Chapter 24: Monopoly. Watanabe Econ Monopoly 1 / 61. Watanabe Econ Monopoly 2 / 61. Watanabe Econ Monopoly 3 / 61

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1 Econ 33 Microeconomic Analysis Chapter 4: Monopoly Instructor: Hiroki Watanabe Spring 13 Watanabe Econ 33 4 Monopoly 1 / 61 1 Introduction Monopolist s Profit Maximization Problem 3 Inefficiency of Monopoly 4 Summary Watanabe Econ 33 4 Monopoly / 61 1 Introduction Monopolist s Profit Maximization Problem 3 Inefficiency of Monopoly 4 Summary Watanabe Econ 33 4 Monopoly 3 / 61

2 Project 1.1 (Overview of Producer Theory) 18 Technology 19 Profit Maximization Problem Cost Minimization Problem 1 Cost Curves Firm Supply 3 Aggregate Supply 4 Monopoly Monopoly Behavior 6 Oligopoly Watanabe Econ 33 4 Monopoly 4 / 61 Closely related to Ch1B Elasticity. A monopolized market has a single seller. The monopolist s demand curve is not flat (like perfect competitors) but aggregate demand curve itself. The monopolist can alter the market price by adjusting its output level. Watanabe Econ 33 4 Monopoly / 61 Example 1. (Coca Cola Faces Downward-Sloping Demand Curve) Take a listen to Marketplace Audio Clip. So when you have price increases hitting, more consumers are going to be looking at that bottle of Coca-Cola and saying, "Do I really need this?" How is Coca Cola s decision different from price taker s? Watanabe Econ 33 4 Monopoly 6 / 61

3 Marginal Cost, Marginal Revenu, Price ($) AC(y) Aggregate Demand Cheesecakes y (slices) Watanabe Econ 33 4 Monopoly 7 / 61 Marginal Cost, Marginal Revenu, Price ($) AC(y) Aggregate Demand Cheesecakes y (slices) Watanabe Econ 33 4 Monopoly 8 / 61 Factor Legal fiat Patent Sole ownership of a resource Large economies of scale Example Watanabe Econ 33 4 Monopoly 9 / 61

4 1 Introduction Monopolist s Profit Maximization Problem Solving Monopolist s PMP Marginal Condition Doesn t Give Price Example 3 Inefficiency of Monopoly 4 Summary Watanabe Econ 33 4 Monopoly 1 / 61 Problem.1 (PMP in a Perfectly Competitive Environment) max y π(y) = py TC(y). Problem. (Monopolist s PMP) Watanabe Econ 33 4 Monopoly 11 / 61 Compare price-taker Jack Example.4 in Ch to monopolistic Jack: Watanabe Econ 33 4 Monopoly 1 / 61

5 Example.3 (Price-Taker Jack) Suppose that Jack has the following production environment ( Example.4 in Ch): y TR(y) TC(y) π(y) Δπ Watanabe Econ 33 4 Monopoly 13 / 61 Total Revenue [$] TR(y) TC(y) π(y) Cheesecake y [slices] Watanabe Econ 33 4 Monopoly 14 / π(y) Total Revenue [$] Cheesecake y [slices] Watanabe Econ 33 4 Monopoly 1 / 61

6 Example.4 (Monopolistic Jack) Suppose that Jack has the following production environment: y TR(y) TC(y) π(y) Δπ Watanabe Econ 33 4 Monopoly 16 / 61 3 TR(y) TC(y) π(y) Total Revenue, Total Cost, Profit ($) Cheesecake y (slices) Watanabe Econ 33 4 Monopoly 17 / 61 8 MWTP, MR, MC ($) π(y) Cheesecake y (slices) Watanabe Econ 33 4 Monopoly 18 / 61

7 Comparison between price-taker Jack and monopolistic Jack. Two oddities with monopolistic Jack (everything else is the same): Fact. (Monopolist s Revenue) 1 Total revenue TR(y) curls up. Marginal revenue is not flat anymore and drops faster than. Watanabe Econ 33 4 Monopoly 19 / 61 Decode ➊ in Fact. : Definition.6 (Two Counteracting Effect on Total Revenue) 1 Quantity effect: Sell more, and earn more. Price effect: Sell more, price drops, and earn less. Watanabe Econ 33 4 Monopoly / 61 3 TR(y) TC(y) π(y) Total Revenue, Total Cost, Profit ($) Cheesecake y (slices) Watanabe Econ 33 4 Monopoly 1 / 61

8 Decode ➋ in Fact. : Breakdown of marginal revenue: If Jack sells the nd slice, price drops from 8 to 7. 1 He will earn $7 from the nd slice (same as MWTP(7)) but he will lose $1 from the 1st slice (take a dollar off MWTP(8)). 1 = } {{ } incremental revenue from an additional slice sold > Δ + y. Δy } {{ } additional revenue from existing sales < 1 See Ch. TR (y) = [y] = + MWTP (y)y. Watanabe Econ 33 4 Monopoly / 61 8 MWTP, MR, MC ($) π(y) Cheesecake y (slices) Watanabe Econ 33 4 Monopoly 3 / 61 Solving Monopolist s PMP How does Fact. affect the way monopolistic Jack solves Problem.? Some are the same as a trap. Problem.1, and then there s Watanabe Econ 33 4 Monopoly 4 / 61

9 Solving Monopolist s PMP Fact.7 (Monopolistic Pricing) Monopolistic Jack s two-step pricing procedure: 1 Use marginal condition to find y. = Now ditch after you get y. (And here s the trap). Then plug y back in (NOT ) to find the price p = MWTP(y ). Watanabe Econ 33 4 Monopoly / 61 Solving Monopolist s PMP Two suspicions with Fact.7 : Question.8 (Monopolistic Pricing) 1 Why do monopolistic Jack and price-taker Jack share the same marginal condition: =? Price-taker Jack used to have p =. Then shouldn t monopolistic Jack do the same thing to find the price rather than setting p =? Watanabe Econ 33 4 Monopoly 6 / 61 Solving Monopolist s PMP Answer to ➊ in Question.8 : TC(y) still runs parallel to TR(y) at y. Watanabe Econ 33 4 Monopoly 7 / 61

10 Solving Monopolist s PMP 3 TR(y) TC(y) π(y) Total Revenue, Total Cost, Profit ($) Cheesecake y (slices) Watanabe Econ 33 4 Monopoly 8 / 61 Solving Monopolist s PMP 8 MWTP, MR, MC ($) π(y) Cheesecake y (slices) Watanabe Econ 33 4 Monopoly 9 / 61 Solving Monopolist s PMP Consider What if not? What would mean? < Watanabe Econ 33 4 Monopoly 3 / 61

11 Marginal Condition Doesn t Give Price Answer to ➋ in Question.8 : Watanabe Econ 33 4 Monopoly 31 / 61 Marginal Condition Doesn t Give Price In Example.4, y = 3 TC(3) = 1 MR(3) = 4 MWTP(3) = 6. If he charges MR(3) and MWTP(3), what would be his profit levels? Total cost is the same. Find the total revenue in the following: Watanabe Econ 33 4 Monopoly 3 / 61 Marginal Condition Doesn t Give Price 8 MWTP, MR, MC ($) π(y) Cheesecake y (slices) Watanabe Econ 33 4 Monopoly 33 / 61

12 Marginal Condition Doesn t Give Price Liz is happy to pay MWTP(3) = 6 dollars for the 3rd slice. Then what s the point of charging MR(3) = 4 dollars instead? Conclude: marginal condition is there to find the optimal quantity y. Not the price. Watanabe Econ 33 4 Monopoly 34 / 61 Example Example.9 (Monopolist s PMP) Suppose monopolistic Jack faces = y + 1 with = y + 1. a His marginal cost is = y. What is his optimal production level y and the price p? a I ll get you in the exam. Just know that drops faster than. Use Fact.7. Watanabe Econ 33 4 Monopoly 3 / 61 Example 1 Marginal Cost, Marginal Revenue, Price ($) Cheesecakes y (slices) Watanabe Econ 33 4 Monopoly 36 / 61

13 1 Introduction Monopolist s Profit Maximization Problem 3 Inefficiency of Monopoly Monopolistic Pricing Yields Deadweight Loss Marginal Cost Pricing Yields Pareto Optimum 4 Summary Watanabe Econ 33 4 Monopoly 37 / 61 Monopolistic Pricing Yields Deadweight Loss A word monopoly has a derogatory connotation to it. Is it? It is. Watanabe Econ 33 4 Monopoly 38 / 61 Monopolistic Pricing Yields Deadweight Loss Monopolistic Jack maximizes his profit by choosing y from = and set the price at p = MWTP(y ). This result (y, p) maximizes Jack s profit. Not society s. Watanabe Econ 33 4 Monopoly 39 / 61

14 Monopolistic Pricing Yields Deadweight Loss How do we evaluate (y, p)? Is there anything better than (y, p) Compute the sum of consumer and producer surplus (called total surplus). If (y, p) maximizes total surplus, then allocation thus derived is Pareto optimal. 3 Take Example.9. 3 More on this in Ch16, 31. Watanabe Econ 33 4 Monopoly 4 / 61 Monopolistic Pricing Yields Deadweight Loss Marginal Cost, Marginal Revenue, Price ($) Cheesecakes y (slices) Watanabe Econ 33 4 Monopoly 41 / 61 Marginal Cost Pricing Yields Pareto Optimum What if we ask monopolistic Jack to act as if he is in a perfectly competitive market? Watanabe Econ 33 4 Monopoly 4 / 61

15 Marginal Cost Pricing Yields Pareto Optimum Marginal Cost, Marginal Revenue, Price ($) Cheesecakes y (slices) Watanabe Econ 33 4 Monopoly 43 / 61 Marginal Cost Pricing Yields Pareto Optimum y p PS CS TS DWL Monopolistic pricing Marginal cost pricing Difference Watanabe Econ 33 4 Monopoly 44 / 61 Marginal Cost Pricing Yields Pareto Optimum Discussion 3.1 (Conflict with Marginal Cost Pricing) 1 Why doesn t monopolistic Jack produce 4 cheesecakes? Why is y = 3 not an efficient outcome? Watanabe Econ 33 4 Monopoly 4 / 61

16 Marginal Cost Pricing Yields Pareto Optimum 1 Jack won t produce the 4th slice because 1 MC(4) = 8 MR(4) = 4. y = 3 is not Pareto optimal because 1 MC(3) = 6 MWTP(3) = 9. Watanabe Econ 33 4 Monopoly 46 / 61 1 Introduction Monopolist s Profit Maximization Problem 3 Inefficiency of Monopoly 4 Summary Watanabe Econ 33 4 Monopoly 47 / 61 Scale economy is one reason that an industry becomes monopolistic. Consider an electricity company. 1 Fixed costs: laying cables Marginal costs: adding a subscriber If there are large fixed costs and small marginal costs with respect to the market size, a phone company becomes a natural monopolist. Natural because it happens without patent protection etc. Watanabe Econ 33 4 Monopoly 48 / 61

17 MR, MWTP, MC, AC ($) AC(y) Cheesecakes y (slices) Watanabe Econ 33 4 Monopoly 49 / 61 A natural monopoly arises when Jack s technology has economies of scale large enough for him to supply the whole market at a lower average total production cost than is possible with more than one firm in the market. Because of a large fixed cost, elimination of deadweight loss becomes a bit tricky. Watanabe Econ 33 4 Monopoly / 61 If we impose marginal cost pricing, what would happen to Jack s profit? Watanabe Econ 33 4 Monopoly 1 / 61

18 MR, MWTP, MC, AC ($) AC(y) Cheesecakes y (slices) Watanabe Econ 33 4 Monopoly / 61 We could get rid of the deadweight loss. But now Jack will exit the market (y = ). Then the whole total surplus will be gone. That s even worse than before. Watanabe Econ 33 4 Monopoly 3 / 61 Alternative regulation: average cost pricing. Watanabe Econ 33 4 Monopoly 4 / 61

19 MR, MWTP, MC, AC ($) AC(y) Cheesecakes y (slices) Watanabe Econ 33 4 Monopoly / 61 y p DWL TR(y) TC(y) π(y) Laissez-faire Marginal cost pricing Average cost pricing Watanabe Econ 33 4 Monopoly 6 / 61 Discussion 4.1 (Average Cost Pricing) Is average cost pricing implementable? If it is, what would be the long-term effect? Watanabe Econ 33 4 Monopoly 7 / 61

20 1 Can a government force average cost pricing? What s the long-term effect? Watanabe Econ 33 4 Monopoly 8 / 61 1 Introduction Monopolist s Profit Maximization Problem 3 Inefficiency of Monopoly 4 Summary Watanabe Econ 33 4 Monopoly 9 / 61 Monopolist s PMP. Inefficiency of monopoly. Possible regulations and associated problems. Watanabe Econ 33 4 Monopoly 6 / 61

21 Index average cost pricing, 4, 7 consumer surplus, 4 deadweight loss, 44,, 3 economies of scale, 9 legal fiat, 9 marginal condition,, 34 marginal cost, 3 marginal cost pricing, 44, 1 marginal revenue, 19, marginal willingness to pay, 16, see marginal cost monopolistic pricing,, see marginal willingness to pay natural monopoly, 48 optimal quantity, 34 Pareto optimal, 4 patent, 9 price effect, producer surplus, 4 profit maximization problem, 11 quantity effect, total revenue, 13, 16, 19 total surplus, 4 TR(y), see total revenue y, see optimal quantity Watanabe Econ 33 4 Monopoly 61 / 61