Transcript Lesson III-3: Monopoly, Chapter 14

Overview
Overview
BA 210 Lesson III.3 Monopoly
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Overview
Monopoly Pricing
What is a Monopoly?
Finding Profit Maximizing Quantity
Markup Rule
Perfect Price Discrimination
Two-Part Pricing
Block Pricing
Imperfect Price Discrimination
Summary
Review Questions
BA 210 Lesson III.3 Monopoly
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What is a Monopoly?
What is a Monopoly?
BA 210 Lesson III.3 Monopoly
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What is a Monopoly?
The Meaning of Monopoly
Our Opposite extreme from Perfect Competition…
 A monopolist is a firm that is the only producer of a good that
has no close substitutes. An industry controlled by a monopolist
is known as a monopoly, for example De Beers (diamonds).
 The ability of a monopolist to raise its price above the
competitive level by reducing output is known as market power.
 What do monopolists do with this market power? Let’s take a
look at the following graph…
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What is a Monopoly?
What a Monopolist Does
Price
P
M
2. … and raises price.
P
S
M
C
C
Equilibrium is at C, where
the price is PC and the
quantity is QC. A
monopolist reduces the
quantity supplied to QM,
and moves up the demand
curve from C to M, raising
the price to PM.
D
QM
QC
Quantity
1. Compared to perfect
competition, a monopolist
reduces output…
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What is a Monopoly?
Why Do Monopolies Exist?
A monopolist has market power and as a result will charge higher
prices and produce less output than a competitive industry. This
generates profit for the monopolist in the short run and long run.
Profits will not persist in the long run unless there is a barrier to entry.
This can take the form of:
 control of natural resources or inputs
 increasing returns to scale
 technological superiority
 government-created barriers including patents and
copyrights
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What is a Monopoly?
Low Supply and Soaring Demand: A Diamond Producer’s Best Friend
 The De Beers Diamond mines in South Africa dwarfed all previous
sources, so almost all of the world’s diamond production was
concentrated in a few square miles.
 De Beers either bought out new producers or entered into agreements
with local governments that controlled some of the new mines,
effectively making them part of the De Beers monopoly.
 De Beers controlled retail prices and when demand dropped, newly
mined stones would be stored rather than sold, restricting retail supply
until demand and prices recovered.
 Government regulators have forced De Beers to loosen control of the
market and competitors have also entered the industry.
 However, De Beers being a “near-monopolist” still mines most
diamonds than any other single producers.
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Finding Profit Maximizing Quantity
Finding Profit Maximizing Quantity
BA 210 Lesson III.3 Monopoly
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Finding Profit Maximizing Quantity
How a Monopolist Maximizes Profit
 The price-taking firm’s optimal output rule is to produce the
output level at which the marginal cost of the last unit produced
is equal to the market price.
 A monopolist, in contrast, is the sole supplier of its good. So its
demand curve is simply the market demand curve, which is
downward sloping.
 This downward slope creates a “wedge” between the price of
the good and the marginal revenue of the good—the change in
revenue generated by producing one more unit.
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Finding Profit Maximizing Quantity
Comparing the Demand Curves of a Perfectly Competitive
Producer and a Monopolist
Price
Market
price
(a) Demand Curve of an Individual
Perfectly Competitive Producer
(b) Demand Curve of a Monopolist
Price
D
C
D
Quantity
M
Quantity
An individual perfectly competitive firm cannot affect the market price of the
good  it faces a horizontal demand curve DC, as shown in panel (a). A
monopolist, on the other hand, can affect the price (sole supplier in the
industry)  its demand curve is the market demand curve, DM, as shown in
panel (b). To sell more output it must lower the price; by reducing output it
raises the price.
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Finding Profit Maximizing Quantity
How a Monopolist Maximizes Profit
 An increase in production by a monopolist has two opposing
effects on revenue:
 A quantity effect. One more unit is sold, increasing total
revenue by the price at which the unit is sold.
 A price effect. In order to sell the last unit, the monopolist
must cut the market price on all units sold. This decreases
total revenue.
 The quantity effect and the price effect are illustrated by the
two shaded areas in panel (a) of the following figure based on
the numbers on the table accompanying it.
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Finding Profit Maximizing Quantity
Price, cost, marginal
revenue of demand
$1,000
(a) Demand and Marginal Revenue
Quantity effect =
+$500
A
550
500
Price effect =
-$450
50
0
–200
B
C
9 10
Marginal revenue = $50
Demand, Total
Revenue, and
Marginal Revenue
Curves
D
Quantity of diamonds 20
MR
–400
(b) Total Revenue
Quantity effect dominates
price effect.
Total
Revenue
Price effect dominates quantity
effect.
$5,000
4,000
3,000
2,000
1,000
0
Quantity of diamonds
10
TR
20
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Finding Profit Maximizing Quantity
The Monopolist’s Demand Curve and Marginal Revenue
 Due to the price effect of an increase in output, the marginal
revenue curve of a firm with market power always lies below
its demand curve. So a profit-maximizing monopolist chooses
the output level at which marginal cost is equal to marginal
revenue—not to price.
 As a result, the monopolist produces less and sells its output at
a higher price than a perfectly competitive industry would. It
earns a profit in the short run and the long run.
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Finding Profit Maximizing Quantity
The Monopolist’s Demand Curve and Marginal Revenue
 To emphasize how the quantity and price effects offset each
other for a firm with market power, notice the hill-shaped total
revenue curve.
 This reflects the fact that at low levels of output, the quantity
effect is stronger than the price effect: as the monopolist sells
more, it has to lower the price on only very few units, so the
price effect is small.
 As output rises beyond 10 diamonds, total revenue actually
falls. This reflects the fact that at high levels of output, the price
effect is stronger than the quantity effect: as the monopolist
sells more, it now has to lower the price on many units of
output, making the price effect very large.
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Finding Profit Maximizing Quantity
The Monopolist’s Profit-Maximizing Output and Price
 To maximize profit, the monopolist compares marginal cost
with marginal revenue.
 If marginal revenue exceeds marginal cost, De Beers increases
profit by producing more; if marginal revenue is less than
marginal cost, De Beers increases profit by producing less. So
the monopolist maximizes its profit by using the optimal output
rule:
 At the monopolist’s profit-maximizing quantity of output:
MR = MC
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Finding Profit Maximizing Quantity
Finding the Monopoly Price
• In order to find the profit-maximizing quantity of output for a
monopolist, you look for the point where the marginal revenue
curve crosses the marginal cost curve. Point A in the following
figure is an example.
• However, it’s important not to fall into a common error:
imagining that point A also shows the price at which the
monopolist sells its output. It doesn’t. It shows the marginal
revenue received by the monopolist, which we know is less
than the price.
• To find the monopoly price, you have to go up vertically from
A to the demand curve. There you find the price at which
consumers demand the profit-maximizing quantity. So the
profit-maximizing price-quantity combination is always a point
on the demand curve, like B in the next figure.
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Finding Profit Maximizing Quantity
The Monopolist’s Profit-Maximizing Output and Price
Price, cost,
marginal revenue
of demand
$1,000
Monopolist’s
optimal point
B
P
M
The optimal output rule: the
profit maximizing level of output
for the monopolist is at MR =
MC, shown by point A, where
the MC and MR curves cross at
an output of 8 diamonds.
600
Perfectly competitive
industry’s optimal point
Monopoly
profit
P
C
200
0
–200
MC = ATC
A
C
D
8
Q
M
10
16
Q
MR
20
Quantity of diamonds
C
–400
The price De Beers can charge per diamond is found by going to the point on
the demand curve directly above point A, (point B here)—a price of $600 per
diamond. It makes a profit of $400 × 8 = $3,200.
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Finding Profit Maximizing Quantity
Is There a Monopoly Supply Curve?
• Given how a monopolist applies its optimal output rule, you
might be tempted to ask what this implies for the supply curve
of a monopolist. But this is a meaningless question:
monopolists don’t have supply curves.
• Remember that a supply curve shows the quantity that
producers are willing to supply for any given market price.
A monopolist, however, does not take the price as given; it
chooses a profit-maximizing quantity, taking into account its
own ability to influence the price.
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Markup Rule
Markup Rule
BA 210 Lesson III.3 Monopoly
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Markup Rule
Monopoly Behavior and the Price Elasticity of Demand
• A monopolist faces marginal revenue that is less than the market
price. But how much lower? The answer depends on price elasticity
of demand.
• When a monopolist increases output by one unit, it must reduce the
market price in order to sell that unit. If the price elasticity of demand
is less than 1, this will actually reduce revenue—that is, marginal
revenue will be negative.
• The monopolist can increase revenue by producing more only if the
price elasticity of demand is greater than 1. The higher the elasticity,
the closer the additional revenue is to the initial market price.
• A monopolist that faces highly elastic demand will behave almost
like a firm in a perfectly competitive industry.
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Markup Rule
The Standard Markup Rule
• Suppose the elasticity of demand for the firm’s product is E.
• MR = P[1 + E]/ E
• Since MR = P[1 + E]/ E, setting MR = MC and simplifying
yields the standard markup rule:
P = [E/(1+ E)]  MC.
• The optimal price is a simple markup over marginal cost.
BA 210 Lesson III.3 Monopoly
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Markup Rule
An Example
• Elasticity of demand for Kodak film is -2.
• P = [E/(1+ E)]  MC
• P = [-2/(1 - 2)]  MC
• P = 2  MC
• Price is twice marginal cost.
• Fifty percent of Kodak’s price is margin above manufacturing
costs (marginal cost).
BA 210 Lesson III.3 Monopoly
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Public Policy
Public Policy
BA 210 Lesson III.3 Monopoly
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Monopoly and Public Policy
 By reducing output and raising price above marginal cost, a
monopolist captures some of the consumer surplus as profit and
causes deadweight loss. To avoid deadweight loss, government
policy attempts to prevent monopoly behavior.
 When monopolies are created, governments should act to prevent
them from forming and break up existing ones.
 The government policies used to prevent or eliminate monopolies
are known as antitrust policy.
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Monopoly Causes Inefficiency
(a)Total Surplus with Perfect Competition
Price,
cost
(b)Total Surplus with Monopoly
Price, cost,
marginal
revenue
Consumer surplus with
perfect competition
Consumer surplus
with monopoly
Profit
P
M
Deadweight
loss
P
C
MC =ATC
MC =ATC
D
D
MR
Q
C
Quantity
Q
M
Quantity
Panel (b) depicts the industry under monopoly: the monopolist decreases
output to QM and charges PM. Consumer surplus (blue triangle) has shrunk
because a portion of it has been captured as profit (light blue area). Total
surplus falls: the deadweight loss (orange area) represents the value of
mutually beneficial transactions that do not occur because of monopoly
behavior.
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Perfect Price Discrimination
Perfect Price Discrimination
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Perfect Price Discrimination
Price Discrimination
• Until now, all models involved a single equilibrium price.
• But there is more profit in charging different prices.
• Price discrimination is the practice of charging different prices
to consumers for the same good.
• Price discrimination can be perfect or imperfect.
 Perfect price discrimination achieves maximum profits,
leaving no surplus for consumers.
 Imperfect price discrimination achieves less than maximum
profits, and leaves some surplus for consumers.
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Perfect Price Discrimination
Perfect Price Discrimination
• Practice of charging each consumer the maximum amount he
or she will pay for each incremental unit (the height of the
demand curve).
• Permits a firm to extract all surplus from consumers.
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Markup Rule
For Reference, Standard Pricing and Profits
Price
Profits from standard pricing
= $8
10
8
6
4
MC
2
D
1
2
3
4
5
Quantity
MR (twice the slope of demand)
BA 445 Lesson I.10 Monopoly Pricing
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Perfect Price Discrimination
Perfect Price Discrimination
Price
Profits*:
.5(4-0)(10 - 2)
= $16
10
8
6
4
Total Cost* = $8
2
MC
D
1
2
3
4
5
Quantity
* Assuming no fixed costs
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Perfect Price Discrimination
Example:
• A Pepperdine professor visiting Mexico paid $15 for a chess
set (about equal to the maximum he was willing to pay).
• When he returned to the same store, he was offered a lower
price on a second set. After refusing the offer, the price
continued to lower as the manager read his posture and tried to
figure out the maximum amount he would be willing to pay.
• Some say perfect price discrimination won’t work if
consumers can resell the good. It does get harder, but it is still
possible:



Suppose a Pepperdine student is only willing to pay $10 for a chess set
for himself, but that student could resell the set to the professor for $15.
How much would the student be charged for the first set?
For the second set? (the one he keeps for himself)
BA 210 Lesson III.3 Monopoly
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Perfect Price Discrimination
Caveat:
• Information constraints make perfect price discrimination
difficult (it is difficult to know how much someone is willing
to pay).
• The information constraints are especially difficult if
consumers can resell the good.
 The manager cannot just appraise the maximum price the
customer before him would pay for the good if he were
buying it for himself, but also how much that customer
could get by reselling the good.
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Two-Part Pricing
Two-Part Pricing
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Two-Part Pricing
Two-Part Pricing
• When consumers can not resell the good and when the firm
has unlimited information, two-part pricing generates the same
maximum profit as perfect price discrimination.
• Two-part pricing consists of a fixed fee and a per unit charge.
• Examples:
 Disneyland with fixed admission fee and zero charge per
ride.
 $2 cokes with free-refills, with the $2 the fixed fee and zero
charge per coke refill.
 Athletic club memberships.
 Other examples?
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Two-Part Pricing
How Two-Part Pricing Works
1. Set price at marginal cost (to maximize total
surplus).
2. Compute consumer surplus.
3. Charge a fixed-fee equal to consumer surplus
(to capture all surplus as profit).
Price
10
8
6
Per Unit
Charge
Fixed Fee = Profits* = $16
4
MC
2
D
* Assuming no fixed costs
1
2
3
4
5
Quantity
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Block Pricing
Block Pricing
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Block Pricing
Block Pricing
• When consumers can not resell the good and when the firm
has unlimited information, block pricing generates the same
maximum profit as perfect price discrimination.
• The practice of packaging multiple units of an identical
product together and selling them as one package.
• Examples
 Paper.
 Six-packs of soda.
 Different sized of cans of green beans.
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Block Pricing
Optimal Price for the Package of 4 units: $24
Consumer’s valuation of 4 units
= .5(8)(4) + (2)(4) = $24.
Therefore, set 4-Pack Price = $24.
Price
10
8
6
4
MC = AC
2
D
1
2
3
4
5
BA 210 Lesson III.3 Monopoly
Quantity
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Block Pricing
Costs and Profits with Block Pricing
Price
10
Profits* = [.5(8)(4) + (2)(4)] – (2)(4)
= $16
8
6
Costs = (2)(4) = $8
4
2
D
1
2
3
4
5
MC = AC
Quantity
* Assuming no fixed costs
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Imperfect Price Discrimination
Imperfect Price Discrimination
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Imperfect Price Discrimination
Imperfect Price Discrimination
• Imperfect price discrimination: The practice of charging
different groups of consumers different prices for the same
product.
• Group must have observable characteristics for third-degree
price discrimination to work.
• Examples include student discounts, senior citizen’s discounts,
regional and international pricing.
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Imperfect Price Discrimination
Implementing Imperfect Price Discrimination
• Suppose the total demand for a product is comprised of two
groups with different elasticities, E1 < E2 < - 1
• Notice that group 1 is more price sensitive than group 2.
• Profit-maximizing prices?
• P1 = [E1/(1+ E1)]  MC < [E2/(1+ E2)]  MC = P2
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Imperfect Price Discrimination
A Numerical Example
• Suppose the elasticity of demand for Kodak film in the US is
EU = -1.5, and the elasticity of demand in Japan is EJ = -2.5.
• Marginal cost of manufacturing film is $3.
• PU = [EU/(1+ EU)]  MC = [-1.5/(1 - 1.5)]  $3 = $9
• PJ = [EJ/(1+ EJ)]  MC = [-2.5/(1 - 2.5)]  $3 = $5
• Kodak’s optimal third-degree pricing strategy is to charge a
higher price in the US, where demand is less elastic.
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Imperfect Price Discrimination
Qualitative Examples
• Why are seniors charged less than adults at Disneyland and at
restaurants and at theaters? Higher elasticity (more
substitutes).
 They shop at Disneyland, like they shop at the mall.
 They eat plain food at restaurants, like they eat at home.

They nap during movies, like they nap at home; and they
cannot see or hear well enough to appreciate theater
quality.
• Why are children charged less than adults at restaurants and
for haircuts? Higher elasticity (more substitutes).
 They eat plain food at restaurants, like they eat at home.
 They can have their hair cut by their parents, or can go
without.
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Review Questions
Review Questions
 You should try to answer some of the following questions
before the next class.
 You will not turn in your answers, but students may request
to discuss their answers to begin the next class.
 Your upcoming cumulative Final Exam will contain some
similar questions, so you should eventually consider every
review question before taking your exam.
BA 210 Lesson III.1 Inputs and Costs
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Review Questions
Follow the link
http://faculty.pepperdine.edu/jburke2/ba210/PowerP3/Set10Answers.pdf
for review questions for Lesson III.3
BA 210 Lesson III.1 Inputs and Costs
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BA 210
Introduction to Microeconomics
End of Lesson III.3
BA 210 Lesson III.1 Inputs and Costs
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