11. h. Monopoly and Price Ceilings P Original Demand curve = D Original Marginal Revenue curve = MR D' = MR' Demand Curve after Price Ceiling = D' Marginal Revenue Curve after Price Ceiling = MR' $8 = PM $6 = Price ceiling D' MR' D 1 2 3 4 QM = 5 10 Figure 11.h.1. Q MR Figure 11.h.1. As seen through the graph above, a price ceiling placed on a monopoly causes a kink in the demand curve which results in a new demand curve, D’. Similarly, the price ceiling causes two kinks in the marginal revenue curve which in turn results in the new marginal revenue curve, MR’. In the section where the demand curve is horizontal, D’=MR’. The profit maximizing point is still where MR=MC. A clearer illustration of this will be shown with the next graph which includes a MC curve. Original Demand curve = D P Original Marginal Revenue curve = MR MC Shrinkage D' = MR' of DWL (gain) Demand Curve after Price Ceiling = D' Marginal Revenue Curve after Price Ceiling = MR' $8 = PM $5 = Price ceiling = P0 + = DWL without price ceiling DWL MR' = MC D QM Q0 =4 =6 Q MR Figure 11.h.2. Figure 11.h.2. When one includes a Marginal Cost Curve in the graph, one can see that the profit maximizing point occurs where MR=MC. The profit maximizing quantity is QM = 4 and the profit maximizing price is PM = $8. However, once a price ceiling is imposed, the profit maximizing quantity becomes Q0 = 6 and the profit maximizing price becomes P 0 = $5 (as a result of the new intersection of the MR’ and MC curves). Furthermore, the DWL of the monopolistic industry shrinks as a result of the price ceiling. Thus, society is better off. Side note: If one remembers however, with a competitive market, society isn’t so much better off as a result of a price ceiling. For ease of comparison, below is the effect of a price ceiling on a competitive industry. This example illustrates a price ceiling imposed on the electricity market. A price ceiling on the competitive industry causes a shortage as quantity demand exceeds quantity supplied. As a result, although the legal price people pay for electricity may be cheaper because of the price ceiling, the actual price (PACTUAL) they pay (the blackouts they experience, the waiting for electricity to come up again, etc), is even greater than the original price they were paying before the price control (when the market was in equilibrium). P COMPETITVE MARKET Actual price you pay DWL PACTUAL = $.30 P* = $.20 S waiting, blackouts, etc. ceiling = $.12 shortage Legal price you pay D Qs Q* QD electricity Original Demand curve = D P Original Marginal Revenue curve = MR MC Demand Curve after Price Ceiling = D' Marginal Revenue Curve after Price Ceiling = MR' $8 = PM P0 = ceiling P1 Best Price Ceiling Level competition (efficient point) Marginal Cost Curve P2 D QM Q2 Q0 Q1 Q MR Figure 11.h.3. Figure 11.h.3. The graph above illustrates the effect of several price ceilings on a monopolistic industry. The original profit maximizing quantity and price occur at P M and QM (MR=MC). If one moves the price ceiling down just a little to P0, the new profit maximizing price and quantity become P 0 and Q0. Move the price ceiling down a little more to P1 and the new profit maximizing quantity becomes Q1. As one can see, P1 is the optimal price ceiling level since it maximizes output and eliminates the DWL. Any price ceiling below P1 will start to decrease output, as seen with the price ceiling, P 2 (the profit maximizing quantity (MR=MC) becomes Q2 which is less than Q0 and Q1. Practice Problems: 1. What effect does a price ceiling have on a monopoly? 2. What effect does a price ceiling have on a competitive firm? 3. True or false: A large reduction in Marginal Cost as a result of the movement from a competitive firm to a monopoly definitely and always means that one should prosecute that firm. 4. What happens to price and output when there is a small reduction in Marginal cost?? Use this graph to answer the next five questions: P a MC PM P0 = ceiling P1 g b c f d D QM Q0 Q1 e MR Q 5. At what price does the best (most efficient) price ceiling level occur? a. P0 b. PM c. P1 d. None of the above 6. What would happen to the output if the price ceiling was instead set below P 1? 7. In setting a price ceiling on a monopoly, what price level eliminates the DWL and maximize the output one can produce?? 8. What is the new MR curve as a result of the price ceiling? a. abcde b. abfde c. gbcde d. None of the above 9. What is the profit maximizing output as a result of the price ceiling? a. Q0 b. QM c.Q1 d. None of the above 10. Illustrate the shrinkage in DWL (gain) as a result of a price ceiling. Answers: 1. A price ceiling on a monopoly reduces its DWL (deadweight loss) and causes its Marginal Revenue and Demand Curves to be horizontal at the price ceiling level (MR=D). However, once the price ceiling level hits the demand curve, the demand curve continues to slope downward again, causing a kink in the new demand curve. See Figure 11.h.1. for the correct shapes of the new MR and D curves as a result of a price ceiling. The price ceiling could also increase or decrease output depending on where the price level is placed. See Figure 11.h.3. 2. A price ceiling on a competitive firm causes a shortage since quantity demanded is greater than quantity supplied. Unlike a price ceiling on a monopoly, it does not change the Demand or Supply curves. 3. False. One has to use cost-benefit analysis to see if the benefits (gains) are greater than the (costs) losses. 4. Price increases and output decreases. 5. c. P1 6. Output would decrease. See Figure 11.h.3. 7. The price level that would eliminate the DWL and maximize the output one can produce is P 1. 8. The new MR curve would be connected by the points gbcde. So the answer is c. 9. a. Q0 10. See Figure 11.h.2.