Monopoly and imperfect competition MB MC MB MC

Monopoly and imperfect competition MB MC

MB MC Announcements n n n Ellie Colema? Assignment due dates Syllabus: Health care? Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 2

MB MC Imperfect Competition n Imperfectly Competitive Firms Have some control over price l Price may be greater than the marginal cost of production l Long-run economic profits are possible l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 3

MB MC Imperfect Competition n Imperfectly Competitive Markets Reduce economic surplus to varying degrees l Are very common l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 4

MB MC Forms of Imperfect Competition n Pure Monopoly (most inefficient) The only supplier of a unique product with no close substitutes l This is the one we’ll pay most attention to l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 5

MB MC Forms of imperfect Competition n Oligopoly (theoretically more efficient than a monopoly) A firm that produces a product for which only a few rival firms produce close substitutes l Many major economic sectors l u Food, media, banking, energy, garbage, pharmaceuticals, electricity, water, hospitals, etc. l Collusion is a big problem u Oil, Electricity, Vitamins, Archer-Daniels Midland Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 6

MB MC Forms of imperfect Competition n Monopolistic Competition (closest to perfect competition) l A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 7

MB MC Imperfect Competition n The Essential Difference Between Perfectly and Imperfectly Competitive Firms The perfectly competitive firm faces a perfectly elastic demand for its product. l The imperfectly competitive firm faces a downward-sloping demand curve. l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 8

MB MC Imperfect Competition n In perfect competition Supply and demand determine equilibrium price. The firm has no market power. l At the equilibrium price, the firm sells all it wishes. l If the firm raises its price, sales will be zero. l The firm’s demand curve is the horizontal line at the market price. l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 9

MB MC Imperfect Competition n With imperfect competition The firm has some control over price or some market power. l The firm faces a downward sloping demand curve. l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 10

MB MC The Demand Curves Facing Perfectly and Imperfectly Competitive Firms D Market price D Quantity Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Imperfectly competitive firm Price $/unit of output Perfectly competitive firm Quantity Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 11

MB MC Five Major Sources of Market Power Market power = barriers to entry n Exclusive control over inputs n Patents and copyrights n Government licenses or franchises n Economies of scale (natural monopolies) n Networked economies Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 12

MB MC n Economies of Scale and the Importance of Fixed Costs Natural Monopolies: Firms with large fixed costs and low variable costs e. g. telephones, electric utilities, sewage, etc. l Have low marginal costs l Average total cost declines sharply as output increases l Economies of scale will exist l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 13

MB MC Total and Average Total Costs for a Production Process with Economies of Scale Average cost ($/unit) Total cost ($/year) TC = F + MQ F + Q 0 F ATC = F/Q + M M Q 0 Quantity Total cost rises at a constant rate as output rises Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Quantity Average costs decline and is always higher than marginal cost Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 14

MB MC Costs for Computers (Hardware+software): Scenario 1 Mac OSX Windows XP Annual production 1, 000 1, 200, 000 Fixed cost $2, 000, 000 Variable cost $8, 000 $9, 600, 000 Total cost $10, 000 $11, 600, 000 Average total cost per system $10. 00 $9. 70 Observations • Fixed costs are a relatively small share of total cost • Variable costs are identical • Cost/system is nearly the same Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 15

MB MC Costs for Computers (Hardware+software): Scenario 2 Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 16

MB MC Costs for Computers: scenario 2 after time passes Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 17

MB MC n Economies of Scale and the Importance of Fixed Costs Fixed investment in research and development has been increasing as a share of production costs. Cost of producing a computer Fixed Cost Software 1984 1990 Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 20% 80% Variable Cost Hardware 80% 20% Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 18

MB MC n Profit Maximization for the Monopolist A price taker (perfect competition) and a price setter (imperfect competition) share two economic goals. They want To maximize profits l To select the output level that maximizes the difference between TR and TC, where MB= MC. l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 19

MB MC n Profit Maximization for the Monopolist For any producer MB = Marginal Revenue (MR) or a change in a firm’s total revenue that results from a one-unit change in output l Increase output when MR > MC. l n For competitive producer l n MR=P For a monopolist l MR<P Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 20

The Monopolist’s Benefit from Selling an Additional Unit MB MC • If P = $6, then TR = $6 x 2 = $12 • If P = $5, then TR = $5 x 3 = $15 • The MR of selling the 3 rd unit = $3 (15 -12) • For the 3 rd unit, MR = $3 < P = $5 Price ($/unit) 8 6 5 D 2 3 8 Quantity (units/week) Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 21

MB MC Marginal Revenue n P Q TR 6 2 12 5 3 15 4 4 16 3 5 15 Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. MR Observations l l 3 1 -1 l l MR < P MR declines as quantity increases MR is the change between two quantities MR < P because price must be lowered to sell an additional unit Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 22

P Q TR 6 2 12 5 3 15 4 4 16 3 5 15 Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. MR 3 1 -1 Price & marginal revenue ($/unit) Marginal Revenue in Graphical Form MB MC 8 3 D 1 -1 2 3 4 5 8 MR Quantity (units/week) Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 23

MB MC n Profit Maximization for the Monopolist Profit Maximizing Decision Rule When MR > MC, output should be increased. l When MR < MC, output should be reduced. l Profits are maximized at the level of output for which MR = MC. l What’s the marginal revenue for a competitive firm? l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 24

The Monopolist’s Profit. Maximizing Output Level MB MC Marginal Cost Price ($/unit of output) 6 Observations • If P = $3 & Q = 12 MR < MC and output should be reduced • Profits are maximized at 8 units where MR = MC • P = $4 where quantity demanded = quantity supplied 4 3 2 MR 8 12 D 24 Quantity (units/week) Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 25

The Demand Marginal Cost Curves for a Monopolist MB MC Why the Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) 6 Marginal cost Deadweight loss • Because MR < P, the monopoly produces less than the socially optimal amount • The deadweight loss of the monopoly to society = (1/2)($2/unit)(4 units/wk) = $4/wk. 4 3 2 MR 8 12 D 24 Quantity (units/week) Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 26

MB MC n Why the Invisible Hand Breaks Down Under Monopoly l l n Profits are maximized where MR = MC. P > MR P > MC Deadweight loss Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Perfect Competition l l Profits are maximized where MR = MC. P = MR P = MC No deadweight loss Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 27

MB MC n Why the Invisible Hand Breaks Down Under Monopoly Difficulties in Reducing the Deadweight Loss of Monopolies l Enforcing antitrust laws u Growing concentration in food, media, energy, pharmaceuticals, etc. Patents, copyrights, and innovation l Natural monopolies l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 28

MB MC Price Discrimination The practice of charging different buyers different prices for essentially the same good or service l E. g. textbooks, medicine l u What l about re-importing medicine? Theoretically maximizes economic surplus, but reduces consumer surplus to zero Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 29

MB MC n Public Policy Toward Natural Monopoly Methods of Controlling Natural Monopolies l State ownership and management u Weighing the benefit of marginal cost pricing versus the cost of less incentive for innovation u Is it true that there is less incentive for innovation? Burlington Electric and VEIC u In a democracy, politicians have to provide public services and keep taxes low to get reelected Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 30

MB MC n Methods of Controlling Natural Monopolies State regulation of private monopolies l Cost-plus regulation u High administrative cost u Less incentive for innovation u P does not equate to MC Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 31

MB MC n Methods of Controlling Natural Monopolies Exclusive contracting for natural monopoly Competition for the contract theoretically sets P = MC l Example of water in Buenos Aires l Difficulty when fixed costs are high l No incentive to maintain infrastructure when contract nears termination l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 32

MB MC n Methods of Controlling Natural Monopolies Vigorous enforcement of anti-trust laws Helps prevent cartels l May prevent economies of scale l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 33