1. Hall and Lieberman, 3 rd edition, Thomson South-Western, Chapter 9 Monopoly

2. 2 Overview  What you will learn in this lecture  What is a monopoly?  Why does a monopoly exist?  How is monopolized optimal output / price level determined?  How is a monopoly different from a perfect competitive firm?  What happens when things change?

3. 3 Part I. Monopoly  Negative reputation of monopoly is in many ways deserved Unfairly prices, extraordinary power, etc This negative characterization goes too far  Monopolies should be avoided in many markets, but in some it may be best to organize the production  We do better by managing monopoly problem, rather than eliminating it

4. 4 What Is A Monopoly?  A monopoly firm is the only seller of a good or service with no close substitutes Monopoly market is the one where the monopoly firm operates Key concept is notion of substitutability Example  How “close” are the substitutes in the real world? Depends on how broadly or how narrowly we define a market when trying to decide if it is a monopoly Example  the only doctor, attorney or food market in a small town

5. 5 Figure 1 What A Monopolist Does? P2P2 D M P1P1 C Q2Q2 Q1Q1 S Quantity Price

6. 6 What A Monopolist Does?  Compared with a firm in perfectly competitive market, a monopolist moves along the demand curve to produce less but charge a higher price To earn higher profit rather than zero profit The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power  Example  Why don’t profit get competed away?

7. 7 The Sources of Monopoly  Existence of a monopoly means that something is causing other firms to stay out of the market  What barrier prevents additional firms from entering the market? Several possible answers  Economies of scale  Legal barriers  Network externalities

8. 8 I. Economies of Scale  Economies of scale: the higher output, the lower LRATC or the lower unit cost Example  If economies of scale persist to the point where the monopoly is producing for entire market, the market is a natural monopoly one firm can operate at lower average cost than can two or more firms

9. 9 Figure 2: A Natural Monopoly from Economy of Scale M Q P Quantity Dollars LRATC D Market Natural monopolist’s break-even price Relevant output range

10. 10 I. Economies of Scale  Why natural monopoly may exist? Incumbent advantages Example: dry cleaning in a small town, Figure 2  Small local monopolies are often natural monopolies Because they continue to enjoy economies of scale up to point at which they are serving entire market

11. 11 II. Legal Barriers  Sometimes public interest is best served by having a single seller in a market Purposely creating barriers leading to monopoly  Many monopolies arise because of legal barriers including Protection of intellectual property Government franchise

12. 12 II. Legal Barrier -- Protection of Intellectual Property  Most important kinds of legal protection for intellectual property are Patents  Temporary grant of monopoly rights over a new product or scientific discovery Copyrights  Grant of exclusive rights to sell a literary, musical, or artistic work

13. 13 II. Legal Barrier -- Protection of Intellectual Property  Government strikes a compromise Allows creators of intellectual property to enjoy a monopoly and earn economic profit, but only for a limited period of time Once time is up, other sellers are allowed to enter the market, and it is hoped that competition among them will bring down prices Free usage if not having purpose of making profit

14. 14 II. Legal Barrier -- Government Franchise  Large firms we usually think of as monopolies have their monopoly status guaranteed through government franchise Grant of exclusive rights over a product  Governments usually grant franchises when they think market is a natural monopoly  Example?

15. 15 III. Network Externalities  Exist when an increase in network’s membership increases its value to current and potential members  Advantages of joining a large network more beneficial than joining a small network  The value to consumers of a good rises as the number of people who also use the good rises Example: computer operating systems  Microsoft Windows

16. 16 Monopoly Goals & Constraints  Goal of a monopoly—Maximize profit like that of any firm  Noncompetitive firms make ONE decision Once firm determines its output level, it has also determined its price  Constraints Cost constraint f or any level of possible Q  Technology of production  Price it must pay for its inputs Demand constraint  maximum price monopolist can charge, given Q

17. 17 Demand Constraints and MR  Monopoly firm faces a downward sloping demand curve, marginal revenue is less than price of output Graphically, marginal revenue curve will lie below demand curve (figure 3a) Why?  By Intuition  By Mathematics  Monopoly will always produce at an output level where marginal revenue is positive

18. 18 Figure 3a: Demand and Marginal Revenue 5,000 B A 18 MR 6,000 20,000 21,000 30,000 20 30 38 48 50 $60 Demand F G C Number of Subscribers Monthly Price per Subscriber 15,000

19. 19 Figure 3b:Profit Maximization by Monopoly -- MC curve crosses MR curve from below E MR 10,000 MC D 30,000 Number of Subscribers Monthly Price per Subscriber 40 $60

20. 20 Profit And Loss  A monopoly earns a profit whenever P > ATC Profit is the shadow area in the Figure 4(a)  Height equal to P - ATC  Width equal to level of output  A monopoly suffers a loss whenever P < ATC Loss is the shadow area in the Figure 4(b)  Height equal to ATC - P  Width equal to level of output

21. 21 Figure 4: Monopoly Profit and Loss E MR 10,000 $40 MC 32 Total Profit ATC D E Total Loss AVC ATC MR 10,000 40 MC D $50 Dollars (a) Number of Subscribers Dollars (b) Number of Subscribers

22. 22 Part II. Equilibrium in Monopoly Markets  A monopoly market is in equilibrium when this only firm in market is maximizing profit  For monopoly—as for perfect competition—we have different expectations about equilibrium in short- run and equilibrium in long-run

23. 23 Short-Run Equilibrium  Monopoly may earn an economic profit or suffer an economic loss  What if a monopoly suffers a loss in short-run? Any firm should shut down if P < AVC at output level where MR = MC  If monopoly suddenly finds that P < AVC, government will usually not allow it to shut down, Instead use tax revenue to make up for firm’s losses

24. 24 Long-Run Equilibrium  Remember that perfectly competitive firms earn zero profit in the long-run equilibrium  However, monopolies may earn economic profit in the long-run May still benefit from economies of scale  A privately owned monopoly suffering an economic loss in long-run will exit the industry

25. 25 Part III. Comparing Monopoly to Perfect Competition  In perfect competition, economic profit is relentlessly reduced to zero by entry of other firms  In monopoly, economic profit can continue indefinitely have a higher price and lower output than an otherwise similar perfectly competitive market  earns economic profit due to this reason  Consumers lose in two ways Pay more for output they buy Due to higher prices they buy less output

26. 26 Figure 5a/b: Comparing Monopoly and Perfect Competition 100,000 E $10 D S 1,000 ATC MC d$10 Quantity of Output Price per Unit (a) Competitive Market (b) Competitive Firm Dollars per Unit Quantity of Output 2.and each firm produces 1,000 units, where P = MC. 1.In this competitive market of 100 firms, equilibrium price is $10 3.When monopoly takes over, the old market supply curve...

27. 27 Figure 5c: Comparing Monopoly and Perfect Competition 100,000 Quantity of Output Price per Unit E 10 D (c) Monopoly S = MC 60,000 MR $15 F 6.with a higher price and lower market output than under perfect competition. 4.becomes the monopoly's MC curve. 5.The monopoly produces where MR = MC,

28. 28 MC MR Demand Figure 5d Comparison of the social loss between Monopoly and Perfect Competition Competitive equilibrium Monopolistic equilibrium PMPM PCPC

29. 29 Comparing Monopoly to Perfect Competition Perfect CompetitionMonopoly Firm’s choiceQP or Q Profit maximization P = MCMR=MC Maximized Profit Zero in the long run Profit / loss in the short run Profit / loss in short run / long run with lower Q and higher P than those in perfect competitive market CharacteristicsMany firms; free entry & exit; undifferentiated goods Entry barrier; only one firm; differentiated goods; Technology’s effect Still zero profit; usually P goes down and Q goes up Generate higher profits; P and Q change is not determined

30. 30 Why Monopolies Often Earn Zero Economic Profit ?  Government regulation  Rent-seeking activity Any costly action a firm undertakes to establish or maintain its monopoly status  Example: Bribes to government officials in corrupt bureaucracies  Or time and money spent lobbying legislators and public for favorable polices in less corrupt governments Rent-seeking activity is part of firm’s costs. It can reduce economic profit of a monopoly, even reduce it to zero.

31. 31 Part IV. What Happens When Things Change?  Once a monopoly is maximizing profit, it has no incentive to change its price or its level of output Unless something that affects these decisions changes  Possible events Change in demand for monopolist’s product Change in its costs

32. 32 I. An Increase in Demand  Monopolist’s reactions Producing more output Charging a higher price Earning a larger profit Figure 6  It will react to a decrease of demand by Reducing output Lowering price Suffering a reduction in profit

33. 33 Figure 6: A Change in Demand A MR 1 10,000 $40 MC D1D1 30,000 (a) Number of Subscribers Monthly Price per Subscriber MR 2 11,000 D2D2 $47 B A D1D1 MR 1 (b) 10,000 40 MC Monthly Price per Subscriber Number of Subscribers

34. 34 II. Cost-Saving Technological Advance  Benefits perspective: Monopoly’s profits will be higher after adoption  Only part of benefits are passed to consumers  In perfect competitive market, all of the benefits are passed to consumers  Costs perspective : After its cost increase, monopoly’s profits will be lower Only part of a cost increase onto consumers in form of a higher price In perfect competitive market, all of the costs are passed to consumers – have to pay higher prices

35. 35 Figure 7: Monopoly Profit and Loss -- Increased Cost Number of Subscribers Dollars E D MR 10,000 12,000 $40 MC 2 MC 1 D 38

36. 36 Summary  Monopoly has market power  Possible reasons for existence of monopoly:  Economies of scale – natural monopoly  Legal barriers  Network externalities  Standard profit maximization approach (MR =MC)  Profit or loss both in short run and long run  Rent seeking activity and zero profit  Increase in demand / technology adoption effects on monopolist’s decision