Chapter 10

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

Monopoly

CHAPTER

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What Is a Monopoly?• Monopoly

– A market in which only one firm sells a product with no close substitutes

– The single firm that sells in that market• “No close substitutes”

– Deciding whether a market or firm is a monopoly • Depends on the how easy it is for consumers

to substitute the products of other sellers


How Monopolies Arise• Barriers to entry

– Something causing other firms to stay out of the market • Rather than enter and compete with firms

already there

– Economies of scale– Legal barriers– Network externalities


Economies of scale• Economies of scale

– Firm’s long-run average cost curve slopes downward• The more output the firm produces, the lower

will be its cost per unit

• Natural monopoly – Arises due to economies of scale

• A single firm can produce for the entire market at lower cost than could two or more firms


Figure

Cost per unit would be even higher with three firms (each operating at point C). Since a single firm could produce at lower cost than two or more firms, this market tends naturally toward monopoly.

A Natural Monopoly


1

Dollars

Articles of Clothing per Day

LRATC

$15

12

5

A

C

B

100 150 300

In the figure, the typical firm has an LRATC curve as shown, with economies of scale through an output level of 300, which is assumed to be the maximum market quantity. A single firm could serve the market at a cost of $5 per unit, operating at point A. Two firms splitting this market would each produce 150 units, with each operating at point B on its LRATC curve. Cost per unit would be $12, higher than with just one firm.

Legal Barriers• Legal barriers

– Protection of intellectual property• Literary, artistic, and musical works, as well as

scientific inventions• For a limited period of time

– Enjoy a monopoly and earn economic profit • Patents• Copyright

– Government franchise


Legal Barriers• Patents

– A temporary grant of monopoly rights over a new product or scientific discovery

– 20 years• Copyright

– A grant of exclusive rights to sell a literary, musical, or artistic work

– At least 70 years


TableLargest Patent Infringement Awards


1

Legal Barriers• Government franchise

– A government-granted right to be the sole seller of a product or service

– Any other firm that enters the market will be prosecuted

– The U.S. Postal Service


Legal Barriers• Governments grant franchises

– When they think the market is a natural monopoly

– To serve the public interest by ensuring that there are no competitors that would cause cost per unit to rise

– The seller must submit to either government ownership and control or government regulation over its prices and profits


Network externalities• Network externalities

– Additional benefits enjoyed by all users of a good or service because others use it as well

– Joining a large network is more beneficial than joining a small network

– Market for computer operating systems– Social networking sites


Monopoly Behavior• Goal of a monopoly

– To earn the highest profit possible• A monopolist faces constraints

– Production costs constraints• Technology• Prices of inputs

– Price constraints• Faces a given market demand curve• Tradeoff: the more it charges for its product,

the fewer units it will be able to sell


Monopoly Behavior• Single-price monopoly

– A monopoly firm that is limited to charging the same price for each unit of output sold

• Price discrimination– Charging different prices to different

consumers• Based on differences in the prices consumers

are willing to pay


Monopoly Behavior• Monopoly pricing OR output decision

– One decision– Once the firm determines its output level, it

has also determined its price– Once the firm determines its price, it has

also determined its output level– Downward-sloping demand curve

• The lower the price, the higher the quantity


TableDemand and Revenue at Patty’s Pool


2

Figure

When a firm faces a downward-sloping demand curve, marginal revenue (MR) is less than price, and the MR curve lies below the demand curve. For example, moving from point A to point B, output rises from 3 to 4 units, while price falls from $10 to $9. For this move, total revenue rises from $30 to $36, so marginal revenue (plotted at point C) is only $6—less than the new price of $9.

Demand and Marginal Revenue for Patty’s Pool


2

Dollars

Quantity

9654321 87

13

0123

-2-1

987654

101112

Demand

MR

B

A

C

Monopoly Behavior• Downward-sloping demand curve

– Marginal revenue is less than the price of output

– Marginal revenue curve lies below the demand curve

• Profit maximization– Produce the quantity where MC = MR and

the MC curve crosses the MR curve from below

– The price is found on the demand curve


Figure

Like any firm, the monopolist maximizes profit by producing where MC equals MR. Here, that quantity is 50 thousand units. The price charged ($100) is read off the demand curve. It is the highest price at which the monopolist can sell the profit-maximizing level of output.

Monopoly Price and Output Determination


3

Dollars

Thousands of Subscribers Serviced per Month

$100

50

D1

MR1

E

MC

Monopoly Behavior• Monopoly

– A firm with market power; a price setter• Market power

– The ability of a seller to raise price without losing all demand for the product being sold

• Price setter – A firm (with market power) that selects its

price rather than accepting the market price as a given


Figure

The monopoly in this figure is earning a profit. At the profit maximizing output level (50 thousand), profit per unit is equal to the difference between price ($100) and ATC ($70). Total profit is equal to profit per unit multiplied by the number of units, or $30 × 50,000 = $1,500,000, represented by the blue shaded rectangle.

A Monopoly Earning Profit


4

Dollars


D1

MC

Total Profit

MR1

ATC

50

$100

$70

E

Monopoly Behavior• Profit per unit = P – ATC• A monopoly earns a profit

– Whenever P > ATC• Total profit at the best output level

– The area of a rectangle• Height = distance between P and ATC• Width = level of output


FigureA Monopoly Suffering a Loss


5

The monopoly in this figure is suffering a loss. At the profit maximizing output level (50 thousand), the loss per unit is equal to the difference between price ($100) and ATC ($125). The total loss is equal to loss per unit multiplied by the number of units, or $25 × 50,000 = $1,250,000, represented by the pink shaded rectangle.

Dollars


D1

MC

Total Loss

MR1

ATC

50

$100

$125

E

AVC

Monopoly Behavior• Loss per unit = ATC – P • A monopoly suffers a loss

– Whenever P < ATC• Total loss at the best output level

– The area of a rectangle• Height = distance between ATC and P• Width = level of output


Equilibrium in Monopoly Markets• Equilibrium

– When the only firm in the market, the monopoly firm, is maximizing its profit

• Short run equilibrium– At the output level where MR = MC

• Profit, if P > ATC• Loss, if P < ATC• Shut down, if P < AVC


Equilibrium in Monopoly Markets• The shutdown rule

– Should accurately predict the behavior of most privately owned and operated monopolies

– If a monopoly operates under a government franchise or regulation• And produces a vital service • The government may not allow it to shut down


Equilibrium in Monopoly Markets• Long run equilibrium

– Monopolies may earn economic profit– A privately owned, unregulated monopoly

• Suffering an economic loss in the long run • Will exit the industry


Equilibrium in Monopoly Markets• Comparing monopoly to perfect

competition– All else equal– A monopoly market will have a higher

price and lower output than a perfectly competitive market


FigureComparing Monopoly and Perfect Competition (a, b)


6

Price per unit

Quantity of output

(a) Competitive market

Dollars per unit

Quantity of output

(b) Competitive firm

$10 d=MR

ATC

MC

1,000

E

$10

S

D

100,000

E

1. In this competitive market of 100 firms, equilibrium price is $10 . . .

2. and each firm produces 1,000 units, where P=MC.

3. When a monopoly takes over, the old market supply curve . . .

FigureComparing Monopoly and Perfect Competition (c)


6

Price

per

unit

Quantity

of output

(c) Monopoly

$10

MC

D

100,000

E

4. becomes the monopoly's MC curve.

MR

60,000

F$15

5. The monopoly produces where MR=MC,

6. with a higher price and lower market output than under perfect competition

Equilibrium in Monopoly Markets• An important proviso

– Comparing monopoly and perfect competition• Price is higher and output is lower under

monopoly• If all else is equal


Equilibrium in Monopoly Markets• Monopolization of a competitive industry

leads to two opposing effects– Higher prices and lower output

• For any given technology of production

– Lower prices and higher output• Because of changes in technology of

production

– Ultimate effect on price and quantity depends on which effect is stronger


Equilibrium in Monopoly Markets• Government and monopoly profit

– Monopolies often exist with government permission

– Monopoly’s total profit may be less than that predicted by the analysis• Government regulation• Rent-seeking activity


Equilibrium in Monopoly Markets• Government regulation (government

franchise) – The monopoly must accept government

regulation, often including the requirement that it submit its prices to a public commission for approval

– Keeps economic profit at zero


Equilibrium in Monopoly Markets• Rent-seeking activity

– Any costly action a firm undertakes to establish or maintain its monopoly status

– Time and money spent lobbying legislators and the public for favorable policies• Reduce a monopoly’s profit

• Economic rent – Any earnings beyond the minimum

needed in order for a good or service to be produced


What Happens When Things Change?• An increase in demand, a monopolist will:

– Produce more output– Charge a higher price– Earn a larger profit

• A decrease in demand, a monopolist will:– Reduce output– Charge a lower price– Earn a smaller profit


Figure

Panel (a) shows Zillion-Channel in equilibrium. It is providing 50 thousand units of cable TV service at a price of $100 per month. Panel (b) shows the same firm following an increase in demand from D 1 to D2. With the increased demand, MR is higher at each level of output. In the new equilibrium, Zillion-Channel is charging a higher price ($125), providing more TV service (75 thousand units), and earning a larger profit.

A Change in Demand


7

Dollars


$100

D1

MR1

E

MC

50

(a) Dollars


$100

D1

MR1

E

MC

50

(b)

D2

MR2

75

F$125

What Happens When Things Change?• A cost-saving technological advance

– A monopoly will pass to consumers only part of the benefits from a cost-saving technological change

– Monopoly’s profits will be higher• Costs increase

– A monopoly will pass only part of a cost increase on to consumers in the form of a higher price

– Monopoly’s profits will be lower


Figure

A cost-saving technological advance shifts the monopolist’s marginal cost curve down, from MC1 to MC2. Consumers gain because the price falls, but the drop in price is less than the drop in marginal cost. The monopoly gains because its profit is greater.

A Cost-Saving Technological Change


8

Dollars


$90

MC1

D1

MR1

50

E$100

MC2

60

H

Price Discrimination• Price discrimination

– Charging different prices to different customers for reasons other than differences in cost

• But a price-discriminating monopoly– Divides its customers into different

categories based on their willingness to pay for the good


Price Discrimination• Requirements

– Market power• Downward-sloping demand curve• Price setter

– Identifying willingness to pay• Difficult

– Prevention of resale• More difficult for goods


Price Discrimination• Effects of price discrimination

– Firm: higher profits– Higher price for some consumers

• Above the price they would pay under a single-price policy

– Lower price for some consumers• Below the price they would pay under a

single-price policy


Figure

Panel (a) shows a single-price monopolist, selling 30 dolls per day at $25 each and earning a profit of $450 per day, as shown by the blue shaded rectangle.

Two Kinds of Price Discrimination (a)


9

Dollars

per

Doll

Number of Dolls per Day

DMR

MC=ATC$10

30

$25

Figure

In panel (b), she price discriminates by charging a higher price of $35 for 10 dolls per day, while still charging $25 for the remaining 20 dolls. Profit increases by $100 per day, the area of the dark-shaded rectangle.

Two Kinds of Price Discrimination (b)


9

Dollars

per

Doll


D

MC=ATC$10

10

MR

30

$25

$35

Figure

Panel (c) shows a different type of price discrimination: charging the original $25 on the first 30 dolls, and a lower price on just 10 additional dolls, bringing her total output to 40. Compared to panel (a), her profit in panel (c) rises by $100 per day—the area of the dark-shaded rectangle.

Two Kinds of Price Discrimination (c)


9

Dollars

per

Doll


D

MC=ATC$10

$25

40

MR

30

$20

Price Discrimination• Perfect price discrimination

– Charging each customer the most he or she would be willing to pay for each unit purchased

– Marginal revenue = price of the additional unit sold• Firm’s MR curve is the same as its demand

curve

– Higher profit• At the expense of consumers


Figure

The single-price monopolist sells 30 dolls per day at $25 each. With a constant ATC of $10, she earns a profit of $450 per day, as shown by the blue rectangle in panel (a). However, if she can charge each customer the maximum the customer is willing to pay, shown by the height of the demand curve, then her MR curve is the demand curve she faces. In panel (b), she would sell 60 dolls ,where MC = P at point J. Her profit would increase to the area of triangle HBJ.

Perfect Price Discrimination


10

Dollars per Doll

Number of Dolls

per Day

Dollars per Doll

Number of Dolls

per Day

D

MC=ATC$10

MR

E

30

$25

MR curve before price discrimination

MC=ATC$10

30

$25

D and MR

60

MR curve with perfect price discrimination

B

H

J

(a) Single price (b) Perfect price discrimination

Price Discrimination• A price discriminating firm

– Facing separate market demand curves in different markets (A, B, C, etc. . .)

– Should choose its prices and output levels– So that marginal revenue in each market

is equal to its marginal cost of production:

MRA = MRB = MRC = . . . = MC


Figure

No-Choice Airlines is able to separate travelers into two different types: Business travelers in panel (a) and students in panel (b). In each market, it sells the profit-maximizing number of tickets at which marginal revenue is equal to marginal cost, and it charges the price on the demand curve for that number of tickets. Because the demand curves are different, so are the marginal revenue curves, so price and output will differ in each market. In panel (a), for business travelers, MR = MC at 50 tickets, and No-Choice charges $140. In panel (b), for students, MR = MC at 60 tickets, and No-Choice charges $70.

How a Price-Discriminating Monopoly Sets Prices in Multiple Markets


11

Dollars per Ticket

Number of Round Trip Tickets

(b) StudentsDollars per Ticket

Number of Round Trip Tickets

(a) Business Travelers

D

MC$40

MR

E

50

$140

A

MC$40

MR

60

$70

D

$200

20

F

Price Discrimination• Price discrimination in everyday life

– It can be practiced by any firm that satisfies the three requirements

– Mail-in rebates – Coupons– Sales– College tuition


Why Americans Pay for theWorld’s Pharmaceuticals

• Pharmaceutical industry– We want new and better drugs

• Help cure or manage more diseases• Fewer side effects

– We also want drugs to be inexpensive• Total research and development (R&D)

cost– For each marketable new drug– Is in the hundreds of millions of dollars



• New drugs are costly to develop• More than 10 years to get a profitable drug to

market• A fraction of those that make it most of the

way down the road are deemed safe and effective enough to get government approval for sale

• Incentives for the industry– Internationally recognized patents to the

companies that discover new drugs



• United States funds the bulk of world’s R&D expenditures for new drugs– Only Americans pay the higher monopoly

price for the new drugs• Directly pay full price (without health

insurance)• Indirectly

– Higher premiums charged by insurance companies

– Higher tax payments to cover government-supported medical care



• Those outside the U.S. – Pay the much lower prices

• Their governments negotiate with the pharmaceutical companies

1. How has this lopsided pricing system come about?

2. What are the consequences?

3. Will it continue?


Pfycor’s New Drug

• Pfycor, Inc.– Holds the patent on a new drug– Two markets drug: the U.S. and Europe– Assumptions

• Identical demand curves• MC = ATC = constant

– Can price discriminate

– Maximize profits: MRUS = MREUROPE = MC• Same price in each market


Figure

The two panels illustrate the situation for a monopoly selling a drug in two markets with identical demand curves: The U.S. in panel (a), and Europe in panel (b). In each market, the monopoly sells the profit-maximizing output level at which marginal revenue is equal to marginal cost, and charges a price given by the demand curve at that output level. With identical demand and marginal revenue curves in the U.S. and Europe, the monopoly will sell the same output (70 million doses) and charge the same price ($2.25 per dose) in each market. Production cost is $0.50 per dose, so total revenue exceeds production cost by ($2.25 − $0.50) × 70 million = $122.5 million in each market (the area of the blue shaded rectangles), for a total of $245 million.

Monopoly Pricing in Two Identical Markets


12

Dollars per Dose

Millions of Doses per Year

(b) EuropeDollars per Dose


(a) U.S.

DUS

MC$0.50 MC$0.50

$2.25

DEUROPE

MR

70

$2.25A B

MR

70

Asymmetrical Pricing from Government Bargaining

• In developed countries– Pharmaceutical companies must negotiate

a price with the government • Governments: strong bargaining position

– Can refuse access to their markets entirely– As long as the price is greater than the

production cost, the firm will still want to sell the drug in their country



• Pharmaceutical companies: some bargaining power– If it refuses to sell at a low price, European

patients will not be able to get the drug • Unless they buy it in the U.S. market at the

high monopoly price



• U.S.– Monopoly pricing (higher price)

• Europe– Lower bargained price (slightly above

production cost)– Lower profit


Figure

As in the previous figure, a monopolist sells a drug in the United States in panel (a), and Europe in panel (b), and both markets have the same demand and marginal revenue curves. But in panel (b), European governments negotiate a lower price per dose of $0.75. Additional revenue from each dose sold in Europe is now $0.75, so that is the new (constant) marginal revenue in Europe. With marginal revenue greater than production cost, the monopoly will sell all that Europeans will buy at $0.75 per dose, which is 130 million doses. Production cost is still $0.50 per dose, so in Europe, total revenue exceeds production cost by ($0.75 − $0.50) × 130 million = $32.5 million. Meanwhile, in panel (a) for the U.S., nothing has changed, so price remains at $2.25. In the U.S., total revenue continues to exceed production cost by ($2.25 − $0.50) × 70 million = $122.5 million. Europe now contributes less to R&D expenses and profit ($32.5 million) than does the U.S. ($122.5 million).

Monopoly Pricing with Bargaining in One Market


13

Dollars per Dose


(b) EuropeDollars per Dose


(a) U.S.

DUS

MC$0.50 MC$0.50

$2.25

DEUROPEMR

70

$2.25A B

MR

70

$0.75E

130


• Will Pfycor continue to develop new drugs? – Yes . . . If the profit earned from both

markets is enough to cover Pfycor’s expected R&D expenses • And provide sufficient profit to compensate its

owners for risking their funds



• Consequences for Americans– Americans pay disproportionately to

develop them• Both Americans and Europeans enjoy the

benefits of new drugs

– Pfycor will choose not to develop some new drugs with especially high R&D costs


Threats to Asymmetrical Pricing

• U.S. consumers– Purchase medications from other

countries over the Internet• At prices substantially below U.S. prices

• Parallel trade– The resale of a product to consumers in

another a country without the manufacturer’s consent


Threats to Asymmetrical Pricing

• U.S. legislators– Want to force down U.S. drug prices– Like to repeal the 1987 law that prohibits

importing pharmaceuticals from other countries without the manufacturer’s consent

– Want to empower Medicare to negotiate lower drug prices• Medicaid and the Department of Veteran’s

Affairs can negotiate drug prices


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Chapter 10

Economy & Finance