Economics 160 Monopoly Chapter 15 Spring 2004

4 Market Structures Think of the 4 market structures as a continuum, not 4 separate categories Perfect Competition Ch. 14 Monopoly Ch. 15 Monopolistic Competition Ch. 17 Oligopoly Ch. 16 CompetitiveAnticompetitive

Monopoly A firm is considered a monopoly if  it is the sole seller of its product or its product does not have close substitutes. Is Microsoft a monopoly?  The United States Government thinks so.  Most economists argue otherwise.

Located in South Africa, DeBeers controls over 80% of the world’s supply of raw diamonds.

Characteristics of Monopoly 2 Basic Characteristics of a Monopoly are  One seller  No easy entry or exit-there are barriers to entry. If firms are making positive economic profit, we would expect other firms to enter and compete. That doesn’t happen here because there are barriers to entry.

Barriers to Entry I Barriers to entry have three sources:  Ownership of a key resource.  The government gives a single firm the exclusive right to produce some good. Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest. Government also creates monopolies that do not serve the public interest.

Barriers to Entry II  Costs of production make a single producer more efficient than a large number of producers. A natural monopoly arises when there are economies of scale over the relevant range of output. Examples: Automobile industry, or the generation of electrical power.

Quantity of Output Demand (a) A Competitive Firm’s Demand Curve-Price Taker (b) A Monopolist’s Demand Curve-Price Maker 0 Price 0Quantity of Output Price Demand Difference between a Competitive Firm and Monopoly—the Demand Curves for Competitive and Monopoly Firms.

Total, Average, and Marginal Revenue for a Monopoly Quantity (Q) Price (P) Total Revenue (TR=PxQ) Average Revenue (AR=TR/Q) Marginal Revenue (MR= ) 0 $11.00 $0.00 1$ $9.00 $18.00 $9.00$ $24.00 $8.00$6.00 4$7.00 $28.00 $7.00$4.00 5$6.00 $30.00 $6.00$2.00 6$5.00 $30.00 $5.00$0.00 7$4.00 $28.00 $4.00-$2.00 8$3.00 $24.00 $3.00-$4.00 QTR  / Total Revenue P x Q = TR Average Revenue TR/Q = AR = P Marginal Revenue ∆TR/∆Q = MR Note: Why is MR always less than the price?

Profit Maximization Rule of a Simple Monopoly A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. It then uses the demand curve to find the highest price that will induce consumers to buy that quantity.

Profit Maximization of a Monopoly Quantity0 Costs and Revenue Demand Average total cost Marginal revenue Marginal cost

Profit Maximization of a Monopoly Quantity0 Costs and Revenue Demand Average total cost Marginal revenue A Marginal cost

Profit Maximization of a Monopoly Quantity0 Costs and Revenue Demand Average total cost Marginal revenue Marginal cost 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity... A

Profit Maximization of a Monopoly QuantityQ MAX 0 Costs and Revenue Demand Average total cost Marginal revenue Marginal cost 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity... A

Profit Maximization of a Monopoly Monopoly price QuantityQ MAX 0 Costs and Revenue Demand Average total cost Marginal revenue Marginal cost B 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity... A 2....and then the demand curve shows the price consistent with this quantity.

The Monopolist’s Profit Quantity0 Costs and Revenue Demand Marginal cost Marginal revenue Average total cost

The Monopolist’s Profit Monopoly price QuantityQ MAX 0 Costs and Revenue Demand Marginal cost Marginal revenue Average total cost

The Monopolist’s Profit Monopoly price Average total cost QuantityQ MAX 0 Costs and Revenue Demand Marginal cost Marginal revenue Average total cost

The Monopolist’s Profit Monopoly price Average total cost QuantityQ MAX 0 Costs and Revenue Demand Marginal cost Marginal revenue B C E D Monopoly profit Average total cost

The Welfare Cost of Monopoly Monopolies redistribute wealth from consumers to producers.  Is this bad?  Most adult consumers are producers of something. Monopolies reduce the amount they produce in order to keep the price high.  The restricted quantity hurts economic growth. (Less wealth is created).

The Efficient or “Right” Level of Output... Price 0 Quantity Marginal cost Demand (value to buyers) Efficient quantity Cost to firm Value to buyers Cost to firm Value to buyers is greater than cost to seller. Value to buyers is less than cost to seller. The quantity produced in a competitive market is efficient or maximizes social welfare because every unit of the good which is valued by consumers more than the cost of production is produced.

The Inefficiency of Monopoly... Quantity0 Demand Marginal revenue Marginal cost Monopoly price Deadweight loss Efficient quantity Monopoly quantity Price The Deadweight Loss. Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost. This wedge causes the quantity sold to fall short of the social optimum. The monopolist produces less than the socially efficient quantity of output.

What’s Wrong with Monopoly-Another Look at the Deadweight Loss. Another way of thinking about why monopolies are usually considered bad is to realize that monopolies distort a market economy’s normally efficient allocation of productive resources.  In a market economy, productive resources will only be used to produce a good if the value of the good to consumers is greater than the cost of production.  Firm’s will only produce a good if it can earn a profit by doing so. Simple monopolists restrict their production to maximize profits. The simple monopolist, when they set MC=MR to determine the profit maximizing output level, produces fewer units of the good than a competitive firm so they can increase the price. At the output level where MC=MR, price exceeds marginal cost, consumers are willing to pay more for extra output than it costs to produce it. From societies point of view, output is too low as some mutually beneficial transactions are missed.

Price D 1 0 A Fable of Deadweight Loss How much water should you sell in order to maximize profits? Q 8910

A Fable of Deadweight Loss II Hint: The marginal revenue curve bisects the angle between the demand curve and the y-axis.

A Fable of Deadweight Loss III Price D MR

A Fable of Deadweight Loss IV Price D MR MC

A Fable of Deadweight Loss V Price D MR MC P

A Fable of Deadweight Loss VI Price D MR MC P This triangle is Dead Weight Loss The Monopolist has 10 units of water, but only sells 5 even though the water was obtained for free. It’s a big waste-Dead Weight Loss.

Price Discrimination Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. It’s not like racial discrimination; it’s discrimination by elasticity! Those with inelastic demand will be discriminated against! Perfect price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price.

More Price Discrimination Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power. Two important effects of price discrimination: u It can increase the monopolist’s profits. u It can reduce deadweight loss.

Examples of Price Discrimination New Cars Airline Tickets New Technology “Skimming the Market”

Welfare Without Price Discrimination... Deadweight loss Consumer surplus Price 0Quantity Profit Demand Marginal cost Marginal revenue Quantity sold Monopoly price (a) Monopolist with Single Price The potential theoretical profit for a monopolist is the sum of all three colored areas. Using a simple pricing scheme the monopolist will be able to capture only the grey area. Using a simple pricing scheme the monopolist is missing out on potential profit equal to the purple and blue areas. Under certain conditions, the monopolist could capture more of the potential theoretical profit by price discriminating.

Price D MR Quantity per week 0 A Graphical Look With perfect price discrimination, the whole area under the demand curve would be profit. There’s no consumer surplus. Is this realistic? Profit

Price P D MR Quantity per week Q Q* 0 No Price Discrimination Profit Consumer Surplus Deadweight Loss

Price $5 D MR Quantity per week Q*15 0 Some Price Discrimination Profit Consumer Surplus Deadweight Loss 4 $2 Consumer Surplus The social loss has been has stayed the same. The redistribution of the gain from trade from consumer to monopolist has increased. Is this price discrimination scheme the most profitable for the monopolist?

Wealth Redistribution, Deadweight Loss and Monopoly- A Summary Monopoly (a) Monopolist with Single Price Price 0QuantityQuantity sold price Profit Deadweight loss Demand Marginal cost Marginal revenue Consumer surplus Quantity sold (b) Monopolist with Perfect Price Discrimination Price 0Quantity Profit Demand Marginal cost Compared to a competitive market, a monopolist using simple pricing produces too few units of the good. By restricting output and raising price, he causes a wealth redistribution from consumer to monopolist, but also produces too few units of the good creating a deadweight loss.

Wealth Redistribution, Deadweight Loss and Monopoly- A Summary Monopoly (a) Monopolist with Single Price Price 0QuantityQuantity sold price Profit Deadweight loss Demand Marginal cost Marginal revenue Consumer surplus Quantity sold (b) Monopolist with Perfect Price Discrimination Price 0Quantity Profit Demand Marginal cost Monopolists who are able to successfully use more sophisticated pricing schemes, increase the wealth redistribution from monopoly while simultaneously expanding output and reducing the deadweight loss.

Public Policy Toward Monopolies oGovernment responds to the problem of monopoly in one of four ways. oMaking monopolized industries more competitive. oRegulating the behavior of monopolies. oTurning some private monopolies into public enterprises. oDoing nothing at all. oIncreasing Competition with Antitrust Laws oAntitrust laws are a collection of statutes aimed at curbing monopoly power. oAntitrust laws give government various ways to promote competition. oThey allow government to prevent mergers. oThey allow government to break up companies. oThey prevent companies from performing activities which make markets less competitive.

Public Policy Toward Monopolies II oWho decides what constitutes a monopoly? oIt becomes a political question. oWhat is the size of the deadweight loss? Are consumers hurt? oTwo Important Antitrust Laws oSherman Antitrust Act (1890) oReduced the market power of the large and powerful “trusts” of that time period. oClayton Act (1914) oStrengthened the government’s powers and authorized private lawsuits.