1. chapter 17 Monopoly Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. 17-2 Learning Objectives Define monopoly and oligopoly markets and discuss the factors that lead to monopoly markets. Identify a monopolist’s profit-maximizing price and sales quantity and determine the effect of monopoly pricing on consumer and aggregate surpluses. Discuss how a monopolist chooses it product’s quality and advertising levels, and the welfare effects of those choices. Define monopsony and analyze a monopsonist’s profit- maximizing behavior. Describe the goals and difficulties involved in regulating monopolists. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

3. 17-3 Overview Unlike competitive markets, some other market structures allow firms to charge a price above its marginal cost (market power) Monopolists determine prices differently than competitive firms, and they also choose their products’ quality, advertise, and engage in research and development to maximize their profits To prevent the welfare loss that accompanies monopoly pricing, governments sometimes regulate the price a monopolist can charge Most firms sell more than one product, altering a monopolist’s profit-maximizing price (multiproduct monopoly) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

4. 17-4 Market Power Market power: when a firm can profitably charge a price that is above its marginal cost Monopoly market: a market with a single seller Oligopoly market: a market with a few sellers Monopsony market: a market with a single buyer Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

5. 17-5 Becoming a Monopolist Government awards and patents Other firms do not find the market profitable Innovation and cost cutting Ownership of all of an essential input Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6. 17-6 Scale Economies and Monopoly It may be impossible for more than one firm to make a positive profit Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7. 17-7 Price and Marginal Revenue Price reduction effect Output expansion effect Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8. 17-8 Marginal Revenue for a Monopolist Output Expansion Effect Price Reduction Effect When monopolist’s output is finely divisible Q – ΔQ is approximately equal to Q Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9. 17-9 Marginal Revenue and Elasticity Elasticity of demand is a negative number, formula shows that marginal revenue is less than price The more elastic the demand, the closer to zero is, therefore the closer marginal revenue is to the price Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10. 17-10 Monopoly Profit Maximization Step 1: Quantity rule – Identify positive sales quantities at which MR=MC. If more than one positive sales satisfies the conditions, identify the one that produces the highest profit. Step 2: Shut-down rule – Check whether the most profitable positive sales quantity from Step 1 is greater profit than shutting down. If it is, that is the profit maximizing choice. If not, then selling nothing is the best option. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

11. 17-11 Profit Maximizing Price and Sales Quantity MR = MC Profits Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

12. 17-12 Markup: A Measure of Market Power The degree of a monopolist’s market power is measured by the extent to which its price exceeds its marginal cost, typically measured as a percentage: Ratio is known as the markup, the price-cost margin, and the Lerner index Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

13. 17-13 Markup: A Measure of Market Power By rearranging past formulas: Monopolist’s markup at its profit-maximizing price always equals the reciprocal of the elasticity of demand, times negative one Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

14. 17-14 Welfare Effects of Monopoly Pricing Monopoly price and quantity Competitive equilibrium DWL Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

15. 17-15 Welfare Effects of Patent Protection Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16. 17-16 Product Quality When a firm raises a product’s quality, it increases consumer’s willingness to pay – When producing a higher-quality product costs more, the firm must decide whether the extra benefit justifies the cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

17. 17-17 Product Quality No change in producer surplus Producer surplus = $1,000 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

18. 17-18 Producing the Right Level of Quality Higher quality is valued more by consumers with a high WTP Higher aggregate surplus Same producer surplus Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

19. 17-19 Advertising Monopolist (any firm with market power) has an incentive to advertise – Each additional sale increases its profits because the monopolist’s marginal cost is less than the price Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20. 17-20 Advertising-Sales Ratio The advertising-sales ratio equals the advertising elasticity divided by the price elasticity of demand, times negative one Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

21. 17-21 Investments to Become a Monopolist Rent seeking: effort devoted to securing a monopoly position – Deadweight loss may be larger The welfare effects of rent seeking are not necessarily bad; expenditures firms make to gain monopoly positions can be socially valuable – E.g., research and development spending Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

22. 17-22 Monopsony Monopsony Market: a market with a single buyer Marginal expenditure curve DWL Competitive equilibrium Monopsonist price and quantity Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

23. 17-23 Marginal Expenditure Marginal Expenditure (ME): the extra cost incurred to hire or purchase the marginal units of an input Input Expansion Effect Price Increase Effect Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

24. 17-24 Monopsony Profit Maximization Profit-maximizing choice is when the monopsony’s willingness to pay (marginal benefit) equals its marginal expenditure (marginal cost): Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

25. 17-25 Welfare Effects of Monopsony Pricing Just as with monopoly, monopsony price setting creates deadweight loss – The monopsonist uses too little of the input, meaning that some potential net benefits from the input are lost – The deadweight loss is the area between the monopsonist’s marginal benefit and market supply curves Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

26. 17-26 Natural Monopoly Natural Monopoly: when a good is produced most economically by a single firm Natural monopolies are a reason why governments create monopolies Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

27. 17-27 First-Best vs. Second-Best Price Regulation First-best regulation: a competitive price, at which the demand and marginal cost curves intersect and aggregate surplus is maximized – This regulation may cause the regulated monopolist to lose money, in which case it would shut down P = $10 < AC Q = 88 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

28. 17-28 First-Best vs. Second-Best Price Regulation Second-best regulation: set the price that makes aggregate surplus as large as possible, while still allowing the firm to avoid losses P = $20 = AC Q = 80 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

29. 17-29 Nonprice Effects of Price Regulation Besides pricing, monopolists make many other decisions like the mix of inputs, efforts to reduce costs, and the introduction of new, higher-quality products. If price regulations force the monopolist’s profits to zero, there would not be much incentive to innovate and lower costs. Alternatively, regulators can set the price so that current profit is zero, but allowing the monopolist to keep future gains from cost reduction. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

30. 17-30 Regulatory Failure Regulators may pursue goals other than the maximization of aggregate surplus – E.g. regulators that are appointed or elected may behave in ways that are designed to improve their chances of reappointment or reelection Regulators have been captured when they promote the regulated firm’s agenda Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

31. 17-31 Trend toward Deregulation The last part of the 19 th and the first half of the 20 th century saw a significant increase in regulation – This increase was in part a response to the industrial revolution, as well as a loss in faith in market following business scandals and the Great Depression The years 1970-2000 saw a dramatic reversal of this trend, with substantial deregulation – This deregulation was caused in part by technological changes which reduced the number of natural monopolies and increased faith in the benefits of competition combined with reduced faith in regulators Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

32. 17-32 Multiproduct Monopoly Most firms sell more than one product. Sometimes those products are substitutes or complements for one another. The firm aims to maximize the combined profit from the sale of all products. Loss leader: a product that is sold at a price below its direct marginal cost to encourage sales of a complementary product Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

33. 17-33 Review A firm has market power if it can profitably charge a price that is above its marginal cost. Because of the price reduction effect, a monopolist’s marginal revenue is less than his price, unlike in a competitive market. Monopoly pricing results in a deadweight loss. The analysis of monopsony parallels the analysis of monopoly. Monopsonists can reduce the amount that they pay for a good by reducing the quantity they buy. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

34. 17-34 Review Regulation of monopolies aims at maximizing aggregate surplus, subject to the constraints that the firm avoids losses and that it has the incentives to continue innovating and reducing costs. When a monopolist sells products that are complements or substitutes, the profit- maximizing price of any given product takes account of the effects on sales of other products Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

35. 17-35 Looking Forward Today we implicitly assumed that a monopolist charges a unique price for all units of the same product. In reality, a firm with market power can increase its profit by charging different prices for different units of the same good. Next, we will focus on this practice, called price discrimination. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.