1 Frank & Bernanke 3 rd edition, 2007 Ch. 10: Ch. 10: Monopoly and Other Forms of Imperfect Competition

2 Perfect Competition An ideal market that maximizes economic surplus An ideal market that maximizes economic surplus A situation that does not always exist A situation that does not always exist

3 Imperfectly Competitive Firms Have some control over price Have some control over price Price may be greater than the cost of production Price may be greater than the cost of production Long-run economic profits are possible Long-run economic profits are possible Reduce economic surplus to varying degrees Reduce economic surplus to varying degrees Are very common Are very common Reduce economic surplus to varying degrees Are very common

4 Different Forms of Imperfect Competition Pure Monopoly (most inefficient) Pure Monopoly (most inefficient) The only supplier of a unique product with no close substitutes The only supplier of a unique product with no close substitutes Monopolistic Competition (closest to perfect competition) Monopolistic Competition (closest to perfect competition) A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another Long-run adjustment to zero economic profits Long-run adjustment to zero economic profits Importance of differentiation Importance of differentiation Oligopoly (more efficient than a monopoly) Oligopoly (more efficient than a monopoly) Industry structure in which a small number of large firms produce products that are either close or perfect substitutes Industry structure in which a small number of large firms produce products that are either close or perfect substitutes Cost advantages from large size may prevent the long-run adjustment to zero economic profit Cost advantages from large size may prevent the long-run adjustment to zero economic profit Undifferentiated and differentiated products Undifferentiated and differentiated products

5 Perfectly and Imperfectly Competitive Firms The perfectly competitive firm faces a perfectly elastic demand for its product. The perfectly competitive firm faces a perfectly elastic demand for its product. Supply and demand determine equilibrium price. The firm has no market power. Supply and demand determine equilibrium price. The firm has no market power. At the equilibrium price, the firm sells all it wishes. At the equilibrium price, the firm sells all it wishes. The imperfectly competitive firm faces a downward-sloping demand curve. The imperfectly competitive firm faces a downward-sloping demand curve. The firm has some control over price or some market power. The firm has some control over price or some market power. The firm faces a downward sloping demand curve. The firm faces a downward sloping demand curve.

6 Perfect Competition If the firm raises its price, sales will be zero. If the firm raises its price, sales will be zero. If the firm lowers its price, sales will not increase. If the firm lowers its price, sales will not increase. The firm’s demand curve is the horizontal line at the market price. The firm’s demand curve is the horizontal line at the market price.

7 The Demand Curves Quantity $/unit of output Quantity D Market price Price D Perfectly competitive firmImperfectly competitive firm

8 Five Sources of Market Power Exclusive control over inputs Exclusive control over inputs Patents and Copyrights Patents and Copyrights Government Licenses or Franchises Government Licenses or Franchises Economies of Scale (Natural Monopolies) Economies of Scale (Natural Monopolies) Network Economies Network Economies

9 Economies of Scale and the Importance of Start-Up Costs Firms with large fixed costs and low variable costs: Firms with large fixed costs and low variable costs: Have low marginal costs Have low marginal costs Average total cost declines sharply as output increases Average total cost declines sharply as output increases Economies of scale will exist Economies of scale will exist

10 Constant Returns to Scale A production process is said to have constant returns to scale if, when all inputs are changed by a given proportion, output changes by the same proportion. A production process is said to have constant returns to scale if, when all inputs are changed by a given proportion, output changes by the same proportion.

11 Increasing Returns to Scale A production process is said to have increasing returns to scale if, when all inputs are changed by a given proportion, output changes by more than that proportion; also called economies of scale. A production process is said to have increasing returns to scale if, when all inputs are changed by a given proportion, output changes by more than that proportion; also called economies of scale.

12 TC and ATC with Economies of Scale Average cost ($/unit) Quantity Total cost ($/year) Quantity F Q0Q0 F + MQ 0 TC = F + MQ Total cost rises at a constant rate as output rises ATC = F/Q + M M Average costs decline and is always higher than marginal cost

13 Costs for Two Computer Game Producers (1) Nintendo Playstation Annual production1,000,000 1,200,000 Fixed cost$200,000 $200,000 Variable cost$800,000 $960,000 Total cost$1,000,000$1,160,000 Average total cost per game $1.00 $0.97 Observations Fixed costs are a relatively small share of total cost Cost/game is nearly the same

14 Costs for Two Computer Game Producers (2) Annual production1,000,000 1,200,000 Fixed cost$10,000,000 $10,000,000 Variable cost$200,000 $240,000 Total cost$10,200,000$10,240,000 Average total cost per game $10.20 $8.53 Nintendo Playstation Observations Fixed costs are a relatively large share of total cost Playstation has a $1.67 average cost advantage Playstation can lower prices, cover cost, and attract customers

15 Annual production500,000 1,700,000 Fixed cost$10,000,000 $10,000,000 Variable cost$100,000 $340,000 Total cost$10,100,000$10,340,000 Average total cost per game $20.20 $6.08 Costs for Two Computer Game Producers (3) Nintendo Playstation Shift of 500,000 units to Playstation Nintendo’s average cost increases to $20.20/unit Playstation average cost falls to $6.08 A large number of firms cannot survive when the cost differential is high

16 Economies of Scale and the Importance of Fixed Costs Fixed investment in research and development has been increasing as a share of production costs. Fixed investment in research and development has been increasing as a share of production costs %80% %20% Cost of producing a computer Fixed CostVariable Cost SoftwareHardware

17 Economic Naturalist How big will Playstation’s unit cost advantage be if it sells 2,000,000 units per year, while Nintendo sells only 200,000? How big will Playstation’s unit cost advantage be if it sells 2,000,000 units per year, while Nintendo sells only 200,000? Why does Intel sell the overwhelming majority of all microprocessors used in personal computers? Why does Intel sell the overwhelming majority of all microprocessors used in personal computers?

18 Profit Maximization Perfect competition and monopolies Perfect competition and monopolies Both increase output when MR > MC. Both increase output when MR > MC. Calculate MC the same way. Calculate MC the same way. Do not have the same MR at a given price. Do not have the same MR at a given price. In perfect competition: MR = P In perfect competition: MR = P In monopoly: MR < P In monopoly: MR < P

19 The Monopolist’s Benefit from Selling an Additional Unit Price ($/unit) Quantity (units/week) D If P = $6, then TR = $6 x 2 = $12 If P = $5, then TR = $5 x 3 = $15 The MR of selling the 3 rd unit = $3 (15-12) For the 3 rd unit, MR = $3 < P = $5

20 Observations Observations MR < P MR < P MR declines as quantity increases MR declines as quantity increases MR is the change between two quantities MR is the change between two quantities MR < P because price must be lowered to sell an additional unit MR < P because price must be lowered to sell an additional unit PQTRMR 3 1 Marginal Revenue

21 Price & marginal revenue ($/unit) Quantity (units/week) PQTRMR D Marginal Revenue in Graphical Form MR Demand: P = 8 – Q MR = 8 – 2Q

22 Monopolist with a Straight-Line Demand Curve Price Quantity Observations The vertical intercept, a, is the same for MR and D The horizontal intercept for MR, Q 0 /2, is one half the demand intercept, Q 0. D Q0Q0 a Q 0 /2 a/2 MR

23 Profit Maximizing Decision Rule When MR > MC, output should be increased. When MR > MC, output should be increased. When MR < MC, output should be reduced. When MR < MC, output should be reduced. Profits are maximized at the level of output for which MR = MC. Profits are maximized at the level of output for which MR = MC.

24 The Monopolist’s Profit- Maximizing Output Level Price ($/unit of output) Quantity (units/week) 6 D Marginal Cost 2 4 MR 8 Observations If P = $3 & Q = 12 MR < MC and output should be reduced Profits are maximized at 8 units where MR = MC P = $4 where quantity demanded = quantity supplied Demand: P = 6 – 0.25QMR = 6-0.5Q MC = 0.25Q

25 Even a Monopolist May Suffer an Economic Loss Price ($/minute) Minutes (millions/day) Price ($/minute) Minutes (millions/day) ATC ATC Economic loss = $400,000/day Economic profit = $400,000/day D 0.05 MC MR D 0.05 MC MR Being a monopolist doesn’t guarantee an economic profit

26 D Marginal cost The socially optimal amount occurs where MC = 12 units Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) Quantity (units/week)

MR 8 The profit maximizing level of output of 8 units, where MR = MC, is less than the socially optimal output of 12 Between 8 and 12, MB to society > MC to society Cannot increase output because MR to the firms is less than MC Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) Quantity (units/week) D Marginal cost

MR 8 Because MR < P, the monopoly produces less than the socially optimal amount The deadweight loss of the monopoly to society = (1/2)($2/unit)(4units/wk) = $4/wk. Deadweight loss Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) Quantity (units/week) D Marginal cost

29 Why the Invisible Hand Breaks Down Under Monopoly Monopoly Monopoly Profits are maximized where MR = MC. Profits are maximized where MR = MC. P > MR P > MR P > MC P > MC Deadweight loss Deadweight loss Perfect Competition Perfect Competition Profits are maximized where MR = MC. Profits are maximized where MR = MC. P = MR P = MR P = MC P = MC No deadweight loss No deadweight loss

30 Enforcing antitrust laws Enforcing antitrust laws Patents, copyrights, and innovation Patents, copyrights, and innovation Natural monopolies Natural monopolies Difficulties in Reducing the Deadweight Loss of Monopolies

31 Price Discrimination The practice of charging different buyers different prices for essentially the same good or service The practice of charging different buyers different prices for essentially the same good or service Examples of Price Discrimination Examples of Price Discrimination Senior citizens and student discounts on movie tickets Senior citizens and student discounts on movie tickets Supersaver discounts on air travel Supersaver discounts on air travel Rebate coupons Rebate coupons

32 Price Discrimination Profit-maximizing seller’s goal is to charge each buyer his/her reservation price. Profit-maximizing seller’s goal is to charge each buyer his/her reservation price. There are two problems to implementing this pricing strategy. There are two problems to implementing this pricing strategy. Seller does not know the reservation prices Seller does not know the reservation prices Seller must separate high and low price buyers Seller must separate high and low price buyers The hurdle method of price discrimination is used to solve these problems. The hurdle method of price discrimination is used to solve these problems.

33 The Hurdle Method The practice of offering a discount to all buyers who overcome some obstacle. The practice of offering a discount to all buyers who overcome some obstacle. Example Example Offering a rebate to those who mail in a coupon Offering a rebate to those who mail in a coupon

34 Examples of Price Discrimination Temporary Sales Temporary Sales Book publishers and paperback books Book publishers and paperback books Automobile producers offer various models Automobile producers offer various models Commercial air carriers Commercial air carriers Movie producers Movie producers

35 Price Discrimination and Economic Surplus MC D MR Q P Q* P* World Price Q**

36 Controlling Natural Monopolies State ownership and management State ownership and management Weighing the benefit of marginal cost pricing versus the cost of less incentive for innovation Weighing the benefit of marginal cost pricing versus the cost of less incentive for innovation State regulation of private monopolies State regulation of private monopolies Cost-plus regulation Cost-plus regulation High administrative cost High administrative cost Less incentive for innovation Less incentive for innovation P does not equate to MC P does not equate to MC Exclusive contracting for natural monopoly Exclusive contracting for natural monopoly Competition for the contract sets P = MC Competition for the contract sets P = MC Difficulty when fixed costs are high such as electric utilities Difficulty when fixed costs are high such as electric utilities Vigorous enforcement of anti-trust laws Vigorous enforcement of anti-trust laws Helps prevent cartels Helps prevent cartels May prevent economies of scale May prevent economies of scale