Transcript THE THEORY OF MONOPOLY

THE THEORY OF MONOPOLY
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Principles of
Microeconomic Theory,
ECO 284
John Eastwood
CBA 213
523-7353
e-mail address:
[email protected]
Read Chapter 10
and pp 281-282.
http://jan.ucc.nau.edu/~jde
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Basic Assumptions:
There is One Seller;
 Unique Product -- no close substitutes;
 High Barriers to Entry
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Barriers to Entry
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“Barriers to entry are obstacles that make it less
profitable or more difficult for new firms to enter
an industry.” p. 228
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Where do entry barriers come from?
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Legal
Strategic
Natural
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Legal (Regulatory) Barriers
Public Franchise
 Patents, Trademarks, Copyrights
 Licenses, and Other Regulations
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Strategic Barriers
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“Strategic barriers raise the costs of entry and
result from the policies of existing firms in an
industry.” p. 230
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Also used by nonmonopolists.
A few examples:
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Sole owner of a vital resource (ALCOA)
Extensive national advertising (Tobacco)
Annual style changes (Cars)
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Natural Barriers
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“Natural barriers arise when economies of scale
are substantial relative to market demand and
severely limit the number of firms in an industry.”
p. 230
“A natural monopoly emerges if economies of
scale permit only one firm to achieve the lowest
possible average cost while serving a specific
market.” p. 230
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Government Monopoly Vs.
Market Monopoly
Monopolies that are legally protected from
competition are referred to as government
monopolies.
 Monopolies that are protected from
competition due to strategic or natural
barriers are called market monopolies.
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MONOPOLY PRICING AND
OUTPUT DECISIONS
The monopolist controls the price of the
product it sells -- as such it is referred to as
a price searcher.
 A price searcher can raise its price and still
sell its product although the number of units
sold will fall as price rises.
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The Monopolist’s Demand and
Marginal Revenue Curve.
The monopolist faces the market demand
curve -- it is the sole supplier.
 The monopolist’s marginal revenue (MR)
curve will, after the first unit of output is
sold, always lie below demand curve.
 See Figure 1, page 223.
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Total Revenue and Marginal
Revenue
Demand is p = 12 - q
 TR = price x quantity =pq
 Substituting 12-q for p gives, TR=(12-q)q
 Multiply through by q to get an equation for
TR, TR = 12q - q2
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Marginal Revenue, MR
Use this formula:
MR = DTR / DQ = (TR2-TR1)/ (Q2-Q1).
 It is more precise to work with the equation
for the demand curve: e.g., Substitute: TR =
12Q - Q2 for DTR
 MR = DTR / DQ = D(12Q - Q2 )/ DQ
MR = 12-2Q. MR has the same y-intercept
as D, but is twice as steep.
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Quantity (million units/year)
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Total Revenue (mil. $/yr)
Price ($/unit)
Demand (P), Total Revenue (TR),
and Marginal Revenue (MR)
10 11 12 P=AR
MR
TR
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Monopoly Price and Output
The profit-maximizing level of output will
be that quantity where MR = MC, Qe.
 The monopolist charges the demand price
for that quantity.
 Notice that P > MC.
 Does the monopolist necessarily earn a
profit? Compare Figures 3 & 4, p. 225.
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Compare P and ATC at Qe to
determine profitability.
If P > ATC the monopolist will earn
economic profits. See Figure 3, p. 225.
 If P < ATC the monopolist will not earn
economic profits. See Figure 4, p. 225.
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Pure Competition v. Monopoly
For the purely competitive firm P = MR;
while for the monopolist, P > MR; and
 For the purely competitive firm P = MC
while for the monopolist, P > MC.
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MONOPOLY PROFITS IN THE
LONG RUN
How a Monopolist responds to an increase
in demand. See Fig. 5, panel A
 Monopolists may earn LR excess profits
 Excess profits may be absorbed by:
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Capitalization of Profits
Monopoly Rent Seeking
X-Inefficiency -- See Fig. 5, panel B
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PRICE DISCRIMINATION
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“Price discrimination occurs when a good
is sold at different prices that do not reflect
differences in production costs.” See page
231.
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Types of Price Discrimination
First-Degree -- charging each customer the
highest price he or she is willing and able to
pay. See Figure 7, page 233.
 Second-Degree -- charging different prices
based upon quantity purchased.
 Third-Degree -- charging different prices to
different segments of the market or the
buying population. See fig 8, p 233.
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Rationale for Price
Discrimination
Price discrimination allows the firm to earn
more revenue.
 If a monopolist could successfully perfectly
price discriminate, then
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P = MR;
consumer surplus equals zero.
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To successfully price discriminate, the
seller must . . .
be a price searcher.
 be able to distinguish between customers
and determine their willingness to pay (and
ed must differ across market segments).
 be able to prevent resale of the good.
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Price Discrimination and
Resource Allocative Efficiency
A perfectly price discriminating monopolist
would produce the quantity where P = MR
= MC. (Allocative eff.)
 The single-price monopolist produces at a
quantity where P > MC. (Ineff. alloc.)
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THE CASE AGAINST
MONOPOLY
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Monopoly is less efficient than pure
competition. See Fig. 9, p. 235.
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The Welfare Costs of a Monopoly
Rent Seeking is Socially Wasteful
As is X-inefficiency
The monopolist may neither build the optimum
plant, nor produce at minimum ATC.
(Technically Inefficient).
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The Case of Natural Monopoly
Under IRS, a single firm may supply the
market at lower unit cost than would be
possible under pure competition.
 See Figure 6, page 230.
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Why Regulate Natural Monopolies?
The unregulated natural monopoly will
restrict its output and raise its price.
 It is not in the monopolist self interest to
increase its output until P=MC.
 No firm may enter the industry.
 Many people argue that natural monopolies
should be regulated.
 But how?
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Price Regulation
Specifically, make the price the monopolist
charges approximate the competitive price.
 Marginal-cost pricing
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Losses may result.
May be overcome through price discrimination
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Profit Regulation
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Limit the monopolist to zero economic
profit,
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taxing all economic profits away,
or requires the monopolist to charge a price
equal to ATC. (aka the “fair” price.)
The monopolist may have little incentive to
minimize costs.
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Output Regulation
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Government mandates the quantity of
output it wants the natural monopoly to
produce. The monopolist can gain
additional economic profits by lowering its
costs.
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Problems with Regulating a
Natural Monopoly
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Distorted Incentives
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Information Problems
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Time Lags
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Regulating Other Industries
Some industries are regulated in order to
ensure service to customers,
 some because the service is considered too
essential to be left to the market,
 others to protect existing firms from "cutthroat" competition.
 Is such regulation justifiable on grounds of
economic efficiency? See Chapter 12
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