Monopoly, Market Power, and Economies of Scale Today: Introduction of situations in which the Invisible Hand breaks down

Up until now… …we have typically analyzed markets with no control over market price Each firm was a price taker, since it only produced a very small fraction of quantity supplied in the market Today, we begin Unit 4 What happens when there are significant imperfections in a market?

Many sellers vs. one seller Many sellers No control over price One seller, also known as a monopolist Complete control over price (sort of)

Sort of? Recall that demand curves are downward-sloping Each time price increases, fewer people are willing to pay the price to purchase the good The monopolist can control price, but must face the consequences that price determines quantity sold

MB in a competitive vs. monopolistic environment Competitive environment MB is price, since price does not depend on quantity supplied by an individual firm Monopolistic environment We will see that MB decreases as quantity supplied increases

What happens to the monopolist when it sells another unit? Each time another unit is sold, price of the good decreases We will go through a simple example, shown to the right, to determine MR for the monopolist PQ

Marginal revenue How much additional is received by selling one more unit of the good? We must first calculate TR Notice that for Q > 1, MR < P PQTRMR

Market inefficiencies of monopoly Decreasing marginal revenue creates inefficiencies in the market We will talk about this more in the next lecture

And now, onto the big question of the day How Do Firms Gain Market Power? Exclusive control over important inputs Patents and copyrights Government licenses or franchises Economies of scale  Natural monopoly Networks

Exclusive control over important inputs If a company controls a significant portion of the important inputs to a product, it can have significant influence on price

Exclusive control over important inputs Example: De Beers Rough diamond explorer Around 40% of world diamond production by value Sales and marketing through the Diamond Trading Company This company sells almost half of the world’s rough diamonds by value (Source: checked Feb. 3, 2008)

De Beers Such large control over the market makes De Beers able to act similarly to a monopolist Marketing of diamond jewelry does not have to be brand specific "A Diamond is Forever" attempts to prevent old jewelry from entering the market De Beers does have some control over world prices

Patents and copyrights Patents and copyrights prohibit others from copying private work and discoveries Example: Copying songs and movies that are copyrighted are typically prohibited by law

Government licenses or franchises Government-owned property often allows exclusive operation of the property for various uses In some cases, this is to prevent competition that could deteriorate a natural destination

Government licenses or franchises Example: Yosemite National Park Limited parking Tasteful hotels Most of the park is undeveloped Most of park development is in only 7 square miles Park is 1,200 square miles Vernal Fall

Economies of scale Some technologies are such that as the quantity produced increases, ATC decreases for all reasonable quantities produced This is due to increasing returns to scale This happens when ALL inputs double and production MORE THAN doubles Often happens with large fixed costs and nearly-linear variable costs

Example where a single firm could gain market power When a firm gains market control with economies of scale, it is called a natural monopoly There are problems with natural monopolies if left uncontrolled Deal with this later Price ($) Quantity D ATC

Network economies Some technologies are slow to get adopted due to not enough people entering the market Video phones (early version at right, the PicturePhone) Fax machines HD DVDs versus Blu-ray See additional reading for more Why? Costs are very high initially

Network economies The internet has created a frenzy of network economies eBay On-line auctions Facebook and MySpace Social networking As more people use eBay, Facebook, and MySpace, the respective companies increased in value Competition became difficult

Monopoly inefficiency As we will see, monopolies typically produce quantities that are less than efficient This leads to positive economic profits

Controlling monopolies Laws have been passed to control monopoly profits Regulation typically tries to set economic profit to be about zero This sometimes makes regulated stocks a relatively safe investment

Controlling monopolies Why are monopolies typically regulated? We will analyze this in the next lecture In the absence of regulation, a monopoly will usually produce a quantity that is below the optimal amount in order to make positive economic profits Monopolies can increase efficiency by price discrimination However, the monopolist sometimes benefits more than consumers do

The rest of today Introducing profit maximization from the monopolist’s point of view All units must be sold for the same price Profit maximization of the monopolist As usual, set MB = MC to maximize profit Revenue is the benefit for the monopolist Remember that MB is decreasing for the monopolist

Single-price profit maximization Remember that marginal revenue is below the price received by the monopolist (except for the first unit in a discrete case) See our continuous example we will use today

Single-price profit maximization We will find the point where MR and MC are equal Surplus and deadweight loss will then be calculated

Important fact to note for linear demand curves MR has same vertical intercept as D, with twice the slope Read Ch. 8 Appendix for algebraic approach to solving monopoly problems

Simple monopoly example For this problem, note: Linear downward- sloping demand curve Linear upward- sloping MC curve Remember: We maximize profit by setting MR = MC

Simple monopoly example In an efficient market with many buyers and sellers, point I is the intersection of the supply (MC) and demand curves Price is G, quantity is H

Simple monopoly example As we will see with a monopoly, a different, less efficient outcome, occurs

Simple monopoly example Point K MR = MC At quantity A, the monopolist can see from point E on the demand curve that price C can be charged

Simple monopoly example Calculating surplus if this was an efficient market Recall that triangle JI0 is total surplus in an efficient market Triangle JIG for consumers Triangle GI0 for suppliers

Simple monopoly example At price C, consumer surplus falls to triangle JCE TR for monopolist is price C times quantity A Surplus for monopolist is trapezoid CEK0

Simple monopoly example What is lost? Triangle EIK is lost, since the monopolist stops producing once quantity reaches A This triangle is deadweight loss (DWL)

Friday More on profit maximization from the monopolist’s point of view Inefficiencies of monopoly Is discrimination legal?