Monopoly

Karl Robert Jandoc, Ph.D.

UP School of Economics
A market with a monopoly
A monopoly is a market with:
• one seller
• one products with no close substitutes
• strict barriers to entry
• the seller is therefore a price maker, that is,
the seller has market power

Price maker/market power: The firms can influence

market price by increasing or decreasing production.
Sources of barriers to entry

• Government patent or copyright

- exclusive right to sell for a period of time
- sometimes used to encourage research or
creativity
• A single firm owns or controls a key input
- e.g. US Alcoa for aluminum, deBeers for
diamond mines
Sources of barriers to entry

• Natural monopoly
- firm with economies of scale: cheaper for
one firm to produce all quantities
- e.g. electricity transmission lines

CEntry

CM

QEntry QM
Profit maximization for a monopolist

Key idea: The monopoly faces a market demand

curve (which is the firm’s own)
Recall: Firms in a perfectly competitive market
take the price as given (horizontal demand curve)
Revenue of a monopolist
Revenue of a monopolist
For a monopolist,
P>MR (compared
to P=MR in perfect
competition)

• To sell more, a
monopolist
lowers its price
to all quantities
(not just the
marginal
quantity)
• Therefore the
marginal
quantity will
generate lower
marginal revenue
Revenue of a monopolist

7
6
5
4
3
2
1
0
-1 0 1 2 3 4 5 6 7 8 9 10
-2
-3
-4
-5

Demand Marginal Revenue

Revenue of a monopolist
7
6
5
4
3
2
1
0
0 1 2 3 4 5 6 7 8 9 10
-1
-2
-3
-4
-5
Demand Marginal Revenue

Rule of thumb: for a linear demand curve, the MR curve has the
same intercept and twice the slope of the demand curve
Proof:
Demand equation: P = a – bQ
Revenue equation TR = PQ = aQ – bQ2
Marginal Revenue: dTR/dQ = a – 2bQ
Profit maximization for a monopolist

Profit maximization condition: MR = MC

• This condition is the same as the perfect

competitive case
• Logic is the same: if MR>MC, sell one more
unit to increase profit, if MR<MC sell one less
unit to cut losses
• The difference is that the MR curve is
different for a monopolist!
 Profit maximization for a monopolist

Profit maximization condition:

v MR = MC

Price is set at
the demand curve
(which is the
willingness to pay
for the quantity)
Profit maximization for a monopolist

Recall: Profit = Total Revenue (TR) – Total Cost (TC)

!" !&
• Profit = ×% - ×%
# #

• Profit = (AR x Q) – (ATC x Q)

• Profit = (AR – ATC) x Q

• We know that Price equals Average Revenue, i.e., P=AR

• Hence, Profit = (P – ATC) x Q

(P – ATC) is profit per

quantity sold
 Profit maximization for a monopolist

Profit = (P – ATC) x Qv

Monopolist is
earning a
positive profit
Subtle implied differences between
perfect competition and monopoly

(1) The MC curve is not the “supply curve” for a

monopoly
• In perfect competition, a portion of the marginal cost
curve is the supply curve

In a monopoly, the relationship of quantity and price

depends on MR, MC and the demand curve
Subtle implied differences between
perfect competition and monopoly

(2) Because of high barriers to entry, there is no

dynamics in the long run that would lead to zero
economic profit.

Recall: Perfect competition leads to zero economic

profit in the long run because a positive economic
profit induces firms to enter the market.
Welfare under a monopoly
Welfare under monopoly

Price Price
Market Marginal
supply/ cost
Marginal
cost

PM
P*

Demand Marginal Demand

Revenue

Q* Quantity QM Quantity

Competitive Market Monopoly

Because of the monopolist’s market power, QM < Q*

and PM > P*
Welfare under monopoly

With perfect competition:

• Consumer surplus =
A+B+C
• Producer surplus =
A
D+E
B C
E For a monopoly
D • Consumer surplus = A
• Producer surplus =
B+D
• Deadweight Loss =
C+E

Society loses C + E when

monopoly maximizes
profit
Public policy toward monopolies

Because of the deadweight loss, government

sometimes undertake the following:

• Do nothing
- government may exacerbate the problem
(government failure)
• Government takeover
- e.g. PhilPost
Public policy toward monopolies

Because of the deadweight loss, government

sometimes undertake the following:

• Antitrust legislation
- prevent M&A (e.g., Uber and Grab)
- break up companies (AT&T)
• Regulation
- government sets allowable price or
quantity (e.g. MERALCO)
Regulated prices of a natural
monopoly
Is it optimal for the government to mandate natural
monopolies to charge price equal to marginal cost?

Natural monopolies
are characterized Forcing a natural
by high fixed cost monopoly to charge
(e.g. transmission MC will make the
wires), hence
declining ATC
firm unprofitable!
Regulated prices of a natural
monopoly

In the Philippines, regulated prices take the form

of:
• Return on Rate Base (RORB)
-rate is set to allow for “recovery of just
and reasonable costs” (e.g. fixed
investments) and a “reasonable
return”
• Performance-based regulation (PBR)
- based on expenditure forecasts and return
on capital
Price discrimination
Price discrimination

Because of market power, it is possible for a

monopolist to price discriminate

Price discrimination is the ‘practice of selling

the same good at different prices to different
customers

Note that in perfect competition, firms cannot

price discriminate because of price-taking: firms
will lose customers by charging higher prices
Price discrimination

How do firms price discriminate?

• Geography (different selling price in Metro

Manila vs provinces)
• Age (senior citizens discount)
• Day of the week (airline tickets on weekdays)
• Income (discount vouchers, financial aid)
Price discrimination
Illustration: assume no fixed cost, two groups of
consumers. Monopolist does not price discriminate
Price Price
Profit with
only P2
Profit with
only P1
P2

P1 P1
MC = ATC MC = ATC

Marginal Marginal Demand

Revenue Demand Revenue

Q1 Quantity Q2 Quantity

Market with Consumers with Low Market with Consumers with High
Willingness to Pay Willingness to Pay
Price discrimination
Illustration: assume no fixed cost, two groups of
consumers. Monopolist will price discriminate
Price Price
By charging P1 to low WTP
customers and P2 to high WTP
customers, monopolist can get
higher profits!

P2

P1
MC = ATC MC = ATC

Marginal Marginal Demand

Revenue Demand Revenue

Q1 Quantity Q2 Quantity

Market with Consumers with Low Market with Consumers with High
Willingness to Pay Willingness to Pay
Price discrimination

To successfully price discriminate, the firm should

be able to prevent arbitrage.

Arbitrage happens when low WTP (hence, price)

group can sell to high WTP group
Perfect Price discrimination

Perfect price discrimination happens when a

firm can charge each consumer his maximum
willingness to pay
Perfect Price discrimination
(1) Monopolist will charge P1 to highest
WTP consumer, P2 to the second highest
WTP consumer, and so on (2) Because of
perfect price
discrimination, the
additional revenue of
selling one more unit
will be equal to the
P1 WTP of that
P2 consumer, hence MR
P3
is equal to demand
curve (which reflects
WTP)!

= ATC
(3) Hence with
= MR perfect price
discrimination,
profits will be
maximized at the
quantity where MR
(demand) = MC!

(4) This quantity is

similar to the quantity
under perfect competition
Perfect Price discrimination

From a welfare
point of view, there
is no deadweight
P1
P2
loss with perfect
P3 price discrimination!

Total surplus is
= ATC
maximized.

Problem is,
= MR
consumer surplus is
also equal to zero.

All surplus goes to

the monopolist