Monopoly and Other Forms of Imperfect Competition 1

Monopoly and Other Forms of Imperfect Competition 1

Perfectly Competitive Market n n An ideal market that maximizes economic surplus A situation that does not always exist Slide 2

Imperfect Competition n Imperfectly Competitive Firms n n n Have some control over price Price may be greater than the marginal cost of production Long-run economic profits are possible Reduce economic surplus to varying degrees Are very common Slide 3

Forms of Imperfect Competition n 1. Pure Monopoly n n The only supplier of a unique product with no close substitutes 2. Monopolistic Competition n A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another Long-run adjustment to zero economic profits Importance of differentiation Slide 4

Forms of Imperfect Competition n 3. Oligopoly n n n Industry structure in which a small number of firms produce products that are either close or perfect substitutes Cost advantages from large size may prevent the long-run adjustment to zero economic profit Undifferentiated and differentiated products Slide 5

Essential Difference Between Perfectly and Imperfectly Competitive Firms n n The perfectly competitive firm faces a perfectly elastic demand for its product. The imperfectly competitive firm faces a downward-sloping demand curve. Slide 6

The Demand Curves Facing Perfectly and Imperfectly Competitive Firms Imperfectly competitive firm D Market price Price $/unit of output Perfectly competitive firm D Quantity Slide 7

Perfectly competitive market n n Supply and demand determine equilibrium price. The firm has no market power. At the equilibrium price, the firm sells all it wishes. n n n If the firm raises its price, sales will be zero. If the firm lowers its price, sales will not increase. The firm’s demand curve is the horizontal line at the market price. Slide 8

Imperfectly Competitive Markets n The firm has some control over price or some market power. n n A firm’s ability to raise the price of a good without losing all its sales Sellers face a downward sloping demand Slide 9

Sources of Market Power n n n Exclusive control over inputs Patents and Copyrights Government Licenses or Franchises Economies of Scale (Natural Monopolies) Network Externalities Slide 10

Economies of Scale and the Importance of Start-Up Costs n Firms with large fixed costs and low variable costs: n n n Have low marginal costs Average total cost declines sharply as output increases Economies of scale will exist Slide 11

Costs for Two Computer Game Producers (1) Nintendo Annual production Playstation 1, 000 1, 200, 000 Fixed cost $200, 000 Variable cost $800, 000 $960, 000 Total cost Average total cost per game $1, 000 $1, 160, 000 $0. 97 Observations • Fixed costs are a relatively small share of total cost • Cost/game is nearly the same Slide 12

Costs for Two Computer Game Producers (2) Nintendo Annual production Fixed cost Variable cost Total cost Average total cost per game Playstation 1, 000 1, 200, 000 $10, 000, 000 $200, 000 $10, 200, 000 $10. 20 $240, 000 $10, 240, 000 $8. 53 Observations • Fixed costs are a relatively large share of total cost • Playstation has a $1. 67 average cost advantage • Playstation can lower prices, cover cost, and attract customers Slide 13

Costs for Two Computer Game Producers (3) Nintendo Annual production 500, 000 Fixed cost $10, 000 Variable cost Total cost Average total cost per game Playstation 1, 700, 000 $10, 000 $100, 000 $340, 000 $10, 100, 000 $20. 20 $10, 340, 000 $6. 08 • Shift of 500, 000 units to Playstation • Nintendo’s average cost increases to $20. 20/unit • Playstation average cost falls to $6. 08 • A large number of firms cannot survive when the cost differential is high Slide 14

Economies of Scale and the Importance of Fixed Costs n 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 20% 80% Variable Cost Hardware 80% 20% Slide 15

Profit Maximization for the Monopolist n A price taker (perfect competition) and a price setter (imperfect competition) share the economic goal. They want: n n To maximize profits; i. e. , To select the output level that maximizes the difference between TR and TC, where MB= MC (when quantity is divisible and not producing at all is not optimal). Slide 16

Profit Maximization for the Monopolist n For a producer n MB = Marginal Revenue (MR) or a change in a firm’s total revenue that results from a one-unit change in output Slide 17

Profit Maximization for the Monopolist n Marginal Revenue for the Monopolist n Perfect competition and monopolies n n n Both increase output when MR > MC. Calculate MC the same way. Do not have the same MR at a given price. n n In perfect competition: MR = P In monopoly: MR < P Slide 18

The Monopolist’s Benefit from Selling an Additional Unit • 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 Quantity (units/week) 8 Slide 19

Marginal Revenue in Graphical Form P Q TR MR n Observations n 6 2 12 5 3 15 4 4 16 3 5 15 3 n 1 -1 n n 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 Slide 20

P Q TR 6 2 12 5 3 15 4 4 16 3 5 15 MR 3 1 -1 Price & marginal revenue ($/unit) Marginal Revenue in Graphical Form 8 3 D 1 -1 2 3 4 5 8 MR Quantity (units/week) Slide 21

The Marginal Revenue Curve for a Monopolist with a Straight-Line Demand Curve Price a a/2 D MR Q 0/2 Q 0 Quantity Observations • The vertical intercept, a, is the same for MR and D • The horizontal intercept for MR, Q 0/2, is one half the demand intercept, Q 0. Slide 22

Profit Maximization for the Monopolist n Profit Maximizing Decision Rule n n n When MR > MC, output should be increased. When MR < MC, output should be reduced. Profits are maximized at the level of output for which MR = MC. Slide 23

The Monopolist’s Profit. Maximizing Output Level Marginal Cost Price ($/unit of output) 6 Observations • If P = $3 & Q = 12, MR < MC and output should reduce • 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) Slide 24

Even a Monopolist May Suffer an Economic Loss Being a monopolist doesn’t guarantee an economic profit 0. 12 0. 10 ATC MC 0. 05 Economic profit = $400, 000/day Price ($/minute) Economic loss = $400, 000/day 0. 10 0. 08 ATC MC 0. 05 D 20 MR Minutes (millions/day) D 20 24 MR Minutes (millions/day) Slide 25

The Demand Marginal Cost Curves for a Monopolist Why the Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) 6 Marginal cost The socially optimal amount occurs where MC = D(=MB) @ 12 units 3 D 12 24 Quantity (units/week) Slide 26

The Demand Marginal Cost Curves for a Monopolist Why the Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) 6 Marginal cost • The profit maximizing level of output of 8 units, where MR = MC, is less than the socially optimal output of 12 • Between 8 and 12, MB to society > MC to society • Does not increase output because MR to the firms is less than MC 4 3 2 MR 8 12 D 24 Quantity (units/week) Slide 27

The Demand Marginal Cost Curves for a Monopolist Why the Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) 6 Deadweight loss 4 3 2 MR 8 12 Marginal cost • Because MR<P, the monopoly produces less than the socially optimal amount • The deadweight loss of the monopoy to society = (1/2)($2/unit)(4 units/wk) = $4/wk. D 24 Quantity (units/week) Slide 28

Why the Invisible Hand Breaks Down Under Monopoly n Profits are maximized where MR = MC. n P > MR P > MC n Deadweight loss n n Perfect Competition n Profits are maximized where MR = MC. n P = MR P = MC n No deadweight loss n Slide 29

Why the Invisible Hand Breaks Down Under Monopoly n Difficulties in Reducing the Deadweight Loss of Monopolies n n n Enforcing antitrust laws Patents, copyrights, and innovation Natural monopolies Slide 30

Price Discrimination n n The practice of charging different buyers different prices for essentially the same good or service Examples n n n Senior citizens and student discounts on movie tickets Supersaver discounts on air travel Rebate coupons Slide 31

Food For Thought n Why do many movie theaters offer discount tickets to students? Slide 32

Example: Carla Edit n How many manuscripts should Carla edit? Slide 33

Total and Marginal Revenue from Editing Student Reservation Price ($ per paper) Total Revenue ($ per week) A 40 40 B 38 76 C 40 36 34 160 136 E 32 F 30 180 G H 36 32 108 D Marginal revenue ($ per paper) 26 28196 208 28 24 20 16 12 Slide 34

Example: Single Price Monopoly n How many manuscripts should Carla edit? n n Opportunity cost = $29 TR = P x Q, or for 4 papers, 4 x $34 = $136/wk MR is the difference in TR from adding another student If MR > MC: increase output Slide 35

Example: Single Price Monopoly n n How many manuscripts should Carla edit? Carla edits 3 papers n TC = 3 x $29 = $87 TR = $108 n Economic profit = $108 - $87 = $21/wk n Slide 36

Example: Social Optimal n How many manuscripts should Carla edit? n n O. C. of her time per editing= $29 Must charge the same price Reservation price > opportunity cost for student A to F Socially efficient number is 6 n TR = 6 x $30 = $180 n TC = 6 x $29 = $174 n Economic profit = $180 - $174 = $6 Slide 37

Example: Perfect Price Discrimination n If Carla can do perfect price discriminate, how many papers should she edit? n Assume Carla can charge each student the reservation price. Slide 38

Example: Perfect Price Discrimination Student Reservation price A 40 B 38 C 36 D 34 E 32 F 30 G 28 H 26 • Carla would edit A to F • TR = $40 + $38… = $210 • TC = 6 x $29 = $174 • Economic Profit = $210 - $174 = $36/wk • Economic Profit is $30 more Slide 39

Perfect Price Discrimination n Perfectly Discriminating Monopolist n Charging each buyer exactly their reservation price n n n Economic surplus is maximized Consumer surplus is zero Economic surplus = producer surplus Slide 40

Limitation to Perfect Price Discrimination n n Seller will not know each buyer’s reservation price. Low price buyers could resell to other buyers at a higher price. Slide 41

The Hurdle Method of Price Discrimination n Profit-maximizing seller’s goal is to charge each buyer his/her reservation price. n There are two problems to implementing this pricing strategy. n n n Seller does not know the reservation prices Seller must separate high and low price buyers The hurdle method of price discrimination is used to solve these problems. Slide 42

The Hurdle Method of Price Discrimination n The practice of offering a discount to all buyers who overcome some obstacle. n Example n Offering a rebate to those who mail in a coupon Slide 43

The Hurdle Method of Price Discrimination n A Perfect Hurdle n n Separates buyers precisely according to their reservation prices What do you think? n Is a perfect hurdle possible? Slide 44

Example: Price Discrimination with a Perfect Hurdle n Question n How much should Carla charge for editing if she uses a perfect hurdle? Slide 45

Example: Price Discrimination with a Perfect Hurdle n Assume n n n Carla offers a mail in rebate coupon Students with at least a $36 reservation price never use the coupon Students with a reservation price below $36 use the coupon Opportunity cost = $29 Discount coupon = $4 Slide 46

Price Discrimination with a. Reservation Perfect Hurdle Price Total Revenue Student ($ per paper) ($ per week) Marginal revenue ($ per paper) List Price Submarket A 40 40 B 38 76 C 40 36 36 32 108 Discount Price Submarket D 34 64 F 30 G H 34 E 26 28112 130 32 90 34 30 26 22 18 Slide 47

Example: Price Discrimination with a Perfect Hurdle n Solution n TR = (3)(36) + (2)(32) = $172 MC = ($5)($29) = $145 n Economic Profit = $27/wk n Slide 48

Price Discrimination with a Perfect Hurdle n Is price discrimination a bad thing? n In fact, the hurdle method raised economic surplus. Slide 49

Economic Surplus Under Price Discrimination with a Perfect Hurdle Calculating Economic Surplus Consumer Surplus Both Single price & discount Reservation Price A B C $40 $38 $36 Actual Price $36 $36 $34 $22 $2 $8 With Discount n $4 $2 $0 $6 Without Discount D Consumer Surplus Producer Surplus n n Single price = 3(36 - 29) = $21/wk Discount price = 3(36 - 29) = $21/wk 2(32 - 29) = $6/wk $27/wk Slide 50

Economic Surplus Under Price Discrimination with a Perfect Hurdle Calculating Economic Surplus Consumer Surplus Both Single price & discount A B C Reservation Price $40 $38 $36 Actual Price Consumer Surplus $36 $36 $6 Without Discount D $34 $22 $2 $8 With Discount n $4 $2 $0 Economic Surplus n n Single price = $6 + $21 = $27/wk Discount price = $8 + $27 = $35/wk Slide 51

Food For Thought n Is Carla’s discount rebate completely efficient? Slide 52

Examples of Price Discrimination n n Temporary Sales Book publishers and paperback books Automobile producers offer various models Commercial air carriers Movie producers Slide 53

Summary n n Single price monopolies are inefficient because P > MR. The hurdle method of price discrimination reduces the inefficiency. n n The more finely the seller can discriminate, the smaller the efficiency loss. Hurdles are not perfect, therefore, there will be some efficiency loss. Slide 54

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