MONOPOLY A monopoly is a firm which is

MONOPOLY A monopoly is a firm which is the sole producer of a good or service for which there are no close substitutes. The monopolist’s demand curve is the same as the market demand curve. The firm must have some way to keep prospective entrants out of the industry, i. e. , there must be barriers to entry. Monopoly slide 1

BARRIERS TO ENTRY Barriers to entry prevent other firms from entering an industry in which a monopolist may be earning profit. Government franchises Patents and copyrights Economies of scale Ownership of a scarce input Monopoly slide 2

Because the demand curve the monopolist sees is negatively sloped, the monopolist can choose price as well as the quantity of output. (Price and quantity sold are linked by the demand curve. The demand curve sets the limit that can be charged for each quantity produced. ) Monopoly slide 3

REVENUE CURVES FOR A MONOPOLIST The market demand curve for a good is the firm’s average revenue curve. Monopoly slide 4

The demand curve shown here is the market demand curve for cable TV hookups in East Lansing. Because the Ripoff Cable TV Co. has an exclusive franchise, the market demand curve is also the firm’s average revenue curve. (AR = price) $/Q To sell 7, 000 hookups per month, they can charge $52. per hookup per month p = $52/mo. 7 Monopoly Thousand hookups demand Q slide 5

From the demand curve we can find the firm’s total revenue curve (TR as a function of Q). Total revenue is price times quantity. We can then compare total revenue with total costs at each output to find the output and price where profits are maximized. When 3, 000 hookups are sold, they can charge $68 and the total revenue from sales is $204 thousand. $/Q p = $68/mo. 3 Monopoly AR = demand Q Thousand hookups slide 6

Q 0 1 2 3 4 5 6 7 8 9 10 11 Monopoly P (=AR) 80 76 72 68 64 60 56 52 48 44 40 36 TR 0 76 144 204 256 300 336 Here are other points on the demand curve and some corresponding amounts of total revenue. Fill in the remaining values for TR. Go to hidden slide 7

Plot the remaining points on the TR curve. TR 450 400 350 300 250 200 150 100 Hidden slide 50 Q 0 0 Monopoly 2 4 6 8 10 12 14 slide 9

D=AR TR Monopoly Here’s the demand curve with the corresponding total revenue curve. Notice that the TR curve is not a straight line! slide 11

Q 0 1 2 3 4 5 6 7 8 9 10 11 Monopoly TC 10 30 54 82 114 154 204 266 342 434 546 682 Here is the total cost curve of the Ripoff Cable TV Co. TC Q slide 12

Q 0 1 2 3 4 5 6 7 8 9 10 11 Monopoly TR 0 76 144 204 256 300 336 364 384 396 400 396 TC 10 30 54 82 114 154 204 266 342 434 546 682 Profit -10 46 132 98 42 -38 -146 -286 Profit = TR - TC We can put the total revenue and total cost curves together to find total profit. Compute the remaining values for profit. Hidden slide 13

TC TR Q Profit is maximized here at 5, 000 units of output. The same problem can be solved by the marginal/ average approach. PROFIT Q Monopoly slide 15

For a monopolist, average revenue is declining as output increases so marginal revenue must be less than average revenue. It is important to understand why MR is less than AR in this case. Monopoly slide 16

Q 0 1 2 3 4 5 6 7 8 9 10 11 P (=AR) 80 76 72 68 64 60 56 52 48 44 40 36 Monopoly TR 0 76 144 204 256 300 336 364 384 396 400 396 MR 76 68 60 52 44 36 Compute the missing values of Marginal Revenue. MR = (300 -256)/ (5 -4) Hidden slide 17

80 $/Q 70 60 50 40 D=AR 30 20 Hidden slide 10 Q 0 -10 Monopoly 0 2 4 6 8 10 12 MR 14 slide 19

Marginal revenue is always less than price for a monopolist because the firm must reduce price in order to sell more. $/Q To sell an extra unit of output, the monopolist must lower price, thus losing the shaded area on all of the previous units sold at a price of p. p p’ Demand or AR q Monopoly q+1 Q slide 21

An increase in sales of one unit requires a reduction in price. $/Q These rectangles have the same area. p p’ So this area is MR, which is less than p’. Demand or AR q Monopoly q+1 Q slide 22

What values of output and price maximize profit for the Ripoff Cable TV Co. ? $/Q MC Here are the average and marginal cost and revenue curves for the same problem. 130 115 100 85 70 AC 55 40 AR=demand 25 10 -5 0 2 4 6 8 10 MR 12 Q Thousand hookups Monopoly slide 23

In this case the best output is 5, 000 hookups, and the best price is $60 per month. Then choose price by going to the demand curve. 130 115 MC Choose output where MC = MR 100 85 70 AC 60 55 40 AR=demand 25 10 -5 0 Monopoly 2 8 5 6 Thousand hookups 4 10 MR 12 Q slide 24

To compute the amount of profits in monopoly, find average profit (AR-AC) at the profit maximizing output and multiply by Q $/Q MC 130 115 100 85 70 AC 55 Total Profits 40 AR=demand 25 10 -5 0 2 4 6 8 10 MR 12 Q Thousand hookups Monopoly slide 25

To compute the amount of LOSS in monopoly, find average loss (AC-AR) at the “profit” maximizing output, and multiply by Q. $/Q MC 130 115 100 AC II 85 TOTAL LOSS 70 AVC 55 40 AR=demand 25 10 -5 0 2 4 6 8 10 MR 12 Q Thousand hookups Monopoly slide 26

Summary of monopoly pricing: To maximize profit a monopolist should choose output where MC = MR. Price is determined from the demand curve. Monopoly slide 27

What values of output and price maximize profit for the Ripoff Cable TV Co. ? $/Q MC= SS 130 115 100 85 70 AC 60 55 55 40 AR=demand 25 10 -5 0 Monopoly 2 5 66. 3 8 Thousand hookups 4 10 MR 12 Q slide 28

Do monopolists choose the best output and price from society’s point of view? Another way to ask the question is whether the monopolist operates in society’s interest, and if not, what can be done to remedy the evils of monopoly. Monopoly slide 29

This requires us to formulate some rule for determining when social welfare is improved by some change, and when social welfare is maximized. The rule we'll use is that social welfare is measured by the sum of producer and consumer surplus. So society ought to produce where the sum of producer and consumer surplus is as large as possible. Monopoly slide 30

Another method for finding the best output takes a different approach, using the concepts of marginal social benefit and marginal social cost. DEFINITIONS: Marginal social benefit (MSB): The MSB is the increase in social welfare that results from consuming another unit of a good. Marginal social cost (MSC): The MSC is the cost to society of producing another unit of a good. Monopoly slide 31

Monopoly summary To maximize profit, the monopolist will produce where MC = MR. From society’s point of view monopolists produce too small an output, and sell it at too high a price. The best output from society’s point of view is where MC = P. We can measure the deadweight loss due to monopoly as the (roughly) triangular area between the MC curve and the demand curve. Monopoly slide 32