CHAPTER 12 Market Structure Monopoly Barriers to Entry

CHAPTER 12 Market Structure: Monopoly

Barriers to Entry A monopoly is the sole supplier of a product with no close substitutes The most important characteristic of a monopolized market is barriers to entry new firms cannot profitably enter the market Barriers to entry are restrictions on the entry of new firms into an industry Legal restrictions Economies of scale Control of an essential resource

Legal Restrictions One way to prevent new firms from entering a market is to make entry illegal Patents, licenses, and other legal restrictions imposed by the government provide some producers with legal protection against competition

Economies of Scale A monopoly sometimes emerges naturally when a firm experiences economies of scale as reflected by the downward-sloping, long-run average cost curve In these situations, a single firm can sometimes supply market demand at a lower average cost per unit than could two or more firms at smaller rates of output

Control of Essential Resources Another source of monopoly power is a firm’s control over some nonreproducible resource critical to production Professional sports teams try to block the formation of competing leagues by signing the best athletes to long-term contracts Alcoa was the sole U. S. maker of aluminum for a long period of time because it controlled the supply of bauxite China is the monopoly supplier of pandas De. Beers controls the world’s diamond trade

Local Monopolies Local monopolies are more common that national or international monopolies Numerous natural monopolies for products sold in local markets However, as a rule long-lasting monopolies are rare because, as we will see, a profitable monopoly attracts competitors

Demand Curves for Competitive and Monopoly Firms. . . Price (a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve Price Demand 0 Quantity of Output

Revenue for the Monopolist Because a monopoly, by definition, supplies the entire market, the demand for goods or services produced by a monopolist is also the market demand The demand curve for the monopolist’s output therefore slopes downward, reflecting the law of demand As seen in the following discussion this has important implications for revenues

Demand, Average and Marginal Revenue Suppose De Beers controls the entire diamond market and suppose they can sell three diamonds a day at $7, 000 each total revenue of $21, 000 Total revenue divided by quantity is the average revenue per diamond which is also $7, 000 Thus, the monopolist’s price equals the average revenue per diamond When a monopoly increases the amount it sells, it has two effects on total revenue (P x Q). The output effect—more output is sold, so Q is higher. The price effect—price falls, so P is lower.

Monopoly Demand Marginal & Total Revenue Note that the marginal revenue curve is below the demand curve and total revenue is at a maximum when marginal revenue equals zero. (a) Demand Marginal Revenue Dollars per diamond Demand marginal revenue are shown in the upper panel and total revenue is in the lower panel. Elastic Unit elastic $3, 750 Inelastic 0 D = Average revenue Marginal revenue 16 1 -carat diamonds per day (b) Total Revenue $60, 000 Total dollars Notice also that when demand is elastic, a decrease in price increases total revenue marginal revenue is positive. Conversely, when demand is inelastic, a decrease in price reduces total revenue marginal revenue is negative 32 Total revenue 0 16 32 10 1 -carat diamonds per day

Demand, Average and Marginal Revenue To sell a fourth diamond, De Beers must lower the price to $6, 750 total revenue for 4 diamonds is $27, 000 and average revenue is again $6, 750 The marginal revenue from selling the fourth diamond is $6, 000 marginal revenue is less than the price or average revenue When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases. Recall that these were equal for the perfectly competitive firm

Exhibit 1: Revenue Schedule Revenue for De Beers, a Monopolist 1 -Carat Price diamonds (average per day revenue) (Q) (p) Q) (1) (2) 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 $7, 750 7, 500 7, 250 7, 000 6, 750 6, 500 6, 250 6, 000 5, 750 5, 500 5, 250 5, 000 4, 750 4, 500 4, 250 4, 000 3, 750 3, 500 Total Marginal revenue (TR = Q x p) (MR = TR / (3) =(1) x (2) 0 $7, 500 14, 500 21, 000 27, 000 32, 500 37, 500 42, 000 46, 000 49, 500 52, 500 55, 000 57, 000 58, 500 59, 500 60, 000 59, 500 (4) $7, 500 7, 000 6, 500 6, 000 5, 500 5, 000 4, 500 4, 000 3, 500 3, 000 2, 500 2, 000 1, 500 1, 000 500 0 -500

Exhibit 2: Loss or Gain from Selling One More Unit $7, 000 By selling another diamond, De Beers gains the revenue from that sale, $6, 750 from the 4 th diamond as shown by the blue-shaded vertical rectangle marked gain. LOSS 6, 750 Price per Diamond D = Average revenue G A I N However, to sell that 4 th unit, De Beers must sell all four diamonds for $6, 750 each it must sacrifice $250 on each of the first three diamonds which could have sold for $7, 000 each. The loss in revenue from the first three units, $750, is shown by the red shaded horizontal rectangle marked Loss. The net change in total revenue from selling the 4 th diamond equals the gain minus the loss $6, 750 - $750 = $6, 000. 0 3 4 1 - carat diamonds per day

Profit Maximization of a Monopoly Profit maximization If MR > MC – increase production If MC > MR – produce less Maximize profit • Produce quantity where MR=MC • Intersection of the marginal-revenue curve and the marginal-cost curve It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Profit-Maximization for a Monopoly. . . 2. . and then the demand curve shows the price consistent with this quantity. Costs and Revenue B Monopoly price 1. The intersection of the marginal-revenue curve and the marginalcost curve determines the profit-maximizing quantity. . . Average total cost A Demand Marginal cost Marginal revenue 0 QMAX Quantity

Comparing Monopoly and Competition For a competitive firm, price equals marginal cost. P = MR = MC For a monopoly firm, price exceeds marginal cost. P > MR = MC

A Monopoly’s Profit equals total revenue minus total costs. Profit = TR - TC Profit = (TR/Q - TC/Q) x Q Profit = (P - ATC) x Q

The Monopolist’s Profit. . . Costs and Revenue Marginal cost Average total cost D B y ol op it on f M pro Monopoly E price Average total cost C Demand Marginal revenue 0 QMAX Quantity

Short-Run Losses and the Shutdown Decision A monopolist is not assured of profit The demand for the monopolists good or service may not be great enough to generate economic profit in either the short run or the long run In the short run, the loss-minimizing monopolist must decide whether to produce or to shut down If the price covers average variable cost, the firm will produce If not, the firm will shut down, at least in the short run

Long-Run Profit Maximization For a monopoly, the distinction between the long and short run is not as important If a monopoly is insulated from competition by high barriers that block new entry, economic profit can persist in the long run However, short-run profit is no guarantee of long-run profit

Benefits of Monopoly Technological Innovations • Incentive for monopoly profits gives firm an incentive to innovate. • Stability of prices • Source of revenue for the government • Massive profits

Perfect Competition vs. Monopoly and perfect competition can be compared/contrasted by using consumer surplus and producer surplus.

Consumer Surplus Consumer surplus is the amount a buyer is willing to pay for a product minus the amount the buyer actually pays. Consumer surplus is the area below the demand curve and above the market price. A lower market price will increase consumer surplus. A higher market price will reduce consumer surplus.

Buyer Willingness to pay David Price paid Individual Consumer Surplus $62 $28 $34 Maggie 55 28 27 Henry 38 28 10 Jamie 18 ---- Anna 11 ---- David’s CS is $62 - 28 = $34 60 40 20 10 0 Total Consumer Surplus equals Maggie’s CS is $55 - 28 = $27 Henry’s CS is $38 - 28 = $10 Price =$28 Jamie Anna 34 + 27 + 10 = $71

Producer Surplus Producer surplus is Difference between the market price received by the seller and the price they would have been prepared to supply at Producer Surplus - the revenue received by the firm above the marginal cost

Producer Surplus P MC p The Shaded Area is the Producer Surplus Q Q

Monopoly vs Perfect Comp. P MC MR P P Monop perf comp D 0 Q Monop Q perf comp Q

Monopoly vs Perfect Comp. P MC MR P P Monop perf comp Total Surplus for Perfect Competition D 0 Q Monop Q perf comp Q

Monopoly vs Perfect Comp. P MC MR P P Monop perf comp Total Surplus for Monopoly D 0 Q Monop Q perf comp Q

Dead Weight Loss If we take the difference between the total social surplus under perfect competition and subtract the total surplus under monopoly we find the dead weight loss This is the loss in surplus to consumers and producers from having a monopoly

Monopoly vs Perfect Comp. P MC MR P P The area of this triangle is the dead weight loss Monop perf comp D 0 Q Monop Q perf comp Q

Disadvantages of Monopoly Inefficient Allocation of Resources • Allocatively Inefficient (higher price and reduced output) Unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost. A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus.

Competition versus monopoly: Summary Similarities Goal of firms Rule for maximizing Can earn economic profits in short run? Differences Number of firms Marginal revenue Price Produces welfaremaximizing level of output? Entry in long run? Can earn economic profits in long run? Price discrimination possible? Competition Monopoly Maximize profits MR=MC Yes Many MR=P P=MC One MR<P P>MC Yes No No Yes 33

How Should a Monopoly Price? So far a monopoly has been thought of as a firm which has to sell its product at the same price to every customer. This is uniform pricing. Can price-discrimination earn a monopoly higher profits?

Price Discrimination Single-price monopoly Firm that is limited to changing same price for each unit of output sold Price discrimination occurs when a firm charges different prices to different customers for reasons other than differences in costs Price-discriminating monopoly does not discriminate based on prejudice, stereotypes, or ill-will toward any person or group Rather, it divides its customers into different categories based on their willingness to pay for good

Requirements for Price Discrimination Although every firm would like to practice price discrimination, not all of them can To successfully price discriminate, three conditions must be satisfied Must be a downward-sloping demand curve for the firm’s output Firm must be able to identify consumers willing to pay more Firm must be able to prevent low-price customers from reselling to high-price customers

Types of Price Discrimination 1 st-degree: Each output unit is sold at a different price. Prices may differ across buyers. This is referred to as “perfect” PD. 2 nd-degree: The price paid by a buyer can vary with the quantity demanded by the buyer. But all customers face the same price schedule. E. g. bulk-buying discounts. 3 rd-degree: Price paid by buyers in a given group is the same for all units purchased. But price may differ across buyer groups. E. g. , senior citizen and student discounts vs. no discounts for middle-aged persons.

First-degree Price Discrimination The firm separates the whole market into each individual consumer and charges them the price they are willing and able to pay. It requires that the monopolist can discover the buyer with the highest valuation of its product, the buyer with the next highest valuation, and so on.

First-degree Price Discrimination $/output unit Sell the th unit for $ Later on sell the th unit for $ Finally sell the th unit for marginal cost, $ MC(y) p(y) y The consumers’ gains are zero.

First-degree Price Discrimination $/output unit PS So the sum of the gains to the monopolist on all trades is the maximum possible total gains-to-trade. MC(y) p(y) y

First-degree Price Discrimination First-degree price discrimination gives a monopolist all of the possible gains-totrade, leaves the buyers with zero consumer surplus, and supplies the efficient amount of output. This is impossible to achieve unless the firm knows every consumer’s preferences and, as a result, is unlikely to occur in the real world.

Second-Degree Price Discrimination Consumers are charged a different price for different quantities, with the schedule of prices set to extract the entire consumer surplus. sellers attempt to maximize profits by selling product in “blocks” or “bundles” rather than one unit at a time. The same price schedule confronts all consumers.

Second-Degree Price Discrimination Block Pricing It involves charging different prices for different “blocks” of goods and services to enhance profits by extracting at least some consumer surplus. Commodity Bundling Commodity bundling involves combining two or more different products into a single package, which is sold at a single price.

Third-degree Price Discrimination Price paid by buyers in a given group is the same for all units purchased. But price may differ across buyer groups. A monopolist manipulates market price by altering the quantity of product supplied to that market.

Third-degree Price Discrimination Two markets, 1 and 2. y 1 is the quantity supplied to market 1. Market 1’s inverse demand function is p 1(y 1). y 2 is the quantity supplied to market 2. Market 2’s inverse demand function is p 2(y 2). For given supply levels y 1 and y 2 the firm’s profit is

Third-degree Price Discrimination ü ý þ • MR 1(y 1) = MR 2(y 2) says that the allocation y 1, y 2 maximizes the revenue from selling y 1 + y 2 output units. • Firm allocates output in two markets which is maximized by equating MC to corresponding MR of each market i. e. , MC = MR 1 = MR 2. • E. g. if MR 1(y 1) > MR 2(y 2) then an output unit should be moved from market 2 to market 1 to increase total revenue.

Third-degree Price Discrimination Market 1 Market 2 p 1(y 1) p 1(y 1*) p 2(y 2*) MC y 1* MR 1(y 1) MC y 2* y 2 MR 2(y 2) MR 1(y 1*) = MR 2(y 2*) = MC and p 1(y 1*) ¹ p 2(y 2*).

Third-Degree Price Discrimination

Third-degree Price Discrimination In which market will the monopolist cause the higher price? Recall that and The monopolist sets the higher price in the market where demand is least own-price elastic.