1. Chapter 8: Monopoly, Oligopoly, and Monopolistic Competition

2. Learning Objectives
Define imperfect competition and compare it to perfect competition
Define market power and explain how it affects the firm's demand curve
Explain how start-up costs affect economies of scale and market power
Understand and use marginal cost and marginal revenue to maximize monopolist's profit
Show how monopoly alters economic surplus compared to perfect competition
Describe price discrimination and its effects
Discuss public policies applied to natural monopolies

3. Imperfect Competition
Millions of people around the world suffer from allergies
The symptoms can be treated using over-the-counter or prescription medication
Over-the-counter medication is affordable
Prescription medication is expensive
Prescription medication costs no more to manufacture than over-the-counter medication  their producer earns an enormous profit
In a perfectly competitive market if an economic profit exists  firms enter the market and prescription medication would sell for roughly its cost of production

4. Imperfect Competition
But prescription medication has been on the market for years now and that hasn’t happened
The reason is that prescription medication is patented, which means the government has granted the creator of the medication an exclusive license to sell it
The holder of a patent is an example of an imperfectly competitive firm, or price setter
A firm with some liberty to set its own price

5. Imperfect Competition
Imperfectly competitive firms have some control of price
Long-run economic profits possible / Reduce economic surplus
Three types
Monopoly has only one seller, no close substitutes
Farthest from perfectly competitive markets
Monopolistic competition has many firms with differentiated products
These products are all close substitutes
No significant barriers preventing firms from entering or leaving the market

6. Imperfect Competition
Three types
Oligopoly is a small number of firms producing close substitutes
Oligopoly is typically a consequence of cost advantages that prevent small firms from being able to compete effectively

7. P, Q, product differentiation
Monopoly
Monopoly
Number of Firms
One firm
Price
Price setter
Entry and Exit
Not free
Product
Unique
Economic Profits
Possible
Decisions
P, Q, product differentiation
Perfect Competition
Many firms
Price taker
Free
Standardized
Zero in long run
Q only

8. Monopolistic Competition
Number of Firms
Many firms
Price
Limited flexibility
Entry and Exit
Free
Product
Differentiated
Economic Profits
Zero in long run
Decisions
P, Q, product differentiation
Perfect Competition
Many firms
Price taker
Free
Standardized
Zero in long run
Q only

9. Oligopoly Oligopoly Number of Firms Few firms, each large Price
Some flexibility
Entry and Exit
Large size firm
Product
Differentiated or standardized
Economic Profits
Possible
Decisions
P, Q, differentiation, advertising
Perfect Competition
Many firms
Price taker
Free
Standardized
Zero in long run
Q only

10. The Essential Difference
Whereas the perfectly competitive firm faces a perfectly elastic demand curve for its product, the imperfectly competitive firm faces a downward-sloping demand curve
Why is the demand curve different?
Market Power
Quantity
Price
Imperfectly Competitive Firm
Quantity
Price
Perfectly Competitive Firm D D

11. The Essential Difference
Market power is the firm's ability to raise its price without losing all its sales
Perfectly competitive firm:
Raise the price  loses all its sales
No incentive to lower price since it can sell as many units as it wants at the market price
Imperfectly competitive firm:
Has incentive to charge a higher price  lose some customers but keep some and maybe gain more

12. Five Sources of Market Power
A firm with a down-ward sloping demand curve is said to enjoy market power
Referring to its ability to set the prices of its products
Five Sources of Market Power
Exclusive control over inputs
Patents and copyrights
Government licenses or franchises
Economies of scale (natural monopolies)
Network economies

13. Exclusive Control over Inputs
If a single firm controls an input essential to the production of a given product, that firm will have market power
For example, to the extent that some tenants are willing to pay a premium for office space in the world’s tallest building, Burj Khalifa, the owner of that building has market power

14. Patents and Copyrights
Patents give the inventors or developers of new products the exclusive right to sell those products for a specified period of time
By insulating sellers from competition for an interval, patents enable innovators to charge higher prices to recoup their product’s development costs
Pharmaceutical companies in the US are given 20 years patents
During that time, these companies can charge a price above their marginal cost

15. Government Licenses or Franchises
Example:
The Tourism Development & Investment Company (TDIC) has an exclusive license from the Abu Dhabi government to manage all operational aspects of eight islands off the western coast of Abu Dhabi
One of the government’s goals in granting this monopoly was to preserve the wilderness character of the area to the greatest degree possible

16. Market Power: Economies of Scale
Returns to scale refers to the percentage change in output from a given percentage change in ALL inputs
Long–run idea
Constant returns to scale: doubling all inputs doubles output
Increasing returns to scale: output increases by a greater percentage than the increase in inputs
Average costs decrease as output increases
Natural monopoly: a monopoly that results from economies of scale

17. Market Power: Network Economies
Network economies occur when the value of the product increases as the number of users increases
VHS format for video tapes, Blu-ray for DVDs
Windows operating system
Facebook and MySpace
Network economies can also be seen as a source of natural monopolies
A product’s quality increases as the number of users increases
Any given quality level can be produced at lower cost as sales volume increases

18. Market Power
The most important and enduring of these sources of market power are economies of scale and network economies
Other sources are weak
Lured by economic profit, firms almost always find substitutes for exclusive inputs
Firms can often evade patent laws by making slight changes in design of products
Patent protection is only temporary in any case
Governments grant very few franchises each year

19. Economies of Scale and Start-Up Costs
New products can have a large fixed development cost
If marginal cost is constant,
Marginal cost = Average variable cost
Total cost is fixed cost (F) plus variable cost
TC = F + (M)*(Q)
Total cost increases as output increases
Average total cost is
ATC = (F/Q) + M
Average total cost decreases as output increases

20. Economies of Scale TC = F + M*Q ATC = F/Q + M Average cost ($/unit)
Quantity F
TC = F + M*Q
ATC = F/Q + M
Total cost ($/year) M
Quantity

21. Video Game – Different Volumes
Nintendo
Playstation
Annual Production (000s)
1,000
1,200
Fixed Cost ($000s)
$200
Variable Cost ($000s)
$800
$960
Total Cost ($000s)
$1,000
$1,160
ATC per game
$1.00
$0.97

22. Video Game – Lower Marginal Costs
Nintendo
Playstation
Annual Production (000s)
1,000
1,200
Fixed Cost ($000s)
$200
Variable Cost ($000s)
$240
Total Cost ($000s)
$400
$440
ATC per game
$0.40
$0.37

23. Video Games – Higher Fixed Cost
Nintendo
Playstation
Annual Production (000s)
1,000
1,200
Fixed Cost ($000s)
$10,000
Variable Cost ($000s)
$200
$240
Total Cost ($000s)
$10,200
$10,240
ATC per game
$10.20
$8.53

24. Video Games – Different Production Levels
Nintendo
Playstation
Annual Production (000s)
500
1,700
Fixed Cost ($000s)
$10,000
Variable Cost ($000s)
$100
$340
Total Cost ($000s)
$10,100
$10,240
ATC per game
$20.20
$6.08

25. Intel's Advantage
In 1984, 80 percent of the cost of a computer was in its hardware (which has relatively high marginal cost)
The remaining 20 percent was in its software
By 1990 those proportions were reversed
Fixed cost now accounts for about 85 percent of total costs in the computer software industry
Development cost of a new chip $2 billion
Marginal cost of making a chip Pennies
Dominating the market Priceless!
Intel supplies more than 80% of the processors for PCs!!!

26. Profit Maximization for a Price Setter
Regardless of whether a firm is a price taker or a price setter its basic goal is to maximize its profit
In both cases:
The firm expands output as long as the benefit of doing so exceeds the cost
Further, the calculation of marginal cost is also the same for the monopolist as for the perfectly competitive firm
Difference is in the calculation of the marginal revenue

27. Monopolist
Pure monopoly: the only seller of a unique product which has no close substitutes
Like all other firms, a monopolist
Maximizes profits
Applies the Cost-Benefit Principle
Increase output if marginal benefit > marginal cost
Decrease output is marginal benefit < marginal cost
Marginal benefit (marginal revenue) for a monopolist is different than for a perfectly competitor

28. Profit Maximization for the Monopolist
For the monopolist, selling one more unit
Decreases market price
Reduces marginal revenue by more than the price
Lower price applied to all units
Price ($/unit)
Quantity (units/week) D 2 6 3 5

29. Monopolist's Marginal Revenue
Price & marginal revenue ($/unit) 8 D
Quantity (units/week) MR 3 2 1 4 -1 5
Price
Quantity $6 2 $5 3 $4 4 $3 5
Total Revenue
$12
$15
$16
Marginal Revenue 3 1 -1

30. Monopoly Demand and Marginal Revenue
In general, the monopolist's marginal revenue curve
Has the same intercept as demand
Has twice the slope of demand
Lies below demand
Price
Quantity a D Q0
Q0/2
a/2 MR

31. Deciding Quantity
A monopolist knows his demand and marginal revenue curves
Marginal cost is also known
If he operates at P = $3 and Q = 12, MC > MR
Decrease output
If the firm operates at Q = 8, then MC = MR = 2
The demand curve sets the price, P = $8
At any output below 8, MC < MR 6 D 12 MR MC 4 8
Price ($/unit of output) 3 2
Quantity (units/week)

32. Does being a Monopolist Guarantee Profits?
Being a monopolist does not guarantee positive profits
The question comes down to:
At MR = MC, is the P larger or smaller than ATC?
If P > ATC  positive profits
If P < ATC  negative profits (losses)

33. Monopoly Losses and Profits
Price ($/minute)
Minutes (millions/day) 24 20
0.08
0.10
ATC D
0.05 MC MR
Economic loss
= $400,000/day
Economic profit
= $400,000/day
0.12
ATC
0.10
Price ($/minute)
0.05 MC D MR 20 24
Minutes (millions/day)

34. The Invisible Hand Fails
The monopolist's optimal
amount occurs where
MC = MR, Q = 8 units and P = $4 24 D 3 12 6
Marginal Cost 2 MR 8 4
The socially optimal
amount occurs where
MC = MB, Q = 12 units and P = $3
Deadweight loss from monopoly = $4
Price ($/unit of output)
Quantity (units/week)

35. The Invisible Hand Fails
Since the monopolist’s marginal revenue is always less than price, the monopolist’s profit-maximizing output level is always below the socially efficient level
Under perfect competition, by contrast, profit maximization occurs when marginal cost equals the market price (MB = Demand) - the same criterion that must be satisfied for social efficiency
This difference explains why the invisible hand of the market is less evident in monopoly markets than in perfectly competitive markets

36. The Invisible Hand Fails
The source of inefficiency in monopoly markets is the fact that the benefit to the monopolist of expanding output is less than the corresponding benefit to society
MR < MB = Demand
From the monopolist’s point of view, the price reduction the firm must grant existing buyers to expand output is a loss
From the point of view of those buyers, each dollar of price reduction is a gain—one dollar more in their pockets

37. Monopoly and Perfect Competition
MC = MR
P >MR
P > MC
Deadweight Loss
Perfect Competition
P = MR
P = MC
No Deadweight Loss

38. Monopolies exist for economic reasons
Managing Monopoly
Monopolies exist for economic reasons
Patents, copyrights and innovation
Economies of scale
Network economies
Anti-trust laws attempt to limit deadweight loss
Limiting monopolies has costs
Patents encourage innovation
Economies of scale minimize ATC
Network economies increase benefits

39. Price Discrimination
Price discrimination means charging different buyers different prices for essentially the same good or service
Separate the groups
No side trades among buyers
Many forms of price discrimination
Perfect discrimination: negotiate separate deals with each customer
Hurdle method: discounts for identifiable groups (e. g., students, senior citizens)

40. Price Discrimination
Whenever a firm offers a discount, the goal is to target that discount to buyers who would not purchase the product without it
People with low incomes generally have lower reservation prices for museum tickets than people with high incomes
Because students generally have lower disposable incomes than working adults, museum owners can expand their visitors by charging lower prices to students than to adults

41. Carla the Editor: Example
Carla is a teaching assistant supplementing her income by editing term papers for undergraduates
There are eight students per week (A,B,C,D,E,F,G and H) for whom she might edit, each with a different reservation price
If the opportunity cost of her time to edit each paper is $29 (also equal to her MC) and she must charge the same price to each student (no price discrimination)
How many papers should she edit?
How much economic profit will she make? How much accounting profit?

42. Opportunity cost of Carla's time is $29
Carla the Editor
Opportunity cost of Carla's time is $29
Student
Reservation Price A
$40 B 38 C 36 D 34 E 32 F 30 G 28 H 26
Total Revenue
$40
$76
$108
$136
$160
$180
$196
$208

43. Opportunity cost of Carla's time is $29
Carla the Editor
Opportunity cost of Carla's time is $29
Student
Reservation Price A
$40 B 38 C 36 D 34 E 32 F 30 G 28 H 26
Total Revenue
$40
$76
$108
$136
$160
$180
$196
$208 MR
$40
$36
$32
$28
$24
$20
$16
$12

44. Carla the Editor: Ordinary Monopolist
Carla is a profit maximizer
Carla should keep expanding the number of students she serves as long as her MR exceeds the opportunity cost of her time (MC)
Carla should stop at 3 papers since MR = 32 > MC = 29
Total opportunity cost = 3 * 29 = $87
Economic profit = 108 – 87 = $21
Accounting profit = $108 (since no explicit costs) = TR

45. Carla the Editor: Social Optimum
What is the socially efficient number of papers for Carla to edit?
Students A to F are willing to pay more than her opportunity cost ($29)
Students G and H are unwilling to pay at least $29
Socially efficient outcome is to edit 6 papers
To be able to achieve that she has to charge a price no higher to $30 (the lowest willing price, here of student F)
TR = 6 * 30 = $180 and Opportunity Cost = 6 * 29 = $174  Economic profit = $6
Accounting profit = TR = $180

46. Carla the Editor: Price Discrimination
Opportunity cost of Carla's time is $29
Student
Reservation Price A
$40 B 38 C 36 D 34 E 32 F 30 G 28 H 26
Total Revenue
$40
$78
$114
$148
$180
$210
$238
$264

47. Carla the Editor: Price Discrimination
What if Carla knew exactly the reservation price of each student? How many papers should she edit, and how much economic and accounting profit will she make?
She will edit papers for students A to F again
But this time charge each their reservation price
Carla is a perfectly discriminating monopolist
TR = = $210
Opportunity cost = 6 * 29 = $174
Economic profit = $36

48. Carla the Editor: Price Discrimination
Notice that the profit-maximizing level of output under perfect price discrimination was exactly the same as the socially efficient level of output
With a perfectly discriminating monopoly, there is no loss of efficiency
Note that although total economic surplus is maximized by a perfectly discriminating monopolist, consumers would have little reason to celebrate
Consumer surplus is exactly zero for the perfectly discriminating monopolist
Total economic surplus and producer surplus are one and the same

49. Carla the Editor: Price Discrimination
In practice, of course, perfect price discrimination can never occur because no seller knows each and every buyer’s precise reservation price
Also in many markets the seller could not prevent buyers who bought at low prices from reselling to other buyers at higher prices, capturing some of the seller’s business in the process
In general imperfect price discrimination is more prevalent
Imperfect price discrimination: at least some buyers are charged less than their reservation prices

50. Carla the Editor: Price Discrimination
The profit-maximizing seller’s goal is to charge each buyer the highest price that buyer is willing to pay
Two primary obstacles prevent sellers from achieving this goal
First, sellers don’t know exactly how much each buyer is willing to pay
Second, they need some means of excluding those who are willing to pay a high price from buying at a low price
One way is to follow the hurdle method of price discrimination

51. Hurdle Method of Price Discrimination
The hurdle method of price discrimination is the practice of offering a discount to all buyers who overcome some obstacle
Hard cover and paperback books
Commercial air carriers
Temporary sales
A perfect hurdle is one that separates buyers precisely according to their reservation prices

52. Carla the Editor: Price Discrimination
Carla offers a rebate coupon that gives a discount to any student who takes the trouble to mail it back to her
Suppose further that students whose reservation prices are at least $36 never mail in the rebate coupons
Those whose reservation prices are below $36 always do so
What should her list price be, and what amount should she offer as a rebate? Will her economic profit be larger or smaller than when she lacked the discount option?

53. If reservation price < $36, mail in rebate
Carla Offers a Rebate
If reservation price < $36, mail in rebate
Student
Reservation Price
Total Revenue A
$40 B 38 76 C 36
108 MR
$40 36 32
Discounted Price Submarket D
$34 E 32 64 F 30 90 G 28
112 H 26
130
$34 30 26 22 18

54. Carla the Editor: Price Discrimination
Carla will divide the market into two groups and act as an ordinary monopolist  compare MR and MC
1st group = list price submarket: A,B and C
Charge $36 and serve all three students
2nd group = discount price submarket: D,E,F,G and H
Charge $32 and serve D and E only (discount = $4)
Combined TR from both submarkets = 3 * * 32 = $172
Opportunity cost = 5 * 29 = $145
Economic profit = 172 – 145 = $27

55. Perfect Discriminator
Carla's Choices
Program
Social Optimum
Papers Edited 6
Price
$30
Total Revenue
$180
Carla's Time 
 $174
Economic Profit $6
Total Surplus
$26
Single Price 3
$36
$108
$87
$21
$27
Perfect Discriminator 6
Reservation
$210
$174 
$36
Hurdle
5 = (3 + 2)
$36, $4 rebate
$172
$145 
$27
$35

56. Is Price Discrimination a Bad Thing?
Although we might think so, but it is not necessary
Total surplus was actually enhanced by the monopolist’s use of the hurdle method of price discrimination
TS = CS+PS
CS = reservation price minus price actually paid
PS = charged price minus reservation price ($29)
Ordinary monopoly: TS = $27
CS = = $6 ; PS = 3(36 – 29) = $21
Hurdle price discriminate: TS = $35
CS = = $8; PS = 3(36 – 29) + 2(32 – 29) = $27

57. Monopoly and Public Policy
Monopoly is problematic:
Loss in efficiency associated with restricted output
Monopolist earns an economic profit at the buyer’s expense
Goal of people is to control monopolies
Policy options
Government ownership and operation
Regulation
Competitive bids for natural monopoly services
Break up

58. State-Owned Natural Monopoly
Marginal cost is always less than average cost
Marginal cost pricing produces losses
Options
Fund losses from tax revenues
Fixed monthly fee plus usage fee
Fixed fee covers losses
Limited incentives to innovate and cut costs
Commonly used for water, Post Office and electricity

59. Used for electricity, telephone and cable Disadvantages
Regulated Monopolies
Cost-plus regulation sets price at per unit explicit costs plus a mark-up for implicit costs
Used for electricity, telephone and cable
Policies vary by state
Disadvantages
High administrative cost
Reduced incentive for cost-saving innovation
Price is greater than marginal cost

60. Government awards contract to low bidder for natural monopoly services
Bid for Contract
Government awards contract to low bidder for natural monopoly services
Garbage collection, fire protection, road construction, Department of Defense
Could achieve marginal cost pricing IF government pays the resulting losses
Asset transfer for large fixed investment is complex

61. Applies to mergers and acquisitions today
Anti-Trust Laws
Two landmark laws
Sherman Act of 1890
Declared conspiracy to create a monopoly illegal
Clayton Act of 1914
Outlawed transactions that would "substantially lessen competition"
Applies to mergers and acquisitions today
IBM avoided break-up; AT&T did not
Microsoft survived

62. Another Policy Option: Ignore Monopoly
Two objections to monopolies
Restrict output, decrease total surplus
Raise price, earn economic profits
Analysis
Discount offers allow some customers to pay less than average cost, though more than marginal cost
Economic profits generated by customers who pay list price – their choice
About two-thirds of economic profits are taxed away
Remainder accrues to shareholders

63. The Algebra of Monopoly Maximization
Chapter 9 Appendix
The Algebra of Monopoly Maximization

64. From Demand to Marginal Revenue
Given a demand curve such as
P = 15 – 2 Q
We can write the marginal revenue curve as
MR = 15 – 4 Q
Suppose marginal cost is a line with zero intercept and a slope of 1
MC = Q
The remaining step is to set marginal revenue equal to marginal cost

65. Let Q* be the profit maximizing level of output
MR = MC
Let Q* be the profit maximizing level of output
MC = MR
Q* = 15 – 4 Q*
5 Q* = 15
Q* = 3
To find P, substitute Q = 3 into the demand equation
P = 15 – 4 Q*
P = 15 – 4 (3)
P = 3