3 Monopoly and Market Power

Market power and monopoly

A monopoly is a market served by one seller with no close substitutes. More broadly, market power is a firm's ability to influence price rather than simply accept the market price. The number of sellers matters, but so do the availability of alternatives, how readily customers can switch, and how easily new firms can enter.

A firm with market power faces a downward-sloping demand curve: to sell more, it generally must lower its price. A price–marginal-cost gap is one indicator of market power, but a markup alone does not establish that a firm is legally a monopolist. That assessment requires defining the relevant market and considering competitive alternatives and entry.

Choosing output and price

A monopolist chooses a quantity and then charges the highest price buyers will pay for that quantity, as indicated by the market demand curve. It cannot independently choose any price and quantity it wants. Because a lower price used to sell an additional unit usually applies to earlier units too, marginal revenue is below price.

The profit-maximizing output rule is:

Here, $\text{MR}$ is marginal revenue and $\text{MC}$ is marginal cost. After finding the output that satisfies this rule, the firm reads the corresponding price from the demand curve. The rule alone does not guarantee an economic profit: profit depends on whether price exceeds average total cost at that output.

Numerical example

Suppose market demand is $P = 100 - Q$ and marginal cost is constant at $\$20$. Total revenue is $\text{TR} = 100Q - Q^2$, so marginal revenue is $\text{MR} = 100 - 2Q$. Setting marginal revenue equal to marginal cost gives $Q = 40$; the demand curve then gives a monopoly price of $\$60$.

Under the price-taking competitive benchmark, price equals marginal cost. In this example, that gives $Q = 80$ and $P = \$20$.

In the standard single-price model, the profit-maximizing markup is larger when demand is less price-sensitive. The price–marginal-cost gap is an indicator of market power, but it does not by itself settle whether the firm is legally a monopolist.

Price discrimination

Price discrimination means charging different prices for the same product when the price differences are not explained by differences in the cost of serving buyers. It can raise profit when a firm has market power, can distinguish customer groups or purchase choices, and can limit resale from lower-price buyers to higher-price buyers.

Three common forms differ in how the firm separates prices:

• First-degree, or personalized, discrimination: the firm charges each buyer, or for each unit sold, close to that buyer's willingness to pay. In the idealized case, the firm captures nearly all consumer surplus.

• Second-degree discrimination: the firm offers a menu of prices or versions and lets customers choose, such as quantity discounts or different service plans.

• Third-degree discrimination: the firm charges different identifiable groups different prices, such as student and regular admission, when demand differs between groups.

With third-degree discrimination, the seller chooses output in each group so that marginal revenue in that group equals the common marginal cost of serving it. All else equal, a group with less elastic demand will generally face a higher price. The price difference alone does not show whether total output or social welfare rises; those outcomes depend on how the pricing changes sales across groups.

Welfare effects

Under the usual assumptions of the basic single-price model, monopoly output is below the efficient output, where buyers' marginal willingness to pay equals marginal cost. The monopoly price exceeds marginal cost. Compared with the competitive benchmark, some surplus shifts from consumers to the firm, while trades that would have benefited buyers and sellers at a price above marginal cost do not occur. The value of those unrealized trades is deadweight loss.

In the numerical example, the competitive quantity is $80$ and the monopoly quantity is $40$. The lost gains from trade form a triangle between the demand curve and the $\$20$ marginal-cost line over units $40$–$80$. Thus:

This is a loss in total surplus. The transfer of surplus from consumers to the monopolist is separate from this deadweight loss.

Price discrimination has no single welfare effect in every case. In the idealized model, perfect first-degree discrimination can expand sales until willingness to pay equals marginal cost, eliminating the output-related deadweight loss while transferring surplus to the seller. Less complete discrimination may expand output and reduce deadweight loss, or restrict sales in some segments; the result depends on the pricing scheme and demand conditions. Higher seller profit alone does not establish that total welfare has increased.