Monopoly

CHAPTER

12

Competition is a sin.
J. D. Rockefeller

I dont think its fair that only one company is allowed to make the Monopoly game.
Stephen Wright

CHAPTER CHECKLIST
When you have completed your study of this chapter, you will be able to 1 Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly. Explain how a single-price monopoly determines its output and price. Compare the performance of a single-price monopoly with that of perfect competition.

2 3

CHAPTER CHECKLIST

4 5

Explain how price discrimination increases profit. Explain why natural monopoly is regulated and the effects of regulation.

MARKET CHARACTERISTICS
Perfect Competition
Many, many, many, many sellers, none so large that they can influence price. Homogeneous product (buyers dont care who they by from).

Monopoly
One seller that likely can influence price Heterogeneous product, no close substitutes

No barriers to entry or exit (easy to get in and out of market).

Long run economic profit = zero. (only
earning normal profit)

HIGH barriers to entry or exit

Long run economic profit is positive

Firms are price takers (no market power, so market sets same price for all firms).

Firms are price makers (lots of market power, market IS the firm).

12.1 MONOPOLY AND HOW IT ARISES

No Close Substitutes
If a good has a close substitute, even though only one firm produces it, that firm effectively faces competition from the producers of substitutes.

Barriers to Entry
Anything that protects a firm from the arrival of new competitors is a barrier to entry.

There are three types of barriers to entry:

Natural Ownership Legal

12.1 MONOPOLY AND HOW IT ARISES

Natural Barrier to Entry

Natural monopoly when one firm is able to meet

the entire market demand at a lower price than two or more firms could (long downward-sloping ATC). Ex - Duke Power can meet the market demand for electricity at a lower cost than two or more firms could.

12.1 MONOPOLY AND HOW IT ARISES

Figure 12.1 shows a natural monopoly. 1. Economies of scale exist over the entire LRAC curve. 2. One firm can distribute 4 million kilowatt hours at a cost of 5 cents a kilowatt-hour.

12.1 MONOPOLY AND HOW IT ARISES

3. This same total output costs 10 cents a kilowatthour with two firms, 4. and 15 cents a kilowatt-hour with four firms. One firm can meet the market demand at a lower cost than two or more firms can, and the market is a natural monopoly.

12.1 MONOPOLY AND HOW IT ARISES

Ownership Barrier to Entry
A monopoly market in which competition and entry are restricted by the concentration of ownership of a natural resource. Ex - DeBeers created barrier to entry by buying control over most of the worlds diamonds.(DeBeers is no longer a
monopoly)

12.1 MONOPOLY AND HOW IT ARISES

Legal Barrier to Entry
A legal barrier to entry creates legal monopoly.

Legal monopoly - competition and entry are restricted

by granting of a public franchise, government license, patent, or copyright.

12.1 MONOPOLY AND HOW IT ARISES

Public Franchise - exclusive right granted to a firm to supply a good or service. (ex, U.S. Postal Service) Government license - controls entry into particular occupations, professions, and industries (ex, CPA). Patent - exclusive right granted to the inventor of a product or service (must be registered, usually 20 years) Copyright - exclusive constitutional right automatically granted to the author or composer of a literary, musical, dramatic, or artistic work. (work created from 1978 on,
copyright last 70 years plus life of author. Time for work prior to 1978 varies, often 28 years)

12.1 MONOPOLY AND HOW IT ARISES

Monopoly Price-Setting Strategies

A monopolist faces a tradeoff between price and the quantity sold.

To sell a larger quantity, the monopolist must set a lower price.

There are two price-setting possibilities that create different tradeoffs: Single price Price discrimination

12.1 MONOPOLY AND HOW IT ARISES Single-price monopoly - firm that must sell each unit
of its output for the same price to all its customers. DeBeers sell diamonds (quality given) at a single price.

Price-discriminating monopoly - firm that is able to

sell different units of a good or service for different prices. Airlines offer different prices for the same trip. (Though
there are multiple airlines, one may have monopoly over certain routes)

12.2 SINGLE-PRICE MONOPOLY

Price and Marginal Revenue

Firm demand curve = market demand curve (because
there is only one seller, the firm IS the market).

Total revenue (TR)

P x Q.

Marginal revenue (MR)

TR / Q.

12.2 SINGLE-PRICE MONOPOLY

The table shows the demand schedule and the graph shows the demand curve.

12.2 SINGLE-PRICE MONOPOLY

The table also calculates total revenue and marginal revenue.

12.2 SINGLE-PRICE MONOPOLY

When the price is $16, the quantity demanded is 2 haircuts an hour.

12.2 SINGLE-PRICE MONOPOLY

When the price falls to $14, the quantity demanded increases to 3 haircuts an hour.

12.2 SINGLE-PRICE MONOPOLY

1. Total revenue lost on the 2 haircuts previously sold is $4.

12.2 SINGLE-PRICE MONOPOLY

2. Total revenue gained on 1 additional haircut is $14.

12.2 SINGLE-PRICE MONOPOLY

3. Marginal revenue is $10 ($14 gain minus $4 loss).

12.2 SINGLE-PRICE MONOPOLY

The marginal revenue curve slopes downward and is below the demand curve. Marginal revenue is less than price.

12.2 SINGLE-PRICE MONOPOLY

Marginal Revenue and Elasticity

1. If a price cut increases TR, demand is elastic. 2. If a price cut decreases TR, demand is inelastic.

12.2 SINGLE-PRICE MONOPOLY

Figure 12.3(a) illustrates this relationship. 1. Over the range from zero to 5 haircuts an hour, marginal revenue is positive. A price fall increases total revenue, so demand is elastic.

MR=ZERO

12.2 SINGLE-PRICE MONOPOLY

2. At 5 haircuts an hour, marginal revenue is zero, so demand is unit elastic.
3. Over the range 5 to 10 haircuts an hour, marginal revenue is negative. A price fall decreases total revenue, so demand is inelastic.
MR=ZERO

12.2 SINGLE-PRICE MONOPOLY

Figure 12.3(b) shows the same information about marginal revenue as steps running along the total revenue curve.
Over the range from zero to 5 haircuts an hour, marginal revenue is positive and total revenue increases as output increases.

12.2 SINGLE-PRICE MONOPOLY

MR=ZERO

Over the range from 5 to 10 haircuts an hour, marginal revenue is negative and total revenue decreases as output increases. The blue line is the total revenue curve.

Total revenue is maximized at 5 haircuts an hour.

12.2 SINGLE-PRICE MONOPOLY

4. Total revenue is maximized at 5 haircuts an hour, where marginal revenue is zero and demand is MR=ZERO unit elastic. The relationship between MR and elasticity implies that a monopoly never profitably produces an output in the inelastic range of its demand curve.

12.2 SINGLE-PRICE MONOPOLY

Output and Price Decision

Monopolists (like perfectly competitive firms) set profit maximizing output where MC=MR. Corresponding price is then found on demand curve.

12.2 SINGLE-PRICE MONOPOLY

Figure 12.4(b) shows the firms profit-maximizing output and price decision. The average total cost curve is ATC. The marginal cost curve is MC. The demand curve is D. The marginal revenue curve is MR.

12.2 SINGLE-PRICE MONOPOLY

Economic profit is maximized when MC=MR. The profit-maximizing quantity is 3 haircuts an hour.

Profit-max price = $14

(determined by the demand curve (D).

Average total cost = $10

(determined by ATC curve at profit max output)

12.2 SINGLE-PRICE MONOPOLY

2. Economic profit, the blue rectangle, is $12.
P-ATC

Profit per unit = P ATC = $ 4. Profit per unit x Q = Total profit = $12.

12.3 MONOPOLY AND COMPETITION COMPARED

Output and Price

Compared to a firm in perfect competition, a single-price monopoly produces a smaller output and charges a higher price.

12.3 MONOPOLY AND COMPETITION COMPARED

Figure 12.5 illustrates this outcome.
In perfect competition, the market demand curve is D. The market supply curve is S. 1. The competitive industry produces the quantity QC at price PC.

12.3 MONOPOLY AND COMPETITION COMPARED

The competitive markets supply curve, S, is the monopolys marginal cost curve, MC.
The market demand curve, D, is the demand for the monopolys output. The monopolys marginal revenue curve is MR.

12.3 MONOPOLY AND COMPETITION COMPARED

2. A single-price monopoly produces the quantity QM where MC=MR and sells that quantity for the price PM.

12.3 MONOPOLY AND COMPETITION COMPARED

Is Monopoly Efficient?
Resources are used efficiently in perfect competition because surplus is max when MB=MC.

Monopolists produce lower quantity at higher price, under-producing relative to efficient output.
Underproduction yields deadweight losses, not efficient.

12.3 MONOPOLY AND COMPETITION COMPARED

Figure 12.6 shows the inefficiency of monopoly. 1. In perfect competition, the quantity, QC, is the efficient quantity because at that quantity, MB=MC=PC.

The sum of 2. consumer surplus and 3. producer surplus is maximized.

12.3 MONOPOLY AND COMPETITION COMPARED

4. In a single-price monopoly, the equilibrium quantity, QM, is inefficient because MB(PM)>MC at that output.
Underproduction creates a deadweight loss.

12.3 MONOPOLY AND COMPETITION COMPARED

5. Consumer surplus shrinks. 6. Part of the producer surplus is lost as deadweight loss, but
7. Producer surplus expands to accrue part of consumer surplus, so producer is better off, consumer is worse off, society is worse off.

12.4 PRICE DISCRIMINATION

Price discrimination - selling a good or service to different buyers at different prices, even though cost of providing the good is not different.

To price discriminate, a firm must Identify and separate different types of buyers. Sell a product that cannot be resold.

12.4 PRICE DISCRIMINATION

Price Discrimination and Consumer Surplus

The key idea behind price discrimination is to convert consumer surplus into economic profit.

To extract every dollar of consumer surplus from every buyer, the monopoly would have to offer each individual customer a separate price schedule based on that customers own willingness to pay.
Remember: consumer surplus is the difference between what Im willing to pay and what I have to pay. Price discriminators find ways to charge customers what they are willing to pay.

12.4 PRICE DISCRIMINATION

Figure 12.8 shows a single price of air travel. As a single-price monopoly, Global Air maximizes profit by selling 8,000 trips a year at $1,200 a trip. 1. Globals customers enjoy a consumer surplusthe green triangleand 2. Globals economic profit is $4.8 million a yearthe blue rectangle.

12.4 PRICE DISCRIMINATION

Figure 12.9 shows how Global can profit from price discrimination.

The $1,200 fare is available only with a 14-day advance purchase and a stay over a weekend. The price of other 14-day advance purchase tickets is $1,400. The price of a 7-day advance purchase ticket is $1,600.

12.4 PRICE DISCRIMINATION

A ticket with no restrictions costs $1,800.

Global sells 2,000 units at each of its four new fares.

Economic profit increases by $2.4 million to $7.2 million a year, shown by the original blue rectangle plus the blue steps. Consumer surplus shrinks to the sum of the green triangles.

12.4 PRICE DISCRIMINATION

Perfect Price Discrimination

Perfect price discrimination extracts the entire
consumer surplus by charging the highest price that consumers are willing to pay for each unit.

12.4 PRICE DISCRIMINATION

Figure 12.10 illustrates perfect price discrimination. With perfect price discrimination, the demand curve becomes the marginal revenue curve. 1. Output increases to 11,000 trips a year, and ... 2. Globals economic profit increases to $9.35 million a year.

12.5 MONOPOLY REGULATION

Efficient Regulation (First Best) of Natural Monopoly

Regulation achieves an efficient allocation of resources if MC=MB(and price). Called first best method because it is most efficient, but causes monopoly firm to earn negative economic profits (losses).

Marginal cost pricing rule - sets P=MC to achieve

an efficient output.

12.5 MONOPOLY REGULATION

1. Price is set equal to marginal cost of $10 a month. 2. At this price, the efficient quantity (8 million households) is served. 3. Consumer surplus, the green triangle, is maximized. 4. The firm incurs a loss on each household served, shown by the red arrow.

12.5 MONOPOLY REGULATION

Inefficient Regulation (Second-Best) of a Natural Monopoly
Two possible ways of enabling a regulated monopoly to avoid an economic loss are Average cost pricing Government subsidy

12.5 MONOPOLY REGULATION

Average Cost Pricing

Average cost pricing rule - sets P = ATC, so firms

earn zero economic profit. Government Subsidy A government subsidy is a direct payment to the firm to offset economic losses. The government must raise the subsidy by taxing some other activity, which will create a deadweight loss.

12.5 MONOPOLY REGULATION

Average Cost Pricing The efficient quantity is 8 million households.
1. Price is set equal to average total cost of $15 a month. 2. At this price, the quantity served (6 million households) is less than the efficient quantity. 3. Consumer surplus shrinks to the smaller green triangle.

12.5 MONOPOLY REGULATION

4. A producer surplus enables the firm to pay its fixed cost and break even. 5. A deadweight loss, shown by the gray triangle, arises.