1 © 2006 by Nelson, a division of Thomson Canada Limited Christopher Michael Trent University Managerial Economics Econ 340 Lecture 7 Price and Output Determination: Monopoly and Dominant Firms

2 © 2006 by Nelson, a division of Thomson Canada Limited ● Sources of Market Power ● Unregulated Monopoly ● Optimal Markups ● Limit Pricing ● Regulated Monopolies ● Peak Load Pricing Topics

3 © 2006 by Nelson, a division of Thomson Canada Limited "Monopoly" conjures images of huge profits, great wealth, and indiscriminate power, labeled robber barons. But some monopolies are NOT very profitable Others dominate their industry Still others are regulated and may have very low rates of return on invested capital. Regulated monopolies are known as utilities. Overview

4 © 2006 by Nelson, a division of Thomson Canada Limited Sources of Market Power for a Monopolist »Legal restrictions -- copyrights & patents. »Control of critical resources creates market power. »Government-authorized franchises, such as provided to cable TV companies. »Economies of size allow larger firms to produce at lower cost than smaller firms. »Brand loyalty and extensive advertising makes entry highly expensive. »Increasing returns in network-based businesses - compatibilities increase market penetration.

5 © 2006 by Nelson, a division of Thomson Canada Limited Apple tried to pursue increasing returns by trying to be the industry standard Tried to protect its graphical interface code from infringement Led to Apple being less compatible with software being developed by third parties Microsoft recognized and became the industry standard What Went Wrong With Apple?

6 © 2006 by Nelson, a division of Thomson Canada Limited Monopoly is a single seller where entry is prohibited and there are no close substitutes 1.FIRM = INDUSTRY 2. MR < P Q D P = Q TR 1 = 6040 = 2400 TR 2 = 5941 = 2419 So, MR = 19 where MR < P 19 An Unregulated Monopoly

7 © 2006 by Nelson, a division of Thomson Canada Limited D D MR 3.At output where MR = MC, profit is maximized MC PMPM PMPM QMQM Proof: Max  = TR – TC Find where d  /dQ = 0 d  /dQ = dTR/dQ - dTC/dQ = 0 MR – MC = 0 So: MR = MC 4.Charge highest price that the market will bear, P M

8 © 2006 by Nelson, a division of Thomson Canada Limited MARGINAL REVENUE is twice as steep as a linear demand curve If P = a - bQ, then TR = aQ - bQ 2 so MR = a - 2bQ This is twice as steep If we use a linear demand curve:

9 © 2006 by Nelson, a division of Thomson Canada Limited Find the monopoly quantity if: P = Q, and where MC = 20. Answer this by starting where MR = MC »TR = PQ = 100Q - Q 2 »MR = Q = 20 »80 = 2Q »Q M = 40 Find Monopoly Price: »P M = = 60 The highest price that the market will bear. A Monopoly Problem

10 © 2006 by Nelson, a division of Thomson Canada Limited P [ 1 + 1/ E D ] = MC Marginal Revenue As E D goes to negative infinity, MR approaches P The Importance of Price Elasticity of Demand for a Monopoly MONOPOLY has MR = MC TR = QP (Q) dTR/dQ = MR = P + (dP/dQ)Q = P [1 + (dP/dQ)(Q/P)] = P[1 + 1/ E D ]

11 © 2006 by Nelson, a division of Thomson Canada Limited The optimal markup can be found using this same formula. P = [E D /( E D +1)]MC. The optimal markup m is: (1+m) = [E D /( E D +1)] For example, if E D = -3, the markup is 50%, since = [-3/( -3 +1)] = 1.5. If E D = -4, the markup is 33.3%, since his is where [-4/( -4 +1)] = If the price elasticity is infinite, the markup is zero. This occurs in competition. Optimal Markups

12 © 2006 by Nelson, a division of Thomson Canada Limited If E D = - 3 & MC = 100 What’s P M ? P[ 1 + 1/( - 3) ] = 100 P[ 2/3 ] = 100 So, P = $150. If E D = -5, then optimal monopoly price falls to $125. The more elastic is the demand, the closer is price to MC. ANSWER Find the Monopoly Price in these Problems

13 © 2006 by Nelson, a division of Thomson Canada Limited A Monopoly Pricing Problem Regression results for Land’s End Women’s light-weight coats: Log Q = Log P Log Y ( 3. 2) ( 4. 5) Let MC of imported women’s light-weight coats be $ Find the Monopoly Price for a Land’s End light-weight coat. ANSWER: P( 1 + 1/E D ) = MC »P ( 1 + 1/(-1.7) ) = »P = $47.36

14 © 2006 by Nelson, a division of Thomson Canada Limited Limit Pricing An established firm considers the possibility of new entrants with distaste. Suppose a new entrant would have a U-shaped average cost curves. Suppose also that the established firm has created some brand loyalty, such that entrants must under-price them to take away their customers. AC

15 © 2006 by Nelson, a division of Thomson Canada Limited The potential competitor (PC) has no demand at limit price P L and D PC is below AC PC P L AC PC D I II time Profit Profile Which profit profile (I or II) represents monopoly pricing? Would a shareholder prefer profile I or II? AC established Q D PC

16 © 2006 by Nelson, a division of Thomson Canada Limited Regulated Monopolies Electric Power Companies Natural Gas Companies Communication Companies Often, Water Companies »All are examples of regulated companies »They are all “naturally monopolistic” as they all have significant declining cost curves. »Suppose we examine railways before regulation as an example of a natural monopoly.

17 © 2006 by Nelson, a division of Thomson Canada Limited Natural Monopolies Declining Cost Industries »economies in distribution »economies of scale Without Regulation they face Cyclical Competition with prices gyrating between P M and P C. »railway history includes periods of huge profits then bankruptcies AC MC DEMAND MR QMQM P M P R = AC P C = MC Q R Q C

18 © 2006 by Nelson, a division of Thomson Canada Limited Solutions to the Problem of Natural Monopolies PREVENT ENTRY, set P = MC and subsidize. »subsidies require some form of taxation, which will tend to distort work effort. »subsidies to Via Rail NATIONALIZE, prevent entry, set price typically low »governments find changing price a highly political event »once popular solution in Europe REGULATE, prevent entry, & set P = AC »common for local water, telephone, electricity FRANCHISE through a bidding war, likely P = AC »Cable TV »concessions at various stadiums

19 © 2006 by Nelson, a division of Thomson Canada Limited Peak Load Pricing Examples: long distance calls, electrical prices, seasonal pricing at amusement parks Conditions: »Not Storable »Same Facilities »Demand Variation

20 © 2006 by Nelson, a division of Thomson Canada Limited Peak and Off-Peak Demand What price should we charge for peak and off-peak users? Off-Peak Demand Peak-Load Demand price PpPoPpPo Q 0 Q P

21 © 2006 by Nelson, a division of Thomson Canada Limited General Solution P(peak) = variable costs + capital costs P(off-peak) = variable costs only Some argue that off-peak users benefit from capacity »Electrical Case: Less chance of a brown out »Amusement Park: Off-peak users enjoy more space »Then off-peak users should pay for some part of the capacity