Monopoly

Monopoly Graph

We have quite a few exciting graphs to show what's going on with a monopoly, so let's get started!

Demand curve for monopoly

What is the demand curve for a monopoly? Let's start from the very beginning!

The biggest difference between a monopolist and a firm in a perfectly competitive market is the firm's ability to influence the price. In a perfectly competitive market, since there are many firms competing for consumer demand, any one firm is just a price-taker. As shown in Figure 1, the firm faces a flat demand curve at the market price Pm. If it charges a higher price than the market price, the consumers would go to the other suppliers, and the firm would lose all demand.

A monopolist is the only supplier in the market, by definition. The monopolist faces the market demand curve, which is downward-sloping, as shown in Figure 2.

Fig. 1 - Demand curve faced by a firm in a perfectly competitive market

Fig. 2 - Demand curve faced by a monopolist

Marginal revenue curve for monopoly

The next element is the monopolist's marginal revenue curve.

Fig. 3 - A monopolist's marginal revenue curve

The thing to remember is that the monopolist's marginal revenue curve is below the demand curve, as shown in Figure 3. Why is the marginal revenue curve below the demand curve? Because the monopolist controls the market and the price. Let's look at the table below for an example of a software company that has monopoly power.

To increase the quantity sold from 1 to 2, the company has to lower the price from $500 to $450; and to sell the third piece of software, it has to lower the price further to $400. You can see from the last column that the marginal revenue for each new unit sold is lower than that for the last unit. This is because the company has to lower its price on all units in order to sell more units. The revenue it loses from lowering prices on the previous units is the price effect. The revenue it gains from selling the additional unit is the quantity effect.

\(\hbox{The price effect of selling the third unit}=(\$400-\$450)\times2=-\$100\)

\(\hbox{The quantity effect of selling the third unit}=\$400\times(3-2)=\$400\)

The marginal revenue of selling the third unit is the sum of the price and quantity effects, which is $300.

Table 1. A software monopoly example

Monopoly Profit Maximization

Let's now explore monopoly profit maximization!

How does a monopolist maximize profit?

As in the case of firms in any market structure, the profit-maximizing point for a monopolist is where marginal revenue equals marginal cost. The difference for a monopolist is that its marginal revenue (MR) curve is below the demand curve. For a monopolist, the demand curve is also its average revenue (AR) curve because it supplies the entire market.

Here in Figure 4, we assume that there is no fixed cost, and that marginal cost is constant. Because there is no fixed cost, the marginal cost (MC) curve is also the average total cost (ATC) curve. The monopolist will produce until point A, where the MR and MC curves intersect. It will charge the corresponding price on the demand curve at point B with price Pm. The orange area is the monopoly profit.

Fig. 4 - Profit maximization by a monopolist

Monopoly Examples

Let's explore some monopoly examples by looking at:

• monopoly vs perfect competition
• natural monopoly

Monopoly vs perfect competition

The difference between a firm in a perfectly competitive market and a monopolist is how much they can charge the consumers for their products. In perfect competition, a firm faces many other competitors and can only take the market price as given. If it charges a higher price, it loses all demand because the consumers will buy from the other firms.

This is shown in Figure 5: the market price in perfect competition (Pc) is given by the marginal cost (MC) curve, and the firms will supply until point C, where the market demand curve intersects with the market price. The quantity produced under perfect competition (Qc) is also the socially optimal quantity. In a perfectly competitive market, the area of 1, 2, and 3 represent consumer surplus.

Compare this to a monopoly, consumer surplus is only a much smaller area (area 2) because of the higher price and less quantity supplied. Area 1 is the profit that goes to the monopolist, and area 3 is the deadweight loss. As you can see from here, a monopoly leads to a higher price and less quantity produced than the social optimum.

Fig. 5 - Monopoly vs perfect competition

Natural monopoly

A natural monopoly occurs when long-run economies of scale exist for just one firm to serve the entire market. In other words, there are large cost savings for a natural monopoly to exist in a market. Because of the high fixed cost involved, it would be too costly for another firm to enter the market. This is often the case for utility companies that require building a large infrastructure to serve the public.

Figure 7 shows such a market where there is a high fixed cost. The average total cost (ATC) decreases as the quantity goes up.

If the monopolist only cares about maximizing profit, it would supply until point A with price Pm. In this case, area 1 is consumer surplus, and area 2 is the monopoly profit. But this creates a large loss for society, so the government may step in and impose regulations on the natural monopolist.

For example, the government can choose to cap the price at the monopolist's average cost at point C with price Pr. At this price, the natural monopolist is breaking even, after taking into account all of its costs. At this point, all of the shaded areas (1, 2, 3) are the consumer surplus. If the price is set at P=MC at point D, as it would have been in perfect competition, the monopolist would be making a loss and would require government subsidies to continue operating.

Fig. 7 - A natural monopoly

Sources:

1. "De Beers - Monopoly Broken." Australian Diamond Portfolio.