PPA 723: Managerial Economics Lecture 15: Monopoly The Maxwell School, Syracuse University Professor John Yinger

PPA 723: Managerial Economics

Lecture 15:

Monopoly

The Maxwell School, Syracuse UniversityProfessor John Yinger

Managerial Economics, Lecture 15: Monopoly

Outline

Monopoly Pricing

Welfare Effects of Monopoly

How Do Monopolies Arise?

Monopolies and Public PolicyAnti-trust laws and regulationPublic monopolies


Monopoly

A monopoly is the only supplier of a good for which there is no close substitute.

A monopoly's output is the market output. A monopoly's demand curve is market

demand curve. Its demand curve is downward sloping. It doesn't lose all its sales if it raises its price.

A monopoly is a price setter, not a price taker.


Monopoly Profit Maximization

Monopolies, like other firms, maximize profits by choosing quantity such that:

marginal revenue = marginal cost

MR(Q) = MC(Q)

But with a monopoly, MR(Q) ≠ P.


Marginal Revenue, MR

MR = the change in revenue from selling one more unit.

MR = R/Q (=R when Q =1)

For a competitive firm, MR = P.

For a monopoly, MR < P.


Figure 11.1a Average and Marginal Revenue

Price, p,$ per unit

q q + 1Quantity, q, Units per year

p 1

(a) Competitive Firm

Demand curve

A B

R1 = A R2 = A + B

R = R2 – R1 = B = p 1


Figure 11.1b Average and Marginal Revenue

Q Q + 1Quantity, Q, Units per year

p1

p2

Price, p,$ per unit

(b) Monopoly

Demand curve

A B

C

R1 = A + CR2 = A + BR = R2 – R1 = B – C = p2 - C


Deriving a Monopoly’s MR CurveA monopoly increases its output by Q,

by lowering its price per unit by P/Q (=slope of demand curve).

So monopoly loses (p/Q) Q on units originally sold at higher price (area C)but earns an additional P on extra output

(area B).Thus: MR = P + (p/Q) Q = P + a negative term < P


Figure 11.2 Elasticity of Demandand Total, Average,

and Marginal Revenue

p, $ per unit

Demand ( p = 24 – Q)

Perfectly elastic

Perfectlyinelastic

Elastic, < –1

Inelastic, –1 < < 0

= –1

p = –1

Q = 1Q = 1

MR = –2

Q, Units per day

24

12

0 12 24MR = 24 – 2Q


Linear MR CurveIf demand curve is linear, P = a - bQ,

Then MR curve is linear, MR = a - 2bQ.MR curve hits vertical (price) axis where

demand curve does.Slope of MR curve = 2 slope of

demand curve.MR curve hits horizontal axis at half the

quantity as the demand curve.


Choosing Price or Quantity• A monopoly can set P or Q to maximize its

profit, . • A monopoly is constrained by market demand.

– It cannot set both Q and P.– If a monopoly sets p, demand curve determines Q. – If a monopoly sets Q, demand curve determines P.

• Because a monopoly wants to maximize , it chooses same profit-maximizing solution whether it sets P or Q


Profit Maximization All firms, including monopolies, use a

two-step analysis:

1. The firm determines output, Q*, at which it makes highest , i.e., where

– MR = MC

2. The firm decides whether to produce Q* or shut down (if P ≤ AVC)


Figure 11.3 Maximizing Profit

12

18

24

8

6

108

144

60

60 12 24

R, , $

0 126 24

AC

AVCe

Demand

= 60

MC

MR

Q, Units per day

Revenue, R

Profit,

Q, Units per day

p, $ per unit

(b) Profit, Revenue


Market PowerA monopolist’s ability to set the price is

an example of a more general phenomenon called market power.

Market power is defined as the ability of a firm to charge a price above marginal cost without losing all its business.

Market power exists when a firm faces a demand curve with an elasticity < -∞.


Causes of Market Power A firm gains market power if

Consumers are willing to pay "virtually anything" for its product.

There exist no close substitutes for the firm's product.

Other firms can't enter the market.


The Welfare Effects of Monopoly Define welfare as consumer surplus +

producer surplus.

Then welfare is lower under monopoly than under competition.

A monopoly sets P > MC, causing deadweight loss (DWL).


= 18

Figure 11.5 Deadweight Loss of Monopolyp, $ per unit

Demand

Q , Units per day

MR

MC

pc = 16B = $12

D =$60

C =$2

E = $4MR = MC = 12

A = $18pm

24

Qm = 6 Q c = 8 24120

em

ec


How Do Monopolies Arise?A firm has a cost advantage over other

firms (e.g. due to better technology). Government regulation prevents entry.Several firms merge into a single firm. Firms act collectively = a cartel.Firms use strategies - such as threats of

violence - that discourage other firms from entering market.


Natural MonopolyA market has a natural monopoly if one

firm can produce total market output at lower cost than could several firms.

If cost for Firm i to produce qi is C(qi), the condition for a natural monopoly is

C(Q) < C(q1) + C(q2) + ... + C(qn),

where Q = q1 + q2 + .. + qn is sum of output of any n > 2 firms


Natural Monopoly, 2

Equivalently, natural monopoly arises if the long-run AC curve is declining.

This corresponds to a technology characterized by economies of scale.


Figure 11.7 Natural Monopoly

15

20

40

10

60 12 15

AC = 10 + 60/Q

MC = 10

Q, Units per day

AC, MC,$ per unit


Government Actions that Reduce Market Power

Antitrust laws prohibit monopolization, price fixing, and so forth.

Regulations prevent monopolies from exercising all of their market power.


Optimal Price Regulation

Price regulation can eliminate DWL.

Regulation is optimal if it leads to the "competitive" outcome.


Figure 11.8 Optimal Price Regulationp , $ per unit

Regulated demand

Market demand

Q , Units per day2412860

MRMR r

MC

18

24

16

DE

CB

A em

eo


Government Created Monopoly

Governments create monopoly through

Barriers to entry (e.g., patents, licenses)

Government provision (e.g. utilities, public safety, education, lotteries)


Government MonopolyP

Q

AC

MR

D=MB

Peff

Peven

Government monopoly can raise revenue by setting price anywhere between the break-even price (Peven) and the private monopoly price (Pmon). It loses money at the efficient price (Peff).

MC

Pmon


Government Monopoly Pricing

If a government monopoly uses the private monopoly price it:

Maximizes its revenue.

Causes the same distortion as the private monopoly!

Transforms monopoly profits into government revenue.


Government Monopoly Pricing, 2

If the government sets the efficient price, it

Maximizes consumer surplus in this market,

But it loses money,

And must raise revenue elsewhere, undoubtedly causing DWL (i.e. lost consumer surplus) in other markets.

Documents

PPA 723: Managerial Economics Lecture 15: Monopoly The Maxwell School, Syracuse University Professor John Yinger