ch10

Chapter 10 Monopoly and other forms of imperfect competition
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan
10-1
Imperfect competition
Perfect competition
Firms have no control over price. Firms produce homogenous products. Price equal the marginal cost of production. Long-run economic profits are not possible due to free entry and exit. An ideal market that maximises economic surplus. A situation that does not always exist.
10-2
Imperfectly competitive firms
Have some control over price. Price may be greater than the cost of production. Long-run economic profits are possible. Face a downward-sloping demand curve. Contribute to loss of efficiency. Are very common in every economy. Reduce economic surplus to varying degrees by restricting output.
10-3
Different forms of imperfect competition
Pure monopoly Oligopoly Monopolistic competition
10-4
Various forms of imperfect competition
Pure monopoly (most inefficient)
The only supplier of a unique product with no close substitutes, examples
City power provider Only petrol station in a small town AFL football league
10-5
Various forms of imperfect competition
Oligopoly (more efficient than a monopoly)
A firm that produces a product for which only a few rival firms produce close substitutes, examples
Major banks in Australia BP, Shell, Mobil Airlines
10-6
Different forms of imperfect competition
Monopolistic competition (closest to perfect competition)
A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another, examples
Restaurants in Lygon Street Novels, films, CDs
10-7
The essential difference between perfectly and imperfectly competitive firms comes from possible substitutability of products
The perfectly competitive firm faces a perfectly elastic demand for its product. The imperfectly competitive firm faces a downwardsloping demand curve.
10-8
In perfect competition
Supply and demand determine equilibrium price. The firm has no market power. At the equilibrium price, the firm sells all it wishes.
10-9
With perfect competition
If the firm raises its price, sales will be zero. If the firm lowers its price, sales will not increase. The firms demand curve is the horizontal line at the market price.
10-10
With imperfect competition
The firm has some control over price or some market power. The firm faces a downward-sloping demand curve. In the case of a monopoly, the firms demand curve is the market demand curve.
10-11
The demand curves facing perfectly and imperfectly competitive firms

Perfectly competitive firm
$/unit of output
Imperfectly competitive firm
Market price
Price
D
Quantity Quantity
10-12
Five sources of market power

Exclusive control over inputs
A singer with gifted talent
Government-created monopolies
A new pharmaceutical drug Taxi licenses
Economies of scale (natural monopolies)

City water supply
Network economies
Microsoft Windows
10-13
Economies of scale and the importance of fixed costs

Firms with large fixed costs and low variable costs
Have low marginal costs Average total cost declines sharply as output increases Have higher proportion of fixed cost than variable cost in average total cost Economies of scale will exist
10-14
Total and average total costs for a production process with economies of scale
TC = F + MQ
Average cost ($/unit)
Total cost ($/year)
F + Q0
ATC = F/Q + M
Q0
Quantity
Quantity
Total cost rises at a constant rate as output rises
Average costs decline and is always higher than marginal cost

10-15
Costs for two computer game producers (1)

Nintendo PlayStation
Annual production Fixed cost Variable cost Total cost Average total cost per game
1,000 000 $200 000 $800 000 $1,000 000 $1.00
1,200 000 $200 000 $960 000 $1,160 000 $0.97
Observations Fixed costs are a relatively small share of total cost. Cost/game is nearly the same.
10-16

Annual production Fixed cost Variable cost
1,000 000 $10,000 000 $200 000
1,200 000 $10,000 000 $240 000
Total cost
Average total cost per game
$10,200 000
$10.20
$10,240 000
$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.
10-17

Annual production Fixed cost Variable cost
500 000 $10,000 000 $100 000
1,700 000 $10,000 000 $340 000
Total cost
Average total cost per game

$10,100 000
$20.20
$10,340 000
$6.08
Shift of 500,000 units to PlayStation. Nintendos 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.
10-18
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 Variable cost Hardware
1984 1990
20% 80%
80% 20%
10-19
Economies of scale and the importance of fixed costs (cont.)

Thinking as an economist
Why does Intel sell the overwhelming majority of microprocessors used in personal computers?
As fixed costs become more important, the perfectly competitive pattern becomes less common.
10-20
Profit maximisation for the monopolist

A price taker (perfect competition) and a price setter (imperfect competition) share two economic goals. They want
to maximise profits to select the output level that maximises the difference between TR and TC, where MR = MC.
10-21

Marginal revenue for the monopolist
Firms in perfect competition and monopoly firms (assuming a single price firm)
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
10-22
The monopolists benefit from selling an additional unit

8
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)
6 5
3 Quantity (units/week)
10-23
Marginal revenue in graphical form

Observations
MR declines as quantity increases. MR is the change between two quantities. MR < P because price must be lowered to sell an additional unit.
P 6 5
Q 2 3
TR 12 15
MR 3 1 -1
4
3
4
5
16
15
10-24
Marginal revenue in graphical form

Price & marginal revenue ($/unit)
P 6 5 4 3
Q 2 3 4 5
TR 12 15 16 15
MR 3 1 -1
3 1 -1 2 3 4 5
D
8
MR
Quantity (units/week)
10-25
The marginal revenue curve for a monopolist with a straight-line demand curve
a
Price
a/2 MR D
Q0/2
Quantity
Q0
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..
10-26

Profit maximising decision rule:
When MR > MC, output should be increased. When MR < MC, output should be reduced. Profits are maximised at the level of output for which MR = MC. Set the price that consumers are willing to pay at that level of output.
10-27
The monopolists profit-maximising output level

6 Price ($/unit of output)
Marginal cost
Observations If P = $3 & Q = 12 MR < MC and output should be reduced. Profits are maximised at 8 units where MR = MC. The maximum single price at which 8 units can be sold is P=$4.
4
3
MR
8 12 Quantity (units/week)
D
24
10-28
Even a monopolist may suffer an economic loss

Being a monopolist doesnt guarantee an economic profit
Economic loss = $400 000/day Economic profit = $400 000/day
0.12
Price ($/minute) Price ($/minute) 0.10
ATC
0.10 0.08
ATC
0.05
0.05
MC D
20
MC D
20
MR
MR
24
Minutes (millions/day)
Minutes (millions/day)
10-29
The demand and marginal cost curves for a monopolist

Why the invisible hand breaks down under monopoly
Marginal cost
The socially optimal amount occurs where MC = D(MR) at 12 units
D
12 Quantity (units/week)
24
10-30
The demand and marginal cost curves for a monopolist (cont.)

Marginal cost
The profit maximising 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. Single-price monopolist will not increase output because MR<MC.
4
3
MR
D
24
10-31
The demand and marginal cost curves for a monopolist (cont.)

6 Price ($/unit of output) Deadweight loss
Marginal cost
Because MR < P, the monopoly produces less than the socially optimal amount The deadweight loss of the monopoly to society = (1/2)($2/unit)(4units/wk) = $4/wk.
4
3
MR
D
24
10-32

Monopoly
Profits are maximised where MR = MC P > MR P > MC Deadweight loss
Perfect competition
Profits are maximised where MR = MC P = MR P = MC No deadweight loss
10-33
Why the invisible hand breaks down under monopoly (cont.)

Difficulties in reducing the deadweight loss of monopolies
Enforcing competition and anti-monopoly laws Patents, copyrights and innovation Natural monopolies
10-34
Using discounts to expand the market

Price discrimination
The practice of charging different buyers different prices for essentially the same good or service, where differences do not simply reflect differences in costs of supplying different buyers.
Examples of price discrimination

Senior citizens and student discounts on movie tickets Supersaver discounts on air travel Rebate coupons
10-35
Using discounts to expand the market (cont.)

Why do many movie theatres offer discount tickets to students? Why do most airlines have peak and off-peak rates? Why do fitness clubs have a membership fee and per unit price?
10-36

Example
Rosie can edit term papers for eight students each with a different reservation price. If Rosies opportunity cost of her time to edit each paper is $29 and she must charge a single price to each student, how many term papers should Rosie edit? How much economic profit would she make?
10-37
Total and marginal revenue from editing

Student
Reservation price ($ per paper)
Total revenue ($ per week)
Marginal revenue ($ per paper)
A B C D E F G H
40 38 36 34 32 30 28 26
40 76 108 136 160 180 196 208
40
36 32 28 24 20 16 12
10-38

Example
How many manuscripts should Rosie edit when she must charge all buyers the same amount?
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
10-39

Example
How many manuscripts should Rosie edit?
Rosie edits 3 papers
TC = 3 x $29 = $87 TR = $108 Economic profit = $108 - $87 = $21/wk Accounting profit = $108
10-40

Example
How many manuscripts should Rosie edit?
Opportunity cost = $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 Accounting profit = $180
10-41

Example
If Rosie can price discriminate, how many papers should she edit?
Assume Rosie can charge each student their reservation price.
10-42
Example
Student
Reservation price
A B C D E F G H
40 38 36 34 32 30 28 26
10-43
Rosie 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 than when she had to charge a single price.

Perfectly discriminating monopolist
Charging each buyer exactly their reservation price
Economic surplus is maximised Consumer surplus is zero Economic surplus = producer surplus No deadweight loss
10-44

Limitations to perfect price discrimination
Seller will not know each buyers reservation price. Low price buyers could resell to other buyers at a higher price.
10-45

Group pricing
A form of price discrimination where different discounts are offered in different submarkets, while members of particular submarket all receive the same discount. Group pricing essentially allows a firm to divide its market into two submarkets in which it can charge two different prices. In each market the firm can charge the same price to every buyer like an ordinary monopolist. Therefore the firm should keep expanding output in each submarket as long as MR in that submarket exceeds MC.
10-46

Group pricing
Question: Suppose Rosie knows that students whose reservation prices are at least $34 are science students, while those whose reservation prices are below $34 are commerce students. How much should Rosie charge for editing if she uses group pricing?
10-47

The hurdle method of price discrimination
The practice by which a seller offers a discount to all buyers who overcome some obstacle. Examples:
Rebate coupon Bundling of goods Foregoing extras that come with a higher price
10-48

The hurdle method of price discrimination is used to solve two problems:
Seller does not know the reservation prices. Seller must separate high and low price buyers.
10-49

A perfect hurdle
Completely segregates buyers whose reservation prices lie above it from others whose reservation prices lie below it, imposing no cost on those who jump the hurdle.
What do you think?

Is a perfect hurdle possible?
10-50

Question
How much should Rosie charge for editing if she uses a perfect hurdle?
Assume
Rosie 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.
10-51
Price discrimination with a perfect hurdle

Student Reservation price ($ per paper) Total revenue ($ per week) Marginal revenue ($ per paper)
List price submarket
A B C D E F G H
40 38 36 34 32 30 28 26
40 76 108 34 64 90 112 130
40 36 32 34 30 26 22 18
10-52
Discount price submarket

Solution
TR = (3)(36) + (2)(32) = $172 MC = ($5)($29) = $145 Economic profit = $27/wk
Question
Is price discrimination a desirable thing?
The hurdle method raised economic surplus.
10-53

Calculating economic surplus
Consumer surplus
Both Single price & discount
Reservation price
Actual price
Consumer surplus
A B C
$40 $38 $36
$36 $36 $36
$4 $2 $0 $6
Without discount
D
With discount
$34
$22
$2
$8
Producer surplus
Single price = 3(36 - 29) = $21/wk Discount price = 3(36 - 29) = $21/wk 2(32 - 29) = $6/wk $27/wk
10-54

Question
Is Rosies discount rebate socially efficient?
10-55

Examples of price discrimination
Temporary sales Book publishers and paperback books Automobile producers offer various models Commercial air carriers Movie producers
10-56

Why might an appliance retailer instruct its salespeople to hammer dents into the sides of its stoves and refrigerators?
10-57

Summary
Single price monopolies are inefficient because P > MR. The hurdle method of price discrimination reduces the inefficiency. Hurdles are not perfect, therefore, there will be some efficiency loss. The more finely the seller can discriminate, the smaller the efficiency loss.
10-58
Public policy towards competition

National competition policy
Competitive markets will generally serve the interests of consumers. Wider community can provide strong incentives for suppliers. Promote efficiency and innovation.
10-59
Public policy towards competition (cont.)

The Trade Practices Act and the ACCC
Promotion of competition and fair trading Provision of consumer protection
How does the ACCC use cost-benefit thinking in applying the Acts authorisation and notification processes?
10-60
Public policy towards competition (cont.)

Regulating natural monopolies
State ownership, marginal cost pricing versus the cost of less incentive for innovation Exclusive contracting for natural monopoly
Competition for the contract sets P = MC Difficulty when fixed costs are high such as electric utilities
10-61
Public policy toward natural monopoly

Regulating natural monopolies in Australia Abandoned direct regulation Incentive compatible regulatory regimes such as price caps
10-62
Public policy toward natural monopoly (cont.)

What do you think?
Should we regulate natural monopolies?
10-63

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Chapter 10 Monopoly and other forms of imperfect competition

The demand curves facing perfectly and imperfectly competitive firms

Imperfectly competitive firm

Five sources of market power

Economies of scale (natural monopolies)

Economies of scale and the importance of fixed costs

Total cost ($/year)

Total cost rises at a constant rate as output rises

Average costs decline and is always higher than marginal cost

Costs for two computer game producers (1)

1,000 000 $200 000 $800 000 $1,000 000 $1.00

1,200 000 $200 000 $960 000 $1,160 000 $0.97

Costs for two computer game producers (2)

Annual production Fixed cost Variable cost

1,000 000 $10,000 000 $200 000

1,200 000 $10,000 000 $240 000

Costs for two computer game producers (3)

Annual production Fixed cost Variable cost

500 000 $10,000 000 $100 000

1,700 000 $10,000 000 $340 000

Economies of scale and the importance of fixed costs

Economies of scale and the importance of fixed costs (cont.)

Profit maximisation for the monopolist

Profit maximisation for the monopolist

The monopolists benefit from selling an additional unit

Marginal revenue in graphical form

Marginal revenue in graphical form

Profit maximisation for the monopolist

The monopolists profit-maximising output level

Even a monopolist may suffer an economic loss

The demand and marginal cost curves for a monopolist

The socially optimal amount occurs where MC = D(MR) at 12 units

The demand and marginal cost curves for a monopolist (cont.)

The demand and marginal cost curves for a monopolist (cont.)

Why the invisible hand breaks down under monopoly

Why the invisible hand breaks down under monopoly (cont.)

Using discounts to expand the market

Examples of price discrimination

Using discounts to expand the market (cont.)

Using discounts to expand the market (cont.)

Total and marginal revenue from editing

Reservation price ($ per paper)

Total revenue ($ per week)

Marginal revenue ($ per paper)

40 76 108 136 160 180 196 208

Using discounts to expand the market

Why the invisible hand breaks down under monopoly

Why the invisible hand breaks down under monopoly

Why the invisible hand breaks down under monopoly

Using discounts to expand the market

Using discounts to expand the market (cont.)

Using discounts to expand the market (cont.)

Using discounts to expand the market (cont.)

Using discounts to expand the market (cont.)

Using discounts to expand the market (cont.)

Using discounts to expand the market (cont.)

What do you think?

Using discounts to expand the market (cont.)

Price discrimination with a perfect hurdle

List price submarket

40 76 108 34 64 90 112 130

Discount price submarket