1. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly Chapter 9

2. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Power Market power is the ability to alter the market price of a good or service.

3. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Downward-Sloping Demand Curve Firms with market power confront downward-sloping demand curves. Competitive firms face a horizontal demand curve.

4. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The industry Quantity (thousands of bushels per day) 0 The competitive firm Quantity (bushels per day) Price (per bushel) 0 Firm vs. Industry Demand Demand facing competitive firm $13 Market demand $13

5. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly The demand curve facing the monopoly firm is identical to the market demand curve for the product. Monopoly is a firm that produces the entire market supply of a particular good or service.

6. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price and Marginal Revenue A monopoly faces a different profit maximizing situation than competitive firms. Unlike competitive firms, marginal revenue for a monopolist is not equal to price. –Profit-maximization rule – Produce at that rate of output where MR = MC.

7. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price and Marginal Revenue Marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

8. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price and Marginal Revenue So long as the demand curve is downward- sloping, MR will always be less than price. The MR curve lies below the demand (price) curve at every point but the first.

9. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price and Marginal Revenue

10. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price and Marginal Revenue 012345678910 2 4 6 8 12 $14 Demand (= price) Marginal revenue Price (per beshel) Quantity (bushels per hour) B C D E F G A b c d e f g

11. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Maximization We need to find the intersection of marginal cost and marginal revenue. This will give us the profit-maximizing rate of output. Only one price is compatible with the profit- maximizing rate of output.

12. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Maximization 0 123456789 1 2 3 4 5 6 7 8 9 10 11 12 13 $14 Price or Cost (per bushel) Quantity (bushel per hour) d Demand Marginal revenue Marginal cost Average total cost D Profits

13. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Power at Work: Computer Market Revisited As an example, we’ll use a fictitious company called Universal Electronics that acquires an exclusive patent on the production of microprocessors.

14. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Power at Work: Computer Market Revisited The patent functions as a barrier to entry. –Barriers to entry – Obstacles that make it difficult or impossible for would-be producers to enter a particular market, such as patents.

15. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Power at Work: Computer Market Revisited For comparison purposes, Universal is not taking advantage of economies of scale. –Economies of scale – Reductions in minimum average costs that come about through increases in the size (scale) of plant and equipment.

16. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Production Decision Like any producer, Universal wants to produce at the rate that maximizes profits. Universal faces a production decision concerning its many plants. –Production decision – The selection of the short-run rate of output (with existing plant and equipment).

17. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Production Decision A monopolist can foresee the impact of increased production on market price. Instead, prevent production increase by coordinating the production decisions of its plants.

18. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Revenue Each Universal plant faces a downward- sloping demand curve, thus, the marginal revenue no longer equals price. Only firms that confront a horizontal demand curve equate marginal cost and price.

19. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Reduced Output The typical Universal plant will produce fewer computers that would be produced by a typical perfectly competitive firm.

20. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Monopoly Price The intersection of the marginal revenue and marginal cost curves establishes the profit-maximization rate of output. The demand curve tells us how much consumers are willing to pay for that output.

21. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Initial Conditions in the Monopolized Computer Market 1200 1000 800 600 400 200 024,000 Price (per computer) Quantity (computers per month) A X Market demand Competitive market supply $1200 1000 800 600 400 200 0 40080012001600 Price (per computer) Quantity (computers per month) W C M B Average total cost Demand curve facing single plant Marginal revenue of single plant Marginal cost Monopoly outcome Competitive outcome

22. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly Profits Total profit equals average profit per unit times the number of units produced. Profit per unit = price – average total cost Profit per unit = p – ATC Total profits = profit per unit X quantity Total profits = (p – ATC) X q

23. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly Profits A monopoly receives larger profits than a comparable competitive industry by reducing the quantity supplied and pushing prices up.

24. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly Profits: The Typical Universal Plant M $1200 1000 800 600 400 200 0 Price (per computer) Quantity (computers per month) 200400600800100012001400 W K B Average total cost Marginal cost Demand curve facing single plant Marginal revenue of single plant C Profit

25. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 0 Quantity (computers per month) Price (per computer) Market demand ATC MR MC Monopoly profit Monopoly Profits: The Entire Company Competitive short-run equilibrium Competitive long-run equilibrium Monopolist's equilibrium A X R T U V qMqM qCqC $1000 $1100

26. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Barriers to Entry High barriers to entry prevent profit-hungry entrepreneurs from entering the market to compete monopoly profits away. Monopoly profits persist as long as barriers to entry prevent competitors from entering the market.

27. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. A Comparative Perspective on Market Power Outcomes differ under competitive and monopoly conditions.

28. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Competitive Industry High prices and profits signal consumers’ demand for more output. The high profits attract new suppliers. Production and supplies expand. Prices slide down the market demand curve.

29. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Competitive Industry A new equilibrium is established. Price equals marginal cost at all times. Throughout the process, there is great pressure to reduce costs or improve product quality.

30. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly Industry High prices and profits signal consumers’ demand for more output. Barriers to entry are erected to exclude potential competition. Production and supplies are constrained. Prices don’t move down the market demand curve.

31. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly Industry No new equilibrium is established. Price exceeds marginal cost at all times. There is no squeeze on profits and thus no pressure to reduce costs or improve product quality.

32. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly Industry Because monopoly markets do not tend towards marginal cost pricing, consumers do not get the mix of output that delivers the most utility from available resources. –Marginal cost pricing – the offer (supply) of goods at prices equal to their marginal cost.

33. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Political Power A firm with considerable market power likely to have significant political power as well.

34. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Limits to Power Monopolists only have absolute control of the quantity of output supplied to the market. Monopolists must still contend with the market demand curve.

35. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Limits to Power The greater the price elasticity of demand, the more a monopolist will be frustrated in its attempts to establish both high prices and high volume. –Price elasticity of demand – The percentage change in quantity demanded divided by the percentage change in price.

36. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Discrimination A monopolist may be able to extract greater profits by practicing price discrimination. Price discrimination is the sale of an identical good at different prices to different consumers by a single seller.

37. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entry Barriers The preservation of monopoly power depends on keeping potential competitors out of the market.

38. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entry Barriers Patents – offers a producer 20 years of exclusive rights to produce a particular product. Monopoly franchises – governments create and maintain monopolies by giving a single firm the exclusive right to supply a particular good or service.

39. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entry Barriers Control of key inputs – a company may lock out competition by securing exclusive access to key inputs. Lawsuits – may be used to prevent new companies from successfully entering an industry.

40. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entry Barriers Acquisition – when all else fails, purchase a potential competitor. Economies of scale – a monopoly may persist because of cost advantages over smaller firms

41. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pros and Cons of Market Power It is conceivable that monopolies could benefit society.

42. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Research and Development Because of their greater profits, monopolists have a greater advantage in pursuing research and development. They do not have a clear incentive to do so.

43. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entrepreneurial Incentives Market power can be an incentive for entrepreneurial activity. An innovator can make substantial profits in a competitive market before the competition catches up.

44. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economies of Scale If economies of scale exist, the monopolist may attain much greater efficiency than a large number of competitive firms. There is no guarantee that such economies of scale will exist in a given industry.

45. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Natural Monopolies A natural monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply. Economies of scale act as a “natural” barrier to entry.

46. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Contestable Markets A contestable market is an imperfectly competitive market subject to potential entry if prices or profits increase.

47. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Contestable Markets Contestable markets are characterized by moderate barriers to entry. When potential profits reach a certain level competitors are enticed to enter the market.

48. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Structure vs. Behavior The structure of monopoly is, in itself, not a problem. If potential rivals force a monopolist to behave like a competitive firm, then a monopoly imposes no cost on consumers or on society at large.

49. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Microsoft: Bully or Genius? Concerning Microsoft, critics argue that Microsoft: –Charges too much for its systems software. –Suppresses substitute technologies. –Bullies potential competitors.

50. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Antitrust Laws The legal foundations for antitrust intervention are contained in three landmark antitrust laws. Sherman Act (1890) – prohibits “conspiracies in restraint of trade.

51. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Antitrust Laws Clayton Act (1914) – principally aimed at preventing the development of monopolies by prohibiting price discrimination, exclusive dealing agreements, certain types of mergers, and interlocking boards of directors among competing firms.

52. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Antitrust Laws The Federal Trade Commission Act (1914) – created the FTC to study industry structures and behavior so as to identify anti-competitive practices.

53. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The AT&T Case The federal government dismantled AT&T in 1984. Prior to the break-up, AT&T supplied 96 percent of all long-distance service and over 80 percent of local telephone service.

54. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Microsoft Case Microsoft was accused of: –Thwarting competitors in operating systems by erecting entry barriers. –Using its monopoly position in operating systems to gain an unfair advantage in the applications market. –It bought out its competitors.

55. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Microsoft’s Defense In its defense, Microsoft asserted that: –It dominates the computer industry because it produces the best products at attractive prices. –The computer industry is highly contestable if not perfectly competitive.

56. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Verdict A federal court concluded that Microsoft abused its monopoly position in operating systems. By limiting consumer choices and stifling competition, Microsoft had denied consumers better and cheaper information technology.

57. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Remedy The trial judge suggested a structural remedy, that Microsoft might have to be broken into two companies to ensure competition. The U.S. Department of Justice decided to seek a behavioral remedy instead.

58. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly End of Chapter 9