Download Chapter 12 Monopoly

These notes provided by Laura Lamb are intended to complement class lectures. The
notes are based on chapter 12 of Microeconomics and Behaviour 2nd Canadian Edition
by Frank and Parker (2004).
Chapter 12 Monopoly
A monopoly market structure is one characterized by a single seller of a unique
product with no close substitutes.
Unlike a competitive firm, a monopoly firm has significant control over the price
it charges. A monopoly faces a __________________ demand curve.
How does a firm become a monopoly? Why don’t other firms enter the industry?
In monopoly markets, barriers to entry exist. The sources of these barriers can be
summarized as follows:
1. ______________________________________
• DeBeers’ once owned most of the world’s diamond mines. They remain
the dominant firm.
• Inco owned most of the world’s nickel deposits.
2. ________________________
• The situation where the least costly way to serve a market is to have one
firm produce all the product.
• The LAC curve slopes downward over a large quantity of output, large
enough to provide for the entire market.
• A natural monopoly is an example i.e. BC hydro
• Returns to scale are important
3. _______________________
• A patent grants the right to exclusive benefit from all exchanges
involving the invention to which it applies.
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• Although patents usually lead to higher prices for consumers, they make
possible research and inventions that would not otherwise occur.
• In fact the firms usually need to sell their products at higher prices to
cover the research and development of the product.
• In Canada, a patent has a life of 20 years.
• Pharmaceutical firms gain monopoly power through patents.
4. ____________________________
• Network economies exist when a product increases in value as the
number of consumers using it rises. (fax machines, cell phones)
• Microsoft’s Windows operating system has resulted in near monopoly
status for Microsoft (90% of world’s pcs). Software developers have an
incentive to write for he Window’s format. It has become difficult to
find software that is not written for Windows.
5. ______________________________
• Governments grant limited licences for radio broadcasting
• Some university campuses have granted exclusive rights for vending
machines sales
We can safely assume, as we did for a competitive firm, that a monopolist’s
goal is to ____________________.
The profit-maximizing behaviour of a monopolist:
2 methods:
1. Compare total revenue and total cost
The total revenue curve for a monopolist is not upward sloping as it is for a
competitive firm. Why?
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The answer lies in the shape of the demand curves faced a firm in each market
model. A competitive firm has a horizontal demand curve and a monopoly firm
has a downward sloping demand curve. Remember the relationship between the
changing elasticity on a downward sloping demand curve and total revenue.
In order for a monopolist to sell a greater quantity of its product it must lower its
price.
Question: Sketch the total revenue curve for a monopolist whose demand curve is
given by 100 – 2Q
A monopolist will produce the quantity of output that corresponds with total
revenue exceeding total cost by the greatest amount.
2. Compare marginal revenue and marginal cost
In the short run, a profit maximizing monopolist will choose the level of output for
which MC = MR, provided _________________________.
Note that marginal revenue is derived from the slope of the total revenue curve.
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Since the total revenue curve for a monopolist has a different shape than that for a
competitive firm, we expect the marginal revenue curve for a monopolist to differ
from that of a competitive firm’s.
For a monopolist, marginal revenue will be less than price, except in the special
case of a perfectly discriminating monopolist discussed later in this chapter.
Marginal revenue = (the gain in revenue from new sales) + (the loss in revenue
from selling the previous output level at the new lower price)
Marginal revenue and elasticity
Remember from chapter 4 that there is a relationship between total revenue and
price elasticity of demand.
If a firm reduces price in the elastic section of the demand curve, total revenue will
_______. In this case, the gain in revenue from the lower price is greater than the
loss of revenue from selling previous output at a lower price, thus marginal
revenue is ________________.
And conversely, if a firm reduces price in the inelastic section of the demand
curve, total revenue will ______. In this case, the gain in revenue from the lower
price is less than the loss of revenue from selling previous output at a lower price,
thus marginal revenue is ___________________.
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Graphing marginal revenue
If demand is linear, marginal revenue is also linear.
The marginal revenue curve has the same vertical intercept and twice the slope of
the demand curve. Its horizontal intercept is half that of the demand curve.
Question: Find the equation for the marginal revenue curve that corresponds to
the demand curve P = 12 -3Q
Graphing the short-run profit maximization condition
Illustrate how to calculate profit
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Question: A monopolist faces a demand curve of P = 100 – 3Q and a short-run
total cost curve of TC = 500 + 20Q. The associated marginal cost curve is MC =
$20 per unit (note that this is the slope of TC).
How much will the monopolist sell?
What is the profit-maximizing price?
How much economic profit will it earn at that price?
Graph this question
Will a monopolist ever produce on the inelastic portion of the demand curve?
______, because the marginal revenue will be _________ and cannot be equated
to ________________________.
Note: inelastic demand implies that reducing output will increase total revenue
and reduce total costs, and necessarily profits will rise. Thus any point where
demand is inelastic cannot be a profit maximum….the firm can do better by
reducing output.
How is profit-maximizing mark-up determined?
P − MC
1
=
MC
η −1
For example, if price elasticity of demand facing a monopolist is equal to -2.5,
then the profit-maximizing mark-up would be 1/(2.5-1)= .67 or 67%.
This means than the profit-maximizing price is 67% higher than marginal cost.
There is a negative relationship between price elasticity of demand and mark-up.
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If price elasticity of demand is infinite (perfectly elastic), what is the mark-up?
Will a monopolist ever shutdown?
Whenever demand is lower than average variable cost for every possible level of
output, the monopolist will produce nothing in the short-run. The economic loss
will equal fixed costs, which is better than the economic loss that would be
incurred if the firm produced any level of output.
For a monopolist, the optimal level of production might occur either on the rising
or on the falling portion of the MC curve, as long as it is a point where the MR
curve intersects the MC curve from above.
Find the optimal price and quantity for the monopolist described by the
information in the following table:
Q
0
10
20
30
40
50
P
500
450
400
350
300
250
MR
500
425
375
325
275
225
SMC
600
425
340
320
275
300
The monopolist maximizes profit by expanding output until MC equal MR.
Where is the monopolist’s supply curve?
Since a monopolist is not a price taker, there is no correspondence between price
and marginal revenue when market demand shifts. A given marginal revenue for
one demand curve can correspond to a particular price, while the same value of
marginal revenue for a different demand curve corresponds to a different price.
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Thus, a monopolist may produce Q*1 and sell at P* in one period, and then sell
Q*2 at P* in another period (price remains constant).
A monopolist does not have a _________________, it has a ___________ which
is to equate MR and MC.
Long-run adjustments for monopolists
A monopolist maximizes profits where MC = MR.
Illustrate long-run profit situation:
Sometimes economic profits will disappear for a monopolist in the long-run.
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What might cause this to occur?
In many cases, positive economic profits may persist in the long-run. Natural
monopolies tend to enjoy positive profits over time.
Price discrimination
So far, we have considered the case of a single price monopolist where it is
assumed that the firm sells its output at the same price to all their customers. In
reality, monopolists often charge different prices to different buyers – a practice
called price discrimination.
Examples: movie theatre tickets, airline tickets
A monopolist can increase its profits by practicing price discrimination. And
further, not all the increase in profit is at the expense of the buyer. Efficiency
actually increases under price discrimination.
Consider the situation where a monopolist sells to two distinct markets. For
instance, a publisher sells a unique economics textbook in Canada and in China. In
other words, the firm is the only supplier in the domestic market and in the foreign
market.
The demand curve and marginal revenue curves for the two markets are given:
(Fig 12-13, p 372)
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In order to maximize profit, the marginal revenue should be the same in each
market, and will be equal to marginal cost at the profit-maximizing quantity of
output. Graphically, the marginal revenue curves are added horizontally across the
two markets.
Question: Suppose a monopolist sells in two separate markets, with demand
curves given by P1 = 15 – Q1 and P2 = 25 – Q2, respectively. If the total cost curve
is given by TC = 7 + 3Q (MC = 2), what quantities should the firm sell and what
prices should it charge in the two markets?
How is price elasticity of demand related to the prices charged in each market?
The monopolist charges the less elastic market ______________________.
This scenario described above is an example of third degree price discrimination,
the case there buyers in separate markets are charged different prices.
Other examples of third degree price discrimination: movie theatre tickets to
seniors and students. Seniors and students have more elastic demand for movie
theatre tickets.
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Price discrimination typically occurs where arbitrage is difficult or impossible.
Arbitrage: ______________________________________________________.
Arbitrage is not possible for movie theatre tickets. It is possible, but difficult, for
the university textbook market.
The case of perfect price discrimination
(a.k.a. first degree price discrimination)
Perfect price discrimination involves the greatest degree of market segregation. In
this case, the monopolist charges each buyer a different price based on their price
elasticity of demand.
If the intervals into which the monopolist can partition the product are arbitrarily
small, the firm’s total revenue will increase by the total area of the triangle…..the
area that used to be consumer surplus.
In this case the consumer pays the maximum he/she is willing to pay for each unit
of output and subsequently receives no consumer surplus.
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How much output will a profit-maximizing, perfectly discriminating monopolist
produce?
What is the MR curve for a perfectly discriminating monopolist?
Rationale for MR curve = demand curve: The firm can lower price to sell
additional output without having to reduce the price on the output originally sold.
This results in a higher level of output.
Comparison of a single price monopolist and a perfectly discriminating
monopolist:
1. Perfectly discriminating monopolist produces a higher level of output.
2. A positive level of consumer surplus typically exists with a single price
monopolist, but not with a perfectly discriminating one.
**” Perfect price discrimination is a never-attained theoretical limit.” (p 375).
Why?
Second-degree price discrimination
The practice, on the part of the seller, of posting a schedule of prices reflecting
price declines with quantity purchases.
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Many electric utility companies use a declining tail-block rate structure, which is
an example of second-degree price discrimination.
Example: First 500 kilowatt-hours
Next 700 kilowatt-hours
Additional kilowatt-hours
@ $0.10 per kilowatt-hour
@ $0.07 per kilowatt-hour
@ $0.04 per kilowatt-hour
It is similar to first-degree price discrimination in that the strategy is an attempt to
take consumer surplus from the buyer.
There are two major differences that set it apart from first-degree price
discrimination:
1. Same rate schedule applies to all buyers, thus the strategy does not attempt
to set prices according to elasticity differences among buyers.
2. Limited rate categories tend to limit the amount of consumer surplus
captured by the firm.
Hurdle model of price discrimination
This model consists of a technique whereby the firm induces the most elastic
buyers to identify themselves.
The seller sets up a hurdle and sets a discount price available to those buyers who
elect to jump over it. “The logic is that those buyers who are most sensitive to
price will be much more likely than others to jump the hurdle” (p 377).
Examples
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1. a rebate form included in the product package
The hurdle is the time and effort it takes to fill out the form, find a stamp and an
envelope, and get it to the post office.
The firm hopes that people who do not care much about the price will not bother
to go through the process.
People with less elastic demand will end up paying the regular price and those
with more elastic demand will pay the lower discount price
2. airlines: hurdles- book 2 weeks in advance and stay over a Saturday night.
The hurdle works somewhat like a tax. The imposition of a hurdle places a perunit transaction cost T on those who choose to jump it.
A buyer will not jump the hurdle if T> (PH – PL)
A buyer will jump the hurdle if T< (PH – PL)
With a perfect hurdle, none of the people who pay the discount price has a
reservation price greater than or equal to the regular price. In other words, the
buyers who jump the hurdle would not have purchased the product without the
discount.
The model is similar to first-degree price discrimination in that it tries to modify
prices to the elasticities of the individual buyers.
The model differs from first-degree price discrimination in that it cannot hope to
capture the entire consumer surplus.
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How efficient is a monopoly?
The long-run equilibrium in a perfectly competitive industry maximum efficiency
is achieved in that there are no possibilities for additional gains from exchange.
The value to the buyers of the last unit of output = market value of the resources
required to produce the last unit of output
This does not hold true for a _______________________________.
A single price monopolist’s equilibrium outcome results in a loss of consumer
surplus. The cost to society is called the deadweight loss from monopoly.
In the case of a perfectly discriminating monopolist, the results are the same as for
a perfectly competitive industry, except that the benefit is producer surplus in
place of consumer surplus.
Public Policy toward natural monopoly
To compare a monopoly to a perfectly competitive ideal is not so practical, but to
compare it to real world market models is both practical and relevant.
Consider a natural monopoly, a firm with an ATC curve that declines over a large
quantity of output, which corresponds to the entire market demand.
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Two objections to a single-price monopolist’s output and price decision:
1. fairness: ____________________________________
2. efficiency: ______________________________________
The efficient level of production: P = MC.
Is there a problem with the efficient level of production?
___________________________________________
Alternative solutions:
1. State ownership and management
Government would charge the efficient price, P = MC and absorb economic
losses out of general tax revenues.
Government enterprises are currently operated by all three levels of
government: federal, provincial and local. Some are run as departments of the
government, some as government-owned Crown corporations, and some as
public-private collaborative enterprises.
For instance, Canada Post is a crown corporation and a legislated monopoly
with first-class mail delivery that may in part be justified by natural monopoly
considerations. As well, it competes directly with private courier companies in
providing express delivery services.
2. State regulation and private monopolies
This option involves leaves firm ownership in private hands while providing
regulations and guidelines that limit the power to price and restrict output.
Rate-of-return regulation in Canada is a common form of government price
regulation. Under this regulation, prices are set allowing the firm to earn a
predetermined rate of return on invested capital. The rate of return is typically
set according to the opportunity cost of its capital, i.e. a competitive rate of
return on investment. Deciding on this rate can be difficult.
Two disadvantages of rate-of-return regulation:
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1. The ____________________________________________: (purchasing
more capital equipment than is necessary; there is an incentive to purchase the
gold-plated rather than the regular water cooler.
2 ________________________: in the case where the monopoly serves
more than one market, it charges below-cost prices in the more elastic
market and cross-subsidizes the loss with above-cost prices in the less
elastic market.
The rationale behind cross-subsidization is that the below-cost price in the
elastic market increases sales by more than the above-cost price in the less
elastic market. The resulting increase in output increases the firm’s capital
requirements and increases the profits allowed by regulation.
Despite some of the difficulties, governments all over the world regulate the
price and output decisions of natural monopolies.
3. ______________________________
The government would specify in detail the service it wanted to provide and
then call for private firms to submit bids to supply the service. The low bidder
would then get the contract.
The contract must specify the details of the service (i.e. postal delivery,
garbage collection, etc.) to be provided in extraordinary detail.
4. Vigorous enforcement of ________________________
This method involves controlling monopoly power through competition policy.
The Competition Act deals with a broad range of issues which include anticompetitive activities. Provisions cover misleading advertising and predatory
pricing (selling products below cost in an attempt to drive out a rival firm).
The Act prohibits collusion between firms in price-setting, bidding for tenders,
or partitioning the market.
The Act requires government approval of any mergers which would
significantly increase the degree of concentration in an industry.
5. ______________________________________
Let the monopolist choose its own price and level of output.
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What about fairness and efficiency?
In some cases, the seriousness of these problems is reduced.
Efficiency:
For instance, the more finely the monopolist partitions the market under the
hurdle model, the smaller the efficiency loss will be. When natural
monopolies use hurdle pricing to expand their markets, the efficiency problem
is reduced.
Fairness:
Hurdle pricing also can result in a reduced fairness problem.
However, not all monopolies use hurdle pricing.
Sum: None of the five options offers a perfect solution. All of the solutions
are used in some form.
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