chapter 24: monopoly - econ 3023 microeconomic...

Intro Monopolist’s PMP Inefficiency Natural Monopoly

Econ 3023 Microeconomic Analysis

Chapter 24: Monopoly

Instructor: Hiroki WatanabeSpring 2013

Watanabe Econ 3023 24 Monopoly 1 / 61


1 Introduction

2 Monopolist’s Profit Maximization Problem

3 Inefficiency of Monopoly

4 Natural Monopoly

5 Summary



1 Introduction



4 Natural Monopoly

5 Summary



Project 1.1 (Overview of Producer Theory)18 Technology19 Profit Maximization Problem20 Cost Minimization Problem21 Cost Curves22 Firm Supply23 Aggregate Supply24 Monopoly25 Monopoly Behavior26 Oligopoly



Closely related to Ch15B Elasticity.A monopolized market has a single seller.The monopolist’s demand curve is not flat (likeperfect competitors) but aggregate demand curveitself.The monopolist can alter the market price byadjusting its output level.



Example 1.2 (Coca Cola Faces Downward-SlopingDemand Curve)Take a listen to Marketplace Audio Clip .

So when you have price increases hitting, moreconsumers are going to be looking at thatbottle of Coca-Cola and saying, "Do I reallyneed this?"

How is Coca Cola’s decision different from price taker’s?



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MC(y)AC(y)Aggregate Demand

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Factor Example

Legal fiatPatent

Sole ownership of a resourceLarge economies of scale



1 Introduction

2 Monopolist’s Profit Maximization ProblemPerfect Competition vs MonopolySolving Monopolist’s PMPMarginal Condition Doesn’t Give PriceExample


4 Natural Monopoly

5 Summary



Perfect Competition vs Monopoly

Problem 2.1 (PMP in a Perfectly CompetitiveEnvironment)

maxyπ(y) = py − TC(y).

Problem 2.2 (Monopolist’s PMP)




Compare price-taker Jack Example 2.4 in Ch22 tomonopolistic Jack:




Example 2.3 (Price-Taker Jack)

Suppose that Jack has the following productionenvironment ( Example 2.4 in Ch22):

y TR(y) TC(y) π(y) MR(y) MC(y) Δπ

0 0 3 -3 - - -1 6 5 1 6 2 42 12 8 4 6 3 33 18 12 6 6 4 24 24 17 7 6 5 15 30 23 7 6 6 06 36 30 6 6 7 -17 42 38 5 6 8 -28 48 47 1 6 9 -3




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TR(y)TC(y)π(y)

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Example 2.4 (Monopolistic Jack)

Suppose that Jack has the following productionenvironment:

y MWTP(y) TR(y) TC(y) π(y) MR(y) MC(y) Δπ

0 - 3 -3 - - -1 8 5 3 2 62 7 8 6 3 33 6 12 6 4 04 5 17 3 5 -35 4 23 -3 6 -66 3 30 -12 7 -97 2 38 -24 8 -128 1 47 -39 9 -15




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Cheesecake y (slices)

TR(y)TC(y)π(y)

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−1

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MWTP(y)MR(y)MC(y)∆π(y)

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Comparison between price-taker Jack andmonopolistic Jack.Two oddities with monopolistic Jack (everything elseis the same):

Fact 2.5 (Monopolist’s Revenue)

1 Total revenue TR(y) curls up.

2 Marginal revenue MR(y) is not flat anymore and dropsfaster than MWTP(y).




Decode Ê in Fact 2.5 :

Definition 2.6 (Two Counteracting Effect on TotalRevenue)

1 Quantity effect: Sell more, and earn more.

2 Price effect: Sell more, price drops, and earn less.




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Decode Ë in Fact 2.5 :Breakdown of marginal revenue:If Jack sells the 2nd slice, price drops from 8 to 7.

1 He will earn $7 from the 2nd slice (same asMWTP(7))

2 but he will lose $1 from the 1st slice (take a dollaroff MWTP(8)).1

MR(y) = MWTP(y)︸︷︷︸

incremental revenue from an additional slice sold >0

+ΔMWTP(y)

Δyy

︸︷︷︸additional revenue from existing sales <0

.

2

1See Ch25.2TR′(y) = [MWTP(y)y]′ = MWTP(y) + MWTP′(y)y.




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Solving Monopolist’s PMP

How does Fact 2.5 affect the way monopolistic Jacksolves Problem 2.2 ?Some are the same as Problem 2.1 , and then there’sa trap.




Fact 2.7 (Monopolistic Pricing)

Monopolistic Jack’s two-step pricing procedure:1 Use marginal condition

MR(y) = MC(y)

to find y∗.

Now ditch MR(y) after you get y∗.

2 (And here’s the trap). Then plug y∗ back inMWTP(y) (NOT MR(y)) to find the price

p = MWTP(y∗).




Two suspicions with Fact 2.7 :

Question 2.8 (Monopolistic Pricing)

1 Why do monopolistic Jack and price-taker Jack share thesame marginal condition:

MR(y) = MC(y)?

2 Price-taker Jack used to have

p = MR(y).

Then shouldn’t monopolistic Jack do the same thing tofind the price rather than setting

p = MWTP(y)?




Answer to Ê in Question 2.8 :TC(y) still runs parallel to TR(y) at y∗.




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($)



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Consider “What if not?” What would

MC(y) < MR(y)

mean?



Marginal Condition Doesn’t Give Price

Answer to Ë in Question 2.8 :




In Example 2.4 ,y∗ = 3TC(3) = 12MR(3) = 4MWTP(3) = 6.

If he charges MR(3) and MWTP(3), what would behis profit levels?Total cost is the same. Find the total revenue in thefollowing:




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Liz is happy to pay MWTP(3) = 6 dollars for the 3rdslice.Then what’s the point of charging MR(3) = 4 dollarsinstead?Conclude: marginal condition is there to find theoptimal quantity y∗. Not the price.



Example

Example 2.9 (Monopolist’s PMP)

Suppose monopolistic Jack faces

MWTP(y) = −y + 12

withMR(y) = −2y + 12.

a His marginal cost is

MC(y) = 2y.

What is his optimal production level y∗ and the price p?aI’ll get you MR(y) in the exam. Just know that MR(y) drops faster

than MWTP(y).

Use Fact 2.7 .Watanabe Econ 3023 24 Monopoly 35 / 61


Example

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1 Introduction


3 Inefficiency of MonopolyMonopolistic Pricing Yields Deadweight LossMarginal Cost Pricing Yields Pareto Optimum

4 Natural Monopoly

5 Summary



Monopolistic Pricing Yields Deadweight Loss

A word “monopoly” has a derogatory connotationto it.Is it?It is.




Monopolistic Jack maximizes his profit by choosingy∗ from

MR(y) = MC(y)

and set the price at

p∗ = MWTP(y∗).

This result (y∗, p) maximizes Jack’s profit. Notsociety’s.




How do we evaluate (y∗, p)?Is there anything better than (y∗, p)Compute the sum of consumer and producersurplus (called total surplus).If (y∗, p) maximizes total surplus, then allocationthus derived is Pareto optimal. 3

Take Example 2.9 .

3More on this in Ch16, 31.Watanabe Econ 3023 24 Monopoly 40 / 61



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Marginal Cost Pricing Yields Pareto Optimum

What if we ask monopolistic Jack to act as if he is ina perfectly competitive market?




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y p PS CS TS DWL

Monopolistic pricing 3 9 18 4.5 22.5 1.5Marginal cost pricing 4 8 16 8 24 0

Difference -2 3.5 1.5




Discussion 3.1 (Conflict with Marginal CostPricing)

1 Why doesn’t monopolistic Jack produce 4cheesecakes?

2 Why is y∗ = 3 not an efficient outcome?




1 Jack won’t produce the 4th slice because1 MC(4) = 82 MR(4) = 4.

2 y∗ = 3 is not Pareto optimal because1 MC(3) = 62 MWTP(3) = 9.



1 Introduction



4 Natural MonopolyNatural Monopoly

5 Summary



Natural Monopoly

Scale economy is one reason that an industrybecomes monopolistic.Consider an electricity company.

1 Fixed costs: laying cables2 Marginal costs: adding a subscriber

If there are large fixed costs and small marginalcosts with respect to the market size, a phonecompany becomes a natural monopolist.“Natural” because it happens without patentprotection etc.



Natural Monopoly

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MWTP(y)MR(y)MC(y)AC(y)

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Natural Monopoly

A natural monopoly arises when Jack’s technologyhas economies of scale large enough for him tosupply the whole market at a lower average totalproduction cost than is possible with more than onefirm in the market.Because of a large fixed cost, elimination ofdeadweight loss becomes a bit tricky.



Natural Monopoly

If we impose marginal cost pricing, what wouldhappen to Jack’s profit?



Natural Monopoly

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MR

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Natural Monopoly

We could get rid of the deadweight loss.But now Jack will exit the market (y = 0).Then the whole total surplus will be gone.That’s even worse than before.



Natural Monopoly

Alternative regulation: average cost pricing.



Natural Monopoly

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Natural Monopoly

y p DWL TR(y) TC(y) π(y)

Laissez-faire 18 27 108 486 450 36Marginal cost pricing 30 15 0 450 600 150Average cost pricing 23 22 36.75 506 506 0



Natural Monopoly

Discussion 4.1 (Average Cost Pricing)

Is average cost pricing implementable? If it is, whatwould be the long-term effect?



Natural Monopoly

1 Can a government force average cost pricing?2 What’s the long-term effect?



1 Introduction



4 Natural Monopoly

5 Summary



Monopolist’s PMP.Inefficiency of monopoly.Possible regulations and associated problems.



Index

average cost pricing, 54,57consumer surplus, 40deadweight loss, 44, 50,53economies of scale, 9legal fiat, 9marginal condition, 25, 34marginal cost, 30marginal cost pricing, 44,51marginal revenue, 19, 22marginal willingness topay, 16MC(y), see marginal costmonopolistic pricing, 25

MWTP(y), see marginalwillingness to paynatural monopoly, 48optimal quantity, 34Pareto optimal, 40patent, 9price effect, 20producer surplus, 40profit maximizationproblem, 11quantity effect, 20total revenue, 13, 16, 19total surplus, 40TR(y), see total revenuey∗, see optimal quantity


chapter 24: monopoly - econ 3023 microeconomic...

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