Pure Monopoly
chapter 9
Pure Monopoly
CHAPTER OVERVIEW
This chapter is divided into six basic sections: the characteristics of pure monopoly; the barriers to entry that create and protect monopolies; price and output determination under monopoly; the economic effects of monopoly; price discrimination under monopoly; and the regulation of monopolies.
The discussion of barriers to entry states at the outset that these barriers may occur to some extent in any form of imperfect competition, not just in a pure monopoly. The concept of a natural monopoly is addressed in this section.
Building on the analysis of the preceding chapter, the discussion of price‑output decision making by monopoly firms points out that the marginal-revenue—marginal-cost rule still applies. Emphasis here is on the major difference between the determination of marginal revenue in pure competition and in pure monopoly. The misconceptions about monopoly pricing behaviour are presented as well as a comparison of efficiency in pure competition and pure monopoly. This section ends with a discussion of effects of monopoly power in the Canadian economy and some policy alternatives.
The case of price discrimination and its effects are discussed along with the conditions necessary for it to occur. At the end of the chapter, the basic issues involved in the regulation of public service monopolies are reviewed.
WHAT’S NEW
The theoretical material remains intact, but the examples have been revised, especially as they pertain to developments in the Microsoft legal battles.
A “Consider This” box on price discrimination has been added. It appeared previously in the “Analogies, Anecdotes, and Insights” section of the website.
A new section on monopoly and deadweight loss has been added
A new end-of-chapter question on price discrimination has been added.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to understand:
1. The conditions required for pure monopoly to arise.
2. About profit-maximizing price and output in pure monopoly.
3. About economic effects of monopoly.
4. Why a monopolist prefers to charge different prices in different markets.
5. The choices facing governments that regulate monopolies.
6. About the deadweight loss associated with monopoly.
COMMENTS AND TEACHING SUGGESTIONS
1. Ask students to list products that they believe are provided by a “pure” monopoly, or at least by firms with a high degree of monopoly power. Then ask them to list substitutes for the products sold by each of these “monopolies.” Demonstrate how the relative “closeness” of the substitutes they listed determines, to a large degree, effective limits to the monopoly power of these firms.
2. Review what is meant by a firm versus the industry in pure competition and compare this with pure monopoly where the firm is the industry.
3. In addition to the example of patents discussed in the text, note how licenses, product safety requirements, zoning laws, environmental impact statements, price controls, etc.—all of which are enforced by various levels of government—can serve as barriers to entry in different situations.
4. Stress that the price-output decision is an either-or-decision, i.e., the monopolist can sell one unit at $162 or two units at $152. Ask how much of an increase in total revenue will occur if the second unit (one unit) is sold for $152: answer $152. Now ask how much total revenue will decrease if the price of the first unit is decreased from $162 to $152.
5. The ability to engage in price discrimination is based on differing price elasticities and demand among customers. There are many good examples given in this chapter. Telephone service, air travel, and electricity are all sold at various prices taking into account the customer’s sensitivity to price. The more substitutes available to the buyer, the more elastic the demand. This is a good opportunity to review price elasticity and demonstrate the many applications of this measure.
6. Electrical utilities and telephone service were regulated monopolies for many years. Deregulation in both industries is a topic worthy of class discussion and student research. In addition to the basic dilemma facing regulators of natural monopolies covered in the text, discuss problems that result when regulators are not well‑intentioned and attempt to maximize their own gains from such an elected or appointed position. The difficulty in finding impartial, yet knowledgeable, people to serve on regulatory commissions is a good topic for discussion, especially if there are any related issues affecting your community, such as an environmental or consumer group that may be challenging a ruling by a regulatory commission
7. The Last Word in this chapter highlights the fact that monopolies do not necessarily last forever.
STUDENT STUMBLING BLOCK
In Chapter 8 the students learned that firms operating in a purely competitive setting equate marginal revenue to price. Now students learn that marginal revenue under imperfect competition is less than price. Students seem to grasp this initially, but because they first learned the identity of marginal revenue and price in a competitive setting, it is sometimes hard to unlearn that when analyzing other market structures. Some instructors avoid this problem by teaching the imperfect competition models first. Students learn to equate marginal revenue and marginal cost in seeking the profit-maximizing output level. Then they can use this rule in studying pure competition and treat the equality of price and marginal revenue as a special case. If you choose to present the material with Chapter 9 coming before Chapter 8, discuss the models in Table 8-1 before assigning this chapter on the monopoly model.
LECTURE NOTES
I. Pure Monopoly: An Introduction
A. Definition: Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes.
B. There are a number of products where the producers have a substantial amount of monopoly power and are called “near” monopolies.
C. There are several characteristics that distinguish pure monopoly.
1. There is a single seller so the firm and industry are synonymous.
2. There are no close substitutes for the firm’s product.
3. The firm is a “price maker,” that is, the firm has considerable control over the price because it can control the quantity supplied.
4. Entry into the industry by other firms is blocked.
5. A monopolist may or may not engage in nonprice competition. Depending on the nature of its product, a monopolist may advertise to increase demand.
D. Examples of pure monopolies and “near monopolies”:
1. Public utilities—gas, electric, water, cable TV, and local telephone service companies—are pure monopolies.
2. The DeBeers diamond syndicate is an example of a “near” monopoly. (See Last Word.)
3. Manufacturing monopolies are virtually nonexistent in nationwide Canadian manufacturing industries.
4. Professional sports leagues grant team monopolies to cities.
5. Monopolies may be geographic. A small town may have only one airline, bank, etc.
E. Analysis of monopolies yields insights concerning monopolistic competition and oligopoly, the more common types of market situations.
II. Barriers to Entry Limiting Competition
A. Economies of scale constitute one major barrier. This occurs where the lowest unit costs and, therefore, lowest unit prices for consumers depend on the existence of a small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale.
1. Public utilities are known as natural monopolies because they have economies of scale in the extreme case where one firm is most efficient in satisfying existing demand.
2. Government usually gives one firm the right to operate a public utility industry in exchange for government regulation of its power.
3. The explanation of why more than one firm would be inefficient involves the description of the maze of pipes or wires that would result if there were competition among water companies, electric utility companies, etc.
B. Legal barriers to entry into a monopolistic industry also exist in the form of patents and licenses.
1. Patents grant the inventor the exclusive right to produce or license a product for seventeen years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits.
2. Licenses are another form of entry barrier. Radio and TV stations, taxi companies are examples of government granting licenses where only one or a few firms are allowed to offer the service.
C. Ownership or control of essential resources is another barrier to entry.
1. International Nickel Co. of Canada controlled about 90 percent of the world’s nickel reserves, and DeBeers of South Africa controls most of world’s diamond supplies.
2. Aluminum Co. of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication.
3. Professional sports leagues control player contracts and leases on major city stadiums.
D. Monopolists may use pricing or other strategic barriers such as selective price-cutting and advertising.
III. Monopoly demand is the industry (market) demand and is therefore downward sloping.
A. Our analysis of monopoly demand makes three assumptions:
1. The monopoly is secured by patents, economies of scale, or resource ownership.
2. The firm is not regulated by any unit of government.
3. The firm is a single‑price monopolist; it charges the same price for all units of output.
B. Price will exceed marginal revenue because the monopolist must lower the price to sell the additional unit. The added revenue will be the price of the last unit less the sum of the price cuts which must be taken on all prior units of output (Table 9-1 and Figure 9-2).
1. Figure 9-3 shows the relationship between demand, marginal-revenue, and total‑revenue curves.
2. The marginal-revenue curve is below the demand curve, and when it becomes negative, the total-revenue curve turns downward as total-revenue falls.
C. The monopolist is a price maker. The firm controls output and price but is not free of market forces, since the combination of output and price that can be sold depends on demand. For example, Table 9-1 shows that at $162 only 1 unit will be sold, at $152 only 2 units will be sold, etc.
D. Price elasticity also plays a role in monopoly price setting. The total revenue test shows that the monopolist will avoid the inelastic segment of its demand schedule. As long as demand is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true when demand becomes inelastic. At this point, total revenue falls as output expands, and since total costs rise with output, profits will decline as demand becomes inelastic. Therefore, the monopolist will expand output only in the elastic portion of its demand curve. (Key Question 4)
IV. Output and Price Determination
A. Cost data is based on hiring resources in competitive markets, so the cost data of Chapters 8 and 9 can be used in this chapter as well. The costs in Table 9-1 restate the data of Table 8-2.
B. The MR = MC rule will tell the monopolist where to find its profit‑maximizing output level. This can be seen in Table 9-1 and Figure 9-4. The same outcome can be determined by comparing total revenue and total costs incurred at each level of production. (Key Question 5)
C. The pure monopolist has no supply curve because there is no unique relationship between price and quantity supplied. The price and quantity supplied will always depend on location of the demand curve.
D. There are several misconceptions about monopoly prices.
1. Monopolist cannot charge the highest price it can get, because it will maximize profits where total revenue minus total cost is greatest. This depends on quantity sold as well as on price and will never be the highest price possible.
2. Total, not unit, profits is the goal of the monopolist. Table 9-1 has an example of this, in which unit profits are $32 at 4 units of output compared with $28 at the profit‑maximizing output of 5 units. Once again, quantity must be considered as well as unit profit.
3. Unlike the purely competitive firm, the pure monopolist can continue to receive economic profits in the long run. Although losses can occur in a pure monopoly in the short run (P>AVC), the less-than-profitable monopolist will shutdown in the long run (P>ATC). Figure 9-5 shows a short‑run loss situation for a monopoly firm.
V. Evaluation of the Economic Effects of a Monopoly
A. Price, output, and efficiency of resource allocation should be considered.
1. Monopolies will sell a smaller output and charge a higher price than would competitive producers selling in the same market, i.e., assuming similar costs.
2. Monopoly price will exceed marginal cost, because it exceeds marginal revenue and the monopolist produces where marginal revenue and marginal cost are equal. The monopolist charges the price that consumers will pay for that output level.
3. Allocative efficiency is not achieved because price (what product is worth to consumers) is above marginal cost (opportunity cost of product). Ideally, output should expand to a level where price = marginal revenue = marginal cost, but this will occur only under pure competitive conditions where price = marginal revenue. (See Figure 9-6)
4. Productive efficiency is not achieved because the monopolist’s output is less than the output at which average total cost is at a minimum.
B. Income distribution is more unequal than it would be under a more competitive situation. The effect of the monopoly power is to transfer income from the consumers to the business owners. This will result in a redistribution of income in favour of higher-income business owners, unless the buyers of monopoly products are wealthier than the monopoly owners.
C. Cost complications may lead to other conclusions.
1. Economies of scale may result in one or two firms operating in an industry experiencing lower ATC than many competitive firms. These economies of scale may be the result of spreading large initial capital cost over a large number of units of output (natural monopoly) or, more recently, spreading product development costs over units of output, and a greater specialization of inputs.
2. X‑inefficiency may occur in monopoly since there is no competitive pressure to produce at the minimum possible costs.
3. Rent‑seeking behaviour often occurs as monopolies seek to acquire or maintain government‑granted monopoly privileges. Such rent‑seeking may entail substantial costs (lobbying, legal fees, public relations advertising, etc.), which are inefficient.
D. Technological progress and dynamic efficiency may occur in some monopolistic industries but not in others. The evidence is mixed.