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5--MONOPOLY

G406, Regulation, Eric Rasmusen, erasmuse@indiana.edu

October 1, 2013

MR = MC

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What does this mean?

Pricing with Market Power

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The simplest case is when the seller has zero marginal cost.

Then its task is to set MR = 0, which means to maximize revenue.

Why not lower all the prices if you aren’t filling up the football stadium?

Note the market failure: some seats were wasted.

Pricing with Market Power

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Linear Demand and Marginal Revenue

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We often use linear (straight line) demand curves in diagrams. When demand is linear, marginal revenue is linear too, with twice as steep a slope. Calculus makes this easy to see. If demand is P = a -bQ , then revenue is R = PQ = (a - bQ)Q = aQ – bQ^2, and marginal revenue is MR=dR/dQ = a - 2bQ, just like demand but with a “2” so it slopes down twice as fast. (I use the notation Q^2 here to mean Q*Q, that is, Q squared.)

Drawing Marginal Revenue

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In drawing, remember that if the demand curve hits the Quantity axis at Q = 10, then the marginal revenue curve hits it at Q = 5.

Also, though quantity demanded is 0 for bigger quantities than 10, the marginal revenue curve keeps going negative, because revenue can certainly decline as output increases.

The Cournot Model

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Profits As Output Rises

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One Firm: A Monopoly

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Asymmetric Cournot Duopoly

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The Reaction Curve

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Asymmetric Reaction Curves

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Firm 2

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Firm 2’s Reaction Function

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Equilibrium Outputs

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Symmetric Cournot Duopoly

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The Symmetric Reaction Curves

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Blank

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Three Firms or More

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Output with N Firms

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Reaction Planes—3 Firms

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N-Firm Outputs

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The Lerner Rule I

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Thus, if the quantity demanded falls by 20% when the price rises by 10%, the elasticity of demand is -2.

The Lerner Rule II

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(old slide)

(new on this slide)

(old slide)

The Lerner Rule III

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MC =100, Elasticity =-2, then P = (-2/(-2+1)(100)= (2)(100)=200. and (P – MC)/P = - 1/(-2) = ½. Elasticity =-3, then P = (-3/(-3+1)(100)= (1.5)(100)=150. and (P – MC)/P = - 1/(-3) = 1/3. The Lerner Rule only applies if demand is elastic. What should the firm do if demand is inelastic?

Price Fixing

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The two most common kinds of illegal monopolizing cases involve:

(a)industries for homogeneous products that have few sellers,

(b) bidders in auctions, whether auctions to sell objects where the high bid wins or auctions for procurement contracts where the low bid wins.

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Harberger Triangles I

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Another source of hope comes from something discovered by Arnold Harberger in 1954: Triangles are smaller than rectangles.

Harberger started by assuming that any 1924–28 manufacturing industry with accounting profit rates above average was earning monopoly profits

Furniture earned a 14% return on capital, 2% more than average, so Harberger took its price to be 2% over marginal cost.

Harberger Triangles II

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From last slide: Price is 2% over marginal cost (draw a triangle on the board)

He used -1 as the elasticity of demand, and calculated that sales were 2% less than the optimum, so the triangle loss of .5 (2) (2) was 2% of furniture sales.

He did this for all manufacturing, and came up with a welfare loss of 1/10 of one percent of GDP.

Harberger Triangle Diagram

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Suppose half of the economy is monopolized so prices rise 20%. Suppose the elasticity of demand for that half of the economy is -1. The triangle is .5(.2)(.2)(.5) of GDP, 1% of GDP, 140 billion dollars.

Does Macro Matter More?

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Prof. Taylor’s Comparison

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Slides after this point probably won’t be used in class

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The Limits of Monopoly

“Caterpillar Inc. closed a 62-year-old locomotive plant in London, Ontario eliminating 450 manufacturing jobs that mostly paid twice US wages.

Caterpillar's decision, ending a standoff with locked-out workers huddled around barrels of burning scrap wood outside the London factory gates, may benefit another downtrodden manufacturing city: Muncie, Ind., where Caterpillar last year opened a locomotive plant and where it is trying to fill jobs at about half the pay workers in Ontario received.

At a job fair in Muncie Saturday, Caterpillar will be offering jobs at that plant at wages ranging from $12 to $18.50 per hour. Wages for most workers at the Ontario plant are about 35 Canadian dollars an hour (US$35.03).”

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Everet v. Williams (1725)

It recites an oral partnership between the defendant and the plaintiff, who was 'skilled in dealing in several sorts of commodities;' and that the parties had 'proceeded jointly in the said dealings with good success on Hounslow Heath, where they dealt with a gentleman for a gold watch' ... Further recitals show how the parties accordingly 'dealt with several gentlemen for divers watches, rings, swords, canes, hats, cloaks, horses, bridles, saddles, and other things to the value of 200 pounds... and that the defendant would not come to a fair account with the plaintiff touching and concerning the said partnership.

http://www.hosteny.com/funcases/highwayman.html

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“The Highwaymen’s Case”

“Whereas, by an order of this Court, made the 29th day of November last, the tipstaff was ordered to take into his custody and bring into this Court William White and William Wreathock the plaintiff's solicitors in this cause --- reflecting upon the honour and dignity of this Court; ... this Court upon consideration had of the premises, doth fyne the said William White 50 pounds, and the said William Wreathock 50 pounds, and commit them to the custody of the Warden of the Fleet until they pay the said fynes.” The defendant was executed 2 years later, and the plaintiff 5 years later.

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Thomas v. UBS (Posner, J.)

“Our plaintiffs ... argue ... that the bank should have prevented them from violatingthe law. This is like suing one’s parents to recover taxpenalties one has paid, on the ground that the parentshad failed to bring one up to be an honest person whowould not evade taxes and so would not subject himselfto penalties.”http://www.leagle.com/xmlresult.aspx?xmldoc=In%20FCO%2020130207166.XML&docbase=CsLwAr3-2007-Curr

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Thomas II

“We needn’t discuss the plaintiffs’ remaining claims—ofnegligence and malpractice—as they are frivoloussquared. This lawsuit, including the appeal, is a travesty.We are surprised that UBS hasn’t asked for the impositionof sanctions on the plaintiffs and class counsel.”

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Packet II Auction Winner: Tommaso Sneider: $14.98.

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