To do today. Profit maximizing equilibrium in Single- price monopoly Price discrimina-ng monopoly

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1 Course informa-on Final exam: Tuesday, 12/ in Machmer W 15 If you have a conflict, go the the Registrar s office and they will give you a form saying which exam can be changed. Final exam will cover the chapters on perfect compe--on, monopoly, monopolis-c compe--on up to page 329 only and oligopoly up to page 350 ( Other Oligopoly Games ).

2 To do today Profit maximizing equilibrium in Single- price monopoly Price discrimina-ng monopoly Regula-ng monopoly Efficient (MC) pricing Average cost pricing Price cap regula-on Rate of return regula-on

3 Elas-city and revenue again 1. If a price fall increases total revenue, demand is elas-c. 2. If a price fall decreases total revenue, demand is inelas-c.

4 Elas-city and the demand curve again Elas-city will change along the demand curve, as we have seen This means that to know the effect of a change in price, must know where you are on the demand curve

5 Elas-city and MR along the demand curve

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7 Monopoly equilibrium Same profit maximizing rule: MC = MR But now, P or AR is above MR So, monopoly sells a smaller output at a higher price

8 Graphing monopoly equilibrium

9 Full profit- maximizing story Rule: MC = MR Again same as profit maximizing rule in compe--on The average total cost curve is ATC. The marginal cost curve is MC. The demand curve is D. The marginal revenue curve is MR.

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11 Monopoly vs compe--on Tricky bit The price the monopoly charges at its profit maximizing output is from its DEMAND curve, like usual Not from its MR curve, which is now below the demand curve

12 Characteris-cs of monopoly Economic profit > 0 Price is higher than compe--ve level Output is less than the compe--ve level And now, have deadweight loss So monopoly is not efficient

13 Where to compare monopoly and compe--on? Perfectly compe--ve equilibrium where MC (S) = MB (price and demand curve) So, on the monopoly graph, perfect compe--ve is where S=MC curve intersects the demand curve

14 Monopoly vs compe--on

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16 Consequences of monopoly Higher equilibrium prices Lower equilibrium quan-ty Deadweight loss (MC not = MB)

17 Efficient regula-on of a monopoly Problem: compared to compe--on, monopoly price too high and output too low Solu+on: Set MC = MB (and price) to mimic compe--ve equilibrium

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19 Price discrimina-ng monopoly Price discrimina-on selling a good or service at a number of different prices is widespread. To be able to price discriminate, a firm must Iden-fy and separate different types of buyers. Sell a product that cannot be resold.

20 Price discrimina-on and consumer surplus Goal: to convert consumer surplus into economic profit by charging different categories of consumers different prices Perfect price discrimina-on: each individual customer pays separate price schedule based on that customer s own willingness to pay.

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22 Perfect price discrimina-on

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24 Price discrimina-on and efficiency Price equals MC, so deadweight loss is zero But consumer surplus now all goes to producer Rent seeking becomes profitable and rent seekers use up the whole producer surplus

25 MC pricing regula-on

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27 Efficient regula-on causes a problem Problem: forces firms to incur losses Solu+on: Second- best regula-on of a natural monopoly Two possible ways of enabling a regulated monopoly to avoid an economic loss Average cost pricing Government subsidy

28 Alterna-ve regula-on Average Cost Pricing Rule: P = ATC Government Subsidy A direct payment to the firm, but the government must finance the subsidy by taxing some other ac-vity, which will create a deadweight loss.

29 Average cost pricing regula-on

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31 Problems with AC pricing Less than efficient quan-ty produced Price higher than MC Deadweight loss Some consumer surplus goes now to producer surplus

32 Rate of return regula-on Problem: might not be possible to be sure what the firm s costs are Solu+on: firm must set its price at a level that enables it to earn a specified target percent return on its capital If the regulator could observe the firm s true costs and be sure that the firm was minimizing cost, this type of regula-on would be like average cost pricing

33 Price cap and earnings share regula-on Problem: same as rate of return regula-on Solu+on: A price cap (ceiling) a rule that specifies the highest price the firm is permiged to charge Can be combined with earnings sharing regula+on a regula-on that requires a firm to make refunds to customers if its profit rises above a target rate.

34 Industries that may have price caps Often important services; many have economies of scale

35 Price cap regula-on

36 Price cap regula-on 1. With no regula-on, the firm maximizes profit by producing the quan-ty at which MC = MR. 2. A price cap set at $ The price cap outcome is at the intersec-on of the demand curve and the price cap. 4. The price falls and output increases.

37 Finishing monopoly: rent seeking Rent is any form of surplus producer, consumer or economic profit Comes from barriers to entry But firms can enter if pay the price NY taxi medallion Poten-al entrants bid up price -ll economic profit = 0

38 Finishing monopoly: rent seeking Point: lobby to create barriers to entry Example: tomato lobby and laws limi-ng tomato imports Compe--on among rent seekers raises costs Equilibrium has no economic profit

39 Finishing monopoly: rent seeking

40 Monopolis-c compe--on A large number of firms compete no market dominance or collusion Each firm produces a differen-ated product Firms compete on price, product quality, and marke-ng Firms are free to enter and exit

41 Product differen-a-on Product that is slightly different from the products of compe-ng firms Has close subs-tutes but not perfect subs-tutes

42 Monopolis-c compe--on vs perfect Two key differences: in monopolis-c compe--on, there is compe--on Excess capacity A markup of price over marginal cost

43 Compe-ng on quality, price, and marke-ng Quality Design, reliability, aker- sales service, etc. Price Compe--on in monopolis-c compe--on Marke+ng Two main forms: adver-sing and packaging

44 The profit maximizing decision and economic profit Decision rule: operate where MC = MR Note the same as the usual decision rule, in perfect compe--on and in monopoly as well.

45 Equilibrium of the monopolis-c compe-tor

46 The profit maximizing output and the 1. Profit is maximized when MR = MC. 2. The profit- maximizing output is 125 pairs of Tommy jeans per day. economic profit 3. The profit- maximizing price is $75 per pair. ATC is $25 per pair, so 4. The firm makes an economic profit of $6,250 a day.

47 Profit maximiza-on might be loss minimizing Some firms in monopolis-c compe--on have a tough -me making a profit. A burst of entry into an industry can limit the demand for each firm s own product.

48 Move to the long run: zero economic profit Economic profit induces entry and economic loss induces exit, as in perfect compe--on. Entry decreases the demand for the product of each firm. Exit increases the demand for the product of each firm. In the long run, economic profit is competed away and firms make zero economic profit.

49 Move to the long run: zero economic profit

50 Long run profit situa-on 1. The output that maximizes profit is 75 pairs of Tommy jeans a day. 2. The price is $50 per pair. Average total cost is also $50 per pair. 3. Economic profit is zero.

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52 Output and price decisions: long run 1. The efficient scale is 100 pairs of Tommy jeans a day. 2. The firm produces less than the efficient scale and has excess capacity. 3. Price exceeds 4. marginal cost by the amount of 5. the markup. 6. Deadweight loss arise.

53 Problems with monopolis-c compe--on in the long run Deadweight Loss Because P > MC, monopolis-c compe--on creates deadweight loss Higher than minimum ATC Lower output and higher price than compe++ve But, economic profit = 0

54 Innova-on and product development Wherever economic profits are earned, imitators emerge. To maintain economic profit, a firm must seek out new products. Cost Versus Benefit of Product Innova+on The firm must balance the cost and benefit at the margin.

55 Efficiency and product innova-on Value of innova-on to the consumer: MB MB = MR = MC in equilibrium Here, because P > MC, product improvement is not pushed to its efficient level.

56 Adver-sing costs and total costs Adver-sing expenditures increase the costs of a monopolis-cally compe--ve firm above those of a perfectly compe--ve firm or a monopoly. Adver-sing costs are fixed costs. Adver-sing costs per unit decrease as produc-on increases.

57 Effect of adver-sing cost on total cost 1. When adver-sing costs are added to 2. The average total cost of produc-on, 3. Average total cost increases by a greater amount at small outputs than at large outputs.

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59 Effect of adver-sing cost on total cost 4. If adver-sing enables sales to increase from 25 pairs of jeans a day to 100 pairs a day, the average total cost falls from $60 a pair to $40 a pair.

60 Adver-sing (selling) costs and demand Adver-sing and other selling efforts change the demand for a firm s product. The effects are complex: A firm s own adver-sing increases the demand for its product. Adver-sing by all firms might decrease the demand for any one firm s product and might make demand more elas-c. The price and markup might fall.

61 No adver-sing graphically

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63 Effects of adver-sing graphically

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65 Summary of effects of adver-sing 1. With adver-sing, average total cost increases. 2. If adver-sing enables more firms to survive, new firms might be encouraged to enter the market. 3. Then demand for any one firm s product decreases. 4. If all firms adver-se, the demand for any one firm s product becomes more elas-c.

66 Why adver-se? Signaling quality Some adver-sing is very costly and has almost no informa-on content about the item being adver-sed. Such adver-sing is used to signal high quality. Signaling works because it is profitable to signal high quality and deliver it but unprofitable to signal a high quality product and not deliver it.

67 Brand names Also used to provide informa-on about the quality of a product Costly to establish a widely recognized brand name Signal high quality Work because it is unprofitable to incur the cost of crea-ng a brand name and then deliver a low quality product

68 Efficiency of adver-sing and brand names Adver-sing and brand name can be efficient if the marginal cost of the informa-on equals its marginal benefit. The final verdict on the efficiency of monopolis-c compe--on is ambiguous: there are benefits (consumer choice of differen-ated products) and costs (deadweight loss and higher than minimum ATC)

69 Introduc-on to oligopoly Core concept - interdependence of firm decisions Structure only a few firms Interdependence if one firm lowers its price, others must do the same to keep its customers Asymmetry but if one firm raises price, others won t and that firm loses customers

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