Monopoly - PowerPoint

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Chapter 14
            Barriers to Entry
• A monopolist is the only producer of a product
  with no close substitute
   – “Local monopoly” (market definition)
• The key reason that there is only one producer is
  that there is some barrier to entry
• Barrier to entry – something that impedes other
  firms from entering the industry
   – Legal restrictions
   – Economies of scale
   – Control of essential (natural) resources
           Legal Restrictions
• Patents, licenses, and other legal restrictions
  (imposed by the government or some governing
  body) provide some producers legal protection
  from competition
• Patents – a way to protect inventors (innovators)
  from having their creations “stolen” by other firms
  or people
• Licenses – when the government grants the
  exclusive right to supply a particular good or
• Some examples…
• New Era Cap Company is the “exclusive supplier”
  of hats for Major League Baseball teams

• Reebok is the official supplier of NFL jerseys (go
  to to get your official Vince Young

• According to the Gillette website, the Gillette M3
  Power razor is protected by 62 patents

• Only Pzifer Pharmaceuticals is the only company
  allowed to sell Lipitor, Celebrex, and Viagra
          Economies of Scale
• A single firm can sometimes satisfy market
  demand at a lower average cost of production than
  two or three firms could
• In other words, one big firm can provide the good
  cheaper than several smaller firms can
• This is usually true for firms or industries where
  average total cost falls as output increases
• Economies of scale can be a reason FOR legal
• Examples…(utilities)

• Comcast is the only cable company allowed to
  operate in my neighborhood
• AT&T is the only local telephone service that I
  can receive
• Electricity (Middle Tennessee Electric Co-op)
Control of Essential Resources
• Sometimes a firm is a monopoly simply because
  they are the only one that possess the product
• No legal entries exist, for example…it’s simply
  that other firms cannot have the product to sell
• The most common example is DeBeers (the
  diamond company)
• Other examples:
   – NFL, NBA, and MLB
   – The Bowl Championship Series (BCS)
    Road Map for Monopoly
1. Profit Maximizing choices of output
   and/or price
2. Comparing monopoly with perfect
3. More “creative” pricing strategies:
  1. Price Discrimination
  2. Bundling
  3. Membership Fees (two-part pricing)
   Revenue for the Monopolist
• When dealing with a monopolist, it is no longer
  necessary to distinguish between a firm’s demand
  curve and the market demand curve
• Why?
• Because the monopolist is the only firm serving
  the market, so the market demand curve IS the
  firm’s demand curve
• The monopolist, therefore, faces a downward
  sloping demand curve for his or her product
  Demand and Marginal Revenue

• Let’s consider the example of Comcast cable
• Comcast has been granted a license by the
  local government to be the sole cable company
  operating in the Nashville area
• Suppose Comcast has 3 million subscribers at
  a price of $70 per month
• Their TOTAL REVENUE is $210,000,000
  Demand and Marginal Revenue
• In order to increase the number of subscribers to 4
  million, Comcast would have to lower the price of
  cable to $67.60 per month
• Even though Comcast is a monopolist, they are
  still constrained by the law of demand
• Comcast’s new TOTAL REVENUE would be
• What is the marginal revenue from selling one
  more unit?
  Demand and Marginal Revenue
• Under perfect competition, the firm’s marginal
  revenue was simply the price (because they could
  sell as many units as they wanted at the market
• For a monopolist, marginal revenue does NOT
  equal the price
• Why?
• In order to sell an additional unit, you need to
  lower your price
  Demand and Marginal Revenue
• Mathematically, what is marginal revenue?

            MR 

• Marginal Revenue – the change in total revenue divided
  by the change in output
 Calculating Marginal Revenue
• So, in our example, Comcast’s Total Revenue went from
  $21 million to $27 million and their sales went from 3
  million to 4 million:

        $270 ,000 ,000  $210 ,000 ,000
   MR                                   $60
           4,000 ,000  3,000 ,000

• The marginal revenue equals $60
                   Loss or Gain from Selling One More
                                                           By selling to additional customers, Comcast
                                                           gains the revenue from selling to more
$70.00                                                     customers than they did before
                                                           However, to gain additional customers,
Price per                                                  Comcast much charge a lower price which
month                                                      means they receive less money per
                           G                    D
                           I                               If the GAIN is greater than the LOSS, then
                           N                               lowering the price increases TOTAL
                                                           REVENUE and MARGINAL REVENUE IS

            0          3       4   Millions of customers
                Monopoly Demand and Marginal and Total

                                                                     (a) Demand and Marginal Revenue
Demand and marginal revenue are
shown in the upper panel and total
revenue is in the lower panel.                                       Elastic

                                        Dollars per month
                                                                                    Unit elastic
Note that the marginal revenue
curve is below the demand curve                                                                    Inelastic

and total revenue is at a maximum
when marginal revenue equals                                                                        D = Average revenue
                                                                                     Marginal revenue
zero.                                                                          16                      32      Millions of customers
                                                                                (b) Total Revenue
Notice also that when demand is
elastic, a decrease in price
                                     $600 million
increases total revenue 
marginal revenue is positive.
                                                Total dollars

Conversely, when demand is
                                                                                                   Total revenue
inelastic, a decrease in price
reduces total revenue  marginal
revenue is negative

                                                                0          16                          32      Millions of customers
            Profit Maximization
• In perfect competition, firm’s were not able to select
  their price…instead they chose the optimal level of
• A monopolist, on the other hand, can choose either
  the price or quantity in order to maximize profit
• Because the monopolist is constrained by the demand
  curve, choosing one things automatically tells you the
  value of the other choice
• Because the monopolist can set price, we say that it
  has some market power
         Profit Maximization
• To illustrate how the monopolist chooses her
  optimal price (or quantity), consider the following
  data for De Beers
We will combine cost data with information on their
  total revenue in order to determine the profit
  maximizing price/quantity
• As you will see, the monopolist (much like the
  perfectly competitive firm) will choose to produce
           Short-Run Revenues and Costs for the Monopolist

                      Short-run Costs and Revenue for a Monopolist
                                                                                               The profit-
            Price                    Marginal               Marginal  Average     Total
Diamonds   (average    Total         Revenue       Total      Cost    Total Cost Profit or     maximizing
per day    revenue) revenue            (MR =       Cost      ( MC =     (ACT =    Loss =       monopolist
  (Q)        (p)    (TR = Q x p)      TR / Q)    (TC)     TC / Q)   TC/Q)    TR - TC
                                                                                               employs the same
  (1)        (2)    (3) =(1) x (2)       (4)        (5)        (6)        (7)       (8)
                                                                                               decision rule as the
   0       $7,750             0           -       $15,000         -          -    -$15,000     competitive firm 
   1        7,500          $7,500      $7,500      19,750      4,750    $19,750    -12,250
                                                                                               the monopolist
   2        7,250           14,500      7,000      23,500      3,750     11,750        9,000
   3        7,000           21,000      6,500      26,500      3,000      8,830       -5,500   produces that
   4        6,750           27,000      6,000      29,000      2,500      7,750       -2,000   quantity where
   5        6,500           32,500      5,500      31,000      2,000      6,200        1,500
                                                                                               total revenue
   6        6,250           37,500      5,000      32,500      1,500      5,420        5,000
   7        6,000           42,000      4,500      33,750      1,250      4,820        8,250   exceeds total cost
   8        5,750           46,000      4,000      35,250      1,500      4,410      10,750    by the greatest
   9        5,500           49,500      3,500      37,250      2,000      4,140      12,250
                                                                                               amount  $12,500
  10        5,250           52,500      3,000      40,000      2,750      4,000      12,500
  11        5,000           55,000      2,500      43,250      3,250      3,930      11,750    per day when
  12        4,750           57,000      2,000      48,000      4,750      4,000        9,000   output is 10 units
  13        4,500           58,500      1,500      54,500      6,500      4,190        4,000
                                                                                               per day. Total
  14        4,250           59,500      1,000      64,000      9,500      4,570       -4,500
  15        4,000           60,000        500      77,500     13,500      5,170       -7,500   revenue is $52,500
  16        3,750           60,000          0      96,000     18,500      6,000     -36,000    and total cost is
  17        3,500           59,500       -500     121,000     25,000      7,120    -61,500
Profit Maximization Graphically
                                             Marginal Cost
     Price per diamond

                                                 Average Total Cost


                                  10   16      32
                                                       Diamonds per day

• The monopolist chooses the level of output by equating
marginal cost and marginal revenue
• But the price comes from the DEMAND CURVE
            Short Run Losses
• I have just drawn the case where the monopolist is
  earning profit in the short run
• A monopolist is not guaranteed profit, however
• For example: I am the only one that owns authentic
  Adam Rennhoff childhood memorabilia!
• However, it would probably be unwise to build a
  store (or museum) to sell my personal items
• Being a monopolist does not guarantee profit
  because the monopolist is still constrained by the
  demand for the product
            Short Run Losses
• If a monopolist is losing money in the short run,
  the firm must make the decision that a perfectly
  competitive firm does:
   – Should I continue to operate even though I’m losing
   – Or should I temporary suspend operations?

• The decision depends on which strategy is more
  effective in minimizing losses
  Long Run Profit Maximization
• The distinction between the short run and long run is
  not as important under monopoly
• Barriers to entry provide some protection for the
  monopolist and allow for the possibility of long run
   – Recall how free entry and exit eliminated profit in the long
• The primary difference between the short run and the
  long run is that the monopolist may adjust the size (or
  scale) of the firm to more efficiently serve the market
Monopoly vs. Perfect Competition
• We will now compare the price level and amount
  of output for a monopolist versus the outcome we
  would’ve had under perfect competition
• Keep in mind the “profit-maximizing rules”
   – Perfect Competition: P = MC
   – Monopoly: MR = MC (and price comes from the
     demand curve)
• Let’s look at a simple picture…
                    Perfect Competition and Monopoly
Equilibrium in perfect                                     a
competition is at point c, where
market demand and the
marginal cost curve intersect to                               m

                                   Dollars per unit
yield price pc and quantity Qc.

                                                               b         c
The monopolist maximizes                              pc                     MC
profit by equating marginal
revenue with marginal cost                                                        D
 point b  equilibrium
price pm and output Qm.

                                               Q'm     0Q'c Quantity per period
Consumer surplus under MONOPOLY is the yellow triangle.
Consumer surplus under PERFECT COMPETITION is the checkered green triangle
NOTE: The green triangle INCLUDES the yellow triangle
Consumer surplus under PERFECT COMPETITION is clearly LARGER
       Welfare Under Monopoly
• There are several reasons to think that the welfare measure we
  have used might understate or overstate the welfare loss due
  to monopoly
• Reasons the Welfare Loss May Be Lower:
   – Economies of scale could make production very cheap
   – The monopolist may under-price because of government regulation
     or public scrutiny
   – Monopolies may under-price in order to keep potential competitors
     out (make it less attractive)
• Reasons the Welfare Loss May Be Greater:
   – Monopolies spend a lot of money in order to protect their product
     (lawyers, advertising, market research)
   – Monopolies may be slow to adopt new technology which would
     benefit the consumer (no competition…why do I need to make the
     product better?)
   Pricing with Market Power
• When firms use a single per-unit uniform price
  (like we have just looked at), this leave consumers
  with consumer surplus

• The desire to capture some of this consumer
  surplus leads firms to adopt more “creative”
  pricing strategies

• Here are some examples…
           Price Discrimination

• Price discrimination – charging different prices for
  the same product

• The fundamental idea: firms believe that different
  groups (or “types”) of individuals have different
  demands for the product
   – The firm then charges each group/type a price that is
     appropriate given their demand
• Three degrees of price discrimination
• The key to all of these examples is that they
  represent times when the firm is charging
  different prices for the same product
• Movie tickets: Senior Citizens & Children vs. Adults
• Haircuts: Women pay more than men
• Airfare: Business travelers vs. Leisure travelers
• Cell phone plans: choosing the number of night and
  weekend minutes vs. anytime minutes
• Buying things in “bulk”…
                                 Price Discrimination
                           (a)                                                   (b)

                                                          Dollars per unit
Dollars per unit


                    1.00                   MC            1.00                                      MC
                                 MR    D                                                         MR'
                      0    400    Quantity per period                        0         500 Quantity per period

   Consumer #1 (the left hand side) has a more inelastic demand for the product than
   Consumer #2 (the right hand side). To exploit this difference the monopolist
   charges separate prices to each consumer. This strategy yields the monopolist
   more profit than simply charging a “uniform” price to both consumers.
• Sometimes a monopolist that makes two separate products will
  try and sell both together
• This is called bundling
• This is typically done when there is a greater demand for one
  product than for the other
• Example: Comcast sells “bundled” cable and DSL (internet)
• Most people want cable, but Comcast tries to increase the
  demand for DSL by “bundling” it with cable subscriptions
• The price for the bundle is typically less than the price of
  buying each item separately
             More Examples…
• Cable channels are also a form of bundling…I would
  not be interested in purchasing the Oxygen Network,
  but cable bundles it with the other channels so that I
  don’t have a choice
• Microsoft Office – if you buy Office, you receive
  Word, Excel, Outlook, PowerPoint, and some
  others…although maybe you would not consider
  buying PowerPoint separately
• CD box sets
• Home theater set (stereo, DVD player, speakers)
               Two-Part Pricing
• Two-part pricing refers to a strategy where the firm
  charges a price per unit and a fee that does not
  depend on the usage
• The goal is to use the fee to “steal” some of the
  consumer surplus that is leftover
• Examples:
   –   Country Clubs, Golf Clubs
   –   Telephone
   –   Amusement parks, Carnivals
   –   Dance clubs & Bars
              How it works…
• Whenever there is consumer surplus, it means that
  the consumer was willing to pay more than he did…
• My favorite band puts out a new CD and I would be
  willing to pay $40 for it
• The store only charges $15, so I get a benefit
  (consumer surplus) of $25
• If the store charged $15 for the CD plus $25 as a
  membership fee, I would still be willing to buy the
  CD ($15 + $15 = $30), but now the firm receives a
  higher profit
              Required Tie-In Sales
• Bundling is sometimes also referred to as a “tie-in”
• The consumer, however, has the option to purchase
  either OR both of the goods
• In required tie-in sales, the consumer is required to
  purchase both goods (you cannot buy one separately)
• Examples
   –   Mach 3 Turbo razor vs. Schick Quattro
   –   Sony Playstation 2 vs. Microsoft X-Box
   –   Polaroid instant camera
   –   Photocopiers (Xerox)
             Peak-Load Pricing
• Charging a higher price during peak times (i.e. high
  demand times)
• Examples:
   – Electricity pricing (the price per kilowatt hour changes
     depending on what time of day…so do you laundry at
   – Rental properties (renting a place in Destin is pretty cheap
     in January)
   – Car Rentals (the price of car rentals is higher during the
     summer…vacation season)
   – Matinee vs. Regular Admission (movie theaters charge
     lower prices during the day…lower demand period)

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