Monopoly and imperfect competition

Chapter 9: Monopoly and Other Forms of Imperfect Competition Announcements Ellie Colema? Assignment due dates Syllabus: Health care? Chapter 9: Monopoly and Other Forms of Imperfect Competition

Imperfect Competition Imperfectly Competitive Firms Have some control over price Price may be greater than the marginal cost of production Long-run economic profits are possible Chapter 9: Monopoly and Other Forms of Imperfect Competition

Imperfect Competition Imperfectly Competitive Markets Reduce economic surplus to varying degrees Are very common Chapter 9: Monopoly and Other Forms of Imperfect Competition

Forms of Imperfect Competition Pure Monopoly (most inefficient) The only supplier of a unique product with no close substitutes This is the one we’ll pay most attention to Chapter 9: Monopoly and Other Forms of Imperfect Competition

Forms of imperfect Competition Oligopoly (theoretically more efficient than a monopoly) A firm that produces a product for which only a few rival firms produce close substitutes Many major economic sectors Food, media, banking, energy, garbage, pharmaceuticals, electricity, water, hospitals, etc. Collusion is a big problem Oil, Electricity, Vitamins, Archer-Daniels Midland Chapter 9: Monopoly and Other Forms of Imperfect Competition

Forms of imperfect Competition Monopolistic Competition (closest to perfect competition) A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another Chapter 9: Monopoly and Other Forms of Imperfect Competition

Imperfect Competition The Essential Difference Between Perfectly and Imperfectly Competitive Firms The perfectly competitive firm faces a perfectly elastic demand for its product. The imperfectly competitive firm faces a downward-sloping demand curve. Chapter 9: Monopoly and Other Forms of Imperfect Competition

Imperfect Competition In perfect competition Supply and demand determine equilibrium price. The firm has no market power. At the equilibrium price, the firm sells all it wishes. If the firm raises its price, sales will be zero. The firm’s demand curve is the horizontal line at the market price. Chapter 9: Monopoly and Other Forms of Imperfect Competition

Imperfect Competition With imperfect competition The firm has some control over price or some market power. The firm faces a downward sloping demand curve. Chapter 9: Monopoly and Other Forms of Imperfect Competition

The Demand Curves Facing Perfectly and Imperfectly Competitive Firms Market price Price $/unit of output Quantity Quantity Chapter 9: Monopoly and Other Forms of Imperfect Competition

Five Major Sources of Market Power Market power = barriers to entry Exclusive control over inputs Patents and copyrights Government licenses or franchises Economies of scale (natural monopolies) Networked economies Chapter 9: Monopoly and Other Forms of Imperfect Competition

Economies of Scale and the Importance of Fixed Costs Natural Monopolies: Firms with large fixed costs and low variable costs e.g. telephones, electric utilities, sewage, etc. Have low marginal costs Average total cost declines sharply as output increases Economies of scale will exist Chapter 9: Monopoly and Other Forms of Imperfect Competition

Chapter 9: Monopoly and Other Forms of Imperfect Competition Total and Average Total Costs for a Production Process with Economies of Scale F Q0 F + Q0 TC = F + MQ Total cost rises at a constant rate as output rises ATC = F/Q + M M Average costs decline and is always higher than marginal cost Average cost ($/unit) Total cost ($/year) Quantity Quantity Chapter 9: Monopoly and Other Forms of Imperfect Competition

Costs for Computers (Hardware+software): Scenario 1 Mac OSX Windows XP Annual production 1,000,000 1,200,000 Fixed cost $2,000,000 $2,000,000 Variable cost $8,000,000 $9,600,000 Total cost $10,000,000 $11,600,000 Average total cost per system $10.00 $9.70 Observations Fixed costs are a relatively small share of total cost Variable costs are identical Cost/system is nearly the same Chapter 9: Monopoly and Other Forms of Imperfect Competition

Costs for for Computers (Hardware+software): Scenario 2 Chapter 9: Monopoly and Other Forms of Imperfect Competition

Costs for for Computers: scenario 2 after time passes Chapter 9: Monopoly and Other Forms of Imperfect Competition

Economies of Scale and the Importance of Fixed Costs Fixed investment in research and development has been increasing as a share of production costs. Cost of producing a computer Fixed Cost Variable Cost Software Hardware 1984 20% 80% 1990 80% 20% Chapter 9: Monopoly and Other Forms of Imperfect Competition

Profit Maximization for the Monopolist A price taker (perfect competition) and a price setter (imperfect competition) share two economic goals. They want To maximize profits To select the output level that maximizes the difference between TR and TC, where MB= MC. Chapter 9: Monopoly and Other Forms of Imperfect Competition

Profit Maximization for the Monopolist For any producer MB = Marginal Revenue (MR) or a change in a firm’s total revenue that results from a one-unit change in output Increase output when MR > MC. For competitive producer MR=P For a monopolist MR<P Chapter 9: Monopoly and Other Forms of Imperfect Competition

The Monopolist’s Benefit from Selling an Additional Unit 3 5 If P = $6, then TR = $6 x 2 = $12 If P = $5, then TR = $5 x 3 = $15 The MR of selling the 3rd unit = $3 (15-12) For the 3rd unit, MR = $3 < P = $5 D 8 2 6 Price ($/unit) Quantity (units/week) Chapter 9: Monopoly and Other Forms of Imperfect Competition

Chapter 9: Monopoly and Other Forms of Imperfect Competition Marginal Revenue Observations MR < P MR declines as quantity increases MR is the change between two quantities MR < P because price must be lowered to sell an additional unit P Q TR MR 6 2 12 5 3 15 4 16 3 1 -1 Chapter 9: Monopoly and Other Forms of Imperfect Competition

Marginal Revenue in Graphical Form 8 D 4 3 2 -1 5 1 MR P Q TR MR 6 2 12 5 3 15 4 16 3 1 -1 Price & marginal revenue ($/unit) Quantity (units/week) Chapter 9: Monopoly and Other Forms of Imperfect Competition

Profit Maximization for the Monopolist Profit Maximizing Decision Rule When MR > MC, output should be increased. When MR < MC, output should be reduced. Profits are maximized at the level of output for which MR = MC. What’s the marginal revenue for a competitive firm? Chapter 9: Monopoly and Other Forms of Imperfect Competition

The Monopolist’s Profit- Maximizing Output Level D 3 12 24 Marginal Cost 6 2 4 MR 8 Observations If P = $3 & Q = 12 MR < MC and output should be reduced Profits are maximized at 8 units where MR = MC P = $4 where quantity demanded = quantity supplied Price ($/unit of output) Quantity (units/week) Chapter 9: Monopoly and Other Forms of Imperfect Competition

The Demand and Marginal Cost Curves for a Monopolist Why the Invisible Hand Breaks Down Under Monopoly 2 4 MR 8 Because MR < P, the monopoly produces less than the socially optimal amount The deadweight loss of the monopoly to society = (1/2)($2/unit)(4units/wk) = $4/wk. Deadweight loss 6 Marginal cost Price ($/unit of output) 3 D 12 24 Quantity (units/week) Chapter 9: Monopoly and Other Forms of Imperfect Competition

Why the Invisible Hand Breaks Down Under Monopoly Profits are maximized where MR = MC. P > MR P > MC Deadweight loss Perfect Competition Profits are maximized where MR = MC. P = MR P = MC No deadweight loss Chapter 9: Monopoly and Other Forms of Imperfect Competition

Why the Invisible Hand Breaks Down Under Monopoly Difficulties in Reducing the Deadweight Loss of Monopolies Enforcing antitrust laws Growing concentration in food, media, energy, pharmaceuticals, etc. Patents, copyrights, and innovation Natural monopolies Chapter 9: Monopoly and Other Forms of Imperfect Competition

Chapter 9: Monopoly and Other Forms of Imperfect Competition Price Discrimination The practice of charging different buyers different prices for essentially the same good or service E.g. textbooks, medicine What about re-importing medicine? Theoretically maximizes economic surplus, but reduces consumer surplus to zero Chapter 9: Monopoly and Other Forms of Imperfect Competition

Public Policy Toward Natural Monopoly Methods of Controlling Natural Monopolies State ownership and management Weighing the benefit of marginal cost pricing versus the cost of less incentive for innovation Is it true that there is less incentive for innovation? Burlington Electric and VEIC In a democracy, politicians have to provide public services and keep taxes low to get re-elected Chapter 9: Monopoly and Other Forms of Imperfect Competition

Methods of Controlling Natural Monopolies State regulation of private monopolies Cost-plus regulation High administrative cost Less incentive for innovation P does not equate to MC Chapter 9: Monopoly and Other Forms of Imperfect Competition

Methods of Controlling Natural Monopolies Exclusive contracting for natural monopoly Competition for the contract theoretically sets P = MC Example of water in Buenos Aires Difficulty when fixed costs are high No incentive to maintain infrastructure when contract nears termination Chapter 9: Monopoly and Other Forms of Imperfect Competition

Methods of Controlling Natural Monopolies Vigorous enforcement of anti-trust laws Helps prevent cartels May prevent economies of scale Chapter 9: Monopoly and Other Forms of Imperfect Competition