CHAPTER 14 Monopoly

Monopoly A monopoly (monopolist) means there is only one producer of a good.

Types of Market Structure Economists have developed four principal models of market structure: perfect competition monopoly oligopoly monopolistic competition

The Meaning of Monopoly A monopoly (monopolist) is a firm that is the only producer of a good that has no close substitutes. Examples: De Beers (diamonds) Hometown newspapers or movie theater Microsoft (word, power point), E-bay? Buying food or a drink at Miller Park The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power.

What does a Monopolist Do? Reduce supply and quantity! Under perfect competition, the price and quantity are determined by supply and demand. A monopolist reduces the quantity supplied to QM, raising the price to PM.

Why Do Monopolies Exist? A monopolist has market power and will charge higher prices and produce less output than a competitive industry. Profits will vanish in the long run unless there is a barrier to entry. Examples - control of natural resources or inputs, economies of scale, technological superiority, or legal restrictions imposed by governments, including patents and copyrights.

Economies of Scale and Natural Monopoly A monopoly created and sustained by economies of scale is called a natural monopoly. Economies of scale provide a large cost advantage to having all of an industry’s output produced by a single firm. Under such circumstances, average total cost is declining over the output range relevant for the industry. This prevents new firms from entering.

Economies of Scale Create Natural Monopoly Example: Electric utilities A natural monopoly can arise when fixed costs required to operate are very high. As a result, output is produced more cheaply by one large firm than by two or more smaller firms.

How a Monopolist Maximizes Profit The price-taking (Perfect competition) firm’s optimal output rule is to produce the output level at which MC = MR. A monopolist, in contrast, is the only supplier of its good. So its demand curve is simply the market demand curve, which is downward sloping.

Comparing the Demand Curves of a Perfectly Competitive Firm and a Monopolist An individual perfectly competitive firm cannot affect the market price of the good. A monopolist can affect the price (sole supplier in the industry). Its demand curve is the market demand curve, as shown in panel (b). To sell more output it must lower the price; by reducing output it raises the price.

How a Monopolist Maximizes Profit An increase in production by a monopolist has two opposing effects on revenue: A quantity effect. One more unit is sold, increasing total revenue by the price at which the unit is sold. A price effect. In order to sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue.

A Monopolist’s Demand, Total Revenue, and Marginal Revenue Curves

The Monopolist’s Demand Curve and Marginal Revenue A profit-maximizing monopolist chooses the output level at which marginal cost is equal to marginal revenue—not to price. MC = MR As a result, the monopolist produces less and sells its output at a higher price than a perfectly competitive industry would. It earns a profit in the short run and the long run.

The Monopolist’s Profit- Maximizing Output and Price To maximize profit, the monopolist compares marginal cost with marginal revenue. If marginal revenue exceeds marginal cost, De Beers increases profit by producing more; if marginal revenue is less than marginal cost, De Beers increases profit by producing less. So the monopolist maximizes its profit by using the optimal output rule: Output quantity is where MR = MC

The Monopolist’s Profit- Maximizing Output and Price The optimal output rule: the profit maximizing level of output for the monopolist is at MR = MC, shown by point A, where the marginal cost and marginal revenue curves cross at an output of 8 diamonds.

Monopoly versus Perfect Competition Compared with a competitive industry, a monopolist does the following: Produces a smaller quantity Charges a higher price Earns an economic (Above normal) profit

The Monopolist’s Profit Profit = TR − TC TR = Q x P TC = ATC x Q

Monopoly and Public Policy Monopoly = less consumer surplus Monopoly causes more deadweight loss When monopolies are “created” rather than natural, governments should act to prevent them from forming and break up existing ones. This is called anti-trust policy.

Monopoly Causes Inefficiency Blue = consumer surplus Green = monopoly profit Yellow = D.W. loss

Dealing with Natural Monopoly What can public policy do about this? There are two common answers… One answer is public ownership, but publicly owned companies are often poorly run. A common response in the United States is price regulation. A price ceiling imposed on a monopolist does not create shortages as long as it is not set too low.

Regulated and Unregulated Natural Monopoly Panel (b) shows the effect of price regulations.The monopolist makes zero profit. This is the greatest consumer surplus possible when the monopolist is allowed to at least break even, making PR* the best regulated price. (socially optimal price in AP language)

Price Discrimination Can a monopolist charge different customers different prices?

Price Discrimination (continued) Example: Airline tickets If you are willing to buy a nonrefundable ticket two weeks in advance and stay over a Saturday night, the round trip may cost only $150,but if you have to go on a business trip tomorrow, and come back the next day, the round trip might cost $550.

The Logic of Price Discrimination Price discrimination is profitable when consumers differ in their sensitivity to the price. A monopolist would like to charge high prices to consumers willing to pay them without driving away others who are willing to pay less. It is profit-maximizing to charge higher prices to low-elasticity consumers and lower prices to high elasticity ones.

Two Types of Airline Customers Air Sunshine has two types of customers, business travelers willing to pay $550 per ticket and students willing to pay $150 per ticket. If Air Sunshine could charge these two types of customers different prices, it would maximize its profit by charging two different prices. It would capture all of the consumer surplus as profit.

Price Discrimination and Elasticity A monopolist able to charge each consumer his or her willingness to pay for the good achieves perfect price discrimination and does not cause inefficiency because all mutually beneficial transactions are exploited. In this case, the consumers do not get any consumer surplus.

Price Discrimination By increasing the number of different prices charged, the monopolist captures more of the consumer surplus and makes a large profit.

Perfect Price Discrimination In the real world, this is probably impossible. In the case of perfect price discrimination, a monopolist charges each consumer his or her willingness to pay; the monopolist’s profit is given by the shaded triangle. Perfect price discrimination is probably impossible.

Perfect Price Discrimination Common techniques for price discrimination are: Advance purchase restrictions Volume discounts (Microsoft) UW-Madison Discounts for locals (Disney World) Time of day discounts (electric utilities) Bundled services (cable tv) Interruptible service discount (Electric)

The End of Chapter 14