Transcript monop99

MONOPOLY
A monopoly is a firm which is the sole producer of a
good or service for which there are no close
substitutes.
The monopolist’s demand curve is the same as the
market demand curve.
The firm must have some way to keep prospective
entrants out of the industry, i.e., there must be
barriers to entry.
Monopoly
slide 1
BARRIERS TO ENTRY
Barriers to entry prevent other firms from
entering an industry in which a monopolist
may be earning profit.
Government franchises
Patents and copyrights
Economies of scale
Ownership of a scarce input
Monopoly
slide 2
Because the demand curve the monopolist sees is
negatively sloped, the monopolist can choose price as
well as the quantity of output. (Price and quantity sold
are linked by the demand curve. The demand curve
sets the limit that can be charged for each quantity
produced.)
Monopoly
slide 3
REVENUE CURVES FOR A
MONOPOLIST
The market demand curve for a good is the
firm’s average revenue curve.
Monopoly
slide 4
The demand curve shown here is the market demand curve
for cable TV hookups in East Lansing. Because the
Ripoff Cable TV Co. has an exclusive franchise, the
market demand curve is also the firm’s average revenue
curve. (AR = price)
$/Q
To sell 7,000 hookups per
month, they can charge
$52. per hookup per month
p = $52/mo.
7
Monopoly
Thousand hookups
demand
Q
slide 5
From the demand curve we can find the firm’s total revenue curve
(TR as a function of Q).
Total revenue is price times quantity.
We can then compare total revenue with total costs at each output to
find the output and price where profits are maximized.
When 3,000 hookups are
sold, they can charge $68
and the total revenue from
sales is $204 thousand.
$/Q
p = $68/mo.
3
Monopoly
AR = demand
Q
Thousand hookups
slide 6
Q
0
1
2
3
4
5
6
7
8
9
10
11
Monopoly
P (=AR)
80
76
72
68
64
60
56
52
48
44
40
36
TR
0
76
144
204
256
300
336
Here are other points on
the demand curve and
some corresponding
amounts of total revenue.
Fill in the remaining values for TR.
slide 7
Plot the remaining points on the TR curve.
TR
450
400
350
300
250
200
150
100
Hidden slide
50
Q
0
0
Monopoly
2
4
6
8
10
12
14
slide 9
100
$/Q
80
60
40
D=AR
20
0
Q
0
2
4
6
8
10
12
Here’s the demand
curve with the
corresponding
total revenue
curve.
14
700
600
Thous. $
500
400
TR
300
Notice that the TR
curve is not a
straight line!
200
100
0
0
2
4
6
8
10
12
14
Thous. Hookups
Monopoly
slide 11
Monopoly
TC
10
30
54
82
114
154
204
266
342
434
546
682
Here is the
total cost curve
of the Ripoff
Cable TV Co.
Thous. $
Q
0
1
2
3
4
5
6
7
8
9
10
11
700
600
500
400
300
200
100
0
TC
Q
0
2
4
6
8
10
Thous. Hookups
12
14
slide 12
Q
0
1
2
3
4
5
6
7
8
9
10
11
Monopoly
TR
0
76
144
204
256
300
336
364
384
396
400
396
TC
10
30
54
82
114
154
204
266
342
434
546
682
Profit
-10
46
132
98
42
-38
-146
-286
Profit = TR - TC
We can put the total
revenue and total cost
curves together to find
total profit. Compute the
remaining values for
profit.
Hidden slide
slide 13
700
TC
600
Thous. $
500
TR
400
300
200
100
0
Q
0
2
4
6
8
10
12
14
Thous. $
Thous. Hookups
700
600
500
400
300
200
100
0
-100 0
-200
-300
Profit is maximized here
at 5,000 units of output.
The same problem can be
solved by the marginal/
average approach.
PROFIT
Q
2
4
6
8
10
12
14
Thous. Hookups
Monopoly
slide 15
For a monopolist, average revenue is declining as output
increases so marginal revenue must be less than
average revenue.
It is important to understand why MR is less than AR in
this case.
Monopoly
slide 16
Q
0
1
2
3
4
5
6
7
8
9
10
11
P (=AR)
80
76
72
68
64
60
56
52
48
44
40
36
Monopoly
TR
0
76
144
204
256
300
336
364
384
396
400
396
MR
76
68
60
52
44
36
Compute the
missing values of
Marginal Revenue.
MR = (300-256)/
(5-4)
Hidden slide
slide 17
$/Q
80
70
60
50
40
D=AR
30
20
Hidden slide
10
Q
0
-10
Monopoly
0
2
4
6
8
10
12
14
MR
slide 19
Marginal revenue is always less than price for a
monopolist because the firm must reduce price in
order to sell more.
$/Q
To sell an extra unit of output,
the monopolist must lower
price, thus losing the shaded
area on all of the previous
units sold at a price of p.
p
p’
Demand or AR
q
Monopoly
q+1
Q
slide 21
An increase in sales of one unit
requires a reduction in price.
$/Q
These rectangles have
the same area.
p
p’
So this area is MR,
which is less than p’.
Demand or AR
q
Monopoly
q+1
Q
slide 22
What values of output and price maximize
profit for the Ripoff Cable TV Co.?
$/Q
MC
Here are the
average and
marginal cost and
revenue curves
for the same
problem.
130
115
100
85
70
AC
55
40
AR=demand
25
10
-5
Q
0
2
4
6
8
10MR 12
Thousand hookups
Monopoly
slide 23
In this case the best output is 5,000 hookups,
and the best price is $60 per month.
MC
Then choose price by
going to the demand
curve.
130
115
Choose output
where MC = MR
100
85
70
AC
55
40
AR=demand
25
10
-5
Q
0
2
4
6
8
10MR 12
Thousand hookups
Monopoly
slide 24
To compute the amount of profits in monopoly, find average profit (ARAC) at the profit maximizing output, and multiply by Q.
$/Q
MC
130
The shaded area is
total profits.
115
100
85
70
AC
55
40
AR=demand
25
10
-5
Q
0
2
4
6
8
10MR 12
Thousand hookups
Monopoly
slide 25
Summary of monopoly pricing:
To maximize profit a monopolist should choose output
where MC = MR.
Price is determined from the demand curve.
Monopoly
slide 26
Do monopolists choose the best output and price from
society’s point of view?
Another way to ask the question is whether the
monopolist operates in society’s interest, and if not,
what can be done to remedy the evils of monopoly.
Monopoly
slide 27
This requires us to formulate some rule for determining
when social welfare is improved by some change, and
when social welfare is maximized.
The rule we'll use is that social welfare is measured by
the sum of producer and consumer surplus. So society
ought to produce where the sum of producer and and
consumer surplus is as large as possible.
Monopoly
slide 28
Producer Surplus
PS is the difference between what producers take in (TR)
at a given level of production and the minimum
amount they would accept for producing that level of
output.
Monopoly
slide 29
AT P’ AND Q’, THE PS IS THE
SHADED AREA.
$/Q
MC
P’
Q’
Monopoly
Q
slide 30
Consumer Surplus
CS is the difference between what consumers pay for a
given quantity and the maximum amount they are
willing to pay.
Monopoly
slide 31
AT P’ AND Q’, THE CS IS THE
SHADED AREA.
$/Q
P’
D
Q’
Monopoly
Q
slide 32
$/Q
AT P’ AND Q’, THE WELFARE IS
THE
SUM OF THE SHADED AREAS.
MC
P’
D
Q’
Monopoly
Q
slide 33
THE SUM OF PRODUCER AND CONSUMER
SURPLUS IS MAXIMIZED WHERE THE
MARGINAL COST CURVE INTERSECTS THE
DEMAND CURVE.
Monopoly
slide 34
Here’s our friendly local monopolist the Ripoff Cable
TV Co. of East Lansing. The profit maximizing
output is Q*, and the profit maximizing price is p*.
The following hidden slides illustrate the computation
of surplus at the monopolist’s output, and the
deadweight loss due to monopoly.
$/Q
MC
P*
D
Q*
Monopoly
Q
Hidden slide
MR
slide 35
GENERAL RULE:
The socially best output is where marginal cost equals
price -- where the marginal cost curve cuts through the
demand curve.
When the socially best output is being produced, the
right amount of resources are being devoted to the
good.
Monopoly
slide 39
We can now see why monopoly is bad: It results in less
than the optimal amount of a good being produced.
Monopolists produce too little of a good and sell it at too
high a price.
Monopoly
slide 40
Note that at the socially best output and price, the firm
is still able to earn positive profits (p>AC). This shows that
it is not the level of profits that economists object to
about a monopolist’s behavior.
$/Q
Profits at socially
best output
P’
MC
AC
D
Q’
Monopoly
Q
MR
slide 41
Producing where marginal cost equals price in order to
maximize social welfare is called marginal cost
pricing.
Monopoly
slide 42
Another method for finding the best output takes a
different approach, using the concepts of marginal
social benefit and marginal social cost.
DEFINITIONS:
Marginal social benefit (MSB): The MSB is the increase
in social welfare that results from consuming another
unit of a good.
Marginal social cost (MSC): The MSC is the cost to
society of producing another unit of a good.
Monopoly
slide 43
OPERATING PRINCIPLE:
Social welfare will be maximized if a good is produced
(and consumed) up to the point where marginal social
benefit equals marginal social cost.
MSC
MSB,MSC
MSB
QSOCIETY
Monopoly
QUANTITY
slide 44
The problem with this rule is that we don’t have any
foolproof way of measuring MSB and MSC.
But all is not lost!
Monopoly
slide 45
Suppose it were true that a good’s price is a good
measure of MSB.
And suppose that a firm’s marginal cost curve is a good
measure of MSC.
Then MSB = MSC boils down to producing where MC =
P, our rule for welfare maximization.
Monopoly
slide 46
If the firm’s MC curve is a good measure of MSC, and if its
demand (AR) curve is a good measure of MSB, then the
best output will is where MC = P.
$/Q
MC = MSC
AC
Psociety
D = MSB
Qsociety
Monopoly
Q
MR
slide 47
How could this work in practice?
In regulating a monopolist we would need information
on market demand and on the firm’s marginal cost at
each level of output.
We could make the monopolist produce the best output
with a series of taxes or subsidies, or even by direct
regulation (price setting by a regulator).
Monopoly
slide 48
In this case equality between MSC and MSB means
having marginal cost equal to price (MC = P).
$/Q
MC = MSC
AC
Psociety
D = MSB
Qsociety
Monopoly
Q
MR
slide 49
Monopoly summary
To maximize profit, the monopolist will produce where
MC = MR.
From society’s point of view monopolists produce too
small an output, and sell it at too high a price.
The best output from society’s point of view is where
MC = P.
We can measure the deadweight loss due to monopoly as
the (roughly) triangular area between the MC curve
and the demand curve.
Monopoly
slide 50
Price Discrimination
Definition:
A situation in which the producer sells
different units of the same good to different consumers
at different prices.
The idea here is that some consumers pay high prices
and some pay lower prices for the same good or
service.
To be successful, a producer must have some way to
keep the two markets separate.
Monopoly
slide 51
First Degree (perfect) Price
Discrimination
In this case the producer sells each unit of output for the
maximum amount it will bring.
The result is that the producer captures all of potential
consumer surplus that would have existed in a single
price system.
Monopoly
slide 52
With perfect price discrimination, q* will be sold.
Profit will be X plus Y. The monopolist captures all
of the surplus!
p
mc
X
Y
demand
q*
Monopoly
q
mr
slide 53
Third degree price discrimination
Here consumers are grouped into sub- markets, and a
different price charged in each sub-market.
There are two important questions. (1) How should any
output be divided between the markets, and (2) how
much total output should be produced?
Monopoly
slide 54
Set up:
Suppose a monopolistic producer of electricity sells in
two markets, residential and commercial. The demand
curves differ in the two markets.
How should any quantity be divided between the
markets if total revenue is to be maximized?
Monopoly
slide 55
Total output is Q* = Q1 + Q2
Is total revenue maximized at the current distribution
between the markets?
$/q
$/q
residential
commercial
d2
d1
Q1
Monopoly
mr1
q1
Q2
mr2
slide 56
q2
Rule:
To maximize TR, sell quantities in the two markets so
that the marginal revenue in market 1 equals marginal
revenue in market 2.
Then set prices accordingly.
hidden slide
Monopoly
slide 57
But how much total output should the firm produce?
It should produce where MR equals MC.
[To be demonstrated in class.]
Monopoly
slide 59
Puzzle:
Prices in the markets are determined by the elasticities of
demand in the two markets. Why? And what is the
relationship between elasticity of demand and the
prices the firm wants to charge?
Monopoly
slide 60