©1989 & 2002 John Petroff. 




The goal of this topic is to show how a monopoly determines
price and quantity for its maximum profit. The monopoly form of
market is defined. Demand and marginal revenue are presented.
The rule of equating marginal revenue to marginal cost is
shown to secure the optimum quantity and price. The economic
effects of monopoly and price discrimination are outlined. The
chapter closes with an analysis of regulated monopolies.

Pure monopoly is a type of market characterized by
- a single seller or producer,
- a unique product, with no close substitute,
- the ability of the seller to ask any price it wishes,
- entry to the industry completely blocked by legal,
technological or economic barriers, and
- no need for nonprice actions, except public relations
or goodwill advertising.

 Examples of pure monopolies are not common because monopolies are
either usually regulated or prohibited altogether. Cases where
a company has substantial amount of monopoly power, but cannot
be considered a pure monopoly, can easily be found.

A monopoly exists when a firm is the only producer of a given
product. That product is therefore unique to that firm. Such
situation is rarely observed because products providing a
similar service can usually be found in other industries or
regions of the world. The product is unique in the sense that
no close substitutes are presently easily available to

 For close to half a century, ALCOA was a virtual monopoly because
it had control over mining of the aluminum ore (bauxite).

A monopoly has extensive power over the price it may want to
charge its customers. The monopolist is sometimes referred to as
a price maker. It must be noted, however, that a monopolist does
not charge the highest possible price. Instead it charges the price
for which its profits are the largest. Moreover, a monopolist does
not set a price independently of the volume produced: quite the
contrary, price setting is implemented by restricting output.

Monopoly exists when entry barriers are present; these may be
- legal, from the ownership of a patent or a copyright,
- legal, from its appointment as public utility for natural
- technological, from a secret method of production,
- due to large size, age, or good reputation,
- stemming from access to a key resource (such as ore), or
- resulting from unfair tactics or unfair competition.

Various strategies used by firms to eliminate competitors by
forcing them into bankruptcy or preventing new firms from
entering the industry, are referred to as unfair competition.
They may include
- drastic underpricing of products, or
- cornering of a resource market.
Most of these tactics have been declared illegal in antitrust

 The history of railroad expansion in the United States during
the latter half of the 19th century is full of examples of
actions by railroad companies seeking to eliminate competitors

Since a monopolist is the only firm in the industry, it appears
that there is no need for nonprice action, such as advertising.
However, advertising and other nonprice action are used
as a form of public relations and for the purpose of avoiding
customer antagonism.

 Electric companies are natural monopolies and do not need to
advertise because customers have no choice but to receive their
electricity from them. But, they do advertise. The purpose is
often to convince consumers that the company is on their side by
giving them tips on energy conservation, for instance.

The demand of a monopoly is downsloping because the monopoly is
the only firm in the market, and demand for most products is price

Graph G-MIC5.1

 The demand of natural monopolies, such as an electric company, is
downsloping. Indeed, if the electric company were successful in
obtaining a large rate increase, many customers may switch to
alternative sources of energy, such as gas for heating and

Marginal revenue is the additional revenue received for the last
unit sold. Since the monopolist can sell one more unit only by
lowering the price on all the units sold, the marginal or
additional revenue is not constant but decreasing. The marginal
revenue is less than price at any quantity. If the demand curve
is a straight line, the slope of marginal revenue is twice the
slope of the demand curve.

 Simple algebra can show that the slope of marginal revenue is
twice that of the corresponding demand curve. If demand can be
written as P=-aQ+b, total revenue is PQ, or PQ=(-aQ+b)Q. Then,
marginal revenue is the first derivative of total revenue, and
that is P=-2aQ+b. Thus, the coefficient of the slope of marginal
revenue is -2a, twice that of demand -a.

The upper portion of the demand curve of a monopoly is elastic,
and marginal revenue is positive for this region of output.
The lower portion of demand is inelastic, and marginal revenue
is negative in that region. It follows that a monopolist would
never want to be in the inelastic portion of its demand since it
can increase revenues by raising price.


A monopoly finds its maximum profit by producing at a level of
output where marginal revenue equals marginal cost (i.e. the
intersection of marginal revenue and marginal cost curves). If
it produces one less unit a profit is foregone (on the last
unit it failed to sell), and if it produces one more unit a
decrease in profit is incurred (as the marginal cost exceeds
the marginal revenue for that last unit).

 Many of the largest fortunes in the United States are the
result of monopoly profits accumulating over time. For instance,
Standard Oil (before it was split up) produced the wealth of the
Rockefeller family.

The profit of a monopoly is determined by first finding the
optimum quantity with the marginal revenue equal to marginal
cost rule. After that, the unit price on the demand curve and
the unit cost on the average total cost curve are found based
on the optimum quantity established first.

The monopoly profit is the difference between total revenue and
total cost. Total revenue is represented as a rectangle with
price (on the demand curve) as its height, and quantity
(determined by MR=MC) as it width. Total cost is a rectangle
with average unit cost (on average total cost) as its height,
and quantity as its width. The area by which total revenue
exceeds total cost is the profit area.

Graph G-MIC5.2

A monopoly seeks to maximize profits, and is capable of
achieving such a goal by controlling price and quantity.
However, should customer demand decrease significantly, the
monopolist will be content with minimizing loss (in the short
run) and may even be forced to close down.

Graph G-MIC5.3

The strategy of a monopoly should be to maximize total profit.
Such outcome would not be obtained by maximizing either unit
profit, unit price or total revenue.
However, in some cases a monopoly may want to use a suboptimal
pricing strategy, for instance, to create additional entry
barriers or to avoid customer confrontation.

A monopoly form of market is highly undesirable for our society
because of the sizable loss of productive and allocative
efficiency: the price paid is higher than in perfect competition
and the quantity is smaller. The monopoly underutilizes the
resources for the production of a good wanted by society. The
price charged is much higher than the cost of additional
resources used. However, economies of scale and technological
progress are possible.

 OPEC is not a pure monopoly. But, in 1973 and 1979, it acted as
a monopoly in successfully increasing prices of oil and fuel
by limiting their supply. Many people throughout the world,
including the United States, were harmed by these actions. Some
could no longer afford the cost of heating their home and the
cost of needed transportation. Others lost their jobs as
businesses were forced to cut production as costs increased.

In spite of the undesirable economic effect of a monopoly in
general, a monopoly may in certain circumstances generate
substantial economies of scale, which can be passed on
to society in a lower price. The small firms of perfect
competition are not large enough to bring about the economies
of scale. Such economies of scale are to be found primarily in
natural monopolies. Some economists have questioned the existence
of this beneficial economic effect.


Another potential benefit to society from monopoly type firms is
that profits are often the motivation for technological progress
and investment in new technology is made possible by the
presence of these profits. However, monopolies well protected by
entry barriers will not need to seek new technology, and if they
do, their goal may be to lower costs for additional profits and
new entry barriers.


Price discrimination exists whenever different prices are
charged for the same product and the difference in price cannot
be explained by costs.

 The telephone company charging different rates for night and day
calls is a good example of price discrimination. The reason why
the telephone company is able to charge the higher day rates is
because the demand is inelastic: certain calls have to be made
during business hours. The regulatory commission tolerates the
price discrimination because it provides a saving for those who
can wait until the evening to make their calls.

In order for the price discrimination to be possible, a firm
- be a monopoly or have some power over price,
- be able to segment its market, and
- be able to prevent cross selling from one market segment to
Generally, the market segments will have different elasticities.

The purpose of price discrimination is to increase the profit
of the monopolist. This is achieved by charging a higher price
to those customers who are more inelastic. Price discrimination
is generally considered harmful to society and an unfair
practice. It is declared illegal in the Sherman Act. However,
price discrimination is, nevertheless, tolerated in many
instances, in part, because it may result in larger overall
output, and is occasionally a form of income redistribution.

Natural monopolies are said to exist in industries where
competition is unworkable and would result in costly
duplication of fixed capital. Most natural monopolies are public
utilities. These are regulated by commissions.

 A water supply company is a typical natural monopoly. It is
usually the only supplier of water for a given section of a
town because it would be wasteful (in fixed assets) to have
more than one company offering water to the same house.

The major task of the commission regulating a natural monopoly
is to set the price (or rate) that the utility is allowed to
charge. One method is the fair-return pricing method. The price
is set at the point where it is equal to average total cost. The
average total cost is allowed to include a market rate of return
to make sure that new funds can be attracted for expansion. This
practice often results in cost padding by utilities.

 Gas, water, electric and telephone companies are all regulated
companies. Many companies in the transportation sector are also
regulated (such as urban bus transportation and trucking).
Deregulation of some of the industries has shown that the
regulatory process was (for instance in the case of airlines) to
the detriment - not benefit - of consumers.

In a few cases of natural monopolies, a price below average cost
is imposed on a utility to require a large output from the firm.
The loss incurred by the firm is then offset with a subsidy.
This is most often present in transportation companies.

Review Quiz


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