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Chapter Ten Monopoly Monopoly • Monopoly – One firm in an industry selling a product for which there are no close substitutes Examples of Monopolies 1) De Beers, the company that controls most (80 percent) of the world’s diamond market. 2) Intel, before AMD became a major competitor. 3) Your local utilities companies. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 2 Monopoly (cont’d) • Barriers to Entry – Anything that prevents firms from entering a market. • Market power – A firm’s power to set its price without losing its entire share of the market. • Price-maker – A firm that has the power to set its price, rather than taking the price set by the market; the opposite of a price-taker. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 3 Market Power • Differences between a Monopoly and Competition: 1) There is no one to undercut a Monopolist’s Price – In a monopoly, there is only one seller. If that seller chooses to sell at a higher price, it does not need to worry about being undercut by other sellers. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 4 Market Power (cont’d) 2) Impact of Quantity Decisions on the Price – In a competitive market, if a firm increases or decreases the quantity that it will sell, it has very little or no effect on the price, because each competitive firm is small relative to the market. In a monopoly, a decrease or an increase in the firm’s quantity will have an effect on the equilibrium price in the market, because it is the only seller. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 5 Market Power (cont’d) • Figure 10.1 graphically illustrates the contrasting market power of a monopoly and a competitive firm. The demand curve faced by a monopoly is downward sloping, showing that a change in quantity will change prices. This is illustrated by the graph on the left in Figure 10.1. Note that the demand curve of a monopoly is the same as the market demand curve. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 6 Market Power (cont’d) • The demand curve faced by a competitive firm is horizontal, implying that a change in quantity will have no effect on prices. This is illustrated by the graph on the right in Figure 10.1. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 7 Market Power (cont’d) Figure 10.1 Copyright © Houghton Mifflin Company. All rights reserved. 10 | 8 Effects of a Monopoly’s Decision on Revenues • From Chapter 6, we learned that for a competitive firm, the marginal revenue or the additional revenue that the firm gets from selling one more unit equals the price of the good. The competitive firm’s demand curve represented by the graph on the right on Figure 10.1 is also the firm’s marginal revenue curve. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 9 Effects of a Monopoly’s Decision on Revenues (cont’d) • For a monopoly, MR = P does not hold, because the firm faces a downward sloping demand curve. If the firm charges a single price to all its customers, then a decision to sell one more unit will require that the firm must decrease the price of all the units that the firm will try to sell. As a result, the marginal revenue of a monopoly will be lower than the price of the good (P>MR). This is best illustrated by the example on Table 10.1. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 10 Effects of a Monopoly’s Decision on Revenues (cont’d) Copyright © Houghton Mifflin Company. All rights reserved. 10 | 11 Effects of a Monopoly’s Decision on Revenues (cont’d) • The first two columns on Table 10.1 represent the market demand curve, where increases in quantity correspond to lower prices. The third column calculates the total revenue that the firm generates by selling each quantity. Recall that total revenue (TR) is calculated by multiplying the price of the good with the quantity of the good sold. TR = P X Q Copyright © Houghton Mifflin Company. All rights reserved. 10 | 12 Effects of a Monopoly’s Decision on Revenues (cont’d) • The fourth column on Table 10.1 shows the marginal revenue brought about by the quantity sold. TR Marginal Revenue = MR Q Copyright © Houghton Mifflin Company. All rights reserved. 10 | 13 Effects of a Monopoly’s Decision on Revenues (cont’d) • Note that the value of the marginal revenue (fourth column) is consistently lower than the price of the good (second column), once the quantity is higher than 1. Further, the marginal revenue drops two times faster than the price as quantity is increased. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 14 Effects of a Monopoly’s Decision on Revenues (cont’d) • Figure 10.2 graphically illustrates the relationship between total revenue, marginal revenue, and demand faced by a monopoly. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 15 Effects of a Monopoly’s Decision on Revenues (cont’d) Figure 10.2 Copyright © Houghton Mifflin Company. All rights reserved. 10 | 16 Effects of a Monopoly’s Decision on Revenues (cont’d) • The graph on the left on Figure 10.2 shows the total revenue curve of the monopoly. Notice that unlike the total revenue curve faced by the competitive firm, the total revenue curve of a monopoly is not a straight line, and the curve becomes flatter as the quantity sold increases. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 17 Effects of a Monopoly’s Decision on Revenues (cont’d) • Since the slope of the total revenue curve is the marginal revenue, the curve shows that the marginal revenue of the monopoly increases as quantity increases. Further, since the total revenue slopes downward after Q = 8, it implies that the marginal revenue of a monopoly can be negative. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 18 Effects of a Monopoly’s Decision on Revenues (cont’d) The graph on the right on Figure 10.2 shows 1) The marginal revenue of a monopoly is a straight line that lies below the demand curve. 2) The marginal revenue curve is steeper than the demand curve (in fact, two times steeper). 3) The marginal revenue curve can be negative. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 19 Why is the Marginal Revenue Declining? • When a monopoly raises output, the effect of the increase in quantity on total revenue is two-fold: 1) A positive effect, since one more additional unit is sold. 2) A negative effect, since selling one more item forces the firm to lower prices. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 20 Why is the Marginal Revenue Declining? (cont’d) Copyright © Houghton Mifflin Company. All rights reserved. 10 | 21 Why the Marginal Revenue can be Negative? • The positive effect of an increase in output is represented with the blue rectangle in the previous graph. The negative effect of a decrease in output is represented with the red rectangle. • The net effect of an increase in output on marginal revenue depends on the sizes of the positive (blue) effect and the negative (red) effect. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 22 Why the Marginal Revenue can be Negative? (cont’d) • If the positive effect (or the blue rectangle) is larger than the negative effect (or the red rectangle), then an increase in output results in a larger total revenue, and the marginal revenue is positive. • If the positive effect (or the blue rectangle) is smaller than the negative effect (or the red rectangle), then an increase in output results in a smaller total revenue, and the marginal revenue is negative. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 23 The Average Revenue • Average Revenue (AR)= total revenue divided by the price. AR = TR/Q = PQ P Q • The average revenue is represented by the demand curve. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 24 The Average Revenue (cont’d) • Since the average revenue is declining, it must be true that the marginal revenue is lower than the average revenue (recall chapter 8). • Hence, as illustrated in Figure 10.2, the marginal revenue curve must lie below the average revenue (or demand) curve. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 25 Finding the Profit Maximizing Output Recall from Chapter 6: • Profits – The total revenue received from selling the product minus the total costs of producing the product, or: • Profits = total revenue – total costs Copyright © Houghton Mifflin Company. All rights reserved. 10 | 26 Finding the Profit Maximizing Output (cont’d) • One way to find profit is to plot a firm’s total revenue and total cost curves, with dollars on the Y-axis and quantity on the X-axis. This is shown in the graph on the right in Figure 10.3. • The profit maximizing quantity is the point when the distance between TR and TC is maximized, and TR > TC. Note: If TR<TC, then profit maximization requires the distance between TR and TC to be minimized. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 27 Finding the Profit Maximizing Output (cont’d) Figure 10.3 Copyright © Houghton Mifflin Company. All rights reserved. 10 | 28 Finding the Profit Maximizing Output (cont’d) • In Figure 10.3, any quantity to the left (a lower quantity) or to the right (a higher quantity) of the profit maximizing quantity will result in a lower profit. The graph on the right of Figure 10.3 illustrates this point. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 29 Finding the Profit Maximizing Output (cont’d) • One characteristic of the profit maximizing level of quantity is that the slopes of the total revenue and the slope of the total cost curves are the same. • Since the slope of the total revenue curve is the marginal revenue and the slope of the total cost curve is the marginal cost, then profit maximization requires that marginal revenue equals marginal cost, or: MR = MC Copyright © Houghton Mifflin Company. All rights reserved. 10 | 30 Finding the Profit Maximizing Output (cont’d) • Notice that the rule for finding the profit maximizing output for a monopoly is the same as in a competitive market. In both markets, the rule for profit maximization is: MR = MC • Figure 10.5 graphically compares and contrasts profit maximization in a competitive market and in a monopoly. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 31 Finding the Profit Maximizing Output (cont’d) Figure 10.5 Copyright © Houghton Mifflin Company. All rights reserved. 10 | 32 Profit Maximization: a Monopoly and a Competitive Firm • In Figure 10.5, we can see that the difference in profit maximization for a monopoly and a competitive firm lies only in the shape of the total revenue curve. In a competitive firm, the total revenue curve is linear. In a monopoly, the total revenue curve has a much steeper slope. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 33 Profit Maximization: a Monopoly and a Competitive Firm (cont’d) • In Figure 10.5, both the competitive firm and the monopoly find the profit maximizing output by equating marginal revenue with marginal cost. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 34 The Generic Diagram of a Monopoly and its Profits • Figure 10.6 shows the generic diagram of how to determine profits of a monopoly. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 35 The Generic Diagram of a Monopoly and its Profits (cont’d) Figure 10.6 Copyright © Houghton Mifflin Company. All rights reserved. 10 | 36 The Generic Diagram of a Monopoly and its Profits (cont’d) • To determine the profits and the profit maximizing quantity of a monopoly, we need to follow these steps, as illustrated in Figure 10.6: – Step 1. Find the intersection of the marginal revenue curve and the marginal cost. This is the profit maximizing rule. – Step 2. The quantity coordinate of the intersection between marginal revenue and marginal cost is the profit maximizing quantity. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 37 The Generic Diagram of a Monopoly and its Profits (cont’d) – Steps 3 and 4. Use the demand curve to find the profit maximizing price. This is done by finding the point on the demand curve that corresponds to the profit maximizing quantity and finding the price coordinate of that point. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 38 The Generic Diagram of a Monopoly and its Profits (cont’d) – Step 5. Use the average total cost curve to find the average total cost of production. This is done by finding the point on the average total cost curve that corresponds to the profit maximizing quantity and finding the price ($) coordinate of that point. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 39 The Generic Diagram of a Monopoly and its Profits (cont’d) – Step 6. The profit earned by the firm is the rectangle formed with the difference between price and the average total cost (P-ATC) with the height and the profit maximizing quantity as the width. This rectangle is the dark shaded area in Figure 10.6. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 40 The Generic Diagram of a Monopoly and its Profits (cont’d) • If the ATC is higher than the profit maximizing price, then the firm is earning negative profits. This is illustrated in Figure 10.7. The size of the firm’s losses in Figure 10.7 is represented by the area of the unshaded hash-marked rectangle. • Note: As in Chapter 8, earning negative profits does not automatically imply that the firm should shut down in the short run. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 41 Competition, Monopoly and Deadweight Loss • Are monopolies harmful to society? One way to answer that question is to compare the consumer surplus and producer surplus in both markets. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 42 Competition, Monopoly and Deadweight Loss (cont’d) • When comparing the market equilibrium in a monopoly and in a competitive market, notice that prices are higher and quantities are lower in a monopoly. This higher price and lower quantity in a monopoly may lower the total surplus (consumer + producer surplus) for society. This is illustrated in detail in Figure 10.8. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 43 Competition, Monopoly and Deadweight Loss (cont’d) Figure 10.8 Copyright © Houghton Mifflin Company. All rights reserved. 10 | 44 Competition, Monopoly and Deadweight Loss (cont’d) • The monopolist’s price increase raises the producer surplus in the monopoly, at the expense of a lower consumer surplus for buyers in the market. This is merely a transfer of surplus from the consumers to producers, and is not considered deadweight loss. The deadweight loss resulting from a monopoly is illustrated by the dark shaded triangle in Figure 10.8. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 45 Marginal Benefit > Marginal Cost • Since the monopoly is producing below the competitive equilibrium quantity, the marginal benefit is greater than the marginal cost of production. This is inefficient because increasing production will result in an improvement in society’s welfare. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 46 Marginal Benefit > Marginal Cost (cont’d) • The size of the inefficiency brought about by having a monopoly can be measured by the difference between the price and the marginal cost. This difference, in turn, is affected by the elasticity of the demand curve. • The more inelastic the demand curve, the larger the difference between the price and the marginal cost. The more elastic the demand curve, the smaller the difference between the price and the marginal cost. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 47 Marginal Benefit > Marginal Cost (cont’d) • One index used to measure market power is the price-cost margin. • Price cost margin – The difference between price and the marginal cost, divided by the price. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 48 Price Cost Margin = Price minus marginal cost Price = 1 price elasticity of demand Copyright © Houghton Mifflin Company. All rights reserved. 10 | 49 Price Cost Margin (cont’d) • If the price cost margin is zero, then the firm has no market power. The higher the price cost margin, the greater a firm’s market power. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 50 Why Monopolies Exist Reasons Why Monopolies Exist 1) Natural Monopolies – Economies of scale (declining average total cost resulting from increasing output) can lead to a monopoly. Specifically, if the minimum efficient scale is larger than the size of the market, then the market will likely be serviced by only one firm, a natural monopoly. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 51 Why Monopolies Exist (cont’d) • Natural Monopolies – A single firm in an industry in which the average total cost is declining over the entire range of production and the minimum efficient scale is larger than the market size. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 52 Why Monopolies Exist (cont’d) 2) Patents and Copyrights – Grant the holder of a patent or a copyright the sole right to produce goods within a specified time period. Patents are awarded to inventions, while copyrights are awarded movies, books, computer software, and songs. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 53 Peter Pan and the Great Ormond Street Hospital Children’s Charity • Sir J.M. Barrie’s story of Peter Pan and Neverland has been a part of every childhood – and many adulthoods too. Barrie gave the rights to the story to Great Ormond Street Hospital in 1929. Since then, the hospital has received royalties every time a production of the play is put on, as well as from the sale of Peter Pan books and other products. Source: copied from gosh.org Copyright © Houghton Mifflin Company. All rights reserved. 10 | 54 Peter Pan and the Great Ormond Street Hospital Children’s Charity (cont’d) • Although UK copyrights expire 50 years after an author’s death, Great Ormond Street has the unique right to royalties from Peter Pan forever. • Throughout the European Union, Peter Pan’s copyright is good until 2007; it extends until 2023 in the United States. Source: copied from gosh.org Copyright © Houghton Mifflin Company. All rights reserved. 10 | 55 Peter Pan and the Great Ormond Street Hospital Children’s Charity (cont’d) • Because the European Union’s copyright of Peter Pan will expire in Europe in 2007, author Geraldine McCaughrean has been chosen by the Great Ormond Street Hospital Children’s Charity (GOSHCC) to write the authorized sequel to the story. Copyrights to the story will be shared by both McCaughrean and the GOSHCC. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 56 Why Monopolies Exist Why award patents and copyrights? • Monopoly rights through patents and copyrights stimulate innovation by giving inventors more incentives to devote resources to invent new products or take a risk and try new ideas. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 57 Creating Other Barriers to Entry • Barriers to entry allow monopolies to persist. Examples of Barriers to Entry: 1) Professional Certification, such as passing the California Bar Exam 2) Threats of potential entry, where a firm keeps prices low when a potential entrant to the market exists. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 58 Price Discrimination • Our discussion on monopolies focused on those that charge a single price to all customers. However, some monopolies can practice price discrimination. • Price Discrimination – A situation in which different groups of consumers are charged different prices for the same good (and the source of the price difference cannot be differences in the cost of providing the product). Copyright © Houghton Mifflin Company. All rights reserved. 10 | 59 Price Discrimination (cont’d) Examples of Price Discrimination 1) Senior citizen discounts at a restaurants 2) Lower airline ticket prices for flights with Saturday-night stayovers 3) Lower college tuition for students from low income families Copyright © Houghton Mifflin Company. All rights reserved. 10 | 60 Why Does Price Discrimination Exist? Reasons why some firms price discriminate 1) Consumers have different price elasticities of demand. Figure 10.9 shows the profit maximizing price for customers with different price elasticities of demand. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 61 Why Does Price Discrimination Exist? (cont’d) Figure 10.9 Copyright © Houghton Mifflin Company. All rights reserved. 10 | 62 Why Does Price Discrimination Exist? (cont’d) • The graph on the left side in Figure 10.9 shows the derivation of the profit maximizing price if customers have a high elasticity of demand. Notice that the price is lower than the price derived on the right graph on Figure 10.9 where the demand curve is more inelastic. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 63 Why Does Price Discrimination Exist? (cont’d) • Figure 10.9 shows that customers who are price sensitive (budget vacation travelers, for example) are charged lower prices as opposed to customers who are not price sensitive (business travelers). Copyright © Houghton Mifflin Company. All rights reserved. 10 | 64 Why Does Price Discrimination Exist? (cont’d) • In order to successfully price discriminate, the monopoly must be able to identify and separate the customers with a low elasticity of demand from those with a high elasticity. Ways to separate customers 1) Senior citizens show ID before getting a discount at movie theaters 2) Saturday night stay is required of budget travelers 3) Students need to show parents’ income tax returns as proof of low income Copyright © Houghton Mifflin Company. All rights reserved. 10 | 65 Quantity Discounts • Another form of price discrimination is by charging a lower price to those that buy more. Examples 1) Amtrak offers monthly passes that are cheaper than if you purchase tickets individually. 2) Buying toothbrushes are cheaper per unit in warehouse clubs than in convenience stores, as long as you buy a lot at a time. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 66 Quantity Discounts (cont’d) • Figure 10.10 graphically illustrates how monopolies generate higher revenues if they price discriminate (the top two graphs) as opposed to when they do not (the bottom graph). Copyright © Houghton Mifflin Company. All rights reserved. 10 | 67 Quantity Discounts (cont’d) Figure 10.10 Copyright © Houghton Mifflin Company. All rights reserved. 10 | 68 Quantity Discounts (cont’d) • The graph on the top left corner of Figure 10.10 shows that by charging a higher price to those who are willing to pay a high price (and buy less), a firm will generate a higher profit. • The graph on the top right corner of Figure 10.10 shows that by charging a lower price to those who are able or willing to buy only at a lower price, a firm will also generate a higher profit. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 69 Quantity Discounts (cont’d) • The bottom graph on Figure 10.10 shows the profits of a monopoly that does not price discriminate. Copyright © Houghton Mifflin Company. All rights reserved. 10 | 70 Key Points • • • • • • • • Monopoly Barriers to entry Market power Price-maker Average revenue Price-cost margin Natural monopoly Price discrimination Copyright © Houghton Mifflin Company. All rights reserved. 10 | 71