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ECMC41 – Week Three Topics: a. Monopoly: Structure, Conduct, Basic Conditions, Performance b. Dominant Firm, Competitive Fringe Or, what happens when competitive firms enter a monopoly industry? Structure, Conduct, Performance c. Monopsony: Structure, Conduct, Performance 1 The Monopoly Model (a) Single seller (b) Entry to market is blocked. Therefore, firm has entire industry demand and no competitors or potential competitors to worry about. Could be: (a) cost advantage – economies of scale which are large relative to the size of the market (known as “natural monopoly” (b) government licence or restriction (patent) (c) ownership of scarce but essential resource (d) some other barrier to entry (e.g., huge advertising costs) 2 Single seller faces entire market demand curve (price maker, not price taker) Graphically: Price per unit quantity MC AC Demand MR 0 3 Quantity produced per unit of time Why is MR < P? 4 Algebraic example Market Demand: P = 100 - .02Q So, total revenue = TR = PxQ = 100Q - .02Q2 Marginal Revenue = dTR/dQ = 100 - .04Q (the rate at which total revenue is changing as output increases) Total cost function of monopoly firm: TC = .01q2 + 10q + 432 or .01Q2 + 10Q + 432 So, MC = .02Q + 10 (the rate at which total cost is changing as output increases) AC = .01Q + 10 + 432Q-1 We can solve by forming the profit function and maximizing with respect to Q TR – TC = 100Q - .02Q2 - .01Q2 + 10Q + 432 5 Or we can set MC = MR and solve for Q (Conduct) Substitute into the demand curve to find P*(Conduct) How much is the profit of the monopolist? (Performance) Where is the monopolist’s supply curve? 6 What about the long run? Is the monopolist efficient? (Performance) Several perspectives: Does the monopolist minimize costs? Is marginal benefit equal to marginal cost at the monopolist’s equilibrium output? 7 Does the monopolist’s output maximize the sum of producer and consumer surpluses? Classic view is that monopoly distorts resource allocation and causes deadweight efficiency loss. Monopolist produces too little output (uses too few resources). In practice, there are other considerations. 8 A distributional concern (not allocative efficiency): Does the monopolist transfer potential CS into PS? 9 What is the role of elasticity? (Basic Conditions) Derive an expression for the market power of the monopolist (any firm, really) First part: Take expression for MR and analyze it (in abstract form): MR = dTR/dQ = d(P x Q)/dQ By the product rule of calculus… d(P x Q)/dQ = (dP/dQ x Q) + (dQ/dQ x P) = (dP/dQ x Q) + P Then divide by P = (dP/dQ x Q/P) + P/P And multiply by P = P[(dP/dQ x Q/P) + 1] But (dP/dQ x Q/P) = 1/ED So, we have: MR = P(1 + 1/ED) 10 Second part: Since, at profit max, MC = MR, then at profit max quantity: MC = P(1 + 1/ED) So, MC/P =(1 + 1/ED) Or MC/P – P/P = 1/ED Or (MC – P)/P = 1/ED Or, multiplying both sides by –1… Or (P - MC)/P = -1/ED Which can be interpreted as proportional markup depends on elasticity of demand (for the output of the firm, not the industry). Interpret (P - MC)/P as an index of market power and call it the Lerner Index 11 How does elasticity affect DWL, and profit? 12 What about natural monopoly? What about dynamic efficiency? 13 Dominant Firm, Competitive Fringe Assumptions (structure): (a) One firm dominant – lower production costs (b) Fringe of other small firms. No market power. Price takers. Competitive Fringe (c) No additional entry 14 Graph (gives conduct): 15 Algebraic example: Industry demand: P = 1000 - .005Q 100 firms in competitive fringe TCCF = 600q + q2 TCDF = 500q 16 Monopsony: What is it? Structure, Conduct, Performance 17