1 Intermediate Microeconomics Monopoly

2 Pure Monopoly A Monopolized market has only a single seller. Examples: XM radio? Microsoft? Walmart in a small town?

3 Monopolies So what causes monopolies? Legal Constraints: e.g patents for new drugs Ownership of a fixed resource e.g. toll highway, land in a given area. Collusion e.g. several producers act as one (OPEC) Large economies of scale (natural monopolies) e.g. land line phone service, utilities, Google? Microsoft?

4 Monopolies Why are we concerned about Monopolies?

5 Implications of Monopoly Key to Monopoly: Seller is not a price taker! Specifically, since monopolist chooses market supply, it essentially picks a point on the market demand curve to operate on. This means that for a monopolist, equilibrium price is a function of the quantity they supply, so they effectively get to choose both i.e. choose where to operate on p(q) (“Inverse Demand Curve”) $ Q Q D (p) or p(q)

6 Monopolist’s Problem In perfect competition, a firm wanted to choose a quantity to maximize profits, given it is a “price taker”. max π(q) = R(q) – C(q) = pq – C(q) To find profit maximizing q, we take derivative of π(q) and set it equal to zero, This gives p - MC(q*) = 0 “First Order Condition” (FOC) or equivalently, keep producing until MC(q*) = p Like any firm, a monopolist wants to choose quantity to maximize profits, but by doing so effectively chooses price as well. max π(q) = R(q) – C(q) = p(q)q – C(q) So what will be profit maximization condition for the monopolist?

7 Monopolist’s Problem $ q R(q) = p(q)q π(q) c(q)

8 Marginal Revenue for Monopolist Profit max condition is always MR(q) = MC(q) (from F.O.C.) For firm in perfect competition, firm is a price taker so MR(q) = p for all q. For monopolist: R(q) = p(q)q So, MR(q) = [p’(q)q + p(q)] Since p(q) is the inverse of the market demand curve, we know p’(q) < 0. Therefore, [p’(q)q + p(q)] < p(q), implying MR(q) < p(q) (i.e. marginal revenue from producing and selling another unit is less than price) What is intuition?

9 Marginal Revenue for Monopolist Ex: Consider a Market Demand Curve: Q D (p) = 400 – 5p What is Equation for the Inverse Demand curve? What is Equation for Marginal Revenue curve? Graphically?

10 Monopolist Behavior Now consider a monopolist facing market demand curve of Q D (p) = 400 – 5p. Suppose cost function given by C(q) = q 2 + 8q + 20 What will be equilibrium price and quantity? Graphically?

11 Profit Maximization and Demand Elasticity Recall that R(q) = p(q)q So MR(q) = p’(q) q + p(q) = p(q)[p’(q) q/p(q) + 1] Recall ε(p) = Q’(p) p/Q(p) = slope of demand curve times price divided by quantity So 1/ε = slope of inverse demand curve times quantity divided by price = p’(q) q/p(q) So MR(q) = p(q)[1/ε + 1] Recalling ε < 0, what does this tell us about output under a monopoly and demand elasticity, recognizing that Monopolist will choose q to equate MR(q) to MC(q)?

12 Profit Maximization and Demand Elasticity We can actually learn even more from elasticity. In competitive markets, firms produced until p = MC(q*) Alternatively, monopolist supplies until MR(q*) = MC(q*), or until: p(q*)[1/ε + 1] = MC(q*) Re-writing we get: p(q*) = MC(q*)ε /[ε +1] So how does monopoly “mark-up” depend on elasticity of demand?

13 Monopoly and Efficiency The key implication of a Pareto Efficient outcome is that all possible gains from trade are exhausted. Will this be true in a monopolized market? Consider first what it means for all gains from trade to be exhausted. Output is produced as long as marginal cost of last unit is less than what a consumer is willing to pay for that unit. How do we know this won’t be true under a profit maximizing monopolist? How would we see this graphically?

14 Monopoly and Efficiency What would happen if a monopolist could charge different prices to different consumers? How much would it supply? What would happen regarding efficiency? Is this possible?

15 Monopoly and Efficiency Price Discrimination – charging different prices to different consumers. Examples? For a firm to effectively price discriminate: Groups must have different demand elasticities. It must be possible to determine which group a given customer belongs to at a low cost. It must be difficult for consumer to resell the good in question. Can increase efficiency, but what happens to consumer surplus?

16 Taxing a Monopolist What if government imposes a tax on monopolist equal to $t/unit sold. Will this somehow increase efficiency? Consider again monopolist with Cost function given by C(q) = q 2 + 8q + 20 and Market Demand Curve of Q D (p) = 400 – 5p (inverse market demand curve of p(Q) = 80 – Q/5) So (from before) we know MC(q) = 2Q + 8 and MR(Q) = 80 – 2Q/5 Therefore, without tax, Q = 30 and p = 74 What will change with tax of t = $12? Graphically?

17 Entry If a monopolist is making all these economic profits, can this monopoly be maintained? Entry constrained by law (patents, patronage/political favors) Natural Monopoly - firm’s technology has economies-of-scale large enough for it to supply the whole market at a lower average cost than is possible with more than one firm in the market. Essentially very high fixed costs of entry. Examples?

18 Monopoly Policy Under natural monopoly it is best for one firm to supply whole market. To prevent inefficiencies of monopoly, there are a couple of strategies. Have government run/regulate industry. Problems? Break-up monopolist Problems? Block mergers that could allow monopolies to form in the first place. Problems?