Chapter 12 Monopoly Power and Firm
Pricing Decisions
The essential condition for competition is freedom of market entry. In perfect
competition entry is assumed to be completely free. Conversely, the essential condition
for monopoly is the presence of barriers to entry. Monopolists can manipulate price
because such barriers protect them from being undercut by rivals.
Barriers to entry can arise from several sources.
• First, the monopolist may have sole ownership of a strategic resource, such as
bauxite (from which aluminum is extracted).
• Second, the monopolist may have a patent or copyright on the product, which
prevents other producers from duplicating it. For years, Polaroid had a patent
monopoly on the instant-photograph market. (Eastman Kodak developed an
alternative process, but was forced to withdraw its camera from the market
when a Federal court ruled that it infringed on Polaroid’s patent.)
• Third, the monopolist may have an exclusive franchise to sell a given product
in a specific geographical area. Consider the exclusive franchise enjoyed by
your local telephone company, or was enjoyed, until very recently, your local
electric utility.
• Fourth, the monopolist may own the rights to a well-known brand name with a
highly loyal group of customers. In that case, the barrier to entry is the costly
process of trying to get customers to try a new product.
• Finally, in a monopolized industry, production may be conducted on a very
large scale, requiring huge plants and large amounts of equipment. The
enormous financial resources needed to produce on such a scale can act as a
barrier to entry, because a new entrant operating on a small scale would have
costs too high to compete effectively with the dominant firm.
All in all, these external barriers to entry can be thought of as costs that must be
borne by potential competitors before they can complete. Such barriers may be “low,”
which means that a sole producer’s monopoly power may be very limited, but such
barriers could, theoretically, be prohibitively high.
The Limits of Monopoly Power
Unlike the competitive seller, the monopolist has the power to withhold supplies from the
market and to charge more than the competitive market price. Even the pure
monopolist’s market power is not completely unchecked, however. It is restricted in two
important ways. First, without government assistance, the monopolist’s control over the
market for a product is never complete. Even if a producer has a true monopoly of a
good, the consumer can still choose a substitute good whose production is not
monopolized. For instance, in most parts of the nation, only one firm is permitted to
provide local telephone service. Yet people can communicate in other ways. They can
talk directly with one another; they can write letters or send telegrams; they can use their
children as messengers. In a more general sense, consumers can use their income to buy
rugs or bicycles instead of private lines. To the extent that the individual has alternatives,
Chapter 12 Monopoly Power and Firm
Pricing Decisions
his consumption of any good must be considered voluntary. As the Nobel Laureate
Friedrich Hayek has written,
If, for instance, I would very much like to be painted by a famous artist (one
who has monopoly power) and if he refuses to paint monopoly efficient for
less than a very high price, it would clearly be absurd for monopoly efficient
to say that I am coerced. The same is true of any other commodity or service
that I can do without. So long as the services of a particular person are not
crucial to my existence or the preservation of what I most value, the
conditions he exacts for rendering these services cannot be called “coercion.”
2
This is not to say that the effects of monopoly are all positive. If monopoly means that
one firm is garnering the assets and markets of all other competitors, it can be viewed as a
force that reduces consumer choice. Although the monopolist’s coercive power may not
be complete, it nevertheless can restrict consumer freedom.
Monopoly power can develop for other reasons. A firm may gain monopoly
power because it has built a better mousetrap or developed a good that was previously
unavailable. In other words, a firm may be the only producer because it is the first
producer, and no one has been able to figure out how to duplicate its product. In this
instance, although monopolized, a new product results in an expansion of consumer
choice. Furthermore, the monopoly may be only temporary, for other competitors are
likely to break into the market eventually.
The monopolist is also restricted by market conditions—that is, by the cost of
production and the downward-sloping demand curve for the good. If the monopolistic
firm raises its price, it must be prepared to sell less. How much less depends on what
substitutes are available. The monopolist must consider as well the costs of expanding
production and of trying to prevent competitors from entering the market. The important
point here is that there is a range of possible costs and prices at which the monopolistic
firm can sell various quantities of a good. Its task is to search through the available price-
quantity combinations for the one that maximizes profit.
In a free and open market, monopoly power can be dissolved in the long run.
With time, competitors can discover weakly protected avenues through which to invade
the monopolist’s domain. The Reynolds International Pen Company had a patent
monopoly on the first ballpoint pen that it introduced in 1945. Two years later other pen
companies had found ways of circumventing the patent and producing a similar but not
identical product. The price of ballpoint pens fell from an initial $12.50 to the low prices
of today. Many other products that are freely produced today—calculators, video games,
car telephones, and cellophane tape, to name a few—were first sold by companies that
enjoyed short-run monopolies. Thus the imperfection of monopoly power is crucial. In
the long run, excessively high prices, restricted supply, and high profits give potential
competitors the incentive to find and exploit imperfections in the monopolist’s power.
Like the proverbial hole in the dike, those imperfections can undermine even the
strongest barrier.
2
F.A Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960). P. 136.
Chapter 12 Monopoly Power and Firm
Pricing Decisions
One of the most effective ways for a monopoly to retain its market power is to
enlist the coercive power of the state in protecting or extending it boundaries. This
strategy has been used effectively for decades in the electric utilities industry and the
cable television market. The insurance industry and the medical profession, both of
which are protected from competition through licensing procedures, are also good
examples. Even the power of the state may not be enough to shield an industry from
competition forever. Consumer tastes and the technology of production and delivery can
change dramatically over the very long run. The franchise-monopoly of electric power
companies, for example, is slowly being weakened by the introduction of home solar
power. The railroad industry’s market, which was protected from price competition by
the state for almost a century, has been gradually eroded by the emergence of new
competitors, principally airlines, buses, and trucks. Even the first-class mail monopoly of
the U.S. Postal Service is being eroded by Federal Express and other overnight delivery
firms. In the long run, government protection may be extended to the very competitors
who arise to break a state-protected monopoly. (Such was the case, until recently, with
the airline, bus, and tracking industries.)
Should government attempt to break up all monopolies? Since without state
protection monopoly may eventually dissipate, the relevant public policy questions are
how long the monopoly power is likely to persist if left alone, and how costly it will be
while it lasts, in terms of lost efficiency and unequal distribution of income. The
machinery of government needed to dissolve monopoly power is costly in itself. Thus
the decision whether to prosecute antitrust violations depends in part on the costs and
benefits of such an action. Often the rise of a monopoly does warrant government action,
but in some cases the benefits of action cannot justify the costs. As described in Chapter
3, the first seller of land calculators enjoyed a temporary monopoly of the U.S. market in
1969. Subsequently the industry developed very rapidly, however, and in retrospect it is
clear that a long, drawn-out antitrust action would have been inappropriate.
To give another example, in 1969 the Justice Department found that IBM enjoyed
an unwarranted monopoly of the domestic computer market, which was dominated by
large mainframe computers. It concluded that an antitrust suit against IBM was justified.
Prosecution of the case, which the Justice Department dropped in January 1982, took
more than a decade. The accumulated documentation from the proceedings filled a
warehouse, and the Justice Department and IBM devoted an untold number of lawyer-
hours to the case. In the meantime, IBM’s alleged monopoly was seriously eroded by
new firms producing mini-and microcomputers, a trend that has continued (and
accelerated) since 1982. Thus the net benefits to society from the antitrust action against
IBM are at best debatable, and probably negative. That is, the costs most likely exceeded
the benefits.
Equating Marginal Cost with Marginal Revenue
In deciding how many times a week to play tennis, an athlete weights the estimated
benefits of each game against its costs. Producers of goods follow a similar procedure,
although the benefits of production are measured in terms of revenue acquired rather than
personal utility. A producer will produce another unit of a good if the additional (or
Chapter 12 Monopoly Power and Firm
Pricing Decisions
marginal) revenue it brings is greater than the additional cost of its production—in other
words, if it increases the firm’s profits. The firm will therefore expand production to the
point where marginal cost equals marginal revenue (MC = MR). This is a fundamental
rule that all profit-maximizing firms follow, and monopolies are no exception.
Suppose you are in the yo-yo business. You have a patent on edible yo-yos,
which come in three flavors—vanilla, chocolate, and strawberry. (We will assume there
is a demand for these products.) The cost of producing the first yo-yo is $0.50, but you
can sell it for $0.75. Your profit on that unit is therefore $0.25 ($0.75 - $0.50). If the
second unit costs you $0.60 to make (assuming increasing marginal cost) and you can sell
it for $0.75, your profit for two yo-yos is $0.40 ($0.25 profit on the first plus $0.15 profit
on the second). If you intend to maximize your profits, you—like the perfect
competitor—will continue to expand production until the gap between marginal revenue
and marginal cost disappears. As a monopolist, however, you will find that your
marginal revenue does not remain constant. Instead, it falls over the range of production.
The monopolist’s marginal revenue declines as output rises because the price
must be reduced to entice consumers to buy more. Consider the price schedule in Table
12.1. Price and quantity are inversely related, reflecting the assumption that a monopolist
faces a downward-sloping demand curve. (Because the monopolist is the only producer
of a product, its demand curve is the market demand curve.) As the price falls from $10
to $6 (column 2), the number sold rises from one to five (column 1). If the firm wishes
to sell only one yo-yo, it can charge as much as $10. Total revenue at that level of
production is then $10. To see more—say, two yo-yos—the monopolist must reduce the
price for each to $9. Total revenue the rises to $18 (column 3).
By multiplying columns 1 and 2, we can fill in the rest of column 3. As the price
is lowered and the quantity sold rises, total revenue rises from $10 for one unit to $30 for
five units. With each unit increase in quantity sold, however, total revenue does not rise
by an equal amount. Instead, it rises in declining amounts—first by $10, then $8, $6, $4,
and $2. These amounts are the marginal revenue from the sale of each unit (column 4),
which the monopolist must compare with the marginal cost of each unit.
At an output level of one yo-yo, marginal revenue equals price, but at every other
output level marginal revenue is less than price. Because of the monopolist’s downward-
sloping demand curve, the second yo-yo cannot be sold unless the price of both units 1
and 2 is reduced from $10 to $9. If we account for the $1 in revenue lost on the first yo-
yo in order to sell the second, the net revenue from the second yo-yo is $8 (the selling
price of $9 minus the $1 lost on the first yo-yo). For the third yo-yo to be sold, the price
on the first two must be reduced by another dollar each. The loss in revenue on them is
therefore $2. And the marginal revenue for the third yo-yo is its $8 selling price less the
$2 loss on the first two units, or $6.
Thus the monopolist’s marginal revenue curve (columns 1 and 4) is derived
directly from the market demand curve (columns 1 and 2). Graphically, the marginal
revenue curve lies below the demand curve, and its distance from the demand curve
Chapter 12 Monopoly Power and Firm
Pricing Decisions
increases as the price falls (see Figure 12.1, above).
3
(More details on the derivation of
the marginal revenue curve can be found in the appendix to this chapter.)
TABLE 12.1 The Monopolist’s Declining Marginal Revenue
Quantity Total Marginal
of Yo-yos Price Revenue Revenue
Sold of Yo-yos (col. 1 x col. 2) (change in col. 3)
(1) (2) (3) (4)
0 $11 $ 0 $ 0
1 10 10 10
2 9 18 8
3 8 24 6
4 7 28 4
5 6 30 2
______________________________
FIGURE 12.1 The Monopolist’s Demand
and Marginal Revenue Curves
The demand curve facing a monopolist
slopes downward, for it is the same as
market demand. The monopolist’s marginal
revenue curve is constructed from the
information contained in the demand curve
(see Table 12.1).
Figure 12.2 adds the monopolist’s marginal cost curve to the demand and
marginal revenue curves from Figure 12.1. Because the profit-maximizing monopolist
will produce to the point where marginal cost equals marginal revenue, our yo-yo maker
will produce Q
2
units. At that quantity, the marginal cost and marginal revenue curves
intersect. If the yo-yo maker produces fewer than Q
2
yo-yos say Q
1
profits are lost
3
Prove this to yourself by plotting the figures in columns 1 and 2 versus the figures in columns 1 and 4, on
a sheet of graph paper. (Another simple way of drawing the marginal revenue curve is to extend the
demand curve until it intersects both the vertical and horizontal axes. Then draw the marginal revenue
curve starting from the demand curve’s point of intersection with the vertical axis to a point midway
between the original and the intersection of the demand curve with the horizontal axis. This method can be
used for any linear demand curve.)
Chapter 12 Monopoly Power and Firm
Pricing Decisions
unnecessarily. The marginal revenue acquired from selling the last yo-yo up to Q
1
, MR
1
,
is greater than the marginal cost of producing it, MC
1
. Furthermore, for all units between
Q
1
and
Q
2
, marginal revenue exceed marginal cost. In other words, by expanding
production from Q
1
to Q
2
, the monopolist can add more to total revenue than to total
cost. Up to an output level of Q
2
, the firm’s profits will rise.
Why does the monopolist produce no more than Q
2
? Because the marginal cost
of all additional units beyond Q
2
is greater than the marginal revenue they bring. Beyond
Q
2
units, profits will fall. If it produces Q
3
yo-yos, for instance, the firm may still make a
profit, but not the greatest profit possible. The marginal cost of the last yo-yo up to Q
3
(MC
2
) is greater than the marginal revenue received from its sale (MR
2
). By producing
Q
3
units, the monopolist adds more to cost than to revenues. The result is lower profits.
Once the monopolistic firm selects the output at which to produce, the market
price of the good is determined. In this illustration, the price that can be charged for Q
2
yo-yos is P
1.
(Remember, the demand curve indicates the price that can be charged for
any quantity.) Of all the possible price-quantity combinations on the demand curve,
therefore, the monopolist will choose combination a.
______________________________________
FIGURE 12.2 Equating Marginal Cost with
Marginal Revenue
The monopolist will move toward production
level Q
2
, the level at which marginal cost equals
marginal revenue. At production levels below
Q
2
, marginal revenue will exceed marginal cost;
the monopolist will miss the chance to increase
profits. At production levels greater than Q
2
,
marginal cost will exceed marginal revenue; the
monopolist will lose money on the extra units. .
Short-Run Profits and Losses
How much profit will a monopolist make by producing where marginal cost equals
marginal revenue? The answer can be found by adding the average total cost curve
developed in the last chapter to the monopolist’s demand and marginal revenue curves
(see Figure 12.3). As we have seen, the monopolist will produce where the marginal cost
and revenue curves intersect, at Q
1
, and will charge what the market will bear for the
quantity, P
1
. We know also that profit equals total revenue minus total cost (Profit = TR
– TC). Total revenue of P
1
times Q
1
, or the rectangular area bounded by 0P
1
aQ
1
. Total
cost is the average total cost, ATC
1
, times quantity, Q
1,
or the rectangular area bounded by
0ATC
1
bQ
1
. Subtracting total cost from total revenue, we find that the monopolist’s profit
Chapter 12 Monopoly Power and
Pricing Decisions
9
is equal to the shaded rectangular area ATC
1
P
1
ab. (Mathematically, the expression profit
= P
1
Q
1
-ATC
1
Q
1
can be converted to the simpler form, profit = Q
1
(P
1
- ATC
1
).)
__________________________________________
FIGURE 12.3 The Monopolist’s Profits
The profit-maximizing monopoly will produce at
the level defined by the intersection of the marginal
cost and marginal revenue curves: Q
1
. It will charge
a price of P
1
as high as market demand will bear -
-for that quantity. Since the average total cost of
producing Q
1
units is ATC
1
, the firm’s profit is the
shaded area ATC
1
P
1
ab.
Like perfectly competitive firms, monopolies are not guaranteed a profit. If
market demand does not allow them to charge a price that covers the cost of production,
they will lose money. Figure 12.4 shows the situation of a monopoly that is losing
money. Because losses are negative profits, the monopolist’s losses are obtained in the
same way as profits, by subtracting total cost from total revenue. The maximum price the
monopolist can charge for its profit-maximizing (or in this case, loss-minimizing) output
level is P
1
, which yields total revenues of P
1
Q
1
or 0P
1
bQ
1
. Total cost is higher: ATC
1
Q
1
,
or 0ATC
1
Q
1
. Thus the monopolist’s loss is equal to the shaded rectangular area bounded
by P
1
ATC
1
ab.
_________________________________________
FIGURE 12.4 The Monopolist’s Short-Run
Losses
Not all monopolists make a profit. With a demand
curve that lies below its average total cost curve,
this monopoly will minimize its short-run losses by
continuing to produce where marginal cost equals
marginal revenue (Q
1
units). It will charge P
1
, a
price that covers its fixed costs, and will sustain
short-run losses equal to the shaded area
P
1
ATC
1
ab.
Chapter 12 Monopoly Power and Firm
Pricing Decisions
10
Why does the monopolist not shut down? Because it follows the same rule as the
perfect competitor. Both will continue to produce as long as price exceeds average
variable cost that is, as long as production will help to defray fixed costs. In Figure
12.4, average fixed cost is equal to the difference between average total cost, ATC
1
, and
average variable cost, AVC
1
–or the vertical distance ac. Total fixed cost is therefore ac
times Q
1
, or the area bounded by AVC
1
ATC
1
ac. Because the firm will suffer a greater
loss if it shuts down (AVC
1
ATC
1
ac) than if it operates (P
1
.ATC
1
ab), it chooses to operate
and minimize its losses.
Of course, in the long run, when the monopoly firm is able to extricate itself from
its fixed costs, it will shut down.
Production Over the Long Run
In the long run the monopolistic firm follows the same production rule as in the short run:
it equates marginal revenue with long-run marginal cost. In Figure 12.5(a), for instance,
the firm produces quantity Q
a
, and sells it for price P
a
,. (As always, profits are found by
comparing the price with the long-run average cost. As an exercise, shade in the profit
areas on the figure.) Unlike the perfect competitor, the monopoly firm does not attempt
to produce at the lowest point on the long-run average cost cure. With no competition,
the monopolistic firm has no need to minimize average total cost. By restricting output,
it can charge a higher price and earn greater profits than it can by taking advantage of
economies of scale.
Monopolists sometimes do produce at the low point of the long-run average cost
curve. They do so only when the marginal revenue curve happens to intersect the long-
run marginal and average cost curves at the exact same point [see Figure 12.5(b)] . In
this case the monopolist produces quantity Q
b
, and sells it at a price of P
b
, earning
substantial monopoly profits in the process.
If the demand is great enough, the monopolist will actually produce in the range
of diseconomies of scale [see Figure 12.5(c)]. How can the monopolist continue to exist
when its price and costs of production are so high? Because barriers to entry protect it
from competition. If barriers did not exist, other firms would certainly enter the market
and force the monopolistic firm to lower its price. The net effect of competition would
be to induce the monopolist to cut back on production, reducing average production costs
in the process.
Monopolists cannot exist without barriers to market entry. If other firms had
access to the market, the monopolist’s profit would be its own undoing—for profit is
what others want and will seek, if they can enter the market.
The Comparative Inefficiency of Monopoly
The last chapter concluded that in a perfectly competitive market, firms tend to produce
at the intersection of the market supply and demand curves. That point (b in Figure 12.6)
is the most efficient production level, in the sense that the marginal benefit to the
Chapter 12 Monopoly Power and Firm
Pricing Decisions
11
consumer of the last unit produced equals its marginal cost to the producer. All units
whose marginal benefits exceed their marginal costs are produced. All possible net
benefits to the consumer have been extracted from production.
FIGURE 12.5 Monopolistic Production Over the
Long Run
In the long run, the monopolist will produce at
the intersection of the marginal revenue and
long-run marginal cost curves (part (a)] .
Unlike the perfect competitor, the monopolist
does not bother to minimize long-run average
cost by expanding its scale of operation. It can
make more profit by restricting production to
Q
b
and charging price P
b
. In part (b), the
monopolist produces at the low point of the
long-run average cost curve only because that
happens to be the point where marginal cost and
marginal revenue curves intersect. In part (c),
the monopolist produces on a scale beyond the
low point of its long-run average cost curve
because demand is high enough to justify the
cost. In each case, the monopolist charges a
price higher than its long-run marginal cost.
Chapter 12 Monopoly Power and Firm
Pricing Decisions
12
When the supply and demand model is applied to a monopolized market, the
industry supply curve becomes the monopolist’s marginal cost curve (for the monopolist
must long-run the plants that in a competitive industry would belong to other producers).
4
Similarly, the industry’s demand curve becomes the monopolist’s demand. Where as
individual competitors must produce at the intersection of supply and demand, the
monopolistic firm can choose the price-quantity combination it prefers. By employing
fewer resources from production, it can sell a smaller quantity at a higher price. That is
just what happens. In short, the monopolist produces less than the competitive level of
production Q
m
instead of Q
c
,
_______________________________________
FIGURE 12.6 The Comparative Efficiency of
Monopoly and Competition
Firms in a competitive market will tend to
produce at point b, the intersection of marginal
cost and demand (marginal benefit).
Monopolists will tend to produce at point c, the
intersection of marginal cost and marginal
revenue, and to charge the highest price the
market will bear P
m
. In a competitive market,
therefore, the price will tend to be lower (P
c
) and
the quantity produced greater (Q
c
) than in a
monopolistic market. The inefficiency of
monopoly is shown by the shaded triangular area
abc, the amount by which the benefits of
producing Q
c
– Q
m
units (shown by the demand
curve) exceed their marginal cost of production.
For each unit between Q
m
and Q
c
, the marginal benefits to the consumer, as
illustrated by the market demand curve, are greater than the marginal costs of production.
These are net benefits that consumers would like to have, but that are not delivered by the
monopolistic firm interested in maximizing profits, not consumer welfare. The resources
that are not used for their manufacture must either remain idle or be used in a less
valuable line of production. (Remember, the cost of doing anything is the value of the
next-best alternative forgone.) In this sense, economists say that resources are
misallocated by monopoly. Too few resources are used in the monopolistic industry, and
too many elsewhere.
On balance, then, the inefficiency of monopoly is the benefits lost to consumers
when production is restricted. When compared to the outcome under perfect competition,
monopoly price is too high and output too low. In Figure 12.6, the gross benefit to
consumers of Q
c
– Q
m
units is equal to the area under the demand curve, or Q
m
abQ
c
. The
cost of those additional units is equal under the marginal cost curve, or Q
m
cbQ
c
.
Therefore the net benefit of the units not produced is equal to the shaded triangular area
abc. This area represents the inefficiency of monopoly, sometimes called the dead-
weight welfare loss of monopoly. To put it another way, area abc represents the gain in
4
The industry supply curve is not the monopolist’s supply curve, however, for a firm’s supply is its price-
quantity relationship—and a monopolist’s price will always exceed its marginal cost.
. a demand for these products.) The cost of producing the first yo-yo is $0.50, but you
can sell it for $0.75. Your profit on that unit is therefore $0.25. duplicating it. For years, Polaroid had a patent
monopoly on the instant-photograph market. (Eastman Kodak developed an
alternative process, but was forced to