Chapter 9 Monopoly © 2006 Thomson/South-Western

Barriers to Entry Sole supplier of a product with no close substitutes Barriers to entry restrictions on the entry of new firms into an industry Legal restrictions Economies of scale Control of an essential resource

Legal Restrictions Patents award an inventor the exclusive right to produce a good or service for 20 years Provide the stimulus to turn an invention into a marketable product, a process called innovation Governments often confer monopoly status by awarding a single firm the exclusive right to supply a particular good or service

Exhibit 1: Economies of Scale $ Monopoly emerges when a firm experiences economies of scale as reflected by the downward-sloping, long-run average cost curve t i n u r e p t s o C Long-run average cost Quantity per period

Economies of Scale Market demand is not great enough to permit more than one firm to achieve sufficient economies of scale A single firm will emerge from the competitive process as the sole seller in the market.

Control of Essential Resources Control over some nonreproducible resource critical to production Professional sports teams Alcoa was the sole U.S. maker of aluminum for a long period of time because it controlled the supply of bauxite China is the monopoly supplier of pandas DeBeers controls the world’s diamond trade

Demand, Average and Marginal Revenue De Beers controls the entire diamond market and suppose they can sell three diamonds a day at $7,000 each  total revenue of $21,000 Total revenue divided by quantity is the average revenue per diamond which is also $7,000  monopolist’s price equals the average revenue per diamond

Exhibit 2: Loss or Gain from Selling One More Unit By selling another diamond, De Beers gains the revenue from the sale of the 4th diamond To sell the 4th unit, De Beers must sell all four diamonds for $6,750 each, sacrificing $250 on each of the first three diamonds that could have been sold for $7,000 each The loss in revenue from the first three units is $750 The net change in total revenue from selling the 4th diamond is $6,750 - $750 = $6,000 $7,000 LOSS 6,750 G A I N Price per Diamond D = Average revenue 3 4 1 - carat diamonds per day

Exhibit 3: Revenue Schedule As De Beers expands output, total revenue increases until quantity reaches 15 diamonds when total revenue tops out For all units of output except the first, marginal revenue is less than price and the gap widens as the price declines because the loss from selling all diamonds at the lower price increases

Exhibit 4: Monopoly Demand and Marginal and Total Revenue (a) Demand and Marginal Revenue Total revenue is maximized when marginal revenue equals zero When demand is elastic, a decrease in price increases total revenue  marginal revenue is positive When demand is inelastic, a decrease in price reduces total revenue  marginal revenue is negative Elastic $ per diamond Unit elastic $3,750 Inelastic Marginal revenue D = Average revenue 16 32 1-carat diamonds per day (b) Total Revenue $60,000 Dollars Total revenue 1-carat diamonds per day 0 16 32

Firm’s Costs and Profit Maximization Monopolist can choose either the price or the quantity, but choosing one determines the other Because the monopolist can select the price that maximizes profit, we say the monopolist is a price maker More generally, any firm that has some control over what price to charge is a price maker

Exhibit 5: Short-Run Revenues and Costs for the Monopolist Short-run Costs and Revenue for a Monopolist Price Marginal Marginal Average Total Diamonds (average Total Revenue Total Cost Total Cost Profit or per day revenue) revenue (MR = Cost ( MC = (ACT = Loss = (Q) (p) (TR = Q x p) TR / Q) (TC) TC / Q) TC/Q) TR - TC (1) (2) (3) =(1) x (2) (4) (5) (6) (7) (8) 0 $7,750 0 - $15,000 - - -$15,000 1 7,500 $7,500 $7,500 19,750 4,750 $19,750 -12,250 2 7,250 14,500 7,000 23,500 3,750 11,750 9,000 3 7,000 21,000 6,500 26,500 3,000 8,830 -5,500 4 6,750 27,000 6,000 29,000 2,500 7,750 -2,000 5 6,500 32,500 5,500 31,000 2,000 6,200 1,500 6 6,250 37,500 5,000 32,500 1,500 5,420 5,000 7 6,000 42,000 4,500 33,750 1,250 4,820 8,250 8 5,750 46,000 4,000 35,250 1,500 4,410 10,750 9 5,500 49,500 3,500 37,250 2,000 4,140 12,250 10 5,250 52,500 3,000 40,000 2,750 4,000 12,500 11 5,000 55,000 2,500 43,250 3,250 3,930 11,750 12 4,750 57,000 2,000 48,000 4,750 4,000 9,000 13 4,500 58,500 1,500 54,500 6,500 4,190 4,000 14 4,250 59,500 1,000 64,000 9,500 4,570 -4,500 15 4,000 60,000 500 77,500 13,500 5,170 -7,500 16 3,750 60,000 0 96,000 18,500 6,000 -36,000 17 3,500 59,500 -500 121,000 25,000 7,120 -61,500 Profit-maximizing monopolist produces that quantity where total revenue exceeds total cost by the greatest amount  $12,500 per day when output is 10 units per day. Total revenue is $52,500 and total cost is $40,000 MR = MC at this same level of output

Exhibit 6: Monopoly Costs and Revenue (a) Per-Unit Cost and Revenue Marginal cost The intersection of the two marginal curves at point e in panel (a) indicates that profit is maximized when 10 diamonds are sold. ATC of $4,000 is identified by point b: the average profit per diamond equals the price of $5,250 minus the ATC of $4,000 = $1,250 – the economic profit is the equal to $1,250 * 10 units sold = $12,500 In panel (b), the firm’s profit or loss is measured by the vertical distance between the TR and TC: profit is maximized where 10 diamonds are produced per day Average total cost Dollars per unit a $5,250 Profit b 4,000 e D = Average revenue MR 10 16 32 Diamonds per day (b) Total Cost and Revenue Total cost Maximum profit $52,500 Total dollars 40,000 Total revenue 15,000 0 10 16 32 Diamonds per day

Exhibit 7: The Monopolist Minimizes Losses in the Short Run Marginal revenue equals marginal cost at point e. At quantity Q, price p (at point b) is less than average total cost (at point a) The monopolist suffers a loss. But the monopolist will continue to produce rather than shut down in the short run because price exceeds average variable cost (at point c). Marginal cost a Average total cost Dollars per unit Loss b p Average variable cost c e Demand = Average revenue Marginal revenue Quantity per period Q

Long-Run Profit Maximization If a monopoly is insulated from competition by high barriers that block new entry, economic profit can persist in the long run A monopolist that earns economic profit in the short-run may find that profit can be increased in the long run by adjusting the scale of the firm Conversely, a monopoly that suffers a loss in the short run may be able to eliminate that loss in the long run by adjusting to a more efficient size

Exhibit 8: Perfect Competition and Monopoly Equilibrium in perfect competition is at point c, where market demand and supply intersect to yield price pc and quantity Qc Monopolist maximizes profit by equating MR with MC: point b and price pm and output Qm Consumer surplus is shown by the shaded triangle ampm m pm Dollars per unit b c pc Sc = MC = ATC D = AR MRm Qm Qc Quantity per period

Exhibit 8: Perfect Competition and Monopoly Consumer surplus under perfect competition is the large triangle acpc while under monopoly it shrinks to the smaller triangle ampm Consumer surplus has been reduced by more than the profit triangle Consumers have also lost the triangle mcb – the deadweight loss of monopoly – allocative inefficiency arising from the higher price and reduced output m p m Dollars per unit b c p Sc = MC = ATC c D = AR MRm Qm Qc Quantity per period

Why the Welfare Loss Might Be Lower If economies of scale are extensive enough, a monopolist may be able to produce output at a lower cost per unit than could competitive firms, thus costs may be lower than under competition Monopolists may, in response to public scrutiny and political pressure, keep prices below what the market could bear A monopolist may keep the price below the profit maximizing level to avoid attracting new competitors

Why the Welfare Loss Might Be Higher If resources must be devoted to securing and maintaining a monopoly position, monopolies may involve more of a welfare loss that simple models suggest Efforts devoted to securing and maintaining a monopoly position are largely a social waste because they use up scarce resources but add nothing to output

Why the Welfare Loss Might Be Higher Activities undertaken by individuals or firms to influence public policy to directly or indirectly redistribute income to them are called rent seeking Without competition, monopolists may become inefficient Monopolists are criticized for being slow to adopt the latest production techniques, develop new products, and for generally lacking innovation

Price Discrimination Charging difference prices to different customers when the price differences are not justified by differences in cost Conditions: Demand curve must slope downward – the firm has some market power and control over price At least two groups of consumers for the product, each with a different price elasticity of demand Ability, at little cost, to charge each group a different price for essentially the same product Ability to prevent those who pay the lower price from reselling the product to those who pay the higher price

Exhibit 9: Price Discrimination At a given price, price elasticity of demand (panel b, elastic) is greater than in panel a (inelastic).

Perfect Price Discrimination If a monopolist could charge a different price for each unit sold, the firm’s marginal revenue curve from selling one more unit would equal the price of that unit the demand curve would become the marginal revenue curve A perfectly discriminating monopolist charges a different price for each unit of the good

Exhibit 10: Perfect Price Discrimination A perfectly discriminating monopolist would maximize profits at point e, where MR = MC a t i n u r P r o f i t e p Long-run average cost = marginal cost e s r c a l l o D D = Marginal revenue Q Quantity per period