MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Last word on invisible hand… There are some important projects that need to be up and running starting like yesterday, because they are key to human survival. Unfortunately, they cannot be funded in the usual ways because of the warped nature of market economics and global finance, which dictates that the only goal of investing money is to make more money. The project of averting disastrous outcomes is not a money-maker, per se, and does not get funded. But shipping in millions of plastic orange Halloween pumpkins from China every year is a sure bet, and so the free market prioritizes orange plastic pumpkins above doing what is essential to keep us all alive. The invisible hand of the free market, it turns out, is attached to an invisible idiot. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 1

MBMC Monopoly and imperfect competition

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 3 Imperfect Competition Imperfectly Competitive Firms Have some control over price Price may be greater than the marginal cost of production Long-run economic profits are possible Reduce economic surplus to varying degrees Are very common

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 4 Forms of Imperfect Competition Pure Monopoly (most inefficient) The only supplier of a unique product with no close substitutes  Patents=monopoly This is the one we’ll pay most attention to

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 5 Forms of imperfect Competition Oligopoly (theoretically more efficient than a monopoly) A firm that produces a product for which only a few rival firms produce close substitutes Many major economic sectors  Food, media, banking, energy, garbage, pharmaceuticals, electricity, water, hospitals, etc. Collusion is a big problem  Oil, Electricity, Vitamins, potash, Archer- Daniels Midland

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 6 Forms of imperfect Competition Monopolistic Competition (closest to perfect competition) A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another E.g. cigarettes

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 7 Imperfect Competition The Essential Difference Between Perfectly and Imperfectly Competitive Firms The perfectly competitive firm faces a perfectly elastic demand for its product. The imperfectly competitive firm faces a downward-sloping demand curve.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 8 Imperfect Competition In perfect competition Supply and demand determine equilibrium price. The firm has no market power. At the equilibrium price, the firm sells all it wishes. If the firm raises its price, sales will be zero. The firm’s demand curve is the horizontal line at the market price.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 9 Imperfect Competition With imperfect competition The firm has some control over price or some market power. In order to sell more, the firm must lower its price  Lower P x higher Q The firm faces a downward sloping demand curve.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 10 The Demand Curves Facing Perfectly and Imperfectly Competitive Firms Quantity $/unit of output Quantity D Market price Price D Perfectly competitive firmImperfectly competitive firm

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 11 Five Major Sources of Market Power Market power = barriers to entry Exclusive control over inputs Patents and copyrights Government licenses or franchises Economies of scale (natural monopolies) Networked economies

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 12 Economies of Scale and the Importance of Fixed Costs Natural Monopolies: Firms with large fixed costs and low variable costs e.g. telephones, electric utilities, sewage, pharmaceuticals, INFORMATION, etc. Have low marginal costs Average total cost declines sharply as output increases Economies of scale will exist

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 13 Total and Average Total Costs for a Production Process with Economies of Scale Average cost ($/unit) Quantity Total cost ($/year) Quantity F Q0Q0 F + Q 0 TC = F + MQ Total cost rises at a constant rate as output rises ATC = F/Q + M M Average costs decline and is always higher than marginal cost

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 14 Costs for Computers (Hardware+software): Scenario 1 Early Mac Early PC Annual production 1,000,000 1,200,000 Fixed cost $2,000,000 $2,000,000 Variable cost $8,000,000 $9,600,000 Total cost $10,000,000 $11,600,000 Average total cost per system $10.00 $9.70 Observations Fixed costs are a relatively small share of total cost Variable costs are identical Cost/system is nearly the same

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 15 Costs for for Computers (Hardware+software): Scenario 2

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 16 Costs for for Computers: scenario 2 after time passes

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 17 Economies of Scale and the Importance of Fixed Costs Fixed investment in research and development has been increasing as a share of production costs %80% %20% Cost of producing a computer Fixed CostVariable Cost SoftwareHardware

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 18 Profit Maximization for the Monopolist A price taker (perfect competition) and a price setter (imperfect competition) share two economic goals. They want To maximize profits To select the output level that maximizes the difference between TR and TC, where MB= MC.

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 19 Profit Maximization for the Monopolist For any producer MB = Marginal Revenue (MR) or a change in a firm’s total revenue that results from a one-unit change in output Increase output when MR > MC. For competitive producer MR=P For a monopolist MR<P

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 20 The Monopolist’s Benefit from Selling an Additional Unit Price ($/unit) Quantity (units/week) D If P = $6, then TR = $6 x 2 = $12 If P = $5, then TR = $5 x 3 = $15 The MR of selling the 3 rd unit = $3 (15-12) For the 3 rd unit, MR = $3 < P = $5

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 21 Observations MR < P MR declines as quantity increases MR is the change between two quantities MR < P because price must be lowered to sell an additional unit PQTRMR 3 1 Marginal Revenue

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 22 Price & marginal revenue ($/unit) Quantity (units/week) PQTRMR D Marginal Revenue in Graphical Form MR

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 23 Profit Maximization for the Monopolist Profit Maximizing Decision Rule When MR > MC, output should be increased. When MR < MC, output should be reduced. Profits are maximized at the level of output for which MR = MC. What’s the marginal revenue for a competitive firm?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 24 The Monopolist’s Profit- Maximizing Output Level Price ($/unit of output) Quantity (units/week) 6 D Marginal Cost 2 4 MR 8 Observations If P = $3 & Q = 12 MR < MC and output should be reduced Profits are maximized at 8 units where MR = MC P = $4 where quantity demanded = quantity supplied

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide MR 8 Because MR < P, the monopoly produces less than the socially optimal amount The deadweight loss of the monopoly to society = (1/2)($2/unit)(4units/wk) = $4/wk. Deadweight loss The Demand and Marginal Cost Curves for a Monopolist Price ($/unit of output) Quantity (units/week) D Why the Invisible Hand Breaks Down Under Monopoly 3 Marginal cost

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 26 Why the Invisible Hand Breaks Down Under Monopoly Monopoly Profits are maximized where MR = MC. P > MR P > MC Deadweight loss Perfect Competition Profits are maximized where MR = MC. P = MR P = MC No deadweight loss

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 27 Difficulties in Reducing the Deadweight Loss of Monopolies Enforcing antitrust laws  Growing concentration in food, media, energy, pharmaceuticals, etc. Patents, copyrights, and innovation Natural monopolies Why the Invisible Hand Breaks Down Under Monopoly

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 28 The practice of charging different buyers different prices for essentially the same good or service E.g. textbooks, medicine, movies, ski resorts  What about re-importing medicine? Theoretically maximizes economic surplus, but reduces consumer surplus to zero Price Discrimination

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 29 Public Policy Toward Natural Monopoly Methods of Controlling Natural Monopolies State ownership/provision and management  Weighing the benefit of marginal cost pricing versus the cost of less incentive for innovation  Is it true that there is less incentive for innovation? WWII, VEIC  In a democracy, politicians have to provide public services and keep taxes low to get re- elected

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 30 Methods of Controlling Natural Monopolies State regulation of private monopolies Cost-plus regulation  High administrative cost  Less incentive for innovation  P does not equate to MC

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 31 Methods of Controlling Natural Monopolies Exclusive contracting for natural monopoly Competition for the contract theoretically sets P = MC Example of water in Buenos Aires Difficulty when fixed costs are high No incentive to maintain infrastructure when contract nears termination

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 32 Methods of Controlling Natural Monopolies Vigorous enforcement of anti-trust laws? Helps prevent cartels May prevent economies of scale