1. Prepared by: Jamal Husein C H A P T E R 6 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monopoly

2. 2 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin MonopolyMonopoly  A monopoly occurs when there is only one firm and a barrier preventing other firms from entering the market.  A monopoly is a market served by a single firm.

3. 3 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Barriers to Entry  A patent, granted by the government, gives an inventor the exclusive right to sell a new product for some period of time  A franchise, or licensing scheme, in which the government designates a single firm to sell a particular product  A natural monopoly, in which large economies of scale in production allow only one firm to be profitable Possible barriers to entry include:

4. 4 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Monopolist’s Output Decision  The firm faces the same laws of production and cost in the short run, associated with diminishing returns.  Like other firms, the monopoly’s objective is to produce the output level that will maximize profit.

5. 5 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Monopolist’s Demand Curve  Since the monopoly is the only firm in the market, it faces the entire market demand for its product.  A downward- sloping demand curve is associated with particular revenue characteristics for the monopoly firm.

6. 6 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin TR and MR for the Monopolist  In order to increase the quantity sold, the monopolist must decrease price for all units sold.  When the monopolist decreases price in order to increase quantity sold, there is good news and bad news regarding additional revenue.

7. 7 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Demand, TR and MR for the Monopolist  Marginal revenue is defined as the change in TR that results from selling one more unit of output  The bad news is that the firm loses revenue from selling at a lower price to all customers combined.  The good news is that the firm sells more output, so it collects more revenue from new customers.

8. 8 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Demand and MR for the Monopolist  When the bad news outweighs the good news, marginal revenue becomes negative.  The combined good and bad news yields the value of marginal revenue for the monopolist.

9. 9 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin TR and MR for the Monopolist  Information from the demand curve (price and quantity sold) can be used to derive the total and marginal revenue curves.

10. 10 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Marginal Principle and the Output Decision  To decide how much output to produce and what price to charge, the monopolist can use the marginal principle. Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

11. 11 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Marginal Rule for Profit Maximization A firm maximizes profit by following the marginal principle—by setting marginal revenue equal to marginal cost; MR = MC

12. 12 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Computing Maximum Profit PriceQMRTR Revenue per Unit TCMCATC Profit (Total Approach Profit Per Unit Profit Per Unit Approach $18600$12$10,800$18$5,710$4$9.52$5,090$8$5,090 17700$11$11,900$17$6,140$4$8.77$5,760$8$5,760 16800$9$12,800$16$6,635$5$8.29$6,165$8$6,165 15900$7$13,500$15$7,20$6$8.00$6,300$7$6,300 141000$5$14,000$14$7,835$6$7.84$6,165$6$6,165 131100$3$14,300$13$8,560$7$7.78$5,740$5$5,740 121200$1$14,400$12$9,400$8$7.83$5,000$4$5,000  Marginal revenue is closest to marginal cost at 900 units of output.

13. 13 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Output Decision When the gap between total revenue and total cost is greatest, marginal revenue is roughly equal to marginal cost. The monopolist maximizes profit when it produces 900 units of output. $ n m c MC AC D MR 900 8 6 15 Doses of Drug per hour

14. 14 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Costs of Monopoly  What are the trade-offs? The costs & benefits of monopoly to society as a whole?  In many cases monopoly results from government policy;  If the costs exceed the benefits, it may be sensible to remove barriers to entry;  The benefits to consumers are measured by Consumer Surplus.

15. 15 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The demand Curve & Consumer Surplus  Consumer Surplus: The difference between the maximum amount a consumer is willing to pay for a product and the price that he/she actually pays. The consumer surplus is the area under the demand curve and above the market price. It is what consumers gain from their Purchases after deducting the cost. The consumer surplus is the area under the demand curve and above the market price. It is what consumers gain from their Purchases after deducting the cost.

16. 16 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The demand Curve & Consumer Surplus 123 Price ($ per lawn) $10 Number of Lawns cut per week $25 $22 Price 5 4 6 Juan Tupak Thurl Forest Fivola Siggy $19 $16 $13 $7 Juan is willing to pay $22, so if the actual price is $10, his consumer surplus is $12 Forest is willing to pay $13,his consumer surplus is $12 Total market Consumer surplus = $12+$9+$6+$3+$0=$30 Fivola is willing to pay $10,her consumer surplus is $0 D Siggy is willing to pay $7,he doesn’t get his lawn cut

17. 17 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Costs of Monopoly  To examine the social costs of monopoly, we start with a perfectly competitive market and then switch to a monopoly …

18. 18 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Monopoly Versus perfect Competition Perfectly competitive price is $8, so the consumer surplus is shown by triangles C and D and rectangle R Monopoly price is $18 and consumer surplus associated with this price is shown by triangle C. Switching from perfect competition to monopoly decreases consumer surplus by the areas R and D. 200 400 $18 $8 $ Doses of Drug per hour LRAC Demand C R D Only part of consumers’ loss is recovered by producers (Rectangle R). The net loss to consumers & society is triangle D (deadweight loss)

19. 19 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Rent Seeking  Rent seeking is a term used to describe the efforts by a monopoly to persuade government to erect barriers to entry.  If rent seeking exists, the monopoly may spend some of its potential profit on rent-seeking activity, and the net loss to society would be areas R and D, not just area D.

20. 20 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin The Costs and Benefits of Monopoly  Costs: a monopoly produces less output than a perfectly competitive market, and people waste resources trying to get and keep monopoly power.  Benefits: a patent or license increases the payoff from research and development, thus encourages innovation.

21. 21 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Natural Monopoly  Examples of natural monopolies: Public utilities (sewerage, water, and electricity generation) Transportation services (railroad freight and mass transit)  A natural monopoly is a firm that serves the entire market at a lower cost than two or more firms can.

22. 22 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Natural Monopoly  The long-run average cost of electricity generation is negatively sloped, reflecting large economies of scale.  As long as the long- run average cost decreases, the long- run marginal cost must lie below it.

23. 23 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Natural Monopoly  Given the structure of demand and marginal revenue, the monopoly maximizes profit by generating 3 thousand kilowatt hours.  Left alone, the monopoly will charge $8.20 and earn a profit of ($8.20-$6.20) = $2 per kilowatt hour (distance between points c and m).

24. 24 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Natural Monopoly  Profit is possible only if there is one firm, unregulated, serving the entire market demand.  Total profit equals (price – average cost) x quantity produced and sold (the green area).

25. 25 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Natural Monopoly  Suppose that the monopoly shared the market demand and output sold with a second firm, and that each firm produced half of the market output (1.5 kw/h).  The cost of producing 1.5 kw/h would exceed the price the firms can receive, thus they would suffer losses.

26. 26 © 2005 Prentice Hall Business PublishingSurvey of Economics, 2/eO’Sullivan & Sheffrin Price Controls for a Natural Monopoly  Under an average-cost pricing policy, the government picks a price equal to the average cost of production, or $5.20.  But regulation gives the utility no incentive to control costs, so costs rise. Price after regulation decreases by less than anticipated.