1. McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Monopoly, Oligopoly, and Monopolistic Competition 1.Distinguish among three types of imperfectly competitive industries 2.Define imperfect competition and describe how it differs from perfect competition 3.Describe why economies of scale are the most enduring source of monopoly power 4.Apply the concepts of marginal cost and marginal revenue to find the output 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

2. 7-2 Imperfect Competition Imperfectly competitive firms have some ability to set their own price: they are price setters –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 producing slightly differentiated products that are reasonably close substitutes 3.Oligopoly has a small number of large firms producing products that are close substitutes

3. 7-3 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

4. 7-4 Oligopoly Number of Firms Few firms, each large PriceSome flexibility Entry and Exit Difficult 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

5. 7-5 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

6. 7-6 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

7. 7-7 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

8. 7-8 Economies of Scale and Start- Up Costs New products can have a large fixed development cost Variable cost: sum of payments made to the variable factors, such as labor Fixed cost: sum of payments made to the fixed factors, such as capital Start-up costs can be thought of as a fixed cost Average total cost (ATC): total cost divided by output A good whose production has a large start-up cost and low variable cost is subject to economies of scale –ATC declines sharply as output increases

9. 7-9 Economies of Scale and Start- Up Costs Consider an example: Assume marginal cost (M) is constant Variable cost is M*Q 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 –Average fixed cost = F/Q

10. 7-10 Economies of Scale Quantity Total cost ($/year) F TC = F + M Q Average cost ($/unit) Quantity ATC = F/Q + M M

11. 7-11 Profit Maximization for the Monopolist 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 is called marginal revenue: –Change in total revenue from a one-unit change in output –Equal to price for the perfectly competitive firm –Less than price for the monopolist

12. 7-12 Price ($/unit) Quantity (units/week) Profit Maximization for the Monopolist To sell another unit the monopolist must lower price –Total revenue from 2 units = $12 –Total revenue from 3 units = $15 Marginal revenue = $3 D 2 6 3 5

13. 7-13 Deciding Quantity Profit is maximized at the level of output where marginal cost equals marginal revenue At P = $3 and Q = 12, MC > MR Decrease output –At Q = 8, MC = MR = 2 The demand curve sets the price at P = $4 –At any output below 8, MC < MR Price ($/unit of output) Quantity (units/week) 3 MC 2 6 D 12 MR 4 8

14. 7-14 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

15. 7-15 Monopoly and Perfect Competition Monopoly MC = MR P >MR P > MC Deadweight Loss Perfect Competition MC = MR P = MR P = MC No Deadweight Loss

16. 7-16 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 monopoly has costs Patents encourage innovation Economies of scale minimize ATC Network economies increase benefits

17. 7-17 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

18. 7-18 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

19. 7-19 Imperfect Competition Monopolistic Competition and Oligopoly Sources of Market Power Monopoly