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CHAPTER 10 Monopoly 1 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 1 Monopoly A monopoly is a market served by a single firm. A monopoly occurs when there is only one firm and a barrier preventing other firms from entering the market. 2 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Barriers to Entry Possible barriers to entry include: A patent, granted by the government, gives an inventor the exclusive right to sell a new product for some period of time A franchise, or licensing scheme, in which the government designates a single firm to sell a particular product A natural monopoly, in which large economies of scale in production allow only one firm to be profitable 3 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin The Monopolist’s Output Decision Like other firms, the monopoly’s objective is to produce the output level that will maximize profit. The firm faces the same laws of production and cost in the short run, associated with diminishing returns. 4 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin The Monopolist’s Demand Curve Since the monopoly is the only firm in the market, it faces the entire market demand for its product. A downwardsloping demand curve is associated with particular revenue characteristics for the monopoly firm. 5 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Demand and Marginal Revenue for the Monopolist In order to increase the quantity sold, the monopolist must decrease price for all units sold. When the monopolist decreases price in order to increase quantity sold, there is good news and bad news. 6 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Demand and Marginal Revenue for the Monopolist The good news is that the firm sells more output, so it collects more revenue from new customers. The bad news is that the firm loses revenue from selling at a lower price to all customers combined. 7 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Demand and Marginal Revenue for the Monopolist The combined good and bad news yields the value of marginal revenue for the monopolist. When the bad news outweighs the good news, marginal revenue becomes negative. 8 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Total Revenue and Marginal Revenue for the Monopolist Information from the demand curve (price and quantity sold) can be used to derive the total and marginal revenue curves. Total Revenue 32 C o s t in $ 24 16 8 0 Price ($) Quantity Sold P Q Total Marginal Revenue Revenue ($) ($) P ric e a n d m a rg in a l re v e n u e 0 1 2 3 4 Quantity sold 5 6 Demand and Marginal Revenue 14 16 14 12 10 8 6 4 0 1 2 3 4 5 6 © 2001 Prentice Hall Business Publishing TR (PxQ) 0 14 24 30 32 30 24 MR TR Q 14 10 6 2 -2 -6 12 10 8 6 4 2 0 -2 -4 -6 0 1 2 3 4 5 6 Quantity sold Demand Economics: Principles and Tools, 2/e Marginal Revenue 9 O’Sullivan & Sheffrin The Marginal Principle and the Output Decision To decide how much output to produce and what price to charge, the monopolist can use the marginal principle. Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost. 10 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin The Marginal Rule for Profit Maximization A firm maximizes profit by following the marginal principle—by setting marginal revenue equal to marginal cost. 11 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Computing Maximum Profit Price Quantity Sold Total Revenue P Q TR (given) (given) (PxQ) 18 17 16 15 14 13 12 600 700 800 900 1000 1100 1200 10,800 11,900 12,800 13,500 14,000 14,300 14,400 Profit Marginal Marginal Average (Totals Revenue Total Cost Cost Total Cost approach) MR TR Q (given) 11 9 7 5 3 1 5,160 5,880 6,560 7,200 7,900 8,800 9,840 STC MC TC Q 7.2 6.80 6.40 7.00 9.00 10.40 SATC TC Q 8.6 8.4 8.2 8 7.9 8 8.2 Profit (Per-unit basis Approach) TR - STC (P-ATC)Q 5,640 6,020 6,240 6,300 6,100 5,500 4,560 5,640 6,020 6,240 6,300 6,100 5,500 4,560 Marginal revenue is closest to marginal cost at 900 units of output. © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin 12 When the gap between total revenue and total cost is greatest, marginal revenue is roughly equal to marginal cost. The monopolist maximizes profit when it produces 900 units of output. 16000 14000 12000 10000 8000 6000 4000 500 600 700 800 900 1000 1100 1200 1100 1200 Quantity of doses sold 20 $ p e r d o se R e v e n u e a n d c o s t ($ ) The Output Decision 15 10 5 0 500 600 700 800 900 1000 Quantity of doses sold MR © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e MC ATC O’Sullivan & Sheffrin 13 Demand The Costs of Monopoly 14 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin The Costs of Monopoly The perfectly competitive produce 400 units at $8, while the monopoly produces 200 units at $18. Consumer surplus is larger under perfect competition (areas C + R + D) than under monopoly (area C). 15 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin The Costs of Monopoly Rectangle R represents a transfer of gains from consumers to the monopoly, but triangle D, called the deadweight loss triangle, is not offset by a gain to anyone. Loss to consumers from monopoly versus competition © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e Triangle C R = Rectangle -200 x $10 = ($2,000) Triangle D = -(200*10)/2 = ($1,000) Total Loss = O’Sullivan & Sheffrin 16 ($3,000) Rent Seeking Rent seeking is a term used to describe the efforts by a monopoly to persuade government to erect barriers to entry. If rent seeking exists, the monopoly may spend some of its potential profit on rent-seeking activity, and the net loss to society would be areas R and D, not just area D. 17 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin The Costs and Benefits of Monopoly Costs: a monopoly produces less output than a perfectly competitive market, and people waste resources trying to get and keep monopoly power. Benefits: a patent or license increases the payoff from research and development, thus encourages innovation. 18 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Natural Monopoly A natural monopoly is a firm that serves the entire market at a lower cost than two or more firms can. Examples of natural monopolies: Public utilities (sewerage, water, and electricity generation) Transportation services (railroad freight and mass transit) 19 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Natural Monopoly The long-run average cost of electricity generation is negatively sloped, reflecting large economies of scale. As long as the longrun average cost decreases, the longrun marginal cost must lie below it. 20 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Natural Monopoly Given the structure of demand and marginal revenue, the monopoly maximizes profit by generating 3 thousand kilowatt hours. Left alone, the monopoly will charge $8.20 and earn a profit of ($8.20$6.20) = $2 per kilowatt hour (distance between points c and m). 21 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Natural Monopoly Total profit equals (price – average cost) x quantity produced and sold (the green area). Profit is possible only if there is one firm, unregulated, serving the entire market demand. 22 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Natural Monopoly Suppose that the monopoly shared the market demand and output sold with a second firm, and that each firm produced half of the market output (1.5 kw/h). The cost of producing 1.5 kw/h would exceed the price the firms can receive, thus they would suffer losses. 23 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin Price Controls for a Natural Monopoly Under an average-cost pricing policy, the government picks a price equal to the average cost of production, or $5.20. But regulation gives the utility no incentive to control costs, so costs rise. Price after regulation decreases by less than anticipated. 24 © 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e O’Sullivan & Sheffrin