CH 15: Monopoly. Lecture

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1 CH 15: Monopoly Lecture

2 Characteristics of Monopolies A monopoly is a market structure in which one firm makes up the entire market Firm=Industry

3 Characteristics of Monopolies The monopolist is a price maker There are no close substitutes for the good the monopolist produces Barriers to entry exist and prevent competition If there were no barriers to entry, profit-maximizing firms would always compete away profits

4 Barriers to Entry 1. Geography Location or control of resources limits competition and leads to one supplier 2. Government Government allows monopolies for public benefits or to stimulate innovation Think water/sewer system

5 Barriers to Entry 3. Technology or Common Use Patents and widespread availability of certain products lead to only one major firm controlling a market Example: Medicine 4. Mass Production and Low Costs If there were three competing electric companies they would have higher costs Having only one electric company keeps prices low

6 Profit Maximizing Level of Output The goal of the monopolistic firm is to maximize profits (difference between total revenue and total cost) The profit-maximizing condition of a monopolistic firm is: MC = MR

7 Profit Maximizing Level of Output For a monopolistic firm, MR < P (ALWAYS) This is because to sell more units a monopolist has to lower its price A monopoly maximizes total profit, not profit per unit When marginal revenue is zero, a monopolist has maximized total revenue

8 If MR > MC, Profit Maximizing Level of Output The monopoly can increase profit by increasing output If MR < MC, The monopoly can increase profit by decreasing its output

9 Demand and Marginal Revenue Curves What happens to TR when MR hits zero? P $15 10 TR 5 $ MR D TR Q Total Revenue is at its peak when MR hits zero Q

10 Drawing the Monopoly Graph The demand curve is always downward sloping and represents the market demand curve Draw your MC curve The MR curve starts at the same point on the price axis as does P The MR curve bisects the demand curve

11 Drawing the Monopoly Graph The output (Q) the monopolist will produce is where MC=MR Put a dot where MC=MR and take the point down to the Q axis

12 Drawing the Monopoly Graph Determine the price the monopolist will charge Take the point where MC=MR and draw a dotted line up to the demand curve Draw a dotted line to the price axis (price is always derived from the demand curve)

13 Drawing the Monopoly Graph Determine profit or loss Subtract ATC from price at that level of output and multiply by the output (P-ATC)*Q

14 Drawing the Monopoly Graph If price is greater than ATC (P>ATC) at this output, the monopolist will make a profit If price equals ATC (P=ATC), the monopolist will not make a profit (zero profit/loss) If price is less than ATC (P<ATC) at this output, the monopolist will incur a loss

15 Graph: Monopolist Earning a Profit Find the output where MC = MR (profit maximizing quantity) Find how much consumers will pay; this is where the profit max Q intersects demand and is the monopolists price Find profit per unit where the profit max Q intersects ATC

16 Graph: Monopolist Earning a Profit Extend the lines from where the quantity line intersects the demand curve and the ATC to the price axis This rectangle is the monopolists profit Since P>ATC at the profit maximizing quantity, this firm is earning a profit

17 Draw the Graph: A Monopoly Earning a Profit Find output where MC = MR, this is the profit maximizing Q P MC Find how much consumers will pay where the profit max Q intersects demand, this is the monopolist price P 1 Profit ATC Find profit per unit where the profit max Q intersects ATC Since P>ATC at the profit maximizing quantity, this firm is earning profits Q profit max MR D Q

18 Graph: A Monopoly with a Loss Find output where MC = MR (profit maximizing Q) Find how much consumers will pay; this is where the profit max Q intersects demand and is the monopolists price Find profit per unit where the profit max Q intersects ATC Since P<ATC at the profit maximizing quantity, this firm is earning a loss

19 Draw the Graph: A Monopoly with a Loss Find output where MC = MR, this is the profit maximizing Q P MC Find how much consumers will pay where the profit max Q intersects demand, this is the monopolist price P 1 Losses ATC Find profit per unit where the profit max Q intersects ATC Since P<ATC at the profit maximizing quantity, this firm is earning a loss Q profit max MR D Q

20 Monopoly: Elastic and Inelastic Range A monopoly will only produce in the elastic range Price Elastic Range Inelastic range So, when MR is zero, demand is unit elastic Demand Quantity Total Revenue Test If price falls and TR increases, then demand is elastic. If price falls and TR falls, then demand is inelastic. Price Marginal Revenue Total Revenue Quantity Note that in the inelastic range of the demand curve, MR is negative and TR falls as Q increases.

21 Are Monopolies Efficient? No, they are inefficient by nature They charge a higher price They under produce and are not allocatively efficiency They produce at higher costs and are not productively efficiency

22 Socially Optimal Level (Allocatively Efficient) for a Monopoly P MC P 1 ATC Socially optimal (allocatively efficient) is where MC=D P SO Q 1 Q SO MR SO/AE D Q This is where CS and PS is maximized

23 Socially Optimal Level (Allocatively Efficient) for a Monopoly The government could institute a price ceiling here to force the monopolist to produce at SO/AE: this would create a loss for the monopolist The government would have to offer a subsidy to the monopolist to produce at SO

24 Fair Return Level for a Monopoly P 1 P FR P Q 1 Q FR MR MC ATC FR D Q Fair return is when the government regulates price with a price ceiling This is where D=ATC and where TR=TC (no economic profit)

25 Monopolies Compared to Perfect Competition A monopolistic firm s MR is not its price MR is always below its price To sell more units, a monopolist has to decrease its price this makes the MR curve less than demand Monopolies create DWL

26 Monopoly and Perfect Competition Let s compare where perfect competitors produce and where monopolists produce P MC P MC ATC ATC P 1 Profit P = D = MR = AR P 1 Profit Q profit max Q MR Q profit max D Q

27 P Monopoly Graph Compared to Perfect Competition Graph MC In a monopoly, P>MR, In perfect competition, P=MR=D MR=MC is the profit max rule for both P M P PC D PC = MR PC First find the monopoly Q and P Then find the perfectly competitive Q and P Q M Q PC MR M D M Q Result: Monopoly output is lower, and price is higher, than perfect competition

28 Why does a monopoly have DWL? Because a monopoly charges a higher price and produces a lower quantity than a perfect competitor Monopolies are allocatively inefficient The welfare loss (DWL) from a monopoly is represented by the blue triangles To maximize CS and PS, a monopolist would have to produce where MC=D

29 CS, PS, and DWL for a Monopoly P MC CS P M DWL PS Q M MR D Q

30 Lump-sum vs. Per-unit Subsidies and Taxes A lump-sum tax (or subsidy) occurs one time It affects fixed costs: AFC and ATC A per-unit tax (or subsidy) is added to every unit produced It affects variable costs: AVC, ATC, and MC (Learn and know these!)

31 Lump-sum vs. Per-unit Tax If a monopoly is earning a profit, the government could institute a lump-sum or per-unit tax A lump-sum tax would affect fixed costs (AFC and ATC) and not MC, so it would not alter the profit maximizing P and Q It would decrease profit

32 Lump-sum vs. Per-unit Tax A per-unit tax would affect variable costs (AVC, ATC, and MC), so it would alter the profit maximizing P and Q It would shift MC up (to the left) Q would decrease and P would increase It would decrease profit

33 Lump-sum vs. Per-unit Subsidy If a monopoly is earning a loss, the government could institute a lump-sum or per-unit subsidy A lump-sum subsidy would affect fixed costs (AFC and ATC) but not MC, so it would not alter the profit maximizing P and Q It would not impact DWL

34 Lump-sum vs. Per-unit Subsidy A per-unit subsidy would affect variable costs (AVC, ATC, and MC), so it would alter the profit maximizing P and Q Q would increase and P would decrease MC would shift down (to the right) and would allow the firm to produce where MC=D (where a perfect competitor would produce)

35 The Price-Discriminating Monopolist All of the graphs you just learned are for unregulated monopolies When a monopolist price discriminates, it charges different prices to different individuals (or groups of individuals)

36 The Price-Discriminating Monopolist Consumers with less elastic demands are charged higher prices Consumers with more elastic demands are charged lower prices Price discrimination increases output and profits

37 Graph: The Price-Discriminating Monopolist P MC D and MR are the same Q is where it would be for a perfect competitor, where MC=MR Profit Q M ATC D=MR Q P, is anywhere on the demand curve because those willing to pay a higher price will There is no CS

38 Natural Monopoly Natural monopoly is when a single firm can produce at a lower cost than can two or more firms Significant economies of scale exist more than one firm would prevent the monopolist from taking advantage of economies of scale There is no DWL

39 Natural Monopoly If demand intersects ATC while demand is downward sloping, we can conclude the industry is a natural monopoly If a firm charges at its profit maximizing point, where MC=MR, it is charging much higher than the socially optimal price (where MC=D) It also restricts its output (or under produces)

40 Natural Monopoly How can society achieve a socially optimal level with a natural monopoly? The government can intervene with price controls and subsidies

41 Natural Monopoly A price control instituted at the socially optimal price would cause the firm to earn economic losses and shutdown A monopolist needs a per-unit subsidy to be able to produce the socially optimal level The natural monopoly is then referred to as a regulated monopoly

42 A Natural Monopoly Graph, Profit and Regulation Average Cost A natural monopolist produces Q M and charges P M, therefore earning a profit P M C M Profits If there is government regulation and a competitive solution where P = MC is required, the monopolist produces Q C and charges P C, therefore earning a loss C C P C Losses Q M MR Q C D ATC MC Q

43 Natural Monopoly P MC P profit max ATC P SO Q profit max MR Q SO D Q

44 Natural Monopoly The government would institute a price control at P G (a price ceiling) and then subsidize the firm to reduce MC MC P profit max ATC P G Q profit max MR Q SO D Q

45 Natural Monopoly What happens is this: MC and ATC shift down into the negative revenue range of the graph and the government subsidizes the firm to produce at the socially optimal level See next graph: I don t think you will ever see this on the AP exam, but this is what the graph would look like

46 Natural Monopoly Graph MC P profit max ATC P G Q profit max MR Q SO D Q ATC 2 MC 2 with subsidy

47 Chapter Summary Monopoly is a market structure, protected by barriers to entry, in which a single firm produces a product for which there are no close substitutes A monopolist maximizes profit or minimizes losses where MR=MC To determine a monopolist s profit or loss: Find output where MR=MC Determine price and ATC at that output Profit or loss = (P ATC) * Q

48 Chapter Summary Monopoly output is lower and price is higher than in competitive markets Because monopolies reduce output and charge P > MC, monopolies create a welfare loss for society A price-discriminating monopolist earns more profit than a normal monopolist by charging a higher price to those with less elastic demand and a lower price to those with more elastic demand Natural monopolies exist in industries with strong economies of scale, so it is more efficient for one firm to produce the entire output In a natural monopoly the competitive outcome where P=MC results in losses