12 MONOPOLY CHAPTER

Objectives After studying this chapter, you will able to Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly Explain how a single-price monopoly determines its output and price Compare the performance and efficiency of single-price monopoly and competition

Objectives After studying this chapter, you will able to Define rent seeking and explain why it arises Explain how price discrimination increases profit Explain how monopoly regulation influences output, price, economic profit, and efficiency

Dominating the Internet eBay and Google are dominant players in the markets they serve. These firms are not like the firms in perfect competition. How do firms that dominate their markets behave? Students get lots of price breaks—at the movies, hairdresser, and on the airlines. Why? How can it be profit maximizing to offer lower prices to some customers?

Market Power Market power and competition are the two forces that operate in most markets. Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale. A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

Market Power How Monopoly Arises A monopoly has two key features: No close substitutes Barriers to entry Legal or natural constraints that protect a firm from potential competitors are called barriers to entry.

Market Power There are two types of barriers to entry: legal and natural. Legal barriers to entry create a legal monopoly, a market in which competition and entry are restricted by the granting of a: Public franchise (like the U.S. Postal Service public franchise to deliver first-class mail). Government license (like a license to practice law or medicine) Patent and copyright

Market Power Natural barriers to entry create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can. Figure 12.1 illustrates a natural monopoly.

Market Power One firm can produce 4 units of output at 5 cents per unit. Two firms can produce 4 units—2 units each—at 10 cents per unit. Four firms can produce 4 units—1 unit each—at 15 cents per unit.

Market Power In a natural monopoly, economies of scale are so powerful that they are still being achieved even when the entire market demand is met. The ATC curve is still sloping downward when it meets the demand curve.

Market Power Monopoly Price-Setting Strategies For a monopoly firm to determine the quantity it sells, it must choose the appropriate price. There are two types of monopoly price-setting strategies: Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms. A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers.

A Single-Price Monopoly’s Output and Price Decision Price and Marginal Revenue A monopoly is a price setter, not a price taker like a firm in perfect competition. The reason is that the demand curve for the monopoly’s output is the market demand curve. To sell a larger output, a monopoly must set a lower price.

A Single-Price Monopoly’s Output and Price Decision Total revenue, TR, is the price, P, multiplied by the quantity sold, Q. Marginal revenue, MR, is the change in total revenue that results from a one-unit increase in the quantity sold. For a single-price monopoly, marginal revenue is less than price at each level of output. That is, MR < P

A Single-Price Monopoly’s Output and Price Decision Figure 12.2 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.

A Single-Price Monopoly’s Output and Price Decision 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.

A Single-Price Monopoly’s Output and Price Decision The marginal revenue curve, MR, passes through the red dot midway between 2 and 3 units and at $10. You can see that MR < P at each quantity.

A Single-Price Monopoly’s Output and Price Decision Marginal Revenue and Elasticity 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.

A Single-Price Monopoly’s Output and Price Decision Marginal Revenue and Elasticity The rise in revenue from the increase in quantity sold outweighs the fall in revenue from the lower price per unit, and MR is positive. Total revenue increases.

A Single-Price Monopoly’s Output and Price Decision 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.

A Single-Price Monopoly’s Output and Price Decision Total revenue decreases.

A Single-Price Monopoly’s Output and Price Decision If demand is unit elastic, a fall in price brings total revenue does not change. 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.

A Single-Price Monopoly’s Output and Price Decision 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.

A Single-Price Monopoly’s Output and Price Decision Price and Output Decision The monopoly faces the same types of technology constraints as the competitive firm, but the monopoly faces a different market constraint. The monopoly selects the profit-maximizing level of output in the same manner as a competitive firm, where MR = MC.

A Single-Price Monopoly’s Output and Price Decision The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity. Table 12.1 provides a numerical example to illustrate the profit-maximizing output and price decision. The monopoly may earn an economic profit, even in the long run, because the barriers to entry protect the firm from market entry by competitor firms.

A Single-Price Monopoly’s Output and Price Decision Figure 12.4 illustrates the profit-maximizing choices of a single-price monopolist. In part (a), the monopoly sets the quantity produced at the level that maximizes total revenue minus total cost.

A Single-Price Monopoly’s Output and Price Decision In part (b), the firm produces the output at which MR = MC and sets the price to sell that quantity. The ATC curve tells us the average cost. Economic profit is the profit per unit multiplied by the quantity produced—the blue rectangle.

Single-Price Monopoly and Competition Compared Comparing Output and Price Figure 12.5 compares the price and quantity in perfect competition and monopoly. The market demand curve, D, in perfect competition is the demand curve that the firm faces in monopoly.

Single-Price Monopoly and Competition Compared The market supply curve in perfect competition is the horizontal sum of the individual firm’s marginal cost curves, S = MC. This curve is the monopoly’s marginal cost curve.

Single-Price Monopoly and Competition Compared Equilibrium in perfect competition occurs where the quantity demanded equals the quantity supplied at quantity QC and price PC.

Single-Price Monopoly and Competition Compared Equilibrium output for a monopoly, QM, occurs where marginal revenue equals marginal cost, MR = MC. Equilibrium price for a monopoly, PM, occurs on the demand curve at the profit-maximizing quantity.

Single-Price Monopoly and Competition Compared Because marginal revenue is less than price at each output level, QM < QC and PM > PC. Compared to perfect competition, monopoly restricts output and charges a higher price.

Single-Price Monopoly and Competition Compared Efficiency Comparison Monopoly is inefficient, and Figure 12.6 shows why. The demand curve is the marginal benefit curve, MB, and the competitive market supply curve is the marginal cost curve, MC. So competitive equilibrium is efficient: MB = MC.

Single-Price Monopoly and Competition Compared Consumer surplus is the area below the demand curve and above the price. Producer surplus is the area below the price and above the marginal cost curve. The sum of the two surpluses is maximized and the efficient quantity is produced.

Single-Price Monopoly and Competition Compared Monopoly is inefficient because price exceeds marginal cost so marginal benefit exceeds marginal cost. On all output levels for which marginal benefit exceeds marginal cost, a deadweight loss is incurred.

Single-Price Monopoly and Competition Compared Redistribution of Surpluses Monopoly redistributes a portion of consumer surplus by changing it to producer surplus.

Single-Price Monopoly and Competition Compared Rent Seeking The social cost of monopoly may exceed the deadweight loss through an activity called rent seeking, which is any attempt to capture consumer surplus, producer surplus, or economic profit. Rent seeking is not confined to a monopoly. There are two forms of rent seeking activity to pursue monopoly: Buy a monopoly—transfers rent to creator of monopoly. Create a monopoly—uses resources in political activity.

Single-Price Monopoly and Competition Compared Rent-Seeking Equilibrium The resources used in rent seeking can exhaust the monopoly’s economic profit and leave the monopoly owner with only normal profit. Figure 12.7 shows the normal profit that result from rent seeking.

Single-Price Monopoly and Competition Compared A potential profit shown by the blue area gets used up in rent seeking. Average total cost increases and the profits disappear to become part of the enlarged deadweight loss from rent seeking.

Price Discrimination Price discrimination is the practice of selling different units of a good or service for different prices. To be able to price discriminate, a monopoly must: Identify and separate different buyer types Sell a product that cannot be resold Price differences that arise from cost differences are not price discrimination.

Price Discrimination Price Discrimination and Consumer Surplus Price discrimination converts consumer surplus into economic profit. A monopoly can discriminate Among units of a good. Quantity discounts are an example. (But quantity discounts that reflect lower costs at higher volumes are not price discrimination.) Among groups of buyers. (Advance purchase and other restrictions on airline tickets are an example.)

Price Discrimination Profiting by Price Discriminating Figures 12.8 and 12.9 show the same market with a single price and price discrimination and show how price discrimination converts consumer surplus into economic profit.

Price Discrimination As a single-price monopolist, this firm maximized profit by producing 8 units, where MR = MC and selling them for $1,200 each.

Price Discrimination By price discriminating, the firm can increase its profit. In doing so, it converts consumer surplus into economic profit.

Price Discrimination Perfect Price Discrimination Perfect price discrimination extracts the entire potential consumer surplus and converts it to economic profit.

Price Discrimination With perfect price discrimination: Output increases to the quantity at which price equals marginal cost Economic profit increases above that earned by a single-price monopoly. Deadweight loss is eliminated

Price Discrimination The airlines have perfected price discrimination.

Price Discrimination Efficiency and Rent Seeking with Price Discrimination The more perfectly a monopoly can price discriminate, the closer its output gets to the competitive output (P = MC) and the more efficient is the outcome. But this outcome differs from the outcome of perfect competition in two ways: The monopoly captures the entire consumer surplus. The increase in economic profit attracts even more rent-seeking activity that leads to an inefficient use of resources.

Monopoly Policy Issues Gains from Monopoly A single-price monopoly creates inefficiency and price discriminating monopoly captures consumer surplus and converts it into producer surplus and economic profit. And monopoly encourages rent-seeking, which wastes resources. But monopoly brings benefits.

Monopoly Policy Issues Product innovation Patents and copyrights provide protection from competition and let the monopoly enjoy the profits stemming from innovation for a longer period of time. Economies of scale and scope Where economies of scale or scope exist, a monopoly can produce at a lower average total cost than what a large number of competitive firms could achieve.

Monopoly Policy Issues Regulating Natural Monopoly When demand and cost conditions create natural monopoly, government agencies regulate the monopoly. Figure 12.11 shows how a natural monopoly might be regulated.

Monopoly Policy Issues With no regulation, the monopoly maximizes profit. It produces the quantity at which marginal revenue equals marginal cost.

Monopoly Policy Issues Regulating a natural monopoly in the public interest sets output where MB = MC and the price equal to marginal cost. This regulation is the marginal cost pricing rule, and it results in an efficient use of resources.

Monopoly Policy Issues With price equal to marginal cost, ATC exceeds price and the monopoly incurs an economic loss. If the monopoly receives a subsidy to cover its loss, taxes must be imposed on other economic activity, which create deadweight loss

Monopoly Policy Issues Where possible, a regulated natural monopoly might be permitted to price discriminate to cover the loss from marginal cost pricing. Another alternative is to produce the quantity at which price equals average total cost and to set the price equal to average total cost—the average cost pricing rule.

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