© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Monopoly 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Barriers to Entry Monopoly –Sole supplier of a product with no close substitutes Barrier to entry –Any impediment that prevents new firms From entering an industry And competing on an equal basis with existing firms 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Barriers to Entry Barriers to entry –Legal restrictions –Economies of scale –Control of essential resources 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Barriers to Entry Legal restrictions –Patents and invention incentives Exclusive right to sell a product for 20 years from the date the patent application is filed Incentive for innovation –Licenses and other entry restrictions Government awarding an individual firm the exclusive right to supply a particular good or service Federal and state license 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Barriers to Entry Economies of scale –Natural monopoly –Downward-sloping long-run average cost curve One firm can supply market demand at a lower average cost per unit than could two firms 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exhibit 1 6 Economies of Scale as a Barrier to Entry Quantity per period Cost per unit $ Long-run average cost A monopoly sometimes emerges naturally when a firm experiences economies of scale as reflected by a downward- sloping long-run average cost curve. One firm can satisfy market demand at a lower average cost per unit than could two or more firms, each operating at smaller rates of output. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Barriers to Entry Control of essential resources –Firm’s control over some resource critical to production –Alcoa (aluminum) Control the supply of bauxite –Professional sports leagues –China (pandas) –DeBeers Consolidated Mines (diamonds) 7

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Barriers to Entry Supplying something that other producers can’t match –Unique experience Monopolies –Local, national, international Long-lasting monopolies –Rare - economic profit attracts competitors –Technological change 8

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Revenue for the Monopolist Monopoly –Supplies the market demand Downward-slopping (law of demand) –To sell more: must lower the price on all units sold Total revenue TR=p ˣ Q Average revenue AR=TR/Q –For monopolist: p=AR Demand curve = average revenue curve 9

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 2 10 A Monopolist’s Gain and Loss in Total Revenue from Selling a Fourth Unit D = Average revenue Dollars per diamond $7,000 6,750 1-carat diamonds per day 340 Loss Gain If De Beers increases quantity supplied from 3 to 4 diamonds per day, the gain in revenue from the fourth diamond is $6,750. But the monopolist loses $750 from selling the first 3 diamonds for $6,750 each instead of $7,000 each. Marginal revenue from the fourth diamond equals the gain minus the loss, or $6,750 $750 $6,000. Thus, the marginal revenue of $6,000 is less than the price of $6,750.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Revenue for the Monopolist Marginal revenue MR=∆TR/∆Q –For monopolist: MR<p –Declines, can be negative Marginal revenue curve –Downward sloping –Below the demand curve (average revenue curve) 11

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 3 12 Revenue for De Beers, a Monopolist To sell more, the monopolist must lower the price on all units sold. Because the revenue lost from selling all units at a lower price must be subtracted from the revenue gained from selling another unit, marginal revenue is less than the price. At some point, marginal revenue turns negative, as shown here when the price is reduced to $3,500.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 4 13 Monopoly Demand, Marginal Revenue, and Total Revenue Dollars per diamond $3,750 0 (a)Demand and marginal revenue (b) Total revenue 1-carat diamonds per day Total dollars $60,000 1-carat diamonds per day 1632 D=Average revenue Elastic Unit elastic Inelastic MR Total revenue Where demand is price elastic, marginal revenue is positive, so total revenue increases as the price falls. Where demand is price inelastic, marginal revenue is negative, so total revenue decreases as the price falls. Where demand is unit elastic, marginal revenue is zero, so total revenue is at a maximum, neither increasing nor decreasing.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Revenue for Monopolist Total revenue curve Reaches maximum where MR=0 Demand curve: p=AR Where demand is elastic, as price falls –Total revenue increases –MR>0 14

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Revenue for Monopolist Where demand is inelastic, as price falls –Total revenue decreases –MR<0 Where demand is unit elastic –Total revenue is maximized –MR=0 15

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Costs and Profit Maximization Monopolist –Choose the price –OR the quantity –‘Price maker’ Price maker –Firm with some power to set the price –Demand curve for its output slopes downward –Firms with market power 16

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Costs and Profit Maximization Profit maximization –Profit = total revenue minus total cost –Supply the quantity where Total revenue exceeds total cost by the greatest amount Marginal revenue equals marginal cost 17

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 5 18 Short-Run Costs and Revenue for a Monopolist

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 6 19 Monopoly Costs and Revenue Dollars per diamond $5,250 4,000 (a)Per-unit cost and revenue (b) Total cost and revenue D=Average revenue MR Total revenue Diamonds per day Total cost Total dollars $52,500 40,000 15,000 Average total cost Marginal cost Diamonds per day a b e Profit Maximum profit Profit is maximized by producing where marginal cost equals marginal revenue, which is point e in panel (a). A profit-maximizing monopolist supplies 10 diamonds per day and charges $5,250 per diamond. Total profit, shown by the blue rectangle in panel (a), is $12,500, the profit per unit multiplied by the number of units sold. In panel (b), profit is maximized by producing where total revenue exceeds total cost by the greatest amount, which occurs at an output rate of 10 diamonds per day. Maximum profit is total revenue ($52,500) minus total cost ($40,000), or $12,500. In panel (a) profit is measured by an area and in panel (b) by a vertical distance. That’s because panel (a) measures cost, revenue, and profit per unit of output while panel (b) measures them as totals.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short-Run Losses If the price exceeds average total cost, p>ATC –Economic profit If the price is between average total cost and average variable cost, ATC>p>AVC –Economic loss –Produce in short run 20

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Shutdown Decision If the price is below the average variable cost, p<AVC –Average variable cost curve is above the demand curve –Economic loss –Shut down in short run 21

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 7 22 The Monopolist Minimizes Losses in the Short Run 0QQuantity per period p Dollars per unit Average total cost Average variable cost Marginal cost Demand=Average revenue Marginal revenue a b c e Loss Marginal revenue equals marginal cost at point e. At quantity Q, price p (at point b) is less than average total cost (at point a), so the monopolist suffers a loss, identified by the pink rectangle. But the monopolist continues to produce rather than shut down in the short run because price exceeds average variable cost (at point c)

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Long-Run profit Maximization Short-run profit –No guarantee of long-run profit High barriers that block new entry –Economic profit Erase a loss or increase profit –Adjust the scale of the firm If unable to erase a loss –Leave the market 23

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Monopoly & Allocation of Resources Perfect competition –Long run equilibrium –Constant-cost industry –Marginal benefit (p) = marginal cost –Allocative efficient market –Maximize social welfare –Consumer surplus 24

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Monopoly & Allocation of Resources Monopoly –Marginal benefit (p) > marginal cost –Restrict quantity below what would maximize social welfare –Smaller consumer surplus –Economic profit –Deadweight loss of monopoly –Allocative inefficiency 25

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Monopoly & Allocation of Resources Deadweight loss of monopoly –Net loss to society –When a firm with market power restricts output and increases the price 26

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. S c =MC=ATC Exhibit 8 27 Perfect Competition and Monopoly Compared Quantity per period QmQm QcQc 0 Dollars per unit pmpm pcpc D c a MR m b m A perfectly competitive industry would produce output Q C, determined by the intersection of the market demand curve D and the market supply curve S C. The price would be p C. A monopoly that could produce output at the same minimum average cost as a perfectly competitive industry would produce output Q m, determined at point b, where marginal cost intersects marginal revenue. The monopolist would charge price p m. Thus, given the same costs, output is lower and price is higher under monopoly than under perfect competition.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Estimating Deadweight Loss Deadweight loss of monopoly might be lower –Substantial economies of scale Lower cost per unit –Keep price below the profit maximizing value Public scrutiny, political pressure Avoid attracting competition 28

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Estimating Deadweight Loss Deadweight loss of monopoly might be higher –Secure and maintain monopoly position Use resources; social waste Influence public policy (Rent seeking) –Inefficiency –Slow to adopt new technology –Reluctant to develop new products –Lack innovation 29

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Price Discrimination Price discrimination –Increasing profit –Charging different groups of consumers Different prices For the same product 30

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Price Discrimination Conditions for price discrimination –Downward sloping demand curve Some market power –At last two groups of consumers With different price elasticity of demand –Ability to charge different prices At low cost –Prevent reselling of the product 31

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A Model of Price Discrimination Two groups of consumers –One group (a): less elastic demand –The other (b): more elastic demand Maximize profit –MR=MC in each market –Lower price for group (b) 32

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 9 33 Price Discrimination with Two Groups of Consumers D (a)Consumer group with less elastic demand LRAC, MC (b) Consumer group with more elastic demand 400Quantity per period0 500Quantity per period0 A monopolist facing two groups of consumers with different demand elasticities may be able to practice price discrimination to increase profit or reduce loss. With marginal cost the same in both markets, the firm charges a higher price to the group in panel (a), which has a less elastic demand than group in panel (b). Dollars per unit $ LRAC, MC MR Dollars per unit $ D’ MR’

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Examples of Price Discrimination Airline travel Businesspeople (business class) –Less elastic demand –Higher price Even within the same class –Different prices –Discount fares –Weekend stay 34

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Examples of Price Discrimination IBM laser printer 5 pages/minute: home; cheaper –Extra chip to insert pauses between pages 10 pages/minute: business; expensive Intel - two versions of the same computer chip –Cheaper version Same as the expensive version Some extra work done to reduce its speed 35

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Examples of Price Discrimination Adobe –Photoshop Elements Cheaper version of Photoshop CD Amusement parks Out-of-towners: less elastic demand –Higher prices Locals: more elastic demand –Discount coupons available at local businesses 36

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Perfect Price Discrimination Perfectly discriminating monopolist –Monopolist who charges a different price –For each unit sold –The monopolist’s dream Charge different price for each unit sold –D curve becomes MR curve –Convert consumer surplus into economic profit –Allocative efficiency: No deadweight loss 37

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit Perfect Price Discrimination Quantity per periodQ0 Dollars per unit c Long-run average cost = Marginal cost D=Marginal revenue c a Profit If a monopolist can charge a different price for each unit sold, it may be able to practice perfect price discrimination. By setting the price of each unit equal to the maximum amount consumers are willing to pay for that unit (shown by the height of the demand curve), the monopolist can earn a profit equal to the area of the shaded triangle. Consumer surplus is zero. Ironically, this outcome is efficient because the monopolist has no incentive to restrict output, so there is no deadweight loss.