Topic3 Monopoly 12 13

8/11/2019 Topic3 Monopoly 12 13

1/36

Topic

3.

Monopoly

Bibliography: Pindyck and Rubinfeld.

Chapter 10 (pages 357-398)

Microeconomics. Antoni Cunyat


2/36


3/36

Topic3.

Monopoly

3 of 36Microeconomics. Antoni Cunyat

Assumptions of Monopoly

The model of monopoly rests on three basic assumptions:(1) One seller, many buyers

(2) Product homogeneity, and

(3) Barriers to entry.

Barriers to entry

Condition that impedes entry by newcompetitors.


4/36

Topic3.

Monopoly


THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1


5/36

Topic3.

Monopoly



Demand curve faced by a monopolist

As the sole producer of a product, monopolists

demand is equal to market demand (downwardsloping). d=D, q=Q

dP/dq


6/36

Topic3.

Monopoly



Total Revenue, Average Revenue and Marginal Revenue

Total Revenue: R(Q)=P(Q)Q

Average Revenue:

Marginal Revenue:

RQ RQ

Q

PQ

Q PQ

MRQ dRQ

dQ

dPQQ

dQ P Q dP

dQ

AR is the market demand function MR < P (as opposed to a competitive market)


7/36

Topic3.

Monopoly



Why the price is greater than Marginal Revenue?

TABLE 10.1 Total, Marginal, and Average Revenue

Total Marginal Average

Price (P) Quantity (Q) Revenue (R) Revenue (MR) Revenue (AR)

$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

Consider a firm facing the following demand curve:

P = 6 Q


8/36

Topic3.

Monopo

ly



Average Revenue and Marginal Revenue

Average and marginalrevenue are shown forthe demand curveP = 6 Q.

Average and MarginalRevenue

Figure 10.1


9/36

Topic3.

Monopo

ly


THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER

3.1

Relationship between Marginal Revenue and theElasticity of Demand

MRQ PQ QPQ

dP

dQ PQ PQ 1 1

Ed

Where is the absolute value of the elasticity of demand.|Ed|

If|Ed| 1 MR 0

If|Ed| 1 MR 0

If|Ed| 1 MR 0


10/36

Topic3.

Monopo

ly


THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER

3.1

Relationship between Marginal Revenue and theElasticity of Demand

If|Ed| MR P (Perfectly Competitive Market)

If|Ed| MR P (Market Power)


11/36

Topic3.

Monopo

ly



The Monopolists output decision

Marginal revenue equals marginal cost at a point at which the

marginal cost curve is rising.

MR=MC

At this output level, the price is determined by the intersect atthe market demand.


12/36

Topic3.

Monopo

ly



The Monopolists Output Decision

Q* is the output level at whichMR = MC.

If the firm produces a smalleroutputsay, Q1it sacrificessome profit because the extra

revenue that could be earnedfrom producing and selling theunits between Q1 and Q*exceeds the cost of producingthem.

Similarly, expanding output from

Q* to Q2 would reduce profitbecause the additional costwould exceed the additionalrevenue.

Profit Is Maximized When MarginalRevenue Equals Marginal Cost

Figure 10.2


13/36

Topic3.

Monopo

ly



An Example

Part (a) shows total revenue R, total cost C,

and profit, the difference between the two.

Part (b) shows average and marginalrevenue and average and marginal cost.

Marginal revenue is the slope of the totalrevenue curve, and marginal cost is the

slope of the total cost curve.The profit-maximizing output is Q* = 10, thepoint where marginal revenue equalsmarginal cost.

At this output level, the slope of the profitcurve is zero, and the slopes of the total

revenue and total cost curves are equal.

The profit per unit is $15, the differencebetween average revenue and averagecost. Because 10 units are produced, totalprofit is $150.

Example of Profit Maximization

Figure 10.3


14/36

T

opic3.

Monopo

ly



Monopolists profits

MC

AC

Q

D = ARMRP*

Q

*

MC

AC

Q

D = ARMR

P*

Q*

P P

SHUT-DOWN CONDITION

Short-run: P AVC

Long-run: P ATC

P*

Monopolist with positive profitsMonopolist with zero profits

Monopolist can have long-runeconomic profits (monopoly rents).


15/36

T

opic3.

Monopo

ly



A Rule of Thumb for Pricing

We want to translate the condition that marginal revenue shouldequal marginal cost into a rule of thumb that can be more easily

applied in practice.To do this, we first remember the former expression for marginalrevenue:

MR PQ 1 1Ed


16/36

T

opic3.

Monopo

ly



A Rule of Thumb for Pricing

(Q/P)(P/Q) is the reciprocal of the elasticity of demand,1/Ed, measured at the profit-maximizing output, and

Now, because the firms objective is to maximize profit, wecan set marginal revenue equal to marginal cost:

which can be rearranged to give us

(10.1)

Equivalently, we can rearrange this equation to expressprice directly as a markup over marginal cost:

(10.2)

MR PQ1

1

Ed

P P 1Ed

C

PMC

P

1Ed

P MC

1

1

Ed


17/36

T

opic3.

Monopo

ly



Remember the important distinction between a perfectly competitivefirm and a firm with monopoly power: For the competitive firm, price

equals marginal cost; for the firm with monopoly power, price exceedsmarginal cost.

Measuring Monopoly Power

Lerner Index of Monopoly PowerMeasure of monopoly power calculated asexcess of price over marginal cost as a

fraction of price.

Mathematically:

This index of monopoly power can also be expressed in terms of the elasticityof demand facing the firm.

L PMCP

1Ed


18/36

T

opic3.

Monopo

ly



The Rule of Thumb for Pricing

The markup (P MC)/P is equal to minus the inverse of the elasticity of demand facing the firm.

If the firms demand is elastic, as in (a), the markup is small and the firm has little monopoly power.

The opposite is true if demand is relatively inelastic, as in (b).

Elasticity of Demand and Price Markup

Figure 10.8


19/36

T

opic3.

Monopo

ly



Although the elasticity of market demand for foodis small (about 1), no single supermarket can

raise its prices very much without losingcustomers to other stores.

The elasticity of demand for any one supermarketis often as large as 10.We find P = MC/(1 0.1) = MC/(0.9) = (1.11)MC.

The manager of a typical supermarket should set prices about 11 percentabove marginal cost.

Small convenience stores typically charge higher prices because its customersare generally less price sensitive.

Because the elasticity of demand for a convenience store is about 5, themarkup equation implies that its prices should be about 25 percent abovemarginal cost.

With designer jeans, demand elasticities in the range of 2 to 3 are typical.

This means that price should be 50 to 100 percent higher than marginal cost.


20/36

T

opic3.

Monopo

ly



TABLE 10.2 Retail Prices of VHS and DVDs

2007

Title Retail Price DVD

Purple Rain $29.88

Raiders of the Lost Ark $24.95

Jane Fonda Workout $59.95

The Empire Strikes Back $79.98An Officer and a Gentleman $24.95

Star Trek: The Motion Picture $24.95

Star Wars $39.98

1985

Title Retail Price VHS

Pirates of the Caribbean $19.99

The Da Vinci Code $19.99

Mission: Impossible III $17.99

King Kong $19.98Harry Potter and the Goblet of Fire $17.49

Ice Age $19.99

The Devil Wears Prada $17.99

Source (2007): Based on http://www.amazon.com. Suggested retail price.


21/36

T

opic3.

Monopo

ly



Between 1990 and 1998, lowerprices induced consumers to buymany more videos.

By 2001, sales of DVDs overtook

sales of VHS videocassettes.High-definition DVDs wereintroduced in 2006, and areexpected to displace sales ofconventional DVDs.

Video Sales

Figure 10.9


22/36

T

opic3.

Monopo

ly



Three factors determine a firms elasticity of demand.

1. The elasticity of market demand. Because the firms owndemand will be at least as elastic as market demand, theelasticity of market demand limits the potential for monopolypower.

2. The number of firms in the market. If there are many firms, itis unlikely that any one firm will be able to affect pricesignificantly.

3. The interaction among firms. Even if only two or three firms

are in the market, each firm will be unable to profitably raiseprice very much if the rivalry among them is aggressive, witheach firm trying to capture as much of the market as it can.

Sources of monopoly power


23/36

T

opic3.

Monopo

ly



If there is only one firma pure monopolistits demand curve is themarket demand curve.

Because the demand for oil is fairly inelastic (at least in the short run),OPEC could raise oil prices far above marginal production cost duringthe 1970s and early 1980s.

Because the demands for such commodities as coffee, cocoa, tin, andcopper are much more elastic, attempts by producers to cartelizethese markets and raise prices have largely failed.

In each case, the elasticity of market demand limits the potentialmonopoly power of individual producers.

The Elasticity of Market Demand


24/36

T

opic3.

Monopo

ly



When only a few firms account for most of the sales in a market, wesay that the market is highly concentrated.

The Number of Firms

barrier to entry Condition thatimpedes entry by new competitors.

Firms might compete aggressively, undercutting one anothers pricesto capture more market share.

This could drive prices down to nearly competitive levels.

Firms might even collude (in violation of the antitrust laws), agreeingto limit output and raise prices.

Because raising prices in concert rather than individually is more likelyto be profitable, collusion can generate substantial monopoly power.

The Interaction Among Firms


25/36


26/36

T

opic3.

Monopo

ly



A monopolistic market has no supply curve.

Monopolists supply curve

There is no-one-to-one relationshipbetween price and the quantityproduced.


27/36

T

opic3.

Monopo

ly



Shifts in Demand

Shifting the demand curve shows

that a monopolistic market has nosupply curvei.e., there is noone-to-one relationship betweenprice and quantity produced.

In (a), the demand curve D1 shiftsto new demand curve D2.

But the new marginal revenuecurve MR2 intersects marginalcost at the same point as the oldmarginal revenue curve MR1.

The profit-maximizing output

therefore remains the same,although price falls from P1 to P2.

In (b), the new marginal revenuecurve MR2 intersects marginalcost at a higher output level Q2.

But because demand is now more

elastic, price remains the same.

Shifts in Demand

Figure 10.4


28/36

T

opic3.

Monopo

ly



The Effect of a Tax

With a tax t per unit, the firmseffective marginal cost isincreased by the amount t toMC + t.

In this example, the increase inprice P is larger than the tax t.

Effect of Excise Tax on Monopolist

Figure 10.5

Suppose a specific tax of t dollars per unit is levied, so that themonopolist must remit t dollars to the government for every unit itsells. If MC was the firms original marginal cost, its optimal production

decision is now given by


29/36

T

opic3.

Monopoly


The social costs of monopoly power3.3


30/36

T

opic3.

Monopoly



The shaded rectangle and trianglesshow changes in consumer and

producer surplus when moving fromcompetitive price and quantity, Pcand Qc,

to a monopolists price and quantity,Pm and Qm.

Because of the higher price,

consumers loseA + B

and producer gainsA C. Thedeadweight loss is B + C.

Deadweight Loss from Monopoly Power

Figure 10.10


31/36

Topic3.

Monopoly



Rent Seeking

rent seeking Spending money insocially unproductive efforts to acquire,maintain, or exercise monopoly.

In 1996, the Archer Daniels Midland Company (ADM) successfullylobbied the Clinton administration for regulations requiring that theethanol (ethyl alcohol) used in motor vehicle fuel be produced from

corn.Why? Because ADM had a near monopoly on corn-based ethanolproduction, so the regulation would increase its gains from monopolypower.


32/36

Topic3.

Monopoly


Price regulation3.4


33/36

Topic3.

Monopoly


Price regulation3.4

Price Regulation

If left alone, a monopolist

produces Qm and charges Pm.When the governmentimposes a price ceiling of P1the firms average andmarginal revenue are constantand equal to P1 for output

levels up to Q1.For larger output levels, theoriginal average and marginalrevenue curves apply.

The new marginal revenue

curve is, therefore, the darkpurple line, which intersectsthe marginal cost curve at Q1.

Price Regulation

Figure 10.11


34/36

Topic3.

Monopoly


Price regulation3.4

Price Regulation

When price is lowered to

Pc, at the point wheremarginal cost intersectsaverage revenue, outputincreases to its maximumQc. This is the output thatwould be produced by a

competitive industry.Lowering price further, toP3 reduces output to Q3and causes a shortage,Q3 Q3.

Price Regulation

Figure 10.11


35/36

Topic3.

Monopoly


Price regulation3.4

Natural Monopoly

A firm is a natural monopoly

because it has economies ofscale (declining average andmarginal costs) over its entireoutput range.

If price were regulated to be Pcthe firm would lose money and

go out of business.

Setting the price at Pryields thelargest possible output consistentwith the firms remaining inbusiness; excess profit is zero.

natural monopoly Firm that can produce theentire output of the market at a cost lower thanwhat it would be if there were several firms.

Regulating the Price of a NaturalMonopoly

Figure 10.12


36/36

Topic3.

Monopoly


Price regulation3.4

Regulation in Practice

rate-of-return regulation Maximum priceallowed by a regulatory agency is based on the

(expected) rate of return that a firm will earn.

The difficulty of agreeing on a set of numbers to be used in rate-of-return calculations often leads to delays in the regulatory response tochanges in cost and other market conditions.

The net result is regulatory lagthe delays of a year or more usuallyentailed in changing regulated prices.

Documents

Topic3 Monopoly 12 13