Managerial Decisions for

Firms with Market Power

 Readings
Hirschey: Economics for Managers, 2009 (Fifth Indian Reprint),
South-Western Cengage Learning Chapters 12 & 13
Hubbard & OBrian: Microeconomics (First Edition), Pearson
Education India Chapters 12 & 14
Mansfield, Allen, Doherty and Weigelt: Managerial Economics:
Theory, Applications and Cases (Seventh Edition), Viva-Norton
Student Edition Chapter 7
Thomas and Maurice: Managerial Economics: Concepts and
Applications (Eighth Edition), Tata McGraw-Hill Chapter 12

2
 Session Objectives:
Why do monopolies arise?
Why is MR < P for a monopolist?
How do monopolies affect societys well-being?
What can the government do about monopolies?
What is two-part tariff and bundling?
How are the price and output decisions taken under
Monopolistic Competition?

3
 Introduction
While a competitive firm is a price taker, a
monopoly firm is a price maker.
The key difference:
A monopoly firm has market power, the ability to
influence the market price of the product it sells.
A competitive firm has no market power.
A firm is considered a monopoly if . . .
it is the sole seller of its product.
its product does not have close substitutes.

4
Pure Monopoly

A pure monopoly
is a market structure
in which a single
seller accounts for
100 percent of
market sales.

5
Effective Monopoly

Pure monopolies are hard to

find in the real world.
Economists and judges as a
rule believe a 90 percent
market share is sufficient to
constitute an effective
monopoly.

6
 Monopoly vs. Competition
In a competitive market, the
market demand curve slopes
downward, but the demand curve A competitive firms
for any individual firms product is
horizontal at the market price. demand curve
P
A competitive firm is a price-taker,
can sell as much as it wants at the
market price
In effect, the competitive firm
sells a product for which there are
many perfect substitutes, so D
demand for its product is perfectly
elastic; if it raises its price above
the market price, demand for its
product falls to zero
The firm can increase Q without

lowering P, so MR = P for the Q

competitive firm.

7
 Monopoly vs. Competition
A monopolist is the
only seller, so it faces
the market demand A monopolists
P
curve. demand curve
To sell a larger Q,
the firm must reduce P.
Thus, MR P.

D
Q

8
 Quick Activity 1
Moonbucks is P (in TR AR MR
Q
the only seller of Rs.)
cappuccinos in town. $4.50 N.A. N.A.
0
The table shows the
1 4.00
market demand for
cappuccinos. 3.50
2
Fill in the missing 3.00
3
spaces of the table.
4 2.50
What is the relation
between P and AR? 5 2.00
Between P and MR?
6 1.50
9
 Quick Activity 1 (Answer)

Here, P = AR, P (in TR AR MR

Q
same as for a Rs.)
competitive firm. 0 4.50 0 N.A. N.A.

1 4.00 4 $4.00 $4
Here, MR < P,
whereas MR = P 2 3.50 7 3.50 3
for a competitive
3 3.00 9 2
firm. 3.00
4 2.50 1
10 2.50
5 2.00 0
10 2.00
6 1.50 1
9 1.50
10
Marginal Revenue
A monopolists marginal
revenue is always less than
the price of its good.
The demand curve is
downward sloping.
When a monopoly drops
the price to sell one
more unit, the revenue
received from previously
sold units also
decreases.

11
 Marginal Revenue
Increasing Q has two effects on revenue:
The output effect: Higher output raises revenue
The price effect: Lower price reduces revenue
To sell a larger Q, the monopolist must reduce the price on all
the units it sells.
Hence, MR < P
MR could even be negative if the price effect exceeds the
output effect (e.g., when Moonbucks increases Q from 5 to 6).
A competitive firm has the output effect but not the price
effect: the competitive firm does not need to reduce its price
in order to sell a larger quantity, so, for the competitive firm,
MR = P
12
 Profit Maximization
Like a competitive firm, a
monopolist maximizes
profit by producing the
quantity where MR = MC.
Once the monopolist
identifies this quantity,
it sets the highest price
consumers are willing to
pay for that quantity.
It finds this price from the
D curve.

13
 Quick Activity - 2
Suppose that the (inverse) demand curve facing a monopolist
is P(Q) = 40 Q and the cost of production is C(Q) = 50 +
Q2. If the objective of the monopolist is to maximize profit,

i. Calculate the profit-maximizing level of output and

price for the monopolist.

ii. Calculate the total profit (or loss) for the monopolist.
Profit Maximization
As with a competitive
firm, the monopolists
profit equals
(P ATC) x Q

The monopolist will

receive economic
profits as long as price
is greater than
average total cost.

15
Think !

Notice the monopolist earns

an economic profit equal to
the shaded are. Question is:
Should this situation not be
ripe for entry of new firms?
Not if there are factors
which impede entry of new
firms.

16
Barriers to Entry
The fundamental cause of monopoly is barriers to entry

Anything which creates a disadvantage for potential

entrants vis vis established firms. The height of the
barriers is measured by the extent to which, in the long
run, established firms can elevate their selling prices
above minimal average cost, without inducing potential
entrants to enter

17
 Where Do Monopolies Come From?
Barriers to entry may be high enough to keep out competing
firms for four main reasons:
1. One firm has control of a key raw material necessary to
produce a good.
2. Government blocks the entry of more than one firm into
a market.
3. Economies of scale are so large that one firm has a
natural monopoly.

18
 Control of a Key Resource
One of the way for a firm to become a monopoly is by
controlling a key resource.
This happens infrequently because most resources, including
raw materials such as oil or iron ore, are widely available from a
variety of suppliers.
There are, however, a few prominent examples of monopolies
based on control of a key resource, such as the Aluminum
Company of America (Alcoa).
For many years until the 1940s, Alcoa either owned or had
long-term contracts to buy nearly all of the available bauxite,
the mineral needed to produce the aluminum. Without access to
bauxite, competitive firms had to use recycled aluminum, which
limited the amount of aluminum they could produce.
19
 Application - 1
The De Beers Diamond Monopoly: A Diamond is Forever
The most famous monopoly based on control of a raw material
is the De Beers diamond mining and marketing company of
South Africa.
Before the 1860s, diamonds were extremely rare. Only a few
pounds of diamonds were produced each year, primarily in
Brazil and India.
Then in 1870, enormous deposits of diamonds were discovered
along the Orange River in South Africa. It became possible to
produce thousands of pounds of diamonds per year, and the
owners of the new mines feared that the price of diamonds
would plummet.
To avoid financial disaster, the mine owners decided in 1888 to
merge and form De Beers Consolidated Mines, Ltd. 20
 Application - 1
De Beers became one of the most profitable and longest-lived
monopolies in history. The company has carefully controlled the supply
of diamonds to keep prices high. As new diamond deposits were
discovered in Russia and Zaire, De Beers was able to maintain prices by
buying most of the new supplies.
Because diamonds are rarely destroyed, De Beers has always worried
about competition from the resale of stones.
Heavily promoting diamond engagement and wedding rings with the
slogan A Diamond is Forever was a way around this problem. Because
engagement and wedding rings have great sentimental value, they are
seldom resold, even by the heirs of the original recipients.
De Beers advertising has been successful even in some countries, such
as Japan, that have had no custom of giving diamond engagement
rings.
21
 Application - 1
As the populations in De Beer's key markets age, its advertising in
recent years has focused on middle-aged men presenting diamond
rings to their wives as symbols of financial success and continuing
love, and on professional women buying right-hand rings for
themselves.
In the past few years, competition has finally come to the diamond
business. By 2000, De Beers directly controlled only about 40 percent
of world diamond production.
The company became concerned about the amount it was spending to
buy diamonds from other sources to keep them off the market. It
decided to adopt a strategy of differentiating its diamonds by relying
on its name recognition.

22
 Application - 1
Other firms, such as BHP Billiton, which owns mines in
Northern Canada, have followed suit by branding their
diamonds.
Sellers of Canadian diamonds stress that they are mined
under ethical, environmentally friendly conditions, as opposed
to blood diamonds, which are supposedly mined under
armed force in war-torn African countries and exported to
finance military campaigns.
Whether consumers will pay attention to brands on diamonds
remains to be seen.

23
 Entry Blocked by Government Action
Governments ordinarily try to promote competition in markets.
But, sometimes, Governments may restrict entry by giving a
single firm the exclusive right to sell a particular good in
certain markets.
Patent and copyright laws are two important examples of how
government creates a monopoly to serve the public interest.
By granting a patent or copyright to an individual or firm,
which gives it the exclusive right to produce a product.
In United States, a patent gives a firm the exclusive right to a
new product for a period of 20 years from the date the product
was invented. Because Microsoft has a patent on the Windows
operating system, other firms cannot sell their own versions of
Windows.
24
 Entry Blocked by Government Action
The government grants patents to encourage firms to spend money on
research and development necessary to create new products. If other
firms could have freely copied Windows, Microsoft is unlikely to have
spent the money necessary to develop it.
Patents involve trade-offs; they restrict competition but encourage
research and development.
Patent protection is of vital importance to pharmaceutical firms as they
develop new prescription drugs. The profits the firm earns from the
drug will increase throughout the period of patent protection which is
usually 10 years as the drug becomes more widely known to doctors
and patients.

25
 Entry Blocked by Government Action
After the patent has expired, other firms are free to legally produce
chemically identical drugs called generic drugs. Gradually, competition
from generic drugs will eliminate the profits the original firm had been
earning.
For example, when patent protection expired for Glucophage, a
diabetes drug manufactured by Bristol-Myers Squibb, sales of the drug
declined by more than $1.5 billion in the first year due to competition
from 12 generic versions of the drug produced by other firms.
When the patent expired on Prozac, an antidepressant drug
manufactured by Eli Lilly, sales dropped by more than 80 percent.
Most economic profits from selling a prescription drug have been
eliminated 20 years after the drug was first offered for sale.

26
The Market For Drugs
Patents on new drugs
give a temporary
monopoly to the seller. Price
When the
patent expires,
the market
becomes competitive, PM
generics appear.
Here, we assume
constant marginal cost, PC = MC
for simplicity
Analysis of the
pharmaceutical industry D
has shown us that
prices of drugs fall after MR
patents expire and new
firms begin production
of that drug. QM Quantity
QC 27
 Natural Monopolies
An industry is a natural monopoly when a single firm can supply
a good or service to an entire market at a smaller cost than
could two or more firms.
A natural monopoly arises when there are economies of scale
over the relevant range of output, implying that average total
cost falls as the firm's scale becomes larger.
Natural monopolies are most likely to occur in markets where
fixed costs are very large compared to variable costs. For
example, a firm that produces electricity must make a
substantial investment in machinery and equipment necessary
to generate electricity and in wires and cables necessary to
distribute it. Once the initial investment has been made,
however, the marginal cost of producing another kilowatt-hour
of electricity is relatively small.
28
Natural Monopolies
With a natural monopoly, the
average total cost curve is still
Example: Electricity
falling when it crosses the demand
curve (point A). If only one firm is
producing electric power in the
market and it produces where
average cost intersects the
demand curve, ATC = $0.04 per
kilowatt-hour of electricity
produced.

If the market is divided between

two firms, each producing 15
billion kilowatt-hours, the average
cost of producing electricity rises to
$0.06 per kilowatt-hour (point B).
In this case, if one firm expands
production, it can move down the
ATC curve, and drive the other firm
out of business. 29
 Degree of Monopoly Power
The ability of a firm to charge a price greater than marginal
cost is called its market power.
This measure of monopoly power was introduced by Abba
Lerner in 1934 and is called Lerners Degree of Monopoly
Power: L = (P MC)/P.
This Lerner index always has a value between zero and one.
For a perfectly competitive firm, P=MC so that L=0. The larger
the L is, the greater the degree of monopoly power.
It may be noted that considerable monopoly power does not
necessarily imply high profits. Profit depends on average cost
relative to price. Firm A might have more monopoly power than
Firm B, but might earn a lower profit because it has much
higher average costs.
30
 Multiplant monopolist
We have seen that a firm maximizes profit by setting output
where marginal revenue equals marginal cost.
For many firms, production takes place in two or more different
plants, whose operating costs can differ.
Suppose a firm has two plants. What should be its total output
and how much of that output should each plant produce?

31
 Welfare Cost of Monopoly
In contrast to a competitive firm, the monopoly charges a
price above the marginal cost.
From the standpoint of consumers, this high price makes
monopoly undesirable.
However, from the standpoint of the owners of the firm, the
high price makes monopoly very desirable.
The total surplus measures the economic well-being of
buyers and sellers in the market.
Total surplus is the sum of consumers surplus and
producers surplus.
Consumer surplus is consumers willingness to pay for a good
less the amount they actually pay for it.
Producer surplus is the amount the producers receive for a
good minus their costs of producing it.
32
Welfare Cost of Monopoly

Dead weight is a
measure of loss due
to resource
misallocationit is
equal to the surplus
lost to consumers
which is not captured
by the producer.

33
 Welfare Cost of Monopoly
The monopolist chooses to produce and sell the
quantity of output at which MR and MC curves
intersect.
The social planner would choose the quantity at
which the demand and marginal cost curves
intersect.
The monopolist produces less than the socially
efficient quantity of output

34
Welfare Cost of Monopoly

We can summarize the effects of

monopoly as follows:
1. Monopoly causes a
reduction in consumer
surplus.
2. Monopoly causes an
increase in producer
surplus.
3. Monopoly causes a
deadweight loss, which
represents a reduction in
economic efficiency.

35
Public Policy Toward Monopolies
Government responds to the problem of
monopoly in one of four ways.
Making monopolized industries more
competitive.
Regulating the behavior of monopolies.
Turning some private monopolies into public
enterprises.
Doing nothing at all.

36
 Increasing Competition with Antitrust Laws
Antitrust laws are a collection of statutes aimed at curbing
monopoly power.
Antitrust laws give government various ways to promote
competition.
They allow government to prevent mergers.
They allow government to break up companies.
They prevent companies from performing activities that
make markets less competitive.
For example, if two firms in the industry are proposing to
merge and form a new firm, the government will sometimes
allow the merger to proceed only if it is satisfied that the
merger will not, by creating a large firm, have an adverse
effect on the competition in the industry.
37
 Increasing Competition with Antitrust Laws
The government regulates business mergers because it knows
that if firms gain market power by merging, they may use the
market power to raise prices and reduce output. As a result,
the government is most concerned with horizontal mergers, or
mergers between firms in the same industry.
Horizontal mergers are more likely to increase market power
than vertical mergers, which are mergers between firms at
different stages of production of a good. An example of a
vertical merger would be a merger between a company making
personal computers and a company making computer hard
drives.

38
 Increasing Competition with Antitrust Laws
Antitrust laws have costs as well as benefits.
The newly merged firm may be more efficient than the merging firms
were individually.
For example, one firm might have an excellent product but a poor
distribution system for getting the product into the hands of the
consumers. A competing firm might have built a great distribution
system but have an inferior product. Allowing these two firms to
merge might be good for both the firms and the consumers.
Or, two competing firms might each have an extensive system of
warehouses that are only half full, but if firms merged, they could
consolidate their warehouses and significantly reduce their costs.
Sometimes companies merge not to reduce competition but to lower
cost. These benefits from mergers are called synergies.
For example, many US banks have merged in recent years and by
combining operations have been able to reduce administrative costs.
Increasing Competition with Antitrust Laws
This figure shows that the result of
all the firms in a perfectly
competitive market merging to form
a monopoly.
If the costs are unaffected by the
merger, the results are same as with
deadweight loss under monopoly
price rises from Pc to Pm, quantity
falls from Qc to Qm, consumer
surplus declines and a loss of
economic efficiency results.
If, however, the monopoly has lower
costs than the perfectly competitive
firms, it is possible the price will
actually decline from Pc to Pmerge
and output will increase from Qc to
Qmerge following the merger.
 Increasing Competition with Antitrust Laws
Although the newly merged firms has a greater deal of market
power, because it is more efficient, consumers are better off
and economic efficiency is improved.
Of course, sometimes a merged firm will be more efficient and
have lower costs, and other times it wont.
As you might expect, whenever large firms propose a merger
they claim that the newly merged firm will be more efficient
and have lower costs. They realize that without these claims it
is unlikely their merger will be approved.

41
 Regulation
Government may regulate the prices that the
monopoly charges.
The allocation of resources will be efficient if
price is set to equal marginal cost.
For natural monopolies, MC < ATC at all Q, so
marginal cost pricing would result in losses
If so, regulators might subsidize the monopolist
or set P = ATC for zero economic profit.

42
Regulatory Dilemma
The socially efficient regulatory regime does
not provide the regulated firm a fair return
to shareholder equity / owners capital.

We will use some simple graphs to

illustrate that marginal cost pricing will, in
the case of sustainable natural monopoly,
saddle the regulated firm with losses.
P
Case 1: Unregulated Monopoly
PM

CM D = AR

LAC

MR LMC

0
QM QC Q
 P
Case 2: Marginal Cost Pricing

D = AR

C1
LAC

PC
MR LMC

0
QC Q
Regulatory Dilemma
Recall the necessary condition
for socially efficient resource
allocation:
P = MC

Hence:
Option 2 is optimal on social efficiency
criteria.
Why not select option 2 and subsidize the
regulated firm by amount C1PC?
Regulatory Dilemma

Subsidies give rise to problems of

distributional equity. For

example, suppose that gas
companies were subsidized from
general tax revenuesdoes this
not amount to an income transfer
from taxpayers to gas users?
 P
Option 3: Average Cost Pricing

PA

LAC

MR LMC

0 QA
Q
 Comparing the results

Dead
Weight
Loss Econ
Optio Price Quantit given Profit given
n y by area by area

1 PM QM PMCM

2 PC QC 0 (C1PC)

3 PA QA 0
 Public Ownership
Rather than regulating a natural monopoly that is
run by a private firm, the government can run the
monopoly itself (e.g. in India, the government
runs the Railways).
Problem: Public ownership is usually less efficient
since no profit motive to minimize costs

50
 Do Nothing
Government can do nothing at all if the market
failure is deemed small compared to the
imperfections of public policies.

51
 Monopolistic Competition
The central feature of monopolistic competition is product
differentiation. Unlike perfect competition, in which all firms sell
an identical product, firms under monopolistic competition sell
somewhat different products.
In many parts of retail trade, producers try to make their
product a little different, by altering the products physical
makeup, the services they offer, and other such variables.
Peter Englands shirts are not exactly the same as Van Heusens,
but they are not too dissimilar either.

Because of the differences among their products, producers

have some control over their price, but it usually is small,
because the products of other firms are very similar to their
own.
52
 Monopolistic Competition
In addition to product differentiation, other conditions must be
met for a market to qualify as a case of monopolistic
competition.
There must be a large number of firms in the product group.
Each firms product a fairly close substitute for the products of the
other firms in the product group.
Entry into the product group must be relatively easy, and there
must be no collusion, such as price fixing or market sharing,
among firms in the product group. If there are a large number of
firms, it generally is difficult, if not impossible, for them to
collude.

53
 Monopolistic Competition
Free entry is an important requirement for a monopolistically
competitive firm. To understand this, let us compare the markets for
soap and automobiles.
The soap market is monopolistically competitive, but the
automobile market is better characterized as an oligopoly.
It is relatively easy for other firms to introduce new brands of
soap that may compete with Lux, Park Avenue, and so on. This
limits the profitability of producing Lux or Park Avenue. If profits
are large, other firms would spend the necessary money (for
development, production, advertisement and promotion) to
introduce new brands of their own, which would reduce the
market shares and profitability of Lux and Park Avenue.
The automobile sector is also characterized by product
differentiation. However, the large-scale economies involved in
production make entry by new firms difficult.

54
 Demand curve for a Monopolistically
Competitive Firm
If each firm produces a somewhat different product, it follows
that the demand curve facing each firm slopes negatively.
If the firm raises its price slightly, it will lose some, but by no
means all, of its customers to other firms.
And if it lowers its price slightly, it will gain some, but by no
means all, of its competitors customers.

Because there are large number of firms in a product group,

the demand curve is very elastic.
The monopolistic
competitor faces a
downward sloping, but
very elastic, demand
curve.
55
Equilibrium in the Short Run

56
Equilibrium in the Long Run
How Does Entry of New Firms Affect the Profits of Existing Firms?
 Equilibrium in the Long Run
In the long run, free entry ensures that each firms profit is
reduced to zero.
The firm still has market power, its long-run demand curve is
downward sloping because the particular brand is still unique.
But the entry and competition of other firms have driven its
profit to zero.
Here, we have assumed for simplicity that marginal and
average costs do not change as new firms enter the market.
More generally, firms may have different costs, and some
brands will be more distinctive than others. In this case firms
may charge slightly different prices, and some will earn small
profit.

58