Monopoly and Other Forms of Imperfect Competition MB

Monopoly and Other Forms of Imperfect Competition MB MC Chapter 9: Monopoly and Other Forms of Imperfect Competition

MB MC Imperfect Competition n Imperfectly Competitive Firms Have some control over price l Price may be greater than the 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 2

MB MC Imperfect Competition n Perfect Competition An ideal market that maximizes economic surplus l A situation that does not always exist l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 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 4

MB MC Imperfect Competition n Various Forms of Imperfect Competition l Pure Monopoly (most inefficient) u The only supplier of a unique product with no close substitutes Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 5

MB MC Imperfect Competition n Various Forms of Imperfect Competition l Oligopoly (more efficient than a monopoly) u. A firm that produces a product for which only a few rival firms produce close substitutes Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 6

MB MC Imperfect Competition n Different Forms of Imperfect Competition l Monopolistic Competition (closest to perfect competition) u. 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 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 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 Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 9

MB MC Imperfect Competition n With perfect competition If the firm raises its price, sales will be zero. l If the firm lowers its price, sales will not increase. 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 10

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 11

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 12

MB MC Five Sources of Market Power n n n Exclusive control over inputs Patents and copyrights Government licenses or franchises Economies of scale (natural monopolies) Network economies Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 13

MB MC n Economies of Scale and the Importance of Fixed Costs Firms with large fixed costs and low variable costs 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 14

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 15

Costs for Two Computer Game Producers (1) MB MC Nintendo Annual production Playstation 1, 000 1, 200, 000 Fixed cost $200, 000 Variable cost $800, 000 $960, 000 Total cost $1, 000 Average total cost per game $1. 00 $1, 160, 000 $0. 97 Observations • Fixed costs are a relatively small share of total cost • Cost/game 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 16

Costs for Two Computer Game Producers (2) MB MC Nintendo Annual production Fixed cost Variable cost 1, 000 1, 200, 000 $10, 000, 000 $200, 000 Total cost $10, 200, 000 Average total cost per game Playstation $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 Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 17

Costs for Two Computer Game Producers (3) MB MC Nintendo Annual production 500, 000 Fixed cost $10, 000 Variable cost Playstation 1, 700, 000 $10, 000 $100, 000 Total cost $340, 000 $10, 100, 000 Average total cost per game $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 Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 18

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 19

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 20

MB MC n Profit Maximization for the Monopolist For a producer l MB = Marginal Revenue (MR) or a change in a firm’s total revenue that results from a one-unit change in output Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 21

MB MC n Profit Maximization for the Monopolist Marginal Revenue for the Monopolist l Perfect competition and monopolies u Both increase output when MR > MC. u Calculate MC the same way. u Do not have the same MR at a given price. o In perfect competition: MR = P o In monopoly: MR < P Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 22

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 23

Marginal Revenue in Graphical Form MB MC 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 24

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 25

The Marginal Revenue Curve for a Monopolist with a Straight-Line Demand Curve MB MC 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. Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 26

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 Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 27

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 28

MB MC 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) Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. D 24 20 MR Minutes (millions/day) Chapter 9: Monopoly and Other Forms of Imperfect Competition 29

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 The socially optimal Amount occurs where MC = D(MB) @ 12 units 3 D 12 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 30

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 • 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 • Cannot increase output because MR to the firms is less than MC 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 31

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 32

MB MC n Why the Invisible Hand Breaks Down Under Monopoly l l 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. n 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 33

MB MC n Why the Invisible Hand Breaks Down Under Monopoly Difficulties in Reducing the Deadweight Loss of Monopolies Enforcing antitrust laws l 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 34

MB MC n Why the Invisible Hand Breaks Down Under Monopoly Price Discrimination l The practice of charging different buyers different prices for essentially the same good or service Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 35

MB MC n Why the Invisible Hand Breaks Down Under Monopoly Examples of Price Discrimination Senior citizens and student discounts on movie tickets l Supersaver discounts on air travel l Rebate coupons l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 36

MB MC n Why the Invisible Hand Breaks Down Under Monopoly Economic Naturalist l Why do many movie theaters offer discount tickets to students? Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 37

MB MC n Using Discounts to Expand the Market Perfectly Discriminating Monopolist l Charging each buyer exactly their reservation price u Economic surplus is maximized u Consumer surplus is zero u Economic surplus = producer surplus Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 38

MB MC n Using Discounts to Expand the Market Limitations to Perfect Price Discrimination Seller will not know each buyer’s reservation price. l Low price buyers could resell to other buyers at a higher price. l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 39

MB MC n Public Policy Toward Natural Monopoly Methods of Controlling Natural Monopolies l State regulation of private monopolies u Cost-plus regulation o High administrative cost o Less incentive for innovation o 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 40

MB MC n Public Policy Toward Natural Monopoly Methods of Controlling Natural Monopolies l Exclusive contracting for natural monopoly u Competition for the contract sets P = MC u Difficulty when fixed costs are high such as electric utilities Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 41

MB MC n Public Policy Toward Natural Monopoly Methods of Controlling Natural Monopolies l Vigorous enforcement of anti-trust laws u Helps prevent cartels u May prevent economies of scale Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 42

MB MC n Public Policy Toward Natural Monopoly What do you think? l Should we regulate natural monopolies? Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition 43

End of Chapter MB MC Chapter 9: Monopoly and Other Forms of Imperfect Competition