Econ 2113: Principles of Microeconomics. Spring 2009 ECU

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1 Econ 2113: Principles of Microeconomics Spring 2009 ECU

2 Chapter 12 Monopoly

3 Market Power Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale. A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

4 Market Power How Monopoly Arises: A monopoly has two key features: No close substitutes Barriers to entry Barriers to Entry Legal or natural constraints that protect a firm from potential competitors are called barriers to entry.

5 Market Power Legal Barriers to Entry Legal barriers to entry create a legal monopoly, a market in which competition and entry are restricted by the granting of a Public franchise (like the U.S. Postal Service, a public franchise to deliver first-class mail) Government license (like a license to practice law or medicine) Patent or copyright

6 Market Power Natural Barriers to Entry Natural barriers to entry create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can.

7 Market Power Natural Monopoly: One firm can produce 4 units of output at 5 cents per unit. Two firms can produce 4 units 2 units each at 10 cents per unit. Four firms can produce 4 units 1 unit each at 15 cents per unit.

8 Market Power In a natural monopoly, economies of scale are so powerful that they are still being achieved even when the entire market demand is met. The LRAC curve is still sloping downward when it meets the demand curve. Therefore, typically one firm prevails in the market and gains monopoly power.

9 Market Power Monopoly Price-Setting Strategies There are two types of monopoly price-setting strategies: A single-price monopoly is a firm that sells each unit of its output for the same price to all its customers. Price discrimination is the practice of selling different units of a good or service for different prices.

10 A Single-Price Monopoly s Output and Price Decision Price and Marginal Revenue A monopoly is a price setter, not a price taker like a firm in perfect competition. The reason is that the demand for the monopoly s output is the market demand. To sell a larger output, a monopoly must lower its price.

11 The demand curves facing a perfectly competitive firm and a single price monopoly Perfectly competitive firm Monopolist $/unit of output Market price (equil. price) D Price D Quantity Quantity

12 Profit Maximization for the Monopolist In perfect competition: MR = P The demand for the firm is horizontal, i.e. infinitely elastic The firm can sell any quantity it wants at the equilibrium price How do we compute the Marginal Revenue curve for the Monopolist? The demand for the monopolist is the market demand (only seller), so it is downward sloping This means that if the monopolist wants to sell more, it has to lower the price Then an increase in production of one unit increases revenues by less than the price

13 The Monopolist s Change in Revenue from Selling an Additional Unit (MR) Price ($/unit) Loss from lower price If P = $6, then TR = $6 x 2 = $12 If P = $5, then TR = $5 x 3 = $15 The MR of selling the 3 rd unit = $3 =$15-$12 For the 3 rd unit, MR = $3 < P = $5 Gain from higher quantity D 2 3 Quantity (units/week) 8

14 The Marginal Revenue Curve Example: Demand curve given by Q = 8 - P P Q TR MR Observations MR < P because price must be lowered to sell an additional unit MR declines as quantity increases

15 The Marginal Revenue Curve for a Monopolist with a Straight-Line Demand Curve a Price a/2 MR D Q 0 /2 Quantity Observations The vertical intercept a, is the same for MR and D MR has twice the slope than D The horizontal intercept for MR, Q 0 /2 =a/2b, is one half the demand intercept, Q 0 =a/b. Q 0

16 Total Revenue, Marginal Revenue and Elasticity Demand: Q = 50 - P/2 Price Quantity Own Price Elasticity Total Revenue

17 Total Revenue, Marginal Revenue and Elasticity Demand: Q = 50 (P/2) P TR 100 Elastic 80 Unit elastic Inelastic Q MR Q

18 A Single-Price Monopoly s Output and Price Decision A single-price monopoly never produces an output at which demand is inelastic. If it did produce such an output, the firm could increase total revenue, decrease total cost, and increase economic profit by decreasing output.

19 A Single-Price Monopoly s Output and Price Decision Price and Output Decision The monopoly selects the profit-maximizing quantity in the same manner as a competitive firm, where MR = MC. But for the monopolist MR does not equal price. The monopoly sets its quantity according to MR = MC, and then it sets its price at the highest level at which it can sell the profitmaximizing quantity.

20 A Single-Price Monopoly s Output and Price Decision The firm produces the output at which MR = MC and sets the price at the maximum at which it can sell that quantity. The ATC curve tells us the average total cost. Economic profit is the profit per unit multiplied by the quantity produced the blue rectangle.

21 Single-Price Monopoly and Competition Compared Equilibrium in perfect competition occurs where the quantity demanded equals the quantity supplied at quantity Q C and price P C. Competitive equilibrium is efficient: MSB = MSC.

22 Single-Price Monopoly and Competition Compared The sum of the two surpluses is maximized and the efficient quantity is produced.

23 Single-Price Monopoly and Competition Compared Equilibrium output for a monopoly, Q M, occurs where marginal revenue equals marginal cost, MR = MC. Equilibrium price for a monopoly, P M, occurs on the demand curve at the profitmaximizing quantity.

24 Single-Price Monopoly and Competition Compared Compared to perfect competition, monopoly produces a smaller output and charges a higher price.

25 Single-Price Monopoly and Competition Compared In monopolistic markets price exceeds marginal social cost, marginal social benefit exceeds marginal social cost, and a deadweight loss arises.

26 Single-Price Monopoly and Competition Compared Redistribution of Surpluses: Monopoly redistributes a portion of consumer surplus by changing it to producer surplus.

27 Price Discrimination Price discrimination is the practice of selling different units of a good or service for different prices. To be able to price discriminate, a monopoly must: 1. Identify and separate different buyer types. 2. Sell a product that cannot be resold. Price differences that arise from cost differences are not price discrimination.

28 Price Discrimination Price Discrimination and Consumer Surplus Price discrimination converts more consumer surplus into economic profit than in the single price case A monopoly can discriminate: Among units of a good. Quantity discounts are an example. Among groups of buyers. Advance purchase and other restrictions on airline tickets are an example.

29 Price Discrimination Profiting by Price Discriminating: Airline example As a single-price monopoly, this firm maximizes profit by producing 8000 trips a year and selling them for $1,200 each.

30 Price Discrimination Perfect Price Discrimination Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price anyone is willing to pay. Marginal revenue now equals price and the demand curve is also the marginal revenue curve.

31 Price Discrimination With perfect price discrimination: The profit-maximizing output increases to the quantity at which price equals marginal cost. Economic profit increases above that made by a singleprice monopoly. Deadweight loss is eliminated

32 Price Discrimination The more finely a monopoly can price discriminate, the closer its output is to the competitive output (P = MC) and the more efficient is the outcome. But the monopoly captures the entire consumer surplus

33 Monopoly Policy Issues A single-price monopoly creates inefficiency and a price-discriminating monopoly captures consumer surplus and converts it into producer surplus and economic profit. But monopoly could also bring benefits: Incentives to innovation Economies of scale

34 Monopoly Policy Issues Incentives to Innovation Patents and copyrights provide protection from competition and let the monopoly enjoy the profits stemming from innovation for a longer period of time. Economies of Scale Where economies of scale exist, a monopoly can produce at a lower average total cost than what a large number of competitive firms could achieve.

35 Monopoly Policy Issues Regulating Natural Monopoly When demand and cost conditions create natural monopoly, government agencies typically regulate the monopoly.

36 Monopoly Policy Issues Profit Maximization The natural monopoly maximizes economic profit by producing the quantity at which marginal revenue equals marginal cost and charging the highest price at which that quantity will be bought.

37 Monopoly Policy Issues The Efficient Regulation: Marginal cost pricing Regulating a natural monopoly in the social interest sets the quantity where MSB = MSC. The demand curve is the MSB curve. The marginal cost curve is the MSC curve. Efficient regulation sets the price equal to marginal cost.

38 Monopoly Policy Issues Regulation that sets the price equal to marginal cost is called the marginal cost pricing rule. The marginal cost pricing rule is efficient but with average cost exceeding price, the firm incurs an economic loss. Therefore the monopolist must be subsidized in this case

39 Monopoly Policy Issues Average Cost Pricing Another alternative is to permit the firm to produce the quantity at which price equals average cost and to set the price equal to average cost the average cost pricing rule. The quantity is still not efficient, but it is closer to the efficient one The monopoly does not need a subsidy in this case, and therefore no taxes have to be collected to support the subsidy

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