Monopoly: Structure, Pricing, and Efficiency in Microeconomics

Monopoly in Microeconomics

Imperfect Competition

Definition and Types

• Imperfect competition occurs when individual sellers can influence the price of their output. Major types include monopoly, oligopoly, and monopolistic competition.

• Firms in imperfect competition are price-makers, not price-takers. They can affect market price by changing the quantity they sell.

Perfect vs. Imperfect Competitors

• Perfect competitors face a horizontal demand curve and can sell any quantity at the market price.

• Imperfect competitors face a downward-sloping demand curve and have some control over price.

• Imperfect competitors are price-makers; perfect competitors are price-takers.

Monopoly and How It Arises

Definition of Monopoly

• A monopoly is a market with:

  • No close substitutes for the product.

  • One supplier protected from competition by barriers to entry.

Key Features of Monopoly

• No close substitutes: If a good has a close substitute, the firm faces competition. A monopoly sells a good with no close substitutes.

• Barriers to entry: Constraints that protect a firm from potential competitors. Three types:

  • Natural barriers (e.g., economies of scale, public utilities)

  • Ownership barriers (e.g., control of essential inputs or distribution channels)

  • Legal barriers (e.g., public franchises, government licenses, patents, copyrights)

Natural Monopoly

• Natural monopoly: One firm can produce the total market output at a lower cost than several firms due to economies of scale.

• Governments may grant monopoly rights to public utilities (water, gas, electricity, mail).

• In a natural monopoly, the long-run average cost (LRAC) curve is still downward-sloping when it meets the demand curve.

• Example: One firm produces 4 million units at 5 cents/unit; two firms produce 2 million each at 10 cents/unit.

Ownership Barriers

• Monopoly can arise from concentration of ownership, such as control over suppliers or distributors (e.g., Luxottica in sunglasses).

Legal Barriers

• Legal monopoly: Market protected by public franchise, government license, patent, or copyright.

• Examples: Canada Post (public franchise), patents for inventions, copyrights for creative works.

Monopoly Price-Setting Strategies

Single-Price Monopoly vs. Price Discrimination

• Single-price monopoly: Sells each unit at the same price to all customers.

• Price discrimination: Sells different units at different prices to different customers.

Single-Price Monopoly’s Output and Price Decision

Price and Marginal Revenue

• Monopoly is a price setter, not a price taker.

• All firms maximize profit by setting marginal revenue (MR) equal to marginal cost (MC).

Marginal Revenue and Price

• Monopoly faces a downward-sloping demand curve; to sell more, it must lower price.

• The marginal revenue curve lies below the demand curve at every positive quantity.

Formulas

• Total revenue: $TR = P imes Q$

• Marginal revenue: $MR = rac{ riangle R}{ riangle q}$

• For a single-price monopoly, $MR < P$ at each output level.

Deriving the Marginal Revenue Curve

• To increase output by $riangle Q$, monopoly lowers price per unit by $rac{ riangle p}{ riangle Q}$.

• By lowering price, monopoly loses $( rac{ riangle p}{ riangle Q}) imes Q$ on units previously sold at higher price, but earns additional $p$ on extra output.

• Marginal revenue equation: $MR = p + rac{ riangle p}{ riangle Q} Q$

Example: Linear Inverse Demand Function

• If $p = 24 - Q$, then $MR = 24 - 2Q$

• The slope of the MR curve is twice as steep as the demand curve.

Marginal Revenue and Elasticity

• If demand is elastic, a fall in price increases total revenue ($MR > 0$).

• If demand is inelastic, a fall in price decreases total revenue ($MR < 0$).

• If demand is unit elastic, a fall in price does not change total revenue ($MR = 0$). Total revenue is maximized when $MR = 0$.

Monopoly Output Decision

• Monopoly never produces where demand is inelastic; always operates where demand is elastic.

• Profit maximization occurs where $MR = MC$.

• Monopoly can adjust price or quantity to maximize profit, constrained by the market demand curve.

• Economic profit is the profit per unit multiplied by the quantity produced.

Monopoly vs. Perfect Competition

Price and Output Comparison

• In perfect competition, equilibrium is where quantity demanded equals quantity supplied ($Q_e$, $P_e$).

• In monopoly, equilibrium output ($Q_m$) is where $MR = MC$; price ($P_m$) is set on the demand curve at that quantity.

• Monopoly produces less output and charges a higher price than perfect competition.

Efficiency Comparison

• Perfect competition is efficient: marginal social benefit (MSB) = marginal social cost (MSC).

• Total surplus (consumer + producer surplus) is maximized in perfect competition.

• Monopoly is inefficient: price exceeds marginal social cost, creating deadweight loss.

• Some lost consumer surplus is transferred to monopoly as producer surplus.

Market Failure Due to Monopoly Pricing

• Welfare is lower under monopoly than competition.

• Monopoly sets price above marginal cost, causing deadweight loss.

Monopoly Regulation

Optimal Price Regulation

• Government can eliminate deadweight loss by requiring monopoly to charge no more than the competitive price.

Problems in Regulation

• Governments may not know actual demand and cost curves, leading to incorrect price setting.

• Regulated firms may influence regulators for their own benefit.

Price Discrimination

Definition and Conditions

• Price discrimination: Selling a good or service at different prices to different buyers.

• Requires ability to identify and separate buyer types and prevent resale.

• Price differences due to cost differences are not price discrimination (e.g., peak-load pricing).

Types of Price Discrimination

• Group price discrimination: Different prices for different groups, same price within group.

• Unit price discrimination: Different prices for different units purchased by the same buyer.

Why Price Discrimination Pays

• Firm captures more consumer surplus by charging higher prices to those willing to pay more.

• Firm sells to customers who would not buy at the uniform price.

Perfect Price Discrimination

• Perfect price discrimination (first-degree): Each unit sold at the maximum price any customer is willing to pay.

• Firm captures entire consumer surplus.

• Output approaches competitive level ($P = MC$), increasing efficiency.

• However, all surplus goes to the firm, and increased profit may attract rent-seeking and inefficiency.

Summary

• Monopoly arises due to lack of close substitutes and barriers to entry.

• Monopolies set prices and output to maximize profit, always operating where demand is elastic.

• Compared to perfect competition, monopoly results in higher prices, lower output, and deadweight loss.

• Price discrimination allows monopolies to increase profit and potentially improve efficiency, but may also lead to rent-seeking and redistribution of surplus.

• Regulation can improve welfare but faces practical challenges.