Transcript Lecture17 - UCSB Economics

Monopoly, Market Power, and
Economies of Scale
Today: Introduction of situations
in which the Invisible Hand breaks
down
Up until now…

…we have typically analyzed markets
with no control over market price

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Each firm was a price taker, since it only
produced a very small fraction of quantity
supplied in the market
Today, we begin Unit 4
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What happens when there are significant
imperfections in a market?
Many sellers vs. one seller
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Many sellers
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No control over price
One seller, also known as a monopolist
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Complete control over price (sort of)
Sort of?
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Recall that demand curves are
downward-sloping
Each time price increases, fewer people
are willing to pay the price to purchase
the good

The monopolist can control price, but must
face the consequences that price
determines quantity sold
MB in a competitive vs.
monopolistic environment

Competitive environment

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MB is price, since price does not depend on
quantity supplied by an individual firm
Monopolistic environment

We will see that MB decreases as quantity
supplied increases
What happens to the monopolist
when it sells another unit?

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Each time another
unit is sold, price of
the good decreases
We will go through a
simple example,
shown to the right,
to determine MR for
the monopolist
P
4
Q
0
3
1
2
2
1
3
0
0
Marginal revenue

Marginal revenue
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How much additional
is received by selling
one more unit of the
good?
We must first
calculate TR
Notice that for
Q > 1, MR < P
P
4
Q
0
TR
0
MR
3
3
1
3
1
2
2
4
-1
1
3
3
-3
0
4
0
Market inefficiencies of
monopoly

Decreasing marginal revenue creates
inefficiencies in the market

We will talk about this more in the next
lecture
And now, onto the big
question of the day
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How Do Firms Gain Market Power?
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Exclusive control over important inputs
Patents and copyrights
Government licenses or franchises
Economies of scale  Natural monopoly
Networks
Exclusive control over
important inputs

If a company controls a significant
portion of the important inputs to a
product, it can have significant
influence on price
Exclusive control over
important inputs
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Example: De Beers


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Rough diamond explorer
Around 40% of world diamond production
by value
Sales and marketing through the Diamond
Trading Company

This company sells almost half of the world’s
rough diamonds by value
(Source: http://en.wikipedia.org/wiki/De_Beers, checked Feb. 3, 2008)
De Beers
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Such large control over the market
makes De Beers able to act similarly to
a monopolist

Marketing of diamond jewelry does not
have to be brand specific

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"A Diamond is Forever" attempts to prevent old
jewelry from entering the market
De Beers does have some control over
world prices
Patents and copyrights

Patents and copyrights prohibit others
from copying private work and
discoveries

Example: Copying songs and movies that
are copyrighted are typically prohibited by
law
Government licenses or
franchises


Government-owned property often
allows exclusive operation of the
property for various uses
In some cases, this is to prevent
competition that could deteriorate a
natural destination
Government licenses or
franchises
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Example: Yosemite
National Park
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Limited parking
Tasteful hotels
Most of the park is
undeveloped

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Most of park development
is in only 7 square miles
Park is 1,200 square miles
Vernal Fall
Economies of scale
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Some technologies are such that as the
quantity produced increases, ATC
decreases for all reasonable quantities
produced
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This is due to increasing returns to scale
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This happens when ALL inputs double and
production MORE THAN doubles
Often happens with large fixed costs and
nearly-linear variable costs
Example where a single firm
could gain market power

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When a firm gains
market control with
economies of scale, it
is called a natural
monopoly
There are problems
with natural
monopolies if left
uncontrolled
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Price ($)
D
ATC
Deal with this later
Quantity
Network economies
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Some technologies are slow to
get adopted due to not enough
people entering the market

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Video phones (early version at
right, the PicturePhone)
Fax machines
HD DVDs versus Blu-ray
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See additional reading for more
Why? Costs are very high
initially
Network economies
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The internet has created a frenzy of network
economies
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eBay
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Facebook and MySpace
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On-line auctions
Social networking
As more people use eBay, Facebook, and
MySpace, the respective companies increased
in value
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Competition became difficult
Monopoly inefficiency
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As we will see, monopolies typically
produce quantities that are less than
efficient
This leads to positive economic profits
Controlling monopolies
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Laws have been passed to control
monopoly profits
Regulation typically tries to set
economic profit to be about zero
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This sometimes makes regulated stocks a
relatively safe investment
Controlling monopolies

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Why are monopolies typically regulated?
We will analyze this in the next lecture
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In the absence of regulation, a monopoly will
usually produce a quantity that is below the
optimal amount in order to make positive
economic profits
Monopolies can increase efficiency by price
discrimination

However, the monopolist sometimes benefits more than
consumers do
The rest of today
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Introducing profit maximization from
the monopolist’s point of view
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All units must be sold for the same price
Profit maximization of the monopolist
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As usual, set MB = MC to maximize profit
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Revenue is the benefit for the monopolist
Remember that MB is decreasing for the
monopolist
Single-price profit
maximization
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Remember that
marginal revenue is
below the price
received by the
monopolist (except
for the first unit in a
discrete case)
See our continuous
example we will use
today
Single-price profit
maximization

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We will find the
point where MR
and MC are
equal
Surplus and
deadweight loss
will then be
calculated
Important fact to note for
linear demand curves

MR has same
vertical intercept
as D, with twice
the slope

Read Ch. 8
Appendix for
algebraic
approach to
solving monopoly
problems
Simple monopoly example

For this problem,
note:
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Linear downwardsloping demand
curve
Linear upwardsloping MC curve
Remember: We
maximize profit by
setting MR = MC
Simple monopoly example

In an efficient
market with many
buyers and
sellers, point I is
the intersection of
the supply (MC)
and demand
curves

Price is G,
quantity is H
Simple monopoly example

As we will see
with a monopoly,
a different, less
efficient outcome,
occurs
Simple monopoly example
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Point K
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MR = MC
At quantity A, the
monopolist can
see from point E
on the demand
curve that price C
can be charged
Simple monopoly example
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Calculating surplus if
this was an efficient
market

Recall that triangle
JI0 is total surplus in
an efficient market
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Triangle JIG for
consumers
Triangle GI0 for
suppliers
Simple monopoly example
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At price C,
consumer surplus
falls to triangle
JCE
TR for monopolist
is price C times
quantity A
Surplus for
monopolist is
trapezoid CEK0
Simple monopoly example
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What is lost?
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Triangle EIK is
lost, since the
monopolist stops
producing once
quantity reaches
A
This triangle is
deadweight loss
(DWL)
Friday
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More on profit maximization from the
monopolist’s point of view
Inefficiencies of monopoly
Is discrimination legal?