Chapter 10 Challenge To Market Effectiveness 1: Monopolies McGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2 Learning Objectives What is monopoly? What are the barriers to entry? How is the demand curve for a monopoly? How does a monopoly decide quantity of output to produce? What are the social costs of monopoly? What is price discrimination? 10-2

3 Monopoly A pure monopoly is a firm without any competition. Pure monopolies do not exist in the real world. The fewer the substitutes there are for a firm’s products, the more monopolistic the firm is. A monopolist can earn long term profits if it keeps other firms from entering its market. Entry barriers stop firms from entering a market and destroying monopoly profits. 10-3

4 Barriers To Entry The Government: Licenses: By limiting entry licenses allow members of protected professions to earn monopoly profits, e.g. teachers, lawyers. Outlawing competition: Government can outlaw competition to a monopolist e.g. U.S. post office. State religion: Government can create religious monopolies. 10-4

5 Barriers To Entry Unions: Unions are organization of workers. Unions engage in collective bargaining with employers. Control of a vital resource: Firms can maintain a monopoly by controlling a vital resource, e.g. silk in ancient China, alum in Ottoman empire. 10-5

6 Barriers To Entry Incompatibility: By making its products incompatible with the complementary goods of its rival, a firm can create and maintain its monopoly. Software: Incompatibility-based barriers to entry are a prime source of Microsoft’s riches. Sports leagues: Incompatibility provides a strong barrier to entry, protecting all professional sports leagues. 10-6

7 Barriers To Entry Economies of scale: If in an industry average total costs decrease as output increases, then a new firm’s costs are extremely high compared to the monopolist’s costs. In industries with significant economies of scale, it is difficult for a new firm to challenge a monopoly. Monopolies based on economies of scale are called “natural monopolies,” e.g. utility companies. 10-7

8 Barriers To Entry Intellectual property: Owning intellectual property gives legal right to demand payment from all who would use that property. Copyrights: No one but the copyright’s holder can legally sell the copyright-protected work. Patents: A patent gives one exclusive right to sell the invention. Patents confer a benefit on innovators proportional to the social benefits of their innovation. 10-8

9 Monopolist Pricing A monopolist can set its own price. The Law of Demand constraints a monopolist’s price-setting powers. If a monopolist wants to increase sales, it must lower its price. Unlike a firm in perfect competition, monopolist’s output influences the market price. 10-9

10 Marginal Revenue and Monopolist Pricing Marginal Revenue = The increase in total revenue a firm receives by selling one more good. For a competitive firm: Marginal Revenue = Price For a monopolist: Marginal Revenue Price 10-10

11 Marginal Revenue and Monopolist Pricing CustomerMost Willing to Pay Total RevenueMarginal Revenue A$100 B$90$90X2 = $180$180-$100 = $80 C$80$80X3 = $240$240-$180 = $60 D$70$70X4 = $280$280-$240 = $40 E$60$60X5 = $300$300-$280 = $20 F$50$50X6 = $300$300-$300 = $0 G$40$40X7 = $280$280-$300 = -$20 H$1$1X8 = $8$8-$280 = -$

12 Monopolist’s Profit Maximization If Marginal Revenue > Marginal Cost, Profits will increase by producing more. If Marginal Revenue < Marginal Cost, Profits will increase by producing less. Profits are maximum when Marginal Revenue = Marginal Cost. This intersection between marginal revenue and marginal cost determines the monopolist’s optimal price and quantity. Marginal Cost Demand Quantity Price Marginal Revenue $14 $8 100 The output the monopolist will choose. The price the monopolist will choose

13 The Social Cost of Monopolies Monopolists do not produce at the lowest possible average total cost. Monopolies usually produce output below the level that maximizes the wealth of society

14 Deadweight Loss of Monopoly Price Quantity Marginal Cost Demand $ A monopolist will produce until Marginal cost = marginal revenue. The wealth maximizing level of output is where Marginal cost = demand. Adam Smith’s invisible hand breaks down. CS PS Marginal Revenue $ If the monopolist produces 150 units. The monopolist will not produce this much output. D 10-14

15 Ways to Reduce Deadweight Loss Competition Price discrimination Antitrust laws 10-15

16 Competition and Deadweight Loss of Monopoly Competition lowers prices and expands output, thereby reducing deadweight loss. For example: U.S. post office and fax, , FedEx. Microsoft and Linux. Cable television and satellite television. De Beers’ diamonds and artificial diamonds. Even the mere threat of potential competition can induce a monopolist to expand output and reduce deadweight loss

17 Price Discrimination Price discrimination occurs when a firm charges separate customers different prices. With price discrimination, a firm can charge its old customers high prices, but still attract new customers by selling to them at lower prices. For economists, price discrimination is beneficial because it increases the wealth of society

18 Price Discrimination Perfect price discrimination: The monopolist charges every customer the maximum they are willing to pay. The total consumer surplus becomes zero. The deadweight loss of monopoly is completely eliminated. Imperfect price discrimination: Monopolists separate customers into groups and then charge separate groups different price. The deadweight loss of monopoly is reduced but not completely eliminated, e.g. student discounts, financial aid, airline tickets

19 Price Discrimination To profitably price discriminate for and against different groups, a monopolist must overcome three challenges: It must determine the value each group places on the monopolist’s product. It must figure out how to sell to separate groups at different prices. It must prevent customers who paid a low price from reselling the good to those customers who paid a high price. Self selection of customers: Firms induce different groups of consumers to take different visible actions. By inducing customers to voluntarily self-select into separate groups, firms can price discriminate e.g. coupons, airline tickets

20 Antitrust Laws Antitrust laws regulate, restrict and punish monopolies. Antitrust laws rely on the government, not the market, to reduce the harm on monopolies. Coming up in Chapter

21 Innovation and Monopoly Because it does not have to share its benefits, a monopolist gets great monetary rewards from innovation. Hence, monopolies encourage innovations. However, strong entry barriers protect a monopoly even without innovation. A monopolist’s employees may not have incentives to work hard to innovate

22 Do You Know? How can economies of scale create barriers to entry? Economies of scale means average total costs decrease as output increases. Since its costs are extremely high compared to the monopolist’s costs, it is difficult for a new firm to challenge a monopoly. Why must a monopolist who can’t price discriminate give a discount to old customers if it wants to sell to new customers? The Law of Demand constraints a monopolist’s price- setting powers. As consumers buy more only at lower price monopolist must lower its price to increase sales

23 Do You Know? How can price discrimination reduce the deadweight loss of a monopolist? A monopolist creates deadweight loss by producing less output. Price discrimination allows a monopolist to charge different prices to different consumers to produce and sell more output. Why are coupons a form of price discrimination? Coupons induce consumers to self-select into two groups: price-sensitive and price-insensitive. Coupons allow price-sensitive consumers to trade time for money

24 Summary A pure monopoly is a firm without any competition. The fewer the substitutes there are for a firm’s products, the more monopolistic the firm is. Entry barriers stop firms from entering a market and destroying monopoly profits such as government regulations, unions, control of vital resource, incompatibility, economies of scale and intellectual property. If a monopolist wants to increase sales, it must lower its price. Monopolist’s profits are maximum when marginal revenue = marginal cost

25 Summary Monopolies usually produce output below the level that maximizes the wealth of society and creates deadweight loss. Competition, price discrimination and antitrust laws can reduce the social cost of monopolies. Price discrimination occurs when a firm charges separate customers different prices. Price discrimination is beneficial because it increases the wealth of society

26 Coming Up What is the other challenge to market effectiveness? 10-26