Session 3 Monopoly Managerial Economics Professor Changqi Wu

MonopolySlide 2 Topics for Today What is a monopoly? How does a monopolist behave? How to sustain a monopoly position? Monopsony Consequences of monopoly

MonopolySlide 3 1. What is A Monopoly? One firm supplies a good or a service that has no close substitute in a well- defined market A monopolist enjoys market power market power measures a firm’s ability to set price

MonopolySlide 4 Monopoly Facing a downward-sloping demand curve, a monopolist’s marginal revenue curve lies below her average revenue curve. How to find marginal revenue As the sole producer, the monopolist works with the market demand to determine output and price. Assume a firm with demand:  P = 6 - Q

MonopolySlide 5 Total, Marginal, and Average Revenue $60$ $5$ TotalMarginalAverage PriceQuantityRevenueRevenueRevenue PQRMRAR

MonopolySlide 6 Average and Marginal Revenue Output $ per unit of output Average Revenue (Demand) Marginal Revenue

MonopolySlide 7 2. Behavior of a Monopolist A monopolist sets the marginal revenue equal to the marginal cost to maximize her profit. A monopolist has no supply curve. Price elasticity of demand influences price setting power of a monopolist.

MonopolySlide 8 Lost profit P1P1 Q1Q1 Lost profit MC AC Quantity $ per unit of output D = AR MR P* Q* Maximizing Profit When Marginal Revenue Equals Marginal Cost P2P2 Q2Q2

Elasticity of Demand and Price Markup $/ Q Quantity AR MR AR MC Q* P* P*-MC The more elastic is demand, the less the markup.

MonopolySlide 10 Elasticity of Demand and Price Markup The ratio of incremental profit margin and price is equivalent to the absolute value of the reverse of price elasticity of demand The markup pricing is based on this principle.

MonopolySlide 11 Monopoly Power and Profit Monopoly power does not guarantee profits. The profit depends on average cost relative to price.

MonopolySlide How does Monopoly Arise? Monopoly comes into existence because of barriers to entry Barriers to entry factors that allow the incumbent firm to earn positive economic profits and make it costly for new comers to enter the same market

MonopolySlide 13 Type of Barriers to Entry Institutional barriers to entry Technical barriers to entry Strategic barriers to entry

MonopolySlide 14 Institutional Barriers to Entry Exclusive franchising Licenses Patent protection

MonopolySlide 15 Technical Barriers to Entry Unique resources Economies of scale and scope Economy of experiences

MonopolySlide 16 Strategic Barriers to Entry Limit pricing Excess capacity Product differentiation (brand proliferation)

MonopolySlide 17 Barriers to Exit Barriers to exit are the opportunities that a firm must give up by leaving the industry. Barriers to exit can have a similar effect as barriers to entry.

MonopolySlide 18 Restraining Competition Horizontal merger Joint ventures Strategic alliance Trade associations

MonopolySlide 19 Cartel: A Virtual Monopoly A cartel is an association of firms that coordinates explicitly the activities of its members An effective cartel must find ways to restrain competition Factors facilitating cartel formation market concentration  Concentration ratio: sum of market shares of the largest 4 firms in the same market  Herfindale index: sum of market shares squared of all firms low organizational cost homogenous good

MonopolySlide Monopsony A monopsonist is the twin sister of a monopolist a single buyer faces a lot of competitive sellers A monopsonist’s marginal expenditure curve lies above the supply curve A monopsonist sets its marginal expenditure (ME) equal to its marginal value (MV) to maximize her profit

MonopolySlide 21 ME S = AE The market supply curve is the monopsonist’s average expenditure curve Monopsonist Buyer Quantity $/Q MV Q* m P* m Monopsony ME > P & above S PCPC QCQC Competitive P = P C Q = Q+C

MonopolySlide 22 Business in Action The role of major banks Banks set deposit rates and lending rates Does the bank act as a monopolist or a monopsonist ?

MonopolySlide Social Cost of Monopoly Deadweight loss occurs, but it appears to be small It is costly to create and to sustain monopolistic position Rent seeking Price mechanism becomes less effective when market conditions change.

MonopolySlide 24 B A Lost Consumer Surplus Deadweight Loss Because of the higher price, consumers lose A+B and producer gains A-C. C Deadweight Loss from Monopoly Power Quantity AR MR MC QCQC PCPC PmPm QmQm $/Q

MonopolySlide 25 Effect of Cost Change on Monopolist Quantity $/Q MC D = AR MR Q0Q0 P0P0 MC’ c Q1Q1 P1P1 Increase in P: P 0 P 1 > increase in cost

MonopolySlide 26 Why Is Monopoly Not Necessarily Bad? Monopoly profit is a carrot Monopoly profit may stimulate innovation Does the government’s effort of cracking down software piracy protect the monopoly interest of Microsoft? Monopolies are only temporary The case of Polaroid When the economy of scale is significant, a natural monopoly is technically efficient

MonopolySlide 27 Natural Monopoly A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms.

MonopolySlide 28 MC AC AR MR $/Q Quantity Setting the price at P r yields the largest possible output;excess profit is zero. QrQr PrPr PCPC QCQC If the price were regulate to be P C, the firm would lose money and go out of business. PmPm QmQm Unregulated, the monopolist would produce Q m and charge P m. Regulating the Price of a Natural Monopoly

MonopolySlide 29 Limiting Market Power Rules and regulations designed to promote a competitive economy by: Prohibiting actions that restrain or are likely to restrain competition Restricting the forms of market structures that are allowable Makes it illegal to monopolize or attempt to monopolize a market. Merger guidelines.

MonopolySlide 30 Key Learning Points Monopoly arises because of the existence of barriers to entry A monopolist sets her marginal revenue equal to her marginal cost to maximize profit. Firms can gain market power by restraining competition. Monopoly reduces social welfare Attempt to gain monopoly profit may encourage innovation.