AP Microeconomics – Chapter 10 Outline I. Learning Objectives—In this chapter students should learn: A. The characteristics of pure monopoly. B. How a pure monopoly sets its profit‐maximizing output and price. C. The economic effects of monopoly. D. Why a monopolist might prefer to charge different prices in different markets. E. The difference between the monopoly price, the socially optimal price, and the fair‐ return price of a government‐regulated monopoly. II. Pure Monopoly: An Introduction A. Definition: Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. B. Characteristics of a Pure Monopoly 1. A single firm is the sole producer, so the firm and industry are synonymous. 2. There are no close substitutes for the firm’s product. 3. The firm is a “price maker;” that is, the firm has considerable control over the price because it can control the quantity supplied. 4. Entry into the industry by other firms is completely blocked. 5. A monopolist may or may not engage in nonprice competition. Depending on the nature of its product, a monopolist may advertise to increase demand. C. A number of producers have a substantial amount of monopoly power and are called “near” monopolies. D. Examples of Pure Monopolies and “Near Monopolies” 1. Public utilities—gas, electric, water, cable TV, and local telephone service companies—are pure monopolies. 2. Intel (computer microprocessors), First Data Resources (Western Union), Wham‐O (Frisbees), and the DeBeers diamond syndicate are examples of “near” monopolies (Last Word). 3. Professional sports leagues grant team monopolies to cities. 4. Monopolies are virtually nonexistent in nationwide manufacturing industries, but monopolies may be geographic; a small town may have only one airline, bank, or grocery store. E. Analysis of monopolies yields insights concerning monopolistic competition and oligopolies, the more common types of market structures (Chapter 11). III. Barriers to Entry Limiting Competition A. The strength of the barriers preventing entry of new firms helps to define a market structure. 1. Pure monopoly—strong barriers effectively block all potential competition. 2. Oligopoly—weaker barriers allow a few firms to dominate the market. 3. Monopolistic competition—weak barriers permit many firms to enter the industry.
AP Microeconomics – Chapter 10 Outline 4. Pure competition—a lack of effective barriers allows the large number of firms in the industry. B. Economies of Scale 1. As the firm grows in size, long‐run average total cost continues to fall over a wide range of output. This occurs where the lowest unit costs (and, therefore, lowest unit prices for consumers) depend on the existence of a small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm is most efficient, new firms cannot afford to start up in industries with economies of scale (Figure 10.1).
2. Public utilities are often natural monopolies because they have economies of scale, so one firm is most efficient in satisfying existing demand; laying additional mazes of water pipes or electric lines, in the name of competition for utilities, would be very inefficient. 3. Government usually gives one firm the right to operate a public utility in exchange for government regulation of its power. C. Legal Barriers to Entry: Patents and Licenses 1. Patents grant the inventor the exclusive right to produce or license a product for twenty years. This exclusive right can earn profits for future research, which results in more patents and monopoly profits. 2. Licenses for radio and TV stations, taxi companies, and liquor stores are means by which government limits the number of producers to only one or a few firms. D. Ownership or Control of Essential Resources 1. International Nickel Company of Canada (now called Inco) controlled about 90 percent of the world’s nickel reserves, and DeBeers of South Africa controls most of the world’s diamond supplies (Last Word). 2. Aluminum Company of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication.
AP Microeconomics – Chapter 10 Outline 3. Professional sports leagues control player contracts and leases on major city stadiums. E. Pricing and Other Strategic Barriers 1. Dentsply, a manufacturer of false teeth that controlled about 70 percent of the market, illegally prevented distributors from carrying competing brands. 2. Microsoft illegally charged higher prices for its Windows operating system to computer manufacturers featuring Netscape Navigator instead of Microsoft’s Internet Explorer. IV. Monopoly Demand A. Analysis of monopoly demand makes three assumptions: 1. The monopoly is secured by patents, economies of scale, or resource ownership. 2. The firm is not regulated by any unit of government. 3. The firm is a single‐price monopolist; it charges the same price for all units of output. B. While the purely competitive firm faced a horizontal demand curve as a “price taker,” the pure monopolist faces a downward sloping market demand curve, because it is the only firm in the industry. The firm is the industry. In order to sell more products, the firm must lower the price of all of the products it sells. C. Price will exceed marginal revenue because the monopolist must lower the price to sell each additional unit. The added revenue will be the price of the last unit less the sum of the price cuts which must be taken on all prior units of output (Table 10.1 and Figure 10.2).
See next page for Figure 10.2
AP Microeconomics – Chapter 10 Outline
1. Figure 10.3 shows the relationship between the demand, marginal‐revenue, and total‐revenue curves.
2. The marginal‐revenue curve is below the demand curve, and when it becomes negative, the total‐revenue curve turns downward as total revenue falls. D. The monopolist is a “price maker”. The firm controls output and price but is not free of market forces, since the combination of output and price depends on demand. For example, Table 10.1 shows that at $162 only 1 unit will be sold, and at $152 only 2 units will be sold.
AP Microeconomics – Chapter 10 Outline E. The monopolist sets prices in the elastic region of the demand curve. The total‐ revenue test shows that a monopolist will avoid the inelastic segment of its demand schedule. As long as demand is elastic, total revenue rises when the monopoly lowers its price. But when demand becomes inelastic, total revenue falls as output expands. Because total costs rise with output, profits will decline as demand becomes inelastic. Therefore, the monopolist will expand output only in the elastic portion of its demand curve. V. Output and Price Determination A. Cost data is based on hiring resources in competitive markets, so the cost data of Chapter 7, used in the price and output determination of the purely competitive firm in Chapters 8 and 9, can be used in this chapter, as well. The costs in Table 10.1 restate the data of Table 7.2. B. The monopolist, like the pure competitor, uses the MR = MC rule to find its profit‐ maximizing output level (Table 10.1 and Figure 10.4). The same result can be found by comparing total revenue and total costs incurred at each level of production.
Figure 10.4
C. Price is determined by extending a vertical line from the MR = MC output up to the demand curve. Be careful to ensure students do not set the price at the MR = MC point. D. The monopolist’s profit or loss is the difference between the price and the average total cost. Price minus ATC is the profit per unit, and the profit per unit times the quantity is the firm’s total profit. Profit can also be determined by subtracting total cost from total revenue. Be careful to ensure students illustrate the area of profit by
AP Microeconomics – Chapter 10 Outline only showing the vertical distance between price and ATC, not the distance between price and the MR = MC point. E. The pure monopolist has no supply curve because there is no unique relationship between price and quantity supplied. The price and quantity supplied will always depend on the location of the demand curve. F. Misconceptions about Monopoly Pricing 1. A monopolist cannot charge the highest possible price, because it will maximize profit where total revenue minus total cost is greatest. This depends on quantity sold as well as on price, and it will never be the highest price possible. 2. Total profit, not unit profit, is the goal of the monopolist. Table 10.1 shows per‐ unit profit is $32 at 4 units of output, compared with $28 at the profit‐ maximizing output of 5 units. Once again, quantity must be considered as well as per‐unit profit.
G. Unlike the pure competitor, the pure monopolist can continue to receive economic profit in the long run because of barriers to entry. H. Although losses can occur in a pure monopoly in the short run (P