2 Overview Sources of Monopoly Power Monopoly pricing Thumb rule for pricingMulti-plant firmThe Social Costs of Monopoly PowerPrice regulation and Natural monopoly2
3 Features of Monopoly 2) One product (no good substitutes) 1) One seller - many buyers2) One product (no good substitutes)3) Barriers to entry4) The monopolist is the supply-side of the market and has complete control over the amount offered for sale.Profits will be maximized at the level of output where marginal revenue equals marginal cost.3
4 Profit Maximization by a Monopolist 1. Why is MR differentfrom & below AR?$/Q40MCACARMRProfit2. Why is MR half-wayin-between AR & verticalaxis?3020153. Why will a monopolistalways operate on theelastic range (|e|>1) range?105101520Quantity
7 A Rule of Thumb for Pricing = the markup over MC as a percentage of price (P-MC)/PTHUMB RULE:The markup should equal theinverse of the elasticity of demand.3
8 Monopoly Power The Rule of Thumb for Pricing Pricing for any firm with monopoly powerIf Ed is large, markup is smallIf Ed is small, markup is large
9 Monopoly Power Monopoly is rare. However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost.Measuring Monopoly PowerIn perfect competition: P = MR = MCMonopoly power: P > MC
10 Elasticity of Demand and Price Markup $/Q$/QMCQ*P*P*-MCThe more elastic isdemand, the less themarkup.ARMRQuantityQuantity
12 Markup Pricing: Supermarkets to Designer Jeans Convenience StoresConvenience stores have more monopoly power.
13 Sources of Monopoly Power A firm’s monopoly power is determined by the firm’s elasticity of demand.The firm’s elasticity of demand is determined by:1) Elasticity of market demand2) Number of firms3) The nature of interaction among firms
14 Effect of Excise Tax on Monopolist ExampleSuppose: Ed = -2, How much would the price change?Should themonopolist thenlobby for moretaxes?
15 The Multi-plant FirmFor many firms, production takes place in two or more different plants whose operating cost can differ.Choosing total output and the output for each plant:The marginal cost in each plant should be equal.The marginal cost should equal the marginal revenue for each plant.3
16 Production with Two Plants $/QMC1MC2MCTMR*Q1Q2Q3P*D = ARMRQuantity
17 The Social Costs of Monopoly Power Monopoly power results in higher prices and lower quantities.Does monopoly power make consumers and producers in the aggregate better or worse off?
18 Deadweight Loss from Monopoly Power BALost Consumer SurplusDeadweightLossBecause of the higherprice, consumers loseA+B and producergains A-C.C$/QARMRMCPmQmQCPCQuantity
19 The Social Costs of Monopoly Power Rent SeekingFirms may spend to gain monopoly power through:LobbyingAdvertisingBuilding excess capacity
20 The Social Costs of Monopoly Power Price RegulationRecall that in competitive markets, price regulation created a deadweight loss.Question:What about a monopoly?
21 Price Regulation MR MC AC AR P3 Q3 Q’3 $/Q Pm Qm P2 = PC Qc P4 If left alone, a monopolistproduces Qm and charges Pm.P3Q3Q’3If price is lowered to P3 outputdecreases and a shortage exists.$/QMCPmQmACIf price is lowered to PC outputincreases to its maximum QC andthere is no deadweight loss.P2 = PCQcAny price below P4 resultsin the firm incurring a loss.P4Quantity
22 The Social Costs of Monopoly Power Natural MonopolyA firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms.
23 Regulating the Price of a Natural Monopoly PmQmUnregulated, the monopolistwould produce Qm andcharge Pm.$/QARMRPCQCIf the price were regulate to be PC,the firm would lose moneyand go out of business.MCACSetting the price at Pryields the largest possibleoutput; profit is zero.QrPrQuantity
24 Regulation in Practice It is very difficult to estimate the firm's cost and demand functions because they change with evolving market conditionsAn alternative pricing technique---rate-of-return regulation allows the firms to set a maximum price based on the expected rate or return that the firm will earn.P = AVC + (D + T + sK)/Q, whereP = price, AVC = average variable costD = depreciation, T = taxess = allowed rate of return, K = firm’s capital stock