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ECON 2001 Microeconomics II 2014 2 nd semester Elliott Fan Economics, NTU Lecture 2 Microeconomics, 2014-2 Elliott Fan Monopoly.

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Presentation on theme: "ECON 2001 Microeconomics II 2014 2 nd semester Elliott Fan Economics, NTU Lecture 2 Microeconomics, 2014-2 Elliott Fan Monopoly."— Presentation transcript:

1 ECON 2001 Microeconomics II nd semester Elliott Fan Economics, NTU Lecture 2 Microeconomics, Elliott Fan Monopoly

2 Elliott Fan: Micro Lecture 22

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4 Introduction Interpretation of monopoly definition Monopoly or market power – Downward sloping demand curve Price setting and quantity – Welfare consequences Sources of monopoly power Profitable pricing strategies Slide 4

5 Elliott Fan: Micro Lecture 2 Competition recap Slide 5

6 Elliott Fan: Micro Lecture 2 Introduction Brotherhood for the Respect, Elevation, and Advancement of Dishwashers Impact of achieving goal – SR life better for dishwashers – LR wages of dishwashers decrease by full amount of tips Slide 6

7 Elliott Fan: Micro Lecture 2 Introduction Why wages bid down by full amount of tips Who benefits from tipping Tools for analyzing competitive industry Slide 7

8 THE COMPETITIVE FIRM Section 7.1 8

9 Elliott Fan: Micro Lecture 2 Competitive Firm Firm sells any quantity wants at going market price – Classic example farm Small part of market served by each firm – Horizontal demand curve Products are interchangeable Buyers can easily buy from another producer Slide 9

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11 Elliott Fan: Micro Lecture 2 Revenue TR = P X Q MR P MR curve is flat – Coincides with demand curve Slide 11

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13 Elliott Fan: Micro Lecture 2 Firms Supply Decision Produce good until MR = MC Competitive firm produces a quantity where P = MC – Note: P MR Supply curve – MC and supply are inverse functions – Supply curve looks like upward sloping portion of MC curve as long as MC curve upward sloping – SR and LR supply curves exist for the firm Slide 13

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16 Elliott Fan: Micro Lecture 2 Shutdowns and Exits Does the producer want to produce the good? Two distinctions – Shutdown: firm stops producing the good but still pays fixed costs – Exit: firm leaves the industry entirely and no longer faces any costs Firms, in SR, can shutdown but not exit – Remains operational if P > AVC In LR, can exit Slide 16

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18 Elliott Fan: Micro Lecture 2 Short-Run Supply Curve Firms SR supply curve identical to part of SRMC curve that lies above AVC curve – Shutdown otherwise – Upward sloping due to AC and MC U-shape Diminishing marginal returns to variable factors of production Elasticity of supply – Percent change in quantity supplied resulting from a 1% change in price Slide 18

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20 THE COMPETITIVE INDUSTRY IN THE SHORT RUN Section

21 Elliott Fan: Micro Lecture 2 Competitive Industry in the SR All firms in industry competitive SR is period of time in which no firm can enter or exit the industry Number of firms cannot change LR is period of time in which any firm can enter or leave the industry Industrys SR supply curve – Sum of SR individual firm supply curves – More elastic than individual supply curves Slide 21

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23 Elliott Fan: Micro Lecture 2 Supply, Demand, and Equilibrium Each firm operates where supply meets demand Industry equilibrium consequence of optimizing behavior on part of individuals and firms – Intersecting industry wide supply and industry wide demand Slide 23

24 Elliott Fan: Micro Lecture 2 Competitive Equilibrium Firms produces where supply (or MC) curve crosses horizontal line at market going price Increase in FC – Price and quantity remain unchanged Increase in VC – Raises firms MC curve – Causes some firms to shutdown – Higher market equilibrium price – Firms output could go up or down Increase in industry demand – Higher market equilibrium price – Increase in firms output Slide 24

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26 Elliott Fan: Micro Lecture 2 Change in Fixed Cost Increase in FC – Price and quantity remain unchanged Slide 26

27 Elliott Fan: Micro Lecture 2 Change in Variable Cost Increase in VC – Raises firms MC curve – Causes some firms to shutdown – Higher market equilibrium price – Firms output could go up or down Slide 27

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29 Elliott Fan: Micro Lecture 2 Change in Industry Demand Increase in industry demand – Higher market equilibrium price – Increase in firms output Slide 29

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31 Elliott Fan: Micro Lecture 2 Industrys Costs Sum of total cost of all individual firms To minimize cost of all firms, use equimarginal principle – Insure that MC same for all producers in industry – Automatic because all firms have same price Slide 31

32 THE COMPETITIVE FIRM IN THE LONG RUN Section

33 Elliott Fan: Micro Lecture 2 Competitive Firm in the LR Some fixed cost in SR become variable cost in the LR Firms can enter and exit in the LR Slide 33

34 Elliott Fan: Micro Lecture 2 Profit and the Exit Decision Profit = TR – TC – Costs includes all foregone opportunities SR versus LR supply response – Firm LR supply curve more elastic than SR supply curve Shuts down if price of output falls below average variable cost Exits if price of output falls below average cost Slide 34

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36 Elliott Fan: Micro Lecture 2 LRMC and Supply Firms operate where P = LRMC – Remain in industry, LR supply curve identical to LRMC curve Exit decision is made at the point P=AC (note that there is no more fixed cost in the LR) Slide 36

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38 THE COMPETITIVE INDUSTRY IN THE LONG RUN Section

39 Elliott Fan: Micro Lecture 2 Competitive Industry in the LR Firms wishing to enter or exit the market do so in the LR, flatting out the LR supply curve So unlike the case in the SR, the LR supply curve is a horizontal line. Important assumption: all firms are identical in costs Break-even price plays an important role here (1) all firms produce at the break-even price; (2) it determines the level of LR supply curve Slide 39

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41 Elliott Fan: Micro Lecture 2 Zero Profit Condition Economic versus accounting profit – Accounting profit refers to total revenue minus total financial cost – Economic profit refers to accounting profit minus the value of the best foregone opportunity Slide 41

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43 Elliott Fan: Micro Lecture 2 Industrys LR Supply Curve All firms identical – Industry supply curve flat at the break-even price Break-even price and the LR supply – Break-even price (P = AC) at which a seller earns zero profit – LR supply curve identical with part of firms LRMC curve lying above LRAC curve Slide 43

44 Elliott Fan: Micro Lecture 2 Flat LR Supply Curve Flatness based on entry and exit P < AC, all firms exit P > AC, unlimited number of firms enter LR zero profit equilibrium almost never reached – Demand and cost curves shift so often that entry and exit never settles down – Approximation to the truth Slide 44

45 Elliott Fan: Micro Lecture 2 Equilibrium LR same as SR between firm and industry – Market price determined by intersection of industrywide demand and supply – Firms face flat demand curves at market price Analysis of changes to equilibrium – Changes in FC – Changes in VC – Changes in demand Slide 45

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49 Elliott Fan: Micro Lecture 2 Application: Government as a Supplier In SR, government policy to build and operate apartment complex increasing housing In LR, supply curve does not shift – Determined by break-even price – Number of privately owned apartments withdrawn from the market equals number of apartments built by government Slide 49

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51 Elliott Fan: Micro Lecture 2 Relaxing the Assumptions Assumption 1: All firms are identical, have identical cost curves – True in industries that do not require unusual skills Assumption 2: Cost curves do not change as industry expands or contracts – True in industries not large enough to affect input prices Without these assumptions, all firms do not have the same break-even price Slide 51

52 Elliott Fan: Micro Lecture 2 Constant Cost Constant cost industry – Satisfies the 2 assumptions Slide 52

53 Elliott Fan: Micro Lecture 2 Increasing Cost Increasing cost industry – Break-even price for new entrants increases as industry expands – Assumption 1 violated: Less-efficient firms – Assumption 2 violated: Factor-price effect – LR industry supply curve slopes upward Slide 53

54 Elliott Fan: Micro Lecture 2Slide 54

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56 Elliott Fan: Micro Lecture 2 Decreasing Cost Decreasing cost industry – Break-even price for new entrants decreases as industry expands – LR industry supply curve slopes downward Slide 56

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58 Elliott Fan: Micro Lecture 2 Applications A tax on motel rooms Tipping the busboy Slide 58

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61 Elliott Fan: Micro Lecture 2 Using the Competitive Model Fundamentals of competitive analysis – Industry versus firm demand and supply – SR versus LR – Entry and exit decisions Slide 61

62 PRICE AND OUTPUT UNDER MONOPOLY 62

63 Elliott Fan: Micro Lecture 2 Price Pricing operates where MR = MC MR curves lies everywhere below demand curve Slide 63

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65 Elliott Fan: Micro Lecture 2 Output Lower price to increase output Monopolist operates on elastic portion of demand curve – Ex. Prices of gasoline, oranges, and music CDs No supply curve – No going market price Slide 65

66 Elliott Fan: Micro Lecture 2 Measuring Monopoly Power Slide 66

67 Elliott Fan: Micro Lecture 2 Welfare Assumption about same industry wide MC curve for competitive and monopolistic industries Social welfare loss under monopoly – Marginal value exceeds marginal cost – Monopolist could produce additional good Slide 67

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69 Elliott Fan: Micro Lecture 2 Subsidies and Public Policy Subsidies for monopolist – Induce monopolist to provide competitive quantity Arises from ideal subsidy Could encourage inefficient production Creates price ceilings Follows rate-of-return regulation Slide 69

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73 Elliott Fan: Micro Lecture 2 Sources of Monopoly Power Natural monopoly – Industry where AC curve decreasing at point where crosses market demand – Industry survive only if monopolized Slide 73

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75 Elliott Fan: Micro Lecture 2 Sources, cont. Welfare economics – Monopoly outcome best for some Imperfect competition – Downward pressure on prices – Innovation Slide 75

76 Elliott Fan: Micro Lecture 2 Other Sources of Monopoly Power Patents – Ex. photography Resource monopolies – Single firm controls productive input Legal barriers to entry Slide 76

77 Elliott Fan: Micro Lecture 2 Monopoly, market, and government This video explains why the concept of monopolies are incompatible with the free market, and actually the result of non-market (government) forces.video 77

78 Elliott Fan: Micro Lecture 2 Price Discrimination Charging different prices for identical items Ability to prevent resell of low-price units Slide 78

79 Elliott Fan: Micro Lecture 2 First Degree First-degree – Charging each customer most willing to pay – Welfare gains Slide 79

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81 Elliott Fan: Micro Lecture 2 Third-Degree Charging different prices in different markets – Groups of consumers identifiable – Different downward sloping demand curve – Producer profit – Production of goods where MR same in both markets and equal to MC – More elastic demand group receives lower price Slide 81

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84 Elliott Fan: Micro Lecture 2 Third-degree: the most common form of price discrimination (student discounts, senior citizens discounts). Suppose there are two groups of people and there is no resale. Then the monopolists profit maximization problem becomes max y 1, y 2 (=p 1 (y 1 )y 1 + p 2 (y 2 )y 2 -c(y 1 +y 2 )). Hence FOC becomes MR 1 (y 1 )=MC(y 1 +y 2 )=MR 2 (y 2 ). Slide 84

85 Elliott Fan: Micro Lecture 2 Since MR 1 (y 1 )=p 1 (y 1 )[1-1/| 1 |] and MR 2 (y 2 )=p 2 (y 2 )[1-1/| 2 |], hence p 1 >p 2 if and only if | 1 |<| 2 |. The market with lower absolute value of elasticity has a higher price. Quite sensible since elasticity measures how sensitive the group is to price changes. There are some other often-observed practices used by firms with monopoly power. Slide 85

86 Elliott Fan: Micro Lecture 2 Second-degree: also known as non- linear pricing since the price per unit of output is not constant, but depends on how much you buy. The monopolist can offer different price-quantity packages so that the consumers can self select. Note that the low-end consumers package is distorted so that the high- end consumer will not choose the low- end package. Slide 86

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88 Elliott Fan: Micro Lecture 2 Compared to perfect price discrimination, without high-end, low-end is offered higher quantity but still ends up with zero surplus. Without low-end, high end gets zero surplus, now gets positive surplus and the quantity offered is the same. Applying this to air travels, by offering a downgraded product, the airlines can charge the consumers who need flexible travel arrangements more for their tickets. Slide 88

89 Elliott Fan: Micro Lecture 2 Many many examples of PD Coupons, rebates, free delivery, coffee lids…… The spirit of PD – to offer lower prices to customers who are more sensitive to price. There is no point to offer coupons if everyone redeemed them, and there is no point to coupons if only a random set of customers redeemed them. Note: almost everything that appears to be price discrimination admits at least one alternative explanation. For example, coupon clippers temp to go shopping when the shop is not crowded. Slide 89

90 Elliott Fan: Micro Lecture 2 Pricing strategies by monopolist: versioning Versioning is a practice of offering an inferior product to charge differently for different customers. For example, hardcopy and paperback of the same book. Another example is the same printers designed to print slower deliberately. Strictly speaking, versioning should not be considered as a form of PD in some cases as products involved are different. Slide 90

91 Elliott Fan: Micro Lecture 2 Pricing strategies by monopolist: Two-Part Tariff First part Entry fee allows purchase of goods or services – Meaning of tariff Slide 91

92 Elliott Fan: Micro Lecture 2 Pricing strategies by monopolist: Two-Part Tariff Second part Customers are charged maximum willing to pay – Charge competitive price as long as no difference in consumers – Charge low initial fee and high usage fee Slide 92

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94 Elliott Fan: Micro Lecture 2 Pricing strategies by monopolist: Two-Part Tariff By implementing the two-part tariff, a monopoly firm can produces at the competitive market level, enhancing the efficiency. Examples – Clubs that charge a member fee and an usage fee – Health insurance – copayment increases efficiency. Slide 94

95 Elliott Fan: Micro Lecture 2 packages of related goods are often offered for sale together: software suite (word processor, spreadsheet, presentation tool), cosmetic products, etc. Bundling may be cost saving or it may be due to complementarities among the goods involved. But there can be reasons involving consumer behavior. Consider the following example. Assume the marginal cost of producing is zero. Pricing strategies by monopolist: Bundling Slide 95

96 Elliott Fan: Micro Lecture 2 Type of consumers word pro spreadsheet A B Suppose the willingness to pay for the bundle is the sum. If each item is sold separately, then revenue will be 400. If instead bundling two goods together, can get the revenue of 440. In other words, the dispersion of willingness to pay may be reduced. Slide 96


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