Chapter Monopoly 15

Why Monopolies Arise Monopoly – Firm that is the sole seller of a product without close substitutes – Price maker – Barriers to entry Legal and Cost Barriers – NBA, Medical, Patents Monopoly resources – Oil, Diamonds Government regulation The production process 2

Why Monopolies Arise Monopoly resources – A key resource required for production is owned by a single firm – Higher price Government regulation – Government gives a single firm the exclusive right to produce some good or service – Government-created monopolies Patent and copyright laws Higher prices; Higher profits 3

Why Monopolies Arise The production process – A single firm can produce output at a lower cost than can a larger number of producers Natural monopoly – Arises because a single firm can supply a good or service to an entire market At a smaller cost than could two or more firms – Economies of scale over the relevant range of output 4

Figure Economies of scale as a cause of monopoly 1 5 Costs When a firm’s average-total-cost curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the smallest cost Quantity of output0 Average total cost

How Monopolies Make Production& Pricing Decisions Monopoly versus competition – Monopoly Price maker Sole producer Downward sloping demand – Market demand curve – Competitive firm Price taker One producer of many Demand – horizontal line (Price) 6

Figure Demand curves for competitive and monopoly firms 2 7 Price Because competitive firms are price takers, they in effect face horizontal demand curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it faces the downward- sloping market demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it wants to sell more output. Quantity of output0 (a) A Competitive Firm’s Demand Curve Price Quantity of output 0 (b) A Monopolist’s Demand Curve Demand

How Monopolies Make Production& Pricing Decisions A monopoly’s revenue – Total revenue = price times quantity – Average revenue Revenue per unit sold – Total revenue divided by quantity – Marginal revenue Revenue per each additional unit of output – Change in total revenue when output increases by 1 unit Can be negative For a monopolist: always MR < P 8

How Monopolies Make Production& Pricing Decisions Increase in quantity sold – Output effect Q is higher Increase total revenue – Price effect P is lower Decrease total revenue Because MR < P – MR curve – is below the demand curve 9

Figure Monopoly MR and Demand

Figure Price $11 -4 Demand and marginal-revenue curves for a monopoly 3 11 The demand curve shows how the quantity affects the price of the good. The marginal-revenue curve shows how the firm’s revenue changes when the quantity increases by 1 unit. Because the price on all units sold must fall if the monopoly increases production, marginal revenue is always less than the price. Quantity of water Demand (average revenue) Marginal revenue

How Monopolies Make Production& Pricing Decisions Profit maximization Δ Π = ΔTR – ΔTC – If ΔTR > ΔTC increasing production increases profits – OTW if ΔTR < ΔTC increased production reduces profits ΔTR = Marginal Revenue (how much TR changes when 1 more unit is sold) ΔTC = Marginal Cost Profit Max occurs when Δ Π = 0 or ΔTR = ΔTC general rule: profit max’ed at MR = MC 12

How Monopolies Make Production& Pricing Decisions Profit maximization – Or since ΔTR = Marginal Revenue And ΔTC = Marginal cost – If MR > MC – increase production – If MC > MR – produce less – Maximize profit Produce quantity where MR=MC Intersection of the marginal-revenue curve and the marginal-cost curve 13

Figure Profit maximization for a monopoly 4 14 Costs and Revenue A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B). Quantity0 Average total cost Demand Marginal revenue Marginal cost Q MAX B Monopoly price A 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity and then the demand curve shows the price consistent with this quantity. Q1Q1 Q2Q2

Figure In Contrast – Perfect Competition In the long run The super-normal profit derived by the firm in the short run acts as an incentive for new firms to enter the market, which increases industry supply and market price falls for all firms until only a normal profit is made (accounting +, but economic profit = 0)

How Monopolies Make Production& Pricing Decisions Profit maximization – Perfect competition: P=MR=MC Price equals marginal cost – Monopoly: P>MR=MC Price exceeds marginal cost A monopoly’s profit – Profit = TR – TC = (P – ATC) ˣ Q 16

Figure The monopolist’s profit 5 17 Costs and Revenue The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the number of units sold. Quantity0 Demand Average total cost B E D Marginal revenue Q MAX Average total cost Marginal cost Monopoly price C Monopoly profit

Figure Deadweight Loss of Monopoly

Figure Contrasting Competition and Monopoly Competitive MarketsMonopoly Many firmsOne firm Produces efficient level of output (since P = MC) Produces less than the efficient level of output (since P > MC) Cannot earn long run economic profits May earn long run economic profits Has no market power (is a price taker) Has significant market power (is a price maker)

Figure The Problems with Monopoly Monopolies can make societies worse off –Restricting output and charging higher prices compared to competitive markets –Operate inefficiently (deadweight loss). This is referred to as market failure. –Less choices for consumers –Unhealthy competition called “rent seeking”

Market for pharmaceutical drugs – New drug, patent laws – monopoly Produce Q where MR=MC P>MC – Generic drugs – competitive market Produce Q where MR=MC And P=MC Price (competitively produced generic drug) – Below the price(monopolist) Monopoly drugs versus generic drugs 21

Allergy sufferers got another Christmas present in 2007 when the patent on Zyrtec, another non-sedating antihistamine, expired. Zertec is now available OTC for about a dollar a pill for the brand name product, while the generic cetirizine costs only $15 to $45 for a bottle of 90 tablets — enough to get through 3 months of the allergy season for those with seasonal allergic rhinitis. It’s also available as a chewable tablet or liquid for children (at a lower dose) and combined with a Decongestant in a capsule.Zyrtec Monopoly drugs versus generic drugs 22

Specialists in infectious disease are protesting a gigantic overnight increase in the price of a 62-year-old drug that is the standard of care for treating a life- threatening parasitic infection. The drug, called Daraprim, was acquired y Turing Pharmaceuticals, a start-up run by a former hedge fund manager. Turing immediately raised the price to $750 a tablet from $13.50,. “What is it that they are doing differently that has led to this dramatic increase?” Turing’s price increase is not an isolated example. While most of the attention on pharmaceutical prices has been on new drugs for diseases like cancer, hepatitis C and high cholesterol, there is also growing concern about huge price increases on older drugs, some of them generic, that have long been mainstays of treatment. Turing’s price increase is not an isolated examplediseases like cancerhepatitis Ccholesterolconcern about huge price Although some price increases have been caused by shortages, others have resulted from a business strategy of buying old neglected drugs and turning them into high-priced “specialty drugs.” Drug Goes From $13.50 a Tablet to $750, Overnight 23

Figure The market for drugs 6 24 Costs and Revenue When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug. When the patent on a drug runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost. Quantity 0 Demand Marginal revenue Monopoly quantity Price during patent life Marginal cost Price after patent expires Competitive quantity

Figure The efficient level of output 7 25 Costs and Revenue A benevolent social planner who wanted to maximize total surplus in the market would choose the level of output where the demand curve and marginal-cost curve intersect. Below this level, the value of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good. Above this level, the value to the marginal buyer is less than marginal cost. Quantity0 Demand (value to buyers) Efficient quantity Marginal cost Value to buyers Value to buyers Cost to monopolist Cost to monopolist Value to buyers is greater than cost to sellers Value to buyers is less than cost to sellers

The Welfare Cost of Monopolies The deadweight loss Monopoly – Produce quantity where MC = MR – Produces less than the socially efficient quantity of output – Charge P>MC – Deadweight loss Triangle between: demand curve and MC curve 26

Figure The allocative inefficiency of monopoly 8 27 Costs and Revenue Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer). Quantity0 Demand Marginal revenue Monopoly quantity Marginal cost Monopoly price Efficient quantity Deadweight loss

Figure Profit maximization for a monopoly 4 28 Costs and Revenue A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B). Quantity0 Average total cost Demand Marginal revenue Marginal cost Q MAX B Monopoly price A 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity and then the demand curve shows the price consistent with this quantity. Q1Q1 Q2Q2 Monopoly PC

Price Discrimination Price discrimination – Business practice – Sell the same good at different prices to different customers – Increase profit 29

Price Discrimination Lessons from price discrimination 1.Rational strategy Increase profit Charges each customer a price closer to his or her willingness to pay Sell more than is possible with a single price 30

$ Price of Albums Measuring consumer surplus with the demand curve 2 31 In panel (a), the price of the good is $80, and the consumer surplus is $20. In panel (b), the price of the good is $70, and the consumer surplus is $ Quantity of Albums John’s consumer surplus ($20) Demand (a) Price = $80 $ Price of Albums Quantity of Albums John’s consumer surplus ($30) (b) Price = $70 Paul’s consumer surplus ($10) Total consumer surplus ($40) Demand

Price Discrimination Lessons from price discrimination 2.Requires the ability to separate customers according to their willingness to pay Certain market forces can prevent firms from price discriminating – Arbitrage – buy a good in one market, sell it in other market at a higher price 3. Can raise economic welfare Can eliminate the inefficiency of monopoly pricing – More consumers get the good – Higher producer surplus (higher profit) 32

Price Discrimination The analytics of price discrimination Perfect price discrimination Charge each customer a different price – Exactly his or her willingness to pay Monopolist - gets the entire surplus (Profit) No deadweight loss Without price discrimination Single price > MC Consumer surplus Producer surplus (Profit) Deadweight loss 33

Figure Welfare with and without price discrimination 9 34 Price Panel (a) shows a monopolist that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus. Quantity0 (a) Monopolist with Single Price Price Quantity 0 (b) Monopolist with Perfect Price Discrimination Profit Consumer surplus Deadweight loss Monopoly price Quantity sold Marginal revenue Demand Marginal cost Quantity sold Profit Demand Marginal cost

Price Discrimination Examples of price discrimination – Movie tickets – Airline prices – Discount coupons – Financial aid – Quantity discounts 35

Public Policy Toward Monopolies Increasing competition with antitrust laws – Sherman Antitrust Act, 1890 Reduce the market power of trusts – Clayton Antitrust Act, 1914 Strengthened government’s powers Authorized private lawsuits – Prevent mergers – Break up companies – Prevent companies from coordinating their activities to make markets less competitive 36

Public Policy Toward Monopolies Regulation – Regulate the behavior of monopolists Price – Common in case of natural monopolies – Marginal-cost pricing May be less than ATC No incentive to reduce costs 37

Figure Marginal-cost pricing for a natural monopoly Price Because a natural monopoly has declining average total cost, marginal cost is less than average total cost. Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost, price will be below average total cost, and the monopoly will lose money. Quantity0 Average total cost Loss Average total cost Demand Marginal cost Regulated price

Public Policy Toward Monopolies Public ownership – How the ownership of the firm affects the costs of production – Private owners Incentive to minimize costs – Public owners (government) If it does a bad job – Losers are the customers and taxpayers 39

Table Competition versus monopoly: A summary comparison 2 40 CompetitionMonopoly Similarities Goal of firms Rule for maximizing Can earn economic profits in short run? Differences Number of firms Marginal revenue Price Produces welfare-maximizing level of output? Entry in long run? Can earn economic profits in long run? Price discrimination possible? Maximize profits MR=MC Yes Many MR=P P=MC Yes No Maximize profits MR=MC Yes One MR<P P>MC No Yes