Econ 101: Microeconomics Chapter 9: Monopoly.

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Presentation transcript:

Econ 101: Microeconomics Chapter 9: Monopoly

Hall & Leiberman; Economics: Principles And Applications, 2004 What Is A Monopoly? A monopoly firm is the only seller of a good or service with no close substitutes Market in which the monopoly firm operates is called a monopoly market Existence of a monopoly means that something is causing other firms to stay out of the market Rather than enter and compete with firm already there What barrier prevents additional firms from entering the market? Several possible answers Economies of scale Network externalities Legal barriers Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 Economies of Scale If economies of scale persist to the point where a single firm is producing for entire market, the market is a natural monopoly Market in which, due to economies of scale, one firm can operate at lower average cost than can two or more firms Unless government intervenes, only one seller would survive—market would naturally become a monopoly Small local monopolies are often natural monopolies Because they continue to enjoy economies of scale up to point at which they are serving entire market Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 1: A Natural Monopoly Pieces of Clothing per Week Dollars A 15 B 12 LRATC C 5 DMarket 300 350 Hall & Leiberman; Economics: Principles And Applications, 2004

Network Externalities Exist when an increase in network’s membership increases its value to current and potential members When network externalities are present, joining a large network is more beneficial than joining a small network Even if product in larger network is somewhat inferior to product in smaller one In addition to advantages of joining a larger network Advantage in not leaving it once you’ve joined Avoiding switching costs Hall & Leiberman; Economics: Principles And Applications, 2004

Network Externalities All of this clearly applies to the market for computer operating systems When you buy a computer already loaded with Microsoft Windows, you benefit By having a large number of people with whom you can easily share documents Huge number of computers everywhere you can easily operate You gain access to many more software programs, like Microsoft Word, Excel, or Outlook, since many more programs are designed for Windows than for the few alternatives You can save time by just calling knowledgeable friends or coworkers Rather than attempting to contact technical support Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 Legal Barriers Sometimes public interest is best served by having a single seller in a market Many monopolies arise because of legal barriers including Protection of intellectual property Government franchise Hall & Leiberman; Economics: Principles And Applications, 2004

Protection of Intellectual Property The words you are reading right now are an example of intellectual property, which includes literary, artistic and musical works, and scientific inventions In dealing with intellectual property government strikes a compromise Allows creators of intellectual property to enjoy a monopoly and earn economic profit, but only for a limited period of time Once time is up, other sellers are allowed to enter the market, and it is hoped that competition among them will bring down prices Most important kinds of legal protection for intellectual property are Patents Temporary grant of monopoly rights over a new product or scientific discovery Copyrights Grant of exclusive rights to sell a literary, musical, or artistic work Copyrights and patents are often sold to another person or firm, but this does not change monopoly status of the market. Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 Government Franchise Large firms we usually think of as monopolies have their monopoly status guaranteed through government franchise Grant of exclusive rights over a product Barrier to entry is Any other firm that enters the market will be prosecuted Governments usually grant franchises when they think market is a natural monopoly Hall & Leiberman; Economics: Principles And Applications, 2004

Monopoly Goals And Constraints Goal of a monopoly—like that of any firm—is to earn highest profit possible However, a monopolist faces constraints Constraint on monopoly’s cost For any level of output it might produce, total cost is determined by Technology of production Price it must pay for its inputs Demand constraint Monopolist’s demand curve tells us maximum price monopolist can charge to sell any given quantity of output And for any level of output it might produce, maximum price it can charge is determined by market demand curve for its product Hall & Leiberman; Economics: Principles And Applications, 2004

Monopoly Price or Output Decision Noncompetitive firms—such as monopolies—do not make two separate decisions about price and quantity, but rather one decision Once firm determines its output level, it has also determined its price When any firm—including a monopoly—faces a downward sloping demand curve, marginal revenue is less than price of output Therefore, marginal revenue curve will lie below demand curve Monopoly will always produce at an output level where marginal revenue is positive Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 2: Demand and Marginal Revenue Number of Subscribers Monthly Price per Subscriber $60 50 A B 48 C 38 30 20 F G 18 Demand 5,000 15,000 20,000 30,000 6,000 MR 21,000 Hall & Leiberman; Economics: Principles And Applications, 2004

The Profit-Maximizing Output Level To maximize profit, the firm should produce level of output where MC = MR and MC curve crosses MR curve from below For a monopoly, price and output are not independent decisions But different ways of expressing the same decision Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 3: Monopoly Price and Output Determination Number of Subscribers Monthly Price per Subscriber 40 $60 MC E D 10,000 30,000 MR Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 Profit And Loss A monopoly earns a profit whenever P > ATC Its total profit at best output level equals area of a rectangle Height equal to distance between P and ATC Width equal to level of output A monopoly suffers a loss whenever P < ATC Its total loss at best output level equals area of a rectangle Height equal to distance between ATC and P Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 4: Monopoly Profit and Loss Dollars (a) Number of Subscribers (b) ATC MC ATC MC AVC $50 E E $40 40 32 Total Loss Total Profit D D 10,000 10,000 MR MR Hall & Leiberman; Economics: Principles And Applications, 2004

Equilibrium in Monopoly Markets A monopoly market is in equilibrium when the only firm in market The monopoly firm is maximizing profit For monopoly—as for perfect competition—we have different expectations about equilibrium in short-run and equilibrium in long-run Hall & Leiberman; Economics: Principles And Applications, 2004

Short-Run Equilibrium Monopoly may earn an economic profit or suffer an economic loss What if a monopoly suffers a loss in short-run? Any firm should shut down if P < AVC at output level where MR = MC If monopoly suddenly finds that P < AVC, government will usually not allow it to shut down, Instead use tax revenue to make up for firm’s losses Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 Long-Run Equilibrium Important insights of previous chapter—perfectly competitive firms cannot earn a profit in long-run equilibrium However, monopolies may earn economic profit in long-run A privately owned monopoly suffering an economic loss in long-run will exit the industry Should not find privately owned monopolies suffering economic losses in long-run Hall & Leiberman; Economics: Principles And Applications, 2004

Comparing Monopoly to Perfect Competition In perfect competition, economic profit is relentlessly reduced to zero by entry of other firms In monopoly, economic profit can continue indefinitely But monopoly differs from perfect competition in another way Can expect a monopoly market to have a higher price and lower output than an otherwise similar perfectly competitive market By raising price and restricting output, new monopoly earns economic profit Consumers lose in two ways Pay more for output they buy Due to higher prices they buy less output Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 5a/b: Comparing Monopoly and Perfect Competition Quantity of Output Price per Unit (a) Competitive Market (b) Competitive Firm Dollars per Unit 2. and each firm produces 1,000 units, where P = MC. S MC ATC E $10 3. When monopoly takes over, the old market supply curve . . . $10 d D 100,000 1,000 1. In this competitive market of 100 firms, equilibrium price is $10 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 5c: Comparing Monopoly and Perfect Competition (c) Monopoly Price per Unit S = MC 4. becomes the monopoly's MC curve. F $15 E 5. The monopoly produces where MR = MC, 10 6. with a higher price and lower market output than under perfect competition. MR D Quantity of Output 100,000 60,000 Hall & Leiberman; Economics: Principles And Applications, 2004

Comparing Monopoly to Perfect Competition Changeover from perfect competition to monopoly benefits owners of monopoly and harms consumers of the product In comparing monopoly and perfect competition, price is higher and output is lower under monopoly if all else is equal General conclusion Monopolization of a competitive industry leads to two opposing effects For any given technology of production, monopolization leads to higher prices and lower output Changes in technology of production made possible under monopoly may lead to lower prices and higher output Ultimate effect on price and quantity depends on relative strengths of two effects Hall & Leiberman; Economics: Principles And Applications, 2004

Why Monopolies Often Earn Zero Economic Profit Forces tending to cut monopoly profits Government regulation Rent-seeking activity Any costly action a firm undertakes to establish or maintain its monopoly status is called rent-seeking activity In countries with corrupt bureaucracies, rent-seeking activity includes bribes to government officials In less corrupt governments, it includes time and money spent lobbying legislators and public for favorable polices Rent-seeking activity that helps establish or maintain a firm’s monopoly position is part of firm’s costs As a result, rent-seeking activity can reduce economic profit of a monopoly May even reduce it to zero Hall & Leiberman; Economics: Principles And Applications, 2004

What Happens When Things Change? Once a monopoly is maximizing profit, it has no incentive to change its price or its level of output Unless something that affects these decisions changes Possible events Change in demand for monopolist’s product Change in its costs What might cause a monopolist to experience a shift in demand? Possible causes are the same as for perfect competition Hall & Leiberman; Economics: Principles And Applications, 2004

An Increase in Demand and a Cost-Saving Technological Advance Monopolist will react to an increase in demand by Producing more output Charging a higher price Earning a larger profit It will react to a decrease of demand by Reducing output Lowering price Suffering a reduction in profit In general, monopoly will pass to consumers only part of benefits from a cost-saving technological change After change in technology, monopoly’s profits will be higher In general, a monopoly will pass only part of a cost increase onto consumers in form of a higher price After its cost increase, monopoly’s profits will be lower Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 6: A Change in Demand Number of Subscribers Monthly Price per Subscriber A D1 MR1 (b) 10,000 40 MC Monthly Price per Subscriber Number of Subscribers MC B A $47 $40 D1 D2 10,000 MR1 30,000 MR2 11,000 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 7: Monopoly Profit and Loss Number of Subscribers Dollars E D MR 10,000 12,000 $40 MC2 MC1 38 Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 Price Discrimination Single-price monopoly Firm that is limited to charging same price for each unit of output sold Price discrimination occurs when a firm charges different prices to different customers for reasons other than differences in costs Price-discriminating monopoly does not discriminate based on prejudice, stereotypes, or ill-will toward any person or group Rather, it divides its customers into different categories based on their willingness to pay for good Hall & Leiberman; Economics: Principles And Applications, 2004

Requirements for Price Discrimination Although every firm would like to practice price discrimination, not all of them can To successfully price discriminate, three conditions must be satisfied Must be a downward-sloping demand curve for the firm’s output Firm must be able to identify consumers willing to pay more Firm must be able to prevent low-price customers from reselling to high-price customers Hall & Leiberman; Economics: Principles And Applications, 2004

Price Discrimination That Harms Consumers Price discrimination always benefits owners of a firm Can use this ability to increase its profit When price discrimination raises price for some consumer above price they would pay under a single-price policy it harms consumers Additional profit for the firm is equal to monetary loss of consumers Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 8a: Price Discrimination Number of Round-trip Tickets Dollars per Ticket MC E ATC $120 80 MR D 30 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 8b: Price Discrimination Dollars per Ticket Additional profit from price discrimination MC $160 120 MR D Number of Round-trip Tickets 10 30 Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 8c: Price Discrimination Dollars per Ticket MC Additional profit from price discrimination $120 F G 100 H MR D Number of Round-trip Tickets 30 40 Hall & Leiberman; Economics: Principles And Applications, 2004

Price Discrimination That Benefits Consumers Price discrimination benefits monopoly at the same time it benefits a group of consumers Since no one’s price is raised, no one is harmed by this policy When price discrimination lowers price for some consumers below what they would pay under a single-price policy, it benefits consumers as well as firm Hall & Leiberman; Economics: Principles And Applications, 2004

Perfect Price Discrimination Suppose a firm could somehow find out maximum price customers would be willing to pay for each unit of output it sells It could increase profits even further by practicing perfect price discrimination Firm charges each customer the most the customer would be willing to pay for each unit he or she buys Increases profit at expense of consumers Perfect price discrimination is very difficult to practice in the real world Would require firm to read its customers’ minds Marginal revenue is equal to price of additional unit sold Firm’s MR curve is same as its demand curve Hall & Leiberman; Economics: Principles And Applications, 2004

Figure 9: Perfect Price Discrimination Number of Dolls per Day Dollars per Doll E 20 $30 25 10 30 60 J B MC = ATC H D MR MR curve before price discrimination Hall & Leiberman; Economics: Principles And Applications, 2004

Hall & Leiberman; Economics: Principles And Applications, 2004 Using the Theory Movie tickets Have local monopoly power Lower price for children, students and senior citizens than for other patrons. Raise profit by price discrimination Airline prices Seats sold at many different prices Lower prices for round-trip if the traveler stays over a Saturday night. Why? Helps to separate business traveler from personal traveler Business traveler has higher willingness to pay and most likely does not want to stay over a Saturday night Financial aid Many colleges and universities give financial aid to students. Wealthy students have higher willingness to pay than needy students. By charging higher tuition and selectively offering financial aid schools charge prices to customers based on the value they place on going to school. Financial aid has been used as an effective method of price discrimination Designed to increase revenue of the college Hall & Leiberman; Economics: Principles And Applications, 2004