BM1709

MONOPOLY
The Monopoly Market
Advantages of Monopolies
 Avoids duplication and wastage of resources. If there is only one (1) business creating a
certain product, production costs for that industry will be low. Therefore, resources can
be used efficiently to make only one (1) product.
 Economies of scale. Economies of scale refer to savings in cost when there is an
increase in production. As the monopolistic firm creates more products, it will save more
in terms of production costs. Recall from the previous lesson that the ideal price of a
product is equal to its average cost. The lower the average cost, the lower the prices
would be.
 Research and development. Since monopolies are the only source of a particular product,
their demand is high. To maintain this level of demand, monopolies set aside a certain
part of their income to develop methods and maintain their status.
 Price discriminations. Since monopolies encompass many types of market, they are able to
offer discounts to groups such as students and other lower-income earners.
 Monopolies are a source of revenue for the government. The government charges a certain
rate of income tax from business firms. Since monopolies have high profits, it follows that the
income tax that the government gets from them is also high.

Disadvantages of Monopolies
 Poor level of service. There is a lot of demand that monopolies must respond to. Since they
have limits on their human resources, the level of service may not be as ideal as those of
competitive markets.
 High prices. Consumers may be charged high prices for the low quality of goods and
services. Recall that monopolies have the power to set and control prices. Therefore, even if
the customers would protest, since they are the only one who can provide the product or
service, the customers are forced to pay anyway.
 Poor quality. Lack of competition may result to poor quality. Although some monopolies use
their profits to develop their products, there are other monopolies who do not bother with
this effort, since they will always have customers whether their products are of good
quality or not.

Types of Monopolies
 Government-Created Monopolies
o This is a form of monopoly where a government grants an exclusive privilege to a
private individual or a firm to be the sole provider of a good or service. Potential
competitors are excluded from the market by laws or regulations. Kings, for example,
once granted exclusive business licenses to their friends and allies.
The patent and copyright laws are two (2) important examples of how government
creates a monopoly to serve the public interest. When a pharmaceutical company
discovers a new drug, it can apply to the government for a patent. If the government
deems the drug to be truly original, it approves the patent, which gives the company
the exclusive right to manufacture and sell the drug for a certain number of years.

09 Handout 1 *Property of STI

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  Natural Monopolies
o An industry is a natural monopoly when a single firm can supply a good or service to an
entire market at a lower cost than two (2) or more firms could. An example of a
natural monopoly is the distribution of water. To provide water to residents of a
town, a firm must build a network of pipes throughout the town. If two (2) or more
firms were to compete in the provisions of this service, each firm would have to pay
the fixed cost of building a network. Thus, the average total cost of water is lowest if
a single firm serves the entire market.
o When a firm is a natural monopoly, it is less concerned about new entrants affecting
its monopoly power. Normally, a firm has trouble maintaining a monopoly position
without ownership of a key resource or protection from the government. The
monopolist’s profit attracts entrants into the market, and these entrants make the
market more competitive.
o By contrast, entering a market in which another firm has a natural monopoly is
unattractive. Would-be entrants know that they cannot achieve the same low cost
that the monopolist enjoys because, after entry, each firm would have a smaller
piece of the market.

Demand Curves for Competitive Firms and Monopolies

 In profit maximization by competitive firms, the demand can be drawn in a horizontal line.
Because a competitive firm can sell as much or as little as it wants at this price, the
competitive firm faces a horizontal demand curve. In effect, because the competitive firm
sells a product with many perfect substitutes, the demand curve that any firm faces is
perfectly elastic. This means that in a perfectly competitive market, buyer demand remains
unaffected because there are many substitutes for the product. Even if a firm would raise
prices, the market’s demand would still remain the same because buyers would simply
go to other producers of the same product.
 By contrast, because a monopoly is the sole producer in its market, the demand goes
down as quantity produced goes up.
 The market demand curve provides a constraint on a monopoly’s ability to profit from its
market power. A monopolist would prefer, if it were possible, to charge a high price and
sell a large quantity at that high price. The market demand curve makes that outcome
impossible. In particular, the market demand curve describes the combinations of price
and quantity that are available to a monopoly firm. By adjusting the quantity produced
(or equivalently, the price charged), the monopolist can choose any point on the demand
curve, but it cannot choose a point off the demand curve.
 For a competitive firm, P = MR. Every unit that the firm sells, it sells at the going market
price. The competitive firm is a small part of the overall market, and its behavior has no
effect on the overall market price. So the incremental or marginal revenue for each new
unit sold is simply the price. For a monopolist, however, the monopolist is the market. If
the firm decides to double its output, the market output will double. The only way the firm
will be able to sell more is to lower its price.
*P – Price, MR – Marginal Revenue

A Monopoly’s Revenue
 Marginal revenue for monopolies is very different from marginal revenue for competitive
firms. When a monopoly increases the amount it sells, it has two (2) effects on total
revenue. Total revenue can be expressed as price multiplied by quantity (P x Q).
o The output effect: More output is sold, so Q is higher.
o The price effect: To sell more, the price must decrease, so P is lower.
  Monopolies have higher marginal costs compared to competitive markets because their
product is unique and would therefore require materials or supplies that are not readily
available in the market.
 A monopoly does not have a supply curve. In a monopoly, the firm is the only supplier of the
good, so it has the freedom to set how much it would supply at the same time that it
chooses the price of its goods. Instead, the average cost curve is used to analyze how a
monopoly maximizes its profit.
 The demand curve shows how the quantity affects the price of the good. The marginal
revenue curve shows how the firm’s revenue changes when the quantity increases by one
(1) unit. When a monopoly increases production by one (1) unit, it must reduce the price it
charges for every unit it sells, and this cut in price reduces revenue on the units it was
already selling. As a result, a monopoly’s marginal revenue is less than its price.
 If the monopolist firm produces at a quantity where marginal cost (MC) is less than
marginal revenue (MR), the firm can still increase profit by producing more units.
 A similar thing happens if MC > MR. If the firm produces at this quantity, the costs of
producing an additional unit exceed the additional revenue from selling the unit.
Therefore, the firm will be able to raise profit by reducing production.
 In the end, the firm will adjust its level of production until the quantity reaches the point
where MC = MR.
 A monopoly maximizes profit by choosing the quantity at which MR = MC.
 Recall that competitive firms also choose the quantity of output at which marginal revenue
equals marginal cost. In following this rule for profit maximization, competitive firms and
monopolies are alike. But there is also an important difference between these types of
firms -- the marginal revenue of a monopoly is less than its price. That is:
o For a competitive firm: P = MR = MC
o For a monopoly firm: P > MR = MC

Inefficiency in Pricing for Monopolies

 A social planner cares not only about the profit earned by the firm’s owners but also
about the benefits received by the firm’s consumers. The planner tries to maximize total
surplus, which equals producer surplus plus consumer surplus. It wants the price where
demand and average total cost intersect.
 A monopolist, on the other hand, would want to charge a price where MR = MC, and
corresponds to the demand.
A deadweight loss occurs when the supply and demand are not in equilibrium. A
monopolist charges a price above the marginal cost, so not all consumers who value the
good at more than its cost will buy it. The deadweight loss is represented by the area of
the triangle between the demand curve (which reflects the value of the good to the
consumers) and the marginal cost curve (which reflects the costs of the monopoly
producer).
Managing Monopolies
 Making Monopolized Industries More Competitive
o If two (2) big companies in the same industry were to merge, the deal would be
closely examined by the government before it went into effect. The government
authorities may decide that a merger between these two (2) large companies
would make the market substantially less competitive and, as a result, would reduce
the economic well-being of the country as a whole.
If so, the government would challenge the merger in court, and if the judge
agreed, the two companies would not be allowed to merge.

 Regulating the Behavior of Monopolies

o This solution is common in the case of natural monopolies, such as water and
electric companies. These companies are not allowed to charge any price they
want. Instead, government agencies regulate their prices.
o What price should the government set for a natural monopoly? Regulators can
respond to this problem in various ways, each with corresponding drawbacks.
 Subsidizing the monopolist – In essence, the government picks up the
losses inherent in marginal-cost pricing. Yet to pay for the subsidy, the
government needs to raise money through taxation.
 Allowing the monopolist to charge a price higher than marginal cost – If
the regulated price equals average total cost, the monopolist earns
exactly zero economic profit. Yet average-cost pricing leads to deadweight
losses because the monopolist’s price no longer reflects the marginal cost
of producing the good.

 Turning Private Monopolies into Public Enterprises

o Rather than regulating a natural monopoly that is run by a private firm, the
government can run the monopoly itself. This solution is common in many European
countries, where the government owns and operates utilities such as telephone,
water, and electric companies.

 Doing Nothing
o Each of the foregoing policies aimed at reducing the problem of monopoly has
drawbacks. As a result, some economists argue that it is often best for the
government not to try to remedy the inefficiencies of monopoly pricing.
o Determining the proper role of the government in the economy requires judgments
about politics as well as economics.
Price Discrimination
Three (3) Kinds of Price Discrimination
 First-Degree Price Discrimination
o It means that the monopolist sells different units of output for different prices and
these prices may differ from person to person. This is sometimes known as the case
of perfect price discrimination. Bidding for goods is a practice that shows perfect
price discrimination.
o In monopolies, the price is ideally the point where marginal costs and demand
would intersect. However, in perfect price discrimination, there are consumers
who would be willing to go beyond this price, creating a surplus in profit for the
monopoly firm. The price that the consumer chooses to pay in a first-degree price
discrimination system is called the reservation price.
o A producer who is able to perfectly price discriminate will sell each unit of the
good at the highest price it will command, that is, at each consumer’s reservation
price. Since each unit is sold to each consumer at his or her reservation price for
that unit, there is no consumers’ surplus generated in this market; the entire
surplus goes to the producer.
o The triangular shaded area indicates the producer’s surplus accruing to the
monopolist. Since the producer gets the entire surplus in the market, it wants to
make sure that the surplus is as large as possible. Put another way, the
producer’s goal is to maximize its profits (producer’s surplus) subject to the
constraint that the consumers are just willing to purchase the good.

 Second-Degree Price Discrimination

o It means that the monopolist sells different units of output for different prices, but
every individual who buys the same amount of the good pays the same price. Thus,
prices differ across the units of the good, but not across people. The most common
example of this is bulk discounts.
o Second-degree price discrimination is also known as the case of non-linear pricing
since it means that the price per unit of output is not constant but depends on
how much you buy. In perfect price discrimination, the firm knows exactly how
much a customer is willing to pay. In second and third-degree price
discriminations, the firm has no way of knowing this information. Furthermore,
since there are many buyers in the market, the monopoly firm must be able to
distinguish those buyers who are willing to buy more compared to those who only
want less of the product.
o As the graph shows, there are different “blocks” or price ranges that a customer
can choose from. Those who have brought the highest quantity would pay the
highest price. However, the monopolist can offer bulk discounts, which also
correspond to the quantity bought.

 Third-Degree Price Discrimination

o It occurs when the monopolist sells output to different people for different prices,
but every unit of output sold to a given person sells for the same price. This is
the most common form of price discrimination, and examples include senior citizens’
discounts, student discounts, and so on.
o The main issue in this kind of price discrimination would be how the monopolist
decides on the optimal price to charge for each market.
 o Market 1 would correspond to the normal consumers of the monopoly, or those
who are willing to pay without a discount. Their demand curves are steeper. Market 2
represents those people who are more affected by prices of the products.
Therefore, their demand curve is flatter, or more elastic than Market 1.
o Note that the market with the higher price must have the lower elasticity of
demand. Upon reflection, this is quite sensible. An elastic demand is a price-
sensitive demand. A firm that price discriminates will therefore set a low price for
the price-sensitive group and a high price for the group that is relatively price
insensitive. In this way, it maximizes its overall profits.

REFERENCES:
Bade, R., & Parkin, M. (2015). Foundations of Microeconomics, Seventh Edition. Upper Saddle River:
Pearson Education Inc.

Case, K. E., Fair, R. C., & Oster , S. E. (2017). Principles of Microeconomics, Twelfth edition. Harlow:
Pearson Education Limited.

Mankiw, N. G. (2015). Principles of Microeconomics. Stamford: Cengage Learning.