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Monopoly Industrial Organization Characterized by:

only one seller the firm is the industry

firm faces the market demand curve and is a price-maker demand is inelastic because no substitutes are

available firm has significant market power entry into industry is blocked by barriers

economies of scale natural monopoly patents ownership of key resources

legal restriction on entry

Lecture 18

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Short run decision making for the a monopoly:1. produce if P > AVC

2. if 1., produce where MR = MC3. determine P based on demand

Q*

MC

D

MR

Q

P

P*

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Case 2: break even = 0 TR = TC P = ATC

Q 2

ATC

MC

D

MR

Q

P

P 2 = ATC

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Case 3: min. losses by producing < 0 TVC < TR < TC AVC < P < ATC

ATC

MC

D

MR

AVC

Q

P

P 3

Q 3

AVC

ATC

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SR equilibrium conditions for monopoly:1. produce if P > AVC

2. if 1., produce where MR = MC3. >=< 0

Long Run Considerations for Monopoly

1. SR < 0 monopoly exits from industry

2. SR > 0 new firms can not enter because entry is

blocked by barriers

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Long Run Equilibrium for Monopoly

Q M

ATCMC

DMR

Q

P

P M

min LRAC

LRAC

min ATC

1. P > MC2. MR = MC3. normally P > ATC > 04. P > min. ATC

5. P > min. LRAC

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Welfare Analysis: Comparing Perfect Competition and Monopoly

Q M

MC

DMR

Q

P

P M

Q C

MC

D

Q

P

P C

Q M

P M

MR

Monopoly produces too little output and charges too

high a price.

1. Compare Production and Prices: What happens to the levels of production and price if a competitive industry is monopolized?

Perfect Competition Monopoly

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Monopoly causes a dead weight loss (DWL) of benefits that wouldotherwise be enjoyed if the market were perfectly competitive.

2. Compare Benefits and Costs: How do benefits and costs changeif a perfectly competitive industry is monopolized?

Q C

D = MB

Q

P

Q M

?TB

Q C

MC

Q

P

Q M

?TC

change in costschange in benefits

Q C

MC

D

Q

P

Q M

DWL

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3. Compare the long run equilibrium conditions of PerfectCompetition and Monopoly

Perfect Competition

1. P = MC: value output equalsvalue of resources used toproduce it.

2. MR = MC: all firms are

maximizing profits.3. P = ATC: all firms earn a

normal profit all resourcesearn exactly their opportunitycost.

4. P = min. ATC: all firms arefully utilizing their plantcapacity

5. P = min. LRAC: all firms buildthe optimal plant size.

1. P > MC: too little output at toohigh of price misallocation of resources.

2. MR = MC: monopolistmaximizes profits.

3. P > ATC: monopolist earnspositive profits earns inexcess of its opportunity cost.

4. P > min. ATC: monopolistunder utilizes its plantcapacity .

5. P > min. LRAC: monopolist

does not build the optimalplant size.

Monopoly

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Alternative View of Monopoly

Monopolies tend to be more technically progressivebecause they have a:

1. greater incentive to be innovative

desire to earn higher profits

desire to protect monopoly position

1. greater ability to innovate because profits providethe resources needed for research and

development.

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The Problems in Dealing with Natural Monopoly

1. Because of economies of scale, costs are lower if only

one firm produces all output LRAC decline over entirerange of production.

2. MC < LRAC because of average-marginal rule.

LRAC

Q

P

MC

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3. Given adequate demand a natural monopolist earns aprofit.

Q M

LRAC

Q

P

P M

MC

MRD

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4. Since P > MC too little output at too high of price misallocation of resources.

Q M

LRAC

Q

P

P M

MC

MRDQ C

P C

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5. Since antitrust action wont work, the policy is to regulatenatural monopoly .

Marginal Cost Pricing: regulate so that P = MC

LRAC

Q

P

LRAC

MC

DQ C

P MClosses

MC pricing fails because firm earns losses and exits industry in the

long run.

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Average Cost Pricing: regulate so that firm earns a normal profit P = LRAC

AC pricing fails because P > MC means a misallocation of resources.

LRAC

Q

P

P AC

MC

DQ AC

MC

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Price Discrimination: charging different prices to the same or different customers

Perfect Price Discrimination: firm charges the demand pricefor each unit sold.

D = MB

Q

P

Q 5Q 1 Q 2 Q 4Q 3

P 1

P 5

P 2

P4

P 3

D = MB

Q

P

Q M

P M

No Price Discrimination Perfect Price Discrimination

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Price discriminating firm collects more total revenue

D = MB

Q

P

Q M

TR = TE

P M

Perfect Price Discrimination

D = MB

Q

P

Q PPD

TR = TE

No Price Discrimination

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Extra total revenue is earned because the pricediscriminating firm is able to capture the consumers surplus

Expenditures MadeBenefits Received

consumers surplus (CS): benefits consumers receive from agood that are over and above the expenditures they must maketo purchase the good

D = MB

Q

P

Q

TB

D = MB

Q

P

Q

TE

P

CS

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Other Forms of Price DiscriminationDeclining Block Pricing

D = MB

Q

P

Q 1 Q 2 Q 3

P 1

P 2

P 3

TE

CS

CSCS

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Other Forms of Price Discrimination

Price Discrimination by Elasticity of Demand

D 2MR 2

Q

P

D 1MR 1

Q

P

MC

CMR

Q

P

Q1 Q2 QT

P1

P2