ECON 211 ELEMENTS OF ECONOMICS I Session 7– Monopoly (Part 1) Lecturer: Dr. (Mrs.) Nkechi S. Owoo, Department of Economics Contact Information: nowoo@ug.edu.gh

Session Overview This session introduces a second type of market structure- Monopoly. We discuss the features, profit maximization conditions and goals of a monopoly firm in the first part of this session. We introduce the concept and consequences of price discrimination within a monopoly market structure in the second part of the session.

Session Outline The key topics to be covered in the session are as follows: What is a Monopoly? What are the Barriers to Entry? Monopoly Behaviour Measuring Profit and Loss

Reading List Hall and Lieberman Chapter 8, pp: 257-277

Topic One what is monopoly?

Monopoly Single firm that serves an entire market Sole seller of a product and product does not have substitutes Classification of monopoly can depend on how broadly a market is defined Is Ghana Water company a monopoly? Is Woodin a monopoly? Is Ruut beer a monopoly? Spectrum of monopolies based on extent of substitutes

How Monopolies Arise Monopolies exist- other firms find it unprofitable or impossible to enter the market Barriers to entry source of monopoly power There are two (2) types of barriers: Technical Barriers Economies of scale Special knowledge of resources or technology Legal barriers Protection of intellectual property Government franchise

Barriers to entry: Technical Barriers Economies of scale One firm can operate at lower average cost than other firms Graphical Illustration of LRATC and economies of scale Natural monopoly - arises when one firm can produce for the entire market at lower cost per unit Once monopoly established, entry difficult because new firm would produce at lower levels of output, and therefore higher cost

A Natural Monopoly C $15 100 Articles of Clothing per Day Dollars 12 B Three firms –each produce 100 units Each operate at C on LRATC curve Cost per unit = $15 Articles of Clothing per Day Dollars 12 B 150 Two firms- each produce 150 units Each firm operate at B on LRATC Cost per unit = $12 (higher) LRATC A 300 5 One firm – produce 300 units Operate at A on LRATC curve Cost per unit=$5

A Natural Monopoly A monopoly that arises because of economies of scale is called a natural monopoly Local monopolies are often natural monopolies One fuel station, one supermarket, one doctor, etc in a small town Due to sizeable lumpy inputs, first firm to enter the market will likely be the last

Barriers to entry: Technical Barriers Special knowledge of resources or low-cost productive technique Knowledge or ownership of unique resources (mineral deposits, land locations, unique managerial talents) Example is DeBeers Diamond Monopoly Controls 80% of world’s production of diamonds As long as consumers believe there are no substitutes for diamonds (a Diamond is forever!), DeBeers continues to wield large market power

Barriers to Entry: Legal Barriers Many pure monopolies created as a matter of law (rather than economic conditions) Protection of intellectual property Patents - temporary grant of monopoly for about 20 years Scientific discoveries Copyrights - grant of exclusive rights to sell a literary, musical, or artistic work for 70 years or longer Possible to sell off patent and copyrights No change in monopoly status Creators of intellectual property enjoy a monopoly and earn profits for a limited period of time Afterwards, other competitors enter the market drive price down.

Barriers to Entry: Legal Barriers Defence for protection i.e. legal barriers?

Barriers to Entry: Legal Barriers Defence for protection i.e. legal barriers? Innovation made more profitable and acts as an incentive

Barriers to Entry: Legal Barriers Government franchise Grant of exclusive rights over a product Rationale basis for this? Hint: natural monopoly Government tries to serve consumers’ interests In exchange for monopoly status: Firm agrees to submit to government regulation and control Government regulates price and profits of firm Discuss in detail later

Topic One Monopoly behaviour

Monopoly Behavior Monopolists demand curve is downward sloping Goal Can control price or quantity, but not both Goal Earn highest profit possible A monopolist face economic constraints that limit its behavior Cost – to produce any level of output Input prices Technology Given market demand curve the highest price it can charge

Monopoly Price or Output Decision Monopolist does not make 2 separate decisions about price and output Once a monopolist determines his/her output level, also determines the price …and v.versa How is profit-maximizing output level determines? Same as any other firm- MC & MR

Illustration: Output and Revenue data Quantity of Water Price (P) TR MR 11 1 10 2 9 18 8 3 24 6 4 7 28 5 30 -2 -4 In order to sell a greater quantity of output, a monopolist must reduce the price on ALL previous units that it sells Downward sloping DD curve A monopolists MR is always < P MR curve lies below demand curve

Demand and Marginal Revenue Dollars Demand $13 MR 10 A 3 9 B 4 C -1

The Profit-Maximizing Output Level We have derived our MR curve for a monopolist To maximize profit Produce the quantity where MC = MR, and the MC crosses the MR from below Graphical Illustration

The Profit-Maximizing Output Level Monopoly Price and Output Determination Qty of Diamonds Price 40 $60 MC E D 10,000 30,000 MR

Profit Maximization and Output Choice A monopolist will choose to produce that output for which marginal revenue equals marginal cost. Then uses demand curve to find the price that will induce consumers to buy that quantity Because monopolist faces a downward-sloping demand curve, market price will exceed marginal revenue and the firm’s marginal cost at this output level. P> MR= MC This condition is crucial to understanding the social cost of monopoly

Monopoly and Market Power A monopoly is an example of a firm with market power The ability to raise prices without causing quantity demanded to go to zero Do perfect competitive firms have market power? Any firm with downward sloping demand curve has some market power Increases in price lead to a fall in quantity demanded Customers who value the product continue to buy at higher price Monopoly firm is a price setter or price maker

Measuring profit and loss Topic One Measuring profit and loss

Profit and Loss Profit Loss When P > ATC Total profit = Profit per unit * Q Profit per Unit = P – ATC Loss When P < ATC Total loss = Loss per unit * Q Loss per unit = ATC - P

Profit and Loss Monopoly Profit and Loss Dollars (a) Quantity of Diamonds (b) ATC MC ATC MC $50 E E $40 40 32 Total Loss Total Profit D D 10,000 10,000 MR MR

Break-even Profits Illustrate a scenario where a monopolist breaks even Zero economic profits

Monopoly Profits: Short-Run Equilibrium In the short run, a monopolist can make profits, losses or break even When a monopolist suffers a loss in the short run, should it shut down or continue to produce?

Monopoly Profits: Short-Run Equilibrium In the short run, a monopolist can make profits, losses or break even When a monopolist suffers a loss in the short run, should it shut down or continue to produce? Depends on relationship between price and AVC Illustrate graphically, the shut-down decision for a firm

Profit and Loss Monopoly Profit and Loss (b) ATC Dollars MC Quantity of Diamonds Dollars (b) ATC MC Monopolist is making a loss, and not able to cover AVC. Should shut down AVC $50 E 40 Total Loss D 10,000 MR

Profit and Loss Monopoly Profit and Loss (b) ATC Dollars MC Quantity of Diamonds Dollars (b) ATC MC Monopolist is making a loss, but is able to cover AVC. Should not shut down $50 AVC E 40 Total Loss D 10,000 MR

Monopoly Profits: Long run equilibrium For a PC market, profits are not possible in the long run. Why? In a monopoly, there are barriers to entry Outsiders are unable to enter even if monopolist making profits Monopolists making losses in the long term are likely to exit the market Exceptions in a number of government regulated businesses Therefore in the long run, monopolists do not make losses

The Welfare Cost of Monopoly A monopoly market will have a higher price and a lower output than a PC market Although profit maximization for both is MC= MR, monopolists charge P > MC Monopolists make profits, possibly even in the long run Desirable for firms Do benefits to firm owners exceed costs to consumers, making monopoly desirable from standpoint of society as a whole?

The Welfare Cost of Monopoly Illustration What would happen if a single firm took over a perfectly competitive market? There are 100 individual identical firms Market is in equilibrium All firms earn zero economic profit in the long run Assume a single firm buys up all PC firms Downward sloping demand curve becomes firm’s individual demand curve Firm does not change the way that output is being produced Then Monopolist’s MC curve is the same as market supply curve for PC market

Monopoly and Perfect Competition 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 3. When monopoly takes over, the old market supply curve . . . E $10 $10 d=MR 1. In this competitive market of 100 firms, equilibrium price is $10… D 100,000 1,000

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

The Welfare Cost of Monopoly Recall Below Q*, value of an extra unit > cost of producing it Increase production Above Q*, value of an extra unit < cost of producing it Reduce production Therefore, price at Q* is charged Efficient outcome!

The Efficient Level of Output Price Marginal cost Demand (marginal value to buyers) Value to buyers Cost to monopolist Efficient quantity Cost to monopolist Value to buyers Quantity Value to buyers is greater than cost to seller. Value to buyers is less than cost to seller.

The Welfare Cost of Monopoly While PC firms produce P= MR= MC Monopolist produces where MR= MC, but P> MR Monopolist produces inefficient quantity Graphical Illustration What happens if monopolist produces at the PC output level? Since P>MC, customers that value good at higher than MC, but lower than P will not buy Inefficiency because customers value good at higher than cost of producing it Monopoly prevents some mutually beneficial trades from taking place

The Inefficiency of Monopoly P > MC; monopoly Price Demand Marginal revenue Marginal cost Deadweight loss Monopoly price quantity P = MC; perfect competition and optimum Efficient quantity The monopolist produces less than the socially efficient quantity Quantity

References Economics: Principles and Applications: Hall R.E. and Lieberman M. (2008), Thomson/ South Western (4th Edition)