Chapter 10

PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
Monopoly
CHAPTER
1© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What Is a Monopoly?
• Monopoly
–A market in which only one firm sells a
product with no close substitutes
–The single firm that sells in that market
• “No close substitutes”
–Deciding whether a market or firm is a
monopoly
• Depends on the how easy it is for consumers
to substitute the products of other sellers
2
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as

How Monopolies Arise
• Barriers to entry
–Something causing other firms to stay out
of the market
• Rather than enter and compete with firms
already there
–Economies of scale
–Legal barriers
–Network externalities
3

Economies of scale
• Economies of scale
–Firm’s long-run average cost curve slopes
downward
• The more output the firm produces, the lower
will be its cost per unit
• Natural monopoly
–Arises due to economies of scale
• A single firm can produce for the entire market
at lower cost than could two or more firms
4

Figure
Cost per unit would be even higher with three firms (each operating at point C). Since a single
firm could produce at lower cost than two or more firms, this market tends naturally toward
monopoly.
A Natural Monopoly
5
1
Dollars
Articles of Clothing
per Day
LRATC
$15
12
5
A
C
B
100 150 300
In the figure, the typical
firm has an LRATC curve
as shown, with
economies of scale
through an output level of
300, which is assumed to
be the maximum market
quantity. A single firm
could serve the market at
a cost of $5 per unit,
operating at point A. Two
firms splitting this market
would each produce 150
units, with each
operating at point B on
its LRATC curve. Cost
per unit would be $12,
higher than with just one
firm.

Legal Barriers
• Legal barriers
–Protection of intellectual property
• Literary, artistic, and musical works, as well as
scientific inventions
• For a limited period of time
– Enjoy a monopoly and earn economic profit
• Patents
• Copyright
–Government franchise
6

Legal Barriers
• Patents
–A temporary grant of monopoly rights over
a new product or scientific discovery
–20 years
• Copyright
–A grant of exclusive rights to sell a literary,
musical, or artistic work
–At least 70 years
7

Table
Largest Patent Infringement Awards
8
1

Legal Barriers
• Government franchise
–A government-granted right to be the sole
seller of a product or service
–Any other firm that enters the market will
be prosecuted
–The U.S. Postal Service
9

Legal Barriers
• Governments grant franchises
–When they think the market is a natural
monopoly
–To serve the public interest by ensuring
that there are no competitors that would
cause cost per unit to rise
–The seller must submit to either
government ownership and control or
government regulation over its prices and
profits
10

Network externalities
• Network externalities
–Additional benefits enjoyed by all users of
a good or service because others use it as
well
–Joining a large network is more beneficial
than joining a small network
–Market for computer operating systems
–Social networking sites
11

Monopoly Behavior
• Goal of a monopoly
–To earn the highest profit possible
• A monopolist faces constraints
–Production costs constraints
• Technology
• Prices of inputs
–Price constraints
• Faces a given market demand curve
• Tradeoff: the more it charges for its product,
the fewer units it will be able to sell
12

Monopoly Behavior
• Single-price monopoly
–A monopoly firm that is limited to charging
the same price for each unit of output sold
• Price discrimination
–Charging different prices to different
consumers
• Based on differences in the prices consumers
are willing to pay
13

Monopoly Behavior
• Monopoly pricing OR output decision
–One decision
–Once the firm determines its output level, it
has also determined its price
–Once the firm determines its price, it has
also determined its output level
–Downward-sloping demand curve
• The lower the price, the higher the quantity
14

Table
Demand and Revenue at Patty’s Pool
15
2

Figure
When a firm faces a
downward-sloping
demand curve, marginal
revenue (MR) is less than
price, and the MR curve
lies below the demand
curve. For example,
moving from point A to
point B, output rises from
3 to 4 units, while price
falls from $10 to $9. For
this move, total revenue
rises from $30 to $36, so
marginal revenue (plotted
at point C) is only $6—
less than the new price of
$9.
Demand and Marginal Revenue for Patty’s Pool
16
2
Dollars
Quantity
9654321 87
13
0
1
2
3
-2
-1
9
8
7
6
5
4
10
11
12
Demand
MR
B
A
C

Monopoly Behavior
• Downward-sloping demand curve
–Marginal revenue is less than the price of
output
–Marginal revenue curve lies below the
demand curve
• Profit maximization
–Produce the quantity where MC = MR and
the MC curve crosses the MR curve from
below
–The price is found on the demand curve
17

Figure
Like any firm, the monopolist
maximizes profit by producing where
MC equals MR. Here, that quantity is
50 thousand units. The price charged
($100) is read off the demand curve. It
is the highest price at which the
monopolist can sell the profit-
maximizing level of output.
Monopoly Price and Output Determination
18
3
Dollars
Thousands of Subscribers
Serviced per Month
$100
50
D1
MR1
E
MC

Monopoly Behavior
• Monopoly
–A firm with market power; a price setter
• Market power
–The ability of a seller to raise price without
losing all demand for the product being
sold
• Price setter
–A firm (with market power) that selects its
price rather than accepting the market
price as a given
19

Figure
The monopoly in this figure is
earning a profit. At the profit
maximizing output level (50
thousand), profit per unit is equal
to the difference between price
($100) and ATC ($70). Total
profit is equal to profit per unit
multiplied by the number of
units, or $30 × 50,000 =
$1,500,000, represented by the
blue shaded rectangle.
A Monopoly Earning Profit
20
4
Dollars
Serviced per Month
D1
MC
Total Profit
MR1
ATC
50
$100
$70
E

Monopoly Behavior
• Profit per unit = P – ATC
• A monopoly earns a profit
–Whenever P > ATC
• Total profit at the best output level
–The area of a rectangle
• Height = distance between P and ATC
• Width = level of output
21

Figure
A Monopoly Suffering a Loss
22
5
The monopoly in this figure is
suffering a loss. At the profit
maximizing output level (50
thousand), the loss per unit is
equal to the difference between
price ($100) and ATC ($125).
The total loss is equal to loss per
unit multiplied by the number of
units, or $25 × 50,000 =
$1,250,000, represented by the
pink shaded rectangle.
Dollars
Serviced per Month
D1
MC
Total Loss
MR1
ATC
50
$100
$125
E
AVC

Monopoly Behavior
• Loss per unit = ATC – P
• A monopoly suffers a loss
–Whenever P < ATC
• Total loss at the best output level
–The area of a rectangle
• Height = distance between ATC and P
• Width = level of output
23

Equilibrium in Monopoly Markets
• Equilibrium
–When the only firm in the market, the
monopoly firm, is maximizing its profit
• Short run equilibrium
–At the output level where MR = MC
• Profit, if P > ATC
• Loss, if P < ATC
• Shut down, if P < AVC
24

• The shutdown rule
–Should accurately predict the behavior of
most privately owned and operated
monopolies
–If a monopoly operates under a
government franchise or regulation
• And produces a vital service
• The government may not allow it to shut down
25

• Long run equilibrium
–Monopolies may earn economic profit
–A privately owned, unregulated monopoly
• Suffering an economic loss in the long run
• Will exit the industry
26

• Comparing monopoly to perfect
competition
–All else equal
–A monopoly market will have a higher
price and lower output than a perfectly
competitive market
27

Figure
Comparing Monopoly and Perfect Competition (a, b)
28
6
Price
per
unit
Quantity of output
(a) Competitive market
Dollars
per
unit
Quantity of output
(b) Competitive firm
$10 d=MR
ATC
MC
1,000
E
$10
S
D
100,000
E
1. In this competitive market of 100
firms, equilibrium price is $10 . . .
2. and each firm
produces 1,000
units, where P=MC.
3. When a monopoly takes over, the old market supply curve . . .

Figure
Comparing Monopoly and Perfect Competition (c)
29
6
Price
per
unit
Quantity
of output
(c) Monopoly
$10
MC
D
100,000
E
4. becomes the
monopoly's MC curve.
MR
60,000
F
$15
5. The monopoly produces
where MR=MC,
6. with a higher
price and lower
market output than
under perfect
competition

• An important proviso
–Comparing monopoly and perfect
competition
• Price is higher and output is lower under
monopoly
• If all else is equal
30

• Monopolization of a competitive industry
leads to two opposing effects
–Higher prices and lower output
• For any given technology of production
–Lower prices and higher output
• Because of changes in technology of
production
–Ultimate effect on price and quantity
depends on which effect is stronger
31

• Government and monopoly profit
–Monopolies often exist with government
permission
–Monopoly’s total profit may be less than
that predicted by the analysis
• Government regulation
• Rent-seeking activity
32

• Government regulation (government
franchise)
–The monopoly must accept government
regulation, often including the requirement
that it submit its prices to a public
commission for approval
–Keeps economic profit at zero
33

• Rent-seeking activity
–Any costly action a firm undertakes to
establish or maintain its monopoly status
–Time and money spent lobbying legislators
and the public for favorable policies
• Reduce a monopoly’s profit
• Economic rent
–Any earnings beyond the minimum needed
in order for a good or service to be
produced
34

What Happens When Things Change?
• An increase in demand, a monopolist will:
–Produce more output
–Charge a higher price
–Earn a larger profit
• A decrease in demand, a monopolist will:
–Reduce output
–Charge a lower price
–Earn a smaller profit
35

Figure
Panel (a) shows Zillion-Channel in equilibrium. It is providing 50 thousand units of cable TV service at
a price of $100 per month. Panel (b) shows the same firm following an increase in demand from D1 to
D2. With the increased demand, MR is higher at each level of output. In the new equilibrium, Zillion-
Channel is charging a higher price ($125), providing more TV service (75 thousand units), and earning
a larger profit.
A Change in Demand
36
7
Dollars
Thousands of Subscribers Serviced per Month
$100
D1
MR1
E
MC
50
(a) Dollars
Thousands of
Subscribers
Serviced per Month
$100
D1
MR1
E
MC
50
(b)
D2
MR2
75
F
$125

What Happens When Things Change?
• A cost-saving technological advance
–A monopoly will pass to consumers only
part of the benefits from a cost-saving
technological change
–Monopoly’s profits will be higher
• Costs increase
–A monopoly will pass only part of a cost
increase on to consumers in the form of a
higher price
–Monopoly’s profits will be lower
37

Figure
A cost-saving technological
advance shifts the monopolist’s
marginal cost curve down, from
MC1 to MC2. Consumers gain
because the price falls, but the
drop in price is less than the
drop in marginal cost. The
monopoly gains because its
profit is greater.
A Cost-Saving Technological Change
38
8
Dollars
Serviced per Month
$90
MC1
D1
MR1
50
E
$100
MC2
60
H

Price Discrimination
• Price discrimination
–Charging different prices to different
customers for reasons other than
differences in cost
• But a price-discriminating monopoly
–Divides its customers into different
categories based on their willingness to
pay for the good
39

• Requirements
–Market power
• Downward-sloping demand curve
• Price setter
–Identifying willingness to pay
• Difficult
–Prevention of resale
• More difficult for goods
40

• Effects of price discrimination
–Firm: higher profits
–Higher price for some consumers
• Above the price they would pay under a
single-price policy
–Lower price for some consumers
• Below the price they would pay under a
single-price policy
41

Figure
Panel (a) shows a single-price monopolist, selling 30 dolls per day at $25 each and earning a
profit of $450 per day, as shown by the blue shaded rectangle.
Two Kinds of Price Discrimination (a)
42
9
Dollars
per
Doll
Number of
Dolls per Day
DMR
MC=ATC$10
30
$25

Figure
In panel (b), she price discriminates by charging a higher price of $35 for 10 dolls per day, while
still charging $25 for the remaining 20 dolls. Profit increases by $100 per day, the area of the
dark-shaded rectangle.
Two Kinds of Price Discrimination (b)
43
9
Dollars
per
Doll
Number of
Dolls per Day
D
MC=ATC$10
10
MR
30
$25
$35

Figure
Panel (c) shows a different type of price discrimination: charging the original $25 on the first 30
dolls, and a lower price on just 10 additional dolls, bringing her total output to 40. Compared to
panel (a), her profit in panel (c) rises by $100 per day—the area of the dark-shaded rectangle.
Two Kinds of Price Discrimination (c)
44
9
Dollars
per
Doll
Number of
Dolls per Day
D
MC=ATC$10
$25
40
MR
30
$20

• Perfect price discrimination
–Charging each customer the most he or
she would be willing to pay for each unit
purchased
–Marginal revenue = price of the additional
unit sold
• Firm’s MR curve is the same as its demand
curve
–Higher profit
• At the expense of consumers
45

Figure
The single-price monopolist sells 30 dolls per day at $25 each. With a constant ATC of $10, she
earns a profit of $450 per day, as shown by the blue rectangle in panel (a). However, if she can
charge each customer the maximum the customer is willing to pay, shown by the height of the
demand curve, then her MR curve is the demand curve she faces. In panel (b), she would sell
60 dolls ,where MC = P at point J. Her profit would increase to the area of triangle HBJ.
Perfect Price Discrimination
46
10
Dollars
per
Doll
Number of Dolls
per Day
Dollars
per
Doll
Number of Dolls
per Day
D
MC=ATC$10
MR
E
30
$25
MR curve before
price discrimination
MC=ATC
$10
30
$25
D and MR
60
MR curve with
perfect price
discrimination
B
H
J
(a) Single price (b) Perfect price discrimination

• A price discriminating firm
–Facing separate market demand curves in
different markets (A, B, C, etc. . .)
–Should choose its prices and output levels
–So that marginal revenue in each market is
equal to its marginal cost of production:
MRA = MRB = MRC = . . . = MC
47

Figure
No-Choice Airlines is able to separate travelers into two different types: Business travelers in panel (a)
and students in panel (b). In each market, it sells the profit-maximizing number of tickets at which
marginal revenue is equal to marginal cost, and it charges the price on the demand curve for that number
of tickets. Because the demand curves are different, so are the marginal revenue curves, so price and
output will differ in each market. In panel (a), for business travelers, MR = MC at 50 tickets, and No-
Choice charges $140. In panel (b), for students, MR = MC at 60 tickets, and No-Choice charges $70.
How a Price-Discriminating Monopoly Sets Prices in Multiple Markets
48
11
Dollars
per
Ticket
Number of Round
Trip Tickets
(b) StudentsDollars
per
Ticket
Number of Round
Trip Tickets
(a) Business Travelers
D
MC$40
MR
E
50
$140
A
MC$40
MR
60
$70
D
$200
20
F

• Price discrimination in everyday life
–It can be practiced by any firm that
satisfies the three requirements
–Mail-in rebates
–Coupons
–Sales
–College tuition
49

Why Americans Pay for the
World’s Pharmaceuticals
• Pharmaceutical industry
–We want new and better drugs
• Help cure or manage more diseases
• Fewer side effects
–We also want drugs to be inexpensive
• Total research and development (R&D)
cost
–For each marketable new drug
–Is in the hundreds of millions of dollars
50

• New drugs are costly to develop
• More than 10 years to get a profitable drug to
market
• A fraction of those that make it most of the
way down the road are deemed safe and
effective enough to get government approval
for sale
• Incentives for the industry
–Internationally recognized patents to the
companies that discover new drugs
51

• United States funds the bulk of world’s
R&D expenditures for new drugs
–Only Americans pay the higher monopoly
price for the new drugs
• Directly pay full price (without health
insurance)
• Indirectly
– Higher premiums charged by insurance
companies
– Higher tax payments to cover government-
supported medical care
52

• Those outside the U.S.
–Pay the much lower prices
• Their governments negotiate with the
pharmaceutical companies
1. How has this lopsided pricing system
come about?
2. What are the consequences?
3. Will it continue?
53

Pfycor’s New Drug
• Pfycor, Inc.
–Holds the patent on a new drug
–Two markets drug: the U.S. and Europe
–Assumptions
• Identical demand curves
• MC = ATC = constant
–Can price discriminate
–Maximize profits: MRUS = MREUROPE = MC
• Same price in each market
54

Figure
The two panels illustrate the situation for a monopoly selling a drug in two markets with identical demand
curves: The U.S. in panel (a), and Europe in panel (b). In each market, the monopoly sells the profit-maximizing
output level at which marginal revenue is equal to marginal cost, and charges a price given by the demand
curve at that output level. With identical demand and marginal revenue curves in the U.S. and Europe, the
monopoly will sell the same output (70 million doses) and charge the same price ($2.25 per dose) in each
market. Production cost is $0.50 per dose, so total revenue exceeds production cost by ($2.25 − $0.50) × 70
million = $122.5 million in each market (the area of the blue shaded rectangles), for a total of $245 million.
Monopoly Pricing in Two Identical Markets
55
12
Dollars
per
Dose
Millions of Doses per Year
(b) EuropeDollars
per
Dose
(a) U.S.
DUS
MC$0.50 MC$0.50
$2.25
DEUROPE
MR
70
$2.25
A B
MR
70

Asymmetrical Pricing from
Government Bargaining
• In developed countries
–Pharmaceutical companies must negotiate
a price with the government
• Governments: strong bargaining position
–Can refuse access to their markets entirely
–As long as the price is greater than the
production cost, the firm will still want to
sell the drug in their country
56

• Pharmaceutical companies: some
bargaining power
–If it refuses to sell at a low price, European
patients will not be able to get the drug
• Unless they buy it in the U.S. market at the
high monopoly price
57

• U.S.
–Monopoly pricing (higher price)
• Europe
–Lower bargained price (slightly above
production cost)
–Lower profit
58

Figure
As in the previous figure, a monopolist sells a drug in the United States in panel (a), and Europe in panel (b), and
both markets have the same demand and marginal revenue curves. But in panel (b), European governments
negotiate a lower price per dose of $0.75. Additional revenue from each dose sold in Europe is now $0.75, so that
is the new (constant) marginal revenue in Europe. With marginal revenue greater than production cost, the
monopoly will sell all that Europeans will buy at $0.75 per dose, which is 130 million doses. Production cost is still
$0.50 per dose, so in Europe, total revenue exceeds production cost by ($0.75 − $0.50) × 130 million = $32.5
million. Meanwhile, in panel (a) for the U.S., nothing has changed, so price remains at $2.25. In the U.S., total
revenue continues to exceed production cost by ($2.25 − $0.50) × 70 million = $122.5 million. Europe now
contributes less to R&D expenses and profit ($32.5 million) than does the U.S. ($122.5 million).
Monopoly Pricing with Bargaining in One Market
59
13
Dollars
per
Dose
(b) Europe
Dollars
per
Dose
(a) U.S.
DUS
MC$0.50 MC$0.50
$2.25
DEUROPE
MR
70
$2.25
A B
MR
70
$0.75
E
130

• Will Pfycor continue to develop new
drugs?
–Yes . . . If the profit earned from both
markets is enough to cover Pfycor’s
expected R&D expenses
• And provide sufficient profit to compensate its
owners for risking their funds
60

• Consequences for Americans
–Americans pay disproportionately to
develop them
• Both Americans and Europeans enjoy the
benefits of new drugs
–Pfycor will choose not to develop some
new drugs with especially high R&D costs
61

Threats to Asymmetrical Pricing
• U.S. consumers
–Purchase medications from other countries
over the Internet
• At prices substantially below U.S. prices
• Parallel trade
–The resale of a product to consumers in
another a country without the
manufacturer’s consent
62

Threats to Asymmetrical Pricing
• U.S. legislators
–Want to force down U.S. drug prices
–Like to repeal the 1987 law that prohibits
importing pharmaceuticals from other
countries without the manufacturer’s
consent
–Want to empower Medicare to negotiate
lower drug prices
• Medicaid and the Department of Veteran’s
Affairs can negotiate drug prices
63

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