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Monopoly and Other Forms of
Imperfect Competition
1
Perfectly Competitive Market


An ideal market that maximizes
economic surplus
A situation that does not always exist
Slide 2
Imperfect Competition

Imperfectly Competitive Firms





Have some control over price
Price may be greater than the marginal
cost of production
Long-run economic profits are possible
Reduce economic surplus to varying
degrees
Are very common
Slide 3
Forms of Imperfect Competition

1. Pure Monopoly


The only supplier of a unique product with no
close substitutes
2. Monopolistic Competition



A large number of firms that produce slightly
differentiated products that are reasonably
close substitutes for one another
Long-run adjustment to zero economic profits
Importance of differentiation
Slide 4
Forms of Imperfect Competition

3. Oligopoly



Industry structure in which a small number
of firms produce products that are either
close or perfect substitutes
Cost advantages from large size may
prevent the long-run adjustment to zero
economic profit
Undifferentiated and differentiated
products
Slide 5
Essential Difference Between Perfectly
and Imperfectly Competitive Firms


The perfectly competitive firm faces a
perfectly elastic demand for its product.
The imperfectly competitive firm faces a
downward-sloping demand curve.
Slide 6
The Demand Curves Facing
Perfectly and Imperfectly
Competitive Firms
Imperfectly competitive firm
D
Market
price
Price
$/unit of output
Perfectly competitive firm
D
Quantity
Quantity
Slide 7
Perfectly competitive market


Supply and demand determine equilibrium
price. The firm has no market power.
At the equilibrium price, the firm sells all it
wishes.



If the firm raises its price, sales will be zero.
If the firm lowers its price, sales will not
increase.
The firm’s demand curve is the horizontal line
at the market price.
Slide 8
Imperfectly Competitive Markets

The firm has some control over price or
some market power.


A firm’s ability to raise the price of a good
without losing all its sales
Sellers face a downward sloping demand
Slide 9
Sources of Market Power





Exclusive control over inputs
Patents and Copyrights
Government Licenses or Franchises
Economies of Scale (Natural Monopolies)
Network Externalities
Slide 10
Economies of Scale and the
Importance of Start-Up Costs

Firms with large fixed costs and low
variable costs:



Have low marginal costs
Average total cost declines sharply as
output increases
Economies of scale will exist
Slide 11
Costs for Two Computer
Game Producers (1)
Nintendo
Playstation
Annual production
1,000,000
1,200,000
Fixed cost
$200,000
$200,000
Variable cost
$800,000
$960,000
$1,000,000
$1,160,000
$1.00
$0.97
Total cost
Average total cost per game
Observations
•Fixed costs are a relatively small share of total cost
•Cost/game is nearly the same
Slide 12
Costs for Two Computer
Game Producers (2)
Annual production
Fixed cost
Variable cost
Total cost
Average total cost per game
Nintendo
Playstation
1,000,000
1,200,000
$10,000,000
$10,000,000
$200,000
$240,000
$10,200,000
$10,240,000
$10.20
$8.53
Observations
•Fixed costs are a relatively large share of total cost
•Playstation has a $1.67 average cost advantage
•Playstation can lower prices, cover cost, and attract customers
Slide 13
Costs for Two Computer
Game Producers (3)
Annual production
Fixed cost
Variable cost
Total cost
Average total cost per game
Nintendo
Playstation
500,000
1,700,000
$10,000,000
$10,000,000
$100,000
$340,000
$10,100,000
$10,340,000
$20.20
$6.08
• Shift of 500,000 units to Playstation
• Nintendo’s average cost increases to $20.20/unit
• Playstation average cost falls to $6.08
• A large number of firms cannot survive when the
cost differential is high
Slide 14
Economies of Scale and the
Importance of Fixed Costs

Fixed investment in research and
development has been increasing as a share
of production costs.
Cost of producing a computer
Fixed Cost
Software
1984
1990
20%
80%
Variable Cost
Hardware
80%
20%
Slide 15
Profit Maximization for the
Monopolist

A price taker (perfect competition) and
a price setter (imperfect competition)
share the economic goal. They want:


To maximize profits; i.e.,
To select the output level that maximizes
the difference between TR and TC, where
MB= MC (when quantity is divisible and
not producing at all is not optimal).
Slide 16
Profit Maximization for the
Monopolist

For a producer

MB = Marginal Revenue (MR) or a change
in a firm’s total revenue that results from a
one-unit change in output
Slide 17
Profit Maximization for the
Monopolist

Marginal Revenue for the Monopolist

Perfect competition and monopolies



Both increase output when MR > MC.
Calculate MC the same way.
Do not have the same MR at a given price.


In perfect competition: MR = P
In monopoly: MR < P
Slide 18
The Monopolist’s Benefit
from Selling an Additional
Unit
• If P = $6, then TR = $6 x 2 = $12
• If P = $5, then TR = $5 x 3 = $15
• The MR of selling the 3rd unit = $3 (=15-12)
• For the 3rd unit, MR = $3 < P = $5
Price ($/unit)
8
6
5
D
2
3
Quantity (units/week)
8
Slide 19
Marginal Revenue in
Graphical Form
P
Q
TR
MR

Observations

6
2
12
5
3
15
4
4
16
3
5
15
3

1
-1


MR < P
MR declines as quantity
increases
MR is the change between
two quantities
MR < P because price must
be lowered to sell an
additional unit
Slide 20
P
Q
TR
6
2
12
5
3
15
4
4
16
3
5
15
MR
3
1
-1
Price & marginal revenue ($/unit)
Marginal Revenue in
Graphical Form
8
3
D
1
-1
2
3
4
5
8
MR
Quantity (units/week)
Slide 21
The Marginal Revenue Curve for a
Monopolist with a Straight-Line
Demand Curve
Price
a
a/2
D
MR
Q0/2
Q0
Quantity
Observations
• The vertical intercept, a, is the same for MR and D
• The horizontal intercept for MR, Q0/2, is one half
the demand intercept, Q0.
Slide 22
Profit Maximization for the
Monopolist

Profit Maximizing Decision Rule



When MR > MC, output should be increased.
When MR < MC, output should be reduced.
Profits are maximized at the level of output
for which MR = MC.
Slide 23
The Monopolist’s ProfitMaximizing Output Level
Marginal Cost
Price ($/unit of output)
6
Observations
• If P = $3 & Q = 12, MR < MC
and output should reduce
• Profits are maximized at 8
units where MR = MC
• P = $4 where quantity
demanded = quantity
supplied
4
3
2
MR
8
12
D
24
Quantity (units/week)
Slide 24
Even a Monopolist May
Suffer
an
Economic
Loss
Being a monopolist doesn’t guarantee an economic profit
0.12
0.10
ATC
MC
0.05
Economic profit
= $400,000/day
Price ($/minute)
Price ($/minute)
Economic loss
= $400,000/day
0.10
0.08
ATC
MC
0.05
D
20
MR
Minutes (millions/day)
D
20
24
MR
Minutes (millions/day)
Slide 25
The Demand and Marginal
Cost Curves for a Monopolist
Why the Invisible Hand Breaks Down Under Monopoly
Price ($/unit of output)
6
Marginal cost
The socially optimal
amount occurs where
MC = D(=MB) @ 12 units
3
D
12
24
Quantity (units/week)
Slide 26
The Demand and Marginal Cost
Curves for a Monopolist
Why the Invisible Hand Breaks Down Under Monopoly
Price ($/unit of output)
6
Marginal cost
• The profit maximizing level of
output of 8 units, where MR =
MC, is less than the socially
optimal output of 12
• Between 8 and 12, MB to
society > MC to society
• Does not increase output
because MR to the firms is less
than MC
4
3
2
MR
8
12
D
24
Quantity (units/week)
Slide 27
The Demand and Marginal Cost
Curves for a Monopolist
Why the Invisible Hand Breaks Down Under Monopoly
Price ($/unit of output)
6
Deadweight loss
4
3
2
MR
8
12
Marginal cost
• Because MR<P, the
monopoly produces less
than the socially optimal
amount
• The deadweight loss of
the monopoy to society
= (1/2)($2/unit)(4
units/wk) = $4/wk.
D
24
Quantity (units/week)
Slide 28
Why the Invisible Hand Breaks
Down Under Monopoly

Monopoly

Profits are
maximized where MR

Perfect Competition

Profits are
maximized where MR


= MC.
P > MR
P > MC

= MC.
P = MR
P = MC

Deadweight loss

No deadweight loss

Slide 29
Why the Invisible Hand Breaks
Down Under Monopoly

Difficulties in Reducing the Deadweight
Loss of Monopolies



Enforcing antitrust laws
Patents, copyrights, and innovation
Natural monopolies
Slide 30
Price Discrimination


The practice of charging different
buyers different prices for essentially
the same good or service
Examples



Senior citizens and student discounts on
movie tickets
Supersaver discounts on air travel
Rebate coupons
Slide 31
Food For Thought

Why do many movie theaters offer
discount tickets to students?
Slide 32
Example: Carla Edit

How many manuscripts should Carla
edit?
Slide 33
Total and Marginal
Revenue from Editing
Student
Reservation Price
($ per paper)
Total Revenue
($ per week)
Marginal revenue
($ per paper)
A
40
40
40
B
38
76
36
C
36
108
32
D
34
136
28
E
32
160
24
F
30
180
20
G
28
196
16
H
26
208
12
Slide 34
Example: Single Price Monopoly

How many manuscripts should Carla
edit?




Opportunity cost = $29
TR = P x Q, or for 4 papers, 4 x $34 =
$136/wk
MR is the difference in TR from adding
another student
If MR > MC: increase output
Slide 35
Example: Single Price Monopoly


How many manuscripts should Carla
edit?
Carla edits 3 papers

TC = 3 x $29 = $87
TR = $108

Economic profit = $108 - $87 = $21/wk

Slide 36
Example: Social Optimal

How many manuscripts should Carla edit?




O.C. of her time per editing= $29
Must charge the same price
Reservation price > opportunity cost for
student A to F
Socially efficient number is 6
 TR = 6 x $30 = $180
 TC = 6 x $29 = $174

Economic profit = $180- $174 = $6
Slide 37
Example: Perfect Price
Discrimination

If Carla can do perfect price
discriminate, how many papers should
she edit?

Assume Carla can charge each student the
reservation price.
Slide 38
Example: Perfect Price
Discrimination
Reservation
Student
A
40
B
38
C
36
D
34
E
32
F
30
G
28
H
26
price
• Carla would edit A to F
• TR = $40 + $38… = $210
• TC = 6 x $29 = $174
• Economic Profit =
$210 - $174 = $36/wk
• Economic Profit is $30
more
Slide 39
Perfect Price Discrimination

Perfectly Discriminating Monopolist

Charging each buyer exactly their
reservation price



Economic surplus is maximized
Consumer surplus is zero
Economic surplus = producer surplus
Slide 40
Limitation to Perfect Price
Discrimination


Seller will not know each buyer’s
reservation price.
Low price buyers could resell to other
buyers at a higher price.
Slide 41
The Hurdle Method of Price
Discrimination

Profit-maximizing seller’s goal is to
charge each buyer his/her reservation
price.

There are two problems to implementing
this pricing strategy.



Seller does not know the reservation prices
Seller must separate high and low price buyers
The hurdle method of price discrimination
is used to solve these problems.
Slide 42
The Hurdle Method of Price
Discrimination

The practice of offering a discount to all
buyers who overcome some obstacle.

Example

Offering a rebate to those who mail in a
coupon
Slide 43
The Hurdle Method of Price
Discrimination

A Perfect Hurdle


Separates buyers precisely according to
their reservation prices
What do you think?

Is a perfect hurdle possible?
Slide 44
Example: Price Discrimination
with a Perfect Hurdle

Question

How much should Carla charge for
editing if she uses a perfect hurdle?
Slide 45
Example: Price Discrimination
with a Perfect Hurdle

Assume





Carla offers a mail in rebate coupon
Students with at least a $36 reservation
price never use the coupon
Students with a reservation price below
$36 use the coupon
Opportunity cost = $29
Discount coupon = $4
Slide 46
Price Discrimination
with aReservation
Perfect
Hurdle
Price Total Revenue
Student
($ per paper)
($ per week)
Marginal revenue
($ per paper)
List Price Submarket
A
40
40
40
B
38
76
36
C
36
108
32
Discount Price Submarket
D
34
34
E
32
64
F
30
90
G
28
112
H
26
130
34
30
26
22
18
Slide 47
Example: Price Discrimination
with a Perfect Hurdle

Solution

TR = (3)(36) + (2)(32) = $172
MC = ($5)($29) = $145

Economic Profit = $27/wk

Slide 48
Price Discrimination
with a Perfect Hurdle

Is price discrimination a bad thing?

In fact, the hurdle method raised
economic surplus.
Slide 49
Economic Surplus Under Price
Discrimination with a Perfect Hurdle
Calculating Economic Surplus
Consumer Surplus
Both
Single price
& discount
Reservation Price
A
B
C
$40
$38
$36
Actual Price
$36
$36
$36
$34
$22
$2
$8
With Discount

$4
$2
$0
$6
Without Discount
D
Consumer Surplus
Producer Surplus


Single price = 3(36 - 29) = $21/wk
Discount price = 3(36 - 29) = $21/wk
2(32 - 29) = $6/wk
$27/wk
Slide 50
Economic Surplus Under Price
Discrimination with a Perfect Hurdle
Calculating Economic Surplus
Consumer Surplus
Both
Single price
& discount
A
B
C
Reservation Price
$40
$38
$36
Actual Price
Consumer Surplus
$36
$36
$36
$6
Without Discount
D
$34
$22
$2
$8
With Discount

$4
$2
$0
Economic Surplus


Single price = $6 + $21 = $27/wk
Discount price = $8 + $27 = $35/wk
Slide 51
Food For Thought

Is Carla’s discount rebate completely
efficient?
Slide 52
Examples of Price Discrimination





Temporary Sales
Book publishers and paperback books
Automobile producers offer various
models
Commercial air carriers
Movie producers
Slide 53
Summary


Single price monopolies are inefficient
because P > MR.
The hurdle method of price discrimination
reduces the inefficiency.


The more finely the seller can discriminate,
the smaller the efficiency loss.
Hurdles are not perfect, therefore, there will
be some efficiency loss.
Slide 54
End
55