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Session 8 Monopoly Outline Chapter 9 in the text Tips for Navigation in the presentation: Right mouse click to advance, or Use the arrow keys to navigate in the presentation : the up or right arrow to advance, the down or left arrow to go back; This image house appears on every slide in the upper left and operates as a hyper link to the slide “Lecture Outline” First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 1.1Monopoly CHAPTER 9 AT&T: Ernestine calls Mr. Veedle: Ernestine the operator is a favorite of anyone who has ever called Directory Assistance. Outline First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination 2 End Outline 1.2 Online Prescription Drugs: Canada An example of how open borders can eat into profits of a US monopolist. Imports of Prescription Drugs from Canada What's Left for Canadians If Americans Buy Their Drugs? Online Pharmacy Sales To the U.S. Raise Risk Of Some Supply Shortages By TAMSIN CARLISLE Staff Reporter of THE WALL STREET JOURNAL, November 4, 2004 U.S. patients can obtain prescription medications from Canadian Internet pharmacies at substantial discounts to their retail prices in the U.S. Some U.S. patients, especially senior citizens without medical insurance, say this is the only way they can afford to fill their prescriptions. But big drug companies say they depend on profits from U.S. sales to fund pharmaceutical research and development. They also point out that the cross-border drug trade is illegal under U.S. federal law. Source: AARP Bulletin Outline First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 1.3 Creating a Monopoly: Advantages of… Source AC/DC is set to become the next major band to sell a new album only through Wal-Mart, a deal highlighting the chain's rising music-industry clout. The arrangement comes at a time when the retail giant is signaling plans to stock fewer CDs. First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline Lecture Outline Session 8 First Slide 2.0 Monopoly Market Structure 3.0 Downward Sloping Demand Curve 4.0 Profit Maximization (MR=MC) 5.0 Compare with Perfect Competition 6.0 Price Discrimination 7.0 Self Evaluation: Flash, Excel, Draw Tool End of Presentation First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 2.0 Monopoly Market Structure 2.1 Terminology 2.2 Single firm 2.3 Barriers to Entry A. Legal Restrictions B. Patents C. Licenses D. Resource Control E. Economies of Scale F. Natural Monopoly Matrix First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 2.1 Market Structure Terminology Key Characteristics Describing Market Structure Number of suppliers • Many or few Product’s degree of uniformity • Do firms in the market supply identical products or are there differences across firms? The ease of entry into the market • Can new firms enter easily or are they blocked by natural or artificial barriers? Control over Price • Do sellers have full control over the selling price? First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 2.2 Single Firm Outline Monopoly Narket Structure Many buyers and one seller the monopolist is the sole supplier and there are so many buyers that each buys only a tiny fraction of the total amount exchanged in the market. The seller is a price maker. The monopolist sells a product for which there are no close substitutes. There are significant barriers to resource mobility over time they can not easily enter or leave the industry First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 2.3 Barriers to Entry Outline The most important characteristic of a monopolized market is barriers to entry new firms cannot profitably enter the market Barriers to entry are restrictions on the entry of new firms into an industry 1. 2. 3. 4. Patents Licenses Resource Control Economies of Scale (Natural Monopoly) Barriers First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 2.3.1 Patent and Invention Incentives Outline A patent awards an inventor the exclusive right to produce a good or service for 20 years Patent laws Encourage inventors to invest the time and money required to discover and develop new products and processes Also provide the stimulus to turn an invention into a marketable product, a process called innovation Barriers First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 2.3.2 Licenses and other Entry Restrictions Outline Governments often confer monopoly status by awarding a single firm the exclusive right to supply a particular good or service These create Local Monopolies Broadcast TV and radio rights State licensing of hospitals Barriers Cable TV and electricity on local level First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 2.3.3 Control of Essential Resources Outline Another source of monopoly power is a firm’s control over some nonreproducible resource critical to production Barriers Professional sports teams try to block the formation of competing leagues by signing the best athletes to long-term contracts Alcoa was the sole U.S. maker of aluminum for a long period of time because it controlled the supply of bauxite China is the monopoly supplier of pandas DeBeers controls the world’s diamond trade First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 2.3.4 Economies of Scale as a Barrier to Entry (NATURAL MONOPOLY) Outline $ Cost per unit When market demand is not great enough to permit more than one firm to achieve sufficient economies of scale a single firm will emerge from the competitive process as the sole seller in the market. Because such a monopoly emerges from the nature of costs, it is called a natural monopoly Long-run average cost Barriers Quantity per period First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 2.4 Matrix of Market Structure Characteristics # of suppliers Product Entry/Exit Standardized Control over Price Perfect Competition Many Yes Very easy None Monopoly One Unique, no close substitutes Blocked Considerable Monopolistic Competition Many Not much as Relatively much differences easy as they want you to think Some, but within narrow limits Oligopoly Few Not much Limited by interdependence, but considerable with collusion First slide 2 Structure 3 Demand 4 Profit Significant obstacles 5 Comparison 6 Discrimination End Outline 3.1 3.2 3.3 3.4 3.0 Downward Sloping Demand Curve Revenue for the Monopolist Revenue in a Table Revenue in a Graph Elasticity & Total Revenue First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 3.1 Revenue for the Monopolist Because a monopoly, by definition, supplies the entire market, the demand for goods or services produced by a monopolist is also the market demand The demand curve for the monopolist’s output therefore slopes downward, reflecting the law of demand This has important implications for the relation between average revenue (which is price) and marginal revenues. First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 3.2 Revenue in a Table Outline Revenue for De Beers, a Monopolist 1-Carat Price diamonds (average Total Marginal per day revenue) revenue revenue (Q) (p=TR/Q) (TR = Q x p) (MR = TR / Q) (1) (2) (3) =(1) x (2) (4) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 $7,750 7,500 7,250 7,000 6,750 6,500 6,250 6,000 5,750 5,500 5,250 5,000 4,750 4,500 4,250 4,000 3,750 3,500 First slide 0 $7,500 14,500 21,000 27,000 32,500 37,500 42,000 46,000 49,500 52,500 55,000 57,000 58,500 59,500 60,000 60,000 59,500 2 Structure Total revenue (quantity times price) is provided in the third column. As De Beers expands output, total revenue increases until quantity reaches 15 diamonds when total revenue tops out. $7,500 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500 3 Demand The first two columns contain the hypothetical price and quantity information for De Beers the monopoly supplier of diamonds. Marginal revenue (the change in total revenue from selling one more diamond) appears in the fourth column. Note that for all units of output except the first, marginal revenue is less than the price, and the gap between the two widens as the price declines because the loss from selling all diamonds at this lower price increases. 4 Profit 5 Comparison 6 Discrimination End 3.3 Revenue in a Graph Outline $7,000 LOSS 6,750 Price per Diamond G A I N D = Average revenue By selling another diamond, De Beers gains the revenue from that sale, $6,750 from the 4th diamond as shown by the blue-shaded vertical rectangle marked gain. However, to sell that 4th unit, De Beers must sell all four diamonds for $6,750 each it must sacrifice $250 on each of the first three diamonds which could have sold for $7,000 each. The loss in revenue from the first three units, $750, is shown by the red shaded horizontal rectangle marked Loss. The net change in total revenue from selling the 4th diamond equals the gain minus the loss $6,750 - $750 = $6,000. 0 First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 3.4 Demand Elasticity and Total Revenue Demand and marginal revenue are shown in the upper panel and total revenue is in the lower panel. Notice also that when demand is elastic, a decrease in price increases total revenue marginal revenue is positive. Conversely, when demand is inelastic, a decrease in price reduces total revenue marginal revenue is negative Dollars per diamond Elastic Unit elastic $3,750 Inelastic 0 D = Average revenue Marginal revenue 16 32 1-carat diamonds per day (b) Total Revenue $60,000 Total dollars Note that the marginal revenue curve is below the demand curve and total revenue is at a maximum when marginal revenue equals zero. (a) Demand and Marginal Revenue Total revenue 1-carat diamonds per day First slide 2 Structure 3 Demand 0 4 Profit 5 Comparison 16 6 Discrimination 32 End Outline 4.1 4.2 4.3 4.4 4.0 Profit Maximization Profit Maximization: (MR=MC) Graph Table Shut Down 4.5 Supply Curve First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 4.1 Monopolist Profit Maximization: The intersection of the two marginal curves at point e in panel (a) indicates that profit is maximized when 10 diamonds are sold. At this rate of output, we move up to the demand curve to find the profitmaximizing price of $5,250. The average total cost of $4,000 is identified by point b the average profit per diamond equals the price of $5,250 minus the average total cost of $4,000 $1,250 economic profit is the equal to $1,250 * 10 units sold $12,500 as shown by the blue shaded area. In panel (b), the firm’s profit or loss is measured by the vertical distance between the total revenue and total cost curves again profit is maximized where De Beers produces 10 diamonds per day (a) Per-Unit Cost and Revenue Marginal cost Average total cost a $5,250 4,000 Profit e 2 Structure 3 Demand D = Average revenue MR 0 10 32 16 Diamonds per day (b) Total Cost and Revenue Maximum profit Total cost $52,500 40,000 Total revenue 15,000 0 First slide b 4 Profit 10 16 5 Comparison 32 Diamonds per day 6 Discrimination End Outline 4.2 Graph Select Output: below MR = MC Select Price : on Demand Curve above MR = MC Profit increased by reducing price and increasing output Maximum Profit First slide 2 Structure 3 Demand 4 Profit 5 Comparison Profit increased by increasing price and reducing output 6 Discrimination End 4.3 Table Outline Short-run Costs and Revenue for a Monopolist Diamonds per day (Q) (1) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Price (average Total revenue) revenue (p) (TR = Q x p) (2) (3) =(1) x (2) $7,750 7,500 7,250 7,000 6,750 6,500 6,250 6,000 5,750 5,500 5,250 5,000 4,750 4,500 4,250 4,000 3,750 3,500 0 $7,500 14,500 21,000 27,000 32,500 37,500 42,000 46,000 49,500 52,500 55,000 57,000 58,500 59,500 60,000 60,000 59,500 First slide Marginal Revenue (MR = TR / Q) (4) Total Cost (TC) (5) $7,500 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500 $15,000 19,750 23,500 26,500 29,000 31,000 32,500 33,750 35,250 37,250 40,000 43,250 48,000 54,500 64,000 77,500 96,000 121,000 2 Structure 3 Demand Marginal Average Total Cost Total Cost Profit or ( MC = (ACT = Loss = TC / Q) TC/Q) TR - TC (6) (7) (8) 4,750 3,750 3,000 2,500 2,000 1,500 1,250 1,500 2,000 2,750 3,250 4,750 6,500 9,500 13,500 18,500 25,000 4 Profit $19,750 11,750 8,830 7,750 6,200 5,420 4,820 4,410 4,140 4,000 3,930 4,000 4,190 4,570 5,170 6,000 7,120 -$15,000 -12,250 9,000 -5,500 -2,000 1,500 5,000 8,250 10,750 12,250 12,500 11,750 9,000 4,000 -4,500 -7,500 -36,000 -61,500 5 Comparison The profitmaximizing monopolist employs the same decision rule as the competitive firm the monopolist produces that quantity where total revenue exceeds total cost by the greatest amount $12,500 per day when output is 10 units per day. Total revenue is $52,500 and total cost is $40,000 6 Discrimination End Outline 4.4 Short Run Losses &Shut Down Point Run Recall that average variable cost and average fixed cost sum to average total cost . Loss minimization occurs at point e, where the marginal revenue curve intersects the marginal cost curve Q and p are the loss minimization quantity and price, respectively. Marginal cost a Loss Average total cost b p Average variable cost c Notice that at point b, the firm is covering its average variable cost it is making some contribution to its fixed costs. However, it is not covering all of its costs. The average loss per unit, measured by ab, is identified by the yellow 0 shaded area. First slide 2 Structure 3 Demand e Demand = Average revenue Marginal revenue Quantity per period Q 4 Profit 5 Comparison 6 Discrimination End 4.5 Supply Curve Outline The intersection of a monopolist’s marginal revenue and marginal cost curve identifies the profit maximizing quantity, but the price is found on the demand curve Thus, there is no curve that shows both price and quantity supplied there is no monopolist supply curve First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 5.0 Comparison with Perfect Competition 5.1 Higher price, Lower output 5.2 Smaller consumer surplus Deadweight loss 5.3 Summary First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 5.1 Higher Price, Lower Output For simplicity, we use a horizontal supply curve based on the assumption of a constant-cost industry. Equilibrium in perfect competition is at point c, where market demand and supply intersect to yield price pc and quantity Qc. The monopolist maximizes profit by equating marginal revenue with marginal cost point b equilibrium price pm and output Qm. a Dollars per unit Outline m p'm b pc c Sc = MC = ATC D = AR MRm 0 Q'm Q'c Quantity per period The price shows the consumers’ marginal benefit at that output rate, point m, which exceeds the marginal cost, point b. Because the marginal benefit consumers attach to additional units exceeds the marginal cost of producing those additional units, society would be better off if output were expanded beyond Qm the monopolist restricts output below the level that maximizes social welfare consumer surplus is shown by the yellow triangle ampm First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 5.2 Smaller Consumer Surplus Outline The monopolist earns economic profit equal to the blue shaded rectangle a transfer from consumer surplus to monopoly profit this amount is not lost to society and so is not considered a welfare loss from monopoly. Dollars per unit a Consumer surplus under perfect competition is the large pink triangle acpc while under monopoly it shrinks to the smaller yellow triangle ampm p'm m pc c b Sc = MC = ATC D = AR MRm 0 Q'm Q'c Quantity per period Notice that consumer surplus has been reduced by more than the profit triangle. Consumers have also lost the red triangle mcb which was part of the consumer surplus under perfect competition the deadweight loss of monopoly because it is a loss to consumers but a gain to nobody. This loss results from the allocative inefficiency arising from the higher price and reduced output. First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination 28 End 5.3 Summary Outline For the monopolist compared to perfect competition: 1. 2. 3. 4. 5. 6. Price to consumer is higher Price exceeds MC Output is less Consumer surplus is smaller Deadweight Loss Economic profits are positive Exception: Perfect Price Discrimination: mitigates #3, and #5 First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 6.0 Price Discrimination 6.1 Examples 6.2 Necessary conditions 6.3 Two Markets 6.4 Separate Markets, Different Elasticities 6.5 Perfect Price Discrimination eliminates deadweight loss Self_Evaluation: Flash, Excel, Draw Tool First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 6.1a Examples of Price Discrimination College Text Book Prices are Less Abroad NATIONAL DESK | October 21, 2003, Tuesday Students Find $100 Textbooks Cost $50, Purchased Overseas By TAMAR LEWIN (NYT) 1667 words Late Edition - Final , Section A , Page 1 , Column 4 ABSTRACT - American college students find that their textbooks cost far less overseas than they do in United States; more and more individual students and college bookstores are ordering textbooks from abroad; National Assn of College Bookstores has written to all leading publishers asking them to end practice they see as unfair to American students; publishing industry defends its pricing policies, saying foreign sales would be impossible if book prices were not pegged to local market conditions; textbook publishers have tried to block re-importing of American texts from overseas; Supreme Court ruled in 1998 that federal copyright law does not protect American manufacturers from having products they arrange to sell overseas at discount shipped back for sale in US. First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination 31 End 6.1c More Examples Outline Business v Leisure Travel Rates Business people are less sensitive to price than householders Telephone companies sort customers by charging different rates based on the time of day . Long-Distance Rates—nights/weekends vs. weekdays different elasticities/willingness to pay between personal and business Subscription vs. New stand prices volume discount (firms like certainty of sales) Early Bird” specials and other discounts for seniors elderly on fixed incomes have more elastic demand/lower willingness to pay Coupons Outline different elasticities/willingness to pay between those who clip and those who don’t clip: those with a low opportunity cost of time more likely to clip coupons. First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination 32 End Outline 6.2 Conditions for Price Discrimination 4 Conditions 1. 2. 3. 4. The demand curve for the firm’s product must slope downward the firm has some market power and control over price There are at least two groups of consumers for the product, each with a different price elasticity of demand The producer must be able, at little cost, to charge each group a different price for essentially the same product The producer must be able to prevent those who pay the lower price from reselling the product to those who pay the higher price First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 6.3a Two Markets Outline (b) Dollars per unit Dollars per unit (a) $3.00 Profit $1.50 1.00 Profit LRAC, MC D' MR D MR' Quantity per period 0 400 0 500 Quantity per period At a given price, the price elasticity of demand in panel b(elastic) is greater than in panel a (inelastic). For simplicity, assume the firm produces at a constant long-run average and marginal cost of $1. This firm maximizes profits by finding the price in each market that equates marginal revenue with marginal cost consumers with the lower price elasticity pay $3 and those with the higher price elasticity pay $1.50 in markets with elastic demand the price will be lower than in markets where demand is inelastic. 34 End Outline 3 Demand 4 Profit 5 Comparison 6 Discrimination First slide 2 Structure 1.00 LRAC, MC Outline 6.3b Two Markets Charging two prices Compared to charging a single price First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline 6.4 It is no more that dividing markets by demand elasticity Demand and marginal revenue are shown in the upper panel and total revenue is in the lower panel. Notice also that when demand is elastic, a decrease in price increases total revenue marginal revenue is positive. Conversely, when demand is inelastic, a decrease in price reduces total revenue marginal revenue is negative Dollars per diamond Elastic Unit elastic $3,750 Inelastic 0 D = Average revenue Marginal revenue 16 32 1-carat diamonds per day (b) Total Revenue $60,000 Total dollars Note that the marginal revenue curve is below the demand curve and total revenue is at a maximum when marginal revenue equals zero. (a) Demand and Marginal Revenue Total revenue 1-carat diamonds per day First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination 36 End Outline 6.5a Perfect Price Discrimination If a monopolist could charge a different price for each unit sold, the firm’s marginal revenue curve from selling one more unit would equal the price of that unit the demand curve would become the marginal revenue curve A perfectly discriminating monopolist charges a different price for each unit of the good First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End 6.5b Graph Outline A perfectly discriminating monopolist would maximize profits at point e where marginal revenue equals marginal cost price set at point e D o lla r s p e r u n it a Profit e c Long-run average cost = marginal cost D = Marginal revenue Quantity per period 0 First slide 2 Structure 3 Demand Q 4 Profit 5 Comparison 6 Discrimination End Self Evaluation: Flash Outline Use objects to represent revenue and cost concepts. First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline Self Evaluation Exercise From a table identify revenue cost concepts, and also in another example generate a table from information on TR and TC. Profit Maximizing Output is 24.9 Profit Maximizing Price is $70 First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End Outline Draw Tool You can draw and drop the objects to practice price discrimination in 2 markets First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination 41 End Outline End of Presentation Click a pic to review the topic First slide 2 Structure 3 Demand 4 Profit 5 Comparison 6 Discrimination End