Monopoly Lecture 7

Principal market types Structural characteristic Perfect competition Monopolistic competition oligopoly monopoly Number of sellers many few one Barriers to entry no usually Yes (no entry) Product differentiation yes perhaps No (one product) examples Agriculture, individual stocks Restaurants, drugstores Cars, breakfast cereals Diamonds, instant photos

Monopoly and monopoly power A monopoly – the only seller of a particular good or service in the market The most extreme case of imperfect competition Monopoly price determined by the market demand for its product Monopoly power – a firm can raise the price by restricting its output

Demand, total revenue and marginal revenue Quantity demanded price Total revenue (Q x price) Marginal revenue O 16 14 1 10 2 12 24 6 3 30 4 8 32 -2 5 -6 -10 7 -14

How much to produce? Economic profit = difference between P1 and average cost AC1 where output = Q1 Total profit = (P1-AC1)  Q

Optimal monopoly output At the optimal output, which maximizes profit MR=MC Monopolist maximizes profit by charging a price above marginal cost Monopolist - a price maker

Monopoly profit Monopoly profit= (P – ATC) x Q It is economic (abnormal) profit – reflects ability to raise the price above marginal cost without attracting competition Do all monopolies make monopoly profit? Not at all. Only if the demand curve lies above its average cost curve

Monopoly versus competition Price and output: Perfect competition: both P and Q determined by the intersection of Demand and Supply , P=MR=MC. Monopoly: Q chosen at the level MR=MC and price read off the demand curve, P>MC Replacing competition by monopoly raises price and lowers output

Perfect competition versus monopoly goal Profit maximization Profit maximization rule MR=MC Econ. Profit – short run yes Number of firms on the market many 1 price P=MC P>MC Possibility to enter the market - long run no Economic profit - long run Possibility of price differentiation

Social cost of monopoly Perfect competition P=MC, value to consumers of an extra unit of output just equals the marginal cost of producing it. Most efficient price in terms of allocation - measures the value to consumers of 1 more unit of the good which is equal the marginal cost of producing it. The output just equal the quantity consumers want to buy. Monopoly- P>MC – an expansion in output would benefit society (the value to consumers of an additional unit of output exceeds the marginal cost of producing it). An expansion of output would not benefit the monopolist Social cost – an opportunity cost: the total benefit that society gives up by allowing production to be restricted to the monopoly level regulated monopoly: a)the price= ATC, it is called the full costs price or break-even price. Monopoly receives normal profit; b) price= MC, most efficient price in terms of allocation. Monopoly realizes abnormal profit, but smaller than in case of unregulated monopoly

Why do monopolies exist 1) Natural monopoly: if any level of output is more cheaply produced by one firm than by two or more (economies of scale), Monopoly natural in the sense that it is cost-minimizing market structure Examples: telephone service cable TV, water distribution, 2) Control over scarce resources (raw materials, knowledge covered by a patent (diamonds, Xerox over copying process 3) Government restrictions on the entry of new firms (patent systems temporary monopolies to encourage innovation, in some cases government itself takes the right to be monopoly)

Natural monopoly in details Exists in industries with especially high benefits of scale Monopoly operates at decreasing average total costs curve A decreasing marginal costs curve lays under ATC curve Output at which profit max. is relatively low, the price relatively high Government intervention, regulated price at the level of ATC (P=ATC), normal profit only and output much higher than in case of unregulated natural monopoly

Price discrimination (1) Price discrimination – when a firm with market power charges different prices to consumers of identical product 3 conditions necessary for price discrimination to occur: 1) market power 2) segregate the market between consumers with different willingness to pay and with different price elasticity of demand 3) no resale

Price discrimination (2) 3 different degrees of price discrimination 3rd degree: by consumers group – age groups, time of purchasing 2nd degree: by quantity of products- bulk buying, one-for-two, more you buy less you pay for a unit 1st degree: perfect price discrimination. By the individual consumer. Each consumer pays exactly what he/she is willing to pay. Charges different prices to consumer based on his/her demand 1st degree p. d. not very common, a good example: the law profession offering a free consultation to obtain information on their clients willingness to pay or a car salesman more common 2nd and 3rd degree of price discrimination

3rd degree price discrimination Monopoly charges different prices to different groups of consumers on the basis of differences in their price demand elasticity Two or more groups of customers with different demand curves An example: business travelers (d. inelastic) and vacationers (d. elastic)

Price discrimination D1 and D2 demand curves of 2 groups of buyers Price= P*and the same for all buyers – MR for group 1 < MR for group2 MR the same for all buyers if the price different for each group ( P1 and P2) Price discrimination increases sales and profits of monopolist Impact on consumer depends on the group he/she belongs

Monopoly and innovations Temporary monopolies granted to inventors to promote technical progress J. Schumpeter: large firms with monopoly power speed technical progress, profits spent on research But in most sectors there appears to be little relationship between the size of a firm and revenue devoted to research Some market power may help but innovation does not depend on giant firms Monopoly more often the result of technical progress than its cause