Principles of Microeconomics ECONOMICS 103. Topic 8: Imperfect Competition. Single price monopoly. Monopolistic competition.

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1 ECONOMICS 103 Topic 8: Imperfect Competition Single price monopoly. Monopolistic competition. 1

2 COMPETITIVE MARKETS V MONOPOLY Thus far, all firms have been price takers. - Markets are characterized by many, many sellers. - Any individual seller is too small to influence the market price. - Price determined by S and ; firm chooses whether or not and how much to produce, given that price. All implies that MR = P for competitive firms. - Same thing as saying that the demand for any individual firm s output is perfectly elastic at the market price. We want to contrast this with the opposite extreme: monopoly. 2

3 MONOPOLY In our final Topic 103, we will look at simplest case of monopoly behaviour: - Single price monopolist; seller charges same P to all customers. We want to understand two things: - MR < P for single-price monopolist. Means there will be a WL due to monopoly power. - Barriers to entry mean that Π > 0 can prevail in LR monopoly. Only thing we need to understand that is new here is that the curve for a monopolist s output is the market demand curve, which is downward sloping. - This is what results in MR < P, which drives everything else. 3

4 MR FOR A COMPETITIVE FIRM q1 q1 + 1 MR = P q Recall that MR = P for a perfectly competitive firm. Can sell as much as it wants at market price P. Selling one extra unit of q yields P in extra revenue. Means that the demand curve for a single competitive firm s output is perfectly elastic at the prevailing market price. True because any given firm is only a small, small part of the market. This is not true for the monopolist: the monopolist is the market, on the selling side, at least. 4

5 MR FOR A MONOPOLIST P1 P2 B The demand curve for the monopolist s output is the market demand curve. A This means that, to sell one more unit, it must P to all buyers. Selling one extra unit has a gain and a loss. - Gain = P2: extra unit sold at new lower price Gain = area A. - Loss = P 1: units that used to sell at P1 now sell at P2. Loss = area B. MR = A - B = P2 - ( P 1) < P1. 5

6 MONOPOLY MR Note: MR could be > 0 or < 0, depending on region of. P1 P2 B High up the curve, A > B MR > 0. A Selling one extra unit has a gain and a loss. - Gain = P2: extra unit sold at new lower price Gain = area A. - Loss = P 1: units that used to sell at P1 now sell at P2. Loss = area B. MR = A - B = P2 - ( P 1) < P1. 6

7 MONOPOLY MR Note: MR could be > 0 or < 0, depending on region of. High up the curve, A > B MR > 0. Low down the curve, A < B MR < 0. P1 P2 B A All depends on e P. We know linear has e P > 1 along top half. - Tells us that P TR MR > 0. We know linear has e P < 1 along bottom half. - Tells us that P TR MR < 0. And, linear has e P = 1 halfway MR = 0 halfway down. 7

8 MONOPOLY MR P MAX $ Along top half of, e P > 1, so TR. MR > 0. (P MAX )/2 Along bottom half of, e P < 1, so TR. $ ( MAX )/2 MAX MR < 0. TR MR >0 TR MR <0 Halfway down, MR = 0. TR () ( MAX )/2 MAX 8

9 MONOPOLY MR $ P()1 We want to draw MR curve, which shows MR for all possible levels of. Recall: we read P off the curve. MR()1 And we deduced that, at any, MR < P. 1 MR Tells us that MR curve must lie below curve. 9

10 MONOPOLY MR Pmax e P > 1 So MR curve lies below since MR < P. max 2 e P = 1 MR > 0 e P > 1 MR < 0 MR = 0 max Marginal Revenue For linear : - MR > 0 over top half; and - MR < 0 over bottom half. Once you understand that MR < P for monopolist, rest is easy. - Profit max monopolist chooses s.t. MR = MC. Same as for a competitive firm. - But for monopolist, MR < P MC < P. P > MC so monopolist does not max mkt surplus. 10

11 MONOPOLY Π max choose s.t. MR = MC - = M. MC P M What P will monopolist charge? MB > MC - The highest it can, given curve. M MR - P = P M. Recall that consumers MB = P, and P > MR = MC. - So at monopoly equilibrium we have MB > MC. - Market surplus is not maximized! 11

12 MONOPOLY Note: comp mkt would produce where MB = MC. i.e., comp mkt would produce C units. For each from M to C, MB > MC. P M MC TB of those units > TC of those units. M C MR Why not? Because in order to sell those units, monopolist would have to lower P to all consumers, and doing so would Π. In comp mkts, Π max behaviour mkt surplus is maximized. With single price monopoly, max behaviour mkt surplus is not maximized. 12 Those units could generate mkt surplus > 0, but they don t get produced and sold.

13 MONOPOLY P M A MC Note: comp mkt would produce C units, monopolist produces M. Assume mkt surplus = SS. - That is, assume no externalities. M C MR Then area A = WL due to the monopoly. Area A = extent to which SS falls short of what it could be. - WL always = unrealized SS. Competitive markets would take us to C, so A = measure of loss to society from having monopoly relative to competition. 13

14 MONOPOLY Note carefully the source of the WL: it arises because monopolist must lower its price to sell more output. - We have constrained the monopolist to charge all customers same price for its output. - That s what a single price monopolist is. What if monopolist could charge different customers different prices for the same product? - We observe this often, in many markets. Movie tickets, plane tickets, software, etc. This is known as price discrimination. - Covered in later micro classes like 203 and

15 CORRECTING MKT FAILURE. Back to the problem of the single P monopolist. - P > MC WL. If we cannot somehow make the market competitive (more on this shortly), what govt policies can help correct mkt failure? Recall the problem is that M is too low, so we don t want to use any policy instrument that reduces. - Taxes, quotas, etc are all inappropriate. How might we get to increase in monopoly markets? - Subsidize monopolists output (distributionally interesting...). - Regulate prices: specifically, mandate that P = MC. 15

16 PRICE REGULATION P C We want to see that price ceiling can now increase. Opposite effect to price ceiling in competitive market. C MR It does so by changing the relationship between MR and P. Set price ceiling = P C. Now for any < C, MR = P C. 16

17 PRICE REGULATION P C : MR=P C MR<P and MR are now as shown above. 17

18 PRICE REGULATION MC ATC P C MR=P C MR<P MR = MC now at C. As long as PC > ATC at C, monopolist will maximize profits by producing C and charging P = P C. 18

19 PRICE REGULATION MC ATC Set price ceiling at P C. As long as P C > ATC, we get to C. P M P C Looks like we might have replicated outcome of competitive mkt, but... M C MR Without actual competition - potential for entry and exit - we don t get the same outcome in the LR as under perf comp. - We don t get to ATC min. - Even with P regulation, monopoly markets are too small. We want to be at min of ATC, with more firms in industry. 19

20 WHY MONOPOLY? So far, we have just assumed the existence of monopolist. Need to ask why monopoly would survive in a mkt economy. Monopoly profits should attract entry, just as in comp mkts. So there must be barriers to entry, if we see monopoly persist. ifferent types of barriers to entry: - Collusive barriers (these are illegal, btw) - Legal barriers, such as patents. - Technological barriers. Text book talks about some of these. Read if you are interested, but won t be on the final exam. 20

21 MARKET STRUCTURE So far we have looked at two extremes: - Perfectly competitive mkts. - Monopoly markets. Real world markets are often in between. Lots and lots of econ models looking at in-between cases: - Take more econ courses! We will look briefly at just one approach to the in-betweens. - A discussion of the model of monopolistic competition. - As the name suggests, this model assumes some aspects of monopoly and some of perfect competition. 21

22 MONOPOLISTIC COMPETITION In competitive markets we assume identical products. - Many products are not really identical. Monopolistic comp assumes that each firm produces goods that are in many ways similar, but not identical: - Substitutes, but not perfectly so; differentiated products. Example: smartphones: - Samsung phone not identical to an iphone, but both are phones. - My decision to buy one over the other depends on price of each, as well as each phone s own unique attributes. - If something happens to make one cheaper relative to the other, some - but not all - consumers will switch. Means that there is a unique curve for each product, but there is an interdependence among those curves. 22

23 MONOPOLISTIC COMPETITION Understanding interdependence among demand curves is key. First, realize that differentiated products means that each monop. comp. firm faces a downward sloping curve for its output. Suppose 2 sellers of differentiated products in a monopolistically competitive market. - If firm 2 lowers its price, for firm 1 s output will decrease. - If firm 2 increases its price, for firm 1 s output will increase. - If a third firm enters the market, for both firm 1 and firm 2 s output will decrease. Understand the above, add it to the basic monopoly model, assume free entry, and you ve got monopolistic competition. 23

24 MONOPOLISTIC COMPETITION Monop. comp. is more or less like monop., but with free entry of sellers whose output is similar, but not identical to, existing firms. Entry/exit occurs for the same reasons as in perf. comp. mkts. - If Π > 0 in industry (broadly defined) then new firms enter. - Entry for existing firms P, eroding Π. - Entry will drive Π = 0, just as in perf comp. This means that P = ATC in the LR in monop. comp. mkts. ifference is that MR < P for monop comp firms, because each firm faces sloping. Importantly, this means that P > MC and P > ATC min: P > MC WL. P > ATCMIN on t get least cost production in the LR. 24

25 MONOPOLISTIC COMPETITION P1 P ATC1 1 MC MR But P1, 1 is NOT a LR equil for monopolistically comp firm. Π > 0 entry of firms who produce an imperfect substitute for this firm s output. This firm will lose some - but not all - customers after entry. The curve for this firm s output will shift in. If shifts in, then MR also shifts. P1, 1 is SR equil for monop comp firm. ATC MR = MC Π max. P > MC there is a WL. 25 P > ATC Π > 0.

26 MONOPOLISTIC COMPETITION P2 P MC ATC shift means this firm will have to charge lower P and sell less. ATC2 MR If new lower P > ATC, still true that Π > 0, so there is still incentive for entry. 2 More entry results in further decrease in and P. Entry continues until P driven down so that P = ATC; Π > 0. In LR in monop competitive industries we will have P = ATC. curve must shift until we have MR = MC at where P = ATC. - If curve doesn t shift in exactly this way, can t a LR equ. 26




30 MONOPOLISTIC COMPETITION MC LR equil, diagrammatically. PLR ATC P = ATC. MR = MC. P > MR. LR MR P > MC. In LR, we still have WL and don t reach minimum cost. That s the price we pay for variety. 30

31 ROUN-UP Comparison of three types of market structure. Market type escription MR v P P v MC LR Π LR ATC WL Perf. Comp. Many sellers, identical goods, free entry in LR MR = P P = MC Π = 0 ATCLR = ATCMIN No Monopoly Single seller, barriers to entry MR < P P > MC Π > 0 ATCLR > ATCMIN Yes Monop. Comp. Many sellers, differentiated products, free entry in LR MR < P P > MC Π = 0 ATCLR > ATCMIN Yes 31