Monopoly CHAPTER 15. Henry Demarest Lloyd. Monopoly is business at the end of its journey. Monopoly 15. McGraw-Hill/Irwin

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1 CHAPTER 15 Monopoly Monopoly is business at the end of its journey. Henry Demarest Lloyd McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2 A Monopolistic Market A monopoly is a market structure in which one firm makes up the entire market Firm=Industry There are no close substitutes for the monopolist s product The monopolist is a price maker 15-2

3 A Monopolistic Market Barriers to entry prevent competition If there were no barriers to entry, profitmaximizing firms would always compete away monopoly profits McGraw-Hill/Irwin Colander, Economics 3

4 1. Geography Barriers to Entry Location or control of resources limits competition and leads to one supplier 2. Government Government allows monopoly for public benefits or to stimulate innovation Think water/sewer system McGraw-Hill/Irwin Colander, Economics 4

5 Barriers to Entry 3. Technology or Common Use Patents and widespread availability of certain products lead to only one major firm controlling a market Example: Microsoft 4. Mass Production and Low Costs If there were three competing electric companies they would have higher costs Having only one electric company keeps prices low McGraw-Hill/Irwin Colander, Economics 5

6 Profit Maximizing Level of Output The goal of the monopolistic firm is to maximize profits (difference between total revenue and total cost) The profit-maximizing condition of a monopolistic firm is: MC = MR 15-6

7 Profit Maximizing Level of Output For a monopolistic firm, MR < P (ALWAYS) This is because to sell more units a monopolist has to lower its price A monopoly maximizes total profit, not profit per unit When marginal revenue is zero, a monopolist has maximized total revenue 15-7

8 If MR > MC, Profit Maximizing Level of Output The monopoly can increase profit by increasing output If MR < MC, The monopoly can increase profit by decreasing its output McGraw-Hill/Irwin Colander, Economics 8

9 Demand and Marginal Revenue Curves What happens to TR when MR hits zero? P $15 Monopoly TR 5 $ MR D TR Q Total Revenue is at its peak when MR hits zero Q 9

10 Drawing the Monopoly Graph The demand curve is always downward sloping and is the market demand curve Draw your MC curve The MR curve starts at the same point on the price axis as does P It bisects the demand curve McGraw-Hill/Irwin Colander, Economics 10

11 Drawing the Monopoly Graph The output (Q) the monopolist will produce is where MC=MR Put a dot where MC=MR and take the point down to the Q axis McGraw-Hill/Irwin Colander, Economics 11

12 Drawing the Monopoly Graph Determine the price the monopolist will charge Take the point where MC=MR and draw a dotted line up to the demand curve Draw a dotted line to the price axis (price is always derived from the demand curve) McGraw-Hill/Irwin Colander, Economics 12

13 Profits and Monopoly Determine profit or loss Subtract ATC from price at that level of output and multiply by the output (P-ATC)*Q (know this) McGraw-Hill/Irwin Colander, Economics 13

14 Profits and Monopoly If price is greater than ATC (P>ATC) at this output, the monopolist will make a profit If price equals ATC (P=ATC), the monopolist will not make a profit (zero profit/loss) If price is less than ATC (P<ATC) at this output, the monopolist will incur a loss McGraw-Hill/Irwin Colander, Economics 14

15 Graph: Monopolist Earning a Profit Find output where MC = MR (profit maximizing quantity) Find how much consumers will pay where the profit max Q intersects demand, this is the monopolists price Find profit per unit where the profit max Q intersects ATC McGraw-Hill/Irwin Colander, Economics 15

16 Graph: Monopolist Earning a Profit Extend the lines from where the quantity line intersects the demand curve and the ATC to the price axis This rectangle is the monopolists profit Since P>ATC at the profit maximizing quantity, this firm is earning a profit McGraw-Hill/Irwin Colander, Economics 16

17 Find output where MC = MR, this is the profit maximizing Q Find how much consumers will pay where the profit max Q intersects demand, this is the monopolist price Draw the Graph: A Monopoly Earning a Profit P MC ATC Find profit per unit where the profit max Q intersects ATC P 1 Profit Since P>ATC at the profit maximizing quantity, this firm is earning profits Q profit max MR D Q 15-17

18 Graph: A Monopoly with Zero Profit or Losses Find output where MC = MR (profit maximizing Q) Find how much consumers will pay where the profit max Q intersects demand, this is the monopolists price Find profit per unit where the profit max Q intersects ATC Since P=ATC at the profit maximizing quantity, this firm is earning zero profit or loss McGraw-Hill/Irwin Colander, Economics 18

19 Draw the Graph: A Monopoly with Zero Profit or Losses P MC ATC Find output where MC = MR, this is the profit maximizing Q Find how much consumers will pay where the profit max Q intersects demand, this is the monopolist price P 1 Find profit per unit where the profit max Q intersects ATC Q profit max MR D Q Since P=ATC at the profit maximizing quantity, this firm is earning zero profit or loss 15-19

20 Graph: A Monopoly with a Loss Find output where MC = MR (profit maximizing Q) Find how much consumers will pay where the profit max Q intersects demand, this is the monopolists price Find profit per unit where the profit max Q intersects ATC Since P<ATC at the profit maximizing quantity, this firm is earning a loss McGraw-Hill/Irwin Colander, Economics 20

21 Find output where MC = MR, this is the profit maximizing Q Find how much consumers will pay where the profit max Q intersects demand, this is the monopolist price Find profit per unit where the profit max Q intersects ATC P 1 P Losses Draw the Graph: A Monopoly with a Loss MC ATC Since P<ATC at the profit maximizing quantity, this firm is earning a loss Q profit max MR D Q 15-21

22 A monopoly will only produce in the elastic range Monopoly: Elastic and Inelastic Range Total Revenue Test If price falls and TR increases, then demand is elastic. If price falls and TR falls, then demand is inelastic. Price Price 0 0 Elastic Range Inelastic range Quantity Marginal Revenue Demand Total Revenue Quantity Monopoly 15 So, when MR is zero, demand is unit elastic Note that in the inelastic range of the demand curve, MR is negative and TR falls as Q increases.

23 Are Monopolies Efficient? 1. NO 2. They charge a higher price 3. They don t produce enough Not allocatively efficiency 4. Produce at higher costs Not productively efficiency 5. Have little incentive to innovate McGraw-Hill/Irwin Colander, Economics 23

24 P 1 P Monopoly 15 Socially Optimal Level (Allocatively Efficient) for a Monopoly MC ATC SO/AE Socially optimal (allocatively efficient) is where MC=D This is where we maximize CS and PS Q profit max MR D Q 15-24

25 Fair Return Level for a Monopoly P 1 P Q profit max MR MC ATC FR D Q Fair return is when the government regulates price with a price ceiling This is where D=ATC and where TR=TC (no economic profit) 15-25

26 The Key Difference Between a Monopolist and a Perfect Competitor A monopolistic firm s marginal revenue is not its price MR is always below its price To sell more units, a monopolist has to decrease its price this makes the MR curve less than demand Monopolies create DWL 15-26

27 Monopolist and a Perfect Competitor Let s compare where perfect competitors produce and where monopolists produce P MC P MC ATC ATC P 1 Profits P = D = MR P 1 Profit Q profit max Q Q profit max MR D Q McGraw-Hill/Irwin Colander, Economics 27

28 P Monopoly Compared to Perfect Competition Graph MC In a monopoly, P>MR, In perfect competition, P=MR=D MR=MC is the profit max rule for both P M P PC D PC = MR PC First find the monopoly Q and P Then find the perfectly competitive Q and P Q M Q PC MR M D M Q Outcome: Monopoly output is lower and price is higher than perfect competition 15-28

29 P M P PC Graph shows a monopolist s price and perfect competitors' price P A B Q M Why is there DWL? Q PC MR MC D Q The welfare loss (DWL) from a monopoly is represented by the triangles A and B This is because a monopoly charges a higher price and produces a lower quantity than a perfect competitor Monopolies are allocatively inefficient To maximize CS and PS a monopolist would have to produce where MC=D 15-29

30 CS, PS, and DWL for a Monopoly P MC P M CS PS DWL Q M MR D Q 15-30

31 Lump-sum tax vs. Per-unit tax Lump-sum tax is a one-time tax It affects fixed costs: AFC and ATC A per-unit tax is added to every unit produced It affects variable costs: AVC, ATC, and MC (Learn and know these!) McGraw-Hill/Irwin Colander, Economics 31

32 The Price-Discriminating Monopolist All of the graphs we just learned are for nonprice discriminating monopolists When a monopolist price discriminates, it charges different prices to different individuals (or groups of individuals) 15-32

33 The Price-Discriminating Monopolist Consumers with less elastic demands are charged higher prices Consumers with more elastic demands are charged lower prices Price discrimination increases output and profits McGraw-Hill/Irwin Colander, Economics 33

34 Graph: The Price-Discriminating Monopolist P Profit MC ATC D=MR Q Q is where it would be for a perfect competitor, where MC=MR P, is anywhere on the demand curve because those willing to pay a higher price will There is no CS Q M 15-34

35 Examples of Price Discrimination Movie discounts to senior citizens and children Airline discounts for Saturday-night stay overs Cars are rarely sold at list price Tracking consumer information and pricing accordingly 15-35

36 Natural Monopoly Natural monopoly is when a single firm can produce at a lower cost than can two or more firms Significant economies of scale exist more than one firm would prevent the monopolist from taking advantage of economies of scale No DWL 15-36

37 Natural Monopoly If demand intersects ATC while demand is downward sloping, we can conclude the industry is a natural monopoly If a firm charges at its profit maximizing point, where MC=MR, it is charging much higher than the socially optimal price (where MC=D) It also restricts its output (or under produces) 15-37

38 Natural Monopoly How can society achieve a socially optimal level with a natural monopoly? The government can intervene with price controls and subsidies 15-38

39 Natural Monopoly A price control instituted at the socially optimal price would cause the firm to earn economic losses and shutdown A monopolist needs a per-unit subsidy to be able to produce the socially optimal level The natural monopoly is then referred to as a regulated monopoly McGraw-Hill/Irwin Colander, Economics 39

40 A Natural Monopoly Graph, Profit and Regulation P M C M Average Cost Profits A natural monopolist produces Q M and charges P M, therefore earning a profit If there is government regulation and a competitive solution where P = MC is required, the monopolist produces Q C and charges P C, therefore earning a loss C C P C Losses Q M MR Q C D ATC MC Q 15-40

41 Natural Monopoly MC P profit max ATC P SO Q profit max MR Q SO D Q 15-41

42 Natural Monopoly The government would institute a price control at P G (a price ceiling) and then subsidize the firm to reduce MC MC P profit max ATC P G Q profit max MR Q SO D Q 15-42

43 Natural Monopoly What happens is this: MC and ATC shift down into the negative revenue range of the graph and the government subsidizes the firm to produce at the socially optimal level See next graph: I don t think you will ever see this on the AP exam, but this is what the graph would look like See Welker natural monopoly video McGraw-Hill/Irwin Colander, Economics 43

44 Natural Monopoly Graph MC P profit max ATC P G Q profit max MR Q SO D Q ATC 2 MC 2 with subsidy

45 Chapter Summary Monopoly is a market structure, protected by barriers to entry, in which a single firm produces a product for which there are no close substitutes A monopolist maximizes profit or minimizes losses where MR=MC To determine a monopolist s profit or loss: Find output where MR=MC Determine price and ATC at that output Profit or loss = (P ATC) * Q 15-45

46 Chapter Summary Monopoly output is lower and price is higher than in competitive markets Because monopolies reduce output and charge P > MC, monopolies create a welfare loss for society A price-discriminating monopolist earns more profit than a normal monopolist by charging a higher price to those with less elastic demand and a lower price to those with more elastic demand 15-46

47 Chapter Summary Natural monopolies exist in industries with strong economies of scale, so it is more efficient for one firm to produce the entire output In a natural monopoly the competitive outcome where P=MC results in losses Normative arguments against monopoly are: Monopolies are inconsistent with freedom Distributional effects of monopoly are unfair Monopolies encourage people to waste time and money trying to get monopolies 15-47