McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly Chapter 12

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve The First Law of Economics: For every economist, there exists an equal and opposite economist. The Second Law of Economics: They're both wrong.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Monopoly is a market structure in which a single firm makes up the entire market. n Monopolies exist because of barriers to entry into a market that prevent competition.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Legal barriers, such as patents, prevent others from entering the market. n Sociological barriers – entry is prevented by custom or tradition.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction n Natural barriers – the firm has a unique ability to produce what other firms can’t duplicate. n Technological barriers – the size of the market can support only one firm.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Key Difference Between a Monopolist and a Perfect Competitor n For a competitive firm, marginal revenue equals price. n For a monopolist it does not. n The monopolist takes into account the fact that its production decision can affect price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Key Difference Between a Monopolist and a Perfect Competitor n A competitive firm is too small to affect the price. n It does not take into account the effect of its output decision on the price it receives.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Key Difference Between a Monopolist and a Perfect Competitor n A competitive firm's marginal revenue is the market price. n A monopolistic firm’s marginal revenue is not its price – it takes into account that its output decision can affect price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Model of Monopoly n How much should the monopolistic firm choose to produce if it wants to maximize profit?

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Monopolist’s Price and Output Numerically n The first thing to remember is that marginal revenue is the change in total revenue that occurs as a firm changes its output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Monopolist’s Price and Output Numerically n When a monopolist increases output, it lowers the price on all previous units. n As a result, a monopolist’s marginal revenue is always below its price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Monopolist’s Price and Output Numerically n In order to maximize profit, a monopolist produces the output level at which marginal cost equals marginal revenue. Producing at an output level where MR > MC or where MR < MC will yield lower profits.

Profit Maximization for a Monopolist

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Monopolist’s Price and Output Graphically n The marginal revenue curve is a graphical measure of the change in revenue that occurs in response to a change in price. n It tells us the additional revenue the firm will get by expanding output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. MR = MC Determines the Profit-Maximizing Output n If MR > MC, the monopolist gains profit by increasing output. n If MR < MC, the monopolist gains profit by decreasing output. n If MC = MR, the monopolist is maximizing profit.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Price a Monopolist Will Charge n The MR = MC condition determines the quantity a monopolist produces. n The monopolist will charge the maximum price consumers are willing to pay for that quantity. n That price is found on the demand curve.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Price a Monopolist Will Charge n To determine the profit-maximizing price (where MC = MR), first find the profit maximizing output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining the Monopolist’s Price and Output MC $ Price D MR Monopolist price

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Comparing Monopoly and Perfect Competition n Equilibrium output for both the monopolist and the competitor is determined by the MC = MR condition.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Comparing Monopoly and Perfect Competition n Because the monopolist’s marginal revenue is below its price, price and quantity will not be the same. n The monopolist’s equilibrium output is less than, and its price is higher than, for a firm in a competitive market.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Comparing Monopoly and Perfect Competition $ Price MC D MR Monopolist price Competitive price

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Profits and Monopoly n Draw the firm's marginal revenue curve. n Determine the output the monopolist will produce by the intersection of the MC and MR curves.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Profits and Monopoly n Determine the price the monopolist will charge for that output. n Determine the average cost at that level of output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Profits and Monopoly n Determine the monopolist's profit (loss) by subtracting average total cost from average revenue (P) at that level of output and multiply by the chosen output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Profits and Monopoly n The monopolist will make a profit if price exceeds average total cost. n The monopolist will make a normal return if price equal average total cost. n The monopolist will incur a loss if price is less than average total cost.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopolist Making a Profit n A monopolist can make a profit.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopolist Making a Profit Price ATC MC Quantity PMPM 0 MR D QMQM Profit CMCM A B

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopolist Breaking Even n A monopolist can break even.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopolist Breaking Even Price MC Quantity PMPM 0 MR D QMQM ATC

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopolist Making a Loss n A monopolist can make a loss.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Monopolist Making a Loss Price ATC MC Quantity0 MR D QMQM Loss PMPM CMCM B A

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Welfare Loss from Monopoly n People’s purchase decisions don’t reflect the true cost to society because monopolies charge a price higher than marginal cost.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Welfare Loss from Monopoly n The marginal cost of increasing output is lower than the marginal benefit of increasing output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Welfare Loss from Monopoly n The welfare loss of a monopolist is represented by the triangles B and D. n The welfare loss is often called the deadweight loss or welfare loss triangle.

A C PMPM D B MC MRD QMQM PCPC QCQC 0 Price Quantity The Welfare Loss from Monopoly McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Price-Discriminating Monopolist n Price discrimination is the ability to charge different prices to different individuals or groups of individuals.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Price-Discriminating Monopolist n In order to price discriminate, a monopolist must be able to: l Identify groups of customers who have different elasticities of demand; l Separate them in some way; and l Limit their ability to resell its product between groups.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Price-Discriminating Monopolist n A price-discriminating monopolist can increase both output and profit. n It can charge customers with more inelastic demands a higher price. n It can charge customers with more elastic demands a lower price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Discrimination Occurs in the Real World n Movie theaters give senior citizens and child discounts. n All airline Super Saver fares include Saturday night stopovers. n Automobiles are seldom sold at their sticker price. n Theaters have midweek special rates.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Discrimination Occurs in the Real World n Retail tire stores run special sales about half the time. n Restaurants generally make most of their profit on alcoholic drinks and just break even on food. n College-town stores often give students discounts.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Barriers to Entry and Monopoly n Monopolies exist because of some barrier to entry. n Barrier to entry – a social, political, or economic impediment that prevents firms from entering the market.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Barriers to Entry and Monopoly n If there were no barriers to entry, profit- maximizing firms would always compete away monopoly profits.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Barriers to Entry and Monopoly n Three important barriers to entry are natural ability, increasing returns to scale, and government restrictions.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Natural Ability n One firm may be more efficient than other firms because it is better at producing a good than those other firms making it.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Natural Ability n The public views “just monopolies” as those which accrue to the firm because of the firm’s ability.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale n If significant economies of scale are possible, it is inefficient to have two producers. n If each produced half of the output, neither could take advantage of economies of scale.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale n A natural monopoly is an industry in which one firm can produce at a lower cost than can two or more firms.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale n A natural monopoly will occur when indivisible set up costs are so large that average total costs fall within the range of potential output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale n There is no welfare loss in the natural monopoly situation. n There can actually be a welfare gain because a single firm is so much more efficient than several firms producing the good.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 0Quantity Average Cost A Natural Monopolist C3C3 C2C2 C1C1 Q⅓Q⅓ ATC Q½Q½ Q1Q1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Natural Monopolist Loss MR D PMPM PCPC C CMCM QMQM QCQC ATC MC 0Quantity Average Cost Profit

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Restrictions n Monopolies can be created by government.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Normative Views of Monopoly n The public generally views monopolies the way the Classical economists did – they consider them unfair and wrong.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Normative Views of Monopoly n The public accepts patents which are a type of government-created monopoly. l Patent – a legal protection of a technical innovation that gives the person holding the patent a monopoly on using that innovation for a specified period of time.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Normative Views of Monopoly n The public does not like the distributional effects of monopoly. n They believe that it transfers income from “deserving” consumers to “undeserving” monopolists.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Normative Views of Monopoly n It is possible for the well-financed and the well-connected to garner government favors. n The public prefers that firms do “productive” things rather than lobby for government favors.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Policy and Monopoly: AIDS Drugs n The patents for AIDS drugs are owned by a small group of pharmaceutical companies. n They can charge a very high price for a drug that costs little to produce.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Policy and Monopoly: AIDS Drugs n What, should the government do? l Should it force the producer to charge a price equal to its marginal cost. l Doing so would create a significant disincentive for drug companies to do further research on other life-threatening diseases.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Policy and Monopoly: AIDS Drugs n The government could buy the patents. l Payment would come from increased taxes and would be quite expensive. l The cost of regulation would drop, but it would raise the question as to which patents the government should buy.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly End of Chapter 12