Frank & Bernanke

3rd edition, 2007

Ch. 10: Monopoly and Other

Forms of Imperfect Competition
1
 Perfect Competition
 An ideal market that maximizes economic
surplus
 A situation that does not always exist

2
 Imperfectly Competitive Firms
 Have some control over price
 Price may be greater than the cost of
production Reduce economic surplus to varying
degrees
 Long-run economic profits are possible
Are very common

 Reduce economic surplus to varying

degrees
 Are very common

3
 Different Forms of Imperfect
Competition
 Pure Monopoly (most inefficient)
 The only supplier of a unique product with no close substitutes
 Monopolistic Competition (closest to perfect 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
 Oligopoly (more efficient than a monopoly)
 Industry structure in which a small number of large 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

4
 Perfectly and Imperfectly
Competitive Firms
 The perfectly competitive firm faces a perfectly
elastic demand for its product.
 Supply and demand determine equilibrium price. The
firm has no market power.
 At the equilibrium price, the firm sells all it wishes.
 The imperfectly competitive firm faces a
downward-sloping demand curve.
 The firm has some control over price or some market
power.
 The firm faces a downward sloping demand curve.

5
 Perfect Competition
 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.

6
 The Demand Curves

Perfectly competitive firm Imperfectly competitive firm

$/unit of output

Market D

Price
price

Quantity Quantity

7
Five Sources of Market Power
 Exclusive control over inputs
 Patents and Copyrights
 Government Licenses or Franchises
 Economies of Scale (Natural Monopolies)
 Network Economies

8
 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

9
 Constant Returns to Scale
 A production process is said to have
constant returns to scale if, when all inputs
are changed by a given proportion, output
changes by the same proportion.

10
 Increasing Returns to Scale
 A production process is said to have
increasing returns to scale if, when all
inputs are changed by a given proportion,
output changes by more than that
proportion; also called economies of scale.

11
 TC and ATC with Economies of Scale

TC = F + MQ

Average cost ($/unit)

Total cost ($/year)

F + MQ0

F ATC = F/Q + M

M
Q0 Quantity Quantity

Total cost rises at a constant Average costs decline and is

rate as output rises always higher than marginal cost
12
 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
Total cost $1,000,000 $1,160,000
Average total cost per game $1.00 $0.97

Observations
•Fixed costs are a relatively small share of total cost
•Cost/game is nearly the same

13
 Costs for Two
Computer Game Producers (2)

Nintendo Playstation

Annual production 1,000,000 1,200,000

Fixed cost $10,000,000 $10,000,000
Variable cost $200,000 $240,000
Total cost $10,200,000 $10,240,000
Average total cost per game $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
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 Costs for Two
Computer Game Producers (3)

Nintendo Playstation

Annual production 500,000 1,700,000

Fixed cost $10,000,000 $10,000,000
Variable cost $100,000 $340,000
Total cost $10,100,000 $10,340,000
Average total cost per game $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
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 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 Variable Cost
Software Hardware

1984 20% 80%

1990 80% 20%

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 Economic Naturalist
 How big will Playstation’s unit cost
advantage be if it sells 2,000,000 units per
year, while Nintendo sells only 200,000?
 Why does Intel sell the overwhelming
majority of all microprocessors used in
personal computers?

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 Profit Maximization
 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

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 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
8 • The MR of selling the 3rd unit = $3 (15-12)
• For the 3rd unit, MR = $3 < P = $5
Price ($/unit)

6
5

2 3 8

Quantity (units/week)

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 Marginal Revenue

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

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 Marginal Revenue in
Graphical Form

Price & marginal revenue ($/unit)

P Q TR MR
6 2 12
3
5 3 15
1 3
D
4 4 16
-1 1
3 5 15
2 3 4 5 8
-1
MR
Quantity (units/week)

Demand: P = 8 – Q
MR = 8 – 2Q
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Monopolist with a Straight-Line Demand Curve

a
Price

a/2

MR D

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.
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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.

23
 The Monopolist’s Profit-
Maximizing Output Level

6 Marginal Cost
Observations
Price ($/unit of output)

Demand: P = 6 – 0.25Q
MC = 0.25Q
• If P = $3 & Q = 12 MR < MC
and output should be
4 reduced
• Profits are maximized at 8
3 units where MR = MC
• P = $4 where quantity
2 demanded = quantity
supplied
D
MR
8 12 24
Quantity (units/week)
MR = 6-0.5Q
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 Even a Monopolist May
Suffer an Economic Loss
Being a monopolist doesn’t guarantee an economic profit

Economic loss Economic profit

= $400,000/day = $400,000/day
0.12
Price ($/minute)

Price ($/minute)
0.10 0.10
ATC
0.08
ATC

0.05 MC 0.05 MC

D D

20 MR 20 MR 24
Minutes (millions/day) Minutes (millions/day)

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Invisible Hand Breaks Down
Under Monopoly

6 Marginal cost
Price ($/unit of output)

The socially optimal

3 amount occurs where
MC = D(MB) @ 12 units

12 24
Quantity (units/week)

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 Invisible Hand Breaks
Down Under Monopoly

6 Marginal cost
Price ($/unit of output)

• The profit maximizing level of

output of 8 units, where MR =
MC, is less than the socially
4
optimal output of 12
• Between 8 and 12, MB to
3 society > MC to society
• Cannot increase output
2 because MR to the firms is less
than MC

D
MR
8 12 24
Quantity (units/week)

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 Invisible Hand Breaks
Down Under Monopoly
6 Deadweight loss Marginal cost
Price ($/unit of output)

• Because MR < P, the monopoly

4 produces less than the socially
optimal amount
3 • The deadweight loss of the
monopoly to society = (1/2)
($2/unit)(4units/wk) = $4/wk.
2

D
MR
8 12 24
Quantity (units/week)

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 Why the Invisible Hand Breaks
Down Under Monopoly
 Monopoly  Perfect Competition
 Profits are  Profits are
maximized where maximized where
MR = MC. MR = MC.
 P > MR  P = MR
 P > MC  P = MC
 Deadweight loss  No deadweight loss

29
 Difficulties in Reducing the
Deadweight Loss of Monopolies
 Enforcing antitrust laws
 Patents, copyrights, and innovation
 Natural monopolies

30
 Price Discrimination
 The practice of charging different buyers
different prices for essentially the same
good or service
 Examples of Price Discrimination
 Senior citizens and student discounts on
movie tickets
 Supersaver discounts on air travel
 Rebate coupons

31
 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.
32
 The Hurdle Method
 The practice of offering a discount to all
buyers who overcome some obstacle.
 Example
 Offering a rebate to those who mail in a
coupon

33
 Examples of Price Discrimination
 Temporary Sales
 Book publishers and paperback books
 Automobile producers offer various
models
 Commercial air carriers
 Movie producers

34
 Price Discrimination and
Economic Surplus
P

MC
P*

World Price

D
MR

Q* Q
Q**
35
 Controlling Natural Monopolies
 State ownership and management
 Weighing the benefit of marginal cost pricing versus the cost of
less incentive for innovation
 State regulation of private monopolies
 Cost-plus regulation
 High administrative cost
 Less incentive for innovation
 P does not equate to MC
 Exclusive contracting for natural monopoly
 Competition for the contract sets P = MC
 Difficulty when fixed costs are high such as electric utilities
 Vigorous enforcement of anti-trust laws
 Helps prevent cartels
 May prevent economies of scale

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