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ECONOMICS: EXPLORE & APPLY by Ayers and Collinge Chapter 20 “Monopoly and Antitrust” ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 1 Learning Objectives 1. Describe how barriers to entry create market power. 2. Discuss the profit maximization process for a monopolist. 3. Explain the inefficiencies of monopoly. 4. Name and briefly discuss major U.S. antitrust laws and potentially punishable practices. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 2 Learning Objectives 5. Identify government policies toward monopoly. 6. Assess the merits of protecting the U.S. Postal Service from competition. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 3 20.1 SOURCES OF MONOPOLY When one firm supplies the entire market, the market structure is called a monopoly. A monopoly is characterized by a single firm selling an output for which there are no close substitutes. Monopoly is caused by very high barriers to entry, which exist when investors or entrepreneurs find obstacles to joining a profitable industry. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 4 Barriers to Entry Monopoly by law (legal monopoly) – when one firm is protected by law from competition, and there are no close substitutes for the good. Monopoly by possession – when one firm is the only owner of a resource needed to produce a good, and there are no close substitutes for the resource or for the good. Natural monopoly – when it is cheaper for one firm to produce the entire industry’s output than it would be for two or more firms to produce the same output. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 5 Barriers to Entry Barriers to entry bring about market power. This market power reveals itself in the slope of the firm’s demand curve. The steeper the demand curve, the more market power the firm has and the greater its ability to determine price. Monopoly represents the most market power, in which case the firm’s demand is identical to market demand. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 6 The Effect of Increasing Market Power $ Increasing market power. Demand facing monopoly, the extreme case of a price taker. Demand facing a price taker Demand Quantity ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 7 Natural Monopoly • Natural monopoly occurs when one firm can supply the entire market at a lower price than two or more separate firms. • This means that natural monopoly will occur any time the minimum point on long-run average cost near or to the right of market demand. • Natural monopoly occurs when there are substantial economies of scale. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 8 Natural Monopoly Long-run average cost declines throughout the relevant range of output. Long-run average cost reaches its minimum point near demand $ $ The larger the firm size, the lower the average cost of output Long-run average cost Demand Quantity ©2004 Prentice Hall Publishing Average cost with multiple firms Lower average cost with one firms Long-run average cost Demand Quantity Ayers/Collinge, 1/e 9 20.2 THE PROFIT-MAXIMIZING MONOPOLY o Total revenue is maximized when the elasticity of demand equals one. o With a straight line demand curve this happens at the midpoint. o Even if production cost were zero, the monopoly would not produce any more than the revenue-maximizing output, since to do so would lower its total revenue, and thus profit. o The monopoly firm always chooses to produce in the elastic range of demand. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 10 The Profit-Maximizing Monopoly o The rule of profit maximization is the same for a monopoly as for all other firms: o Produce at the point where marginal revenue equals marginal cost. o MR=MC rule ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 11 The Profit-Maximizing Monopoly When total revenue is maximized, marginal revenue is zero. • $ Unit Elastic • Demand Total revenue • Monopoly output is in the elastic range of demand. ©2004 Prentice Hall Publishing Quantity Marginal revenue Ayers/Collinge, 1/e 12 The Profit-Maximizing Monopoly A downward sloping demand curve is associated with a marginal revenue curve that slopes down even more steeply. The result is that the marginal revenue from an additional unit of output would equal the price of that unit minus the price reduction on every other unit sold. The monopolist has no unique supply curve. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 13 Marginal Revenue less than Price $ ...minus less revenue from lower price on other units sold. Lower price Marginal revenue equals added revenue from one more unit sold... Demand Quantity Larger quantity ©2004 Prentice Hall Publishing Marginal revenue Ayers/Collinge, 1/e 14 Demand and Revenue Revenue Marginal revenue Total revenue (change in price/ Price Quantity (price x quantity) change in quantity) $12 0 $0 undefined $11 1 $11 $11 $10 2 $20 $9 $9 3 $27 $7 $8 4 $32 $5 30 25 20 15 Demand 10 5 Marginal revenue 0 0 The data above is plotted. Note that the data confirm that marginal revenue has a steeper slope than demand. ©2004 Prentice Hall Publishing Total revenue 1 2 3 4 Quantity Ayers/Collinge, 1/e 15 Monopoly Output and Price Marginal Cost #2 The monopolist charges as much as the market will bear for that output. Monopoly price #1 the monopolist sets output to equate marginal revenue and marginal cost Demand Monopoly output ©2004 Prentice Hall Publishing Marginal Revenue Quantity Ayers/Collinge, 1/e 16 Monopoly Output and Price Marginal Cost • Monopoly price • #2 The monopolist price falls. #1 When elasticity of demand rises…. • Demand Monopoly output ©2004 Prentice Hall Publishing Marginal Revenue Quantity Ayers/Collinge, 1/e 17 Profit, Breakeven, or Loss The profit-maximizing quantity graphically, for a monopolist occurs at the point where marginal revenue equals marginal cost. The profit maximizing price is set at the corresponding point on the demand curve. The average profit per unit sold is multiplied by the number of units sold. The average profit per unit is the difference between price and average cost at the profitmaximizing quantity. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 18 Profit, Breakeven, or Loss Marginal Cost Average Cost Price Profit per unit Profit Number of unit Demand Profit maximizing output ©2004 Prentice Hall Publishing Marginal Revenue Quantity Ayers/Collinge, 1/e 19 Monopoly Breakeven, or Loss Maximum profit is zero profit Average cost exceeds price Marginal cost Average Price cost Loss per unit Price Demand Marginal cost Average cost Number of units Demand Quantity Profit-maximizing output Quantity Loss-minimizing Marginal revenue quantity Marginal revenue ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 20 Efficiency and Price Discrimination • Monopoly is allocatively inefficient because the quantity that equates marginal cost and marginal revenue falls short of the quantity that equates marginal cost and demand. – The profit-maximizing quantity is less than the efficient quantity. – The area of deadweight loss shows the benefits that consumers would have received from the additional output minus the cost the firm would have incurred to produce it. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 21 Limit Pricing •In order to avoid the threat of potential competition, a monopolist might practice limit pricing. •This is where the monopolist charges the highest price customers will pay, subject to the limit that the price not be so high that it attracts potential competitors. •The limit price will be lower than the short-run profit-maximizing price. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 22 The Inefficiency of Monopoly Efficiency forgone: the deadweight loss from monopoly. Monopoly Price Marginal Cost • Average cost Marginal revenue Monopoly Output ©2004 Prentice Hall Publishing Efficient Output Demand = marginal benefit Quantity Ayers/Collinge, 1/e 23 Price Discrimination Price discrimination is selling a good or service at different prices to various buyers, when such differences are not justified by cost differences. Price discrimination is feasible when different prices can be charged to different market segments. Matching prices exactly to the demand curve is the extreme of perfect price discrimination ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 24 Price Discrimination The arrows are prices, which differ from customer to customer $ $19 $18 $17 $16 $15 $14 $13 $12 Marginal cost $11 • $10 Demand = Marginal benefit = Marginal revenue 1 2 3 4 5 6 7 8 9 10 ©2004 Prentice Hall Publishing Efficient and profitmaximizing output Quantity Ayers/Collinge, 1/e 25 Price Discrimination o Another example of price discrimination is multipart pricing. o Multi-part pricing depends on the amount consumed. o The monopolist sets sets the price high for the first units consumed, since those are the hardest to do without. The price for additional units could be lower. o Multi-part pricing causes marginal revenue to fall somewhere between the extremes of the monopolist with a single price, and one able to practice perfect price discrimination. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 26 20.3 ANTITRUST POLICY Antitrust law is a body of public policies designed to limit the abuse of market power, and is enforced by the justice department. The antitrust laws neither make monopoly illegal nor apply only to monopoly. Antitrust laws are intended to curb abuses of market power, of which monopolist have the most. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 27 Examples of Antitrust Legislation Sherman Act (1890) Federal Trade Commission Act (1914) Clayton Act (1914) Robinson-Patman Act (1936) Celler-Kefauver Antimerger Act (1950) ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 28 Antitrust Policy GLOSSARY OF TERMS Exclusive dealing: A firm prohibits its distributors from selling competitors’ products. Exclusive territories: A firm assigns a geographic area to a distributor and prohibits other distributors from operating in that territory. A firm prices a product below the marginal cost of producing it to drive rivals out of business. Predatory pricing: Price A firm charges different customers different discrimination: prices for the same product. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 29 Antitrust Policy GLOSSARY OF TERMS Refusals to deal: A firm prohibits rivals from purchasing/using scarce resources (called essential facilities) that are needed to stay in business. Resale price maintenance: A manufacturer sets a minimum retail price for its product. Tie-in sales: A firm conditions the purchase of one product upon the purchase of another. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 30 Alternatives to Regulation If a monopoly is a natural monopoly the government will typically either own it or regulate it with rate-of-return regulation that restrict the monopolist from charging more than average cost. Rate-of-return pricing is also known as average cost pricing. To avoid the inefficiencies of regulation, economist recommend alternatives like franchise monopoly, which is a right to be the exclusive provider of a service. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 31 Alternatives to Regulation o The government has allowed deregulation in some industries. o Deregulation is the scaling back of government regulation of industry. o The reduction of government ownership of industries is referred to as privatization. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 32 20.4 EXPLORE & APPLY The U.S. Postal Service A Monopoly in the Public Interest The U.S. Post Office is the oldest monopoly in the U.S. It is intended to be self supporting. In 2001, it had 776,000 employees, and earned $65.9 billion in revenues. It expenses however were $67.6 billion, and as a result lost $1.68 billion dollars. To try to make up for the losses it hired FedEx to handle its overnight deliveries, and increased the basic rate for mailing a letter to 37 cents. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 33 The U.S. Postal Service A Monopoly in the Public Interest Other cost cutting measure include: Possibly eliminating Saturday deliveries. Installing new automated equipment. Privatization Additional challenges include: The growing popularity of email. The cost of protecting employees and customers from the threat of anthrax. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 34 Terms Along the Way o o o o monopoly barriers to entry monopoly by law monopoly by possession o natural monopoly o price maker o limit pricing ©2004 Prentice Hall Publishing o price discrimination o perfect price discrimination o Multi-part pricing o antitrust law o rate of return regulation o average price pricing Ayers/Collinge, 1/e 35 Terms Along the Way (continued) o franchising monopoly o deregulation o privatization ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 36 Test Yourself 1. a. b. c. Barriers to entry increase the number of firms in an industry. decrease the number of firms in an industry. have no effect on the number of firms in an industry. d. have unpredictable effects on the number of firms in an industry. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 37 Test Yourself 2. a. b. c. d. Market power is indicated by a(n) horizontal demand curve. shortage of barriers to entry. ability to pick your selling price. j shape to the marginal cost curve. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 38 Test Yourself 3. Which statement is true about monopoly? a. A monopoly is a price taker. b. A monopoly will have many good substitutes for its output. c. The monopoly demand curve is also the market demand curve. d. An unregulated monopoly is always profitable. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 39 Test Yourself 4. A natural monopoly occurs when a. government grants a patent to a firm. b. government prohibits the entry of new competitor firms. c. one firm can produce at lower average cost than any combination of two or more firms. d. the product that is monopolized pertains to natural resources. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 40 Test Yourself 5. A marginal revenue curve for a monopoly will a. be shaped like the letter J. b. lie below the demand curve. c. lie above the demand curve. d. be identical to the demand curve. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 41 Test Yourself 6. The best example of a natural monopoly is a. a local electric utility. b. the U.S. Postal Service. c. an airline. d. a public school. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 42 Test Yourself 7. If a monopolist is able to practice perfect price discrimination, the result will be a. b. c. d. inefficient, but consumers will be better off. inefficient, and consumers will be worse off. efficient, and consumers will be better off. efficient, but consumers will be worse off. ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 43 The End! Next Chapter 21 “Oligopoly and Monopolistic Competition" ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 44