Micro Monopoly Essentials 1 WCC As we've said before, perfect competition is the benchmark against which we will judge all other market structures. It is ideal in the sense that it achieves productive and allocative efficiency in the long run. Not all industries are perfectly competitivethe first of these alternative structures is monopoly. Pure Monopoly an industry in which there is only one supplier of a product for which there are no close substitutes, and in which it is very hard or impossible for other firms to enter or exist Monopoly assumptions 1) One firm 2) Significant barriers to entry exist 3) No close substitutes Types of barriers to entry Legal restrictions often government granted or supported monopolies o U.S. Postal Service, local utilities Patents in some sense, these are a form of legal restriction o Sole commercial rights to an invention or creation o Designed to encourage innovation and technical progress Sole control of a scarce resource o Perrier Water controls the springs at Perrier, France Deliberately erected barriers to entry barriers created by the firm itself o Threats of lawsuits, aggressive price cutting and heavy advertising Gross technical superiority tends to be temporary o IBM, Google, Facebook are all examples Economies of scale perhaps the most interesting barrier o Results from declining analytical ATC curve o Often leads to the regulation of the industry
Graph Analytical versus historical cost curves ATC ATC T Economies of scale is most interesting case as far as we are concerned. Their existence means one large firm can produce output more cheaply than several smaller firms. This results in what we will call a natural monopoly. Demand curve for the perfectly competitive firm We assumed there were many, many firms producing identical products. As a result, the PC firm s demand curve is horizontal. They can only charge the market price. As a result, we refer to PC firms as price takers. Demand curve for the monopolist There is only one firm in this market. The market demand curve is the firm s demand curve Demand for a monopolist is downward sloping. Therefore, monopolists have many prices to chose from. Monopolists are price searchers. This does not meant monopolists can sell any quantity and charge any price. Once they pick a price, the demand curve tells them how much they can sell. Once the pick a quantity, the demand curve tells them how much they can charge. D = AR= PC Firm Monopoly
Average revenue AR = TR/ = Px/ = P The monopolist's AR curve is the same as his demand curve. (Again, this is true for every industry type.) Marginal revenue Keep in mind that every unit is sold at the same price here. = TR/ P = P1 (P 0 P 1 ) * 0 selling an additional unit requires discounting all previous units < P Graph P 0 P 1 D 0 1
Calculus Aside A little calculus quickly shows us what looks like. Start by assuming that the demand curve is linear o It can be written in this form then: P = b + m Total Revenue = Px, so substitute in (b + m) for P her to get: TR = b + m2 is the slope of TR, so is the first derivative of TR. Take the first derivative of the TR. o = dtr/d = b + 2m Results This equation has the same vertical intercept as the demand curve, b. So, and the demand curve start at the same point. The equation is fits the template for an equation of a line. So, is linear, just like the demand curve. The slope of the curve is 2m, twice as steep as the slope of the demand curve. So, falls twice as fast as the demand curve. b Slope = -m Slope = -2m D
Profit maximization Despite appearances, monopolists have the same fundamental goal as perfect competitors profit maximization. Profit is still defined as TR TC, so our old rule applies. Profit is maximized when the firm produces *, where =MC. To find the price, we go up to the demand curve at the level of output. This gives us P*. P MC ATC P* AVC * Monopoly Profit in the Short Run Monopolists are not omnipotent. Being a monopolist does not guarantee one a profit. o Profit is still defined as = TR TC o TR = Px and TC = ATCx o So = Px ATCx o Or = (P ATC)x Thus, if P > ATC at optimal output, the monopolist is earning a profit. This is no different than profit for a PC firm. Likewise the shutdown conditions remain the same.
Summarizing shut down conditions Situation If P > ATC IF P < AVC If AVC < P < ATC Action The firm is earning a profit and should keep producing. The firm is losing money and should shut down immediately. The firm is losing money, but should produce in the short run and shut down in the long run. Monopoly Profit in the Long Run Being a monopolist does not guarantee you a profit in the short run. However, there are significant barriers to entry under monopoly. Thus no firm can enter the industry to compete away profits that may exist in the longrun. Ergo, while PC firms cannot earn an economic profit in the long run, economic profits may persist for monopolists in the long run. Comparing the monopolized industry to a PC industry Assume we monopolize a PC industry. The demand curve for the PC industry would then be the monopoly firm s demand curve. The supply curve for the PC industry is the same as the monopoly s MC curve. The PC industry would have produced where the MC/Supply curve hit the demand curve. The monopoly firm will produce where the curve intersects the MC curve. Essentially, monopolies restrict output and raise price. The monopolist produces less and charges more than a perfectly competitive industry. P MC P M P PC M PC
Monopoly efficiency, or lack thereof Examine the graph below. Monopolies do not produce at the low point of the ATC curve. o Therefore, monopolies are not productively efficient. We know perfectly competitive output was allocatively efficient. Monopolies produce less than a perfectly competitive industry. o Therefore, monopolies are not allocatively efficient. Monopolies lead to inefficient production and inefficient resource allocation. The price that a monopoly charges is above the lowest point on the ATC curve. o Therefore, monopolies charge more than PC firms would. Caveats Monopoly may shift the demand curve out by advertising. This can close the gap between monopoly production and PC production. Very large firms may sometimes be needed to fund innovation. Monopolies may exist due to economies of scale. o These are what we call natural monopolies. Monopolies and fixed costs/taxes Why don't monopolies like taxes? Do they care when their fixed costs go up? Can t they just pass the tax or fixed cost on to the consumer? Examine the graph below. In this graph, a monopoly has been hit with a licensing fee, a fixed cost. o ATC rises, but there is no change on or MC, so * does not change. o Neither does P*. None of this tax is passed on to the consumer in the form of a higher price. The monopolist bears the full burden of the tax. P MC ATC 1 P* ATC 0 AVC *
Monopolies and variable costs/taxes In this graph, a monopoly has been hit with an excise tax, a variable cost. o All three cost curves rise, and the intersection between and MC occurs at a lower output level. o The new level of output is lower than the old level of output. o The new price, P, is higher than the old price, P*. o However, the price does not go up as much as the MC went up. o In other words, the monopolist does not pass on all of the tax to us. Only a portion of this tax is passed on to the consumer in the form of a higher price. The monopolist bears part of the burden. P P P* MC ATC AV *