Monopoly Example 2 - Haircuts Quantity demanded (Q) (haircuts per hour) Total revenue (TR = P x Q) (dollars) Marginal revenue (MR = DTR/DQ) (dollars) Marginal cost (MC = DTC/DQ) (dollars) Price (P) (dollars per haircut) Total cost (TC) (dollars) Profit (TR - TC) (dollars) a b c d e f 20 18 16 14 12 10 0 1 2 3 4 5 0 18 32 42 48 50 20 21 24 30 40 55 -20 -3 +8 +12 +8 -5 18 14 10 6 2 1 3 6 10 15 32

A Monopoly’s Output and Price MC 20 MR ATC Profit = $12 (P-ATC)XQ = ($4 x 3 units) 14 Price and cost (dollars per hour) Economic profit $12 10 D MC=MR at Q=3 & P=$14 0 1 2 3 4 5 Quantity (haircuts per hour) 45

Demand and Marginal Revenue Curves and Elasticity 20 Elastic Inelastic Over the range 5 to 10 haircuts an hour, a price cut decreases total revenue, so demand is inelastic. MR D d f Unit elastic Price and marginal revenue (dollars per haircut) 10 Quantity (haircuts per hour) Profit maximizing monopolies will never produce an output in the inelastic range of the demand curve. Maximum total revenue 5 10 –10 – 20 27

Monopoly: “Supply” Short Run Equilibria There is no “supply” as we know it in monopoly The output decision is dependant on the “demand” and there is no independent “supply” Short Run Equilibria Profit Break even Loss minimization Shut down

Break Even Loss Minimization MC Losses Output per Time Period Price, Marginal Revenue, and Cost per Unit ATC MC D E C1 Pm Qm MR AVC ATC D MR Pm Price, Marginal Revenue, and Cost per Unit Qm Output per Time Period Practice by drawing the SR Shut Down for a monopolist

Long-Run Equilibrium For the Monopolist In the long run: there are two possible equilibria for the monopolist break even economic profit Otherwise the monopoly will simply shut down (which generally means no market; if a monopolist can’t make money the only other option is for the government to operate at a loss)

Summary & Conclusions 1. MR < P, production always takes place in the elastic portion of D 2. Profit max rule MR  MC….. 3. Monopolist exercises market power, the ability to set price (ability to raise price without losing all sales). 4. Market forces constrain monopoly choices. 5. There is no “supply” as we know it. 6. Monopoly does not guarantee economic profit, but if there is economic profit, it can persist in the long run

Price Discrimination To maximize profit – a producer sells a specific commodity to different buyers for different prices for reasons not associated with costs Only makes sense for a producer with market power Ed asks: What about those empty seats? Return to original cost data.

Ed finds a way - Price Discrimination 100 1000 900 800 700 600 500 400 300 200 1 2 3 8 5 6 4 7 9 10 Tickets per Week $ per Ticket DFaculty&Staff MRFS Faculty & Staff pay $6.50 and buy qf =325 TR $6.50x325 + $3.50x375 = $3425.00 TC: $2200.00 Profit: $1225 DStudent MRStudent Students pay $3.50 and buy qs=375

Price Discrimination Summary Find low-cost, techniques for distinguishing high-price from low-price buyers Potential customers with elastic demands are the targets for price reductions, Provided resale can be prevented.

Conclusions Price Discrimination Price discrimination is a rational strategy for a profit maximizing monopolist facing a downward sloping demand curve For effective price discrimination the seller must be able to distinguish, at reasonable cost, different groups with different abilities to pay; i.e., different elasticities of demand.

Conclusions Price Discrimination 3. For effective price discrimination the seller must be able to prevent resale from the low price buyers to the high price buyers. 4. Justification for price discriminations can be an important part of its success: prevents resentment.

Efficiency of Monopoly Compare monopoly to “the standard”: perfect competition. Assume: no technological advantage for a single firm producer constant returns to scale

The Social Cost of Monopolies Efficiency of Monopoly The Social Cost of Monopolies Perfect Competition Monopoly D D MR ATC Qm Pm MCm Pm > Pc Pm > MCm PmminATC E Pe Marginal Revenue per Unit ($) Price, Marginal Costs, and Price per Unit Q2 Value to society Pm > MCm therefore not enough produced P>MinATC inefficient resource use Quantity per Time Period Quantity per Time Period

Comparing the Competitive Market & Monopoly Outcomes Efficiency of Monopoly Comparing the Competitive Market & Monopoly Outcomes Monopolist charges a higher price, produces a lower quantity. (could even earn an economic profit in the long run.)

Loss in Efficiency From Monopoly (Social Cost) Efficiency of Monopoly Loss in Efficiency From Monopoly (Social Cost) Recall when P(MSB) = MC(MSC), allocative efficiency is achieved. in monopoly the firm is under-producing P > MC,  MSB > MSC.

Loss in Efficiency From Monopoly (Social Cost) Efficiency of Monopoly Loss in Efficiency From Monopoly (Social Cost) Recall that productive efficiency is achieved when P=Min ATC monopoly does not operate at min ATC (even in the case of zero economic profit)

Deadweight Loss: Measuring the Social Costs of Monopoly Efficiency of Monopoly Deadweight Loss: Measuring the Social Costs of Monopoly The perfectly competitive equilibrium maximizes total surplus: total economic well being In monopoly, there is a loss of surplus ”dead- weight loss”

Efficiency of Monopoly Measuring the Social Costs of Monopoly: The deadweight loss of a Monopoly Efficiency of Monopoly MC = Supply Price Redistributed surplus PM QM Monopoly Deadweight Loss QE Perfectly Competitive Efficient Quantity! D=MSB MR Quantity

Public Policy Toward Monopolies 1. Try to make monopolized industries more competitive through legislation…. 2. Regulation: (Rate of Return) used in the case of natural monopolies. What price should the government set for such monopolies? What about P = MC, the “allocatively” efficient price?

Profit Maximization Before Regulation Economies of large-scale production lead to a single-firm industry: Natural Monopoly -Produce 5,000, where MC =MR -Price = $8: P > MR & MC -Inefficient allocation of resources, & productive ineffiency 8 Dollars per Unit LATC 4 A LMC D 5,000 MR Quantity per Time Period

Regulation Through Marginal Cost Pricing Regulatory Goal: P = MC losses -Set price at $4, where MC = P -Output = 9,000 -P = MC & P < LATC -Losses will occur -Monopolist will go out of business 6 LATC Dollars per Unit 8 4 LMC D MR 7,000 9,000 Quantity per Time Period

Natural Monopoly Regulation Natural monopolies have declining ATC, \ MC < ATC, at P = MC ® firms will experience losses. Regulators could then subsidize the monopoly or choose P = ATC ® average-cost pricing or fair return pricing

Regulation Through Average Cost Pricing Regulatory Goal: P = LATC -Set price at $6, where LAC =D -Output = 8,000 -P = LATC --Monopolist is breaking even 8,000 8 Dollars per Unit 6 LATC 4 LMC D MR Quantity per Time Period

Natural Monopoly Regulation  choosing a price is a problem any regulated price will result in a lack of incentive on the part of the monopolist to reduce costs: and perhaps an effort to hide “true costs”. Capture Hypothesis Predicts that the regulators will eventually be captured by the special interests of the industry being regulated

Public Policy Toward Monopolies 3. Public Ownership private vs public ownership loss of profit motive in public enterprise can lead to higher costs. 4. Do nothing