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Jun. 15, 2011

IMPERFECT COMPETITION AND MONOPOLIES

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The fall of the Berlin Wall in 1989 was seen by many as a victory for democracy and the
free market. In the wake of this momentous event, we have learned that introducing a market
economy to non-market economies is not easy at all. There is more to a functioning market
economy than having demand equal supply through free decision making on the part of
consumers and producers. There are many institutions necessary for a market economy to
function well. Property rights have to be defined well to determine who owns what, there needs
to be the rule of law in order to enforce contracts, there have to be institutions that will look at
whether all products are safe and comply with pollution standards, and so on. When listening to
the public debate, one almost gets the impression that deciding for more or less government
intervention or more or less market freedom is purely an ideological decision. This note helps us
think about the market and how it allocates resources in a somewhat more nuanced way.

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As is well understood and often argued, in many instances, market transactions give way
to the most efficient allocation of resources, and they create the highest welfare (highest
producer and consumer surplus).1 They ensure that only those consumers who care most about a
product buy that product and that only the lowest-cost firms get to produce the goods that are
sold. What is often forgotten is that this optimal outcome only materializes under certain
conditions. For example, there has to be a sufficient number of suppliers, so that no individual
firm can set the price (has market power), there has to be full information so that both consumers
and producers are fully informed about the quality of the product, and there also cannot be any
externalities (i.e., social costs associated with pollution).2

No

In this note, we look at what happens when there are only few producers. For simplicity,
we start with a market with only one supplier, a monopolist. We analyze the price the monopolist
charges and the amount of output he or she produces, how those decisions affect overall welfare,
and in what circumstances government intervention can increase overall welfare.

Do

See Peter Debaere, Supply, Demand, and Equilibrium: A Class Experiment, UVA-G-0593 (Charlottesville,
VA: Darden Business Publishing, 2007) for basic welfare analysis.
2
See Peter Debaere, A Framework to Think about Pollution: Externalities, Pollution Taxes, and Cap and
Trade, UVA-GEM-0104 (Charlottesville, VA: Darden Business Publishing, 2011) for an analysis of externalities.
This technical note was prepared by Associate Professor Peter Debaere. Copyright 2011 by the University of
Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.

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The Fundamental Decision Rule: Marginal Revenue = Marginal Cost

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The monopolist is in an extraordinary position of control. As the sole provider of a good

or service, he or she is able to determine the price because he or she can restrict the quantity
supplied. The monopolist will use this control to maximize profits. Needless to say, profits are
the difference between total revenue (TR) and total costs (TC). Any profit-maximizing firm,
monopolist or not, that seeks the optimal quantity (Q) of goods to produce compares marginal
revenue (MR) and marginal cost (MC). The firm considers whether the marginal revenue or the
additional revenue from producing an extra unit of a good (MR = TR/Q) is larger than the
marginal cost or the extra cost of producing an additional unit (MC = TC/Q). Whenever MR >
MC, the firm will increase its production; if MR < MC, the firm will reduce production. The firm
has found its optimal production amount when marginal revenue equals marginal cost, MR =
MC.

tC

The first thing to note is that for a monopolist, the marginal revenue of selling a good is
not just the price that is given in the market. In a competitive market with many sellers, an
individual seller has no impact on the price, no matter how many units he or she may sell. This is
not the case for the monopolist. The monopolist is the only supplier, which is why all the
demand for the product the supplier offers is directed toward him or her (e.g., in a far-off village,
there is only one plumber, so anyone who needs plumbing services has to go to the same
supplier). Therefore, through his or her supply, the monopolist will also control price. And this is
why the marginal revenue of a monopolist does not equal the price. Consider an example:
Suppose you can sell 10 goods for $10 or 11 goods for $9. The marginal revenue of the eleventh
good is then (11 9) (10 10) = $1 and not the price at which the eleventh good is sold on
the market, which is $9. The marginal revenue is lower than the price because the price of all
goods (not just the price of the eleventh, additional good) will be reduced as you increase the
quantity of goods by one unit.

Do

No

Figure 1 depicts the monopolists production decision. The monopolist faces the (solid)
downward-sloping demand, which indicates that he or she can affect the price of the good by
varying the quantity. (In a world of perfect competition with many firms, the price would just be
constanta flat line.) As you can see, the dashed marginal revenue curve is steeper than the
demand curve and lies underneath the demand curve because it decreases with quantity.3

Technically speaking, the marginal revenue curve is the first derivative of total revenue with respect to
quantity, or MR = dTR(Q)/dQ with TR = P(Q) Q.

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Figure 1. A monopolists production decision.4

Price,P
ab

Demand

p *

MarginalCost,MC

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c
de
MarginalRevenue,MR
Ppc

Q*

Qpc

Quantity,Q

For simplicity, we have assumed that the marginal cost is horizontal: The cost to produce
each additional good is the same. This assumption need not always be appropriate. For example,
in the production of airplanes, the MC will clearly decrease with output because there are
significant learning effects with every plane built.

tC

Our profit-maximizing firm chooses to produce at Q*, where MC = MR. At this point, the
price consumers are willing to pay for Q* and that which the monopolist will charge is higher
than the marginal cost. In the absence of other costs, the monopolist will make a profit. In other
words, by restricting supply, the monopolist can increase the price. The monopolist thus has
price-setting power. In a world of perfect competition, the marginal cost always equals the price.

Welfare Analysis of a Monopolist

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No

It is well known that in a perfectly competitive market, we attain the welfare-maximizing

output and price where demand and supply meet each other. With a monopolist in the market,
however, it is clear that less will be produced (Q* < Qpc), and that the price will be higher
(P* > Ppc). How does this affect overall welfare? Note that the sum of consumer surplus (a + b)
and producer surplus (c + d) that characterizes welfare with a monopolist is smaller than under
perfect competition: Welfare shrinks by the triangle e. Overall welfare has gone down because
less is produced and a higher price is charged than under perfect competition. This is a welfare
loss, associated with reduced competition. Note also that there is a shift within total welfare: The
monopolists producer surplus increases relative to the surplus that the consumers get. (Note that
in the case of perfect competition, p = MC, and the producer surplus is zero.) Monopolists get a
bigger slice of the overall benefits of any transaction. Because of this welfare loss, and because
of this shift in welfare gains (from consumers to producers), it is not the case that the market
always finds the best solution. How to attain an outcome that is better than the welfare situation
under a monopolist depends to a large extent on the reason why a monopoly exists.
4

Qpc = Quantity under perfect competition; Ppc = Price under perfect competition.

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Note that there is an additional way in which a monopolist can manifest his or her impact.
He or she can also discriminate in price. It is clear that this cannot happen in a perfectly
competitive market because competing firms would easily undercut any price that is too high.
Granted, the monopolist will have to avoid arbitrage and will therefore often differentiate the
product sold to various groups a little bit. This is a well-known marketing tactic. If the
monopolist could perfectly discriminate by price, he or she would charge each customer
according to his or her willingness to pay and in doing so usurp the entire consumer surplus.

Types of Monopolists

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There can be different reasons why a firm is the sole provider in a market. Key is that
there is a barrier to entry, so competing firms are restricted from entering the market and bidding
down the price. The entry can be hampered because one company has most of the resources. The
best-known example here is DeBeers, which, especially in the past, was the dominant player in
the diamond market. Government regulation can easily create monopolies by restricting
production licenses. Well-known examples are patents that give firms the right to be exclusive
producers of the project they developed. Oftentimes, in order to make innovation and
technological progress attractive, governments allow for patents. Without these patents, firms
would not be able to recover the fixed cost of R&D that went into developing the product; other
companies would just copy the new technology. Although most people would agree that some
type of patent protection is warranted, the debate is mostly about how long a firm can hold a
patent on a particular innovation. Finally, there are natural monopolies such as power companies
that emerge because the fixed costs of providing electricity and making it available to citizens
are so high that it would be inefficient for multiple companies to duplicate the job.

Do

No

What can be done about monopolies? There is a whole body of antitrust legislation that
attempts to discourage practices such as price fixing, which allow separate firms to operate like
one monopoly. Similarly, by opposing mergers and acquisitions, antitrust authorities may try to
preserve competition. Needless to say, those decisions have to weigh the pros and cons, and the
type of monopoly will matter. If it is nothing but preferential treatment that gives a firm the sole
right to produce something, taking that right away is obviously optimal. When we are dealing
with a natural monopoly where the lowest cost is achieved when only one firm produces (there
are increasing returns), one may argue for guidelines as to how a company can set its price. Note
that opening up to trade, which introduces more competition from abroad, is oftentimes an
effective way of undercutting the monopoly power in a country.

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Permissions@hbsp.harvard.edu or 617.783.7860

Monopolist versus Monopolistic Competition

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Do

No

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Although there may not be very many true monopolies in the sense that only one firm is
supplying, the framework outlined in Figure 1 is quite useful for thinking about many other
cases. One could argue that firms that produce differentiated or branded products will to some
extent act like monopolists because they have a set of dedicated consumers who are interested in
their specific brand. This loyalty gives the producers of those differentiated products some power
to set price. What is different, however, from the pure monopolistic power is that if too much
profit is made in a given market, more and more firms will enter that market. As more firms
enter the market, the demand curve the firm faces will shift inward and become flatteruntil
virtually no profit is made. At the limit, the price will equal the average cost, and profits will be
zero. Competition among multiple firms that produce differentiated products is sometimes
referred to as monopolistic competition. Note that if we are dealing with a branded product, a
significant part of the fixed costs will include the cost of branding the product.

This document is authorized for educator review use only by Santiago Davila, HE OTHER until December 2016. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860