Chapter 8: Pure Monopoly

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin What is a Pure Monopoly? A pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. Examples: local telephone company, local gas and electric company, small town gas station

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Characteristics of Pure Monopoly Single supplier – the firm and the industry are synonymous. No close substitutes – the product is unique and unlike any others. Price maker – the firm has considerable control over price since it controls the total quantity supplied. Blocked entry – barriers to entry exist because there is no immediate competition.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Barriers to Entry Barriers to entry are factors that prohibit firms from entering an industry. They include: Economies of scale Legal barriers to entry Ownership or control of essential resources Pricing and other strategic barriers to entry

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economies of Scale If as a firm expands average total cost falls, then economies of scale exist. Only a few large firms, or even a single firm, can achieve low average total costs, given market demand. A natural monopoly exists because economies of scale are large and the firm can achieve minimum efficient scale.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economies of Scale If the market is controlled by a pure monopolist, economies of scale serve as an entry barrier. New firms face very large start up costs which result in high average total costs. This makes it hard to compete with a monopolist that is already well established.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Legal Barriers to Entry: Patents and Licenses Government-created barriers include patents and licenses. A patent is the exclusive right of an inventor to use, or to allow another to use, her or his invention. Licensing also limits the production of a product at the federal, state, or municipal level.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Ownership or Control of Essential Resources A firm that owns or controls an essential resource can prohibit the entry or rival firms. Private property serves as an obstacle to potential rivals.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Pricing and Other Strategic Barriers to Entry Monopolists can bar entry into a market in other ways, including Price cutting Increase funding for advertising Exclusive contracts with distributors The legality of such behavior may be challenged in court according to laws and regulations.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Monopoly Demand Recall that in pure competition, a firm faces a perfectly elastic demand since it is a price taker. The market supply and demand curves determine price, which determines the firm’s demand curve. In pure monopoly, the firm’s demand curve is the market demand curve. The pure monopolist is the industry; therefore, the demand curve is downward-sloping.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Demand Pure CompetitionPure Monopoly Price Quantity P firm’s demand Market Demand

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Monopoly Marginal Revenue Because market demand slopes downward, in order for a monopolist to increase sales it must lower its price. Consequently, marginal revenue is less than price for every level of output except the first.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Monopoly Marginal Revenue If the monopolist increases output by one more unit, the price charged for all units sold will fall. Each additional unit of output sold increases total revenue by an amount equal to its own price less the sum of the price cuts that apply to all price units of output.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Monopoly Marginal Revenue Example: An increase in production from 2 to 3 units causes price to fall from $46 to $44. Total revenue rises from $92 to $132. QuantityPrice (AR) Total Revenue 0$50$ For the third unit, marginal revenue = $40 < Price = $44. (MR = $44 for 3rd unit minus $2*2 for price cuts of the first two units.)

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Monopolist Is a Price Maker A pure monopolist can influence market supply through its output decisions. Subsequently, it can also influence the product price. Each output is associated with a unique price; by changing the market output, a monopolist is indirectly determining the market price.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Output and Price Determination To determine the price-quantity combination that will maximize profit, cost data is needed. Furthermore, a monopolist will employ the MR = MC Rule in order to maximize profit.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Determining Monopoly Price and Quantity A monopolist produces a level of output where MR = MC. This determines the profit maximizing output, Q m. Price is determined by the market demand curve. A vertical line is drawn from Q m to the demand curve. P m is the profit-maximizing price.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Finding P m and Q m Price Quantity of output Market Demand MR MC PmPm QmQm MC = MR Cost data will determine a monopolist’s profit.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin A Profitable Monopolist Price Quantity of output D MR MC PmPm QmQm ATC Economic Profit Profit per unit

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Misconceptions Concerning Monopoly Pricing Three fallacies concerning monopoly behavior include: Not Highest Price Total, Not Unit, Profit Profitability Not Assured

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Misconceptions Concerning Monopoly Pricing Higher prices often yield smaller-than- maximum total profit. The “highest price possible” is not ideal because it results in lower output and reduces total revenue. The monopolist seeks to maximize total profit, not unit profit.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Misconceptions Concerning Monopoly Pricing A monopolist suffers from weak demand, bad market conditions or resource cost increases. Thus, profit is not always guaranteed.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economics Effects of Monopoly Compared to pure competition, a monopoly lacks productive efficiency and allocative efficiency.  It is considered inefficient. A monopolist charges a higher price and sells a smaller level of output than firms in a purely competitive industry.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Inefficiency of Pure Monopoly Because the monopolist’s MR curve lies below demand and it produces output where MR = MC, price exceeds MC. In pure competition, entry and exit of firms ensure that P = MC = min. ATC.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Inefficiency of Pure Monopoly Pure CompetitionPure Monopoly Price Quantity PcPc D D QcQc S = MC PcPc MC QcQc MR QmQm PmPm P = MC = min. ATC MR = MC

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Economics Effects of Monopoly Monopoly increases income inequality because monopoly profits are not equally distributed. Monopolists levy a “private tax” on consumers by transferring income from consumers to shareholders who own the monopoly. Cost may vary in monopoly because of economies of scale, X-inefficiency, rent- seeking expenditures, and technological advance.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Cost Complications Some firms achieve large economies of scale due to specialized inputs, the spreading of product developing costs, simultaneous consumption and network effects.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Cost Complications Cost also vary because firms produce a level of output that is higher than the lowest ATC. This is called X-efficiency. Rent-seeking behavior alters costs when firms gain special benefits from the government at the expense of taxpayers. In the very long run, firms can reduce their costs through technological advances.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Price Discrimination Price discrimination is the business practice of selling the same good at different prices to different consumers when the price differences are not justified by differences in costs.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Price Discrimination Price discrimination is not possible when a good is sold in a purely competitive market since there are many firms all selling at the market price.

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Price Discrimination In order to price discriminate, the firm must: have monopoly power be able to segregate the market into difference groups be able to prevent resale of the product

Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Monopoly and Antitrust Policy Monopoly is not widespread because barriers to entry are seldom completely successful. Governments deal with monopoly behavior through antitrust laws if the monopoly arises through anticompetitive actions or creates substantial economic inefficiencies. Otherwise, the government can do nothing.