# Chapter 11. Monopoly. I think it s wrong that only one company makes the game Monopoly. Steven Wright

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1 Chapter 11 Monopoly I think it s wrong that only one company makes the game Monopoly. Steven Wright

2 Chapter 11 Outline 11.1 Monopoly Profit Maximization 11.2 Market Power 11.3 Welfare Effects of Monopoly 11.4 Taxes and Monopoly 11.5 Cost Advantages that Create Monopolies 11.6 Government Actions that Create Monopolies 11.7 Government Actions that Reduce Market Power 11.8 Monopoly Decisions Over Time and Behavioral Economics 11-2

3 11.1 Monopoly Profit Maximization A monopoly is the only supplier of a good for which there is no close substitute. Monopolies are not price takers like competitive firms Monopoly output is the market output Monopoly demand curve is the market demand curve Monopolists can set their own price given market demand Because demand is downward sloping, monopolists set price above marginal cost to maximize profit. Like all firms, monopolies maximize profits by setting price or output so that marginal revenue (MR) equals marginal cost (MC). 11-3

4 11.1 Monopoly Profit Maximization Monopolies maximize profits by setting price or output so that marginal revenue (MR) equals marginal cost (MC). Profit function to be maximized by choosing output, Q: (Q) = R(Q) C(Q), where R(Q) is the revenue function C(Q) is the cost function The necessary condition for profit maximization: The sufficient condition for profit maximization: 11-4

5 11.1 Monopoly Profit Maximization A firm s MR curve depends on its demand curve. MR is also downward sloping and lies below D If p(q) is the inverse demand function, which shows the price received for selling Q, then the marginal revenue function is: Given a positive value of Q, MR lies below inverse demand. Selling one more unit requires the monopolist to lower the price Price is lowered on the marginal unit and all other units sold 11-5

6 11.1 Monopoly Profit Maximization Monopoly s marginal revenue is less than the price it charges by an amount equal to area C 11-6

7 11.1 MR Curve and Price Elasticity of Demand We can rewrite MR function so that it is stated in terms of elasticity: This makes the relationship between MR, D, and elasticity quite clear. The quantity at which MR = 0 corresponds to the unitary elastic portion of the demand curve. Everywhere that MR > 0, demand is elastic. Where demand hits the vertical axis, MR=P and demand is perfectly elastic. 11-7

8 11.1 MR Curve and Price Elasticity of Demand Relationship for inverse demand function of and marginal revenue function of 11-8

9 11.1 Monopoly Example Inverse demand function: Can be used to find the marginal revenue function: Quadratic SR cost function: Can be used to find the marginal cost function: Profit-maximizing output is obtained by producing Q * : Solving this expression reveals Q * =6 The inverse demand function indicates that people are willing to pay p = \$18 for 6 units of output. 11-9

10 11.1 Monopoly Example The monopolist s profit maximizing choice of output is found where MR=MC and p comes from the demand curve

11 11.1 Monopoly Example Should a profit-maximizing monopoly produce at Q * or shut down? As with competitive firms, a monopoly should shut down in the monopolist s price is less than its AVC. In our example, AVC at Q * of 6 is \$6. Because p = \$18 is clearly above \$6, the monopoly in this example should produce in the SR

12 11.1 Effects of a Shift of Demand Curve Shifts in demand need not affect monopolist s level of Q * 11-12

13 11.2 Market Power Market power is the ability of a firm to charge a price above marginal cost and earn a positive profit. Monopoly has market power; competitive firms do not. Market power is related to the price elasticity of demand Recall that Rewrite as Thus, the ratio of price to MC depends only on the elasticity of demand at the profit maximizing quantity. The more elastic the demand curve, the less a monopoly can raise its price without losing sales (and vice versa)

14 11.2 Market Power The Lerner Index (or price markup) is another way to examine the way in which elasticity affects a monopoly s price relative to its MC. The Lerner Index ranges from 0 to 1 for a profitmaximizing firm. Competitive firms have a Lerner Index of 0. The Lerner Index gets closer to 1 as a firm has more market power (and faces less elastic demand)

15 11.2 Sources of Market Power Elasticity of the market demand curve depends on consumers tastes and options. Demand becomes more elastic (which implies less market power for the firm): as better substitutes for the firm s product are introduced as more firms enter the market selling a similar product as firms that provide the same service locate closer to the firm As a profit-maximizing monopoly faces more elastic demand, it has to lower its price. Examples: Xerox, USPS, McDonald s 11-15

16 11.3 Welfare Effects of Monopoly Recall from Chapter 9 that competition maximizes welfare, which is the sum of consumer surplus and producer surplus, because price equals marginal cost. By contrast, a monopoly sets price above marginal cost (and above the competitive price) causes consumers to buy less than the competitive level of output generates deadweight loss 11-16

17 11.3 Welfare Effects of Monopoly The competitive equilibrium, e c, has no DWL, while the monopoly equilibrium, e m, has DWL = C+E

18 11.4 Taxes and Monopoly Taxes (ad valorem and specific) affect monopoly differently than a competitive industry: 1.Tax incidence on consumers (the change in the consumers price divided by the change in the tax) can exceed 100% in a monopoly market but not a competitive market. 2.If tax rates α and τ are set so that the after-tax output is the same with either type of tax, the government raises the same amount of tax revenue in a competitive market using either type of tax, but raises more revenue using an ad valorem tax than a specific tax under monopoly

19 11.4 Taxes and Monopoly Comparative Statics (of specific tax, τ) Before-tax cost function is C(Q) After-tax cost function is C(Q) τq Necessary condition for maximizing after-tax profit: Derivative (with respect to τ) of the sufficient condition for maximizing after-tax profit: As the specific tax rises, the monopoly reduces its output. Downward sloping means the monopoly raises its price

20 11.4 Taxes and Monopoly Tax Incidence on Consumers Consumer price may rise by an amount greater than the tax. Assume constant marginal cost, m, and inverse demand function with constant elasticity, ε, p = Q 1/ε Maximize profit by equating after-tax marginal cost and marginal revenue: Substituting for Q in inverse demand yields the price set by monopoly: Differential with respect to τ is greater than one because monopoly operates on elastic portion of demand curve

21 11.4 Taxes and Monopoly Governments typically use an ad valorem tax rather than a specific tax because the tax revenue is greater

22 11.5 Cost Advantages that Create Monopolies Sources of cost advantages: 1. Control of an essential facility, a scarce resource that a rival firm needs to use to survive Example: owning the only quarry in a region generates a cost advantage in the production of gravel 2. Use of superior technology or a better way of organizing production Example: Henry Ford s assembly lines and standardization 3. Protection from imitation through patents or informational secrets Secrets are more common in new and improved processes; patents more common with new products 11-22

23 11.5 Cost Advantages that Create Monopolies A market has a natural monopoly if one firm can produce the total output of the market at lower cost than several firms could. where Q = q 1 + q q n for n > 1 firms Examples: public utilities such as water, gas, electric, and mail delivery Natural monopolies may have high fixed costs, but low and fairly constant marginal costs

24 11.5 Cost Advantages that Create Monopolies A natural monopoly has economies of scale at all levels of output, so average costs fall as output increases

25 11.6 Government Actions that Create Monopolies Governments typically create monopolies in 1 of 3 ways: 1. By making it difficult for new firms to obtain a license to operate Example: U.S. cities require new hospitals to secure a certificate of need to demonstrate the need for a new facility 2. By granting a firm the rights to be a monopoly Example: public utilities operated by private company 3. By auctioning the rights to be a monopoly Example: selling government monopolies to private firms (privatization) 11-25

26 11.7 Government Actions that Reduce Market Power Governments limit monopolies market power in various ways: 1.Optimal Price Regulation: government regulates the monopoly by imposing a price ceiling that is equal to the competitive price, which eliminates DWL. 2.Nonoptimal Price Regulation: governmentimposed price ceiling is not set at the competitive level, which reduces but does not eliminate DWL. 3.Increasing Competition: allowing/encouraging market entry by new domestic firms and ending import bans that kept out international firms

27 11.7 Government Actions that Reduce Market Power With optimal price regulation, the government imposes a price ceiling that is equal to the competitive price

28 11.8 Monopoly Decisions Over Time and Behavioral Economics In some markets, today s decisions affect demand or cost in the future. Some monopoly decisions may maximize LR profit but not SR profit. Example: low introductory pricing to build up customers Why would consumers demand in the future depend on a monopoly s actions in the present? 11-28

29 11.8 Monopoly Decisions Over Time and Behavioral Economics A good has a network externality if one person s demand depends on the consumption of a good by others. With a positive network externality, value to the consumer grows as the number of units sold increases (e.g. telephones, ATMs) With a negative network externality, value to the consumer grows as fewer people possess the good (e.g. numbered paintings) A bandwagon effect is a popularity-based explanation for a positive network externality (e.g. ipod, UGG boots). A snob effect is an explanation for a negative network externality (e.g. original painting by an unknown artist)

30 Figure 11.3 Maximizing Profit 11-30

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