A monopoly exists if a single firm produces and sells a good or service for which there are no close substitutes and new firms are prevented from entering the market in the long run. While these conditions are seldom met in the real world, many firms do have the power to make price and output decisions in essentially the same way that a monopolist chooses price and output to maximize profit. For this reason, managers can use the theory of monopoly as a guide to making pricing decisions when their firms possess a high degree of market power and no other significant rivals compete in the market.

Market power is the ability of a firm to raise price without losing all its sales. Any firm that faces a downwardsloping demand curve has market power. Market power gives a firm the ability to raise price above average cost and earn economic profit, demand and cost conditions permitting. In the long run, a firm with market power may be able to earn economic profit because entry of new firms is difficult. In order to be a true monopolist, there must be some barriers to entry to prevent rival firms from entering and competing away the monopolist's profit. Market power is possessed not absolutely but, rather, to varying degrees. The degree to which a firm possesses market power is inversely related to the availability of close substitutes for the firm's product and thus can be measured (approximately) by the price and cross-price elasticities of demand.

As in the case of competition, the profit-maximizing decision for a monopoly can take either of two equivalent forms. The manager can choose either output or input usage to maximize profit using the rule MR = MC or MRP = _{<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/free/0073402818/459499/w_char.jpg','popWin', 'width=65,height=84,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (0.0K)</a>}, respectively. The two rules lead to identical prices, outputs, input usage, and profits. We also showed you how a multiplant firm—possessing any degree of market power—should allocate total output among two or more production facilities to minimize total cost and maximize profit.

In this chapter, we also briefly developed the theory of monopolistic competition. Of all firms with market power, a monopolistically competitive firm has the least. The barriers to entry are so low that it is easy for new firms to enter the market when economic profits are made by existing firms. As we showed, the key feature of monopolistic competition is that, in the long run, the firm's economic profit is competed away even though each firm has some market power.