Market Structures: Monopoly Monopoly Assumptions • One seller and many buyers – Implication: The seller is a price maker and the buyers are price takers. • Barriers to Entry – Ownership of a unique resource (Diamonds) – Government granted rights for exclusive production (e.g. patents, copyrights, licenses, concessions) – Economies of scale and declining long-run average costs – Implication: Monopolist faces the entire market demand curve and profits can persist in the short and long-run. Limits to Monopoly • Size of the market (Pavarotti versus Joe, uncongested bridge) • Definition of market and close substitutes (ornamental versus industrial diamonds, bottled water). • Potential competition Production Decisions • Monopolist versus competitive firm. – CF is a price taker who faces a perfectly elastic demand curve  MR=P – M is a price maker who faces the entire market demand curve  MR<P • Intuitive proof – to sell another unit the monopolist must lower the price. This means lowering the price not only on the extra unit sold, but also all the other units the monopolist was selling. So MR = Price of the additional unit – the sum of the decreases in all the units previously sold ( e.g. selling 4 units @$100, to sell the 5 unit the price must be lowered to $90, so the monopolist’s MR = $90 – 4X$10=$50) • Tabular proof – see next table and handout • Graphical proof A Monopoly’s Revenue • Total Revenue P  Q = TR • Average Revenue TR/Q = AR = P • Marginal Revenue DTR/DQ = MR Table 1 A Monopoly’s Total, Average, and Marginal Revenue Copyright©2004 South-Western Figure 2 Demand Curves for Competitive and Monopoly Firms (a) A Competitive Firm’s Demand Curve Price (b) A Monopolist’s Demand Curve Price Demand Demand 0 Quantity of Output 0 Quantity of Output Copyright © 2004 South-Western Figure 3 Demand and Marginal-Revenue Curves for a Monopoly Price $11 10 9 8 7 6 5 4 3 2 1 0 –1 –2 –3 –4 Demand (average revenue) Marginal revenue 1 2 3 4 5 6 7 8 Quantity of Water Copyright © 2004 South-Western Profit Maximization • A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. • It then uses the demand curve to find the price that will induce consumers to buy that quantity. • Profit Maximization – – Set MR = MC to find Q that maximizes profits. – Use the market demand curve to find the P that the Q brings – Find ATC and AVC cost to determine profits, losses, or shutdown. • Difference between the monopolist decision and the competitive firms decision – The monopolist does not have a supply curve like the CF, rather they pick a single price and quantity – Monopolists produce where P>MR and P>MCversus CFs who produce where P=MR and P=MC. Figure 4 Profit Maximization for a Monopoly Costs and Revenue 2. . . . and then the demand curve shows the price consistent with this quantity. B Monopoly price 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity . . . Average total cost A Demand Marginal cost Marginal revenue 0 Q QMAX Q Quantity Copyright © 2004 South-Western Figure 5 The Monopolist’s Profit Costs and Revenue Marginal cost Monopoly E price B Monopoly profit Average total D cost Average total cost C Demand Marginal revenue 0 QMAX Quantity Copyright © 2004 South-Western Figure 6 The Market for Drugs Costs and Revenue Price during patent life Price after patent expires Marginal cost Marginal revenue 0 Monopoly quantity Competitive quantity Demand Quantity Copyright © 2004 South-Western Welfare Costs of Monopoly • In competitive markets, firms produce where P=MC And since P=MB=willingness to bud And MC=willingness to sell P=MC  MB=MC or Maximum total surplus • In monopoly, P>MR so P>MC Or MB>MC Output falls short of the efficient amount  Deadweight Welfare Loss Figure 7 The Efficient Level of Output Price Marginal cost Value to buyers Cost to monopolist Value to buyers Cost to monopolist Demand (value to buyers) Quantity 0 Value to buyers is greater than cost to seller. Value to buyers is less than cost to seller. Efficient quantity Copyright © 2004 South-Western Figure 8 The Inefficiency of Monopoly Price Deadweight loss Marginal cost Monopoly price Marginal revenue 0 Monopoly Efficient quantity quantity Demand Quantity Copyright © 2004 South-Western • Monopoly profit is not usually a social cost but a transfer of surplus from consumer to producer. • Profit can be a social cost if extra costs are incurred to maintain it, such as political lobbying, or if the lack of competition leads to costs not being minimized (Xinefficiency again!) Public Policy and Monopolies Working towards P=MC • Attempts to increase competition through antitrust legislation – Sherman Antitrust Act of 1890 – Examples: Breakup of Standard Oil and turning MA Bell into Baby Bells • Regulation – Natural Monopolies – P=MC doesn’t work with extensive economies of scale – Regulated forms have little incentive to minimize costs • Public Ownership – Public utilities and the Postal Service • Hands-off Approach Price-Discriminating Monopolist • Price discrimination occurs when different prices are charged to different consumer that do no reflect differences in the cost of providing th good • Perfect Price Discrimination – charging each customer their maximum willingness to pay. • Imperfect Price Discrimination – segmenting the market into different consumer groups. – Parable – Hardcopy versus paperback copy – Allows firms to increase profits – Requires separating customers into different groups and minimize arbitrage – Results in greater economic welfare than single-pricing monopolists. Basis for Price Descrimination • Different consumers have different willingness to pay  different price elasticities of demand • Rule: segment the market according to price elasticity of demand and charge the consumers will less elastic demand more than those with more elastic demand • Examples: (remember the smaller the % of income or the greater the number of close substitutes the less price elastic the demand,) – – – – – Movie Tickets Airline Tickets Discount Coupons Financial Aid Quantity Discounts Summary • Monopolies contribute to inefficiency because: – P>MC  DWWL – Less than the socially optimal level of output is produced – Incentives for cost reduction may diminish – Too many resources may be spent on political protection • However, discriminating monopolist can help reduce DWWL. Figure 10 Welfare with and without Price Discrimination (a) Monopolist with Single Price Price Consumer surplus Deadweight loss Monopoly price Profit Marginal cost Marginal revenue 0 Quantity sold Demand Quantity Copyright © 2004 South-Western Figure 10 Welfare with and without Price Discrimination (b) Monopolist with Perfect Price Discrimination Price Profit Marginal cost Demand 0 Quantity sold Quantity Copyright © 2004 South-Western Price Maker – Profit Taker http://www.youtube.com/watch?v=ZcSBurP8yLs&feature=re lated Queue 51 You’re a Price Maker Price Maker Money Taker Price Maker Profit Taker Don’t you mess around with me You’re a Price Maker Price Maker Money Taker Price Maker Profit Taker Don’t you mess around with me, no no. no!