Chapter 25 Monopoly

2 Learning Objectives  Identify situations that can give rise to monopoly  Describe the demand and marginal revenue conditions a monopolist faces  Discuss how a monopolist determines how much output to produce and what price to charge  Evaluate the profits earned by a monopolist  Understand price discrimination  Explain the social cost of monopolies

3 Did You Know That...  A monopoly can arise whenever sellers are given exclusive rights to distribute a good?

4 Definition of a Monopolist  Monopolist –A single supplier of a good or service for which there is no close substitute –The monopolist therefore constitutes the entire industry.

5 Barriers to Entry  Question –How does a firm obtain monopoly power?  Answers –Barriers to entry that allow the firm to make long-run economic profits –Barriers to entry are restrictions on who can start as well as stay in business.

6 Barriers to Entry  Barriers to entry include –Ownership of resources without close substitutes –Economies of scale –Legal or governmental restrictions

7 Barriers to Entry  Ownership of resources without close substitutes

8 Barriers to Entry  Economies of scale –Low unit costs and prices drive out rivals. –The largest firm can produce at the lowest average total cost.

9 The Cost Curves That Might Lead to a Natural Monopoly

10 Barriers to Entry  Legal or governmental restrictions –Licenses, franchises, and certificates of convenience –Examples include Electrical utilities Radio and television broadcasting

11 International Policy Example: Malaysia’s Drug-Labeling Monopoly  Sellers of drugs and medical products are required to affix holographic labels providing information on usage.  To obtain these labels, sellers have only one choice. They must buy the labels from a company called Mediharta.  This company is the only label manufacturer that Malaysia’s Registrar of Companies has approved to produce holographic labels.

12 Barriers to Entry  Legal or governmental restrictions –Patents Intellectual property –Tariffs Taxes on imported goods –Regulation Safety and quality

13 Barriers to Entry  Cartels –An association of producers in an industry that agree to set common prices and output quotas to prevent competition

14 The Demand Curve a Monopolist Faces  The monopolist faces the industry demand curve because the monopolist is the entire industry.

15  Recall that under perfect competition –Firm faces perfectly elastic demand curve, it is a price taker –The forces of supply and demand establish the price per unit –Marginal revenue, average revenue, and price are all the same The Demand Curve a Monopolist Faces

16 The Demand Curve a Monopolist Faces  Perfect competition versus monopoly –The perfect competitor doesn’t have to worry about lowering price to sell more. –In a purely competitive situation, the firm accounts for a small part of the market. It can sell its entire output, whatever that may be, at the same price.

17 The Demand Curve a Monopolist Faces  Perfect competition versus monopoly –The more the monopolist wants to sell, the lower the price it has to charge on the last unit sold. –To sell the last unit, the monopolist has to lower the price because it is facing a downward sloping demand curve.

18 Demand Curves for the Perfect Competitor and the Monopolist

19 MonopolyPerfect Competition Single seller Faces entire industry demand Must lower price to sell more Not all units sold for same price (MR < P) Many sellers Faces perfectly elastic demand Must produce more to sell more All units sold for same price (P = MR) The Demand Curve a Monopolist Faces

20 Marginal Revenue: Always Less Than Price

21 Elasticity and Monopoly  The monopolist faces a downward-sloping demand curve, and cannot charge any price. –A common misconception  Thus, depending on the price charged a different quantity will be demanded.

22 Elasticity and Monopoly  Recall –Monopolist is a single seller of a well-defined good or service with no close substitute. Think of some imperfect substitutes. –The demand curve slopes downward because individuals compare marginal satisfaction to cost.

23 Elasticity and Monopoly  After all, consumers have limited incomes and unlimited wants.

24 Cost and Monopoly Profit Maximization  We presume profit maximization is the goal of the pure monopolist, just as it is for the prefect competitor.

25 Cost and Monopoly Profit Maximization  Perfect competitor has only to decide on the profit-maximizing output rate because price is given. –The perfect competitor is a price taker.  For the pure monopolist, we must seek a profit-maximizing price output combination. –The monopolist is a price searcher.

26 Cost and Monopoly Profit Maximization  Price Searcher –A firm that must determine the price-output combination that maximizes profit because it faces a downward-sloping demand curve

27 Cost and Monopoly Profit Maximization  We can determine the profit-maximizing price-output combination with either of two equivalent approaches. –By looking at total revenues and total costs or by looking at marginal revenues and marginal costs

28 Cost and Monopoly Profit Maximization  Total revenues-total costs approach –Maximize the positive difference between total revenues and total costs  Marginal revenue-marginal cost approach –Profit maximization will also occur where marginal revenue equals marginal cost.

29 Cost and Monopoly Profit Maximization  Question –Why produce where marginal revenue equals marginal cost?  Answer –This is where the greatest positive difference between total revenue and total cost occurs.

30 Monopoly Costs, Revenues, and Profits

31 Monopoly Costs, Revenues, and Profits

32 Cost and Monopoly Profit Maximization  Producing past where MR = MC –Incremental cost exceeds incremental revenue  Producing less than where MR = MC –Monopolist not maximizing profits here either

33 Maximizing Profits

34 Calculating Monopoly Profit  Monopoly profit is given by the shaded area, which is equal to total revenues (P  Q) minus total costs (ATC  Q).

35 Monopoly Profit

36 Calculating Monopoly Profit  No guarantee of profit –The term monopoly conjures up the notion of a greedy firm ripping off the public. If ATC is everywhere above AR, or demand  No price-output combination allows the monopolist to cover costs

37 Monopolies: Not Always Profitable

38 On Making Higher Profits: Price Discrimination  Price Discrimination –Selling a given product at more than one price, with the difference being unrelated to differences in cost

39 On Making Higher Profits: Price Discrimination  Price Differentiation –Establishing different prices for similar products to reflect differences in marginal cost in providing those commodities to different groups of buyers

40 On Making Higher Profits: Price Discrimination  Necessary conditions for price discrimination 1.The firm must face a downward-sloping demand curve. 2.The firm must be able to readily (and cheaply) identify buyers or groups of buyers with predictably different elasticities of demand. 3.The firm must be able to prevent resale of the product or service.

41 Example: Why Students Pay Different Prices to Attend College  Out-of-pocket tuition rates for any two college students can differ by considerable amounts.  The reason is that colleges offer students diverse financial aid packages depending on their “financial need.”  The college determines prices that families are most likely to pay, so that it can engage in price discrimination.

42 Toward Perfect Price Discrimination in College Tuition Rates

43 The Social Cost of Monopolies  Comparing monopoly with perfect competition –Let’s assume a monopolist comes in and buys up every single perfect competitor. –Notice the monopolist produces a smaller quantity and sells at a higher price.

44 The Social Cost of Monopolies  Comparing monopoly with perfect competition –Monopolists raise the price and restrict production compared to a perfectly competitive situation. –Consumers pay a price that exceeds the marginal cost of production and resources are misallocated in such a situation.

45 The Effects of Monopolizing an Industry

46 Issues and Applications: For This Monopoly Location is the Key  A resource with literally few close substitutes is the Ambassador Bridge.  Price searching for the profit-maximizing toll rates have boosted profits.  Total revenues in excess of $60 million have been generated per year.  Estimates of the market value of the bridge value it in excess of half a billion dollars.

47 Summary Discussion of Learning Objectives  Why a monopoly can occur –Barriers to entry  Demand and marginal revenue conditions faced by a monopolist –Because the monopolist constitutes the entire industry, it faces the entire market demand curve. –Marginal revenue is less than price.

48 Summary Discussion of Learning Objectives  How a monopolist determines how much output to produce and what price to charge –Seeks to maximize its economic profits –Produces where marginal revenue equals marginal cost –Charges maximum price for the amount of output where MR = MC

49 Summary Discussion of Learning Objectives  A monopolist’s profits –Profit earned by monopolist is equal to the difference between the price it charges and its average production cost times the amount of output it produces and sells. –Monopolist typically earns positive economic profits.

50 Summary Discussion of Learning Objectives  Price discrimination –Selling at more than one price with the price differences being unrelated to differences in production costs. –Monopolist sells some of its output at higher prices to consumers with less elastic demand.

51 Summary Discussion of Learning Objectives  Social cost of monopolies –Price exceeds marginal cost. –The price is higher and output is lower for a monopolist as compared to a perfectly competitive industry.