Chapter 10 Monopoly Topics to be Discussed l

Chapter 10 Monopoly

Topics to be Discussed l Monopoly and Monopoly Power l Sources of Monopoly Power

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 © 2005 Pearson Education, Inc. Chapter 10 3

Review of Perfect Competition Market P D P S Individual Firm LMC P 0

Monopoly l Monopoly 1. 2. 3. 4. One seller - many buyers One product

Monopoly l The monopolist is the supply-side of the market and has complete control over the amount offered for sale. l Monopolist controls price but must consider consumer demand l Profits will be maximized at the level of output where marginal revenue equals marginal cost. © 2005 Pearson Education, Inc. Chapter 10 6

Average & Marginal Revenue l The monopolist’s average revenue, price received per unit sold, is the market demand curve. l Monopolist also needs to find marginal revenue, change in revenue resulting from a unit change in output. © 2005 Pearson Education, Inc. Chapter 10 7

Average & Marginal Revenue l Finding Marginal Revenue m As the sole producer, the monopolist works with the market demand to determine output and price. m An example can be used to show the relationship between average and marginal revenue m Assume a monopolist with demand: P=6 -Q © 2005 Pearson Education, Inc. Chapter 10 8

Total, Marginal, and Average Revenue © 2005 Pearson Education, Inc. Chapter 10 9

Total, Marginal, and Average Revenue l Revenue is zero when price is $6 l At lower prices, revenue increases as quantity sold increases l When demand is downward sloping, the price (average revenue) is greater than marginal revenue m For sales to increase, price must fall © 2005 Pearson Education, Inc. Chapter 10 10

Average and Marginal Revenue $ per unit of output 7 6 5 Average Revenue

Monopoly l Observations 1. 2. 3. To increase sales the price must fall MR

Monopolist’s Output Decision 1. Profits maximized at the output level where MR = MC

Monopolist’s Output Decision l At output levels below MR = MC the decrease in revenue is greater than the decrease in cost (MR > MC). l At output levels above MR = MC the increase in cost is greater than the decrease in revenue (MR < MC) © 2005 Pearson Education, Inc. Chapter 10 14

Monopolist’s Output Decision $ per unit of output MC P 1 P* AC P

Monopoly: An Example © 2005 Pearson Education, Inc. Chapter 10 16

Monopoly: An Example © 2005 Pearson Education, Inc. Chapter 10 17

Example of Profit Maximization $/Q 40 Profit = (P - AC) x Q =

Monopoly l Monopoly pricing compared to perfect competition pricing: m Monopoly l. P > MC l Price is larger than MC by an amount that depends inversely on the elasticity of demand m Perfect Competition l. P = MC l Demand is perfectly elastic so P=MC © 2005 Pearson Education, Inc. Chapter 10 19

Monopoly l If demand is very elastic, there is little benefit to being a monopolist l The larger the elasticity, the closer to a perfectly competitive market l Notice a monopolist will never produce a quantity in the inelastic portion of demand curve m In inelastic portion, can increase revenue by decreasing quantity and increasing price © 2005 Pearson Education, Inc. Chapter 10 20

Monopoly l Shifts in demand usually cause a change in both price and quantity. l Example show monopolistic market differs from perfectly competitive market l Competitive market supplies specific quantity a every price m This relationship does not exist for a monopolistic market © 2005 Pearson Education, Inc. Chapter 10 21

Monopoly Power l Pure monopoly is rare. l However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost. l Firms often product similar goods that have some differences thereby differentiating themselves from other firms © 2005 Pearson Education, Inc. Chapter 10 22

Monopoly Power: Example l Four firms with equal share a market for 20, 000 toothbrushes at a price of $1. 50. l Profits maximizing quantity for each from is where MR – MC l In our example that is 5000 units for Firm A with a price of $1. 50 which is greater than marginal cost l Although Firm A is not a pure monopolist, they have monopoly power © 2005 Pearson Education, Inc. Chapter 10 23

The Demand for Toothbrushes $/Q At a market price of $1. 50, elasticity of demand is -1. 5. 2. 00 Firm A has some monopoly power and charges a price which exceeds MC where MR=MC. 1. 60 1. 50 MCA 1. 50 1. 40 DA Market Demand 1. 00 MRA 1. 00 10, 000 20, 000 30, 000 Quantity Chapter 10 3, 000 5, 000 QA 7, 000 24

Measuring Monopoly Power l Our firm would have more monopoly power of course if it could get rid of the other firms m But the firm’s monopoly power might still be substantial l How can we measure monopoly power to compare firms l What are the sources of monopoly power? m Why do some firms have more than others? © 2005 Pearson Education, Inc. Chapter 10 25

Measuring Monopoly Power l Could measure monopoly power by the extent to which price is greater than MC for each firm l Lerner’s Index of Monopoly Power m L = (P - MC)/P l The larger the value of L (between 0 and 1) the greater the monopoly power. m L is expressed in terms of Ed l. L = (P - MC)/P = -1/Ed l Ed is elasticity of demand for a firm, not the market © 2005 Pearson Education, Inc. Chapter 10 26

Monopoly Power l Monopoly power, however, does not guarantee profits. l Profit depends on average cost relative to price. l One firm may have more monopoly power, but lower profits due to high average costs © 2005 Pearson Education, Inc. Chapter 10 27

Sources of Monopoly Power l Why do some firm’s have considerable monopoly power, and others have little or none? l Monopoly power is determined by ability to set price higher than marginal cost l A firm’s monopoly power, therefore, is determined by the firm’s elasticity of demand. © 2005 Pearson Education, Inc. Chapter 10 28

Sources of Monopoly Power l The less elastic the demand curve, the more monopoly power a firm has. l The firm’s elasticity of demand is determined by: 1) Elasticity of market demand 2) Number of firms in market 3) The interaction among firms © 2005 Pearson Education, Inc. Chapter 10 29

Elasticity of Market Demand l With one firm their demand curve is market demand curve m Degree of monopoly power determined completely by elasticity of market demand l With more firms, individual demand may differ from market demand m Demand for a firm’s product is more elastic than the market elasticity © 2005 Pearson Education, Inc. Chapter 10 30

Number of Firms l The monopoly power of a firm falls as the number of firms increases all else equal m More important are the number of firms with significant market share m Market is highly concentrated if only a few firms account for most of the sales l Firms would like to create barriers to entry to keep new firms out of market m Patent, scale © 2005 Pearson Education, Inc. copyrights, licenses, economies of Chapter 10 31

Interaction Among Firms l If firms are aggressive in gaining market share by, for example, undercutting the other firms, prices may reach close to competitive levels. l If firms collude (violation of antitrust rules), could generate substantial monopoly power l Markets are dynamic and therefore, so is the concept of monopoly power © 2005 Pearson Education, Inc. Chapter 10 32

The Social Costs of Monopoly Power l Monopoly power results in higher prices and lower quantities. l However, does monopoly power make consumers and producers in the aggregate better or worse off? l We can compare producer and consumer surplus when in a competitive market and in a monopolistic market © 2005 Pearson Education, Inc. Chapter 10 33

The Social Costs of Monopoly l Perfectly competitive firm will produce where MC = D PC and QC l Monopoly produces where MR = MC, getting their price from the demand curve PM and QM l There is a loss in consumer surplus when going from perfect competition to monopoly l A deadweight loss is also created with monopoly © 2005 Pearson Education, Inc. Chapter 10 34

Deadweight Loss from Monopoly Power $/Q Lost Consumer Surplus Deadweight Loss Pm A MC Because of the higher price, consumers lose A+B and producer gains A -C. B PC C AR=D MR Qm © 2005 Pearson Education, Inc. QC Chapter 10 Quantity 35

The Social Costs of Monopoly l Social cost of monopoly is likely to exceed the deadweight loss l Rent Seeking m Firms may spend to gain monopoly power l Lobbying l Advertising l Building © 2005 Pearson Education, Inc. excess capacity Chapter 10 36

The Social Costs of Monopoly l The incentive to engage in monopoly practices is determined by the profit to be gained. l The larger the transfer from consumers to the firm, the larger the social cost of monopoly. © 2005 Pearson Education, Inc. Chapter 10 37