Monopoly and monopoly behavior Alexandre Mateus Sara Levy Tiago Ratinho

2 Monopoly We’ve seen the behaviour of a competitive industry, a market structure characterised by a great number of small firms Now, we consider the opposite extreme and study the behaviour of a market structure with only one firm in the industry  MONOPOLY The level of price is chosen in order to maximize its profits The monopolist can choose the price and let the consumers pick the quantity or it can choose the quantity and see what price the consumers wish to pay for it.

3 Maximizing Profits Inverse demand curve - p(y) Inverse cost curve – c(y) Inverse revenue curve – r(y) = p(y).y max  = max (r(y) - c(y))  The optimal choice we must equal marginal costs with marginal revenue: If Marginal Revenue were less than Marginal Costs, it would pay the firm to decrease output; If Marginal Revenue were greater than Marginal Costs, it would pay the firm to increase output

4 MR=MC  The condition is the same for competitive firms: the marginal revenue equals the market price, constant and unaffected by any actions of the individual firms Monopolist: marginal revenue is not constant When output is increased by : –More output, extra revenue, –Increase of output, prices reduce, less revenue for every unit sold, Maximizing Profits

5 The total effect will be The effects are contradictory: if the monopolist produces more, it sells more but at lower prices for all units sold, thus reducing its revenue

6 Maximizing Profits The expression can be re-written This implies that: –In a competitive market, the firm faces an horizontal demand curve, infinitely elastic, so optimal condition is price equals marginal costs –The monopolist will never position itself where elasticity since in this case reducing output will increase revenue, raising profits –For a monopolist, maximization of profits occurs for

7 Linear Demand Curve and Monopoly Suppose the monopolist faces a linear inverse demand curve p(y) = a-by Revenue:r(y)=p(y)y=ay-by 2 Marginal Revenue:MR(y)=a-2by

8 Linear Demand Curve and Monopoly Q P Demand Slope=-b MR Slope=-2b a MC AC p*p* y*y*

9 Markup Pricing Rewriting the optimal condition where is the markup. Since, the markup is greater than one, the price will be higher than the Marginal Costs

10 Markup Pricing Q P p*p* y*y* D MC

11 The Impact of Taxes on a Monopolist Consider a firm with constant marginal costs and a tax levied: –The marginal costs increase –Price? The optimal condition now yields The change in the output is The demand curve is so the price will change by a factor of a half.

12 The Impact of Taxes on a Monopolist This factor cannot be assumed as true in general. Considering the monopolist facing a constant-elasticity demand curve, we have and, which is greater than one. Hence, the monopolist passes on more than the amount of tax.

13 The Impact of Taxes on a Monopolist Another kind of tax could be a profits tax In this case, the monopolist is levied on a fraction  of its profits The maximization of profit becomes Thus, a pure profits tax will have no effect on a monopolist’s choice of output

14 Inefficiency of Monopoly The monopolist operates with prices greater than Marginal Costs  prices higher and output lower than in a competitive environment  consumers typically be worse In contrast, firms will be better under monopoly, as they can manipulate the price in order to increased profits An economic arrangement is Pareto efficient if there is no way to make anyone better without making anyone worse, so Is the monopoly Pareto Efficient?

15 Inefficiency of Monopoly NO! Q P ymym ycyc MC D MR pcpc pmpm

16 Inefficiency of Monopoly Since p > Marginal Costs  extra output could be sold at a price lower than the market price, but still higher than MC  each side gets better The monopoly is not Pareto efficient because the monopolist cannot lower the price of the extra units without lowering the prices of all units

17 Deadweight Loss of the Economy Measure how inefficient is a monopoly  variations of producers’ and consumers’ surpluses by imposing a perfect competition to a monopoly situation

18 Deadweight Loss of the Economy Q P y* MC pcpc p* MR D A B C

19 Deadweight Loss of the Economy The consumers’ surplus goes up for: –Paying less for the same units than under monopoly (A) –Getting the same surplus on the extra units that are being sold The producers’ surplus is affected in contradictory ways: –Profits are driven downwards due to a lower price (A) –Extra profits by selling more (C)

20 Deadweight Loss of the Economy Hence: –The area A is just a transfer from the monopolist to the consumer  total surplus remains the same –The area B+C represents the gain from moving from a monopoly to perfect competition, measuring the value that consumers and producers place on extra units Thus, the area A+B measures the deadweight loss due to the monopoly  the cost of monopoly Example: The optimal life of a Patent

Natural Monopoly

22 Natural Monopoly Pareto efficiency occurs when price equals MC; Monopolist firms produce where MR equals MC: –Too little output. Government intervention: –Set the price equal to the Marginal Cost. The monopolist might make negative profit!

23 output price MC ACDemand y MC p MC Natural Monopoly Losses due to marginal cost pricing

24 Natural Monopoly Often arises with public utilities: –Gas / electricity / telecom companies; Very large fixed costs; Very small marginal costs; Natural Monopoly

25 Problem Monopolist price: –Pareto inefficiency; Forcing competitive price: –Negative profits; Government options: –Regulate the monopoly; –Operate the monopoly; Most natural monopolies are regulated or operated by governments.

26 Government regulation Regulation without subsidy: –The regulated firm must make nonnegative profits; On or above the AC curve; –Provide service to all that are willing to pay for it; On the Demand curve. Too little output relative to the efficient output level.

27 output price MC ACDemand y AC p AC Government regulation

28 Government regulation Solution adopted as second best pricing policy: –Government regulators set prices that the public utility is allowed to charge: Ideally prices that allow the firm to break even (p = AC); –Difficulty: Determine the firm’s true costs.

29 Government operation Operate at the point where the price equals the marginal costs (p=MC); Provide a lump-sum subsidy to keep the firm in operation. Difficulty: –Determine the firm’s true costs;

30 output price MC ACDemand y MC p MC Government operation Government lump-sum subsidy

What causes monopolies?

32 What causes monopolies? When is an industry competitive and when is it monopolized? –In general it depends on the relationship between the Demand and the Average Cost curves; –Crucial factor: Size of the Minimum Efficient Scale (MES) relative to the size of demand. MES = level of output that minimizes average cost

33 Competitive / Monopolized output price Demand AC MES p*p* Competitive industry output price Demand AC MES p*p* Monopolized industry

34 Competitive / Monopolized Average Cost curve: –Shape determined by the underlying technology; Important to determine if the industry is competitive or monopolized: –Relation between the MES and the size of the market; Economic policy: –Can influence the size of the market;

35 Other reasons Cartel: –Different firms in the same industry collude; Restrict output; Raise prices; Generate more profit; –Illegal! Historical accident: –One large firm that entered the market first; –Cost advantage to discourage other firms to enter the market.

Monopoly behavior

37 Introduction Competitive market: –A firm raises the price above the market price: Costumers desert it in favor of its competitors; Monopolized market: –Monopolist firm raises the price: Looses some customers, but not all. Most firms stand somewhere between these extremes. Firm with some degree of monopoly has more options: –More complex pricing and marketing strategies; –Some degree of differentiation.

Price discrimination

39 Price discrimination Monopoly has an inefficient level of output: –People are willing to pay more for extra output that it costs to produce it; –Monopolist does not want to produce the extra output: Force down the price of all the output. Can the monopolist sell different units at different prices? –Price discrimination. First-degree (perfect) price discrimination; Second-degree price discrimination; Third-degree price discrimination.

First-degree price discrimination

41 First-degree price discrimination Each unit of the good is sold to the person that values it the most: –At the maximum price that individual is willing to pay for it. No consumer surplus generated; –The producer is able to appropriate it to itself. Producer’s goal: –Maximize its surplus; As long as customers are willing to purchase; –Pareto efficiency: Producer’s profits are at maximum; Consumer’s surplus can’t increase without reducing producer’s profits;

42 quantity willingness to pay MC quantity willingness to pay MC Reservation price Producer’s surplus

43 Perfect price discriminator producer Produces at an output level where price equals Marginal Cost; –Price  MC someone willing to pay more for an extra unit than it costs to produce it; –Price < MC Negative profit;

44 Different perspective So far: –“selling each unit as the maximum price someone is willing to pay for it” Another perspective: –Selling a fixed amount of the good at a “take it or leave it” price.

45 Linear demand quantity willingness to pay MC x02x02 quantity willingness to pay MC x01x01 Producer’s surplus Sell x 0 1 units at price equal to area Sell x 0 2 units at price equal to area

Second degree price discrimination

47 Second degree price discrimination Price per unit is not constant but depends on how much is bought; –Non-linear pricing; Commonly used by public utilities; –Price per unit of electricity; Sometimes available in other industries; –Bulk discounts for great quantities.

48 Hard to discriminate In perfect price discrimination: –To set the right prices the monopolist has to know the demand curves of the consumers. –Not enough: Consumers of one type may pretend to be consumers of another type; No effective way to tell them apart! Construct price-quantity packages that will induce the consumer to choose the package meant for him: –Self-selection.

49 Self-selection problem quantity willingness to pay x01x01 A C B x02x02 Quantity: x 0 2 Price: A+B+C Quantity: x 0 1 Price: A High end customer would choose to buy x 0 1 at price A with a surplus of B instead of x 0 2 with no surplus. One solution: Offer x 0 2 at price A+C

50 Reduce of output for consumer 1 quantity willingness to pay x01x01 A C B x02x02 Decreasing x 0 1 : A decreases; C increases Profits increase: The decrease of A is smaller than the increase of C.

51 Profit maximization solution quantity willingness to pay x0mx0m A C B x02x02 D Point where marginal benefits and costs of quantity reduction balance. Low-demand costumer: Quantity: x 0 m Price: A Surplus: 0 High-demand costumer: Quantity: x 0 2 Price: A+C+D Surplus: B

52 In practice Self-selection encouraged by adjusting the quality of the good instead of its quantity. Example: –Airline companies: Business tickets: –No restrictions; Other tickets: –Stay over Saturday night, buy 14 days in advance, etc; –Business travelers are willing to pay for business tickets; –Tourists consider the restrictions acceptable; –Company profits more than by selling tickets at a flat price.

Third degree price discrimination

54 Third degree price discrimination Different prices for different people Same price for a given group –student’s discounts; senior citizen’s discounts,...; Profit maximization:

55 Third degree price discrimination The market with the higher prices must have the lower elasticity

56 Bundling Packages of related goods offered for sale together – cost savings – complementarities – consumers with different preferences good 1good 2price = 100bundle type A x 1001 x 300 type B x 1001 x

57 Two part tariffs Complementary goods with separate prices that influence one another p* x* MC CS Lost profit Profit p’ x’ MC Profit entrance price + usage priceentrance price + free usage

58 Monopolistic competition A monopolistic firm still has to compete with close substitutes… – demand depends on output and price of substitutes – slope of demand depends on how similar substitutes are – raising price will make the firm loose some customers – just how many, depends on the elasticity of the demand – most prevalent form of industry structure – most difficult to model product differentiation ➲ less elasticity more monopoly power p x as more firms enter the market; more identical products ➲ demand shifts left and gets flatter

59 Monopolistic competition Monopolistic competition equilibrium: as more firms enter monopolistic competition – each firm is selling at price and output on its demand curve – each firm is maximizing its profits, given its demand curve – entry of other firms is forcing the profits down to zero p x output price combination must be on demand curve output price combination must be on average cost curve ➲ demand and average cost curves are tangent AC p* x* AC positive profit

60 Monopolistic competition Monopolistic competition equilibrium: – is Pareto inefficient (price > marginal cost) – excess capacity (firms are operating above minimum average cost) p x if there were fewer firms ➲ each could operate at a more efficient scale ➲ less product variety AC p* x* AC positive profit

61 Product differentiation Monopolistic competition equilibrium: – doesn’t promote product differentiation – example of ice-cream vendors – vendors tend to move close to each other in order to ”steal” the other’s market share without loosing their own customers