Download Lecture 10 - Cal Poly Pomona

EC 201
Cal Poly Pomona
Dr. Bresnock
Lecture 10
Pure Monopoly: Price and Output Determination
Remember these pure monopoly characteristics:
(1)
(2)
(3)
(4)
(5)
Single Seller -- “The firm is the industry.”
No Close Substitutes -- Unique product.
“Price Maker” -- Firm has power to determine price on its own.
Significant “Barriers to Entry” -- See examples below.
Goodwill Advertising Only -- Typically public service or educational ads.
Note: Examples of “pure monopoly” are few. Public utilities are government-owned, or regulated
monopolies. Even something like DeBeers diamond syndicate controls 70% rather than the entire
diamond supply. Most monopolies tend to be “dominant firm” monopolies in which one firm has a
substantial market share relative to the remaining firms (often referred to as the “competitive fringe”
and composed of many, small firms). Examples of “dominant firm monopolies” include: Gillette,
70% of razor blade sales; Xerox, 75 – 80% of electrostatic copier revenues, etc.
However, about 5 – 6% of economic activity is conducted under conditions that are similar to “pure
monopolies”. Our study of the “pure monopoly” will show us the general differences between
purely competitive and imperfectly competitive market structures, such as oligopoly and
monopolistic competition. The latter two market structures combine characteristics of pure
competition and pure monopoly in differing degrees.
“Barriers to Entry” -- Economic, technological, legal or geographic factors that block, or inhibit,
other firms from entering an industry. With a “pure monopoly”, the “barriers to entry” are complete
and entry is totally blocked. With other imperfectly competitive market structures, “barriers to
entry” are present but to a lesser degree. Examples of “barriers to entry” include:
(1)
Economies of Scale -- technology that leads to efficient, low-cost production is
often achieved by producers that are larger, incumbent firms that control substantial
portions of market sales. These firms experience declining long run average cost,
LRAC (or economies of scale), that can create financial obstacles for new firms to
enter the market. The existing firms will be able to pass cost savings along to the
customers in the form of lower prices. Such low prices may be so low that new
firms will find it difficult to compete on a price basis, and will often earn economic
losses if they try to do so.
EC 201
Dr. Bresnock
Graph 1 Economies of Scale as a “Barrier to Entry”
Lecture 10
$M, QM = Monopolist can sell at this price and quantity due to the existing demand for its product
and economies of scale.
$NF, QNF = New firm’s needed price to just cover costs at QNF.
$NF - $M = Advantage in pricing ability of incumbent firm.
“Natural Monopoly” -- if the market demand cuts the declining portion of the LRAC, then the
single firm is referred to as a natural monopoly. In such a case, the firm will be motivated to earn
economic profits and change a price above its LRAC. As a result, governments typically regulate
natural monopolies – specifically the prices charged. This is often justified, as with public utilities,
as limiting wasteful spending, i.e. duplicating extensive capital equipment like generators, water
mains, pumps, transmission lines.
(2)
Patents and Licenses -- legal barriers to entry. Patent = exclusive right of an
inventor to use, or allow another to use, his/her invention. Patent length = 20 years
as per GATT, 1995. License = a limit on the entry of a firm into an industry that is
enforced by government.
(3)
Ownership of Essential Raw Materials -- owning or controlling a substantial
amount of an essential raw material via private property rights, i.e. DeBeers,
Aluminum Company of America.
(4)
Pricing and Other Strategic Barriers -- aggressive price cutting, increased
advertising, and other actions that make it difficult for an entering firm to succeed.
While these actions have a negative connotation, there are other actions that arise
from more positive circumstances that can make it difficult for new entrants to
survive, i.e. longevity advantages -- well established clientele, favorable financing
to long-term customers.
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EC 201
Dr. Bresnock
Lecture 10
Note: Barriers to entry may not, however, be complete. Why? First, new substitutes will emerge
over time. Second, foreign competition will increase over time as well as domestic
competition.
Price and Output Determination: Pure Monopoly (Non- Price Discriminating)
Monopoly Demand -- for the firm…
(1)
IS the industry demand.
(2)
Is downward sloping -(a)
As P  Q thus
MR < P (= AR)
The firm can lower price to increase sales. The MR for each additional unit
falls faster than the price as quantity is increased.
(b)
The monopolist chooses both P and Q. The quantity is selected first based
on the profit maximization, or loss minimization, principle. Once the
quantity is chosen, the monopolist selects the price associated with that
quantity demanded for its product. The total and marginal approaches for
this decision are:
Total Approach
(1)
Pick Q where
Max. Total Economic Profits
Max. (TR – TC)
(2)
or
Pick P at the Q selected in (1).
Marginal Approach
(1)
Pick Q where
MR = MC (Guarantees that TOTAL profit is maximized.)
MC > 0
(Marginal profit is ZERO.)
(2)
Pick P at the Q selected in (1).
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EC 201
Dr. Bresnock
Table 1
Lecture 10
Price and Output Determination for Pure Monopolist (Non-Price Discrimination)
(1)
Q
(2)
P=AR
0
1
2
3
4
5
6
7
8
9
10
11
12
13
$26
24
22
20
18
16
14
12
10
8
6
4
2
Graph 2
(3)
TR
(4)
MR
(5)
TC
(6)
ATC
(7)
MC
(8)
Total
Economic
Profit (+)
or Loss ()
(3) – (5)
$15
35
50
60
65
75
90
110
135
165
200
240
285
335
Price and Output Determination: Pure Monopoly (Total Approach)
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EC 201
Dr. Bresnock
Lecture 10
Graph 3 Price and Output Determination: Pure Monopoly (Marginal Approach)
Other Possible Outcomes
(1) Breakeven -- TR = TC for the total approach. Firms earn “normal profits” only.
“Economic profits” are zero. For the marginal approach, when the quantity is selected at
MR = MC and MC > 0 and Marginal Profit = 0. At that quantity, the price will be…
PBE = ATC.
Graph 4 Price and Output Determination: Pure Monopoly (Total Approach, Break-Even)
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EC 201
Dr. Bresnock
Lecture 10
Graph 5 Price and Output Determination: Pure Monopoly (Marginal Approach,
Break-Even)
(2) Loss Minimization -- Min. TR – TC, or Min. Total Economic Losses for the total
approach. For the marginal approach, when the quantity is selected at MR = MC and MC
> 0 and Marginal Profit = 0. At that quantity, the price will be… PMIN < ATC but PMIN
> AVC.
Graph 6 Price and Output Determination: Pure Monopoly (Total Approach,
Loss Minimization)
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EC 201
Dr. Bresnock
Lecture 10
Graph 7 Price and Output Determination: Pure Monopoly (Marginal Approach,
Loss Minimization)
(3) Shut-Down -- Min. TR – TC, or Min. Total Economic Losses for the total approach.
This occurs when Q = 0. For the marginal approach, when the quantity is selected at MR
= MC and MC > 0 and Marginal Profit = 0. At that quantity, the price will be… PSD <
AVC. The firm will lose its TFC and go out of business.
Graph 8 Price and Output Determination: Pure Monopoly (Total Approach, Shut-Down)
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EC 201
Dr. Bresnock
Lecture 10
Graph 9 Price and Output Determination: Pure Monopoly (Marginal Approach,
Shut-Down, In Business)
Graph 10 Price and Output Determination: Pure Monopoly (Marginal Approach,
Shut-Down, Out of Business)
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