Market Structures: Monopoly. Monopoly Assumptions One seller and many buyers –Implication: The seller is a price maker and the buyers are price takers

Market Structures: Monopoly

MonopolyAssumptions

• One seller and many buyers– Implication: The seller is a price maker and the buyers

are price takers.

• Barriers to Entry – Ownership of a unique resource (Diamonds)– Government granted rights for exclusive production

(e.g. patents, copyrights, licenses, concessions)– Economies of scale and declining long-run average costs– Implication: Monopolist faces the entire market demand

curve and profits can persist in the short and long-run.

Limits to Monopoly

• Size of the market (Pavarotti versus Joe, uncongested bridge)

• Definition of market and close substitutes (ornamental versus industrial diamonds, bottled water).

• Potential competition

Production Decisions

• Monopolist versus competitive firm.– CF is a price taker who faces a perfectly elastic demand

curve MR=P– M is a price maker who faces the entire market demand

curve MR<P• Intuitive proof – to sell another unit the monopolist must lower the

price. This means lowering the price not only on the extra unit sold, but also all the other units the monopolist was selling. So MR = Price of the additional unit – the sum of the decreases in all the units previously sold ( e.g. selling 4 units @$100, to sell the 5 unit the price must be lowered to $90, so the monopolist’s MR = $90 – 4X$10=$50)

• Tabular proof – see next table and handout• Graphical proof

A Monopoly’s Revenue

• Total Revenue

P Q = TR

• Average Revenue

TR/Q = AR = P

• Marginal Revenue

TR/Q = MR

Table 1 A Monopoly’s Total, Average, and Marginal Revenue

Copyright©2004 South-Western

Figure 2 Demand Curves for Competitive and Monopoly Firms

Copyright © 2004 South-Western

Quantity of Output

Demand

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve

0

Price

Quantity of Output0

Price

Demand

Figure 3 Demand and Marginal-Revenue Curves for a Monopoly


Quantity of Water

Price

$1110

9876543210

–1–2–3–4

Demand(averagerevenue)

Marginalrevenue

1 2 3 4 5 6 7 8

Profit Maximization

• A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.

• It then uses the demand curve to find the price that will induce consumers to buy that quantity.

• Profit Maximization –– Set MR = MC to find Q that maximizes profits.– Use the market demand curve to find the P that the Q brings– Find ATC and AVC cost to determine profits, losses, or

shutdown.

• Difference between the monopolist decision and the competitive firms decision– The monopolist does not have a supply curve like the CF,

rather they pick a single price and quantity– Monopolists produce where P>MR and P>MCversus CFs

who produce where P=MR and P=MC.

Figure 4 Profit Maximization for a Monopoly


QuantityQ Q0

Costs andRevenue

Demand

Average total cost

Marginal revenue

Marginalcost

Monopolyprice

QMAX

B

1. The intersection of themarginal-revenue curveand the marginal-costcurve determines theprofit-maximizingquantity . . .

A

2. . . . and then the demandcurve shows the priceconsistent with this quantity.

Figure 5 The Monopolist’s Profit


Monopolyprofit

Averagetotalcost

Quantity

Monopolyprice

QMAX0

Costs andRevenue

Demand

Marginal cost

Marginal revenue

Average total cost

B

C

E

D

Figure 6 The Market for Drugs


Quantity0

Costs andRevenue

DemandMarginalrevenue

Priceduring

patent life

Monopolyquantity

Price afterpatent

expires

Marginalcost

Competitivequantity

Welfare Costs of Monopoly

• In competitive markets, firms produce where

P=MCAnd since

P=MB=willingness to budAnd

MC=willingness to sell

P=MC MB=MC orMaximum total surplus

• In monopoly,P>MR so

P>MC

Or

MB>MC

Output falls short of the efficient amount Deadweight Welfare Loss

Figure 7 The Efficient Level of Output


Quantity0

Price

Demand(value to buyers)

Marginal cost

Value to buyersis greater thancost to seller.

Value to buyersis less thancost to seller.

Costto

monopolist

Costto

monopolist

Valueto

buyers

Valueto

buyers

Efficientquantity

Figure 8 The Inefficiency of Monopoly


Quantity0

Price

Deadweightloss


Marginal cost

Efficientquantity

Monopolyprice

Monopolyquantity

• Monopoly profit is not usually a social cost but a transfer of surplus from consumer to producer.

• Profit can be a social cost if extra costs are incurred to maintain it, such as political lobbying, or if the lack of competition leads to costs not being minimized (X-inefficiency again!)

Public Policy and MonopoliesWorking towards P=MC

• Attempts to increase competition through anti-trust legislation – Sherman Antitrust Act of 1890 – Examples: Breakup of Standard Oil and turning MA Bell into Baby Bells

• Regulation – Natural Monopolies– P=MC doesn’t work with extensive economies of scale– Regulated forms have little incentive to minimize costs

• Public Ownership – Public utilities and the Postal Service

• Hands-off Approach

• Monopolies contribute to inefficiency because:– P>MC – Less than the socially optimal level of output is produced– Incentives for cost reduction may diminish– Too many resources may be spent on political protection

.

Price-Discriminating Monopolist• Price discrimination occurs when different prices are charged

to different consumer that do no reflect differences in the cost of providing th good

• Perfect Price Discrimination – charging each customer their maximum willingness to pay.

• Imperfect Price Discrimination – segmenting the market into different consumer groups.– Parable – Hardcopy versus paperback copy – Allows firms to increase profits– Requires separating customers into different groups and minimize

arbitrage– Results in greater economic welfare than single-pricing monopolists.

Basis for Price Descrimination

• Different consumers have different willingness to pay different price elasticities of demand

• Rule: segment the market according to price elasticity of demand and charge the consumers will less elastic demand more than those with more elastic demand

• Examples: (remember the smaller the % of income or the greater the number of close substitutes the less price elastic the demand,)– Movie Tickets– Airline Tickets– Discount Coupons– Financial Aid– Quantity Discounts

Summary

• Monopolies contribute to inefficiency because:– P>MC DWWL

– Less than the socially optimal level of output is produced

– Incentives for cost reduction may diminish

– Too many resources may be spent on political protection

• However, discriminating monopolist can help reduce DWWL.

Figure 10 Welfare with and without Price Discrimination


Profit

(a) Monopolist with Single Price

Price

0 Quantity

Deadweightloss


Consumersurplus

Quantity sold

Monopolyprice

Marginal cost

Figure 10 Welfare with and without Price Discrimination


Profit

(b) Monopolist with Perfect Price Discrimination

Price

0 Quantity

Demand

Marginal cost

Quantity sold

Documents

Market Structures: Monopoly. Monopoly Assumptions One seller and many buyers –Implication: The seller is a price maker and the buyers are price takers