Transcript Ch09
A Lecture Presentation in PowerPoint to accompany Exploring Economics by Robert L. Sexton and Peter Fortura Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Chapter 9 Monopoly Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.1 Monopoly: The Price Maker 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.1 Monopoly: The Price Maker 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.1 Monopoly: The Price Maker Pure monopolies are a rarity because few goods and services truly have only one producer. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.1 Monopoly: The Price Maker 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.1 Monopoly: The Price Maker 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 Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.1 Monopoly: The Price Maker Natural monopoly one large firm can provide the output of the market at a lower cost than two or more smaller firms With 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Cost Economies of Scale ATC QSMALL FIRM QLARGE FIRM Quantity of Output Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.1 Monopoly: The Price Maker Another barrier to entry is control over an important input. Alcoa's control over bauxite in the 1940s DeBeers control over much of the world's output of diamonds Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.2 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.2 Demand and Marginal Revenue in Monopoly Unlike perfect competition, the demand curve for a monopolist’s product is downward sloping because the market demand curve is downward sloping. If the monopolist reduces output, the price will rise. If the monopolist expands output, the price will fall. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . D Price Price Comparing Demand Curves: Perfect Competition Versus Monopoly D 0 0 Quantity of Output Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Quantity of Output Total, Average, and Marginal Revenue Total Average Revenue Revenue Price Quantity (TR = P q) (AR = TR/q) $6 5 4 3 2 1 0 0 1 2 3 4 5 6 $0 5 8 9 8 5 0 Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . – $5 4 3 2 1 0 Marginal Revenue (MR = TR/q) $5 3 1 –1 –3 --5 0 9.2 Demand and Marginal Revenue in Monopoly The marginal revenue curve for a monopolist lies below the demand curve. In order to get revenue from marginal customers, the firm has to lower the price. So marginal revenue is always less than price. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.2 Demand and Marginal Revenue in Monopoly In monopoly, if the seller wants to expand output, it will have to lower its price on all units. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.2 Demand and Marginal Revenue in Monopoly 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Demand and Marginal Revenue for the Monopolist $7 Price 6 5 4 Marginal Revenue 3 Demand (Average Revenue) 2 1 0 1 2 3 4 5 6 Quantity of Output Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.2 Demand and Marginal Revenue in Monopoly The relationship between the elasticity and marginal and total revenue can be shown graphically. 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Demand and Marginal Revenues Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.2 Demand and Marginal Revenue in Monopoly 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.3 The Monopolist's Equilibrium 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Price (dollars per unit) Equilibrium Output and Price for a Pure Monopolist MC P* Lost total profits from Producing too little output; MR < MC Lost total profits from Producing too much output; MC > MR MR 0 D Q1 Q* Q2 Quantity of Output Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.3 The Monopolist's Equilibrium 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 Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.3 The Monopolist's Equilibrium 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . A Monopolist’s Profits MC Price Total Profit A P* C ATC B D 0 Q* MR Quantity Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.3 The Monopolist's Equilibrium In perfect competition, profits in an economic sense will persist only in the short run because in the long run, new firms will enter the industry, increasing industry supply and thus driving down the price of the good. Thus, profits are eliminated. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.3 The Monopolist's Equilibrium In monopoly, profits are not eliminated because barriers to entry exist. Other firms cannot enter, so economic profits can persist in the long run. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.3 The Monopolist's Equilibrium 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . A Monopolist’s Losses Price Total Loss MC A C P* B D 0 Q MR Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Quantity ATC 9.3 The Monopolist's Equilibrium Patents and copyrights 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Impact of Patent Protection on Equilibrium Price and Quantity Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.4 The Welfare Costs of a Monopoly 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 Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.4 The Welfare Costs of a Monopoly Efficiency objection: monopolist 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Perfect Competition Versus Monopoly Welfare loss due to monopoly Price MC = S PM PPC MCM MR 0 QM QPC Quantity Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . D 9.4 The Welfare Costs of a Monopoly The actual amount of the welfare loss in monopoly is of considerable debate among economists. Estimates across nations vary between 0.1 percent to 6 percent of national income. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.4 The Welfare Costs of a Monopoly Some argue that a lack of competition hinders 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 hinders innovation can be disputed. Many near-monopolists are important innovators. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.4 The Welfare Costs of a Monopoly 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy Two major approaches to dealing with the monopoly problem: Anti-combine laws and government regulation Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy By imposing anti-combine laws to prevent monopolies and promote competition the government enhances economic behaviour. Canada’s anti-combine laws are covered by the Competition Act of 1986. Penalties range from: fines to Possible imprisonment Criminal offences include mergers, fixing prices, bid-rigging and predatory pricing. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy Recently a number of high profile cases have come under the Competition Act. These include: The merger of Canada Packers Inc. and John Labatt Ltd. Royal Bank of Canada and the Bank of Montreal These mergers were prevented by the Competition Tribunal. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy It could be concluded that these mergers would likely lead to substantial lessening or prevention of competition. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy The monopolist is producing relatively little output, charging a relatively high price, and producing at a point where price is above marginal cost. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Marginal Cost Pricing Versus Average Cost Pricing Price PM A Monopoly pricing Average cost pricing Marginal cost pricing B PAC PMC C MR 0 ATC MC Losses with MC pricing QM QAC QMC Quantity Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . D 9.5 Monopoly Policy Socially allocative efficiency With natural monopoly, where P = MC. where P = MC, the ATC > P. The optimal output, then, is an output that produces losses for the producer. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy 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). Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Changes in Average Costs P1 ATC1 ATC0 P0 0 Q1 Q0 Quantity Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.5 Monopoly Policy 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.6 Price Discrimination Price discrimination when sellers charge different customers different prices for the same good or service when the cost does not differ. is possible only with monopoly or where members of a small group of firms (oligopolists, to be considered later) follow identical pricing policies. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.6 Price Discrimination When there are a number of competing firms, discrimination is less likely because competitors tend to undercut the high prices charged those discriminated against. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.6 Price Discrimination Price discrimination results from the profit-maximization motive. Sometimes, different groups of people have different demand curves, so that they react differently to price changes. A producer can make more money by charging those different buyers different prices. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.6 Price Discrimination A profit-maximizing seller will price where MR = MC for each different group of demanders, resulting in a higher price for more inelastic demanders (such as adult movie-goers) and a lower price for more elastic demanders (such as children). Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . Price Discrimination in Movie Ticket Prices a. Adults b. Children Price Price PA MCC MCA MRA 0 PC DC MCC MCC MRC DA 0 QA Quantity Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . QC Quantity 9.6 Price Discrimination For price discrimination to work, the purchaser 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. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.6 Price Discrimination Price discrimination is usually limited to services and to some goods where it is inherently difficult to resell or where the producer can effectively prevent resale. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.6 Price Discrimination and Time A publisher can price discriminate with hardback and paperback editions of a book. Some people are willing to pay a higher price to be among the first to read a book or see a movie; their demand curve is relatively inelastic. When different groups of consumers are charged different prices in different time periods it is called intertemporal price discrimination. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. . 9.6 Price Discrimination Quantity discounts are another form of price discrimination. The seller charges a higher price for the first unit than for later units, allowing the producer to extract some consumer surplus. Copyright © 2007, Nelson, a division of Thomson Canada Ltd. .