Monopolistic Markets. Causes of Monopolies

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1 Monopolistic Markets Causes of Monopolies

2 The causes of monopolization Monoplositic resources Only one firm owns a resource which is crucial for production (e.g. diamond monopol of DeBeers). Monopols created by the government Patents and copyrights (e.g. pharma industry). Natural monopols One single firm is able to produce the aggregate output of an industry at a lower cost than if there were multiple firms. Economies of scale (e.g.

3 The natural monopol P P M Suppose there are economies of scale in the interval relevant for production (AC decreasing). If production was shared amongst several firms, each firm would produce less than the monopolistic quantity and would therefore have higher average costs. One single firm can produce any given output at the lowest possible cost. For such a market a monopol is therefore the natural industry structure. MC AC Example: Large fixed costs. MR Q M Q

4 Comparison of market-structures Competitive Many buyers and sellers. Price-taking behaviour. Homogeneous products Free entry and exit Monopolistic One seller and many buyers. The seller can determine the price. The product does not have close substitutes Barriers to entry

5 Monopol versus competition The demand curve faced by a competitive firm is horizontal. The demand curve faced by a monopolist is identical to market demand P P P d D The production of the individual firm does not affect the market price. q The output decision of the monopolist influences the market price. Q

6 Monopolistic Markets Equilibrium in a Monopoly

7 The monopolist`s decision The objectives of a monopolistic and a competitive firm are the same: Maximization of profits. Profits = Total revenue Total cost π(q) = R(Q) - C(Q) Total revenue R(Q) = P(Q) Q

8 Profit maximization The firm chooses Q to maximize π: π (Q) = R(Q) - C(Q) = P(Q)Q - C(Q) First order condition: Marginal revenue = Marginal cost

9 The marginal revenue of a monopolist When Q increases, total revenue changes for two reasons: 1. For every additional unit sold total revenue increases by P (Quantity effect) 2. When Q increases, P(Q) decreases. This implies that total revenue decreases as all units of output are sold at a lower price. (Price effect)

10 The marginal revenue of a monopolist Profits are maximized when P(Q) + Q P (Q) = MC(Q)

11 Profit maximization of a monopolist P R(Q)=P(Q)Q (Slope = MR) C(Q) (Slope = MC) π (Q) Q* Q

12 Average revenue and marginal revenue P Average revenue = revenue per unit produced: AR = R/Q = P(Q) Marginal revenue = revenue from one additional unit: MR = P(Q)+P (Q)Q Marginal revenue Average revenue (demand) Given the negative slope of the demand curve, P (Q)<0, the marginal revenue curve always lies below the demand curve P(Q). Q

13 Profits are maximized when marginal revenue is equal to marginal cost P MR MC MC P M MR D Q M Q

14 Profits are maximized when marginal revenue is equal to marginal cost P MR MC MC P 1 P M MR P 2 D = AR Profit loss Profit loss Q 1 Q M Q 2 Q

15 The profits of a monopolist P Revenue = P M Q M Cost = AC(Q M )Q M Profits = (P M - AC(Q M ) ) Q M MC P M AC AC(Q M ) π D MR Q M Q

16 Example The demand for the product of a monopolist is given by P(Q)=23-Q. His total costs are C(Q)=3Q. Calculate monopoly price and output. Calculate monopoly profits and consumer surplus. Calculate the competitive equilibrium price and output. What is the welfare loss associated with the existence of the monopol?

17 Example MR = 23-2Q; MC=AC=3; MR=MC Q M =10; P M = 13; E P =Profits: (P M -AC)Q M =100; E C = 0.5(23-P M )Q M = 50; P=MC Q C =20; P C =3; E P =0; E C = 0.5(23-P C )Q C =200;

18 Monopolistic Markets The Lerner Index

19 The monopoly price-cost margen Profits are maximized when MR = MC

20 The monopoly price-cost margen Therefore the condition MR=MC can be written as

21 The monopoly price-cost margen The elasticity of demand E d serves as a measure of market power.

22 The monopoly price-cost margen If demand is very elastic (E d large), the margen is small. If demand is very inelastic (E d small), The margen is large. P P MC P M MC P M MC(Q M ) MR D MC(Q M ) D MR Q M Q Q M Q

23 The Lerner index The Lerner index measures the monopoly power. L = (P - MC) / P = 1 / E d It`s value lies between 0 and 1 The larger L the greater is the monopoly power (If the firm was perfectly competitive L would be zero)

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