Eco 300 Intermediate Micro Instructor: Amalia Jerison Office Hours: T 12:00-1:00, Th 12:00-1:00, and by appointment BA 127A, aj4575@albany.edu A. Jerison (BA 127A) Eco 300 Spring 2010 1 / 61
Monopoly Market power: a seller or a buyer has market power if they can on their own influence the price of a good. Monopoly and monopsony are examples of markets where some agents have market power. Monopoly is a market with only one seller. Monopsony is a market with only one buyer. Competition can be viewed as a special case of monopoly where the demand curve is horizontal. Therefore we discuss monopoly first, then competition. A. Jerison (BA 127A) Eco 300 Spring 2010 2 / 61
In reality, purely competitive markets are rare. Most markets have buyers, sellers with some degree of power to affect price of good. The monopoly model can be used to describe the output (or pricing policy) of firms that have sufficient market power so that they don t have strategic interactions with rival firms. Strategic interaction means that a firm must consider responses by other firms to a change in price or quantity of its own good. A. Jerison (BA 127A) Eco 300 Spring 2010 3 / 61
Microsoft can be considered a monopoly with its operating system. Despite the fact that there are substitutes to the Microsoft operating system (Linux, Apple), the products are differentiated enough so that people still buy Microsoft even though the Linux operating system is free. The compatibility between Microsoft programs and the Linux operating system is not perfect. This causes many people who use Microsoft programs to stay with the Microsoft operating system. A. Jerison (BA 127A) Eco 300 Spring 2010 4 / 61
The classic example of a monopsony is a one-employer town. For example a mining town where the only work is in the mine. The employing firm would also have a monopoly in the sale of food and other goods to its workers. They could keep workers at subsistence level by raising prices whenever wages increased. Now in the United States, the availability of cars has allowed workers in such communities not to buy at the company store, thus breaking the monopoly power of such firms. A. Jerison (BA 127A) Eco 300 Spring 2010 5 / 61
A firm doesn t need to be the only employer in a town to have monopsony power. For example, if every family has one member working for a certain firm, that firm can exert monopsony power by threatening to lay off large numbers of workers if they don t accept low wages. A. Jerison (BA 127A) Eco 300 Spring 2010 6 / 61
In this class, we will concentrate on monopoly. The special thing about the demand curve for a monopolist s output is that it is the market demand curve (you have to define the market to be small enough). If the output is not a Giffen good, the demand curve does not slope upward. The demand curve for the output of a single competitive firm is a horizontal line. A. Jerison (BA 127A) Eco 300 Spring 2010 7 / 61
A monopolist can control the price of its product by controlling the amount of output supplied. Monopolists can take advantage of this control to get more profit in general than a competitive firm. In general the price of a product under monopoly will be higher, quantity supplied lower, than in competitive market. Look at how the monopolist chooses output quantity to maximize profit. A. Jerison (BA 127A) Eco 300 Spring 2010 8 / 61
To choose the profit-maximizing quantity, firm must know its average revenue and its marginal revenue as well as its marginal cost. average revenue is the revenue received per unit sold. Monopolist s average revenue is the market demand P (Q). Revenue equals Q P (Q), so average revenue is = P (Q). Q P (Q) Q Monopolist s marginal revenue is the additional revenue it gets from an additional unit sold. This is not equal to the price, because when the firm increases output, the price for all units sold must decrease. Therefore the marginal revenue is less than the price at all units greater than zero. A. Jerison (BA 127A) Eco 300 Spring 2010 9 / 61
The marginal revenue curve lies below the demand curve. To see this, note that marginal revenue is the derivative of revenue with respect to quantity. Revenue is given by QP (Q), the quantity of the good sold times the price it was sold at. Differentiating revenue with respect to quantity, we get d(qp (Q))/dQ = QP (Q) + P (Q). Since demand is downward-sloping (for a non-giffen good), P (Q) < 0 at all Q. So for positive Q, MR = QP (Q) + P (Q) < P (Q). A. Jerison (BA 127A) Eco 300 Spring 2010 10 / 61
Consider a monopolist whose demand curve is given by the equation P = 6 Q There are two ways to calculate the marginal revenue for this firm. The first way is to take the difference between revenues for successive units of output sold. At P = $6, no unit is sold. At P = $5, 1 unit is sold. So the marginal revenue at 1 unit of output is the price of the first unit sold, which is $5. At P = $4, 2 units are sold. The marginal revenue at 2 units of output is the difference between revenue at 2 units and revenue at 1 unit. This is 2 4 1 5 = $3. A. Jerison (BA 127A) Eco 300 Spring 2010 11 / 61
At P = $3, 3 units are sold. The marginal revenue at 3 units of output is 3 3 8 = 1. At P = $2, 4 units are sold. The marginal revenue at 4 units of output is 4 2 9 = 1. So the marginal revenue has become negative for 4 units of output sold. Graphing the marginal revenue curve with the demand curve, it can be seen that marginal revenue curve lies below the demand curve and both are downward-sloping. A. Jerison (BA 127A) Eco 300 Spring 2010 12 / 61
The other way to get the marginal revenue for this particular demand function is to take the derivative with respect to Q of the revenue function. This is d(qp (Q))/dQ = d/dq(6q Q 2 ) = 6 2Q. To compare with the marginal revenue we got in the other way, we calculate the marginal revenue for Q = 1, 2, 3, 4. At Q = 1, it is $4. At Q = 2, it is $2. At Q = 3, it is $0. The marginal revenue found in this way is clearly not the same as the marginal revenue found the other way. This way gives the exact marginal revenue. The other way gives an approximation. A. Jerison (BA 127A) Eco 300 Spring 2010 13 / 61
How does the monopolist decide how much to produce? The monopolist chooses the output level that sets marginal cost equal to marginal revenue. This is the solution to the first-order condition for maximizing revenue minus cost. The firm wants to maximize profit, which is revenue minus cost. This can be written Π(Q) = QP (Q) C(Q). To maximize it, find the value of Q at which its derivative equals zero. For this to be a maximum and not a minimum, the second derivative has to be negative (i.e. the function is concave). A. Jerison (BA 127A) Eco 300 Spring 2010 14 / 61
dπ/dq = QP (Q) + P (Q) C (Q) = 0. So MR(Q) = C (Q) at the solution, which means marginal revenue equals marginal cost. To see if this is a maximum, take the second derivative of profit. This is QP (Q) + 2P (Q) C (Q). If this is negative, then the solution to dπ/dq = 0 is a profit-maximizing quantity. It will be negative as long as the marginal cost curve is higher than the demand curve somewhere and at some price quantity demanded is zero. A. Jerison (BA 127A) Eco 300 Spring 2010 15 / 61
Intuitively we can explain why MR should equal MC in the following way: Let Q be the quantity at which MR=MC. Suppose the monopolist produces at Q 1 < Q. Then MR > MC. The monopolist could increase profit by the amount MR MC by producing slightly more. It could keep on increasing profit in this way until it reaches Q. Suppose the monopolist produces at Q 2 > Q. Then MR < MC. The monopolist could increase profit by MC MR by producing slightly less, until it reaches Q. So the monopolist will produce at Q, the output at which marginal revenue equals marginal cost. A. Jerison (BA 127A) Eco 300 Spring 2010 16 / 61
To determine the price the monopolist will charge, the monopolist first chooses its output level as the output level Q that sets marginal revenue equal to marginal cost. Then, using the demand curve, the firm determines at what price Q units of output will be bought. That is the price that the monopolist charges. Monopolist s profit is (AR(Q) AC(Q)) Q. A. Jerison (BA 127A) Eco 300 Spring 2010 17 / 61
Example: Suppose C(Q) = 50 + Q 2. This means that there is a fixed cost of production of $50 and the variable cost is Q 2. Suppose demand is given by P (Q) = 40 Q. Set marginal revenue equal to marginal cost to find profit maximizing output. Draw total cost, marginal cost, marginal revenue, and demand (average revenue) curves. Show graphically the monopolist s profit. A. Jerison (BA 127A) Eco 300 Spring 2010 18 / 61
The marginal revenue curve can be found by finding revenue at each quantity and differentiating it. Revenue at Q is P (Q)Q, which is 40Q Q 2. The derivative of this is MR(Q) = 40 2Q. Notice that when the demand curve is linear, the slope of the marginal revenue curve is twice that of the demand curve. Also notice that the P intercept of marginal revenue is the same as that of demand. A. Jerison (BA 127A) Eco 300 Spring 2010 19 / 61
Costs, Price P* MC AC MR D Q* A. Jerison (BA 127A) Eco 300 Spring 2010 20 / 61 Q
A rule for pricing In practice, managers of a firm may not know exactly what demand and costs are. Thus they don t know their exact marginal revenue and marginal cost functions. To find a rule for pricing, notice that marginal revenue equals d(p Q)/dQ = P + QdP/dQ = P (1 + (Q/P )dp/dq) = P (1 + 1/ɛ d ), where ɛ d is the firm s price elasticity of demand. Setting marginal revenue equal to marginal cost gives P + P/ɛ d = MC, or (P MC)/P = 1/ɛ d. Then P = MC/(1 + 1/ɛ d ). A. Jerison (BA 127A) Eco 300 Spring 2010 21 / 61
This is a helpful way of judging whether current prices should be changed. If the marginal cost is significantly lower than before and managers have no reason to think that elasticity of demand has changed, they should probably lower prices. As a rough estimate, firms often assume that elasticity of demand does not vary too much with quantity sold. A. Jerison (BA 127A) Eco 300 Spring 2010 22 / 61
Example: Suppose marginal cost is initially $2, optimal price is $3. What must the elasticity of demand be for this product? What if the marginal cost decreased to $1 with no change in elasticity. How would the firm change the price? A. Jerison (BA 127A) Eco 300 Spring 2010 23 / 61
Shifts in demand In a competitive market, the relationship between price and quantity supplied is given by a supply curve. A monopoly has an optimal output quantity for each demand curve. In the special case of a competitive firm, each demand curve is determined by the output price, so the firm s response to changes in demand curves is the competitive response to changes in prices. Effect of a shift in the demand curve - show graphically. A. Jerison (BA 127A) Eco 300 Spring 2010 24 / 61
price MC P1 P2 D2 D1 Q2 Q1 MR2 MR1 quantity A. Jerison (BA 127A) Eco 300 Spring 2010 25 / 61
A shift in the demand curve will often have an effect on both the price and the output. The shift in demand curve changes the marginal revenue, which changes the output level at which marginal revenue equals marginal cost (assuming the marginal cost function stays the same). The amount of output bought at each price will also be different from before the shift. A. Jerison (BA 127A) Eco 300 Spring 2010 26 / 61
The effect of a tax In a monopoly, the price change due to a tax can sometimes be larger than the amount of the tax. Suppose a tax of t dollars per unit of output sold is imposed on a monopolist. The firm s marginal and average costs are increased by the amount t. So, if MC is the original marginal cost function, the new profit maximizing quantity Q should solve MR(Q) = MC(Q) + t. The marginal cost curve shifts upward by the amount t. This results in smaller quantity and higher price. The increase in price may exceed the amount of the tax. This could not happen in a competitive market. A. Jerison (BA 127A) Eco 300 Spring 2010 27 / 61
Price, cost MC2 MC1 Pb P1 Ps MR D quantity A. Jerison (BA 127A) Eco 300 Spring 2010 28 / 61
Price, cost Pb P0 MC+t D MC MR quantity A. Jerison (BA 127A) Eco 300 Spring 2010 29 / 61
Price, cost Pb MC P1 Ps MR2 MR 1 D2 D Q2 Q1 quantity A. Jerison (BA 127A) Eco 300 Spring 2010 30 / 61
A multiplant firm Many firms produce in several different plants. The production costs of these plants may be different. How should a firm divide output between the plants? A. Jerison (BA 127A) Eco 300 Spring 2010 31 / 61
Suppose a firm has two plants. Total output should be divided between the plants so that marginal cost is the same in both plants. (Note that average costs need not be the same). Suppose marginal costs were not the same, and MC 1 (Q 1 ) > MC 2 (Q 2 ). Then the firm could reduce costs by increasing production in firm 2 and decreasing it in firm 1, keeping total production the same. A. Jerison (BA 127A) Eco 300 Spring 2010 32 / 61
Since output is produced so that marginal revenue equals marginal cost, the marginal cost at both firms equals marginal revenue. To show this algebraically, let Q 1 and C 1 be the output and cost function for firm 1, and Q 2 and C 2 the output and cost function for firm 2. Let Q T = Q 1 + Q 2. Then profit is π = P (Q T )Q T C 1 (Q 1 ) C 2 (Q 2 ). The derivative of this with respect to Q 1 is MR(Q T ) MC 1 (Q 1 ), which must equal zero at a maximum. Thus MR = MC 1 (Q 1 ) at a profit-maximizing level of output. The same argument shows that MR = MC 2 (Q 2 ) as well. A. Jerison (BA 127A) Eco 300 Spring 2010 33 / 61
Monopoly power There are not many examples of pure monopoly. But a firm can still face a downward-sloping demand curve even when there are other firms in the market. The demand curve for each firm is likely to be more elastic than the demand curve for the industry. Suppose that initially all firms in the market are charging the same price for their product. When one firm raises its price, demand will not necessarily drop to zero. This can be because that firm s product is slightly different from the other firms. A. Jerison (BA 127A) Eco 300 Spring 2010 34 / 61
Measuring monopoly power A difference between a competitive firm and a firm with monopoly power is: For a competitive firm price equals marginal cost at the profit maximizing output level. For a firm with monopoly power, price exceeds marginal cost at the profit maximizing output level. Such a firm sets marginal revenue equal to marginal cost, and the demand curve lies above the marginal revenue curve. A. Jerison (BA 127A) Eco 300 Spring 2010 35 / 61
A way to measure monopoly power is to see by how much price exceeds marginal cost. The Lerner index of monopoly power is L = P MC P. For a perfectly competitive firm, L = 0. The larger L a firm has, the more monopoly power it will tend to have. A. Jerison (BA 127A) Eco 300 Spring 2010 36 / 61
From above, (P MC)/P = 1/E d, where E d is the elasticity of the firm s demand curve. So the smaller in magnitude elasticity of demand is, the larger the markup. The equation P = MC 1+(1/E d can be used by a firm to determine its ) price. However, it is more difficult to determine the elasticity of demand for one firm than for the whole market. A. Jerison (BA 127A) Eco 300 Spring 2010 37 / 61
Sources of monopoly power The less elastic a firm s demand curve, the more monopoly power it has (other things equal). What determines the elasticity of demand for a firm s product? 1. Elasticity of market demand (a firm s demand curve is at least as elastic as the market demand curve). A. Jerison (BA 127A) Eco 300 Spring 2010 38 / 61
2. Number of firms in the market. In general the more firms there are, the less effect on price one firm s actions will have. Natural barriers to entry into a market can limit the number of firms in it. For example high fixed costs that a firm must incur in order to enter the market. 3. Interaction among firms. The interaction between firms in a market could be more or less aggressive. The more aggressive it is, the less a firm will try to raise prices. A. Jerison (BA 127A) Eco 300 Spring 2010 39 / 61
Competition A competitive market is characterized by these three conditions: 1. Firms are price takers. An individual firm s actions cannot have an effect on the price of the output (or inputs). 2. Firms produce nearly identical products. So the output of any one firm is a close substitute for the output of another firm. If one firm raises the price, all the business will go to other firms. 3. There is free entry and exit. New firms can easily enter the market without incurring any special costs. They can easily exit the market if they are not making profit in the long run. A. Jerison (BA 127A) Eco 300 Spring 2010 40 / 61
Examples of competitive industries: Agriculture the quality of agricultural products is similar for different farms in the same region. There are a large number of farms. Oil, gasoline, raw materials are quite homogeneous. The pharmaceutical industry is not competitive, as potential entrants must incur high costs of research and development to produce their own drugs, or pay license fees to a firm that holds a patent. A. Jerison (BA 127A) Eco 300 Spring 2010 41 / 61
How to tell if a market is competitive? It can be difficult to tell. Even with many firms in a market, it is possible for them to collude (agree to set prices at some level higher than marginal cost). Even when there are few firms in the market, there can be intense competition among them. If the market demand for a product is very elastic, it is possible that even with only a few firms, the market is close to competitive. A. Jerison (BA 127A) Eco 300 Spring 2010 42 / 61
The demand curve for an individual competitive firm is a horizontal line whatever quantity the firm offers, the price they can get is the same. This is unlike a monopoly, which can increase price by reducing output. For a competitive industry, though, the demand curve is generally downward sloping. A. Jerison (BA 127A) Eco 300 Spring 2010 43 / 61
Since the demand curve for a competitive firm is horizontal, the firm s marginal revenue (the additional revenue it gets from selling an additional unit of output) equals price. Unlike for a monopoly, price does not decrease when more output is sold. All firms produce where marginal revenue equals marginal cost. So for a competitive firm, this is equivalent to marginal cost equals price. A. Jerison (BA 127A) Eco 300 Spring 2010 44 / 61
Short run profit maximization by a competitive firm If a firm produces at all it should produce where marginal revenue equals marginal cost. If the price is below average variable cost, the firm should shut down. If the price is equal to or above average variable cost, the firm should produce where P = MR = MC. A. Jerison (BA 127A) Eco 300 Spring 2010 45 / 61
If the firm shuts down, it still has to pay the fixed costs. It can only avoid paying these by going out of business. But the firm may expect to earn more profits in the future, and not want to go out of business. Since the fixed costs cannot be retrieved by shutting down, the firm makes more by producing when price exceeds average variable cost. This is true even if price is below average total cost, so that the firm is making a loss. Therefore the competitive firm s short run supply curve is the portion of its marginal cost curve above the average variable cost. A. Jerison (BA 127A) Eco 300 Spring 2010 46 / 61
When an input price changes, the firm s cost function and marginal cost function will change. An increase in input price will cause the marginal cost curve to shift up. Then the new intersection of the short run supply curve with the demand curve (horizontal at price) moves to the left. A. Jerison (BA 127A) Eco 300 Spring 2010 47 / 61
The short run market supply curve is the sum of the individual firms short run supply curves. At each price, sum the quantities supplied by all the firms. A. Jerison (BA 127A) Eco 300 Spring 2010 48 / 61
Long run profit maximization In the long run, all inputs are variable. Also, in the long run firms can decide to enter or exit the industry. The long run demand curve for an individual firm is still a horizontal line. The long run profit maximizing output of a competitive firm is where long run marginal cost equals price. A. Jerison (BA 127A) Eco 300 Spring 2010 49 / 61
Long run competitive equilibrium An industry is in long run competitive equilibrium if three conditions hold: 1. All firms are maximizing profits 2. All firms are earning zero economic profit. So no firm has an incentive to enter or exit the industry. 3. The quantity supplied by the industry equals the quantity demanded at that price. A. Jerison (BA 127A) Eco 300 Spring 2010 50 / 61
Firms stay in business when earning zero economic profit. The costs of the firm include the opportunity costs of not investing the money used for capital elsewhere, and the opportunity cost of the owner s time and effort. So when a firm earns zero economic profit, it could do no better by going out of business. If a firm earns negative economic profit in the long run, it will go out of business, because it could do better by investing its resources elsewhere. A. Jerison (BA 127A) Eco 300 Spring 2010 51 / 61
Suppose all firms in an industry have the same costs. If firms in the industry are earning positive profit, more firms will enter the market. This causes the market supply curve to shift to the right, causing equilibrium price to fall if the market demand curve is downward sloping. Firms will enter until price falls enough so that profits are zero. At this point, no more firms will enter. A. Jerison (BA 127A) Eco 300 Spring 2010 52 / 61
If all firms in an industry are earning negative profit, then firms will exit the industry. This will cause the market supply curve to shift to the left. Price rises until it is such that firms are earning zero economic profit. A. Jerison (BA 127A) Eco 300 Spring 2010 53 / 61
Now consider an industry where firms have different costs. For example, one firm could have been started later, and built its factories with newer technology. This allows it to produce at lower average and marginal cost. In this case firms with lower costs can earn positive profit in the long run. A. Jerison (BA 127A) Eco 300 Spring 2010 54 / 61
Industry s long run supply curve We can t add up individual firms long run supply curves to get the market long run supply curve. This is because in the long run firms will be entering and exiting the market. So we don t know how many firms supply curves to add. Distinguish between industries where there are economies of scale (input prices fall as more output is produced), diseconomies of scale (input prices rise as more output is produced) or constant returns (input prices do not change as more output is produced). A. Jerison (BA 127A) Eco 300 Spring 2010 55 / 61
1. Constant-cost industry Cost, price Firm Cost, price Industry MC S1 S2 AC P1 D1 D output outp A. Jerison (BA 127A) Eco 300 Spring 2010 56 / 61
The long run supply curve in a constant cost industry is a horizontal line at the price that is the long run minimum average cost. If price were any higher in the short run (for example due to a demand shock), firms would make positive profit. Then new firms would enter, shifting the short run supply curve to the right. This happens until price again equals minimum average cost. A. Jerison (BA 127A) Eco 300 Spring 2010 57 / 61
Firm Cost, price Industry S2 SL P3 AC1 MC2 AC2 P2 P1 MC1 S1 D1 D2 output output A. Jerison (BA 127A) Eco 300 Spring 2010 58 / 61
The long run market supply curve in an increasing cost industry is upward sloping. When the market demand curve shifts to the right, short run price increases to equal the new point of intersection between short run supply and demand. Then existing firms are making positive profit, so more firms enter the industry. As more firms enter, the input prices for all firms increase. So average cost curves rise. This happens until profits for all firms again equal zero. At that point no more firms enter the market. The new equilibrium price is higher than the original price. A. Jerison (BA 127A) Eco 300 Spring 2010 59 / 61
Firm Cost, price Industry D1 D2 S1 S2 P2 AC1 P1 AC2 P3 SL output output A. Jerison (BA 127A) Eco 300 Spring 2010 60 / 61
When there is a positive demand shock, the new intersection of short run supply and demand lies above the original price. Thus firms make positive profits, so more firms enter the market. As more firms enter the market, the short run supply curve shifts to the right, and average costs decrease for all firms. Then even more firms enter, until the short run supply curve intersects the demand curve at the new minimum of average costs. A. Jerison (BA 127A) Eco 300 Spring 2010 61 / 61