Transcript Document

A Lecture Presentation
to accompany
Exploring Economics
3rd Edition
by Robert L. Sexton
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Printed in the United States of America
ISBN 0-324-26086-5
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Chapter 12
Monopoly
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12.1 Monopoly: The Price
Maker
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A true or pure monopoly exists
where there is only one seller of a
product for which no close substitute
is available.
The firm and “the industry” are one
and the same.
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Because a monopoly firm faces the
industry demand curve, it can pick
the most profitable point on that
demand curve.
Monopolists are price makers (rather
than takers) who try to pick the price
that will maximize their profits.
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Pure Monopoly is a Rarity

Pure monopolies are a rarity because
few goods and services truly have
only one producer.
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Near-monopoly conditions may exist,
such as many public utilities, but
absolute total monopoly is rather
unusual.
However, the number of situations
where monopoly conditions are fairly
closely approximated are numerous
enough to make the study of
monopoly useful.
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Barriers to Entry
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For a monopoly to persist, it must be virtually
impossible for other firms to overcome barriers
to entry.
Barriers to entry
 legal barriers
 franchising
 licensing
 patents
 economies of scale
 control of important inputs
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
The situation in which one large firm
can provide the output of the market
at a lower cost than two or more
smaller firms is called a natural
monopoly. With a natural monopoly,
it is more efficient to have one firm
produce the good. The reason for the
cost advantage is economies of scale
throughout the relevant output range.
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Quantity of Output
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Another barrier to entry is control
over an important input.
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Alcoa's control over aluminum in the
1940s
DeBeers control over much of the world's
output of diamonds
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12.2 Demand and Marginal
Revenue in Monopoly

In monopoly, the market demand
curve may be regarded as the
demand curve for the firm's product
because the monopoly firm is the
market for that particular product.
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
Unlike perfect competition, the
demand curve for a monopolist’s
product is downward sloping because
the market demand curve is
downward sloping.
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If the monopolist reduces output, the
price will rise.
If the monopolist expands output, the
price will fall.
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Price
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
The marginal revenue curve for a
monopolist lies below the demand
curve.
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In order to get revenue from marginal
customers, the firm has to lower the
price.
So marginal revenue is always less than
price.
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
In monopoly, if the seller wants to
expand output, it will have to lower
its price on all units.
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That means that the monopolist
receives additional revenue from the
new unit sold, but it will receive less
revenue on all of the units it was
previously selling.
So when the monopolist cuts price to
attract new customers, the old
customers benefit.
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
In Exhibit 4, we can compare
marginal revenue for the competing
firm with the marginal revenue for
the monopolist.
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The Monopolist’s Price in the Elastic
Portion of the Demand Curve
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The relationship between the
elasticity of demand and marginal
and total revenue are shown in
Exhibit 5.
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In the elastic portion of the curve, when
the price falls, total revenue rises, so
that marginal revenue is positive.
In the inelastic portion of the curve,
when the price falls, total revenue falls,
so that marginal revenue is negative.
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
A monopolist will never knowingly
operate in the inelastic portion of its
demand curve.

Increased output will lead to lower total
revenue and higher total cost in that
region.
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12.3 The Monopolist's
Equilibrium
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The monopolist, like the perfect
competitor, will maximize profits at
that output where MR = MC. Profits
continue to grow until that output is
reached.
Therefore, the equilibrium output is
where MR = MC.
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Three Step Method for
Monopolists
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The three-step method for determining
economic profits, economic losses, or zero
economic profits
 Find where MR equals MC, which is the
profit-maximizing output level.
 Go straight up to the demand curve, then
left to find the corresponding market price.
 Find TC as ATC times the quantity produced.
TC = ATC  Q
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Profits for a Monopolist
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If TR > TC (the price exceeds average
total cost), the monopolist is
generating economic profits.
If TR < TC (the price is less than
average total cost), the monopolist is
generating economic losses.
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
In perfect competition, profits in an
economic sense will persist only in
the short run because in the long run,
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new firms will enter the industry,
increasing industry supply
and thus driving down the price of the
good.
Thus, profits are eliminated.
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In monopoly, profits are not
eliminated because barriers to entry
exist.
Other firms cannot enter, so economic
profits can persist in the long run.
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Losses for the Monopolist
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Being a sole supplier does not
guarantee that consumers will
demand your product.
A monopolist will incur a loss if there
is insufficient demand to cover
average total costs at any price and
output combination along the demand
curve.
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Patents
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Patents and copyrights
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examples of monopoly power
designed to provide an incentive to
develop new products
The fall in the price of a patented
good when the patent expires
illustrates the effect of introducing
competition.
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12.4 Monopoly and
Welfare Loss
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The major objections to monopoly
 not “fair” for monopoly owners to
have persistent economic profits
 monopoly leads to lower output
and higher prices than would exist
under perfect competition
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Does Monopoly Promote
Inefficiency?
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Efficiency objection: monopolists charge
higher prices and produce less output.
 Monopolist produces an output where the
price is greater than its cost,
 so that the value to society from the last
unit produced is greater than its cost,
 so the monopoly is not producing enough
of the good from society's perspective,
creating a welfare loss.
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The actual amount of the welfare loss
in monopoly is of considerable debate
among economists.
Estimates vary between 0.1 percent
to 6 percent of national income.
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Does Monopoly Retard
Innovation?
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Some argue that a lack of competition
retards technological advance.
 Already reaping monopolistic profits, firms
do not work at
 product improvement,
 technical advances designed to promote
efficiency, and so forth.
The notion that monopoly retards innovation
can be disputed. Many near-monopolists are
important innovators.
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Indeed, innovation helps firms initially
obtain a degree of monopoly status.
Even monopolists want more profits,
and any innovation that lowers costs
or expands revenues creates profits
for a monopolist.
Therefore, the incentive to innovate
may well exist in monopolistic market
structures.
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12.5 Monopoly Policy
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Two major approaches to dealing
with the monopoly problem:
 antitrust policies
 regulation
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Antitrust Policies
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By imposing monetary and
nonmonetary costs on monopolists
antitrust policies reduce the
profitability of monopoly.
 the fear of lawsuits
 even jail sentences
Policies include attempts to keep firms
from getting “too big” and eliminating
restrictions on price competition.
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Have Antitrust Policies Been
Successful?
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The success of antitrust policies can
be debated.
It is very likely that at least some
anticompetitive practices have been
prevented simply by the very
existence of laws prohibiting
monopoly-like practices.
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
While the laws have been enforced
in an imperfect fashion, on balance,
they have probably successfully
impeded monopoly influences.
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Government Regulation
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Government regulation is an
alternative approach to dealing with
monopolies.
The goal is to achieve the efficiency
of large-scale production without
permitting the high monopoly prices
and low output that can promote
allocative inefficiency.
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Regulators often face a basic policy
dilemma.
Without regulation, profit-maximizing
monopolist will produce where
MR = MC.

At that output, the price exceeds average
total cost, so economic profits exist.
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
The monopolist is
 producing relatively little output
 charging a relatively high price
 producing at a point where price is
above marginal cost
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Quantity
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Socially allocative efficiency
 where P = MC
With natural monopoly,
 where P = MC, the ATC > P
The optimal output, then, is an output
that produces losses for the producer.
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Any regulated business that produced
for long at this “optimal” output
would go bankrupt; it would be
impossible to attract new capital to
the industry.
Therefore, the “optimal” output from
a welfare perspective really is not
viable.
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A compromise between unregulated
monopoly and marginal cost pricing is
average cost pricing, where price
equals average total cost.
The monopolist is permitted to price
the product where economic profits are
zero, meaning that a normal return is
being permitted, like firms experience
in perfect competition in the long run.
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Difficulties in Average Cost
Pricing
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The actual implementation of a rate
(price) that permits a “fair and
reasonable” return is more difficult
than the graphical analysis suggests.
The calculations of costs and values is
very difficult, often forcing regulatory
agencies to use profits as a guide
instead.
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
Another problem is that average cost
pricing gives the monopolist no
incentive to reduce costs (which
regulators have tackled by letting the
firm keep some of the profits that
come from lower costs).
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
Also, consumer groups are constantly
battling for lower rates, while the
utilities themselves are lobbying for
higher rates so that they can achieve
some monopoly profits.
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The temptation is great for the
commissioners to be generous to the
utilities.
On the other hand, there may be a
tendency for regulators to bow to
pressure from consumer groups.
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12.6 Price Discrimination and
Peak Load Pricing
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Sometimes sellers will charge different
customers different prices for the same
good or service when the cost does not
differ is called price discrimination.
Under certain conditions , the monopolist
finds it profitable to discriminate among
various buyers, charging higher prices to
those that are more willing to pay and
lower prices to those less willing to pay.
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Conditions for Price
Discrimination
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Monopoly Power
Price discrimination is possible only with
monopoly or where members of a small
group of firms follow identical pricing
policies.
When there are a number of competing
firms, discrimination is less likely because
competitors tend to undercut the higher
prices charged by the firms engaging in
price discrimination.
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Conditions for Price
Discrimination
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Market Segregation
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Price discrimination can only occur if the
demand curve for markets, groups or
individuals are different. If the demand
curves are not different, a profit
maximizing monopolist would charge the
same price in both markets.
In short, price discrimination requires the
ability to separate customers according
to their willingness to pay.
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Conditions for Price
Discrimination
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No Resale
For price discrimination to work, the
purchaser buying the product at a
discount must have difficulty in reselling
the product to customers being charged
more. Otherwise, consumers would buy
extra product at the discounted price and
sell it at a profit to others, reducing the
number of customers paying the higher
price.
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Examples of Price Discrimination
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AIRLINE TICKETS
Seats on airlines usually go for different prices.
The airlines can discriminate against business
travelers who usually have little advance warning
and often travel on weekdays—preferring to be
home on the weekends.
Because the business traveler has a high
willingness to pay (a relatively inelastic demand
curve) the airlines can charge them a higher price.
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College and University Tuition
Students who are well off financially
tend to pay more for their education
than do students who are less well off
because of different financial aid
packages.
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Quantity discounts
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The seller charges a higher price for the first
unit than for later units, allowing the producer
to extract some consumer surplus.
Six pack of soda might be less than buying each
separately. Or you might be able to buy a
bakers dozen of donuts—13 for the price of 12.
With this type of price discrimination you are
charging more for the first units than say for
the 20th unit.
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The Welfare Effects of Perfect
Price Discrimination

When the firm able to perfectly price
discriminate, each unit is sold at its
reservation price—that the firm sells each
unit at the maximum amount that the
customer would be willing to pay. Because
each customer pays exactly the amount
she or he is willing to pay, the marginal
revenue is the same as the demand curve.
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Peak Load Pricing
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Sometimes producers will charge different prices
during different periods of time because the
demand and the cost of producing the product
vary over time.
For a number of goods and services, demand
peaks at particular times—bridges, roads and
tunnels during rush hour traffic, telephone
services during business hours, electricity during
late summer afternoons, movie theaters on
weekend evenings and amusement parks and ski
resorts during holidays.
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
In price discrimination we saw that prices reflected
different demands from buyers but with peak load
pricing we have different demands and different
costs. Peak load pricing leads to greater efficiency
because consumer prices reflect the higher
marginal costs of production during peak periods.
That is, buyers are charged a higher price for
goods and services during peak periods and a
lower price during non-peak periods.
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