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Business Economics
Managerial Decisions for Firms
with Market Power
Monopoly
Thomas & Maurice, Chapter 12
Herbert Stocker
Institute of International StudiesUniversity of Ramkhamhaeng
&Department of EconomicsUniversity of Innsbruck
Monopoly
Definition
A firm is considered a monopoly if . . .
it is the sole seller of its product.
its product does not have closesubstitutes.
Repetition
Remember:
Firms maximize their profits subject to therestrictions they face.There are two kinds of restrictions:
Technological restrictions.Market restrictions.
Repetition
Remember:
Technological restrictions are the same formonopolies and firms on competitive markets;they are embedded in the cost function!(Price P was not needed to derive it!)
Market restrictions differ between monopoliesand firms on competitive markets.
Monopoly & Perfect Competition
Perfect Competition: Every supplier perceivesdemand for his own product as perfectly elastic,he can sell every unit of output for the same price.
⇒ marginal revenue is equal price: MR = P
firms are price-takers!
Monopoly & Perfect Competition
Monopoly: A Monopolist is the only supplier andthere are no close substitutes for his product.
⇒ Monopolist does not loose ALL sales if heincreases price; but he perceives that the demandfor his product is falling when he increases price.
⇒ Monopolistic firms are price-seekers; if they wantto sell more they can do so at lower prices!
This has important implications for the marginalrevenue of a monopoly ⇒ MR 6= P!
Perfect Competition vs. Monopoly
Perfect Competition:
P
Q
‘perceived’Market Demand
Each producer perceives thedemand for his product asperfectly elastic.
Monopoly:
‘perceived’Market Demand
P
Q
Monopolist perceives demandto be less than perfectly elastic.
Total and Marginal Revenue
Example:
Q = 6− P Total Marginal AveragePrice Quantity Revenue Revenue RevenueP Q R = P × Q MR AR = P
6 0 0 – –5 1 5 5 54 2 8 3 43 3 9 1 32 4 8 −1 21 5 5 −3 10 6 0 −5 0
Marginal Revenue
Demand: Q = 6− P ⇒ Inverse Demand: P = 6− Q
[Inverse Demand allows us to express revenue as a function of Q only]
0123456
0 1 2 3 4 5 6
PMR
Q
Revenue:
R = PQ = (6− Q)Q
= 6Q − Q2
Marginal Revenue:
MR ≡dR
dQ= 6− 2Q
Linear demand curves⇒MRcurve is double as steep as de-mand curve!
Marginal Revenue
If a monopolist increases output there are twoeffects:
he can sell the additional produced units of outputonly at a lower price P : P ×∆Q
but he has to sell also all other units of output at thislower price: Q ×∆P
The resulting change in total revenue is therefore
∆R = Q ×∆P + P ×∆Q
Marginal Revenue is
∆R
∆Q≡ MR = Q ×
∆P
∆Q+ P
Marginal Revenue
In detail:
R1 = P1Q1
R2 = P2Q2 /−∆R ≡ R1 − R2 = P1Q1 − P2Q2
= P1(Q1 − Q2) + P1Q2 − P2Q2
= P1(Q1 − Q2) + Q2(P1 − P2)= P1∆Q + Q2∆P
≈ P∆Q + Q∆P
MR= ∆R∆Q
= P+Q ∆P∆Q
Marginal Revenue
With Calculus:
Market Demand is a function of price: Q = Q(P)
We rewrite this and express price as a function ofquantity: P = P(Q).This is called inverse demand function.
Revenue R can then be expressed as a function ofQ only, i.e.
R = P(Q)× Q
For differentiating this use the product rule:
MR ≡dR
dQ=
dP
dQ× Q + P
Marginal Revenue
Rearranging terms gives
MR = P + Q ×∆P
∆Q
= P + P
(Q
P
)(∆P
∆Q
)
= P
(
1 +Q
P
∆P
∆Q
)
= P
(
1 +1
EQ,P
)
= P
(
1−1
|EQ,P |
)
Marginal Revenue
Therefore, marginal revenue depends in a very specificway on the price elasticity of demand:
MR ≡∆R
∆Q= P
(
1−1
|EQ,P |
)
When demand is elastic (|EQ,P | > 1) increasingoutput will increase revenue (MR > 0).
When demand is inelastic (|EQ,P | < 1) increasingoutput will decrease revenue (MR < 0).
Output, Price Elasticity & Revenue
What happens with monopolist’s revenue, when hereduces output?
elastic
inelastic
E = −1
E = −∞
E = 0
P
Q
bc
∆Q
bc∆P
Elastic Demand:
Q ↓ ⇒ P ↑ ⇒ R ↓
elastic
inelastic
E = −1
E = −∞
E = 0
P
Q
bc
∆Q
bc∆P
Inelastic Demand:
Q ↓ ⇒ P ↑ ⇒ R ↑
Monopoly
Example
Therefore a monopolist will never produce a quantityin the inelastic portion of the demand curve. Why?
If demand is inelastic a decrease of quantity wouldincrease revenue.
Producing less would lower cost.
This implies he could make higher profits byproducing less, therefore this cannot be amaximum!
More generally . . .
Profit Maximization
Monopolists like all firms maximize profit, andprofit is the difference between revenue and costπ = R − C
For a maximum it must be true that
dπ
dQ=
dR
dQ︸︷︷︸
MR
−dC
dQ︸︷︷︸
MC
!= 0
Therefore profit maximization implies
MR = MC
This result is true for monopolists and for firms on perfectlycompetitive markets!
Profit Maximization
Perfect Competition
For a firm on a perfectly competitive market demand isperfectly elastic, this implies MR = P .Therefore, profit maximizing firms choose output where
MR = P = MC
Profit Maximization
Monopoly
A monopolist faces falling market demand, thereforemarginal revenue is
MR = P
(
1−1
|EQ,P |
)
Monopolist chooses output and price where
MR = P
(
1−1
|EQ,P |
)
= MC
MR = MC holds generally, but MR differs between firms underperfect and imperfect competition!
Monopoly: Profit Maximization
P
Q
D(P)
MR
AC
MC
MC MR
⇒
LostProfit
MR MC
⇐
What is the profitmaximizing quantity?
MR > MC ⇒ firmshould produce more!
MR < MC ⇒ firmshould produce less!
Monopoly: Profit Maximization
P
Q
D(P)
MR
AC
MC
MC MR
bc
Q∗M
What is the profitmaximizing quantity?
Profits are maximizedwhen the cost of the
last unit are equal the
revenue of the last
unit,
MR = MC
Monopoly: Profit Maximization
P
Q
D(P)
MR
AC
MC
bc
Q∗M
b
bP∗M
b
Monopolies are
‘price-seekers’:
Monopolist choosesthe output whereMR(Q) = MC(Q)
⇒ charges the maxi-mum price consumersare willing to pay forthis output.
Monopoly: Profit Maximization
Profits:P
Q
D(P)
MR
AC
MC
bc
Q∗M
b
bP∗M
b
b
bcπ
Profits are defined as
π = (P − AC)Q
i.e. profits depend
on average cost and
price!
Monopoly: Profit Maximization
Profits:P
Q
D(P)
MR
AC
MC
bc
Q∗M
b
bP∗M
b
b
bc
Loss If AC are high profitsbecome negative, themonopoly runs a loss!
(Still, this output level
minimizes losses.)
Monopoly
In perfect competition, the market supply curve isdetermined by marginal cost.
For a monopoly, output is determined by marginalcost and the shape of the demand curve (demandelasticity).
Since supply depends on the demand curve, thereis no supply curve for monopolistic market.
Shifts in demand usually cause a change in bothprice and quantity.
Example
Monopoly
Profits of a monopolist:
P
Q
b
elastic
inelastic
b
E = −1
E = −∞
E = 0
R
Cb
b
π1 ⇒
b
b
π2⇐
⇒ If R is ‘steeper’ than Cincreasing Q increases Rand π
⇒ If R is ‘flatter’ than Cincreasing Q increases Rand π
Slope of R is MR,Slope of C is MC
Monopoly
Profits of a monopolist:
0
1
2
3
4
0 1 2 3 4
P
Q
R
MR
C
MC
bc
bc
Q∗
P∗
bc
bc
bc
π∗
Market demand: P = 4− Q
Revenue: R = 4Q − Q2
Marginal revenue: MR = 4− 2QCost: C = 0.2Q2 + 0.5Marginal cost: MC = 0.4Q
Condition for profit maximum:
MR = MC
4− 2Q = 0.4Q
Q∗ = 1.667
π∗ = R∗ − C∗ = 2.833
Monopoly
Profits of a monopolist:
0
1
2
3
4
0 1 2 3 4
P
Q
R
MR
C
MC
bc
bc
Q∗
P∗
bc
bc
bc
π∗
Q = 4− P ↔ P = 4− Q
R = 4Q − Q2, MR = 4− 2Q
C = 0.2Q2 + 0.5, MC = 0.4Q
Q P R MR C MC π
0.00 4.00 0.00 4.00 0.50 0.00 -0.500.50 3.50 1.75 3.00 0.55 0.20 1.201.00 3.00 3.00 2.00 0.70 0.40 2.301.50 2.50 3.75 1.00 0.95 0.60 2.801.67 2.33 3.89 0.67 1.06 0.67 2.832.00 2.00 4.00 0.00 1.30 0.80 2.702.50 1.50 3.75 -1.00 1.75 1.00 2.003.00 1.00 3.00 -2.00 2.30 1.20 0.703.50 0.50 1.75 -3.00 2.95 1.40 -1.204.00 0.00 0.00 -4.00 3.70 1.60 -3.70
Monopoly: Alternative Presentation
Profit with Total Cost:
0
1
2
3
4
0 1 2 3 4
P
Q
R
MR
C
MC
bc
bc
Q∗
P∗
bc
bc
bc
π∗
π∗ = R(Q)− C (Q)
Profit with Average Cost:
0
1
2
3
4
0 1 2 3 4
P
Q
MR
MC
bc
bc
Q∗
P∗
ACbc
Attention:
AC(Q∗) = 0.63̇
MC(Q∗) = 0.66̇
π∗
π∗ = (P − AC)Q
Long-Run Profit Maximization
In the long run . . .
Monopolist maximizes profit by choosing toproduce output where MR = LMC, as long asP > LAC
Will exit industry if P < LAC!
Monopolist will adjust plant size to the optimallevel.
Long-Run Profit Maximization
Optimal plant is where the short-run average cost curve is tangent
to the long-run average cost at the profit-maximizing output level.
A General Rule for Pricing
Markup Pricing
RememberMR = P
[
1−1
|EQ,P |
]
= MC
This can be rearranged to express price directly asa markup over marginal cost MC
P =MC
[
1− 1|EQ,P |
]
If e.g. |EQ,P | = 2 thenP = MC/(1− 0.5) = 2×MC,i.e. the monopolist charges double MC!
Markup Pricing
RememberMR = P
[
1−1
|EQ,P |
]
= MC
Another way to rewrite this is
P −MC
P=
1
|EQ,P |
The left-hand side, (P −MC)/P , is the markupover marginal cost as a percentage of price.
Therefore, the optimal markup as a percentage ofprice is simply the inverse of the demand elasticity!
Markup Pricing: Supermarkets &Convenience Stores
Example
Supermarkets:
Many firms, similar products.
The estimated demand elasticity for individualstores is EQ,P ≈ −10
The profit maximizing markup is thereforeP = MC/(1− 0.1) = MC/0.9 ≈ 1.11MC
Empirical evidence shows that prices are set about10 – 11% above MC.
Markup Pricing: Supermarkets &Convenience Stores
Example
Convenience Stores:
Convenience differentiates shops
The estimated demand elasticity for individualstores is EQ,P ≈ −5
The profit maximizing markup is thereforeP = MC/(1− 0.2) = MC/0.8 ≈ 1.25MC
Prices are set about 25% above MC.
Convenience stores might still have lower profits because of lowersales volume and high AFC! . . .
Market Power
If demand is very elastic, there is little benefit tobeing a monopolist; the larger the elasticity, thecloser to a perfectly competitive market.
Pure monopoly is rare; firms with differentiatedproducts have also some (limited) market power.
Firms with differentiated products face adownward sloping demand curve, therefore theywill also produce where price exceeds marginalcost!
→ The analysis in this chapter is also applicable inthese cases.
Sources of Monopoly Power
Why do some firms have considerable monopoly power,and others have little or none?
Managers have little control over elasticity ofdemand;
Sometimes technology or the government ‘helps’;
Monopoly power of a firm falls c.p. as the numberof firms increases;
⇒ Managers would like to create barriers to entry
to keep new firms out of market.
Barriers to Entry
Natural Monopoly
Barriers created by government.
Input barriers.
Economies of scale and mergers.
Brand loyalties.
Consumer lock-in and switching costs.
Network externalities.
Barriers to Entry: Natural Monopolies
Natural Monopoly: when a firm can supply agood or service to an entire market at a smallercost than could two or more firms.
A natural monopoly arises when there areeconomies of scale over the relevant range ofoutput, i.e., average cost curve is falling over therelevant range of output.
Natural monopolies cause market failure, and aretherefore often regulated or run by thegovernment.
Examples include tap water distribution systems,bridges, . . .
Barriers to Entry
Barriers Created by the Government
Licenses (e.g. for physicians and otherprofessionals).Patents and copyrights: The need for patentprotection arises because innovations representnew information that has the characteristics of apublic good.
Public goods: A good that has high costs of exclusionand is nonrival in consumption.Because of free riding behaviour public goods wouldnot be provided on free markets.
Barriers to Entry
Input Barriers
Control over raw materials (e.g. diamonds andDeBeers).Barriers in financial capital markets
Larger firms can get lower interest rates.Smaller firms need more collateral for loans.Smaller firms are perceived as riskier.
Barriers to Entry
Economies of Scale and Mergers
Exist when a firm’s long run average cost curveslopes downward or when lower production costsare associated with larger scale of operation.
Can act as a barrier to entry in different industries(→ MES)
Mergers are particularly important in industrieswith economies of scale, e.g. technology, media,and telecommunications.
Minimum Efficient Scale (MES)
MES & Market Entries:
Average cost at half of the MES (1/2 MES) is aindicator for technological market entry barriers.
Highmarketentrybarriers
AC
Q
bcbc
bc
MES
MES
12MES
Lowmarketentrybarriers
AC
Q
bcMES
bc
MES
12MES
→ important for intensity of competition, Mergers & Acquisitions, . . .
Barriers to Entry
Creation of Brand Loyalties
The creation of brand loyalties through advertisingand other marketing efforts is a strategy thatmanagers use to create and maintain marketpower.
Managers hope that demand for their productbecomes less elastic by these measures.
Barriers to Entry
Consumer Lock-In and Switching Costs
When consumers become locked into certain typesor brands and would incur substantial switchingcosts if they changed.
Managers often use consumer lock-in andswitching costs strategies to gain market power.Examples for consumer lock-in and switchingcosts strategies:
Contractual commitmentsDurable purchasesBrand-specific trainingSpecialized suppliersSearch costsLoyalty programs, . . .
Barriers to Entry
Network Externalities
Act as a barrier to entry because the value of aproduct depends on number of customers usingthe product.
Can be considered demand-side economies ofscale, in contrast to supply-side economies.
Example: software systems.
Social Costs of
Monopoly Power
Social Costs of Monopoly Power
P
Q
Q(P)MR
MC = AC
b
b bP∗C
Q∗C
bc
b
b bP∗M
Q∗M
(For simplicity we assume constant MC andAC.)
Monopoly powerresults in higherprices and lowerquantities.
However, doesmonopoly powermake consumers andproducers in theaggregate better orworse off?
→ compare producerand consumersurplus.
Perfect Competition & Welfare
P
Q
Qs
Qd
bcValueto
buyersCost toproducers
Value to buyersis greater thancost to sellers!
Cost toproducers
Value tobuyers
Value to buyersis less than
cost to sellers!
Perfect Competition & Welfare
P
Q
Qs
Qd
Consu-mer surplus
Producersurplus
bc
Perfect competition is efficient, becausethe allocation of resources
maximizes totalsurplus!
P∗C
Q∗C
Monopoy & Welfare
P
Q
MC
D
bcP∗C
Q∗C
bc
MRbcPM
QM
DeadweightLoss
Social Costs of Monopoly
Social cost of monopoly may exceed thedeadweight loss.
The incentive to engage in monopoly practices isdetermined by the profit to be gained.
⇒ Rent Seeking: Firms may spend to gainmonopoly power
LobbyingAdvertisingBuilding excess capacity
Public Policy Toward Monopolies
Government responds to the problem of
monopoly in one of four ways:
Making monopolized industries more competitive.
Regulating the behavior of monopolies.
Turning some private monopolies into publicenterprises.
Doing nothing at all (if the market failure isdeemed small compared to the imperfections ofpublic policies).
Antitrust Laws
Antitrust laws are a collection of statutes aimedat curbing monopoly power.Antitrust laws give government various ways topromote competition.
They allow government to prevent mergers.They allow government to break up companies.They prevent companies from performing activitiesthat make markets less competitive.
Antitrust Issues
Legislation limits market power of firms andregulates how firms use their market power tocompete.Antitrust legislation focuses for example on . . .
Price discrimination that lessens competition.The use of tie-in sales and exclusive dealings.Mergers between firms that reduce competition.
Antitrust Issues
Focus of the Horizontal Merger Guidelines:
Definition of the relevant market.
Level of seller competition in that market.
Possibility that a merging firm might affect priceand output.
Nature and extent of entry into the market.
Other factors influencing coordination amongsellers.
Extent to which any cost savings and efficienciescould offset increase in market power.
Measures of Market Power
Lerner Index:
measure of market power that focuses on thedifference between a firm’s product price and marginalcost of production.
L =P −MC
P=
1
|EQ,P |
Under perfect competition, i.e. when P = MC,L = 0.
When L = 1 the market power is highest possible.
Measures of Market Power
Cross Elasticity of Demand:
Percentage change in the quantity demanded of goodX relative to the percentage change in the price ofgood Y:
EQX ,PY=
∂QX
∂PY
PY
QX
The higher the cross price elasticity, the greater thepotential substitution between goods and, therefore,the lower is market power.
Measures of Market Power
Concentration Ratios:
Measure market power by focusing on share of themarket held by the largest firms.
Assume that the larger the share of the marketheld by few firms, the more market power thosefirms have.Problems:
Describe only one point on the size distribution.Market definitions may be arbitrary.
Regulation
Government may regulate the prices that the monopolycharges:
The allocation of resources will be efficient if priceis set to equal marginal cost.
However, in natural monopolies this will result in aloss! (When average cost (AC) fall marginal cost (MC) must be
lower than AC. Optimal pricing P = MC would therefore result in
losses!)
In practice, regulators will allow monopolists tokeep some of the benefits from lower costs in theform of higher profit, a practice that requiressome departure from marginal-cost pricing.
Public Policy Toward Monopolies
Rather than regulating a natural monopoly that isrun by a private firm, the government can run themonopoly itself (e.g., sometimes the governmentruns the Postal Service).
Government can do nothing at all if the marketfailure is deemed small compared to theimperfections of public policies.
Any questions?
Thanks!