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Monopoly can be viewed as the opposite of perfect competition. Instead of many firms, there is only one: the monopolist. This has important consequences for both price setting and the quantity produced.

Barriers to Entry

Why do monopolies arise? There are many different reasons, but all of them have to do with barriers to entry in the market. The reasons for these barriers could be

  • Structural. There are properties of the market that automatically shut competitors out:
  1. Economies of scale. If there are economies of scale, large-scale advantages, the size of the firm is crucial for average cost. A situation can then arise in which only one firm can recover its costs. This is called a natural monopoly and an example of this is railroads.
  2. Cost advantages. If the monopolist has access to a cheaper way of producing the good, for instance if she has a patent on a cheaper technology, she can push competitors out of the market.
  • Strategic limitations. The monopolist can create barriers to entry. An example is limit pricing, where the monopolist sets the price so low that it becomes unattractive for competitors to enter.
  • Political. The government may decide to grant a firm a monopoly in a certain market. A common example is for pharmaceutical goods.
  • Patents and exclusive rights. If a firm has a patent on a certain good, other firms are shut out during the life span of the patent. It is also possible to have exclusive right to extracting, for instance, oil or metals.

Demand and Marginal Revenue

we will assume that the monopolist charges all customers the same price. The monopolist faces the whole demand of the market. The individual firm in a competitive market only faces a small part of the market. Therefore, it can be represented as in the right-hand side of the figure. A monopolist is the whole market. Therefore, it looks like the left-hand side of the figure. In order to sell more goods, the monopolist has do reduce the price, and the demand curve it faces will therefore slope downwards. Now, note that the demand curve is decided by the consumers and not by the firm. It answers the question: if we would offer a certain price, how many units would we then be able to sell? In the perfectly competitive market, marginal revenue was equal to the price. That is not the case for a monopolist. For the an additional unit of the good, she must lower the price of all units. The total effect of selling one more unit then consists of both what she is paid for the last unit and of the reduction of revenue from all the other units that she now has to sell at the lower price. Consequently, the marginal

Let us see what this means for a good with linear demand. If the demand curve is a straight line, the MR curve will also be a straight line with the same intercept on the Y-axis as the demand curve. However, it will have a slope with twice the magnitude.

We will use the demand curve QD = 30 - p, or if we solve for p: p = 30 - QD . If the MR curve is to start in the same point and have a slope that is twice as large, its functional form must be MR = 30 - 2*QD. (The constant is the same, 30, and the slope is changed from -1 to -2). In Figure 11.1 the curves are drawn as D and MR. We have also drawn a marginal cost curve, MC (= 2*Q), an average cost curve, ATC, and an average variable cost curve, AVC (= Q), and, in the lower part of the figure, total revenue, TR, and profit, π.

Profit Maximum

The monopolist wants to maximize her profit. She does that by producing the quantity, Q*, at which MC = MR:

In Figure 11.1, this corresponds to the quantity 7.5, where both MR and MC equal 15. To see that this choice maximizes the profit, think of what would happen if she would produce more than that quantity. If she would produce one more unit, she would get paid MR but also incur a cost of MC. Moreover, since MC > MR, the cost is larger than the revenue and she would reduce profit; similarly if she would reduce the production. The profit at a quantity of 7.5 is, according to the lower diagram, 82.5. The price the monopolist will charge is the one that the consumers, according to the prepared to pay when the total production is 7.5, i.e. 22.50. The corresponding ATC is 11.50. In other words, the monopolist makes 22.50 - 11.50 = 11 per unit sold, totaling to 11*7.5 = 82.5. This corresponds to the grey rectangle in the upper part of the figure. Similarly to the firms in a perfectly competitive market , the price must also be above the average variable cost, AVC. If it is not, it is better to produce nothing at all. In the long run, the firm must also cover its fixed cost, and then the price must be above the average total cost, ATC. In Figure 11.1, we have also indicated where total revenue is maximized. This occurs at the quantity Q = 15 and corresponds to the point in the upper part of the Figure where MR = 0. Note that this point does not maximize the profit. In the example, the firm makes a loss at that quantity.

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