Lecture Seventeen: Monopolies and How They Arise
November 29, 2011
What is a Monopoly?
A monopoly is a market
- That producers a good or service for which no close substitute exists
- In which there is one supplier that is protected from competition by a barrier
preventing the entry of new firms
How a Monopoly Arises
Two Key Features
- No close substitutes
- Barriers to entry
No Close Substitutes
If a good has a close substitute, even if it is produce by only one firm, that firm
effectively faces competition from the producers of the substitute.
A monopoly sells a good that has no close substitutes
Barriers to Entry
A barrier to entry is a constraint that protects a firm from potential competitors
are called barriers to entry.
There are three types of barriers to entry
-Natural: the fixed costs are so high that it deters other companies from
entering the market
-Ownership: a company has a special good or service that is difficult to
-Legal: a legal reason, such as a patent or a copyright
A natural monopoly is an industry in which economies of scale enable one firm
to supply the entire market at the lowest possible cost.
In a natural monopoly, economies of scale are so powerful that they are even
being achieve when the entire market demand is met. Ownership Barriers to Entry
An ownership barrier to entry occurs if one firm owns a significant portion of a
Legal Barriers to Entry
Legal barriers to entry create a legal monopoly.
A legal monopoly is a market in which competition and entry are restricted by
the granting of a
- Public franchise (Canada Post distributing the mail)
- Government license or grant (Being a lawyer or doctor, the barrier would be the
education required and the passing of certain exams)
- Patent or copyright
Monopoly Price-Setting Strategies
For a monopoly firm to determine the quantity it sells, it must choose the
appropriate price. There are two types of monopoly price setting strategies.
A single price monopoly is a firm that must sell each unit of its output for the
same price to all its customers.
Price discrimination is the practice of selling different units of a good or service
for different prices. Many firms price discriminate, but not all of them are
Single-Price Monopoly’s Output and Price Decision
Price and Marginal Revenue
A monopoly is a price setter, not a price taker like a firm in perfect competition.
The reason is that the demand for the monopoly’s output is the market demand.
- To sell a larger output, a monopoly must set a lower price.
Total Revenue (TR) is the Price (P), multiplied by the Quantity sold (Q).
Marginal revenue (MR) is the change in total revenue that results from a one-
unit increase in the quantity sold. For a single-price monopoly, marginal revenue is less than price at each level
of output. That is, MR < P
Marginal Revenue and Elasticity
A single-price monopoly’s marginal revenue is related to the elasticity of demand
for its good:
-If demand is elastic, a fall in price brings an increase in total revenue
- If the increase in revenue from the increase in quantity sold outweighs the
decrease in revenue from the lower price per unit, then MR is positive
- As the price falls, total revenue increases
If demand is inelastic, a fall in price brings a decrease in total revenue
- If the rise in revenue from the increase in quantity sold is outweighed by the fall
in revenue from the lower price per unit, then MR is negative
If demand is unit elastic, a fall in price does not change total revenue.
- If the rise in revenue from the increase in quantity sold equals the fall in
revenue from the lower price per unit, then MR = 0
- Total revenue is maximized when MR = 0
In Monopoly, Demand is Always Elastic
A single-price monopoly never produces an output at which demand is
If it did produce such an output, the firm could increase total revenue, decrease
total revenue, decrease total cost, and increase economic profit by decreasing
Price and Output Decision
The monopoly faces the same types of technology constraints as the competitive
firm, but the monopoly faces a different market constraint
The monopoly selects the profit-maximizing quantity in the same manner as
a competitive firm, where MR = MC.
The monopoly sets its price at the highest level at which it can sell the profit-
The ATC Curve shows the average total cost. Economic profit is the profit per unit multiplied by the quantity produced.
The monopoly might make an economic profit, even in the long run, because the
barriers to entry protect the firm from market entry by competitor firms.
A monopoly that incurs an economic loss might shut down temporarily in the
short run or exit the market in the long run.
Equilibrium occurs where the quantity demanded equals the quantity supplied
at quantity Qc and price Pc.
Equilibrium output, Qm, occurs where marginal revenue equals marginal cost.
Equilibrium price, Pm, occurs on the demand curve at the profit-maximizing
Compared to perfect competition, monopoly produces a smaller output and
charges a higher price.
Consumer surplus is the area below the demand curve and above the price.
Producer surplus is the area below the price and above the supply curve
Total surplus, the sum of the two surpluses, is maximized and the quantity
produced is efficient.
Inefficiency of a monopoly - price exceeds marginal social cost, marginal
social benefit exceeds marginal social cost and a deadweight loss arises.
Redistribution of Surpluses