chapter monopoly 15. why monopolies arise monopoly firm that is the sole seller of a product...

Chapter

Monopoly

15

Why Monopolies Arise• Monopoly

– Firm that is the sole seller of a product without close substitutes

– Price maker– Barriers to entry

• Legal and Cost Barriers– NBA, Medical, Patents

• Monopoly resources– Oil, Diamonds

• Government regulation• The production process

2

Why Monopolies Arise• Monopoly resources

– A key resource required for production is owned by a single firm

– Higher price• Government regulation

– Government gives a single firm the exclusive right to produce some good or service

– Government-created monopolies• Patent and copyright laws• Higher prices; Higher profits

3

Why Monopolies Arise

• The production process– A single firm can produce output at a lower

cost than can a larger number of producers• Natural monopoly

– Arises because a single firm can supply a good or service to an entire market• At a smaller cost than could two or more firms

– Economies of scale over the relevant range of output

4

FigureEconomies of scale as a cause of monopoly

1

5

Costs

When a firm’s average-total-cost curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the smallest cost

Quantity of output 0

Average total cost

How Monopolies Make Production& Pricing Decisions

• Monopoly versus competition– Monopoly

• Price maker• Sole producer• Downward sloping demand

– Market demand curve

– Competitive firm• Price taker• One producer of many• Demand – horizontal line (Price)

6

FigureDemand curves for competitive and monopoly firms

2

7

Price

Because competitive firms are price takers, they in effect face horizontal demand curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it faces the downward-sloping market demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it wants to sell more output.


(a) A Competitive Firm’s Demand Curve

Price


(b) A Monopolist’s Demand Curve

Demand

Demand


• A monopoly’s revenue – Total revenue = price times quantity– Average revenue

• Revenue per unit sold– Total revenue divided by quantity

– Marginal revenue• Revenue per each additional unit of output

– Change in total revenue when output increases by 1 unit

• Can be negative

• For a monopolist: always MR < P8


• Increase in quantity sold– Output effect

• Q is higher• Increase total revenue

– Price effect• P is lower• Decrease total revenue

• Because MR < P– MR curve – is below the demand curve

9

FigureMonopoly MR and Demand

Figure

Price

21

-1-2-3

543

6789

10$11

-4

Demand and marginal-revenue curves for a monopoly

3

11

The demand curve shows how the quantity affects the price of the good. The marginal-revenue curve shows how the firm’s revenue changes when the quantity increases by 1 unit. Because the price on all units sold must fall if the monopoly increases production, marginal revenue is always less than the price.

Quantity of water

01 2 3 4 5 6 7 8

Demand(average revenue)

Marginal revenue


• Profit maximization• Δ Π = ΔTR – ΔTC

– If ΔTR > ΔTC increasing production increases profits– OTW if ΔTR < ΔTC increased production reduces

profits

ΔTR = Marginal Revenue (how much TR changes when 1 more unit is sold)

ΔTC = Marginal CostProfit Max occurs when Δ Π = 0 or ΔTR = ΔTC

general rule: profit max’ed at MR = MC12


• Profit maximization– Or since ΔTR = Marginal Revenue

• And ΔTC = Marginal cost– If MR > MC – increase production– If MC > MR – produce less

– Maximize profit• Produce quantity where MR=MC• Intersection of the marginal-revenue curve and

the marginal-cost curve

13

FigureProfit maximization for a monopoly

4

14

Costsand

Revenue

A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B).

Quantity0

Average total cost

Demand

Marginal revenue

Marginal cost

QMAX

BMonopolyprice

A

1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity . . .

2. . . . and then the demand curve shows the price consistent with this quantity.

Q1 Q2

FigureIn Contrast – Perfect Competition

In the long runThe super-normal profit derived by the firm in the short run acts as an incentive for new firms to enter the market, which increases industry supply and market price falls for all firms until only a normal profit is made (accounting +, but economic profit = 0)


• Profit maximization– Perfect competition: P=MR=MC

• Price equals marginal cost– Monopoly: P>MR=MC

• Price exceeds marginal cost

• A monopoly’s profit– Profit = TR – TC = (P – ATC) ˣ Q

16

FigureThe monopolist’s profit

5

17

Costsand

Revenue

The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the number of units sold.

Quantity0

DemandAveragetotalcost

BE

D

Marginal revenue

QMAX

Average total cost

Marginal cost

Monopolyprice

C

Monopolyprofit

Figure Deadweight Loss of Monopoly

FigureContrasting Competition and Monopoly

Competitive Markets Monopoly

Many firms One firm

Produces efficient level of output

(since P = MC)

Produces less than the efficient level of output

(since P > MC)

Cannot earn long run economic profits

May earn long run economic profits

Has no market power (is a price taker)

Has significant market power(is a price maker)

FigureThe Problems with Monopoly

• Monopolies can make societies worse off– Restricting output and charging higher prices

compared to competitive markets– Operate inefficiently (deadweight loss). This

is referred to as market failure.– Less choices for consumers– Unhealthy competition called “rent seeking”

• Market for pharmaceutical drugs– New drug, patent laws – monopoly

• Produce Q where MR=MC• P>MC

– Generic drugs – competitive market• Produce Q where MR=MC• And P=MC

• Price (competitively produced generic drug)– Below the price(monopolist)

Monopoly drugs versus generic drugs

21

• Allergy sufferers got another Christmas present in 2007 when the patent on Zyrtec, another non-sedating antihistamine, expired. Zertec is now available OTC for about a dollar a pill for the brand name product, while the generic cetirizine costs only $15 to $45 for a bottle of 90 tablets — enough to get through 3 months of the allergy season for those with seasonal allergic rhinitis. It’s also available as a chewable tablet or liquid for children (at a lower dose) and combined with a Decongestant in a capsule.

Monopoly drugs versus generic drugs

22

• Specialists in infectious disease are protesting a gigantic overnight increase in the price of a 62-year-old drug that is the standard of care for treating a life-threatening parasitic infection.

• The drug, called Daraprim, was acquired y Turing Pharmaceuticals, a start-up run by a former hedge fund manager. Turing immediately raised the price to $750 a tablet from $13.50,.

• “What is it that they are doing differently that has led to this dramatic increase?”

• Turing’s price increase is not an isolated example. While most of the attention on pharmaceutical prices has been on new drugs for diseases like cancer, hepatitis C and high cholesterol, there is also growing concern about huge price increases on older drugs, some of them generic, that have long been mainstays of treatment.

• Although some price increases have been caused by shortages, others have resulted from a business strategy of buying old neglected drugs and turning them into high-priced “specialty drugs.”

Drug Goes From $13.50 a Tablet to $750, Overnight

23

FigureThe market for drugs

6

24

Costsand

Revenue

When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug. When the patent on a drug runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost.

Quantity0

DemandMarginal revenue

Monopolyquantity

Priceduring

patent life

Marginal costPrice afterpatent

expires

Competitivequantity

FigureThe efficient level of output

7

25

Costsand

Revenue

A benevolent social planner who wanted to maximize total surplus in the market would choose the level of output where the demand curve and marginal-cost curve intersect. Below this level, the value of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good. Above this level, the value to the marginal buyer is less than marginal cost.

Quantity0

Demand(value to buyers)

Efficientquantity

Marginal cost

Valueto

buyers

Valueto

buyers

Cost tomonopolist

Cost tomonopolist

Value to buyers is greater than cost to sellers

Value to buyers is less than cost to sellers

The Welfare Cost of Monopolies

• The deadweight loss• Monopoly

– Produce quantity where• MC = MR

– Produces less than the socially efficient quantity of output

– Charge P>MC– Deadweight loss

• Triangle between: demand curve and MC curve

26

FigureThe allocative inefficiency of monopoly

8

27

Costsand

Revenue

Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer).

Quantity0

Demand

Marginal revenue

Monopolyquantity

Marginal cost

Monopolyprice

Efficientquantity

Deadweightloss

FigureProfit maximization for a monopoly

4

28

Costsand

Revenue

A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B).

Quantity0

Average total cost

Demand

Marginal revenue

Marginal cost

QMAX

BMonopolyprice

A

1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity . . .

2. . . . and then the demand curve shows the price consistent with this quantity.

Q1

Q2

MonopolyPC

Price Discrimination

• Price discrimination– Business practice– Sell the same good at different prices to

different customers– Increase profit

29


• Lessons from price discrimination1. Rational strategy

• Increase profit• Charges each customer a price closer to his or her

willingness to pay• Sell more than is possible with a single price

30

$100

8070

50

Price ofAlbums

Measuring consumer surplus with the demand curve

2

31

In panel (a), the price of the good is $80, and the consumer surplus is $20. In panel (b), the price of the good is $70, and the consumer surplus is $40.

0 431 2Quantity of Albums

John’s consumersurplus ($20)

Demand

(a) Price = $80

$100

8070

50

Price ofAlbums

0 431 2Quantity of Albums

John’s consumersurplus ($30)

(b) Price = $70

Paul’s consumersurplus ($10)

Total consumersurplus ($40)

Demand


• Lessons from price discrimination2. Requires the ability to separate customers

according to their willingness to pay• Certain market forces can prevent firms from price

discriminating– Arbitrage – buy a good in one market, sell it in other

market at a higher price

3. Can raise economic welfare• Can eliminate the inefficiency of monopoly pricing

– More consumers get the good– Higher producer surplus (higher profit)

32

Price Discrimination• The analytics of price discrimination• Perfect price discrimination

• Charge each customer a different price– Exactly his or her willingness to pay

• Monopolist - gets the entire surplus (Profit)• No deadweight loss

• Without price discrimination• Single price > MC• Consumer surplus• Producer surplus (Profit)• Deadweight loss

33

FigureWelfare with and without price discrimination

9

34

Price

Panel (a) shows a monopolist that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus.

Quantity0

(a) Monopolist with Single Price

Price

Quantity0

(b) Monopolist with Perfect Price Discrimination

Profit

Consumersurplus

Deadweightloss

Monopolyprice

Quantitysold

Marginalrevenue

Demand

Marginal cost

Quantitysold

Profit

Demand

Marginal cost


• Examples of price discrimination– Movie tickets– Airline prices– Discount coupons– Financial aid– Quantity discounts

35

Public Policy Toward Monopolies• Increasing competition with antitrust laws

– Sherman Antitrust Act, 1890• Reduce the market power of trusts

– Clayton Antitrust Act, 1914• Strengthened government’s powers• Authorized private lawsuits

– Prevent mergers– Break up companies– Prevent companies from coordinating their

activities to make markets less competitive36

Public Policy Toward Monopolies

• Regulation – Regulate the behavior of monopolists

• Price – Common in case of natural monopolies– Marginal-cost pricing

• May be less than ATC• No incentive to reduce costs

37

FigureMarginal-cost pricing for a natural monopoly

10

38

Price

Because a natural monopoly has declining average total cost, marginal cost is less than average total cost. Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost, price will be below average total cost, and the monopoly will lose money.

Quantity0

Average total cost

Loss

Averagetotal cost

Demand

Marginal costRegulatedprice

Public Policy Toward Monopolies

• Public ownership – How the ownership of the firm affects the

costs of production– Private owners

• Incentive to minimize costs– Public owners (government)

• If it does a bad job– Losers are the customers and taxpayers

39

TableCompetition versus monopoly: A summary comparison

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40

Competition Monopoly

SimilaritiesGoal of firmsRule for maximizingCan earn economic profits in short run?

DifferencesNumber of firmsMarginal revenuePriceProduces welfare-maximizing level of output?Entry in long run?Can earn economic profits in long run?Price discrimination possible?

Maximize profitsMR=MC

Yes

ManyMR=PP=MC

YesYes

NoNo

Maximize profitsMR=MC

Yes

One MR<PP>MC

NoNo

YesYes

chapter monopoly 15. why monopolies arise monopoly firm that is the sole seller of a product...

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