2. Pure Monopoly Look for: 1.Determination of the profit maximizing price and quantity. 2.Implications for efficiency 3.What should the government do? Study monopoly as a Market Structure To Better Understand monopolistic competition and oligopoly Consist of elements of pure competition and pure monopoly Please listen to the audio as you work through the slides.

3. Learning objectives Students should be able to thoroughly and completely explain: 1.The characteristics of pure monopoly 2.The various barriers to entry that can be exploited by the monopolist. 3.In what region of the demand curve is the monopolist most likely to set price and why. 4.How the monopolist determines the profit maximizing level of output and price. 5.Price Discrimination and discuss the likely outcomes. 6.The dilemma of regulation

4. Summary of topics Characteristics of Pure Monopoly Sources of monopoly power – Barriers to entry Model of monopoly demand – Analyze price and output decisions Output and price determination – At what price – quantity pair will a profit maximizing monopolist choose to operate? Cost considerations Economic effects of pure monopoly – Efficiency issues Price Discrimination Regulated Monopoly issues

5. Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Pure Monopoly : Characteristics Single Seller (seller = industry) No Close Substitutes for the product sold Price Maker – controls total quantity supplied and therefore price Faces downward sloping demand curve To increase sales, must lower price

6. Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Four Market Models Pure Monopoly: Characteristics Entry blocked by monopolist Blocking tools: Economic, technological, legal, etc. Pure Monopoly firm sells: Standardized product – natural gas, PR advertising

7. Monopoly Examples Regulated Monopoly local electric utility, cable TV Check Texas PUC Unregulated or near Monopoly Branack Device Company – 80% Market Luxottica – eyewear multinational (Italy) - 80% global market share Intel 90% market share – R&D

8. Barriers to Entry Economies of Scale – declining ATC with increasing firm size - often due to technology, Intel http://dividendmonk.com/7-companies-with-unrivaled-economies-of-scale/ The Natural Monopoly Case – market demand curve cuts the LR ATC curve where ATC are still declining “When long run ATC is declining, only a single producer can produce any particular output at minimum LR ATC.” Key Points: 1. Low unit cost does not equal low price charged 2. P > ATC leads to economic profit increase, and possible regulation – we will see this later

9. Average Total Cost Quantity $20 15 10 050100200 ATC If ATC declines over extended output range, least-cost production is realized only if there is one producer - a natural monopoly. The Natural Monopoly Case D

10. Barriers to Entry Legal Barriers to Entry (government created) Patents – pharmaceutical industry, R&D Licenses – FCC radio & TV stations, cable TV Ownership or Control of Essential Resources – At one time, International Nickel of Canada controlled 90% of world’s nickel. At local level – single Cement company may control access to sand and gravel in the area.

11. Barriers to Entry Pricing and Other Strategic Barriers to Entry: In anticipation of a potential competitor: Temporarily cut prices, or Increase advertising,

12. Barriers to Entry These guys went too far! 2001 Microsoft – 95% market share, threatened by Netscape, made IE free bundled with OS, restrict resellers of product, preserve long run near monopoly position 2005 Dentsply – maker of false teeth (70% market share) - charging higher prices to distributors that sold a competitors product

13. Agenda 1.Monopoly Demand 2.Output and price determination 3.Implications for efficiency 4.Assessment of government policy options 5.Cost considerations 6.Price Discrimination 7.Government approaches to regulating the monopoly

14. Monopoly Demand 3 Basic Assumptions: 1.Monopoly Status is Secured by: patents, economies of scale, resource ownership. 2.No Governmental Regulation 3.Firm Charges the Same Price for all Units Sold The crucial difference between a pure monopolist and a purely competitive seller – demand is elastic versus perfectly elastic!!!!

15. 3 implications of the monopolist’s downward sloping demand curve: 1.Marginal revenue is less than price. 2.The monopolist is a price maker 3.The monopolist sets prices in the elastic region of the demand curve Monopoly demand

16. The monopolist’s downward sloping demand curve means it can increase sales only by charging a lower price. Consequently marginal revenue is less than price for every level of output except the first. MR < P Marginal revenue is less than price.

17. Monopoly Demand The monopolist is a price maker 1.Firms facing downward sloping demand curves can influence total supply through their own output decisions. 2.The monopolist firm controls output. 3.Each level of output is related to a unique price. 4.Control output, control price

18. Monopoly Demand The monopolist sets prices in the elastic region of the demand curve. When demand is elastic, a decline in price will increase total revenue. When demand is inelastic, a decline in price will reduce total revenue. In the inelastic region: Monopolist must lower price to increase output. Lower price means less total revenue. Increased output means increased total cost Less total revenue and increased total cost means less profit. The monopolist will never choose a price-quantity pair in the inelastic part of the demand curve where total revenue could be reduced.

19. Monopoly Revenues and Costs Dollars $200 150 200 50 $750 500 250 MR Elastic 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 D Q TR Q

20. Monopoly Revenues and Costs Q Total Revenue In Dollars Price in Dollars $200 150 200 50 $750 500 250 TR MR D InelasticElastic 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Q

21. Output and Price Determination for the Pure Monopolist At what price quantity combination will monopolist operate? MR = MC Rule – applies to the monopolist

22. Output and Price Determination Add production Cost to the analysis: monopolist buys resources in purely competitive market No Monopoly Supply Curve – no unique relationship between price and Quantity supplied. The monopolist does not equate MC to price, therefore it is possible for different demand conditions to bring about different prices for the same output. Monopoly Pricing Misconceptions it’s maximum total profit, Not Highest Price Total, Not Unit Profit Possibility of Losses – monopolists also can minimize losses.

23. Profit Maximization Under Monopoly D MC ATC MR ATC=$94 P=$122 Profit MR = MC Profit Per Unit Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue Remember the MR=MC Rule? Output and Price Determination

24. Profit Maximization Under Monopoly D MC ATC MR $94 $122 Profit MR = MC Profit Per Unit Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue What About Loss Minimization? Due to cost or demand changes Output and Price Determination

25. Loss Minimization Under Monopoly D MC ATC MR ATC Price m Loss MR = MC Loss Per Unit Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue AVC QmQm Since P m exceeds AVC, the firm will produce Output and Price Determination

26. Loss Minimization Under Monopoly D MC ATC MR A PmPm Loss MR = MC Loss Per Unit Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue AVC QmQm V What are the Economic Effects of Monopoly? Output and Price Determination

27. Q Inefficiency of Pure Monopoly P D MR S = MC PcPc PmPm QcQc QmQm At MR=MC A monopolist will sell less units at a higher price than a firm in pure competition An industry in pure competition sells where supply and demand are equal

28. The efficiency issue In pure competition we had P = MC = minimum ATC P = minimum ATC (productive efficiency) P = MC (allocative efficiency) Monopoly yields neither productive efficiency nor allocative efficiency Monopoly price exceeds minimum ATC Monopoly price exceeds MC 1.The monopolist’s profit maximizing output results in an under allocation of resources. 2.Output is less than that found in the purely competitive model. Not productively efficient - P  Minimum ATC Not allocatively efficient - Price  MC

29. Profit Maximization Under Monopoly D MC ATC MR ATC=$94 P=$122 Profit MR = MC Profit Per Unit Output and Price Determination Q 200 175 150 125 100 75 50 25 0 1 2 3 4 5 6 7 8 9 10 Price, costs, and revenue Remember the MR=MC Rule?

30. Q Inefficiency of Pure Monopoly P D MR S = MC PcPc PmPm QcQc QmQm At MR=MC A monopolist will sell less units at a higher price than in pure competition Monopoly pricing effectively creates an income transfer from buyers to the seller!

31. Cost Complications Costs may not be the same for purely competitive and monopolistic producers. Reasons for the difference in costs between purely competitive and monopolistic firms. Economies of scale – three factors that contribute 1. Market demand may not be sufficient to support a large number of competing firms each producing at MES. 2. Simultaneous consumption – product’s ability to satisfy a large number of consumers at once. Software, music, etc. ATC decreases as number of customers increase. 3. Network effects – increase in value of a product to each user as the total number of users rises. Buyers tend to purchase the products that everyone else buys. Producers able to expand and achieve economies of scale. Cell phones

32. Cost Complications Costs may not be the same for purely competitive and monopolistic producers. Reasons for the difference: X inefficiency - A firm’s actual cost of producing any output is greater than the lowest possible cost of producing it. managers’ goals conflict with cost minimization. firms becomes lethargic and complacent.

33. Cost Complications Graphic Representation Of X-Inefficiency Average total costs Quantity Average Total Costs X X’ Q1Q1 Q2Q2 ATC x ATC 1 ATC 2 ATC x’ X-Inefficiency Inefficient internal operation leads to higher-than- necessary costs

34. Cost Complications The need for monopoly preserving expenditures Activity designed to transfer income or wealth to a particular firm or resource supplier at someone else’s expense. Monopolist would do anything to maintain a patent, license, or other factor that ensures monopoly position.

35. Cost Complications A pure monopolist will not be technologically progressive! Absence of rivals reduces the motivation to innovate

36. Agenda Price Discrimination Government policy options about Monopolies The regulation dilemma

37. Price Discrimination Under certain conditions the monopolist can increase its profit by charging different prices to different buyers. Forms of Price Discrimination: 1.Charging each customer in a market the maximum price they will pay 2.Charging each customer one price for the first few units and a lower price for subsequent units 3.Charging some customers one price and other customers another price

38. 1.Monopoly Power: Seller must be monopolist, or possess some degree of monopoly power, (some control over price and output) 2.Market Segregation: At relatively low cost to itself, the seller must be able to segregate buyers into distinct classes, each with a different willingness or ability to pay for the product. (different price elasticity of demand) 3.No Resale: The original purchaser cannot resell the product. Some examples: service industries like transportation, legal, medical 3 Price Discrimination Conditions

39. Examples of Price Discrimination Electric utilities (peak and off peak pricing), Movie theaters (time of day pricing) Airlines (buy early or buy late) Golf courses (time of day pricing) Railroads (by type of freight) Discount coupons vs no coupon

40. Outcomes 1.Greater profits and output than a single price monopolist 2.Some consumers pay more and some pay less than the single price case 3.Perfect price discriminating monopolist and pure competition are equally efficient! Price Discrimination

41. Government policy options toward monopoly: Rules of thumb 1.If: Monopoly is achieved / sustained through anticompetitive actions, creates substantial economic inefficiency, or appears to be long lasting. Government would Pursue antitrust action 2. If: It’s a Natural monopoly or there is no emerging competition, Government may regulate prices and operations. 3. If, Monopoly appears to be unsustainable over a long period of time, or competitors might emerge. Leave it alone

42. Natural Monopolies The Dilemma of Regulation: what to do with the Monopoly? Choices 1.Socially Optimum Price P = MC (allocative efficiency) 2.Fair-Return Price P = ATC (productive efficiency) 3.No regulation Monopolist sets price to maximize profits Regulated Monopoly

43. Q D MR MC ATC P Price and Costs Monopoly Price MR = MC QmQm PmPm The unRegulated Monopoly. P>ATC means economic profit Demand curve cuts LR ATC while it is falling. Achieving economies of scale. Only one seller needed. P>MC means under-allocation of resources to the product

44. Regulated Monopoly Q D MR MC ATC P Price and Costs Socially-Optimal Price model P = MC QrQr PrPr Can government cause a better allocation of resources? Set price ceiling to eliminate incentive to restrict output to Q m and therefore maximize profits Price is below ATC and the firm incurs a loss

45. Regulated Monopoly Q D MR MC ATC P Price and Costs Fair-Return Price model Normal Profit Only QfQf PfPf P=ATC

46. Regulated Monopoly Q D MR MC ATC P Price and Costs MR = MC Fair-Return Price Socially-Optimum Price QmQm QfQf QrQr Dilemma of Regulation Which Price to use? PmPm PfPf PrPr

47. pure monopoly barriers to entry simultaneous consumption network effects X-inefficiency rent-seeking behavior Price Discrimination socially optimal price fair-return price