Unit 5: Monopoly
5.1: Single-price monopoly
A monopoly is a market where there is only one seller of some good or service that has no close substitutes. Although General Mills is the only seller of Cheerios, this does not constitute a monopoly since there are other cereals that are a close substitute for Cheerios. On the other hand, water service at your house is a monopoly because the public utility company is your only choice, and there is no reasonable substitute for having a water hookup at your house.
Sources of Monopoly
There are several reasons that monopolies might arise.
• Exclusive control of key inputs: At one time, De Beers owned nearly all the world’s diamond mines and, as a result, maintained a near monopoly in diamond sales.
• Patent and copyright laws: A patent on a product gives the patent-holder exclusive rights to sell the product. Patents are granted by the government for a limited time to allow an inventor sole rights to sell his invention.
• Government franchises: In some states, alcohol is available only in state-owned liquor stores. Similarly, the US Postal Service has a kind of monopoly on mail delivery since other firms are not legally allowed to pick up mail from or deliver mail to your mailbox.
• Network externalities: A network externality occurs when an increase in the number of users of some product raises the value of the product to existing users. For example, there are many word processing programs with features similar to Microsoft Word. However, part of the value of Microsoft Word is that you can share files with other users. As more and more people use Microsoft Word, the software becomes more valuable to you. In such cases, it may benefit consumers for there to be a single firm with a monopoly in word processing software, making it easier for customers to share files.
Monopoly – Marginal Revenue and Price
The key difference between monopoly and perfect competition is price-setting behavior. In perfect competition, there is a market price and each firm accepts this price. In other words, there is a fixed market price that is independent of the level of output that any one firm produces.
In monopoly, the firm chooses the price. We say that the monopoly firm is a price-maker rather than a price-taker. While a monopoly can choose its own price, the tradeoff is that a higher price leads to selling a lower level of output. There is an inverse relationship between the price and the output sold. This is an important difference. In perfect competition, there is a market price, and the firm can sell as much output as it wants at the market price. A single firm is too small to have any impact on the market price. By contrast, a monopoly that wants to sell more output has to set a lower price in order to do so.
This is the first principle of monopoly pricing.
• In order to sell more output, a monopolist has to lower the price.
The myth that a monopoly can charge whatever price it wants is incorrect because even a monopoly will see a decline in sales if it raises the price too much.
Q P TR MR
0 12 0 --
1 11 11 11
2 10 20 9
3 9 27 7
4 8 32 5
5 7 35 3
6 6 36 1
7 5 35 -1
8 4 32 -3
The marginal revenue from the first unit is $11 since total revenue rises from $0 to $11 when the firm sells the first unit.
But notice something interesting for the second unit – The second unit sells at a price of $10, but yet the marginal revenue from the sale of the second unit is only $9. The reason for this difference is the key to understanding the main issue underlying monopoly pricing. When the firm sells only one unit, it sells it for $11. But if the firm makes a decision to sell two units, then it must cut the price to $10 in order to get the second customer. But this $10 price applies to both units sold. Thus, although the firm makes an additional $10 by selling to the second customer, it also loses $1 because it now charges the first customer $10 instead of $11. As a result, the firm’s marginal revenue from adding this second customer is only $9, not the full price of $10.
Similarly, look at the third unit. In order to expand its output from 2 to 3 units, the firm must lower its price from $10 to $9. So, it gets an extra $9 by adding the third customer, who is willing to pay $9. But the firm also loses $2 by dropping the price because the first two customers are now paying $9 instead of $10. Combining, the marginal revenue from dropping the price from $10 to $9 is only $7, not the full $9 that is paid by the third customer.
This is the second important principle of monopoly pricing.
• When a monopolist cuts price in order to sell more output, the price is cut for all units sold, not just the additional units. This means that marginal revenue is lower than price.
cutting price on other units that would have sold at a higher price. All in all, the firm’s marginal revenue from cutting price and expanding output is less than the new price of $9.
In general, when the firm expands its output (sales) by reducing its price, there are two effects. The quantity effect is the additional revenue that results from the new units sold. It is positive. But the price effect is the decline in revenue that results from dropping the price for existing customers, who would have paid a higher price.
Taking this into consideration, it is actually possible that expanding output could lead to a decline
in revenue. This occurs when the price effect is stronger than the quantity effect. For the example above, expanding output from 6 units to 7 units actually reduces revenue from $36 to $35. The effect of the price cut for the 6 units is not made up for by the additional (seventh) unit sold.
For a practical example, sports matches frequently operate with lots of empty seats. The team could
fill the arena by cutting the ticket price, but it would actually lose more revenue from the price cut than it would gain from the extra seats sold. The team makes more money by setting high prices and selling fewer tickets. In economic language, the price effect from filling the stadium is stronger than the quantity effect.
For the graphical approach, recall that the demand curve gives the price at which various levels of output will be sold. For example, for the demand curve shown below, in order to sell 10 units of output the firm can set its price at $8, but to sell 20 units of output, the firm must lower its price to $6.
The marginal revenue curve that corresponds to the demand curve is shown here. For example, although the 20th unit sells for a price of $6, the firm does not actually earn a marginal revenue of $6 by adding this 20th unit sold. The marginal revenue is lower, to reflect the price cut for all units in order to sell this 20th unit.
Monopoly Profit Maximization
Let’s add cost information for the firm we considered in the previous section. The table below shows the total cost of production and calculates the marginal cost – the cost to produce each additional unit of output.
Q P TR MR TC MC
0 12 0 -- 5 --
1 11 11 11 9 4
2 10 20 9 14 5
3 9 27 7 20 6
4 8 32 5 27 7
5 7 35 3 36 9
6 6 36 1 48 12
7 5 35 -1 64 16
Using simple marginal benefit / marginal cost analysis, this firm maximizes profit by selling 3 units of output and by charging a price of $9. This is the last unit for which marginal revenue (additional revenue from selling the unit) is greater than marginal cost (additional cost incurred by producing the unit).
Note something interesting – if the firm could sell only the fourth unit for $8, it would be worth doing. The customer is willing to pay $8, and it costs the firm only $7 extra to produce that fourth unit. But the firm does not want to cut the price for all units to $8.
Using the graphical approach, it is worth it for the firm to continue producing output as long as the marginal revenue exceeds the marginal cost.
• The profit-maximizing level of output occurs where MR=MC.
For the example below, the profit-maximizing output is 𝑄𝑄∗= 20. The optimal price, read from the demand curve, that corresponds to this level of output is 𝑃𝑃∗ = $6. (Note that the price is not $2, where MR and MC cross – this is a common mistake. You have to go up to the demand curve at the optimal output to find the price).
Supply Curve
A monopoly firm can choose any point on the demand curve that it wants to choose. Now, we know it will choose the output level where MR = MC, which is the point that maximizes profit. But since a monopoly chooses the price on its own, the idea of a supply curve does not apply.
Profits and Shut Down
Profits for a monopolist are shown on the diagram, calculated exactly the same way as for a perfect competitor. For the monopolist in the diagram below, its optimal output where 𝑀𝑀𝑇𝑇=𝑀𝑀𝑀𝑀 is at
𝑄𝑄 = 20, with a corresponding price of $6. But, at this output level, production cost per unit (ATC) is equal to $4. This monopolist therefore earns a $2 profit per unit on each of the 20 units of output that it sells, for a total profit of $40. The profit is shown in the diagram below.
Monopoly in the Long Run
In perfect competition, entry by new firms drives economic profit down to zero in the long-run. But, in a monopoly, there is no entry by new firms. Thus, monopolists can continue to earn excess profits, even in the long-run.
Inefficiency of Monopoly
In the unit on perfect competition, we saw that – in the long-run – perfectly competitive firms produce at the productively efficient level of output (lowest per-unit production cost). Additionally, perfectly competitive markets are allocatively efficient. By contrast, monopoly-controlled markets are neither productively nor allocatively efficient.
The example below shows that a monopoly firm does not generally produce at the productively efficient level of output. An output level 𝑄𝑄 = 25 minimizes the average total cost of production (cost per unit), but the monopoly’s profit-maximizing output where 𝑀𝑀𝑇𝑇=𝑀𝑀𝑀𝑀 occurs at 𝑄𝑄= 20 units of output. Indeed, monopolies generally produce less than the productively efficient level of output.
Monopolies are also allocatively inefficient. To see this, we consider two markets below with the same demand curve and with the same constant marginal cost of production. The characteristics of both markets are the same, except that the market in the left diagram is perfectly competitive, while the market shown in the right diagram is controlled by a monopolist.
In perfectly competitive markets, price is set at marginal cost and firms make no profit in the long-run. The price is 𝑃𝑃𝐶𝐶, equal to marginal cost, and corresponding level of output is 𝑄𝑄𝐶𝐶. Both are shown on the left diagram. All consumers willing to pay more than marginal cost earn consumer surplus. This outcome is allocatively efficient – All efficient transactions, where the consumer is willing to pay more than the marginal cost of production, take place. But notice that all the surplus in perfectly competitive markets goes to the consumers. Since units are sold at cost, producers earn no surplus. Perfect competition is great for consumers.
The monopoly outcome is different. The monopolist is going to raise the price higher than marginal cost in order to earn a profit. A monopoly’s objective is not to maximize total surplus in the market. Its objective is to maximize producer surplus (profit). As we saw, the monopolist maximizes profit by setting its output level where 𝑀𝑀𝑇𝑇= 𝑀𝑀𝑀𝑀 and charging the corresponding price on the demand curve. The output and price 𝑄𝑄𝑀𝑀 and 𝑃𝑃𝑀𝑀 are shown on the diagram. The consumer surplus is the area under the demand curve down to the price charged. The profit is also shown on the diagram. The profit exists because the firm sets a price higher than production cost.
Where does the deadweight loss come from? The monopolist makes more profit by selling fewer units but charging a higher price. Thus, although the units between 𝑄𝑄𝑀𝑀 and 𝑄𝑄𝐶𝐶 are efficient trades from society’s perspective, expanding output and dropping price reduces monopoly profit. Monopolies find it more profitable to set a high price and a relatively low level of output.
The basis of the allocative inefficiency in monopoly markets is that the price is set higher than marginal cost, which means that there are some efficient trades that are lost. While setting price higher than marginal cost generates profit for the monopolist, it creates deadweight loss in the market and harms consumers.
If we compare the two markets, we see some fairly stark conclusions in terms of the outcomes generated for society.
• In monopoly markets, the price is higher and the quantity of output sold is lower than in competitive markets.
• Monopoly markets are allocatively inefficient and generate a deadweight loss because price is set higher than marginal cost. Perfectly competitive markets are allocatively efficient and free of deadweight loss because price is set at marginal cost.
• Monopoly firms are productively inefficient. Firms in perfectly competitive markets are productively efficient.
Benefits of Monopoly
We just saw that monopoly imposes cost on society, but there can be benefits too. First, for natural monopolies, large firms produce at lower cost because of economies of scale. Specifically, monopolies might have access to technologies that wouldn’t make sense for smaller firms. For example, a large power plant that serves a million customers might be able to invest in a nuclear plant that can operate more efficiently than a conventional power plant. But if the market consisted of ten smaller, competitive firms, the investment wouldn’t be possible. In this case, the comparison above is invalid because we assumed that the firms operated with the same costs. If there are economies of scale, the monopoly might operate with costs that are lower than if the market consisted of many small firms.
Regulation of Monopoly
Although we know that monopolies create substantial inefficiencies for society, we discussed two cases in the previous section where monopoly could actually be beneficial for society. How can we balance these competing effects?
In the first case – when there are economies of scale and monopolies make sense – the answer is regulation. We allow public utilities to be monopolies, but we regulate the prices that they can charge in order to minimize the deadweight loss imposed on society. In other words, the local water company might have a monopoly by being the only seller of water in a town, but the government carefully controls the price they charge. They can’t abuse their monopoly power by charging consumers extremely high prices, which would create large inefficiencies. This is a well-developed area in economics, and in a later class you can learn about different regulatory schemes and their efficiency consequences.
5.2: Price discrimination
Let’s begin with a simple example. Suppose a movie theater has two types of customers – adults, who are willing to pay a high price for movie tickets; and children, who want to see the movie but can’t pay as much for the ticket. We assume that the theater has enough seats for both types of customers.
If the theater sets a single price for tickets, it faces the usual monopoly pricing problem. If it lowers the price enough to attract children to buy tickets, it’s losing out on lots of revenue that it could have earned by charging a higher ticket price to adults. If this price effect (lost revenue from charging lower prices to adults) is greater than the quantity effect (increased revenue because children buy tickets now), then the theater may actually be better off setting a high price and selling tickets only to adults.
But there is an obvious solution in this case. Charge two different prices! Charge a high price for adults, and set a lower ticket price only for children. The theater can expand its ticket sales for children without cutting into revenues from high ticket prices for adults.
Price Discrimination
Price discrimination occurs when a firm charges different prices to different customers for the same product. There are a few requirements for price discrimination to be successful.
• The firm can identify customers willing to pay more: If a firm intends to charge different prices to different customers, it needs an easy way to identify which customers get charged which prices. In the example above, we might make students show a student ID in order to get a discounted ticket.
• Market power: A firm that price discriminates has to have some kind of market power. Otherwise, there would be an opportunity for a new entrant to join the market by undercutting the price charged to the high-price customers.
• The firm can prevent resale: Selling a bag of cookies to men for $10 and to women for $5 won’t work very well because a man who wants cookies can easily ask a woman to buy them at the low price, and then the man can buy the cookies from her. In general, arbitrage
Doctors and barbers frequently price discriminate because customers can’t buy and resell surgeries or haircuts. But you could buy and resell a laptop.
There are three varieties of price discrimination.
• First-degree price discrimination or perfect price discrimination occurs when all buyers are charged a price exactly equal to their willingness to pay. Each customer is charged a different price, equal exactly to what the customer is willing to pay. This is usually impossible in practice, but is useful as a reference point.
• Second-degree price discrimination occurs when the per-unit price depends on the total number of units purchased. For example, soda and electricity are sold at a different unit price depending upon the total amount purchased.
• Third-degree price discrimination involves charging different prices to different groups of customers. Movie theaters that set one price for adult tickets and one price for children’s tickets, or hotels that charge a different price depending on whether you pay with a personal or a corporate account are practicing third-degree price discrimination.
First-Degree Price Discrimination
Let’s begin with an example. You run a consulting company that writes computer databases and you have 5 clients who might be interested in buying one of your databases. The table below shows your 5 potential clients and how much they would be willing to pay for a database.
Client Price
Applebees $35,000
Burger King $30,000
Chipotle $25,000
Dairy Queen $20,000
Einstein $15,000
Price Quantity Total Revenue
Marginal
Revenue Total Cost
Marginal Cost
>$35,000 0 $0 -- $0 --
$35,000 1 $35,000 $35,000 $17,000 $17,000
$30,000 2 $60,000 $25,000 $34,000 $17,000
$25,000 3 $75,000 $15,000 $51,000 $17,000
$20,000 4 $80,000 $5000 $68,000 $17,000
$15,000 5 $75,000 −$5000 $85,000 $17,000
As usual, marginal revenue is lower than price. Although the second customer (Burger King) is willing to pay $30,000 for one of your programs, in order to sell the second program, you have to drop your price to $30,000 for both customers. Thus, when you choose to sell the second program, you earn $30,000 of additional revenue from Burger King, but you lose $5000 of revenue by dropping the price for Applebees from $35,000 to $30,000. All in all, your marginal revenue is only $25,000. Selling more output requires setting a lower price for all customers.
The firm will choose to sell 2 programs – the last unit for which marginal revenue is greater than marginal cost. It charges a price of $30,000 and earns a profit of $26,000, which is the difference between total revenue and total cost at the profit-maximizing output.
But things are different if you can price discriminate. Now, when you expand your output to 2 programs, you can sell to Burger King for $30,000 while continuing to charge Applebees $35,000. In this case, your revenue when you sell 2 programs is actually $65,000.
Similarly, when you choose to sell 3 programs, you sell the program to Applebees for $35,000, to Burger King for $30,000 and to Chipotle for $25,000 – for total revenue of $90,000. Continuing on like this, the table below shows total and marginal revenue when the firm can perfectly price discriminate by charging each customer what he is willing to pay.
Quantity Total Revenue
Marginal
Revenue Total Cost
Marginal Cost
0 $0 -- $0 --
1 $35,000 $35,000 $17,000 $17,000
2 $65,000 $30,000 $34,000 $17,000
3 $90,000 $25,000 $51,000 $17,000
4 $110,000 $20,000 $68,000 $17,000
5 $125,000 $15,000 $85,000 $17,000
• If a firm can perfectly price discriminate, marginal revenue is equal to price.
For the perfect price discriminator, the optimal level of output is to sell 4 programs (last unit where MR > MC). And your profit is $42,000. When you can price discriminate across customers, you sell to more customers and you earn a higher profit than when you simply set a single price for all customers. Indeed, this simple example demonstrates that the ability to price discriminate can bring more customers into a market and raise profit for the firm.
In terms of efficiency consequences, let’s return to the diagram from last section. Recall the comparison of surplus for a perfectly competitive firm and a single-price monopoly.
In contrast to the single-price monopoly, a perfect price discriminator will sell to any customer who is willing to pay more than the marginal cost of producing an additional unit. Selling to additional customers does not cut into revenues from previous customers since the firm charges a different price to each customer. A single-price monopoly doesn’t want to expand output beyond
𝑄𝑄𝑀𝑀 because it doesn’t want to cut the price for all customers. But this isn’t a problem for a perfect price discriminator, because he charges a different price to each customer.
There is no consumer surplus in perfect price discrimination. Consumer surplus is the difference between what a consumer would have been willing to pay and the price that he actually pays. But the definition of perfect price discrimination is that each consumer is charged a price exactly equal to what he is willing to pay. Thus, there is no consumer surplus for any consumer.
A final and very important point is that total surplus is the same under perfect price discrimination as it is under perfect competition. Both lead to the same output in the market, and both are allocatively efficient in the sense that neither creates a deadweight loss (in contrast to single-price monopoly, where there is a deadweight loss). The difference is that, in perfect competition, all the surplus goes to consumers whereas in perfect price discrimination all the surplus goes to producers.
Both perfect competition and perfect price discrimination generate maximum surplus in the market, so both are allocatively efficient. The difference is distributional.
Third-Degree Price Discrimination
Third-degree price discrimination occurs when firms charge different prices to different groups of customers.
than men do. Finally, people who take time to clip coupons can get lower prices for groceries than people who don’t. You might not have thought about it like this, but it’s price discrimination. People who take the time to clip coupons probably are more price conscious and have more elastic demand. Forcing customers to spend time clipping coupons to get lower prices achieves price discrimination – effectively charging different prices to different customers.
Two-Part Tariffs
Two-part tariffs are an example of second-degree price discrimination that is effective for many firms. A two-part tariff is a pricing strategy where consumers pay some fixed fee 𝐹𝐹 for the right to enter a market and then pay a per-unit price of 𝑝𝑝 for each unit they buy once in the market. For example, Sam’s Club and Cost-Co charge an annual membership fee for access to the market and then buyers also pay for what they buy in the store. As another example, night clubs often charge a cover charge and then charge patrons for food and drinks once they’re inside the club.
Two part tariffs are a good strategy for markets where consumers enter and then buy multiple units of the product. The key principle is that giving consumers a good deal by charging a low unit price
𝑝𝑝 means that the customers get more consumer surplus and are willing to pay a higher fee 𝐹𝐹 to enter. The entrance fee 𝐹𝐹 can be set equal to each consumer’s consumer surplus, since this is value that the consumer gets from joining the market.
It follows that the profit-maximizing strategy is to set the unit price 𝑝𝑝 equal to the marginal cost of production and then set 𝐹𝐹 to capture the entire consumer surplus. For the example below, the demand curve shows the number of drinks that each customer will buy once they enter a club, depending upon the price charged. Note that this is an individual demand curve, not a market
This firm should set the price of drinks at 𝑝𝑝 = $2, which is the marginal cost of selling a drink. The customer will buy 8 drinks. As a result, the customer earns consumer surplus of $32. The firm can turn around and charge this $32 as a fixed fee for the consumer to enter, so the appropriate entrance fee for the club is 𝐹𝐹 = $32. This pricing strategy captures all the surplus in the market for the firm.
The key is that the firm makes no profit off the sale of drinks, since it sells drinks at cost, but rather makes all its profit by charging a high fixed fee. This is why gyms charge monthly membership fees and then let customers visit as many times as they want for free. Once the gym is operating, the marginal cost for another customer to visit is 0, so the gym is better off letting people enter for
𝑝𝑝= 0 at each visit, and then making their money from a high membership fee. Along similar lines, Sam’s Club gives you a good deal on food, making consumers willing to pay a higher annual fee.
Bundling
Consider a theatre that puts on two performances: a symphony and a ballet. There are two customers: Michael and Nina. The table below shows what each is willing to pay for a ticket to each performance.
Symphony Ballet
Michael $100 $75
Nina $35 $120
One option for the firm is to sell tickets separately.
For symphony tickets:
• If symphony tickets are sold for $100, only Michael will buy one Revenue = $100
• If symphony tickets are sold for $35, both Nina and Michael will buy one Revenue = $70
The best option is to price symphony tickets at $100 and sell one only to Michael.
For ballet tickets:
• If ballet tickets are sold for $120, only Nina will buy one Revenue = $120
• If ballet tickets are sold for $75, both Michael and Nina will buy one Revenue = $150
Overall, the firm earns $250 of revenue from pricing separately.
Now suppose instead that the firm doesn’t sell the tickets separately, but only sells a bundle that includes both a symphony and a ballet ticket. Notice that Michael is willing to pay $175 for a bundle and Nina is willing to pay $155 for a bundle. Selling bundles for $155 is a better option.
• If a bundle is sold for $175, only Michael will buy one Revenue = $175
• If a bundle is sold for $155, both Nina and Michael will buy one Revenue = $310
Overall, the firm earns $310 of revenue when it sells tickets bundled. Using bundled pricing instead of pricing each item separately increases profit from $250 to $310.
What happened is that, by bundling the tickets together, the theatre forced both Michael and Nina to buy both tickets. Basically, when Michael buys a $155 bundle, he’s mostly paying for the symphony ticket. But when Nina buys a $155 bundle, she’s mostly paying for the ballet ticket. The bundle can simultaneously capture their surplus from the two different performances while forcing both of them to buy both tickets.
