Monopoly

April 8, 2013

Announcements

• Problem Set 1 is due! Pass to end of aisle.

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• Today is the beginning of our discussion of imperfections. (New material for nearly everyone.)

Last Class

• Studied how marginal revenue and marginal cost are calculated in simple examples.

• We will apply this basic knowledge to study how monopolies profit-maximize.

Learning Goals for Today

• List the sources of market power that make a firm a monopoly.

– We will study how monopolies gain special privilege in the market place, and what this means.

• Show how a given monopoly will behave in the market place

– Use marginal revenue and marginal cost to predict profit-maximizing behavior.

What is a perfectly competitive market?

• Firms have no influence over what the going price in the market is.– ``Price-takers.’’

• Characteristic of perfectly competitive markets:– All firms sell the same (really the same!) product.

– There are many buyers and sellers.

– There are no costly barriers to starting a business.

– Both consumers and firms are well-informed.

What is individual firm demand under perfect competition?

N firms(Whole Market) One Firm Demand

S=MC

D

D

P

Q Q

P

NQ* Q*

S=MC

P*

Geometry of Profits• Individual firm profits:

– ∏=PDQ*-TC(Q*)– ATC=TC/Q* implies ∏=(PD-ATC)Q*.

• Recall: Why does MC intersect ATC at its trough?

One Firm Profit

Q

P

S=MCATC

Q*

PD

Putting it together: perfect competition.

• Individual profits must be zero.

• If profits were negative, firms would shut down.

• If profits were positive, more firms would enter market

N firms One Firm Demand One Firm Profit

S=MC

D

D

P

Q Q Q

P P

NQ* Q*

S=MC S=MCATC

Q*

Why does firm entry squeeze out profits?

A. An entering firm can steal all unmet demand.

B. An entering firm causes quantity sold by each original firm to decrease.

Answer: B• Assume profits (red rectangle) are positive and the market quantity is is

NQ*.• If another firm enters market, NQ* quantity now shared amongst N+1 firms.• In this case, Q* being produced by each firm reduces to N(N+1)Q* being

produced by each firm, so red rectangle gets smaller.

One Firm Profit

Q

P

S=MCATC

Q*

PD

N/(N+1)Q*

Market Power

• Another interpretation of ``price takers’’ is that they have no market power.

• Conversely, but equivalently, market power is the ability of an individual firm to set the going price in the market place.

• What are some sources of market power?

Some sources of market power

1 Exclusive control of inputs.

2 Patents and copyrights.

3 Government licenses.

4 Network economies.

When market power allows one firm to take over the market, that firm is called a monopoly.

Fifth type: Natural monopolies

• Average production cost falls as output increases

• One source: Economies of scale

• Another source: High fixed costs

High Fixed Costs

• FC = fixed cost (start-up cost)

• MC=marginal cost (assume constant: Example is one more unit takes one more laborer which costs one more wage)

• TC=FC + VC

• ATC=FC/Q + VC/Q where VC/Q=MC

Q

ATC=FC/Q+MC

MC

High Fixed Costs Due to R&D

• Approximate cost of building a state-of-the-art manufacturing plant for microprocessors in Asia: $3 billion.

• Average cost of bringing a new drug to market: $1.3 billion.

• Annual R&D expenditures

– Google: 5.2 billion

– Microsoft: 9.4 billion

– Apple: 2.6 billion

– Pfizer: 8.4 billion

Recall what a perfectly competitive market is

• Characteristic of perfectly competitive markets:

– All firms sell the same (really the same!) product.

– There are many buyers and sellers.

– There are no costly barriers to starting a business.

– Both consumers and firms are well-informed.

• Which do monopolies contradict?

The Essential Difference Between Perfectly and Imperfectly Competitive Firms

P P

Q Q

D

D

Perfectly Competitive Firm

Imperfectly Competitive Firm

Under perfect competition, P* is the market price. What price would a

profit-maximizing firm charge if there were no competition, ie, one firm?

A. PA

B. PB

C. PC

D. PD(=0)

E. P*

Q*

PA

PB

PC

PD

Q

MC

PD

MR

P*

P

Deciding Quantity

• Q=8, P=4,

MC=3, MR=0

MC>MR, decrease Q

• Q=4, P=6

MC=1.5, MR=4

MC<MR, increase Q

• Q=6, P=5

MC=2=MR, optimal Q

Q determined by setting MC=MR

$

MR

D

16

8

8

MC

642

1

2

3

4

5

6

7

10 12 14

Deciding Price

• Q=6, P=5

MC=2=MR, optimal Q

Q determined by setting MC=MR

• Don’t charge $2! Trace up to demand curve; consumers willing to pay $5 when Q=6, so charge them that.

$

MR

D

16

8

8

MC

642

1

2

3

4

5

6

7

10 12 14

Again: Under perfect competition, P* is the market price. What price would

a profit-maximizing firm charge if there were no competition, ie, one

firm?A. PA

B. PB

C. PC

D. PD(=0)

E. P*

P

PA

PB

PC

PD

Q

MC

PD

MR

P*

Q*

22

The Invisible Hand Fails

Q

The socially optimalamount occurs where

MC = MB

The monopolist's optimalamount occurs where

MC = MR

MRQM

D

S=MC

P

PM

23

Causes DWL

QMR

D

P

CS

DWL

PS

24

Which Monopoly should shut down?

$

MR

D

16

8

8

MC

642

1

2

3

4

5

6

7

10 12 14

$

MR

D

16

8

8

MC

642

1

2

3

4

5

6

7

10 12 14

ATC

ATC

A B

25

Answer: A. Recall: Profits=(P-ATC)Q

$

MR

D

16

8

8

MC

642

1

2

3

4

5

6

7

10 12 14

$

MR

D

16

8

8

MC

642

1

2

3

4

5

6

7

10 12 14

ATC

ATC

A: LOSS B: PROFIT

26

Summary: Comparing Monopoly and Perfect Competition

Monopoly

MC = MR

P >MR

P > MC

Deadweight Loss

Perfect Competition

MC = MR

P = MR

P = MC

No Deadweight Loss

Price Discrimination

• Price discrimination: the practice of charging different buyers different prices for essentially the same good.

• How does price discrimination affect output and profits?

• Simple model

– Assume fixed costs=0 and that marginal costs are constant.

– Implies that marginal costs equal average costs

– Example: If marginal cost=5, then if Q=5, TC=25 and ATC (=TC/Q)=5.

Output With and Without Price Discrimination

P P

Q Q

D D

MC=ATC

MR

MC=ATCPS

DWL

CS

Single-Price MonopolistPerfectly Price

Discriminating Monopolist

Can charge each buyer exactly his or her reservation price.

Example

• Rebates: The assumption is that people with high reservation prices are wealthy and that the opportunity cost of their time is too high to be bothered to fill out the paperwork to get the rebate.

What type of monopoly is Verizon / what is the source of its market

power?

1 Exclusive control of inputs.

2 Patents and copyrights.

3 Government licenses.

4 Network economies.

A. Natural monopoly.

Which of the following is price discrimination in this case?

A. Good

B. Bad

C. Can’t Say