Chapter 15: Monopoly Econ 2100 MONOPOLY

What works in the public sector? Course Outline What; why; who? How markets work? Are markets good? How firms behave? Chapters 13 - 17 Why are you hired? What works in the public sector?

Chapter 15 Outline MONOPOLY Monopolies: What & Why Why MR < P Profit Max Decisionmaking Impact on society’s well-being Gov’t Role in Monopoly Markets Price Discrimination MONOPOLY

Introduction A monopoly is a firm that is the sole seller of a product without close substitutes. In this chapter, we study monopoly and contrast it with perfect competition. The key difference: A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power. Most students already know that monopoly means the firm is the only seller of its product. But the definition here has another very important part: In order for the firm to be considered a monopoly, the product it sells must have no close substitutes available from other firms. MONOPOLY 3

Why Monopolies Arise The main cause of monopolies is barriers to entry – other firms cannot enter the market. Three sources of barriers to entry: 1. A single firm owns a key resource. E.g., DeBeers owns most of the world’s diamond mines 2. The govt gives a single firm the exclusive right to produce the good. E.g., patents, copyright laws MONOPOLY 4

ATC slopes downward due to huge FC and small MC Why Monopolies Arise 3. Natural monopoly: a single firm can produce the entire market Q at lower cost than could several firms. Example: 1000 homes need electricity Electricity Q Cost ATC ATC slopes downward due to huge FC and small MC ATC is lower if one firm services all 1000 homes than if two firms each service 500 homes. The horizontal axis of the graph measures number of homes provided electricity. The vertical axis measures the average total cost of providing electricity per home. 500 $80 1000 $50 MONOPOLY 5

Chapter 15 Outline MONOPOLY Monopolies: What & Why Why MR < P Profit Max Decisionmaking Impact on society’s well-being Gov’t Role in Monopoly Markets Price Discrimination MONOPOLY

Monopoly vs. Competition: Demand Curves In a competitive market, the market demand curve slopes downward. But the demand curve for any individual firm’s product is horizontal at the market price. The firm can increase Q without lowering P, so MR = P for the competitive firm. A competitive firm’s demand curve P Q A competitive firm is a price-taker, can sell as much as it wants at the market price. In effect, the competitive firm sells a product for which there are many perfect substitutes, so demand for its product is perfectly elastic; if it raises its price above the market price, demand for its product falls to zero. The relationship between P and MR is what distinguishes a competitive firm from a monopoly firm, in terms of both firm behavior and welfare implications. D MONOPOLY 7

Monopoly vs. Competition: Demand Curves A monopolist is the only seller, so it faces the market demand curve. To sell a larger Q, the firm must reduce P. Thus, MR ≠ P. A monopolist’s demand curve P Q D This slide introduces the notion that MR is not equal to P for the monopolist. The next slide presents an exercise to lead students to see for themselves what this relationship looks like. MONOPOLY 8

Common Grounds’ D and MR Curves P, MR $ 5 1.50 6 2.00 5 2.50 4 3.00 3 3.50 2 4.00 1 $4.50 MR P Q –1 $4 Demand curve (P) 4 MR 3 2 1 The numbers in the table are from the preceding exercise. Students can see either from the table or the graph that, at any Q, MR < P. -1 -2 -3 Q 1 2 3 4 5 6 7 MONOPOLY 9

Understanding the Monopolist’s MR Increasing Q has two effects on revenue: Output effect: higher output raises revenue Price effect: lower price reduces revenue To sell a larger Q, the monopolist must reduce the price on all the units it sells. Hence, MR < P MR could even be negative if the price effect exceeds the output effect (e.g., when Common Grounds increases Q from 5 to 6). Note that a competitive firm has the output effect but not the price effect: the competitive firm does not need to reduce its price in order to sell a larger quantity, so, for the competitive firm, MR = P. MONOPOLY 10

Chapter 15 Outline MONOPOLY Monopolies: What & Why Why MR < P Profit Max Decisionmaking Impact on society’s well-being Gov’t Role in Monopoly Markets Price Discrimination MONOPOLY

Profit-Maximization Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC. Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity. It finds this price from the D curve. MONOPOLY 12

Profit-Maximization 1. The profit- maximizing Q is where MR = MC. Quantity Costs and Revenue 1. The profit- maximizing Q is where MR = MC. 2. Find P from the demand curve at this Q. D MR MC P Q Profit-maximizing output MONOPOLY 13

The Monopolist’s Profit Quantity Costs and Revenue ATC D MR MC As with a competitive firm, the monopolist’s profit equals (P – ATC) x Q P ATC Q MONOPOLY 14

A Monopoly Does Not Have an S Curve A competitive firm takes P as given has a supply curve that shows how its Q depends on P. A monopoly firm is a “price-maker,” not a “price-taker” Q does not depend on P; rather, Q and P are jointly determined by MC, MR, and the demand curve. So there is no supply curve for monopoly. MONOPOLY 15

CASE STUDY: Monopoly vs. Generic Drugs The market for a typical drug Patents on new drugs give a temporary monopoly to the seller. When the patent expires, the market becomes competitive, generics appear. Quantity Price D MR PM QM PC = MC QC Here, we assume constant marginal cost for simplicity. PM and QM denote the monopoly price and quantity, respectively. PC and QC denote the competitive price and quantity, respectively. MONOPOLY 16

Chapter 15 Outline MONOPOLY Monopolies: What & Why Why MR < P Profit Max Decisionmaking Impact on society’s well-being Gov’t Role in Monopoly Markets Price Discrimination MONOPOLY

The Welfare Cost of Monopoly Recall: In a competitive market equilibrium, P = MC and total surplus is maximized. In the monopoly eq’m, P > MR = MC The value to buyers of an additional unit (P) exceeds the cost of the resources needed to produce that unit (MC). The monopoly Q is too low – could increase total surplus with a larger Q. Thus, monopoly results in a deadweight loss. MONOPOLY 18

The Welfare Cost of Monopoly Competitive eq’m: quantity = QC P = MC total surplus is maximized Monopoly eq’m: quantity = QM P > MC deadweight loss Quantity Price Deadweight loss D MR MC P MC QM P = MC QC It’s worth mentioning the following: Most people know that monopoly changes the way the economic “pie” is divided: by charging higher prices, the monopoly gets more surplus and consumers get less surplus. The analysis on this slide shows that the monopoly also reduces the size of the economic pie – by producing less than the socially efficient quantity and causing a deadweight loss. MONOPOLY 19

Chapter 15 Outline MONOPOLY Monopolies: What & Why Why MR < P Profit Max Decisionmaking Impact on society’s well-being Gov’t Role in Monopoly Markets Price Discrimination MONOPOLY

Price Discrimination Discrimination: treating people differently based on some characteristic, e.g. race or gender. Price discrimination: selling the same good at different prices to different buyers. The characteristic used in price discrimination is willingness to pay (WTP): A firm can increase profit by charging a higher price to buyers with higher WTP. MONOPOLY 21

Perfect Price Discrimination vs. Single Price Monopoly Here, the monopolist charges the same price (PM) to all buyers. A deadweight loss results. Consumer surplus Quantity Price D MR Deadweight loss PM QM Monopoly profit MC To keep the graph simple, this example assumes constant marginal cost. MONOPOLY 22

Perfect Price Discrimination vs. Single Price Monopoly Here, the monopolist produces the competitive quantity, but charges each buyer his or her WTP. This is called perfect price discrimination. The monopolist captures all CS as profit. But there’s no DWL. Quantity Price Monopoly profit D MR MC Q Here, there is no horizontal price line. The “price line”, if you will, is the demand curve: At each Q, the height of the demand curve shows the marginal buyer’s willingness to pay, which is the price the monopolist charges that buyer under perfect price discrimination. MONOPOLY 23

Price Discrimination in the Real World In the real world, perfect price discrimination is not possible: No firm knows every buyer’s WTP Buyers do not announce it to sellers So, firms divide customers into groups based on some observable trait that is likely related to WTP, such as age. MONOPOLY 24

Examples of Price Discrimination Movie tickets Discounts for seniors, students, and people who can attend during weekday afternoons. They are all more likely to have lower WTP than people who pay full price on Friday night. Airline prices Discounts for Saturday-night stayovers help distinguish business travelers, who usually have higher WTP, from more price-sensitive leisure travelers. MONOPOLY 25

Public Policy Toward Monopolies Increasing competition with antitrust laws Ban some anticompetitive practices, allow govt to break up monopolies. E.g., Sherman Antitrust Act (1890), Clayton Act (1914) Regulation Govt agencies set the monopolist’s price. For natural monopolies, MC < ATC at all Q, so marginal cost pricing would result in losses. If so, regulators might subsidize the monopolist or set P = ATC for zero economic profit. MONOPOLY 26

Public Policy Toward Monopolies Public ownership Example: U.S. Postal Service Problem: Public ownership is usually less efficient since no profit motive to minimize costs Doing nothing The foregoing policies all have drawbacks, so the best policy may be no policy. MONOPOLY 27

CONCLUSION: The Prevalence of Monopoly In the real world, pure monopoly is rare. Yet, many firms have market power, due to: selling a unique variety of a product having a large market share and few significant competitors In many such cases, most of the results from this chapter apply, including: markup of price over marginal cost deadweight loss MONOPOLY 28

Test Bank Questions MONOPOLY

Questions 2 & 3 2. One difference between a perfectly competitive firm and a monopoly is that a perfectly competitive firm produces where 3. A monopoly a. can set the price it charges for its output and earn unlimited profits. b. takes the market price as given and earns small but positive profits. c. can set the price it charges for its output but faces a downward-sloping demand curve so it cannot earn unlimited profits. d. can set the price it charges for its output but faces a horizontal demand curve so it can earn unlimited profits. a. marginal cost equals price, while a monopolist produces where price exceeds marginal cost. b. marginal cost equals price, while a monopolist produces where marginal cost exceeds price. c. price exceeds marginal cost, while a monopolist produces where marginal cost equals price. d. marginal cost exceeds price, while a monopolist produces where marginal cost equals price. MONOPOLY

Questions 5 & 8 5. Which of the following are necessary characteristics of a monopoly? 8. Which of the following is not a reason for the existence of a monopoly? (i) The firm is the sole seller of its product. (ii) The firm's product does not have close substitutes. (iii) The firm generates a large economic profit. (iv) The firm is located in a small geographic market. a. sole ownership of a key resource b. patents c. copyrights d. diseconomies of scale a. (i) and (ii) only b. (i) and (iii) only c. (i), (ii), and (iii) only d. (i), (ii), (iii), and (iv) MONOPOLY

Questions 4 & 5 4. When a firm operates under conditions of monopoly, its price is 5. In order to sell more of its product, a monopolist must a. sell to the government. b. sell in international markets. c. lower its price. d. use its market power to force up the price of complementary products. a. not constrained. b. constrained by marginal cost. c. constrained by demand. d. constrained only by its social agenda. MONOPOLY

Questions 65, 66 & 67 65. Refer to Figure 15-3. What price will the monopolist charge? a. A b. B c. C d. F 66. Refer to Figure 15-3. How much output will the monopolist produce? a. O b. J c. K d. L 67. Refer to Figure 15-3. What area measures the monopolist’s profit? a. (B-F)*K b. (A-H)*J c. (B-G)*K d. 0.5[(B-F)*(L-K)] MONOPOLY

Questions 30, 31 & 32 30. Refer to Figure 15-7. What is the socially efficient price and quantity? a. price = F; quantity = A b. price = G; quantity = B c. price = G; quantity = A d. price = D; quantity = A 31. Refer to Figure 15-7. What is the monopoly price and quantity? 32. Refer to Figure 15-7. What is the area of deadweight loss? a. price = F; quantity = A b. price = G; quantity = B c. price = G; quantity = A d. price = D; quantity = A a. the rectangle (F-D)xA b. the triangle 1/2[(F-D)x(B-A)] c. the triangle 1/2[(F-G)x(B-A)] d. the rectangle (F-D)xA plus the triangle 1/2[(F-D)x(B-A)] MONOPOLY

Question 4 & 17 4. The practice of selling the same goods to different customers at different prices, but with the same marginal cost, is known as a. price segregation. b. price discrimination. c. arbitrage. d. monopoly pricing. 17 If the monopoly firm perfectly price discriminates, then consumer surplus amounts to a. $0. b. $250. c. $500. d. $1,000. MONOPOLY

Questions 1 & 2 1. Which of the following may eliminate some or all of the inefficiency that results from monopoly pricing? 2. Antitrust laws have economic benefits that outweigh the costs if they a. prevent mergers that would decrease competition and lower the costs of production. b. prevent mergers that would decrease competition and raise the costs of production. c. allow mergers that would decrease competition and raise the costs of production. d. None of the above is correct because antitrust laws never have economic benefits that outweigh the costs. a. The government can regulate the monopoly. b. The monopoly can be prohibited from price discriminating. c. The monopoly can be forced to operate at a point where its marginal revenue is equal to its marginal cost. d. None of the above would eliminate any inefficiency associated with a monopoly. MONOPOLY