Monopoly & Oligopoly Chapter 15 & 16 Week 12, 13

Definition Monopoly: a firm that is the sole seller of a product without close substitutes.

Competitive firm: price taker Monopolist: price maker

Why Monopolies Arise Key resource owned by single firm. Government granted restriction. Increasing returns to scale (natural monopoly).

Figure 1 Economies of Scale as a Cause of Monopoly Cost Average total cost Quantity of Output Copyright © 2004 South-Western

Figure 2 Demand Curves for Competitive and Monopoly Firms (a) A Competitive Firm ’ s Demand Curve (b) A Monopolist ’ s Demand Curve Price Price Demand Demand Quantity of Output Quantity of Output Copyright © 2004 South-Western

Table 1 A Monopoly’s Total, Average, and Marginal Revenue Copyright©2004 South-Western

Figure 3 Demand and Marginal-Revenue Curves for a Monopoly Price $11 10 9 8 7 6 5 4 3 Demand (average revenue) 2 Marginal revenue 1 –1 1 2 3 4 5 6 7 8 Quantity of Water –2 –3 –4 Copyright © 2004 South-Western

Figure 4 Profit Maximization for a Monopoly Costs and 2. . . . and then the demand curve shows the price consistent with this quantity. Revenue 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity . . . Marginal revenue Demand Monopoly price QMAX B Marginal cost Average total cost A Q Q Quantity Copyright © 2004 South-Western

Figure 5 The Monopolist’s Profit Costs and Revenue Marginal revenue Demand Marginal cost Monopoly price QMAX B C E D Monopoly profit Average total cost Average total cost Quantity Copyright © 2004 South-Western

Figure 6 The Market for Drugs Costs and Revenue Marginal revenue Demand Price during patent life Monopoly quantity Price after patent expires Marginal cost Competitive quantity Quantity Copyright © 2004 South-Western

Figure 7 The Efficient Level of Output Price Marginal cost Demand (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. Copyright © 2004 South-Western

Figure 8 The Inefficiency of Monopoly Price Demand Marginal revenue Marginal cost Deadweight loss Monopoly price quantity Efficient quantity Quantity Copyright © 2004 South-Western

Public Policy Sherman Anti-trust Act (1890) Clayton Act (1914)

Policy Options Try to make monopolized industries more competitive. Regulate behavior. Turn monopoly into public enterprise. Do nothing.

Figure 9 Marginal-Cost Pricing for a Natural Monopoly Price Demand Average total cost Average total cost Loss Regulated price Marginal cost Quantity Copyright © 2004 South-Western

Price Discrimination Sometime a monopolist can get away with charging different prices to different customers. This is called price discrimination. It can lead to higher profits and less of a deadweight loss.

Price Discrimination Examples Movie tickets Airline prices Discount coupons Financial aid Quantity discounts

Figure 10 Welfare with and without Price Discrimination (a) Monopolist with Single Price Price Consumer surplus Demand Marginal revenue Deadweight loss Quantity sold Monopoly price Profit Marginal cost Quantity Copyright © 2004 South-Western

Figure 10 Welfare with and without Price Discrimination (b) Monopolist with Perfect Price Discrimination Price Profit Demand Marginal cost Quantity sold Quantity Copyright © 2004 South-Western

Figure 1 The Four Types of Market Structure Number of Firms? One firm Few firms Many firms Type of Products? Differentiated products Identical products • Novels Movies Monopolistic Competition (Chapter 17) Perfect • Wheat Milk Competition (Chapter 14) • Tap water Cable TV Monopoly (Chapter 15) • Tennis balls Crude oil Oligopoly (Chapter 16) Copyright © 2004 South-Western

Oligopoly Temptations Collusion An agreement among firms in a market about quantities to produce or prices to charge. Cartel A group of firms acting in unison.

Table 1 The Demand Schedule for Water Copyright©2004 South-Western

Equilibrium for an Oligopoly Price lower than monopoly price and higher than competitive price. Quantity higher than monopoly quantity and lower than competitive quantity.

Nash Equilibrium A situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen.

GAME THEORY AND THE ECONOMICS OF COOPERATION Game theory is the study of how people behave in strategic situations. Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

GAME THEORY AND THE ECONOMICS OF COOPERATION Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.

The Prisoners’ Dilemma The prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

Figure 2 The Prisoners’ Dilemma Bonnie’ s Decision Confess Remain Silent Bonnie gets 8 years Clyde gets 8 years Bonnie gets 20 years Clyde goes free Confess Clyde’s Decision Bonnie goes free Clyde gets 20 years gets 1 year Bonnie Clyde gets 1 year Remain Silent Copyright©2003 Southwestern/Thomson Learning

Figure 3 An Oligopoly Game Iraq ’ s Decision High Production Low Production Iraq gets $40 billion Iran gets $40 billion Iraq gets $30 billion Iran gets $60 billion High Production Iran ’ s Decision Iraq gets $60 billion Iran gets $30 billion Iraq gets $50 billion Iran gets $50 billion Low Production Copyright©2003 Southwestern/Thomson Learning

Actual phone call by one airline president to another ROBERT : I think it’s dumb as hell … to sit here and pound the --- out of each other and neither one of use making a --- dime. HOWARD: Do you have a suggestion for me? ROBERT : Yes, I have a suggestion for you. Raise your --- fares 20%. I’ll raise mine the next morning. HOWARD : Robert, we … ROBERT : You’ll make more money, and I will, too. HOWARD : We can’t talk about pricing! ROBERT: Oh --- , Howard. We can talk about any --- thing we want to talk about.