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Slides by John F. Hall
Animations by Anthony Zambelli
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 8 / MONOPOLY AND IMPERFECT COMPETITION
2005, South-Western/Thomson Learning
Chapter 8
Monopoly and
Imperfect Competition
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Lieberman & Hall; Introduction to Economics, 2005 2
Monopoly
A monopoly firm is the only seller of a good or service withno close substitutes Market in which the monopoly firm operates is called a monopoly
market
Key concept is notion of substitutability
Definition of monopoly firm or market may seem precise But in real world, definition is not always so clear-cut
Because we all have different tastes and characteristics, wecan have different opinions about what is, and what is not, a
close substitute As a result, we can have different ideas about how broadly or how
narrowly we should define a market when trying to decide if it is amonopoly
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Lieberman & Hall; Introduction to Economics, 2005 3
Why Monopolies Exist
Existence of a monopoly means thatsomething is causing other firms to stay outof the market
Rather than enter and compete with firm alreadythere
What barrier prevents additional firms fromentering the market?
Several possible answers Economies of scale Legal barriers Network externalities
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Lieberman & Hall; Introduction to Economics, 2005 4
Economies of Scale
If economies of scale persist to the point where asingle firm is producing for entire market, themarket is a natural monopoly Market in which, due to economies of scale, one firm can
operate at lower average cost than can two or more firms Unless government intervenes, only one seller
would survivemarket would naturally become amonopoly
Small local monopolies are often natural
monopolies Because they continue to enjoy economies of scale up to
point at which they are serving entire market
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Lieberman & Hall; Introduction to Economics, 2005 5
Figure 1: A Natural Monopoly
B
A
300
C5
12
15
Pieces of Clothingper Week
Dollars
350
LRATC
DMarket
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Lieberman & Hall; Introduction to Economics, 2005 6
Legal Barriers
Sometimes public interest is bestserved by having a single seller in amarket
Many monopolies arise because of legalbarriers including
Protection of intellectual property
Government franchise
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Lieberman & Hall; Introduction to Economics, 2005 7
Protection of Intellectual Property
The words you are reading right now are an example of intellectualproperty, which includes literary, artistic and musical works, andscientific inventions
In dealing with intellectual property government strikes a compromise Allows creators of intellectual property to enjoy a monopoly and earn
economic profit, but only for a limited period of time
Once time is up, other sellers are allowed to enter the market, and it ishoped that competition among them will bring down prices
Most important kinds of legal protection for intellectual property are Patents
Temporary grant of monopoly rights over a new product or scientific discovery Copyrights
Grant of exclusive rights to sell a literary, musical, or artistic work
Copyrights and patents are often sold to another person or firm, but thisdoes not change monopoly status of the market, since there is still justone seller
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Lieberman & Hall; Introduction to Economics, 2005 8
Government Franchise
Large firms we usually think of as monopolies havetheir monopoly status guaranteed throughgovernment franchise
Grant of exclusive rights over a product
Barrier to entry is
Any other firm that enters the market will be prosecuted
Governments usually grant franchises when they
think market is a natural monopoly
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Lieberman & Hall; Introduction to Economics, 2005 9
Network Externalities
Exist when an increase in networks membershipincreases its value to current and potentialmembers
When network externalities are present, joining a
large network is more beneficial than joining asmall network Even if product in larger network is somewhat inferior to
product in smaller one
In addition to advantages of joining a larger
network Advantage in not leaving it once youve joined
Avoiding switching costs
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Lieberman & Hall; Introduction to Economics, 2005 10
Network Externalities
All of this clearly applies to the market for computeroperating systems When you buy a computer already loaded with Microsoft Windows,
you benefit By having a large number of people with whom you can easily share
documents Huge number of computers everywhere you can easily operate
You gain access to many more software programs, like MicrosoftWord, Excel, or Outlook, since many more programs are designedforWindows than for the few alternatives
You can save time by just calling knowledgeable friends orcoworkers
Rather than attempting to contact technical support
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Lieberman & Hall; Introduction to Economics, 2005 11
Monopoly Goals And Constraints
Goal of a monopolylike that of any firmis toearn highest profit possible
However, a monopolist faces constraints Constraint on monopolys cost
For any level of output it might produce, total cost is determinedby Technology of production Price it must pay for its inputs
Demand constraint Monopolists demand curve tells us maximum price monopolist
can charge to sell any given quantity of output And for any level of output it might produce, maximum price it can
charge is determined by market demand curve for its product
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Lieberman & Hall; Introduction to Economics, 2005 12
Monopoly Price or Output Decision
Noncompetitive firmssuch as monopoliesdo not maketwo separate decisions about price and quantity, but ratherone decision Once firm determines its output level, it has also determined its price
When any firmincluding a monopolyfaces a downwardsloping demand curve, marginal revenue is less than priceof output Therefore, marginal revenue curve will lie below demand curve
Monopoly will produce at an output level where marginal
revenue is positive
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Lieberman & Hall; Introduction to Economics, 2005 13
Figure 2: Demand and MarginalRevenue
5,000
BA
18
MR6,00020,000
21,00030,000
20
3038
4850
$60
Demand
FG
C
Number of Subscribers
MonthlyPrice per
Subscriber
15,000
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Lieberman & Hall; Introduction to Economics, 2005 14
The Profit-Maximizing Output Level
To maximize profit, the firm should producelevel of output where MC = MR and
MC curve crosses MR curve from below
For a monopoly, price and output are notindependent decisions
But different ways of expressing the same
decision
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Lieberman & Hall; Introduction to Economics, 2005 16
Profit And Loss
A monopoly earns a profit whenever P > ATC
Its total profit at best output level equals area of arectangle Height equal to distance between P and ATC
Width equal to level of output
A monopoly suffers a loss whenever P < ATC
Its total loss at best output level equals area of arectangle
Height equal to distance between ATC and P Width equal to level of output
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Lieberman & Hall; Introduction to Economics, 2005 17
Figure 4: Monopoly Profit and Loss
E
MR10,000
$40
MC
32
Total
Profit
ATC
D
E
Total Loss
AVC
ATC
MR10,000
40
MC
D
$50
Dollars
(a)
Number ofSubscribers
Dollars
(b)
Number ofSubscribers
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Lieberman & Hall; Introduction to Economics, 2005 18
The Shut-Down Decision
What if a monopoly suffers a loss in short-run?Any firm should shut down if P < AVC at output
level where MR = MC If monopoly suddenly finds that P < AVC,
government will usually not allow it to shutdown, Instead use tax revenue to make up for firms
losses
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Lieberman & Hall; Introduction to Economics, 2005 19
Monopoly in the Long-Run
In the short run, a monopoly may earn an economicprofit or suffer an economic loss But what about the long run?
Important insights of previous chapterperfectly
competitive firms cannot earn a profit in long-runequilibrium However, monopolies may earn economic profit in
long-run A privately owned monopoly suffering an economic
loss in long-run will exit the industry Should not find privately owned monopolies suffering
economic losses in long-run
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Lieberman & Hall; Introduction to Economics, 2005 20
Comparing Monopoly to PerfectCompetition
In perfect competition, economic profit is relentlesslyreduced to zero by entry of other firms In monopoly, economic profit can continue indefinitely
But monopoly differs from perfect competition in another
way Can expect a monopoly market to have a higher price and loweroutput than an otherwise similar perfectly competitive market
By raising price and restricting output, new monopoly earnseconomic profit
Consumers lose in two ways Pay more for output they buy
Due to higher prices they buy less output
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Lieberman & Hall; Introduction to Economics, 2005 21
Figure 5(a/b): Comparing Monopolyand Perfect Competition
100,000
E
$10
D
S
1,000
ATCMC
d$10
Quantity ofOutput
Priceper
Unit
(a) Competitive Market (b) Competitive FirmDollars
perUnit
Quantity ofOutput
2. and each firm produces1,000 units, where P= MC.
1. In this competitivemarket of 100 firms,equilibrium price is $10
3.When monopolytakes over, the oldmarket supplycurve . . .
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Lieberman & Hall; Introduction to Economics, 2005 22
Figure 5(c): Comparing Monopoly andPerfect Competition
100,000Quantity of
Output
Priceper
Unit
E
10
D
(c) Monopoly
S= MC
60,000
MR
$15F
6. with a higher price and lower marketoutput than under perfect competition.
4. becomes the monopoly's MCcurve.
5.The monopoly produces where MR= MC,
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Lieberman & Hall; Introduction to Economics, 2005 23
Comparing Monopoly to PerfectCompetition
Changeover from perfect competition to monopoly benefitsowners of monopoly and harms consumers of the product Important proviso concerning this result
In comparing monopoly and perfect competition, price is higher andoutput is lower under monopoly if all else is equal
General conclusion Monopolization of a competitive industry leads to two opposing
effects
For any given technology of production, monopolization leads to higherprices and lower output
Changes in technology of production made possible under monopolymay lead to lower prices and higher output
Ultimate effect on price and quantity depends on relative strengths oftwo effects
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Lieberman & Hall; Introduction to Economics, 2005 24
Monopolistic Competition
Imperfect competition refers to market structures between perfectcompetition and monopoly In imperfectly competitive markets, there is more than one seller, but still too
few to create a perfectly competitive market In addition, imperfectly competitive markets often violate other conditions of
perfect competition, such as the requirement of a standardized product orfree entry and exit
Monopolistic competition is a market sturcture with three fundamentalcharacteristics 1. Many buyers and sellers 2. Sellers offer a differentiated product 3. Sellers can easily enter into or exit from the market
Because it produces a differentiated product, a monopolistic competitorfaces a downward-sloping demand curve When it raises its price a modest amount, quantity demanded will decline
(but not all the way to zero)
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Lieberman & Hall; Introduction to Economics, 2005 25
Monopolistic Competition in the Short-Run
Individual monopolistic competitor behavesvery much like a monopoly
Key difference is this
While a monopoly is the only seller in its market,a monopolistic competitor is one of many sellers
When a monopolistic competitor raises its price,its customers have one additional option
Can buy similar good from some other firm
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Lieberman & Hall; Introduction to Economics, 2005 26
Figure 6: A MonopolisticallyCompetitive Firm in the Short Run
MR1
$70
30
250
d1
A MC
ATC
Dollars
Homes Serviced per Month
2. and charges$70 per home.
4. Kafka's monthlyprofit$10,000isthe area of theshaded rectangle.
1. Kafka services 250 homesper month, where MCandMRintersect . . .
3.ATCat 250 units is lessthan price, so profit perunit is positive.
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Lieberman & Hall; Introduction to Economics, 2005 27
Monopolistic Competition in the Long-Run
Under monopolistic competitionin which there are nobarriers to entry and exitthe firm will not enjoy its profit forlong Entry will continue to occur, and demand curve will continue to shift
leftward
Under monopolistic competition, firms can earn positive ornegative economic profit in short-run But in long-run, free entry and exit will ensure that each firm earns
zero economic profit just as under perfect competition
In real world, monopolistic competitors often earn economicprofit or loss in the short-run
Butgiven enough timeprofits attract new entrants, and lossesresult in an industry shakeout
Until firms are earning zero economic profit
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Lieberman & Hall; Introduction to Economics, 2005 28
Figure 7: A MonopolisticallyCompetitive Firm in the Long Run
d2MR2
E
MC
$40
100 250
Dollars
Homes Servicedper Month
ATC
MR1
In the long run, profit attractsentry, which shifts the firm'sdemand curve leftward.
The typical firm
produces whereits newMRcrosses MC.
d1
Entry continues until P= ATCat the best output level, andeconomic profit is zero.
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Lieberman & Hall; Introduction to Economics, 2005 29
Nonprice Competition
If monopolistic competitor wants to increase its output it cancut its price Move along its demand curve
Any action a firm takes to increase demand for its outputother than cutting its priceis called nonprice competition
Examples include better service, product guarantees, free homedelivery, more attractive packaging
Nonprice competition is another reason why monopolisticcompetitors earn zero economic profit in long-run
All this nonprice competition is costly
Must pay for advertising, for product guarantees, for better stafftraining Costs must be included in each firms ATC curve, shifting it upward
None of this changes conclusion that monopolisticcompetitors will earn zero economic profit in long-run
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Lieberman & Hall; Introduction to Economics, 2005 30
Oligopoly
When just a few large firms dominate a market So that actions of each one have an important impact on
the others
Would be foolish for any one firm to ignore its
competitors reactions In such a market, each firm recognizes its strategic
interdependence with others
An oligopoly is a market dominated by a small
number of strategically interdependent firms
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Lieberman & Hall; Introduction to Economics, 2005 31
Economies of Scale: NaturalOligopolies
When minimum efficient scale (MES) for a typicalfirm is a relatively large percentage of market
A large firmsupplying a large share of the marketwillhave lower cost per unit than a small firm
Since small firms cant compete, only a few large firms survive Market becomes an oligopoly
Tends to happen on its own unless there is governmentintervention
Such a market is often called a natural oligopolyanalogous to
natural monopoly
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Lieberman & Hall; Introduction to Economics, 2005 32
Reputation as a Barrier
A new entrant may suffer just from being new
Established oligopolists are likely to have favorablereputations
In some cases, where potential profits are great,investors may decide it is worth the risk and acceptinitial losses in order to enter industry
In other industries, the initial losses may be too
great and probability of success too low forinvestors to risk their money starting a new firm
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Lieberman & Hall; Introduction to Economics, 2005 33
Strategic Barriers
Oligopoly firms often pursue strategies designed tokeep out potential competitors Maintain excess production capacity as a signal to a
potential entrant that they could easily saturate market
and leave new entrant with little or no revenue Make special deals with distributors to receive best shelf
space in retail stores
Make long-term arrangements with customers to ensurethat their products are not displaced quickly by those of a
new entrant Spend large amounts on advertising to make it difficult
for a new entrant to differentiate its product
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Lieberman & Hall; Introduction to Economics, 2005 34
Legal Barriers
Patents and copyrightswhich can beresponsible for monopolycan also createoligopolies
Like monopolies, oligopolies are not shyabout lobbying government to preserve theirmarket domination
Government barriers can operate againstdomestic entrants, too
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Lieberman & Hall; Introduction to Economics, 2005 35
Oligopoly Behavior
Oligopoly presents the greatest challenge toeconomists
Essence of oligopoly is strategic interdependence Wherein each firm anticipates actions of its rivals when
making decisions In order to understand and predict behavior in
oligopoly markets Economists have had to modify the tools used to analyze
other market structures and to develop entirely new tools
as well One approachgame theoryhas yielded rich
insights into oligopoly behavior
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Lieberman & Hall; Introduction to Economics, 2005 36
The Game Theory Approach
Game theory An approach to modeling strategic interaction of
oligopolists in terms of moves and countermoves
In all gamesexcept those of pure chance, such
as roulettea players strategy must take accountof the strategies followed by other players
Game theory analyzes oligopoly decisions as ifthey were games by
Looking at the rules players must follow Payoffs they are trying to achieve
Strategies they can use to achieve them
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Lieberman & Hall; Introduction to Economics, 2005 37
Simple Oligopoly Games
Duopoly
Oligopoly market with only two sellers
Assume that Gus and Filip must make their
decisions independently Without knowing in advance what the other will do
No matter what Filip does, Guss best move is tocharge a low pricehis dominant strategy
A similar analysis from Filips point of view, would tell usthat his dominant strategy is the same: a low price
Equilibrium price in market is the low price
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Lieberman & Hall; Introduction to Economics, 2005 38
Fig. 4: A Duopoly Game
Confess
Confess
Dont Confess
Filips Actions
Guss profit= $25,000
FilipsProfit =$25,000
Guss profit= $10,000
Guss profit
= $75,000
Guss profit
= $50,000
FilipsProfit =$10,000
FilipsProfit =$75,000
FilipsProfit =$50,000
Guss Actions
Dont Confess
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Lieberman & Hall; Introduction to Economics, 2005 39
Cooperative Behavior in Oligopoly
In real world, oligopolists will usually getmore than one chance to choose their prices
The equilibrium in a game with repeated
plays may be very different from equilibriumin a game played only once
Often, firms will evolve some form of cooperation
in the long run
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Lieberman & Hall; Introduction to Economics, 2005 40
Explicit Collusion
Simplest form of cooperation is explicit collusion Managers meet face-to-face to decide how to set prices
Most extreme form of explicit collusion is creation of a cartel Group of firms that tries to maximize total profits of the group as a
whole
If explicit collusion to raise prices is such a good thing foroligopolists, why dont they all do it? Usually illegal
Penalties, if the oligopolists are caught, can be severe
But oligopolists can collude in other, implicit ways
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Lieberman & Hall; Introduction to Economics, 2005 41
Tacit Collusion
Any time firms cooperate without an explicitagreement, they are engaging in tacit collusion
Tit for tat
A game-theoretic strategy of doing to another player thisperiod what he has done to you in previous period
However, gentle reminder of tit-for-tat is not alwayseffective in maintaining tacit collusion
Oligopolist will sometimes go further Attempting to punish a firm that threatens to destroy tacit
cooperation
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Lieberman & Hall; Introduction to Economics, 200542
Tacit Collusion
Another form of tacit collusion is price leadership One firmthe price leadersets its price and other
sellers copy that price
With price leadership, there is no formal agreement
Rather the decisions come about because firms realizewithout formal discussionthat system benefits all ofthem
Decisions include Choice of leader Criteria it uses to set its price Willingness of other firms to follow
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Lieberman & Hall; Introduction to Economics, 200543
The Limits to Collusion
Oligopoly powereven with collusionhasits limits
Even colluding firms are constrained by market
demand curve Collusioneven when it is tacitmay be illegal
Collusion is limited by powerful incentives tocheat on any agreement
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Lieberman & Hall; Introduction to Economics, 200544
Antitrust Legislation and Enforcement
Antitrust enforcement has focused on three types of actions Preventing collusive agreements among firms
Such as price-fixing agreements
Breaking up or limiting activities of large firmsoligopolists andmonopolistswhose market dominance harms consumers
Preventing mergers that would lead to harmful market domination
Managers of other firms considering anticompetitive moveshave to think long and hard about consequences of acts thatmight violate antitrust laws
While thrust of these policies is to preserve competition Type of competition preservedand zeal with which policies are
appliedcan shift
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Lieberman & Hall; Introduction to Economics, 200545
The Globalization of Markets
By enlarging markets from national ones to global ones,international trade can increase the number of firms in amarket Decreasing market dominance by a few, and increasing competition
Although oligopolists often try to prevent it, they faceincreasingly stiff competition from foreign producers
Entry of U.S. producers has helped to increase competitionin foreign markets for movies, television shows, clothing,
household cleaning products, and prepared foods While consumers in each nation may have access to more
firms, these may be larger and more powerful firms Creating greater likelihood of strategic interaction and danger of
collusion
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Lieberman & Hall; Introduction to Economics, 200546
Technological Change
Technological change works to increase competition bycreating new substitute goods
Can reduce barriers to entry in much the same way thatglobalization does By increasing size of market
Technologythe internethas enabled residents in manysmaller towns to choose among a dozen or more onlinesellers of the same merchandize Trend can also be seen as encouraging oligopoly Result could be strategic interaction, or collusion, among large
national players
Finally, some technologies actually increase MES of typicalfirm Thereby encouraging formation of oligopolies
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Lieberman & Hall; Introduction to Economics, 200547
The Four Market Structures: APostscript
Different market structures
Perfect competition
Monopoly
Monopolistic competition Oligopoly
Market structure models help us organize
and understand apparent chaos of real-worldmarkets