Eco205 Chapter 11 – Monopoly 13th January 2013
Causes of Monopoly
Barriers to entry are the source of all monopoly power. There are two general types of barriers to entry: technical
barriers and legal barriers.
Technical Barriers to Entry
Barriers to entry - Factors that prevent new firms from entering a market
Large-scale firms are more efficient than small ones.
Once a monopoly has been established, entry by other firms is difficult because any new firm must produce at low levels
of output and therefore at high average costs. Because this barrier to entry arises naturally as a result of the technology
of production, the monopoly created is sometimes called a natural monopoly
Natural monopoly - A firm that exhibits diminishing average cost over a broad range of output levels.
Another technical basis of monopoly is special knowledge of a low-cost method of production. In this case, the problem
for the monopoly firm fearing entry by other firms is to keep this technique uniquely to itself. When matters of
technology are involved, this may be extremely difficult, unless the technology can be protected by a patent. Ownership
of unique resources (mineral deposits or land locations) or the possession of unique managerial talents may also be a
lasting basis for maintaining a monopoly.
Legal Barriers to Entry
An example of a legally created monopoly is the awarding of an exclusive franchise or license to serve a market. These
are awarded in cases of public utility (gas and electric) services, communication services, the post office, some airline
routes, some television and radio station markets, and a variety of other businesses
The restrictions on entry into certain industries are needed to ensure adequate quality standards (licensing of
physicians, for example) or to prevent environmental harm
In other cases, the restrictions act mainly to limit the competition faced by existing firms and seem to make little
A profit-maximizing monopoly will choose to produce that output level for which MR = MC. Because the monopoly faces
a downward-sloping demand curve for its product, the MR < P (market price). To sell an additional unit, the monopoly
must lower its price on all units to be sold in order to generate the extra demand necessary to find a taker for this
marginal unit. In equating marginal revenue to marginal cost, the monopoly produces an output level for which price
exceeds marginal cost. This feature of monopoly pricing is the primary reason for the negative effect of monopoly on
resource allocation. Monopoly Supply Curve
The monopolist bases its supply decision on marginal revenue rather than demand directly, and marginal revenue
depends on the shape of the demand curve (both the slope of the demand curve as well as its level). Therefore, in the
monopoly case, we refer to the firm’s supply ‘‘decision’’
rather than supply ‘‘curve”
Profits are positive when market price exceeds average total
cost. Since no entry is possible into a monopoly market,
these profits can exist even in the long run.
For this reason, some authors call the profits that a
monopolist earns in the long run monopoly rents. These
profits can be regarded as a return to the factor that forms
the basis of the monopoly (such as a patent). Some other
owner might be willing to pay that amount in rent for the right to operate the monopoly and obtain its profits. The huge
prices paid for television stations or baseball franchises reflect the capitalized values of such rents
What’s wrong with Monopoly?
First, monopolies produce too little output; and second, the high prices they charge end up redistributing wealth from
consumers to the ‘‘fat cat’’ firm owners.
> A perfectly competitive industry would produce output level Q* at a price of P*. A monopolist would opt for Q** at a
price of P**. Consumer expenditures and productive inputs worth AEQ*Q** are reallocated into the production of other
goods. Consumer surplus equal to P**BAP* is transferred into monopoly profits. There is a deadweight loss given by
It has been assumed that the monopoly produces under conditions of constant marginal cost and that the competitive
industry also exhibits constant costs with the same minimum long-run average cost as the monopolist. The market at
Q* is produced at a price of P*. The total value of this output to consumers is given by the area under the demand curve
(by area FEQ*0), for which they pay P*EQ*0. Consumer surplus is given by the difference between these two areas (the
triangle FEP*). A monopoly would choose output level Q**, for which marginal revenue equals marginal cost. Consumer
surplus is FBP**, and consumer spending on the monopoly good is P**BQ**0.
The loss of consumer surplus given by the area BEA is an unambiguous reduction in welfare as a result of the monopoly.
Redistribution from Consumers to the Firm
If the market is a monopoly, that portion of consumer surplus is transferred into monopoly profits. The area P**BAP*
does not necessarily represent a loss of social welfare. It does measure the redistribution effects of a monopoly from
consumers to the firm, and these may or may not be undesirable However, profits from a monopoly may not always to go the wealthy
Because perfectly competitive firms earn no economic profits in the long run, a firm with a monopoly position in a
market can earn higher profits than if the market is competitive.
It is the ability of monopolies to raise price above marginal cost that reflects their monopoly power. Because profitability
reflects the difference between price and average cost, profits are not necessarily a definite consequence of monopoly
Buying a Monopoly Position
Monopoly profits, after all, provide a tantalizing target for firms, and they may spend real resources to achieve those
profits. They may adopt extensive advertising campaigns or invest in ways to erect barriers to entry against other firms
and hence obtain monopoly profits.
A monopoly sells all its output at one price. The firm was assumed to be unwilling or unable to adopt different prices for
different buyers of its product. There are two consequences of such a policy. First, the monopoly must forsake some
transactions that would in fact be mutually beneficial if they could be conducted at a lower price. Second, although the
monopoly does succeed in transferring a portion of consumer surplus into monopoly profits, it still leaves some
consumer surplus to those individuals who value the output more highly than the price that the monopolist charges. The
existence of both of these areas of untapped opportunities suggests that a monopoly has the possibility of increasing its
profits even more by practicing price discrimination—by selling its output at different prices to different buyers.
Price discrimination - Selling identical units of output at different prices
Perfect Price Discrimination
Perfect price Discrimination – is selling each unit of output
for the highest price obtainable. Extracts all of the
consumer surplus available in a given market
One way for a monopoly to practice price
discrimination is to sell each unit of its output for the
maximum amount that buyers are willing to pay for that
Under this scheme, a monopoly would sell the first unit of
its output at a price slightly below F, the second unit at a
slightly lower price, and so forth. When the firm has the ability to sell one unit at a time in this way, there is no reason
now to stop at output level Q**. Because it can sell the next unit at a price only slightly below P** (which still exceeds
marginal and average cost by a considerable margin), it might as well do so. Indeed, the firm will continue to sell its output one unit at a time until it reaches output level Q*. For output levels greater than Q*, the price that buyers are
willing to pay falls below marginal cost; hence, these sales would not be profitable.
The result of this perfect price discrimination scheme is the firm’s receiving total revenues of 0FEQ*, incurring total costs
of 0P*EQ*, and, therefore, obtaining total monopoly profits given by area P*FE.
In this case, the entire consumer surplus available in the market has been transferred into monopoly profits. Consumers
have had all the ex