Chapter 10 Market Power: Monopoly and Monopsony Market Power: Monopoly and Monopsony

Chapter 10Slide 2 Topics to be Discussed Monopoly Monopoly Power Sources of Monopoly Power The Social Costs of Monopoly Power

Chapter 10Slide 3 Topics to be Discussed Monopsony Monopsony Power Limiting Market Power: The Antitrust Laws

Chapter 10Slide 4 Perfect Competition Review of Perfect Competition P = LMC = LRAC Normal profits or zero economic profits in the long run Large number of buyers and sellers Homogenous product Perfect information Firm is a price taker

Perfect Competition Q Q PP MarketIndividual Firm DS Q0Q0 P0P0 P0P0 D = MR = P q0q0 LRACLMC

Chapter 10Slide 6 Monopoly 1) One seller - many buyers 2)One product (no good substitutes) 3)Barriers to entry

Chapter 10Slide 7 Monopoly The monopolist is the supply-side of the market and has complete control over the amount offered for sale. Profits will be maximized at the level of output where marginal revenue equals marginal cost.

Chapter 10Slide 8 Monopoly Finding Marginal Revenue As the sole producer, the monopolist works with the market demand to determine output and price. Assume a firm with demand:  P = 6 - Q

Chapter 10Slide 9 Total, Marginal, and Average Revenue $60$ $5$ TotalMarginalAverage PriceQuantityRevenueRevenueRevenue PQRMRAR

Chapter 10Slide 10 Average and Marginal Revenue Output $ per unit of output Average Revenue (Demand) Marginal Revenue

Chapter 10Slide 11 Monopoly Observations 1)To increase sales the price must fall 2)MR < P 3)Compared to perfect competition  No change in price to change sales  MR = P

Chapter 10Slide 12 Monopoly Monopolist ’ s Output Decision 1)Profits maximized at the output level where MR = MC 2)Cost functions are the same

Chapter 10Slide 13 Maximizing Profit When Marginal Revenue Equals Marginal Cost At output levels below MR = MC the decrease in revenue is greater than the decrease in cost (MR > MC). At output levels above MR = MC the increase in cost is greater than the decrease in revenue (MR < MC) The Monopolist ’ s Output Decision

Chapter 10Slide 14 Lost profit P1P1 Q1Q1 Lost profit MC AC Quantity $ per unit of output D = AR MR P* Q* Maximizing Profit When Marginal Revenue Equals Marginal Cost P2P2 Q2Q2

Chapter 10Slide 15 Monopoly An Example The Monopolist ’ s Output Decision

Chapter 10Slide 16 Monopoly An Example The Monopolist ’ s Output Decision

Chapter 10Slide 17 Monopoly An Example The Monopolist ’ s Output Decision

Chapter 10Slide 18 Monopoly An Example By setting marginal revenue equal to marginal cost, it can be verified that profit is maximized at P = $30 and Q = 10. This can be seen graphically: The Monopolist ’ s Output Decision

Chapter 10Slide 19 Quantity $ R Profits t t' c c’c’ Example of Profit Maximization C

Chapter 10Slide 20 Example of Profit Maximization Observations Slope of rr ’ = slope cc ’ and they are parallel at 10 units Profits are maximized at 10 units P = $30, Q = 10, TR = P x Q = $300 AC = $15, Q = 10, TC = AC x Q = 150 Profit = TR - TC  $150 = $300 - $150 Quantity $ R C Profits t t' c c

Chapter 10Slide 21 Profit AR MR MC AC Example of Profit Maximization Quantity $/Q

Chapter 10Slide 22 Example of Profit Maximization Observations AC = $15, Q = 10, TC = AC x Q = 150 Profit = TR = TC = $300 - $150 = $150 or Profit = (P - AC) x Q = ($30 - $15)(10) = $150 Quantity $/Q MC AR MR AC Profit

Chapter 10Slide 23 Monopoly A Rule of Thumb for Pricing We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in practice. This can be demonstrated using the following steps:

Chapter 10Slide 24 A Rule of Thumb for Pricing

Chapter 10Slide 25 A Rule of Thumb for Pricing

Chapter 10Slide 26 A Rule of Thumb for Pricing

Chapter 10Slide 27 = the markup over MC as a percentage of price (P-MC)/P A Rule of Thumb for Pricing 8. The markup should equal the inverse of the elasticity of demand.

Chapter 10Slide 28 A Rule of Thumb for Pricing

Chapter 10Slide 29 Monopoly Monopoly pricing compared to perfect competition pricing: Monopoly P > MC Perfect Competition P = MC

Chapter 10Slide 30 Monopoly Monopoly pricing compared to perfect competition pricing: The more elastic the demand the closer price is to marginal cost. If E d is a large negative number, price is close to marginal cost and vice versa.

Chapter 10Slide 31 Astra-Merck Prices Prilosec 1995 Price of Prilosec = $3.50/daily dose Price of Tagamet and Zantac = $ $2.25/daily dose MC of Prolosec = cents/daily dose The Monopolist ’ s Output Decision

Chapter 10Slide 32 Astra-Merck Prices Prilosec The Monopolist ’ s Output Decision Price of $3.50 is consistent with “ the rule of thumb pricing ”

Chapter 10Slide 33 Monopoly Shifts in Demand In perfect competition, the market supply curve is determined by marginal cost. For a monopoly, output is determined by marginal cost and the shape of the demand curve.

Chapter 10Slide 34 D2D2 MR 2 D1D1 MR 1 Shift in Demand Leads to Change in Price but Same Output Quantity MC $/Q P2P2 P1P1 Q 1 = Q 2

Chapter 10Slide 35 D1D1 MR 1 Shift in Demand Leads to Change in Output but Same Price MC $/Q MR 2 D2D2 P 1 = P 2 Q1Q1 Q2Q2 Quantity

Chapter 10Slide 36 Monopoly Observations Shifts in demand usually cause a change in both price and quantity. A monopolistic market has no supply curve.

Chapter 10Slide 37 Monopoly Observations Monopolist may supply many different quantities at the same price. Monopolist may supply the same quantity at different prices.

Chapter 10Slide 38 Monopoly The Effect of a Tax Under monopoly price can sometimes rise by more than the amount of the tax. To determine the impact of a tax: t = specific tax MC = MC + t MR = MC + t : optimal production decision

Chapter 10Slide 39 Effect of Excise Tax on Monopolist Quantity $/Q MC D = AR MR Q0Q0 P0P0 MC + tax t Q1Q1 P1P1 Increase in P: P 0 P 1 > increase in tax

Chapter 10Slide 40 Question Suppose: E d = -2 How much would the price change? Effect of Excise Tax on Monopolist

Chapter 10Slide 41 Answer What would happen to profits? Effect of Excise Tax on Monopolist

Chapter 10Slide 42 Monopoly The Multiplant Firm For many firms, production takes place in two or more different plants whose operating cost can differ.

Chapter 10Slide 43 Monopoly The Multiplant Firm Choosing total output and the output for each plant:  The marginal cost in each plant should be equal.  The marginal cost should equal the marginal revenue for each plant.

Chapter 10Slide 44 Monopoly Algebraically: The Multiplant Firm

Chapter 10Slide 45 Monopoly Algebraically: The Multiplant Firm

Chapter 10Slide 46 Monopoly Algebraically: The Multiplant Firm

Chapter 10Slide 47 Monopoly Algebraically:

Chapter 10Slide 48 Production with Two Plants Quantity $/Q D = AR MR MC 1 MC 2 MC T MR* Q1Q1 Q2Q2 Q3Q3 P*

Chapter 10Slide 49 Production with Two Plants Observations: 1)MC T = MC 1 + MC 2 2)Profit maximizing output:  MC T = MR at Q T and P *  MR = MR*  MR* = MC 1 at Q 1, MC* = MC 2 at Q 2  MC 1 + MC 2 = MC T, Q 1 + Q 2 = Q T, and MR = MC 1 + MC 2 Quantity $/Q D = AR MR MC 1 MC 2 MC T MR* Q1Q1 Q2Q2 Q3Q3 P*

Chapter 10Slide 50 Monopoly Power Monopoly is rare. However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost.

Chapter 10Slide 51 Monopoly Power Scenario: Four firms with equal share (5,000) of a market for 20,000 toothbrushes at a price of $1.50.

Quantity 10, QAQA $/ Q ,00030,0003,0005,0007, At a market price of $1.50, elasticity of demand is Market Demand The Demand for Toothbrushes The demand curve for Firm A depends on how much their product differs, and how the firms compete.

At a market price of $1.50, elasticity of demand is Quantity 10, QAQA $/ Q ,00030,0003,0005,0007, DADA MR A Market Demand Firm A sees a much more elastic demand curve due to competition--E d = -.6. Still Firm A has some monopoly power and charges a price which exceeds MC. MC A The Demand for Toothbrushes

Chapter 10Slide 54 Monopoly Power Measuring Monopoly Power In perfect competition: P = MR = MC Monopoly power: P > MC

Chapter 10Slide 55 Monopoly Power Lerner ’ s Index of Monopoly Power L = (P - MC)/P  The larger the value of L (between 0 and 1) the greater the monopoly power. L is expressed in terms of E d  L = (P - MC)/P = -1/E d  E d is elasticity of demand for a firm, not the market

Chapter 10Slide 56 Monopoly Power Monopoly power does not guarantee profits. Profit depends on average cost relative to price. Question: Can you identify any difficulties in using the Lerner Index (L) for public policy?

Chapter 10Slide 57 Monopoly Power The Rule of Thumb for Pricing Pricing for any firm with monopoly power  If E d is large, markup is small  If E d is small, markup is large

Elasticity of Demand and Price Markup $/ Q Quantity AR MR AR MC Q* P* P*-MC The more elastic is demand, the less the markup.

Chapter 10Slide 59 Markup Pricing: Supermarkets to Designer Jeans Supermarkets

Chapter 10Slide 60 Convenience Stores Markup Pricing: Supermarkets to Designer Jeans

Chapter 10Slide 61 Convenience stores have more monopoly power. Question: Do convenience stores have higher profits than supermarkets? Markup Pricing: Supermarkets to Designer Jeans Convenience Stores

Chapter 10Slide 62 Designer jeans E d = -3 to -4  Price % > MC  MC = $12 - $18/pair  Wholesale price = $18 - $27 Markup Pricing: Supermarkets to Designer Jeans Designer Jeans

The Pricing of Prerecorded Videocassettes TitleRetail Price($)TitleRetail Price($) Purple Rain$29.98Austin Powers$10.49 Raiders of the Lost Ark24.95A Bug ’ s Life17.99 Jane Fonda Workout59.95There ’ s Something about Mary13.99 The Empire Strikes Back79.98Tae-Bo Workout24.47 An Officer and a Gentleman24.95Lethal Weapon Star Trek: The Motion Picture24.95Men in Black12.99 Star Wars39.98Armageddon15.86

What Do You Think? Should producers lower the price of videocassettes to increase sales and revenue? The Pricing of Prerecorded Videocassettes

Chapter 10Slide 65 Sources of Monopoly Power Why do some firm ’ s have considerable monopoly power, and others have little or none? A firm ’ s monopoly power is determined by the firm ’ s elasticity of demand.

Chapter 10Slide 66 Sources of Monopoly Power The firm ’ s elasticity of demand is determined by: 1)Elasticity of market demand 2)Number of firms 3) The interaction among firms

Chapter 10Slide 67 The Social Costs of Monopoly Power Monopoly power results in higher prices and lower quantities. However, does monopoly power make consumers and producers in the aggregate better or worse off?

Chapter 10Slide 68 B A Lost Consumer Surplus Deadweight Loss Because of the higher price, consumers lose A+B and producer gains A-C. C Deadweight Loss from Monopoly Power Quantity AR MR MC QCQC PCPC PmPm QmQm $/Q

Chapter 10Slide 69 Rent Seeking Firms may spend to gain monopoly power  Lobbying  Advertising  Building excess capacity The Social Costs of Monopoly Power

Chapter 10Slide 70 The incentive to engage in monopoly practices is determined by the profit to be gained. The larger the transfer from consumers to the firm, the larger the social cost of monopoly. The Social Costs of Monopoly Power

Chapter 10Slide 71 Example 1996 Archer Daniels Midland (ADM) successfully lobbied for regulations requiring ethanol be produced from corn Question Why only corn? The Social Costs of Monopoly Power

Chapter 10Slide 72 Price Regulation Recall that in competitive markets, price regulation created a deadweight loss. Question: What about a monopoly? The Social Costs of Monopoly Power

Chapter 10Slide 73 AR MR MC PmPm QmQm AC P1P1 Q1Q1 Marginal revenue curve when price is regulated to be no higher that P 1. If left alone, a monopolist produces Q m and charges P m. If price is lowered to P 3 output decreases and a shortage exists. For output levels above Q 1, the original average and marginal revenue curves apply. If price is lowered to P C output increases to its maximum Q C and there is no deadweight loss. Price Regulation $/Q Quantity P 2 = P C QcQc P3P3 Q3Q3 Q’3Q’3 Any price below P 4 results in the firm incurring a loss. P4P4

Chapter 10Slide 74 Natural Monopoly A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms. The Social Costs of Monopoly Power

Chapter 10Slide 75 Regulating the Price of a Natural Monopoly $/Q Natural monopolies occur because of extensive economies of scale Quantity

Chapter 10Slide 76 MC AC AR MR $/Q Quantity Setting the price at P r yields the largest possible output;excess profit is zero. QrQr PrPr PCPC QCQC If the price were regulate to be P C, the firm would lose money and go out of business. PmPm QmQm Unregulated, the monopolist would produce Q m and charge P m. Regulating the Price of a Natural Monopoly

Chapter 10Slide 77 Regulation in Practice It is very difficult to estimate the firm's cost and demand functions because they change with evolving market conditions The Social Costs of Monopoly Power

Chapter 10Slide 78 Regulation in Practice An alternative pricing technique---rate-of- return regulation allows the firms to set a maximum price based on the expected rate or return that the firm will earn.  P = AVC + (D + T + sK)/Q, where P = price, AVC = average variable cost D = depreciation, T = taxes s = allowed rate of return, K = firm ’ s capital stock The Social Costs of Monopoly Power

Chapter 10Slide 79 Regulation in Practice Using this technique requires hearings to arrive at the respective figures. The hearing process creates a regulatory lag that may benefit producers (1950s & 60s) or consumers (1970s & 80s). Question Who is benefiting in the 1990s? The Social Costs of Monopoly Power

Chapter 10Slide 80 Monopsony A monopsony is a market in which there is a single buyer. An oligopsony is a market with only a few buyers. Monopsony power is the ability of the buyer to affect the price of the good and pay less than the price that would exist in a competitive market.

Chapter 10Slide 81 Monopsony Competitive Buyer Price taker P = Marginal expenditure = Average expenditure D = Marginal value

Competitive Buyer Compared to Competitive Seller Quantity $/Q AR = MR D = MV ME = AE P* Q* ME = MV at Q* ME = P* P* = MV P* Q* MC MR = MC P* = MR P* = MC BuyerSeller

Chapter 10Slide 83 ME S = AE The market supply curve is the monopsonist ’ s average expenditure curve Monopsonist Buyer Quantity $/Q MV Q* m P* m Monopsony ME > P & above S PCPC QCQC Competitive P = P C Q = Q+C

Chapter 10Slide 84 Monopoly and Monopsony Quantity AR MR MC $/Q QCQC PCPC Monopoly Note: MR = MC; AR > MC; P > MC P* Q*

Chapter 10Slide 85 Monopoly and Monopsony Quantity $/Q MV ME S = AE Q* P* PCPC QCQC Monopsony Note: ME = MV; ME > AE; MV > P

Chapter 10Slide 86 Monopoly and Monopsony Monopoly MR < P P > MC Q m < Q C P m > PC Monopsony ME > P P < MV Q m < Q C P m < P C

Chapter 10Slide 87 Monopsony Power A few buyers can influence price (e.g. automobile industry). Monopsony power gives them the ability to pay a price that is less than marginal value.

Chapter 10Slide 88 Monopsony Power The degree of monopsony power depends on three similar factors. 1)Elasticity of market supply  The less elastic the market supply, the greater the monopsony power.

Chapter 10Slide 89 Monopsony Power The degree of monopsony power depends on three similar factors. 2)Number of buyers  The fewer the number of buyers, the less elastic the supply and the greater the monopsony power.

Chapter 10Slide 90 Monopsony Power The degree of monopsony power depends on three similar factors. 3)Interaction Among Buyers  The less the buyers compete, the greater the monopsony power.

ME S = AE ME S = AE Monopsony Power: Elastic versus Inelastic Supply Quantity $/Q MV Q* P* MV - P* P* Q* MV - P*

Chapter 10Slide 92 A Deadweight Loss from Monopsony Power Determining the deadweight loss in monopsony Change in seller ’ s surplus = -A-C Change in buyer ’ s surplus = A - B Change in welfare = -A - C + A - B = -C - B Inefficiency occurs because less is purchased Quantity $/Q MV ME S = AE Q* P* PCPC QCQC B C Deadweight Loss

Chapter 10Slide 93 Monopsony Power Bilateral Monopoly Bilateral monopoly is rare, however, markets with a small number of sellers with monopoly power selling to a market with few buyers with monopsony power is more common. The Social Costs of Monopsony Power

Chapter 10Slide 94 Monopsony Power Question In this case, what is likely to happen to price? The Social Costs of Monopsony Power

Chapter 10Slide 95 Limiting Market Power: The Antitrust Laws Antitrust Laws: Promote a competitive economy Rules and regulations designed to promote a competitive economy by:  Prohibiting actions that restrain or are likely to restrain competition  Restricting the forms of market structures that are allowable

Chapter 10Slide 96 Sherman Act (1890) Section 1  Prohibits contracts, combinations, or conspiracies in restraint of trade Explicit agreement to restrict output or fix prices Implicit collusion through parallel conduct Limiting Market Power: The Antitrust Laws

Chapter 10Slide Six companies and six executives indicted for price of copper tubing 1996 Archer Daniels Midland (ADM) pleaded guilty to price fixing for lysine -- three sentenced to prison in 1999 Limiting Market Power: The Antitrust Laws Examples of Illegal Combinations

Chapter 10Slide Roche A.G., BASF A.G., Rhone-Poulenc and Takeda pleaded guilty to price fixing of vitamins -- fined more than $1 billion. Limiting Market Power: The Antitrust Laws Examples of Illegal Combinations

Chapter 10Slide 99 Sherman Act (1890) Section 2  Makes it illegal to monopolize or attempt to monopolize a market and prohibits conspiracies that result in monopolization. Limiting Market Power: The Antitrust Laws

Chapter 10Slide 100 Clayton Act (1914) 1)Makes it unlawful to require a buyer or lessor not to buy from a competitor 2)Prohibits predatory pricing Limiting Market Power: The Antitrust Laws

Chapter 10Slide 101 Clayton Act (1914) 3)Prohibits mergers and acquisitions if they “ substantially lessen competition ” or “ tend to create a monopoly ” Limiting Market Power: The Antitrust Laws

Chapter 10Slide 102 Robinson-Patman Act (1936) Prohibits price discrimination if it is likely to injure the competition Limiting Market Power: The Antitrust Laws

Chapter 10Slide 103 Federal Trade Commission Act (1914, amended 1938, 1973, 1975) 1)Created the Federal Trade Commission (FTC) 2)Prohibitions against deceptive advertising, labeling, agreements with retailer to exclude competing brands Limiting Market Power: The Antitrust Laws

Chapter 10Slide 104 Antitrust laws are enforced three ways: 1)Antitrust Division of the Department of Justice  A part of the executive branch--the administration can influence enforcement  Fines levied on businesses; fines and imprisonment levied on individuals Limiting Market Power: The Antitrust Laws

Chapter 10Slide 105 Antitrust laws are enforced three ways: 2)Federal Trade Commission  Enforces through voluntary understanding or formal commission order Limiting Market Power: The Antitrust Laws

Chapter 10Slide 106 Antitrust laws are enforced three ways: 3)Private Proceedings  Lawsuits for damages  Plaintiff can receive treble damages Limiting Market Power: The Antitrust Laws

Chapter 10Slide 107 Two Examples American Airlines -- Price fixing Microsoft  Monopoly power  Predatory actions  Collusion Limiting Market Power: The Antitrust Laws

Chapter 10Slide 108 Summary Market power is the ability of sellers or buyers to affect the price of a good. Market power can be in two forms: monopoly power and monopsony power.

Chapter 10Slide 109 Summary Monopoly power is determined in part by the number of firms competing in the market. Monopsony power is determined in part by the number of buyers in the market.

Chapter 10Slide 110 Summary Market power can impose costs on society. Sometimes, scale economies make pure monopoly desirable. We rely on the antitrust laws to prevent firms from obtaining excessive market power.

End of Chapter 10 Market Power: Monopoly and Monopsony Market Power: Monopoly and Monopsony