Monopoly and Other Forms of Imperfect Competition Monopoly

Monopoly and Other Forms of Imperfect Competition Monopoly → Oligopoly → Monopolistic Comp. → Perfect Comp. MB MC

MB MC Imperfect Competition n Imperfectly Competitive Firms Have some control over price l Long-run economic profits are possible l * Perfectly competitive firms are price takers (have no control over prices), long-run economic profits are zero. 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 Markets l l n Reduce economic surplus to varying degrees Are very common Perfect Competition l l An ideal market that maximizes economic surplus A situation that does not always exist 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 Various Forms of Imperfect Competition n Pure Monopoly (most inefficient) u The l only supplier of a unique product with no close substitutes Oligopoly (more efficient than a monopoly) u. A firm that produces a product for which only a few rival firms produce close substitutes 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 Slide 4

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 5

MB MC Imperfect Competition n In perfect competition l l l n Supply and demand determine equilibrium price. The firm has no market power. At the equilibrium price, the firm sells all it wishes. (The firm’s demand curve is the horizontal line at the market price. ) If the firm raises its price, sales will be zero. With imperfect competition l l The firm has some control over price or some market power. The firm faces a downward sloping demand curve. 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 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 7

MB MC n Profit Maximization for the Monopolist For a producer to maximize profits: select the output level that maximizes the difference between TR and TC, where MB = MC. 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 Slide 8

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. In perfect competition: MR = P 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 Slide 9

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 10

MB MC Marginal Revenue for Monopolist 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 11

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 12

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 Slide 13

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 Slide 14

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 15

MB MC Even a Monopolist May Suffer an Economic Loss Being a monopolist doesn’t guarantee an economic profit = $400, 000 0. 12 0. 10 ATC MC 0. 05 Price ($/minute) loss = $400, 000 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 Slide 16

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 Slide 17

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 Slide 18

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 Slide 19

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 This is called 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 20

MB MC Economies of Scale due to fixed costs (constant V) 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 21

Two Producers (an Example with Low Fixed Costs) MB MC Nintendo Playstation Annual production 1, 000 1, 200, 000 Fixed cost $200, 000 Variable cost $800, 000 $960, 000 Total cost $1, 000 $1, 160, 000 Average total cost per game $1. 00 $0. 97 V= $ 0. 8/unit Fixed costs are a relatively small share of total cost • Cost per unit 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 22

Two Producers (an example with High Fixed Costs) MB MC Nintendo Playstation Annual production Fixed cost Variable cost Total cost 1, 000 1, 200, 000 $10, 000, 000 $200, 000 $240, 000 $10, 200, 000 $10, 240, 000 Average total cost per game $10. 20 $8. 53 V= $ 0. 2 / unit • 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 Slide 23

Now, Playstation exploits cost advantage and increases its sales MB MC Nintendo Playstation Annual production 500, 000 Fixed cost $10, 000 Variable cost Total cost 1, 700, 000 $10, 000 $100, 000 $340, 000 $10, 100, 000 $10, 340, 000 Average total cost per game $20. 20 $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 Slide 24

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 1984 1990 n Fixed Cost Software Variable Cost Hardware 20% 80% 20% Why does Intel sell the overwhelming majority of all microprocessors used in personal computers? 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 Difficulties in Reducing the Deadweight Loss of Monopolies Problems in 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 Slide 27

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 Slide 28

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 ? Why do many movies 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 Slide 29

Example: Total and Marginal Revenue from Editing MB MC Student Reservation Price ($ per paper) Total Revenue ($ per week) A 40 40 B 38 76 C Marginal revenue ($ per paper) 40 36 108 D 34 160 Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 32 F 30 180 G H 136 E 26 28196 208 Chapter 9: Monopoly and Other Forms of Imperfect Competition 36 32 28 24 20 16 12 Slide 30

MB MC n Why the Invisible Hand Breaks Down Under Monopoly Example l How many manuscripts should Dijana edit? u Opportunity cost = $29 u TR = P x Q, or for 4 papers, 4 x $34 = $136/wk u MR is the difference in TR from adding another student u If MR > MC: increase output 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 How many manuscripts should Dijana edit? u Dijana o o n n edits 3 papers TC = 3 x $29 = $87 TR = $108 Economic profit = $108 - $87 = $21/wk Accounting profit = $108 Opportunity cost = $29 Must charge the same price u Reservation price > opportunity cost for student A to F u Socially efficient number is 6 o TR = 6 x $30 = $180 o TC = 6 x $29 = $174 o Economic profit = $180 - $174 = $6 o Accounting profitand=Other $180 Copyright c 2004 by The Mc. Graw-Hill Chapter 9: Monopoly Forms of Imperfect Competition Companies, Inc. All rights reserved. Slide 32

MB MC n Why the Invisible Hand Breaks Down Under Monopoly Example l If Dijana can price discriminate, how many papers should she edit? u Assume Dijana can charge each student the reservation price. Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 33

MB MC Example Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Student Reservation price A 40 B 38 C 36 D 34 E 32 F 30 G 28 H 26 • Dijana 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 Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 34

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 Slide 35

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 Slide 36

MB MC n Using Discounts to Expand the Market The Hurdle Method of Price Discrimination l Profit-maximizing seller’s goal is to charge each buyer his/her reservation price. Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 37

MB MC n Using Discounts to Expand the Market The Hurdle Method of Price Discrimination l There are two problems to implementing this pricing strategy. u Seller does not know the reservation prices u Seller must separate high and low price buyers l The hurdle method of price discrimination is used to solve these problems. Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 38

MB MC n Using Discounts to Expand the Market The Hurdle Method of Price Discrimination The practice involves offering a discount to all buyers who overcome some obstacle. l Example l u Offering a rebate to those who mail in a coupon u Why might an appliance retailer instruct its clerks to hammer dents into the sides of its stoves and refrigerators? Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 39

MB MC l Price Discrimination and Economic Efficiency Is price discrimination a bad thing? u. No. Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. It raises economic surplus. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 40

MB MC n Using Discounts to Expand the Market Examples of Price Discrimination (Seasonal) Sales l Book publishers and paperback books l Automobile producers offer various models l Commercial air carriers l Movie producers l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 41

MB MC n Using Discounts to Expand the Market Summary Single price monopolies are inefficient because P > MR. l The hurdle method of price discrimination reduces the inefficiency. l The more finely the seller can discriminate, the smaller the efficiency loss. l Copyright c 2004 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 9: Monopoly and Other Forms of Imperfect Competition Slide 42