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Monopoly Monopoly While a competitive firm is a price taker, a monopoly firm is a price maker. Chapter 15 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Monopoly Because a monopoly is a price maker, a monopolist gets to choose what price they will sell their good for rather than having the market determine the price. u How does a monopolist decide to price their good at $100 rather than $1,000? u Although monopolies can control the prices of their goods, their profits are not unlimited. u Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Monopoly uA firm is considered a monopoly if . . . …it is the sole seller of its product. …its product does not have close substitutes. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why Monopolies Arise Why Monopolies Arise Barriers to entry have three sources: Ownership of a key resource. The government gives a single firm the exclusive right to produce some good. u Costs of production make a single producer more efficient than a large number of producers. u The fundamental cause of monopoly is barriers to entry. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. u Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 1 Monopoly Resources Monopoly Resources Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason. u The classic example of a company with a monopoly due to the ownership of a key resource is DeBeers . u DeBeers owns land in South Africa where more than 80% of the diamonds are found worldwide. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. DeBeers Example “A diamond is forever.” Why does DeBeers advertise if it is a monopoly? u Remember a firm is considered a monopoly when there are no close substitutes. u DeBeers advertises just to make sure how important diamonds are compared to other gems such as emeralds or rubies. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Government-Created Monopolies u u Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Government-Created Monopolies Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Government-Created Monopolies Because patents and copyrights give one producer a monopoly, they lead to higher prices than would occur under competition. u So why does the government give patents? u Patents and copyrights give individuals and firms an incentive for creative research. u Example: Drug companies spend much money in the research and development of new drugs because they know they will have a monopoly for that drug for the life of the patent. u Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 2 Natural Monopolies Natural Monopolies An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A natural monopoly arises when there are economies of scale over the relevant range of output. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Economies of Scale as a Cause of Monopoly... Natural Monopolies Cost u An Average total cost 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Quantity of Output Monopoly versus Competition Monopoly example of a natural monopoly is the local utilities. u Power lines have to be strung up all across town which implies a huge fixed cost. u It is cheaper for one company to provide this service rather than having multiple companies setting up power lines. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Competition versus Monopoly Competitive Firm uIs the sole producer uIs uHas uHas a horizontal demand curve uIs uIs a downward-sloping demand curve a price maker uReduces price to increase sales Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. one of many producers a price taker uSells as much or as little at same price Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 3 Demand Curves for Competitive and Monopoly Firms... Price (a) A Competitive Firm’s Demand Curve A Monopoly’s Revenue (b) A Monopolist’s Demand Curve u Total Revenue Price P x Q = TR u Average Revenue Demand TR/Q = AR = P u Marginal Revenue Demand 0 Quantity of Output 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Monopoly’s Total, Average, and Marginal Revenue Quantity (Q) 0 1 2 3 4 5 6 7 8 Price (P) $11.00 $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 Total Revenue (TR=PxQ) $0.00 $10.00 $18.00 $24.00 $28.00 $30.00 $30.00 $28.00 $24.00 ∆TR/∆ Q = MR Quantity of Output Average Revenue (AR=TR/Q) Marginal Revenue (MR=∆ TR / ∆ Q ) $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 -$2.00 -$4.00 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Monopoly’s Marginal Revenue A monopolist’s marginal revenue is always less than the price of its good. uThe demand curve is downward sloping. a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases. uWhen Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. A Monopoly’s Marginal Revenue When a monopoly increases the amount it sells, it has two effects on total revenue (P x Q). uThe output effect—more output is sold, so Q is higher. uThe price effect—price falls, so P is lower. Demand and Marginal Revenue Curves for a Monopoly... Price $11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 Demand (average revenue) Marginal revenue 1 2 3 4 5 6 7 8 Quantity of Water Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 4 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Profit Maximization of a Monopoly uA monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. u It then uses the demand curve to find the price that will induce consumers to buy that quantity. Profit-Maximization for a Monopoly... 2. ...and then the demand curve shows the price consistent with this quantity. Costs and Revenue B Monopoly price 1. The intersection of the marginal-revenue curve and the marginalcost curve determines the profit-maximizing quantity... Average total cost A Demand Marginal cost Marginal revenue 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Comparing Monopoly and Competition u For a competitive Quantity A Monopoly’s Profit firm, price equals marginal cost. Profit equals total revenue minus total costs. Profit = TR - TC Profit = (TR/Q - TC/Q) x Q Profit = (P - ATC) x Q P = MR = MC u For a monopoly firm, QMAX price exceeds marginal cost. P > MR = MC Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Monopolist’s Profit... The Monopolist’s Profit Costs and Revenue Marginal cost Average total cost D B ly po no fit Mo pro Monopoly E price Average total cost The monopolist will receive economic profits as long as price is greater than average total cost. C Demand Marginal revenue 0 QMAX Quantity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 5 The Market for Drugs... The Welfare Cost of Monopoly Costs and Revenue uIn Price during patent life Price after patent expires Marginal cost Marginal revenue 0 Monopoly quantity Demand Competitive quantity contrast to a competitive firm, the monopoly charges a price above the marginal cost. uFrom the standpoint of consumers, this high price makes monopoly undesirable. uHowever, from the standpoint of the owners of the firm, the high price makes monopoly very desirable. Quantity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Efficient Level of Output... Price Marginal cost Value to buyers Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost. Cost to monopolist Value to buyers Cost to monopolist 0 Demand (value to buyers) Efficient quantity Value to buyers is greater than cost to seller. The Deadweight Loss uThis wedge causes the quantity sold to fall short of the social optimum. Quantity Value to buyers is less than cost to seller. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Inefficiency of Monopoly... Price The Inefficiency of Monopoly Deadweight loss Marginal cost Monopoly price The monopolist produces less than the socially efficient quantity of output. Marginal revenue 0 Monopoly quantity Efficient quantity Demand Quantity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 6 The Deadweight Loss The Deadweight Loss u The monopoly profit itself does not represent a shrinkage in the size of the economic pie; it merely represents a bigger slice for producers and a smaller slice for consumers. u The problem arises because the firm produces a quantity of output below the level that maximizes total surplus. uThe deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax. uThe difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Increasing Competition with Antitrust Laws Public Policy Toward Monopolies Government responds to the problem of monopoly in one of four ways. Making monopolized industries more competitive. u Regulating the behavior of monopolies. u Turning some private monopolies into public enterprises. u Doing nothing at all. u Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Antitrust laws are a collection of statutes aimed at curbing monopoly power. u Antitrust laws give government various ways to promote competition. u u They allow government to prevent mergers. allow government to break up companies. u They prevent companies from performing activities which make markets less competitive. u They Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Two Important Antitrust Laws u Sherman Antitrust Act (1890) u Reduced the market power of the large and powerful “trusts” of that time period. u Clayton Act (1914) u Strengthened the government’s powers and authorized private lawsuits. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Regulation Government may regulate the prices that the monopoly charges. uThe allocation of resources will be efficient if price is set to equal marginal cost. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 7 Regulation Marginal -Cost Pricing for a Natural Monopoly... Price u 1. 2. There are two problems with marginal cost pricing as a regulatory system. When ATC is declining, MC is less than ATC. If regulators are to set price equal to MC, that price will be less than the firm’s ATC, and the firm will lose money. The monopolist has no incentive to reduce costs if they know the regulator will lower price as costs fall. Average total cost Regulated price Loss Average total cost Marginal cost Demand 0 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Regulation In practice, regulators will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Quantity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Public Ownership Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself. (e.g. in the U.S., the government runs the Postal Service). Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Public Ownership Doing Nothing u Economists usually prefer private to public ownership of natural monopolies. u Firms are motivated by profit (assuming regulators allow the firm to keep some profit when the firm reduces costs). u If government bureaucrats who run a monopoly do a bad job, the losers are the customers and tax payers. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 8 Price Discrimination Price Discrimination Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Price Discrimination Perfect Price Discrimination u In order for a firm to price discriminate, it must be able to separate customers according to their willing to pay. u Sometimes firms price discriminate by a consumer’s age. u Examples: movies and restaurants. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Perfect price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Price Discrimination Price Discrimination It may be surprising, but price discrimination raises economic welfare. u This is accomplished by producers receiving much more surplus since they can charge different consumers different prices. u Consumers are no better off if they are charged their willingness to pay. u The entire increase in total surplus from price discrimination goes to the producer in the form of higher profit. u u Two important effects of price discrimination: u It u It can increase the monopolist’s profits. can reduce deadweight loss. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 9 Welfare Without Price Discrimination... Welfare With Price Discrimination... (a) Monopolist with Single Price Price Price (b) Monopolist with Perfect Price Discrimination Consumer surplus Deadweight loss Monopoly price Profit Profit Marginal revenue 0 Quantity sold Marginal cost Marginal cost Demand Demand Quantity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 0 tickets u Airline prices u Discount coupons u Financial aid u Quantity discounts Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Most airlines charge a lower price for a round trip ticket between two cities if the traveler stays over a Saturday night. u Why is this? u The reason is that this provides a way to distinguish business travelers from personal travelers. u Assuming business travelers have a higher willingness to pay, this type of price discrimination makes sense. u Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary The Prevalence of Monopoly u How prevalent are the problems of monopolies? u Monopolies are common. u Most firms have some control over their prices because of differentiated products. u Firms with substantial monopoly power are rare. u Few goods are truly unique. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Quantity Airlines Examples of Price Discrimination u Movie Quantity sold Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. uA monopoly is a firm that is the sole seller in its market. u It faces a downward-sloping demand curve for its product. u A monopoly’s marginal revenue is always below the price of its good. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 10 Summary u Like a competitive firm, a monopoly maximizes profit by producing the quantity at which marginal cost and marginal revenue are equal. u Unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Policymakers can respond to the inefficiencies of monopoly behavior with antitrust laws, regulation of prices, or by turning the monopoly into a government-run enterprise. u If the market failure is deemed small, policymakers may decide to do nothing at all. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary uA monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus. u A monopoly causes deadweight losses similar to the deadweight losses caused by taxes. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Monopolists can raise their profits by charging different prices to different buyers based on their willingness to pay. u Price discrimination can raise economic welfare and lessen deadweight losses Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 11