ECN 3103 INDUSTRIAL ORGANISATION

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1 ECN 3103 INDUSTRIAL ORGANISATION 3. Monopoly Mr. Sydney Armstrong Lecturer 1 The University of Guyana 1 Semester 1, 2016

2 OUR PLAN Monopoly Reference for reviewing these concepts: Carlton, Perloff, Modern Industrial Organisation, Addison Wesley Longman, Inc, Chapter 4 Motta, Massimo, Competition Policy: Theory and Practise, Cambridge University Press, chapter 8. 2

3 A MONOPOLY A firm is a monopoly if it is the only supplier of a product for which there is no close substitute. A monopoly sets its price without fear that it will be undercut by a rival firm A monopoly faces a downward-sloping demand curve and sets price above MC. As a result, less is sold than if the market were competitive and society suffers a deadweight loss. 3

4 MONOPOLY PRICING monopolist faces a downward sloping demand q = D(p) or inverse demand p = P(q) = D -1 (q) monopolist chooses price-quantity pair on demand curve to maximize profits profit-maximizing choice independent of whether monopolist chooses price or quantity if monopolist cannot price discriminate, it chooses exactly one price/quantity profit of monopolist = revenues minus cost: Π m (q) = R(q) -C(q) = P(q)q- C(q) let MR(q) = R= q denote marginal revenue 4

5 profit-maximising quantity equates marginal revenue and marginal cost: MR(q) = MC(q) under perfect competition: marginal revenue equals market price for monopolist: MR changes along demand curve (see next graph) in fact, marginal revenue can be negative: marginal revenue always less than inverse demand negative second term outweighs the first term if q is sufficiently large 5

6 Graph: Demand and marginal revenue 6

7 Graph: Decomposition of marginal revenue 7

8 - the following relationship between the elasticities holds: we can thus reformulate the optimal quantity equation as follows 8

9 hence the optimal price-cost margin of the monopolist is optimal price-cost margin is high if demand elasticity is low and vice versa left-hand side of equation (Lerner index) is always positive - monopolist charges inefficiently high price above MC and sells too low quantity - market power = ability to raise price above marginal cost - market power of monopolist is inversely related to demand elasticity 9

10 Graph: Price-cost margin and demand elasticity 10

11 Graph: Monopoly solution the difference in total welfare between perfect competition (= efficient allocation) and the monopoly allocation is the yellow triangle 11

12 Why does a monopolist choose inefficient price-quantity pair? - decrease in price/increase in quantity implies profit loss on infra-marginal consumers - monopolist does not serve all consumers with willingness-topay larger than MC - the fact that the monopolist accounts for his revenues from infra-marginal consumers when setting his price leads to inefficient exclusion of consumers - the associated reduction in social surplus is called deadweight loss - the more elastic demand is, the less DWL but also the lower the profit of the monopolist - with perfectly inelastic demand, monopoly choose socially efficient quantity and appropriates all consumer surplus 12

13 Example: Patented prescription drugs - US does not regulate prices of prescription drugs, many of which are patented - Canada does have price regulation for prescription drugs - 20 mg Lipitor (cholesterol-lowering drug made by Pfizer) sells from US websites at $150, while Canadian online pharmacies charge $60 - on average: US prescription drugs are 40-70% more expensive Example: Calculate DWL of monopolist. P(q) = 100-q, C(q) = 10q. - profit function of monopolist: Π(q) = (P(q)- c)q = ( q)q - take derivative with respect to q: 13

14 - the corresponding monopoly price is - the efficient quantity in this market is where P(q) = MC = 10, that is qc = 90 - the deadweight loss is the area of the triangle between efficient and monopoly quantity and demand and cost: Nb. That a monopoly profit and Deadweight loss vary with the elasticity of demand. 14

15 THE BENEFITS OF MONOPOLY The welfare harm from monopoly may be offset by several benefits. For example, the prospect of receiving monopoly profits may motivate firms to develop new products, improve products, or find a lower cost method of manufacturing. Were it not for the quest to obtain monopoly profits, firms might innovate less. The benefits of monopoly is most clearly recognized in research and development. Patents is awarded to a firm that creates a new products. 15

16 CREATING AND MAINTAINING A MONOPOLY There are several ways in which a firm may become and remain a monopoly, 3 which we would examine in this course are: Natural Monopoly ( we will explore under Regulation) Government-Created Monopolies Knowledge Advantage Government-Created monopolies: A firm may be a monopoly because the government protects it from entry by other firms. For example, in cases where there are new innovations, patent laws protects the firm from imitations, hence granting it monopoly over the new product for a fixed period of time. 16

17 Aside form patent laws, other type of government restriction on entry can serve to create and maintain monopolies. Generally government restriction on entry allow at least a few firms to produce, but prevent the normal competitive force from driving prices and profits down to competitive levels. Similarly trade barriers can be used to prevent entry into markets. 17

18 Knowledge Advantage: A firm may be a monopoly because only it knows how to produce a certain product or it can produce the product at lower cost than other firms. A firm may have special knowledge that enables it to produce a new or better product that other cannot imitate. A firm with an important secret faces a downward-sloping demand curve for its product and does not the entry of a rival firm or the introduction of products that are close substitutes. 18

19 Similarly, a firm may have special knowledge about production techniques that enable it to produce the same product at lower cost than other firms, which may be unable to discover the production technique of the efficient firm. This is illustrated on the following slide Initially all the firms in the competitive market have constant marginal cost, m1, so the equilibrium price, p1 equals m1 and the equilibrium quantity is Q1. One firm discovers a new production technique that it can keep secret and lowers its marginal cost from m1 to m0. It faces a residual demand curve that is horizontal at p1 (equal to m1) up to Q1 because many firms can produce and sell at price m1. Beyond Q1 the residual demand curve coincide with the market demand because below p1 no other firm can profitably produce. 19

20 If m0 is close to m1, the firm may maximize its profits by selling at a price equal to p1. But in this case this is not so, hence price will be below m1 but above m0. Because the residual demand curve is kinked at Q1, the corresponding marginal revenue is discontinuous at output Q1. The marginal revenue curve is horizontal where the residual demand curve is horizontal and slopes down where the demand curve slopes down. 20

21 To maximize profit the firm with the secret produces Q0 where its MR=MC with its price being p0, which is less than p1=m1, so no other firm remain in the market. 21

22 Graph: Monopoly created by special knowledge $ p1 m1 p0. m0 Q1 Q0 Quantity 22

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