Chapter 10Slide 2 Topics to be Discussed Monopoly Monopoly Power Sources of Monopoly Power The Social Costs of Monopoly Power
Chapter 10Slide 3 Perfect Competition Review of Perfect Competition P = LMC = LRAC Normal profits or zero economic profits in the long run Large number of buyers and sellers Homogenous product Perfect information Firm is a price taker
Perfect Competition Q Q PP MarketIndividual Firm DS Q0Q0 P0P0 P0P0 D = MR = P q0q0 LRACLMC
Chapter 10Slide 5 Monopoly 1) One seller - many buyers 2)One product (no good substitutes) 3)Barriers to entry
Chapter 10Slide 6 Monopoly 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.
Chapter 10Slide 7 Monopoly Finding Marginal Revenue As the sole producer, the monopolist works with the market demand to determine output and price. Assume a firm with demand: P = 6 - Q
Chapter 10Slide 8 Total, Marginal, and Average Revenue $60$ $5$ TotalMarginalAverage PriceQuantityRevenueRevenueRevenue PQRMRAR
Chapter 10Slide 9 Average and Marginal Revenue Output $ per unit of output Average Revenue (Demand) Marginal Revenue
Chapter 10Slide 10 Monopoly Observations 1)To increase sales the price must fall 2)MR < P 3)Compared to perfect competition No change in price to change sales MR = P
Chapter 10Slide 11 Monopoly Monopolist’s Output Decision 1)Profits maximized at the output level where MR = MC 2)Cost functions are the same
Chapter 10Slide 12 Maximizing Profit When Marginal Revenue Equals Marginal Cost At output levels below MR = MC the decrease in revenue is greater than the decrease in cost (MR > MC). At output levels above MR = MC the increase in cost is greater than the decrease in revenue (MR < MC) The Monopolist’s Output Decision
Chapter 10Slide 13 Lost profit P1P1 Q1Q1 Lost profit MC AC Quantity $ per unit of output D = AR MR P* Q* Maximizing Profit When Marginal Revenue Equals Marginal Cost P2P2 Q2Q2
Chapter 10Slide 14 Monopoly An Example The Monopolist’s Output Decision
Chapter 10Slide 15 Monopoly An Example The Monopolist’s Output Decision
Chapter 10Slide 16 Monopoly An Example The Monopolist’s Output Decision
Chapter 10Slide 17 Monopoly An Example By setting marginal revenue equal to marginal cost, it can be verified that profit is maximized at P = $30 and Q = 10. This can be seen graphically: The Monopolist’s Output Decision
Chapter 10Slide 18 Quantity $ R Profits t t' c c’ Example of Profit Maximization C
Chapter 10Slide 19 Example of Profit Maximization Observations Slope of rr’ = slope cc’ and they are parallel at 10 units Profits are maximized at 10 units P = $30, Q = 10, TR = P x Q = $300 AC = $15, Q = 10, TC = AC x Q = 150 Profit = TR - TC $150 = $300 - $150 Quantity $ R C Profits t t' c c
Chapter 10Slide 20 Profit AR MR MC AC Example of Profit Maximization Quantity $/Q
Chapter 10Slide 21 Example of Profit Maximization Observations AC = $15, Q = 10, TC = AC x Q = 150 Profit = TR = TC = $300 - $150 = $150 or Profit = (P - AC) x Q = ($30 - $15)(10) = $150 Quantity $/Q MC AR MR AC Profit
Chapter 10Slide 22 Monopoly A Rule of Thumb for Pricing We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in practice. This can be demonstrated using the following steps:
Chapter 10Slide 23 A Rule of Thumb for Pricing
Chapter 10Slide 24 A Rule of Thumb for Pricing
Chapter 10Slide 25 A Rule of Thumb for Pricing
Chapter 10Slide 26 = the markup over MC as a percentage of price (P-MC)/P A Rule of Thumb for Pricing 8. The markup should equal the inverse of the elasticity of demand.
Chapter 10Slide 27 A Rule of Thumb for Pricing
Chapter 10Slide 28 Monopoly Monopoly pricing compared to perfect competition pricing: Monopoly P > MC Perfect Competition P = MC
Chapter 10Slide 29 Monopoly Monopoly pricing compared to perfect competition pricing: The more elastic the demand the closer price is to marginal cost. If E d is a large negative number, price is close to marginal cost and vice versa.
Chapter 10Slide 30 Monopoly Power Measuring Monopoly Power In perfect competition: P = MR = MC Monopoly power: P > MC
Chapter 10Slide 31 Monopoly Power Lerner’s Index of Monopoly Power L = (P - MC)/P The larger the value of L (between 0 and 1) the greater the monopoly power. L is expressed in terms of E d L = (P - MC)/P = -1/E d E d is elasticity of demand for a firm, not the market
Chapter 10Slide 32 Monopoly Power Monopoly power does not guarantee profits. Profit depends on average cost relative to price. Question: Can you identify any difficulties in using the Lerner Index (L) for public policy?
Chapter 10Slide 33 Monopoly Power The Rule of Thumb for Pricing Pricing for any firm with monopoly power If E d is large, markup is small If E d is small, markup is large
Elasticity of Demand and Price Markup $/ Q Quantity AR MR AR MC Q* P* P*-MC The more elastic is demand, the less the markup.
Chapter 10Slide 35 Sources of Monopoly Power Why do some firm’s have considerable monopoly power, and others have little or none? A firm’s monopoly power is determined by the firm’s elasticity of demand.
Chapter 10Slide 36 Sources of Monopoly Power The firm’s elasticity of demand is determined by: 1)Elasticity of market demand 2)Number of firms 3) The interaction among firms
Chapter 10Slide 37 The Social Costs of Monopoly Power Monopoly power results in higher prices and lower quantities. However, does monopoly power make consumers and producers in the aggregate better or worse off?
Chapter 10Slide 38 B A Lost Consumer Surplus Deadweight Loss Because of the higher price, consumers lose A+B and producer gains A-C. C Deadweight Loss from Monopoly Power Quantity AR MR MC QCQC PCPC PmPm QmQm $/Q
Chapter 10Slide 39 Rent Seeking Firms may spend to gain monopoly power Lobbying Advertising Building excess capacity The Social Costs of Monopoly Power
Chapter 10Slide 40 The incentive to engage in monopoly practices is determined by the profit to be gained. The larger the transfer from consumers to the firm, the larger the social cost of monopoly. The Social Costs of Monopoly Power
Chapter 10Slide 41 Price Regulation Recall that in competitive markets, price regulation created a deadweight loss. Question: What about a monopoly? The Social Costs of Monopoly Power
Chapter 10Slide 42 AR MR MC PmPm QmQm AC P1P1 Q1Q1 Marginal revenue curve when price is regulated to be no higher that P 1. If left alone, a monopolist produces Q m and charges P m. If price is lowered to P 3 output decreases and a shortage exists. For output levels above Q 1, the original average and marginal revenue curves apply. If price is lowered to P C output increases to its maximum Q C and there is no deadweight loss. Price Regulation $/Q Quantity P 2 = P C QcQc P3P3 Q3Q3 Q’ 3 Any price below P 4 results in the firm incurring a loss. P4P4
Chapter 10Slide 43 Natural Monopoly A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms. The Social Costs of Monopoly Power
Chapter 10Slide 44 Regulating the Price of a Natural Monopoly $/Q Natural monopolies occur because of extensive economies of scale Quantity
Chapter 10Slide 45 MC AC AR MR $/Q Quantity Setting the price at P r yields the largest possible output;excess profit is zero. QrQr PrPr PCPC QCQC If the price were regulate to be P C, the firm would lose money and go out of business. PmPm QmQm Unregulated, the monopolist would produce Q m and charge P m. Regulating the Price of a Natural Monopoly
Chapter 10Slide 46 Regulation in Practice It is very difficult to estimate the firm's cost and demand functions because they change with evolving market conditions The Social Costs of Monopoly Power
Chapter 10Slide 47 Regulation in Practice An 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, where P = price, AVC = average variable cost D = depreciation, T = taxes s = allowed rate of return, K = firm’s capital stock The Social Costs of Monopoly Power
Chapter 10Slide 48 Regulation in Practice Using this technique requires hearings to arrive at the respective figures. The hearing process creates a regulatory lag that may benefit producers (1950s & 60s) or consumers (1970s & 80s). Question Who is benefiting in the 1990s? The Social Costs of Monopoly Power
Chapter 10Slide 49 Limiting Market Power: The Antitrust Laws Antitrust Laws: Promote a competitive economy Rules and regulations designed to promote a competitive economy by: Prohibiting actions that restrain or are likely to restrain competition Restricting the forms of market structures that are allowable
Chapter 10Slide 50 Sherman Act (1890) Section 1 Prohibits contracts, combinations, or conspiracies in restraint of trade Explicit agreement to restrict output or fix prices Implicit collusion through parallel conduct Limiting Market Power: The Antitrust Laws
Chapter 10Slide 51 Sherman Act (1890) Section 2 Makes it illegal to monopolize or attempt to monopolize a market and prohibits conspiracies that result in monopolization. Limiting Market Power: The Antitrust Laws
Chapter 10Slide 52 Clayton Act (1914) 1)Makes it unlawful to require a buyer or lessor not to buy from a competitor 2)Prohibits predatory pricing Limiting Market Power: The Antitrust Laws
Chapter 10Slide 53 Clayton Act (1914) 3)Prohibits mergers and acquisitions if they “substantially lessen competition” or “tend to create a monopoly” Limiting Market Power: The Antitrust Laws