Chapter 11: Monopoly

Objectives After studying this chapter, you will be 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 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 for Internet auction and search services. These firms are not price takers, they can set the prices of their service How do firms like eBay and Google decide the quantity to produce and the price to charge? Students get lots of discounts—at the movies, hairdresser, and on public transport. Why? How can it be profit maximising to offer lower prices to some customers? In this chapter, we study markets in which the firm can influence the price Students love monopoly! Most of your students are taking an economics course because they think it will help them either get a better job or run a better business. Many of your students are aspiring entrepreneurs. You’ve just had them slog through a heavy chapter on perfect competition, the bottom line of which is: The bottom line is miserable. Normal profit maybe the best that many people can achieve but it is not very exciting. This chapter teaches the students how to make a serious entrepreneurial income. Innovate, create a monopoly that produces something that people value much more than the cost of producing it, and price-discriminate as much as possible. The monopoly model as a benchmark. Explain (like you did in the case of perfect competition) that although no real-world industry satisfies the full definition of a monopoly market, the behavior of firms in many real world industries can be predicted by using the monopoly model. Mention that this chapter examines the least competitive end of the spectrum of markets, just like Chapter 11 discussed the most competitive end.

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 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: Monopoly franchise (like Australia Post). 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. Example: Electric utility

Natural Monopoly 15 10 5 LRAC D 1 2 3 4 Figure 11.1 15 Price (cents per kilowatt-hour) 10 5 Instructor Notes: 1) The demand curve for electric poser is D, and the average total cost curve is ATC. 2) Economies of scale exist over the entire ATC curve. 3) One firm can distribute 4 million kilowatt-hour at a cost of 5 cents a kilowatt-hour. 4) This same total output costs 10 a kilowatt-hour with two firms and 15 cents a kilowatt-hour with four firms. 5) So one firm can meet the market demand at a lower cost than two or more firms can, and the market is a natural monopoly. LRAC D 1 2 3 4 Quantity (millions of kilowatt-hours) 10

Market Power Monopoly Price-Setting Strategies. 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 demand curve for the monopoly’s output is the market demand curve. To sell a larger output, a monopoly must set a lower price. Marginal revenue is less than price

Demand and Marginal Revenue Table 11.2 Instructor Notes: 1) The table shows Lisa’s demand schedule. 2) Total revenue (TR) is price multiplied by quantity sold. 3) For example, in row c the price is $16 a haircut, 2 haircuts are sold, and total revenue is $32. 4) Marginal revenue (MR) is the change in total revenue that results from a one-unit increase in the quantity sold. 5) For example, when the price falls from $16 to $14 a haircut, the quantity sold increases by 1 haircut and total revenue increases by $10. 6) Marginal revenue is $10 18

Demand and Marginal Revenue Figure 11.2 20 Total revenue loss $4 MR c 16 Price & marginal revenue (dollars per haircut) d 14 Total revenue gain $14 10 Marginal revenue $10 Instructor Notes: The demand curve, D, and the marginal revenue curve, MR, are based on the numbers in the table and illustrate the calculation of marginal revenue when the price falls from $16 to $14. D 2 3 Quantity (haircuts per hour) 21

Marginal Revenue and Elasticity A single-price monopoly’s marginal revenue is related to the elasticity of demand for its good. A profit-maximising monopoly never produces an output in the inelastic range of its demand curve 22

Marginal Revenue and Elasticity Figure 11.3(a) Demand and marginal revenue curves 20 Elastic D d Unit elastic Price $ marginal revenue (dollars per haircut) 10 Inelastic f Quantity (haircuts per hour) Maximum total revenue 5 10 –10 – 20 MR 27

Marginal Revenue and Elasticity Figure 11.3(b) 50 Zero marginal revenue Total revenue curve 40 Total revenue (dollars per hour) 30 20 Instructor Notes: 1) The total revenue curve is shown above. 2) Total revenue is maximised where MR is zero--5 haircuts per hour. 10 Quantity (haircuts per hour) TR 5 10 30

A Single-Price Monopoly’s Output and Price Decision Price and Output Decisions A monopoly sets its price and output at the levels that maximise economic profit that is where MR = MC. A monopoly faces the same types of technology constraints as the competitive firm The monopoly sets its price at the highest level at which it can sell the profit-maximising quantity The monopoly may earn an economic profit, even in the long run, because of barriers to entry.

A Monopoly’s Output and Price Decision Table 11.01 Instructor Notes: 1) Profit is maximised when the price is $14 and 3 haircuts are sold. 2) Total revenue is $42, total cost is $30, and economic profit is $12 ($42 - $30). 37

A Monopoly’s Output and Price TC Economic Profit = $12 50 TR 42 Total revenue and total cost (dollars per hour) 30 Figure 11.4(a) Total revenue and total cost curves 20 10 0 1 2 3 4 5 Quantity (haircuts per hour) 41

A Monopoly’s Output and Price MC 20 MR D ATC Profit = $12 ($4 x 3 units) 14 Economic Profit $12 Price and cost (dollars per hour) Figure 11.4(b) Demand and marginal revenue and cost curves 10 Instructor Notes: 1) In this related graph, economic profit is maximised when marginal cost (MC) equals marginal revenue (MR). 2) The price is determined by the demand curve (D) and is $14. 3) Economic profit, the blue rectangle, is $12--the profit per haircut ($4) multiplied by 3 haircuts. 0 1 2 3 4 5 Quantity (haircuts per hour) 45

Single-Price Monopoly and Competition Compared Equilibrium output for a monopoly, QM, occurs where marginal revenue equals marginal cost, MR = MC. Compared to perfect competition, monopoly restricts output and charges a higher price

Single Price Monopoly and Competition Compared monopoly: Higher price and smaller output Figure 11.5 Price S =MC D MR PM QM Perfect competition PC QC Quantity

Inefficiency of Monopoly Figure 11.6(a) Consumer surplus S=MSC D=MSB Price and cost QC PC Producer surplus Efficient quantity Quantity 61

Inefficiency of Monopoly QC Inefficiency of Monopoly Figure 11.6(b) Monopoly Price PA Consumer surplus MC PM Deadweight loss Monopoly’s gain PC Producer surplus MR D QM Quantity 61

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 Rent seeking, which is any attempt to capture consumer surplus, producer surplus, or economic profit. There are two forms of rent seeking activity to pursue by a 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.

Rent Seeking Equilibrium Figure 11.7 Price Rent seeking costs exhaust producer surplus ATC Consumer surplus MC PM Deadweight loss MR D QM Quantity

Price Discrimination 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 discrimination may not be fair, but it is efficient. Be sure that the students understand that aside from equity considerations, resources will be allocated more efficiently in a monopoly market under any price discrimination scenario than under a single-price scenario.

Price Discrimination Price Discrimination and Consumer Surplus Price discrimination converts consumer surplus into economic profit. A monopoly can discriminate in two broad ways: Among units of a good. (Example: quantity discounts) Among groups of buyers. (Example: business travellers and holiday travellers)

Price Discrimination Profiting by Price Discriminating Figure 11.8 shows a single-price monopolist. This firm maximises profit by producing 8 units, where MR = MC and selling them for $1,200 each.

A Single Price of Air Travel Figure 11.8 Consumer surplus MC 2100 MR 1800 ATC Economic profit Price (dollars per trip) 1500 1200 $48 million 900 Instructor Notes: 1) The first graph shows the demand curve (D), marginal revenue curve (MR), and marginal cost curve (MC) for a route on which Global Air has a monopoly. 2) As a single-price monopoly, Global maximises profit by selling 10,000 trips a year at $1,500 a trip. 3) Its profit is $5 million, which is shown by the blue rectangle in the first graph. 4) The demand curve in the first graph is the horizontal sum of the demand curves for business travel (DB) in the second graph and the demand for vacation travel (DV) in the third. 5) Global sells 6,000 trips to business travelers for a profit of $3 million and 4,000 trips to vacation travelers for a profit of $2 million. 600 300 D 5 8 10 15 20 Passengers (thousands per year) 52

Price Discrimination Profiting by Price Discriminating Figure 11.9 show the same market with price discrimination. By price discriminating, the firm can increase its profit. In doing so, it converts consumer surplus into economic profit.

Price Discrimination MC ATC D Increased economic profit from price Figure 11.9 MC 2100 1800 ATC 1600 1400 1200 Price and cost (dollars per trip) 900 600 300 D 2 4 6 8 10 15 20 Passengers (thousands per year) 52

Perfect Price Discrimination When a firm practices perfect price discrimination it extracts the entire consumer surplus. Global must develop different fares which appeal to small segments of the market. Global extracts the entire consumer surplus.

Perfect Price Discrimination Increase in economic profit from perfect price discrimination MC Figure 11.10 2100 1800 ATC 1600 Price (dollars per trip) 1400 1200 900 600 Increase in output 300 D 2 4 6 8 11 15 20 Passengers (thousands per year) 52

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. 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: 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 regulates the price of monopoly. By regulation, some of the worst aspects of monopoly can be avoided

Regulating a Natural Monopoly Profit maximisation The Efficient Regulation Marginal cost pricing rule sets price equal to marginal cost Average Cost Pricing Average cost pricing rule sets price equal to average total cost

Regulating a Natural Monopoly Figure 11.11 30 Profit maximising Price and cost (cents per cubic foot) 20 Average cost pricing 18 15 ATC Marginal cost pricing MR 10 MC 1 2 3 4 Quantity (millions of cubic feet per day) 52

END CHAPTER 11