MONOPOLY ESSENTIALS One firm Unique product: no close substitutes Industry demand equals firm demand Demand slopes down Marginal Revenue is below demand and slopes down twice as fast

Profit Maximizing of Monopolist If the MC > MR raise price and reduce sales. MC will fall and MR will rise, Profits will rise. If the MC < MR lower price and increase sales. MC will rise and MR will fall. Profits will rise. If MC = MR you are doing the best you can.

Tricks and traps to using the monopolist’s diagram Find the profit maximising quantity by finding the intersection of MR and MC. Find the profit maximising price by finding the highest quantity at which the firm can sell that quantity. You can read the price by going up vertically from the best quantity and finding the best price on the demand curve. TRAP: giving MR as the price

Profit Maximising Price, Quantity and Profit

Monopolists can make Losses

LOSSES If the ATC curve is everywhere above the Demand curve, a profit is not possible. Produce where MR = MC so long as P>AVC so loss is less than or equal to fixed costs Urban transit systems are often in this situation

LONG-RUN EQUILIBRIUM

Because there is no entry in a monopoly, profits can persist in the long-run.

EFFICIENCY AND MONOPOLY Allocative efficiency is never achieved: P > MR = MC. The price, what people are willing to pay, is always greater than the cost of one more unit. We are always willing to give up more than what must be given up to obtain one more unit of the good

EFFICIENCY AND MONOPOLY Productive efficiency is achieved only by chance. If price is greater than ATC, the firm may produce at an output that causes ATC to be greater than or less than the minimum Because firms do not enter or leave the industry, the number of firms in the industry doesn’t adjust until each firm is the ideal size.

EQUITY AND MONOPOLY Monopolist can earn excessive profits at the expense of the consumer Monopoly power permits these firms to be nasty capitalists who systematically exploit the consumer.

Regulation of Monopoly Economists regulate a monopoly to achieve allocative efficiency The price is set where the Marginal Cost curve intersects the Demand curve As a result P = MC, producing allocative efficiency

Marginal Cost Pricing

REGULATION Regulating so that P=MC sometimes results in a profit (but less than if unregulated) Regulating so that P=MC sometimes results in a loss. Profits should be taxed away. Firms must receive subsidies to cover losses

REGULATING DRUG COMPANIES

Unregulated Drug Companies Monopoly caused by government patent MC is very low. Manufacturing one more unit of drug is usually fairly cheap. Demand is very inelastic. The price must be very high before MR>0 and TR is at a maximum. The firm is very far from allocative or productive efficiency. Much more should be produced.

REGULATING DRUG COMPANIES Firm has very high fixed costs due to research and development If price equals the cost of manufacturing one more unit, the fixed costs are unlikely to be covered by the price Firms will make a loss No one would develop new drugs

Average Cost Pricing

AVERAGE COST PRICING Setting Price so that the firm makes only a normal return (P=ATC) is politically easier. Measuring costs is difficult. The firms may know, but the firms have an incentive to lie. Developing drugs is risky. What is a large enough return to induce firms to take the risks? The firms will tell you it is very high.

CANADA VS. THE U.S. Canada regulates drug companies to restrain profits. Whether they have reached prices that give only a fair return is debatable. Prices are much lower than in the U.S. where they are unregulated. U.S. firms have more incentive to develop new drugs. The American public has a large incentive to buy drugs in Canada.