1. 1 Ch 11: Monopoly and Monopsony In the Perfectly Competitive market, the individual firm or consumer had no effect on the market price A monopolist or monopsonist has market power; the market price is affected by their choice of quantity A monopolist or monopsonist must then choose q to maximize their profits, given that p depends on q.

2. 2 Chapter 11: Monopoly & Monopsony In this chapter we will cover: 11.1 Monopoly Features 11.2 Monopolistic Profit 11.3 Monopoly Supply 11.4 Inverse Elasticity Pricing Rule 11.5 Welfare Effect of Monopolies 11.6 Why Monopolies? 11.7 Monopsonists

3. 3 A MONOPLY is an industry where there is only ONE producer/seller. The monopolist is the market; they face the market demand curve P(Q). By lowering price, the monopolist is able to sell more goods.

4. 4 A monopolist faces the market demand curve: P=f(Q) ie: P=a-bQ A monopolist’s revenue is equal to: TR=PQ ie: TR=aQ-bQ 2 A monopolist’s costs increase with production: TC=f(Q) ie: TC=Q 2

5. 5 A monopolist’s profit is the difference between total revenue and total cost: Profit=TR-TC Ie: Profit=aQ-bQ 2 -Q 2 The monopolist's profit maximization problem: Max  (Q) = TR(Q) - TC(Q) Q

6. 6 If MR > MC, the monopolist is increasing profit and should produce If MR< MC, the monopolist is decreasing profit and should not produce Therefore (like PC), the monopolist maximizes profits when MR=MC.

7. 7 Q Q TR TC Profit D MC MR P MR=MC

8. 8 Demand: P=20-2Q MR=20-4Q MC=5+Q MR=MC 5+Q=20-4Q 5Q=15 Q=3 P=20-2q P=14

9. 9 When a monopolist increases production, 2 things occur: 1)The monopolist earns MORE revenue from the extra goods sold 2)The monopolist earns LESS revenue from the previous goods sold due to a reduced price:

10. 10 Revenue Change: Q increases to Q2 Demand Revenue Lost on units Q P Q2Q2 P2P2 Q1Q1 Revenue gained on new units P1P1 Therefore marginal revenue is less than price.

11. 11 A monopolist facing demand curve P=28-2Q originally produces 10 units. Calculate the revenue gained and lost by moving to 11 units. P(10)=28-2(10) P(10)=8 P(11)=6 Revenue gained = P(11) = 6 Revenue lost =[P(10)-P(11)]10 Revenue lost = (8-6)(10)=20

12. 12 Marginal Revenue and Linear Demand Q P Demand: P=100-4Q When demand is linear, MR has a slope twice as steep. MR=100-8Q

13. 13 For the monopolist, AR(Q)=TR(Q)/Q AR(Q)=P(Q) Or, since price is found on the demand curve, AR(Q)=D Since MR is always below the demand curve, AR(Q)>MR(Q) If Q>0

14. 14 1)The Monopolist will produce Q where MR=MC 2)Given this Q, the monopolist will charge a price determined by their demand curve 3)Monopolist profit is equal to: TR-TC Or PxQ-ACxQ Or (P-AC)Q

15. 15 Price Quantity Demand curve MR 20 80 MC AC 20 100 50 e Profit

16. 16 The Monopolist does not have a suply curve! Why? For the Perfect Competitor, price is exogenous; taken as given. For the Monopolist, price is endogenous; it is part of the Monopolist’s decision.

17. 17 Price Quantity D2D2 MR 2 20 80 MC 20 D1D1 MR 1 Here the monopolist offers 20 units at 2 different prices, dependent on demand Therefore, no supply curve exists

18. 18 We can rewrite the MR curve as follows: MR = P + Q  P/  Q = P(1 + (Q/P)(  P/  Q)) = P(1 + 1/  ) where:  is the price elasticity of demand, (P/Q)(  Q/  P)

19. 19 Using this formula: When demand is elastic (  0 When demand is inelastic (  > -1), MR < 0 When demand is unit elastic (  = -1), MR= 0 Therefore, The monopolist will always operate on the elastic region of the market demand curve

20. 20 Example: Elastic Region of the Demand Curve Quantity Price a/2b a/b a Elastic region (  0 Inelastic region (0>  >-1), MR<0 Unit elastic (  =-1), MR=0

21. 21 Since at equilibrium, MC=MR: IEPR: The monopolist’s markup above MC (as a percentage of price) is the negative inverse of elasticity of demand

22. 22 Example:  = -2 MC = $50 a. What is the monopolist's optimal price? MR = MC  P(1+1/  ) = MC  P(1+1/(-2)) = 50 P* = 100

23. 23 Since at equilibrium, MC=MR: IEPR: The monopolist’s markup above MC (as a percentage of price) is the negative inverse of elasticity of demand Note: The IEPR is related to the Lerner Index of Market Power…….

24. 24 While a firm may be a monopoly, its MARKET POWER, or control over price may be limited. -Perhaps people don’t really need the good -Perhaps imperfect substitutes exist The Lerner index of market power measures market power; the control a firm has over price

25. 25 Lerner Index =(P-MC)/P=-1/  The Lerner Index lies between 0 and 1 The Lerner Index is 0 for a perfectly competitive firm (P=MC, the firm has no control over price).

26. 26 Shifts in market demand A shift in market demand will cause the monopolist’s MR curve to shift also This will cause a new equilibrium (MR=MC) This new equilibrium will cause a new price

27. 27 Price Quantity D0D0 MR 0 Q0Q0 P0P0 MC D1D1 MR 1 P1P1 Q1Q1 Here an increase in demand increased monopoly price and quantity

28. 28 An ice cream monopolist with a MC curve of MC=Q originally faced a demand curve of P=20-2Q. Due to an increase in temperature, demand shifted to P=35-2Q. Calculate the change in price and quantity due to this shift in demand.

29. 29 ORIGINALLY:P=20-2Q MR=20-4Q MR=MC 20-4Q=Q 4=Q P=20-2Q P=20-2(4) P=12

30. 30 AFTER DEMAND SHIFT:P=35-2Q MR=35-4Q MR=MC 35-4Q=Q 7=Q P=35-2Q P=35-2(7) P=21

31. 31 The shift in demand caused: -An increase in monopoly price of $9 ($21-$12) -An increase in quantity produced of 3 cones (7-4)

32. 32 Shifts in marginal cost A shift in marginal cost will create a new equilibrium (MR=MC) This new equilibrium will cause a new price Increases in cost will always raise price and decrease quantity supplied for a monopolist

33. 33 Price Quantity D0D0 MR 0 Q0Q0 P0P0 MC MC 1 P1P1 Q1Q1 An increase in cost increases monopoly price and decreases quantity supplied

34. 34 We saw before how a perfectly competitive market maximized consumer and producer surplus Since a monopoly decreases output to increase prices, a monopoly will normally create a DEADWEIGHT LOSS:

35. 35 MC=S Demand MR QMQM PMPM PCPC QCQC CS with competition: A+B+C PS with competition: D+E A B C D E

36. 36 MC=S Demand MR QMQM PMPM PCPC QCQC A B C D E DWL = C+E CS with monopoly: A PS with monopoly:B+D

37. 37 Since P M >AC for most Monopolists, they earn ECONOMIC PROFIT. There is an incentive for a monopoly to maintain market power. RENT SEEKING is any activity aimed an creating or preserving monopoly power:  Government lobbying/bribes  Advertising  Hiring Thugs This rent seeking behaviour is a social cost beyond simple deadweight losses

38. 38 MC=S Demand MR QMQM PMPM PCPC QCQC A B C D E DWL = C+E Maximum rent seeking cost=B+D

39. 39 Monopolies exist for a number of reasons, some “good”, some “bad”:  Natural Monopolies  Barriers to Entry  Structural  Legal  Strategic

40. 40 A natural monopoly exists in an industry with INCREASING RETURNS TO SCALE: One large firm is a natural monopoly if it can supply the total market at a lower total cost than any other 2 firms:

41. 41 Quantity Price Demand AC If total market quantity is 45,000, one firm has a natural monopoly Example: Natural Monopoly 45,000 22,500

42. 42 Q Price Demand AC If total market quantity increased to 80,000, the natural monopoly might not stand Example: Natural Monopoly 80,00040,000

43. 43 Normally, if economic profit is available in an industry, firms will enter until that profit is pushed to zero. A BARRIER TO ENTRY is any factor that allows a firm to earn positive economic profit while making it unprofitable for another firm to enter

44. 44  A structural barrier to entry is a cost or demand advantage that prevents another firm from entering -Cost Advantages (includes natural monop.) -Positive Externalities (iTunes/Ebay) -Advertising/Brand Dominance (Kleenex, Heinz) -May be seen as strategic barrier

45. 45  A legal barrier to entry exists when a firm is legally protected from competition. -Patents (encourages research) -Exclusive Rights -ie: Marijuana growers -ie: Out-of-country vehicle inspections (ie: Canadian Tire) -ie: Printing Money (Canadian Mint) -ie: Degrees (Universities)  Often these barriers are set up for good reasons

46. 46  A strategic barrier to entry exists when a firm takes EXPLICT steps to prevent entry -Operating at a loss/reduced profit -Developing a Predatory Reputation -”Unofficial” agreements to maintain monopoly -Consumer Contracts -Incompatible inputs (ie: Phone numbers, memory cards, software, chargers, etc.)

47. 47 MC=S Demand MR QMQM PMPM PCPC QCQC If P X was still profitable to the monopolist, it could keep other firms out of the market. Lowering profits to avoid competition PXPX PC Losses

48. 48 A MONOPSONIST is a single buyer of a good or input. -ie: Only the government purchases military equipment (we hope). -If the film Teenage Mutant Ninja Star Spidermen 4: The Ballet of the Forgotten Princess were to film in Edmonton, there’d be 1 film but many people wanting to be extras -The monopsonist faces the market supply curve

49. 49 Marginal Product (MP) is the additional productivity of another unit of input. -ie: 1 more worker increases output by 7 Marginal Revenue Product (MRP) is the additional revenue of another unit of input. -ie: 1 more worker increases revenue by $21 (if each output sells for $3) MRP=P x MP

50. 50 Since the monopsonist faces the market supply curve, it can only increase inputs (ie: Labour) by increasing the price To hire another worker, the monopsonist both has to give that worker a higher wage, plus increase the wage of every other worker:

51. 51 Monopsonist Increases Labour: Supply Wage increase of current workers L W L2L2 W2W2 L1L1 Wage of additional workers W1W1

52. 52 If supply of any input is linear, the Marginal Expenditure (ME) if that input has TWICE the slope of the supply curve. Ie: Supply: W=50+3Q ME: W=50+6Q

53. 53 If, for the next input (worker) MRP>ME, the firm should use that input, as the input will earn the firm more than it increases costs. If, for the next input (worker) MRP<ME, the firm should not use that input, as the input will earn the firm less than it increases costs. Therefore a monopsonist maximizes when MRP=ME

54. 54 Monopsonist Maximization: Supply L W W* L* MRP L ME L ME=MRP Wage

55. 55 A film crew comes to the city to hire extras. It faces a supply curve of: W=10+Q Extras have a marginal revenue product curve of W=100-2Q Maximize the film’s hiring of extras.

56. 56 Supply: W=20+Q ME:W=20+2Q ME=MRP 20+2Q=100-2Q 4Q=80 Q=20 W=20+Q W=20+20 W=40

57. 57 Welfare Effects of Monopsonists: Supply L W W* L* MRP L =D PC ME L PC Consumer Surplus Wage PC Producer Surplus

58. 58 Monopsonist DWL: Supply L W W* L* MRP L =D PC ME L Monopsonist Consumer Surplus Wage Monopsonist Producer Surplus DWL

59. 59 Chapter 11 Summary  A monopoly consists of one firm selling a good  A monopolist faces the market demand curve  To sell more, it must decrease price  MR is therefore less than demand  A monopolist chooses quantity where MC=MR  This quantity is sold at a price found on the demand curve  This typically produces a profit

60. 60 Chapter 11 Summary  A monopolist always operates on the ELASTIC portion of the demand curve  The elasticity of demand determines a monopolist’s market power through the Learner Index of Market Power  Monopolies cause deadweight loss  This loss increases if Monopolies spend resources to maintain their monopoly  Monopolies exist due to barriers to entry (structural – includes natural monopoly - strategic, legal,

61. 61 Chapter 11 Summary  A monopsonist is a single BUYER of a good or input  Monopsonists deal with the market supply curve  Monopsonists operate where marginal revenue product equals marginal expenditure (MRP=ME)  Monopsonists cause Deadweight loss **Remember that Deadweight Loss could be a reason for government intervention, but that intervention itself carries a cost