CHAPTER 25



CHAPTER 25

MONOPOLY

CHAPTER OVERVIEW

In this chapter monopoly is defined and its causes and implications are discussed. Various possible barriers to entry are identified and examined in this process. Another objective is to differentiate between the monopolist's demand curve and that of the perfect competitor's. Because the monopolist's demand curve is downward sloping, it follows that the monopolist's marginal revenue curve lies below its average revenue (demand) curve. The major implication of the relationship between the demand and marginal revenue curves for profit maximization and output determination under monopoly conditions is examined. The relationship between total revenue and price elasticity of demand is again explored, along with their impact on the profit-maximizing rate of output for the monopolist. An analysis of price discrimination is presented. Finally, the social costs of monopoly are discussed.

CHAPTER OBJECTIVES

After studying this chapter students should be able to

1. Identify situations that can give rise to monopoly.

2. Describe the demand and marginal revenue conditions a monopolist faces.

3. Discuss how a monopolist determines how much output to produce and what price to charge.

4. Evaluate the profits earned by a monopolist.

5. Understand price discrimination.

6. Explain the social cost of monopolies.

CHAPTER OUTLINE

I. DEFINITION OF A MONOPOLIST: A single supplier that comprises its entire industry for a good or service for which there is no close substitute.

II. BARRIERS TO ENTRY: For any amount of monopoly power to continue to exist in the long-run, the market must be closed to entry in some way. Either legal means or certain aspects of the industry's technical or cost structure may prevent entry.

A. Ownership of Resources Without Close Substitutes: If one firm owns the entire supply of raw material input that is essential to production of a particular commodity, then that ownership serves as a barrier to entry until an alternative source of raw material input is found or an alternative technology not requiring the raw material in question is developed.

B. Problems in Raising Adequate Capital: Certain industries require a large initial capital investment. Firms already in the industry can, according to some economists, obtain monopoly profits in the long run because no competitors can raise the large amount of capital needed to enter the industry.

C. Economies of Scale: When economies of scale exist firms with larger output have lower average costs that enable them to charge a lower price and drive smaller firms out of business. A natural monopoly arises when there are large economies of scale relative to the industry's demand, and one firm can produce at a lower average cost than can be achieved by multiple firms.

D. Legal or Governmental Restrictions:

1. Licenses, Franchises and Certificates of Convenience: In many industries it is illegal to enter without a government license, or certificate of convenience and public necessity. Since franchises or licenses are restricted, long-run monopoly profits might be earned by firms already in the industry.

2. Patents: A patent is issued to an inventor to provide protection from having the invention copied or stolen for a period of 17 years. The patent holder has a monopoly.

3. Tariffs: Tariffs are special taxes that are imposed on certain imported goods. If tariffs are high enough, imports become overpriced and domestic producers gain monopoly advantage as the only suppliers.

4. Regulation: Government regulation has increased in the interest of safety and quality. Large expenditures have been necessary by certain industries to comply. Large fixed costs spread over a larger number of units of output by larger firms can put smaller firms at a competitive disadvantage. This can deter entry of new firms into an industry.

E. Cartels: An association of producers in an industry that agree to set common prices and output quotas to prevent competition.

III. THE DEMAND CURVE A MONOPOLIST FACES: The monopolist faces the market demand curve because the monopolist is the industry.

A. Profit to be made from Increasing Production: Firms may benefit by changing production rates.

1. Marginal Revenue for the Perfect Competitor: Marginal revenue is the change in total revenue due to a one-unit change in the quantity produced and sold. In the case of a competitive industry, each time a firm changes production by one unit total revenue changes by the going price.

2. Marginal Revenue for the Monopolist: Since a monopolist is the entire industry, the monopoly firm's demand curve is the market demand curve. In order to sell more of a product given the market demand curve, the monopolist must lower the price. If all buyers are charged the same price, the monopolist must lower the price of all units sold in order to sell more.

B. The Monopolist's Marginal Revenue: Less than Price: For the monopolist, marginal revenue is always less than price. To understand why, let sales increase by one unit due to a reduction in the price. Price times the last unit sold is not the addition to total revenues received from selling that last unit, because price had to be reduced on all previous units sold in order to sell the larger quantity.

IV. ELASTICITY AND MONOPOLY: The price elasticity of demand for the monopolist depends on the number and similarity of imperfect substitutes. The more numerous and more similar are these imperfect substitutes, the greater the price elasticity of demand of the monopolist's demand curve. The monopolist faces a downward-sloping demand curve. This means that it cannot charge just any price with no changes in sales because, depending on the price charged, a different quantity will be demanded.

V. COSTS AND MONOPOLY PROFIT MAXIMIZATION: The pure monopolist, and the perfect competitor, both seek a profit-maximizing price and output combination. The monopolist is a price searcher, i.e. a firm that, because it faces a downward sloping demand curve, must determine the price-output combination that maximizes profit. The profit-maximizing price-output combination can be determined by looking at total revenues and total costs, or by looking at marginal revenues and marginal costs.

A. Total Revenue-Total Costs Approach: Profit maximization involves maximizing the positive difference between total revenues and total costs. For any given demand curve, in order to sell more, the monopolist must lower the price.

B. Marginal Revenue-Marginal Cost Approach: Profit maximization occurs where marginal revenue equal marginal cost. This is true for a monopolist as it is for a perfect competitor, but the monopolist will charge a higher price.

1. Why Produce Where Marginal Revenue Equals Marginal Costs?: If the monopolist goes past the point where marginal revenue equals marginal cost, marginal cost will exceed marginal revenue and the incremental cost of producing any more units will exceed the incremental revenue. By reducing production, costs fall by more than revenues and profits rise. If the monopolist produces less than the output where marginal revenue equals marginal cost, it can increase output, revenues will increase by more than costs, and profits will rise.

C. What Price to Charge for Output?: The basic procedure for finding the profit-maximizing short-run price-quantity combination is first to determine the profit-maximizing rate of output by the marginal revenue-marginal cost method. Then, by use of the demand curve, determine the maximum price that can be charged to sell the profit maximizing output.

VI. CALCULATING MONOPOLY PROFIT: The monopolist is maximizing profits where marginal cost equals marginal revenue. If the monopolist produces less than that, it will be forfeiting some profits. If it produces more than that, it will be forfeiting some profits.

A. No Guarantee of Profits: The mere existence of a monopoly does not guarantee high profits. If the average total cost curve lies everywhere above the demand curve, then there is no price output combination that will allow the monopolist even to cover costs.

VII. ON MAKING HIGHER PROFITS: PRICE DISCRIMINATION: Price discrimination is selling a given product at more than one price, with the price difference being unrelated to cost difference. Price discrimination is different from price differentiation in which price differences reflect differences in the marginal cost of providing the good to different groups of buyers.

A. Necessary Conditions for Price Discrimination:

1. The firm must have some market power; it must not be a price taker. It must face a downward-sloping demand curve.

2. The firm must be able to distinguish markets at a reasonable cost.

3. The buyers in the various markets must have different price elasticities of demand.

4. The firm must be able to prevent resale of the product or service.

VIII. THE SOCIAL COST OF MONOPOLIES: The monopolist will charge a higher price and produce a lower output than will a perfectly competitive industry, assuming the same cost structure. Also, P > MC for the monopolist compared to P = MC for a competitive industry.

SELECTED REFERENCES

Brozen, Yale, "Is Government the Source of Monopoly?" The Intercollegiate Review, Winter 1968-69.

"Are U.S. Manufacturing Markets Monopolized?" Is Government the Source of Monopoly?, The Cato Institute, 1979.

The Competitive Economy, Morristown, NJ: General Learning Press, 1975.

Coase, R.H., "Durability and Monopoly," Journal of Law and Economics, Vol. XV, No. 1, April 1972, pp. 143-149.

Hicks, J.R., "The Theory of Monopoly," Econometrics, Vol. 3, 1935, pp. 1-20, rep. in American Economic Association, Readings in Price Theory, Homewood, IL: Irwin, 1952.

Liebeler, Wesley J., "Market Power and Competitive Superiority in Concentrated Industries," UCLA Law Review 25, 1978.

Mansfield, Edwin, Monopoly Power and Economic Performance, 3rd ed., New York: Norton, 1974.

Miller, Roger LeRoy and Roger Meiners, Intermediate Microeconomics: Theory, Issues, and Applications, 4th ed., New York: McGraw Hill, 1987.

Stigler, George J., "The Tactics of Economic Reform," Selected papers of the Graduate School of Business, University of Chicago, No. 13, 1970.

"The Economists and the Problem of Monopoly," American Economic Review, Vol. 72, May 1982, pp. 1-11.

Wenders, John, "Entry and Monopoly Pricing," Journal of Political Economy, October 1967, pp. 755-760.

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