Economics 2 Emmanuel Saez

Fall 2024

LECTURE 8
Monopoly and Market Power
I. INTRODUCTION TO MARKET FAILURES
 Overview
• So far we have been talking about well-functioning
markets (rationality, competition, no external effects).
• In this case, the market outcome maximizes the
total surplus (=efficiency)

• Now we are going to think about market failures

(when markets don’t function well).
• Will show that market outcomes in these cases
do not maximize the total surplus.
• Government intervention can make things
better (reduce the deadweight loss).
Markets function well under key assumptions
• Economic agents are rational: firms maximize
profits, people maximize their own utility

• Perfect competition: firms and consumers are

price takers

• No externalities: economic activity does not

create external harm
Markets function well under key assumptions
• Economic agents are rational: firms maximize
profits, people maximize utility

• Perfect competition: firms and consumers are

price takers

Monopoly: perfect competition assumption fails

• No externalities: economic activity does not

create external harm
 Monopoly
• There is only one producer of a good

• Most goods are specific to a brand/company

where monopoly reasoning applies:
– Only Apple makes and sells I-phones or Macbooks

– Monopoly power stronger when there are no close

substitutes

• The monopoly chooses the price to maximize

profits and taking into account that demand falls
with the price
 Natural monopoly
• A natural monopoly is a situation in which one single
producer can supply the whole market at a lower average
cost than multiple firms
• Marginal cost pretty low so efficient to price low; fixed
costs high so efficient pricing cannot recoup fix costs.
Examples:
– utility companies like PG&E (gas and electricity)
– Railways
– Software, digital books/news/music (zero marginal cost)
• Facebook, rideshare (UBER/Lyft) also natural monopolies
as value increases with larger customer base.
 Barriers to Entry
• A barrier to entry is any force that prevents firms
from entering a market.

• Main types of barriers to entry:

• High fixed costs (railway construction)
• Patents and other legal protections (medical
drugs)
• Anti-competitive practices (sink/buy
competitors)
II. PROFIT MAXIMIZATION FOR A MONOPOLIST
 Monopoly Profit Maximization
• Monopoly is the only producer of the good (e.g.
Apple I-Phone)

• Monopoly faces a demand curve D(P) that

decreases with P (from consumers’ choices)

• Monopoly has a curve of marginal cost of

production MC

• Monopoly chooses the price P that maximizes its

profits: Profits = P × Q - C(Q) with Q=D(P)
 Profit Maximization for a Monopolist
P

MC
Consumer
Surplus

P*
Profits

Q* Q
P*,Q* is the competitive efficient equilibrium but
monopolist can choose any point along demand curve
 Profit Maximization for a Monopolist
P

MC
Consumer
Surplus
P1
P* Profits

Q1 Q
Increasing P above P* increases monopoly’s profit
 Profit Maximization for a Monopolist
P

Consumer MC
Surplus
P1
P* Profits

Q1 Q
Increasing P above P* increases monopoly’s profit
until red area is maximized
 Profit Maximization for a Monopolist
P

Consumer
Surplus
MC
P1
P* Profits

Q1 Q
Increasing P above P* increases monopoly’s profit
until red area is maximized
 Profit Maximization for a Monopolist
P

Deadweight loss
Consumer MC
Surplus
P1 •
P* Profits

Q1 Q
Monopoly squeezes consumer surplus (inequitable) and
creates deadweight loss (inefficient)
 Quiz:
Question: Why is monopoly bad relative to perfect
competition?

• A. Because it reduces quantity produced

• B. Because it creates deadweight loss

• C. Because it increases profits at the expense of

consumers

• D. Because of all A, B, C.
 Monopolist with elastic demand
P

Deadweight loss
Consumer MC
Surplus

P1 •
Profits
D

Q1 Q
Monopoly distortion is small when demand is very elastic
When demand is perfectly elastic, we are back to competitive model
 With infinitely elastic demand:
Monopoly is equivalent to perfect competition
P
No Deadweight loss
No Consumer MC
Surplus

P1 •
Profits D

Q1 Q
Monopoly distortion is small when demand is very elastic
When demand is perfectly elastic, we are back to competitive model
 Implications of Monopoly
• A monopoly doesn’t take the price as given.
– However, monopoly is constrained by demand curve.

• A monopoly produces below where MC = P.

– This reduces consumer surplus and increases profits
(inequitable)

– This also creates deadweight loss (inefficient)

• If demand is inelastic, monopoly distortion is large

– Monopoly with close substitutes (where demand is very
elastic) is not as bad (e.g. Android vs. I-phone)
 Mathematics of Monopoly
• Monopolist chooses P to maximize:
Profits = P × D(P)-C(D(P))

• Profits are maximized when derivative of profits

with respect to P is zero:

D(P)+P × D’(P)-C’(D(P)) × D’(P)=0

D(P)+(P-MC) × D’(P)=0 with MC=C’(D(P))

1=-D’(P)/D(P) × (P-MC) > 0 => P>MC

1= -εD × (P-MC)/P => P>MC

 Example of Monopoly Maximization
• D(P)=a – b × P [and D(P)=0 if P>=a/b]

• C(Q)=d × Q => MC=d

• Profits = P × D(P)-C(D(P))=P ×(a-b × P)-d ×(a-b × P)

=-d × a+(a +d × b) × P-b × P2

• Profits maximized when dProfits/dP=0 =>

a +d × b -2b × P=0

P = (a +d × b)/(2b) =a/(2b)+d/2

• Note that P<a/b implies that P<d=MC

V. LONG-RUN PROFIT MAXIMIZATION
FOR A MONOPOLIST
 Profit Maximization for a Monopolist
P

Deadweight loss
Consumer MC
Surplus
P1 •
Profits

Q1 Q
Red area represents profits before the fixed costs of production
are paid. Final profits = red area - fixed cost of production
 How Does a Monopolist Respond to Profits?
• Graphical analysis ignored fixed costs. Fixed costs
need to be deducted from red profit area in figure
(but don’t change price choice analysis)

• If fixed costs higher than profits red area:

monopolist makes negative profits and the
monopolist will want to leave the industry.

• If fixed costs smaller than red area profits, the

monopolist makes positive economic profits in the
long run, and positive profits are sustainable [as
no competitors can enter by definition]
 Barriers to entry
• The monopolist can make positive profit, but
unlike the perfectly competitive case with
identical firms it can sustain them in the long run

• This is because of the barriers to entry

• In the competitive industry, profits attracts new

entrants
– This expands industry supply and so drives down the
price and the profit of producers
 Quiz:
Question: Look at the shoes you are wearing. Were
they produced and sold in:

• A. Perfect competition

• B. Monopolistic competition

• C. Oligopoly

• D. Monopoly
 Effect of Advertisement for a Monopolist

P2 Consumer • MC
Surplus
P1 •
Profits
D2
D

Q1 Q2 Q
Advertisement to drive up demand only makes sense with
monopolistic competition (not perfect competition)
 Quiz:
Question: Suppose Apple ads for the new I-Phone 16 shift
up the demand curve. This increases Apple profits but also
the consumer surplus people get from the new I-phone 16.
Is this good for consumers?

• A. Yes, more people learn about how great the new I-

phone 16 is

• B. Yes, people feel more special about getting it.

• C. Uncertain, it shifts demand from Samsung to Apple

• D. No, people get manipulated into buying

• E. A, B, C, or D could each be true for different people

VI. GOVERNMENT RESPONSES TO MONOPOLY
 Monopoly in the real world
• With monopoly, consumers lose, producers gain
but by less (deadweight loss)

• But bigger producers can sometimes operate at

lower costs which may mean win-win for
producers and consumers if the cost savings are
shared.

• So how do we identify market power?

– Look at market shares of biggest firms in industry

• What can and should we do about it?

FIGURE 2.

U.S. Market Share by Firm, Selected Markets

Ask Other Other TNT Motorola HTC
100
AOL/
Sprint Other Other Other
Yahoo
DHL
Other
U.S. market share (percent)

80 Dish
Microsoft T-Mobile Reddit
Network
Twitter

60 UPS Charter Samsung United

Spectrum YouTube
AT&T
Delta
40
DirecTV
Google
Apple Southwest
20 FedEx Facebook
Verizon
Comcast
American

0
Search Wireless Delivery Pay TV Smartphones Social Airlines
engines carriers services media
Market
Source: comScore 2018a, 2018b (search engines and smartphones); FierceWireless 2018 (wireless carriers); DHL 2018 (delivery services); Informitv
2018 (Pay TV); MarketingCharts 2016 (social media); Bureau of Transportation Statistics 2018a (airlines). All accessed via Statista.com.
Note: Social media shows the share of all visits; smartphones and wireless carriers show the share of subscribers; airlines show the share of domestic
revenue passenger miles. Data for social media are for November 2016; data for search engines, wireless carriers, and pay TV are for December 2017;
data for delivery services are for 2017 for both North and South America; data for smartphones and airlines are for January 2018. The delivery firm TNT
is a subsidiary of FedEx.

10 The State of Competition and Dynamism: Facts about Concentration, Start-Ups, and Related Policies

Many US industries are heavily concentrated (data from 2017-8)

 Policies to Deal with Monopoly
• Antitrust laws – laws designed to promote
competition and prevent monopolization:
– 2024 judgement: Google has an illegal monopoly on
search

– 2024 lawsuit: VISA stifled competition in debit cards

• Regulations that range from pricing regulations

(US local utilities for water, electricity, gas) all the
way to nationalization (government owns and
controls monopoly: US postal service)

• Limits on patents and other legal protections.

 Trade-off innovation vs. competition
• Innovating and inventing new products is costly. High
fixed costs of invention and low marginal costs of
production (e.g. drug industry)

• Innovation costs are recouped by future profits when

invention is successful

• Future profits are eroded by competition if new

product can be replicated/reverse engineered by
competitors

• Most countries protect innovations by granting time

limited monopoly power through intellectual
property: patents for inventions, copyrights for
authors, trademarks for brands
Drug Humira provides treatment against pain from arthritis.
Pfizer Covid vaccine surpassed Humira in 2022 for profits.
 Patents and Innovation
• Considerable amount of innovation happens outside
patent system (secret innovations in firms, publicly funded
research)

• Difficult to evaluate empirically if more generous patent

protections fosters innovation

• Easier to find examples where firms strategically use

patent protections (e.g., patent more when protections
become more generous)

• Some evidence that patents hinder follow-on innovation

(Williams 2003)

• In the long-run, growth driven by innovations that are in

the public domain for anybody to use
 Sequencing of Human Genome: Private vs. Public

Genes sequenced by Celera with Intellectual Property led to

reductions in later scientific research and product development by
20–30 percent relative to Genes sequenced in the public domain.
Source is Williams 2003
 Historical Context
• Industrial revolution of 1800s: many industries (railroads,
shipping, oil, etc.) consolidated into monopolies

• US Gilded Age (late 1800s): monopolized industry and

wealth concentration (Robber Barons) squeezing
customers, workers, buying competitors and politicians.

• US developed antitrust laws in early 1900s: successful at

dismantling monopolies of the Gilded Age. Utilities (water,
electricity, gas, telecom, airlines) were regulated

• Since late 1970s, wave of deregulation (e.g., telecom and

airlines). Resurgence of monopoly power in new utilities
such as cable/broadband and new tech sectors.
Robber Barons illustration: Standard Oil became the US monopoly of
oil industry making owner John D. Rockefeller immensely wealthy.
Was broken in 1911 into many companies through antitrust.
 New Gilded Age
• Today: large tech companies have redeveloped
monopoly power (GAFAM: Google, Amazon,
Facebook, Apple, Microsoft)

• Apple brand gives it market power, Microsoft has

monopoly on operating system of PCs

• Google, Facebook don’t charge users but make

money by charging advertisers on platform.
Network effect leads to monopoly power

• Amazon doesn’t squeeze consumers (yet) but

squeezes suppliers to increase consumer base.
262 T. Piketty et al.

Top .00001% = top 20

wealthiest Americans today

Fig. 3 The Top .00001% Wealth Share in the US using Rich Lists. This figure depicts the share of total
household wealth owned by the richest .00001% US families using the Forbes 400 Rich list for 1982–2021, the
1957 Fortune magazine Rich list, and the Forbes rich list for 1918 (aged back to 1913 using overall US equity
prices and using John D. Rockefeller estimated wealth of $900 million in 1913). The top .0001% includes 3.8
families in 1913, and 18 families today. The denominator is total US household wealth from Piketty et al. (2018)

Source:
Zucman Piketty,
(2019) Saez,that
estimate andtheZucman (2022)is regressive in 2018 above the top .01% and
US tax system
 Current Debate on Antitrust Policy
• Consumer welfare standard has come to dominate US
antitrust thinking since late 1970s (law&economics)

• As long as price is low and consumer is not harmed, no

concern for industry concentration per-se

• Has allowed new monopolies to rise: Walmart, Amazon,

Google, Facebook, etc.

• New monopolies develop market share by pricing low and

staying dominant by acquiring potential competitors (e.g.
Facebook bought Instagram and WhatsApp)

• European Union and US under Biden (Lina Kahn at FTC)

have become tougher in antitrust in recent years
 Quiz:
Question: What is your view about GAFAM: Google,
Amazon, Facebook, Apple, Microsoft:

• A. They provide great new products at low cost

• B. It’s great for the US to have such dominant

companies

• C. I am concerned that they are too dominant in

their industry and stifle innovation

• D. I am concerned that they have too much power

to influence society

• E. All of A, B, C, D
 Monopoly Sum-up
• Businesses make more profits if they have
monopoly power and hence have strong
incentives to become monopolists.

• Historically, even industries with standard

products (e.g. oil with Standard oil) become
monopolized. Perfect competition is rare.

• Requires constant vigilance from governments to

regulate monopoly power.

• Analogous to how a democracies can devolve into

tyrannies when rulers concentrate power
 References
• CORE-The Economy, Unit 7.

• Principles of Economics, Chapter 8.