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CHAPTER 7 Monopoly LEARNING OBJECTIVES After reading this chapter, you should be able to: 1 2 3 4 5 Define what a monopoly is. Explain why price exceeds marginal revenue in monopoly. Describe how a monopoly sets output and price. Illustrate how monopoly and competitive outcomes differ. List the pros and cons of monopoly structures. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-1 CHAPTER 7 The goal of this chapter is to examine how a market controlled by a single producer—a monopoly—behaves. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-2 MONOPOLY STRUCTURE A monopoly is one firm that produces the entire market supply of a particular good or service. • • • • Barriers to entry. Market power over price and quantity. The firm is the industry. The firm’s demand curve is the market demand curve. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-3 MONOPOLY STRUCTURE Monopolists do not maximize profit where price equals marginal cost. For perfectly competitive firms: • Price = MR because it is a price taker. • Profit maximizing rule is MR = MC. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-4 MONOPOLY STRUCTURE Because monopolists face a downward sloping demand curve, marginal revenue is not constant. • Marginal revenue is the change in total revenue from a unit increase in quantity. • A monopolist can sell additional output only if it reduces prices. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-5 MONOPOLY STRUCTURE Marginal revenue is always less than price for a monopolist. Quantity Price Total Revenue Marginal Revenue A 1 X $13 = $13 B 2 X $13 = 24 $11 C 3 4 $13 $13 = = 33 40 9 D X X E 5 X $13 = 45 5 F 6 X $13 = 48 3 G 7 X $13 = 49 1 7 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-6 MONOPOLY STRUCTURE MR curve is always below the demand curve. PRICE (per pound) $14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 A Marginal revenue is less than price for a monopoly. B C D b E F c G d Demand (price charged by monopolist) e f Marginal revenue g 1 2 3 4 5 6 7 8 9 10 QUANTITY (pounds of fish per hour) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-7 MONOPOLY BEHAVIOR A monopolist maximizes profits by producing a rate of output where MR = MC. • A monopolists identifies the price corresponding to this output using the demand curve. • Demand curve indicates highest price consumers are willing to pay for a specific quantity of output. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-8 MONOPOLY BEHAVIOR PRICE OR COST (per pound) A monopolist’s production decisions are: 1. Output by setting MR = MC. 2. Price using the demand curve. $14 13 12 D 11 10 9 Total profit 8 d 7 6 5 4 3 Marginal 2 Cost 1 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 0 Average Total cost Profit per unit = p – ATC Total profit = (p – ATC) x q Demand MR = MC Marginal revenue 1 2 3 4 5 6 7 8 9 QUANTITY (pounds of fish per hour) 7-9 MONOPOLY BEHAVIOR The profit maximization rule of setting MR = MC applies to all firms. • A monopoly firm produces an output where MC = MR (< p). • A perfectly competitive firm produces an output where MC = MR (= p). Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-10 MONOPOLY BEHAVIOR PRICE OR COST (per pound) A monopolist produces less output and charges a higher price than a competitive industry. 13 12 11 10 9 8 7 MC = MR 6 5 4 3 Marginal 2 cost 1 0 1 Average total cost D E d • Monopolist price of $10 and output of 4. MC = p • Competitive price of $9 and output of 5. Demand Marginal revenue 2 3 4 5 6 7 8 9 QUANTITY (pounds of fish per hour) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-11 BARRIERS TO ENTRY Monopolists earn positive profits due to complete barriers to entry. • Barriers to entry are obstacles making it difficult or impossible for firms to enter the market. • Positive profit requires the restriction of output through limiting the number of firms in the industry. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-12 PATENT PROTECTION Several barriers exist that prohibit entry. • • • • • Patent: Exclusive rights to an innovation Legal harassment: Sue potential entrants. Exclusive license: Contract restricting factors of production. Bundling products: Selling complementary products. Government franchise: Exclusive production right. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-13 COMPARATIVE OUTCOMES A monopoly’s market power allows it to change the way the market responds to consumer demands. • A monopolist prohibits entry of new firms, keeping price high. • A perfectly competitive firm cannot prohibit entry of new firms, price tends to fall. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-14 COMPARATIVE OUTCOMES High price and profit signal consumers’ demand for more output. In a competitive industry: 1. High profit attract new suppliers. 2. Production and supply expand. 3. Price falls. 4. Economic profit squeezed to zero. 5. Pressure to innovate to keep ahead. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-15 COMPARATIVE OUTCOMES High price and profit signal consumers’ demand for more output. In a monopoly industry: 1. Barriers to entry prohibit competition. 2. Production and supply constrained. 3. Price remains high. 4. Economic profit remains. 5. No pressure to innovate. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-16 NEAR MONOPOLIES Market power is not solely concentrated with monopolists. • Two or more firms may rig the market to replicate monopoly outcomes and profits. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-17 NEAR MONOPOLIES Three significant industry structures provide firms with some market power. 1. Duopoly: Two firms dominate market. • • • These firms set price and output even if other firms are present. May engage in price wars. May engage in price fixing. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-18 NEAR MONOPOLIES 2. Oligopoly: Several firms dominate the market. • • • • • Goods are close substitutes. May collude to control price or output. May engage in price wars. Relay on clever advertising to persuade consumers to their product. Barriers to entry are high. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-19 NEAR MONOPOLIES 3. Monopolistic competition: Many firms selling a differentiated product. • • • • No one firm has complete market power. Contend with competing brands. Each has monopoly power on their brand. Few barriers to entry. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-20 WHAT GETS PRODUCED Firms with market power alter the output of goods and services in specific ways. 1. Less is produced 2. Sold at higher price. The result is fewer workers are needed and fewer customers purchase the products, but producer make profits. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-21 RESEARCH AND DEVELOPMENT In principle, monopolies have a greater ability to pursue research and development. • Have profits to invest in expensive R&D. • No incentive to improve products. • Continue to make profits by maintaining market power. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-22 ENTREPRENEURIAL INCENTIVES In principle, monopolies potentially drive entrepreneurial activities. However: • Positive profit by innovation is not exclusive to monopoly industry. • Innovators in perfect competition have the ability to earn large profits. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-23 ECONOMIES OF SCALE One firm producing all output may benefit consumers if lower costs are achieved at higher output rates. • Economies of scale are present if average costs fall as the size (scale) of plant and equipment increases. • Firm could use its size to achieve greater efficiency. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-24 NATURAL MONOPOLY A natural monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply. • Large monopolist may not achieve greater efficiency. • Consumers may not benefit if monopolist doesn’t lower prices. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-25 CONTESTABLE MARKETS A monopolist earning large profits entices potential rivals to enter the market. • A contestable market is an imperfectly competitive industry subject to potential entry if prices or profits increase. • How contestable a market is depends not so much on its structure as it does on its barriers to entry. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-26 STRUCTURE VERSUS BEHAVIOR If potential rivals force a monopolist to behave like a competitive firm, then a monopoly imposes no cost on consumers. • Potential rivals must have a reasonable chance to enter the market and reduce the monopoly’s market power. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-27 AIR TRANSPORTATION INDUSTRY Market structure explains why it can be cheap to fly to one place and expensive to fly somewhere else of equal distance. • Collectively, airlines look competitive. • Air routes between cities are limited markets. • Must analysis each route separately to understand market power. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-28 AIR TRANSPORTATION INDUSTRY Airlines price routes differently depending on how many airlines fly the route. • If several airlines fly a route, airlines behave competitively. • If one or two airlines fly a route, airlines behave like monopolists and duopolists. • 1 in 10 domestic routes is monopolized. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-29 AIR TRANSPORTATION INDUSTRY Airports dominated by one or two carriers have higher fares. • Fares from airports with 1-2 carriers are 45-85% higher than at more competitive airports. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-30 AIR TRANSPORTATION INDUSTRY Fares change significantly when competitors enter/exit market. • Entry and exit can be used to assess market structure on prices. • Monopolies may use a sharp, temporary price reduction to drive out competitors or discourage entry, called predatory pricing. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-31 AIR TRANSPORTATION INDUSTRY Large carriers maintain monopoly routes by owning landing rights and gates. • Act as barriers to entry. • New carriers unable to enter. • Lottery system for new slots didn’t improve competition as large carriers paid substantial sums to lottery winners to sell. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-32 SUMMARY 1. 2. 3. 4. 5. Defined what a monopoly is. Explained why price exceeds marginal revenue in monopoly. Described how a monopoly sets output and price. Illustrated how monopoly and competitive outcomes differ. Listed the pros and cons of monopoly structures. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 7-33