Transcript Chapter 12

Chapter 12
Monopoly
12 Monopoly
Chapter 12 Outline
12.1 Introducing a New Market Structure
12.2 Sources of Market Power
12.3 The Monopolist’s Problem
12.4 Choosing the Optimal Quantity and Price
12.5 The “Broken” Invisible Hand: The Cost of Monopoly
12.6 Restoring Efficiency
12.7 Government Policy toward Monopoly
Key Ideas
1. Monopoly represents an extreme market structure with a single seller.
2. Monopolies arise both naturally and through government protection.
3. Monopolists are price-makers and produce at the point where
marginal revenue equals marginal cost.
4. The monopolist maximizes profits by producing a lower quantity and
charging a higher price than perfectly competitive sellers. By doing so,
deadweight loss results
12 Monopoly
5. Efficiency can be established in monopoly through first-degree
price discrimination or government intervention.
12.1 Introducing a New Market Structure
Price makers - Sellers that can set the price of a good
Market power -- The ability to set the price
Monopoly -- One seller of a good or service with no close substitutes
12.1 Introducing a New Market Structure
Exhibit 12.1 Two Market Structures
12.2 Sources of Market Power
Barriers to entry -circumstances that prevent potential
competitors from entering the
market
Types of barriers to entry
1.
2.
Legal market power
Natural market power
 Control of key resources
 Economies of scale
12.2 Sources of Market Power Legal Market Power
1.
Legal market power
Patent ® --- government-granted permission to be the
sole producer and seller of a good
Copyright ©-- Government-granted rights to the creator
of literary or artistic work.
2. Natural market power --- when a single firm
obtains market power through barriers to entry created by
the firm itself
12.2 Sources of Market Power Natural Market Power
Control of key resources
Key resources --- are essential for the production of a
good or service
Examples:
 Alcoa controlling bauxite, used in production of
aluminum
 Professional sports teams controlling talent
 De Beers’ control of diamond production
12.2 Sources of Market Power Natural Market Power
Network externalities -- when a product’s value
increases as more consumers use it
Examples: eBay, Facebook, Angie’s List.
Economies of scale
Natural monopoly -- emerges because it enjoys
economies of scale over a very large range of output
12.2 Sources of Market Power Natural Market Power
Exhibit 12.2 Average Total Cost and Marginal
Cost for a Natural Monopoly
 If this firm were to be broken up into two firms, ATC would be higher.
Example: if a new electric company entered the market, it would have to install
poles, string electric lines—all would increase the cost per unit.
 Natural monopolies occur when fixed costs are high. The natural monopoly
doesn’t have to worry about new firms coming in because of the high fixed
costs—no firm would want to enter.
12.3 The Monopolist’s Problem
Both monopolist and perfect competitor
 Produce an output using a production process and
inputs
 Incur production costs
 that monopolists and perfect competitors are
alike in terms of their production—they combine
inputs and turn them into outputs, and they
incur the costs of doing so. The difference is the
conditions under which that output is sold
12.3 The Monopolist’s Problem
Exhibit 12.3 Perfectly Competitive Firms and Monopolies Face Different Demand Curves
 The graph of a monopolist’s demand is the same thing as the demand for the entire
perfectly competitive industry—in the case of a monopolist, the firm is the industry,
so it is the same as the industry graph in perfect competition.
 The monopolist is constrained by the market demand curve, just as the perfectly
competitive industry is. Since market exchange is voluntary, a monopolist cannot
force consumers to pay any price for any quantity of output.
12.3 The Monopolist’s Problem Revenue Curves
Exhibit 12.4 The Market Demand Curve for Claritin
 Unlike perfect competitors, the monopolist must figure out
how much revenue it will make at different prices. As the
example with Claritin shows, selling a greater quantity
requires the monopolist to charge a lower price.
12.3 The Monopolist’s Problem Revenue Curves
Exhibit 12.5 Revenues and Costs for Claritin at Different Levels of Output
Two things here: (1). marginal costs are constant, which is common in this kind
of industry. Once a drug is developed, the marginal cost of producing another
pill is very low and constant; (2) the relationship between price and marginal
revenue. Remember that in perfect competition, price and marginal revenue
were the same because a firm in perfect competition doesn’t have to lower
price to sell another unit since it is such a small part of the entire market. That’s
not the case in monopoly (by definition).
12.3 The Monopolist’s Problem Revenue Curves
Example: Assume this monopolist is selling 200 units
at a price of $5 each and wants to increase the quantity
it sells to 400 units. It has to lower the price to $4 to do
so.
Good News
Selling 200 more units
at $4 each = $800
Bad News
Charging $1 less on
200 units it was
selling before = -$200
 That a downwardly sloping demand curve means there is a
tradeoff between quantity and price, so increasing output leads
to an increase in revenue of $800. But, because price has to be
reduced in order to achieve the increase in output, there is a
reduction in revenue of $200, for a net of $600.
 This is the change in revenue between selling 200 and 400 units ,
so the marginal revenue of selling 1 more unit is $600/200 or $3.
Point out that $3 is less than the price.
12.3 The Monopolist’s Problem Revenue Curves
Exhibit 12.6 The Quantity Effect and the Price Effect on Revenues for Claritin
 The good news is the quantity effect (increase in quantity) and the bad news (the
reduction in price) is the price effect.
 The net effect on total revenue depends upon whether price is being increased or
decreased, and whether the quantity or price effect is bigger.
12.3 The Monopolist’s Problem Revenue Curves
 Graphing the table’s columns 1, 2
and 4 (top graph) and columns 1
and 3 (lower graph) reveals some
important relationships.
 (1)price is higher than marginal
revenue, as discussed in previous
slides. (2). marginal revenue is zero
when total revenue is maximized.
 When marginal revenue is
positive, total revenue is increasing,
and when marginal revenue is
negative, total revenue is falling.
 So, some prices should obviously
not be chosen—any price that
results in a negative marginal
revenue, for example.
Exhibit 12.7 Relationship among Price, Marginal
Revenue, and Total Revenue
12.4 Choosing the Optimal Quantity and PriceProducing the Optimal
Quantity
Exhibit 12.8 Marginal Revenue and Marginal Cost for Claritin
 Recall the logic behind the
profit .Apply it to this
graph, using quantities
other than 500 to illustrate.
 For example, at 100 million
units, the marginal revenue
of the last unit is $5, while
the cost of producing it is
$1; therefore, it should be
produced and sold. On the
other hand, the 550th unit
has a marginal revenue of
$0.50 and the same cost of
$1; therefore, it should not
be produced and sold. So
profit maximization occurs
where MR = MC, at 500
million units of output.
12.4 Choosing the Optimal Quantity and PriceSetting the Optimal Price
 A monopolist cannot
charge any price it
wants to for any
quantity it wants to
sell. The monopolist
chooses one and the
market chooses the
other. This monopolist
chooses a quantity of
500 million; therefore
the “choice” of price is
really the price that the
market will bear.
 Exhibit 12.9 is the
same with two more
curves, but the logic is
the same: the market
determines what the
price will be for a
quantity of 500 -- $3.50
Exhibit 12.9 Choosing the Profit-Maximizing Price for Claritin
12.4 Choosing the Optimal Quantity and Price How a Monopolist
Calculates Profits
Profit = Total revenue – total cost
Total revenue = P x Q
Total cost = ATC x Q
Profit = (P x Q) – (ATC x Q)
= Q (P – ATC)
Profit = 500M($3.50 - $1.02)
= $1,240,000,000
The resulting profit-maximizing price and quantity and data
from Exhibit 12.5
12.4 Choosing the Optimal Quantity and Price
How a Monopolist Calculates Profits
 The graph shows
the same
information as the
previous slide. As
P > ATC, this firm
is earning an
economic profit.
 Will this profit will
continue in the
long-run.
 Remember that
there are barriers
to entry with a
monopoly, so
economic profits
will continue.
Exhibit 12.10 Computing Profits for a Monopolist
12.4 Choosing the Optimal Quantity and Price Does a Monopoly Have a
Supply Curve?
A supply curve answers the question:
 If the price is $x, how many units does the firm want to
produce?
A monopolist is not a price taker, but a price maker;
therefore, the supply relationship does not exist.
12.5 The “Broken” Invisible Hand: The Cost of Monopoly
Exhibit 12.11 Surplus Allocations: Perfect Competition Versus Monopoly
 A perfectly competitive firm chooses to
produce: MR = MC and P = MR .
 The graph on the left illustrates a profitmaximizing quantity where MR = P =
MC, or 1,000 units. This is the efficient
output since the last unit has a societal
marginal benefit = the cost of making it.
 The monopolist’s profit-maximizing
output is presented: 500 units.
 For units between 500 and 1,000 the
monopolist does NOT maximize its
own profit and does not choose a
quantity that maximizes societal
efficiency (1,000 units).
12.6 Restoring Efficiency
Exhibit 12.11 Surplus Allocations: Perfect Competition Versus Monopoly
 If 1,000 units is the efficient quantity and $1 is
the efficient price, what could make this
monopolist produce at that point on the
demand curve?
 One extreme solution is the
government stepping in and
forcing the monopolist to
produce as if it were a perfect
competitor, increasing output
and reducing price
12.6 Restoring Efficiency Three Degrees of Price Discrimination
Why do firms offer mail-in (or online) rebates instead of
just discounting the price up front?
Price discrimination -- Charging different customers different prices
for the same good or service when there are no cost differences
Three degrees of price discrimination
1.
First-degree (perfect)
2.
Second-degree
3.
Third-degree
12.6 Restoring Efficiency Three Degrees of Price Discrimination
Exhibit 12.13 Surplus Allocations For a Monopoly: With and Without Perfect Price Discrimination
Willingness to pay is reflected by the demand
curve. The left side of the graph is the right
side of the previous graph, showing the
monopolist’s surplus and consumer surplus
when the monopolist charges one price
But if the monopolist can charge a
different price to each consumer, there
is no consumer surplus remaining; it
all accrues to the monopolist. So,
perfect price discrimination maximizes
surplus (no deadweight loss); it’s just
that it all goes to the monopolist.
12.6 Restoring Efficiency Three Degrees of Price Discrimination
Second-degree price discrimination --- consumers are
charged different prices based on the characteristics of the
purchase
Examples: when firms sell blocks of product at a lower
price than advertised—last-minute hotel rooms; utility
company pricing for commercial vs. residential usage
Third-degree price discrimination -- consumers are
charged different prices based on the characteristics of the
customer or location
Examples: senior citizen discounts, student discounts,
theater matinee discounts
12.6 Restoring Efficiency Three Degrees of Price Discrimination
Why create different markets?
 Why a firm would go to the trouble of
dividing up its customer base into different
markets
 This is an elasticity issue. Firms will lower the
price for subgroups that have a higher
elasticity of demand. Revenue increases when
demand is elastic and the price falls. For the
other subgroup that has an inelastic demand,
revenue increases when price is increased
 So price discrimination allows a firm to
increase revenue IF subgroups have different
elasticities of demand by lowering price for
the elastic group and raising price for the
inelastic group.
 If you were a member of the inelastic group,
faced with a higher price, the solution is to
become a member of the lower-price group.
So a successful price discriminator must find a
way to keep members from crossing over to
the lower-price group. So they ask for IDs, or
other evidence.
12.6 Restoring Efficiency Three Degrees of Price Discrimination
What if firms don’t know what someone’s willingness
to pay (elasticity) is?
Answer: Consumers usually give
firms an idea of what our
elasticity is by our actions.
Have you ever…?
gone to a Black Friday
sale?
bought a hardcover
book?
stood in line for new
technology?
12.6 Restoring Efficiency Three Degrees of Price Discrimination
Why do firms offer mail-in (or online) rebates instead of just
discounting the price up front?
 Offering rebate checks is another way for firms to get
information from us about our elasticities. If we go to the
trouble of filling out a form to get a rebate, that tells the firm
that our demand curve is fairly elastic and they can adjust
direct mail advertising accordingly. If they just discount it up
front, the people who have inelastic demand will be getting it
at a lower price even though they might be willing to pay a
higher price for it.
12.7 Government Policy toward Monopoly
Antitrust policy -- government policies that try to
prevent anti-competitive pricing, low from emerging and
dominating markets
Sherman Act (1890) -- Prohibited restraint of trade --monopoly markets: Recent application: Microsoft.
Microsoft accused of restraint of trade
 Monopolizing market
 Bundling Windows operating system with Internet
Explorer browser
 Keeping competitors from obtaining large market share
Ruling
 Microsoft was not broken up into two separate firms (one
for operating system and one for applications)
12.7 Government Policy toward Monopoly
Ruling
 But it had to change marketing practices and make it
easier for other browsers to work with Windows
12.7 Government Policy toward Monopoly Price Regulation
 Efficient (socially optimal) price - price is equal to
marginal cost
 Fair-returns price --- price is equal to average total
cost
12.7 Government Policy toward Monopoly Price Regulation
Exhibit 12.11 Surplus Allocations: Perfect Competition Versus Monopoly
 The government could force this firm to
produce 1,000 units (and charge $1), or
where P = MC. The government could,
enforce pricing where P = ATC,
meaning that this firm would earn a
zero economic profit, with output
somewhere between 500 and 1,000, and
price somewhere between $1 and $3.50.
 In panel (b), the efficient, or
socially optimal price was $1,
but the monopolist wants to
charge $3.50 since that
corresponds to the profitmaximizing level of output.
12 Monopoly
Evidence-Based Economics Example:
Can a monopoly ever be good for society?
 Many might say no, that they are inefficient and charge higher prices than a perfect
competitor would—both of these are correct answers. Remember the barriers to
entry, particularly(1) the natural monopoly and (2) the patent protection. What
would happen if the electric company suddenly had 4 new competitors? What firm
would invest in developing new drugs, for example, if it couldn’t be protected by
patents.
 Monopolies are inefficient, but that they also provide needed innovation to the
market -- innovation that wouldn’t occur if firms couldn’t be assured they could get
the profits for some amount of time.