PURE MONOPOLY
A pure monopolyis a market that has only one seller: a single firm. It is worth
noting at the outset that pure monopolies are very rare. It is estimated that less
than 3 percent of the U.S. gross domestic product (the dollar value of all goods
and services) is produced in monopolistic markets. (Here a monopoly is
defined as a market in which a single firm has 90 percent or more of the mar-
ket.) Nonetheless, the case of pure monopoly is important not only in its own
right but also because of its relevance for cases of near monopolies, in which a
few firms dominate a market. The monopoly model also explains the behavior
of cartels—groups of producers that set prices and outputs in concert.
There are two main issues to address in analyzing monopoly. First, one
must understand monopoly behavior—how a profit-maximizing monopolist
determines price and output. Second, one must appreciate that a precondi-
tion for monopoly is the presence of barriers to entry, factors that prevent other
firms from entering the market and competing on an equal footing with the
monopolist.
Let’s start by considering a monopolist’s price and output decision. Being
the lone producer, the monopolist is free to raise price without worrying about
losing sales to a competitor that might charge a lower price. Although the
monopolist has complete control over industry output, this does not mean it
can raise price indefinitely. Its optimal price and output policy depends on
market demand. Because the monopolist isthe industry, its demand curve is
given simply by the industry demand curve. Figure 8.1 depicts the industry
demand curve and long-run costs for the monopolist. Given information on
demand and cost, it is straightforward to predict monopoly price and output.
As a profit maximizer, the monopolist should set its output such that marginal
revenue (derived from the industry demand curve) equals the marginal cost
of production. In the figure, this output, QM, is shown where the monopolist’s
marginal revenue and marginal cost curves intersect. According to the indus-
try demand curve, the corresponding monopoly price is PM. The area of the
shaded rectangle measures the monopolist’s total excess profit. This profit is
the product of the monopolist’s profit per unit, PMAC (the rectangle’s
height), and total output, QM(the rectangle’s base).
We should make two related remarks about the potential for excess prof-
its under pure monopoly. First, monopoly confers a greater profit to the firm
than it would have if the firm shared the market with competitors. We have seen
that economic profits in perfect competition are zero in the long run—not so
for the monopolist. Second, even when the firm occupies a pure-monopoly
position, its excess profits depend directly on the position of industry demand
versus its cost. Figure 8.2 makes the point by depicting three different indus-
try demand curves. It should be evident that only curve D 1 offers significant
excess profits. Demand curves D 2 and D 3 offer very little in the way of profit
possibilities. Although they differ with respect to elasticities, both curves barely320 Chapter 8 Monopolyc08Monopoly.qxd 9/29/11 1:31 PM Page 320