Chapter 11. Monopoly

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1 Chapter 11 Monopoly

2 Topics Monopoly Profit Maximization. Market Power. Welfare Effects of Monopoly. Cost Advantages That Create Monopolies. Government Actions That Create Monopolies. Government Actions That Reduce Market Power. Monopoly Decisions over Time and Behavioral Economics Copyright 2012 Pearson Addison-Wesley. All rights reserved.

3 Monopoly Profit Maximization Monopoly the only supplier of a good for which there is no close substitute. A monopoly can set its price not a price taker. Maximizes profits by setting marginal revenue equal to marginal cost Copyright 2012 Pearson Addison-Wesley. All rights reserved.

4 Marginal Revenue and Price A firm s revenue is: R = pq. A firm s marginal revenue, MR, is: the change in its revenue from selling one more unit. MR = ΔR/Δq. w If the firm sells exactly one more unit, Δq = 1, its marginal revenue is MR = ΔR Copyright 2012 Pearson Addison-Wesley. All rights reserved.

5 Marginal Revenue and Price (cont.) The marginal revenue of a monopoly differs from that of a competitive firm because the monopoly faces a downwardsloping demand curve unlike the competitive firm. Thus, the monopoly s marginal revenue curve lies below the demand curve at every positive quantity Copyright 2012 Pearson Addison-Wesley. All rights reserved.

6 Figure 11.1 Average and Marginal Revenue (a) Competiti v e Fi r m (b) Monopoly P r ic e, p, $ per unit p 1 Demand cu r v e P r ic e, p, $ per unit p 1 C p 2 Demand cu r v e A B A B q q + 1 Quantit y, q, Units per y ear Q Q + 1 Quantit y, Q, Units per y ear 11-6 Copyright 2012 Pearson Addison-Wesley. All rights reserved.

7 Deriving the Marginal Revenue Curve For a monopoly to increase its output by ΔQ, the monopoly lowers its price per unit by Δp/ΔQ, w the slope of the demand curve. By lowering its price, the monopoly loses: (Δp/ΔQ) x Q w on the Q units it originally sold at the higher price, w but it earns an additional p on the extra output it now sells Copyright 2012 Pearson Addison-Wesley. All rights reserved.

9 Solved Problem 11.1 Derive the marginal revenue curve when the monopoly faces the linear inverse demand function, p=24 Q, in Figure How does the slope of the marginal revenue curve compare to the slope of the inverse demand curve? 11-9 Copyright 2012 Pearson Addison-Wesley. All rights reserved.

10 Solved Problem 11.1 p = 24 Q MR = p + Δp ΔQ Q = (24 Q) + ( 1) Q = 24 2Q The slope of this marginal revenue curve is ΔMR/ΔQ = 2, w so the marginal revenue curve is twice as steeply sloped as is the demand curve Copyright 2012 Pearson Addison-Wesley. All rights reserved.

11 Marginal Revenue and Price Elasticity of Demand At a given quantity, 1 MR = p 1 + ε Marginal revenue is closer to price as demand becomes more elastic. Where the demand curve hits the price axis (Q = 0), the demand curve is perfectly elastic, so the marginal revenue equals price: MR = p. Where the demand elasticity is unitary, ε = 1, marginal revenue is zero: MR = p[1 + 1/( 1)] = 0. Marginal revenue is negative where the demand curve is inelastic, 1 < ε Copyright 2012 Pearson Addison-Wesley. All rights reserved.

12 Figure 11.2 Elasticity of Demand and Total, Average, and Marginal Revenue p, $ per unit 24 P er f ectly elastic Elasti c, e < 1 12 DMR = 2 DQ = 1 Dp = 1 DQ = 1 e = 1 Inelasti c, 1 < e < 0 Demand ( p = 24 Q ) P er f ectly inelastic MR = 24 2 Q Q, Units per d a y Copyright 2012 Pearson Addison-Wesley. All rights reserved.

14 Choosing Price or Quantity Any firm maximizes its profit by setting its marginal revenue equal to its marginal cost. Unlike a competitive firm, a monopoly can adjust its price it has a choice of setting its price or its quantity to maximize its profit. The monopoly is constrained by the market demand curve. Because the demand curve slopes downward, the monopoly faces a trade-off between a higher price and a lower quantity or a lower price and a higher quantity Copyright 2012 Pearson Addison-Wesley. All rights reserved.

16 Profit-Maximizing Output Because a linear demand curve is more elastic at smaller quantities, w monopoly profit is maximized in the elastic portion of the demand curve. Equivalently, a monopoly never operates in the inelastic portion of its demand curve Copyright 2012 Pearson Addison-Wesley. All rights reserved.

17 Mathematical Approach The monopoly faces a short-run cost function of: C(Q) = Q w where Q 2 is the monopoly s variable cost as a function of output and $12 is its fixed cost. Given this cost function the monopoly s marginal cost function is MC = 2Q Copyright 2012 Pearson Addison-Wesley. All rights reserved.

18 Mathematical Approach (cont.) The average variable cost is: AVC = Q 2 /Q = Q, w so it is a straight line through the origin with a slope of Copyright 2012 Pearson Addison-Wesley. All rights reserved.

19 Mathematical Approach (cont.) We determine the profit-maximizing output by: MR = 24 2Q = 2Q = MC. Solving for Q, we find that Q = 6. Substituting Q = 6 into the inverse demand function: p = 24 Q = 24 6 = $ Copyright 2012 Pearson Addison-Wesley. All rights reserved.

20 Mathematical Approach (cont.) At that quantity, AVC = $6, w which is less than the price, so the firm does not shut down. w The average cost is AC = $(6 + 12/6) = $8, which is less than the price, so the firm makes a profit Copyright 2012 Pearson Addison-Wesley. All rights reserved.

21 Solved Problem 11.2 We now address the first question in the Challenge at the beginning of the chapter: How did Apple set the price of the ipod when the player was first introduced and Apple had a virtual monopoly? Initially, Apple s constant marginal cost of producing its top-of-the-line ipod was $200, its fixed cost was $736 million, and its inverse demand function was p = Q where Q is millions of ipods per year. What was Apple s average cost function? Assuming that Apple was maximizing short-run monopoly profit, what was its marginal revenue function? What were its profit-maximizing price and quantity and what was its profit? Show Apple s profit-maximizing solution in a figure Copyright 2012 Pearson Addison-Wesley. All rights reserved.

23 Effects of a Shift of the Demand Curve Unlike a competitive firm, a monopoly does not have a supply curve. A given quantity can correspond to more than one monopoly-optimal price. w A shift in the demand curve may cause the monopoly optimal price to stay constant and the quantity to change or both price and quantity to change Copyright 2012 Pearson Addison-Wesley. All rights reserved.

25 Market Power Market power - the ability of a firm to charge a price above marginal cost and earn a positive profit. MR p 1 = 1 + = ε w and rearranging the terms: p MC 1 = 1+ (1/ ε ) MC w so the ratio of the price to marginal cost depends only on the elasticity of demand at the profit-maximizing quantity Copyright 2012 Pearson Addison-Wesley. All rights reserved.

27 Lerner Index Lerner Index - the ratio of the difference between price and marginal cost to the price: (p MC)/p. w In terms of the elasticity of demand: p MC p 1 = ε w Because MC 0 and p MC, 0 p MC p, so the Lerner Index ranges from 0 to 1 for a profitmaximizing firm Copyright 2012 Pearson Addison-Wesley. All rights reserved.

28 Application: Apple s Lerner Index Apple s marginal cost for ipod Shuffle was $21.77, $ for a 16GB iphone 4, and $ for a non-3g 16GB ipad. These products retailed for $79, $600, and $499 respectively. Thus, Apple s Lerner indexes are ( )/ , ( )/600.69, and ( )/ Copyright 2012 Pearson Addison-Wesley. All rights reserved.

29 Solved Problem 11.3 If Apple is producing at the short-run profit-maximizing level, what is the elasticity of demand for the ipod, iphone 4, and ipad discussed in the previous application, Apple s Lerner Indexes? Answer w Determine the Lerner Index using Equation Copyright 2012 Pearson Addison-Wesley. All rights reserved.

30 Sources of Market Power All else the same, the demand curve a firm faces becomes more elastic as: 1. better substitutes for the firm s product are introduced, 2. more firms enter the market selling the same product, or 3. firms that provide the same service locate closer to this firm Copyright 2012 Pearson Addison-Wesley. All rights reserved.

31 Welfare Effects of a Monopoly Welfare, W, is lower under monopoly than under competition. Competition maximizes welfare because price equals marginal cost. By setting its price above its marginal cost, a monopoly causes consumers to buy less than the competitive level of the good, so a deadweight loss to society occurs Copyright 2012 Pearson Addison-Wesley. All rights reserved.

33 Solved Problem 11.4 In the linear example in Figure 11.3, how does charging the monopoly a specific tax of τ = $8 per unit affect the monopoly optimum and the welfare of consumers, the monopoly, and society (where society s welfare includes the tax revenue)? What is the incidence of the tax on consumers? Copyright 2012 Pearson Addison-Wesley. All rights reserved.

35 Cost Advantages That Create Monopolies Why are some markets monopolized? w A firm has a cost advantage over other firms or w A government created the monopoly Copyright 2012 Pearson Addison-Wesley. All rights reserved.

36 Sources of Cost Advantages Reasons for cost advantages: w the firm controls an essential facility: a scarce resource that a rival needs to use to survive. w the firm uses a superior technology or has a better way of organizing production Copyright 2012 Pearson Addison-Wesley. All rights reserved.

37 Natural Monopoly Natural monopoly - situation in which one firm can produce the total output of the market at lower cost than several firms could. Believing that they are natural monopolies, governments frequently grant monopoly rights to public utilities to provide essential goods or services such as water, gas, electric power, or mail delivery Copyright 2012 Pearson Addison-Wesley. All rights reserved.

38 Natural Monopoly (cont.) If the cost for any firm to produce q is C(q), the condition for a natural monopoly is where Q=q 1 +q 2 + +q n is the sum of the output of any n 2 firms Copyright 2012 Pearson Addison-Wesley. All rights reserved.

40 Solved Problem 11.5 A firm that delivers Q units of water to households has a total cost of C(Q) = mq + F. If any entrant would have the same cost, does this market have a natural monopoly? Answer w Determine whether costs rise if two firms produce a given quantity Copyright 2012 Pearson Addison-Wesley. All rights reserved.

41 Government Actions That Create Monopolies Governments create many monopolies. w Sometimes governments own and manage monopolies. w In the United States, as in most countries, the postal service is a government monopoly. Frequently, however, governments create monopolies by preventing competing firms from entering a market Copyright 2012 Pearson Addison-Wesley. All rights reserved.

42 Barriers to Entry Governments create monopolies in one of three ways: 1. by making it difficult for new firms to obtain a license to operate, 2. by granting a firm the rights to be a monopoly, or 3. by auctioning the rights to be monopoly Copyright 2012 Pearson Addison-Wesley. All rights reserved.

43 Patents Patent - an exclusive right granted to the inventor to sell a new and useful product, process, substance, or design for a fixed period of time. w The length of a patent varies across countries. Question: If a firm with a patent monopoly sets a high price that results in deadweight loss then why do governments grant patent monopolies? Copyright 2012 Pearson Addison-Wesley. All rights reserved.

Application: Botox Patent Monopoly 11-44

45 Optimal Price Regulation In some markets, the government can eliminate the deadweight loss of monopoly by requiring that a monopoly charge no more than the competitive price Copyright 2012 Pearson Addison-Wesley. All rights reserved.

47 Solved Problem 11.6 Suppose that the government sets a price, p 2, that is below the socially optimal level, p 1, but above the monopoly s minimum average cost. How do the price, the quantity sold, the quantity demanded, and welfare under this regulation compare to those under optimal regulation? Copyright 2012 Pearson Addison-Wesley. All rights reserved.

49 Problems in Regulating Problems that governments face in regulating monopolies: w because they do not know the actual demand and marginal cost curves, governments may set the price at the wrong level. w Second, many governments use regulations that are less efficient than price regulation. w Third, regulated firms may bribe or otherwise influence government regulators to help the firms rather than society as a whole Copyright 2012 Pearson Addison-Wesley. All rights reserved.

50 Nonoptimal Price Regulation If the regulated price is not optimal, a deadweight loss results. If the price is set below the firm s minimum average cost, the firm will shut down Copyright 2012 Pearson Addison-Wesley. All rights reserved.

53 Monopoly Decisions over Time and Behavioral Economics In some markets decisions today affect demand or cost in a future period. In such markets the monopoly may maximize its long-run profit by making a decision today that does not maximize its short-run profit Copyright 2012 Pearson Addison-Wesley. All rights reserved.

54 Network Externalities Network externality - the situation where one person s demand for a good depends on the consumption of the good by others Copyright 2012 Pearson Addison-Wesley. All rights reserved.

55 Direct Size Effect Many industries exhibit positive network externalities where the customer gets a direct benefit from a larger network. w Example: the larger an ATM network such as the Plus network Copyright 2012 Pearson Addison-Wesley. All rights reserved.

56 Behavioral Economics Bandwagon effect - the situation in which a person places greater value on a good as more and more other people possess it. Snob effect - the situation in which a person places greater value on a good as fewer and fewer other people possess it Copyright 2012 Pearson Addison-Wesley. All rights reserved.

57 Indirect Size Effect In some markets, positive network externalities are indirect. They stem from complementary goods that are offered when a product has a critical mass of users. w The more applications (apps) available for a smart phone, the more people want to buy that smart phone; however, many of these extra apps will be written only if a critical mass of customers buys the smart phone Copyright 2012 Pearson Addison-Wesley. All rights reserved.

58 A Two-Period Monopoly Model A monopoly may be able to solve the chicken-and-egg problem of getting a critical mass for its product by initially selling the product at a low introductory price. By doing so, the firm maximizes its longrun profit but not its short-run profit Copyright 2012 Pearson Addison-Wesley. All rights reserved.

59 A Two Period Monopoly Model (cont.) Suppose that a monopoly sells its good only two periods. If the monopoly sells less than a critical quantity of output, Q, in the first period, its second-period demand curve lies close to the price axis. However, if the good is a success in the first period at least Q units are sold the second-period demand curve shifts substantially to the right Copyright 2012 Pearson Addison-Wesley. All rights reserved.

60 A Two Period Monopoly Model (cont.) Should the monopoly charge a low introductory price in the first period? The firm chooses to charge a low introductory period in the first period if its first period loss (from charging a less than optimal price) is less than its extra profit in the second period Copyright 2012 Pearson Addison-Wesley. All rights reserved.

Chapter Eleven. Monopoly

Chapter Eleven. Monopoly Chapter Eleven Monopoly Topics Monopoly Profit Maximization. Effects of a Shift of the Demand Curve. Market Power. Welfare Effects of Monopoly. Cost Advantages That Create Monopolies. Government Actions