Chapter 24 Monopoly Copyright 2012 Pearson AddisonWesley All

Chapter 24 • Monopoly Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Introduction In New York City, a taxicab requires a medallion as legal possession of a license to operate the taxi business. Thus, the medallion constitutes a barrier to entry to New York City’s taxicab industry. In this chapter, you will learn how governmentally imposed and other types of barriers to entry give rise to monopolies, or single-firm industries. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -2

Learning Objectives • Identify situations that can give rise to monopoly • Describe the demand marginal revenue conditions a monopolist faces • Discuss how a monopolist determines how much output to produce and what price to charge • Evaluate the profits earned by a monopolist • Understand price discrimination • Explain the social cost of monopolies Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -3

Chapter Outline • • Definition of a Monopolist Barriers to Entry The Demand Curve a Monopolist Face Elasticity and Monopoly Cost and Monopoly Profit Maximization Calculating Monopoly Profit On Making Higher Profits: Price Discrimination • The Social Cost of Monopolies Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -4

Did You Know That. . . • Today the activities of 35 percent of U. S. employees of private businesses are licensed, certified, or regulated by government agencies, up from just 3 percent five decades ago? • In this chapter, you will learn that a consequence of such government-established barriers to entry can be a situation called monopoly. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -5

Definition of a Monopolist • Monopolist – A single supplier of a good or service for which there is no close substitute – The monopolist therefore constitutes the entire industry Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -6

Barriers to Entry • Question – How does a firm obtain monopoly power? • Answer – Barriers to entry that allow the firm to make long-run economic profits – Barriers to entry are restrictions on who can start as well as stay in business. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -7

Barriers to Entry (cont'd) • Barriers to entry include: – Ownership of resources without close substitutes – Economies of scale – Legal or governmental restrictions Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -8

Barriers to Entry (cont'd) • Ownership of resources without close substitutes – The Aluminum Company of America (ALCOA) at one time owned most of of the world’s bauxite Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -9

Barriers to Entry (cont'd) • Economies of scale – Low unit costs and prices drive out rivals – The largest firm can produce at the lowest average total cost Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -10

Barriers to Entry (cont'd) • Natural Monopoly – A monopoly that arises from the peculiar production characteristics in an industry – It usually arises when there are large economies of scale – One firm can produce at a lower average cost than can be achieved by multiple firms Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -11

Figure 24 -1 The Cost Curves That Might Lead to a Natural Monopoly Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -12

Barriers to Entry (cont'd) • Legal or governmental restrictions – Licenses, franchises, and certificates of convenience – Examples include • Electrical utilities • Radio and television broadcasting Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -13

Why Not … stop erecting government barriers to entry? • Despite the understanding that governmentestablished entry barriers reduce competition, vested interests often promote insincere public safety rationales for licensing and certification rules. • On example is the requirement in some states for all qualified people to arrange furniture and accessories in office buildings to be American Society of Interior Designers members, who must earn a college degree in interior design, complete a 2 -year apprenticeship, and pass a licensing exam. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -14

Policy Example: Congress Decides to License Tax Preparers • Many firms offering tax preparation services are unlicensed and uncertified by any governmental authorities. • The Internal Revenue Service (IRS), however, has convinced Congress to require all tax preparers to reregister with the federal government and to satisfy government-defined minimum competency standards. • The government-erected entry barriers essentially make tax preparation firms public utilities. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -15

Barriers to Entry (cont'd) • Legal or governmental restrictions – Patents • Intellectual property – Tariffs • Taxes on imported goods – Regulation • Government enforcement of safety and quality Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -16

The Demand Curve a Monopolist Faces • The monopolist faces the industry demand curve because the monopolist is the entire industry Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -17

The Demand Curve a Monopolist Faces (cont'd) • Recall that under perfect competition – Firm faces perfectly elastic demand curve, it is a price taker – The forces of supply and demand establish the price per unit – Marginal revenue, average revenue, and price are all the same Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -18

The Demand Curve a Monopolist Faces (cont'd) • Marginal revenue equals the change in total revenue due to a one-unit change in the quantity produced and sold Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -19

The Demand Curve a Monopolist Faces (cont'd) • Perfect competition versus monopoly – The perfect competitor doesn’t have to worry about lowering price to sell more – In a purely competitive situation, the firm accounts for a small part of the market • It can sell its entire output, whatever that may be, at the same price Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -20

The Demand Curve a Monopolist Faces (cont'd) • Perfect competition versus monopoly – The more the monopolist wants to sell, the lower the price it has to charge on the last unit sold – To sell the last unit, the monopolist has to lower the price because it is facing a downward sloping demand curve Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -21

Figure 24 -2 Demand Curves for the Perfect Competitor and the Monopolist Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -22

The Demand Curve a Monopolist Faces (cont'd) Monopoly Perfect Competition Single seller Many sellers Faces entire industry demand Faces perfectly elastic demand Must lower price to sell more Must produce more to sell more Not all units sold for same price (MR < P) All units sold for same price (P = MR) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -23

Figure 24 -3 Marginal Revenue: Always Less Than Price Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -24

Elasticity and Monopoly • The monopolist faces a downward-sloping demand curve (its average revenue curve) • That means that it cannot charge just any price with no changes in quantity (a common misconception) because, depending on the price charged, a different quantity will be demanded Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -25

Elasticity and Monopoly (cont'd) • Question – If a monopoly raises price, what will happen to quantity demanded? • Hint – Remember how consumers respond to a change in price Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -26

Elasticity and Monopoly (cont'd) • Recall – A monopolist is a single seller of a well-defined good or service with no close substitute • Think of some imperfect substitutes. – The demand curve slopes downward because individuals compare marginal satisfaction to cost Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -27

Elasticity and Monopoly (cont'd) • After all, consumers have limited incomes and unlimited wants • The market demand curve, which the monopolist alone faces in this situation, slopes downward because individuals compare the marginal satisfaction they will receive to the cost of the commodity to be purchased Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -28

Costs and Monopoly Profit Maximization • We assume profit maximization is the goal of the pure monopolist, just as it is for the perfect competitor Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -29

Costs and Monopoly Profit Maximization (cont'd) • Perfect competitor has only to decide on the profit-maximizing output rate because price is given – The perfect competitor is a price taker • For the pure monopolist, we must seek a profit-maximizing price output combination – The monopolist is a price searcher Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -30

Costs and Monopoly Profit Maximization (cont'd) • Price Searcher – A firm that must determine the price-output combination that maximizes profit because it faces a downward-sloping demand curve Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -31

Costs and Monopoly Profit Maximization (cont'd) • We can determine the profit-maximizing price-output combination with either of two equivalent approaches: – By looking at total revenues and total costs or – By looking at marginal revenues and marginal costs Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -32

Costs and Monopoly Profit Maximization (cont'd) • Total revenues-total costs approach – Maximize the positive difference between total revenues and total costs • Marginal revenue-marginal cost approach – Profit maximization will also occur where marginal revenue equals marginal cost Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -33

Costs and Monopoly Profit Maximization (cont'd) • Question – Why produce where marginal revenue equals marginal cost? • Answer – This is where the greatest positive difference between total revenue and total cost occurs Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -34

Figure 24 -4 Monopoly Costs, Revenues, and Profits, Panel (a) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -35

Figure 24 -4 Monopoly Costs, Revenues, and Profits, Panels (b) and (c) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -36

Costs and Monopoly Profit Maximization (cont'd) • Producing past where MR = MC – Result is that incremental cost will exceed incremental revenue • Producing less than where MR = MC – The monopolist is not maximizing profits through this approach either Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -37

Figure 24 -5 Maximizing Profits Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -38

Cost and Monopoly Profit Maximization (cont’d) • Real-World Informational Limitations – Price searching by a less-than perfect competitor is a process – A monopolist can only estimate the actual demand curve and make an educated guess when it sets its profit-maximizing profit – For the perfect competitor, price is given already by the intersection of market demand supply Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -39

Calculating Monopoly Profit • Monopoly profit is given by the shaded area in Figure 24 -6, which is equal to total revenues (P Q) minus total costs (ATC Q) Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -40

Figure 24 -6 Monopoly Profit Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -41

Calculating Monopoly Profit (cont'd) • No guarantee of profits – The term monopoly conjures up the notion of a greedy firm ripping off the public • If ATC is everywhere above AR, or demand – No price-output combination allows the monopolist to cover costs Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -42

Figure 24 -7 Monopolies: Not Always Profitable Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -43

International Example: A Mexican Cement Monopoly Finds a Way to Incur Losses • In Mexico, a single company, Cemex, accounts for almost 80 percent of the nation’s cement production and sales. • Thus, Cemex sells cement to Mexican consumers at almost twice the market price in the United States, where a number of firms make and sell cement. • Recently, Cemex has been incurring losses as a result of falling demand in 2008 and its debt costs from short-term loans that the company had borrowed during periods of expansion. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -44

On Making Higher Profits: Price Discrimination • Price Discrimination – Selling a given product at more than one price, with the difference being unrelated to differences in cost Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -45

On Making Higher Profits: Price Discrimination (cont'd) • Price Differentiation – Establishing different prices for similar products to reflect differences in marginal cost in providing those commodities to different groups of buyers Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -46

On Making Higher Profits: Price Discrimination (cont'd) • Necessary conditions for price discrimination 1. The firm must face a downward-sloping demand curve 2. The firm must be able to readily (and cheaply) identify buyers or groups of buyers with predictably different elasticities of demand 3. The firm must be able to prevent resale of the product or service Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -47

Example: Why Students Pay Different Prices to Attend College • Out-of-pocket tuition rates for any two college students can differ by considerable amounts, even if the students happen to major in the same subjects and enroll in many of the same courses. • The reason for this is that colleges offer students diverse financial aid packages depending on their “financial need. ” • To document their “need” for financial aid, students must provide detailed information about family income and wealth. This information helps the college determine the prices that different families are most likely to be willing and able to pay, so that it can engage in price discrimination. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -48

Figure 24 -8 Toward Perfect Price Discrimination in College Tuition Rates Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -49

The Social Cost of Monopolies • Comparing monopoly with perfect competition – Let’s assume a monopolist comes in and buys up every single perfect competitor – Notice the monopolist produces a smaller quantity and sells at a higher price Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -50

The Social Cost of Monopolies (cont'd) • Comparing monopoly with perfect competition – Monopolists raise the price and restrict production compared to a perfectly competitive situation – Consumers pay a price that exceeds the marginal cost of production and resources are misallocated in such a situation Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -51

Figure 24 -9 The Effects of Monopolizing an Industry Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -52

You Are There: A Texas Veterinary Board Whittles Down Vets’ Competition • The Texas Board of Veterinary Medical Examiners has determined that horse-teeth floaters, who provide basic dental services for horses, must be certified or else they must work under the supervision of a licensed veterinarian. • This way, many skilled horse-teeth floaters without a license will no longer able to compete with licensed veterinarians in the market for horse dental services. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -53

Issues & Applications: This Medallion Is Not Simply a Decorative Pendant • The number of taxi medallions issued by New York City is controlled by the city’s Taxi and Limousine Commission. • The commission’s medallions serve as a barrier to entry in the taxicab market. • The medallions can be bought and sold, and the market clearing prices have generally risen since 2004, now exceeding $600, 000 for individual owners and $800, 000 for corporate owners. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -54

Figure 24 -10 Market Prices of New York City Taxi Medallions Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -55

Summary Discussion of Learning Objectives (cont'd) • Why a monopoly can occur – Barriers to entry • Demand marginal revenue conditions faced by a monopolist – Because the monopolist constitutes the entire industry, it faces the entire market demand curve. – Marginal revenue is less than price. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -56

Summary Discussion of Learning Objectives (cont'd) • How a monopolist determines how much output to produce and what price to charge – Seeks to maximize its economic profits – Produces where marginal revenue equals marginal cost – Charges maximum price for the amount of output where MR = MC Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -57

Summary Discussion of Learning Objectives (cont'd) • A monopolist’s profits – Profit earned by monopolist is equal to the difference between the price it charges and its average production cost times the amount of output it produces and sells. – Monopolist typically earns positive economic profits. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -58

Summary Discussion of Learning Objectives (cont'd) • Price discrimination – Selling at more than one price with the price differences being unrelated to differences in production costs. – Monopolist sells some of its output at higher prices to consumers with less elastic demand. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -59

Summary Discussion of Learning Objectives (cont'd) • Social cost of monopolies – Price exceeds marginal cost. – The price is higher and output is lower for a monopolist as compared to a perfectly competitive industry. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -60

Appendix G: Consumer Surplus in a Perfectly Competitive Market • Given the market clearing price that prevails in the perfectly competitive market, consumer surplus is: – the difference between the total amount that consumers would have been willing to pay and the total amount that they actually pay Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -61

Figure G-1 Consumer Surplus in a Perfectly Competitive Market Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -62

Appendix G: How Society Loses from Monopoly • Deadweight Loss – The portion of consumer surplus that no one in society is able to obtain in a situation of monopoly – No one in society, not even the monopoly, can obtain this deadweight loss Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -63

Appendix G: How Society Loses from Monopoly (cont’d) • As a result of monopoly, consumers are worse off in two ways: – The monopoly profits that result constitute a transfer of a portion of consumer surplus away from consumers to the monopolist – The failure of the monopoly to produce as many units as would have been produced under perfect competition eliminates consumer surplus that otherwise would have been a benefit to consumers Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -64

Figure G-2 Losses Generated by Monopoly Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 24 -65