nuhfil hanani : web site : BAB 11 Market Power: Monopoly and Monopsony Market Power: Monopoly and Monopsony

nuhfil hanani : web site : Topics to be Discussed u Monopoly u Monopoly Power u Sources of Monopoly Power u The Social Costs of Monopoly Power

nuhfil hanani : web site : Topics to be Discussed u Monopsony u Monopsony Power u Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : Perfect Competition u Review of Perfect Competition – P = LMC = LRAC – Normal profits or zero economic profits in the long run – Large number of buyers and sellers – Homogenous product – Perfect information – Firm is a price taker

nuhfil hanani : web site : Perfect Competition Q Q PP MarketIndividual Firm DS Q0Q0 P0P0 P0P0 D = MR = P q0q0 LRACLMC

nuhfil hanani : web site : Monopoly u Monopoly 1) One seller - many buyers 2)One product (no good substitutes) 3)Barriers to entry

nuhfil hanani : web site : Monopoly u The monopolist is the supply-side of the market and has complete control over the amount offered for sale. u Profits will be maximized at the level of output where marginal revenue equals marginal cost.

nuhfil hanani : web site : Monopoly u Finding Marginal Revenue – As the sole producer, the monopolist works with the market demand to determine output and price. – Assume a firm with demand: v P = 6 - Q

nuhfil hanani : web site : Total, Marginal, and Average Revenue $60$ $5$ TotalMarginalAverage PriceQuantityRevenueRevenueRevenue PQRMRAR

nuhfil hanani : web site : Average and Marginal Revenue Output $ per unit of output Average Revenue (Demand) Marginal Revenue

nuhfil hanani : web site : Monopoly u Observations 1)To increase sales the price must fall 2)MR < P 3)Compared to perfect competition v No change in price to change sales v MR = P

nuhfil hanani : web site : Monopoly u Monopolist’s Output Decision 1)Profits maximized at the output level where MR = MC 2)Cost functions are the same

nuhfil hanani : web site : Maximizing Profit When Marginal Revenue Equals Marginal Cost u At output levels below MR = MC the decrease in revenue is greater than the decrease in cost (MR > MC). u At output levels above MR = MC the increase in cost is greater than the decrease in revenue (MR < MC) The Monopolist’s Output Decision

nuhfil hanani : web site : Lost profit P1P1 Q1Q1 Lost profit MC AC Quantity $ per unit of output D = AR MR P* Q* Maximizing Profit When Marginal Revenue Equals Marginal Cost P2P2 Q2Q2

nuhfil hanani : web site : Monopoly u An Example The Monopolist’s Output Decision

nuhfil hanani : web site : Monopoly u An Example The Monopolist’s Output Decision

nuhfil hanani : web site : Monopoly u An Example The Monopolist’s Output Decision

nuhfil hanani : web site : Monopoly u An Example – By setting marginal revenue equal to marginal cost, it can be verified that profit is maximized at P = $30 and Q = 10. – This can be seen graphically: The Monopolist’s Output Decision

nuhfil hanani : web site : Quantity $ R Profits t t' c c’ Example of Profit Maximization C

nuhfil hanani : web site : Example of Profit Maximization u Observations – Slope of rr’ = slope cc’ and they are parallel at 10 units – Profits are maximized at 10 units – P = $30, Q = 10, TR = P x Q = $300 – AC = $15, Q = 10, TC = AC x Q = 150 – Profit = TR - TC v $150 = $300 - $150 Quantity $ R C Profits t t' c c

nuhfil hanani : web site : Profit AR MR MC AC Example of Profit Maximization Quantity $/Q

nuhfil hanani : web site : Example of Profit Maximization u Observations – AC = $15, Q = 10, TC = AC x Q = 150 – Profit = TR = TC = $300 - $150 = $150 or – Profit = (P - AC) x Q = ($30 - $15)(10) = $150 Quantity $/Q MC AR MR AC Profit

nuhfil hanani : web site : Monopoly u A Rule of Thumb for Pricing – We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in practice. – This can be demonstrated using the following steps:

nuhfil hanani : web site : A Rule of Thumb for Pricing

nuhfil hanani : web site : A Rule of Thumb for Pricing

nuhfil hanani : web site : A Rule of Thumb for Pricing

nuhfil hanani : web site : = the markup over MC as a percentage of price (P- MC)/P A Rule of Thumb for Pricing 8. The markup should equal the inverse of the elasticity of demand.

nuhfil hanani : web site : A Rule of Thumb for Pricing

nuhfil hanani : web site : Monopoly u Monopoly pricing compared to perfect competition pricing: – Monopoly P > MC – Perfect Competition P = MC

nuhfil hanani : web site : Monopoly u Monopoly pricing compared to perfect competition pricing: – The more elastic the demand the closer price is to marginal cost. – If E d is a large negative number, price is close to marginal cost and vice versa.

nuhfil hanani : web site : Astra-Merck Prices Prilosec u 1995 –Price of Prilosec = $3.50/daily dose –Price of Tagamet and Zantac = $ $2.25/daily dose –MC of Prolosec = cents/daily dose The Monopolist’s Output Decision

nuhfil hanani : web site : Astra-Merck Prices Prilosec The Monopolist’s Output Decision Price of $3.50 is consistent with “the rule of thumb pricing”

nuhfil hanani : web site : Monopoly u Shifts in Demand – In perfect competition, the market supply curve is determined by marginal cost. – For a monopoly, output is determined by marginal cost and the shape of the demand curve.

nuhfil hanani : web site : D2D2 MR 2 D1D1 MR 1 Shift in Demand Leads to Change in Price but Same Output Quantity MC $/Q P2P2 P1P1 Q 1 = Q 2

nuhfil hanani : web site : D1D1 MR 1 Shift in Demand Leads to Change in Output but Same Price MC $/Q MR 2 D2D2 P 1 = P 2 Q1Q1 Q2Q2 Quantity

nuhfil hanani : web site : Monopoly u Observations –Shifts in demand usually cause a change in both price and quantity. –A monopolistic market has no supply curve.

nuhfil hanani : web site : Monopoly u Observations –Monopolist may supply many different quantities at the same price. –Monopolist may supply the same quantity at different prices.

nuhfil hanani : web site : Monopoly u The Effect of a Tax – Under monopoly price can sometimes rise by more than the amount of the tax. u To determine the impact of a tax: – t = specific tax – MC = MC + t – MR = MC + t : optimal production decision

nuhfil hanani : web site : Effect of Excise Tax on Monopolist Quantity $/Q MC D = AR MR Q0Q0 P0P0 MC + tax t Q1Q1 P1P1 Increase in P: P 0 P 1 > increase in tax

nuhfil hanani : web site : u Question – Suppose: E d = -2 – How much would the price change? Effect of Excise Tax on Monopolist

nuhfil hanani : web site : u Answer u What would happen to profits? Effect of Excise Tax on Monopolist

nuhfil hanani : web site : Monopoly u The Multiplant Firm – For many firms, production takes place in two or more different plants whose operating cost can differ.

nuhfil hanani : web site : Monopoly u The Multiplant Firm – Choosing total output and the output for each plant: v The marginal cost in each plant should be equal. v The marginal cost should equal the marginal revenue for each plant.

nuhfil hanani : web site : Monopoly u Algebraically: The Multiplant Firm

nuhfil hanani : web site : Monopoly u Algebraically: The Multiplant Firm

nuhfil hanani : web site : Monopoly u Algebraically: The Multiplant Firm

nuhfil hanani : web site : Monopoly u Algebraically:

nuhfil hanani : web site : Production with Two Plants Quantity $/Q D = AR MR MC 1 MC 2 MC T MR* Q1Q1 Q2Q2 Q3Q3 P*

nuhfil hanani : web site : Production with Two Plants u Observations: 1)MC T = MC 1 + MC 2 2)Profit maximizing output: v MC T = MR at Q T and P * v MR = MR* v MR* = MC 1 at Q 1, MC* = MC 2 at Q 2 v MC 1 + MC 2 = MC T, Q 1 + Q 2 = Q T, and MR = MC 1 + MC 2 Quantity $/Q D = AR MR MC 1 MC 2 MC T MR* Q1Q1 Q2Q2 Q3Q3 P*

nuhfil hanani : web site : Monopoly Power u Monopoly is rare. u However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost.

nuhfil hanani : web site : Monopoly Power u Scenario: – Four firms with equal share (5,000) of a market for 20,000 toothbrushes at a price of $1.50.

nuhfil hanani : web site : Quantity 10, QAQA $/ Q ,00030,0003,0005,0007, At a market price of $1.50, elasticity of demand is Market Demand The Demand for Toothbrushes The demand curve for Firm A depends on how much their product differs, and how the firms compete.

nuhfil hanani : web site : At a market price of $1.50, elasticity of demand is Quantity 10, QAQA $/ Q ,00030,0003,0005,0007, DADA MR A Market Demand Firm A sees a much more elastic demand curve due to competition--E d = -.6. Still Firm A has some monopoly power and charges a price which exceeds MC. MC A The Demand for Toothbrushes

nuhfil hanani : web site : Monopoly Power u Measuring Monopoly Power – In perfect competition: P = MR = MC – Monopoly power: P > MC

nuhfil hanani : web site : Monopoly Power u Lerner’s Index of Monopoly Power – L = (P - MC)/P v The larger the value of L (between 0 and 1) the greater the monopoly power. – L is expressed in terms of E d v L = (P - MC)/P = -1/E d v E d is elasticity of demand for a firm, not the market

nuhfil hanani : web site : Monopoly Power u Monopoly power does not guarantee profits. u Profit depends on average cost relative to price. u Question: – Can you identify any difficulties in using the Lerner Index (L) for public policy?

nuhfil hanani : web site : Monopoly Power u The Rule of Thumb for Pricing – Pricing for any firm with monopoly power v If E d is large, markup is small v If E d is small, markup is large

nuhfil hanani : web site : Elasticity of Demand and Price Markup $/ Q Quantity AR MR AR MC Q* P* P*-MC The more elastic is demand, the less the markup.

nuhfil hanani : web site : Markup Pricing: Supermarkets to Designer Jeans u Supermarkets

nuhfil hanani : web site : u Convenience Stores Markup Pricing: Supermarkets to Designer Jeans

nuhfil hanani : web site : u Convenience stores have more monopoly power. u Question: – Do convenience stores have higher profits than supermarkets? Markup Pricing: Supermarkets to Designer Jeans Convenience Stores

nuhfil hanani : web site : – Designer jeans E d = -3 to -4 v Price % > MC v MC = $12 - $18/pair v Wholesale price = $18 - $27 Markup Pricing: Supermarkets to Designer Jeans Designer Jeans

nuhfil hanani : web site : The Pricing of Prerecorded Videocassettes TitleRetail Price($)TitleRetail Price($) Purple Rain$29.98Austin Powers$10.49 Raiders of the Lost Ark24.95A Bug’s Life17.99 Jane Fonda Workout59.95There’s Something about Mary13.99 The Empire Strikes Back79.98Tae-Bo Workout24.47 An Officer and a Gentleman24.95Lethal Weapon Star Trek: The Motion Picture24.95Men in Black12.99 Star Wars39.98Armageddon15.86

nuhfil hanani : web site : u What Do You Think? –Should producers lower the price of videocassettes to increase sales and revenue? The Pricing of Prerecorded Videocassettes

nuhfil hanani : web site : Sources of Monopoly Power u Why do some firm’s have considerable monopoly power, and others have little or none? u A firm’s monopoly power is determined by the firm’s elasticity of demand.

nuhfil hanani : web site : Sources of Monopoly Power u The firm’s elasticity of demand is determined by: 1)Elasticity of market demand 2)Number of firms 3) The interaction among firms

nuhfil hanani : web site : The Social Costs of Monopoly Power u Monopoly power results in higher prices and lower quantities. u However, does monopoly power make consumers and producers in the aggregate better or worse off?

nuhfil hanani : web site : B A Lost Consumer Surplus Deadweight Loss Because of the higher price, consumers lose A+B and producer gains A-C. C Deadweight Loss from Monopoly Power Quantity AR MR MC QCQC PCPC PmPm QmQm $/Q

nuhfil hanani : web site : u Rent Seeking – Firms may spend to gain monopoly power v Lobbying v Advertising v Building excess capacity The Social Costs of Monopoly Power

nuhfil hanani : web site : u The incentive to engage in monopoly practices is determined by the profit to be gained. u The larger the transfer from consumers to the firm, the larger the social cost of monopoly. The Social Costs of Monopoly Power

nuhfil hanani : web site : u Example – 1996 Archer Daniels Midland (ADM) successfully lobbied for regulations requiring ethanol be produced from corn u Question – Why only corn? The Social Costs of Monopoly Power

nuhfil hanani : web site : u Price Regulation – Recall that in competitive markets, price regulation created a deadweight loss. u Question: – What about a monopoly? The Social Costs of Monopoly Power

nuhfil hanani : web site : AR MR MC PmPm QmQm AC P1P1 Q1Q1 Marginal revenue curve when price is regulated to be no higher that P 1. If left alone, a monopolist produces Q m and charges P m. If price is lowered to P 3 output decreases and a shortage exists. For output levels above Q 1, the original average and marginal revenue curves apply. If price is lowered to P C output increases to its maximum Q C and there is no deadweight loss. Price Regulation $/Q Quantity P 2 = P C QcQc P3P3 Q3Q3 Q’ 3 Any price below P 4 results in the firm incurring a loss. P4P4

nuhfil hanani : web site : u Natural Monopoly –A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms. The Social Costs of Monopoly Power

nuhfil hanani : web site : Regulating the Price of a Natural Monopoly $/Q Natural monopolies occur because of extensive economies of scale Quantity

nuhfil hanani : web site : MC AC AR MR $/Q Quantity Setting the price at P r yields the largest possible output;excess profit is zero. QrQr PrPr PCPC QCQC If the price were regulate to be P C, the firm would lose money and go out of business. PmPm QmQm Unregulated, the monopolist would produce Q m and charge P m. Regulating the Price of a Natural Monopoly

nuhfil hanani : web site : u Regulation in Practice – It is very difficult to estimate the firm's cost and demand functions because they change with evolving market conditions The Social Costs of Monopoly Power

nuhfil hanani : web site : u Regulation in Practice – An alternative pricing technique--- rate-of-return regulation allows the firms to set a maximum price based on the expected rate or return that the firm will earn. v P = AVC + (D + T + sK)/Q, where – P = price, AVC = average variable cost – D = depreciation, T = taxes – s = allowed rate of return, K = firm’s capital stock The Social Costs of Monopoly Power

nuhfil hanani : web site : u Regulation in Practice – Using this technique requires hearings to arrive at the respective figures. – The hearing process creates a regulatory lag that may benefit producers (1950s & 60s) or consumers (1970s & 80s). u Question – Who is benefiting in the 1990s? The Social Costs of Monopoly Power

nuhfil hanani : web site : Monopsony u A monopsony is a market in which there is a single buyer. u An oligopsony is a market with only a few buyers. u Monopsony power is the ability of the buyer to affect the price of the good and pay less than the price that would exist in a competitive market.

nuhfil hanani : web site : Monopsony u Competitive Buyer – Price taker – P = Marginal expenditure = Average expenditure – D = Marginal value

nuhfil hanani : web site : Competitive Buyer Compared to Competitive Seller Quantity $/Q AR = MR D = MV ME = AE P* Q* ME = MV at Q* ME = P* P* = MV P* Q* MC MR = MC P* = MR P* = MC BuyerSeller

nuhfil hanani : web site : ME S = AE The market supply curve is the monopsonist’s average expenditure curve Monopsonist Buyer Quantity $/Q MV Q* m P* m Monopsony ME > P & above S PCPC QCQC Competitive P = P C Q = Q+C

nuhfil hanani : web site : Monopoly and Monopsony Quantity AR MR MC $/Q QCQC PCPC Monopoly Note: MR = MC; AR > MC; P > MC P* Q*

nuhfil hanani : web site : Monopoly and Monopsony Quantity $/Q MV ME S = AE Q* P* PCPC QCQC Monopsony Note: ME = MV; ME > AE; MV > P

nuhfil hanani : web site : Monopoly and Monopsony u Monopoly – MR < P – P > MC – Q m < Q C – P m > PC u Monopsony – ME > P – P < MV – Q m < Q C – P m < P C

nuhfil hanani : web site : Monopsony Power u A few buyers can influence price (e.g. automobile industry). u Monopsony power gives them the ability to pay a price that is less than marginal value.

nuhfil hanani : web site : Monopsony Power u The degree of monopsony power depends on three similar factors. 1)Elasticity of market supply v The less elastic the market supply, the greater the monopsony power.

nuhfil hanani : web site : Monopsony Power u The degree of monopsony power depends on three similar factors. 2)Number of buyers v The fewer the number of buyers, the less elastic the supply and the greater the monopsony power.

nuhfil hanani : web site : Monopsony Power u The degree of monopsony power depends on three similar factors. 3)Interaction Among Buyers v The less the buyers compete, the greater the monopsony power.

nuhfil hanani : web site : ME S = AE ME S = AE Monopsony Power: Elastic versus Inelastic Supply Quantity $/Q MV Q* P* MV - P* P* Q* MV - P*

nuhfil hanani : web site : A Deadweight Loss from Monopsony Power u Determining the deadweight loss in monopsony – Change in seller’s surplus = -A-C – Change in buyer’s surplus = A - B – Change in welfare = -A - C + A - B = -C - B – Inefficiency occurs because less is purchased Quantity $/Q MV ME S = AE Q* P* PCPC QCQC B C Deadweight Loss

nuhfil hanani : web site : Monopsony Power u Bilateral Monopoly – Bilateral monopoly is rare, however, markets with a small number of sellers with monopoly power selling to a market with few buyers with monopsony power is more common. The Social Costs of Monopsony Power

nuhfil hanani : web site : Monopsony Power u Question – In this case, what is likely to happen to price? The Social Costs of Monopsony Power

nuhfil hanani : web site : Limiting Market Power: The Antitrust Laws u Antitrust Laws: – Promote a competitive economy – Rules and regulations designed to promote a competitive economy by: v Prohibiting actions that restrain or are likely to restrain competition v Restricting the forms of market structures that are allowable

nuhfil hanani : web site : u Sherman Act (1890) – Section 1 v Prohibits contracts, combinations, or conspiracies in restraint of trade – Explicit agreement to restrict output or fix prices – Implicit collusion through parallel conduct Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : u 1983 –Six companies and six executives indicted for price of copper tubing u 1996 –Archer Daniels Midland (ADM) pleaded guilty to price fixing for lysine -- three sentenced to prison in 1999 Limiting Market Power: The Antitrust Laws Examples of Illegal Combinations

nuhfil hanani : web site : u 1999 –Roche A.G., BASF A.G., Rhone- Poulenc and Takeda pleaded guilty to price fixing of vitamins -- fined more than $1 billion. Limiting Market Power: The Antitrust Laws Examples of Illegal Combinations

nuhfil hanani : web site : u Sherman Act (1890) – Section 2 v Makes it illegal to monopolize or attempt to monopolize a market and prohibits conspiracies that result in monopolization. Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : u Clayton Act (1914) 1)Makes it unlawful to require a buyer or lessor not to buy from a competitor 2)Prohibits predatory pricing Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : u Clayton Act (1914) 3)Prohibits mergers and acquisitions if they “substantially lessen competition” or “tend to create a monopoly” Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : u Robinson-Patman Act (1936) – Prohibits price discrimination if it is likely to injure the competition Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : u Federal Trade Commission Act (1914, amended 1938, 1973, 1975) 1)Created the Federal Trade Commission (FTC) 2)Prohibitions against deceptive advertising, labeling, agreements with retailer to exclude competing brands Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : u Antitrust laws are enforced three ways: 1)Antitrust Division of the Department of Justice v A part of the executive branch-- the administration can influence enforcement v Fines levied on businesses; fines and imprisonment levied on individuals Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : u Antitrust laws are enforced three ways: 2)Federal Trade Commission v Enforces through voluntary understanding or formal commission order Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : u Antitrust laws are enforced three ways: 3)Private Proceedings v Lawsuits for damages v Plaintiff can receive treble damages Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : u Two Examples –American Airlines -- Price fixing –Microsoft v Monopoly power v Predatory actions v Collusion Limiting Market Power: The Antitrust Laws

nuhfil hanani : web site : Summary u Market power is the ability of sellers or buyers to affect the price of a good. u Market power can be in two forms: monopoly power and monopsony power.

nuhfil hanani : web site : Summary u Monopoly power is determined in part by the number of firms competing in the market. u Monopsony power is determined in part by the number of buyers in the market.

nuhfil hanani : web site : Summary u Market power can impose costs on society. u Sometimes, scale economies make pure monopoly desirable. u We rely on the antitrust laws to prevent firms from obtaining excessive market power.