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Session 3
MonopolyMonopoly
Managerial Economics
Professor Changqi Wu
Monopoly Slide 2
Topics for Today
What is a monopoly?
How does a monopolist behave?
How to sustain a monopoly position?
Monopsony
Consequences of monopoly
Monopoly Slide 3
1. What is A Monopoly?
One firm supplies a good or a service that has no close substitute in a well-defined market
A monopolist enjoys market power market power measures a firm’s ability to
set price
Monopoly Slide 4
Monopoly
Facing a downward-sloping demand curve, a monopolist’s marginal revenue curve lies below her average revenue curve.
How to find marginal revenue As the sole producer, the monopolist works with
the market demand to determine output and price.
Assume a firm with demand: P = 6 - Q
Monopoly Slide 5
Total, Marginal, and Average Revenue
$6 0 $0 --- ---
5 1 5 $5 $5
4 2 8 3 4
3 3 9 1 3
2 4 8 -1 2
1 5 5 -3 1
Total Marginal AveragePrice Quantity Revenue Revenue Revenue
P Q R MR AR
Monopoly Slide 6
Average and Marginal Revenue
Output0
1
2
3
$ perunit ofoutput
1 2 3 4 5 6 7
4
5
6
7
Average Revenue (Demand)
MarginalRevenue
Monopoly Slide 7
2. Behavior of a Monopolist
A monopolist sets the marginal revenue equal to the marginal cost to maximize her profit.
A monopolist has no supply curve.
Price elasticity of demand influences price setting power of a monopolist.
Monopoly Slide 8
Lostprofit
P1
Q1
Lostprofit
MC
AC
Quantity
$ perunit ofoutput
D = AR
MR
P*
Q*
Maximizing Profit When Marginal Revenue Equals Marginal Cost
P2
Q2
Elasticity of Demand and Price Markup
$/Q $/Q
Quantity Quantity
AR
MR
MR
AR
MC MC
Q* Q*
P*
P*
P*-MC
The more elastic isdemand, the less the
markup.
Monopoly Slide 10
Elasticity of Demand and Price Markup
The ratio of incremental profit margin and price is equivalent to the absolute value of the reverse of price elasticity of demand
The markup pricing is based on this principle.
Monopoly Slide 11
Monopoly Power and Profit
Monopoly power does not guarantee profits.
The profit depends on average cost relative to price.
Monopoly Slide 12
3. How does Monopoly Arise?
Monopoly comes into existence because of barriers to entry
Barriers to entryfactors that allow the incumbent firm to
earn positive economic profits and make it costly for new comers to enter the same market
Monopoly Slide 13
Type of Barriers to Entry
Institutional barriers to entry
Technical barriers to entry
Strategic barriers to entry
Monopoly Slide 14
Institutional Barriers to Entry
Exclusive franchising
Licenses
Patent protection
Monopoly Slide 15
Technical Barriers to Entry
Unique resources
Economies of scale and scope
Economy of experiences
Monopoly Slide 16
Strategic Barriers to Entry
Limit pricing
Excess capacity
Product differentiation (brand proliferation)
Monopoly Slide 17
Barriers to Exit
Barriers to exit are the opportunities that a firm must give up by leaving the industry.
Barriers to exit can have a similar effect as barriers to entry.
Monopoly Slide 18
Restraining Competition
Horizontal merger
Joint ventures
Strategic alliance
Trade associations
Monopoly Slide 19
Cartel: A Virtual Monopoly
A cartel is an association of firms that coordinates explicitly the activities of its members
An effective cartel must find ways to restrain competition
Factors facilitating cartel formation market concentration
Concentration ratio: sum of market shares of the largest 4 firms in the same market
Herfindale index: sum of market shares squared of all firms low organizational cost homogenous good
Monopoly Slide 20
4. Monopsony
A monopsonist is the twin sister of a monopolista single buyer faces a lot of competitive sellers
A monopsonist’s marginal expenditure curve lies above the supply curve
A monopsonist sets its marginal expenditure (ME) equal to its marginal value (MV) to maximize her profit
Monopoly Slide 21
ME
S = AE
The market supply curve is the monopsonist’saverage expenditure curve
Monopsonist Buyer
Quantity
$/Q
MV
Q*m
P*m
Monopsony•ME > P & above S
PC
QC
Competitive•P = PC
•Q = Q+C
Monopoly Slide 22
Business in Action
The role of major banksBanks set deposit rates and lending rates
Does the bank act as a monopolist or a monopsonist ?
Monopoly Slide 23
5. Social Cost of Monopoly
Deadweight loss occurs, but it appears to be small
It is costly to create and to sustain monopolistic positionRent seeking
Price mechanism becomes less effective when market conditions change.
Monopoly Slide 24
BA
Lost Consumer Surplus
Deadweight Loss
Because of the higherprice, consumers lose
A+B and producer gains A-C.
C
Deadweight Loss from Monopoly Power
Quantity
AR
MR
MC
QC
PC
Pm
Qm
$/Q
Monopoly Slide 25
Effect of Cost Change on Monopolist
Quantity
$/Q
MCD = AR
MR
Q0
P0 MC’
c
Q1
P1
P
Increase in P: P0P1 > increase in cost
Monopoly Slide 26
Why Is Monopoly Not Necessarily Bad?
Monopoly profit is a carrot
Monopoly profit may stimulate innovationDoes the government’s effort of cracking down
software piracy protect the monopoly interest of Microsoft?
Monopolies are only temporaryThe case of Polaroid
When the economy of scale is significant, a natural monopoly is technically efficient
Monopoly Slide 27
Natural Monopoly
A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms.
Monopoly Slide 28
MC
AC
ARMR
$/Q
Quantity
Setting the price at Pr yields the largest possible
output;excess profit is zero.
Qr
Pr
PC
QC
If the price were regulate to be PC,the firm would lose money
and go out of business.
Pm
Qm
Unregulated, the monopolistwould produce Qm and
charge Pm.
Regulating the Priceof a Natural Monopoly
Monopoly Slide 29
Limiting Market Power
Rules and regulations designed to promote a competitive economy by:Prohibiting actions that restrain or are likely
to restrain competition
Restricting the forms of market structures that are allowable
Makes it illegal to monopolize or attempt to monopolize a market. Merger guidelines.
Monopoly Slide 30
Key Learning Points
Monopoly arises because of the existence of barriers to entry
A monopolist sets her marginal revenue equal to her marginal cost to maximize profit.
Firms can gain market power by restraining competition.
Monopoly reduces social welfare
Attempt to gain monopoly profit may encourage innovation.