC and
all 1000 homes $80 small MC
than if two firms $50 ATC
each service
500 homes. Q
500 1000
MONOPOLY 5
Monopoly vs. Competition: Demand
Curves
In a competitive market,
the market demand curve
slopes downward.
A
But the demand curve
P c demand curve
for any individual firm’s o
product is horizontal m
p
at the market price. e
t
The firm can i D
t
increase Q i
without lowering P, v
e
so MR = P for Q
f
the competitive i
firm.
MONOPOLY r 6
Monopoly vs. Competition: Demand
Curves
A monopolist is the only
seller, so it faces the
market demand curve.
A monopolist’s
To sell a larger Q, demand
P
the firm must reduce P. curve

Thus, MR ≠ P.

D
Q

MONOPOLY 7
A C TI V E L E A R NI N G 1
A monopoly’s revenue
Common Grounds
Q P TR AR
is the only seller
MR
of 0
cappuccinos in $4.50 n.a.
town. 1
The table shows the 4.00
market demand for 2
cappuccinos. 3.50
Fill in the missing 3
spaces of the table. 3.00
What is the relation 4
between P and AR? 2.50 8
A C TI V E L E A R NI N G 1
Answers
Q P TR AR MR
Here, P = AR,
same as for 0 $4.50 $0 n.a.
a $4
1 4.00 4 $4.00
competitive 3
firm. 2 3.50 7 3.50
2
Here, MR < P, 3 3.00 9 3.00
whereas MR = P 1
4 2.50 10 2.50
for a 0
competitive 5 2.00 10 2.00
–1
firm. 6 1.50 9 1.50

9
 Common Grounds’ D and MR Curves
P, MR

Q P MR $5

0 $4.50 4 De man d cu rve (P)

$4 3
1 4.00
3 2
2 3.50
2 1
3 3.00 0
1 MR
4 2.50 -1
0 -2
5 2.00
–1 -3 0 1 2 3 4 5 6 7 Q
6 1.50
MONOPOLY 10
Understanding the Monopolist’s MR
 Increasing Q has two effects on revenue:
Output effect: higher output raises
revenue
Price effect: lower price reduces
revenue
 To sell a larger Q, the monopolist must reduce
the price on all the units it sells.
 Hence, MR < P
 MR could even be negative if the price effect
exceeds the output effect(e.g., when
Common Grounds increases Q from 5 to 6).
MONOPOLY 11
 Profit-Maximization
 Like a competitive firm, a monopolist maximizes
profit by producing the quantity where MR = MC.
 Once the monopolist identifies this quantity,
it sets the highest price consumers are willing to
pay for that quantity.
 It finds this price from the D curve.

MONOPOLY 12
 Profit-Maximization

Costs and
1. The profit- MC
maximizing Q Revenue
is where P
MR = MC.

2. Find P from
D
the demand
curve at this Q. MR

Q Quantity

Profit-maximizing output
MONOPOLY 13
 The Monopolist’s Profit

Costs and
MC
Revenue
As with a P
ATC
competitive firm,
the monopolist’s ATC
profit equals D
(P – ATC) x Q MR

Q Quantity

MONOPOLY 14
 A Monopoly Does Not Have an S Curve
A competitive firm
takes P as given
has a supply curve that shows how its Q depends
on P.
A monopoly firm
is a “price-maker,” not a “price-taker”
Q does not depend on P;
rather, Q and P are jointly determined by
MC, MR, and the demand curve.

So there is no supply curve for monopoly.

MONOPOLY 15
CASE STUDY: Monopoly vs. Generic Drugs

The market for

Patents on new drugs Price a typical
give a temporary
drug
monopoly to the seller.
PM
When the
patent expires,
the market PC = MC
becomes competitive, D
generics appear.
MR

QM Quantity
QC

MONOPOLY 16
 The Welfare Cost of Monopoly
 Recall: In a competitive market equilibrium,
P = MC and total surplus is maximized.
 In the monopoly eq’m, P > MR = MC
The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to
produce that unit (MC).
The monopoly Q is too low –
could increase total surplus with a larger Q.
Thus, monopoly results in a deadweight
loss.

MONOPOLY 17
 The Welfare Cost of Monopoly
Competitive eq’m:
Price Deadweight
quantity = QC MC
P = MC loss
P
total surplus is P=
maximized MC
Monopoly M
D
eq’m: C
quantity = QM MR

P > MC QM QC Quantity
deadweight
loss
MONOPOLY 18
 Price Discrimination
 Discrimination:treating people differently
based on some characteristic, e.g. race or
gender.
 Price discrimination: selling the same
good at different prices to different buyers.
 The characteristic used in price discrimination
is willingness to pay (WTP):
 A firm can increase profit by charging a
higher price to buyers with higher WTP.

MONOPOLY 19
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist Consumer
Price
charges the same surplus
price (PM) to all D
buyers. PM e
a
loss
A deadweight loss d
results. MC
Monopoly w
profit ei D
gMR
ht
QM Quantity

MONOPOLY 20
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist
produces the Price
Monopoly
competitive quantity,
profit
but charges each
buyer his or her WTP.
This is called perfect
MC
price discrimination.
D
The monopolist
captures all MR
CS as profit.
Quantity
But there’s no Q
DWL.
MONOPOLY 21
 Price Discrimination in the Real World
 In the real world, perfect price discrimination is
not possible:
No firm knows every buyer’s WTP
Buyers do not announce it to sellers
 So, firms divide customers into groups
based on some observable trait
that is likely related to WTP, such as
age.

MONOPOLY 22
 Examples of Price Discrimination
Movie tickets
Discounts for seniors, students, and people
who can attend during weekday afternoons.
They are all more likely to have lower WTP
than people who pay full price on Friday night.
Airline prices
Discounts for Saturday-night stayovers help
distinguish business travelers, who usually have
higher WTP, from more price-sensitive leisure
travelers.

MONOPOLY 23
 Examples of Price Discrimination
Discount coupons
People who have time to clip and organize
coupons are more likely to have lower income
and lower WTP than others.
Need-based financial aid
Low income families have lower WTP for
their children’s college education.
Schools price-discriminate by offering
need-based aid to low income families.

MONOPOLY 24
 Examples of Price Discrimination
Quantity discounts
A buyer’s WTP often declines with additional
units, so firms charge less per unit for large
quantities than small ones.
Example: A movie theater charges $4 for
a small popcorn and $5 for a large one that’s
twice as big.

MONOPOLY 25
 Public Policy Toward Monopolies
 Increasing competition with antitrust laws
Ban some anticompetitive practices,
allow govt to break up monopolies.
E.g., Sherman Antitrust Act (1890),
Clayton Act (1914)
 Regulation
Govt agencies set the monopolist’s
price.
For natural monopolies, MC < ATC
at all Q,
so marginal cost pricing would
result in losses.
MONOPOLY 26
 Public Policy Toward Monopolies
 Public ownership
Example: U.S. Postal Service
Problem: Public ownership is usually less
efficient since no profit motive to minimize costs
 Doing nothing
The foregoing policies all have drawbacks,
so the best policy may be no policy.

MONOPOLY 27
CONCLUSION: The Prevalence of Monopoly

 In the real world, pure monopoly is

 Yet, many firms have market power, due to:
rare.
selling a unique variety of a product
having a large market share and few significant
competitors
 In many such cases, most of the results from this
chapter apply, including:
markup of price over marginal cost
deadweight loss

MONOPOLY 28
CHAPTER SUMMARY

 A monopoly firm is the sole seller in its market.

Monopolies arise due to barriers to entry, including:
government-granted monopolies, the control of a
key resource, or economies of scale over the entire
range of output.
 A monopoly firm faces a downward-sloping
demand curve for its product. As a result, it
must reduce price to sell a larger quantity, which
causes marginal revenue to fall below price.

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CHAPTER SUMMARY

 Monopoly firms maximize profits by producing the

quantity where marginal revenue equals
marginal cost. But since marginal revenue is less
than price, the monopoly price will be greater
than marginal cost, leading to a deadweight loss.
 Monopoly firms (and others with market power)
try to raise their profits by charging higher prices
to consumers with higher willingness to pay.
This practice is called price discrimination.

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CHAPTER SUMMARY

 Policymakers may respond by regulating

monopolies, using antitrust laws to promote
competition, or by taking over the monopoly and
running it. Due to problems with each of these
options, the best option may be to take no action.

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