Market Structures: Monopoly

Monopoly Assumptions One seller and many buyers Barriers to Entry Implication: The seller is a price maker and the buyers are price takers. Barriers to Entry Ownership of a unique resource (Diamonds) Government granted rights for exclusive production (e.g. patents, copyrights, licenses, concessions) Economies of scale and declining long-run average costs Implication: Monopolist faces the entire market demand curve and profits can persist in the short and long-run.

Limits to Monopoly Size of the market (Pavarotti versus Joe, uncongested bridge) Definition of market and close substitutes (ornamental versus industrial diamonds, bottled water). Potential competition

Production Decisions Monopolist versus competitive firm. CF is a price taker who faces a perfectly elastic demand curve  MR=P M is a price maker who faces the entire market demand curve  MR<P Intuitive proof – to sell another unit the monopolist must lower the price. This means lowering the price not only on the extra unit sold, but also all the other units the monopolist was selling. So MR = Price of the additional unit – the sum of the decreases in all the units previously sold ( e.g. selling 4 units @$100, to sell the 5 unit the price must be lowered to $90, so the monopolist’s MR = $90 – 4X$10=$50) Tabular proof – see next table and handout Graphical proof

A Monopoly’s Revenue Total Revenue P  Q = TR Average Revenue TR/Q = AR = P Marginal Revenue DTR/DQ = MR

Table 1 A Monopoly’s Total, Average, and Marginal Revenue Copyright©2004 South-Western

Figure 2 Demand Curves for Competitive and Monopoly Firms (a) A Competitive Firm ’ s Demand Curve (b) A Monopolist ’ s Demand Curve Price Price Demand Demand Quantity of Output Quantity of Output Copyright © 2004 South-Western

Figure 3 Demand and Marginal-Revenue Curves for a Monopoly Price $11 10 9 8 7 6 5 4 3 Demand (average revenue) 2 Marginal revenue 1 –1 1 2 3 4 5 6 7 8 Quantity of Water –2 –3 –4 Copyright © 2004 South-Western

Profit Maximization A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Profit Maximization – Set MR = MC to find Q that maximizes profits. Use the market demand curve to find the P that the Q brings Find ATC and AVC cost to determine profits, losses, or shutdown. Difference between the monopolist decision and the competitive firms decision The monopolist does not have a supply curve like the CF, rather they pick a single price and quantity Monopolists produce where P>MR and P>MCversus CFs who produce where P=MR and P=MC.

Figure 4 Profit Maximization for a Monopoly Costs and 2. . . . and then the demand curve shows the price consistent with this quantity. Revenue 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity . . . Marginal revenue Demand Monopoly price QMAX B Marginal cost Average total cost A Q Q Quantity Copyright © 2004 South-Western

Figure 5 The Monopolist’s Profit Costs and Revenue Marginal revenue Demand Marginal cost Monopoly price QMAX B C E D Monopoly profit Average total cost Average total cost Quantity Copyright © 2004 South-Western

Figure 6 The Market for Drugs Costs and Revenue Marginal revenue Demand Price during patent life Monopoly quantity Price after patent expires Marginal cost Competitive quantity Quantity Copyright © 2004 South-Western

Welfare Costs of Monopoly In competitive markets, firms produce where P=MC And since P=MB=willingness to bud And MC=willingness to sell P=MC  MB=MC or Maximum total surplus

Output falls short of the efficient amount  Deadweight Welfare Loss In monopoly, P>MR so P>MC Or MB>MC Output falls short of the efficient amount  Deadweight Welfare Loss

Figure 7 The Efficient Level of Output Price Marginal cost Demand (value to buyers) Value to buyers Cost to monopolist Efficient quantity Cost to monopolist Value to buyers Quantity Value to buyers is greater than cost to seller. Value to buyers is less than cost to seller. Copyright © 2004 South-Western

Figure 8 The Inefficiency of Monopoly Price Demand Marginal revenue Marginal cost Deadweight loss Monopoly price quantity Efficient quantity Quantity Copyright © 2004 South-Western

Monopoly profit is not usually a social cost but a transfer of surplus from consumer to producer. Profit can be a social cost if extra costs are incurred to maintain it, such as political lobbying, or if the lack of competition leads to costs not being minimized (X-inefficiency again!)

Public Policy and Monopolies Working towards P=MC Attempts to increase competition through anti-trust legislation Sherman Antitrust Act of 1890 Examples: Breakup of Standard Oil and turning MA Bell into Baby Bells Regulation – Natural Monopolies P=MC doesn’t work with extensive economies of scale Regulated forms have little incentive to minimize costs Public Ownership Public utilities and the Postal Service Hands-off Approach Monopolies contribute to inefficiency because: P>MC Less than the socially optimal level of output is produced Incentives for cost reduction may diminish Too many resources may be spent on political protection .

Price-Discriminating Monopolist Price discrimination occurs when different prices are charged to different consumer that do no reflect differences in the cost of providing th good Perfect Price Discrimination – charging each customer their maximum willingness to pay. Imperfect Price Discrimination – segmenting the market into different consumer groups. Parable – Hardcopy versus paperback copy Allows firms to increase profits Requires separating customers into different groups and minimize arbitrage Results in greater economic welfare than single-pricing monopolists.

Basis for Price Descrimination Different consumers have different willingness to pay  different price elasticities of demand Rule: segment the market according to price elasticity of demand and charge the consumers will less elastic demand more than those with more elastic demand Examples: (remember the smaller the % of income or the greater the number of close substitutes the less price elastic the demand,) Movie Tickets Airline Tickets Discount Coupons Financial Aid Quantity Discounts

Summary Monopolies contribute to inefficiency because: P>MC  DWWL Less than the socially optimal level of output is produced Incentives for cost reduction may diminish Too many resources may be spent on political protection However, discriminating monopolist can help reduce DWWL.

Figure 10 Welfare with and without Price Discrimination (a) Monopolist with Single Price Price Consumer surplus Demand Marginal revenue Deadweight loss Quantity sold Monopoly price Profit Marginal cost Quantity Copyright © 2004 South-Western

Figure 10 Welfare with and without Price Discrimination (b) Monopolist with Perfect Price Discrimination Price Profit Demand Marginal cost Quantity sold Quantity Copyright © 2004 South-Western