Jack Lawrence

AP Microeconomics 9th

Theory of the Firm II

Pure Monopoly

Assumptions and characteristics:

1. All other things equal 2. No close substitutable good 3. Monopolist controls the entire market and therefore sets the price 4. Entry is nearly impossible due to patents, licenses, and control of resources. A

monopolist may also lower price simply to deter new entrants from being able to compete. Finally, monopolists are large firms and may block entry due to “economies of scale”, when the massiveness of a firm makes competition difficult.

5. Non-price competition such as advertising and brand awareness. 6. No government regulation 7. Single price non-discriminatory consumer, meaning that the monopoly does not set price

for different demographics or age groups etc.

In a pure monopoly, the monopolist is the market because it is the only firm, so the firm’s demand curve is the same as the market demand curve, which is downward sloping. It is downward sloping because monopolies must still set price and output with regards to the market’s demand curve, which is naturally downward sloping.

Because demand is downward sloping, a monopolist may only increase sales by lowering price. Therefore marginal revenue is less than price and average revenue except for the first unit. As you can see from the graph titled “Marginal Revenue, demand, and total revenue”, profit is maximized where demand is unit elastic, marginal revenue is zero, and total revenue is at a maximum. A monopolistic firm will produce where MR=MC, or the point at which TR is maximized. A monopolistic firm will set price at the maximum willingness to pay at that output, as determined by the demand curve.

The graph titled “Pure Monopoly” illustrates the quantity set at MR=MC and price on the demand curve above MR=MC. Profit is shown as the area above average total cost and below the price at that point of production. Note that this may not correspond to minimum ATC since a monopoly does not care about efficiency losses. They may charge a higher or lower price because they seek to maximize total profit. This leads to an efficiency loss as shown by the red shaded region.

The government promotes competition because it seeks to decrease efficiency losses and therefore increase producer and consumer surplus by filing charges against abusive monopolies. If the monopoly is natural, the government will allow it to continue until it becomes abusive or if it becoming unsustainable, in which case the government will ignore it or help it to fail faster.

Inefficiencies: In a pure monopoly, the monopolistic firm sets quantity where MR=MC and price where that quantity supplied meets the demand curve. On the Pure Monopoly graph, this is shown by the point labeled Long run pure monopoly with price at Pm and quantity at Qm. Because a pure monopolist doesn’t need to use the most efficient method of production (shown by long run pure monopoly point not resting at the minimum ATC of the ATC pure monopoly curve), the monopolistic firm will not sell at equilibrium supply and demand. Marginal cost is also less than price because of economies of scale (the market cannot support a large number of firms, where as a pure monopoly is one firm) and X-inefficiency, where a firm produces at a higher cost than is necessary to produce. On the other hand, a purely competitive firm will produce at the point labeled long run pure competition with the pure competition ATC curve where supply=MC=D=minimum ATC. Therefore there is a productive and allocative efficiency loss (shown in pink) because the pure monopoly is not producing the quantity demanded and it isn’t producing with the least-cost combination of resources.

Regulated Monopolies: In reference to the graph titled “Regulated Monopoly”, a monopoly wishes to produce at Qm with price Pm. To achieve allocative efficiency a firm should produce at the socially optimal price where P=MC=D as shown on the graph at Qr and Pr. To achieve this the government will impose a price ceiling at Pr. However, a pure monopoly will not operate at a loss and therefore the government may provide a subsidy so that the firm will realize a normal profit and stay in business at Pf and Qf.

Monopolistic Competition:

Assumptions and characteristics:

1. All other things equal 2. Differentiated products 3. Large number of sellers 4. Easy entry and exit of the industry 5. Non-price competition such as advertising and brand awareness. 6. In order for an industry to be considered monopolistically competitive, the ratio of the

output of the four largest firms divided by the total industry output must be below 40%.

Demand: A monopolistically competitive firm’s demand curve is highly elastic because there is close substitutability of goods. It is not perfectly elastic because the products may be slightly differentiated. On the Monpolistic competition graph, D1 is very elastic.

Short Run: The profit-maximizing quantity is set where MR=MC at Q1 and price (P1) is set at the demand at that quantity. In this case, an economic profit is realized (pink region) because price is above ATC. To simulate a loss, ATC would need to be above price.

Long Run: In the long run, firms enter when firms in the industry are realizing profits and leave when firms are realizing losses. Therefore, similar to pure competition, demand ultimately moves to become tangent to ATC. Because of this, monopolistically competitive firms in the long run realize a normal profit.

Unlike pure competition, there is still some inefficiency in the market (similar to pure monopoly). Therefore while the demand curve is tangent to ATC, it may not be tangent at

minimum ATC. Price isn’t equal to marginal cost and price is not equal to ATC so monopolistically competitive firms are not allocatively or productively efficient.

Quantity

pri

ceMarginal Revenue, demand, and total revenue

TR

Maximum TR

D

MR

Elastic Inelastic

Q1

P1 Unit Elastic

quantity

Tot

al u

tilit

yTotal and Marginal Utility

TU

MU

Quantity

Pric

e/co

st

Monopolistic Competition

D1

MR

MC ATC

Q1

P1

Economic Profit

a

Quantity

Pric

ePure Monopoly

DMR

MC

ATC (pure monopoly)

Qm

Pm

Profit

Efficiency Loss

Qc

Long run pure competition

Long run pure monopoly

ATC pure competition

Pc

Quantity

Pric

e an

d C

osts

Regulated Monopoly

ATC

MR

D

Qm

PmMonopoly price

MC

Fair-return price

Socially optimal price

Qf Qr

PfPr

MR=MC