• Document: CHAPTER 10: PURE MONOPOLY
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CHAPTER 10: PURE MONOPOLY Introduction While the perfectly competitive firm has no power over prices in the marketplace, the monopoly has the power necessary to determine both the price and output of the product. The monopoly model shows us important differences from perfect competition in terms of efficiency and effects on producer and consumer surplus. Chapter 10 focuses on the ways monopolies develop, output and price determination, the effects of monopoly behavior, and government regulation. The monopoly model is important to understanding the oligopoly and monopolistic competition, which will be covered in Chapter 11. Material from Chapter 10 appears on the AP microeconomics exam in a large number of multiple-choice questions, and a free-response question about decision making in at least one of the market structures is part of nearly every AP microeconomics exam. Pure Monopoly A pure monopoly is a market structure with only one producer, no close substitutes, and complete barriers to entry. Unlike a price-taking perfectly competitive firm, the pure monopoly is a price maker, with the firm determining its own output and the price it will charge for its product. Because the monopoly faces a downward-sloping demand curve, it can restrict output in order to raise the product price. Pure monopolies include local natural gas, electricity, and water companies, as well as pharmaceutical companies that hold patents on particular medications. Near monopolies also exist where a single firm provides the vast majority of sales in a particular industry. Barriers to Entry Monopolies hold market power, the power to determine prices, because of barriers to entry- factors that prevent competitors from entering the industry. While perfectly competitive firms face no barriers and are free to enter and exit the industry, imperfectly competitive firms must deal with barriers. Monopolies, for a variety of reasons, are able to completely prevent potential competitors from entering the industry. $20 til 8 15 1i S "~ 10 ~ o 50 100 200 Quantity Economies of scale One important barrier to entry is economies of scale. The larger the firm's output, the more efficient the firm becomes. Natural monopolies achieve economies of scale, with their average total cost curves continuing to fall over a very large range of output. In this example, if one firm produced 200 products, the average total cost would be $10. But if two firms each produced 100 86 Chapter 10: Pure Monopoly units, the average total cost would be $15; four firms each producing 50 units would lead to an average total cost of $20. Clearly, it is more cost-effective to have one large producer. These economies of scale also serve as a barrier to entry for new firms, which face those higher costs as smaller producers. The government also creates barriers to entry by granting patents and licenses. The government grants a patent, which protects an inventor's ownership rights, in order to encourage investment in research and development. For the life of the patent, the owner has monopoly control of the product and can use revenues to recoup research and development costs and potentially to support further development of other products. The government can also create a barrier to entry by licensing producers, from taxi drivers and cosmetologists to teachers and electricians. Other firms create barriers to entry by controlling the resources necessary to produce the product. Monopolists deeply cut their prices to undercut the competition, make deals with retailers to reinforce their monopoly status, or find other ways to make the competitor's product more expensive or less desirable. Monopoly Demand Analysis of the pure monopoly assumes no firms can enter the industry, the government does not regulate the firm, and the firm charges the same price for every product. The most important difference between the perfectly competitive firm and the pure monopoly is the demand curve. Remember, the perfectly competitive firm was a price-taker, accepting the price set in the industry. So the individual firm had a perfectly elastic, horizontal demand curve, with the marginal revenue equal to the product price. Because it is the only firm in the industry, a monopoly has only one graph, unlike the side-by-side graphs for perfect competition. Also, a monopoly faces a different demand curve. Because it is the only producer, industry demand is the firm's demand. Therefore, a monopoly faces a downward-sloping demand curve, with quantity demanded increasing as price falls. This difference has important ramifications for price and output decisions. First, the marginal revenue curve is lower than the price curve. For the firm to sell more products, it must lower the price for all the goods it sells, not just the last one. Therefore, the marginal revenue-the change in total revenue from selling one more product-will be lower

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