Roadmap:

Chapter 14 provided a theory of competitive markets.One important feature:

Firms are price takers.

Chapter 15 deals with . . .Monopoly: a firm that is the sole seller of a product without close substitutes.

For a competitive firm, priceis independent of output. Thedemand curve faced byan individual firm, is perfectlyelastic at the market-determinedprice:

($/widget)

(widgets/day)

p*

Firm’sdemand

A monopoly firm faces theentire (downward-sloping)market demand curve:

($/widget)

(widgets/day)

Firm’s = market demand

This gives the monopolistthe opportunity to chooseits price.

We could say that a monopoly is a “price maker,”

. . . or, more formally, a monopoly has

Market power: the ability of a single firm to influence price.

(Actually, much of what we do in chapter 15 will apply to any firm that has market power -- whether or not it is literally a monopoly.)

Obviously, being a monopoly is (usually) a very advantageous position . . .

. . . leading to positive economic profit.

Preserving a monopoly requires a barrier to entry.

1. A key resource is owned by a single firm.

2. The government gives a single firm the exclusive right to produce some good or service.

3. Technology is such that 1 firm (supplying the whole market) is more efficient than 2 or more firms.

Government-created monopolies.

Patents and copyrights . . .. . . give the holder title to an idea (“intellectual

property rights”)

They differ, mainly, in the types of “property” to which they apply.

Patents are for products and production processes.

Copyrights are for books, movies, musical compositions and recordings, computer software, etc.

Patents:Firm or individual invents a new product (let’s say).

Applies to U.S. Patent Office. (http://www.uspto.gov/)

Patent Office investigates originality of idea.If original, a patent is granted.

Patent holder has exclusive right to make and sell product for 20 years.

(Can “license” others to sell product, however.)

Enforcement of patent right? That’s theresponsibility of patent holder.

During period of patent protection:Patent holder (or its licensee) is a monopoly.As we’ll see, this means “high” prices, “toolittle output,” and “high” monopoly profit.(bad for consumers and society)

When patent expires:Other firms can enter the market with their own“copycat” (or “generic”) versions.Competition drives prices and profit down;output increases.(good for consumers and society)

Why offer patent protection?

Firms and individuals need an incentive to undertake costly research and development.

Incentive: the promise of (temporary) monopoly profit if R&D is successful.

The tradeoff in government’s patent laws:

Create a temporary monopoly (bad) . . .. . . in order to stimulate R&D

(good).

Another type of barrier to entry:

Because of the nature of technology, 1 firm can supply the market at lower cost than 2 or more firms.

“Natural Monopoly”

For example: public utilities (electric power, water, or gas companies).

Significant fixed cost of “distribution network”(power lines, water or gas pipes, etc.)

Because of significant fixed cost, ATC decreases with output over entire range . . .

gal./day

$/gal.

Entry into a natural monopoly is not attractive.

Q*

c1

One firm supplying entire market would operate at lower average cost . . .

c2

½ Q*

. . . than two (or more) firms sharing the market.

ATC

Price and output decisions for a monopoly.

Recall: The key difference between a competitive and a monopoly firm:

For a competitive firm, price is independent of output (demand is perfectly elastic).

This means MR = price.

For a monopoly firm, price decreases with output (demand slopes down).

We will see that this means MR < price.

Output (wdgts/day)

0

1

2

3

4

5

6

7

8

9

Price ($/wdgt) 9

8

7

6

5

4

3

2

1

0

TR ($/day)

0

8

14 18

20

20

18

14

8

0

MR ($/wdgt)

8

6

4

2

0

-2

-4

-6

-8

($/widget)

(widgets/day)

9

9

Demand

For the increase in output from 2 to 3 widgets/day . . .

MR = +6

+

- 2 = 4

-

2 3

76

($/widget)

(widgets/day)

9

9

Demand

2 3

For the increase in output from 2 to 3 widgets/day . . .

MR = +6 - 2 = 4

4

Plotting this value (against output = 2.5) . . .

. . . we have one point on the MR curve.

MR =

($/widget)

(widgets/day)

9

9

Demand

For the increase in output from 6 to 7 widgets/day . . .

+2

+

- 6 = - 4

-32

6 7

($/widget)

(widgets/day)

9

9

Demand

MR = +2 - 6 = - 4

Plotting this value (against output = 6.5) . . .

. . . we have another point on the MR curve.

For the increase in output from 6 to 7 widgets/day . . .

6 7

- 4

($/widget)

(widgets/day)

9

9

Demand

Marginal revenue

“Connecting the dots” gives us the monopoly’s marginal revenue curve.

Note: For a monopoly:

MR is less than price (MR is below demand).

MR can be negative.

Profit maximization for monopoly:

Demand

MR

($/widget)

ATC

MC

(widgets/day)

Start with conventionalcost curves.

Bring in demand.

MR is below demand.

The same profit-max rules still apply so . . .

Q*

. . . the profit-maximizingoutput level, Q*, isdetermined by MR = MC.

The monopolist charges the demand price at Q*; call this p*.

Profit = [p* - ATC(Q*)] x Q*. . . the green area in the diagram

ATC(Q*)

p*