Chapter 15: Monopoly. Notes. Watanabe Econ Monopoly 1 / 83. Notes. Watanabe Econ Monopoly 2 / 83. Notes

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1 Econ 3 Introduction to Economics: Micro Chapter : Monopoly Instructor: Hiroki Watanabe Spring 3 Watanabe Econ 93 Monopoly / 83 Monopolistic Market Monopolistic Pricing 3 Inefficiency of Monopoly Price Discrimination Public Policy Summary Watanabe Econ 93 Monopoly / 83 Monopolistic Market Questions Why Monopolies Aries Natural Monopoly Monopolistic Pricing 3 Inefficiency of Monopoly Price Discrimination Public Policy Summary Watanabe Econ 93 Monopoly 3 / 83

2 Questions Question. (Agenda for Chpt 3-7) Where does the supply curve come from? What do firms do? 3 How does the market structure affect the firms decision making? Chpt 3: Preparation Chpt : Deriving the supply curve, perfect competition 3 Chpt : Monopoly Chpt 7: Oligopoly Chpt (?): Monopolistic competition Watanabe Econ 93 Monopoly / 83 Why Monopolies Aries Definition. (Monopolist) is a firm that is the sole seller of a product without close substitutes. Price setter. Major cause: barriers to entry. Watanabe Econ 93 Monopoly / 83 Why Monopolies Aries Barriers to entry: Government regulation Monopoly resources 3 The production process Watanabe Econ 93 Monopoly / 83

3 Why Monopolies Aries Government regulation Government gives a single firm the exclusive right to produce some good or service Government-created monopolies Patent and copyright laws E.g., new drugs, postal services (legal fiat) Watanabe Econ 93 Monopoly 7 / 83 Why Monopolies Aries Monopoly resources A key resource required for production is owned by a single firm. E.g., DeBeers, toll highway Watanabe Econ 93 Monopoly 8 / 83 Why Monopolies Aries 3 The production process A single firm can produce output at a lower total cost than can a larger number of producers. E.g., local utility companies Watanabe Econ 93 Monopoly 9 / 83

4 Natural Monopoly Definition.3 (Natuaral Monopoly) is a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. Increasing returns to scale in a relevant region. Watanabe Econ 93 Monopoly / 83 Natural Monopoly Example. (Natural Monopoly and IRS) Suppose production function takes the form ƒ ( ) =. To produce y =, which economy produces with fewer inputs? Jack and Dotcom splitting the production. Jack producing all. Watanabe Econ 93 Monopoly / 83 Natural Monopoly y=f J (x C ) y=f D (x ) C Cheesecakes y [slices]..88 Number of Chefs x C [persons] Watanabe Econ 93 Monopoly / 83

5 Natural Monopoly Split: J C =, D C =. chefs in total. Single firm: J C = (< ). Watanabe Econ 93 Monopoly 3 / 83 Natural Monopoly In natural monopoly, The average number of chefs you need to bake a slice decreases as y increases. Accordingly, the average total cost decreases with y. Watanabe Econ 93 Monopoly / 83 Natural Monopoly 3. Costs [$] 3... TC(y) ATC(y) Co Production Single Firm Production 3 Cheesecakes y [slices] Watanabe Econ 93 Monopoly / 83

6 Monopolistic Market Monopolistic Pricing Monopolist vs Competitive Firm Monopolistic Pricing MR(y) MWTP(y) 3 Inefficiency of Monopoly Price Discrimination Public Policy Summary Watanabe Econ 93 Monopoly / 83 Monopolist vs Competitive Firm Monopolists face a different demand curve than competitive firms do. Optimal pricing rule for competitive firms (c.f. Proposition. in Ch ): MR(y )(= p) = MC(y ). Watanabe Econ 93 Monopoly 7 / 83 Monopolist vs Competitive Firm Does the same pricing rule (p = ) still apply to a monopolist? Example. (Monopolistic Pricing) Listen to Marketplace Clip. Watanabe Econ 93 Monopoly 8 / 83

7 Monopolist vs Competitive Firm Demand the Firm Faces 8 MC, MWTP [$] 8 Cheesecakes y [slices] Watanabe Econ 93 Monopoly 9 / 83 Monopolist vs Competitive Firm Demand the Firm Faces 8 MC, MWTP [$] 8 Cheesecakes y [slices] Watanabe Econ 93 Monopoly / 83 Monopolist vs Competitive Firm Monopoly price setter sole producer 3 faces downward sloping demand. Competitive firm price taker lots of infinitesimally small producers 3 faces flat demand curve Watanabe Econ 93 Monopoly / 83

8 Monopolistic Pricing Definition. (Competitive Frim s PMP) max y π(y) = py TC(y). Definition.3 (Monopolist s PMP) max y π(y) = MWTP(y)y TC(y). Total revenue is not linear for a monopolist. Recall Ch Elasticity: State lawmakers: Increase in revenue because they can collect larger tax from each tourist. Bill Connors: Reduction in revenue because increased tax reduces the number of tourists. Watanabe Econ 93 Monopoly / 83 Monopolistic Pricing Example. (Preview) Metrolink s total cost function is given by TC(y) = y +, where y is the # of passengers. Inverse demand for the train service is MWTP(y) = y +. Competitive firms profit: π(y) = y TC(y). Monopolist s profit: π(y) = ( y + )y TC(y). Watanabe Econ 93 Monopoly 3 / 83 Monopolistic Pricing TC(y) 3 MWTP(y) TR(y) 3 π(y) TC, MWTP, TR, π [$] 8 Watanabe Econ 93 Monopoly / 83

9 Monopolistic Pricing TC(y) 3 MWTP(y) TR(y) 3 π(y) TC, MWTP, TR, π [$] 8 Watanabe Econ 93 Monopoly / 83 Monopolistic Pricing Different from perfect competition: Total revenue is not linear. Similar to perfect competition: At the optimal level, additional increase in revenue (MR) is cancelled by additional decrease in total cost (TC) of the equal size. Watanabe Econ 93 Monopoly / 83 Monopolistic Pricing How do monopolists find the optimal output level y? Watanabe Econ 93 Monopoly 7 / 83

10 Monopolistic Pricing Instead of plugging in random y s in π(y), we ask: If Jack sells one more slice, does it increase his profit? If it does, go ahead. If it decreases the profit, downsize. 3 If it doesn t change, then that s the y he s looking for. Watanabe Econ 93 Monopoly 8 / 83 Monopolistic Pricing Change in profit from an additional unit sold has two sources: MR(y): additional revenue that the additional unit brings in (just p in a perfectly competitive market, but not anymore here) Breaks further down into two components (next slide) : additional cost that the additional unit inflicts (varies with y) Watanabe Econ 93 Monopoly 9 / 83 Monopolistic Pricing Monopolists still follow Proposition. in Ch : Proposition. (Finding the Optimal Production Scale) The output level y that maximizes Jack s profit satisfies: MR(y) =. except that MR(y) does not coincide with MWTP(y) anymore. Watanabe Econ 93 Monopoly 3 / 83

11 MR(y) MWTP(y) Two effects by producing one more y: : If Metrolink carries one more passenger, it will cost them ΔTC(y) =. Δy : If Metrolink carries one more passenger, they get MR(y) = quantity effect + price effect } {{ }} {{ } > < Watanabe Econ 93 Monopoly 3 / 83 MR(y) MWTP(y) Break down the marginal effect of quantity change over the total revenue: Price-change effect (Bill Connors) : the marginal revenue lost by reduced price: have to sell everything for a dollar less. ΔMWTP(y) y Δy Quantity-change effect (State lawmakers) : the marginal revenue gained by increased output: can sell one more slice. MWTP(y) Note Metrolink can t increase output and price at the same time. Also note that the problem Metrolink faces is PMP, not total revenue maximization. Watanabe Econ 93 Monopoly 3 / 83 MR(y) MWTP(y) The additional profit is Δπ(y) Δy = MR(y) = MWTP(y) + ΔMWTP(y). Δy At y π(y) does not increase nor decrease i.e., Δπ(y) Δy =. MR(y ) = MC(y ). So, set p = MR(y )? Watanabe Econ 93 Monopoly 33 / 83

12 MR(y) MWTP(y) Example. (Finding the Price) Metrolink s marginal revenue (additional revenue from one more passenger): MR(y) = y +. Their marginal cost: = y a a You re not responsible for deriving two equations above. At the optimal level, MR offsets MC: MR(y) =. y = 3. Watanabe Econ 93 Monopoly 3 / 83 MR(y) MWTP(y) MWTP, MR, MC [$] MWTP(y) MR(y) Watanabe Econ 93 Monopoly 3 / 83 MR(y) MWTP(y) The most common mistake: p = MR(y = 3) =. If they charge p =, demand is rather than 3. Setting MR(y) = finds the optimal quantity but not the optimal price. Price corresponds to y = 3 is MWTP(y = 3) = 9. NOT. (what is the point of selling tickets for $ when you can sell them for $9 anyway?). Watanabe Econ 93 Monopoly 3 / 83

13 MR(y) MWTP(y) Another common mistake: (y, p) = (, 8) is tempting, where marginal cost meets marginal willingness to pay. Why does Metrolink choose (y, p) = (3, ) instead? (y, p) = (, 8) ignores Bill Connors effect. Confirm: π(y = ) = 3 7 =. π(y = 3) = 7 = 7(> ). Watanabe Econ 93 Monopoly 37 / 83 MR(y) MWTP(y) Exercise.7 (Monopolistic Pricing) Find Metrolink s profit maximizing service level (y ) and corresponding price (p ) for the following: Steps: Inverse demand: MWTP(y) = y + with MR(y) = y +. =. Use MR(y) = to find y. Plug y in MWTP(y) to find p. Watanabe Econ 93 Monopoly 38 / 83 MR(y) MWTP(y) MWTP(y) MR(y) MWTP, MR, MC [$] Watanabe Econ 93 Monopoly 39 / 83

14 Monopolistic Market Monopolistic Pricing 3 Inefficiency of Monopoly Efficiency Loss due to Monopolistic Pricing Price Discrimination Public Policy Summary Watanabe Econ 93 Monopoly / 83 Efficiency Loss due to Monopolistic Pricing A monopolist sets p higher than their marginal cost. In perfect competition, p is exactly =. Monopoly sounds good for a producer and bad for consumers. What is total surplus (social economic welfare)? The allocation is efficient if it achieves the maximum possible social economic welfare. Watanabe Econ 93 Monopoly / 83 Efficiency Loss due to Monopolistic Pricing The first fundamental theorem: When RP(y) meets MWTP(y), the market outcome is efficient. Monopoly: RP(y) is lower than MWTP(y), i.e., the set price >. Is a monopolistic market still efficient? Watanabe Econ 93 Monopoly / 83

15 Efficiency Loss due to Monopolistic Pricing CS PS MWTP(y) 9 MR(y) 8 MWTP, MR, MC [$] Watanabe Econ 93 Monopoly 3 / 83 Efficiency Loss due to Monopolistic Pricing CS PS MWTP(y) 9 MR(y) 8 MWTP, MR, MC [$] Watanabe Econ 93 Monopoly / 83 Efficiency Loss due to Monopolistic Pricing Due to the price-change effect, the monopolist stop produceing before y reaches the point = MWTP(y) but rather = MR(y). Reduced total surplus as a result. Creates deadweight loss. Watanabe Econ 93 Monopoly / 83

16 Efficiency Loss due to Monopolistic Pricing Exercise 3. (Finding DWL) For MWTP(y) = y +, MR(y) = y + and =, find passengers surplus, Metrolink s surplus and deadweight loss. Watanabe Econ 93 Monopoly / 83 Efficiency Loss due to Monopolistic Pricing CS MWTP(y) MR(y) MWTP, MR, MC [$] Watanabe Econ 93 Monopoly 7 / 83 Efficiency Loss due to Monopolistic Pricing CS PS MWTP(y) MR(y) MWTP, MR, MC [$] Watanabe Econ 93 Monopoly 8 / 83

17 Efficiency Loss due to Monopolistic Pricing What can we do about the deadweight loss? price discrimination government fixes (public policy) Watanabe Econ 93 Monopoly 9 / 83 Monopolistic Market Monopolistic Pricing 3 Inefficiency of Monopoly Price Discrimination Price Discrimination Public Policy Summary Watanabe Econ 93 Monopoly / 83 Price Discrimination Does a monopolist really charge the uniform price? Watanabe Econ 93 Monopoly / 83

18 Price Discrimination Watanabe Econ 93 Monopoly / 83 Price Discrimination Definition. (Price Discrimination) is the business practice of selling the same good at different prices to different customers. Doesn t sound fair but it can eliminate the DWL. Watanabe Econ 93 Monopoly 3 / 83 Price Discrimination Perfect price discrimination: Charge each customer a different price Charge exactly his or her willingness to pay. The monopolist gets the entire surplus (Profit) No deadweight loss. How? Watanabe Econ 93 Monopoly / 83

19 Price Discrimination Example. (Perfect Price Discrimination) Metrolink has Inverse demand: MWTP(y) = y + with MR(y) = y +. =. If Metrolink sets the price as p(y) = MWTP(y), what is their surplus? Watanabe Econ 93 Monopoly / 83 Price Discrimination MWTP, MR, MC [$] 3 CS MWTP(y) MR(y) Watanabe Econ 93 Monopoly / 83 Price Discrimination MWTP, MR, MC [$] 3 CS PS MWTP(y) MR(y) Watanabe Econ 93 Monopoly 7 / 83

20 Price Discrimination MWTP, MR, MC [$] 3 PS MWTP(y) MR(y) Watanabe Econ 93 Monopoly 8 / 83 Price Discrimination Why don t they stop producing at y =? Watanabe Econ 93 Monopoly 9 / 83 Price Discrimination Examples of price discrimination Movie tickets Airline prices Discount coupons Financial aid Quantity discounts Watanabe Econ 93 Monopoly / 83

21 Monopolistic Market Monopolistic Pricing 3 Inefficiency of Monopoly Price Discrimination Public Policy Types of Regulations Antitrust Laws Public Ownership Summary Watanabe Econ 93 Monopoly / 83 Types of Regulations Antitrust laws Public Ownership 3 Price regulation Watanabe Econ 93 Monopoly / 83 Antitrust Laws Increasing competition with antitrust laws Sherman Antitrust Act, 89 Clayton Antitrust Act, 9 Prevent mergers Break up companies Prevent companies from coordinating their activities to make markets less competitive Watanabe Econ 93 Monopoly 3 / 83

22 Public Ownership Private owners Maximize producer surplus Public owners (government) Maximize total surplus Weak incentive to minimize cost Possible efficiency loss due to inefficient production Watanabe Econ 93 Monopoly / 83 Why don t we simply ask the firm to produce more and set the price down to p =? We can, but problematic for natural monopoly. Watanabe Econ 93 Monopoly / 83 Example. (Marginal Cost Pricing) Consider the following environment: MWTP(y) =.y + MR(y) = y + TC(y) = y + =. What happens to the monopolist if the government imposes marginal cost pricing? Watanabe Econ 93 Monopoly / 83

23 Ask Metrolink to serve y = 8 at p =. The total surplus will be maximized. Watanabe Econ 93 Monopoly 7 / 83 MWTP, MR, MC, ATC [$] 3 CS MWTP(y) MR(y) ATC(y) Watanabe Econ 93 Monopoly 8 / 83 But then Metrolink will stop its operation in the long run. Then the whole total surplus will be gone. Watanabe Econ 93 Monopoly 9 / 83

24 MWTP, MR, MC, ATC [$] 3 π MWTP(y) MR(y) ATC(y) Watanabe Econ 93 Monopoly 7 / 83 Unfortunately, this result is inevitable. Natural monopoly happens when the firm is operating in the region where the ATC is decreasing. Watanabe Econ 93 Monopoly 7 / 83 Note that Metrolink does not have to stop its operation if there were no government intervention. Watanabe Econ 93 Monopoly 7 / 83

25 MWTP, MR, MC, ATC [$] 3 π (Long Run) MWTP(y) MR(y) ATC(y) Watanabe Econ 93 Monopoly 73 / 83 We don t want monopolistic pricing (inflicts DWL). We want to but can t impose marginal cost pricing (eliminates DWL but the firm exits eventually). 3 Second best solution: average cost pricing. Watanabe Econ 93 Monopoly 7 / 83 If we impose the price where MWTP(y) = ATC(y), y increases, and π(y) won t be negative. DWL still exists but not worse than monopolistic pricing. Watanabe Econ 93 Monopoly 7 / 83

26 MWTP, MR, MC, ATC [$] 3 DWL Averted DWL MWTP(y) MR(y) ATC(y) Watanabe Econ 93 Monopoly 7 / 83 y CS PS TS π(y) DWL Laissez-Faire 8 MC Pricing 8 - AC Pricing 9 Watanabe Econ 93 Monopoly 77 / 83 Discussion. (Average-Cost Pricing) Is average cost pricing implementable? Can a government force average cost pricing? What s the long-term effect? Watanabe Econ 93 Monopoly 78 / 83

27 Who would tell the true average cost? What s worse, in the long term, Metrolink won t get motivated to reduce its cost (no innovation occurs). Watanabe Econ 93 Monopoly 79 / 83 Monopolistic Market Monopolistic Pricing 3 Inefficiency of Monopoly Price Discrimination Public Policy Summary Watanabe Econ 93 Monopoly 8 / 83 Monopolist s pricing rule Efficiency loss Price discrimination Price regulation Watanabe Econ 93 Monopoly 8 / 83

28 Airline du Jour Today s color theme is provided by courtesy of Alitalia Watanabe Econ 93 Monopoly 8 / 83 Index antitrust laws, 3 average cost pricing, 7 barriers to entry, deadweight loss, increasing returns to scale, marginal cost, 9 marginal cost pricing,, 7 marginal revenue, 9 monopolist, monopolistic pricing, 7 natural monopoly,, perfect price discrimination, price effect, 3 price setter, price-change effect, 3 profit maximization problem, public ownership, quantity effect, 3 quantity-change effect, 3 Watanabe Econ 93 Monopoly 83 / 83