Transcript Ch10 my ppt

Frank & Bernanke
rd
3 edition, 2007
Ch. 10: Monopoly and Other
Forms of Imperfect Competition
1
Perfect Competition
An ideal market that maximizes economic
surplus
 A situation that does not always exist

2
Imperfectly Competitive Firms
Have some control over price
 Price may be greater than the cost of
production Reduce economic surplus to varying
degrees
 Long-run economic
profits are possible
Are very common
 Reduce economic surplus to varying
degrees
 Are very common

3
Different Forms of Imperfect
Competition

Pure Monopoly (most inefficient)


Monopolistic Competition (closest to perfect competition)




The only supplier of a unique product with no close substitutes
A large number of firms that produce slightly differentiated
products that are reasonably close substitutes for one another
Long-run adjustment to zero economic profits
Importance of differentiation
Oligopoly (more efficient than a monopoly)



Industry structure in which a small number of large firms produce
products that are either close or perfect substitutes
Cost advantages from large size may prevent the long-run
adjustment to zero economic profit
Undifferentiated and differentiated products
4
Perfectly and Imperfectly
Competitive Firms

The perfectly competitive firm faces a perfectly
elastic demand for its product.



Supply and demand determine equilibrium price. The
firm has no market power.
At the equilibrium price, the firm sells all it wishes.
The imperfectly competitive firm faces a
downward-sloping demand curve.


The firm has some control over price or some market
power.
The firm faces a downward sloping demand curve.
5
Perfect Competition
If the firm raises its price, sales will
be zero.
 If the firm lowers its price, sales will
not increase.
 The firm’s demand curve is the
horizontal line at the market price.

6
The Demand Curves
D
Market
price
Imperfectly competitive firm
Price
$/unit of output
Perfectly competitive firm
D
Quantity
Quantity
7
Five Sources of Market Power
Exclusive control over inputs
 Patents and Copyrights
 Government Licenses or Franchises
 Economies of Scale (Natural Monopolies)
 Network Economies

8
Economies of Scale and the
Importance of Start-Up Costs

Firms with large fixed costs and low
variable costs:
Have low marginal costs
 Average total cost declines sharply as
output increases
 Economies of scale will exist

9
Constant Returns to Scale

A production process is said to have
constant returns to scale if, when all inputs
are changed by a given proportion, output
changes by the same proportion.
10
Increasing Returns to Scale

A production process is said to have
increasing returns to scale if, when all
inputs are changed by a given proportion,
output changes by more than that
proportion; also called economies of scale.
11
TC and ATC with Economies of Scale
Average cost ($/unit)
Total cost ($/year)
TC = F + MQ
F + MQ0
F
ATC = F/Q + M
M
Q0
Quantity
Total cost rises at a constant
rate as output rises
Quantity
Average costs decline and is
always higher than marginal cost
12
Costs for Two
Computer Game Producers (1)
Nintendo
Playstation
Annual production
1,000,000
1,200,000
Fixed cost
$200,000
$200,000
Variable cost
$800,000
$960,000
$1,000,000
$1,160,000
$1.00
$0.97
Total cost
Average total cost per game
Observations
•Fixed costs are a relatively small share of total cost
•Cost/game is nearly the same
13
Costs for Two
Computer Game Producers (2)
Annual production
Fixed cost
Variable cost
Total cost
Average total cost per game
Nintendo
Playstation
1,000,000
1,200,000
$10,000,000
$10,000,000
$200,000
$240,000
$10,200,000
$10,240,000
$10.20
$8.53
Observations
•Fixed costs are a relatively large share of total cost
•Playstation has a $1.67 average cost advantage
•Playstation can lower prices, cover cost, and attract customers
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Costs for Two
Computer Game Producers (3)
Annual production
Fixed cost
Variable cost
Total cost
Average total cost per game
Nintendo
Playstation
500,000
1,700,000
$10,000,000
$10,000,000
$100,000
$340,000
$10,100,000
$10,340,000
$20.20
$6.08
• Shift of 500,000 units to Playstation
• Nintendo’s average cost increases to $20.20/unit
• Playstation average cost falls to $6.08
• A large number of firms cannot survive when the
cost differential is high
15
Economies of Scale and the
Importance of Fixed Costs

Fixed investment in research and
development has been increasing as a
share of production costs.
Cost of producing a computer
Fixed Cost
Software
1984
1990
20%
80%
Variable Cost
Hardware
80%
20%
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Economic Naturalist
How big will Playstation’s unit cost
advantage be if it sells 2,000,000 units per
year, while Nintendo sells only 200,000?
 Why does Intel sell the overwhelming
majority of all microprocessors used in
personal computers?

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Profit Maximization

Perfect competition and monopolies
Both increase output when MR > MC.
 Calculate MC the same way.
 Do not have the same MR at a given price.

 In
perfect competition: MR = P
 In monopoly: MR < P
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The Monopolist’s Benefit
from Selling an Additional Unit
• If P = $6, then TR = $6 x 2 = $12
• If P = $5, then TR = $5 x 3 = $15
• The MR of selling the 3rd unit = $3 (15-12)
• For the 3rd unit, MR = $3 < P = $5
Price ($/unit)
8
6
5
D
2
3
8
Quantity (units/week)
19
Marginal Revenue

P
Q
TR
6
2
12
5
3
15
4
4
16
3
5
15
MR
Observations


3
1
-1


MR < P
MR declines as quantity
increases
MR is the change between
two quantities
MR < P because price must
be lowered to sell an
additional unit
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P
Q
TR
6
2
12
5
3
15
4
4
16
3
5
15
MR
3
1
-1
Price & marginal revenue ($/unit)
Marginal Revenue in
Graphical Form
8
3
D
1
-1
2
3
4
8
5
MR
Quantity (units/week)
Demand: P = 8 – Q
MR = 8 – 2Q
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Monopolist with a Straight-Line Demand Curve
Price
a
a/2
D
MR
Q0/2
Q0
Quantity
Observations
• The vertical intercept, a, is the same for MR and D
• The horizontal intercept for MR, Q0/2, is one half the
demand intercept, Q0.
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Profit Maximizing Decision Rule
When MR > MC, output should be
increased.
 When MR < MC, output should be
reduced.
 Profits are maximized at the level of
output for which MR = MC.

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The Monopolist’s ProfitMaximizing Output Level
Marginal Cost
Price ($/unit of output)
6
Observations
• If P = $3 & Q = 12 MR < MC
and output should be
reduced
• Profits are maximized at 8
units where MR = MC
• P = $4 where quantity
demanded = quantity
supplied
4
3
2
MR
8
12
D
24
Quantity (units/week)
Demand: P = 6 – 0.25Q
MR = 6-0.5Q
MC = 0.25Q
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Even a Monopolist May
Suffer an Economic Loss
Being a monopolist doesn’t guarantee an economic profit
0.12
0.10
ATC
MC
0.05
D
20
MR
Minutes (millions/day)
Economic profit
= $400,000/day
Price ($/minute)
Price ($/minute)
Economic loss
= $400,000/day
0.10
0.08
ATC
MC
0.05
D
20
24
MR
Minutes (millions/day)
25
Invisible Hand Breaks Down
Under Monopoly
Price ($/unit of output)
6
Marginal cost
The socially optimal
amount occurs where
MC = D(MB) @ 12 units
3
D
12
24
Quantity (units/week)
26
Invisible Hand Breaks
Down Under Monopoly
Price ($/unit of output)
6
Marginal cost
• The profit maximizing level of
output of 8 units, where MR =
MC, is less than the socially
optimal output of 12
• Between 8 and 12, MB to
society > MC to society
• Cannot increase output
because MR to the firms is less
than MC
4
3
2
MR
8
12
D
24
Quantity (units/week)
27
Invisible Hand Breaks
Down Under Monopoly
Price ($/unit of output)
6
Marginal cost
Deadweight loss
• Because MR < P, the monopoly
produces less than the socially
optimal amount
• The deadweight loss of the
monopoly to society =
(1/2)($2/unit)(4units/wk) = $4/wk.
4
3
2
MR
8
12
D
24
Quantity (units/week)
28
Why the Invisible Hand Breaks
Down Under Monopoly

Monopoly




Profits are
maximized where
MR = MC.
P > MR
P > MC
Deadweight loss

Perfect Competition




Profits are
maximized where
MR = MC.
P = MR
P = MC
No deadweight loss
29
Difficulties in Reducing the
Deadweight Loss of Monopolies
Enforcing antitrust laws
 Patents, copyrights, and innovation
 Natural monopolies

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Price Discrimination
The practice of charging different buyers
different prices for essentially the same
good or service
 Examples of Price Discrimination

Senior citizens and student discounts on
movie tickets
 Supersaver discounts on air travel
 Rebate coupons

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Price Discrimination
Profit-maximizing seller’s goal is to charge
each buyer his/her reservation price.
 There are two problems to implementing
this pricing strategy.

Seller does not know the reservation prices
 Seller must separate high and low price
buyers
 The hurdle method of price discrimination is
used to solve these problems.

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The Hurdle Method
The practice of offering a discount to all
buyers who overcome some obstacle.
 Example


Offering a rebate to those who mail in a
coupon
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Examples of Price Discrimination
Temporary Sales
 Book publishers and paperback books
 Automobile producers offer various
models
 Commercial air carriers
 Movie producers

34
Price Discrimination and
Economic Surplus
P
MC
P*
World Price
D
MR
Q*
Q**
Q
35
Controlling Natural Monopolies

State ownership and management

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Weighing the benefit of marginal cost pricing versus
the cost of less incentive for innovation
State regulation of private monopolies

Cost-plus regulation

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Exclusive contracting for natural monopoly

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High administrative cost
Less incentive for innovation
P does not equate to MC
Competition for the contract sets P = MC
Difficulty when fixed costs are high such as electric
utilities
Vigorous enforcement of anti-trust laws


Helps prevent cartels
May prevent economies of scale
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