Extreme Markets II: Monopoly Chapter 6 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be...

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

1

Extreme Markets II: MonopolyChapter 6


2

Introduction


3

USPS

Since 1863, the U.S. Postal Service (USPS) has had a monopoly on light, sealed correspondence known as first-class mail.


4

What’s Ahead

In this chapter we shall study the situation in which a single seller is so dominant and substitutes for its

product are so poor that we can treat that seller as having no competitors who can respond quickly to its

choices.


5

One-Price Monopoly


6

Some Ground RulesProduct definition: The monopolist produces a

single, homogeneous, divisible product or service.

Certainty: The firm knows with certainty the demand and cost conditions it faces.

Ignorance or disregard of rivals: The monopolist attempts to maximize its immediate profit. In particular, it does not consider the possible

reactions of future competitorsor firms that produce close substitutes for its

output.Single price: The monopolist must charge all customers identical prices at all times.


7

Maximizing Revenue and Maximizing Profit

For a monopolist, the marginalrevenue from selling an extra unit

is less than the price for that unit.

For the demand curve at the rightthe monopolist can sell 3 units at

a price of $10, earning $30 inrevenue. To sell 4 units, the

monopolist must lower price to $9,yielding $36 in revenue.

The monopolist can sell 4 units atA price of $9, but the marginal

For the 4th unit is only $6.


8

Maximizing Revenue and Maximizing Profit

Revenue is maximized when MR = 0,at 6 units of output.

Profit is maximized when MR = MC,at 4 units of output.


9

Comparing Monopoly and Perfect CompetitionThis is the demand for spring

water.Assume that MC = 0. Suppose

there are 110 competitive firms each capable of producing 1/10 of a

gallon.With a fixed supply of 11

gallons, theprevailing market price will be

$1.Now imagine a single firm monopolizes

the industry. The monopolist willproduce 6 gallons and charge a price

of $6 per unit.


10

Comparing Monopoly and Perfect Competition – Deadweight Loss

The problem with this monopoly is not the 6 gallons that still change hands. It is

the 5 gallons that are no longer produced

and exchanged. The gallons that go unexchanged

engenderwhat economists call a

deadweight loss—a loss of benefits to consumers and/orproducers that is gained by

no one.


11

Do Monopolies Raise Prices? - Some Historical Cases

Standard Oil of New Jersey: Between 1880 and 1895, John D. Rockefeller’s company controlled

between 82 and 88 percent of U.S. refining capacity. A gallon of refined

oil in the barrel that sold for 9.33 cents in 1880 had fallen to 5.91 cents by 1897.14 Over that period,

Standard Oil increased its output of kerosene by 74 percent and

lubricating oil by 82 percent. (Gasoline was unimportant before the automobile.) In 1892,

Standard Oil refined 39 million barrels of crude oil, which grew to 99 million

barrels in 1911, the eve of the company’s breakup by federal authorities.


12


American Sugar Refining Company: Mergers between competitors in the late 1880s gave American Sugar

95 percent of U.S. sugar-refining capacity in 1893.16. Wholesale refined sugar sold for 9.60 cents a pound in 1880, 6.17 cents in 1890, and 4.97 cents in 1910.

Because the wholesale price of refined sugar is heavily influenced by the price of raw sugar, the margin per pound between the raw and refined

products may be more informative. It fell from 1.44 cents in 1882 to 0.50 cents in 1899.


13


American Tobacco Company: In 1880 (long before health concerns arose), cigarettes were a minor part of tobacco product output, which was mostly cigars and bagged tobacco for pipes and handmade cigarettes. Manufactured cigarettes became popular, but the growth of sales was hindered by high production costs. In 1890, JamesB. “Buck” Duke (benefactor of Duke University) merged 90 percent of U.S. cigarette-making capacity into the American Tobacco Company, which dominated the industry until its forced breakup in 1911. American’s engineers designed and built the first reliable, low-cost cigarette-making machines and continuously improved them. Its cigarettes sold for $2.77 per thousand in 1895, and $2.20 per thousand in 1907. This decline is remarkable because over those years the price of leaf tobacco rose by 40 percent, from 6 cents to 10.5 cents per pound.


14

Do Monopolies Raise Prices? - Innovation or Inefficiency?

This shows that a monopolist

whose marginal costs fall will increase its profits by

raising output and lowering price,

but not by the full drop in cost. Thus, innovation

thatlowers a monopolists

costswill benefit both the monopolist and her

customers.


15

Monopoly in the Long Run

Any monopoly worth having must be hard for competitors to erode quickly.

Some important ones have been based on ownership of a resource with few good substitutes,

like DeBeer’s diamonds.

An exclusive resource can also take the form of intellectual property, like inventions.

Some monopolies exist because competitors are legally unable to challenge them.


16

MULTIPLE-PRICE MONOPOLY


17

Separating Markets by Demand Elasticity: Price DiscriminationHere is the daily market demand curve for sparkling mineral water

that only you produce. Assume that your fixed costs are zero and

marginal cost is $2 a gallon. If you must charge only one price, you

maximize profit by selling 5 gallons at $7 each for a profit of $25.

Assume that later in the day you see another opportunity to sell to buyers

with lower valuations. You set an afternoon price of $4 per gallon for people to take home and drink with

dinner. These customers buy an additional 3 gallons, and your profit

rises to $31.


18

Separating Markets by Demand Elasticity: Price Discrimination

Three principles for successful price discrimination :1. The seller must be able to group buyers by their willingness to pay for the good (elasticity of demand).2. The seller must be able to prevent low-price buyers from reselling their purchases to those who would otherwise pay high prices.3. Barriers to entry must be set for competitors who produce good substitutes and do not price discriminate, because they could take away the seller’s high-price customers.


19

Other Forms of Price Discrimination – The ChevetteJapanese competition with domestic auto producers

began inthe early 1970s, when more economical models

became popular as buyers responded to the gasoline shortages that occurred during that decade’s energy

crises. In 1975, GeneralMotors (GM) introduced the Chevette, a tiny, no-frills Chevrolet that promised fuel economy comparable to

that of Japanese cars. GM charged dealers in the Northeast higher wholesale prices than dealers in

California for identical Chevettes. Why? The Japanese imports were more abundant on the West coast making the demand for Chevettes more price

elastic on the West coast than in the Northeast.


20

Other Forms of Price Discrimination – Parking Garages

Price discrimination does not require actually quoting different prices to customers. The Wells

Fargo Bank Tower in downtown Los Angeles displays this sign at its parking entrance: “First

hour $8, second through fourth hours $5 each, park all day for $25.” Everyone sees the same sign, but customers staying for only an hour pay $8. Those who stay 3 hours pay an average of $6 per hour ($8.00 + 2 × $5.00)/3, and those who stay for 8

hours pay an average of $3.12 per hour. Charging less per hour for longer stays is consistent with the

elasticity rule.


21

Other Forms of Price Discrimination – Discount Coupons

About once a week many households receive large envelopes in

the mail containing discount coupons from such local businesses as carpet cleaners, gardeners, and grocery

stores. Coupon users can save an average of 30 percent on each item offered, but some people throw the

envelope away unopened. Coupons attract people who can be enticed into buying items for a small cash

discount, that is, those with more elastic demands for particular products.


22

VARIATIONS ON PRICE DISCRIMINATION


23

Cover ChargesClubs with live

entertainment often collect a cover charge from all

patrons before they enter. After paying it, you can stay as long as you want and buy as many drinks as you want.With the demand curve for drinks shown, at a price of

$5you would buy 8 drinks. The diagram also shows that you

would be willing to pay a cover charge up to $28.


24

Self-Selection

Some sellers let customers choose from a menu of cover charge/commodity charge combinations. A

supplier of cell phone service might do this by offering two options: (1) a low service (cover) charge

and a high price per minute of use (commodity charge), or (2) a high service charge and a low price

per minute.


25

Tying and Bundling - The Consumer Benefits of Bundling

Goods or services are often sold as packages of potentially separable components. Customers gain in several ways when GM gives them no choice but to

buy cars with preinstalled engines built by the company.

By comparison, most boats are sold without engines. The buyer of a hull can easily install an outboard motor just by clamping it on, and the right motor

depends on the customer.


26

Tying and Bundling - Price Discrimination by Tie-Ins

A seller can also tie two goods together in a single

package to facilitate price discrimination, a potentially profitable strategy if their demands are interrelated. In the early and mid-twentieth

century, for example, International Business Machines Corporation (IBM) dominated the market for punch-card tabulating equipment

used for accounting and other record-keeping purposes. IBM Chose to lease their machines so that they could terminate any customer who did

not use IBM-made punch cards.


27

Tying and Bundling

Bundling unrelated products is a losing strategy. If demands for the two goods are independent, this

strategy cannot possibly raise your profits and more likely will lower them.

A monopolist can increase profits by bundling two goods whosedemands are negatively correlated but will reduce profit by

trying to bundle two goods whose demand is positivelycorrelated.

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