Chapter 24 Monopoly Introduction States have various licensing requirements for individuals who wish to practice specific professions. For example, Ohio requires a $100 license fee to become a kick boxer. Other states mandate specific education requirements for interior designers. What are the economic effects of these and other legal requirements for entry into a profession? Chapter 24 will explore the answer to this question. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-2 Learning Objectives Identify situations that can give rise to monopoly Describe the demand and marginal revenue conditions a monopolist faces Discuss how a monopolist determines how much output to produce and what price to charge Evaluate the profits earned by a monopolist Understand price discrimination Explain the social cost of monopolies Copyright 2014 Pearson Education, Inc. All rights reserved. 24-3 1
Chapter Outline Definition of a Monopolist Barriers to Entry The Demand Curve a Monopolist Face Elasticity and Monopoly Cost and Monopoly Profit Maximization Calculating Monopoly Profit On Making Higher Profits: Price Discrimination The Social Cost of Monopolies Copyright 2014 Pearson Education, Inc. All rights reserved. 24-4 Did You Know That... Private hospitals are among the most profitable companies in the U.S.? A common characteristic among the most profitable private hospitals is that they are all the only large, full-service hospitals located within the regions surrounding the cities in which they are based. In this chapter, you will learn the reasons for substantial profits earned by a monopoly, a business that is the only seller. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-5 Definition of a Monopolist Monopolist A single supplier of a good or service for which there is no close substitute The monopolist therefore constitutes the entire industry Copyright 2014 Pearson Education, Inc. All rights reserved. 24-6 2
Barriers to Entry Question How does a firm obtain monopoly power? Answer Barriers to entry that allow the firm to make long-run economic profits Barriers to entry are restrictions on who can start as well as stay in business. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-7 International Example: The Canadian Wheat Monopoly In Canada, the Canadian Wheat Board is the only entity permitted by law to sell the wheat produced by the country s farmers. It purchases the harvest from all farmers and then acts as the sole supplier. This is an example of monopoly. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-8 Barriers to Entry (cont'd) Barriers to entry include: Ownership of resources without close substitutes Economies of scale Legal or governmental restrictions Copyright 2014 Pearson Education, Inc. All rights reserved. 24-9 3
Barriers to Entry (cont'd) Ownership of resources without close substitutes The Aluminum Company of America (ALCOA) at one time owned most of of the world s bauxite Copyright 2014 Pearson Education, Inc. All rights reserved. 24-10 Barriers to Entry (cont'd) Economies of scale Low unit costs and prices drive out rivals The largest firm can produce at the lowest average total cost Copyright 2014 Pearson Education, Inc. All rights reserved. 24-11 Barriers to Entry (cont'd) Natural Monopoly A monopoly that arises from the peculiar production characteristics in an industry It usually arises when there are large economies of scale One firm can produce at a lower average cost than can be achieved by multiple firms Copyright 2014 Pearson Education, Inc. All rights reserved. 24-12 4
Figure 24-1 The Cost Curves That Might Lead to a Natural Monopoly Copyright 2014 Pearson Education, Inc. All rights reserved. 24-13 Barriers to Entry (cont'd) Legal or governmental restrictions Licenses, franchises, and certificates of convenience Examples include Electrical utilities Radio and television broadcasting Copyright 2014 Pearson Education, Inc. All rights reserved. 24-14 Policy Example: Waging Economic War on Children s Lemonade Stands Some children who become entrepreneurs by opening a neighborhood lemonade stand find themselves confronted with law-enforcement officials requiring payment of a license fee. Typically, these children give up the lemonade business and search for other income-generating opportunities in the neighborhood. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-15 5
Barriers to Entry (cont'd) Legal or governmental restrictions Patents Intellectual property Tariffs Taxes on imported goods Regulation Government enforcement of safety and quality Copyright 2014 Pearson Education, Inc. All rights reserved. 24-16 The Demand Curve a Monopolist Faces The monopolist faces the industry demand curve because the monopolist is the entire industry Copyright 2014 Pearson Education, Inc. All rights reserved. 24-17 The Demand Curve a Monopolist Faces (cont'd) Recall that under perfect competition Firm faces perfectly elastic demand curve, it is a price taker The forces of supply and demand establish the price per unit Marginal revenue, average revenue, and price are all the same Copyright 2014 Pearson Education, Inc. All rights reserved. 24-18 6
The Demand Curve a Monopolist Faces (cont'd) Marginal revenue equals the change in total revenue due to a one-unit change in the quantity produced and sold Copyright 2014 Pearson Education, Inc. All rights reserved. 24-19 The Demand Curve a Monopolist Faces (cont'd) Perfect competition versus monopoly The perfect competitor doesn t have to worry about lowering price to sell more In a purely competitive situation, the firm accounts for a small part of the market It can sell its entire output, whatever that may be, at the same price Copyright 2014 Pearson Education, Inc. All rights reserved. 24-20 The Demand Curve a Monopolist Faces (cont'd) Perfect competition versus monopoly The more the monopolist wants to sell, the lower the price it has to charge on the last unit sold To sell the last unit, the monopolist has to lower the price because it is facing a downward sloping demand curve Copyright 2014 Pearson Education, Inc. All rights reserved. 24-21 7
Figure 24-2 Demand Curves for the Perfect Competitor and the Monopolist Copyright 2014 Pearson Education, Inc. All rights reserved. 24-22 The Demand Curve a Monopolist Faces (cont'd) Monopoly Single seller Faces entire industry demand Must lower price to sell more Not all units sold for same price (MR < P) Perfect Competition Many sellers Faces perfectly elastic demand Must produce more to sell more All units sold for same price (P = MR) Copyright 2014 Pearson Education, Inc. All rights reserved. 24-23 Elasticity and Monopoly The monopolist faces a downward-sloping demand curve (its average revenue curve) That means that it cannot charge just any price with no changes in quantity (a common misconception) because, depending on the price charged, a different quantity will be demanded Copyright 2014 Pearson Education, Inc. All rights reserved. 24-24 8
Figure 24-3 Marginal Revenue: Always Less Than Price Copyright 2014 Pearson Education, Inc. All rights reserved. 24-25 Elasticity and Monopoly (cont'd) Question If a monopoly raises price, what will happen to quantity demanded? Hint Remember how consumers respond to a change in price Copyright 2014 Pearson Education, Inc. All rights reserved. 24-26 Elasticity and Monopoly (cont'd) Recall A monopolist is a single seller of a well-defined good or service with no close substitute Think of some imperfect substitutes. The demand curve slopes downward because individuals compare marginal satisfaction to cost Copyright 2014 Pearson Education, Inc. All rights reserved. 24-27 9
Elasticity and Monopoly (cont'd) After all, consumers have limited incomes and unlimited wants The market demand curve, which the monopolist alone faces in this situation, slopes downward because individuals compare the marginal satisfaction they will receive to the cost of the commodity to be purchased Copyright 2014 Pearson Education, Inc. All rights reserved. 24-28 Costs and Monopoly Profit Maximization We assume profit maximization is the goal of the pure monopolist, just as it is for the perfect competitor Copyright 2014 Pearson Education, Inc. All rights reserved. 24-29 Costs and Monopoly Profit Maximization (cont'd) Perfect competitor has only to decide on the profit-maximizing output rate because price is given The perfect competitor is a price taker For the pure monopolist, we must seek a profit-maximizing price output combination The monopolist is a price searcher Copyright 2014 Pearson Education, Inc. All rights reserved. 24-30 10
Costs and Monopoly Profit Maximization (cont'd) Price Searcher A firm that must determine the price-output combination that maximizes profit because it faces a downward-sloping demand curve Copyright 2014 Pearson Education, Inc. All rights reserved. 24-31 Costs and Monopoly Profit Maximization (cont'd) We can determine the profit-maximizing price-output combination with either of two equivalent approaches: By looking at total revenues and total costs or By looking at marginal revenues and marginal costs Copyright 2014 Pearson Education, Inc. All rights reserved. 24-32 Costs and Monopoly Profit Maximization (cont'd) Total revenues-total costs approach Maximize the positive difference between total revenues and total costs Marginal revenue-marginal cost approach Profit maximization will also occur where marginal revenue equals marginal cost Copyright 2014 Pearson Education, Inc. All rights reserved. 24-33 11
Costs and Monopoly Profit Maximization (cont'd) Question Why produce where marginal revenue equals marginal cost? Answer This is where the greatest positive difference between total revenue and total cost occurs Copyright 2014 Pearson Education, Inc. All rights reserved. 24-34 Figure 24-4 Monopoly Costs, Revenues, and Profits, Panel (a) Copyright 2014 Pearson Education, Inc. All rights reserved. 24-35 Figure 24-4 Monopoly Costs, Revenues, and Profits, Panels (b) and (c) Copyright 2014 Pearson Education, Inc. All rights reserved. 24-36 12
Costs and Monopoly Profit Maximization (cont'd) Producing past where MR = MC Result is that incremental cost will exceed incremental revenue Producing less than where MR = MC The monopolist is not maximizing profits through this approach either Copyright 2014 Pearson Education, Inc. All rights reserved. 24-37 Figure 24-5 Maximizing Profits Copyright 2014 Pearson Education, Inc. All rights reserved. 24-38 Cost and Monopoly Profit Maximization (cont d) Real-World Informational Limitations Price searching by a less-than perfect competitor is a process A monopolist can only estimate the actual demand curve and make an educated guess when it sets its profit-maximizing profit For the perfect competitor, price is given already by the intersection of market demand and supply Copyright 2014 Pearson Education, Inc. All rights reserved. 24-39 13
Example: Trial and Error Yields Profits from Monopoly Time in the Air Since the late 2000s, airlines have been taking advantage of their position as monopoly sellers during the duration of flights. In addition to charging for checked bags, snacks, and pillows, some airlines are now experimenting with fees for more comfortable seats. Other airlines offer travel concierge services that assist passengers with booking items in their destination cities. As monopoly providers, airlines are searching for prices that will maximize profits. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-40 Calculating Monopoly Profit Monopoly profit is given by the shaded area in Figure 24-6, which is equal to total revenues (P Q) minus total costs (ATC Q) Copyright 2014 Pearson Education, Inc. All rights reserved. 24-41 Figure 24-6 Monopoly Profit Copyright 2014 Pearson Education, Inc. All rights reserved. 24-42 14
Calculating Monopoly Profit (cont'd) No guarantee of profits The term monopoly conjures up the notion of a greedy firm ripping off the public If ATC is everywhere above AR, or demand No price-output combination allows the monopolist to cover costs Copyright 2014 Pearson Education, Inc. All rights reserved. 24-43 Figure 24-7 Monopolies: Not Always Profitable Copyright 2014 Pearson Education, Inc. All rights reserved. 24-44 Policy Example: The U.S. Rail Monopoly that Subsists on Taxpayer Handouts Amtrak has a near-monopoly on U.S. intercity rail service. Nevertheless, it continues to suffer economic losses. To keep passenger rail lines operating, the federal government provides a subsidy to cover Amtrak s losses. So even though Amtrak charges loss-minimizing prices, the revenues generated from passenger fares are less than total costs. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-45 15
On Making Higher Profits: Price Discrimination Price Discrimination Selling a given product at more than one price, with the difference being unrelated to differences in cost Copyright 2014 Pearson Education, Inc. All rights reserved. 24-46 On Making Higher Profits: Price Discrimination (cont'd) Price Differentiation Establishing different prices for similar products to reflect differences in marginal cost in providing those commodities to different groups of buyers Copyright 2014 Pearson Education, Inc. All rights reserved. 24-47 On Making Higher Profits: Price Discrimination (cont'd) Necessary conditions for price discrimination 1. The firm must face a downward-sloping demand curve 2. The firm must be able to readily (and cheaply) identify buyers or groups of buyers with predictably different elasticities of demand 3. The firm must be able to prevent resale of the product or service Copyright 2014 Pearson Education, Inc. All rights reserved. 24-48 16
Example: Why Students Pay Different Prices to Attend College Out-of-pocket tuition rates for any two college students can differ by considerable amounts, even if the students happen to major in the same subjects and enroll in many of the same courses. The reason for this is that colleges offer students diverse financial aid packages depending on their financial need. To document their need for financial aid, students must provide detailed information about family income and wealth. This information helps the college determine the prices that different families are most likely to be willing and able to pay, so that it can engage in price discrimination. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-49 Figure 24-8 Toward Perfect Price Discrimination in College Tuition Rates Copyright 2014 Pearson Education, Inc. All rights reserved. 24-50 The Social Cost of Monopolies Comparing monopoly with perfect competition Let s assume a monopolist comes in and buys up every single perfect competitor Notice the monopolist produces a smaller quantity and sells at a higher price Copyright 2014 Pearson Education, Inc. All rights reserved. 24-51 17
The Social Cost of Monopolies (cont'd) Comparing monopoly with perfect competition Monopolists raise the price and restrict production compared to a perfectly competitive situation Consumers pay a price that exceeds the marginal cost of production and resources are misallocated in such a situation Copyright 2014 Pearson Education, Inc. All rights reserved. 24-52 What If... Governments protect local retailers from big-box retailers such as Wal-Mart and Target? When local activists succeed in opposing the opening of a new retailer, they also serve to protect local stores from competition. This means that local sellers can charge prices higher than what would prevail under perfect competition. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-53 Figure 24-9 The Effects of Monopolizing an Industry Copyright 2014 Pearson Education, Inc. All rights reserved. 24-54 18
You Are There: Seeking Higher Rents from Souvenir Vendors in Atlanta For the past 20 years, Stanley Hambrick and Larry Miller have been paying an annual rent of $250 to operate a vending stand at Turner Field, where they sell baseball souvenirs and T-shirts. Now, Atlanta has granted monopoly rights for the vending space to a property-management company. Rental rates now range from $500 per month to $1,600 per month, depending on the location of the vending stand. Vendors now face monopoly rents as much as 77 times higher than what they used to pay. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-55 Issues & Applications: The U.S. Occupational License Explosion In states across the land, licensing rules have been expanding with each passing year. Table 24-1 on the next slide lists some of the occupations that require licenses in at least a few U.S. states. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-56 Table 24-1 Selected Occupations Requiring Licenses in Some U.S. States Copyright 2014 Pearson Education, Inc. All rights reserved. 24-57 19
Issues & Applications: The U.S. Occupational License Explosion (cont d) To obtain an occupational license, people typically must pay a fee and engage in a period of study. These licenses create monopoly profits for incumbents already established in the profession. After controlling for other determinants of incomes, economists have found licensing requirements can boost incomes by 15 percent. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-58 Summary Discussion of Learning Objectives (cont'd) Why a monopoly can occur Barriers to entry Demand and marginal revenue conditions faced by a monopolist Because the monopolist constitutes the entire industry, it faces the entire market demand curve. Marginal revenue is less than price. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-59 Summary Discussion of Learning Objectives (cont'd) How a monopolist determines how much output to produce and what price to charge Seeks to maximize its economic profits Produces where marginal revenue equals marginal cost Charges maximum price for the amount of output where MR = MC Copyright 2014 Pearson Education, Inc. All rights reserved. 24-60 20
Summary Discussion of Learning Objectives (cont'd) A monopolist s profits Profit earned by monopolist is equal to the difference between the price it charges and its average production cost times the amount of output it produces and sells. Monopolist typically earns positive economic profits. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-61 Summary Discussion of Learning Objectives (cont'd) Price discrimination Selling at more than one price with the price differences being unrelated to differences in production costs. Monopolist sells some of its output at higher prices to consumers with less elastic demand. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-62 Summary Discussion of Learning Objectives (cont'd) Social cost of monopolies Price exceeds marginal cost. The price is higher and output is lower for a monopolist as compared to a perfectly competitive industry. Copyright 2014 Pearson Education, Inc. All rights reserved. 24-63 21
Appendix G: Consumer Surplus in a Perfectly Competitive Market Given the market clearing price that prevails in the perfectly competitive market, consumer surplus is: the difference between the total amount that consumers would have been willing to pay and the total amount that they actually pay Copyright 2014 Pearson Education, Inc. All rights reserved. 24-64 Figure G-1 Consumer Surplus in a Perfectly Competitive Market Copyright 2014 Pearson Education, Inc. All rights reserved. 24-65 Appendix G: How Society Loses from Monopoly Deadweight Loss The portion of consumer surplus that no one in society is able to obtain in a situation of monopoly No one in society, not even the monopoly, can obtain this deadweight loss Copyright 2014 Pearson Education, Inc. All rights reserved. 24-66 22
Appendix G: How Society Loses from Monopoly (cont d) As a result of monopoly, consumers are worse off in two ways: The monopoly profits that result constitute a transfer of a portion of consumer surplus away from consumers to the monopolist The failure of the monopoly to produce as many units as would have been produced under perfect competition eliminates consumer surplus that otherwise would have been a benefit to consumers Copyright 2014 Pearson Education, Inc. All rights reserved. 24-67 Figure G-2 Losses Generated by Monopoly Copyright 2014 Pearson Education, Inc. All rights reserved. 24-68 23