1. Chapter Ten Monopolies

2. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 2 A Model of Monopoly Monopoly: One firm in an industry selling a product for which there are no close substitutes Barriers to Entry: Anything that prevents firms from entering a market. Monopoly will choose level of output that maximizes profit Difference between monopoly and competitive firm is how actions affect market price. –Monopoly has MARKET POWER: Firm’s power to set its price without losing its entire share of the market –Monopoly is a PRICE-MAKER: A firm that has the power to set its price, rather than taking the price set by the market

3. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 3 Monopoly Market Power –There is no one to undercut the monopolist’s price –The impact of quantity decisions on the price Competitive firm cutting production has very little impact on market price. Monopoly cutting production has large impact on market price.

4. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 4 Figure 10.1: How the Market Power of a Monopoly and a Competitive Firm Differ

5. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 5 Revenue, Costs, and Profits for a Monopoly QPTRMRTCMCPROF 01600----70----70 1150 79971 2140280130845196 31303901109410296 41204809011420366 51105507014834402 61006005019648404 7906303026165369 8806401035190289 970630-10481130149 1060600-30656175-56

6. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 6 Figure 10.2: Total Revenue, Marginal Revenue, and Demand

7. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 7 Maximizing Profits As long as marginal revenue is greater than marginal cost, a monopoly should keep producing to maximize profits. The monopolist should produce up to the level of production where marginal cost = marginal revenue (MC=MR)

8. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 8 Figure 10.3: Finding a Quantity of Output to Maximize Profits

9. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 9 Figure 10.4: Marginal Revenue and Marginal Cost

10. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 10 MC = MR vs. MC = P For a competitive firm, TR = Q x P where the firm cannot affect the price –MC = MR is virtually the same as MC = P

11. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 11 Figure 10.5: Profit Maximization for a Monopoly and a Competitive Firm

12. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 12 Figure 10.6: The Generic Diagram for a Monopoly

13. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 13 Figure 10.7: A Monopoly with Negative Profits

14. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 14 Figure 10.8: Deadweight Loss from Monopoly

15. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 15 The Monopoly Price is Greater than Marginal Cost The price with a monopoly is higher than with competition (since a monopoly can withhold production and drive the price up) The loss to society can be measured as the difference between price and marginal cost The size of the difference (or of the loss) can be measured by the elasticity of the monopoly’s demand curve. –If the demand curve is highly elastic then the difference between price and marginal cost is small

16. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 16 Monopoly price is greater than marginal cost Price-cost margin: The difference between price and marginal cost divided by the price. –Indicates market power: 0 is no market power Price – Marginal Cost Price Price-cost margin of a competitive firm is 0 1 / Price Elasticity of Demand

17. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 17 Why Monopolies Exist If big firms are needed in order to produce at a low cost, it may be natural for a few firms or only one firm to exist. –Economies of scale – decreasing long run ATC – can lead to a monopoly. Minimum efficient scale of a firm is the minimum size of the firm for which ATC is lowest. If minimum efficient scale is a small fraction of the market then there will be many firms. Water Company: Large fixed costs to lay pipes, but connecting each house has low cost. As connect more houses, ATC declines. (Electricity and Local Telephone Service)

18. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 18 Monopolies, con’t. Natural monopoly: A single firm in an industry in which ATC is declining over the entire range of production and the minimum efficient scale is larger than the size of the market. –Usually regulated by the government to keep the price below the monopoly price and closer to the competitive price, reducing the deadweight loss –Nationwide telephone service no longer a natural monopoly due to advances in technology

19. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 19 Patents and Copyrights Another way monopolies arise is through the granting of patents and copyrights by the government. –Intel had a patent on computer chips –If granted a patent, can have a monopoly for 20 years –Pharmaceutical drugs are another example –Provides good incentive for innovation –Government could lower prices on drugs, but would not be an incentive to create new and improved products

20. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 20 Licenses The government can create a monopoly by giving or selling to one firm a license to produce the product. –U.S. Postal Service Attempts to create barriers –Adam Smith encouraged free trade between countries to try to eliminate monopolies De Beers, Standard Oil –Contestable Market: A market in which the threat of competition is enough to encourage firms to act like competitors.

21. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 21 Price Discrimination Price Discrimination: A situation in which different groups of consumers are charged different prices for the same good. –Senior citizen discounts, Foreign Markets, Quantity Discounts Price Discrimination is partly determined by the elasticity of demand

22. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 22 Figure 10.9: Price Discrimination Targeted at Different Groups

23. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 23 Quantity Discounts By charging higher fees for lower quantities, monopolies increase their profits and also increase consumer surplus, thereby reducing deadweight loss.

24. Copyright © by Houghton Mifflin Company, Inc. All rights reserved10 - 24 Figure 10.10: Price Discrimination Through Quantity Discounts or Premiums