Lecture seven © copyright ： qinwang 2013 SHUFE school of international business

Firm decision in monopoly  The reason for monopoly  Price strategy Short-run decision Long-run decision  Warfare loss in monopoly  the Theory of Contestable Markets

Why to be monopoly  Resources monopoly: ALCOA (aluminum); DeBeers (diamond)  Natural monopoly: it is efficient for one firm to supply the whole market.  Government-authorized franchise: only one firm is approved by government.  Competition lead to monopoly Patent or copyright

Monopolist: price decision

Would Monopolist be in loss? Super profit loss Break even

Long-run decision in monopoly Monopolist maximizes profit by choosing to produce output where MR = LMC, as long as P  LAC Will exit industry if P < LAC Monopolist will adjust plant size to the optimal level  Optimal plant is where the short-run average cost curve is tangent to the long-run average cost at the profit-maximizing output level

Monopolist’s decision in long-run

Monopolist will loss in long-run?

Optimal markup, contribution margin and gross profit margin.  Optimal markup MR=MC MR=P(1+1/Ep);so P=MC*Ep/(Ep+1)  Contribution margin: P-MC Contribution margin percentage: (P- MC)/P  Gross profit margin: P-MC-FC

the Theory of Contestable Markets  In 1982, William ． Baumol set up this theory. William ． Baumol  a perfectly contestable market would have no barriers to entry or exit. Contestable markets are characterized by "hit and run" competition; if a firm in a contestable market raises its prices much beyond the average price level of the market, and thus begins to earn excess profits, potential rivals will enter the market, hoping to exploit the price level for easy profit. When the original incumbent firm(s) respond by returning prices to levels consistent with normal profits, the new firms will exit. Because of this, even a single-firm market can show highly competitive behavior.firmprice levelexcess profits

 Entry of new firms into a market erodes market power of existing firms by increasing the number of substitutes  A firm can possess a high degree of market power only when strong barriers to entry exist Conditions that make it difficult for new firms to enter a market in which economic profits are being earned Barriers to Entry

Common Entry Barriers  Economies of scale When long-run average cost declines over a wide range of output relative to demand for the product, there may not be room for another large producer to enter market  Product differentiation  Barriers created by government Licenses, exclusive franchises

 Essential input barriers One firm controls a crucial input in the production process  Brand loyalties Strong customer allegiance to existing firms may keep new firms from finding enough buyers to make entry worthwhile Common Entry Barriers

 Consumer lock-in Potential entrants can be deterred if they believe high switching costs will keep them from inducing many consumers to change brands  Network externalities Occur when benefit or utility of a product increases as more consumers buy & use it Make it difficult for new firms to enter markets where firms have established a large base or network of buyers Common Entry Barriers

Monopoly profit and limit pricing A limit price is the price set by a monopolist to discourage entry into a market, and is illegal in many countries. When MR=MC, monopolist may earn short-run profit maximization, that would inducing new entries. Monopolist falls its price to discourage entry, that may reduce its shout-rum profit but would gain more in long-run.

E.g: price strategy of Galanz The sale of Galanz ’ s microwave (sales volume):  1993:10000 ; 1994:100000;  1995:250000,market share 25.1%(Xianhua 24.8%);  1996:600000,market share 34.7% ；  1997: , market share 49.6% ； sales profit rate 11%  1998: (export), (demestic),ma rket share 61.43%,sales profit rate 9%  1999,price falled and reduce sales profit rate to 6%.

limit pricing

Short-run Long-run

Natural monopoly and price regulation  A natural monopoly by contrast is a condition on the cost-technology of an industry whereby it is most efficient (involving the lowest long- run average cost) for production to be concentrated in a single form.monopoly  Examples: power grid companies, gas companies, electric power companies

price discrimination  Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider Doctors or lawyers charge for different fee for the same service. Power plant differents its price to firm and individual. Restaurant charges different price for old and young person.

First-Degree (Perfect) Price Discrimination  Every unit is sold for the maximum price each consumer is willing to pay Allows the firm to capture entire consumer surplus  Difficulties Requires precise knowledge about every buyer ’ s demand for the good Seller must negotiate a different price for every unit sold to every buyer

First-Degree (Perfect) Price Discrimination (Figure 14.2)

Second-Degree Price Discrimination  Lower prices are offered for larger quantities and buyers can self-select the price by choosing how much to buy  When the same consumer buys more than one unit of a good or service at a time, the marginal value placed on additional units declines as more units are consumed Declining block pricing Offers quantity discounts over successive discrete blocks of quantities purchased

Block Pricing with Five Blocks D

Two-part pricing Charges buyers a fixed access charge ( A ) to purchase as many units as they wish for a constant fee ( f ) per unit Total expenditure ( TE ) for q units is:

Third-Degree Price Discrimination If a firm sells in two markets, 1 & 2; ask for different price for each market. How to allocate output?  Allocate output (sales) so MR 1 = MR 2  Optimal total output is that for which MR T = MC For profit-maximization, allocate sales of total output so that MR T = MC = MR 1 = MR 2

Why choose price discrimination ?  Different Demand elasticity?  Different cost?  Different time?