LUBS1940: Topic 5 Perfect Competition and Monopoly Market Structures Students find this topic challenging. Part of their problem is that it builds on the cost curves of the previous chapter and many of them still have only a shaky grasp of that material. So emphasize the cumulative nature of economics and remind the students of the huge payoff from mastering material a bite at a time. You can help your students by emphasizing the two primary goals of this chapter: (1) To derive the market supply curve in a competitive industry and (2) to deepen your students’ understanding of how competition among self-interested consumers and producers moves resources from where they are less valued to where they are more valued and to an efficient allocation. Explain that although Chapter 3 (Demand and Supply) and Chapter 5 (Efficiency and Equity) covered these same topics, they did so at a level that is one step removed from the decision makers. Remind the students that they’ve seen how consumer decisions lead to the best use of a household’s income. Point out that they are now going see how producer decisions are made and how they interact with consumer decisions. You might like to use the metaphor that the chapter strips away more of the veil that hides the invisible hand. © Pearson Education, 2005

After studying this topic, you will able to: Define perfect competition Explain how price and output are determined in a competitive industry and why firms sometimes shut down temporarily and lay off workers Explain why firms enter and leave the industry Predict the effects of a change in demand and of a technological advance Explain why perfect competition is efficient Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly Explain how a single-price monopoly determines its output and price Compare the performance and efficiency of single-price monopoly and competition. Explain how price discrimination increases profit Explain how monopoly regulation influences output, price, economic profit and efficiency © Pearson Education, 2005

What is Perfect Competition? Perfect competition is an industry in which: Many firms sell identical products to many buyers. There are no restrictions to entry into the industry. Established firms have no advantages over new ones. Sellers and buyers are well informed about prices. Competition is fierce in the PC business and over the last few years prices have tumbled. How do firms operate when they face the fiercest competition from other firms? Does competition bring efficiency? How do firms react when demand changes or the costs of production change? We study a fiercely competitive market in this chapter. How Perfect Competition Arises Perfect competition arises: When firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the industry. And when each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from. The range of market types. Remind the students of what they learned in Chapter 9 about the spectrum of markets that range from perfect competition to monopoly. The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets. Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a fancier model! Economists use the model of “perfect competition” in a similar way to understand our economic world. Emphasize to students that although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition. © Pearson Education, 2005

What is Perfect Competition? Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that cannot influence the price of a good or service. Economic Profit and Revenue The goal of each firm is to maximize economic profit, which equals total revenue minus total cost. Total cost is the opportunity cost of production, which includes normal profit. A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P  Q. Price taking. Be sure to spend a few minutes providing intuition to ensure that your students understand why firms in perfect competition are price takers: They can offer to sell for a lower price, but they’re giving profits away; and they can ask for a higher price, but no one will pay. You might like to note that if the market is not in equilibrium, the firm isn’t a price taker. If there is a shortage, firms can get away with a higher price and they ask for more. That’s how prices rise. If there is a surplus, firms offer a lower price to move their product. That’s how prices fall. But in equilibrium, there is nothing to do but take the going price. And competitive markets get to equilibrium fast. No single firm can influence the price  it must “take” the equilibrium market price. Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic. © Pearson Education, 2005

What is Perfect Competition? A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. Figure 11.1(a) shows that market demand and supply determine the price that the firm must take. Figure 11.1(b) shows the firm’s total revenue curve. Because in perfect competition the price remains the same as the quantity sold changes, marginal revenue equals price. Figure 11.1(c) shows the its marginal revenue curve, which is also the demand curve for the firm’s product. © Pearson Education, 2005

© Pearson Education, 2005

The Firm’s Decisions in Perfect Competition A perfectly competitive firm faces two constraints: Market constraint summarized by the market price and the firm’s revenue curves A technology constraint summarized by firm’s product curves and cost curves. The perfectly competitive firm makes four key decisions. Short-run decisions: Whether to produce or temporarily shut down If the decision is to produce, what quantity to produce Long-run decisions: Whether to increase or decrease its plant size Whether to stay in the industry or leave it © Pearson Education, 2005

The Firm’s Decisions in Perfect Competition The perfectly competitive firm makes four key decisions. Short-run decisions: Whether to produce or temporarily shut down If the decision is to produce, what quantity to produce Long-run decisions: Whether to increase or decrease its plant size Whether to stay in the industry or leave it © Pearson Education, 2005

The Firm’s Decisions in Perfect Competition Profit-Maximizing Output A perfectly competitive firm chooses the output that maximizes its economic profit. One way to find the profit-maximizing output is to look at the firm’s total revenue and total cost curves. Do firms really choose the output that maximizes profit? It is useful to explain to your students that many big firms routinely make tables using spreadsheets of total revenue, total cost, and economic profit—and make graphs—similar to those in Figure 11.2. But most firms, and certainly most small firms like Cindy’s sweater knitting firm, don’t make such calculations. Nonetheless, they do make their decisions at the margin. They can figure out how much it will cost to hire one more worker and how much output that worker will produce. So they can figure out their marginal cost—wage rate divided by marginal product. They can compare that number with the price. They are choosing at the margin. © Pearson Education, 2005

The Firm’s Decisions in Perfect Competition Part (a) shows the total revenue curve (TR). Part (a) also shows the total cost curve (TC), which is like the one in Chapter 10. Total revenue minus total cost is economics profit (or loss), shown in part (b). Economic profit is maximized when the firm produces 9 jumpers a day. At small output levels, the firm incurs an economic loss  the firm can’t cover its fixed costs. At intermediate output levels, the firm earns an economic profit. At large output levels, the firm again incurs an economic loss  now it faces steeply rising costs because of diminishing returns. © Pearson Education, 2005

© Pearson Education, 2005

The Firm’s Decisions in Perfect Competition Marginal Analysis The firm can use marginal analysis to determine the profit-maximizing output. Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue (MR) equals marginal cost (MC). Figure 11.3 shows the marginal analysis that determines the profit-maximizing output. © Pearson Education, 2005

The Firm’s Decisions in Perfect Competition Marginal Analysis If MR > MC, economic profit increases if output increases. If MR < MC, economic profit decreases if output increases. If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized. The firm can use marginal analysis to determine the profit-maximizing output. Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue (MR) equals marginal cost (MC). © Pearson Education, 2005

© Pearson Education, 2005

The Firm’s Decisions in Perfect Competition Profits and Losses in the Short Run Maximum profit is not always a positive economic profit. To determine whether a firm is making an economic profit or incurring an economic loss, we compare the firm’s average total cost (ATC) at the profit-maximizing output with the market price. © Pearson Education, 2005

The Firm’s Decisions in Perfect Competition Profits and Losses in the Short Run In part (a), price equals ATC and the firm makes zero economic profit (normal profit). Operating a business at zero economic profit. Students are often skeptical that a zero economic profit is an acceptable outcome for an entrepreneur. The key is to reinforce the meaning of normal profit. A rational decision is one that is based on a weighing of the full opportunity cost of each alternative against its full benefits—for a firm weighing the total revenue against the opportunity cost for each alternative. Opportunity cost includes the benefits from forgone opportunities as well as explicit costs. One of these forgone opportunities is that of the entrepreneur pursuing her/his next best activity. The value of this forgone opportunity is normal profit. So, when a firm earns zero economic profit, the entrepreneur earns normal profit and enjoys the same benefits as those available in the next best activity. There is no incentive to change to the next best activity. In part (b), price exceeds ATC and the firm makes a positive economic profit. In part (c), price is less than ATC and the firm incurs an economic loss  economic profit is negative and the firm does not earn normal profit. Operating a business at a loss. Students often have a hard time understanding why operating at an economic loss can be the best action. The key is appreciating that: The firm’s short-run decisions are made after some irrevocable commitments have generated sunk costs. The firm considers only avoidable costs when making decisions. Unavoidable costs have no impact on the decision. So for the firm to produce its revenues need only exceed avoidable costs, not total costs. The profit maximization goal doesn’t require the firm to earn a positive economic profit in the short run. © Pearson Education, 2005

The Firm’s Decisions in Perfect Competition The Firm’s Short-run Supply Curve A perfectly competitive firm’s short-run supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same. Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. But there is a price below which the firm produces nothing and shuts down temporarily. Temporary Plant Shutdown If price is less than the minimum average variable cost, the firm shuts down temporarily and incurs a loss equal to total fixed cost. This loss is the largest that the firm must bear. If the firm were to produce just 1 unit of output at price below average variable cost, it would incur an additional (and avoidable) loss. Temporary shutdown. In our experience, this topic is the hardest for the students to understand. You can help them with the intuition by pointing out that the rationale for temporary shutdown isn’t confined to perfect competition and that they can see the phenomenon right around the corner. Many restaurants close on Sunday evening and Monday. Many hairdressers close on Sunday and Monday. Why? Your students will easily figure out that total revenue is less than total variable cost and equivalently that price is less than average variable cost. The mechanics of the shutdown analysis will be a lot easier to explain once the students have thought about these real situations with which they are familiar. The shutdown point is the output and price at which the firm just covers its total variable cost. This point is where average variable cost is at its minimum. It is also the point at which the marginal cost curve crosses the average variable cost curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily and incurs a loss equal to total fixed cost. If the price exceeds minimum average variable cost, the firm produces the quantity at which marginal cost equals price. Price exceeds average variable cost, so the firm covers all its variable cost and at least part of its fixed cost. When to increase and when to decrease output. Students need repeated reminders that to determine whether a firm can increase profit by changing output, price, and marginal cost are the only things to consider. Questions that throw average total cost into the mix often cause confusion. © Pearson Education, 2005

The Firm’s Decisions in Perfect Competition Firm’s short-run supply curve If price equals minimum average variable cost, £17 a jumper in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T. If the price is £25 a jumper, the firm produces 9 jumpers a day, the quantity at which P = MC. If the price is £31 a jumper, the firm produces 10 jumpers a day, the quantity at which P = MC. The blue curve in part (b) traces the firm’s short-run supply curve. © Pearson Education, 2005

© Pearson Education, 2005

The Firm’s Decisions in Perfect Competition The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price. © Pearson Education, 2005

The Firm’s Decisions in Perfect Competition Short-run Industry Supply Curve The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant. The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price. At a price equal to minimum average variable cost  the shutdown price  the industry supply curve is perfectly elastic because some firms will produce the shutdown quantity and others will produces zero. © Pearson Education, 2005

© Pearson Education, 2005

Output, Price and Profit in Perfect Competition A Change in Demand An increase in demand bring a rightward shift of the industry demand curve: the price rises and the quantity increases. A decrease in demand bring a leftward shift of the industry demand curve: the price falls and the quantity decreases. Start With Short-run Equilibrium: Short-run industry supply and industry demand determine the market price and output. Figure 11.7 shows a short-run equilibrium at the intersection of the demand and supply curves. D1 P=20 and Q=9. © Pearson Education, 2005

© Pearson Education, 2005

Output, Price and Profit in Perfect Competition Long-run Adjustments In short-run equilibrium, a firm might make an economic profit, incur an economic loss or break even (make normal profit). Only one of these situations is a long run equilibrium. In the long run, an industry adjusts in two ways: Entry or exit: New firms enter an industry in which existing firms make an economic profit. Firms exit an industry in which they incur an economic loss. Changes in plant size: Firms change their plant size whenever doing so is profitable. If average total cost exceeds the minimum long-run average cost, firms change their plant size to lower costs and increase profits. © Pearson Education, 2005

Output, Price and Profit in Perfect Competition The Effects of Entry As new firms enter an industry, industry supply increases. The industry supply curve shifts rightward. The price falls, the quantity increases and the economic profit of each firm decreases. © Pearson Education, 2005

© Pearson Education, 2005

Output, Price and Profit in Perfect Competition Long-run equilibrium occurs when the firm is producing at the minimum long-run average cost and making zero economic profit. If the price is £25, firms make zero economic profit with the current plant. But if the LRAC curve is sloping downward at the current output, the firm can increase profit by expanding the plant. As the plant size increases, short-run supply increases, the price falls, and economic profit decreases. © Pearson Education, 2005

© Pearson Education, 2005

Output, Price and Profit in Perfect Competition Long-run Equilibrium Long-run equilibrium occurs in a competitive industry when: Economic profit is zero, so firms neither enter nor exit the industry. Long-run average cost is at its minimum, so firms don’t change their plant size. © Pearson Education, 2005

Changing Tastes and Advancing Technology A Permanent Change in Demand A decrease in demand shifts the demand curve leftward. The price falls and the quantity decreases. Starting from long-run equilibrium, the fall in price puts the price below minimum average total cost and firms incur an economic loss. Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward. As industry supply decreases, the price rises and the market quantity continues to decrease. With a rising price, each firm that stays in the industry increases output in a movement along the firm’s marginal cost curve (short-run supply curve). A new long-run equilibrium occurs when the price has risen to equal minimum ATC so that firms do not incur economic losses and leave the industry. The main difference between the initial and new long-run equilibrium is the number of firms in the industry. In the new equilibrium, a smaller number of firms produce the equilibrium quantity. A permanent increase in demand has the opposite effects to those shown in Figure 11.9. An increase in demand shifts the demand curve rightward. The price rises and the quantity increases. Economic profit induces entry, which increases the short-run industry supply. As industry supply increases, the price falls and the market quantity continues to increase. With a falling price, each firm decreases its output in a movement along its marginal cost curve (short-run supply curve). A new long-run equilibrium occurs when the price has fallen to equal minimum ATC so that firms do not make economic profits and firms no longer enter the industry. In the new long-run equilibrium, a larger number of firms produce the equilibrium quantity. © Pearson Education, 2005

© Pearson Education, 2005

Changing Tastes and Advancing Technology External Economics and Diseconomies The change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies. External economies are factors beyond the control of an individual firm that lower the firm’s costs as the industry output increases. External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases. In the absence of external economies or external diseconomies, a firm’s costs remain constant as industry output changes. © Pearson Education, 2005

Changing Tastes and Advancing Technology Figure 11.11 illustrates the three possible cases and shows the long-run industry supply curve. The long-run industry supply curve shows how the quantity supplied by an industry varies as the market price varies after all the possible adjustments have been made, including changes in plant size and the number of firms in the industry. © Pearson Education, 2005

Changing Tastes and Advancing Technology Figure shows that when external diseconomies are present, the price rises when demand increases. The long-run industry supply curve is upward sloping. Leave Constant Cost {Figure 11.11(a) shows that in the absence of external economies or external diseconomies, the price remains constant when demand increases. Vertical LS} and Decreasing Cost {Figure 11.11(c) shows that when external economies are present, the price falls when demand increases. Negatively sloped LS}. © Pearson Education, 2005

© Pearson Education, 2005

Changing Tastes and Advancing Technology Technological Change New technologies are constantly discovered that lower costs. A new technology enables firms to producer at a lower average cost and lower marginal cost  firms’ cost curves shift downward. Firms that adopt the new technology earn an economic profit. New-technology firms enter and old-technology firms either exit or adopt the new technology. Industry supply increases and the industry supply curve shifts rightward. The price falls and the quantity increases. Eventually, a new long-run equilibrium emerges in which all the firms use the new technology, the price has fallen to the minimum ATC, and each firm makes normal profit. The adjustment process as old-technology firms exit or adopt the new technology and new-technology firms enter can create great changes in local geographic prosperity. Some regions experience economic decline while others experience economic growth. © Pearson Education, 2005

Competition and Efficiency Efficient Use of Resources Resources are used efficiently when no one can be made better off without making someone else worse off. This situation arises when marginal benefit equals marginal cost. Pulling it all together : In this section, you can show your students what they’ve learned and pull together the entire course to date. Begin by reiterating the two primary goals of this chapter and then note that you are now dealing with the second goal. Emphasize that the pressures of competition force self-interested firms to produce incredible long run results: Each firm produces at the lowest possible average total cost –at the minimum point of the long run average cost curve, Consumers pay the lowest possible price that keeps firms in business—P = minimum ATC. Each firm uses the least-cost technology, Firms produce the efficient quantity—price, which equals marginal benefit equals marginal cost. The forces of competition, which Adam Smith called an invisible hand, guide firms to produce output and charge prices that maximize the value of our scarce resources. © Pearson Education, 2005

Competition and Efficiency Choices, Equilibrium and Efficiency Choices: D is MB curve and S is MC curve. Equilibrium: D=S. Efficiency: No external benefits or costs. We can describe an efficient use of resources in terms of the choices made by consumers and firms coordinated in market equilibrium. Consumer demand is derived by finding how the best budget allocation changes as the price of a good changes. So consumers get the most value out of their resources at all points along their demand curves, which are also their marginal benefit curves. We derive a competitive firm’s supply curve by finding how the profit-maximizing quantity changes as the price of a good changes. So firms get the most value out of their resources at all points along their supply curves, which are also their marginal cost curves. In competitive equilibrium, the quantity demanded equals the quantity supplied, so marginal benefit equals marginal cost. The gains from trade are maximized. Competitive equilibrium is efficient only if there are no external benefits or costs. External benefits are benefits that accrue to people other than the buyer of a good. External costs are costs that are borne not by the producer of a good or service but by someone else. © Pearson Education, 2005

Competition and Efficiency Figure 11.12 illustrates an efficient allocation of resources in a perfectly competitive industry. In part (a), each firm is producing at the lowest possible long-run average cost at the price P* and the quantity q*. © Pearson Education, 2005

© Pearson Education, 2005

Competition and Efficiency The quantity Q* and price P* are the competitive equilibrium values. Competitive equilibrium is efficient. The consumer gains the consumer surplus, Figure 11.12(b) shows the market. Along the demand curve D = MB, the consumer is efficient. Along the supply curve S = MC, the producer is efficient. and the producer gains the producer surplus. © Pearson Education, 2005

© Pearson Education, 2005

Market Power Market power and competition are the two forces that operate in most markets. Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale. A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms. Students love monopoly! Most of your students are taking an economics course because they think it will help them either get a better job or run a better business. Many of your students are aspiring entrepreneurs. You’ve just had them slog through a heavy chapter on perfect competition, the bottom line of which is: The bottom line is miserable. Normal profit maybe the best that many people can achieve but it is not very exciting. This chapter teaches the students how to make a serious entrepreneurial income. Innovate, create a monopoly that produces something that people value much more than the cost of producing it, and price-discriminate as much as possible. The monopoly model as a benchmark. Explain (like you did in the case of perfect competition) that although no real-world industry satisfies the full definition of a monopoly market, the behavior of firms in many real world industries can be predicted by using the monopoly model. Mention that this chapter examines the least competitive end of the spectrum of markets, just like Chapter 11 discussed the most competitive end. eBay and Google are dominant players in the markets they serve. These firms are not like the firms in perfect competition. How do firms that dominate their markets behave? How do they choose the quantities to produce the prices to charge? Do they charge too much and produce too little? © Pearson Education, 2005

Market Power How Monopoly Arises A monopoly has two key features: No close substitutes Barriers to entry: Legal or natural constraints that protect a firm from potential competitors are called barriers to entry. Barriers to Entry Legal or natural constraints that protect a firm from potential competitors are called barriers to entry. Two types of barriers to entry: legal and natural. Legal barriers to entry create a legal monopoly, a market in which competition and entry are restricted by the granting of a monopoly franchise, government licence, a patent or a copyright. © Pearson Education, 2005

Market Power In a natural monopoly, economies of scale are so powerful that they are still being achieved even when the entire market demand is met. The LRAC curve is still sloping downward when it meets the demand curve. Natural barriers to entry create a natural monopoly, an industry in which one firm can supply the entire market at a lower price than two or more firms can. Figure 12.1 illustrates a natural monopoly. One firm can produce 4 million kilowatt-hours at 5 pence a kilowatt-hour. Two firms can produce 4 million kilowatt-hours  2 million kilowatt-hours each  at 10 pence a kilowatt-hour. Four firms can produce 4 million kilowatt-hours  1 million kilowatt-hours each  at 15 pence a kilowatt-hour. © Pearson Education, 2005

© Pearson Education, 2005

Market Power Monopoly Price-setting Strategies All monopolies face a trade-off between price and the quantity sold. To sell a larger quantity, the monopoly must lower the price. But two broad monopoly situations that create different trade-offs: Price discrimination: is the practice of selling different units of a good or service for different prices. Single price: is a firm that must sell each unit of its output for the same price to all its customers. Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms. A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers. © Pearson Education, 2005

A Single-Price Monopoly’s Output and Price Decision Price and Marginal Revenue A monopoly is a price setter, not a price taker like a firm in perfect competition. The reason is that the demand curve for the monopoly’s output is the market demand curve. To sell a larger output, a monopoly must set a lower price. Total revenue, TR, is the price, P, multiplied by the quantity sold, Q. Marginal revenue, MR, is the change in total revenue that results from a one-unit increase in the quantity sold. For a single-price monopoly, marginal revenue is less than price at each level of output. That is, MR < P © Pearson Education, 2005

A Single-Price Monopoly’s Output and Price Decision Now suppose the firm cuts the price to £14 to sell 3 haircuts an hour. It loses £4 of total revenue on the 2 haircuts it was selling at £16 each. And it gains £14 of total revenue on the 3rd haircut. Marginal revenue curve: Students don’t find the concept of marginal revenue difficult, but they do need to be clear on the intuition of the MR curve and the reason why MR < P for a single-price monopoly. This fact is the central source of the monopoly predictions. Suppose the monopoly sets a price of £16 and sells 2 haircuts an hour. So total revenue increases by £10, which is marginal revenue. © Pearson Education, 2005

© Pearson Education, 2005

A Single-Price Monopoly’s Output and Price Decision The marginal revenue curve, MR, passes through the red dot midway between 2 and 3 haircuts and at £10 a haircut. You can see that MR < P at each quantity. © Pearson Education, 2005

© Pearson Education, 2005

A Single-Price Monopoly’s Output and Price Decision If demand is unit elastic, a fall in price leaves total revenue unchanged. The rise in revenue from the increase in quantity sold equals the fall in revenue from the lower price per unit, and MR = 0. A single-price monopoly’s marginal revenue is related to the elasticity of demand for its good: If demand is elastic, a fall in price brings an increase in total revenue. The rise in revenue from the increase in quantity sold outweighs the fall in revenue from the lower price per unit, and MR is positive. Total revenue increases. If demand is inelastic, a fall in price brings a decrease in total revenue. The rise in revenue from the increase in quantity sold is outweighed by the fall in revenue from the lower price per unit, and MR is negative. In Monopoly, Demand is Always Elastic A single-price monopoly never produces an output at which demand is inelastic. If it did produce such an output, the firm could increase total revenue, decrease total cost and increase economic profit by decreasing output. © Pearson Education, 2005

A Single-Price Monopoly’s Output and Price Decision When marginal revenue is zero, total revenue is maximized. In Monopoly, Demand is Always Elastic A single-price monopoly never produces an output at which demand is inelastic. If it did produce such an output, the firm could increase total revenue, decrease total cost and increase economic profit by decreasing output. © Pearson Education, 2005

© Pearson Education, 2005

A Single-Price Monopoly’s Output and Price Decision Price and Output Decision The monopoly faces the same types of technology constraints as the competitive firm, but the monopoly faces a different market constraint. The monopoly selects the profit-maximizing level of output in the same manner as a competitive firm, where MR = MC. The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity. Table 12.1 provides a numerical example to illustrate the profit-maximizing output and price decision. The monopoly may earn an economic profit, even in the long run, because the barriers to entry protect the firm from market entry by competitor firms. © Pearson Education, 2005

A Single-Price Monopoly’s Output and Price Decision Figure 12.4 illustrates the profit-maximizing choices of a single-price monopolist. In part (a), the monopoly sets the quantity produced at the level that maximizes total revenue minus total cost. © Pearson Education, 2005

© Pearson Education, 2005

A Single-Price Monopoly’s Output and Price Decision In part (b), the firm produces the output at which MR = MC and sets the price to sell that quantity. The ATC curve tells us the average cost. Economic profit is the profit per unit multiplied by the quantity produced  the blue rectangle. The classic monopoly diagram The classic monopoly diagram, Figure 12.4b provides a good opportunity to tell your students about the contribution of one of the most brilliant economists of the 20th century, Joan Robinson. This diagram first appeared in her book, The Economics of Imperfect Competition, published in 1933 when she was just 30 years old. You can learn more about Joan Robinson at http://cepa.newschool.edu/het/profiles/robinson.htm (or use the link on the Economics Place Web site). Women are still not attracted to economics on the scale that they’re attracted to most other disciplines. So the opportunity to talk about an outstanding female economist shouldn’t be lost. Joan Robinson was a formidable debater and reveled in verbal battles, a notable one of which was with Paul Samuelson on one of her visits to MIT. Anxious to make and illustrate a point, Samuelson asked Robinson for the chalk. Monopolizing the chalk and the blackboard, the unyielding Robinson snapped, “Say it in words young man.” Samuelson meekly obeyed. This story illustrates Joan Robinson’s approach to economics: work out the answers to economic problems using the appropriate techniques of math and logic, but then “say it in words.” Don’t be satisfied with formal argument if you don’t understand it. Your students will benefit from this story if you can work it into your class time. © Pearson Education, 2005

© Pearson Education, 2005

Single-Price Monopoly and Competition Compared Because marginal revenue is less than price at each output level, QM < QC and PM > PC. Compared to perfect competition, monopoly produces less output and charges a higher price. Comparing Output and Price Figure 12.5 compares the price and quantity in perfect competition and monopoly. The market demand curve, D, in perfect competition is the demand curve that the firm faces in monopoly. The market supply curve in perfect competition is the horizontal sum of the individual firm’s marginal cost curves, S = MC. This curve is the monopoly’s marginal cost curve. Equilibrium in perfect competition occurs where the quantity demanded equals the quantity supplied at quantity QC and price PC. Equilibrium output for a monopoly, QM, occurs where marginal revenue equals marginal cost, MR = MC. Equilibrium price for a monopoly, PM, occurs on the demand curve at the profit-maximizing quantity. © Pearson Education, 2005

© Pearson Education, 2005

Single-Price Monopoly and Competition Compared Redistribution of Surpluses Monopoly redistributes a portion of consumer surplus by changing it to producer surplus. Efficiency Comparison Monopoly is inefficient, and Figure 12.6 shows why. The demand curve is the marginal benefit curve, MB, and the competitive market supply curve is the marginal cost curve, MC. So competitive equilibrium is efficient: MB = MC. Consumer surplus is the area below the demand curve and above the price. Producer surplus is the area below the price and above the marginal cost curve. The sum of the two surpluses is maximized and the efficient quantity is produced. Monopoly is inefficient. The inefficiency of monopoly is one of the key propositions in this chapter. Because P > MR, and because MR = MC, P > MC—single-price monopoly under-produces and creates deadweight loss. Rent seeking uses further resources so potentially the social cost of monopoly is the sum of the deadweight loss and the economic profit that a monopoly might earn. Adam Smith described the situation thus: “People in the same trade seldom meet together, even for merriment and diversion, but the conversation ends in some contrivance to raise prices.” © Pearson Education, 2005

© Pearson Education, 2005

Price Discrimination Price discrimination is the practice of selling different units of a good or service for different prices. To be able to price discriminate, a monopoly must: Identify and separate different buyer types. Sell a product that cannot be resold. Price differences that arise from cost differences are not price discrimination. Price discrimination may not be fair, but it is efficient: Be sure that the students understand that aside from equity considerations, resources will be allocated more efficiently in a monopoly market under any price discrimination scenario than under a single-price scenario. Price Discrimination and Consumer Surplus Price discrimination converts consumer surplus into economic profit. A monopoly can discriminate: Among units of a good. Quantity discounts are an example. (But not quantity discounts that reflect lower costs at larger volumes) Among groups of buyers. (Advance purchase airline tickets are an example.) © Pearson Education, 2005

Price Discrimination With perfect price discrimination: Output increases to the quantity at which price equals marginal cost. Economic profit increases above that earned by a single-price monopoly. Deadweight loss is eliminated. By price discriminating, the firm can increase its profit. In doing so, it converts consumer surplus into economic profit. Perfect Price Discrimination Perfect price discrimination extracts the entire potential consumer surplus and converts it to economic profit. © Pearson Education, 2005

© Pearson Education, 2005

Price Discrimination Efficiency and Rent Seeking with Price Discrimination The more perfectly a monopoly can price discriminate, the closer is its output gets to the competitive output (P = MC) and the more efficient is the outcome. But there are two differences between perfect competition and perfect price discrimination: The monopoly captures the entire consumer surplus. The increase in economic profit attracts even more rent-seeking activity that leads to an inefficient use of resources. © Pearson Education, 2005

Monopoly Policy Issues Gains from Monopoly A single-price monopoly creates inefficiency and a price-discriminating monopoly captures consumer surplus and converts it into producer surplus and economic profit. And monopoly encourages rent-seeking, which wastes resources. But monopoly brings benefits. Incentives to Innovate Patents and copyrights provide protection from competition and let the monopoly enjoy the profits stemming from innovation for a longer period of time. Economies of scale and economies of scope Where economies of scale or scope exist, a monopoly can produce at a lower average total cost than what a large number of competitive firms could achieve. A quick introduction The treatment of monopoly policy here is brief and designed for the instructor who wants to cover the topic briefly and at this point in the course. Chapter 17 provides a more extensive treatment of regulation and antitrust law. You can cover that chapter, in whole or part, right now if you want to do more on the topic. © Pearson Education, 2005

Monopoly Policy Issues Regulating Natural Monopoly Profit Maximization Efficient Regulation Average Cost Pricing Regulating Natural Monopoly When demand and cost conditions create natural monopoly, government agencies regulate the monopoly. Figure 12.11 shows how a natural monopoly might be regulated. Profit Maximization With no regulation, the monopoly maximizes profit. It produces the quantity at which marginal revenue equals marginal cost. Efficient Regulation Regulating a natural monopoly to achieve an efficient outcome requires the monopoly to produce the output at which MB = MC. This regulation is the marginal cost pricing rule, which sets the price equal to marginal cost. With price equal to marginal cost, ATC exceeds price and the monopoly incurs an economic loss. If the monopoly receives a subsidy to cover its loss, taxes must be imposed on other economic activity, which create deadweight loss. Where possible, a regulated monopoly might be permitted to price discriminate to cover the loss from marginal cost pricing. Average Cost Pricing Another alternative is to require the monopoly to produce the quantity at which price equals average total cost and to set the price equal to average total cost  the average cost pricing rule. © Pearson Education, 2005

© Pearson Education, 2005