Monopoly and Other Forms of Imperfect Competition

Perfectly Competitive Market An ideal market that maximizes economic surplus A situation that does not always exist

Imperfect Competition Imperfectly Competitive Firms Have some control over price Price may be greater than the marginal cost of production Long-run economic profits are possible Reduce economic surplus to varying degrees Are very common

Forms of Imperfect Competition 1. Pure Monopoly The only supplier of a unique product with no close substitutes 2. Monopolistic Competition A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another Long-run adjustment to zero economic profits Importance of differentiation

Forms of Imperfect Competition 3. Oligopoly Industry structure in which a small number of firms produce products that are either close or perfect substitutes Cost advantages from large size may prevent the long-run adjustment to zero economic profit Undifferentiated and differentiated products

Essential Difference Between Perfectly and Imperfectly Competitive Firms The perfectly competitive firm faces a perfectly elastic demand for its product. The imperfectly competitive firm faces a downward-sloping demand curve.

The Demand Curves Facing Perfectly and Imperfectly Competitive Firms Market price $/unit of output Price D Quantity Quantity

Perfectly competitive market Supply and demand determine equilibrium price. The firm has no market power. At the equilibrium price, the firm sells all it wishes. If the firm raises its price, sales will be zero. If the firm lowers its price, sales will not increase. The firm’s demand curve is the horizontal line at the market price.

Imperfectly Competitive Markets The firm has some control over price or some market power. A firm’s ability to raise the price of a good without losing all its sales Sellers face a downward sloping demand

Sources of Market Power Exclusive control over inputs Patents and Copyrights Government Licenses or Franchises Economies of Scale (Natural Monopolies) Network Externalities

Economies of Scale and the Importance of Start-Up Costs Firms with large fixed costs and low variable costs: Have low marginal costs Average total cost declines sharply as output increases Economies of scale will exist

Costs for Two Computer Game Producers (1) Nintendo Playstation Annual production 1,000,000 1,200,000 Fixed cost $200,000 $200,000 Variable cost $800,000 $960,000 Total cost $1,000,000 $1,160,000 Average total cost per game $1.00 $0.97 Observations Fixed costs are a relatively small share of total cost Cost/game is nearly the same

Costs for Two Computer Game Producers (2) Nintendo Playstation Annual production 1,000,000 1,200,000 Fixed cost $10,000,000 $10,000,000 Variable cost $200,000 $240,000 Total cost $10,200,000 $10,240,000 Average total cost per game $10.20 $8.53 Observations Fixed costs are a relatively large share of total cost Playstation has a $1.67 average cost advantage Playstation can lower prices, cover cost, and attract customers

Costs for Two Computer Game Producers (3) Nintendo Playstation Annual production 500,000 1,700,000 Fixed cost $10,000,000 $10,000,000 Variable cost $100,000 $340,000 Total cost $10,100,000 $10,340,000 Average total cost per game $20.20 $6.08 Shift of 500,000 units to Playstation Nintendo’s average cost increases to $20.20/unit Playstation average cost falls to $6.08 A large number of firms cannot survive when the cost differential is high

Economies of Scale and the Importance of Fixed Costs Fixed investment in research and development has been increasing as a share of production costs. Cost of producing a computer Fixed Cost Variable Cost Software Hardware 1984 20% 80% 1990 80% 20%

Profit Maximization for the Monopolist A price taker (perfect competition) and a price setter (imperfect competition) share the economic goal. They want: To maximize profits; i.e., To select the output level that maximizes the difference between TR and TC, where MB= MC (when quantity is divisible and not producing at all is not optimal).

Profit Maximization for the Monopolist For a producer MB = Marginal Revenue (MR) or a change in a firm’s total revenue that results from a one-unit change in output

Profit Maximization for the Monopolist Marginal Revenue for the Monopolist Perfect competition and monopolies Both increase output when MR > MC. Calculate MC the same way. Do not have the same MR at a given price. In perfect competition: MR = P In monopoly: MR < P

The Monopolist’s Benefit from Selling an Additional Unit 8 If P = $6, then TR = $6 x 2 = $12 If P = $5, then TR = $5 x 3 = $15 The MR of selling the 3rd unit = $3 (=15-12) For the 3rd unit, MR = $3 < P = $5 6 5 Price ($/unit) D 2 3 8 Quantity (units/week)

Marginal Revenue in Graphical Form Observations MR < P MR declines as quantity increases MR is the change between two quantities MR < P because price must be lowered to sell an additional unit P Q TR MR 6 2 12 5 3 15 4 16 3 1 -1 Slide 20

Marginal Revenue in Graphical Form Price & marginal revenue ($/unit) Quantity (units/week) 8 D 4 3 2 -1 5 1 MR P Q TR MR 6 2 12 5 3 15 4 16 3 1 -1

The Marginal Revenue Curve for a Monopolist with a Straight-Line Demand Curve Price a/2 D MR Q0/2 Q0 Quantity Observations The vertical intercept, a, is the same for MR and D The horizontal intercept for MR, Q0/2, is one half the demand intercept, Q0.

Profit Maximization for the Monopolist Profit Maximizing Decision Rule When MR > MC, output should be increased. When MR < MC, output should be reduced. Profits are maximized at the level of output for which MR = MC.

The Monopolist’s Profit- Maximizing Output Level Marginal Cost 6 Observations If P = $3 & Q = 12, MR < MC and output should reduce Profits are maximized at 8 units where MR = MC P = $4 where quantity demanded = quantity supplied 4 Price ($/unit of output) 3 2 D MR 8 12 24 Quantity (units/week)

Even a Monopolist May Suffer an Economic Loss Being a monopolist doesn’t guarantee an economic profit Economic loss = $400,000/day Economic profit = $400,000/day 0.12 0.10 0.10 ATC 0.08 Price ($/minute) Price ($/minute) ATC MC 0.05 MC 0.05 D D 20 MR 20 MR 24 Minutes (millions/day) Minutes (millions/day)

The Demand and Marginal Cost Curves for a Monopolist Why the Invisible Hand Breaks Down Under Monopoly D 3 12 6 24 Marginal cost The socially optimal amount occurs where MC = D(=MB) @ 12 units Price ($/unit of output) Quantity (units/week)

Price ($/unit of output) Quantity (units/week) The Demand and Marginal Cost Curves for a Monopolist Why the Invisible Hand Breaks Down Under Monopoly 6 Marginal cost 2 4 MR 8 The profit maximizing level of output of 8 units, where MR = MC, is less than the socially optimal output of 12 Between 8 and 12, MB to society > MC to society Does not increase output because MR to the firms is less than MC Price ($/unit of output) 3 D 12 24 Quantity (units/week)

Price ($/unit of output) Quantity (units/week) The Demand and Marginal Cost Curves for a Monopolist Why the Invisible Hand Breaks Down Under Monopoly 6 Marginal cost 2 4 MR 8 Because MR<P, the monopoly produces less than the socially optimal amount The deadweight loss of the monopoy to society = (1/2)($2/unit)(4 units/wk) = $4/wk. Deadweight loss Price ($/unit of output) 3 D 12 24 Quantity (units/week) Slide 28

Why the Invisible Hand Breaks Down Under Monopoly Profits are maximized where MR = MC. P > MR P > MC Deadweight loss Perfect Competition Profits are maximized where MR = MC. P = MR P = MC No deadweight loss

Why the Invisible Hand Breaks Down Under Monopoly Difficulties in Reducing the Deadweight Loss of Monopolies Enforcing antitrust laws Patents, copyrights, and innovation Natural monopolies

Price Discrimination The practice of charging different buyers different prices for essentially the same good or service Examples Senior citizens and student discounts on movie tickets Supersaver discounts on air travel Rebate coupons

Food For Thought Why do many movie theaters offer discount tickets to students?

Example: Carla Edit How many manuscripts should Carla edit?

Total and Marginal Revenue from Editing Reservation Price Total Revenue Marginal revenue Student ($ per paper) ($ per week) ($ per paper) A 40 40 B 38 76 C 36 108 D 34 136 E 32 160 F 30 180 G 28 196 H 26 208 40 36 32 28 24 20 16 12

Example: Single Price Monopoly How many manuscripts should Carla edit? Opportunity cost = $29 TR = P x Q, or for 4 papers, 4 x $34 = $136/wk MR is the difference in TR from adding another student If MR > MC: increase output

Example: Single Price Monopoly How many manuscripts should Carla edit? Carla edits 3 papers TC = 3 x $29 = $87 TR = $108 Economic profit = $108 - $87 = $21/wk

Example: Social Optimal How many manuscripts should Carla edit? O.C. of her time per editing= $29 Must charge the same price Reservation price > opportunity cost for student A to F Socially efficient number is 6 TR = 6 x $30 = $180 TC = 6 x $29 = $174 Economic profit = $180- $174 = $6

Example: Perfect Price Discrimination If Carla can do perfect price discriminate, how many papers should she edit? Assume Carla can charge each student the reservation price.

Example: Perfect Price Discrimination Reservation Student price A 40 B 38 C 36 D 34 E 32 F 30 G 28 H 26 Carla would edit A to F TR = $40 + $38… = $210 TC = 6 x $29 = $174 Economic Profit = $210 - $174 = $36/wk Economic Profit is $30 more

Perfect Price Discrimination Perfectly Discriminating Monopolist Charging each buyer exactly their reservation price Economic surplus is maximized Consumer surplus is zero Economic surplus = producer surplus

Limitation to Perfect Price Discrimination Seller will not know each buyer’s reservation price. Low price buyers could resell to other buyers at a higher price.

The Hurdle Method of Price Discrimination Profit-maximizing seller’s goal is to charge each buyer his/her reservation price. There are two problems to implementing this pricing strategy. Seller does not know the reservation prices Seller must separate high and low price buyers The hurdle method of price discrimination is used to solve these problems.

The Hurdle Method of Price Discrimination The practice of offering a discount to all buyers who overcome some obstacle. Example Offering a rebate to those who mail in a coupon

The Hurdle Method of Price Discrimination A Perfect Hurdle Separates buyers precisely according to their reservation prices What do you think? Is a perfect hurdle possible?

Example: Price Discrimination with a Perfect Hurdle Question How much should Carla charge for editing if she uses a perfect hurdle?

Example: Price Discrimination with a Perfect Hurdle Assume Carla offers a mail in rebate coupon Students with at least a $36 reservation price never use the coupon Students with a reservation price below $36 use the coupon Opportunity cost = $29 Discount coupon = $4

Price Discrimination with a Perfect Hurdle Reservation Price Total Revenue Marginal revenue Student ($ per paper) ($ per week) ($ per paper) List Price Submarket 40 36 32 A 40 40 B 38 76 C 36 108 D 34 34 E 32 64 F 30 90 G 28 112 H 26 130 Discount Price Submarket 34 30 26 22 18

Example: Price Discrimination with a Perfect Hurdle Solution TR = (3)(36) + (2)(32) = $172 MC = ($5)($29) = $145 Economic Profit = $27/wk

Price Discrimination with a Perfect Hurdle Is price discrimination a bad thing? In fact, the hurdle method raised economic surplus.

Calculating Economic Surplus Economic Surplus Under Price Discrimination with a Perfect Hurdle Calculating Economic Surplus Consumer Surplus Reservation Price Actual Price Consumer Surplus A $40 $36 $4 B $38 $36 $2 C $36 $36 $0 Both Single price & discount Without Discount $6 D $34 $22 $2 With Discount $8 Producer Surplus Single price = 3(36 - 29) = $21/wk Discount price = 3(36 - 29) = $21/wk 2(32 - 29) = $6/wk $27/wk

Calculating Economic Surplus Economic Surplus Under Price Discrimination with a Perfect Hurdle Calculating Economic Surplus Consumer Surplus Reservation Price Actual Price Consumer Surplus A $40 $36 $4 B $38 $36 $2 C $36 $36 $0 Both Single price & discount Without Discount $6 D $34 $22 $2 With Discount $8 Economic Surplus Single price = $6 + $21 = $27/wk Discount price = $8 + $27 = $35/wk Slide 51

Food For Thought Is Carla’s discount rebate completely efficient?

Examples of Price Discrimination Temporary Sales Book publishers and paperback books Automobile producers offer various models Commercial air carriers Movie producers

Single price monopolies are inefficient because P > MR. Summary Single price monopolies are inefficient because P > MR. The hurdle method of price discrimination reduces the inefficiency. The more finely the seller can discriminate, the smaller the efficiency loss. Hurdles are not perfect, therefore, there will be some efficiency loss.

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