1. 1 1 BA 445 Lesson A.9 Monopolistic Markets ReadingsReadings Baye 6 th edition or 7 th edition, Chapter 8

2. 2 2 BA 445 Lesson A.9 Monopolistic Markets OverviewOverview

3. 3 3Overview Monopolistic Price and Quantity starts with quantity set where marginal cost equals marginal revenue, then price set to the maximum willingness to pay for the last unit. Inefficient Output Inefficient Output is implied when price and willingness to pay is greater than marginal cost. — So, after your market purchases, there is a deal between you and Microsoft that can benefit you both. Monopolistically Competitive Entry and Exit drives profits to zero as in competitive markets. — So, Pizza Hut profits from stuffed-crust pizza eventually vanish, and profits require new variations. Comparing Markets reveals different equilibrium for perfect competition, monopoly, and monopolistic competition — So, Monsanto’s seed monopoly has equilibrium unlike Pizza Hut’s pizza.

4. 4 4 BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

5. 5 5 Overview Monopolistic Output maximizes profit with quantity equating marginal revenue to marginal cost, then price equals the maximum willingness to pay for that quantity. BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

6. 6 6 Monopoly verses Perfect Competition Monopoly verses Perfect Competition differ in the price or quantity interaction between firms:Monopoly verses Perfect Competition differ in the price or quantity interaction between firms: n Perfect competition has other firms producing perfect substitutes. That makes each firm’s demand perfectly elastic, and each firm has to match other firms’ price. n Monopoly has no other firm producing perfect substitutes. That makes each firm’s demand less than perfectly elastic. Demand inelasticity is called monopoly or market power. If no one produces close substitutes to the monopolist, there is more inelasticity and power.Demand inelasticity is called monopoly or market power. If no one produces close substitutes to the monopolist, there is more inelasticity and power. BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

7. 7 7 Monopoly verses Perfect Competition The simplest monopoly model further assumes the price and quantity chosen by the monopolist does not interact with the prices and quantities chosen by other firms.The simplest monopoly model further assumes the price and quantity chosen by the monopolist does not interact with the prices and quantities chosen by other firms. n That is never perfectly accurate since demand for each good is affected by the prices of most other goods, at least through the income effect. For example, the demand for computers is affected by the price of gas.For example, the demand for computers is affected by the price of gas. n We later (Part B) consider more complex and realistic monopoly models where prices and quantity choices interact with other firms, with those firms producing either substitutes (like different kinds of computers) or complements (like computer hardware and software). BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

8. 8 8 Monopoly verses Perfect Competition Monopoly verses Perfect Competition differ in the potential entry of new firms:Monopoly verses Perfect Competition differ in the potential entry of new firms: n Perfect competition has free entry of firms producing perfect substitutes. Any such entry takes the long-run since it takes the long-run to adjust rented or owned capital.Any such entry takes the long-run since it takes the long-run to adjust rented or owned capital. Monopoly has no entry of firms producing perfect substitutes.Monopoly has no entry of firms producing perfect substitutes. The simplest monopoly model further assumes there is no entry of firms whose prices or quantities affect the demand for the monopolist’s product.The simplest monopoly model further assumes there is no entry of firms whose prices or quantities affect the demand for the monopolist’s product. BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

9. 9 9 Natural Source of Monopoly Power The primary natural source of monopoly power is economies of scale, meaning it is cheaper for one firm to produce or supply a single product that it is to divide production or supply between many firms. For example, it is cheaper to have a single grocery in a neighborhood. n When monopoly power comes from being the only supplier in a neighborhood, call it a local monopoly. BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

10. 10 Artificial Sources of Monopoly Power Patents, copyrights, and other legal barriers to enter an industry generate and sustain monopoly power.Patents, copyrights, and other legal barriers to enter an industry generate and sustain monopoly power. n Copyrighted movies are monopolies because there are no perfect substitutes. n Monopoly power is limited by the closeness of substitutes (like pirated copies of Armageddon, or similar movies like Deep Impact) Collusion can generate monopoly power.Collusion can generate monopoly power. n OPEC (Organization of the Petroleum Exporting Countries) would be a monopoly if all exporting countries were included. Its monopoly power is limited by substitutes for gas (like fuel efficient cars)Its monopoly power is limited by substitutes for gas (like fuel efficient cars) BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

11. 11 Review: Monopolist’s Marginal Revenue QQ P TR 100 001020 304050 1020 304050 800 60 1200 40 20 Inelastic Elastic Inelastic Unit elastic MR BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

12. 12 $ Q ATC MC D MR QMQM PMPM Set Monopolistic Quantity by increasing production output until MR(Q M ) = MC(Q M ). Then, charge the price on the demand curve that corresponds to that quantity. BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

13. 13 $ Q ATC MC D MR QMQM PMPM Profit ATC Profit Computation  = (P-ATC) x Q (from before) BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

14. 14 Marginal Revenue Formulae What is MR if a firm faces a linear demand curve for its product? What is MR if a firm faces a general demand curve (with elasticity E)? BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

15. 15 Marginal Revenue Formulae and Monopoly Power MR = P(1+1/E) means, if demand is more elastic (E more negative), then MR is higher, so MC(Q) = MR(Q) is higher, so Q is higher, so P is lower.MR = P(1+1/E) means, if demand is more elastic (E more negative), then MR is higher, so MC(Q) = MR(Q) is higher, so Q is higher, so P is lower. Likewise, demand less elastic implies Q is lower and P is higher.Likewise, demand less elastic implies Q is lower and P is higher. Lower demand elasticity (fewer substitutes) thus means more monopoly power.Lower demand elasticity (fewer substitutes) thus means more monopoly power. n Product differentiation increases monopoly power. Apple computers are artistic, so Apple has more monopoly power, and higher prices. n Jimmy Choo is fashionable, and so more power and higher prices. BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

16. 16 A Numerical Example Given estimates of Demand: P = 10 - Q Cost: C(Q) = 6 + 2Q Monopolistic output? MR = 10 - 2Q, since R(Q) = (10-Q) x Q MC = 2 10 - 2Q = 2 Q = 4 units Monopolistic price? P = 10 - (4) = $6 Monopolistic profits? PQ - C(Q) = (6)(4) - (6 + 8) = $10 BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

17. 17 Long Run Adjustments? None, as long as the source of monopoly power remains. BA 445 Lesson A.9 Monopolistic Markets Monopolistic Price and Quantity

18. 18 BA 445 Lesson A.9 Monopolistic Markets Inefficient Output

19. 19 Overview Inefficient Output Inefficient Output is implied when price and willingness to pay is greater than marginal cost. — So, after your market purchases, there is a deal between you and Microsoft that can benefit you both. BA 445 Lesson A.9 Monopolistic Markets Inefficient Output

20. 20 Inefficient Output is implied when P > MC Inefficiency means it is possible for some people to help themselves without hurting anyone else.Inefficiency means it is possible for some people to help themselves without hurting anyone else. For example, consider DVDs selling at monopoly price P = $20 while MC = $1.For example, consider DVDs selling at monopoly price P = $20 while MC = $1. n There now exist “victimless crimes” if consumers adopt a policy of paying for a DVD if they value the DVD at the monopoly price P = $20 or more, but they illegally download the DVD if they value it less than the monopoly price P (and at more than the cost of the download). n Those victimless crimes help the consumers when they download DVDs, without hurting the monopolist since the monopolist has the same sales as when there is no downloading. BA 445 Lesson A.9 Monopolistic Markets Inefficient Output

21. 21 Measuring Social Inefficiency Deadweight loss of monopoly. n There is a loss in the total of consumer surplus plus producer surplus. n That is a loss in total happiness (a loss in the American Pie). BA 445 Lesson A.9 Monopolistic Markets Inefficient Output

22. 22 $ Q ATC MC D MR QMQM PMPM MC Deadweight Loss of Monopoly BA 445 Lesson A.9 Monopolistic Markets Inefficient Output

23. 23 Arguments for Monopoly are that the negative effects (deadweight loss) of monopoly market power may be outweighed by beneficial effects, including the beneficial effects of economies of scale that reduce costthe beneficial effects of economies of scale that reduce cost the beneficial effects of patents and copyrights that encourage the development of new productsthe beneficial effects of patents and copyrights that encourage the development of new products BA 445 Lesson A.9 Monopolistic Markets Inefficient Output

24. 24 BA 445 Lesson A.9 Monopolistic Markets Monopolistically Competitive Entry and Exit

25. 25 Overview Monopolistically Competitive Entry and Exit drives profits to zero as in competitive markets. — So, Pizza Hut profits from stuffed-crust pizza eventually vanish, and profits require new variations. BA 445 Lesson A.9 Monopolistic Markets Monopolistically Competitive Entry and Exit

26. 26 Monopolistic competition is one market environment that lies between Monopoly and Perfect Competition. Price or quantity competition with other firms: Like perfect competition, monopolistic competition has other firms producing substitutes (but not perfect substitutes), and so each firm’s demand is affected by other firms’ prices and quantities. But like the simplest monopoly model, we do not consider the monopolist’s prices and quantities affecting other firms own prices and quantities, which in turn affect the monopolist’s profit. Entry into the industry: Like perfect competition, monopolistic competition has free entry of firms producing substitutes (but not perfect substitutes). BA 445 Lesson A.9 Monopolistic Markets Monopolistically Competitive Entry and Exit

27. 27 When are markets monopolistically competitive? Numerous buyers and sellers n Implication: There is little or no strategic interaction between sellers (unlike the forthcoming analysis of oligopoly). Differentiated products n Implication: Since products are differentiated (not perfect substitutes), each firm faces a downward sloping demand curve. Consumers view differentiated products as close substitutes: there exists some willingness to substitute. Free entry and exit of production of close substitutes --- What is a close substitute for the movie “Spiderman”? n Implication: Firms will earn zero profits in the long run. BA 445 Lesson A.9 Monopolistic Markets Monopolistically Competitive Entry and Exit

28. 28 Managing a Monopolistically Competitive Firm Like a monopoly, monopolistically-competitive firms n have market power that permits pricing above marginal cost. n level of sales depends on the price it sets. But … n The presence of other brands in the market makes the demand for your brand more elastic than if you were a monopolist. Monopolistically-competitive firm’s demand is more elastic, and so prices are lower than monopoly prices. n Free entry and exit cause zero economic profit in the long run. Therefore, monopolistically-competitive firms have limited market power. BA 445 Lesson A.9 Monopolistic Markets Monopolistically Competitive Entry and Exit

29. 29 Marginal Revenue Like a Monopolist QQ P TR 100 001020 304050 1020 304050 800 60 1200 40 20 Inelastic Elastic Inelastic Unit elastic MR BA 445 Lesson A.9 Monopolistic Markets Monopolistically Competitive Entry and Exit

30. 30 $ ATC MC D MR QMQM PMPM Profit ATC Quantity of Brand X BA 445 Lesson A.9 Monopolistic Markets Short-Run (fixed number of firms) Monopolistic Competition Maximize profits like a monopolistMaximize profits like a monopolist n Produce output where MR = MC. n Charge the price on the demand curve that corresponds to that quantity. Monopolistically Competitive Entry and Exit

31. 31 Long Run Adjustments? If the industry is monopolistically competitive, there is free entry. n In this case other firms start producing close substitutes, and their new brands steal market share. n This reduces the demand for your product until economic profits are zero. BA 445 Lesson A.9 Monopolistic Markets Monopolistically Competitive Entry and Exit

32. 32 $ AC MC D MR Q* P* Quantity of Brand X MR 1 D1D1 Entry P1P1 Q1Q1 Long Run Equilibrium (P = AC, so zero profits) Long-Run monopolistic competition, as entry decreases demand. BA 445 Lesson A.9 Monopolistic Markets Monopolistically Competitive Entry and Exit

33. 33 BA 445 Lesson A.9 Monopolistic Markets Comparing Markets

34. 34 Overview Comparing Markets reveals different equilibrium for perfect competition, monopoly, and monopolistic competition — So, Monsanto’s seed monopoly has equilibrium unlike Pizza Hut’s pizza. BA 445 Lesson A.9 Monopolistic Markets Comparing Markets

35. 35 A Numerical Example C(Q) = 125 + 4Q 2 Determine the profit-maximizing output and price, and discuss its implications, if n You are a price taker and other firms charge $40 per unit; n You are a monopolist and the inverse demand for your product is P = 100 - Q; n You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 – Q. BA 445 Lesson A.9 Monopolistic Markets Comparing Markets

36. 36 Price Taker or Perfect Competition MC = 8Q MR = P = $40. Set MR = MC. 40 = 8Q. Q = 5 units. Cost of producing 5 units. C(Q) = 125 + 4Q 2 = 125 + 100 = $225. Revenues: PQ = (40)(5) = $200. Maximum profits of -$25. Implications: Expect exit in the long-run. BA 445 Lesson A.9 Monopolistic Markets Comparing Markets

37. 37 Monopoly and Monopolistic Competition MR = 100 - 2Q (since P = 100 - Q). Set MR = MC, or 100 - 2Q = 8Q. n Optimal output: Q = 10. n Optimal price: P = 100 - (10) = $90. n Maximal profits: PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375. Implications n Monopolist will not face entry (unless patent or other entry barriers are eliminated). n Monopolistically competitive firm should expect other firms to clone (produce close substitutes), so profits will decline over time. BA 445 Lesson A.9 Monopolistic Markets Comparing Markets

38. 38 BA 445 Lesson A.9 Monopolistic Markets SummarySummary

39. 39 Summary Firms operating in a perfectly-competitive market take the market price as given.Firms operating in a perfectly-competitive market take the market price as given. n Produce output where MC = P. n Firms may earn profits or losses in the short run. n But, in the long run, entry or exit forces profits to zero. A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power continues.A monopoly firm, in contrast, can earn persistent profits provided that source of monopoly power continues. A monopolistically-competitive firm can earn profits in the short run, but entry by competing brands (producing close substitutes) will erode these profits over time.A monopolistically-competitive firm can earn profits in the short run, but entry by competing brands (producing close substitutes) will erode these profits over time. BA 445 Lesson A.9 Monopolistic MarketsSummary

40. 40 Review Questions BA 445 Lesson A.9 Monopolistic Markets Review Questions  You should try to answer some of the review questions (see the online syllabus) before the next class.  You will not turn in your answers, but students may request to discuss their answers to begin the next class.  Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exams.

41. 41 End of Lesson A.9 BA 445 Managerial Economics BA 445 Lesson A.9 Monopolistic Markets