Download Chapter 10 - McGraw Hill Higher Education

Chapter 10
Challenge To Market
Effectiveness 1: Monopolies
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Learning Objectives
•
•
•
•
What is monopoly?
What are the barriers to entry?
How is the demand curve for a monopoly?
How does a monopoly decide quantity of
output to produce?
• What are the social costs of monopoly?
• What is price discrimination?
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Monopoly
• A pure monopoly is a firm without any
competition.
• Pure monopolies do not exist in the real world.
• The fewer the substitutes there are for a firm’s
products, the more monopolistic the firm is.
• A monopolist can earn long term profits if it
keeps other firms from entering its market.
• Entry barriers stop firms from entering a market
and destroying monopoly profits.
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Barriers To Entry
The Government:
•
•
•
Licenses: By limiting entry licenses allow
members of protected professions to earn
monopoly profits, e.g. teachers, lawyers.
Outlawing competition: Government can
outlaw competition to a monopolist e.g. U.S.
post office.
State religion: Government can create
religious monopolies.
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Barriers To Entry
•
•
•
Unions:
Unions are organization of workers.
Unions engage in collective bargaining
with employers.
Control of a vital resource:
Firms can maintain a monopoly by
controlling a vital resource, e.g. silk in
ancient China, alum in Ottoman empire.
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Barriers To Entry
Incompatibility:
•
•
•
By making its products incompatible with the
complementary goods of its rival, a firm can
create and maintain its monopoly.
Software: Incompatibility-based barriers to
entry are a prime source of Microsoft’s riches.
Sports leagues: Incompatibility provides a
strong barrier to entry, protecting all
professional sports leagues.
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Barriers To Entry
Economies of scale:
•
•
•
If in an industry average total
costs decrease as output
increases, then a new firm’s
costs are extremely high
compared to the monopolist’s
costs.
In industries with significant
economies of scale, it is
difficult for a new firm to
challenge a monopoly.
Monopolies based on
economies of scale are called
“natural monopolies,” e.g.
utility companies.
Costs
Average Total Costs
The new firm
would be here with
high average total
costs.
The monopolist is
here with low
average total costs.
Output Per Month
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Barriers To Entry
Intellectual property:
•
•
•
Owning intellectual property gives legal right to
demand payment from all who would use that
property.
Copyrights: No one but the copyright’s holder
can legally sell the copyright-protected work.
Patents: A patent gives one exclusive right to
sell the invention. Patents confer a benefit on
innovators proportional to the social benefits of
their innovation.
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Monopolist Pricing
• A monopolist can set its own price.
• The Law of Demand constraints a
monopolist’s price-setting powers.
• If a monopolist wants to increase sales, it
must lower its price.
• Unlike a firm in perfect competition,
monopolist’s output influences the market
price.
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Marginal Revenue
and Monopolist Pricing
Marginal Revenue
= The increase in total revenue a firm
receives by selling one more good.
For a competitive firm:
• Marginal Revenue = Price
For a monopolist:
• Marginal Revenue  Price
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Marginal Revenue
and Monopolist Pricing
Customer
Most Willing to
Pay
Total Revenue
Marginal
Revenue
A
$100
$100
$100
B
$90
$90X2 = $180
$180-$100 = $80
C
$80
$80X3 = $240
$240-$180 = $60
D
$70
$70X4 = $280
$280-$240 = $40
E
$60
$60X5 = $300
$300-$280 = $20
F
$50
$50X6 = $300
$300-$300 = $0
G
$40
$40X7 = $280
$280-$300 = -$20
H
$1
$1X8 = $8
$8-$280 = -$272
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Monopolist’s Profit Maximization
• If Marginal Revenue
> Marginal Cost,
Profits will increase
by producing more.
• If Marginal Revenue
< Marginal Cost,
Profits will increase
by producing less.
• Profits are
maximum when
Marginal Revenue =
Marginal Cost.
Price
This intersection between
marginal revenue and
marginal cost determines the
monopolist’s optimal price and
quantity.
The price
the
monopolist
will choose.
$14
Marginal Cost
$8
Demand
Marginal
Revenue
100
Quantity
The output the
monopolist will choose.
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The Social Cost of Monopolies
• Monopolists do not produce at the lowest possible
average total cost.
• Monopolies usually produce output below the level that
maximizes the wealth of society.
$
Marginal Cost
Average Total Cost
The monopolist
sets output where
marginal cost
intersects
marginal revenue.
Demand
The monopolist’s
average total cost.
Marginal Revenue
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Deadweight Loss of Monopoly
• A monopolist will produce
until Marginal cost =
marginal revenue.
• The wealth maximizing
level of output is where
Marginal cost = demand.
• Adam Smith’s invisible
hand breaks down.
If the monopolist produces 150 units.
The monopolist will not produce this
much output.
Price
Marginal
Cost
CS
$14
$12
PS
Demand
150
100
Marginal
Revenue
Quantity
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Ways to Reduce Deadweight Loss
• Competition
• Price discrimination
• Antitrust laws
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Competition and
Deadweight Loss of Monopoly
• Competition lowers prices and expands output,
thereby reducing deadweight loss.
For example:
• U.S. post office and fax, email, FedEx.
• Microsoft and Linux.
• Cable television and satellite television.
• De Beers’ diamonds and artificial diamonds.
• Even the mere threat of potential competition
can induce a monopolist to expand output and
reduce deadweight loss.
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Price Discrimination
• Price discrimination occurs when a firm charges
separate customers different prices.
• With price discrimination, a firm can charge its
old customers high prices, but still attract new
customers by selling to them at lower prices.
• For economists, price discrimination is beneficial
because it increases the wealth of society.
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Price Discrimination
Perfect price discrimination:
• The monopolist charges every customer the maximum
they are willing to pay.
• The total consumer surplus becomes zero.
• The deadweight loss of monopoly is completely
eliminated.
Imperfect price discrimination:
• Monopolists separate customers into groups and then
charge separate groups different price.
• The deadweight loss of monopoly is reduced but not
completely eliminated, e.g. student discounts, financial
aid, airline tickets.
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Price Discrimination
•
•
•
•
To profitably price discriminate for and against different
groups, a monopolist must overcome three challenges:
It must determine the value each group places on the
monopolist’s product.
It must figure out how to sell to separate groups at
different prices.
It must prevent customers who paid a low price from
reselling the good to those customers who paid a high
price.
Self selection of customers:
Firms induce different groups of consumers to take
different visible actions. By inducing customers to
voluntarily self-select into separate groups, firms can
price discriminate e.g. coupons, airline tickets.
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Antitrust Laws
• Antitrust laws regulate, restrict and punish
monopolies.
• Antitrust laws rely on the government, not
the market, to reduce the harm on
monopolies.
Coming up in Chapter 11
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Innovation and Monopoly
• Because it does not have to share its
benefits, a monopolist gets great monetary
rewards from innovation. Hence,
monopolies encourage innovations.
• However, strong entry barriers protect a
monopoly even without innovation. A
monopolist’s employees may not have
incentives to work hard to innovate.
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Do You Know?
• How can economies of scale create barriers to entry?
Economies of scale means average total costs decrease
as output increases. Since its costs are extremely high
compared to the monopolist’s costs, it is difficult for a
new firm to challenge a monopoly.
• Why must a monopolist who can’t price discriminate give
a discount to old customers if it wants to sell to new
customers?
The Law of Demand constraints a monopolist’s pricesetting powers. As consumers buy more only at lower
price monopolist must lower its price to increase sales.
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Do You Know?
• How can price discrimination reduce the deadweight
loss of a monopolist?
A monopolist creates deadweight loss by producing less
output. Price discrimination allows a monopolist to
charge different prices to different consumers to produce
and sell more output.
• Why are coupons a form of price discrimination?
Coupons induce consumers to self-select into two
groups: price-sensitive and price-insensitive. Coupons
allow price-sensitive consumers to trade time for money.
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Summary
• A pure monopoly is a firm without any competition.
• The fewer the substitutes there are for a firm’s products,
the more monopolistic the firm is.
• Entry barriers stop firms from entering a market and
destroying monopoly profits such as government
regulations, unions, control of vital resource,
incompatibility, economies of scale and intellectual
property.
• If a monopolist wants to increase sales, it must lower its
price.
• Monopolist’s profits are maximum when marginal
revenue = marginal cost.
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Summary
• Monopolies usually produce output below the
level that maximizes the wealth of society and
creates deadweight loss.
• Competition, price discrimination and antitrust
laws can reduce the social cost of monopolies.
• Price discrimination occurs when a firm charges
separate customers different prices.
• Price discrimination is beneficial because it
increases the wealth of society.
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Coming Up
What is the other challenge to
market effectiveness?
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