Transcript Price

Chapter 8
Monopoly, Oligopoly, and
Monopolistic Competition
McGraw-Hill/Irwin
©2009 The McGraw-Hill Companies, All Rights Reserved
Market Imperfections
Ch 10
Externalities
and Property
Rights
Ch 8
Imperfect
Competition
Ch 9
Games and Strategic
Behavior
LO 8 - All
8-2
Learning Objectives
1. Distinguish among three types of imperfectly competitive
industries
2. Define imperfect competition and describe how it differs from
perfect competition
3. Understand why economies of scale are the most enduring
source of monopoly power
4. Understand the concepts of marginal cost and marginal revenue
 Find the output level and price that maximizes a monopolist's
profits
5. Explain why the profit-maximizing output level for a monopolist is
too small from society's perspective
6. Discuss why firms offer discounts to buyers who are willing to
jump a hurdle
LO 8 - All
8-3
Imperfect Competition
 Imperfectly competitive firms have some control of
price
 Long-run economic profits possible
 Reduce economic surplus
 Three types
1. Monopoly has only one seller, no close substitutes
2. Monopolistic competition has many firms with
differentiated products
 These products are all close substitutes
3. Oligopoly is a small number of firms producing
close substitutes
LO 8 - 2
8-4
Monopolistic Competition
Number of
Firms
Price
Entry and Exit
Product
Economic
Profits
Decisions
LO 8 - 1
Monopolistic
Competition
Perfect
Competition
Many firms
Many firms
Limited flexibility
Free
Price taker
Free
Differentiated
Standardized
Zero in long run
Zero in long run
P, Q, product
differentiation
Q only
8-5
Oligopoly
Oligopoly
Number of
Firms
Price
Entry and Exit
Product
Few firms,
each large
Some flexibility
Large size firm
Differentiated or
standardized
Perfect
Competition
Many firms
Price taker
Free
Standardized
Economic
Profits
Possible
Zero in long run
Decisions
P, Q, differentiation,
advertising
Q only
LO 8 - 1
8-6
The Essential Difference
 Market power is the firm's ability to raise its price
without losing all its sales
 Any firm facing a downward sloping demand curve
 Firm picks P and Q on the demand curve
 Market power comes from factors that limit competition
Perfectly
Competitive Firm
Price
Price
Imperfectly
Competitive Firm
D
D
Quantity
LO 8 - 2
Quantity
8-7
Five Sources of Market Power
1.
2.
3.
4.
5.
Exclusive control over inputs
Patents and copyrights
Government licenses or franchises
Economies of scale (natural monopolies)
Network economies
LO 8 - 3
8-8
Market Power: Economies of Scale

Returns to scale refers to the percentage change in
output from a given percentage change in ALL inputs
 Long-run idea
 Constant returns to scale: doubling all inputs
doubles output
 Increasing returns to scale: output increases by a
greater percentage than the increase in inputs
 Average costs decrease as output increases
 Natural monopoly: a monopoly that results from
economies of scale
LO 8 - 3
8-9
Market Power: Network Economies

Network economies occur when the value of the
product increases as the number of users increases
 VHS format for video tapes, Blu-ray for DVDs
 Telephones
 Windows operating system
 eBay
 Facebook and MySpace
LO 8 - 3
8 - 10
Economies of Scale and Start-Up Costs
 New products can have a large fixed development cost
 If marginal cost is constant,
Marginal cost = Average variable cost
 Total cost is fixed cost (F) plus variable cost
TC = F + (M) (Q)
 Total cost increases as output increases
 Average total cost is
ATC = F / Q + M
 Average total cost decreases as output increases
LO 8 - 3
8 - 11
TC = F + M Q
F
Average cost ($/unit)
Total cost ($/year)
Economies of Scale
ATC = F/Q + M
M
Quantity
LO 8 - 3
Quantity
8 - 12
Video Game – Different Volumes
Nintendo
Playstation
Annual Production
(000s)
1,000
1,200
Fixed Cost ($000s)
$200
$200
Variable Cost ($000s)
$800
$960
Total Cost ($000s)
$1,000
$1,160
ATC per game
$1.00
$0.97
LO 8 - 3
8 - 13
Video Game – Lower Marginal Costs
Nintendo
Playstation
Annual Production
(000s)
1,000
1,200
Fixed Cost ($000s)
$200
$200
Variable Cost ($000s)
$200
$240
Total Cost ($000s)
$400
$440
ATC per game
$0.40
$0.37
LO 8 - 3
8 - 14
Video Games – Higher Fixed Cost
Nintendo
Playstation
Annual Production
(000s)
1,000
1,200
Fixed Cost ($000s)
$10,000
$10,000
$200
$240
Total Cost ($000s)
$10,200
$10,240
ATC per game
$10.20
$8.53
Variable Cost ($000s)
LO 8 - 3
8 - 15
Video Games – Different Production Levels
Nintendo
Playstation
Annual Production
(000s)
500
1,700
Fixed Cost ($000s)
$10,000
$10,000
$100
$340
Total Cost ($000s)
$10,100
$10,240
ATC per game
$20.20
$6.08
Variable Cost ($000s)
LO 8 - 3
8 - 16
Intel's Advantage
 Development cost of a new chip
 Marginal cost of making a chip
 Dominating the market
$2 billion
Pennies
Priceless
 Intel supplies more than 80% of the processors for PCs
LO 8 - 3
8 - 17
Monopolist
 Pure monopoly: the only seller of a unique product
which has no close substitutes
 Like all other firms, a monopolist
 Maximizes profits
 Applies the Cost-Benefit Principle
 Increase output if marginal benefit > marginal cost
 Decrease output is marginal benefit < marginal cost
 Marginal benefit for a monopolist is different than for a
perfectly competitor
LO 8 - 4
8 - 18
Profit Maximization for the Monopolist
Price ($/unit)
 For the monopolist, selling one more unit
 Decreases market price
 Reduces marginal revenue by more than the price
 Lower price applied to all units
6
5
D
2
3
Quantity (units/week)
LO 8 - 4
8 - 19
Price & marginal revenue ($/unit)
Monopolist's Marginal Revenue
LO 8 - 4
8
3
D
1
2
-1
3
4
8
5
MR
Quantity (units/week)
Price
Quantity
Total Revenue
$6
2
$12
Marginal
Revenue
$5
3
$15
3
$4
4
$16
1
$3
5
$15
-1
8 - 20
Monopoly Demand and Marginal Revenue
 In general, the
monopolist's marginal
revenue curve
 Has the same
intercept as demand
 Has twice the slope of
demand
 Lies below demand
Price
a
a/2
D
MR
Q0
Q0/2
Quantity
LO 8 - 4
8 - 21
Deciding Quantity
LO 8 - 4
6
Price ($/unit of output)
 A monopolist knows his
demand and marginal
revenue curves
 Marginal cost is also known
 If he operates at P = $3 and
Q = 12, MC > MR
 Decrease output
 If the firm operates at Q = 8,
then MC = MR = 2
 The demand curve sets the
price, P = $8
 At any output below 8,
MC < MR
MC
4
3
D
2
MR
12
8
Quantity (units/week)
8 - 22
Monopoly Losses and Profits
Economic profit
= $400,000/day
Price ($/minute)
0.12
ATC
0.10
MC
0.05
MR
0.10
0.08
ATC
MC
0.05
D
20
24
Minutes (millions/day)
LO 8 - 4
Price ($/minute)
Economic loss
= $400,000/day
MR
D
20
24
Minutes (millions/day)
8 - 23
The Invisible Hand Fails
Price ($/unit of output)
6
The monopolist's optimal
amount occurs where
MC = MR, Q = 8 units
and P = $4
4
Deadweight loss
from monopoly = $4
The socially optimal
amount occurs where
MC = MB, Q = 12 units
and P = $3
3
2
Marginal Cost
MR
D
8
12
24
Quantity (units/week)
LO 8 - 5
8 - 24
Monopoly and Perfect Competition
LO 8 - 5
Monopoly
Perfect Competition
MC = MR
MC = MR
P >MR
P > MC
P = MR
P = MC
Deadweight
Loss
No Deadweight
Loss
8 - 25
Managing Monopoly
 Monopolies exist for economic reasons
 Patents, copyrights, and innovation
 Economies of scale
 Network economies
 Anti-trust laws attempt to limit deadweight loss
 Limiting monopolies has costs
 Patents encourage innovation
 Economies of scale minimize ATC
 Network economies increase benefits
LO 8 - 5
8 - 26
Price Discrimination
 Price discrimination means charging different buyers
different prices for essentially the same good or service
 Separate the groups
 No side trades among buyers
 Many forms of price discrimination
 Hurdle method: discounts for identifiable groups
(e. g., students, AARP)
 Perfect discrimination: negotiate separate deals
with each customer
LO 8 - 6
8 - 27
Carla the Editor
What is the
social optimum?
What's Carla's
revenue?
 Opportunity cost of Carla's time is $29
Reservation
Total
Student
Price
Revenue
A
B
C
D
E
F
G
LO 8 - 6
$40
38
36
34
32
30
28
$40
$76
$108
$136
$160
$180
$196
8 - 28
Carla the Editor
What if Carla
What's Carla's
maximizes her profit?
revenue?
 Opportunity cost of Carla's time is $29
Student
A
B
C
D
E
F
G
LO 8 - 6
Reservation
Price
Total
Revenue
$40
38
36
34
32
30
28
$40
$76
$108
$136
$160
$180
$196
MR
$40
$36
$32
$28
$24
$20
$16
8 - 29
What's Carla's
What if Carla is
Carla the Editor perfect discriminator?
revenue?
 Opportunity cost of Carla's time is $29
Reservation
Total
Student
Price
Revenue
A
B
C
D
E
F
G
LO 8 - 6
$40
38
36
34
32
30
28
$40
$78
$114
$148
$180
$210
$238
8 - 30
Carla Offers a Rebate
 If reservation price < $36, mail in rebate
Reservation
Price
Total
Revenue
A
$40
$40
B
38
76
C
36
108
Student
Discounted Price Submarket
LO 8 - 6
D
$34
$34
E
32
64
F
30
90
MR
$40
36
32
$34
30
26
8 - 31
Carla's Choices
Program
Social
Optimum
Single
Price
Perfect
Discriminator
Hurdle
Papers Edited
6
3
6
5 = (3 + 2)
Price
$30
$36
Reservation
$36, $4
rebate
Total Revenue
$180
$108
$210
$172
Carla's Time
$174
$87
$174
$145
Economic Profit
$6
$21
$36
$27
Total Surplus
$26
$27
$36
$35
LO 8 - 6
8 - 32
Hurdle Method of Price Discrimination
 The hurdle method of price discrimination is the
practice of offering a discount to all buyers who
overcome some obstacle.
 Temporary Sales
 Hard cover and paperback books
 Multiple car models from one manufacturer
 Commercial air carriers
 Movie producers and phased releases
 Scratch and Dent appliance sales
LO 8 - 6
8 - 33
Imperfect Competition
Imperfect Competition
Monopolistic Competition
and Oligopoly
Sources of Market Power
Monopoly
LO 8 - All
8 - 34
Chapter 8 Appendix
The Algebra of Monopoly Maximization
McGraw-Hill/Irwin
©2009 The McGraw-Hill Companies, All Rights Reserved
From Demand to Marginal Revenue
 Given a demand curve such as
P = 15 – 2 Q
 We can write the marginal revenue curve as
MR = 15 – 4 Q
 Suppose marginal cost is a line with zero intercept and
a slope of 1
MC = Q
 The remaining step is to set marginal revenue equal to
marginal cost
LO 8 - 4
8 - 36
MR = MC
 Let Q* be the profit maximizing level of output
MC = MR
Q* = 15 – 4 Q*
5 Q* = 15
Q* = 3
 To find P, substitute Q = 3 into the demand equation
P = 15 – 4 Q*
P = 15 – 4 (3)
P=3
LO 8 - 4
8 - 37