Monopoly, Oligopoly, and Monopolistic Competition Chapter 8 McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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1 Monopoly, Oligopoly, and Monopolistic Competition Chapter 8 McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2 Learning Objectives 1. Distinguish among three types of imperfectly competitive industries and describe how imperfect competition differs from perfect competition 2. Identify the five sources of monopoly power and describe why economies of scale are the most enduring of the various sources of market power 3. Apply the concepts of marginal cost and marginal revenue to find the output and price that maximizes a monopolist's profits 4. Explain why the profit-maximizing output level for a monopolist is too small from society's perspective 5. Discuss why firms offer discounts to buyers who are willing to jump a hurdle 6. Discuss public policies that are often applied to natural monopolies 8-2

3 Imperfect Competition Imperfectly competitive firms have some ability to set their own price: they are price setters Long-run economic profits possible Reduce economic surplus Three types: 1. Monopoly has only one seller, no close substitutes 2. Monopolistic competition has many firms producing slightly differentiated products that are reasonably close substitutes 3. Oligopoly has a small number of large firms producing products that are close substitutes 8-3

4 Monopolistic Competition Number of Firms Price Entry and Exit Product Economic Profits Decisions Monopolistic Competition Many firms Limited flexibility Free Differentiated Zero in long run P, Q, product differentiation Perfect Competition Many firms Price taker Free Standardized Zero in long run Q only 8-4

5 Oligopoly Number of Firms Price Entry and Exit Product Economic Profits Decisions Oligopoly Few firms, each large Some flexibility Difficult Differentiated or standardized Possible P, Q, differentiation, advertising Perfect Competition Many firms Price taker Free Standardized Zero in long run Q only 8-5

6 Imperfect Competition Examples of monopoly Electricity and Magic Cards Examples of monopolistic competition Retail gas stations Convenience stores Examples of oligopoly Wireless phone service Cement Automobiles and tobacco 8-6

7 The Essential Difference Market power is the firm's ability to raise its price without losing all its sales Any firm facing a downward sloping demand curve Firm picks P and Q on the demand curve Market power comes from factors that limit competition Imperfectly Competitive Firm Perfectly Competitive Firm Price Price D D Quantity Quantity 8-7

8 Five Sources of Market Power 1. Exclusive control over inputs 2. Patents and copyrights 3. Government licenses or franchises 4. Economies of scale (natural monopolies) 5. Network economies 8-8

9 Market Power: Economies of Scale Returns to scale refers to the percentage change in output from a given percentage change in ALL inputs Long-run idea Constant returns to scale: doubling all inputs doubles output Increasing returns to scale: output increases by a greater percentage than the increase in inputs Average costs decrease as output increases Natural monopoly: a monopoly that results from economies of scale 8-9

10 Market Power: Network Economies Network economies occur when the value of the product increases as the number of users increases VHS format for video tapes, Blu-ray for DVDs Telephones Windows operating system ebay Facebook and MySpace 8-10

11 Economies of Scale and Start- Up Costs New products can have a large fixed development cost Variable cost: sum of payments made to the variable factors, such as labor Fixed cost: sum of payments made to the fixed factors, such as capital Start-up costs can be thought of as a fixed cost Average total cost (ATC): total cost divided by output A good whose production has a large start-up cost and low variable cost is subject to economies of scale ATC declines sharply as output increases 8-11

12 Economies of Scale and Start- Up Costs Consider an example: Assume marginal cost (M) is constant Variable cost is M*Q Total cost is fixed cost (F) plus variable cost TC = F + M*Q Total cost increases as output increases Average total cost is ATC = F / Q + M Average total cost decreases as output increases Average fixed cost = F/Q 8-12

13 F Economies of Scale TC = F + M Q ATC = F/Q + M Quantity 8-13 Total cost ($/year) Average cost ($/unit) M Quantity

14 Example: Video Game Producers Different Volumes Annual Production (000s) Nintendo Playstation 1,000 1,200 Fixed Cost ($000s) $200 $200 Variable Cost ($000s) $800 $960 Total Cost ($000s) $1,000 $1,160 ATC per game $1.00 $

15 Example: Video Game Producers Lower Marginal Costs Annual Production (000s) Nintendo Playstation 1,000 1,200 Fixed Cost ($000s) $200 $200 Variable Cost ($000s) $200 $240 Total Cost ($000s) $400 $440 ATC per game $0.40 $

16 Example: Video Game Producers Higher Fixed Cost Annual Production (000s) Nintendo Playstation 1,000 1,200 Fixed Cost ($000s) $10,000 $10,000 Variable Cost ($000s) $200 $240 Total Cost ($000s) $10,200 $10,240 ATC per game $10.20 $

17 Example: Video Game Producers Different Production Levels Annual Production (000s) Nintendo Playstation 500 1,700 Fixed Cost ($000s) $10,000 $10,000 Variable Cost ($000s) $100 $340 Total Cost ($000s) $10,100 $10,240 ATC per game $20.20 $

18 Intel's Advantage Development cost of a new chip $2 billion Marginal cost of making a chip Pennies Dominating the market Priceless Intel supplies more than 80% of the processors for PCs 8-18

19 Profit Maximization for the Monopolist Like all other firms, a monopolist: Maximizes profits Applies the Cost-Benefit Principle: Increase output if marginal benefit > marginal cost Decrease output is marginal benefit < marginal cost Marginal benefit is called marginal revenue: Change in total revenue from a one-unit change in output Equal to price for the perfectly competitive firm Less than price for the monopolist 8-19

20 Profit Maximization for the Monopolist To sell another unit the monopolist must lower price Total revenue from 2 units = $12 Total revenue from 3 units = $15 Marginal revenue = $3 Price ($/unit) 6 5 D 2 3 Quantity (units/week) 8-20

21 Monopolist's Marginal Revenue Price & marginal revenue ($/unit) Quantity (units/week) D MR 8 Price Quantity $6 2 $5 3 $4 4 $3 5 Total Revenue $12 $15 $16 $15 Marginal Revenue

22 Monopoly Demand and Marginal Revenue a The monopolist's marginal revenue curve: Price a/2 MR Q 0 /2 D Quantity Q 0 Has the same intercept as the straight-line demand curve Has twice the slope of the demand curve Lies below the demand curve 8-22

23 Deciding Quantity Profit is maximized at the level of output where marginal cost equals marginal revenue At P = $3 and Q = 12, MC > MR Decrease output At Q = 8, MC = MR = 2 The demand curve sets the price at P = $4 At any output below 8, MC < MR Price ($/unit of output) MC D MR 8 12 Quantity (units/week) 8-23

24 Monopoly Profit Profit = Total revenue total cost Total cost = ATC x Q Profit = P x Q ATC x Q Profit = (P-ATC) x Q If P > ATC then the firm earns a profit If P < ATC then the firm suffers a loss This can be graphically illustrated 8-24

25 Monopoly Losses and Profits Price ($/minute) Economic loss = $400,000/day ATC 0.05 MC Price ($/minute) Economic profit = $400,000/day ATC 0.05 MC MR 20 Minutes (millions/day) D 24 MR D Minutes (millions/day) 8-25

26 The Invisible Hand Fails Price ($/unit of output) 6 The monopolist's optimal amount occurs where MC = MR, Q = 8 units and P = $4 Marginal Cost Deadweight loss 4 from monopoly = $4 3 2 MR The socially optimal amount occurs where MC = MB, Q = 12 units and P = $3 D 8 12 Quantity (units/week)

27 Monopoly and Perfect Competition Monopoly Perfect Competition MC = MR P >MR P > MC Deadweight Loss MC = MR P = MR P = MC No Deadweight Loss 8-27

28 Managing Monopoly: The Breakdown of the Invisible Hand Monopolies exist for economic reasons Patents, copyrights, and innovation Economies of scale Network economies Anti-trust laws attempt to limit deadweight loss Limiting monopoly has costs Patents encourage innovation Economies of scale minimize ATC Network economies increase benefits 8-28

29 Price Discrimination Price discrimination means charging different buyers different prices for essentially the same good or service Separate the groups No side trades among buyers Many forms of price discrimination Hurdle method: discounts for identifiable groups (e. g., students, AARP) Perfect discrimination: negotiate separate deals with each customer 8-29

30 Carla the Editor: Social Optimum What is the social optimum? 6 papers with an economic profit of $6 Opportunity cost of Carla's time is $29 Reservation Student Price A $40 B 38 C 36 D 34 E 32 F 30 G 28 Total Revenue $40 $76 $108 $136 $160 $180 $196 What if Carla is a profit maximizer? What is Carla's total revenue? 8-30

31 Carla the Editor: Marginal Revenue What is Carla's marginal revenue? Opportunity cost of Carla's time is $29 Reservation Student Price A $40 B 38 C 36 D 34 E 32 F 30 G 28 3 papers with an economic profit of $21 Total Revenue $40 $76 $108 $136 $160 $180 $196 MR $40 $36 $32 $28 $24 $20 $

32 Carla the Editor: Price Discriminator Opportunity cost of Carla's time is $29 Reservation Student Price A $40 B 38 C 36 D 34 E 32 F 30 G 28 What if Carla is a perfect price discriminator? Total Revenue $40 $78 $114 $148 $180 $210 $238 What is Carla's total revenue? 6 papers with an economic profit of $

33 Hurdle Method of Price Discrimination The hurdle method of price discrimination is the practice of offering a discount to all buyers who overcome some obstacle. Temporary sales Hard cover and paperback books Multiple car models from one manufacturer Commercial air carriers Movie producers and phased releases Scratch and Dent appliance sales 8-33

34 Carla Offers a Rebate 5 papers, price $36, rebate $4, economic profit $27 If reservation price < $36, student will mail in rebate Student Reservation Price Total Revenue A $40 $40 B C Discounted Price Submarket D $34 $34 E F MR $ $

35 Carla's Choices Program Social Optimum Single Price Perfect Discriminator Hurdle Papers Edited = (3 + 2) Price $30 $36 Reservation $36, $4 rebate Total Revenue $180 $108 $210 $172 Carla's Time $174 $87 $174 $145 Economic Profit $6 $21 $36 $27 Total Surplus $26 $27 $36 $

36 Monopoly and Public Policy Challenge: create the greatest increase in total surplus Policy options Government ownership and operation Regulation Competitive bids for natural monopoly services Break up 8-36

37 State-Owned Natural Monopoly Marginal cost is always less than average cost Marginal cost pricing produces losses Options Fund losses from tax revenues Fixed monthly fee plus usage fee Fixed fee covers losses Limited incentives to innovate and cut costs Commonly used for water, Post Office, and some electricity 8-37

38 Regulated Monopolies Cost-plus regulation sets price at per unit explicit costs plus a mark-up for implicit costs Used for electricity, telephone, and cable Policies vary by state Disadvantages High administrative cost Reduced incentive for cost-saving innovation Price is greater than marginal cost 8-38

39 Exclusive Contracting for Natural Monopolies Government awards contract to low bidder for natural monopoly services Garbage collection, fire protection, road construction, Department of Defense Could achieve marginal cost pricing IF government pays the resulting losses Asset transfer for large fixed investment is complex 8-39

40 Enforcement of Anti-Trust Laws Two landmark laws Sherman Act of 1890 Declared conspiracy to create a monopoly illegal Clayton Act of 1914 Outlawed transactions that would "substantially lessen competition" Applies to mergers and acquisitions today IBM avoided break-up; AT&T did not Microsoft survived 8-40

41 Another Policy Option: Ignore Monopoly Two objections to monopolies Restrict output, decrease total surplus Raise price, earn economic profits Analysis Discount offers allow some customers to pay less than average cost, though more than marginal cost Economic profits generated by customers who pay list price their choice About two-thirds of economic profits are taxed away Remainder accrues to shareholders 8-41

42 Imperfect Competition Imperfect Competition Monopolistic Competition and Oligopoly Sources of Market Power Monopoly Public Policy 8-42

43 The Algebra of Monopoly Maximization Chapter 8 Appendix

44 From Demand to Marginal Revenue Given a demand curve such as P = 15 2 Q We can write the marginal revenue curve as MR = 15 4 Q Suppose marginal cost is a line with zero intercept and a slope of 1 MC = Q The remaining step is to set marginal revenue equal to marginal cost 8-44

45 MR = MC Let Q* be the profit maximizing level of output MC = MR Q* = 15 4 Q* 5 Q* = 15 Q* = 3 To find P, substitute Q = 3 into the demand equation P = 15 4 Q* P = 15 4 (3) P =