1. McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 8 Monopoly, Oligopoly, and Monopolistic Competition

2. 8 - 2LO 8 - All Market Imperfections Ch 8 Imperfect Competition Ch 9 Games and Strategic Behavior Ch 10 Externalities and Property Rights

3. 8 - 3LO 8 - All Learning Objectives 1.Distinguish among three types of imperfectly competitive industries 2.Define imperfect competition and describe how it differs from perfect competition 3.Understand why economies of scale are the most enduring source of monopoly power 4.Understand the concepts of marginal cost and marginal revenue  Find the output level and price that maximizes a monopolist's profits 5.Explain why the profit-maximizing output level for a monopolist is too small from society's perspective 6.Discuss why firms offer discounts to buyers who are willing to jump a hurdle

4. 8 - 4LO 8 - 2 Imperfect Competition  Imperfectly competitive firms have some control of price  Long-run economic profits possible  Reduce economic surplus  Three types 1.Monopoly has only one seller, no close substitutes 2.Monopolistic competition has many firms with differentiated products  These products are all close substitutes 3.Oligopoly is a small number of firms producing close substitutes

5. 8 - 5LO 8 - 1 Monopolistic Competition Number of Firms Many firms PriceLimited flexibility Entry and ExitFree ProductDifferentiated 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

6. 8 - 6LO 8 - 1 Oligopoly Number of Firms Few firms, each large PriceSome flexibility Entry and ExitLarge 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

7. 8 - 7LO 8 - 2 The Essential Difference  Market power is the firm's ability to raise its price without losing all its sales  Any firm facing a downward sloping demand curve  Firm picks P and Q on the demand curve  Market power comes from factors that limit competition Quantity Price Imperfectly Competitive Firm D Quantity Price Perfectly Competitive Firm D

8. 8 - 8LO 8 - 3 Five Sources of Market Power 1.Exclusive control over inputs 2.Patents and copyrights 3.Government licenses or franchises 4.Economies of scale (natural monopolies) 5.Network economies

9. 8 - 9LO 8 - 3 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

10. 8 - 10LO 8 - 3 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  Telephones  Windows operating system  eBay  Facebook and MySpace

11. 8 - 11LO 8 - 3 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

12. 8 - 12LO 8 - 3 Economies of Scale Quantity Total cost ($/year) F TC = F + M Q Average cost ($/unit) Quantity ATC = F/Q + M M

13. 8 - 13LO 8 - 3 Video Game – Different Volumes NintendoPlaystation Annual Production (000s) 1,0001,200 Fixed Cost ($000s)$200 Variable Cost ($000s)$800$960 Total Cost ($000s)$1,000$1,160 ATC per game$1.00$0.97

14. 8 - 14LO 8 - 3 Video Game – Lower Marginal Costs NintendoPlaystation Annual Production (000s) 1,0001,200 Fixed Cost ($000s)$200 Variable Cost ($000s)$200$240 Total Cost ($000s)$400$440 ATC per game$0.40$0.37

15. 8 - 15LO 8 - 3 Video Games – Higher Fixed Cost NintendoPlaystation Annual Production (000s) 1,0001,200 Fixed Cost ($000s)$10,000 Variable Cost ($000s)$200$240 Total Cost ($000s)$10,200$10,240 ATC per game$10.20$8.53

16. 8 - 16LO 8 - 3 Video Games – Different Production Levels NintendoPlaystation Annual Production (000s) 5001,700 Fixed Cost ($000s)$10,000 Variable Cost ($000s)$100$340 Total Cost ($000s)$10,100$10,240 ATC per game$20.20$6.08

17. 8 - 17LO 8 - 3 Intel's Advantage  Development cost of a new chip$2 billion  Marginal cost of making a chipPennies  Dominating the marketPriceless  Intel supplies more than 80% of the processors for PCs

18. 8 - 18LO 8 - 4 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 for a monopolist is different than for a perfectly competitor

19. 8 - 19LO 8 - 4 Price ($/unit) Quantity (units/week) 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 D 2 6 3 5

20. 8 - 20LO 8 - 4 Monopolist's Marginal Revenue Total Revenue $12 $15 $16 $15 PriceQuantity $62 $53 $44 $35 Price & marginal revenue ($/unit) 8 8 D Quantity (units/week) MR 32 3 1 4 5 Marginal Revenue 3 1

21. 8 - 21LO 8 - 4 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 Q0Q0 Q 0 /2 a/2 MR

22. 8 - 22LO 8 - 4 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 = $8  At any output below 8, MC < MR Price ($/unit of output) Quantity (units/week) 3 MC 2 6 D 12 MR 4 8

23. 8 - 23LO 8 - 4 Monopoly Losses and Profits Price ($/minute) Minutes (millions/day) 20 0.12 0.10 ATC Economic loss = $400,000/day D 0.05 MC MR 24 Price ($/minute) Minutes (millions/day) 2420 0.08 0.10 ATC D 0.05 MC MR Economic profit = $400,000/day

24. 8 - 24LO 8 - 5 The Invisible Hand Fails Price ($/unit of output) Quantity (units/week) The socially optimal amount occurs where MC = MB, Q = 12 units and P = $3 The monopolist's optimal amount occurs where MC = MR, Q = 8 units and P = $4 2 MR 8 4 24 D 3 12 6 Marginal Cost Deadweight loss from monopoly = $4

25. 8 - 25LO 8 - 5 Monopoly and Perfect Competition Monopoly MC = MR P >MR P > MC Deadweight Loss Perfect Competition MC = MR P = MR P = MC No Deadweight Loss

26. 8 - 26LO 8 - 5 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

27. 8 - 27LO 8 - 6 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  Hurdle method: discounts for identifiable groups (e. g., students, AARP)  Perfect discrimination: negotiate separate deals with each customer

28. 8 - 28LO 8 - 6 Carla the Editor  Opportunity cost of Carla's time is $29 What is the social optimum? What's Carla's revenue? Student Reservation Price A$40 B38 C36 D34 E32 F30 G28 Total Revenue $40 $76 $108 $136 $160 $180 $196

29. 8 - 29LO 8 - 6 Carla the Editor  Opportunity cost of Carla's time is $29 What if Carla maximizes her profit? What's Carla's revenue? Student Reservation Price A$40 B38 C36 D34 E32 F30 G28 MR $40 $36 $32 $28 $24 $20 $16 Total Revenue $40 $76 $108 $136 $160 $180 $196

30. 8 - 30LO 8 - 6 Carla the Editor  Opportunity cost of Carla's time is $29 What if Carla is perfect discriminator? What's Carla's revenue? Student Reservation Price A$40 B38 C36 D34 E32 F30 G28 Total Revenue $40 $78 $114 $148 $180 $210 $238

31. 8 - 31LO 8 - 6 Carla Offers a Rebate  If reservation price < $36, mail in rebate Student Reservation Price Total Revenue A$40 B38 76 C36 108 Discounted Price Submarket D$34 E3264 F3090 MR $40 36 32 $34 30 26

32. 8 - 32LO 8 - 6 Carla's Choices Program Social Optimum Papers Edited6 Price$30 Total Revenue$180 Carla's Time $174 Economic Profit$6 Total Surplus$26 Hurdle 5 = (3 + 2) $36, $4 rebate $172 $145 $27 $35 Perfect Discriminator 6 Reservation $210 $174 $36 Single Price 3 $36 $108 $87 $21 $27

33. 8 - 33LO 8 - 6 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.  Temporary Sales  Hard cover and paperback books  Multiple car models from one manufacturer  Commercial air carriers  Movie producers and phased releases  Scratch and Dent appliance sales

34. 8 - 34LO 8 - All Imperfect Competition Monopolistic Competition and Oligopoly Sources of Market Power Monopoly

35. McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 8 Appendix The Algebra of Monopoly Maximization

36. 8 - 36LO 8 - 4 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

37. 8 - 37LO 8 - 4 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