1. Chapter Monopoly 15

2. In economic terms, why are monopolies bad? Explain. 2

3. Draw Me Some Graphs 1.A perfectly competitive firm at long run equilibrium 2.A perfectly competitive firm operating at a loss, shade me the loss 3.A monopoly: label the profit maximizing quantity, price, the socially optimal quantity, and shade the box of economic profit.

4. Key Questions for Chapter 15 What is a monopoly? Why do monopolies arise? How is a monopoly’s profit maximizing different than a competitive firm’s? What is the Deadweight loss of a monopoly? What is price discrimination? How does the government deal with monopolies? 4

5. Why Monopolies Arise Monopoly – Firm that is the sole seller of a product without close substitutes – Price maker – Barriers to entry Monopoly resources Government regulation The production process 5

6. Key Questions for Monopoly Decisions What are the 3 ways a monopoly arises? How does a monopoly differ from a competitive firm in a market? How does a monopoly maximize its profit? 6

7. Why Monopolies Arise Monopoly resources – A key resource required for production is owned by a single firm – Higher price Government regulation – Government gives a single firm the exclusive right to produce some good or service – Government-created monopolies Patent and copyright laws Higher prices; Higher profits 7

8. Why Monopolies Arise The production process – A single firm can produce output at a lower cost than can a larger number of producers Natural monopoly – Arises because a single firm can supply a good or service to an entire market At a smaller cost than could two or more firms – Economies of scale over the relevant range of output 8

9. Figure Economies of scale as a cause of monopoly 1 9 Costs When a firm’s average-total-cost curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the smallest cost Quantity of output0 Average total cost

10. How Monopolies Make Production& Pricing Decisions Monopoly versus competition – Monopoly Price maker Sole producer Downward sloping demand – Market demand curve – Competitive firm Price taker One producer of many Demand – horizontal line (Price) 10

11. Figure Demand curves for competitive and monopoly firms 2 11 Price Because competitive firms are price takers, they in effect face horizontal demand curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it faces the downward- sloping market demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it wants to sell more output. Quantity of output0 (a) A Competitive Firm’s Demand Curve Price Quantity of output 0 (b) A Monopolist’s Demand Curve Demand

12. How Monopolies Make Production& Pricing Decisions A monopoly’s revenue – Total revenue = price times quantity – Average revenue Revenue per unit sold – Total revenue divided by quantity – Marginal revenue Revenue per each additional unit of output – Change in total revenue when output increases by 1 unit Can be negative Always: MR < P 12

13. Table A monopoly’s total, average, and marginal revenue 1 13 Quantity of water (Q) Price (P) Total revenue (TR=P ˣ Q) Average revenue (AR=TR/Q) Marginal revenue (MR= Δ TR/ Δ Q) 0 gallons 1 2 3 4 5 6 7 8 $11 10 9 8 7 6 5 4 3 $0 10 18 24 28 30 28 24 - $10 9 8 7 6 5 4 3 $10 8 6 4 2 0 -2 -4

14. How Monopolies Make Production& Pricing Decisions Increase in quantity sold – Output effect Q is higher Increase total revenue – Price effect P is lower Decrease total revenue Because MR < P – MR curve – is below the demand curve 14

15. Figure Price 2 1 -2 -3 5 4 3 6 7 8 9 10 $11 -4 Demand and marginal-revenue curves for a monopoly 3 15 The demand curve shows how the quantity affects the price of the good. The marginal-revenue curve shows how the firm’s revenue changes when the quantity increases by 1 unit. Because the price on all units sold must fall if the monopoly increases production, marginal revenue is always less than the price. Quantity of water 0 12345678 Demand (average revenue) Marginal revenue

16. How Monopolies Make Production& Pricing Decisions Profit maximization – If MR > MC – increase production – If MC > MR – produce less – Maximize profit Produce quantity where MR=MC Intersection of the marginal-revenue curve and the marginal-cost curve 16

17. Figure Profit maximization for a monopoly 4 17 Costs and Revenue A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B). Quantity0 Average total cost Demand Marginal revenue Marginal cost Q MAX B Monopoly price A 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity... 2.... and then the demand curve shows the price consistent with this quantity. Q1Q1 Q2Q2

18. How Monopolies Make Production& Pricing Decisions Profit maximization – Perfect competition: P=MR=MC Price equals marginal cost – Monopoly: P>MR=MC Price exceeds marginal cost A monopoly’s profit – Profit = TR – TC = (P – ATC) ˣ Q 18

19. Figure The monopolist’s profit 5 19 Costs and Revenue The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the number of units sold. Quantity0 Demand Average total cost B E D Marginal revenue Q MAX Average total cost Marginal cost Monopoly price C Monopoly profit

20. Market for pharmaceutical drugs – New drug, patent laws – monopoly Produce Q where MR=MC P>MC – Generic drugs – competitive market Produce Q where MR=MC And P=MC Price (competitively produced generic drug) – Below the price(monopolist) Monopoly drugs versus generic drugs 20

21. Figure The market for drugs 6 21 Costs and Revenue When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug. When the patent on a drug runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost. Quantity 0 Demand Marginal revenue Monopoly quantity Price during patent life Marginal cost Price after patent expires Competitive quantity

22. Key Questions for Monopoly Decisions Review What are the 3 ways a monopoly arises? How does a monopoly differ from a competitive firm in a market? How does a monopoly maximize its profit? 22

23. Key Questions for Monopoly Welfare How does a monopoly affect welfare? What is the Deadweight Loss of a monopoly? What is the social cost of a monopoly? 23

24. The Welfare Cost of Monopolies Total surplus – Economic well-being of buyers & sellers in a market – Sum of consumer surplus & producer surplus Consumer surplus – Consumers’ willingness to pay for a good – Minus the amount they actually pay for it Producer surplus – Amount producers receive for a good – Minus their costs of producing it 24

25. The Welfare Cost of Monopolies The deadweight loss Benevolent planner – maximize total surplus – Produce quantity where Marginal cost curve intersects demand curve – Charge P=MC 25

26. Figure The efficient level of output 7 26 Costs and Revenue A benevolent social planner who wanted to maximize total surplus in the market would choose the level of output where the demand curve and marginal-cost curve intersect. Below this level, the value of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good. Above this level, the value to the marginal buyer is less than marginal cost. Quantity0 Demand (value to buyers) Efficient quantity Marginal cost Value to buyers Value to buyers Cost to monopolist Cost to monopolist Value to buyers is greater than cost to sellers Value to buyers is less than cost to sellers

27. The Welfare Cost of Monopolies The deadweight loss Monopoly – Produce quantity where MC = MR – Produces less than the socially efficient quantity of output – Charge P>MC – Deadweight loss Triangle between: demand curve and MC curve 27

28. Figure The inefficiency of monopoly 8 28 Costs and Revenue Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer). Quantity0 Demand Marginal revenue Monopoly quantity Marginal cost Monopoly price Efficient quantity Deadweight loss

29. The Welfare Cost of Monopolies The monopoly’s profit: a social cost? Monopoly – Higher profit – Not a reduction of economic welfare Bigger producer surplus Smaller consumer surplus Monopoly profit – Not a social problem 29

30. Key Questions for Monopoly Welfare Review How does a monopoly affect welfare? What is the Deadweight Loss of a monopoly? What is the social cost of a monopoly? 30

31. Key Questions for Price Discrimination What is price discrimination? What 3 lessons can we learn about price discrimination? Can price discrimination raise welfare? 31

32. Price Discrimination Price discrimination – Business practice – Sell the same good at different prices to different customers – Increase profit 32

33. Price Discrimination Lessons from price discrimination 1.Rational strategy Increase profit Charges each customer a price closer to his or her willingness to pay Sell more than is possible with a single price 33

34. Price Discrimination Lessons from price discrimination 2.Requires the ability to separate customers according to their willingness to pay Certain market forces can prevent firms from price discriminating – Arbitrage – buy a good in one market, sell it in other market at a higher price 3. Can raise economic welfare Can eliminate the inefficiency of monopoly pricing – More consumers get the good – Higher producer surplus (higher profit) 34

35. Price Discrimination The analytics of price discrimination Perfect price discrimination Charge each customer a different price – Exactly his or her willingness to pay Monopolist - gets the entire surplus (Profit) No deadweight loss Without price discrimination Single price > MC Consumer surplus Producer surplus (Profit) Deadweight loss 35

36. Figure Welfare with and without price discrimination 9 36 Price Panel (a) shows a monopolist that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus. Quantity0 (a) Monopolist with Single Price Price Quantity 0 (b) Monopolist with Perfect Price Discrimination Profit Consumer surplus Deadweight loss Monopoly price Quantity sold Marginal revenue Demand Marginal cost Quantity sold Profit Demand Marginal cost

37. Price Discrimination Examples of price discrimination – Movie tickets – Airline prices – Discount coupons – Financial aid – Quantity discounts 37

38. Key Questions for Public Policy How can policymakers deal with monopolies? What are Anti-Trust Laws? What are some options for regulating monopolies? 38

39. Public Policy Toward Monopolies Increasing competition with antitrust laws – Sherman Antitrust Act, 1890 Reduce the market power of trusts – Clayton Antitrust Act, 1914 Strengthened government’s powers Authorized private lawsuits – Prevent mergers – Break up companies – Prevent companies from coordinating their activities to make markets less competitive 39

40. Public Policy Toward Monopolies Regulation – Regulate the behavior of monopolists Price – Common in case of natural monopolies – Marginal-cost pricing May be less than ATC No incentive to reduce costs 40

41. Figure Marginal-cost pricing for a natural monopoly 10 41 Price Because a natural monopoly has declining average total cost, marginal cost is less than average total cost. Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost, price will be below average total cost, and the monopoly will lose money. Quantity0 Average total cost Loss Average total cost Demand Marginal cost Regulated price

42. Public Policy Toward Monopolies Public ownership – How the ownership of the firm affects the costs of production – Private owners Incentive to minimize costs – Public owners (government) If it does a bad job – Losers are the customers and taxpayers 42

43. Table Competition versus monopoly: A summary comparison 2 43 CompetitionMonopoly Similarities Goal of firms Rule for maximizing Can earn economic profits in short run? Differences Number of firms Marginal revenue Price Produces welfare-maximizing level of output? Entry in long run? Can earn economic profits in long run? Price discrimination possible? Maximize profits MR=MC Yes Many MR=P P=MC Yes No Maximize profits MR=MC Yes One MR<P P>MC No Yes

44. Key Questions for Public Policy Review How can policymakers deal with monopolies? What are Anti-Trust Laws? What are some options for regulating monopolies? 44

45. Key Questions for Chapter 15 Review What is a monopoly? Why do monopolies arise? How is a monopoly’s profit maximizing different than a competitive firm’s? What is the welfare impact of a monopoly? What is price discrimination? How does the government deal with monopolies? 45