1 Monopoly

2 Four Basic Market Structures u Perfectly Competitive: many firms, identical products, free entry and exit, full and symmetric info u Monopoly: single firm, no close substitutes, barriers to entry, full and symmetric info u Oligopoly: several firms, similar products, degree of product differentiation varies depending upon the market, might be barriers, full and symmetric info u Monopolistic competition: many firms, similar products, slightly differentiated products, free entry and exit, full and symmetric info

3 Competitive Market u This is the classic “textbook” market structure. u Firms in a competitive market all make a product that is perfectly substitutable: all demanders are equally satisfied with any supplier’s product.

4 Monopoly u The single seller makes a product that has no “good” substitute. u Other firms may be able to produce the good or service but choose not to enter the market or are barred from it.

5 Oligopoly u A few sellers make products that are good, but not perfect, substitutes. u Consumers can be induced to change suppliers but have only a limited number of choices.

6 Monopolistic Competition u The market has many firms but each supplier’s product is differentiated. u Consumers can be induced to change brands but they have brand preferences.

7 Question u What is the market structure for each of these products or firms: competitive, monopoly, oligopoly, monopolistic competition? –The Campus Store –Kinko’s –Pepperidge Farm’s Whole Wheat Bread –PowerMac computer –Windows computer –NYSEG (electricity utility) –Morton salt –AT&T long distance

8 Answer u The Campus Store: most products competitive, textbooks oligopoly, but location is very important. u Kinko’s: monopolistic competition (differentiated service) u Pepperidge Farm’s Whole Wheat Bread: competition or monopolistic competition (slightly differentiated recipes) u PowerMac computer and clones: monopoly, under license. u Windows computer: monopolistic competition (differentiated features) u NYSEG (electricity utility): monopoly u Morton salt: competitive u AT&T long distance: oligopoly

9 Monopoly u single firm u no close substitutes u barriers to entry u full and symmetric information

10 Sources of Monopoly Entry Barriers u Natural monopoly: the most efficient scale of production is so large, relative to market demand, that a single firm dominates the market. u Patents, copyrights, licenses, franchises: government protection of a firm’s right to produce a unique product. u Economic and/or legal restrictions, strategies or situations that make entry more difficult for new competitors than for the existing monopoly firm.

11 Natural Monopolies u Goods and services whose delivery requires the construction of a physical network (wires, pipes, etc..) u In such industries (local phone service, water, sewage removal, electricity, gas) the physical networks display decreasing marginal cost over essentially all quantities. u Thus, average total cost is always declining and the minimum efficient scale is much larger than the size of the market. u Natural monopolies are often regulated: they cannot charge a higher price without government approval.

12 Patents: Are There “Good” Monopolies? u Consider the protease inhibitor Crixivan from Merck. u A very effective AIDS therapy. u Development costs were more than one billion dollars. u Annual revenue now from treating around 90,000 patients is $500,000,000.

13 What is a “Good” Monopoly? u Why is Merck given a monopoly? u The granting of a patent on the drug Crixivan guarantees that Merck can earn monopoly profits on its sale. u These monopoly profits provide the incentive to invest in the research and development required to create the new drug.

14 “Good” Monopolies u The granting of patent protection (legal monopoly) gives firms a strong incentive to invest in new product development. u Would firms make the R&D investments if they could not protect them through patents and trade secrets? u Probably not because competitors could steal the design at a fraction of the cost after the product is brought to market.

15 “Other” Monopolies - Good? Bad? u Input Ownership –DeBeer’s and diamonds u Industry Secret or Know-how –IBM and mainframes? u Strategic Behavior –buy ‘em up –blow’ em up –let’s make a deal –Microsoft and operating systems?

16 Caveats u monopoly does not => big u big does not => monopoly u monopoly does not => absolute and unlimited control over price u monopoly does not => must have economic profit u short run profit does not => monopoly power u monopoly does not => badly behaved firm

17 Classic Simple Monopoly u Polar extreme from perfect competition. u Monopolist is a “price maker.” u Cost curves are pretty much the same (except in the case of natural monopoly). u The big change from before is in the demand side of the profit function.

18 The Simple Monopolist u The simple monopolist abides by the “law of one price.” Everyone pays the same market price for all units purchased. u A monopolist faces the declining market demand curve for its product and simultaneously chooses price and quantity. u Now P>MR (before P=MR) because the simple monopolist must lower the price on all preceding units to sell an additional unit. u A monopolist has no “supply curve.”

19 The Simple Monopolist: Rules for Profit Maximization u Suppose we are in the short run. u Rules for profit maximization are the same as before. u If X SM maximizes profit, then –MR(X SM ) = MC(X SM ) »very important note: for a simple monopolist P>MR at all positive levels of X. –X SM is a max and not a min. –at X SM it’s worth operating.

20 Simple Monopoly u Economic profits equal total revenue minus total costs. u Marginal revenue is the rate of change of total revenue (just like marginal cost is the rate of change of total cost) as quantity increases. u Economic profits are maximized when marginal revenue equals marginal costs

21 Graphical Display of Monopolist’s Solution u The monopolist sets marginal revenue equal to marginal cost at MR=MC=$10. u The optimal quantity is thus 90 units, which implies a market price of $55/unit. u The monopoly profits (light blue in the graph) are the difference between price ($55) and average total cost ($44.44) times the number of units sold. u Notice that our monopolist is a “natural monopoly” the average total costs decline over the entire relevant range of production and the minimum efficient scale (150) is bigger than the entire market. u Notice that if our monopolist operated at the competitive equilibrium (Price=MC=$30, Quantity=140), the firm would make a loss (ATC>Price).

22 Implications of the Monopolist’s Profit Maximum u Price will exceed the competitive price. u Quantity will be less than the competitive quantity. u The monopolist sells the output at a price greater than marginal costs but the monopoly price can be above or below average total costs. Thus, the monopolist need not always make a profit. In the long run, of course, unprofitable monopolists will either stop production or raise the price further above marginal cost until it covers average total costs. u The monopolist will always try to operate on the elastic portion of the demand curve because when the elasticity of demand is greater than -1 (inelastic, between 0 and 1 in absolute value), marginal revenue is negative and, necessarily, less than marginal cost. u Since there is no entry to consider monopolists can have persistent long run economic profit.

23 Simple Monopoly- Performance u Efficiency: –Is the monopoly equilibrium Pareto Efficient? That is, at X SM is net social surplus maximized? Does $MB=$MC at X SM ? –Is the monopolist productively efficient? Does the monopolist operate at minimum efficient scale? u Equity: –Is the outcome of monopoly fair? Equitable? Just?

24 Simple Monopoly- Performance Answers u The simple monopoly equilibrium is not Pareto Efficient. –The simple monopolist creates “dead-weight- loss.” –At X SM, $MB>$MC. Recall: $MR=$MC at X SM while $P SM >$MR at all X. So $P SM >$MC. Since $P=$MB, then $MB>$MC. u The simple monopolist may or may not be productively efficient. u Compared to the competitive equilibrium, there is a transfer of surplus from consumers to producers.

25 Price Discriminating Monopolists u A monopolist might be able to charge different prices for different units sold and enhance its profits. –charge different people different prices –charge the same person different prices for different units u price discrimination –charging different prices for different units with no cost basis –charging the same price for different units when there are cost differences

26 Requirements for Price Discrimination u Some amount of monopoly power. u An ability to prevent resale. u Detailed information about who is buying what unit and what demanders are willing to pay.

27 Believe It Or Not u What would you do to prevent resale??? u when: 1940’s u market: plastic molding powder –industrial users:.85/pound –denture manufacturers: $22/pound u firm: Rohm and Haas u problem: resale from industrial users to denture manufacturers u solution: rumor you are mixing arsenic in the powder sold to industrial users!

28 Two classic forms of Price Discrimination u Perfect or First Degree Price Discrimination –charge a different price for each unit sold –the most extreme form of price discrimination u Third Degree Price Discrimination –segment market and then charge a different price in each market –exploit the observation that at the simple monopoly price the own price elasticity of demand differs across the defined segmented markets u Price discrimination comes in many other “flavors”

29 Question u The data on your handout show the demand curves for movie tickets of adults and seniors. The market described has only one movie theatre. –Find the best single price. –If the movie theater can charge separate prices for adults and seniors, what are the best two prices?

30 Two Prices are Better than One for Movie Tickets u The best single price in this market is $7.50/ticket, which makes economic profits of $4,225 (blue entries). Set marginal cost = marginal revenue with the single price. u The price discriminating monopolist can make more economic profits by charging adults $8.50 (yellow entries) and seniors $6.50 (green entries). Set marginal cost = marginal revenue separately for each market.

31 Summary of Price Discrimination Example u Calculating economic profits separately for the two markets (adult and senior) shows that the total is greater than with the best single price. u Taking advantage of different elasticities of demand.

32 Believe It Or Not u when: early 1990’s u market: contact lenses u firm: Bausch & Lomb u Lenses: $70/pair - wash and keep 1 year $15/pair - wash and keep 2 months –SeeQuence $8/pair - wash and keep 2 weeks $3/pair - daily and disposable each day u Guess what?

33 Believe It Or Not u They were all the same lenses! u Just packaged differently! u What would you pay for a year? –Optima = $70/pair - wash and keep 1 year –Medalist = $15x6=$90 (last 2 months) –SeeQuence 2 = $8x26=$208 (last 2 weeks) –Occasions = $3x365 = $1095 u What would I do? Buy the Occasions and wash and wear until my eyes hurt. u Class action suits were eventually settled.

34 First Degree Price Discrimination u The monopolist charges the demand price for each unit sold. u In this case the market demand curve becomes the monopolist’s marginal revenue curve. u The monopolist sets MR=MC to get X FDPD. u The monopolist charges a different price for each unit according to the demand curve. u Performance: X FDPD is Pareto Efficient and all the net social surplus goes to the monopolist as producer surplus. Consumer surplus = $0!

35 Should the Government Regulate Monopolies? u Essentially all monopolies are regulated. u Natural monopolies are regulated by price commissions that determine the rates the monopolies may charge. u Patent, copyright and license protections are a form of ex ante regulation: firms that follow the rules for establishing the validity of their innovations receive the protection of the patent, copyright or license. u Should the government do more? Good question.