VIII 1 TOPIC VIII: MONOPOLY AND OTHER INDUSTRY STRUCTURES. I. Monopoly - Single Firm With No Threat of Close Competition. Other Industry Structures

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1 TOPIC VIII: MONOPOLY AND OTHER INDUSTRY STRUCTURES I. Monopoly - Single Firm With No Threat of Close Competition II. Other Industry Structures CONCEPTS AND PRINCIPLES MONOPOLY We now consider the opposite end of the "competition spectrum" -- the case of Monopoly. A monopoly represents a situation in which there is a single firm in an industry and there are no threats of other firms entering the industry. In this sense, the firm is the industry. That is, the firm faces the industry demand curve for the product the firm is producing. This is the critical difference between monopoly and perfect competition. In both cases the industry demand curve is expected to follow the law of demand - to be a downward sloping demand curve. In perfect competition, however, the firm is seen as facing a perfectly elastic demand for its product since there are other firms producing perfect substitutes. In the case of monopoly, there are no other firms. Thus, the firm's demand curve is equivalent to the market demand curve. What kind of world would create a monopoly situation? There are many. For example, a firm invents a new product that can' t be duplicated (or there are patent laws); or the firm is the sole owner of a resource necessary to produce a good. Another interesting example of monopoly power is the entertainer or athlete - especially for the "super star." In this case, the individual is the firm, producing a product such as music, art, or a.420 batting average. What makes this individual a monopolist is that no one can strictly "duplicate" their product. This example also points out that monopoly power is a "relative" concept. Some firms face a world in which the demand for their product is highly inelastic, partially because there are no other products that come close to being good substitutes. In other cases, the firm faces a downward sloping demand curve, but the curve is still relatively elastic. There are no perfect substitutes, but there are pretty good ones. This helps explain the wide range of salaries observed on a professional team, or in the entertainment industry. What difference does this make in the decision of the firm about what price to charge and what output to produce? The difference is seen by considering the MR curve for the monopolist. We will consider two scenarios. One is where the monopolist charges different prices to different customers - this is called "price discrimination." The other scenario is where the monopolist charges a single price to every consumer of its product. VIII 1

2 Price Discriminating Monopolist If we allow the monopolist the opportunity to charge different prices to different customers, numerous "pricing options" become available. Let s consider the extreme case. What if the monopolist can charge each customer the maximum price that customer is willing to pay - charge the customer their limit price. In this case, the MR schedule shown above, becomes simply: Q $P $TR $MR $MC Now, MR is equal to the price charge for each unit of output. Thus, as shown in the graph below, for the price discriminating monopolist, demand and marginal revenue are the same. What output would maximize this monopolist s profits? If there are no fixed costs, what would profits equal? In our example, we have gone from the extreme where the monopolist must charge every customer the same price to one in which the monopolist can charge every customer a different price - their limit price. As noted, there are many other possibilities. One good example is when "groups" get charged different prices, kids eat free. Other examples include out of state tuition, over 60 discounts, etc. What kinds of factors would allow a seller to charge different prices to different customers? How would information about the price that others pay affect the ability of the seller to charge different customers (do most people know what others have paid for a the same new car?). How would the ability of buyers to resale a product affect a seller s ability to price discriminate? In the example above, the monopolist would produce 4 units. Why? In this example, assuming no fixed costs, the monopolist would earn a profit of $44 per time period. Why? VIII 2

3 Now we turn to a situation where the monopolist cannot price discriminate. That is, the monopolist must charge the same price to every customer. We refer to this situation as the single price monopolist. Single Price Monopolist Consider a monopolist facing the demand schedule shown below. To sell more output the firm must lower its price - to all customers. That means that MR also falls for each additional unit of output the firm produces and sells. Q $P $TR $MR $MC Notice at every quantity of output (except the first), the MR of selling an additional unit of output is less than the price charged for that output. The reason is that the firm is receiving additional revenue for selling an additional unit - but it is losing some revenue on "previous" units since it is lowering its price on those units. What would this firm do to maximize profits? There is nothing new here. The rule is to continue to produce additional output as long as MR> MC. This is true for the 1st, 2nd, and 3rd units of output. This firm would produce at Q= 3 and sell that quantity at a price of $16. If this firm had no fixed costs, what would be its profits? For illustrative purposes, the schedule above is shown in the graph below. The MR curve is below the demand curve at every quantity. VIII 3

4 Below, we show the information for a single price monopolist, with the addition of the ATC curve. Note that we use the same logic as above to find the optimum price and quantity. That is, the single price monopolist would produce a quantity of 80 units, with a price of $15 per unit. Total revenue would be 80x$15= $1200. Total cost would be 80x$12= $960. Total Profit would be $240. Notice there is no supply curve for a monopolist. The notion of a supply curve is only applicable to situations in which we approximate the conditions of perfect competition. VIII 4

5 Final Note on Monopoly Does monopoly power guarantee economic profits? No, there are plenty of examples where firms with a "new product" have gone bankrupt. There is one important difference, however, between monopoly and perfect competition in this regard. If a monopolist is making economic profits, firms are constrained in entering the industry to compete away those profits. This last statement must, however, be qualified. Given sufficient time, and a sufficient profit incentive, firms find ways to compete, regardless of the market structure. MARKET STRUCTURES - BETWEEN PERFECT COMPETITION AND MONOPOLY STRATEGIC INTERACTION BETWEEN FIRMS Between the extremes of perfect competition and monopoly, there are other ways in which one can characterize the "industry structure." The figure we saw in an earlier chapter is useful in this respect. A useful way of thinking about industry structure is to begin with a monopolist producing a new product that generates economic profit. Over time (maybe a long time) firms will find some way to begin to compete. Initially there might be only a few firms in the industry. We refer to this situation as "oligopoly." In this case, the firms are highly interdependent. That is, if one makes a pricing change the others are expected to react to this pricing change. If economic profits remain, we find more firms and more competition - leading to what we refer to as "monopolistic competition." In this situation, we expect a high degree of competition between firms, but also an attempt by firms to convince the public that their products are "truly different." This is the monopolistic side of this industry structure. Finally, if competition is sufficiently intense, we can expect some markets to move closer and closer to the case of perfect competition. In the eyes of the customer, we move toward a situation where all firms produce a product that is virtually identical to that of others. VIII 5

6 QUESTIONS Short Answer 1. Create a demand curve and a MC curve. Calculate MR and profits for each level of output for a single price monopolist and also for a perfect price discriminating monopolist. 2. In what sense do all firms always face "some competition?" 3. In what sense does the "profit success" of a monopolist depend on both the elasticity of demand for its product and the "level of demand" for its product? 4. What kinds of conditions would be important for a firm to successfully "price discriminate." Hint: How are buying the services of a medical doctor, or a mechanic, or a new car different from buying a movie ticket, an ice cream cone, or a watch? 5. Calculate the maximum profits for a single price monopolist producing in the situations shown in the figures below. VIII 6

7 Multiple Choice 1. A single price monopoly is producing an output level of 100 units where MC= $5 and MR= $5. At this output, ATC= $8, AVC= $6, and consumers' limit price is $10. What is the firm' s profit? A. $500 B. $200 C. -$300 D. -$200, the firm should shut down 2. A single price monopoly is producing an output level of 100 units where MC= $5 and MR= $8. At this output, ATC= $8, AVC= $6, and consumers' limit price is $10. The firm should: A. increase output and lower price. B. decrease output and lower price. C. increase output and increase price. D. decrease output and increase price. 3. A single price monopoly is producing an output level of 100 units where MC= $5 and MR= $3. At this output, ATC= $8, AVC= $6, and consumers' limit price is $10. The firm should: A. increase output and lower price. B. decrease output and lower price. C. increase output and increase price. D. decrease output and increase price. 4. A single price monopoly is producing an output level of 100 units where MC= $5 and MR= $5. At this output, ATC= $12, AVC= $6, and consumers' limit price is $10. This firm should: A. increase output and raise price. B. close down. C. continue to operate at a loss in the SR. D. lower output and raise price. 5. A single price monopoly is producing an output level of 100 units where MC= $5 and MR= $5. At this output, ATC= $12, AVC= $11, and consumers' limit price is $10. This firm should: A. increase output and raise price. B. close down. C. continue to operate at a loss in the SR. D. lower output and raise price. 6. Unlike perfectly competitive firms, profit maximizing monopolists produce an output where: A. MR > MC. B. P > MC. C. FC costs are maximized and AVC are minimized to take advantage of economies of scale. D. all of the above would be true. VIII 7