Transcript Monopoly

Chapter 13
Monopoly
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline





Market Power
How a Firm Uses Market Power to Maximize Profit
The Costs of Monopoly: Deadweight Loss
The Costs of Monopoly: Corruption and Inefficiency
The Benefits of Monopoly: Incentives for Research
and Development
 Economies of Scale and the Regulation of Monopoly
 Other Sources of Market Power
2
Introduction
 Since 1981 AIDS has
killed over 36 million
people.
 In the U.S., deaths from
AIDS dropped 50% due
to drugs like Combivir.
 A Combivir pill costs $0.50 to produce, but sells
for 25 times higher - $12.50.
INGRAM PUBLISHING/VETTA/GETTY IMAGES
3
Definition
Market power:
the power to raise price above marginal
cost without fear that other firms will
enter the market.
Monopoly:
a firm with market power.
4
Market Power
 GlaxoSmithKline owns the patent on Combivir.
 A patent gives exclusive rights to make, use, or
sell the product.
 GSK’s patent prevents competition.
 This gives GSK market power.
 India does not recognize the Combivir patent.
 In India, an equivalent drug sells for $0.50, or
the marginal cost.
5
Definition
Marginal revenue (MR):
the change in total revenue from selling
an additional unit.
Marginal cost (MC):
the change in total cost from selling an
additional unit.
6
Self-Check
Market power allows a firm to raise price:
a. Above average cost.
b. Above marginal cost.
c. Above marginal revenue.
Answer: b – market power allows a firm to raise
price above marginal cost, without fear that other
firms will enter the market.
7
Market Power
 To maximize profit, firms produce at the level of
output where:
MC = MR
 A firm with market power faces a downward
sloping demand curve.
 It must lower price to sell an additional unit.
 The additional revenue per unit < current price,
or:
MR < P
8
Marginal Revenue
 When price ↓ from
$16 to $14,
quantity ↑ from 2
to 3 units
 Total revenue ↑
from $32 to $42.
 MR, or the change
in total revenue, is
$10.
9
Marginal Revenue
Price
$20
Revenue loss
$2 x 2 = $4
18
16
Price ↓ $16 to $14
14
12
10
Revenue gain
14 x $1 = $14
8
6
Demand
MR =
$10
4
2
1
2
3
4
5
6
MR
7
Quantity
10
Short-Cut for Finding MR
 MR begins at same point on the vertical axis as demand.
 MR has twice the slope.
Price
a
Demand: P = a – b x Q
2b
1
b
1
a/2b
MR = a – 2b x Q
Quantity
a/b
11
Self-Check
For a firm with market power, marginal revenue
is:
a. Higher than price.
b. Equal to price.
c. Lower than price.
Answer: c – A firm with market power must drop
its price to sell more units, so the marginal
(additional) revenue is lower than price.
12
Using Market Power to Maximize Profit
Price
($/pill)
Demand
Profit maximizing output:
MR = MC at 80 million pills
Profit maximizing price = $12.50
Profit per pill = $10.00
Total profit = $10 x 80 = $800 m
$12.50
Profit
2.50
//
AC
MC
0.50
80
MR
Quantity
(millions of pills)
13
Elasticity of Demand and Markup
 Two effects make demand for pharmaceuticals
inelastic:
• The “you can’t take it with you” effect:
 People with serious illnesses are relatively
insensitive to the price of life saving drugs.
• The “other people’s money” effect:
 If third parties are paying for the medicine,
people are less sensitive to price.
 The more inelastic the demand curve, the more
a monopolist will raise price above MC.
14
Elasticity of Demand and Markup
Price
Price
Relatively elastic demand
→ small markup
Relatively inelastic demand
→ big markup
P
Demand
P
MC
MC
Demand
QE
MR
Quantity
Q
MR
Quantity
15
Costs of Monopoly: Deadweight Loss
 Monopolies charge a higher price and produce
less than competitive firms.
 Monopolies reduce total surplus (consumer
surplus + producer surplus).
 This implies a deadweight loss - sales that do
not occur because the monopoly price is above
the competitive price.
16
Costs of Monopoly: Deadweight Loss
P
P
Consumers get this
Consumers
get this
Monopolist gets this
PM
PC
No one gets this
(deadweight loss)
Supply
MC = AC
Demand
Demand
MR
QC
Competition: P = MC
Q
QM
Q
QC
Monopoly: P > MR
17
Self-Check
A monopolist’s price is:
a. Lower than a competitive firm’s.
b. Higher than a competitive firm’s.
c. The same as a competitive firm’s.
Answer: b – a monopolist’s price is higher than a
competitive firm’s.
18
Costs of Monopoly: Corruption and
Inefficiency
 Many monopolies are the result of government
corruption.
 Tommy Suharto, the Indonesian president’s son,
was given the clove monopoly.
 He bought the
Lamborghini company
with the monopoly
profits.
PETER HARHOLDT/SUPERSTOCK
19
Costs of Monopoly: Corruption and
Inefficiency
 Monopolies are especially harmful if they control a
good that is used to produce other goods.
 In Algeria a dozen or so army generals each
control a key good
• People refer to these men as General wheat,
General tire….
• Each general tries to get a larger share of the
economic pie.
 The result is greater deadweight loss, and the
“pie” shrinks.
20
Benefits of Monopoly: Incentives for R&D
 Drug prices are lower in India and Canada.
• India does not offer strong patent protection.
• Canada’s government controls drug prices.
 It costs $1 billion to develop a new drug.
 Patents are one way of rewarding research and
development (R&D).
 Without patents firms would not spend on R&D,
fewer new drugs would be developed.
21
Benefits of Monopoly: Incentives for R&D
 Prizes can reward research and development
without creating monopolies.
 Patent buyouts are another alternative.
• Reduce price without reducing R&D.
• Must raise taxes to pay for the patent.
• May be difficult to determine a price.
22
Definition
Economies of Scale:
the advantages of large-scale
production that reduce average cost as
quantity increases.
Natural Monopoly:
when a single firm can supply the entire
market at a lower cost than two or more
firms.
23
Natural Monopoly
 Monopolies can arise naturally when economies
of scale allow a single firm to produce at lower
cost than many small firm.
 Utilities such as water, natural gas, and cable
television are often natural monopolies.
 If economies of scale are large enough, price can
be lower under natural monopoly than under
competition.
24
Natural Monopoly
P
Average costs
for small firms
Competitive
price PC
It is possible for PM < PC
If economies of scale are
large enough
Monopoly
price PM
AC
MC
Demand
Competitive
Quantity QC
Monopoly
Quantity QM MR
Q
25
Self-Check
Which of the following is most likely to be a
natural monopoly:
a. A home builder.
b. A restaurant.
c. A railroad company.
Answer: c – a railroad company is most likely to
be a natural monopoly, due to economies of scale
and the high cost of duplicating tracks.
26
Price Control and Natural Monopoly
 A price control can increase output.
 Price = MC is the optimal level of output.
 At P = MC, P < AC.
 The firm is operating at a loss and will exit
the industry.
 Price = AC is the lowest price the firm will accept.
 Firm is earning zero (normal) profit.
 Output is higher than at monopoly price.
27
Price Control and Natural Monopoly
Price
• PM and QM are set where MR = MC
• Optimal quantity is where P = MC
• At optimal Q, firm suffers a loss
Monopoly
price PM
P = MC
AC
Loss (P < AC)
QM
Monopoly
quantity
Optimal
quantity
MC
Demand
Quantity
MR
28
Price Control and Natural Monopoly
Price
• At P = AC, firm has normal profit
• Results in some deadweight loss
Monopoly
price PM
Deadweight Loss
P = AC
AC
P = MC
QM
Monopoly
quantity
Optimal
quantity
MC
Demand
Quantity
MR
29
Self-Check
A monopolist will have normal profit when its
price is set equal to:
a. Marginal cost.
b. Average cost.
c. Total cost.
Answer: a – a monopolist will have normal profit
when P = AC.
30
Definition
Barriers to entry:
factors that increase the cost to new
firms of entering an industry.
31
Other Sources of Monopoly Power
32
Takeaway
 For a monopolist, marginal revenue is less than
market price (MR < P).
 Monopolies:
• Charge a higher price than competitive firms.
• Reduce total.
• Create a deadweight loss.
• Use market power to earn above normal profits.
 The markup of price over marginal cost is larger
the more inelastic the demand.
33
Takeaway
 Patent monopolies involve a trade-off between
deadweight loss and innovation,
 Natural monopolies involve a trade-off between
deadweight loss and economies of scale.
 Outcomes can be improved by:
• Opening the industry up to competition.
• Regulating the monopolist.
34