Unit IV: Imperfect Competition Characteristics of Monopolies

Unit IV: Unit IV: Imperfect CompetitionImperfect Competition

Characteristics Characteristics of Monopoliesof Monopolies

5 Characteristics of a Monopoly5 Characteristics of a Monopoly

3. “Price Maker”

2. Unique good with no close substitutes

• The firm can change the price by changing the quantity it produces (ie. shifting the supply curve to the left).

• The Firm IS the Industry

1. Single Seller• One Firm controls the vast majority of a market

5. Some “Nonprice” Competition

4. High Barriers to Entry

• No immediate competitors

• Despite having no close competitors, monopolies still advertise their products in an effort to increase demand.

5 Characteristics of a Monopoly5 Characteristics of a Monopoly

• New firms CANNOT enter market

Examples of Examples of MonopoliesMonopolies

Four Origins of MonopoliesFour Origins of Monopolies1. Geographical MonopoliesEx: Nowhere gas stations, De Beers Diamonds, San Diego

Chargers, Cable TV, Qualcomm Hot Dogs…-Location or control of resources limits competition and leads to one supplier.

2. Government MonopoliesEx: Water Company, Firefighters, The Army,

Pharmaceutical drugs, rubix cubes… -Government allows monopoly for public benefits or

to stimulate ingenuity. -The government issues patents to protect inventors

and forbids others from using their invention. (They last 20 years)

Four Origins of MonopoliesFour Origins of Monopolies3. Technological MonopoliesEx: Microsoft, Intel, Frisbee, Band-Aide…-Patents and widespread availability of certain products

lead to only one major firm controlling a market.

4. Natural MonopoliesEx: Electric Companies (SDGE)• If there were three competing electric companies

they would have higher costs.• Having only one electric company keeps prices low-Economies of scale make it impractical to have

smaller firms. -Low average total costs act as a barrier to entry for

other firms.

Ave

rag

e T

ota

l C

ost

Quantity

$20

15

10

0 50 100 200

LRATC

Electric companies have economies of scale. The more they produce the lower the average cost.

•If there are 4 firms, the ATC is $20•If there are 2 firms the ATC is $15•If there is 1 firm the ATC is $10

Assume that 200 units need to be

produced

Drawing Drawing MonopoliesMonopolies

Good news…1. Only one graph because the firm

IS the industry.2. The cost curves are the same3. The MR= MC rule still applies4. Shut down rule still applies

• Unlike perfect competition, all imperfectly competitive firms have downward sloping demand curve.

• To sell more a firm must lower its price.

D

Combine the Demand of an industry with the costs of a firm.

Quantity

Co

sts

(do

llar

s)

ATC

MC

What about MR?

To sell more a firm must lower its price. What happens to Marginal Revenue?

Price Quantity

Demanded

Total Revenue

Marginal Revenue

$6 0

$5 1

$4 2

$3 3

$2 4

$1 5

Does the Marginal Revenue equal the price?


Price Quantity

Demanded

Total Revenue

Marginal Revenue

$6 0 0

$5 1 5

$4 2 8

$3 3 9

$2 4 8

$1 5 5

Does the Marginal Revenue equal the price?


Price Quantity

Demanded

Total Revenue

Marginal Revenue

$6 0 0 -

$5 1 5 5

$4 2 8 3

$3 3 9 1

$2 4 8 -1

$1 5 5 -3

Plot Demand and Marginal Revenue Curves

MR DOESN’T EQUAL PRICE

Plot Demand and Marginal Revenue CurvesQuantity Price TR MR

0 $16 0 -

1 15 15 15

2 14 28 13

3 13 39 11

4 12 48 9

5 11 55 7

6 10 60 5

7 9 63 3

8 8 64 1

9 7 63 -1

10 6 60 -3

Plot Demand and Marginal Revenue CurvesQuantity Price TR MR

0 $16 0 -

1 15 15 15

2 14 28 13

3 13 39 11

4 12 48 9

5 11 55 7

6 10 60 5

7 9 63 3

8 8 64 1

9 7 63 -1

10 6 60 -3

Why is MR below Demand?

1 2 3 4 5 6

P

Q

$100 90

60

40D

As price decreases from$100 to $90...

revenue will increase with the

additional unit sold.

TR=$300

TR = $360

1 2 3 4 5 6

P

Q

$100 90

60

40D

TR=$300

TR = $360

Loss = $30

But a lower price results in a loss of the $30 that was earned when

price was $10 higher

Gain = $90


1 2 3 4 5 6

P

Q

$100 90

60

40D

TR=$300

TR = $360

Loss = $30

Marginal Revenue is ADDITIONAL REVENUE MR= (Price –Loss from lowering price)

MR= $90 - $30 = $60

Gain = $90


1 2 3 4 5 6

P

Q

$100 90

80

60

40D

Loss= $40

Gain = $80

MR= $80 – 40 = $40

As price decreases from$90 to $80 TR increases


1 2 3 4 5 6

P

Q

$100 90

80

60

40D

MR



1 2 3 4 5 6

P

Q

$100 90

80

60

40D

MR

MR CURVE IS LESS THAN

DEMAND CURVE!!!

Elastic vs. Inelastic Elastic vs. Inelastic Range of Demand Range of Demand

CurveCurve

Do

llar

sD

oll

ars

$200

150

100

50

$750

500

250

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Q0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Q

Elastic and Inelastic Range


Do

llar

sD

oll

ars

$200

150

100

50

$750

500

250

MR

Elastic

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

DQ

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

TR

Q

Total Revenue TestIf price falls and

TR increases then demand is

elastic.

Q

Do

llar

sD

oll

ars

$200

150

100

50

$750

500

250

TR

MR D

InelasticElastic

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18Q

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18



TR falls then demand is inelastic.

When MR goes negative, TR will fall


TR increases then demand is

elastic.

Putting Putting Demand, MR, Demand, MR,

and Cost and Cost TogetherTogether

What output should this monopoly produce?

D

MC

ATC

MR

Profit =$5

MR = MC

Q

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

e

$9

8

7

6

5

4

3

2

How much is the TR, TC and Profit or Loss?

D

MRQ

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

e

$9

8

7

6

5

4

3

2

Conclusion: A monopolists produces where MR=MC, buts charges the price consumer are willing to pay identified by the demand curve.

MC

ATC

What if cost are higher?

D

MCATC

MR

140 Loss

Q

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

e

AVC

Q

Minimum AVC is shut down point

How much is the TR, TC, and Profit or Loss?

D

MC

MR

$110

$130

TR=TC=

Profit/Loss=Profit/Loss per Unit=

Identify and Calculate:

Q

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

e

$780

$180$600

ATC

$30

Are Are Monopolies Monopolies Efficient?Efficient?

Monopolies are inefficient because they…1. Charge a higher price2. Under produce• Not allocativly efficiency

3. Produce at higher costs • No productive efficiency

4. Have little incentive to innovate

Why?Because there is little external

pressure to be efficient

Q

INEFFICIENCY OF PURE MONOPOLY

P

D

S = MC

Pc

Qc

An industry in pure competition

CS

PS

Q

INEFFICIENCY OF PURE MONOPOLYP

DMR

S = MC

Pc

Pm

QcQm

At MR=MCA monopolist will sell less units at a

higher price than in competition

Q

CS and PS of a MonopolyP

DMR

S = MC

Pc

Pm

QcQm

Result is DEADWEIGHT LOSS

to society

CS

PS

Q

CS and PS of a MonopolyP

DMR

S = MC

Pc

Pm

QcQm

Result is DEADWEIGHT LOSS

to society

CS

PS

Monopoly pricing causes consumers to overpay so CS becomes PS

D

MC

MR

Q

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

eAre Monopolies Productively Efficient?

Does Price = Min ATC?

ATC

No. They are not producing at the lowest

cost (min ATC)

D

MC

MR

Q

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

eDo Monopolies Have Allocative Efficiency?

Does Price = MC?

ATC

No. Price is greater. The monopoly is under

producing.

Regulating Regulating MonopoliesMonopolies

How do they regulate?•Use Price controls: Price Ceilings•Why don’t taxes work?•Taxes limit supply-that’s the problem

Why Regulate?Why would the government regulate

an monopoly? 1. To keep prices low 2. To make monopolies efficient

1.Socially Optimal PriceP = MC (Allocative Efficiency)

Where should the government place the price ceiling?

2. Fair-Return Price (Break–Even)

P = ATC (Normal Profit)

OR

Q

D

MR

MCATC

P

Pri

ce a

nd

Co

sts

Monopoly PriceMR = MC

Qm

Pm

REGULATED NATURAL MONOPOLY

Q

D

MR

MCATC

P

Pri

ce a

nd

Co

sts

Fair-Return PriceNormal Profit Only

Qf

Pf

TR = TC


Q

D

MR

MCATC

P

Pri

ce a

nd

Co

sts

Socially-OptimumPrice

P = MC

Qr

Pr


Q

D

MR

MCATC

P

Pri

ce a

nd

Co

sts

MR = MC

Fair-Return Price

Socially-OptimumPrice

Qm Qf Qr

Dilemma of RegulationWhich Price?

Pm

Pf

Pr


Price Price DiscriminationDiscrimination

Requires the following conditions:•Firm must have monopoly power•Firm must be able to segregate the market •Consumers must not be able to resell product

PRICE DISCRIMINATION

Definition:Practice of selling the same products to different buyers at different prices


Examples:

•Price discrimination seeks to charge each consumer what they are willing to pay in an effort to increase profits.

•Airline Tickets (vacation vs. business)•Movie Theaters (child vs. adult) •All Coupons (spenders vs. savers) •SPHS soda machine (students vs. teachers)

•Those with inelastic demand are charged more than those with elastic

Q

DMR

MC

ATC

P

Q1

Pri

ce a

nd

Co

sts

Economic profits witha single MR=MC

price


Q

D

MC

ATC

P

Q1

Pri

ce a

nd

Co

sts

Q2

A perfectly discriminating can charge each person differently so the Marginal Revenue = Demand

MR=D

Q

D

MC

ATC

P

Pri

ce a

nd

Co

sts

What output do they make? Where is Consumer Surplus?

Q2

MR=D

Q

D

MC

ATC

P

Q1

Pri

ce a

nd

Co

sts

Profit withprice discrimination

Where is the Profit?

Q2

MR=D

What’s the Point?•Perfectly price discriminating firms:•Make more profit•Produce more•Produce at allocative efficiency

Q

D

MC

ATC

P

Q1

Pri

ce a

nd

Co

sts

Price = MC

Allocative Efficiency

Q2

MR=D

Can You Do The Following?

1.Draw a monopoly making a profit at long-run equilibrium and identify price, quantity, and profit.

3. Draw a price discriminating monopoly at equilibrium and label price, quantity, MR, and profit

2. Draw a perfectly competitive industry AND firm at long-run equilibrium

Monopolistic CompetitionMonopolistic Competition

Market Structure Continuum

PureCompetition

PureMonopoly

MonopolisticCompetition Oligopoly

FOUR MARKET MODELSMonopolistic Competition:

•Relatively Large Number of Sellers•Differentiated Products•Some control over price•Easy Entry and Exit•Extensive non-price competition

Examples:1. Fast Food Restaurants2. Furniture companies3. Jewelry stores4. Hair Salons5. Clothing Manufacturers

Monopolistic Qualities• Control over price of own good due

to differentiated product.• D > MR • Plenty of non-price competition• Not efficient

“Monopolistic” +”Competition”

Perfect Competition Qualities• Large number of smaller firms• Relatively easy entry and exit• Zero Economic Profit in Long-Run

since firms can enter.

Differentiated Products•Goods are NOT identical.•Firms seek to capture a piece of the

market by making unique goods.•Since these products have substitutes,

firms use NON-PRICE Competition • Brand Names and Packaging• Product Attributes • Service• Location• Advertising (Two Goals)

1. Increase Demand 2. Make demand more INELASTIC

Drawing Drawing Monopolistic Monopolistic CompetitionCompetition

D

MR

$4

ATCP

rice

an

d C

ost

s

Q1

Short-RunEconomic

Profits

What Happens?

PRICE AND OUTPUT INMONOPOLISTIC COMPETITION

$2

MC

Quantity

$4

$2

D

MR

ATCP

rice

an

d C

ost

s

Q1

New Firms Enter

Quantity

MC

Short-RunEconomic

Profits

In the long-run, new firms will enter, driving down the DEMAND for firms

already in the market.


D

MR

$4

ATCP

rice

an

d C

ost

s

Q1

Short-RunEconomic

Profits

What will happen?

$2

MC


Quantity

D

MR

$4

ATCP

rice

an

d C

ost

s

Q1

Normal Profit

$2

MC

$1

LONG- RUN EQUILIBRIUM

Quantity

Why does DEMAND shift?• When short-run profits are made… –New firms enter–New firms mean more close substitutes and

less market shares for each existing firm.–Demand for each firm falls

• When short-run losses are made…– Firms exit –Result is less substitutes and more market

shares for remaining firms.–Demand for each firm rises

D

MR

$7

Pri

ce a

nd

Co

sts

Q1

Short-RunEconomic

Loss

What happens? MC

$1


With economic losses, firms willexit the market – stability occurswhen economic profits are zero.

ATC

Quantity

D

MR

ATC

Pri

ce a

nd

Co

sts

Q1

Short-RunEconomic

Loss

What happens? MC

$1


$7

Quantity

D

MR

MC

ATCP

rice

an

d C

ost

s

Q3

Quantity

Long-Run EquilibriumNormalProfitOnly


$7

MONOPOLISTIC MONOPOLISTIC COMPETITIONCOMPETITION

AND EFFICIENCYAND EFFICIENCY

MONOPOLISTIC COMPETITIONAND EFFICIENCY

• Not Productively Efficient Minimum ATC

• Not Allocatively EfficientPrice MC

• Firm has Excess Capacity

Graphically…

D

MR

MC

P3 = A3

ATCP

rice

an

d C

ost

s

Q3

Quantity

Long-Run EquilibriumPrice is Not= Minimum

ATC

Price MC


Excess Capacity• The gap between the minimum

ATC output and the profit maximizing output• Given current resources, the firm

can produce at minimum ATC, but they decide not to.


D

MR

MC

P3 = A3

ATCP

rice

an

d C

ost

s

Q3

Quantity

Long-Run Equilibrium

Excess Capacity


• Large number of firms and product variation meets societies needs• Nonprice Competition (product

differentiation and advertising) may result in sustained profits for some firms.

Ex: Nike might continue to make above normal profit because they are a well known brand.

Advantages ofMONOPOLISTIC COMPETITION

Oligopoly

Market Structure Continuum

PureCompetition

PureMonopoly

MonopolisticCompetition Oligopoly

FOUR MARKET MODELSOligopoly:•A Few Large Producers• Identical or Differentiated Products•Control Over Price, But Mutual

Interdependence•Firms use Strategic Pricing

•High Entry Barriers•Examples: OPEC, Cereal Companies,

Car Producers

Oligopolies occur when only a few large firms start to control an industry.

High barriers to entry keep others from entering.

Types of Barriers to Entry•Economies of Scale•High Start-up Costs•Ownership of Raw Materials

HOW DO OLIGOPOLIES OCCUR?

Game Theory

What is game theory?

The study of how people behave in strategic situations

A thorough understanding of game theory helps firms in an oligopoly

maximize profit.

Why learn about game theory?

•Oligopolies are interdependent since they compete with only a few other firms.• Their pricing and output decisions must be strategic as to avoid economic losses. •Game theory helps us analyze their strategies.

SIMULATION!!!!!

The Prisoner’s DilemmaCharged with a crime, each

prisoner has one of two choices: Deny or Confess

Prisoner 2

Prisoner 1

Both Deny = 3 Years in jail each

Both Confess= 5 Years in jail each

Deny Confess

Deny

ConfessConfess = 1 Year

Deny = 7 Years

Confess =1 Year

Deny =7 Years

Strategic PricingEach firm has one of two choices:

Price High or Price Low.

Firm 2

Firm 1

Both High = 2 Each

Both Low= 1 each

High Low

High

LowLow = 3High = 0

Low = 3High = 0

OLIGOPOLY BEHAVIORA Game-Theory Overview

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg

yRareAir’s Price Strategy

BA

DC

$12 $15

$12 $6

$6 $8

$8$15

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg


BA

DC

$12 $15

$12 $6

$6 $8

$8$15

Greatest Combined Profit if both Sell High

OLIGOPOLY BEHAVIOR

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg


BA

DC

$12 $15

$12 $6

$6 $8

$8$15

Each firm recognizes that more profit is made if they lower price

OLIGOPOLY BEHAVIOR

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg


BA

DC

$12 $15

$12 $6

$6 $8

$8$15

BUT if both lower price they end up in the Worst Case

OLIGOPOLY BEHAVIOR

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg


BA

DC

$12 $15

$12 $6

$6 $8

$8$15

To make more profit, firms may try to cooperate (collude)

OLIGOPOLY BEHAVIOR

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg


BA

DC

$12 $15

$12 $6

$6 $8

$8$15

OLIGOPOLY BEHAVIORTo make more profit, firms may try to cooperate (collude)

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg


BA

DC

$12 $15

$12 $6

$6 $8

$8$15

But now each firm has the incentive to cheat.

OLIGOPOLY BEHAVIOR

What did we learn?1. Oligopoly pricing must be

strategic2. Oligopolies have a tendency to

collude to gain profit.(Collusion is the act of cooperating

with rivals in order to “rig” a situation.)

3. Collusion results in the incentive to cheat.

Oligopoly Graphically

Not one standard model due to...Complications of Interdependence

1 – Price Leadership (no graph)2 – Cartels and Collusion (known graph)3 – Kinked Demand Curve (new graph)

THREE OLIGOPOLY MODELS

Instead there are 3 Alternative Models:

Price Leadership

PRICE LEADERSHIP MODEL

•Collusion is ILLEGAL.•Firms CANNOT set prices.•Price leadership is a strategy used by firms to coordinate prices without outright collusion

General Process: 1. “Dominant firm” initiates a price change2. Other firms follow the leaderExample: 3 competing gas stations.

PRICE LEADERSHIP MODEL

Breakdowns in Price Leadership •Temporary Price Wars may occur if other firms don’t follow price increases of dominant firm.•Each firm tries to undercut each other.

Example: Employee Pricing for Ford

Cartels and Collusion

A cartel is a group of producers that create a formal agreement to fix prices high. Examples: 1. Overt Collusion- OPEC ( Organization of Petroleum Exporting Countries) 11 countries set limits on the supply of oil2. Covert Collusion- In 1998, Toys R’ Us and Toy manufacturers were sued by the government for having secret price fixing meetings.

Cartel = Colluding Oligopoly

CARTELS AND COLLUSION

1. Cartels set price and output at an agreed upon price

2. Firms require identical or highly similar demand and costs

3. Cartel must have a way to punish cheaters

4. Together they act as a monopoly

Characteristics of Cartels

Graphically…

Colluding Oligopolists WillSplit the Monopoly Profits.

D

MC

ATC

MR

EconomicProfit

MR = MC

Pri

ce a

nd

co

sts

Q0

P0

A0

CARTELS AND OTHER COLLUSION

Kinked Demand Curve

1. Match price-If one firm cuts it’s prices, then the other firms follow suit causing inelastic demand

Kinked Demand Curve Model

Noncollusive firms are likely to react to competitor’s pricing in two ways:

2. Ignore change-If one firm raises prices, others maintain same price causing elastic demand

The kinked demand curve model is a graphic portrayal of the interdependency of noncollusive firms.

D1

MR1Quantity

KINKED DEMAND THEORY:

Pri

ce

The demand and MR curves if other firms match lower pricing

If this firm lowers its price and

others follow, Qd will increase

mildly

MR2

D2

Quantity

KINKED DEMAND THEORY:

Pri

ce

The demand and MR curves if other firms ignore higher pricing

If this firm increases its price and others ignore it, Qd for this firm will decrease significantly

MR2D1

D2

MR1Quantity

Two sets of curves based on the pricing decisions of other firms

Pri

ce

The firm’s demand andmarginal revenue curves

MR2D1

D2

MR1Quantity

Pri

ce

Rivals tend tofollow a price cut


MR2D1

D2

MR1Quantity

Pri

ce

Rivals tend tofollow a price cut

or ignore aprice increase


MR2D1

D2

MR1Quantity

Effectively creatinga kinked demand curve

Pri

ce


D

Quantity

Effectively creatinga kinked demand curve

Pri

ce


MR2D1

D2

MR1Quantity

What about MR?

Pri

ce


D

MR1Quantity

Since we use sections of both MR curves, the MR has a

vertical gap. P

rice MR2


D

Quantity

Profit maximizationMR = MC occurs

at the kink.

KINKED DEMAND THEORY:NONCOLLUSIVE OLIGOPOLY

Pri

ce MR2

MR1

D

Quantity

Notice that changes in costs don’t easily change profit maximizing

output.


Pri

ce

MC2

MC1

MR2

MR1

D

Quantity

The result is stable (or sticky) prices for noncolluding firms.


Pri

ce

MC2

MC1

MR2

MR1

Documents

Unit IV: Imperfect Competition Characteristics of Monopolies