Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 10 Monopoly, Cartels, and Price Discrimination

Copyright © 2008 Pearson Addison-Wesley. All rights reserved In this chapter you will learn to 1.Explain why marginal revenue is less than price for a profit-maximizing monopolist. 2. Describe how entry barriers allow monopolists to maintain positive profits in the long run. 3. Describe how firms can form a cartel to restrict industry output and increase price and profits. 4. Describe the various forms of price discrimination.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Cost and Revenue in the Short Run A monopolist faces the (downward-sloping) market demand curve. If the monopolist charges the same price for all units sold, its total revenue (TR) is: TR = p x Q A Single-Price Monopolist

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Average revenue (AR) is total revenue divided by quantity: AR = TR/Q = (p x Q)/Q = p Marginal revenue (MR) is the revenue resulting from the sale of an additional unit of production: The monopolist must reduce the price to increase sales – therefore the MR curve is below the demand curve. MR =  TR/  Q Avenue and Marginal Revenue

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 10.1 A Monopolist’s Average and Marginal Revenue

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 10.2 Short-Run Profit Maximization for a Monopolist

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Monopolist’s Profit-Maximizing Behavior There is no unique relationship between market price and the quantity of output supplied.  A monopolist does not have a supply curve The monopolist is the only producer in an industry.  A monopolist is the industry.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Unlike a competitive firm, the monopolist does not have a supply curve because it chooses its price. Can we compare the monopoly outcome to the competitive outcome? In a perfectly competitive industry price equals MC. But a monopolist produces at a lower level of output, with price exceeding MC. The monopolist is the industry, so that its profit-maximizing conditions is the equilibrium of the industry. Competition and Monopoly Compared

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 10.3 The Inefficiency of Monopoly

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Entry Barriers and Long-Run Equilibrium Despite incentives to enter, effective entry barriers allow monopoly profits to persist in the long run. Entry barriers are of two types: - “natural” – such as economies of scale - “created” – by advertising campaigns or – by government regulation

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Very Long Run and Creative Destruction In the very long run, technological changes and innovations can circumvent effective entry barriers. Joseph Schumpeter defended monopoly on the basis that the pursuit of monopoly profits provides incentives to innovate. He called the replacement of one monopolist by another through innovation the process of creative destruction.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved APPLYING ECONOMIC CONCEPTS 10.1 Entry Barriers for Irish Pubs Entry Barriers

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Joseph Schumpeter ( ) “What we have to accept is that [monopoly] has come to be the most powerful engine of progress and in particular of the long-run expansion of total output not only in spite of, but to a considerable extent through, this strategy [of creating monopolies], which looks so restrictive when viewed in the individual case and from the individual point of time.” LESSONS FROM HISTORY 10.1 Creative Destruction Through History Creative Destruction

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 10.4 The Effect of Forming a Cartel in a Competitive Industry

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 10.5 A Cartel Member’s Incentive to Cheat

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Any one firm within the cartel has an incentive to cheat. But if all firms cheat, the price will fall back toward the competitive level, and joint profits will not be maximized. Enforcing output restrictions and preventing entry are difficult. Thus, cartels rarely last for long. Problems of Cartels

Copyright © 2008 Pearson Addison-Wesley. All rights reserved A producer practices price discrimination by charging different prices for the same products that have the same cost. Central to this is that different consumers value the product at different amounts. Price Discrimination Any firm facing a downward-sloping demand curve can increase profits if it is able to price discriminate.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved When Price Discrimination Is Possible 1. When firms have market power. 2. When consumers differ in their valuations of the product. 3. When firms can prevent arbitrage.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Price Discrimination Among Units of Output A firm captures consumer surplus by charging different prices for different units sold. Different Forms of Price Discrimination “Perfect” price discrimination transfers all consumer surplus to the seller.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 10.6 Price Discrimination among Units of Output

Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 10.7 A Numerical Example of Profitable Price Discrimination

Copyright © 2008 Pearson Addison-Wesley. All rights reserved The Consequences of Price Discrimination Price discrimination increases firms’ profits (otherwise they wouldn’t do it!). For price discrimination by the unit, firms will often increase their output and overall efficiency will increase. The effect on consumers is unclear – they may lose consumer surplus, but they could also gain surplus (if output increases as a result).