Transcript Chapter 10

CHAPTER
10
Monopoly
1
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
1
Monopoly


A monopoly is a market served by a
single firm.
A monopoly occurs when there is only
one firm and a barrier preventing other
firms from entering the market.
2
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Barriers to Entry
Possible barriers to entry include:
 A patent, granted by the government, gives an
inventor the exclusive right to sell a new
product for some period of time
 A franchise, or licensing scheme, in which
the government designates a single firm to sell
a particular product
 A natural monopoly, in which large economies
of scale in production allow only one firm to be
profitable
3
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Monopolist’s Output Decision

Like other firms, the monopoly’s objective
is to produce the output level that will
maximize profit.

The firm faces the same laws of
production and cost in the short run,
associated with diminishing returns.
4
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Monopolist’s Demand Curve


Since the monopoly is
the only firm in the
market, it faces the
entire market
demand for its
product.
A downwardsloping demand
curve is associated
with particular
revenue
characteristics for
the monopoly firm.
5
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Demand and Marginal Revenue for
the Monopolist

In order to increase the
quantity sold, the
monopolist must
decrease price for all
units sold.

When the monopolist
decreases price in
order to increase
quantity sold, there is
good news and bad
news.
6
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Demand and Marginal Revenue for
the Monopolist

The good news is
that the firm sells
more output, so it
collects more
revenue from new
customers.

The bad news is that
the firm loses
revenue from selling
at a lower price to all
customers combined.
7
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Demand and Marginal Revenue for
the Monopolist

The combined good
and bad news yields
the value of marginal
revenue for the
monopolist.

When the bad news
outweighs the good
news, marginal
revenue becomes
negative.
8
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Total Revenue and Marginal
Revenue for the Monopolist
Information from the demand
curve (price and quantity sold)
can be used to derive the total
and marginal revenue curves.
Total Revenue
32
C o s t in $

24
16
8
0
Price
($)
Quantity
Sold
P
Q
Total
Marginal
Revenue Revenue
($)
($)
P ric e a n d m a rg in a l re v e n u e
0
1
2
3
4
Quantity sold
5
6
Demand and Marginal Revenue
14
16
14
12
10
8
6
4
0
1
2
3
4
5
6
© 2001 Prentice Hall Business Publishing
TR
(PxQ)
0
14
24
30
32
30
24
MR
 TR
Q
14
10
6
2
-2
-6
12
10
8
6
4
2
0
-2
-4
-6
0
1
2
3
4
5
6
Quantity sold
Demand
Economics: Principles and Tools, 2/e
Marginal Revenue
9
O’Sullivan & Sheffrin
The Marginal Principle and the
Output Decision

To decide how much output to produce and
what price to charge, the monopolist can use
the marginal principle.
Marginal PRINCIPLE
Increase the level of an activity if its marginal benefit
exceeds its marginal cost, but reduce the level if the
marginal cost exceeds the marginal benefit. If
possible, pick the level at which the marginal benefit
equals the marginal cost.
10
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Marginal Rule for Profit
Maximization

A firm maximizes profit by following the
marginal principle—by setting marginal
revenue equal to marginal cost.
11
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Computing Maximum Profit
Price
Quantity
Sold
Total
Revenue
P
Q
TR
(given)
(given)
(PxQ)
18
17
16
15
14
13
12
600
700
800
900
1000
1100
1200
10,800
11,900
12,800
13,500
14,000
14,300
14,400

Profit
Marginal
Marginal Average
(Totals
Revenue Total Cost
Cost
Total Cost approach)
MR
 TR
Q
(given)
11
9
7
5
3
1
5,160
5,880
6,560
7,200
7,900
8,800
9,840
STC
MC
 TC
Q
7.2
6.80
6.40
7.00
9.00
10.40
SATC
TC
Q
8.6
8.4
8.2
8
7.9
8
8.2
Profit
(Per-unit
basis
Approach)
TR - STC (P-ATC)Q
5,640
6,020
6,240
6,300
6,100
5,500
4,560
5,640
6,020
6,240
6,300
6,100
5,500
4,560
Marginal revenue is closest to marginal cost at 900
units of output.
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
12

When the gap
between total
revenue and total
cost is greatest,
marginal revenue is
roughly equal to
marginal cost.
The monopolist
maximizes profit
when it produces
900 units of output.
16000
14000
12000
10000
8000
6000
4000
500
600
700
800
900
1000
1100
1200
1100
1200
Quantity of doses sold
20
$ p e r d o se

R e v e n u e a n d c o s t ($ )
The Output Decision
15
10
5
0
500
600
700
800
900
1000
Quantity of doses sold
MR
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
MC
ATC
O’Sullivan & Sheffrin
13
Demand
The Costs of Monopoly
14
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Costs of Monopoly


The perfectly competitive
produce 400 units at $8,
while the monopoly
produces 200 units at $18.
Consumer surplus is
larger under perfect
competition (areas C + R
+ D) than under
monopoly (area C).
15
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Costs of Monopoly

Rectangle R represents a
transfer of gains from
consumers to the
monopoly, but triangle D,
called the deadweight
loss triangle, is not offset
by a gain to anyone.
Loss to consumers from monopoly
versus competition
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
Triangle C R
=
Rectangle
-200 x $10 =
($2,000)
Triangle D =
-(200*10)/2 =
($1,000)
Total Loss =
O’Sullivan & Sheffrin
16
($3,000)
Rent Seeking


Rent seeking is a term used to describe the efforts
by a monopoly to persuade government to erect
barriers to entry.
If rent seeking exists,
the monopoly may
spend some of its
potential profit on
rent-seeking activity,
and the net loss to
society would be
areas R and D, not
just area D.
17
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Costs and Benefits of Monopoly

Costs: a monopoly produces less
output than a perfectly competitive
market, and people waste resources
trying to get and keep monopoly power.

Benefits: a patent or license increases
the payoff from research and
development, thus encourages
innovation.
18
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Natural Monopoly


A natural monopoly is a firm that serves
the entire market at a lower cost than two
or more firms can.
Examples of natural monopolies:


Public utilities (sewerage, water, and
electricity generation)
Transportation services (railroad freight
and mass transit)
19
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Natural Monopoly

The long-run average
cost of electricity
generation is
negatively sloped,
reflecting large
economies of scale.

As long as the longrun average cost
decreases, the longrun marginal cost
must lie below it.
20
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Natural Monopoly

Given the structure of
demand and marginal
revenue, the monopoly
maximizes profit by
generating 3 thousand
kilowatt hours.

Left alone, the monopoly
will charge $8.20 and
earn a profit of ($8.20$6.20) = $2 per kilowatt
hour (distance between
points c and m).
21
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Natural Monopoly

Total profit equals
(price – average cost) x
quantity produced and
sold (the green area).

Profit is possible only if
there is one firm,
unregulated, serving
the entire market
demand.
22
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Natural Monopoly


Suppose that the
monopoly shared the
market demand and
output sold with a
second firm, and that
each firm produced
half of the market
output (1.5 kw/h).
The cost of producing
1.5 kw/h would exceed
the price the firms can
receive, thus they
would suffer losses.
23
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Price Controls for a Natural Monopoly


Under an average-cost
pricing policy, the
government picks a
price equal to the
average cost of
production, or $5.20.
But regulation gives the
utility no incentive to
control costs, so costs
rise. Price after
regulation decreases by
less than anticipated.
24
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin