Market Power & Monopoly

Lecture 7

Recap: Perfect Competition

In the case of perfect competition, firms produce where MR = P = MC.

Recap: Perfect Competition

The demand curve faced by a competitive firm is perfectly elastic, a horizontal line equal to MR.

This is because the competitive firm is a price-taker: it can’t charge more than P, and it makes no sense to charge less.

Monopoly

But a perfectly competitive market is an extreme case with extreme assumptions:

Many buyers and sellers, each too small to affect price.
All firms sell identical (homogeneous) products.
Free entry and exit.

The opposite extreme is a market with a monopoly.

Monopoly

The opposite extreme is a market with a monopoly.

Characteristics of a monopoly:

A single firm
Producing a good that is differentiated from that of any other firm
It may be prohibitively costly for other firms to enter

Monopolies?

Which of the following are (or were) true monopolies?

Monopolies?

First-class mail?

Yes

Windows OS?

Yes

Diamonds?

Yes

Harry Potter?

Yes

Monopolies?

First-class mail?

Yes

Windows OS?

Yes

Diamonds?

Yes

Harry Potter?

Yes

Shipping services?

No

Operating Systems?

No

Precious stones?

No

Fantasy novels?

No

Monopoly: Price-Maker

A monopolist’s choice of Q and P are dependent on one another. A monopoly is a price-maker.

There is a downward-sloping demand for its good. MR is a curve that always lies below D.

Why is MR Always Below D?

A monopolist can sell 5 units of Whazzagizmo™ at $4/unit. Total revenue: $20.

Or sell 7 units at $3/unit. Total revenue: $21.

Selling 2 additional units at P = $3 generates only MR = $1. Why?

Why is MR Always Below D?

Selling 2 extra units at $3 (instead of 5 at $4) generates only $1 in net marginal revenue.

Selling 2 more units at P = $3 adds 2 × $3 = $6 of revenue …

… but the original 5 units now sell at $3 instead of $4, losing 5 × $1 = $5.

Net MR = $6 − $5 = $1. For a monopolist, MR < P always.

Monopoly Profit Maximization

Profit maximization still implies that output Q is set at MC = MR.

Having set Q, the highest price at which that quantity can be sold is read from the demand curve D.

Deadweight Loss from Monopoly

Total surplus can be increased if the monopoly produces where MC = D (the competitive quantity) rather than MC = MR.

The loss in total surplus from monopoly pricing is deadweight loss (DWL). It represents mutually beneficial exchanges that do not occur because the monopolist restricts output.

Deadweight Loss from Monopoly

Monopolies create DWL by increasing profits at the cost of larger decreases in consumer surplus.

The Spectrum of Market Power

Perfect competition and monopoly are both extreme cases not found in pure form in the real world.

The extreme cases help us think about how real-world firms behave depending on:

Whether they face more or less competition
Whether their goods are more or less differentiable from those of other firms

Monopolistic Competition

Economists often refer to markets as monopolistically (or imperfectly) competitive when there are a modest number of firms, each with significant market share, each producing a good that is an imperfect substitute for others on the market.

Whether firms have relatively great or lesser market power can be represented by the slopes of D and MR.

Market Power Spectrum

Example: US auto brands or PC vendors, a few large firms each hold meaningful market share, with differentiated products.

Are There Any Benefits to Monopoly?

We know the costs: higher prices, lower output, deadweight loss.

What about benefits? Incentives to innovate.

“If one wants to induce firms to undertake R&D one must accept the creation of monopolies as a necessary evil.”

Joseph Schumpeter (1943)

Example: pharmaceutical patents grant temporary monopoly rights as an incentive to develop new drugs.

Perfect Competition vs. Monopoly

	Perfect Competition	Monopoly
Number of firms	Many	One
Price-setter?	No (price-taker)	Yes (price-maker)
Demand curve	Perfectly elastic	Downward-sloping
MR vs. P	MR = P	MR < P
Deadweight loss	None	Yes
Long-run profit	Zero (competed away)	Possible (barriers to entry)

Interactive: Market Power Spectrum

Competitive (0) (10) Monopoly

Key Terms

Practice Questions

Question 1 of 5

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