2 Why Monopolies Arise Monopoly Firm that is the sole seller of a product without close substitutesPrice makerBarriers to entryMonopoly resourcesGovernment regulationThe production process
3 Why Monopolies Arise Monopoly resources Government regulation A key resource required for production is owned by a single firmHigher priceGovernment regulationGovernment gives a single firm the exclusive right to produce some good or serviceGovernment-created monopoliesPatent and copyright lawsHigher prices; Higher profits
4 Why Monopolies Arise The production process Natural monopoly A single firm can produce output at a lower cost than can a larger number of producersNatural monopolyArises because a single firm can supply a good or service to an entire marketAt a smaller cost than could two or more firmsEconomies of scale over the relevant range of output
5 Economies of scale as a cause of monopoly 1Economies of scale as a cause of monopolyCostsAverage total costQuantity of outputWhen a firm’s average-total-cost curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the smallest cost
6 How Monopolies Make Production& Pricing Decisions Monopoly versus competitionMonopolyPrice makerSole producerDownward sloping demandMarket demand curveCompetitive firmPrice takerOne producer of manyDemand – horizontal line (Price)
7 Demand curves for competitive and monopoly firms 2Demand curves for competitive and monopoly firms(a) A Competitive Firm’s Demand Curve(b) A Monopolist’s Demand CurvePricePriceDemandDemandQuantity of outputQuantity of outputBecause competitive firms are price takers, they in effect face horizontal demand curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it faces the downward-sloping market demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it wants to sell more output.
8 How Monopolies Make Production& Pricing Decisions A monopoly’s revenueTotal revenue = price times quantityAverage revenueRevenue per unit soldTotal revenue divided by quantityMarginal revenueRevenue per each additional unit of outputChange in total revenue when output increases by 1 unitCan be negativeAlways: MR < P
9 A monopoly’s total, average, and marginal revenue 1A monopoly’s total, average, and marginal revenueQuantity of water (Q)Price (P)Total revenue (TR=P ˣ Q)Average revenue (AR=TR/Q)Marginal revenue (MR=ΔTR/ΔQ)0 gallons$11109876543$018242830-$10$
10 How Monopolies Make Production& Pricing Decisions Increase in quantity soldOutput effectQ is higherIncrease total revenuePrice effectP is lowerDecrease total revenueBecause MR < PMR curve – is below the demand curve
11 Demand and marginal-revenue curves for a monopoly 3Demand and marginal-revenue curves for a monopolyPrice21-1-2-3543678910$11-4Marginal revenueDemand(average revenue)Quantityof water12345678The demand curve shows how the quantity affects the price of the good. The marginal-revenue curve shows how the firm’s revenue changes when the quantity increases by 1 unit. Because the price on all units sold must fall if the monopoly increases production, marginal revenue is always less than the price.
12 How Monopolies Make Production& Pricing Decisions Profit maximizationIf MR > MC – increase productionIf MC > MR – produce lessMaximize profitProduce quantity where MR=MCIntersection of the marginal-revenue curve and the marginal-cost curve
13 Profit maximization for a monopoly 4Profit maximization for a monopolyCostsandRevenueand then the demand curve shows the price consistent with this quantity.Marginal costDemandMarginal revenue1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity . . .BMonopolypriceQMAXAverage total costAQ1Q2QuantityA monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B).
14 How Monopolies Make Production& Pricing Decisions Profit maximizationPerfect competition: P=MR=MCPrice equals marginal costMonopoly: P>MR=MCPrice exceeds marginal costA monopoly’s profitProfit = TR – TC = (P – ATC) ˣ Q
15 The monopolist’s profit 5The monopolist’s profitCostsandRevenueMarginal costDemandMarginal revenueEBMonopolypriceAverage total costQMAXMonopolyprofitAveragetotalcostDCQuantityThe area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the number of units sold.
16 The Welfare Cost of Monopolies Total surplusEconomic well-being of buyers & sellers in a marketSum of consumer surplus & producer surplusConsumer surplusConsumers’ willingness to pay for a goodMinus the amount they actually pay for itProducer surplusAmount producers receive for a goodMinus their costs of producing it
17 The Welfare Cost of Monopolies The deadweight lossBenevolent planner – maximize total surplusProduce quantity whereMarginal cost curve intersects demand curveCharge P=MC
18 The efficient level of output 7The efficient level of outputCostsandRevenueDemand(value to buyers)Marginal costValuetobuyersCost tomonopolistEfficientquantityValuetobuyersCost tomonopolistQuantityValue to buyers is greater than cost to sellersValue to buyers is less than cost to sellersA benevolent social planner who wanted to maximize total surplus in the market would choose the level of output where the demand curve and marginal-cost curve intersect. Below this level, the value of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good. Above this level, the value to the marginal buyer is less than marginal cost.
19 The Welfare Cost of Monopolies The deadweight lossMonopolyProduce quantity whereMC = MRProduces less than the socially efficient quantity of outputCharge P>MCDeadweight lossTriangle between: demand curve and MC curve
20 The inefficiency of monopoly 8The inefficiency of monopolyCostsandRevenueDemandMarginal revenueMarginal costDeadweightlossMonopolypriceMonopolyquantityEfficientquantityQuantityBecause a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer).
21 The Welfare Cost of Monopolies The monopoly’s profit: a social cost?MonopolyHigher profitNot a reduction of economic welfareBigger producer surplusSmaller consumer surplusMonopoly profitNot a social problem
22 Price Discrimination Price discrimination Business practice Sell the same good at different prices to different customersIncrease profit
23 Price Discrimination Lessons from price discrimination Rational strategyIncrease profitCharges each customer a price closer to his or her willingness to paySell more than is possible with a single price
24 Price Discrimination Lessons from price discrimination Requires the ability to separate customers according to their willingness to payCertain market forces can prevent firms from price discriminatingArbitrage – buy a good in one market, sell it in other market at a higher priceCan raise economic welfareCan eliminate the inefficiency of monopoly pricingMore consumers get the goodHigher producer surplus (higher profit)
25 Price Discrimination The analytics of price discrimination Perfect price discriminationCharge each customer a different priceExactly his or her willingness to payMonopolist - gets the entire surplus (Profit)No deadweight lossWithout price discriminationSingle price > MCConsumer surplusProducer surplus (Profit)Deadweight loss
26 Welfare with and without price discrimination 9Welfare with and without price discrimination(a) Monopolist with Single Price(b) Monopolist with Perfect Price DiscriminationPricePriceConsumersurplusDemandMarginalrevenueProfitDemandDeadweightlossMonopolypriceProfitQuantitysoldMarginal costMarginal costQuantitysoldQuantityQuantityPanel (a) shows a monopolist that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus.
27 Price Discrimination Examples of price discrimination Movie tickets Airline pricesDiscount couponsFinancial aidQuantity discounts
28 Public Policy Toward Monopolies RegulationRegulate the behavior of monopolistsPriceCommon in case of natural monopoliesMarginal-cost pricingMay be less than ATCNo incentive to reduce costs
29 Marginal-cost pricing for a natural monopoly 10Marginal-cost pricing for a natural monopolyPriceDemandAverage total costAveragetotal costLossMarginal costRegulatedpriceQuantityBecause a natural monopoly has declining average total cost, marginal cost is less than average total cost. Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost, price will be below average total cost, and the monopoly will lose money.
30 Public Policy Toward Monopolies Public ownershipHow the ownership of the firm affects the costs of productionPrivate ownersIncentive to minimize costsPublic owners (government)If it does a bad jobLosers are the customers and taxpayers
31 Competition versus monopoly: A summary comparison 2Competition versus monopoly: A summary comparisonCompetitionMonopolySimilarities Goal of firms Rule for maximizing Can earn economic profits in short run? Differences Number of firms Marginal revenue Price Produces welfare-maximizing level of output? Entry in long run? Can earn economic profits in long run? Price discrimination possible?Maximize profitsMR=MCYesManyMR=PP=MCNoOneMR<PP>MC