Ch 24 Pure

= ? Mission: “to organize the world's information and make it universally accessible and useful” Informal slogan: “Don’t be evil.” (included in their IPO S1) “You can make money without doing evil.” (sixth point of Google’s 10-point corporate philosophy) AP: http://www.youtube.com/watch?v=sMCmmjlEteo CNN: http://www.youtube.com/watch?v=3RWSXpjW7fw FTC: http://www.youtube.com/watch?v=NssfPApe5iQ

Geography must be considered in relation to monopoly power Chapter 24 Pure Introduction to Pure Monopoly Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. Characteristics of pure monopoly: 1. Single seller (firm = industry). 2. No close substitutes. 3. “price maker” Blocked Entry Nonprice competition very limited… monopolist may advertise to: i. increase demand ii. Sustain entry barriers “near” monopolies: producers have a substantial amount of monopoly power Examples: Selco, Google, Logan airport, professional sports teams, etc. Geography must be considered in relation to monopoly power

Barriers to Entry Limit Competition Economies of scale -- large single producer may be able to produce at lower per unit costs than two smaller producers … lower per unit costs may translate to lower prices  consider public utilities (gas or water supply)  “natural monopoly” Legal barriers -- patents and licenses 3. Control of essential resources -- ownership of mineral /diamond mines… resources may be scarce Pricing / Advertising / Other strategies -- Wal-mart v. local “five and dime”

MONOPOLY DEMAND For an unregulated, single price monopolist with full barriers to entry: Firm = Market  demand is downward sloping Unlike pure competition, price exceeds marginal revenue... …why? Because: A non-discriminating monopolist must lower the price to sell more output; every buyer gets the benefit of the lower price. * Note that the marginal-revenue curve is below the demand curve; when MR becomes negative, TR begins to fall

Monopoly: Output and Price Determination Costs: The monopolist acquires resources from competitive markets; costs to the monopolist mirror costs to firms in other market structures. Supply: The pure monopolist has no supply curve (McConnell & Brue); there is no unique relationship between price and quantity supplied. Price and quantity supplied will depend on demand. Output for maximum profit: Marginal Revenue = Marginal Cost (MR = MC) Price: highest price allowed by market demand at MR = MC output Misconceptions/clarifications/points of note: The monopolist does not try to maximize price; it maximize profits (total revenue minus total cost). Maximizing total profits is the goal; not maximizing per unit profit. Unlike pure competition, pure monopoly can produce long run economic profits. Short run losses can occur in monopoly (AVC < P < ATC); but in the long run the loss-producing monopolist shuts down (P < AVC).

Q P D MR MC Pc Pm Qc Qm Economic Effects of a Monopoly Monopoly results in lower output and higher price when compared to pure competition. Allocative efficiency not achieved.  P > MC. Price (what product is worth to consumers) is above marginal cost.  Ideally, output should expand to a level where P = MC (pure competition) Productive efficiency is not achieved.  monopolist’s output is less than the output of pure competition (when ATC is at its minimum). Also, income distribution is more unequal than it would be under a more competitive situation. The effect of the monopoly power is to transfer income from the consumers to the business owners. Q INEFFICIENCY OF PURE MONOPOLY P D MR MC Pc Pm Qc Qm

“marginal cost pricing” “average cost” pricing Regulated Monopoly Monopoly power may result in an adverse effect upon the economy. Government may choose to intervene on a case-by-case basis. Regulation often occurs where a “natural monopoly” make one firm desirable: -- natural monopoly may not last forever; -- changes in technology tend to destroy monopoly (e.g. phone service) Regulation involves a trade-off between the monopolist and the consumer. Regulators may set monopoly prices at the “socially optimal price.” P = MC (set price where D = MC) The socially optimal price may cause losses. Regulators may set a “fair return” price. P = ATC (set price where D = ATC) Remember that ATC includes a normal or “fair” profit. a.k.a. “marginal cost pricing” a.k.a. “cost-of-service” or “average cost” pricing

A given product is sold at more than one price Price Discrimination A given product is sold at more than one price and the price differences are not based on cost differences Conditions needed to practice price discrimination: Monopoly power (ability to control output and price). Market segregation (ability to divide buyers into separate classes that have a different willingness or ability to pay for the product …usually based on different elasticities of demand). Buyers must be unable to resell the original product or service. Examples of price discrimination: Airlines charge high fares to executive travelers (inelastic demand) than vacation travelers (elastic demand). Electricity: different rates for electric heat v. other electricity use (lights, fridge, etc).  lighting: no close substitutes  heating: oil and natural gas

Consequences of price discrimination: More profits for the seller (assuming perfect discrimination in a pure monopoly) More profits for the seller  Price is what each buyer is willing to pay (each point on the demand curve) Zero consumer surplus Higher output  MR = MC for profit maximizing output Allocative efficiency? (sort of… does P = MC?) Productive efficiency? (possibly … does P = min ATC?)

Electric company, town water, etc. are very close to pure monopoly. 24‑1 “No firm is completely sheltered from rivals; all firms compete for the consumer dollars. Pure monopoly, therefore, does not exist.” Do you agree? Explain. Electric company, town water, etc. are very close to pure monopoly. Pure monopoly is a bookend along the spectrum of market structures. Comparisons of real market economies to pure monopoly can help to measure the efficiency and competitiveness of an industry. How might you use Chapter 20’s concept of cross elasticity of demand to judge whether monopoly exists? Cross elasticity of demand can be used to measure the presence of close substitutes for the product of a monopoly firm. If the cross elasticity of demand is greater than zero, then the demand that the monopoly faces is elastic with respect to substitute products; the firm has less control over its product price (and less monopoly power) than if the cross elasticity of demand were inelastic. Conclusion: the monopoly faces competition from producers of substitute products.

Natural monopolies give rise to monopoly that is socially justifiable. 24-2. Discuss the major barriers to entry into an industry. Explain how each barrier can foster monopoly or oligopoly. Which barriers, if any, do you feel give rise to monopoly that is socially justifiable? Economies of scale Natural monopolies give rise to monopoly that is socially justifiable. i.e. two or more firms serving the market could increase costs unreasonably. Patents and licenses: socially justifiable; in that they preserve the incentive to invent and invest in R&D Control/ownership of materials: Little social justification Other strategies (pricing, etc.): Unfair competition has no social justification  is often illegal… though difficult to prove

The firm in pure competition sees a perfectly elastic demand curve, 24-3 How does the demand curve faced by a purely monopolistic seller differ from that confronting a purely competitive firm? The firm in pure competition sees a perfectly elastic demand curve, whereas the monopolist sees a downward sloping demand curve. Why does it differ? The firm is the entire industry but is subject to market demand (the law of demand) Of what significance is the difference? The firm has control over price. Why is the pure monopolist’s demand curve not perfectly inelastic? The curve is not perfectly elastic because demand is determined by the buyer. E.g. although a cable company may be a pure monopolist, the quantities of cable service demanded will still vary based on price (law of demand).

the pure monopolist will: charge a higher price, 24‑7 Assume a pure monopolist and a purely competitive firm have the same unit costs. Contrast the two with respect to (a) price, (b) output, (c) profits, (d) allocation of resources, and (e) impact upon the distribution of income. the pure monopolist will: charge a higher price, have a smaller output, have higher economic profits in both the short run and the long run (d) resources are underallocated in monopolistic industries, because: the monopolist does not produce at the point of minimum ATC and does not equate price and MC. (e) the distribution of income is more unequal with monopoly than with pure competition because long run profits can be earned in monopoly but not pure competition Since both monopolists and competitive firms follow the MC = MR rule in maximizing profits, how do you account for the different results? In pure competition, MR = P because the firm’s supply is an insignificant part of industry supply; its output has no effect on price. The firm is a price-taker. The monopolist is the industry, and is price maker. Changes in output change price. MR = P in pure competition; in pure monopoly, MR < P. Why might the costs of a purely competitive firm and a monopolist not be the same? Economies of scale What are the implications of such cost differences? Economies of scale may give a monopolist a lower cost structure; this may allow a monopolist to sell at a lower price. If so, inefficiency is reduced.

24‑7 Since both monopolists and competitive firms follow the MC = MR rule in maximizing profits, how do you account for the different results? In pure competition, MR = P because the firm’s supply is an insignificant part of industry supply; its output has no effect on price. The firm is a price-taker. The monopolist is the industry, and is price maker. Changes in output change price. MR = P in pure competition; in pure monopoly, MR < P. Why might the costs of a purely competitive firm and a monopolist not be the same? Economies of scale What are the implications of such cost differences? Economies of scale may give a monopolist a lower cost structure; this may allow a monopolist to sell at a lower price. If so, inefficiency is reduced.

24‑8 Critically evaluate and explain: “Because they can control product price, monopolists are always assured of profitable production by simply charging the highest price consumers will pay.” False. Remember the law of demand; charging the highest price would result in sales of one unit. “The pure monopolist seeks the output that will yield the greatest per-unit profit.” (b) False. The monopolist seeks the output that will yield the greatest total profit. “An excess of price over marginal cost is the market’s way of signaling the need for more production of a good.” (c) True. Price is the value society sets on the last item produced. When P>MC, consumers are willing to pay more. “The more profitable a firm, the greater its monopoly power.” Usually true… profits allow expansion to gain economies of scale, preventing the entry of rivals profits could enable the firm to price below cost, engaging (illegally) in a price war in a competitive industry, only normal (not economic) profits exist

24‑8 “The monopolist has a price policy; the competitive producer does not.” True. The monopolist equates MR and MC, then sets the price according to Demand. The pure competitor accepts the market price (which is its MR) then equates it with MC and produces the amount determined by this equality. “With respect to resource allocation, the interests of the seller and of society coincide in a purely competitive market but conflict in a monopolized market.” True. In pure competition, P = MC. In monopoly, P>MC. This means that consumers value the last item produced more than its cost. g. “In a sense the monopolist makes a profit for not producing; the monopolist produces profits more than it does goods.” in a sense True. IF a (nondiscriminating) monopolist produced when P = MC, it would produce more at a lower price, and earn a lower profit. By producing when MR = MC, the monopolist sets P > MC and gains a greater profit. Better said “The monopolist tries to maximize profits by restricting the output of goods as much as necessary to ensure the equality of MR and MC.”

24‑9 Assume a monopolistic publisher agrees to pay an author 15 percent of the total revenue from text sales. Will the author and the publisher want to charge the same price for the text? Explain. The publisher is a monopolist seeking to maximize profits. This will occur at the quantity of output where MC = MR. The author who will receive 15% of the total revenue will maximize his payment if the book is priced where MR = 0. This will occur where the price elasticity of demand is equal to 1 and total revenue is maximum. The author would prefer a lower price than the publisher.

When TR decreases, MR becomes negative. 24-4. (Key Question) Use the demand schedule that follows to calculate total revenue and marginal revenue at each quantity. Plot the demand, total-revenue, and marginal-revenue curves and explain the relationships between them. TR increases at a decreasing rate, coinciding with a downward sloping MR curve. When TR decreases, MR becomes negative. Explain why the MR of the fourth unit of output is $3.50, even though its price is $5.00. MR is below D: to sell an extra unit, the monopolist must lower the price on the marginal unit as well as on each of the preceding units sold. (not price discriminating)

Elastic Demand: from P = $6.50 to $3.50 (TR rising). 24-4. Use Chapter 20’s total-revenue test for price elasticity to designate the elastic and inelastic segments of your graphed demand curve. Elastic Demand: from P = $6.50 to $3.50 (TR rising). Unit elasticity: P = $3.50 (TR at its maximum). Inelastic demand: P < $3.50 (TR falling). What generalization can you make regarding the relationship between marginal revenue and elasticity of demand? Positive MR corresponds with elastic demand. Negative MR corresponds with inelastic demand. When MR = zero, demand is unit elastic.

If MC is zero, the monopolist produces 7 units; 24-4. Suppose that somehow the marginal cost of successive units of output were zero. What output would the profit seeking firm produce? If MC is zero, the monopolist produces 7 units; MR approximates zero (but is not below zero). Finally, use your analysis to explain why a monopolist would never produce in the inelastic region of demand. Demand is inelastic where MR is negative. To produce an extra unit of output, MC ≥ 0. In the inelastic part of the demand curve, MC > MR and the monopolist would never produce.

MR “equals” marginal cost at 4 units of output. 24-5. (Key Question) Suppose a pure monopolist is faced with the demand schedule shown below and the same cost data as the competitive producer discussed in question 4 at the end of Chapter 23. Calculate the missing total- and marginal-revenue amounts, and determine the profit-maximizing price and output for this monopolist. What is the monopolist’s profit? MR “equals” marginal cost at 4 units of output. Price (per unit) would be $63. Profit per unit would be $10.50. Total profit would be $42.00.

24-6. (Key Question) If the firm described in question 5 could engage in perfect price discrimination, what would be the level of output? Of profits? MR “equals” MC at 6 units of output TR = $420 (100 + 83 + 71 + 63 + 55 + 48) – TC = $285 ($47.50 x 6) P = $135 Draw a diagram showing the relevant demand, marginal revenue, average total-cost, and marginal cost curves and the equilibrium price and output for a non-discriminating monopolist. Use the same diagram to show the equilibrium position of a monopolist that is able to practice perfect price discrimination. Compare equilibrium outputs, total revenues, economic profits, and consumer prices in the two cases. price discrimination leads to higher output, higher revenues, and higher profits; some consumers pay higher prices, some lower Comment on the economic desirability of price discrimination. Good: higher output; higher efficiency Bad: income shift from consumer to monopolist