Economics of P-Setting Firms (emphasis on monopoly) Chapter 13: Economics of P-Setting Firms (emphasis on monopoly)

Key Topics Alternative market structures Barriers to entry Perfect competition Imperfect competition Barriers to entry Revenue concepts for a price-taking firm P = AR MR TR

Key Topics (cont’d) 4. Operating decisions for a price-taking firm TR max ($ sales max) Π max Rent-seeking actions Price discrimination 5. Revenue concepts and operating decisions for a P-setting firm 6. Monopolies and roles of government Restrict market power Grant & regulate ‘natural’ monopolies

Characteristics of ‘perfectly’ competitive markets Many firms each relatively small compared to the size of the entire market or industry. Firms produce ‘homogeneous’ products. Relative ease of firm entry in to or exit out of the market. Information about prices and production costs widely available. Firms have no control over prices and are price ‘takers’. In long run, product price = minimum average cost = marginal cost (i.e. no excess profits or losses).

Characteristics of ‘imperfectly’ competitive markets Limited number of firms so each has a relatively significant share of total output for the industry or market. Firms produce ‘heterogeneous’ products. Relative difficulty of firm entry in to or out of the market. Information about prices and production costs NOT widely available. Firms have some control over prices charged for their products and are price ‘setters’. In long run, product price > average cost and price > marginal cost.

General types of imperfectly competitive markets Monopolistic competition Many firms selling slightly differentiated products Oligopoly Few firms selling products with varying degrees of differentiation Monopoly ONE firm selling product that has no (or few) close substitutes

Barriers to entry Government franchises = exclusive licenses to sell product/services Why? - Economies of scale (i.e. greater efficiency  lower production costs) - Greater governmental control (e.g. alcohol) Patents = exclusive right to sell a product or use a process to the inventor (for 20 years) - To promote research, scientific progress

Barriers to entry (cont’d) High capital costs (e.g. production, marketing) Ownership of scarce factor of production

Prices charged by imperfectly competitive firms They are a choice decision, not given (or taken) They are constrained by consumer demand for the firm’s product (i.e. can set either P or Q, but NOT both).

Demand Curve ‘Constraint’ P D curve facing P-setting firm (shows max P & Q combinations) a Not possible Pa q qa

Recall, P = MR for P-taking (competitive firm) $ P = MR = AR q However, MR < P for P-setting firm

MR for P-setting firm of lowering P to sell 1 more Q (graph) { P1 ΔP -$ P2 +$ q q1 { (q1+1) Δq = 1

MR for P-setting firm of lowering P to sell 1 more Q (math) ΔTR (note: = MR if Δq = 1, because MR = ΔTR/Δq) = TR2 – TR1 = P2(q1+1)-P1(q1) = P2Δq-ΔPq1 = P2-ΔPq1 (note:  MR < P2) = “Q” effect + “P” effect = ΔTR due to ΔQ at new P + ΔTR due to ΔP on previous Q If lower P ( ΔP < 0) Q effect > 0, P effect < 0   TR if Q effect > P effect (else  TR)

P (= AR), MR, and TR for P-setting firm P = AR = a – bq (b > 0) MR = a – 2bq (same vert. axis intercept, twice the slope) TR = P ∙ q = (a-bq)q = aq – bq2 e.g. P = 11 – q (b = 1) MR = 11 – 2q TR = 11q – q2

MR and TR max vs π max MR = slope of TR TR max = $ sales max  MR = 0 (= D curve mid point) Π max  MR = MC

TR max example P = 11-q TR max P  P = mid point = $5.50 q at P = 5.50 = 11 – 5.50 = 5.50 Max TR = ($5.50)(5.50) = $30.25

TR max vs π max (graph) MR=0  TR max $ TC MR=MC  π max TR q

Monopoly (vs Perfect Competition) Profits can persist LR (entry blocked) Output less & price higher ( loss of consumer surplus) May act to preserve profits (= rent-seeking behavior)

Price Discrimination = charging different prices to different groups of buyers (i.e. different markets) Examples: Airlines, movie theatres, golf courses, restaurants, telephone companies, utility companies

Price Discrimination (graph) $ $ PB Pa MC = ATC dA MRa MRB dB q q Mkt B Mkt A

Monopolies and the Roles of Government Promote competition/restrict market power  antitrust laws - Sherman Antitrust Act, 1890 (restraint of trade illegal) - Clayton Act, 1914 (anticompetitive mergers and tying contracts illegal) - Federal Trade Commission Act, 1914 (established FTC as regulatory agency and made ‘unfair methods of competition illegal) Other legality issues: rule of reason vs. per se; conduct vs structure; remedies = consent decrees, treble damages, etc.

Monopolies and the Roles of Government 2. Grant monopolies (natural) and regulate so consumers benefit from economies of scale

Proof: MR = a – 2bq (if P = a-bq) ΔTR = TR2 – TR1 = P2q2 – P1q1 = ΔPq1 + P2Δq MR = ΔTR / Δq = P2 + (ΔP / Δq) q1 = P2 – bq1 = a – bq2 – bq1 = a – 2bq (for given point on demand curve or an infinitesimal Δ in q  q2 = q1 = q)