Monopoly and Dominant Firms Chapter 8 "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 by State Public Service or Utility Commissions, and may have very low rates of return on invested capital. Regulated monopolies are known as utilities. 2005 South-Western Publishing 1

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. 2

What Went Wrong With Apple? Apple tried to pursue increasing returns by trying to be the industry standard Tried to protect is graphical interface code (GIC) from infringement Lead to Apple being less compatible with software being developed Microsoft recognized and became the industry standard

An Unregulated Monopoly Monopoly is a single seller where entry is prohibited and there are no close substitutes 1. FIRM = INDUSTRY 2. MR < P P = 100 - Q 60 59 D TR1 = 60•40 = 2400 TR2 = 59•41 = 2419 40 41 Q 19 So. MR = 19 where MR < P 3

3. At output where MR = MC, profit is maximized MC PM D QM Proof: Max  = TR – TC Find where dP/dQ = 0 d/dQ = dTR/dQ - dTC/dQ = 0 MR – MC = 0 So: MR = MC D PM QM 4. Charge highest price that the market will bear, PM MR 4

If P = a - b•Q, then TR = aQ - bQ2 so This is twice as steep If we use a linear demand curve: MARGINAL REVENUE is twice as steep as a linear demand curve If P = a - b•Q, then TR = aQ - bQ2 so MR = a - 2b•Q This is twice as steep 5

Find the monopoly quantity if: P = 100 - Q, and where MC = 20. A MONOPOLY PROBLEM Find the monopoly quantity if: P = 100 - Q, and where MC = 20. Answer this by starting where MR = MC TR = P•Q = 100•Q - Q2 MR = 100 - 2•Q = 20 80 = 2•Q QM = 40 Find Monopoly Price: PM = 100 - 40 = 60 The highest price that the market will bear. 6

The Importance of Price Elasticity of Demand for a Monopoly MONOPOLY has MR = MC TR = Q•P(Q) dTR/dQ = MR = P + (dP/dQ)Q = P [ 1 + (dP/dQ)(Q/P) ] = P[ 1 + 1/ EP ] As EP goes to negative infinity, MR approaches P P [ 1 + 1/ EP ] = MC Marginal Revenue 7

Optimal Markups The optimal markup can be found using this same formula. P = [ED /( ED+1)]•MC. The optimal markup m is: (1+m) = [ED /( ED+1)] For example, if ED = -3, the markup is 50%, since = [-3/( -3 +1)] = 1.5. If ED = -4, the markup is 33.3%, since his is where [-4/( -4 +1)] = 1.333. If the price elasticity is infinite, the markup is zero. This occurs in competition.

Find the Monopoly Price in these Problems ANSWER P[ 1 + 1/( - 3) ] = 100 P[ 2/3 ] = 100 So, P = $150. If EP = -5, then optimal monopoly price falls to $125. The more elastic is the demand, the closer is price to MC. If EP = - 3 & MC = 100 What’s PM ? 8

A Monopoly Pricing Problem Regression results for Land’s End Women’s light-weight coats: Log Q = - .4 -1.7 Log P + 1.2 Log Y ( 3 . 2) ( 4. 5) Let MC of imported women’s light-weight coats be $19.50. Find the Monopoly Price for a Land’s End light-weight coats. ANSWER: P( 1 + 1/EP ) = MC P ( 1 + 1/(-1.7) ) = 19.50 P = $47.36 11

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

Profit Profile PL ACPC II I D time The potential competitor (PC) has no demand at limit price PL as DPC is below ACPC Profit Profile PL ACPC II I D ACestablished Q time DPC Which profit profile (I or II) represents monopoly pricing? Would a stockholder prefer profile I or II?

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 railroads before regulation as an example of a nature monopoly. 12

Natural Monopolies AC Declining Cost Industries economies in distribution economies of scale Without Regulation they face Cyclical Competition with prices gyrating between PM and PC. railroad history includes periods of huge profits then bankruptcies DEMAND P M AC MC PR = AC PC = MC QR QC QM MR 12

Solutions to the Problem of Natural Monopolies REGULATE, prevent entry, & set P = AC common in US for local telephone, electricity, water FRANCHISE through a bidding war, likely P = AC Cable T.V. concessions at various stadiums PREVENT ENTRY, set P = MC and subsidize. subsidies require some form of taxation, which will tend to distort work effort. subsidies to AMTRAK NATIONALIZE, prevent entry, set price typically low governments find changing price a highly political event once popular solution in Europe 13

Peak Load Pricing Examples: Long Distance Calls, Electrical Prices, Seasonally Pricing at Amusement Parks Conditions Not Storable Same Facilities Demand Variation 18

Peak and Off-Peak Demand What price should we charge for peak and off-peak users? price Pp Po Off Peak Demand Peak Load Demand Q0 QP 19

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 20