Transcript Chapter 11

Chapter 11
Monopoly
Key issues
1.
2.
3.
4.
5.
6.
7.
monopoly profit maximization: MR = MC
market power
monopoly welfare effects: p > MC  DWL
cost advantages that create monopolies
government actions that create monopolies
government actions that reduce market power
dominant firm and competitive fringe
Monopoly
• monopoly: only supplier of a good for which there
is no close substitute
• monopoly's output is the market output: q = Q
• monopoly's demand curve is market demand curve
• its demand curve is downward sloping
• it doesn't lose all its sales if its raises its price
• it is a price setter
Profit maximization
all firms maximize profits by choosing
quantity such that
marginal revenue = marginal cost
MR(Q) = MC(Q)
Marginal revenue
• firm's MR curve depends on its demand curve
• monopoly's MR curve
• lies below its demand curve at any positive quantity
• because its demand curve is downward sloping
• demand curve shows price, p, it receives for
selling a given quantity, Q
• price = p = average revenue
Marginal revenue, MR
• change in revenue from selling one more
unit
• MR = R/Q (Calculus: MR = dR(Q)/dQ)
• if firm sells exactly one more unit, Q = 1,
• its marginal revenue is MR = R
• R = R2 – R1
• MR < p at any given Q for a monopoly (but
not for a competitive firm)
Figure 11.1a Average and Marginal Revenue
R1 = A
R2 = A + B
(a) Competitive Firm
Price, p,
$ per unit
R = R2 – R1 = B = p 1
Demand curve
p1
A
B
q q +1
Quantity, q, Units per year
Figure 11.1b Average and Marginal Revenue
(b) Monopoly
R1 = A + C
R2 = A + B
Price, p,
$ per unit
R = R2 – R1 = B – C = p2 - C
p1
C
p2
Demand curve
A
B
Q Q+1
Quantity, Q, Units per year
Deriving monopoly’s MR curve
• monopoly increases its output by Q,
• by lowering its price per unit by p/Q (slope
of demand curve)
• so monopoly loses (p/Q)  Q on units
originally sold at higher price: area C
• but earns an additional p on extra output: area B
• thus: MR = p + (p/Q)  Q
= p + a negative term < p
Calculus derivation
• monopoly’s revenue is R(Q) = p(Q)Q
• differentiating with respect to Q:
dR(Q)
dp(Q)
MR 
 p(Q)  Q
dQ
dQ
• thus: MR = p + a negative term < p
Figure 11.2 Elasticity of Demand and Total, Average,
and Marginal Revenue
p, $ per unit
24
Perfectly elastic
Elastic, e < –1
 MR = –2
Q = 1
12
 p = –1
Q = 1
e = –1
Inelastic, –1 < e < 0
Demand ( p = 24 – Q)
Perfectly
inelastic
0
12
MR = 24 – 2Q
24
Q, Units per day
Linear MR curve
• for all linear demand curves, p = a - bQ
• MR curve is a straight line, MR = a - 2bQ
• MR curve hits vertical (price) axis where
demand curve does
• slope of MR curve = 2  slope of demand
curve
• MR curve hits horizontal axis at half the
quantity as the demand curve
In our example
• p = 24 – Q
• so a = 24 and b = 1
• p /Q = -1
• hence MR = p + (p/Q)  Q
= (24 – Q) + (-1)  Q
= 24 – 2Q
Using calculus
R(Q) = p(Q)Q
if linear:
R(Q) = [a - bQ]Q = aQ - bQ2
MR = dR/dQ = a - 2bQ
MR and elasticity of demand
• MR at any given quantity depends on
• demand curve's height (price)
• demand curve's shape (elasticity)
• thus, it depends on its elasticity
Derive MR/elasticity formula
• demand elasticity:
e = (Q/Q)/(p/p) = (Q/p)(p/Q)
• MR = p + (p/Q)  Q
 1
= p + (p/Q)(Q/p)p  p 1  
 e
MR and price
 1
• MR  p 1  
 e
• MR closer to p the more elastic is demand
• where demand curve hits price axis (Q = 0),
demand curve is perfectly elastic  MR = p
• MR = 0 where demand elasticity is e = -1
• MR < 0 where demand is inelastic: 0  e > -1
Table 11.1 Quantity, Price, Marginal Revenue, and Elasticity for
the Linear Inverse Demand Curve p=24-Q
Figure 11.2 Elasticity of Demand and Total, Average,
and Marginal Revenue
p, $ per unit
24
Perfectly elastic
Elastic, e < –1
 MR = –2
Q = 1
12
 p = –1
Q = 1
e = –1
Inelastic, –1 < e < 0
Demand ( p = 24 – Q)
Perfectly
inelastic
0
12
MR = 24 – 2Q
24
Q, Units per day
Choosing price or quantity
• monopoly can set p or Q to maximize its profit, 
• monopoly is constrained by market demand curve
• it cannot set both Q and p (cannot pick a point above
demand curve)
• if monopoly sets p, demand curve determines Q
• if monopoly sets Q, demand curve determines p
• because monopoly wants to maximize , it
chooses same profit-maximizing solution whether
it sets p or Q
Profit maximization
all firms, including monopolies, use a twostep analysis
1. firm determines output, Q*, at which it
makes highest , where
•
•
MR = MC
in elastic portion of demand curve
2. firm decides whether to produce Q* or
shut down: p  AVC
(a) Monopolized Market
Figure 11.3 Maximizing Profit
MC
p, $ per unit
24
AC
AVC
e
18
 = 60
12
8
6
Demand
MR
0
6
12
24
Q, Units per day
(b) Profit, Revenue
R, , $
144
Revenue, R
108
Profit, 
60
0
6
12
24
Q, Units per day
SR cost in our example
• C(Q) = Q2 + 12
• MC = dC(Q)/dQ = 2Q
• AVC = VC/Q = Q2/Q = Q
• AC = C/Q = (Q2 + 12)/Q = Q + 12/Q
Profit is maximized where
• MR = 24 – 2Q = 2Q = MC
Q=6
• inverse demand: p = 24 – Q = 24 – 6 = 18
• AVC = Q = 6 < p = 18 so produce
•  > 0 because AC = Q + 12/Q = 8 < p = 18
Market power
ability of a firm to charge a price above
marginal cost profitably
No check on bank market power
banks exercise substantial market power on
the rate for bounced checks
• although you had no idea that a check
wouldn't clear, bank charges you an average
of $4.75 to $7.50 (up to $10)
• large banks charge more than small ones
• bad check writer also pays an average of
$15 to $19.50 (up to $30)
Bank costs
• bank's handling fees for bad checks = $1.32
• most checks eventually clear (check writer
merely miscalculated balances)
• even including losses from fraud, total MC
= $2.70 (Center for the Study of Responsive
Law)
• thus, banks are exercising substantial
market power: price > MC
Market power and shape of
demand curve
• market power depends on shape of demand
curve (elasticity)
• at profit-maximizing quantity:
 1
MR  p 1    MC
 e
p
1

MC 1  1/ e 
Lerner index (price markup)
• Lerner index is (p – MC)/p
• if firm profit maximizes,
p  MC
1

p
e
• Lerner index ranges from 0 to 1
• p  MC
• 0  p – MC  p
• 0  (p – MC)/p  p/p = 1
Causes of market power
•
•
•
•
•
monopoly's demand curve is relatively
inelastic if
consumers are willing to pay "virtually
anything" for it
no close substitutes for firm's product exist
other firms can't enter market
other similar firms are located far away
other firms’ products very different
Welfare effects of monopoly
• welfare = consumer surplus + producer
surplus
• W = CS + PS
• welfare is < under monopoly than under
competition
• monopoly sets p > MC, causing deadweight
loss (DWL)
Figure 11.5 Deadweight Loss of Monopoly
p, $ per unit
24
MC
pm = 18
p c = 16
MR=MC=12
A= $18
B= $12
D =$60
em
C=$2
ec
E= $4
Demand
MR
0
Q m = 6 Q c= 8
12
24
Q , Units per day
Solved problem
• in our linear example,
• how does subjecting a monopoly to a
specific tax of  = $8 per unit affect
• monopoly optimum
• welfare of consumers, the monopoly, and
society?
• what is tax incidence on consumers?
Solved Problem 11.1
p, $ per unit
24
MC2 (after tax)
p 2 = 20 A
B
p1 = 18
D
8
e2
 = $8
MC 1 (before tax)
e
C
1
E
F
G
MR
0
Q 2 = 4 Q 1= 6
12
Demand
24
Q, Units per day
Competitive vs. monopoly sugar tax
incidence
• incidence of a tax on consumers may be less for a
monopolized than a competitive market
• in 1996, Florida voted on (and rejected) a one-cents-perpound excise tax on refined cane sugar in the Florida
Everglades Agricultural Area
• given linear supply (or marginal cost) and demand curves
the tax incidence on consumers from this tax is
• 70% if the market is competitive
• 41% if monopolistic
• thus, a competitive Florida sugar industry passes on
substantially more of the tax to demanders than it would if
the industry were monopolized
Welfare effects of taxes
• governments use ad valorem taxes (p per
unit) more often than specific taxes ( per
unit) – why?
• suppose both taxes cut output by the same
amount
• which one raises the most government tax
revenue?
Figure 11.6 Ad Valorem Versus Specific Tax
p, $ per unit
e1
p2
A
e2
p1
ps = p 2 – 
pa = (1 – )p 2
B
MC
Before-tax
demand, D
MR
Ds
Q2
Q1
MR s
MR a
Da
Q, Units per year
Why monopolies?
•
•
•
•
•
firm has cost advantage over others firms
government created monopoly
merger of several firms into a single firm
firms act collectively: cartel
strategies - such as threats of violence - that
discourage other firms from entering market
Sources of cost advantages
• firm controls a key input:
• essential facility: scarce resource that rival
needs to use to survive
• firm knows of superior technology, or
• has better way of organizing production
Natural monopoly
• market has a natural monopoly if one firm
can produce total market output at lower
cost than could several firms
• if cost for Firm i to produces qi is C(qi),
condition for a natural monopoly is
C(Q) < C(q1) + C(q2) + ... + C(qn),
• where Q = q1 + q2 + .. + qn is sum of output
of any n > 2 firms
Sufficient condition
natural monopoly if
• AC curve falls at any observed quantity for
all firms
• economies of scale
Electricity example
• F = $60 (build plant & connect houses)
• MC = m = $10 (constant)
• AC = m + F/Q = 10 + 60/Q, declines as
output rises
Costs of producing Q = 12
# of firms
output
AC = 10+60/Q
C
1
12
$15
$180
2
6
$20
$240
having only one firm produce avoids a
second fixed cost (MC doesn’t vary with
number of firms)
Figure 11.7 Natural Monopoly
AC, MC,
$ per unit
40
20
AC = 10 + 60/Q
15
10
0
MC = 10
6
12
15
Q, Units per day
Public utilities
•
•
•
•
apparently believing they’re natural
monopolies, governments grant monopoly
rights for essential good or service “public
utilities”
water
gas
electric power
mail delivery
Electric power utilities
• AC curve for U.S electric-power-producing
firms in 1970
• was U-shaped
• reached its minimum at 33 billion kWh per year
• whether an electric power utility is a natural
monopoly depends on demand it faces
Economies of scale
• natural monopolies: most electric companies
operated in regions of substantial economies of
scale
• Newport Electric produced 0.5 billion kWh/year
• Iowa Southern Utilities: 1.3 billion kWh/year
• not natural monopolies: a few operated in upwardsloping section of AC curve
• Southern produced 54 kWh/year
• 2 firms could produce that quantity at 3¢ less per
thousand kWh than could a single firm
Application Electric Power Utilities
Cost, $ per
thousand kWh
5.10
D
AC
4.85
4.79
0
33
66
Q, Billion kWh per year
Government created monopolies
• barriers to entry (e.g, patents)
• own and manage many monopolies
• postal services
• garbage collection
• utilities
•
•
•
•
electricity
water
gas
phone services
Barriers to entry
governments prevent other firms from
entering a market in 3 ways
• by making it difficult for new firms to
obtain a license to operate
• by granting a firm rights to be a monopoly
• by auctioning rights to be a monopoly
Patents
• grants an inventor right to be monopoly
provider of good for a number of years
• stimulates research
Iceland’s government creates genetic
monopoly
• starting in 874, Viking crews from western Norway
grabbed young Celtic women from Ireland and took them
to Iceland
• 11 centuries later, the descendents of these 10,000 to
15,000 pirates and their about five-times-as-many slave
wives form an unusually isolated population with a
relatively homogeneous gene pool
• Iceland has tissue samples dating back to the 1940s and
meticulous records on every citizen since 1915
• careful genealogic records have been kept that allows
researchers to trace disease genes back more than 10
generations
deCODE Genetics
• Dr. Kari Stefansson believed that the unique genetic
dataset of the 286,000 current Icelanders (and their
forbearers) would help pinpoint genetics of some serious
common diseases
• he formed a firm, deCODE Genetics
• in 1998, deCODE acquired 12 years of monopoly rights to
the genetic, medical, and genealogical records of Iceland
for about $200 million
• the firm agreed to provide Icelanders for free with drugs
and diagnostic tools stemming from their research
• the firm has collected voluntary blood samples from tens
of thousands of people to augment their databases
• by 2002, deCODE announced findings for a number of
diseases and had revenues of $13.4 million
Drug patent: Botox
• Dr. Alan Scott turned a deadly poison,
botulinum toxin, into a miracle drug to treat
• strabismus, or cross-eyes, which affects about
4% of children
• blepharospasm, an uncontrollable closure of the
eyes, which left about 25,000 Americans
functionally blind before his discovery
• his patented drug, Botox, is sold by
Allergan Inc.
Other uses
• Dr. Scott has been amused to see several of the
unintended beneficiaries of his research at the
Academy Awards
• even before it was explicitly approved for
cosmetic use, many doctors were injecting Boxtox
into the facial muscles of actors, models, and other
people to smooth out their wrinkles
• ideally for Allergan, the treatment is only
temporary, lasting up to 120 days, so repeated
injections are necessary
Profits
• Allergan had expected to sell $400 million
worth of Botox in 2002
• however, in April 2002, the FDA approved
Botox for cosmetic purposes—allows
Allegran to advertise the drug widely
• The firm expects Botox to eventually earn a
$1 billion a year (becoming another Viagra)
Compare
• Mattel sold $1.4 billion worth of Barbie
dolls over 37 years
Justification
• patent monopoly profits spur new research
• people benefit greatly from many inventions
(new drugs)
Botox profit maximization
• Dr. Scott can produce a vial of Botox in his lab for about
$25
• Allergan sells a vtal to doctors for about $400
• assuming that the firm is setting its price to maximize its
short-run profit, the elasticity of demand for Botox is
determined by:
p
400
e 

 1.067.
p  MC
400  25
• thus, demand it faces is only slightly elastic
Linear demand
• if the demand curve is linear and elasticity of demand
is -1.067 at 2002 monopoly optimum (1 million vials sold
at $400 each), Allergan’s inverse demand function is
p = 775 – 375Q.
• demand curve:
• slope is -375
• hits price axis at $775
• hits quantity axis at 2.07 million vials per year
• corresponding marginal revenue curve is
MR = 775 – 750Q,
• strikes the price axis at $775
• has twice the slope, -750, as the demand curve
Monopoly optimum
• intersection of the marginal revenue and
marginal cost curves,
MR = 775 – 750Q = 25 = MC,
• determines the monopoly equilibrium at the
profit-maximizing quantity of 1 million
vials per year and a price of $400 per vial
p, $ per vial
775
A= $187.5 million
em
400
Demand
B= $375 million
C= $187.5 million
ec
25
1
MR
MC = AVC
2 2.07
Q, Millions vials of Botox per year
Botox Benefits
• SR relief from eye problems and wrinkles (CS at
monopoly price):
A = $187.5 million per year
• LR CS after patent expired (buy at MC):
A + B + C = $750 million per year
• Patent monopoly profit (ignoring fixed costs):
B = $375 million per year
Auctions
• Oakland cable TV
• SF auctioned monopoly rights to store cars towed
for illegal parking
• monopoly, City Tow, collects $40 per car, of which
$15.03 goes to the city
• losing company's bid promised the city only $7.50
• ASUC tried to create a bookstore monopoly
without holding an auction
Government actions that reduce
market power
• antitrust laws prohibit monopolization, price
fixing, and so forth
• regulations prevent monopolies from
exercising all of their market power
Optimal price regulation
• price regulation may eliminate DWL
• regulation is optimal if it leads to
"competitive" outcome
Figure 11.8 Optimal Price Regulation
p, $ per unit
24
MC
Market demand
18
16
A
em
B
C
Regulated demand
eo
E
D
MR r
MR
0
6
8
12
24
Q , Units per day
Nonoptimal price regulation
• welfare is reduced if government does not set
price optimally
• if regulated p is < minimum of monopoly's AVC,
monopoly shuts down
• if regulated price is between shut-down point and
monopoly price but not equal to competitive price
• too little is produced
• welfare is below competitive level
Figure 11.9 Regulating an Electric Utility
p, Yen ( ¥ ) per
hundred KWH
53
MC
30.3
26.9
22.3
21.9
19.5
AC
e1
A
e2
B
e3
Demand
MR
0
23
31 34
54
Q, Billion kWh per year
Solved problem 11.3
What's the effect of a price regulation on a
monopoly that is below the competitive
price?
Solved Problem 11.3
p, $ per unit
MC
Market demand
B
A
p1
p2
C
D
e1 Regulated demand
e2
E
MR
Q 2 Q1
MR r
Qd
Excess demand
Q, Units per day
Creation and destruction of an
aluminum monopoly
• cost advantages and government actions
gave Aluminum Company of America
(Alcoa) a U.S. monopoly in aluminum
• monopoly lasted for decades
Alcoa becomes a monopoly
• Alfred Hall invented and patented a new process
in 1893
• allowed his firm, Pittsburgh Reduction (which
became Alcoa) to produce aluminum at much
lower cost than competitors
• this firm controlled most domestic and many
international sources of bauxite ore
•  Alcoa was only American producer of
aluminum
WWI to WWII
• Alcoa faced some competition from foreign
producers, but U.S. established high tariffs on
aluminum imports
• during WWI, when foreign competitors were
unable to effectively produce and sell in other
countries, Alcoa became an exporter
• Alcoa continued to export after war
• between WWI and WWII, Alcoa remained only
aluminum smelter (producer) in U.S. due to its
technological advantages and economies of scale
WWII
• demand for aluminum increased substantially with
start of WWII
• aluminum was used to produce planes and other
manufactured products for the war effort.
• during WWII, government financed new plants
that were built and run by Alcoa and encouraged
development of other aluminum producers
Break up
• at end of WWII in 1945, U.S. Supreme Court
ruled Alcoa monopoly should be broken up
• government-financed Alcoa plants sold at low
prices to Reynolds Metals Company &
Permanente Metals Corporation (owned by Henry
Kaiser) creating oligopoly by 1950
• Alcoa: 50.9% of all sales
• Reynolds: 30.9%
• Kaiser Aluminum & Chemical Corporation (renamed
Permanente Metals): 18.2%
Textbook prices
• textbook authors tell students that they urge
the publisher to charge lower prices
• are they telling the truth?
Sharing textbook revenues
• college-textbook publishers usually pay
authors a royalty: fraction of wholesale
revenues
• why pay a percentage of revenues rather
than
• lump-sum payment
• percentage of profit?
Explanations
• neither authors nor publishers can
accurately forecast sales, hence agreeing on
a lump-sum payment is difficult
• authors don't want a percentage of profit
because they don't trust publishers to
accurately report profit
Maximizing joint profit
Which royalty method(s) maximizes joint
profit: sum of publisher’s and author’s
profit?
Author’s royalty is a
A. fraction of revenue
B. fraction of economic profit
C. lump-sum payment
Problem with revenue sharing
• leads to inefficiency: too few books are sold
• no inefficiency with
• lump-sum fee
• percentage of profit
Lump-sum fee
• if publisher paid author fixed fee, L,
publisher would get residual profit
• hence publisher has an incentive to
maximize joint profit, 
• number of books that maximizes joint
profit, Q*, maximizes residual profit,  - L
• to sell Q*, publisher must set optimal price
p*
Profit, $
E
 , Joint profit
E*
 – L,
’
Publisher’s
profit
0
Q*
Books per year
Percentage of joint profit
• if used, publisher would set price to maximize
joint profit, , which maximizes both parties’
shares
• however, authors do not trust publishers to
truthfully report economic profit
• even without falsifying its accounts, publisher can
report very low profit
• because many costs of publishing are shared across
textbooks (joint product)
• authors put more trust in reported revenue
Model
• demand for textbook is downward sloping
• so there is some market power
• rival texts limit the market power
• constant marginal cost
Dominant firm/competitive
fringe
• dominant firm (DF): a price-setting firm that
competes with price-taking firms
(competitive fringe)
• DF maximizes its profit given
• its cost curves and
• demand curve it faces
• (before fringe enters, DF faces market demand)
Residual demand curve
after entry, DF faces residual demand curve: the
market demand that is not met by other firms
(competitive fringe) at any given price:
Dr(p) = D(p) – Sf(p)
where Sf is fringe’s supply curve
Figure 11.10 Dominant Firm-Competitive Fringe Equilibrium
p, $ per unit
D
Sf
p2
p*
f
d
MC d
e
Dr
p1
MR r
Q*f
q*d
Q*d
Q, Units of output per year
1. Monopoly profit maximization
• chooses p or Q
• maximizes profit where MR = MC
• operates if p  AVC
2. Market power
• ability of a firm to charge a price above MC
and earn a positive profit
• more elastic is demand at Q where
monopoly maximizes its profit
• closer is its p to its MC
• closer is Lerner Index, (p - MC)/p, to zero
(competitive level)
3. Welfare effects of monopoly
•
•
•
•
•
because a monopoly's p > MC
too little output is produced
society suffers a DWL
consumers are worse off
monopoly's profit > competitive level
4. Cost advantages that create
monopolies
•
•
•
•
firm may become a monopoly if it
controls a key input
has superior knowledge about producing or
distributing a good
has substantial economies of scale
in markets with substantial economies of
scale, single seller is a natural monopoly
5. Government actions that create
monopolies
• governments may establish
• government-owned and operated
monopolies
• private monopolies by
• establishing barriers to entry
• patents
6. Government actions that
reduce market power
• government can eliminate welfare harm of a
monopoly by forcing firm to set its price at
competitive level
• government can eliminate or reduce harms
of monopoly by allowing or facilitating
entry