Principles of Economics Monopoly Oligopoly and Monopolistic Competition

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Principles of Economics Monopoly, Oligopoly, and Monopolistic Competition Chapter 8 ©Mc. Graw-Hill Education. All

Principles of Economics Monopoly, Oligopoly, and Monopolistic Competition Chapter 8 ©Mc. Graw-Hill Education. All rights reserved.

Learning Objectives 1. Distinguish among three types of imperfectly competitive industries and describe how

Learning Objectives 1. Distinguish among three types of imperfectly competitive industries and describe how imperfect competition differs from perfect competition 2. Identify the five sources of monopoly power and describe why economies of scale are the most enduring of the various sources of market power 3. Apply the concepts of marginal cost and marginal revenue to find the output and price that maximizes a monopolist's profits 4. Explain why the profit-maximizing output level for a monopolist is too small from society's perspective 5. Discuss why firms offer discounts to buyers who are willing to jump a hurdle 6. Discuss public policies that are often applied to natural monopolies ©Mc. Graw-Hill Education. All rights reserved. 7 -2

Imperfect Competition • Imperfectly competitive firms have some ability to set their own price:

Imperfect Competition • Imperfectly competitive firms have some ability to set their own price: they are price setters – Long-run economic profits possible – Reduce economic surplus • Three types: 1. Monopoly has only one seller, no close substitutes 2. Monopolistic competition has many firms producing slightly differentiated products that are reasonably close substitutes 3. Oligopoly has a small number of large firms producing products that are close substitutes ©Mc. Graw-Hill Education. All rights reserved. 7 -3

Monopolistic Competition Number of Firms Price Entry and Exit Product Economic Profits Decisions Monopolistic

Monopolistic Competition Number of Firms Price Entry and Exit Product Economic Profits Decisions Monopolistic Competition Perfect Competition Many firms Limited flexibility Price taker Free Differentiated Standardized Zero in long run P, Q, product differentiation Q only ©Mc. Graw-Hill Education. All rights reserved. 7 -4

Oligopoly and Monopoly Oligopoly Number of Firms Price Entry and Exit Product Economic Profits

Oligopoly and Monopoly Oligopoly Number of Firms Price Entry and Exit Product Economic Profits Decisions Few firms, each is large Some flexibility Monopoly One Differentiated or standardized Price setter Entry is impossible or very difficult Differentiated or standardized Possible P, Q, differentiation, advertising Difficult ©Mc. Graw-Hill Education. All rights reserved. 7 -5

Imperfect Competition • Examples of monopoly – Lottery and gambling in Hungary • Examples

Imperfect Competition • Examples of monopoly – Lottery and gambling in Hungary • Examples of monopolistic competition – Retail gas stations – Convenience stores • Examples of oligopoly – Wireless phone service – Cement – Automobiles ©Mc. Graw-Hill Education. All rights reserved. 7 -6

The Essential Difference • Market power is the firm's ability to raise its price

The Essential Difference • Market power is the firm's ability to raise its price without losing all its sales • Any firm facing a downward sloping demand curve – Firm picks P and Q on the demand curve • Market power comes from factors that limit competition Perfectly Competitive Firm Price Imperfectly Competitive Firm D D Quantity ©Mc. Graw-Hill Education. All rights reserved. Quantity 7 -7

Five Sources of Market Power 1. Exclusive control over inputs 2. Patents and copyrights

Five Sources of Market Power 1. Exclusive control over inputs 2. Patents and copyrights 3. Government licenses or franchises 4. Economies of scale (natural monopolies) 5. Network economies ©Mc. Graw-Hill Education. All rights reserved. 7 -8

Market Power: Network Economies • Network economies occur when the value of the product

Market Power: Network Economies • Network economies occur when the value of the product increases as the number of users increases – VHS format for video tapes, Blu-ray for DVDs – Telephones – Windows operating system – e. Bay – Facebook and My. Space ©Mc. Graw-Hill Education. All rights reserved. 7 -9

Market Power: Economies of Scale • Returns to scale refers to the percentage change

Market Power: Economies of Scale • Returns to scale refers to the percentage change in output from a given percentage change in ALL inputs – Long-run idea – Constant returns to scale: doubling all inputs doubles output – Increasing returns to scale: output increases by a greater percentage than the increase in inputs • Average costs decrease as output increases • Natural monopoly: a monopoly that results from economies of scale ©Mc. Graw-Hill Education. All rights reserved. 7 -10

Economies of Scale • Increasing returns to scale (economies of scale): • Constant returns

Economies of Scale • Increasing returns to scale (economies of scale): • Constant returns to scale (economies of scale): • Diminishing returns to scale (economies of scale): 7 -11

Economies of Scale • Increasing returns to scale (economies of scale): • Constant returns

Economies of Scale • Increasing returns to scale (economies of scale): • Constant returns to scale (economies of scale): • Diminishing returns to scale (economies of scale): Slide 12

Economies of Scale and the Importance of Fixed Costs • Firms with large fixed

Economies of Scale and the Importance of Fixed Costs • Firms with large fixed costs and low variable costs – Have low marginal costs – Average total cost declines sharply as output increases – Economies of scale will exist Slide 13

Total and Average Total Costs for a Production Process with Economies of Scale Average

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 Slide 14 Quantity Average costs decline and is always higher than marginal cost

Economies of Scale and Start-Up Costs • New products can have a large fixed

Economies of Scale and Start-Up Costs • New products can have a large fixed development cost • Variable cost: sum of payments made to the variable factors, such as labor • Fixed cost: sum of payments made to the fixed factors, such as capital • Start-up costs can be thought of as a fixed cost • Average total cost (ATC): total cost divided by output • A good whose production has a large start-up cost and low variable cost is subject to economies of scale – ATC declines sharply as output increases ©Mc. Graw-Hill Education. All rights reserved. 7 -15

Economies of Scale and Start-Up Costs • • Consider an example: Assume marginal cost

Economies of Scale and Start-Up Costs • • Consider an example: Assume marginal cost (M) is constant Variable cost is M*Q Total cost is fixed cost (F) plus variable cost TC = F + M*Q – Total cost increases as output increases • Average total cost is ATC = F / Q + M – Average total cost decreases as output increases – Average fixed cost = F/Q ©Mc. Graw-Hill Education. All rights reserved. 7 -16

TC = F + M Q F Average cost ($/unit) Total cost ($/year) Economies

TC = F + M Q F Average cost ($/unit) Total cost ($/year) Economies of Scale ATC = F/Q + M M Quantity ©Mc. Graw-Hill Education. All rights reserved. Quantity 7 -17

Example: Video Game Producers – Different Volumes Nintendo Sony Annual Production (000 s) 1,

Example: Video Game Producers – Different Volumes Nintendo Sony Annual Production (000 s) 1, 000 1, 200 Fixed Cost ($000 s) $200 Variable Cost ($000 s) $800 $960 Total Cost ($000 s) $1, 000 $1, 160 ATC per game $1. 00 $0. 97 ©Mc. Graw-Hill Education. All rights reserved. 7 -18

Example: Video Game Producers – Lower Marginal Costs Nintendo Sony Annual Production (000 s)

Example: Video Game Producers – Lower Marginal Costs Nintendo Sony Annual Production (000 s) 1, 000 1, 200 Fixed Cost ($000 s) $200 Variable Cost ($000 s) $200 $240 Total Cost ($000 s) $400 $440 ATC per game $0. 40 $0. 37 ©Mc. Graw-Hill Education. All rights reserved. 7 -19

Example: Video Game Producers – Higher Fixed Cost Nintendo Sony Annual Production (000 s)

Example: Video Game Producers – Higher Fixed Cost Nintendo Sony Annual Production (000 s) 1, 000 1, 200 Fixed Cost ($000 s) $10, 000 $200 $240 Total Cost ($000 s) $10, 200 $10, 240 ATC per game $10. 20 $8. 53 Variable Cost ($000 s) ©Mc. Graw-Hill Education. All rights reserved. 7 -20

Example: Video Game Producers – Different Production Levels Nintendo Sony Annual Production (000 s)

Example: Video Game Producers – Different Production Levels Nintendo Sony Annual Production (000 s) 500 1, 700 Fixed Cost ($000 s) $10, 000 $100 $340 Total Cost ($000 s) $10, 100 $10, 240 ATC per game $20. 20 $6. 08 Variable Cost ($000 s) ©Mc. Graw-Hill Education. All rights reserved. 7 -21

Intel's Advantage • Development cost of a …………$2 billion new chip • Marginal cost

Intel's Advantage • Development cost of a …………$2 billion new chip • Marginal cost of making …………. Pennies a chip • Dominating the market ………. . . Priceless • Intel supplies more than 80% of the processors for PCs ©Mc. Graw-Hill Education. All rights reserved. 7 -22

Profit Maximization for the Monopolist • Like all other firms, a monopolist: – Maximizes

Profit Maximization for the Monopolist • Like all other firms, a monopolist: – Maximizes profits – Applies the Cost-Benefit Principle: • Increase output if marginal benefit > marginal cost • Decrease output is marginal benefit < marginal cost • Marginal benefit for firms is called marginal revenue: – Change in total revenue from a one-unit change in output – Equal to price for the perfectly competitive firm – Less than price for the monopolist ©Mc. Graw-Hill Education. All rights reserved. 7 -23

Profit Maximization for the Monopolist • To sell another unit the monopolist must lower

Profit Maximization for the Monopolist • To sell another unit the monopolist must lower price – Total revenue from 2 units = $12 – Total revenue from 3 units = $15 Price ($/unit) • Marginal revenue = $3 6 5 D 2 3 Quantity (units/week) ©Mc. Graw-Hill Education. All rights reserved. 7 -24

Price & marginal revenue ($/unit) Monopolist's Marginal Revenue 8 3 D 1 -1 2

Price & marginal revenue ($/unit) Monopolist's Marginal Revenue 8 3 D 1 -1 2 3 4 8 5 MR Quantity (units/week) Price Quantity Total Revenue $6 2 $12 $5 3 $15 $4 4 $16 $3 5 $15 ©Mc. Graw-Hill Education. All rights reserved. Marginal Revenue 3 1 -1 7 -25

Monopoly Demand Marginal Revenue • The monopolist's marginal revenue curve: Price a a/2 D

Monopoly Demand Marginal Revenue • The monopolist's marginal revenue curve: Price a a/2 D MR Q 0/2 Quantity – Has the same intercept as the straight-line demand curve – Has twice the slope of the demand curve – Lies below the demand curve ©Mc. Graw-Hill Education. All rights reserved. 7 -26

Marginal Revenue of, and Price Charged by the Monopolist • MR changes with price

Marginal Revenue of, and Price Charged by the Monopolist • MR changes with price and with quantity • The monopoly’s price will be on the elastic part of the inverse demand curve (P = a – b. Q) Pmax = a P* =a/2 Elastic Inelastic Q* =Qmax/2 Qmax 7 -27

Deciding Quantity • Decrease output – At Q = 8, MC = MR =

Deciding Quantity • Decrease output – At Q = 8, MC = MR = 2 • The demand curve sets the price at P = $4 – At any output below 8, MC < MR 6 Price ($/unit of output) • Profit is maximized at the level of output where marginal cost equals marginal revenue • At P = $3 and Q = 12, MC > MR MC 4 3 D 2 MR 12 8 Quantity (units/week) ©Mc. Graw-Hill Education. All rights reserved. 7 -28

Monopoly Profit • • Profit = Total revenue – total cost Total cost =

Monopoly Profit • • Profit = Total revenue – total cost Total cost = ATC x Q Profit = P x Q – ATC x Q Profit = (P-ATC) x Q If P > ATC then the firm earns a profit If P < ATC then the firm suffers a loss This can be graphically illustrated ©Mc. Graw-Hill Education. All rights reserved. 7 -29

Monopoly Losses and Profits Economic profit = $400, 000/day Price ($/minute) 0. 12 ATC

Monopoly Losses and Profits Economic profit = $400, 000/day Price ($/minute) 0. 12 ATC 0. 10 MC 0. 05 MR Price ($/minute) Economic loss = $400, 000/day 0. 10 0. 08 ATC MC 0. 05 D 20 24 Minutes (millions/day) MR D 20 24 Minutes (millions/day) ©Mc. Graw-Hill Education. All rights reserved. 7 -30

Monopoly and Social Optimum Price ($/unit of output) 6 The monopolist's optimal amount occurs

Monopoly and Social Optimum Price ($/unit of output) 6 The monopolist's optimal amount occurs where MC = MR, Q = 8 units and P = $4 Marginal Cost Deadweight loss from monopoly = $4 4 3 2 The socially optimal amount occurs where MC = MB, Q = 12 units and P = $3 MR D 8 12 24 Quantity (units/week) ©Mc. Graw-Hill Education. All rights reserved. 7 -31

Monopoly and Perfect Competition Monopoly: Perfect Competition MC = MR P >MR P =

Monopoly and Perfect Competition Monopoly: Perfect Competition MC = MR P >MR P = MC P > MC Deadweight Loss No Deadweight Loss ©Mc. Graw-Hill Education. All rights reserved. 7 -32

Are Monopolies Always Bad? Should We Try to Eliminate Them? • Monopolies exist for

Are Monopolies Always Bad? Should We Try to Eliminate Them? • Monopolies exist for economic reasons – Patents, copyrights, and innovation – Economies of scale – Network economies • Anti-trust laws attempt to limit deadweight loss – Limiting monopoly has costs • Patents encourage innovation • Economies of scale minimize ATC • Network economies increase benefits ©Mc. Graw-Hill Education. All rights reserved. 7 -33

Price Discrimination • Price discrimination means charging different buyers different prices for essentially the

Price Discrimination • Price discrimination means charging different buyers different prices for essentially the same good or service – Separate the groups – No side trades among buyers • Many forms of price discrimination – Hurdle method: discounts for identifiable groups (e. g. , students, pensioners) – Perfect discrimination: negotiate separate deals with each customer ©Mc. Graw-Hill Education. All rights reserved. 7 -34

Carla the Editor: Social Optimum 6 papers with an economic surplus of What is

Carla the Editor: Social Optimum 6 papers with an economic surplus of What is the social $6 person, total surplus = $36 optimum? • Opportunity cost of Carla's time is $29 Student A B C D E F G Reservation Total Price Revenue $40 $76 38 $108 36 $136 34 $160 32 $180 30 $196 28 ©Mc. Graw-Hill Education. All rights reserved. What if Carla is a profit maximizer? What is Carla's total revenue? 7 -35

Carla the Editor: Marginal Revenue What is Carla's marginal revenue? 3 papers with a

Carla the Editor: Marginal Revenue What is Carla's marginal revenue? 3 papers with a total economic profit of $21 • Opportunity cost of Carla's time is $29 Student A B C D E F G Total Reservation Revenue Price $40 $76 38 $108 36 $136 34 $160 32 $180 30 $196 28 ©Mc. Graw-Hill Education. All rights reserved. MR $40 $36 $32 $28 $24 $20 $16 7 -36

Carla the Editor: Price Discriminator • Opportunity cost of Carla's time is $29 What

Carla the Editor: Price Discriminator • Opportunity cost of Carla's time is $29 What if Carla is a Reservation Total Student Revenue perfect price Price discriminator? $40 A $40 $78 B 38 What is Carla's $114 C 36 total revenue? $148 D 34 6 papers with $180 E 32 an economic $210 F 30 profit of $36 $238 G 28 ©Mc. Graw-Hill Education. All rights reserved. 7 -37

Hurdle Method of Price Discrimination • The hurdle method of price discrimination is the

Hurdle Method of Price Discrimination • The hurdle method of price discrimination is the practice of offering a discount to all buyers who overcome some obstacle. – Temporary sales – Hard cover and paperback books – Multiple car models from one manufacturer – Commercial air carriers – Movie producers and phased releases ©Mc. Graw-Hill Education. All rights reserved. 7 -38

Carla Offers a Rebate • If reservation price < $36, student will mail in

Carla Offers a Rebate • If reservation price < $36, student will mail in rebate A Reservation Price $40 Total Revenue $40 B 38 76 36 C 36 108 32 Student 5 papers, price Discounted Price Submarket $36, rebate $4, D $34 economic E 32 64 profit $27 F 30 90 ©Mc. Graw-Hill Education. All rights reserved. MR $40 $34 30 26 7 -39

Carla's Choices Program Social Optimum Single Price Perfect Discriminator Hurdle Papers Edited 6 3

Carla's Choices Program Social Optimum Single Price Perfect Discriminator Hurdle Papers Edited 6 3 6 5 = (3 + 2) Price $30 $36 Reservation $36, $4 rebate Total Revenue $180 $108 $210 $172 Carla's Time $174 $87 $174 $145 Economic Profit $6 $21 $36 $27 Total Surplus $36 $27 $36 $35 ©Mc. Graw-Hill Education. All rights reserved. 7 -40

Monopoly and Public Policy • Challenge: create the greatest increase in total surplus •

Monopoly and Public Policy • Challenge: create the greatest increase in total surplus • Policy options – Government ownership and operation – Regulation – Competitive bids for natural monopoly services – Break up ©Mc. Graw-Hill Education. All rights reserved. 7 -41

State-Owned Natural Monopoly • Marginal cost is always less than average cost – Marginal

State-Owned Natural Monopoly • Marginal cost is always less than average cost – Marginal cost pricing produces losses • Options – Fund losses from tax revenues – Fixed monthly fee plus usage fee • Fixed fee covers losses • Limited incentives to innovate and cut costs • Commonly used for water, Post Office, and some electricity ©Mc. Graw-Hill Education. All rights reserved. 7 -42

Regulated Monopolies • Cost-plus regulation sets price at per unit explicit costs plus a

Regulated Monopolies • Cost-plus regulation sets price at per unit explicit costs plus a mark-up for implicit costs • Used for electricity and telephone (etc. ) – Policies vary by state • Disadvantages – High administrative cost – Reduced incentive for cost-saving innovation – Price is greater than marginal cost ©Mc. Graw-Hill Education. All rights reserved. 7 -43

Exclusive Contracting for Natural Monopolies • Government awards contract to low bidder for natural

Exclusive Contracting for Natural Monopolies • Government awards contract to low bidder for natural monopoly services – Garbage collection, fire protection, road construction, Department of Defense • Could achieve marginal cost pricing IF government pays the resulting losses • Asset transfer for large fixed investment is complex ©Mc. Graw-Hill Education. All rights reserved. 7 -44

Enforcement of Anti-Trust Laws • Two landmark laws in the US – Sherman Act

Enforcement of Anti-Trust Laws • Two landmark laws in the US – Sherman Act of 1890 • Declared conspiracy to create a monopoly illegal – Clayton Act of 1914 • Outlawed transactions that would "substantially lessen competition" • Applies to mergers and acquisitions today – IBM avoided break-up; AT&T did not – Microsoft survived ©Mc. Graw-Hill Education. All rights reserved. 7 -45

Another Policy Option: Ignore Monopoly • Two objections to monopolies – Restrict output, decrease

Another Policy Option: Ignore Monopoly • Two objections to monopolies – Restrict output, decrease total surplus – Raise price, earn economic profits • Analysis – Discount offers allow some customers to pay less than average cost, though more than marginal cost • Economic profits generated by customers who pay list price – their choice – About two-thirds of economic profits are taxed away • Remainder accrues to shareholders ©Mc. Graw-Hill Education. All rights reserved. 7 -46

Imperfect Competition Monopolistic Competition and Oligopoly Sources of Market Power Monopoly Public Policy ©Mc.

Imperfect Competition Monopolistic Competition and Oligopoly Sources of Market Power Monopoly Public Policy ©Mc. Graw-Hill Education. All rights reserved. 7 -47

Principles of Economics Chapter 8 Appendix The Algebra of Monopoly Maximization ©Mc. Graw-Hill Education.

Principles of Economics Chapter 8 Appendix The Algebra of Monopoly Maximization ©Mc. Graw-Hill Education. All rights reserved. 7 -48

From Demand to Marginal Revenue • Given a demand curve such as P =

From Demand to Marginal Revenue • Given a demand curve such as P = 15 – 2 Q • We can write the marginal revenue curve as MR = 15 – 4 Q • Suppose marginal cost is a line with zero intercept and a slope of 1 MC = Q • The remaining step is to set marginal revenue equal to marginal cost ©Mc. Graw-Hill Education. All rights reserved. 7 -49

MR = MC • Let Q* be the profit maximizing level of output MC

MR = MC • Let Q* be the profit maximizing level of output MC = MR Q* = 15 – 4 Q* 5 Q* = 15 Q* = 3 • To find P, substitute Q = 3 into the demand equation P = 15 – 2 Q* P = 15 – 2 (3) P = 9 ©Mc. Graw-Hill Education. All rights reserved. 7 -50