Chapter 10 Market Power Monopoly and Monopsony Chapter

Chapter 10 Market Power: Monopoly and Monopsony Chapter 10 1

Topics to be Discussed n Monopoly Power n Sources of Monopoly Power n The Social Costs of Monopoly Power Chapter 10 2

Topics to be Discussed n Monopsony Power n Limiting Market Power: The Antitrust Laws Chapter 10 3

Perfect Competition n Review of Perfect Competition l P = LMC = LRAC l Normal profits or zero economic profits in the long run l Large number of buyers and sellers l Homogenous product l Perfect information l Firm is a price taker Chapter 10 4

Perfect Competition Market P D P S Individual Firm LMC P 0 Q 0 Chapter 10 Q LRAC D = MR = P q 0 Q 5

Monopoly n Monopoly 1) One seller - many buyers 2) One product (no good substitutes) 3) Barriers to entry Chapter 10 6

Monopoly n The monopolist is the supply-side of the market and has complete control over the amount offered for sale. n Profits will be maximized at the level of output where marginal revenue equals marginal cost. Chapter 10 7

Monopoly n Finding Marginal Revenue l As the sole producer, the monopolist works with the market demand to determine output and price. l Assume a firm with demand: u Chapter 10 P=6 -Q 8

Total, Marginal, and Average Revenue Price P Quantity Q $6 5 4 3 2 1 Chapter 10 0 1 2 3 4 5 Total Revenue R $0 5 8 9 8 5 --$5 3 1 -1 -3 Marginal Revenue MR Average Revenue AR --$5 4 3 2 1 9

Average and Marginal Revenue $ per unit of output 7 6 5 Average Revenue (Demand) 4 3 2 Chapter 10 1 Marginal Revenue 0 1 2 3 4 5 6 7 Output 10

Monopoly n Observations 1) To increase sales the price must fall 2) MR < P 3) Compared to perfect competition Chapter 10 u No change in price to change sales u MR = P 11

Monopoly n Monopolist’s Output Decision 1) Profits maximized at the output level where MR = MC 2) Cost functions are the same Chapter 10 12

Maximizing Profit When Marginal Revenue Equals Marginal Cost The Monopolist’s Output Decision n At output levels below MR = MC the decrease in revenue is greater than the decrease in cost (MR > MC). n At output levels above MR = MC the increase in cost is greater than the decrease in revenue (MR < MC) Chapter 10 13

Maximizing Profit When Marginal Revenue Equals Marginal Cost $ per unit of output MC P 1 P* AC P 2 Lost profit D = AR MR Q 1 Chapter 10 Q* Q 2 Lost profit Quantity 14

Monopoly The Monopolist’s Output Decision n An Example Chapter 10 15

Monopoly The Monopolist’s Output Decision n An Example Chapter 10 16

Monopoly The Monopolist’s Output Decision n An Example Chapter 10 17

Monopoly The Monopolist’s Output Decision n An Example l By setting marginal revenue equal to marginal cost, it can be verified that profit is maximized at P = $30 and Q = 10. l This can be seen graphically: Chapter 10 18

Example of Profit Maximization $ C t' 400 R 300 c’ 200 t Profits 150 100 50 0 Chapter 10 c 5 10 15 20 Quantity 19

Example of Profit Maximization n Observations Slope of rr’ = slope cc’ and they are parallel at 10 units 400 l Profits are maximized at 10 units 300 l P = $30, Q = 10, TR = P x Q = $300 l l l AC = $15, Q = 10, TC = AC x Q = 150 Profit = TR - TC u $150 = $300 - $150 C $ t' R c 200 t 150 Profits 100 50 c 0 5 10 15 20 Quantity Chapter 10 20

Example of Profit Maximization $/Q 40 MC 30 AC Profit 20 AR 15 10 MR 0 Chapter 10 5 10 15 20 Quantity 21

Example of Profit Maximization n Observations $/Q l AC = $15, Q = 10, TC = AC x Q = 150 40 l Profit = TR = TC = $300 - $150 = $150 or 30 l Profit = (P - AC) x Q = ($30 - $15)(10) = $150 MC AC Profit 20 AR 15 MR 10 0 5 10 15 20 Quantity Chapter 10 22

Monopoly n A Rule of Thumb for Pricing l We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in practice. l This can be demonstrated using the following steps: Chapter 10 23

A Rule of Thumb for Pricing Chapter 10 24

A Rule of Thumb for Pricing Chapter 10 25

A Rule of Thumb for Pricing Chapter 10 26

A Rule of Thumb for Pricing = the markup over MC as a percentage of price (P-MC)/P 8. The markup should equal the inverse of the elasticity of demand. Chapter 10 27

A Rule of Thumb for Pricing Chapter 10 28

Monopoly n Monopoly pricing compared to perfect competition pricing: l Monopoly P > MC l Perfect Competition P = MC Chapter 10 29

Monopoly n Monopoly pricing compared to perfect competition pricing: l The more elastic the demand the closer price is to marginal cost. l If Ed is a large negative number, price is close to marginal cost and vice versa. Chapter 10 30

Astra-Merck Prices Prilosec The Monopolist’s Output Decision n 1995 l Price of Prilosec = $3. 50/daily dose of Tagamet and Zantac = - $2. 25/daily dose l MC Chapter 10 $1. 50 of Prolosec = 30 - 40 cents/daily dose 31

Astra-Merck Prices Prilosec The Monopolist’s Output Decision • Price of $3. 50 is consistent with “the rule of thumb pricing” Chapter 10 32

Monopoly n Shifts in Demand l In perfect competition, the market supply curve is determined by marginal cost. l For a monopoly, output is determined by marginal cost and the shape of the demand curve. Chapter 10 33

Shift in Demand Leads to Change in Price but Same Output $/Q MC P 1 P 2 D 1 MR 2 MR 1 Q 1= Q 2 Chapter 10 Quantity 34

Shift in Demand Leads to Change in Output but Same Price $/Q MC P 1 = P 2 D 2 MR 2 D 1 MR 1 Q 1 Chapter 10 Q 2 Quantity 35

Monopoly n Observations l Shifts in demand usually cause a change in both price and quantity. l. A Chapter 10 monopolistic market has no supply curve. 36

Monopoly n Observations l Monopolist may supply many different quantities at the same price. l Monopolist may supply the same quantity at different prices. Chapter 10 37

Monopoly n The Effect of a Tax l n Under monopoly price can sometimes rise by more than the amount of the tax. To determine the impact of a tax: l t = specific tax l MC = MC + t l MR = MC + t : optimal production decision Chapter 10 38

Effect of Excise Tax on Monopolist $/Q Increase in P: P 0 P 1 > increase in tax P 1 P 0 MC + tax D = AR MC MR t Q 1 Chapter 10 Q 0 Quantity 39

Effect of Excise Tax on Monopolist n Question l Suppose: Ed = -2 l How much would the price change? Chapter 10 40

Effect of Excise Tax on Monopolist n Answer n What would happen to profits? Chapter 10 41

Monopoly n The Multiplant Firm l Chapter 10 For many firms, production takes place in two or more different plants whose operating cost can differ. 42

Monopoly n The Multiplant Firm l Choosing total output and the output for each plant: u u Chapter 10 The marginal cost in each plant should be equal. The marginal cost should equal the marginal revenue for each plant. 43

Monopoly The Multiplant Firm n Algebraically: Chapter 10 44

Monopoly The Multiplant Firm n Algebraically: Chapter 10 45

Monopoly The Multiplant Firm n Algebraically: Chapter 10 46

Monopoly n Algebraically: Chapter 10 47

Production with Two Plants $/Q MC 1 MC 2 MCT P* D = AR MR* MR Q 1 Chapter 10 Q 2 Q 3 Quantity 48

Production with Two Plants n Observations: 1) MCT = MC 1 + MC 2 $/Q MC 1 MC 2 2) Profit maximizing output: u u MCT = MR at QT and P* MR = MR* = MC 1 at Q 1, MC* = MC 2 at Q 2 MC 1 + MC 2 = MCT, Q 1 + Q 2 = QT, and MR = MC 1 + MC 2 Chapter 10 MCT P* D = AR MR* MR Q 1 Q 2 Q 3 Quantity 49

Monopoly Power n Monopoly is rare. n However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost. Chapter 10 50

Monopoly Power n Scenario: l Chapter 10 Four firms with equal share (5, 000) of a market for 20, 000 toothbrushes at a price of $1. 50. 51

The Demand for Toothbrushes $/Q At a market price of $1. 50, elasticity of demand is -1. 5. 2. 00 The demand curve for Firm A depends on how much their product differs, and how the firms compete. 1. 60 1. 50 1. 40 Market Demand 1. 00 10, 000 20, 000 Chapter 10 30, 000 Quantity 3, 000 5, 000 QA 7, 000 52

The Demand for Toothbrushes $/Q At a market price of $1. 50, elasticity of demand is -1. 5. 2. 00 Firm A sees a much more elastic demand curve due to competition--Ed = -. 6. Still Firm A has some monopoly power and charges a price which exceeds MC. 1. 60 1. 50 MCA 1. 50 1. 40 DA Market Demand 1. 00 MRA 1. 00 10, 000 20, 000 Chapter 10 30, 000 Quantity 3, 000 5, 000 QA 7, 000 53

Monopoly Power n Measuring Monopoly Power l In perfect competition: P = MR = MC l Monopoly power: P > MC Chapter 10 54

Monopoly Power n Lerner’s Index of Monopoly Power l L = (P - MC)/P u l L is expressed in terms of Ed u u Chapter 10 The larger the value of L (between 0 and 1) the greater the monopoly power. L = (P - MC)/P = -1/Ed Ed is elasticity of demand for a firm, not the market 55

Monopoly Power n Monopoly power does not guarantee profits. n Profit depends on average cost relative to price. n Question: l Chapter 10 Can you identify any difficulties in using the Lerner Index (L) for public policy? 56

Monopoly Power n The Rule of Thumb for Pricing l Chapter 10 Pricing for any firm with monopoly power u If Ed is large, markup is small u If Ed is small, markup is large 57

Elasticity of Demand Price Markup $/Q The more elastic is demand, the less the markup. P* MC MC P* AR P*-MC MR AR MR Q* Chapter 10 Quantity Q* Quantity 58

Markup Pricing: Supermarkets to Designer Jeans n Supermarkets Chapter 10 59

Markup Pricing: Supermarkets to Designer Jeans n Convenience Stores Chapter 10 60

Markup Pricing: Supermarkets to Designer Jeans Convenience Stores n Convenience stores have more monopoly power. n Question: l Chapter 10 Do convenience stores have higher profits than supermarkets? 61

Markup Pricing: Supermarkets to Designer Jeans l Designer jeans Ed = -3 to -4 Chapter 10 u Price 33 - 50% > MC u MC = $12 - $18/pair u Wholesale price = $18 - $27 62

The Pricing of Prerecorded Videocassettes 1985 Title 1999 Retail Price($) Purple Rain $29. 98 Raiders of the Lost Ark 24. 95 Jane Fonda Workout 59. 95 about Mary 13. 99 The Empire Strikes Back 79. 98 An Officer and a Gentleman 24. 95 Star Trek: The Motion Picture 24. 95 Star Wars 39. 98 Chapter 10 Title Retail Price($) Austin Powers A Bug’s Life There’s Something Tae-Bo Workout Lethal Weapon 4 Men in Black Armageddon $10. 49 17. 99 24. 47 16. 99 12. 99 15. 86 63

The Pricing of Prerecorded Videocassettes n What Do You Think? l Should producers lower the price of videocassettes to increase sales and revenue? Chapter 10 64

Sources of Monopoly Power n Why do some firm’s have considerable monopoly power, and others have little or none? n A firm’s monopoly power is determined by the firm’s elasticity of demand. Chapter 10 65

Sources of Monopoly Power n The firm’s elasticity of demand is determined by: 1) Elasticity of market demand 2) Number of firms 3) The interaction among firms Chapter 10 66

The Social Costs of Monopoly Power n Monopoly power results in higher prices and lower quantities. n However, does monopoly power make consumers and producers in the aggregate better or worse off? Chapter 10 67

Deadweight Loss from Monopoly Power $/Q Lost Consumer Surplus Deadweight Loss Pm A Because of the higher price, consumers lose A+B and producer gains A-C. MC B C PC AR MR Qm Chapter 10 QC Quantity 68

The Social Costs of Monopoly Power n Rent Seeking l Chapter 10 Firms may spend to gain monopoly power u Lobbying u Advertising u Building excess capacity 69

The Social Costs of Monopoly Power n The incentive to engage in monopoly practices is determined by the profit to be gained. n The larger the transfer from consumers to the firm, the larger the social cost of monopoly. Chapter 10 70

The Social Costs of Monopoly Power n Example l n 1996 Archer Daniels Midland (ADM) successfully lobbied for regulations requiring ethanol be produced from corn Question l Chapter 10 Why only corn? 71

The Social Costs of Monopoly Power n Price Regulation l n Recall that in competitive markets, price regulation created a deadweight loss. Question: l Chapter 10 What about a monopoly? 72

Price Regulation $/Q Marginal revenue curve when price is regulated to be no higher that P 1. MR MC Pm P 1 P 2 = P C AC P 3 P 4 AR Forprice output levels above Q 1 , below P results If Any price is lowered to PC output 4 Ifthe leftoriginal alone, a monopolist average and in. Ifthe firm incurring a to loss. price is lowered P increases to its maximum 3 Qoutput produces Q and charges Pm. C and m marginal revenue curves apply. decreases a shortage exists. there is noand deadweight loss. Qm Q 1 Chapter 10 Q 3 Qc Q’ 3 Quantity 73

The Social Costs of Monopoly Power n Natural Monopoly l. A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms. Chapter 10 74

Regulating the Price of a Natural Monopoly $/Q Natural monopolies occur because of extensive economies of scale Quantity Chapter 10 75

Regulating the Price of a Natural Monopoly $/Q Unregulated, the monopolist would produce Qm and charge Pm. If the price were regulate to be PC, the firm would lose money and go out of business. Pm Setting the price at Pr yields the largest possible output; excess profit is zero. AC Pr MC PC AR MR Qm Chapter 10 Qr QC Quantity 76

The Social Costs of Monopoly Power n Regulation in Practice l Chapter 10 It is very difficult to estimate the firm's cost and demand functions because they change with evolving market conditions 77

The Social Costs of Monopoly Power n Regulation in Practice l An alternative pricing technique---rate-ofreturn regulation allows the firms to set a maximum price based on the expected rate or return that the firm will earn. u P = AVC + (D + T + s. K)/Q, where l. P = price, AVC = average variable cost l D = depreciation, T = taxes l s = allowed rate of return, K = firm’s capital stock Chapter 10 78

The Social Costs of Monopoly Power n n Regulation in Practice l Using this technique requires hearings to arrive at the respective figures. l The hearing process creates a regulatory lag that may benefit producers (1950 s & 60 s) or consumers (1970 s & 80 s). Question l Chapter 10 Who is benefiting in the 1990 s? 79

Monopsony n A monopsony is a market in which there is a single buyer. n An oligopsony is a market with only a few buyers. n Monopsony power is the ability of the buyer to affect the price of the good and pay less than the price that would exist in a competitive market. Chapter 10 80

Monopsony n Competitive Buyer l Price taker l P = Marginal expenditure = Average expenditure l D = Marginal value Chapter 10 81

Competitive Buyer Compared to Competitive Seller Buyer $/Q Seller ME = AE P* MC AR = MR P* ME = MV at Q* ME = P* P* = MV D = MV Q* Chapter 10 MR = MC P* = MR P* = MC Quantity Q* Quantity 82

Monopsonist Buyer $/Q The market supply curve is the monopsonist’s average expenditure curve ME Monopsony • ME > P & above S S = AE Competitive • P = P C • Q = Q+C PC P*m MV Q*m Chapter 10 QC Quantity 83

Monopoly and Monopsony $/Q Monopoly Note: MR = MC; AR > MC; P > MC MC P* PC AR MR Q* Chapter 10 QC Quantity 84

Monopoly and Monopsony $/Q ME Monopsony Note: ME = MV; ME > AE; MV > P S = AE PC P* MV Q* Chapter 10 QC Quantity 85

Monopoly and Monopsony n Monopoly n Monopsony l MR < P l ME > P l P > MC l P < MV l Qm < Q C l Pm > PC l Pm < P C Chapter 10 86

Monopsony Power n A few buyers can influence price (e. g. automobile industry). n Monopsony power gives them the ability to pay a price that is less than marginal value. Chapter 10 87

Monopsony Power n The degree of monopsony power depends on three similar factors. 1) Elasticity of market supply u Chapter 10 The less elastic the market supply, the greater the monopsony power. 88

Monopsony Power n The degree of monopsony power depends on three similar factors. 2) Number of buyers u Chapter 10 The fewer the number of buyers, the less elastic the supply and the greater the monopsony power. 89

Monopsony Power n The degree of monopsony power depends on three similar factors. 3) Interaction Among Buyers u Chapter 10 The less the buyers compete, the greater the monopsony power. 90

Monopsony Power: Elastic versus Inelastic Supply ME $/Q MV - P* S = AE ME S = AE P* P* MV Q* Chapter 10 Quantity MV Q* Quantity 91

Deadweight Loss from Monopsony Power n Determining the deadweight loss in monopsony l l $/Q ME Change in seller’s surplus = -A-C Change in buyer’s surplus = A - B l Change in welfare = -A - C + A - B = -C - B l Inefficiency occurs because less is purchased Deadweight Loss S = AE PC P* A B C MV Q* Chapter 10 QC Quantity 92

Monopsony Power The Social Costs of Monopsony Power n Bilateral Monopoly l Chapter 10 Bilateral monopoly is rare, however, markets with a small number of sellers with monopoly power selling to a market with few buyers with monopsony power is more common. 93

Monopsony Power The Social Costs of Monopsony Power n Question l Chapter 10 In this case, what is likely to happen to price? 94

Limiting Market Power: The Antitrust Laws n Antitrust Laws: l Promote a competitive economy l Rules and regulations designed to promote a competitive economy by: u u Chapter 10 Prohibiting actions that restrain or are likely to restrain competition Restricting the forms of market structures that are allowable 95

Limiting Market Power: The Antitrust Laws n Sherman Act (1890) l Section 1 u. Prohibits contracts, combinations, or conspiracies in restraint of trade l Explicit agreement to restrict output or fix prices l Implicit collusion through parallel conduct Chapter 10 96

Limiting Market Power: The Antitrust Laws Examples of Illegal Combinations n 1983 l Six companies and six executives indicted for price of copper tubing n 1996 l Archer Daniels Midland (ADM) pleaded guilty to price fixing for lysine -- three sentenced to prison in 1999 Chapter 10 97

Limiting Market Power: The Antitrust Laws Examples of Illegal Combinations n 1999 l Roche A. G. , BASF A. G. , Rhone-Poulenc and Takeda pleaded guilty to price fixing of vitamins -- fined more than $1 billion. Chapter 10 98

Limiting Market Power: The Antitrust Laws n Sherman Act (1890) l Section 2 u. Makes it illegal to monopolize or attempt to monopolize a market and prohibits conspiracies that result in monopolization. Chapter 10 99

Limiting Market Power: The Antitrust Laws n Clayton Act (1914) 1) Makes it unlawful to require a buyer or lessor not to buy from a competitor 2) Prohibits predatory pricing Chapter 10 100

Limiting Market Power: The Antitrust Laws n Clayton Act (1914) 3) Prohibits mergers and acquisitions if they “substantially lessen competition” or “tend to create a monopoly” Chapter 10 101

Limiting Market Power: The Antitrust Laws n Robinson-Patman Act (1936) l Chapter 10 Prohibits price discrimination if it is likely to injure the competition 102

Limiting Market Power: The Antitrust Laws n Federal Trade Commission Act (1914, amended 1938, 1973, 1975) 1) Created the Federal Trade Commission (FTC) 2) Prohibitions against deceptive advertising, labeling, agreements with retailer to exclude competing brands Chapter 10 103

Limiting Market Power: The Antitrust Laws n Antitrust laws are enforced three ways: 1) Antitrust Division of the Department of Justice u u Chapter 10 A part of the executive branch--the administration can influence enforcement Fines levied on businesses; fines and imprisonment levied on individuals 104

Limiting Market Power: The Antitrust Laws n Antitrust laws are enforced three ways: 2) Federal Trade Commission u Chapter 10 Enforces through voluntary understanding or formal commission order 105

Limiting Market Power: The Antitrust Laws n Antitrust laws are enforced three ways: 3) Private Proceedings Chapter 10 u Lawsuits for damages u Plaintiff can receive treble damages 106

Limiting Market Power: The Antitrust Laws n Two Examples l American Airlines -- Price fixing l Microsoft Chapter 10 u Monopoly power u Predatory actions u Collusion 107

Summary n Market power is the ability of sellers or buyers to affect the price of a good. n Market power can be in two forms: monopoly power and monopsony power. Chapter 10 108

Summary n Monopoly power is determined in part by the number of firms competing in the market. n Monopsony power is determined in part by the number of buyers in the market. Chapter 10 109

Summary n Market power can impose costs on society. n Sometimes, scale economies make pure monopoly desirable. n We rely on the antitrust laws to prevent firms from obtaining excessive market power. Chapter 10 110

End of Chapter 10 Market Power: Monopoly and Monopsony Chapter 10 111