Session 3

MonopolyMonopoly

Managerial Economics

Professor Changqi Wu

Monopoly Slide 2

Topics for Today

What is a monopoly?

How does a monopolist behave?

How to sustain a monopoly position?

Monopsony

Consequences of monopoly

Monopoly Slide 3

1. What is A Monopoly?

One firm supplies a good or a service that has no close substitute in a well-defined market

A monopolist enjoys market power market power measures a firm’s ability to

set price

Monopoly Slide 4

Monopoly

Facing a downward-sloping demand curve, a monopolist’s marginal revenue curve lies below her average revenue curve.

How to find marginal revenue As the sole producer, the monopolist works with

the market demand to determine output and price.

Assume a firm with demand: P = 6 - Q

Monopoly Slide 5

Total, Marginal, and Average Revenue

$6 0 $0 --- ---

5 1 5 $5 $5

4 2 8 3 4

3 3 9 1 3

2 4 8 -1 2

1 5 5 -3 1

Total Marginal AveragePrice Quantity Revenue Revenue Revenue

P Q R MR AR

Monopoly Slide 6

Average and Marginal Revenue

Output0

1

2

3

$ perunit ofoutput

1 2 3 4 5 6 7

4

5

6

7

Average Revenue (Demand)

MarginalRevenue

Monopoly Slide 7

2. Behavior of a Monopolist

A monopolist sets the marginal revenue equal to the marginal cost to maximize her profit.

A monopolist has no supply curve.

Price elasticity of demand influences price setting power of a monopolist.

Monopoly Slide 8

Lostprofit

P1

Q1

Lostprofit

MC

AC

Quantity

$ perunit ofoutput

D = AR

MR

P*

Q*

Maximizing Profit When Marginal Revenue Equals Marginal Cost

P2

Q2

Elasticity of Demand and Price Markup

$/Q $/Q

Quantity Quantity

AR

MR

MR

AR

MC MC

Q* Q*

P*

P*

P*-MC

The more elastic isdemand, the less the

markup.

Monopoly Slide 10

Elasticity of Demand and Price Markup

The ratio of incremental profit margin and price is equivalent to the absolute value of the reverse of price elasticity of demand

The markup pricing is based on this principle.

Monopoly Slide 11

Monopoly Power and Profit

Monopoly power does not guarantee profits.

The profit depends on average cost relative to price.

Monopoly Slide 12

3. How does Monopoly Arise?

Monopoly comes into existence because of barriers to entry

Barriers to entryfactors that allow the incumbent firm to

earn positive economic profits and make it costly for new comers to enter the same market

Monopoly Slide 13

Type of Barriers to Entry

Institutional barriers to entry

Technical barriers to entry

Strategic barriers to entry

Monopoly Slide 14

Institutional Barriers to Entry

Exclusive franchising

Licenses

Patent protection

Monopoly Slide 15

Technical Barriers to Entry

Unique resources

Economies of scale and scope

Economy of experiences

Monopoly Slide 16

Strategic Barriers to Entry

Limit pricing

Excess capacity

Product differentiation (brand proliferation)

Monopoly Slide 17

Barriers to Exit

Barriers to exit are the opportunities that a firm must give up by leaving the industry.

Barriers to exit can have a similar effect as barriers to entry.

Monopoly Slide 18

Restraining Competition

Horizontal merger

Joint ventures

Strategic alliance

Trade associations

Monopoly Slide 19

Cartel: A Virtual Monopoly

A cartel is an association of firms that coordinates explicitly the activities of its members

An effective cartel must find ways to restrain competition

Factors facilitating cartel formation market concentration

Concentration ratio: sum of market shares of the largest 4 firms in the same market

Herfindale index: sum of market shares squared of all firms low organizational cost homogenous good

Monopoly Slide 20

4. Monopsony

A monopsonist is the twin sister of a monopolista single buyer faces a lot of competitive sellers

A monopsonist’s marginal expenditure curve lies above the supply curve

A monopsonist sets its marginal expenditure (ME) equal to its marginal value (MV) to maximize her profit

Monopoly Slide 21

ME

S = AE

The market supply curve is the monopsonist’saverage expenditure curve

Monopsonist Buyer

Quantity

$/Q

MV

Q*m

P*m

Monopsony•ME > P & above S

PC

QC

Competitive•P = PC

•Q = Q+C

Monopoly Slide 22

Business in Action

The role of major banksBanks set deposit rates and lending rates

Does the bank act as a monopolist or a monopsonist ?

Monopoly Slide 23

5. Social Cost of Monopoly

Deadweight loss occurs, but it appears to be small

It is costly to create and to sustain monopolistic positionRent seeking

Price mechanism becomes less effective when market conditions change.

Monopoly Slide 24

BA

Lost Consumer Surplus

Deadweight Loss

Because of the higherprice, consumers lose

A+B and producer gains A-C.

C

Deadweight Loss from Monopoly Power

Quantity

AR

MR

MC

QC

PC

Pm

Qm

$/Q

Monopoly Slide 25

Effect of Cost Change on Monopolist

Quantity

$/Q

MCD = AR

MR

Q0

P0 MC’

c

Q1

P1

P

Increase in P: P0P1 > increase in cost

Monopoly Slide 26

Why Is Monopoly Not Necessarily Bad?

Monopoly profit is a carrot

Monopoly profit may stimulate innovationDoes the government’s effort of cracking down

software piracy protect the monopoly interest of Microsoft?

Monopolies are only temporaryThe case of Polaroid

When the economy of scale is significant, a natural monopoly is technically efficient

Monopoly Slide 27

Natural Monopoly

A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms.

Monopoly Slide 28

MC

AC

ARMR

$/Q

Quantity

Setting the price at Pr yields the largest possible

output;excess profit is zero.

Qr

Pr

PC

QC

If the price were regulate to be PC,the firm would lose money

and go out of business.

Pm

Qm

Unregulated, the monopolistwould produce Qm and

charge Pm.

Regulating the Priceof a Natural Monopoly

Monopoly Slide 29

Limiting Market Power

Rules and regulations designed to promote a competitive economy by:Prohibiting actions that restrain or are likely

to restrain competition

Restricting the forms of market structures that are allowable

Makes it illegal to monopolize or attempt to monopolize a market. Merger guidelines.

Monopoly Slide 30

Key Learning Points

Monopoly arises because of the existence of barriers to entry

A monopolist sets her marginal revenue equal to her marginal cost to maximize profit.

Firms can gain market power by restraining competition.

Monopoly reduces social welfare

Attempt to gain monopoly profit may encourage innovation.