Our concern in this chapter was the conduct and performance of the imperfectly competitive firm, a firm that has at least some latitude to set its own price. Economists often distinguish among three different types of imperfectly competitive firms: the pure monopolist, the lone seller of a product in a given market; the oligopolist, one of only a few sellers of a given product; and the monopolistic competitor, one of a relatively large number of firms that sell similar though slightly differentiated products.
Although advanced courses in economics devote much attention to differences in behavior among these three types of firm, our focus was on the common feature that differentiates them from perfectly competitive firms. Whereas the perfectly competitive firm faces an infinitely elastic demand curve for its product, the imperfectly competitive firm faces a downward-sloping demand curve. For convenience, we use the term monopolist to refer to any of the three types of imperfectly competitive firms.
Monopolists are sometimes said to enjoy market power, a term that refers to their power to set the price of their product. Market power stems from exclusive control over important inputs, from economies of scale, from patents and government licenses or franchises, and from network economies. The most important and enduring of these five sources of market power are economies of scale and network economies.
Unlike the perfectly competitive firm, for which marginal revenue exactly equals market price, the monopolist realizes a marginal revenue that is always less than its price. This shortfall reflects the fact that to sell more output, the monopolist must cut the price not only to additional buyers but to existing buyers as well. For the monopolist with a straight-line demand curve, the marginal revenue curve has the same vertical intercept and a horizontal intercept that is half as large as the intercept for the demand curve.
Whereas the perfectly competitive firm maximizes profit by producing at the level at which marginal cost equals the market price, the monopolist maximizes profit by equating marginal cost with marginal revenue, which is significantly lower than the market price. The result is an output level that is best for the monopolist but smaller than the level that would be best for society as a whole. At the profit-maximizing level of output, the benefit of an extra unit of output (the market price) is greater than its cost (the marginal cost). At the socially efficient level of output, where the monopolist's marginal cost curve intersects the demand curve, the benefit and cost of an extra unit are the same.
Both the monopolist and its potential customers can do better if the monopolist can grant discounts to price-sensitive buyers. The extreme example is the perfectly discriminating monopolist, who charges each buyer exactly his or her reservation price. Such producers are socially efficient, because they sell to every buyer whose reservation price is at least as high as the marginal cost.
One common method of targeting discounts toward price-sensitive buyers is the hurdle method of price discrimination, in which the buyer becomes eligible for a discount only after overcoming some obstacle, such as mailing in a rebate coupon. This technique works well because those buyers who care most about price are more likely than others to jump the hurdle. While the hurdle method reduces the efficiency loss associated with single-price monopoly, it does not completely eliminate it.
The various policies that governments employ to mitigate concerns about fairness and efficiency losses arising from natural monopoly include state ownership and management of natural monopolies, state regulation, private contracting, and vigorous enforcement of antitrust laws. Each of these remedies entails costs as well as benefits. In some cases, a combination of policies will produce a better outcome than simply allowing natural monopolists to do as they please. But in other cases, a hands-off policy may be the best available option.
The chapter appendix shows the analysis of monopoly profit maximization using algebra.
