Chapter 24 Monopoly

2 Pure Monopoly A monopolized market has a single seller. The monopolist’s demand curve is the (downward sloping) market demand curve. So the monopolist can alter the market price by adjusting its output level. 2

3 Pure Monopoly Output Level, y $/output unit p(y) Higher output y causes a lower market price, p(y). 3

4 Why Monopolies? Some examples:  a patent; e.g. a new drug  sole ownership of a resource; e.g. a toll highway  formation of a cartel; e.g. OPEC  large economies of scale; e.g. local utility companies. 4

5 Pure Monopoly Suppose that the monopolist seeks to maximize its economic profit, What output level y* maximizes profit? 5

6 Profit-Maximization At the profit-maximizing output level y* so, for y = y*, 6

7 Profit-Maximization At the profit-maximizing output level the slopes of the revenue and total cost curves are equal: MR(y*) = MC(y*). 7

8 Marginal Revenue Marginal revenue is the rate-of-change of revenue as the output level y increases: dp(y)/dy is the slope of the market inverse demand function so dp(y)/dy < 0. Therefore for y > 0. 8

9 Marginal Revenue E.g. if p(y) = a - by then R(y) = p(y)y = ay - by 2 and therefore MR(y) = a - 2by 0. p(y) = a - by a y a/b MR(y) = a - 2by a/2b 9

10 Marginal Cost Marginal cost is the rate-of-change of total cost as the output level y increases; E.g. if c(y) = F +  y +  y 2 then 10

11 Marginal Cost F y y c(y) = F +  y +  y 2 $ MC(y) =  + 2  y $/output unit  11

12 Profit-Maximization: An Example At the profit-maximizing output level y*, MR(y*) = MC(y*). So if p(y) = a - by and if c(y) = F +  y +  y 2 then and the profit-maximizing output level is causing the market price to be 12

13 Profit-Maximization; An Example $/output unit y MC(y) =  + 2  y p(y) = a - by MR(y) = a - 2by a  13

14 Profit-Maximization; An Example $/output unit y MC(y) =  + 2  y p(y) = a - by MR(y) = a - 2by a  14

15 Profit-Maximization; An Example $/output unit y MC(y) =  + 2  y p(y) = a - by MR(y) = a - 2by a  15

16 Monopolistic Pricing & Own-Price Elasticity of Demand Suppose that market demand becomes less sensitive to changes in price ( i.e. the own-price elasticity of demand becomes less negative). Does the monopolist exploit this by causing the market price to rise? 16

17 Monopolistic Pricing & Own-Price Elasticity of Demand Own-price elasticity of demand is so 17

18 Monopolistic Pricing & Own-Price Elasticity of Demand Suppose the monopolist’s marginal cost of production is constant, at $k/output unit. For a profit-maximum which is 18

19 Monopolistic Pricing & Own-Price Elasticity of Demand E.g. if  = -3 then p(y*) = 3k/2, and if  = -2 then p(y*) = 2k. So as  rises towards -1 the monopolist alters its output level to make the market price of its product to rise. 19

20 Monopolistic Pricing & Own-Price Elasticity of Demand Notice that, since That is, So a profit-maximizing monopolist always selects an output level for which market demand is own-price elastic. 20

21 Markup Pricing Markup pricing: Output price is the marginal cost of production plus a “markup.” How big is a monopolist’s markup and how does it change with the own-price elasticity of demand? 21

22 Markup Pricing is the monopolist’s price. The markup is E.g. if  = -3 then the markup is k/2, and if  = -2 then the markup is k. The markup rises as the own-price elasticity of demand rises towards

23 A Profits Tax Levied on a Monopoly A profits tax levied at rate t reduces profit from  (y*) to (1-t)  (y*). Q: How is after-tax profit, (1-t)  (y*), maximized? A: By maximizing before-tax profit,  (y*). So a profits tax has no effect on the monopolist’s choices of output level, output price, or demands for inputs. I.e. the profits tax is a neutral tax. 23

24 Quantity Tax Levied on a Monopolist A quantity tax of $t/output unit raises the marginal cost of production by $t. So the tax reduces the profit-maximizing output level, causes the market price to rise, and input demands to fall. The quantity tax is distortionary. 24

25 Quantity Tax Levied on a Monopolist $/output unit y MC(y) p(y) MR(y) y* p(y*) 25

26 Quantity Tax Levied on a Monopolist $/output unit y MC(y) p(y) MR(y) MC(y) + t t y* p(y*) 26

27 Quantity Tax Levied on a Monopolist $/output unit y MC(y) p(y) MR(y) MC(y) + t t y* p(y*) ytyt p(y t ) 27

28 Quantity Tax Levied on a Monopolist $/output unit y MC(y) p(y) MR(y) MC(y) + t t y* p(y*) ytyt p(y t ) The quantity tax causes a drop in the output level, a rise in the output’s price and a decline in demand for inputs. 28

29 Linear Demand p=a-by, MR=a-2by With tax, MC=c+t Profit maximization: a-2by=c+t y=(a-c-t)/2b p(y)=a-by=a-(a-c-t)/2 dp/dt=1/2 The monopolist passes on half of the tax. 29

30 Linear Demand

31 Constant Elasticity Demand Can a monopolist “pass” all of a $t quantity tax to the consumers in the case of constant elasticity demand? Suppose the marginal cost of production is constant at $k/output unit. With no tax, the monopolist’s price is 31

32 Constant Elasticity Demand The tax increases marginal cost to $(k+t)/output unit, changing the profit- maximizing price to The amount of the tax paid by buyers is 32

33 Constant Elasticity Demand is the amount of the tax passed on to buyers. E.g. if  = -2, the amount of the tax passed on is 2t. Because  1 and so the monopolist passes on to consumers more than the tax! 33

34 The Inefficiency of Monopoly Social welfare=consumer surplus+ producer surplus A market is Pareto efficient if it achieves the maximum possible total gains-to-trade (i.e. social welfare). Otherwise a market is Pareto inefficient. 34

35 The Inefficiency of Monopoly $/output unit y MC(y) p(y) yeye p(y e ) The efficient output level y e satisfies p(y) = MC(y). 35

36 The Inefficiency of Monopoly $/output unit y MC(y) p(y) yeye p(y e ) The efficient output level y e satisfies p(y) = MC(y). CS 36

37 The Inefficiency of Monopoly $/output unit y MC(y) p(y) yeye p(y e ) The efficient output level y e satisfies p(y) = MC(y). CS PS 37

38 The Inefficiency of Monopoly $/output unit y MC(y) p(y) yeye p(y e ) The efficient output level y e satisfies p(y) = MC(y). Total gains-to-trade is maximized. CS PS 38

39 The Inefficiency of Monopoly $/output unit y MC(y) p(y) MR(y) y* p(y*) 39

40 The Inefficiency of Monopoly $/output unit y MC(y) p(y) MR(y) y* p(y*) CS 40

41 The Inefficiency of Monopoly $/output unit y MC(y) p(y) MR(y) y* p(y*) CS PS 41

42 The Inefficiency of Monopoly $/output unit y MC(y) p(y) MR(y) y* p(y*) CS PS 42

43 The Inefficiency of Monopoly $/output unit y MC(y) p(y) MR(y) y* p(y*) CS PS 43

44 The Inefficiency of Monopoly $/output unit y MC(y) p(y) MR(y) y* p(y*) CS PS MC(y*+1) < p(y*+1) so both seller and buyer could gain if the (y*+1)th unit of output was produced. Hence the market is Pareto inefficient. 44

45 The Inefficiency of Monopoly $/output unit y MC(y) p(y) MR(y) y* p(y*) DWL Deadweight loss measures the gains-to-trade not achieved by the market. 45

46 The Inefficiency of Monopoly $/output unit y MC(y) p(y) MR(y) y* p(y*) yeye p(y e ) DWL The monopolist produces less than the efficient quantity, making the market price exceed the efficient market price. 46

47 Natural Monopoly A natural monopoly occurs when a firm cannot operate at an efficient level of output without losing money. When there are large fixed costs and small marginal costs, you can easily get the kind of situation described above. Many public utilities are natural monopolies of this sort. 47

48 Natural Monopoly

49 Inefficiency of a Natural Monopoly Like any profit-maximizing monopolist, the natural monopolist causes a deadweight loss. If allowing a natural monopolist to set the monopoly price is undesirable due to the Pareto inefficiency, and forcing the natural monopoly to produce at the competitive price is infeasible due to negative profits, what is left? For the most part natural monopolies are regulated or operated by governments. 49

50 Natural Monopoly: Solutions Pricing policy: Set the prices that just allow the firm to break even – produce at a point where price equals average costs. But it is difficult to determine the true costs of the firm… The other solution is to let the government operate it at price equals marginal cost and provide a lump-sum subsidy to keep the firm in operation.

51 What Causes Monopolies? 1. Nature of technology. If the minimum efficient scale (MES) is large relative to demand, then the market is likely to be monopolized. But if the MES is small relative to demand, there is room for many firms in the industry, and there is a hope for a competitive market structure.

52 What Causes Monopolies?

53 What Causes Monopolies? 2. Cartel. Several different firms in an industry might be able to collude and restrict output in order to raise prices and thereby increase their profits. When firms collude in this way and attempt to reduce output and increase price, we say the industry is organized as a cartel. Cartels are illegal.

54 What Causes Monopolies? 3. Entry deterrence. An industry may have one dominant firm purely by historical accident. If one firm is first to enter some market, it may have enough of a cost advantage to be able to discourage other firms from entering the industry. The incumbent may be able to convince potential entrants that it will cut its prices drastically if they attempt to enter the industry. By preventing entry in this manner, a firm can eventually dominate a market.

55 What Causes Monopolies? 4. Patent. A patent offers inventors the exclusive right to benefit from their inventions for a limited period of time. Thus a patent offers a kind of limited monopoly.