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Economics for Today Instructor’s Manual

Chapter 8 Monopoly Chapter summary This chapter examines the market structure of monopoly. The characteristics of a monopoly are that it is a single seller, the product produced is unique and there are barriers to entry. Barriers to entry may include ownership of a vital resource, legal barriers or economies of scale. The latter barrier also leads to what is known as a natural monopoly. Being a single seller indicates that the monopoly is a price maker – that is, it sets the price in the market by producing an output level that maximises its profits thereby effectively determining market supply; this in turn sets the market price. The monopolist faces the market demand curve. Therefore, the monopolist’s marginal revenue curve lies below the market demand curve it faces. The profit-maximising output is still where marginal revenue (MR) equals marginal cost (MC). Long-run economic profits are expected for a monopolist because of the strong barriers to entry, which limit others from entering and competing in the market. Monopolies may price discriminate in order to increase their profits if they are able to do so. Price discrimination means the firm is charging different prices to different people where those price differences are not a reflection of cost differences. A comparison with perfect competition is also made in order to look at the disadvantages of a monopoly and advantages of perfect competition. This chapter concludes with an analysis of the pros and cons of monopoly.

Key concepts •

Monopoly

•

Price discrimination

•

Natural monopoly

•

Arbitrage

•

Price maker

Instructional objectives After completing this chapter, students should be able to: •

describe the characteristics of a monopoly

•

graphically express the monopolist’s demand curve and understand that this curve is really the market demand curve

•

graphically find the profit maximising output to produce and explain why this output is the profit maximising level

•

graphically determine the area representing any economic profits or losses

•

explain why short-run economic profits may persist in the long run

•

explain what is meant by price discrimination, what must be accomplished in order to do so and why a monopolist may price discriminate

•

discuss the ethical dilemmas involved in some forms of price discrimination

•

compare and contrast the competitive market environment and the monopoly market

•

list the monopoly disadvantages from society’s perspective.

Chapter 8 outline Introduction 74 © Cengage Learning Australia 2015

Chapter 8: Monopoly

The monopoly market structure Single seller Unique product Barriers to entry Ownership of a vital resource Legal barriers Global perspective: Tesla – swapping one barrier for another? Economies of scale Exhibit 8.1: Minimising costs in a natural monopoly Price and output decisions for a monopolist Marginal revenue, total revenue and price elasticity of demand Exhibit 8.2: Demand, marginal revenue and total revenue Monopoly in the short run Exhibit 8.3: Profit maximisation and loss minimisation for a monopolist Monopoly in the long run Price discrimination Conditions for price discrimination Exhibit 8.4: Price discrimination Economics and ethics You’re the economist: What do publishers, car makers, developers and flat-pack furniture deliverers have in common? Comparing monopoly and perfect competition The monopolist as a resource misallocator Exhibit 8.5: Comparing a perfectly competitive firm and a monopolist Perfect competition means more output for less Exhibit 8.6: The impact of monopolising an industry The case against and for monopoly Analyse the issue: Does size matter? Key concepts Summary Study questions and problems Answers to ‘You’re the economist’ Multiple-choice questions Cengage CourseMate

Hints for effective teaching 1

Ask students to give some examples of monopoly markets. In the past, some examples included local telephone services, local cable TV and utilities companies. But note that times have changed and that competition is the main driving force towards efficiency and productivity. Note also that monopolies can be found at the local level (e.g. the only service station or hotel in small town).

Point out that many real-world monopolies are natural monopolies, which are government owned or government regulated. Ask them to explain this, and discuss economies of scale. © Cengage Learning Australia 2015

Economics for Today Instructor’s Manual

Students may have had some difficulty with P = D = MR = AR in perfect competition but they can struggle too with having separate D and MR curves in monopoly. Take them through as example, such as in Exhibit 8.2, so that they can see why the demand curve is downward sloping and why, therefore, the marginal revenue curve will be below the demand curve. Once this is established, then, using a diagram, you can add the MC curve and identify the point where MR = MC. Remind the students that this is the profit-maximising output rule, i.e. for all market structures. However, in perfect competition, it would end here as we would have profit-maximising output (where MR = MC) and price (as P = MR). For monopoly, we have the profit-maximising output by going down to the horizontal axis to find the quantity at the point where MR = MC, but then we need to see what P relates to this Q by going up to the demand curve. This means that the monopolist will maximise profit by charging a price above marginal cost.

Following on from profit maximisation, it is then possible to add the ATC curve to see whether the monopolist will be making a profit or loss. This is important, as students often expect that because it is a price taker the monopoly will never make a loss. Remind them again of what the demand curve is telling them: even though it is the market demand curve as well as the monopoly demand curve, to sell more it is necessary to lower the price.

Have students think of some examples of price discrimination. Examples could include doctors’ services, movie theatres, flights and university fees as they are likely to have experienced price discrimination in these cases.

Stress the negative social outcomes associated with monopolised markets. It would also be useful to compare the negativity in light of perfect competitive markets.

Point out that the ACCC is charged with combating the growth of monopoly power. Moreover, this is a most effective way to combat monopoly power. In the text, the discussion on ‘Analyse the issue: Does size matter?’ would be a good one. You could use an example of airports, which could be seen as a natural monopoly achieving economies of scale (it is hardly practical to have multiple airports in a relatively small city), but which attract attention from the ACCC for use of their monopoly power in providing and charging for various services, including parking. Do a search on the ACCC site (www.accc.gov.au) for its annual report on airport performance.

Chapter 8: Monopoly

Solutions to text problems Analyse the issue Does size matter? (pp. 202–3) 1

In order to become competitive internationally, firms must do more than just reduce their input cost levels. This is possible with economies of scale, which can be achieved through mergers with other firms producing similar products/services.

Mergers were approved because the ACCC determined that these mergers did not significantly reduce competition in the Australian market. These mergers it is believed will improve the welfare of the public. Use the ACCC website (www.accc.gov.au) to find instances of where mergers have or have not been approved and why or why not.

Study questions and problems: Solutions (pp. 206–7) 1

a The fact that there is only one casino in the city indicates that it has monopoly power within the city as it is the only provider of gambling activities and the product is unique b The supplier of the NBN operates as a natural monopoly in which average costs decline continuously as output increases in the long run. There is a large setup cost in the NBN which is why there is only one NBN. c The City of Sydney owns the Harbour Bridge and would give a permit for one company to organise bridge climbing. Hence, the product/service is unique, with only one supplier/seller.

A monopoly situation enables price discrimination under certain conditions. Price discrimination increases economic welfare of some segments of society. For example, as the textbook points out that ‘price discrimination means that lower prices are available to the needy when they use public transport, visit the hairdresser or use doctors’ and lawyers’ services’ (p. 199). In other words, some buyers are prevented from being excluded from consuming some products or services. Furthermore, since a monopolist produces less at a higher price, it can be argued that such a system reduces waste. In some cases, a monopoly situation is also good for the environment, which in turn increases human welfare.

The cafeteria at the football game can charge higher prices than the nearby snack bar because game attendees can purchase the pies more easily and conveniently rather than take the time to travel to the snack bar. There is also a ‘captive’ element at a football game, so the cafeteria situated at the game has a locational monopoly.

Barriers to entry derive from the ownership of assets, legal barriers and economies of scale. An example of each would be De Beers and its diamond mines (ownership of assets), Australia Post having a government franchise to sell postage stamps (legal barriers) and a gas or electricity provider (a natural monopoly from economies of scale)

In the inelastic range of the demand curve, MR is negative while MC is positive. Because the monopolist will profit maximise by setting MR equal to MC and since MC is always positive, then MR must be positive. That is, it will always operate where demand is elastic (see the table and graph at question 6).

Economics for Today Instructor’s Manual

6 Price ($)

Quantity demanded

Total revenue ($)

Marginal revenue ($)

Price elasticity of demand

5.00

– elastic

4.50

4.50 elastic

4.00

3.50 elastic

3.50

2.50 elastic

3.00

1.50 elastic

2.50

.50 unit elastic

2.00

-.50 inelastic

1.50

-1.50 inelastic

1.00

-2.50 inelastic

0.50

-3.50 inelastic

0.00

-4.50 inelastic

This graph below is similar to what was shown in Exhibit 5.5, p.111. Figure 8A-1

Output will be 5, where MR = MC (see Figure 8A-1) so Price will be $2.50 (see table in 6 above or figure for P when Q = 5) and this gives us Profit of $12.50 (see table or figure). The price elasticity of demand is unit elastic. If MC > 0, the price will be above $2.50 and output will be less than 5 (see the table or figure).

When MC > MR, the monopolist will decrease output.

When MR > MC, the monopolist will increase output.

Chapter 8: Monopoly

There will be no price or output. The monopolist shown in the graph would shut down, because the price is below average variable cost (AVC) at the point where MR = MC output. (The demand curve is everywhere below the AVC curve.)

10 A single seller is likely to emerge because the firm with the higher cost will leave the market since it cannot compete with the other firm’s lower cost. Alternatively, the higher cost firm might merge with the lower cost firm. 11 See Figure 8A-2. Before the takeover, the price of lawn mowing is Pc and the output is Qc. Since Pc = MC, the allocation of resources to the perfectly competitive mowing service is efficient. After the takeover, the price rises to Pm, and the quantity supplied falls to Qm. To profit maximise, the monopolist equates MR and MC, with P > MC. As a result, resources are under-allocated to a monopolistic lawn mowing business. As there are no barriers to entry, the monopoly would not survive. Figure 8A-2

12 The reason why this occurs is that the firm that sells the clothing and shoes intends to compete in all segments of the market by selling at a single price. Hence no market segment is left out. It can also reduce certain administrative costs (e.g. advertisements, printing different price labels, etc) by charging a single price. Hence, this strategy is quite attractive to consumers and increases the profits of the seller (larger quantity sold). There is in effect price discrimination where some sizes (e.g. large sizes) earn less profit than smaller sizes. However, the quantity sold increases – hence increased profits for the firm. 13 Durable goods do not wear out as quickly as their complementary good. Hence, durable goods are sold at a low price (perhaps below cost) to entice consumers to purchase them. Once this happens the durable good relies in many cases for specialised complementary goods to operate, without which the durable good cannot function smoothly. Furthermore, cheaper complementary goods cannot be used for other purposes (e.g. warranty). Hence, the heavy reliance on specified complementary goods. In such cases the demand is quite inelastic where the price charged in higher (well above costs). The concepts of competition and monopoly were useful in understanding why this occurs.

Multiple-choice solutions (pp. 208–9) 1d

price at which marginal revenue equals marginal cost.

Economics for Today Instructor’s Manual

200 units per day.

earns positive economic profit.

None of the above statements is true.

6c 7d

five. the same as the market demand curve.

will shut down if its demand curve lies wholly below the average total cost curve.

All of the above are true.

10b differences in the price elasticity of demand among different groups of buyers. 11d arbitrage. 12c Manufacturers of cars in Korea sell their cars at higher prices in Australia than in Korea (all else being equal).

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