Download MONOPOLY Pure monopoly

MONOPOLY
• Pure monopoly: a single seller of a good or service
with no close substitutes. The firm IS the industry.
Monopoly power: the ability of a firm to control the
market price of it’s good by making more or less of
it available to buyers.
Conditions for monopoly to exist
1. A single seller of a good.
The firm is the industry.
2. No close substitutes for this good or service.
3. Very high barriers to entry into this
industry...
...constraint that prevents additional sellers
from entering the industry and competing
with the monopolist.
Types of Barriers to Entry
1) Natural barriers to entry...
...the existence of large economies of scale makes it
cheaper for one large firm to produce the good
compared with many small firms.
Once this firm is established, it will have a cost
advantage over any new entry.
Examples: Water, Electricity, Natural gas, Local
telephone service (Utilities)
Monopolies due to economies of scale are referred to
as Natural Monopolies.
Types of Barriers to Entry
2) Legal barriers to entry
a) government franchises and license
Examples: Postal service, Utilities, Cable TV, Taxi’s,
Medicine, Law
Government usually takes Natural Monopolies and
legally prevents any other firm from producing that
good. Why?
Since it is more efficient(lowest cost) for one firm to
produce this good, the government wants to make
sure customers enjoy this efficiency...
...by the government regulating prices that are charged!
b) Patents and copyrights...
...granted to inventors and performers to encourage
research and development.
Good for a 20 year period.
Types of Barriers to Entry
3)The ownership of an entire supply of a resource
Examples:
Having control over all diamond mines in the world
The special ability or knowledge a person may have.
The “best” of the best...
...Performers, actors, songwriters, etc
Monopoly and Price
A Monopoly has control over price (Monopoly power)
• Unlike perfect competition, a monopolist can raise
price and still be able to sell some of it’s good. Why?
The consumer has no where else to buy the good:
Single Firm is the INDUSTRY with barriers to entry
• Will a monopolist simply raise prices to outrageous
levels to gouge the consumer?
Not if they want to maximize profit!
• The monopolist faces the MARKET (Industry)
Demand curve (which is downward sloping)…
…if prices are too high consumers can
stop buying the good
Example: A Monopolist (Market)
$110
Demand Curve
Price
Price
$110
$100
$ 90
$ 80
$ 70
$ 60
$ 50
$ 40
$ 30
$ 20
$ 10
QD
0
20
40
60
80
100
120
140
160
180
200
$100
$ 90
$ 80
$ 70
$ 60
$ 50
$ 40
$ 30
Demand
$ 20
$ 10
0 20 40 60 80 100 120 140 160 180 200 Q
• Assuming a monopolist charges only one price for it’s good it is
clear that if the firm lowers the price of the good it will sell more.
What will happen to total revenue as the monopolist sells more?
Will Marginal Revenue be equal to Price as in perfect competition?
Example: A Monopolist (Market)
$110
Demand Curve
Price
Price
$110
$100
$ 90
$ 80
$ 70
$ 60
$ 50
$ 40
$ 30
$ 20
$ 10
QD
0
20
40
60
80
100
120
140
160
180
200
TR
$0
$2,000
$3,600
$4,800
$5,600
$6,000
$6,000
$5,600
$4,800
$3,600
$2,000
$100
$ 90
$ 80
$ 70
$ 60
$ 50
$ 40
$ 30
Demand
$ 20
$ 10
0 20 40 60 80 100 120 140 160 180 200 Q
Total revenue increases as the monopolist lowers price then reaches a
peak and then declines.
Marginal revenue(MR) = change in total revenue / change in output
Marginal revenue measures how much will total revenue change by
selling the NEXT UNIT of the good
What will MR be for each level of OUTPUT?
Example: A Monopolist (Market)
$110 0
Demand Curve
Price
Price QD TR
MR
0 $110 0
$0
--1
$100
1 $100 20 $2,000 $100
2
$ 90
2 $ 90 40 $3,600 $ 80
3
$ 80
4
3 $ 80 60 $4,800 $ 60
$ 70
4 $ 70 80 $5,600 $ 40
5
$ 60
5 $ 60 100 $6,000 $ 20
6
$ 50
6 $ 50 120 $6,000 $ 0
$ 40
$ 40 140 $5,600 $ -20
$ 30
Demand $ 30 160 $4,800 $ -40
Marginal
$ 20
Revenue
$ 20 180 $3,600 $ -60
$ 10
$ 10 200 $2,000 $ -80
0 20 40 60 80 100 120 140 160 180 200 Q
Marginal revenue(MR) = change in total revenue / change in output
From point 1 to point 2 = $1,600 / 20 = $80
From point 2 to point 3 = $1,200 / 20 = $60
From point 3 to point 4 = $ 800 / 20 = $40
Marginal revenue IS LESS THAN PRICE, and IT DECLINES
more rapidly than price. Why?
Example: A Monopolist (Market)
$110 0
Demand Curve
Price
Price QD TR
MR
0 $110 0
$0
--1
$100
1 $100 20 $2,000 $100
2
$ 90
2 $ 90 40 $3,600 $ 80
$ 80
The firms revenue change from
$ 70
lowering price to $90 and selling
40 units is $1600 ($1800 - $200)
$ 60
Divide this by 20 units and you
$ 50 T
get $1,600/20 = $80 (MR)
$ 40 R
The reason MR < P is due
$ 30
to the lost revenue from
$ 20
having to lower the price in
Demand
$ 10
order to sell more goods!
0 20 40 60 80 100 120 140 160 180 200 Q
Suppose the monopolist sells 20 units for $100 originally. TR = $2000
If the monopolist wants to sell 40 units it must lower the price to $90
The monopolist gains $1,800(20 x $90) from selling the next 20 units
But the firm must lower the price on ALL PREVIOUS UNITS it
could have sold for $100. The firm loses $200 from lowering price
($10 difference x 20 units)
Summary of MR for a Monopolist
Price
($)
MR
Total
Revenue
Demand
Q1
Quantity
Total Revenue
MR < P for all relevant levels
of output
For a linear Demand curve
the MR curve intersects the
horizontal axis 1/2 of the
distance the Demand curve
does…
…at this point Total
Revenue is Maximized…
The price that maximizes
TR is NOT the price that
maximizes Profit!
Q1
Quantity
Price
A Monopolist won’t
Price
$110
$100
$ 90
$ 80
$ 70
$ 60
$ 50
$ 40
$ 30
$ 20
$ 10
QD
0
20
40
60
80
100
120
140
160
180
200
MR
--$100
$ 80
$ 60
$ 40
$ 20
$ 0
$ -20
$ -40
$ -60
$ -80
MC
---$35
$22
$32
$40
$52
$68
$83
$98
$115
$130
$110 0 charge more than $70
0
since
it
can’t
sell
1
$100
MC
1
80 units
2
$ 90
2
3
$ 80
4
3
$ 70 P
4
5
$ 60
5
6
$ 50
6
$ 40 MC
$ 30
Demand
$ 20
$ 10
MR
0 20 40 60 80 100 120 140 160 180 200 Q
Any firm maximizes profit at the output level where MR = MC
This monopolist will produce 80 units of output when MR = MC.
Does the monopolist charge only $40 for it’s product?
No, it will seek out the highest price consumers will pay for 80 units.
This is represented by the Demand curve(MB).
The Monopolist SEARCHES for the highest price, which is $70.
Price
If a Monopolist’s ATC is
low enough then it will
make an Economic profit
$110
$100
MC
$ 90
ATC
$ 80
4
$ 70 P
$ 60
$ 50 ATC
$ 40 MC
$ 30
Demand
$ 20
$ 10
MR
0 20 40 60 80 100 120 140 160 180 200 Q
Economic Profit
A monopolist will make an economic profit if P >ATC at
the level of output where MR = MC.
Note: A monopoly will charge a price greater than marginal
cost Unlike perfect competition, the consumer pays more than
what it costs to produce the good
Price
MC
If a Monopolist’s costs
(including the ATC) are
higher then it may only
make a Normal profit
$110
$100
ATC
$ 90
$ 80 P = ATC
$ 70
A monopoly is not guaranteed of
$ 60
making an economic profit…
$ 50 MC
$ 40
$ 30
Demand
$ 20
$ 10
MR
0 20 40 60 80 100 120 140 160 180 200 Q
…it depends on the cost of the product and the market demand
for the product.
If a monopolist has very high costs for a product consumers are
not willing to pay a very high price for the monopolist could
make a loss...
Price
MC
A case where a
Monopolist is making an
Economic Loss
$110
ATC
$100
$ 90 ATC
$ 80 P
AVC
$ 70
$ 60 MC
$ 50
$ 40
$ 30
Demand
$ 20
$ 10
MR
0 20 40 60 80 100 120 140 160 180 200 Q
Economic Loss
This is an example of a monopoly making an economic loss, but
operating because it covers all of it’s variable costs in the short
run
Is there a Supply curve for a Monopolist?
NO.
Why?
• The supply curve derived in perfect competition
(the firms MC curve) was done based on the fact that a
competitive firm is a Price Taker and REACTS to price.
A Monopolist is a Price Searcher
It DOES NOT REACT to price changes
If demand increases there is no guarantee that a
monopoly will decide to produce more.
It depends on the shifting of the MR curve.
There is NO unique relationship between price and
quantity made available from a monopolist.
Long run equilibrium.
• Will be the same as short-run equilibrium…
...Profits are signals for new firms to enter the
industry...
...to take away economic profit...
...but barriers to entry prevent this from happening
and a monopolist that makes a profit in the short
run can expect to make one in the long run.
A monopolist that makes an economic
loss will exit the industry...
....and the industry will cease to exist.
Comparing Perfect competition &
Monopoly
Suppose that we are able to transform
a constant costs competitive industry
into a Pure Monopoly.
• How would that effect the quantity of the good
produced by the industry?
• How would that effect the price of the good?
• How would that effect the well being of
consumers of that good?
Price
CONSTANT COST INDUSTRY
Price
S
P*
S
’
SRATC
LRIS
MC = LRAC
D’
D
q (Tomatoes)
A representative firm
Competitive marketQ(Tomatoes)
A constant cost industry has a perfectly elastic Long run Industry
supply curve...
...this implies that LRAC for firms never change or are Constant.
Because LRAC never change, neither can MC (Marginal Average rule)....so MC = LRAC for a Constant Cost Industry.
We can use the MC=LRAC curve for the market graph as well
Price A
PM
PPC C
Market for Tomatoes
Consumer Surplus
Monopoly Profit
Make
Industry into
a Monopoly
Competitive
situation
Comparing Monopoly & Perfect Competition
A Monopolist will produce LESS
than a Competitive Industry
A Monopolist will charge a HIGHER
Price than a Competitive firm
B
MC =LRAC = LRIS
Since PM > LRAC the Monopoly
will make an Economic profit
MR
Demand
Quantity(Tomatoes)
QM
QPC
Competitive Equilibrium occurs where LRIS = Demand.
P=MC=Min LRAC
Consumers are as well off as possible
(Maximizing consumer surplus) Triangle ABC
A monopoly maximizes profit at the output level where MR = MC,
so the MR curve is added to the graph.
A monopolist then searches out the highest price to charge off the
Demand curve
Price A
Market for Tomatoes
Comparing Monopoly &
Perfect Competition
Consumer Surplus
Monopoly Profit
Welfare Loss of
Monopoly
It has evaporated! It’s a Net
Loss(Deadweight Loss) to the Economy
PM
B
PPC C
MR
QM
MC =LRAC = LRIS
Demand
QPC
Quantity(Tomatoes)
Consumer Surplus is much smaller in Monopoly than
Competition because of the lower quantity and higher price
What happened to the Consumer surplus in
Competition(Triangle ABC)?
The red area is “lost” by the consumer (lower quantity) but not
gained by the Monopolist (lower quantity)
Price A
Market for Tomatoes
Comparing Monopoly &
Perfect Competition
PM
Consumer Surplus
Monopoly Profit
Welfare Loss of
Monopoly
Net Loss(Deadweight Loss)
B
PPC C
MR
QM
MC =LRAC = LRIS
Demand
QPC
Quantity(Tomatoes)
The Monopolist gains at the expense of consumers welfare…
…and the economy as a whole suffers, because overall welfare
(Consumer + Monopoly) decreases {Deadweight loss}.
P > MC: Indicates that consumers want(and can be made
better off) more of the good produced.
Monopoly is not allocatively efficient
Monopoly is NOT productively efficient
Price
MC
PM
ATC
ATC M
Minimum ATC
Demand
MR
QM
Quantity
The Monopolist also produces it’s level of output
at greater than minimum ATC.
Price A
Rent Seeking Behavior...
In past, Monopoly
profit has been called
Rent
PM
PPC
B
C
MR
QM
Consumer Surplus
Monopoly Profit
Welfare Loss of
Monopoly
MC =LRAC = LRIS
Demand
QPC Quantity(Tomatoes)
…seeking or attempting to maintain Monopoly profit
Problem of Rent-Seeking behavior:
In today’s economy the easiest way to attain or maintain a monopoly
is through government intervention to PREVENT COMPETITON...
…this means rent seeking behavior:
1)Consumes and wastes resources in having to lobby elected and
appointed government officials
2) Leads to government failure: government becomes the “tool”
of the rent seeker and makes the allocation of resources even
worse than with monopoly alone.
In search of even greater
profits: Price Discrimination
• Definition: Selling a good with the same costs and
quality at different prices to different buyers.
Examples: Senior discounts or rates, utilities
charging different prices for residential use than
commercial use, coupons, others
• Many industries practice price discrimination:
Airlines, movie theaters, golf courses, cereal
companies, colleges, others…
…by practicing price discrimination a firm can earn
more revenue and profits than by charging only a
single price.
Conditions needed to practice price discrimination
a) Firm must have control over the price it can charge.
This will be true except for perfectly competitive firms
b)The firm must distinguish between buyers who they
can charge higher prices to and those who will pay
lower prices.
In practice this means to distinguish between buyers with
inelastic demand and buyers with elastic demand.
• Rule: Raise prices on buyers with inelastic demand and
lower prices on buyers with elastic demand to increase
revenue and profits.
c) The good or service must not be re-sellable.
If it was buyers who pay the lower price can resell to
buyers who must buy at a higher price from the
monopolist...
…at a slightly lower price than the monopolist and
pocket the difference.
Types of Price discrimination
1) Discrimination among quantities (Block pricing)...
…charging a different unit price for a different
quantity sold.
• Example: Block Pricing by a utility that supplies
electricity (Residents pay cheaper rates per
kilowatt than industry)
• Other examples: In the food industry, a lower
unit price is charged for bigger containers than
for small containers…
…those that buy bigger containers will have
greater elasticity of demand)
i.e. Storage capacity
Types of Price discrimination
2) Discrimination among buyers or markets...
...charging different prices for different sets of buyers
because they have different characteristics.
• The firm must find consumers that have inelastic
demand and those with elastic demand and charge
higher prices and lower prices respectively.
Examples: Airline industry...business travelers
(inelastic) and tourists (elastic).
Develop a pricing scheme that exploits these
segmented markets.
• Movie theater industry...those that can attend
during the day and those who only can attend at
night.
A possible remedy: Anti-Trust laws
• If a monopoly exists the government can break up
the firm (among other penalties) using anti-trust
laws to reestablish competition.
• Examples: Standard Oil in 1911, ATT in mid 1980’s
NCAA in early 1980’s
• Laws also used to prevent Mergers, if they restrict
competition. Ex: Pepsi - Dr. Pepper, Coke -7 UP
• At the discretion of the Justice Department
• IBM was charged for monopoly practices in late
1960’s, but by 1982 the case was dismissed.
• Microsoft was accused of monopoly practices.
Natural monopoly...
…an Industry with such large economies of scale
LRAC always declines as more of the good is
produced (for the relevant market)
• Implies that one large firm can produce this good
at much lower cost than many small firms…
…so breaking up a Natural Monopoly does no
good…
Price
Problem with
Natural Monopoly...
Solution: Government steps in
and forces the monopolist to
charge a lower price and
produce a higher quantity
(Regulation)
A Natural Monopoly
Economic
Profit
PM
Demand
LRAC
MR
QM
LRMC
Quantity of Electricity
…although it is cheaper for one firm to produce this good
at high levels of output, the Monopolist will not produce
that output.
Reason: It is not profitable to produce beyond MR=MC.
So P > LRAC: Consumers DO NOT get the benefit of
lower costs
Price
A Natural Monopoly
Economic
Profit
PM
Demand
Solution: Government steps in
and forces the monopolist to
charge a lower price and
produce a higher quantity
(Regulation)
Loss per unit with MC price
PAC
PMC
LRAC
QM
MR
QA QMC
LRMC
Quantity of Electricity
a) Price = marginal cost. This Cwill maximize consumer surplus.
Called Marginal cost pricing
Problem: Monopolist will make economic losses at this price
and decide not to produce this good or service unless subsidized
Solution: allow the firm to charge where Price = Average cost.
b) Average cost or “Rate of return” pricing
The Price is higher than Marginal Cost pricing, but it allows
the monopolist to stay in business without subsidies.
Rate of Return: Reality problems
1) A commission is set up to establish and monitor
prices for the utility.
a. Usually, commission members are former
members of the particular industry they regulate.
b. This may grant some additional power to the
monopolist when it comes to asking for price
increases.
2)The monopolist will be granted a “fair rate of
return” over it’s costs, most of which will be capital.
Example: No matter the firm’s per unit costs it will
always receive a 5% return over those costs
Cost can be difficult to establish.
The firm has an incentive to exaggerate the cost of
providing this product.
Rate of Return: Reality problems
• Since the monopolist is guaranteed a “fair rate of
return” over their costs, they have no incentive to
minimize costs...
…the firm can purchase expensive machinery, staff,
offices, etc that may not be necessary to produce this
product...
…the consumer will have to pick up the tab in the
form of higher prices if the commission allows the
price increase to go through
(which it probably will if “taken over” by the firm).
Benefits of a Monopoly?
• Research and development of new technologies...
...without monopoly profits as an incentive firms may
not spend resources to develop new technologies and
goods.
• Joseph Schumpeter : “Creative Destruction”
Even if a firm has a Monopoly today, other firms will
try to develop substitutes for the good and attempt to
create their own monopoly.
This “destroys” the old monopoly and “creates” a new one
Ballpoint pens replaced fountain pens
• If a firm is not protected from competition by the
government it is increasingly difficult to maintain
monopoly profits…
…due to other firms developing substitute products.