perf Comp & Monopoly

Lecture 8

Dynamics: Cobweb Model

Consumer Theory

• Consumers optimize their well being subject to a budget constraint

• Enjoyment from consumption referred to as utility

Good 1: Number of Units Purchased

1 2 3

Total Value $18 $30 $36

Good 2: Number of Units Purchased

1 2 3

Total value $4 $8 $12

Price of good 1= $12 , price of good 2 = $3

Good 1: Number of Units Purchased

1 2 3

Total Value $18 $30 $36

Good 2: Number of Units Purchased

1 2 3

Total value $4 $8 $12

Price of good 1= $12 , price of good 2 = $3Income = $18

Good 1: Number of Units Purchased 1 2 3

Total Value 18 30 36

Marginal value 18 12 6

Marginal value per dollar 1.5 1 0.5

Good 2: Number of Units Purchased 1 2 3

Total value 4 8 12

Marginal value 4 4 4

Marginal value per dollar 1.33 1.33 1.33

Price of good 1= $12 , price of good 2 = $3, Income = $18

Good 1: Number of Units Purchased 1 2 3

Total Value 18 30 36

Marginal value 18 12 6

Marginal value per dollar 1.5 1 0.5

Good 2: Number of Units Purchased 1 2 3

Total value 4 8 12

Marginal value 4 4 4

Marginal value per dollar .8 .8 .8

Price of good 1= $12 , price of good 2 = $5, Income = $18

Budget Set

• Set of goods and services you can buy with the money you have available to you

• Price of coke = $1 per unit, price of snickers =$2 per unit

coke

snickers

2.5

5

1 unit of coke, 2 units of snickers

List some other combinations

How do you decide what to choose?

coke

snickers

2.5

You rank all the combinations and choose your best one.

3 units coke, 1 unit snickers

Now suppose prices change• Price of coke = $1 per unit, price of snickers =$1 per unit

snickers

52 unit of coke, 3 units of snickers

5 coke

List some other combinations

You rank all the combinations and choose your best one.

snickers

5

coke5

2 units of coke, 3 units of snickers

Individual Demand for snickers

Price of snickers

3 Quantity of snickers

2

1

21

Demand curve for snickers

Notes for individual demand

• Income constant• Price of other goods constant• Tastes constant

Demand curve

Price Rs.

Quantity of Cake per week

Rs. 30

5

Rs. 15

10

Willingness to pay

Market Demand: Horizontal Summation

Marginal Cost

The cost of producing one more unit of good or service

Decreasing marginal returns

• Marginal Product: The additional units of a good or service that can be produced with an additional unit of input ( e.g. labour)

• Principle of decreasing marginal returns– The marginal product of an input decreases as

additional units of the input are employed

Output Labour units Total Cost Marginal Cost

0 0 0

1 1 10 10

2 2.5 25 15

3 4.5 45 20

Price of labor = Rs. 10

Marginal cost curve

Quantity of Cake per week

Rs. 15:Marketprice

20

Rs. 30

• If the market price is Rs. 15 how much should producer produce?

Quantity produced2

Marginal cost in Rs.

10

1

15

• What if the price changes if the producer produces more?

• We assume price remains constant – firm is a price taker

• Marginal cost curve is the supply curve of the individual firm in a perfectly competitive market

Price taker demand curve

D

S

30

• QD = 625 – 25P• QS = 175 + 15P• P = 45• Q = 400• 100 firms, 4 units each• Suppose 1 firm increases output to 5(25% increase)• QS = 176 + 15P• P = 44.9• 1000 firms?

• P = MR

Producer’s decision

Quantity

Rs. 30

MC

Q

• Producers maximize profit by selling the quantity for which marginal revenue equals marginal cost

• Long run equilibrium is attained where MR=MC=ATC

• Economic profit is zero and only normal return is realized

Firm and market supply

price

quantity

price

quantity

AVC

ATC Sshort run

Monopoly

Single seller that produces a good with no close substitutes

Sources of monopolyWhat could be the causes of monopoly to exist

Barriers to entry

• Legal barriers– Patents– Government granted franchises

• Natural barriers– Economies of scaleAverage cost of production is falling through the

relevant range of consumer demand

Is at the opposite extreme of perfect competition. Monopolist is a price maker as against perfect competitor is who price taker

Profit maximising under monopoly

Q O

MR

AR

Rs

Q O

MC

AR

Qm

MR

AR

a

Rs

Q O

AC

MC

AR

AC

Qm

MR

AR

a

b

Rs

c

Case StudyThe Market Value of Monopoly Profits in the New York

City Taxi IndustryNY city requires a license (medallion) to operate a taxi. These are limited in numbers and confer a monopoly power (I.e. ability to earn economic profits) to owners. Value of medallion is the PV of future streams of earnings from medallion. For example the # of medallions in NY city have remained at 11787 since 1937 till 1996. In 1996 it was increased by only 400 to 12187 medallions. The value of medallion has risen from $ 10 in 1937 to 250000 in 1999 (18% p.a.). The price of medallion is lower in other cities (e.g. $ 90000 in Boston, $ 25000 in Chicago) reflecting much lower capacity in these cities.

Proposals to increase the # in NY blocked by Taxi Unions.

Case StudyThe Market Value of Monopoly Profits in the New York

City Taxi Industry (Contd..)

If the city authorities could give freely the medallions then the price of medallions could fall to zero. Alternatively the Municipality has allowed sharp increase in the radio taxis - although they are much less flexible.

As a result the profit of NY taxi operators has come down from 32% to only about 11% in 1999.

Monopoly

Comparison of monopolywith perfect competition:

(a) same industry MC curve

Q O

MC

Q1

MR

AR = D

P1

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

Rs

Q O

MC

Q1

MR

P1

P2

Q2

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

AR = D

Rs

Q O

MC ( = supply under perfect competition)

Q1

MR

P1

P2

Q2

Equilibrium of industry under perfect competition and monopoly: with the same MC curve

AR = D

Rs

Monopoly

Comparison of monopolywith perfect competition:

(b) monopoly has lower MC curve (i.e. it is experiencing economies of scale)

Q O Q1

MR

P1

MCmonopoly

Equilibrium of industry under perfect competition and monopoly: with different MC curves

AR = D

Rs

Q O

MC ( = supply)perfect competition

Q1

MR

P1

P2

Q2

MCmonopoly

AR = D

Equilibrium of industry under perfect competition and monopoly: with different MC curves

Rs

Q O

MC ( = supply)perfect competition

Q1

MR

P1

P2

Q2

MCmonopoly

x

AR = D

Equilibrium of industry under perfect competition and monopoly: with different MC curves

Rs

Q O

MC ( = supply)perfect competition

Q1

MR

P1

P2

Q2

MCmonopoly

Q3

P3

AR = D

Equilibrium of industry under perfect competition and monopoly:with different MC curves

Rs

MONOPOLY

• Disadvantages of monopoly– high prices / low output: short run– high prices / low output: long run– lack of incentive to innovate– X-inefficiency

• Advantages of monopoly– economies of scale– profits can be used for investment

MONOPOLY

• Disadvantages of monopoly– high prices / low output: short run– high prices / low output: long run– lack of incentive to innovate– X-inefficiency

• Advantages of monopoly– economies of scale– profits can be used for investment– promise of high profits encourages risk taking

Deadweight loss under monopoly

Deadweight loss under monopoly

O

£

Q

Ppc

Qpc

MC(= S under perfect competition)

AR = D

(a) Industry equilibrium under perfect competition

Consumersurplus

a

Producersurplus

Deadweight loss under monopoly

O

£

Q

Ppc

Qpc

MC(= S under perfect competition)

AR = D

a

Pm

Qpc

MR

b

(b) Industry equilibrium under monopoly

Consumersurplus

Producersurplus

Deadweightwelfare loss