1 1OverviewOverview BA 210 Lesson III.3 Monopoly

2 2 Monopoly Pricing What is a Monopoly? Finding Profit Maximizing Quantity Markup Rule Perfect Price Discrimination Two-Part Pricing Block Pricing Imperfect Price Discrimination Summary Review Questions Overview BA 210 Lesson III.3 Monopoly

3 3 What is a Monopoly? BA 210 Lesson III.3 Monopoly What is a Monopoly?

4 4 The Meaning of Monopoly Our Opposite extreme from Perfect Competition…  A monopolist is a firm that is the only producer of a good that has no close substitutes. An industry controlled by a monopolist is known as a monopoly, for example De Beers (diamonds).  The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power.  What do monopolists do with this market power? Let’s take a look at the following graph… What is a Monopoly?

5 5 What a Monopolist Does M C S D Q C Q M Quantity Price P M P C 2. … and raises price. 1. Compared to perfect competition, a monopolist reduces output… Equilibrium is at C, where the price is P C and the quantity is Q C. A monopolist reduces the quantity supplied to Q M, and moves up the demand curve from C to M, raising the price to P M. What is a Monopoly?

6 6 Why Do Monopolies Exist? A monopolist has market power and as a result will charge higher prices and produce less output than a competitive industry. This generates profit for the monopolist in the short run and long run. Profits will not persist in the long run unless there is a barrier to entry. This can take the form of:  control of natural resources or inputs  increasing returns to scale  technological superiority  government-created barriers including patents and copyrights What is a Monopoly?

7 7 Low Supply and Soaring Demand: A Diamond Producer’s Best Friend  The De Beers Diamond mines in South Africa dwarfed all previous sources, so almost all of the world’s diamond production was concentrated in a few square miles.  De Beers either bought out new producers or entered into agreements with local governments that controlled some of the new mines, effectively making them part of the De Beers monopoly.  De Beers controlled retail prices and when demand dropped, newly mined stones would be stored rather than sold, restricting retail supply until demand and prices recovered.  Government regulators have forced De Beers to loosen control of the market and competitors have also entered the industry.  However, De Beers being a “near-monopolist” still mines most diamonds than any other single producers. What is a Monopoly?

8 8 Finding Profit Maximizing Quantity BA 210 Lesson III.3 Monopoly Finding Profit Maximizing Quantity

9 9 How a Monopolist Maximizes Profit  The price-taking firm’s optimal output rule is to produce the output level at which the marginal cost of the last unit produced is equal to the market price.  A monopolist, in contrast, is the sole supplier of its good. So its demand curve is simply the market demand curve, which is downward sloping.  This downward slope creates a “wedge” between the price of the good and the marginal revenue of the good—the change in revenue generated by producing one more unit. Finding Profit Maximizing Quantity

10 Comparing the Demand Curves of a Perfectly Competitive Producer and a Monopolist (a)Demand Curve of an Individual Perfectly Competitive Producer D C Price (b)Demand Curve of a Monopolist D M Market price Quantity An individual perfectly competitive firm cannot affect the market price of the good  it faces a horizontal demand curve DC, as shown in panel (a). A monopolist, on the other hand, can affect the price (sole supplier in the industry)  its demand curve is the market demand curve, DM, as shown in panel (b). To sell more output it must lower the price; by reducing output it raises the price. Price Finding Profit Maximizing Quantity

11 How a Monopolist Maximizes Profit  An increase in production by a monopolist has two opposing effects on revenue:  A quantity effect. One more unit is sold, increasing total revenue by the price at which the unit is sold.  A price effect. In order to sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue.  The quantity effect and the price effect are illustrated by the two shaded areas in panel (a) of the following figure based on the numbers on the table accompanying it. Finding Profit Maximizing Quantity

12 Demand, Total Revenue, and Marginal Revenue Curves A MR TR D (a) 9 20 $1,000 –200 – Quantity of diamonds (b) $5,000 4,000 3,000 2,000 1,000 Total Revenue B C Demand and Marginal Revenue Total Revenue Price, cost, marginal revenue of demand Price effect = -$450 Quantity effect = +$500 Marginal revenue = $50 Quantity effect dominates price effect. Price effect dominates quantity effect. 10 Quantity of diamonds Finding Profit Maximizing Quantity

13 The Monopolist’s Demand Curve and Marginal Revenue  Due to the price effect of an increase in output, the marginal revenue curve of a firm with market power always lies below its demand curve. So a profit-maximizing monopolist chooses the output level at which marginal cost is equal to marginal revenue—not to price.  As a result, the monopolist produces less and sells its output at a higher price than a perfectly competitive industry would. It earns a profit in the short run and the long run. Finding Profit Maximizing Quantity

14 The Monopolist’s Demand Curve and Marginal Revenue  To emphasize how the quantity and price effects offset each other for a firm with market power, notice the hill-shaped total revenue curve.  This reflects the fact that at low levels of output, the quantity effect is stronger than the price effect: as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small.  As output rises beyond 10 diamonds, total revenue actually falls. This reflects the fact that at high levels of output, the price effect is stronger than the quantity effect: as the monopolist sells more, it now has to lower the price on many units of output, making the price effect very large. Finding Profit Maximizing Quantity

15 The Monopolist’s Profit-Maximizing Output and Price  To maximize profit, the monopolist compares marginal cost with marginal revenue.  If marginal revenue exceeds marginal cost, De Beers increases profit by producing more; if marginal revenue is less than marginal cost, De Beers increases profit by producing less. So the monopolist maximizes its profit by using the optimal output rule:  At the monopolist’s profit-maximizing quantity of output: MR = MC Finding Profit Maximizing Quantity

16 Finding the Monopoly Price In order to find the profit-maximizing quantity of output for a monopolist, you look for the point where the marginal revenue curve crosses the marginal cost curve. Point A in the following figure is an example. However, it’s important not to fall into a common error: imagining that point A also shows the price at which the monopolist sells its output. It doesn’t. It shows the marginal revenue received by the monopolist, which we know is less than the price. To find the monopoly price, you have to go up vertically from A to the demand curve. There you find the price at which consumers demand the profit-maximizing quantity. So the profit-maximizing price-quantity combination is always a point on the demand curve, like B in the next figure. Finding Profit Maximizing Quantity

17 The Monopolist’s Profit-Maximizing Output and Price The price De Beers can charge per diamond is found by going to the point on the demand curve directly above point A, (point B here)—a price of $600 per diamond. It makes a profit of $400 × 8 = $3,200. The optimal output rule: the profit maximizing level of output for the monopolist is at MR = MC, shown by point A, where the MC and MR curves cross at an output of 8 diamonds. B C MR Monopoly profit MC  ATC D $1, –200 –400 0 Quantity of diamonds A P C P M Q M Q C Price, cost, marginal revenue of demand Monopolist’s optimal point Perfectly competitive industry’s optimal point Finding Profit Maximizing Quantity

18 Is There a Monopoly Supply Curve? Given how a monopolist applies its optimal output rule, you might be tempted to ask what this implies for the supply curve of a monopolist. But this is a meaningless question: monopolists don’t have supply curves. Remember that a supply curve shows the quantity that producers are willing to supply for any given market price. A monopolist, however, does not take the price as given; it chooses a profit-maximizing quantity, taking into account its own ability to influence the price. Finding Profit Maximizing Quantity

19 Markup Rule BA 210 Lesson III.3 Monopoly Markup Rule

20 Monopoly Behavior and the Price Elasticity of Demand A monopolist faces marginal revenue that is less than the market price. But how much lower? The answer depends on price elasticity of demand. When a monopolist increases output by one unit, it must reduce the market price in order to sell that unit. If the price elasticity of demand is less than 1, this will actually reduce revenue—that is, marginal revenue will be negative. The monopolist can increase revenue by producing more only if the price elasticity of demand is greater than 1. The higher the elasticity, the closer the additional revenue is to the initial market price. A monopolist that faces highly elastic demand will behave almost like a firm in a perfectly competitive industry. Markup Rule

21 The Standard Markup Rule Suppose the elasticity of demand for the firm’s product is E. MR = P[1 + E]/ E Since MR = P[1 + E]/ E, setting MR = MC and simplifying yields the standard markup rule: P = [E/(1+ E)]  MC. The optimal price is a simple markup over marginal cost. BA 210 Lesson III.3 Monopoly Markup Rule

22 An Example Elasticity of demand for Kodak film is -2. P = [E/(1+ E)]  MC P = [-2/(1 - 2)]  MC P = 2  MC Price is twice marginal cost. Fifty percent of Kodak’s price is margin above manufacturing costs (marginal cost). BA 210 Lesson III.3 Monopoly Markup Rule

23 Public Policy BA 210 Lesson III.3 Monopoly Public Policy

24 Monopoly and Public Policy  By reducing output and raising price above marginal cost, a monopolist captures some of the consumer surplus as profit and causes deadweight loss. To avoid deadweight loss, government policy attempts to prevent monopoly behavior.  When monopolies are created, governments should act to prevent them from forming and break up existing ones.  The government policies used to prevent or eliminate monopolies are known as antitrust policy.

25 Monopoly Causes Inefficiency Panel (b) depicts the industry under monopoly: the monopolist decreases output to QM and charges PM. Consumer surplus (blue triangle) has shrunk because a portion of it has been captured as profit (light blue area). Total surplus falls: the deadweight loss (orange area) represents the value of mutually beneficial transactions that do not occur because of monopoly behavior. (a)Total Surplus with Perfect Competition(b)Total Surplus with Monopoly D MC =ATC ATC Quantity Q C P C Q M P M D MR Quantity Price, cost Profit Deadweight loss Consumer surplus with perfect competition Consumer surplus with monopoly Price, cost, marginal revenue

26 Perfect Price Discrimination BA 210 Lesson III.3 Monopoly Perfect Price Discrimination

27 Price Discrimination Until now, all models involved a single equilibrium price.Until now, all models involved a single equilibrium price. But there is more profit in charging different prices.But there is more profit in charging different prices. Price discrimination is the practice of charging different prices to consumers for the same good.Price discrimination is the practice of charging different prices to consumers for the same good. Price discrimination can be perfect or imperfect.Price discrimination can be perfect or imperfect. n Perfect price discrimination achieves maximum profits, leaving no surplus for consumers. n Imperfect price discrimination achieves less than maximum profits, and leaves some surplus for consumers. BA 210 Lesson III.3 Monopoly Perfect Price Discrimination

28 Perfect Price Discrimination Practice of charging each consumer the maximum amount he or she will pay for each incremental unit (the height of the demand curve). Permits a firm to extract all surplus from consumers. BA 210 Lesson III.3 Monopoly Perfect Price Discrimination

29 BA 445 Lesson I.10 Monopoly Pricing For Reference, Standard Pricing and Profits Price Quantity D MC MR (twice the slope of demand) Profits from standard pricing = $8 Markup Rule

30 Perfect Price Discrimination Price Quantity D Profits*:.5(4-0)(10 - 2) = $16 Total Cost* = $8 MC * Assuming no fixed costs BA 210 Lesson III.3 Monopoly Perfect Price Discrimination

31 Example: A Pepperdine professor visiting Mexico paid $15 for a chess set (about equal to the maximum he was willing to pay).A Pepperdine professor visiting Mexico paid $15 for a chess set (about equal to the maximum he was willing to pay). When he returned to the same store, he was offered a lower price on a second set. After refusing the offer, the price continued to lower as the manager read his posture and tried to figure out the maximum amount he would be willing to pay.When he returned to the same store, he was offered a lower price on a second set. After refusing the offer, the price continued to lower as the manager read his posture and tried to figure out the maximum amount he would be willing to pay. Some say perfect price discrimination won’t work if consumers can resell the good. It does get harder, but it is still possible:Some say perfect price discrimination won’t work if consumers can resell the good. It does get harder, but it is still possible: n Suppose a Pepperdine student is only willing to pay $10 for a chess set for himself, but that student could resell the set to the professor for $15. n How much would the student be charged for the first set? n For the second set? (the one he keeps for himself) BA 210 Lesson III.3 Monopoly Perfect Price Discrimination

32 Caveat: Information constraints make perfect price discrimination difficult (it is difficult to know how much someone is willing to pay).Information constraints make perfect price discrimination difficult (it is difficult to know how much someone is willing to pay). The information constraints are especially difficult if consumers can resell the good.The information constraints are especially difficult if consumers can resell the good. n The manager cannot just appraise the maximum price the customer before him would pay for the good if he were buying it for himself, but also how much that customer could get by reselling the good. BA 210 Lesson III.3 Monopoly Perfect Price Discrimination

33 Two-Part Pricing BA 210 Lesson III.3 Monopoly Two-Part Pricing

34 Two-Part Pricing When consumers can not resell the good and when the firm has unlimited information, two-part pricing generates the same maximum profit as perfect price discrimination.When consumers can not resell the good and when the firm has unlimited information, two-part pricing generates the same maximum profit as perfect price discrimination. Two-part pricing consists of a fixed fee and a per unit charge.Two-part pricing consists of a fixed fee and a per unit charge. Examples:Examples: n Disneyland with fixed admission fee and zero charge per ride. n $2 cokes with free-refills, with the $2 the fixed fee and zero charge per coke refill. n Athletic club memberships. n Other examples? BA 210 Lesson III.3 Monopoly Two-Part Pricing

35 How Two-Part Pricing Works 1. Set price at marginal cost (to maximize total surplus). 2. Compute consumer surplus. 3. Charge a fixed-fee equal to consumer surplus (to capture all surplus as profit). Quantity D MC Fixed Fee = Profits* = $16 Price Per Unit Charge * Assuming no fixed costs Two-Part Pricing

36 Block Pricing BA 210 Lesson III.3 Monopoly Block Pricing

37 Block Pricing When consumers can not resell the good and when the firm has unlimited information, block pricing generates the same maximum profit as perfect price discrimination.When consumers can not resell the good and when the firm has unlimited information, block pricing generates the same maximum profit as perfect price discrimination. The practice of packaging multiple units of an identical product together and selling them as one package.The practice of packaging multiple units of an identical product together and selling them as one package. ExamplesExamples n Paper. n Six-packs of soda. n Different sized of cans of green beans. BA 210 Lesson III.3 Monopoly Block Pricing

38 Optimal Price for the Package of 4 units: $24 Price Quantity D MC = AC Consumer’s valuation of 4 units =.5(8)(4) + (2)(4) = $24. Therefore, set 4-Pack Price = $24. BA 210 Lesson III.3 Monopoly Block Pricing

39 Costs and Profits with Block Pricing Price Quantity D MC = AC Profits* = [.5(8)(4) + (2)(4)] – (2)(4) = $16 Costs = (2)(4) = $8 * Assuming no fixed costs BA 210 Lesson III.3 Monopoly Block Pricing

40 Imperfect Price Discrimination BA 210 Lesson III.3 Monopoly Imperfect Price Discrimination

41 Imperfect Price Discrimination Imperfect price discrimination: The practice of charging different groups of consumers different prices for the same product.Imperfect price discrimination: The practice of charging different groups of consumers different prices for the same product. Group must have observable characteristics for third-degree price discrimination to work.Group must have observable characteristics for third-degree price discrimination to work. Examples include student discounts, senior citizen’s discounts, regional and international pricing.Examples include student discounts, senior citizen’s discounts, regional and international pricing. BA 210 Lesson III.3 Monopoly Imperfect Price Discrimination

42 Implementing Imperfect Price Discrimination Suppose the total demand for a product is comprised of two groups with different elasticities, E 1 < E 2 < - 1 Notice that group 1 is more price sensitive than group 2. Profit-maximizing prices? P 1 = [E 1 /(1+ E 1 )]  MC < [E 2 /(1+ E 2 )]  MC = P 2 BA 210 Lesson III.3 Monopoly Imperfect Price Discrimination

43 A Numerical Example Suppose the elasticity of demand for Kodak film in the US is E U = -1.5, and the elasticity of demand in Japan is E J = -2.5.Suppose the elasticity of demand for Kodak film in the US is E U = -1.5, and the elasticity of demand in Japan is E J = Marginal cost of manufacturing film is $3.Marginal cost of manufacturing film is $3. P U = [E U /(1+ E U )]  MC = [-1.5/( )]  $3 = $9P U = [E U /(1+ E U )]  MC = [-1.5/( )]  $3 = $9 P J = [E J /(1+ E J )]  MC = [-2.5/( )]  $3 = $5P J = [E J /(1+ E J )]  MC = [-2.5/( )]  $3 = $5 Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic.Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic. BA 210 Lesson III.3 Monopoly Imperfect Price Discrimination

44 Qualitative Examples Why are seniors charged less than adults at Disneyland and at restaurants and at theaters? Higher elasticity (more substitutes). n They shop at Disneyland, like they shop at the mall. n They eat plain food at restaurants, like they eat at home. n They nap during movies, like they nap at home; and they cannot see or hear well enough to appreciate theater quality. Why are children charged less than adults at restaurants and for haircuts? Higher elasticity (more substitutes). n They eat plain food at restaurants, like they eat at home. n They can have their hair cut by their parents, or can go without. BA 210 Lesson III.3 Monopoly Imperfect Price Discrimination

45 Review Questions BA 210 Lesson III.1 Inputs and Costs Review Questions  You should try to answer some of the following questions before the next class.  You will not turn in your answers, but students may request to discuss their answers to begin the next class.  Your upcoming cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exam.

46 Review Questions BA 210 Lesson III.1 Inputs and Costs Follow the link for review questions for Lesson III.3

47 End of Lesson III.3 BA 210 Introduction to Microeconomics BA 210 Lesson III.1 Inputs and Costs