Pure Monopoly: Price and Output Determination

EC 201 Cal Poly Pomona Dr. Bresnock

Lecture 10

Remember these pure monopoly characteristics:

(1) Single Seller -- “The firm is the industry.” (2) No Close Substitutes -- Unique product. (3) “ Price Maker” -- Firm has power to determine price on its own. (4) Significant “Barriers to Entry” -- See examples below. (5) Goodwill Advertising Only -- Typically public service or educational ads.

Note: Examples of “pure monopoly” are few. Public utilities are government-owned, or regulated monopolies. Even something like DeBeers diamond syndicate controls 70% rather than the entire diamond supply. Most monopolies tend to be “dominant firm” monopolies in which one firm has a substantial market share relative to the remaining firms (often referred to as the “competitive fringe” and composed of many, small firms). Examples of “dominant firm monopolies” include: Gillette, 70% of razor blade sales; Xerox, 75 – 80% of electrostatic copier revenues, etc.

However, about 5 – 6% of economic activity is conducted under conditions that are similar to “pure monopolies”. Our study of the “pure monopoly” will show us the general differences between purely competitive and imperfectly competitive market structures, such as oligopoly and monopolistic competition. The latter two market structures combine characteristics of pure competition and pure monopoly in differing degrees.

“ Barriers to Entry” -- Economic, technological, legal or geographic factors that block, or inhibit, other firms from entering an industry. With a “pure monopoly”, the “barriers to entry” are complete and entry is totally blocked. With other imperfectly competitive market structures, “barriers to entry” are present but to a lesser degree. Examples of “barriers to entry” include:

(1) Economies of Scale -- technology that leads to efficient, low-cost production is often achieved by producers that are larger, incumbent firms that control substantial portions of market sales. These firms experience declining long run average cost, LRAC (or economies of scale), that can create financial obstacles for new firms to enter the market. The existing firms will be able to pass cost savings along to the customers in the form of lower prices. Such low prices may be so low that new firms will find it difficult to compete on a price basis, and will often earn economic losses if they try to do so. EC 201 Lecture 10 Dr. Bresnock

Graph 1 Economies of Scale as a “Barrier to Entry”

$M, QM = Monopolist can sell at this price and quantity due to the existing demand for its product and economies of scale.

$NF, QNF = New firm’s needed price to just cover costs at QNF.

$NF - $M = Advantage in pricing ability of incumbent firm.

“ Natural Monopoly” -- if the market demand cuts the declining portion of the LRAC, then the single firm is referred to as a natural monopoly. In such a case, the firm will be motivated to earn economic profits and change a price above its LRAC. As a result, governments typically regulate natural monopolies – specifically the prices charged. This is often justified, as with public utilities, as limiting wasteful spending, i.e. duplicating extensive capital equipment like generators, water mains, pumps, transmission lines.

(2) Patents and Licenses -- legal barriers to entry. Patent = exclusive right of an inventor to use, or allow another to use, his/her invention. Patent length = 20 years as per GATT, 1995. License = a limit on the entry of a firm into an industry that is enforced by government.

(3) Ownership of Essential Raw Materials -- owning or controlling a substantial amount of an essential raw material via private property rights, i.e. DeBeers, Aluminum Company of America.

(4) Pricing and Other Strategic Barriers -- aggressive price cutting, increased advertising, and other actions that make it difficult for an entering firm to succeed. While these actions have a negative connotation, there are other actions that arise from more positive circumstances that can make it difficult for new entrants to survive, i.e. longevity advantages -- well established clientele, favorable financing to long-term customers.

2 EC 201 Lecture 10 Dr. Bresnock Note: Barriers to entry may not, however, be complete. Why? First, new substitutes will emerge over time. Second, foreign competition will increase over time as well as domestic competition.

Price and Output Determination: Pure Monopoly (Non- Price Discriminating)

Monopoly Demand -- for the firm…

(1) IS the industry demand.

(2) Is downward sloping --

(a) As P  Q thus MR < P (= AR) The firm can lower price to increase sales. The MR for each additional unit falls faster than the price as quantity is increased.

(b) The monopolist chooses both P and Q. The quantity is selected first based on the profit maximization, or loss minimization, principle. Once the quantity is chosen, the monopolist selects the price associated with that quantity demanded for its product. The total and marginal approaches for this decision are:

Total Approach

(1) Pick Q where

Max. Total Economic Profits or Max. (TR – TC)

(2) Pick P at the Q selected in (1).

Marginal Approach

(1) Pick Q where

MR = MC (Guarantees that TOTAL profit is maximized.) MC > 0 (Marginal profit is ZERO.)

(2) Pick P at the Q selected in (1).

3 EC 201 Lecture 10 Dr. Bresnock

Table 1 Price and Output Determination for Pure Monopolist (Non-Price Discrimination)

(8) (1) (2) (3) (4) (5) (6) (7) Total Q P=AR TR MR TC ATC MC Economic Profit (+) or Loss (-) (3) – (5) 0 $15 1 $26 35 2 24 50 3 22 60 4 20 65 5 18 75 6 16 90 7 14 110 8 12 135 9 10 165 10 8 200 11 6 240 12 4 285 13 2 335

Graph 2 Price and Output Determination: Pure Monopoly (Total Approach)

4 EC 201 Lecture 10 Dr. Bresnock

Graph 3 Price and Output Determination: Pure Monopoly (Marginal Approach)

Other Possible Outcomes

(1) Breakeven -- TR = TC for the total approach. Firms earn “normal profits” only. “Economic profits” are zero. For the marginal approach, when the quantity is selected at MR = MC and MC > 0 and Marginal Profit = 0. At that quantity, the price will be… PBE = ATC.

Graph 4 Price and Output Determination: Pure Monopoly (Total Approach, Break-Even)

5 EC 201 Lecture 10 Dr. Bresnock

Graph 5 Price and Output Determination: Pure Monopoly (Marginal Approach, Break-Even)

(2) Loss Minimization -- Min. TR – TC, or Min. Total Economic Losses for the total approach. For the marginal approach, when the quantity is selected at MR = MC and MC > 0 and Marginal Profit = 0. At that quantity, the price will be… PMIN < ATC but PMIN > AVC.

Graph 6 Price and Output Determination: Pure Monopoly (Total Approach, Loss Minimization)

6 EC 201 Lecture 10 Dr. Bresnock

Graph 7 Price and Output Determination: Pure Monopoly (Marginal Approach, Loss Minimization)

(3) Shut-Down -- Min. TR – TC, or Min. Total Economic Losses for the total approach. This occurs when Q = 0. For the marginal approach, when the quantity is selected at MR = MC and MC > 0 and Marginal Profit = 0. At that quantity, the price will be… PSD < AVC. The firm will lose its TFC and go out of business.

Graph 8 Price and Output Determination: Pure Monopoly (Total Approach, Shut-Down)

7 EC 201 Lecture 10 Dr. Bresnock

Graph 9 Price and Output Determination: Pure Monopoly (Marginal Approach, Shut-Down, In Business)

Graph 10 Price and Output Determination: Pure Monopoly (Marginal Approach, Shut-Down, Out of Business)