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Monopoly CHAPTER12

I dont think its fair that only one

company is allowed to make theMonopolygame.

Stephen Wright

Competition is a sin.

J. D. Rockefeller

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C H A P T E R C H E C K L I S T

When you have completed your study of thischapter, you will be able to

1 Explain how monopoly arises and distinguish betweensingle-price monopoly and price-discriminatingmonopoly.

2 Explain how a single-price monopoly determines its

output and price.

3 Compare the performance of a single-price monopolywith that of perfect competition.

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C H A P T E R C H E C K L I S T

4 Explain how price discrimination increases profit.

5 Explain why natural monopoly is regulated and theeffects of regulation.

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MARKET CHARACTERISTICS

Perfect Competition Monopoly

Many, many, many, many sellers,none so large that they can influenceprice.

One seller that likely can influenceprice

Homogeneous product (buyers dont

care who they by from).

Heterogeneous product, no closesubstitutes

No barriers to entry or exit (easy toget in and out of market).

HIGH barriers to entry or exit

Long run economic profit = zero. (onlyearning normal profit)

Long run economic profit is positive

Firms are price takers (no marketpower, so market sets same price for

all firms).

Firms are price makers (lots of marketpower, market IS the firm).

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12.1 MONOPOLY AND HOW IT ARISES

No Close Substitutes

If a good has a close substitute, even though only one firm produces

it, that firm effectively faces competition from the producers of

substitutes.

Barriers to Entry

Anything that protects a firm from the arrival of new competitors is a

barrier to entry.There are three types of barriers to entry:

Natural

Ownership

Legal

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Natural Barrier to Entry

Natural monopoly when one firm is able to meet

the entire market demand at a lower price than two ormore firms could (long downward-sloping ATC).

Ex - Duke Power can meet the market demand for

electricity at a lower cost than two or more firms could.

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Figure 12.1 shows anatural monopoly.

1. Economies of

scale exist overthe entire LRACcurve.

2.One firm can

distribute 4 millionkilowatt hours atacost of 5 centsa kilowatt-hour.


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4. and 15 cents akilowatt-hour withfour firms.

3.This same totaloutput costs 10cents a kilowatt-hour with two firms,

One firm can meet themarket demand at alower cost than two ormore firms can, andthe market is a natural

monopoly.


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Ownership Barrier to Entry

A monopoly market in which competition and entry are

restricted by the concentration of ownership of a naturalresource.

Ex - DeBeers created barrier to entry by buying control

over most of the worlds diamonds.(DeBeers is no longer a

monopoly)

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Legal Barrier to Entry

A legal barrier to entry creates legal monopoly.

Legal monopoly - competition and entry are restrictedby granting of a public franchise, government license,

patent, or copyright.

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Public Franchise- exclusive right granted to a firm to

supply a good or service. (ex, U.S. Postal Service)

Government license-controls entry into particular

occupations, professions, and industries (ex, CPA).

Patent- exclusive right granted to the inventor of a

product or service (must be registered, usually 20 years)

Copyright- exclusive constitutionalright automaticallygranted to the author or composer of a literary, musical,

dramatic, or artistic work. (work created from 1978 on,copyright last 70 years plus life of author. Time for work prior to

1978 varies, often 28 years)

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Monopoly Price-Setting Strategies

A monopolist faces a tradeoff between price and the

quantity sold. To sell a larger quantity, the monopolist must set a

lower price.

There are two price-setting possibilities that create

different tradeoffs:

Single price

Price discrimination

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Single-price monopoly - firm that must sell each unitof its output for the same price to all its customers.

DeBeers sell diamonds (quality given) at a single price.

Price-discriminating monopoly - firm that is able tosell different units of a good or service for different

prices.

Airlines offer different prices for the same trip. (Thoughthere are multiple airlines, one may have monopoly over certain routes)

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12.2 SINGLE-PRICE MONOPOLY

Price and Marginal Revenue

Firm demand curve = market demand curve (because

there is only one seller, the firm IS the market). Total revenue (TR)

P x Q.

Marginal revenue (MR)

TR / Q.

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The table shows the demand schedule and the graphshows the demand curve.


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The table also calculates total revenue and marginalrevenue.


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When the price is $16, the quantity demanded is 2haircuts an hour.


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When the price falls to $14, the quantity demandedincreases to 3 haircuts an hour.


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1. Total revenue lost on the 2 haircuts previously soldis $4.


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2. Total revenue gained on 1 additional haircut is $14.


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3.Marginal revenue is $10 ($14 gain minus $4 loss).


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The marginal revenue curve slopes downward and is belowthe demand curve. Marginal revenue is less than price.


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Marginal Revenue and Elasticity

1. If a price cut increases TR, demand is elastic.

2. If a price cut decreases TR, demand is inelastic.

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Figure 12.3(a) illustratesthis relationship.

1. Over the range fromzero to 5 haircuts anhour, marginalrevenue is positive.

A price fall increasestotal revenue, sodemand is elastic.


MR=ZERO

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2. At 5 haircuts an hour,marginal revenue iszero, so demand is unit

elastic.

3. Over the range 5 to10 haircuts an hour,marginal revenue isnegative.

A price fall decreasestotal revenue, sodemand is inelastic.


MR=ZERO

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Over the range from zero

to 5 haircuts an hour,marginal revenue ispositive and totalrevenue increases asoutput increases.

Figure 12.3(b) shows thesame information aboutmarginal revenue as

steps running along thetotal revenue curve.


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Over the range from 5 to10 haircuts an hour,marginal revenue is

negative and totalrevenue decreases asoutput increases.

The blue line is the total

revenue curve.

Total revenue ismaximized at 5 haircutsan hour.


MR=ZERO

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4. Total revenue ismaximized at 5 haircutsan hour, wheremarginal revenue iszero and demand isunit elastic.


MR=ZERO

The relationship between

MR and elasticity impliesthat a monopoly never

profitably produces an

output in the inelastic range

of its demand curve.

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Output and Price Decision

Monopolists (like perfectly competitive firms) set profit

maximizing output where MC=MR. Corresponding priceis then found on demand curve.

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Figure 12.4(b) shows thefirms profit-maximizingoutput and price decision.

The average total costcurve is ATC.

The marginal cost curve

is MC.The demand curve is D.

The marginal revenuecurve is MR.


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Economic profit is maximizedwhen MC=MR.

The profit-maximizingquantity is 3 haircuts an hour.

Profit-max price = $14(determined by the demand curve

(D).

Average total cost = $10(determined by ATCcurve at profitmax output)


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2.Economic profit, the bluerectangle, is $12.

Profit per unit = P ATC= $ 4.

Profit per unit x Q = Total profit= $12.


P-ATC

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12.3 MONOPOLY AND COMPETITION COMPARED

Output and Price

Compared to a firm in perfect competition, a single-price

monopoly produces a smaller output and charges ahigher price.

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Figure 12.5 illustrates thisoutcome.

1. The competitive industryproduces the quantity QCat price PC.

In perfect competition, themarket demand curve is D.

The market supply curve isS.


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The market demand curve,D, is the demand for themonopolys output.

The competitive markets

supply curve, S, is themonopolys marginal cost

curve, MC.

The monopolys marginal

revenue curve is MR.


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2. A single-pricemonopoly producesthe quantity QMwhere

MC=MR and sells thatquantity for the pricePM.


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Is Monopoly Efficient?

Resources are used efficiently in perfect competition

because surplus is max when MB=MC. Monopolists produce lower quantity at higher price,

under-producing relative to efficient output.

Underproduction yields deadweight losses, not

efficient.

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Figure 12.6 shows theinefficiency of monopoly.

1. In perfect competition, the

quantity, QC, is the efficientquantity because at that

quantity, MB=MC=PC.

The sum of 2. consumersurplus and 3. producersurplus is maximized.


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4. In a single-price

monopoly, the equilibrium

quantity, QM, is inefficient

because MB(PM)>MC at

that output.

Underproduction creates adeadweight loss.


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5.Consumer surplusshrinks.

6. Part of the producersurplus is lost asdeadweight loss, but

7. Producer surplus

expands to accrue part ofconsumer surplus, soproducer is better off,consumer is worse off,

society is worse off.


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12.4 PRICE DISCRIMINATION

Price discrimination - selling a good or service to

different buyers at different prices, even though cost of

providing the good is not different.

To price discriminate, a firm must

Identify and separate different types of buyers.

Sell a product that cannot be resold.

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Price Discrimination and Consumer Surplus

The key idea behind price discrimination is to convert

consumer surplus into economic profit. To extract every dollar of consumer surplus from

every buyer, the monopoly would have to offer each

individual customer a separate price schedule based

on that customers own willingness to pay. Remember: consumer surplus is the difference between

what Im willing to pay and what I have to pay. Price

discriminators find ways to charge customers what theyare willing to pay.

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Figure 12.8 shows asingle price of air travel.

As a single-price monopoly,Global Air maximizes profit byselling 8,000 trips a year at$1,200 a trip.

1. Globals customers enjoy aconsumer surplusthegreen triangleand

2.Globals economic profit is$4.8 million a yearthe

blue rectangle.


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Figure 12.9 shows howGlobal can profit from pricediscrimination.

The $1,200 fare is availableonly with a 14-day advancepurchase and a stay over aweekend.

The price of other 14-dayadvance purchase tickets is$1,400.

The price of a 7-day advance

purchase ticket is $1,600.


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A ticket with no restrictionscosts $1,800.

Global sells 2,000 units at

each of its four new fares.

Economic profit increases by$2.4 million to $7.2 million ayear, shown by the original

blue rectangle plus the bluesteps.

Consumer surplus shrinks tothe sum of the green triangles.


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Perfect Price Discrimination

Perfect price discrimination extracts the entire

consumer surplus by charging the highest price thatconsumers are willing to pay for each unit.

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Figure 12.10 illustratesperfect price discrimination.

1. Output increases to

11,000 trips a year, and...

2.Globals economic profitincreases to $9.35

million a year.

With perfect price

discrimination, the demandcurve becomes themarginal revenue curve.


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12.5 MONOPOLY REGULATION

Efficient Regulation (First Best) of NaturalMonopoly

Regulation achieves an efficient allocation of

resources if MC=MB(and price).

Called first bestmethod because it is most efficient,but causes monopoly firm to earn negative economicprofits (losses).

Marginal cost pricing rule- sets P=MC to achievean efficient output.

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2. At this price, the efficientquantity (8 millionhouseholds) is served.

1. Price is set equal tomarginal cost of $10 amonth.

3. Consumer surplus, the

green triangle, ismaximized.

4.The firm incurs a loss oneach household served,

shown by the red arrow.

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Inefficient Regulation (Second-Best) of a NaturalMonopoly

Two possible ways of enabling a regulated monopoly toavoid an economic loss are

Average cost pricing

Government subsidy

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Average Cost Pricing

Average cost pricing rule- sets P = ATC, so firmsearn zero economic profit.

Government Subsidy

A government subsidy is a direct payment to the firm tooffset economic losses.

The government must raise the subsidy by taxing someother activity, which will create a deadweight loss.

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2. At this price, the quantityserved (6 million

households) is less thanthe efficient quantity.

Average Cost PricingThe efficient quantity is 8million households.

1.Price is set equal toaverage total cost of $15a month.

3.Consumer surplus shrinksto the smaller greentrian le.

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4. A producer surplusenables the firm to payits fixed cost and break

even.

5.A deadweight loss,shown by the gray

triangle, arises.

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