1. PPA 723: Managerial Economics Lecture 15: Monopoly The Maxwell School, Syracuse University Professor John Yinger

2. Managerial Economics, Lecture 15: Monopoly Outline  Monopoly Pricing  Welfare Effects of Monopoly  How Do Monopolies Arise?  Monopolies and Public Policy  Anti-trust laws and regulation  Public monopolies

3. Managerial Economics, Lecture 15: Monopoly Monopoly  A monopoly is the only supplier of a good for which there is no close substitute.  A monopoly's output is the market output.  A monopoly's demand curve is market demand curve.  Its demand curve is downward sloping.  It doesn't lose all its sales if it raises its price.  A monopoly is a price setter, not a price taker.

4. Managerial Economics, Lecture 15: Monopoly Monopoly Profit Maximization  Monopolies, like other firms, maximize profits by choosing quantity such that: marginal revenue = marginal cost MR(Q) = MC(Q)  But with a monopoly, MR(Q) ≠ P.

5. Managerial Economics, Lecture 15: Monopoly Marginal Revenue, MR  MR = the change in revenue from selling one more unit.  MR =  R/  Q (=  R when  Q =1)  For a competitive firm, MR = P.  For a monopoly, MR < P.

6. Managerial Economics, Lecture 15: Monopoly Figure 11.1a Average and Marginal Revenue Price, p, $ per unit qq +1 Quantity,q, Units per year p 1 (a) Competitive Firm Demand curve AB R 1 = A R 2 = A + B  R = R 2 – R 1 = B = p 1

7. Managerial Economics, Lecture 15: Monopoly Figure 11.1b Average and Marginal Revenue QQ +1 Quantity,Q, Units per year p 1 p 2 Price, p, $ per unit (b) Monopoly Demand curve AB C R 1 = A + C R 2 = A + B  R = R 2 – R 1 = B – C = p 2 - C

8. Managerial Economics, Lecture 15: Monopoly Deriving a Monopoly’s MR Curve  A monopoly increases its output by  Q,  by lowering its price per unit by  P/  Q (=slope of demand curve).  So monopoly loses (  p/  Q)  Q on units originally sold at higher price (area C)  but earns an additional P on extra output (area B).  Thus: MR = P + (  p/  Q)  Q = P + a negative term < P

9. Managerial Economics, Lecture 15: Monopoly Figure 11.2 Elasticity of Demand and Total, Average, and Marginal Revenue p, $ per unit Demand (p = 24– Q) Perfectly elastic Perfectly inelastic Elastic,  <–1 Inelastic,–1 <  < 0  =–1  p =–1  Q =1  Q =1  MR =–2 Q, Units per day 24 12 0 24 MR = 24– 2Q

10. Managerial Economics, Lecture 15: Monopoly Linear MR Curve  If demand curve is linear, P = a - bQ,  Then MR curve is linear, MR = a - 2bQ.  MR curve hits vertical (price) axis where demand curve does.  Slope of MR curve = 2  slope of demand curve.  MR curve hits horizontal axis at half the quantity as the demand curve.

11. Managerial Economics, Lecture 15: Monopoly Choosing Price or Quantity A monopoly can set P or Q to maximize its profit, . A monopoly is constrained by market demand. –It cannot set both Q and P. –If a monopoly sets p, demand curve determines Q. –If a monopoly sets Q, demand curve determines P. Because a monopoly wants to maximize , it chooses same profit-maximizing solution whether it sets P or Q

12. Managerial Economics, Lecture 15: Monopoly Profit Maximization  All firms, including monopolies, use a two-step analysis: 1.The firm determines output, Q*, at which it makes highest , i.e., where –MR = MC 2. The firm decides whether to produce Q* or shut down (if P ≤ AVC)

13. Managerial Economics, Lecture 15: Monopoly Figure 11.3 Maximizing Profit 12 18 24 8 6 108 144 60 601224 R, , $ 012624 AC AVC e Demand  = 60 MC MR Q, Units per day Revenue,R Profit,  Q, Units per day p, $ per unit (b) Profit, Revenue

14. Managerial Economics, Lecture 15: Monopoly Market Power  A monopolist’s ability to set the price is an example of a more general phenomenon called market power.  Market power is defined as the ability of a firm to charge a price above marginal cost without losing all its business.  Market power exists when a firm faces a demand curve with an elasticity < -∞.

15. Managerial Economics, Lecture 15: Monopoly Causes of Market Power  A firm gains market power if  Consumers are willing to pay "virtually anything" for its product.  There exist no close substitutes for the firm's product.  Other firms can't enter the market.

16. Managerial Economics, Lecture 15: Monopoly The Welfare Effects of Monopoly  Define welfare as consumer surplus + producer surplus.  Then welfare is lower under monopoly than under competition.  A monopoly sets P > MC, causing deadweight loss (DWL).

17. Managerial Economics, Lecture 15: Monopoly = 18 Figure 11.5 Deadweight Loss of Monopoly p, $ per unit Demand Q, Units per day MR MC p c = 16 B = $12 D =$60 C =$2 E = $4 MR =MC =12 A = $18 p m 24 Q m = 6Q c = 824120 e m e c

18. Managerial Economics, Lecture 15: Monopoly How Do Monopolies Arise?  A firm has a cost advantage over other firms (e.g. due to better technology).  Government regulation prevents entry.  Several firms merge into a single firm.  Firms act collectively = a cartel.  Firms use strategies - such as threats of violence - that discourage other firms from entering market.

19. Managerial Economics, Lecture 15: Monopoly Natural Monopoly  A market has a natural monopoly if one firm can produce total market output at lower cost than could several firms.  If cost for Firm i to produce q i is C(q i ), the condition for a natural monopoly is  C(Q) < C(q 1 ) + C(q 2 ) +... + C(q n ),  where Q = q 1 + q 2 +.. + q n is sum of output of any n > 2 firms

20. Managerial Economics, Lecture 15: Monopoly Natural Monopoly, 2  Equivalently, natural monopoly arises if the long-run AC curve is declining.  This corresponds to a technology characterized by economies of scale.

21. Managerial Economics, Lecture 15: Monopoly Figure 11.7 Natural Monopoly 15 20 40 10 601215 AC = 10 + 60/Q MC = 10 Q, Units per day AC,MC, $ per unit

22. Managerial Economics, Lecture 15: Monopoly Government Actions that Reduce Market Power  Antitrust laws prohibit monopolization, price fixing, and so forth.  Regulations prevent monopolies from exercising all of their market power.

23. Managerial Economics, Lecture 15: Monopoly Optimal Price Regulation  Price regulation can eliminate DWL.  Regulation is optimal if it leads to the "competitive" outcome.

24. Managerial Economics, Lecture 15: Monopoly Figure 11.8 Optimal Price Regulation p, $ per unit Regulated demand Market demand Q, Units per day 2412860 MR r MC 18 24 16 D E C B A e m e o

25. Managerial Economics, Lecture 15: Monopoly Government Created Monopoly  Governments create monopoly through  Barriers to entry (e.g., patents, licenses)  Government provision (e.g. utilities, public safety, education, lotteries)

26. Managerial Economics, Lecture 15: Monopoly Government Monopoly P Q AC MR D=MB P eff P even Government monopoly can raise revenue by setting price anywhere between the break-even price (P even ) and the private monopoly price (P mon ). It loses money at the efficient price (P eff ). MC P mon

27. Managerial Economics, Lecture 15: Monopoly Government Monopoly Pricing  If a government monopoly uses the private monopoly price it:  Maximizes its revenue.  Causes the same distortion as the private monopoly!  Transforms monopoly profits into government revenue.

28. Managerial Economics, Lecture 15: Monopoly Government Monopoly Pricing, 2  If the government sets the efficient price, it  Maximizes consumer surplus in this market,  But it loses money,  And must raise revenue elsewhere, undoubtedly causing DWL (i.e. lost consumer surplus) in other markets.