Monopoly. Basic Economics Chapter 15. Why Monopolies Arise. Monopoly

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1 1 Why Monopolies Arise Basic Economics Chapter 15 Monopoly Monopoly - The monopolist is a firm that is the sole seller of a product (or service) without close substitutes - The monopolist is a price maker (setter) Barriers to entry explain a monopolist s existence 1. Monopoly resource (a single firm owns a key resource in production; resulting price is high ( high) because of mkt. power) 2. Govt. reg n (called govt.-created monopoly, the govt. gives a single firm the exclusive right to the production of a good/service; e.g., patents (e.g., ) and copyright (e.g., ) laws, that lead to higher prices due to lack of competition; cost/benefit) 3. The production process (firm is low-cost producer; e.g. natural monopoly = the firm can produce the good/service for (or supply) an entire market at a lower cost (due to economies of scale) than two or more firms; the single supplier model avoids duplication) Fig.1 Economies of Scale as a Cause of Monopoly When a firm s average-totalcost curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the smallest cost.

2 Production and Pricing Decisions Monopoly = the monopolist is a price maker; it is the sole producer; it has a downward-sloping demand curve; its demand curve is the market demand curve; thus, the monopoly has to accept a lower price if it wants to sell more output. 2 Competitive firm = is a price taker; it is one of many producers in the mkt.; its demand curve is a horizontal line (it takes price as a given); unlike the monopolist which can influence the price it charges for the good, the competitive firm has no influence. A monopoly s revenue = price times quantity Average revenue (AR) = revenue per unit sold (TR Q) Marginal revenue (MR) = revenue per each additional unit of output (or, TR Q, i.e., change in total revenue when output increases by 1 unit); MR < P, i.e., marginal revenue is always less than the price ( or the MR curve below the demand curve); MR can be negative (when price effect > output effect) When a monopolist increases its quantity sold (Q): Output effect on TR: - Q is higher so it increases total revenue Price effect on TR: - P is lower (as you move down the demand curve), so it decreases total revenue

3 Table 1 A Monopoly s Total, Average, and Marginal Revenue 3 Fig. 3 Demand and Marginal-Revenue Curves for a Monopoly The demand curve shows how the quantity affects the price of the good. The marginal-revenue curve shows how the firm s revenue changes when the quantity increases by 1 unit. Because the price on all units sold must fall if the monopoly increases production, marginal revenue is always less than the price. Profit maximization: If MR > MC, then increase production If MR < MC, then lower production Maximize profit: Produce quantity where MR = MC (i.e., at the intersection of the MR and MC curves; given Q, calculate price on the demand curve)

4 4 Profit maximization: Perfect competition: P = MR = MC Price equals marginal cost Monopoly: P > MR = MC Price exceeds marginal cost A monopoly s profit: Profit, = TR TC = (P ATC) ˣ Q Fig. 4 Profit Maximization for a Monopoly A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B).

5 Fig. 5 The Monopolist s Profit 5 Case Study: Monopoly Drugs versus Generic Drugs The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the number of units sold. Market for pharmaceutical drugs For a new drug, patent laws give the firm monopoly power. Thus, the firm produces Q where MR = MC but also where P > MC The generic drugs mkt. is a competitive mkt. so the typical firm produces Q where MR = MC but also where P = MC. Thus the price of the competitively produced generic drug is below the monopolist s price Fig. 6 The Market for Drugs When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug. When the patent on a drug runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost.

6 The Welfare Cost of Monopolies Total surplus = the economic well-being of buyers and sellers in a market (it s the sum of consumer surplus and producer surplus); consumer surplus = consumers willingness to pay for a good minus what they actually pay for it; producer surplus = amount producers receive for a good minus their costs of producing it 6 If a benevolent social planner runs a monopoly, to maximize total surplus it would produce Q where the MC intersects the demand curve, i.e., where price charged is P = MC On the other hand, the monopolist produces Q where MR = MC But it produces less than the socially efficient quantity of output and so charges a higher price, P > MC, resulting in a deadweight loss (the triangle between the demand curve and MC curve) Fig. 7 The Efficient Level of Output A benevolent social planner who wanted to maximize total surplus in the market would choose the level of output where the demand curve and marginalcost curve intersect. Below this level, the value of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good. Beyond this level, the value to the marginal buyer is less than marginal cost.

7 Fig. 8 The Inefficiency of Monopoly 7 The monopoly s profit: a social cost? Monopolist s higher profit does not necessarily mean a reduction of economic welfare because with the smaller consumer surplus, there is also a bigger producer surplus; thus, it s not a social problem Social loss (due to the deadwt. loss that comes from the inefficiently low quantity of output; the low output is due to consumers discouraged by the higher price) Price Discrimination Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer). Price discrimination = the business practice of selling the same good at different prices to different customers. Examples: movie tickets; airline prices; discount coupons; quantity discounts; others? (1) it s a rational strategy to increase profit (2) it requires the ability to separate customers according to their willingness to pay (market segmentation) (3) it can raise economic welfare

8 8 Monopoly with perfect price discrimination - Charge each customer a different price (which is exactly his or her willingness to pay) - As a result the monopolist gets the entire surplus (Total surplus = Profit) - No deadweight loss (consumer surplus = 0) Monopoly without price discrimination (single uniform price but > MC) - Total surplus = Consumer surplus + Producer surplus (also = Profit) - There is deadweight loss because some consumers can t afford the higher price. Fig. 9 Welfare with and without Price Discrimination Panel (a) shows a monopolist that charges the same (uniform) price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus.

9 Public Policy Toward Monopolies Increasing competition with antitrust laws Sherman Antitrust Act, 1890; Clayton Antitrust Act, 1914; Prevent mergers (but some mergers have synergies); Break up companies/promote competition; Prevent companies from coordinating their activities to make markets less competitive Regulation Regulate the behavior of monopolists (pricing) Common in the case of natural monopolies like water and electric companies Marginal-cost pricing but price may be less than ATC and would make the firm exit the business; It gives the firm no incentive to reduce costs on its own Table 2 Competition versus Monopoly: A Summary Comparison 9