1. ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall Monopoly

2. 2 “Monopoly” is as close as economics comes to a dirty word –Negative reputation of monopoly is in many ways deserved –At the same time a mythology has developed around monopolies –This negative characterization goes too far We do better by managing monopoly problem, rather than eliminating it

3. 3 What Is A Monopoly? A monopoly firm is the only seller of a good or service with no close substitutes –Market in which the monopoly firm operates is called a monopoly market Key concept is notion of substitutability Definition of monopoly firm or market may seem precise –But in real world, definition is not always so clear-cut Because we all have different tastes and characteristics, we can have different opinions about what is, and what is not, a “close” substitute –As a result, we can have different ideas about how broadly or how narrowly we should define a market when trying to decide if it is a monopoly

4. 4 The Sources of Monopoly Existence of a monopoly means that something is causing other firms to stay out of the market –Rather than enter and compete with firm already there What barrier prevents additional firms from entering the market? –Several possible answers Economies of scale Legal barriers Network externalities

5. 5 Economies of Scale If economies of scale persist to the point where a single firm is producing for entire market, the market is a natural monopoly –Market in which, due to economies of scale, one firm can operate at lower average cost than can two or more firms Unless government intervenes, only one seller would survive—market would naturally become a monopoly Small local monopolies are often natural monopolies –Because they continue to enjoy economies of scale up to point at which they are serving entire market

6. 6 Figure 1: A Natural Monopoly

7. 7 Legal Barriers Sometimes public interest is best served by having a single seller in a market Many monopolies arise because of legal barriers including –Protection of intellectual property –Government franchise

8. 8 Protection of Intellectual Property The words you are reading right now are an example of intellectual property, which includes literary, artistic and musical works, and scientific inventions In dealing with intellectual property government strikes a compromise –Allows creators of intellectual property to enjoy a monopoly and earn economic profit, but only for a limited period of time –Once time is up, other sellers are allowed to enter the market, and it is hoped that competition among them will bring down prices Most important kinds of legal protection for intellectual property are –Patents Temporary grant of monopoly rights over a new product or scientific discovery –Copyrights Grant of exclusive rights to sell a literary, musical, or artistic work Copyrights and patents are often sold to another person or firm, but this does not change monopoly status of the market, since there is still just one seller

9. 9 Government Franchise Large firms we usually think of as monopolies have their monopoly status guaranteed through government franchise –Grant of exclusive rights over a product Barrier to entry is –Any other firm that enters the market will be prosecuted Governments usually grant franchises when they think market is a natural monopoly

10. 10 Network Externalities Exist when an increase in network’s membership increases its value to current and potential members When network externalities are present, joining a large network is more beneficial than joining a small network –Even if product in larger network is somewhat inferior to product in smaller one In addition to advantages of joining a larger network –Advantage in not leaving it once you’ve joined Avoiding switching costs

11. 11 Network Externalities All of this clearly applies to the market for computer operating systems –When you buy a computer already loaded with Microsoft Windows, you benefit By having a large number of people with whom you can easily share documents Huge number of computers everywhere you can easily operate –You gain access to many more software programs, like Microsoft Word, Excel, or Outlook, since many more programs are designed for Windows than for the few alternatives –You can save time by just calling knowledgeable friends or coworkers Rather than attempting to contact technical support

12. 12 Monopoly Goals And Constraints Goal of a monopoly—like that of any firm—is to earn highest profit possible However, a monopolist faces constraints –Constraint on monopoly’s cost For any level of output it might produce, total cost is determined by –Technology of production –Price it must pay for its inputs –Demand constraint Monopolist’s demand curve tells us maximum price monopolist can charge to sell any given quantity of output And for any level of output it might produce, maximum price it can charge is determined by market demand curve for its product

13. 13 Monopoly Price or Output Decision Noncompetitive firms—such as monopolies—do not make two separate decisions about price and quantity, but rather one decision –Once firm determines its output level, it has also determined its price When any firm—including a monopoly—faces a downward sloping demand curve, marginal revenue is less than price of output –Therefore, marginal revenue curve will lie below demand curve Monopoly will always produce at an output level where marginal revenue is positive

14. 14 Figure 2: Demand and Marginal Revenue

15. 15 The Profit-Maximizing Output Level To maximize profit, the firm should produce level of output where MC = MR and –MC curve crosses MR curve from below For a monopoly, price and output are not independent decisions –But different ways of expressing the same decision

16. 16 Figure 3: Monopoly Price and Output Determination

17. 17 Profit And Loss A monopoly earns a profit whenever P > ATC –Its total profit at best output level equals area of a rectangle Height equal to distance between P and ATC Width equal to level of output A monopoly suffers a loss whenever P < ATC –Its total loss at best output level equals area of a rectangle Height equal to distance between ATC and P Width equal to level of output

18. 18 Figure 4: Monopoly Profit and Loss

19. 19 Equilibrium in Monopoly Markets A monopoly market is in equilibrium when the only firm in market –The monopoly firm is maximizing profit For monopoly—as for perfect competition— we have different expectations about equilibrium in short-run and equilibrium in long-run

20. 20 Short-Run Equilibrium Monopoly may earn an economic profit or suffer an economic loss What if a monopoly suffers a loss in short-run? –Any firm should shut down if P < AVC at output level where MR = MC If monopoly suddenly finds that P < AVC, government will usually not allow it to shut down, –Instead use tax revenue to make up for firm’s losses

21. 21 Long-Run Equilibrium Important insights of previous chapter— perfectly competitive firms cannot earn a profit in long-run equilibrium However, monopolies may earn economic profit in long-run A privately owned monopoly suffering an economic loss in long-run will exit the industry –Should not find privately owned monopolies suffering economic losses in long-run

22. 22 Comparing Monopoly to Perfect Competition In perfect competition, economic profit is relentlessly reduced to zero by entry of other firms –In monopoly, economic profit can continue indefinitely But monopoly differs from perfect competition in another way –Can expect a monopoly market to have a higher price and lower output than an otherwise similar perfectly competitive market By raising price and restricting output, new monopoly earns economic profit Consumers lose in two ways –Pay more for output they buy –Due to higher prices they buy less output

23. 23 Figure 5: Comparing Monopoly and Perfect Competition

24. 24 Comparing Monopoly to Perfect Competition Changeover from perfect competition to monopoly benefits owners of monopoly and harms consumers of the product –Important proviso concerning this result In comparing monopoly and perfect competition, price is higher and output is lower under monopoly if all else is equal General conclusion –Monopolization of a competitive industry leads to two opposing effects For any given technology of production, monopolization leads to higher prices and lower output Changes in technology of production made possible under monopoly may lead to lower prices and higher output –Ultimate effect on price and quantity depends on relative strengths of two effects

25. 25 Why Monopolies Often Earn Zero Economic Profit Forces tending to cut monopoly profits –Government regulation –Rent-seeking activity Any costly action a firm undertakes to establish or maintain its monopoly status is called rent-seeking activity In countries with corrupt bureaucracies, rent-seeking activity includes bribes to government officials –In less corrupt governments, it includes time and money spent lobbying legislators and public for favorable polices Rent-seeking activity that helps establish or maintain a firm’s monopoly position is part of firm’s costs –As a result, rent-seeking activity can reduce economic profit of a monopoly May even reduce it to zero

26. 26 What Happens When Things Change? Once a monopoly is maximizing profit, it has no incentive to change its price or its level of output –Unless something that affects these decisions changes Possible events –Change in demand for monopolist’s product –Change in its costs What might cause a monopolist to experience a shift in demand? –Possible causes are the same as for perfect competition

27. 27 An Increase in Demand and a Cost- Saving Technological Advance Monopolist will react to an increase in demand by –Producing more output –Charging a higher price –Earning a larger profit It will react to a decrease of demand by –Reducing output –Lowering price –Suffering a reduction in profit In general, monopoly will pass to consumers only part of benefits from a cost-saving technological change –After change in technology, monopoly’s profits will be higher In general, a monopoly will pass only part of a cost increase onto consumers in form of a higher price –After its cost increase, monopoly’s profits will be lower

28. 28 Figure 6: A Change in Demand

29. 29 Figure 7: Monopoly Profit and Loss

30. 30 Price Discrimination Single-price monopoly –Firm that is limited to changing same price for each unit of output sold Price discrimination occurs when a firm charges different prices to different customers for reasons other than differences in costs Price-discriminating monopoly does not discriminate based on prejudice, stereotypes, or ill-will toward any person or group –Rather, it divides its customers into different categories based on their willingness to pay for good

31. 31 Requirements for Price Discrimination Although every firm would like to practice price discrimination, not all of them can To successfully price discriminate, three conditions must be satisfied –Must be a downward-sloping demand curve for the firm’s output –Firm must be able to identify consumers willing to pay more –Firm must be able to prevent low-price customers from reselling to high-price customers

32. 32 Price Discrimination That Harms Consumers Price discrimination always benefits owners of a firm –Can use this ability to increase its profit When price discrimination raises price for some consumer above price they would pay under a single-price policy it harms consumers –Additional profit for the firm is equal to monetary loss of consumers

33. 33 Figure 8: Price Discrimination

34. 34 Price Discrimination That Benefits Consumers Price discrimination benefits monopoly at the same time it benefits a group of consumers Since no one’s price is raised, no one is harmed by this policy –When price discrimination lowers price for some consumers below what they would pay under a single-price policy, it benefits consumers as well as firm

35. 35 Perfect Price Discrimination Suppose a firm could somehow find out maximum price customers would be willing to pay for each unit of output it sells It could increase profits even further by practicing perfect price discrimination –Firm charges each customer the most the customer would be willing to pay for each unit he or she buys –Increases profit at expense of consumers Perfect price discrimination is very difficult to practice in the real world –Would require firm to read its customers’ minds Marginal revenue is equal to price of additional unit sold –Firm’s MR curve is same as its demand curve

36. 36 Figure 9: Perfect Price Discrimination

37. 37 The Decline of Monopoly? Past century was not kind to monopolies Today, monopolies face a different threat –Relentless advance of technology The world of monopolies is changing rapidly –But monopolies in many forms will be with us for some time

38. 38 Using the Theory: Price Discrimination at Colleges and Universities Most colleges and universities give some kind of financial aid to a large proportion of their students Financial aid has been used as an effective method of price discrimination –Designed to increase revenue of the college Colleges have long been in an especially good position to benefit from price discrimination, because they satisfy all three requirements –Face downward-sloping demand curves –Able to identify consumers willing to pay more –Able to prevent low-price customers from reselling to high-price customers

39. 39 Using the Theory: Price Discrimination at Colleges and Universities Most colleges have been active price discriminators for decades Under newer systems, those who can signal a lower willingness to pay have benefited from reduced prices –While those signaling greater willingness to pay have suffered a price increase Result is vastly different prices for different students –Highly correlated to their families’ willingness to pay Increased price discrimination at colleges, like so many other economic issues, is a matter of tradeoffs