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                           Monopoly                                                a.         Market structures
                                                                                   b.         Meaning of monopoly
                                                                                   c.         Monopoly equilibrium
                        November 2, 2006                                                i.      Demand curve and marginal revenue
                                                                                        ii.     Profit maximization
                       Reading: Chapter 14                                              iii.    Monopoly versus perfect competition
                                                                                   d.         Monopoly and public policy
Start examining markets in which perfect competition                                    i.      Welfare effect of monopoly
  does not prevail. We examine the case of monopoly –                                   ii.     Preventing monopoly
  single seller - and explore how it results in market                                  iii.    Dealing with natural monopoly
  failure and efficiency loss. Discuss appropriate policies                        e.         Price discrimination
  to address the problem. Also examine the case of
  discriminating monopolist.                                                                                                                                2

    Market Structures                                                           Meaning of Monopoly
One of the assumptions we have made      Four principal models of market
                                                                                What a Monopolist Does
so far in examining markets is perfect      structure:                          A monopolist is a firm that is the only producer of a good that has no close
competition: many small sellers.         1. perfect competition                 substitutes. An industry or market with one seller is known as a monopoly.
Implication: markets are efficient       2. monopoly
(under some conditions). But is          3. oligopoly                           The ability of a monopolist (or other firm) to raise its price above the
perfect competition a valid              4. monopolistic competition            competitive level by reducing output is known as market power.
assumption? For many markets, no.                                               Under perfect competition, price
Models of market structures                                                     and quantity are determined by
can be distinguished on two                                                     supply and demand. Equilibrium is
dimensions:                                                                     at C, with price PC and quantity is
                                                                                QC. A monopolist reduces the
  The number of
producers in the market:                                                        quantity supplied to QM, and moves
one, few, or many (few is                                                       up the demand curve, raising the
not defined by numbers but                                                      price to PM. Firms in perfectly
qualitatively).                                                                 competitive markets cannot do this
                                                                                because they are price takers.
   Whether the goods
offered are identical or                                                        A monopolist has market power and
differentiated                                                                  hence charges higher price and
(considered different by                                                        produces less output than a
consumers but similar in                                                        competitive industry. Monopolist
the sense that they are
substitutable).                                                            3
                                                                                makes in the short and long runs.                                           4

                                                                                Monopoly Equilibrium
    Meaning of Monopoly                                                         Demand curve
    Why Do Monopolies Exist?                                                    Profit maximizing firms produce at the level of output at which profit, or
                                                                                revenue minus cost is at its maximum. This is the same as the output at which
Why does profit persist in the long                                             MC = MR.
run? Why do other firms not enter the                                           In a market with perfect competition, the individual firm is a price taker.
market? Monopolies can exist because                                            Cannot charge a higher price than market price: buyers will buy from other
of barriers to entry due to:                                                    firms. Will not charge a lower price than market price: it can sell any amount
  control of natural resources or                                               at the going price – why sell for less. So the firm’s demand curve is a perfectly
inputs. Ex: De Beers and diamonds                                               elastic, although the market demand curve is negatively sloped. The firm here
                                                                                is small.
  economies of scale, which create
natural monopolies. Ex: utilities like                                          For the monopolist,
gas – large fixed costs and falling                                             the demand curve is
average total cost                                                              the market demand
  technological superiority. Ex:                                                curve: it is therefore
Computer chips. But others can copy,                                            downward sloping.
temporary                             As a firm expands output, ATC falls due   The monopolist knows
                                      to economies of scale. Other firms        that if it produces
  legal restrictions imposed by       who are smaller will not be able to       more it will obtain a
governments, giving exclusive rights, compete and exit. New firms cannot        lower price for its
including patents and copyrights.     enter, because of high fixed costs and    product and will take
                                      high ATC at low output levels.            this into account.
                                                                           5                                                                                6

Monopoly Equilibrium                                                                        Monopoly Equilibrium
Demand curve and marginal revenue                                                           Profit Maximization
                                                                   Increase in              Monopolist’s profit maximizing equilibrium occurs at output at which MC = MR.
                                                                   production by
                                                                   monopolist has           Take simple case in which MC = ATC = constant, no fixed costs. MC is a
                                                                   two opposing             flat line. TC curve has a constant slope.
                                                                   effects on               MR and D (=P=PQ/Q=TR/Q=AR) curve are shown.
                                                                   Quantity                 Profit maximizing output is where MC=MR or where Profit = TR-TC is
                                                                   effect. One              maximum. Price is read of from the D curve and from TR line.
                                                                   more unit is sold,       Profit = (P-ATC) x Q
                                                                   increasing total
                                                                   revenue by the                                                                   Profit = XY
                                                                   price at which                                                          $        MC = slope of TC
                                                                   the unit is sold.                                                                MR = slope of TR
                                                                                                                                                    Equilibrium price = XZ/0Z
                                                                   Price effect. In
                                                                   order to sell the
                                                                   last unit, the
                                                                   monopolist must                                                                        X
                                                                                                                                                                  Total revenue
                                                                   cut the market
                                                                   price on all units
                                                                   sold. This
                                                                   decreases total
                                                                   revenue.                                                                               Y   Total cost

                                                                   So MR curve is                                                              0
                                                                   below demand

Monopoly Equilibrium
Profit maximization, cont.                                                                      Monopoly Equilibrium
In the general case MC curve is upward sloping and there are fixed costs,
so average total cost curve is U-shaped.                                                        Monopoly versus Perfect Competition
Monopolist maximizes profit by producing output at which MR = MC, given by                  To compare monopoly and perfectly competitive equilibria, return to the case
point A, implying quantity QM. Find monopoly price, PM , from the point on the              of constant MC. Demand curve same for both cases.
demand curve directly above point A, point B. The average total cost for QM is
shown by point C. Profit is given by the area of the shaded rectangle.                                                         P = MC at the perfectly competitive firm’s
                 Profit = TR − TC                       Profit = XY                                                            profit-maximizing quantity of output
                 = (PM × QM) − (ATCM × QM)              MC = slope of TC
                 = (PM − ATCM) × QM            $        MR = slope of TR                                                       P > MR = MC at the monopolist’s profit-
                                                        Equilibrium price = XZ/0Z
                                                                                                                               maximizing quantity of output
                                                                                                                               Compared with a competitive industry, a
                                                                          Total cost                                           monopolist does the following:
                                                                                                                                 Produces smaller quantity: QM < QC
                                                                                                                                 Charges higher price: PM > PC
                                                                                                                                  Earns a profit
                                                                                                                               The comparison suggests that the more
                                                               Y            Total revenue                                      inelastic the demand curve, the lower the
                                                   0                                                                           output and higher the price.
                                                                                 9                                                                                         10

Monopoly and Public Policy                                                                  Monopoly and Public Policy
Welfare effects of monopoly                                                                 Preventing monopoly
By reducing output and raising price above marginal cost, a monopolist
captures some of the consumer surplus as profit and causes deadweight loss.
This implies inefficiency and a loss in social welfare. Income distribution and
                                                                                               To avoid social welfare loss, government policy
fairness implications are also likely to be negative.                                            attempts to prevent monopoly behavior.
Show using total surplus, consumer surplus and producer surplus or profit.
                                                                                               When monopolies are “created” rather than
                                                                                                natural, governments can act to prevent them
                                                                                                from forming and break up existing ones.
                                                                                               The government policies that prevent or eliminate
                                                                                                 monopolies are known as antitrust policy. If
                                                                                                 firms are trying to get together and create a
                                                                                                 monopoly, government gets involved to prevent
                                                                                                 mergers or collusion.
                                                                                11                                                                                         12

Monopoly and Public Policy                                                        Monopoly and Public Policy
Dealing with natural monopoly                                                     Dealing with natural monopoly, cont.

If there is a natural policy, it cannot be broken up without raising
     average costs. Also, one firm is likely to emerge as the only
     seller. Three approaches:
1.   Public ownership. Government ownership of utilities,
     transportation. Sometimes works well, reducing welfare loss.
     But publicly owned companies often create inefficiencies
     because they have high costs (managers don’t try to keep
     costs down) and they are open to political pressures, for
     instance, to keep employment high.
2.   Price regulation. Common in the US. A price ceiling
     imposed on a monopolist does not create shortages as long                    Unregulated monopolist is allowed to     Regulated monopolist which must
     as it is not set too low.                                                    charge PM, it makes a profit, shown by   charge a price equal to average total cost,
                                                                                  the green area; consumer surplus is      the price PR*. Output is QR*, and consumer
3.   Doing nothing: monopoly is a bad thing, but the cure may                     shown by blue area. If it is regulated   surplus is entire blue area. The
     sometimes be worse than the disease. Politicization of prices.               and must charge the lower price PR,      monopolist makes zero profit. This is the
                                                                                                                           greatest consumer surplus possible when
     Not knowing what is the correct cost. Cost padding by                        output increases from QM to QR, and
                                                                                                                           the monopolist is allowed to at least break
     regulated firms. But doing nothing results in welfare losses.
                                                               13                 consumer surplus increases.
                                                                                                                           even, making PR* the best regulated price.

Price Discrimination                                                              Price Discrimination, cont.
So far we examine only single-price monopolist, one who                           It is profit-maximizing to charge higher prices to low-elasticity consumers
                                                                                  and lower prices to high elasticity ones.
charges all consumers the same price. Not all monopolists do this.
                                                                                  Discriminating monopolists can charge more than two prices to different
In fact, many monopolists find that they can increase their profits               sets of customers. Example with three prices.
by charging different customers different prices for the same
good: they engage in price discrimination.
Price discrimination is possible if
there are two or more groups of
potentially customers who can be
easily distinguished and who
cannot resale what they buy to
each other. It is profitable if the
groups of customers have
different characteristics – such as
how elastic their demand is or
how much they are willing to pay.
Example: airline tickets for                                                             By increasing the number of different prices charged, the
businesses and students.                                                                 monopolist captures more of the consumer surplus and makes
                                                                                         a large profit.
                                                                         15                                                                                    16

 Price Discrimination
 Perfect Price Discrimination
                                                          Perfect price
In the case of perfect price discrimination, a            discrimination is
monopolist charges each consumer his or her               probably impossible
willingness to pay; the monopolist’s profit is given by   in practice.
the shaded triangle. There is no deadweight loss!         Creates a problem for
                                                          prices as economic
                                                          signals; consumer’s
                                                          true willingness to
                                                          pay can easily be
                                                          However, monopolists
                                                          do try to move
                                                          towards perfect price
                                                          through a variety of
                                                          pricing strategies,
                                                          such as:
                                                          Advance purchase
                                                          Volume discounts
                                                          Two-part tariffs: fee
                                                          plus price.
                                                          Fairness issues.


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