Download Principles of Economics

Principles of Economics
Session 7
Topics To Be Covered
Characteristics of Monopoly
Sources of Monopoly
Monopoly vs. Competition
Profit Maximization for a Monopoly
Pricing for a Monopoly
Measuring Monopoly Power
Monopoly vs. Efficiency
Price Discrimination
Value-Based Pricing
Market Structure
Perfect Competition
Monopoly
Oligopoly
Monopolistic Competition
Characteristics of Monopoly
One seller but many buyers
One product (no good substitutes)
Barriers to entry
Price maker
Monopoly
While a competitive firm is a
price taker, a monopoly firm is
a price maker.
Why Monopolies Arise
The fundamental cause of
monopoly is barriers to entry.
Sources of Barriers to Entry
Ownership of a key resource.
The government gives a single firm the
exclusive right to produce some good.
Costs of production make a single producer
more efficient than a large number of
producers.
Ownership of a Key Resource
Although exclusive ownership of a
key resource is a potential source of
monopoly, in practice monopolies
rarely arise for this reason.
Government-Created Monopolies
Governments may restrict entry by
giving a single firm the exclusive right to
sell a particular good in certain markets.
Patent and copyright laws are two
important examples of how government
creates a monopoly to serve the public
interest.
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.
A natural monopoly arises when there
are economies of scale over the
relevant range of output.
Average
Total
Cost
Economies of Scale as a
Cause of Monopoly
The scale on which
natural monopoly exists
Economies
of scale
0
Constant Returns
to scale
ATC in long run
Diseconomies
of scale
Quantity of
Cars per Day
Monopoly versus Competition
Monopoly
 Is
the sole producer
 Has a downward-sloping demand curve
 Is a price maker
 Reduces price to increase sales
Competition versus Monopoly
Competitive Firm
 Is
one of many producers
 Has a horizontal demand curve
 Is a price taker
 Sells as much or as little at same price
Demand Curves for Competitive
and Monopoly Firms
Price
A Competitive Firm
Price
A Monopolist
Demand
Demand
0
Quantity of
Output
0
Quantity of
Output
A Monopoly’s Revenue
 Total Revenue
P x Q = TR
 Average
Revenue
TR/Q = AR = P
 Marginal
Revenue
DTR/DQ = MR
A Monopoly’s Total, Average, and
Marginal Revenue
Quantity
0
1
2
3
4
5
6
7
8
Price
$11.00
$10.00
$9.00
$8.00
$7.00
$6.00
$5.00
$4.00
$3.00
Total
Revenue
$0.00
$10.00
$18.00
$24.00
$28.00
$30.00
$30.00
$28.00
$24.00
Average
Revenue
-$10.00
$9.00
$8.00
$7.00
$6.00
$5.00
$4.00
$3.00
Marginal
Revenue
-$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
-$2.00
-$4.00
A Monopoly’s Marginal
Revenue
A monopolist’s marginal revenue is
always less than the price of its good.
The
demand curve is downward sloping.
When a monopoly drops the price to sell one
more unit, the revenue received from
previously sold units also decreases.
A Monopoly’s Marginal
Revenue
 Demand
P = a + bQ
 Total Revenue
TR = PQ = (a + bQ)Q = aQ + bQ2
 Marginal
Revenue
MR = TR’(Q) = a + 2bQ
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
P =11 －Q
Demand
(average revenue)
P =11 －2Q
Marginal
revenue
1
2
3
4
5
6
7
8
9
10
11
Quantity of Water
MR and Elasticity for a Monopoly
P, MR
$3.00
When Ed＞1, MR ＞ 0
When Ed = 1, MR = 0
Ed＞1
When Ed＜1, MR ＜ 0
Ed = 1
1.50
Ed＜1
MR
0 1
P=AR=D
2 3 4 5 6 7 8 9 10 11 12
Qd
A Monopoly’s Marginal
Revenue
When a monopoly increases the
amount it sells, it has two effects on
total revenue (P×Q).
The
quantity effect—more output is
sold, so Q is higher.
The price effect—price falls, so P is
lower.
MR, P
$3.00
TR=P ×Q
TR=P ×Q
1.50
MR
0 1
TR=P ×Q
P
2 3 4 5 6 7 8 9 10 11 12
Qd
TR
9.00
0
TR
1
2 3 4 5 6
7 8 9 10 11 12
Qd
Profit Maximization of a
Monopoly
A monopoly maximizes profit by
producing the quantity at which
marginal revenue equals marginal cost.
MR=MC
Profit-Maximization for a Monopoly
The demand curve
shows the price
consistent with this
quantity.
Costs and
Revenue
B
Monopoly
price
The intersection of
MR and MC
determines the profitmaximizing quantity
Average total cost
A
Demand
Marginal
cost
Marginal revenue
0
QMAX
Quantity
Profit Maximization
for a Monopoly
Revenue
($s per year)
TR
Slope of TR = MR
0
Output (units per year)
Profit Maximization
for a Monopoly
Cost
$ (per year)
TC
Slope of TC = MC
0
Output (units per year)
Profit Maximization
for a Monopoly
Cost,
Revenue,
Profit
($s per year)
TC
A
TR
B
0
q1
MR=MC
Output (units per year)
Profit
Profit Maximization
for a Monopoly
Cost,
Revenue,
Profit
($s per year)
TC
TR
A
B
0
q2
Profits are maximized
when MC = MR.
q1
q3
Output (units per year)
Profit
Pricing for a Monopoly
MR=MC can be translated into a
rule of thumb for pricing which can
be more easily applied in practice
through the following steps.
Pricing for a Monopoly
DTR D ( PQ )
MR  TR' (Q ) 

DQ
DQ
DQ
DP
DP
P
Q
 P Q
DQ
DQ
DQ
Q DP
 P  P(
)
P DQ
%DQ DQ / Q DQ P
Ed =



%DP
DP / P
DP Q
Pricing for a Monopoly
Q DP
1

P DQ
Ed
1
MR = P  P
Ed
1
 P(1 
)
Ed
Pricing for a Monopoly
Profit is maximized at MR=MC
1
MC = P( 1 
)
Ed
MC
P=
1＋1／Ed
Pricing for a Monopoly
Assume MC = $9 and Ed = -4, the
price can be decides as follows so
as to maximize the profit:
MC
P
1  1／Ed 
9
9


 $12
1   1 / 4  0.75
Monopoly vs. Competition
For a competitive firm, price equals
marginal cost.
P = MR = MC
For a monopoly firm, price exceeds
marginal cost.
P > MR = MC
The Monopolist’s Profit
Costs and
Revenue
MC
Monopoly E
price
B
ATC
Average
total cost D
C
D= AR
MR
0
QMAX
Quantity
The Monopolist’s Profit
The monopolist will receive
economic profits as long as price
is greater than average total cost.
However, monopoly does not
necessarily mean profit.
The Monopolist’s Loss
Costs and
Revenue
MC
Loss
ATC
Average
total cost
Monopoly
price
c
B
E
D= AR
MR
0
QMAX
Quantity
Monopoly vs. Competition
Costs and
Revenue
Price
during
patent life
MC
Price after
patent
expires
MR
0
Monopoly Competitive
quantity
quantity
D
Quantity
No Supply Curve for a
Monopolistic Market
Monopolist may supply many
different quantities at the same
price.
Monopolist may supply the same
quantity at different prices.
No Supply Curve for a
Monopolistic Market
$/Q
Shift in demand leads to change
in price but same output
MC
P1
P2
D2
D1
MR2
MR1
Q1= Q2
Quantity
No Supply Curve for a
Monopolistic Market
$/Q
Shift in demand leads to change
in output but same price
MC
P1 = P2
D2
MR2
D1
MR1
Q1
Q2
Quantity
Measuring Monopoly Power
Lerner’s index (L) is an efficient way to
measure the monopoly power. The larger
the value of L (between 0 and 1), the
greater the monopoly power.
L = (P - MC)/P = -1/Ed
•Ed is elasticity of demand
for a firm, not the market
The Welfare Cost of Monopoly
In contrast to a competitive firm, the
monopoly charges a price above the
marginal cost.
From the standpoint of consumers, this
high price makes monopoly undesirable.
However, from the standpoint of the
owners of the firm, the high price makes
monopoly very desirable.
The Efficient Level of Output
Price
Marginal cost
Value
to
buyers
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.
Value to buyers is less
than cost to seller.
Quantity
The Deadweight Loss
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.
This
wedge causes the quantity sold to
fall short of the social optimum.
The Inefficiency of Monopoly
Price
Deadweight
loss
Marginal cost
Monopoly
price
Marginal
revenue
0
Monopoly Efficient
quantity quantity
Demand
Quantity
The Deadweight Loss
The deadweight loss caused by a monopoly
is similar to the deadweight loss caused by
a tax.
The difference between the two cases is
that the government gets the revenue from
a tax, whereas a private firm gets the
monopoly profit.
Public Policy Toward
Monopolies
Government responds to the problem of
monopoly in one of four ways.
Making monopolized industries more
competitive.
Regulating the behavior of monopolies.
Turning some private monopolies into public
enterprises.
Doing nothing at all.
Increasing Competition with
Antitrust Laws
Antitrust laws are a collection of statutes aimed at
curbing monopoly power.
Antitrust laws give government various ways to
promote competition.
 They
allow government to prevent mergers.
 They allow government to break up companies.
 They prevent companies from performing activities
which make markets less competitive.
Two Important
Antitrust Laws
Sherman Antitrust Act (1890)
 Reduced
the market power of the large and
powerful “trusts” of that time period.
Clayton Act (1914)
 Strengthened
the government’s powers and
authorized private lawsuits.
Regulation
Government may regulate the prices
that the monopoly charges.
The
allocation of resources will be
efficient if price is set to equal
marginal cost.
Marginal-Cost Pricing for a
Natural Monopoly
Price
Average
total cost
Regulated
price
Loss
Average total cost
Marginal cost
Demand
0
Quantity
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.
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 China, the government
runs China Post).
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.
Prerequisites for Implementing
Price Discrimination
The firm must have some market power. Price
discrimination is impossible in a perfectly
competitive market.
The good or service cannot be resold between
customers.
Some objective criteria can be applied to
segment customers according to their
elasticity of demand.
First Degree
Price Discrimination
First degree price discrimination is also
called perfect price discrimination, under
which the monopolist knows exactly the
willingness to pay of each customer for
each unit of product and charges a
different price for each unit.
First Degree
Price Discrimination
Under first degree price discrimination, the
lower price charged to one customer won’t
lead to the decrease of higher prices
charged to other customers, so the negative
price effect is effectively prevented, thus:
P = MR
Welfare Without Price
Discrimination
Price
Monopolist with Single Price
Consumer
surplus
Monopoly
price
Deadweight
loss
Profit
Marginal cost
Marginal
revenue
0
Quantity sold
Demand
Quantity
Welfare With Price
Discrimination
Price
Monopolist with Perfect Price Discrimination


Profit
Profit increases while consumer
surplus becomes zero.
Deadweight loss is avoided, thus
efficiency is realized.
Marginal cost
Demand＝P＝MR
0
Quantity sold
Quantity
Second Degree
Price Discrimination
Second degree price discrimination is
pricing according to quantity consumed
or in blocks. For example, when
consumers purchase 6 units of goods, the
price is $6, when consumers purchase 4
units more, the price for the additional 4
units is $5, and so on.
Third Degree
Price Discrimination
Under third degree price discrimination,
the monopolist charges different prices
for goods sold at different markets or to
different groups of consumers.
Welfare With Third Degree
Price Discrimination
Price
Consumer Surplus
P1
Deadweight Loss
P2
P3
Marginal cost
Marginal
revenue
0
Q1
Q2
Q3
Demand
Quantity
Examples of Price
Discrimination
Airline prices
Discount coupons
Quantity discounts
Value-Based Pricing
Value-Based Pricing
Don’t need to price by identity
Offer product line, and watch choices
Design menu of different versions

Target different market segments

Price accordingly (self selection)
Dimensions to Use
Delay (Feeleral Express, PAWWS)
User Interface (DialogWeb, DataStar)
Image Resolution (PhotoDisk)
Speed of operation (Mathematica)
Flexibility of use
Dimensions to Use
Capability (Kurzweil)
Features and functions (Quicken)
Comprehensiveness (DialogWeb,
DataStar)
Annoyance
Support
Making Self-Selection Work
May need to cut price of high end
May need to cut quality at low end
Value-subtracted versions
 May
cost more to produce the low-quality
version.
In design, make sure you can turn
features off!
Online and Offline
Versions
The Whole Internet
Netscape Navigator
Dyson Dictum: think of content as free
 Focus
on adding value to online version
National Academy of Science Press
 Format
for browsing, not printing
How Many Versions?
One is too few
Ten is (probably) too many
Two things to do
 Analyze
market
 Analyze product
Bundling
Offer a package
Microsoft Office

90% market share
Work together
Discount one of the products
Option value: zero incremental price
Microsoft's per-processor license
Reduce Dispersion
Example: price separate or together
Mark: $120 for WP, $100 for spreadsheet
Noah: $100 for WP, $120 for spreadsheet
Profits
 Without
bundling: $400
 With bundling: $440
Information Bundles
Magazines and newspapers
Customized bundles
 Nonlinear pricing
 In
previous example sell first item for $120
 Sell second item for $100
 Example: MusicMaker
Assignment
Review Chapter 9
Answer questions on P169
Preview Chapter 10
Thanks