Chapter 17 Monopoly McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics Market power Monopoly pricing Welfare effects of monopoly pricing Distinguishing monopoly from perfect competition Monopsony – Basics Only 17-2

Market Power In many situations, competition is not intense A firm has market power when it can profitably charge a price that is above its marginal cost Most firms have some market power, though it may be very slight Depends on whether their competitors’ products are close substitutes. Two market structures in which firms have market power: A monopoly market has a single seller An oligopoly market has a few, but not many, producers Determining what is and is not a monopoly market can be trickier than simple definitions might suggest 17-3

How Do Firms Become Monopolists? Firms get to be monopolists in various ways: Government grants a monopoly position to a firm (cable TV companies in local communities, drug patents) Economies of scale (concrete supply in a small town) Being first to produce a new product (iPod) Owning/controlling all of an essential input (De Beers diamond producer) Natural Monopolies Many of these ways of initially capturing market power tend to erode over time 17-4

Figure 17.1: Scale Economies and Monopoly Monopolist can make a profit because AC lies below the demand curve at some quantities Two firms cannot make positive profits AC lies above D half for all quantities Also think about natural monopolies! 17-5

Monopoly Pricing Monopolist will choose the price that maximizes its profit, given the demand for its product Whenever the firm’s profit-maximizing sales quantity is positive, marginal revenue equals marginal cost at that sales quantity Marginal cost curve applies as usual Need to examine the shape of the marginal revenue curve (downward sloping) Recall that a firm’s marginal revenue curve captures the additional revenue it gets from the marginal units it sells, measured on a per-unit basis 17-6

Figure 17.4: Monopoly Profit Maximization 17-7

Marginal Revenue for a Monopolist An increase in sales quantity (  Q) changes revenue in two ways Firm sells  Q additional units of output, each at a price of P(Q), the output expansion effect Firm also has to lower price as dictated by the demand curve; reduces revenue earned from the original (Q-  Q) units of output, the price reduction effect The overall effect on marginal revenue is: So the price reduction effect makes the monopolist’s marginal revenue less than price 17-8

Figure 17.2: Marginal Revenue and Price 17-9

Monopoly Profit Maximization When a monopolist maximizes its profit by selling a positive amount, its marginal revenue must equal its marginal cost at that quantity If marginal revenue exceeded marginal cost the firm would be better off selling more If marginal revenue were less than marginal cost the firm would be better off selling less Two-step procedure for finding the profit-maximizing sales quantity Step 1: Quantity Rule Identify positive sales quantities at which MR=MC If more than one, find one with highest profit Step 2: Shut-Down Rule Check whether the quantity from Step 1 yields higher profit than shutting down 17-10

Figure 17.4: Monopoly Profit Maximization 17-11

Markup A monopolist facing a downward sloping demand curve will set its price above marginal cost Firm in a perfectly competitive market sets price equal to marginal cost, meaning that the firm has no market power Extent to which price exceeds marginal cost is a measure of monopolist’s market power A firm’s markup, price-cost margin, or Lerner index equals the difference between its price and its marginal cost, as a percentage of its price 17-12

Markup The less elastic the demand curve, the greater the firm’s markup over its marginal cost When demand is less elastic, raising the price is more attractive because fewer sales are lost This also implies that demand must be elastic at the profit-maximizing price Remember, on a normal demand curve, some points are inelastic and others are more elastic. If a point is inelastic, we can still raise up the price more before we are loosing too many sales. So, we will raise (theoretically) until we hit an elastic point

Welfare Effects of Monopoly Pricing By charging a price above marginal cost, the monopolist makes consumers worse off than under perfect competition Consumers who buy the product pay more for it Some who would have bought it under perfect competition will not buy it at the higher price Welfare effects of monopoly pricing: Firm gains Consumers lose Deadweight loss incurred Deadweight loss from monopoly pricing is the amount by which aggregate surplus falls short of its maximum possible level, which is attained in a competitive market 17-14

Figure 17.5: Welfare Effects of Monopoly Pricing 17-15

Distinguishing Monopoly from Perfect Competition Existence of more than one firm in a market does not guarantee perfect competition How can we tell whether multiple firms in a market are behaving like price takers or colluding and acting like a monopoly? Easy to answer if we could observe marginal costs and compare to price Monopolists and perfectly competitive industries behave differently in responses to changes in demand and changes in costs 17-16

Response to Changes in Demand Monopolist’s profit-maximizing price depends on elasticity of demand Price in perfectly competitive market depends on level of demand If elasticity of demand changes but level of demand does not, provides a way to distinguish between market structures Can investigate this through data collection over time and statistical analysis 17-17

Figure 17.7: Response to a Change in Demand 17-18

Response to Changes in Cost How do monopolies and perfectly competitive markets differ in their response to changes in costs? Consider the case of a marginal cost increase by a given amount at every level of output Example: a specific tax, T, on firms The pass-through rate is the increase in price that occurs in response to a small increase in marginal cost, measured per dollar of increase in marginal cost In a competitive market, the pass-through rate is never greater than one The monopolist’s pass-through rate depends on the shape of the demand curve Can be greater than one with a constant-elasticity demand curve 17-19

Monopsony Market power isn’t limited to the sellers of a product: it also can be held by buyers A monopsony market has a single buyer Examples? Analysis of monopsony parallels the analysis of monopoly A monopsonist faces an upward-sloping supply curve By lowering the quantity he buys, can pay less Monopsonist can think either in terms of what price to pay or in terms of how many units to employ 17-20

Welfare Effects of Monopsony Pricing Like with a monopoly, monopsony price setting creates deadweight loss Monopsonist uses too little of the input Potential net benefits from the input are lost Deadweight loss is created between the marginal benefit and market supply curves 17-21

What Should We Do…. Resolution approaches: Natural Monopolies 1 st Best vs. 2 nd Best Regulation Govt. Ownership Break up Do Nothing! Issues…