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Chapter 7: Monopoly McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved. Monopoly Structure: Monopoly = Industry o The essence of market power is the ability to alter the price of a good or service. o A monopoly is one firm that produces the entire market supply of a particular good or service. o Since there is only one firm in a monopoly industry, the firm is the industry. 7-2 LO-1 Monopoly = Industry o The firm’s demand curve is identical to the market demand curve for the product. o Market demand is the total quantities of a good or service people are willing and able to buy at alternative prices in a given time period. 7-3 LO-1 Price versus Marginal Revenue o Marginal revenue (MR) is the change in total revenue that results from a one-unit increase in quantity sold. o Price equals marginal revenue only for perfectly competitive firms. o Marginal revenue is always less than price for a monopolist. 7-4 LO-1 Price versus Marginal Revenue o A monopolist can sell additional output only if it reduces prices. o The MR curve lies below the demand (price) curve at every point but the first. 7-5 LO-2 Price versus Marginal Revenue o Total revenue before price reduction = 1 ton x $6,000/ton = $6,000 • Total revenue after price reduction = 2 tons x $5,000/ton = $10,000 • Marginal revenue = $10,000 – $6,000 = $4,000 7-6 LO-2 Where Price Exceeds Marginal Revenue 7-7 LO-2 Where Price Exceeds Marginal Revenue 7-8 LO-2 Monopoly Behavior o A monopolist must make a pricing decision that perfectly competitive firms never make. 7-9 LO-3 Profit Maximization o The monopolist uses the profitmaximization rule to determine its rate of output. o According to the rule, a monopolist maximizes profit at the rate of output where MR = MC. 7-10 LO-3 Profit Maximization o The profit maximization rule applies to all firms: – A perfectly competitive firm produces the quantity where MC = MR (= p). – A monopolist produces the quantity where MC = MR (<P). 7-11 LO-3 The Production Decision o Choosing a rate of output is a firm’s production decision. o It is the selection of the short-term rate of output (with existing plant and equipment). o A monopolist finds the rate of output where the marginal revenue and marginal cost curves intersect. 7-12 LO-3 The Monopoly Price o The intersection of the marginal revenue and marginal cost curves establishes the profit-maximizing rate of output. o The demand curve tells us the highest price consumers are willing to pay for that specific quantity of output. o Only one price is compatible with the profit-maximizing rate of output. 7-13 LO-3 The Monopoly Price and Profit Maximization 7-14 LO-3 Monopoly Profits o Total profit equals profit per unit times the number of units produced. o Profit per unit = price minus average total cost Profit per unit = p – ATC •Total profit = profit per unit times quantity Total profit = (p – ATC) x q 7-15 LO-3 Monopoly Profits o Profit can also be calculated by subtracting total cost from total revenue: Total profit = TR - TC 7-16 LO-3 Monopoly versus Competitive Outcomes o A monopolist produces less and charges a higher price than a competitive industry. 7-17 LO-4 Barriers to Entry o Barriers to entry are obstacles that make it difficult or impossible for would-be producers to enter a particular market, e.g., patents. 7-18 LO-4 Threat of Entry o A monopoly attains higher prices and profits by restricting output. o The threat of entry does not affect a monopolist due to high barriers to entry. 7-19 LO-4 Barriers to Entry o Patent Protection o Legal Harassment o Exclusive Licensing o Bundled Products o Government Franchises 7-20 LO-4 Patent Protection o A patent is a government grant of exclusive ownership of an innovation. o A patent is a source of monopoly power. o Polaroid’s patents forced Kodak out of the instant-photography business. 7-21 LO-4 Legal Harassment o Suing potential new entrants can deter entry into an industry. o Lengthy legal battles are so expensive that the threat of legal action may deter entry into a monopolized market. 7-22 LO-4 Exclusive Licensing o Lack of a license makes it difficult for potential competitors to acquire the factors of production they need. 7-23 LO-4 Bundled Products o Forcing consumers to purchase complementary products thwarts competition. o Bundling products makes it difficult for competitors to sell their products profitably: o Microsoft bundles software applications with its Windows operating systems. 7-24 LO-4 Government Franchises o A monopoly granted by a government license: o These include local power, telephone, and cable TV companies. o Another example is the U.S. Postal Service in providing first-class mail. 7-25 LO-4 Comparative Outcomes o A monopoly’s market power allows it to change the way the market responds to consumer demands. 7-26 LO-4 Competition versus Monopoly o In competition, as well as monopoly, high prices and profits signal consumers’ demand for more output. o In competition, the high profits attract new suppliers. o In monopoly, barriers to entry are erected to exclude potential competition. 7-27 LO-4 Competition versus Monopoly o In competition, production and supplies expand and prices slide down the market demand curve. o In monopoly, production and supplies are constrained and prices don’t move down the market demand curve. 7-28 LO-4 Competition versus Monopoly o In competition, a new equilibrium is established and average costs of production approach their minimum. o In monopoly, no new equilibrium is established and average costs are not necessarily at or near a minimum. 7-29 LO-4 Competition versus Monopoly o In competition, economic profits approach zero and price equals marginal cost throughout the process. o In monopoly, economic profits are at a maximum and price exceeds marginal cost at all times. 7-30 LO-4 Competition versus Monopoly o In competition, the profit squeeze pressures firms to reduce costs or improve product quality. o In monopoly, there is no profit squeeze to pressure the firm to reduce costs or improve product quality. 7-31 LO-4 Near Monopolies o Two or more firms may rig the market to replicate monopoly outcomes and profits. 7-32 LO-4 Near Monopolies o In duopoly two firms together produce the industry output. • In oligopoly several firms dominate the market. • In monopolistic competition many firms each have a monopoly on its own brand image but still must contend with competing brands. 7-33 LO-4 WHAT Gets Produced o There is a basic tendency for monopolies to inhibit economic growth. o There is no pressure to produce at minimum average cost. 7-34 LO-5 WHAT Gets Produced o Monopolies do not engage in marginal cost pricing: – Marginal cost pricing means firms offer (supply) goods at prices equal to their marginal cost. Monopolies do not deliver the most utility with the available resources. 7-35 LO-5 FOR WHOM o Higher prices charged by monopolists favor purchases by higher-income consumers. o Monopolists get fat profits and thus access to more goods and services. 7-36 LO-5 HOW o Monopolists have less of an incentive to innovate. o They can continue to make profits with existing equipment and technology. o There is a tendency to inhibit technological improvement by keeping competition out of the market. 7-37 LO-5 Any Redeeming Qualities? o Despite the strong and general case to be made against monopoly, monopolies could also benefit society. 7-38 LO-5 Research and Development o In principle, monopolies have a greater ability to pursue research and development. o They have the resources available to invest in expensive R&D functions. o They have no clear incentive for invention and innovation and can continue to make profits by maintaining market power. 7-39 LO-5 Entrepreneurial Incentives o The promise of even greater profits is a strong incentive for monopolies to innovate. o Innovators in perfect competition also have the ability to earn large profits. 7-40 LO-5 Economies of Scale o Economies of scale are present if average costs fall as the size (scale) of plant and equipment increases. 7-41 LO-5 Economies of Scale o A large firm can produce goods at a lower unit cost than a small firm because of economies of scale. o Consumers may not benefit from the lower costs if the monopolist doesn’t lower its prices. 7-42 LO-5 Diseconomies of Scale o Even though large size may result in greater efficiencies, there is no assurance that it actually will. o Monopolies may generate diseconomies of scale, producing at higher cost than a competitive industry. 7-43 LO-5 Natural Monopoly o A natural monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply. o Examples include local telephone, cable, and utility services. 7-44 LO-1 Natural Monopoly o Economies of scale are a natural barrier to entry. o There exists a potential for abuse in a natural monopoly. o Government regulation may be necessary to ensure that the benefits of increased efficiency are shared with consumers. 7-45 LO-1 Contestable Markets o Potential competition is a threat even to monopolies. o This may cause them to behave more competitively. 7-46 LO-5 Contestable Markets o A contestable market is an imperfectly competitive industry subject to potential entry if prices or profits increase. o How contestable a market is depends not so much on its structure as on entry barriers. 7-47 LO-5 Structure versus Behavior o If potential rivals force a monopolist to behave like a competitive firm, then monopoly imposes no cost on consumers or on society at large. o The experience with the Model T suggests that potential competition can force a monopoly to change its ways. 7-48 LO-5 Structure versus Behavior o Critics argue that even if markets are contestable, there will always exist a gap between a monopoly and a competitive outcome. o This gap can be very costly to consumers. 7-49 LO-5 Flying Monopoly Air o Market structure explains why it is cheap to fly to one place and expensive to fly somewhere else of equal distance. 7-50 LO-5 Industry Structure o From a national perspective, the airline industry looks pretty competitive. o However, all of these companies do not fly to the same place. 7-51 LO-5 Industry Structure o When assessing market structure, it is essential to specify the relevant market. o In many markets, there is only one or two air carriers, thus the firms in this market act like duopolies or monopolies. 7-52 LO-5 Industry Behavior o Air fares from airports dominated by one or two carriers are 45-85 percent higher than at more competitive airports. 7-53 LO-5 Entry Effects o How fares change when airlines enter or exit a specific market can be used to assess the impact of market structure on prices. o American Airlines cut its fares when lowcost carriers entered a market it dominated – then raised them when they left. 7-54 LO-5 Entry Effects o Predatory pricing – temporary price reductions designed to drive out competition. 7-55 LO-5 Barriers to Entry o One of the most formidable entry barriers to the airline industry is the ownership of landing rights and gates. o At Washington, D.C.’s National Airport, the six largest carriers owned 97 percent of available takeoff/landing slots in 2000. 7-56 LO-5 Barriers to Entry o To offer service from that airport, a new entrant would have to buy or lease a slot from one of these firms. o If existing firms are unwilling to sell or lease their slots, then competition is thwarted. 7-57 LO-5 Monopoly End of Chapter 7 7-58