Lecture 11: Monopoly Readings: Chapter 13

Monopoly Q: How realistic is the perfectly competitive model of supply? A: Very few industries have firms that resemble the price taking small producers of the perfect competitive model. Q: Is the model of perfect competition wrong? A: All models are wrong in the literal sense. The important question is whether the model is useful.

Monopoly Q: In what sense is the model of supply under perfect competition useful? A: There are a number of general insights: Firms maximize profits by setting output strategies where the MR=MC. Losses cause exit and shift the supply curve to the left over the long run. Profits cause entry and shift supply to the right over the long run.

Q: Does the model of perfect competition fail? Monopoly Q: Does the model of perfect competition fail? A: The model does not explain: Pricing strategies in industries with few competitors? Non-price strategies (advertising, product differentiation, R&D, etc.) Strategic interdependence between firms.

Monopoly Q: How can we get a better understanding of pricing strategies? A: The simplest model that investigates pricing strategy is the model of a monopoly supplier. Monopoly will be our starting point from which we will proceed to a more detailed and complete understanding of the theory of supply.

Monopoly Q: What is a monopoly? A: A Monopoly is an industry with one supplier of a product with no close substitutes. Q: When do monopolies occur? A: Whenever there are barriers to entry. Legal Monopolies (public franchise, government license, patent, or copyright) Natural Monopoly (IRS)

The Theory of Supply - Monopoly Q: What is the simplest type of monopoly? A: A Single-price monopoly charges same price for every unit of output. Q: How is the single price monopoly’s problem different from the perfectly competitive firm’s problem? A: In addition to deciding how much to produce, the single price monopoly must decide what price to charge for its good. continued

The Theory of Supply - Monopoly Q: Why can’t a firm in a perfectly industry choose the price it sells its good for? A: Because suppliers in a competitive industry can sell as much as they want at the market price, but cannot sell even one unit at any price above the market price. (eg. Wheat farmer) For a firm in a competitive industry, P = MR = AR = firm’s demand curve. A monopolist can choose the price it sells at.

Monopoly Q: What is the monopolist’s MR? A: Consider the problem of selling one more unit. To do so, the monopolist must lower the price on all units. This creates two impacts on revenue: For those goods already being sold revenue falls because of the lower price per unit. The lower price also increases sales which increases revenue. The total impact is illustrated in the next diagram.

Suppose the monopoly sets a price of $16 and sells 2 units. Figure 13.2 illustrates the relationship between price and marginal revenue and derives the marginal revenue curve. Suppose the monopoly sets a price of $16 and sells 2 units. Marginal revenue curve Students don’t find the concept of marginal revenue difficult, but they do need to be clear on the intuition of the MR curve and the reason why MR < P for a single-price monopoly. This fact is the central source of the monopoly predictions.

Monopoly Now suppose the firm cuts the price to $14 to sell 3 units. It loses $4 of total revenue on the 2 units it was selling at $16 each. And it gains $14 of total revenue on the 3rd unit. So total revenue increases by $10, which is marginal revenue.

Monopoly The marginal revenue curve, MR, passes through the red dot midway between 2 and 3 units and at $10. Notice that MR < P at each quantity.

Monopoly A single-price monopoly’s marginal revenue is related to the elasticity of demand for its good: If demand is elastic, a fall in price brings an increase in total revenue.

Monopoly The increase in revenue from the increase in quantity sold outweighs the decrease in revenue from the lower price per unit, and MR is positive. As the price falls, total revenue increases.

Monopoly If demand is inelastic, a fall in price brings a decrease in total revenue. The rise in revenue from the increase in quantity sold is outweighed by the fall in revenue from the lower price per unit, and MR is negative.

Monopoly As the price falls, total revenue decreases.

Monopoly If demand is unit elastic, a fall in price does not change total revenue. The rise in revenue from the increase in quantity sold equals the fall in revenue from the lower price per unit, and MR = 0. Total revenue is maximized when MR = 0.

Monopoly Surprising Implication: A Monopoly will always choose an output strategy where Demand Is Elastic A single-price monopoly never produces an output at which demand is inelastic. If it did produce such an output, the firm could increase total revenue, decrease total cost, and increase economic profit by decreasing output.

Monopoly Q: Does the monopoly choose a price that maximizes revenue for the firm? A: No! The monopoly must maximize profits to satisfy its owners. Q: What is the profit maximizing monopolist’s best strategy? A: Choose Q where π = TR - TC, and then set the maximum price that will sell precisely this many units of their output.

Monopoly The profit-maximizing choice of a single-price monopoly is Q=3, where total revenue minus total cost is maximized

Monopoly Q: What if the managers of monopoly do not know the TR or TC curves. What will they do? A: Follow the marginal algorithm for finding the optimal strategy. Increase Q if MR>MC Decrease Q if MR<MC Q is best when MR = MC

Monopoly Q: What does such a strategy look like? A: We can merge the market demand curve with the firm’s average and total cost curves. This is possible because a monopoly firm’s demand is the full market demand.

The ATC curve tells us the average total cost. Monopoly The firm chooses Q=3 where MR = MC and sets the price at which it can sell that quantity. The ATC curve tells us the average total cost. Economic profit is the profit per unit multiplied by the quantity produced—the blue rectangle. The classic monopoly diagram The classic monopoly diagram, Figure 13.4(b) provides a good opportunity to tell your students about the contribution of one of the most brilliant economists of the 20th century, Joan Robinson. This diagram first appeared in her book, The Economics of Imperfect Competition, published in 1933 when she was just 30 years old. You can learn more about Joan Robinson at http://cepa.newschool.edu/het/profiles/robinson.htm (or use the link on the Economics Place Web site). Women are still not attracted to economics on the scale that they’re attracted to most other disciplines, so the opportunity to talk about an outstanding female economist shouldn’t be lost. Joan Robinson was a formidable debater and reveled in verbal battles, a notable one of which was with Paul Samuelson on one of her visits to MIT. Anxious to make and illustrate a point, Samuelson asked Robinson for the chalk. Monopolizing the chalk and the blackboard, the unyielding Robinson snapped, “Say it in words young man.” Samuelson meekly obeyed. This story illustrates Joan Robinson’s approach to economics: work out the answers to economic problems using the appropriate techniques of math and logic, but then “say it in words.” Don’t be satisfied with formal argument if you don’t understand it. Your students will benefit from this story if you can work it into your class time.

(b) Demand, marginal revenue, marginal cost, and average cost P 20 Monopoly TR, TC TC (a) Total revenue and total cost TR 3 30 42 10 14 Economic profit $12 Q (b) Demand, marginal revenue, marginal cost, and average cost P 20 MC ATC D MR Q Copyright © 1997 Addison-Wesley Publishers Ltd. Textbook p. 266

Monopoly Q: What does this model tell us about monopoly supply behaviour? A: There are several interesting characteristics of monopoly supply: A monopoly never operates in the inelastic range of the demand curve. A monopoly has no supply curve. Monopolistic firms make economic profits, even in long run, because barriers prevent entry new firms.

Monopoly Q: What is missing from this analysis of monopoly supply behaviour? A: Monopolists only rarely charge a single price for there product. It is more usual for monopolists to price discriminate. Q: What is price discrimination? A: Charging different customers different prices, for the same good.

Q: Why price discrimination? Monopoly Q: Why price discrimination? A: Price discrimination increasing profits by identifying who will pay more than the current monopoly price, and charging them a higher price. It isn’t just monopolists who benefit from price discrimination. Examples include: Airline ticket pricing Declining block pricing for electricity. Long-Distance Telephone rates. Next Page: Three groups identified , three prices continued

Figure 12. 4b. A Monopoly’s Output and Price: Demand Figure 12.4b A Monopoly’s Output and Price: Demand and Marginal Revenue and Cost Curves P 20 MC 3 10 14 ATC D MR Q Copyright © 1997 Addison-Wesley Publishers Ltd. Textbook p. 266

Monopoly Q: What is the most profitable price discrimination strategy? A: Perfect price discrimination - Charge each customer the maximum price they are willing to pay (P= maximum willingness to pay) Q: How much will a perfect price discriminating monopoly choose to supply? A: It will depend on what the MR looks like under perfect price discrimination. Once we know what MR curve is, the most profitable Q is where MR=MC.

Monopoly If perfect price discrimination is possible, then there is no need to reduce the price for all goods sold if the monopoly wants to sell more. The monopoly simply reduces the price to the new consumers, while keeping the price to his existing consumers unchanged. Implications: 1. MR curve same as demand curve 2. Q is same as under perfect competition

Monopoly Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price anyone is willing to pay. Marginal revenue now equals price and the demand curve is also the marginal revenue curve.

Monopoly With perfect price discrimination: The profit-maximizing output increases to the quantity at which price equals marginal cost. Economic profit increases above that made by a single-price monopoly.

Monopoly Q: Is perfect price discrimination a viable strategy option? A: No. It requires the firm to know what each person is willing to pay for the good. The consumer is unlikely to tell the monopolist this information. Q: What is a viable strategy option? A: Identify a few groups, and develop a separate monopoly strategy for each group.

Monopoly Consider the case of an airline monopoly that has identified two traveling groups: Business Tourist Suppose the profit maximizing strategy for the single price monopoly is to charge $1500. If Business and Tourist travelers have a different price elasticity of demand at this price then profits can be increased by charging a different price to each group.

Monopoly Q: How should the price strategy be changed? A: Revenue will increase if you increase the price for customers who inelastically demand airline trips, while revenue can also rise if you drop the price for customers who elastically demand airline trips. Business travelers are known to inelastically demand the good at this price Tourist travelers are known to elastically demand

Monopoly But airlines are not revenue maximizers, they are profit maximizers. Q: What price should each group be charged if the airline is to maximize profits? A: For each group find where the MR curve intersects the MC curve, supply that many seats to that group, then go up to the demand curve to find the maximum price that will sell all the seats. (in following example MC is constant)

Figure 12.6a Price Discrimination: Business Travellers No price discrimination profit $3m 2,000 5 1,700 Decrease in quantity demanded $3.5m 1,500 1,000 MC DB MRB 6 Q Copyright © 1997 Addison-Wesley Publishers Ltd. Textbook p. 269

Figure 12.6b Price Discrimination: Vacation Travellers No price discrimination profit $2m 2,000 7 1,350 Increase in quantity demanded MRV $2.45 m 1,500 1,000 MC DV 4 Q Copyright © 1997 Addison-Wesley Publishers Ltd. Textbook p. 269

Monopoly Q: Is that all the airline has to do to increase profits by price discrimination? A: No! The monopolist must make it impossible for the low price consumers to sell to the high price consumers. Airlines do this by putting the customers name on the ticket Without prevention of resale, the strategy would be destroyed by arbitraging (ie ticket scalping)

Monopoly Q: How does a monopoly compare to a perfectly competitive industry? A: For a single price monopolist: Price is higher Quantity supplied is lower Consumer Surplus is lower Deadweight Loss

Monopoly Compared to perfect competition, monopoly produces a smaller output and charges a higher price.

Monopoly Perfect Competition produces more output at a lower price → Perfect Competition is more efficient. Recall: The market demand curve is the marginal social benefit curve, MSB, and the market supply curve is the marginal social cost curve, MSC. At competitive equilibrium MSB = MSC, and so the competitive market is efficient.

Monopoly Consumer surplus is the area below the demand curve and above the price. Producer surplus is the area below the price and above the supply curve. Total surplus, the sum of the two surpluses, is maximized and the quantity produced is efficient.

Monopoly produces less at a higher price. Because price exceeds marginal social cost, marginal social benefit exceeds marginal social cost, and a deadweight loss arises. Monopoly is inefficient. The inefficiency of monopoly is one of the key propositions in this chapter. Because P > MR, and because MR = MC, P > MC—single-price monopoly under-produces and creates deadweight loss. Rent seeking uses further resources so potentially the social cost of monopoly is the sum of the deadweight loss and the economic profit that a monopoly might earn. Adam Smith described the situation thus: “People in the same trade seldom meet together, even for merriment and diversion, but the conversation ends in some contrivance to raise prices.”

Monopoly Q: What happens to the surpluses? CS ↓ PS ↑ some surplus disappears completely (DWL)

Monopoly Q: Should price discrimination be allowed? A: If possible, price discrimination can be expected to: Increase monopoly profits Reduce consumer surplus for some, increase for others. Increase QS towards perfect competition output level. Deadweight Loss is lower Exercise: Prove these at home.

Monopoly Q: Is Monopoly really that bad? A: It may be worse than we have shown: The lure of monopoly creates wasteful rent seeking behavior. Surplus is transferred from consumers to a small number of monopoly owners, which reduces the fairness of the market. Monopoly creates inequality which can lead to wasteful social unrest.

Monopoly Q: What can be done? A: There are two things governments can do: Regulate prices when monopoly is unavoidable (Natural Monopoly). Deregulate when government regulations have created un-necessary monopoly, or when government regulation has reduced competition.

End of Lecture 11