Topic 4.2 Notes – Monopoly

1. What a Monopoly Is

A monopoly is a market structure where one firm is the industry.

That firm is a price maker because it faces the entire market demand curve, which is downward sloping.

Core characteristics

• One seller, many buyers
• Unique product (no close substitutes)
• High barriers to entry
• Long-run economic profit possible
• May use non-price competition (advertising, branding)

Why monopolies exist - barriers to entry

These barriers block new firms from entering:

• Legal barriers → patents, copyrights, licenses
  • Example: pharmaceutical patents
• Control of key resources → rare inputs
• Economies of scale → large cost advantages at high output
• Government franchise → exclusive rights (local utilities)

Historical anchor:

• Standard Oil controlled oil refining in the late 1800s until broken up under the Sherman Antitrust Act. Antitrust laws exist to limit monopoly power.

2. The Monopoly Graph and Profit Maximization

Monopoly profit maximization graph

Why MR Is Below Demand

On the graph above, notice that the marginal revenue curve lies below the demand curve.

To sell one more unit, the firm must lower price for all units sold.

So:

• Marginal revenue < Price
• MR lies below the demand curve.

If the firm could perfectly price discriminate, MR would equal demand, but the standard AP model assumes it cannot.

Profit-Maximizing Output and Price

Monopolies maximize profit in two steps:

1. Find where MR = MC → this gives $Q_{m}$ (point where the MR and MC curves intersect)
2. Go up to the demand curve at that quantity to find $P_{m}$

Important result:

• $P_{m} > MC$ → monopoly is allocatively inefficient

Calculating Profit or Loss

Profit formula:

$$\text{Profit} = (P - ATC) \times Q$$

On the graph, this is the shaded rectangle between the price on the demand curve and the ATC curve at $Q_{m}$.

You can also calculate:

• $TR = P \times Q$
• $TC = ATC \times Q$
• Profit = TR − TC

Quick example (different from your textbook numbers):

If price is 15 dollars, output is 80 units, and ATC is 11 dollars:

• $TR = 15 \times 80 = 1200$
• $TC = 11 \times 80 = 880$
• Profit = 320 dollars

Shade that rectangle on the graph.

If ATC is above price, that same rectangle becomes a loss.

Because of barriers to entry, there is no long-run entry to eliminate profits.

3. Surplus and Deadweight Loss

Socially Optimal Output

Look at the graph below. The socially efficient quantity is where the demand curve intersects the marginal cost (MC) curve, labeled $q_{c}$. That point represents:

$$\text{Demand (MB)} = MC$$

Monopoly output, competitive output, and deadweight loss

In perfect competition:

• $P = MC$

In monopoly, the firm produces where MR = MC at $q_{m}$, then charges the price on the demand curve at that quantity:

• $P_{m} > MC$
• $Q_{m} < Q_{s}$ (here shown as $q_{c}$)

The monopoly underproduces and overcharges.

Effects on Surplus

• Consumer surplus decreases
• Producer surplus increases per unit
• Deadweight loss (DWL) forms

On the graph, the shaded rectangle represents monopoly profit. The dark triangle between the demand and MC curves from $q_{m}$ to $q_{c}$ is the deadweight loss.

DWL represents trades that would benefit buyers and sellers but do not occur.

On FRQs, you may need to calculate:

• Consumer surplus (triangle)
• Producer surplus
• DWL (triangle between D and MC over lost units)

The key inefficiency is that price does not equal marginal cost, so resources are misallocated.

4. Elasticity and Total Revenue

The monopoly demand curve has three regions:

• Elastic
• Unit elastic
• Inelastic

Where MR = 0, demand is unit elastic.

• Above that quantity → elastic region (MR > 0)
• Below that quantity → inelastic region (MR < 0)

A monopoly will never produce in the inelastic region because:

• MR is negative
• MC is positive
• That lowers profit

Connection to Total Revenue:

• In elastic region → lowering price increases TR
• In inelastic region → lowering price decreases TR

If you see a question asking where TR is maximized, look for MR = 0.

5. Natural Monopoly and Regulation

A natural monopoly exists when economies of scale continue over the entire market demand, so one firm can produce at lower cost than multiple firms.

ATC keeps falling across the demand range.

Examples:

• Electricity distribution
• Water utilities

Because breaking them up would raise costs, governments regulate them.

Regulatory Outcomes

Socially optimal pricing is often imposed with a price ceiling. If ATC is above that price, the firm may need a subsidy.

Fair-return pricing ensures:

$$TR = TC$$

Many state utility commissions use this approach.