Micro Lecture 16: Measuring Monopoly s Effect and Multi-plant Monopoly Review: Perfect Competition, Monopoly, and Efficiency Perfect Competition, Monopoly, and Profit Maximization Perfect Competition Monopoly Large number of small independent firms. One large firm. A single firm s production A monopoly produces a decisions cannot significantly quantity and charges a price that lies affect the price. on the market demand curve. MR curve is horizontal: Profit MR curve lies beneath demand curve: MR = Price Maximization MR < Price or or Price = MR MR = MC Price > MR é ã é ã Price = MR = MC Price > MR = MC Price = MC Price > MC Pareto s Efficiency Question: Are we getting the most from our economy s finite resources? Pareto s Query: Given the state of affairs in question, is it possible to make at least one individual better off without hurting anyone else? Yes No Is state of affairs getting the most Is state of affairs getting the most from the economy s resources? No from the economy s resources? Yes State of affairs is inefficient. State of affairs is efficient.
2 Price, Marginal Cost, and Efficiency Price Consumers base their decisions on the price Marginal Cost Reflects the costs of the resources needed to produce the good Price > Marginal Cost Price < Marginal Cost Consumption decisions are Consumption decisions are based on information that based on information that overestimates underestimates the real production costs the real production costs Consumers demand too little Consumers demand too much Inefficiently low Inefficiently high level of production level of production é ã Price = Marginal Cost Efficient level of production Intuition: Accurate Information, Misleading Information, and Efficiency If the price does not equal marginal cost Consumers base their decisions on misleading information Inefficiency results If the price does equal marginal cost Consumers base their decisions on accurate information Efficiency results.
3 Quantifying the Effect of Monopoly: Consumer and Producer Surplus Review: Consumer and Producer Surplus See figure 16.1. Consumer Surplus: The net benefit buyers enjoy from purchasing and consuming the good. Height of Market emand Curve: Reflects the benefit a buyer enjoys from consuming a specific unit of the good. Consumer Surplus: The net benefit buyers enjoy from purchasing and consuming the good; the benefit each buyer enjoys from consuming the good less what each buyer must pay. Area Beneath the emand Curve Lying Above the Price: Reflects all the net benefits buyers enjoy, the consumer surplus, from purchasing and consuming the good. Producer Surplus: The net benefit sellers enjoy from producing and selling the good Height of Market Supply Curve: The seller s opportunity cost of providing a specific unit of the good. Producer Surplus: The net benefit sellers enjoy from producing and selling the good; what each seller receives from the sale of the good less the opportunity cost each seller incurs by providing it. Area above the Supply Curve Lying Beneath the Price: Reflects all the net benefit sellers enjoy, the producer surplus, from producing and selling the good. WHAT IF Question: WHAT IF the monopoly firm acted as though it was a firm in a perfectly competitive industry? To address the WHAT IF question, let us review what we learned about perfect competition. In a perfectly competitive industry: The price and quantity are determined by the market demand and supply curves. The market supply curve is the horizontal sum of each individual firm s supply curve. An individual firm s supply curve is its marginal cost curve (as long as price exceeds average variable cost). Consider figure 11.1. If the monopoly firm were to act as though it was a firm in a perfectly competitive industry: The market supply curve would be the monopolist s marginal cost curve. P C and Q C would equal the resulting price and quantity. Price ($ per hamburger) Figure 16.1: Summary of consumer and producer surplus Now, compare the monopoly and competitive Figure 16.2: Mary s fast food restaurant prices and quantities as shown in figure 16.2: P M > P C The price charged by the monopoly is greater than the competitive price. Q M < Q C The quantity produced by the monopoly is less than the competitive quantity. 2.00 P M = 1.50 P C = 1.25 1.00.50 P* P Consumer surplus MR Producer surplus Q* MC 25 50 75 100 125 150 Q M Q C Quantity (hamburgers) S Q Question: Who does monopoly hurt? Answer: Consumers. Question: Who does monopoly help? Answer: The monopoly firm.
4 Question: How can we quantify the effect on consumers, producers, and society as a whole? Price ($ per hamburger) MC A P M = 1.50 P C = 1.25 1.00 B F C E 25 50 75 100 125 150 Q M Q C Quantity (hamburgers) Figure 16.3: Mary s fast food restaurant To simplify the diagram, we have removed the grid lines and marginal revenue curve in figure 16.3: Competition Monopoly Change Consumer surplus A + B + C A Lose B and Lose C Producer surplus + E + F B + + F Gain B and Lose E Total surplus A + B + C + + E + F A + B + + F Lose C and Lose E Table 16.1: Comparison of competition and monopoly From table 16.1 we see that monopoly results in a loss to society as a whole. Total surplus decreases by C and E. This is called the dead weight loss or excess burden of a monopoly.
5 A Multi-Plant Monopoly Suppose that a monopoly firm has two plants, Plant A and Plant B. The marginal cost curves for each plant appear above along with the demand and marginal revenue curves of the monopoly in figure 16.4: Plant A Plant B emand and Marginal Revenue MC A MC A MC B MC B 100 80 60 20 MR q A q B Q 50 100 50 100 150 200 50 100 150 200 250 (units per day) (units per day) (units per day) Figure 16.4: Multi-plant monopoly Question: To maximize profits, how many units of output should Plant A produce and how many units should Plant B produce? Claim: To maximize profits, two conditions must be satisfied when a firm has two plants: Marginal costs of each plant must be equal: MC A = MC B Marginal revenue must equal each plant s marginal cost: MR = MC A = MC B
6 Now let us justify these two conditions: Marginal costs of each plant must be equal: MC A = MC B. Strategy: Show that when the marginal costs are not equal (MC A MC B ) the firm is not maximizing profits. Such a scenario is illustrated in figure 16.5: Plant A produces 50 units Plant B produces 25 units. The monopoly firm is producing a total of 75 units. Plant A Plant B q A = 50 q B = 25 MC A = $60 MC B = $30 Plant A Plant B emand and Marginal Revenue MC A MC A MC B MC B 100 80 60 20 30 MR q A q B Q 50 100 25 50 100 150 200 50 100 150 200 250 (units per day) (units per day) (units per day) Figure 16.5: Multi-plant monopoly Review the definition of marginal cost: Marginal Cost (MC) = Change in the firm s total cost resulting from a one unit change in production. Question: How would the firm s total costs be affected if Plant B produces one more unit and Plant A one less: Plant A Plant B produces 1 less unit produces 1 more unit Plant A s total costs Plant B s total costs decreases by $60 increases by $30 In net, total costs decrease by $30 while total production (and hence total revenue) remains the constant. Therefore, the firm s profits will rise by $30. Intuition: We can reduce the firm s total costs without reducing the total quantity of output produced by shifting production from the high marginal cost plant to the low marginal cost plant.
7 Question: Can this go on indefinitely? As more and more production is shifted from Plant B to Plant A: MC A decreases MC B increases Eventually, marginal costs will be equalized and no further cost reductions of this type can be achieved by transferring production. The least costly way to produce 75 units occurs whenever the marginal costs are equal; that is, whenever Plant A produces 25 units and Plant B 50 units as illustrated in figure 16.6: Plant A Plant B q A = 25 q B = 50 MC A = $ MC B = $ Plant A Plant B emand and Marginal Revenue MC A MC A MC B MC B 100 80 60 20 MR q A q B Q 25 50 100 50 100 150 200 50 100 150 200 250 (units per day) (units per day) (units per day) Figure 16.6: Multi-plant monopoly Click on the red computer icon to access the following Micro Lab 16.1. The lab allows you to check the calculations: Micro Lab 16.1: Multi-Plant Cost Minimization Marginal revenue must equal each plant s marginal cost: MR = MC A = MC B. Strategy: Show that when the firm s marginal revenue does not equal its marginal costs (MR MC A = MC B ) the firm is not maximizing profits. This scenario is illustrated in figure 16.7: Plant A produces 25 units Plant B produces 50 units. The monopoly firm is producing a total of 75 units. Plant A Plant B Total Production q A = 25 q B = 50 Q = 75 MC A = $ MC B = $ MR = $90 The monopoly firm can increase it profits by increasing total production.
8 Plant A Plant B emand and Marginal Revenue MC A MC A MC B MC B 100 80 90 60 20 MR q A q B Q 25 50 100 50 100 150 200 75 150 200 250 (units per day) (units per day) (units per day) Figure 16.7: Multi-plant monopoly Of course, as production increases at the plants, the monopoly must take care to keep the marginal costs of the two plants equal. Eventually, when Plant A produces 50 units and Plant B 100 units, firm s profits will be maximized as shown in figure 16.8: Plant A Plant B Total Production q A = 50 q B = 100 Q = 150 MC A = $60 MC B = $60 MR = $60 Plant A Plant B emand and Marginal Revenue MC A MC A MC B MC B 100 80 60 60 60 20 MR 50 100 q A 50 100 150 200 q B 50 100 150 200 2500 Q (units per day) (units per day) (units per day) Figure 16.8: Multi-plant monopoly
9 Question: What price will the monopoly charge? Answer: Figure 16.9 answers this question. The monopoly charges a price of $90 because the monopoly always produces a quantity and charges a price that lies on the market demand curve. Plant A Plant B emand and Marginal Revenue MC A MC A MC B MC B 100 80 90 60 60 60 20 MR 50 100 q A 50 100 150 200 q B 50 100 150 200 2500 Q (units per day) (units per day) (units per day) Figure 16.9: Multi-plant monopoly Access the following lab to confirm our calculations: Micro Lab 16.2: Multi-Plant Profit Maximization Today Firm A Firm B Monopoly Quantity 50 100 150 Price 90.00 Total Revenue 4,500 9,000 Total Cost 3,000 5,000 Profit 1,500 4,000 5,500 Marginal Revenue 60 Marginal Cost 60 60
Micro Lecture 17: Oligopoly and Cheating Oligopolies Many important industries in the U.S. include a few moderately sized firms. For example, the automobile industry, the cell phone industry, the airline industry, etc. These industries are not monopolies because they have more than one large firm, but on the other hand they are not perfectly competitive because they are not composed of a large number of small independent firms. These industries are called oligopolies. Perfect Competition Oligopoly Monopoly Large number of small independent firms. Few moderately sized firms. One large firm. Question: Will industries that are oligopolies they act like a monopoly or will they act like a perfectly competitive industry? Answer: In general we cannot tell. It depends on how the firms interact with each other. Why is the answer important? The answer is important from a public policy perspective. If such an industry acts like a monopoly, inefficiency would result providing justification for government intervention. In fact, anti-trust legislation is designed to prevent oligopolies from acting as though they were a monopoly. Alternatively, if the firms act like a perfectly competitive industry, intervention based on efficiency grounds would be undesirable. Perfect Competition Oligopoly Monopoly Large number of small independent firms. Few moderately sized firms. One large firm. Efficient Inefficient Preview: Challenge of Oligopoly If an industry is perfectly competitive we can straightforwardly describe the resulting price and quantity. The market demand and supply curves permit us to do this. If an industry is a monopoly, we can also straightforwardly describe the resulting price and quantity. The market demand, the monopoly s marginal revenue, and the monopoly s marginal cost curves permit us to do this. If an industry is an oligopoly, the situation is not as straightforward. The resulting price and quantity depend on how the firms interact with each other. Project: Explaining OPEC s Vacillating Behavior. We can also motivate our study of oligopoly by considering the vacillating behavior of OPEC, the Organization of Petroleum Exporting Countries. When the firms in an industry attempt to act as though they were a monopoly we say that they are acting as a cartel. OPEC is an excellent example of a cartel because the member nations meet regularly to set production quota in an effort to affect the price of petroleum. September 27, 1993: Wall Street Journal article, Bahree and Tanner report that OPEC was meeting: in an urgent attempt to regain the initiative in its effort to prop up petroleum prices Prices have fallen sharply, by about $3 a barrel this year, largely because OPEC has been producing about one million barrels a day more than its widely ignored ceiling The fall in prices has left the OPEC benchmark about $6 a barrel under the $21 target
2 September 30, 1993: Within a few days, the members of OPEC agreed upon production quotas and oil prices rose. Tanner and Bahree report in the Wall Street Journal: OPEC members agreed on how to divide their new production level and, surprisingly, extended the output arrangement to six months rather than the expected three. The accord sets a ceiling of 24.5 million barrels a day for OPEC. It is intended to reduce actual output by some 200,000 barrels a day and raise world oil prices as a result. [In London,] Brent crude rose 68 cents a barrel [In New York,] crude soared 71 cents a barrel The oil minister hailed the agreement as one of the best ever October 11, 1993: Tanner reported that World oil prices are likely to rise further over the next few weeks if the Organization of Petroleum Exporting Countries stick to its new production quotas. October 12, 1993: The New York Times reported a chink in OPEC s resolve appeared, however. An extra 300,000 or 0,000 barrels of crude oil were being produced every day: The weekly Middle East Economic Survey estimated that production by members of the Organization of Petroleum Exporting Countries rebounded to 24.8 million barrels a day The daily Platt s Oilgram News [estimated] production at nearly 24.9 million barrels a day. [Both estimates exceeded] the output ceiling of 24.5 million barrels October 26, 1993: In of the Wall Street Journal, Tanner reported oil prices quickly responded: petroleum prices [dropped] to the lowest levels since the September meeting of the Organization of Petroleum Exporting Countries. Prices of crude oil fell 50 cents a barrel or more, Summary In late September, the members of OPEC negotiated quotas to restrict the quantity of oil produced. The agreement was applauded by OPEC oil ministers. Oil prices promptly rose. The increase in oil prices proved to be short lived, however. OPEC members violated their agreement within two weeks of consummating it. Within a few weeks, the price of oil fell. Question: How can we explain the behavior of OPEC members? Preview: Conflicting Interests of an Oligopolies and Cartels: Collective Interests versus Individual Interests It is in the collective interests of the firms in an industry to establish a cartel. By colluding to reduce production below the competitive level, the firms can act like a monopoly to maximize their joint profits. Alternatively, if a cartel is established it may be in the individual interests of a firm to cheat on the cartel agreement. If the cartel agreement is in place, it may be in an individual firm s interests to produce more than the agreement allows thereby pushing production toward the competitive level. Strategy: Begin with a multi-plant monopoly and then convert it to an oligopoly.
3 Review: Multi-Plant Monopoly Recall that in the last lecture we consider a monopoly with two plants: Plant A and Plant B. Figure 17.1 depicts the profit maximizing state of affairs for the two-plaint monopoly. As we showed, to maximize profits, two conditions must be satisfied: Marginal costs of each plant must be equal: MC A = MC B Marginal revenue must equal each plant s marginal cost: MR = MC A = MC B When Plant A produces 200 units and Plant B 0 units, firm s profits will be maximized. Plant A Plant B Total Production q A = 50 q B = 100 Q = 150 MC A = $60 MC B = $60 MR = $60 Plant A Plant B emand and Marginal Revenue MC A MC A MC B MC B 100 80 90 60 60 60 20 MR 50 100 q A 50 100 150 200 q B 50 100 150 200 2500 Q (units per day) (units per day) (units per day) Figure 17.1: Multi-plant monopoly Today Firm A Firm B Monopoly Quantity 50 100 150 Price 90.00 Total Revenue 4,500 9,000 Total Cost 3,000 5,000 Profit 1,500 4,000 5,500 Marginal Revenue 60 Marginal Cost 60 60 Preview: Conflicting Interests of an Oligopolies and Cartels: Collective Interests versus Individual Interests It is in the collective interests of the firms in an industry to establish a cartel. By colluding to reduce production below the competitive level, the firms can act like a monopoly to maximize their joint profits. Alternatively, if a cartel is established it may be in the individual interests of a firm to cheat on the cartel agreement. If the cartel agreement is in place, it may be in an individual firm s interests to produce more than the agreement allows thereby pushing production toward the competitive level. Strategy: Begin with a multi-plant monopoly and then convert it to an oligopoly.
4 Oligopolies and Cartels Suppose that the owner of the monopoly firm retires and gives his two plants to his two children. The owner gives Plant A to his son, Adam, and Plant B to his daughter, Beth. Now there are two separate firms, Firm A and Firm B. Initially, Adam and Beth agree to operate the plants just like their father did. By doing so, they will be maximizing their joint profits. They will be acting as though they are simply two different plants of a single monopoly firm. As we have learned, this situation is called a cartel; their agreement is called a cartel agreement. Cartel Agreement: Adam s Firm Beth s Firm Total Production q A = 50 q B = 100 Q = 150 Price = $90 MC A = $60 MC B = $60 MR = $60 Let us calculate the total revenues of the siblings today, when the cartel agreement is in place: Today: Adam s Firm Beth s Firm TR A = Pq A TR B = Pq B = 90.0050 = 90.00100 = 4,500.00 = 9,000.00 Micro Lab 17.1 illustrates the joint profit maximizing state of affairs: Micro Lab 17.1: Joint Profit Maximization Today Firm A Firm B Joint Quantity 50 100 150 Price 90.00 Total Revenue 4,500 9,000 Total Cost 3,000 5,000 Profit 1,500 4,000 5,500 Marginal Cost 60 60 Question: Will the siblings agreement persist or will the siblings have an incentive to cheat on the agreement? Claim: The stability of the agreement depends on how each sibling would react to the actions of the other. We will consider two cases: Scenario 1: When one sibling cheats the other does not retaliate. Scenario 2: When one sibling cheats the other does retaliate.
5 Scenario 1: When one sibling cheats the other does not retaliate. We begin with the joint profit maximizing agreement in place. Today Adam s firm produces 50 units and Beth s firm 100 units; total production equals 150 units. Question: oes Adam have an incentive to cheat if Beth does not retaliate? To answer this question we should calculate Adam s marginal revenue and compare it to his marginal cost. Question: What experiment could we conduct tomorrow to calculate Adam s marginal revenue based on the premise that Beth will not retaliate? Answer: Adam could increase his production from 50 to 51 while Beth continues to produce 100 units: Quantity Firm A Firm B Joint Price Tomorrow 51 100 151 Today 50 100 150 90.00 Question: What will the price equal tomorrow? Consider the market demand curve as illustrated in figure 17.2: emand Curve Today the price equals $90.00 and consumers demand 150 units. 100 Hence, to clear the market tomorrow, the quantity demanded must increase by 1 unit. 80 To increase the quantity demanded by 1 unit, by how much must the price fall? To answer this question we calculate the slope of the demand curve: o What does the slope of the market demand 60 curve equal?.20. Slope = Rise Run = 20 20 100 =.20 o Hence, to increase the quantity demanded by 1 unit, the price must fall by $.20, from $90.00 to $89.80. 100 Figure 17.2: emand curve Now we can calculate Adam s marginal revenue: Adam s Quantity Price Adam s Total Revenue = PriceQuantity Tomorrow: 51 89.80 89.80 51 89.80 (1+50) = 89.80 + 89.80 50 Today: 50 90.00 90.00 50 Adam s Marginal Revenue = 89.80 + 89.80 50 90.00 50 = 89.80 + (89.80 90.00) 50 = 89.80 + (.20) 50 ã é TR tends to rise by 89.80, the price, as a consequence of the additional unit sold. TR tends to fall by 10.00 as a consequence of the lower price. Output Effect Price Effect é ã MR A = Adam s Marginal Revenue = 89.80 10.00 = 79.80 80 50 150 200 250 Q (units per day)
6 Now, compare Adam s marginal revenue with his marginal cost: Adam s Firm Marginal Revenue 80 Marginal Cost 60 When Adam produces one more unit and Beth does not retaliate, his profit rises by about $20: Adam produces 1 more unit Beth does not retaliate Adam s Profit = Adam s TR Adam s TC Up by 20 Up by 80 Up by 60 NB: Adam has an incentive to cheat if Beth does not retaliate. Micro Lab 17.2 allows us to check out logic: Micro Lab 17.2: Cheating without Retaliation Joint Profit Maximization Firm A Cheats Firm B oes Not Retaliate Firm A Firm B Firm A Firm B Quantity 50 100 51 100 Total Revenue 4,500 9,000 4,580 8,980 Total Cost 3,000 5,000 3,060 5,000 Profit 1,500 4,000 1,520 3,980 Cons Surplus 2,250 2,280 Firm A Cheats Firm B oes Not Retaliate Change from Joint Profit Maximization Firm A Firm B Consumer Society Profit Profit Surplus +20 20 +30 +30 The lab reveals some important points. When Adam cheats and Beth does not retaliate: Firms: o Adam s profit rises; hence, Adam has an incentive to cheat in this case. o Beth s profit falls; hence, Beth has good reason to be upset. Consumer: Consumer surplus increases. The gain in consumer surplus is greater than the loss in joint profits. Society as a whole (firms and consumers together) is better off.
7 Question: oes Beth have an incentive to cheat if Adam does not retaliate? Question: What experiment could we conduct tomorrow to calculate Beth s marginal revenue based on the premise that Adam will not retaliate? Answer: Beth could increase her production from 100 to 101 while Adam continues to produce 50 units: Quantity Firm A Firm B Joint Price Tomorrow 50 101 151 89.80 Today 50 100 150 90.00 Once again, to clear the market the quantity demanded must increase by 1 unit; since the slope of the demand curve is.20, the price must fall by $.20, from $90.00 to $89.80. Beth s Quantity Price Beth s Total Revenue = PriceQuantity Tomorrow: 101 89.80 89.80 51 89.80 (1+50) = 89.80 + 89.80 100 Today: 100 90.00 90.00 100 Beth s Marginal Revenue = 89.80 + 89.80 100 90.00 100 = 89.80 + (89.80 90.00) 100 = 89.80 + (.20) 100 ã é TR tends to rise by 89.80, the price, as a consequence of the additional unit sold. TR tends to fall by 20.00 as a consequence of the lower price. Output Effect Price Effect é ã MR B = Beth s Marginal Revenue = 89.80 20.00 = 69.80 70 Comparing Beth s marginal revenue with her marginal cost: Beth s Firm, Firm B Marginal Revenue 70 Marginal Cost 60 When Beth produces one more unit and Adam does not retaliate, her profit rises by about $10: Beth produces 1 more unit Adam does not retaliate Beth s Profit = Beth s TR Beth s TC Up by 10 Up by 70 Up by 60 NB: Beth has an incentive to cheat if Adam does not retaliate.
8 Micro Lab 17.3 allows us to check out logic: Micro Lab 17.3: Cheating without Retaliation Joint Profit Maximization Firm A Cheats Firm B oes Not Retaliate Firm A Firm B Firm A Firm B Quantity 50 100 50 101 Total Revenue 4,500 9,000 4,490 9,070 Total Cost 3,000 5,000 3,000 5,060 Profit 1,500 4,000 1,490 4,010 Cons Surplus 2,250 2,280 Firm B Cheats Firm A oes Not Retaliate Change from Joint Profit Maximization Firm A Firm B Consumer Society Profit Profit Surplus 10 +10 +30 +30 The lab reveals some important points. When Beth cheats and Adam does not retaliate: Firms: o Beth s profit rises; hence, Beth has an incentive to cheat in this case. o Adam s profit falls; hence, Adam has good reason to be upset. Consumer: Consumer surplus increases. Society as a whole: Welfare of society as a whole (firms and consumers together) increases. Summary of Scenario 1: The No Retaliation Scenario Adam s Firm, Firm A Beth s Firm, Firm B Marginal Revenue 80 70 Marginal Cost 60 60 We now calculate the effect of each sibling s profit when one sibling produces 1 more unit and the other does not retaliate: Adam produces 1 more unit Beth does not retaliate Beth produces 1 more unit Adam does not retaliate Adam s Profit = Adam s TR Adam s TC Beth s Profit = Beth s TR Beth s TC Up by 20 Up by 80 Up by 60 Up by 10 Up by 70 Up by 60 NB: Each sibling has an incentive to cheat if the other does not retaliate.
9 When one sibling cheats and the other does not retaliate: Firms: Joint profit decreases. o Cheating sibling s profit rises; hence, a sibling has an incentive to cheat. o Non-cheating sibling s profit falls; hence, the non-cheating sibling has good reason to be upset. Consumer: Consumer surplus increases. The gain in consumer surplus is greater than the loss in joint profits. Society as a whole (firms and consumers together) is better off. Adam has a greater incentive to cheat because his profit rises by more than Beth s. Why? While marginal cost is identical for the two siblings, marginal revenue is not. Marginal revenue is greater for Adam than it is for Beth. This occurs because marginal revenue depends on both the output effect and the price effect. Marginal Revenue = Output Effect Price Effect epends on Quantity The price effect tends to reduce marginal revenue and it depends on the quantity produced. Since Adam produces less, his price effect is less and consequently, his marginal revenue is greater.