1. Monopoly

2. ●Monopoly Defined ●The Monopolist’s Supply Decision ●Can Anything Good Be Said About Monopoly? ●Price Discrimination Under Monopoly ●Monopoly Defined ●The Monopolist’s Supply Decision ●Can Anything Good Be Said About Monopoly? ●Price Discrimination Under Monopoly Contents Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

3. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Monopoly Defined ●Only one firm in the industry ●No close substitute for the product ●Little chance of successful entry by a competitor ●Only one firm in the industry ●No close substitute for the product ●Little chance of successful entry by a competitor

4. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Barriers to entry: ♦Legal restrictions (USPS) ♦Patents (esp. pharmaceutical industry) ♦Control of a scarce resource (diamonds) ♦Deliberate entry barriers (advertising) ♦Large sunk costs (i.e. entry costs) ●Cost advantages ♦Technical superiority ♦Economies of scale ●Barriers to entry: ♦Legal restrictions (USPS) ♦Patents (esp. pharmaceutical industry) ♦Control of a scarce resource (diamonds) ♦Deliberate entry barriers (advertising) ♦Large sunk costs (i.e. entry costs) ●Cost advantages ♦Technical superiority ♦Economies of scale Sources of Monopoly

5. ●When a large firm can produce and sell more cheaply than a small firm ●Technically, firm that has declining long- run average cost curve ♦So the more stuff is produced, the cheaper it is to produce in terms of per-unit cost of production ●When a large firm can produce and sell more cheaply than a small firm ●Technically, firm that has declining long- run average cost curve ♦So the more stuff is produced, the cheaper it is to produce in terms of per-unit cost of production Natural Monopoly Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

6. FIGURE 1: Natural Monopoly AC Average Cost Quantity Supplied 2.521 2.00 2.50 $3.00 B A Copyright© 2006 South-Western/Thomson Learning. All rights reserved. C

7. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Monopolist’s Supply Decision ●Not a price taker ♦So can’t sell as much as she wants at the market price ●Instead, faces a negatively sloped demand curve ●Previous analysis of perfectly competitive firm does not apply here ●Not a price taker ♦So can’t sell as much as she wants at the market price ●Instead, faces a negatively sloped demand curve ●Previous analysis of perfectly competitive firm does not apply here

8. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Monopolist’s Supply Decision ●Consumers are willing to buy more only at lower prices ●But if monopolist lowers price, he sells all output at new, lower price ●So profit-maximizing behavior for monopolist is not to set MC = P ●Consumers are willing to buy more only at lower prices ●But if monopolist lowers price, he sells all output at new, lower price ●So profit-maximizing behavior for monopolist is not to set MC = P

9. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Monopolist’s Supply Decision ●Joint decision about price and output ♦If select price – quantity demanded is given by market demand curve ♦If select output – price is given by market demand curve ●Marginal revenue < selling price ●Joint decision about price and output ♦If select price – quantity demanded is given by market demand curve ♦If select output – price is given by market demand curve ●Marginal revenue < selling price

10. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Monopolist’s Supply Decision ●Monopolist selects quantity to make MR = MC ♦If MR > MC, extra unit of output will increase total profit, so produce more ♦If MR < MC, reducing output will increase total profit, so produce less ●Profit is highest when MR = MC ●M●Monopolist selects quantity to make MR = MC ♦I♦If MR > MC, extra unit of output will increase total profit, so produce more ♦I♦If MR < MC, reducing output will increase total profit, so produce less ●P●Profit is highest when MR = MC

11. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Monopolist’s Supply Decision ●Monopolist sets output where MC = MR ●Market demand then determines price for this output ●P > MR ●Monopolist makes profits (or losses) to the extent that price is greater (less) than average cost. ●Monopolist sets output where MC = MR ●Market demand then determines price for this output ●P > MR ●Monopolist makes profits (or losses) to the extent that price is greater (less) than average cost.

12. FIGURE 2: Profit-Maximizing Equilibrium for a Monopolist MC 0 4 $9 AC Quantity Price per Unit 7 150 C D D P MR M Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 300

13. TABLE 1: A Monopolist’s Price- Output Decision Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

14. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Monopolist’s Supply Decision ●Compared to perfect competition, a monopoly: ♦May enjoy a long-run profit ♦Restricts its output to raise its selling price (both in the long and short runs) ♦Leads to inefficient resource allocation ●Compared to perfect competition, a monopoly: ♦May enjoy a long-run profit ♦Restricts its output to raise its selling price (both in the long and short runs) ♦Leads to inefficient resource allocation

15. FIGURE 3: Compare Monopoly to Competitive Industry 300 $9 AC Quantity Price per Unit 7 150 D D MC MR B P M C Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

16. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Can Anything Good Be Said About Monopoly? ●Under some circumstances monopoly may: ♦Raise demand for its product, i.e. through advertising (thus negating the inefficient reduction in output noted above) ♦Reduce marginal and average cost (produce more efficiently) ♦Stimulate innovation ●Under some circumstances monopoly may: ♦Raise demand for its product, i.e. through advertising (thus negating the inefficient reduction in output noted above) ♦Reduce marginal and average cost (produce more efficiently) ♦Stimulate innovation

17. ●Natural monopoly = average costs fall as output rises ●Costs of production would be higher if a natural monopoly were broken up into many smaller firms. ●Natural monopoly = average costs fall as output rises ●Costs of production would be higher if a natural monopoly were broken up into many smaller firms. Natural Monopoly: Where Single- Firm Production Is Cheapest Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

18. ●Natural monopolies may allow lower average cost than a market with numerous competing firms. ●Must be regulated in order for consumers to receive lower prices, however ●Monopolist may have incentive to produce more innovation than firms in more competitive markets. ●Natural monopolies may allow lower average cost than a market with numerous competing firms. ●Must be regulated in order for consumers to receive lower prices, however ●Monopolist may have incentive to produce more innovation than firms in more competitive markets. Natural Monopoly: Where Single- Firm Production Is Cheapest Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

19. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Price Discrimination Under Monopoly ●Three types of price discrimination: ♦First Degree Price Discrimination ♦Second Degree Price Discrimination ♦Third Degree Price Discrimination ●We only study last one, drop the “Third Degree” part ●Three types of price discrimination: ♦First Degree Price Discrimination ♦Second Degree Price Discrimination ♦Third Degree Price Discrimination ●We only study last one, drop the “Third Degree” part

20. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Price Discrimination Under Monopoly ●Price discrimination = charge different prices to different groups of customers for the same good ♦or charge the same price in markets where costs vary ■Example: it costs the same to mail envelope to Hawaii and to St. Cloud, though mailing costs are clearly different ●Allows a monopolist to maximize profits ●Price discrimination = charge different prices to different groups of customers for the same good ♦or charge the same price in markets where costs vary ■Example: it costs the same to mail envelope to Hawaii and to St. Cloud, though mailing costs are clearly different ●Allows a monopolist to maximize profits

21. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Price Discrimination Under Monopoly ●Monopolist sets marginal revenue (not price) equal in each market ♦With different demands, prices will in general be different ●Assumes equal cost conditions in each markets ●Monopolist sets marginal revenue (not price) equal in each market ♦With different demands, prices will in general be different ●Assumes equal cost conditions in each markets

22. FIGURE 4: Prices and Quantities under Price Discrimination D b D b MR a Q a b Q b P b W (b) Customer Group BCustomer Group A Quantity 0 HH Price (a) Quantity D a D a 0 J P a Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

23. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Price Discrimination Under Monopoly ●Sometimes price discrimination is not profitable ♦Two markets: ■Large with many wealthy customers ■Small with few poor customers ♦Then monopolist is better-off not servicing poor guys at all ♦Example: luxury cars are expensive, because rich guys agree to pay a lot ●Sometimes price discrimination is not profitable ♦Two markets: ■Large with many wealthy customers ■Small with few poor customers ♦Then monopolist is better-off not servicing poor guys at all ♦Example: luxury cars are expensive, because rich guys agree to pay a lot

24. ●No, although sometimes justice appears to demand different prices in different markets (same mailing price example) ●In some cases, price discrimination may be necessary for a firm to survive (if costs are very different) ●In some cases, where there are significant economies of scale, price discrimination may actually lead to lower prices. ●No, although sometimes justice appears to demand different prices in different markets (same mailing price example) ●In some cases, price discrimination may be necessary for a firm to survive (if costs are very different) ●In some cases, where there are significant economies of scale, price discrimination may actually lead to lower prices. Is Price Discrimination Always Undesirable? Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

25. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Monopsonies ●Monospony – situation when there is a single buyer on the market ●Examples are hard to find but: ♦A small town with a single industrial power plant – here the plant is almost a sole employer, i.e. buyer of human labor ♦Even if multiple employers, but all workers are members of a single union, then union is a sole purchaser of labor ●Monospony – situation when there is a single buyer on the market ●Examples are hard to find but: ♦A small town with a single industrial power plant – here the plant is almost a sole employer, i.e. buyer of human labor ♦Even if multiple employers, but all workers are members of a single union, then union is a sole purchaser of labor

26. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Monopsonies ●Analysis is pretty similar to that of monopolized industry ●Sometimes have a bilateral monopoly: ♦When a single buyer meets a single seller, i.e. power plant with a union ♦Need more advanced tools to analyze this situation, so won’t do that in this course ●Analysis is pretty similar to that of monopolized industry ●Sometimes have a bilateral monopoly: ♦When a single buyer meets a single seller, i.e. power plant with a union ♦Need more advanced tools to analyze this situation, so won’t do that in this course

27. Some Problems on Monopoly

28. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 1 ●Consider the following table. What is the profit maximizing quantity for monopoly, what profits will it earn? Qty18161412104 Price123456 TC443832262014

29. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 1: Solution ●Consider the following table. What is the profit maximizing quantity for monopoly, what profits will it earn? ●Monopoly would maximize profits ●So must compute profit: Profit = TR − TC ●Make up two extra table rows, TR and Profit ●Monopoly would maximize profits ●So must compute profit: Profit = TR − TC ●Make up two extra table rows, TR and Profit

30. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 1: Solution ●What is the profit maximizing quantity for monopoly, what profits will it earn? Qty 18161412104 Price 123456 TC 443832262014 TR 18 * 1=1816 * 2=3214 * 3=4212 * 4=4810 * 5=504 * 6=24 Profit 18-44 =-26 32-38 =-6 42-32 =10 48-26 =22 50-20 =30 24-14 =10

31. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 1: Solution ●Consider the following table. What is the profit maximizing quantity for monopoly, what profits will it earn? ●So Monopoly would sell 10 units for $5 each ●And would earn a profit of $50 ●This concludes the problem! ●I hope you’ll be able to complete similar problem on the midterm if I ask you ●So Monopoly would sell 10 units for $5 each ●And would earn a profit of $50 ●This concludes the problem! ●I hope you’ll be able to complete similar problem on the midterm if I ask you

32. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 2 ●Suppose that there is a monopolized industry where a monopoly firm has total cost function TC(Q) = 2Q 2 +5Q+10, and a marginal cost curve MC(Q) = 4Q+5 ●Industry inverse demand is given by P(Q) = 105−3Q and the marginal revenue curve is MR(Q) = 105−6Q ●What is the profit maximizing (PM) output of the monopoly? What are her profits? What is the CS in this industry? And what is the TS? ●S●Suppose that there is a monopolized industry where a monopoly firm has total cost function TC(Q) = 2Q 2 +5Q+10, and a marginal cost curve MC(Q) = 4Q+5 ●I●Industry inverse demand is given by P(Q) = 105−3Q and the marginal revenue curve is MR(Q) = 105−6Q ●W●What is the profit maximizing (PM) output of the monopoly? What are her profits? What is the CS in this industry? And what is the TS?

33. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 2: Solution ●To find PM output, we have to put MR = MC: 105−6Q = 4Q+5 100 = 10Q Q = 10 ●To find the price, we plug Q=10 into demand: P = 105−3Q = 105−30 = 75 ●Thus monopolist sells 10 units of output and charges $75 per unit ●To find PM output, we have to put MR = MC: 105−6Q = 4Q+5 100 = 10Q Q = 10 ●To find the price, we plug Q=10 into demand: P = 105−3Q = 105−30 = 75 ●Thus monopolist sells 10 units of output and charges $75 per unit

34. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 2: Solution ●We know that P = 75 and Q = 10 ●Profits of monopolist are TR−TC ♦TR = P (Q) = 75 (10) = 750 ♦TC = TC(10) = 2(10) 2 + 5 (10) + 10 = 260 ♦So profits are 750 − 260 = 490 ●Consumer surplus is computed straightforwardly: ♦CS = ½ (105 − 75) 10 = (15) 10 = 150 ●So TS = profit + CS = 490 + 150 = 640 ●We know that P = 75 and Q = 10 ●Profits of monopolist are TR−TC ♦TR = P (Q) = 75 (10) = 750 ♦TC = TC(10) = 2(10) 2 + 5 (10) + 10 = 260 ♦So profits are 750 − 260 = 490 ●Consumer surplus is computed straightforwardly: ♦CS = ½ (105 − 75) 10 = (15) 10 = 150 ●So TS = profit + CS = 490 + 150 = 640

35. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 2: Continued ●Now antitrust agency splits the monopoly into many identical competitive firms. ●So the industry is now perfectly competitive with inverse supply curve P(Q) = 2Q+5 ●What is the new equilibrium? What are the CS, PS and TS in this equilibrium? Compare with the monopoly case. ●Now antitrust agency splits the monopoly into many identical competitive firms. ●So the industry is now perfectly competitive with inverse supply curve P(Q) = 2Q+5 ●What is the new equilibrium? What are the CS, PS and TS in this equilibrium? Compare with the monopoly case.

36. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 2: Solution ●To find eq’m, we put Demand = Supply 105−3Q = 2Q+5 100 = 5Q Q = 25 ●To find the price, we plug Q = 25 into demand: P = 105−3Q = 105−75 = 30 ●Thus in equilibrium 25 units will be sold for a price of $30 per unit ●To find eq’m, we put Demand = Supply 105−3Q = 2Q+5 100 = 5Q Q = 25 ●To find the price, we plug Q = 25 into demand: P = 105−3Q = 105−75 = 30 ●Thus in equilibrium 25 units will be sold for a price of $30 per unit

37. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 2: Solution ●We know that P = 30 and Q = 25 ●Consumer surplus is computed straightforwardly: ♦CS = ½ (105 − 30) 25 = ½ (75) 25 = 937.5 ●Producer Surplus is also straightforward to get: ♦PS = ½ (30 − 5) 25 = ½ (25) 25 = 312.5 ●So TS = PS + CS = 937.5 + 312.5 = 1250 ●Under monopoly had TS = 640, P = 75, Q = 10, CS = 150 and PS (which was profit) = 490 ●We know that P = 30 and Q = 25 ●Consumer surplus is computed straightforwardly: ♦CS = ½ (105 − 30) 25 = ½ (75) 25 = 937.5 ●Producer Surplus is also straightforward to get: ♦PS = ½ (30 − 5) 25 = ½ (25) 25 = 312.5 ●So TS = PS + CS = 937.5 + 312.5 = 1250 ●Under monopoly had TS = 640, P = 75, Q = 10, CS = 150 and PS (which was profit) = 490

38. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Problem 2: Solution ●Perfectly competitive industry makes everyone except monopolist better-off ●The total welfare is also bigger under perfect competition ●That is why economists believe we should keep an eye on monopolies so that they do not cause this sort of inefficiencies ●Perfectly competitive industry makes everyone except monopolist better-off ●The total welfare is also bigger under perfect competition ●That is why economists believe we should keep an eye on monopolies so that they do not cause this sort of inefficiencies

39. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The End ???