Chapter 10:    Pure Monopoly

   As mentioned previously, when we refer to something in economics as "pure" or "perfect," it likely does not exist in the real world.  So, pure competition and pure monopoly are theoretical ideals which we study and analyze in order to understand the real world lying between these extremes at either end of the competitiveness spectrum or continuum.

I.    Characteristics of pure monopoly:

        A.    single seller

        B.    of a good for which there are no close substitutes

        C.    "price maker"

        D.    absolute barriers to entry

                   1.    Economies of scale - in some cases a firm's long-run average cost declines over a wide range of output.  In these cases, market demand will only support a single large firm producing at minimum ATC.  Note:  If the market demand curve intersects long-run ATC where ATC is still declining, we refer to this as a natural monopoly.

                  2.    Legal barriers

                        a.    patents   

                        b.    licenses

                  3.   Ownership or control of essential resources

                  4.    Predatory pricing and other business strategies

II.    Monopoly Demand:    The crucial difference between the monopolist and the purely competitive seller lies on the demand side.

        A.    Because the monopolist is the industry supply, it's demand curve is the market demand curve and must be down sloping.

        B.    Three (3) implications of down sloping demand curve:

                1.    Marginal revenue is less than price (AR) for every level of output except the first.  (See: Figure 10.2)

                        a.    In order to sell more, the monopolist must lower price, but the lower price applies not only to the extra output sold but to all prior units.

                        b.    So, each additional unit sold increases total revenue by an amount equal to the price of the extra unit less the sum of the price cuts that apply to all prior units.

                2.    The monopolist is a "price maker.     Because the monopolist faces a down sloping demand curve, the decision on what output to produce indirectly determines price.

                3.    The monopolist will always choose an output/price combination on the elastic portion of the demand curve.

                        a.    Recall from Chapter 6 that if demand is price elastic, a decrease in price will increase total revenue.  Conversely, if demand is price inelastic, then a price cut will decrease total revenue.

                        b.    Therefore, the monopolist will never choose a price/output combination where reducing price will lower total revenue.

                        c.    WHY?    To get to the inelastic portion of the demand schedule, the monopolist would have to lower price and increase output.      In the inelastic region, lower price means less revenue, but increased output means increased total cost.  That combination of lower revenue and higher cost yields less profit.

III.    Output and price determination:

        A.    A monopolist seeking to maximize profits/minimize losses will employ the same rationale (MR=MC) as the competitive seller assuming that producing is preferable to shutting down.

          B.    The monopolist has no supply curve!  In other words there is no unique relationship between price and quantity supplied.  Because MR< P, the monopolist does not equate MC and Price.  Therefore it is possible for different demand conditions to bring about different prices for the same output.

IV.    Misconceptions about monopoly pricing:

        A.    The monopolist does not always charge the highest price.  Her goal is to maximize profits, not price!

        B.    The monopolist seeks to maximize total profit, not unit profit.  She will accept lower than maximum per unit profit because additional sales more than compensate for lower unit profit.

V.    Possibility of losses:

        A.     The likelihood of economic profits is greater for the pure monopolist since barriers to entry keep new competitors out.  Recall from Chapter 9 that short-run economic profits would attract new producers which would increase market supply, resulting in lower price and less profit.

        B.    But, pure monopoly does guarantee economic profit.  The monopolist is not immune to changes in consumer tastes and other determinants of market demand, or to increased production costs which may result in short-run losses.

        C.    And, just like the competitive seller, the monopolist will not persist in operating at a loss.

VI.    Economic effects of monopoly:

       A.    The monopolist's output will be less than that which results from a competitive market.  In other words, in the long run, the monopolist will produce an output which will not be at the lowest ATC, and thus does not achieve productive efficiency.

        B.    Because P > MR  and MR = MC, then P > MC in long run equilibrium.  Since price reveals the marginal benefit to society of consuming the last unit of the good, in monopoly MB > MC and this reflects an under allocation of resources.  Therefore, in monopoly we fail to achieve allocative efficiency.

        C.    Be sure to spend some extra time with Figure 10.6 and pages 198 and 199!!

VII.    Income transfers resulting from monopoly:

        A.    Because the monopolist charges a higher price than would a competitive seller, the monopoly essentially levies a private tax on consumers in order to earn substantial economic profits.

        B.     But this private tax is not spread equally across income groups.  Since upper income households are more likely to own corporate stock, the private tax on consumers increases income inequality.

VIII.     Cost complications:    Our comparison between the competitive and monopoly seller has assumed the two face identical production costs.  However, in the real world, costs will not be the same.  You should be able to explain how each of the following factors may cause differences in production costs.

        A.    Economies of scale:

        B.    X-inefficiency:

        C.    Rent-seeking expenditures:

        D.    Technological advance:

IX.    Price discrimination:

        A.    Defined:  Price discrimination refers to the practice of selling a specific product to different groups of consumers at different prices which are not justified by cost differences.  Read again the discussion of consumer surplus on page 190.  In a competitive industry, sellers must sell to all buyers at the market equilibrium price.  Because some buyers would be willing to pay more for the good, they receive more benefit than they pay for.  Of course this does not please sellers and they would like to recover some or all of this consumer surplus.  The practice of price discrimination reflects that effort.

        B.    Necessary conditions:

                1.    The seller must be a monopolist or at least have significant monopoly power.

                2.    The seller must be able to segregate buyers into distinct groups, each with a different willingness and ability to pay.

                3.    The original buyer cannot resell the product.

        C.    Examples:   Electric utilities, movie theaters, etc.

        D.    Market outcomes with price discrimination:

                1.    The easiest way to understand the impact of price discrimination on seller profits and output is to consider the situation in which the seller is able to practice perfect price discrimination.  This would occur when the monopolist charges each customer the price that he or she is willing to pay.    Read page 204 carefully!!!

                2.    For the discriminating monopolist, economic profits increase. Make sure you understand (can explain) why!

                3.    Price discrimination also results in greater output than would otherwise be the case and thus greater allocative efficiency. Why?

X.      Regulated Monopoly:             Natural monopolies traditionally have been regulated in order to assure the monopolist does not take advantage of her monopoly power to the detriment of consumers.  This presents the regulating authority with the choice between the socially optimal price and the fair return price (the dilemma of regulation).

        A.    The socially optimal price or rate is the price at which P = MC.  This represents the allocative forces of pure competition.  In other words, the price that will achieve allocative efficiency.  See, Figure 10.9.

        B.     But the socially optimal price may be so low that the monopolist cannot cover average total cost and will suffer short-run economic losses and long-run bankruptcy.  The United States Supreme Court has held that such a price deprives the monopolies owners of their property without due process. So, in practice, regulatory commissions have pursued a fair-return price.

Out-of class assignment:   

1.    Complete Question #5 on Page 208.   

2.    If the firm described in question 5 could engage in perfect price discrimination, what would be the profit maximizing level of output?  What would be her economic profit?  What happens to "consumer surplus?"

3.    Respond to the following:

        A pure monopolist sells output for $4.00 per unit at the current level of production.  At this level of output, the marginal cost is $3.00, average variable costs are $3.75 and average total costs are $4.25.  The marginal revenue is $3.00.  What is the short-run condition for the monopolist and what output changes would you recommend?