Monopoly 1

FOUR MARKET STRUCTURES Perfect Competition Monopolistic Competition Pure Monopoly Oligopoly Characteristics of a Monopoly: Single Seller One firm dominates the market The firm IS the industry 2. Unique good with no close substitutes 3. The Firm is a “Price Maker” Because it has no competitors, the firm can decide what price to charge 2

5 Characteristics of Monopoly 4. High Barriers to Entry New firms can’t easily enter market No immediate competitors Firm CAN make economic profit in the long-run 5. Some “Nonprice” Competition Despite having no close competitors, monopolies still advertise their products in an effort to increase demand 3

Real World Examples 1. Public utilities e.g. natural gas, water, cable, telephone companies, internet service providers In industries like these, firms have very high fixed costs and relatively low variable costs Having several firms provide the same product might actually reduce efficiency by raising costs These are sometimes called natural monopolies

Real World Examples 2. Patents A patent is a license issued by the government which gives an inventor the exclusive right to sell a product s/he invented A patent protects the inventor from rivals who didn’t share in the costs of developing the invention The idea is to encourage people to spend time and effort developing new products

Real World Examples 3. Awesome Companies Sometimes a firm simply becomes so good at what it does that it gains a very large market share e.g. Intel provides 80% of central microprocessors used in PC 90% of internet searches are done on Google

4. Control of Key Resources Real World Examples 4. Control of Key Resources If one firm controls most or all of the available resources in the production of the good or service, it will become difficult or impossible for other firms to compete with it E.g. De Beers Diamond Corporation

Review How many firms are there in a monopoly? True/False: A monopolist is a price taker (it cannot choose where to set the price) What is a natural monopoly? What is a patent? What is DeBeers?

Graphing Monopolies 9

Good news… Only one graph because the firm IS the industry. The cost curves are the same The MR= MC rule still applies 10

The Main Difference Monopolies (and all Imperfectly competitive firms) face a downward sloping demand curve for their products To sell more, a firm must lower its price This changes marginal revenue… Marginal Revenue doesn’t equal Price! 11

NO NO

My Dad is DEAD?!!!?!!!!

Nooooooooooooooooooooooooooooooooooooooo!!!!!

Why is MR ≠ D? P Qd TR MR $11 - 16

Why is MR ≠ D? P Qd TR MR $11 - $10 1 10 $10 17

Why is MR ≠ D? P Qd TR MR $11 - $10 1 10 $9 2 18 8 $10 $9 $9 18

Why is MR ≠ D? $10 $9 $9 $8 $8 $8 P Qd TR MR $11 - $10 1 10 $9 2 18 8 - $10 1 10 $9 2 18 8 $8 3 24 6 $10 $9 $9 $8 $8 $8 19

Why is MR ≠ D? $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 P Qd TR MR $11 - $10 1 - $10 1 10 $9 2 18 8 $8 3 24 6 $7 4 28 $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 20

Why is MR ≠ D? $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 $6 $6 $6 $6 $6 P Qd TR $11 - $10 1 10 $9 2 18 8 $8 3 24 6 $7 4 28 $6 5 30 $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 $6 $6 $6 $6 $6 21

Why is MR ≠ D? $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 $6 $6 $6 $6 $6 $5 $5 $5 P Qd TR MR $11 - $10 1 10 $9 2 18 8 $8 3 24 6 $7 4 28 $6 5 30 $5 $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 $6 $6 $6 $6 $6 $5 $5 $5 $5 $5 $5 22

Why is MR ≠ D? $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 $6 $6 $6 $6 $6 $5 $5 $5 P Qd TR MR $11 - $10 1 10 $9 2 18 8 $8 3 24 6 $7 4 28 $6 5 30 $5 $4 7 -2 $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 $6 $6 $6 $6 $6 $5 $5 $5 $5 $5 $5 $4 $4 $4 $4 $4 $4 $4 23

Why is MR ≠ D? $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 $6 $6 $6 $6 $6 $5 $5 $5 P Qd TR MR $11 - $10 1 10 $9 2 18 8 $8 3 24 6 $7 4 28 $6 5 30 $5 $4 7 -2 $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 $6 $6 $6 $6 $6 $5 $5 $5 $5 $5 $5 $4 $4 $4 $4 $4 $4 $4 24

MR IS LESS THAN PRICE Why is MR ≠ D? $10 $9 $9 $8 $8 $8 $7 $7 $7 $7 $6 Qd TR MR $11 - $10 1 10 $9 2 18 8 $8 3 24 6 $7 4 28 $6 5 30 $5 $4 7 -2 $10 $9 $9 MR IS LESS THAN PRICE $8 $8 $8 $7 $7 $7 $7 $6 $6 $6 $6 $6 $5 $5 $5 $5 $5 $5 $4 $4 $4 $4 $4 $4 $4 25

Maximizing Profit 26

6 How much output will the firm produce?____________ What price will it charge?____________ How much is its total revenue?_____________ How much is its total cost?_______________ How much profit/loss?__________________ $7 $42 $36 $9 8 7 6 5 4 3 2 $6 A monopolist produces where MR=MC, buts charges the price consumers are willing to pay identified by the demand curve P MC ATC Profit =$6 D TC=$36 TR=$42 MR Q 1 2 3 4 5 6 7 8 9 10 27

6 How much output will the firm produce?____________ What price will it charge?____________ How much is its total revenue?_____________ How much is its total cost?_______________ How much profit/loss?__________________ $9 $54 $42 $12 P MC ATC 10 9 8 7 6 D 5 MR 0 4 6 8 9 10 Q 28

What if costs are higher? How much is the TR, TC, and Profit or Loss? MC $10 9 8 7 6 5 4 3 P ATC AVC D TR= TC= Loss= $90 $100 MR $10 Q 6 7 8 9 10 29

How much output will the firm produce?____________ What price will it charge?____________ How much is its total revenue?_____________ How much is its total cost?_______________ How much profit/loss?__________________ 7 $10 $70 $56 $14 P $10 9 8 7 6 5 4 MC ATC D MR 1 2 3 4 5 6 7 8 9 10 Q 30

Are Monopolies Efficient? 31

Perfect Competition S = MC P In perfect competition, the sum of consumer and producer surplus is maximized consumer surplus (CS) Ppc producer surplus (PS) D Q Qpc (perfect competition) 32

Monopoly S = MC P Pm Ppc D MR Q Qm Qpc Because MR is below D, a monopolist’s profit-maximizing quantity (MR=MC) is lower Pm Ppc D MR Q Qm Qpc 33

Where is CS and PS for a monopoly? Now there is DEADWEIGHT LOSS S = MC P CS Total surplus falls. Now there is DEADWEIGHT LOSS Pm PS Compared to Perfectly Competitive Markets, Monopolies Produce Less and Charge More, Resulting in a Deadweight Loss to Society D MR Q Qm 34

Are Monopolies Productively Efficient? No. The monopoly does not produce at the lowest cost (min ATC) Does Q = Min ATC? $9 8 7 6 5 4 3 2 MC ATC D MR 1 2 3 4 5 6 7 8 9 10 Q 35

Monopolies are NOT efficient! Are Monopolies Allocatively Efficient? No. Price is greater. The monopoly is underproducing. Does Price = MC? $9 8 7 6 5 4 3 2 P MC ATC Monopolies are NOT efficient! D MR 1 2 3 4 5 6 7 8 9 10 Q 36

They don’t have to because they have no competitors! Monopolies are inefficient because they… Overcharge Underproduce Not allocatively efficient Produce at higher costs Not productively efficient Have little incentive to innovate Why not? They don’t have to because they have no competitors! 37

Regulating Monopolies 38

Regulating Monopolies There are two major ways that governments deal with monopolies: Break ‘em up! – this is called antitrust law 2. Restrict how much the monopolist can charge or force them to produce a certain quantity This is the one case where a price ceiling might actually improve economic efficiency 39

Antitrust Law Sherman Anti-Trust Act of 1890 The first federal statute to restrict monopolies Authorized the federal government to investigate and break up large companies Clayton Anti-Trust Act of 1914 Added further regulations to the Sherman Anti-Trust law by seeking to prevent anti competitive practices

Price Ceilings Where might the government place a price ceiling to promote efficiency?

Monopoly Price Ceiling Where does the firm produce if it is unregulated? P MC Pm ATC D MR Q Qm 42

Monopoly Price Ceiling Price Ceiling at Socially Optimal Socially Optimal = Allocative Efficiency P MC Pm ATC Pso D MR Q Qm Qso 43

Monopoly Price Ceiling Price Ceiling at Fair Return Fair Return means no economic profit P MC Pm ATC Pso Pfr D MR Q Qm Qso Qfr 44

Monopoly Price Ceiling Unregulated Socially Optimal P MC Fair Return Pm ATC Pso Pfr D MR Q Qm Qso Qfr 45

Monopolistic Competition

Characteristics of Monopolistic Competition: Perfect Competition Monopolistic Competition Monopolistic Competition Pure Monopoly Pure Monopoly Oligopoly Oligopoly Characteristics of Monopolistic Competition: Relatively Large Number of Sellers Differentiated Products Some control over price Easy Entry and Exit (Low Barriers) A lot of non-price competition (Advertising)

Differentiated Products 48

Examples: Almost everything

“Monopoly” + ”Competition” Monopolistic Qualities Control over price of own good due to differentiated product D greater than MR Plenty of Advertising Not efficient Perfect Competition Qualities Large number of smaller firms Relatively easy entry and exit Zero Economic Profit in Long-Run since firms can enter

Differentiated Products Products are NOT identical. Each firm seeks to capture a piece of the market by making its product unique in some way Since these products have substitutes, firms use NON-PRICE Competition. Examples of NON-PRICE Competition Branding Unique Product Attributes Advertising (Two Goals) 1. Increase Demand 2. Make demand more INELASTIC

Oligopoly

Characteristics of Oligopolies: FOUR MARKET MODELS Perfect Competition Monopolistic Competition Pure Monopoly Oligopoly Characteristics of Oligopolies: A Few Large Producers High Barriers to Entry Control Over Price (Price Maker) Mutual Interdependence Firms use Strategic Pricing Examples: Computer Operating Systems, Car Manufacturers

HOW DO OLIGOPOLIES OCCUR? Oligopolies occur when high barriers to entry keep new firms from entering Types of Barriers to Entry 1. Economies of Scale/ High Start-Up Costs e.g. It is very difficult to compete with existing automakers because they have already invested enormous sums to produce at a low average cost 2. Ownership of Raw Materials e.g. Until recently, OPEC member countries owned most of the world’s known oil reserves

The study of how people behave in strategic situations Game Theory The study of how people behave in strategic situations An understanding of game theory helps firms in an oligopoly maximize profit.

Why learn about game theory? Oligopolies are interdependent since they compete with only a few other firms Their pricing and output decisions must be strategic in order to maximize profit and minimize losses Game theory helps us analyze their strategies

Game Theory Payoff Matrices A payoff matrix represents the known payoffs to individuals (players) in a strategic situation given choices made by other individuals in the same situation

Dominant Strategy A player’s dominant strategy is the best move for a him/her to make regardless of what the other player does A player may or may not have a dominant strategy depending on the potential payoffs

Example Suppose Bert and Ernie are arrested on suspicion of manufacturing and distributing crystal meth They are taken in for questioning in separate rooms How many years they’ll spend in jail for their crimes depend on whether they confess or deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert The payoff matrix below shows the number of years that Bert and Ernie will spend in jail based on their decisions Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert What is Ernie’s dominant strategy (if any)? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert What is Ernie’s dominant strategy (if any)? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert What is Ernie’s dominant strategy (if any)? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert What is Bert’s dominant strategy (if any)? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert What is Bert’s dominant strategy (if any)? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert What is Bert’s dominant strategy (if any)? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert What will happen if both Bert and Ernie follow their dominant strategies? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert Is this the best outcome for both? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert Confess Deny Confess Imagine that you’re Ernie. Suppose that the police leave you and Bert alone for a few minutes in the police station before they begin interrogating you. What might you try to convince Bert to do? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

5, 5 10, 10 20 , 0 0, 20 Payoff Matrix Ernie Bert Confess Deny Confess Suppose you’re convinced that you’ve persuaded Bert to deny. It is now your turn to be interrogated. What do you do? Do you confess or deny? Ernie Confess Deny   Confess 10, 10 0, 20 Bert 20 , 0 5, 5 Deny

Without talking, write down your choice Example 2: You and your tablemate are competing firms. You have one of two choices: Price High or Price Low. Without talking, write down your choice Firm 2 High Low   High $20K, $20K $0, $30K Firm 1 $30K, $0 $10K, $10K Low

What is Firm 1’s dominant strategy? Example 2: What is Firm 1’s dominant strategy? Firm 2 High Low   High $20K, $20K $0, $30K Firm 1 $30K, $0 $10K, $10K Low

What is Firm 2’s dominant strategy? Example 2: What is Firm 2’s dominant strategy? Firm 2 High Low   High $20K, $20K $0, $30K Firm 1 $30K, $0 $10K, $10K Low

Example 2: Firm 2 Firm 1 $20K, $20K $0, $30K $30K, $0 $10K, $10K Notice that each player has an incentive to collude (cooperate) but also an incentive to cheat Firm 2 High Low   High $20K, $20K $0, $30K Firm 1 $30K, $0 $10K, $10K Low

What is each player’s dominant strategy? Video: Split or Steal What is each player’s dominant strategy? Player 2 Split Steal   Split 50K, 50K 0, 100K Player 1 100K, 0 0, 0 Steal

What did we learn? Firms in an oligopoly are mutually interdependent and must behave strategically to maximize profit or minimize losses (they have to worry about the other guy) Oligopolies have a tendency to collude to increase profit. (Collusion is the act of cooperating with rivals in order to “rig” a market) Collusion may result in the incentive to cheat