Monopoly

Tutorial 9

Page 2

Perfect Competition

Characteristics of Monopoly:- One seller

- No close substitutes

- Barriers to Entry

• Legal

• Technical:

o Ownership of unique resources, such as mineral deposits or land locations

o Natural Monopoly

As ALL firms select an output level to maximize economic profits, to analyze the firm’s output choice, we need:- The firm’s cost curves

- The demand curve facing the firm

Page 3

Demand Curve facing a Monopoly

The demand curve facing a monopoly is the market demand curve, which is downward sloping.

p

Q

D

a

MR

a/b

If a monopoly’s demand curve is linear, it can be shown that its marginal revenue curve is also linear, with the same intercept and twice as steep as the demand curve

Elastic: Q↑(P↓) TR ↑MR > 0

Inelastic: Q↑(P↓) TR ↓MR < 0

Mid-point

Page 4

Demand Curve facing a Monopoly

Mathematical Deviation (for reference only):

If a monopoly’s demand curve is linear, it can be shown that its marginal revenue curve is also linear, with the same intercept and twice as steep as the demand curve

A general form of the inverse demand function of any linear demand curve is:

where a and b are positive constants. The total revenue function can be expressed as

Differentiating the revenue function with respect to Q, the marginal revenue can be derived:

bQap

2)( bQaQQQpR

bQadQ

dRQMR 2)( (8.3)

(8.2)

Page 5

Monopoly Profit Maximization

p($)

Q

D

AC*

Q*

p*

AC

MR

MC

A

Page 6

Discussion Question 1

Consider the market for the Olympic souvenir featuring Fuwa, the official Beijing Olympic mascots. Only the firm obtaining the license from the Beijing Organizing Committee for the Olympic Game (BOCOG) has a monopoly on selling the official Olympic souvenirs. During the summer, the Beijing government devoted much effort to fight counterfeited Olympic souvenirs. Explain how the sale of counterfeited souvenirs would affect the monopoly

Page 7

Discussion Question 1

Suppose the market demand for official Olympic souvenirs drops due to counterfeit. How would a decrease in demand affect the monopoly?

p($)

QD2

Q2

p2

A

AC

MR2

MC

D1MR1

p1

Q1

B

If the monopoly makes a loss, what will it do?

Page 8

Discussion Question 1

Stores around Beijing reported total sales of close to 2.3 billion yuan during the first seven months this year, and have generated over 212 million yuan of taxes, according to the Beijing Youth Daily quoting data from the city's local taxation bureau.

(Source: Olympic souvenir stores see sales boom as team China collects gold , People’s Daily Online, August 22, 2008)

Page 9

Discussion Question 3

In question 1, the firm becomes monopoly because it obtains a license from the BOCOG. If it costs the firm certain amount of money to gain the exclusive right from the BOCOG, what is the maximum amount that the firm is willing to pay?

Because, by assumption, no entry is possible into a monopoly market, the monopolist’s positive profits can exist even in the long run. For this reason some economists refer to the profits that a monopoly earns in the long run as monopoly rents.

- The profits can be regarded as a return to that factor forming the basis of the monopoly, such as a monopoly right granted from government in a form of patent.

- Hence, another possible owner might be willing to pay that amount in rent for the right to the monopoly.

Page 10

Example: CCTV’s Monopoly Rent

CCTV, the state monopoly broadcaster of the 2008 Olympic Game in China, have paid about $9m for the right of coverage, from which it has generated about $400m in advertising revenues.

China’s broadcasting costs for these games were tied up in a rights deal signed in the 1990s (before China was awarded the 2008 games and when China was not winning many medals) to cover the games from 2000 – 2008.

Timo Lumme, marketing director for the International Olympic Committee, said the IOC would now negotiate with mainland China for future games rights, and that he expected to extract a sum well in excess of $100m!

Source: Financial Times, 21 Aug, 2008

Page 11

Welfare Analysis (Chapter 8)

An analysis of the consequences of changing economic conditions on the welfare of market participants.

One commonly used measure of the welfare of society, is the sum of the consumer surplus and producer surplus:

Consumer Surplus = Willingness to pay – Price actually paid - the area under the market demand curve and above the market price up to the

quantity the consumers buy.

Producer Surplus = Price actually received – Willingness to sell- the area above the market demand curve and below the market price up to the

quantity the firms sell.

PSCSTS

Page 12

Competitive Market Equilibrium

p

Q

S (∑MC)

D (willingness to pay)

p*

Q*

(willingness to pay) p1

(marginal cost) p2

Q1 Q2

Willingness to pay > marginal cost

Page 13

Welfare Analysis of Monopoly

Recall that welfare, which is defined as the sum of consumer surplus and producer surplus (i.e. TS = CS + PS), is maximized in the perfectly competitive market equilibrium. Therefore, it is concluded that resources are allocated efficiently under a perfectly competitive market.

To evaluate the welfare effects of a monopoly, we need a precisely defined basis of comparison. It is convenient to think of a monopoly as arising from the “capture” of a competitive industry and to treat the individual firms that constituted the competitive industry as now being single plants in the monopolist’s empire.

It can be easily shown that the social welfare with a monopoly is lower than that with a competitive market.

Page 14

Welfare Analysis of Monopoly

p($)

QD

Qm

pm

A

B

D

C

MR

MC

pc

Qc

E

Competition Monopoly Change

CS A + B + C A – (B + C)

PS D + E B + D B – E

W = CS + PS A + B + C + D + E A + B + D DWL = – C – E

Page 15

Discussion Question 2

Tamiflu, a pricey antiviral pill invented in 1996 in Vietnam and made in part from a spice used in Chinese cookery, had emerged as the world’s first line of defense against bird flu in 2005. The patent to produce Tamiflu was held by Swiss pharmaceuticals giant Roche. The revenues of Tamiflu were over $254 million in 2004 and more than $1000 million in 2005 due to the threat of bird flu. (Source: “Bird flu drug maker won’t share patent,” www.sfgate.com, October 13, 2005.)

a) As many countries anticipated of the outbreak of bird flu, they started to stockpile Tamiflu. Explain how it would affect the market of Tamiflu and the profits of Roche.

b) Because of the high price, many developing countries could not afford to buy large amount of Tamiflu. The World Health Organization suggested Roche to voluntarily give up the patent and allow other firms to produce the life-saving drugs. However, the company spokesman Terry Hurly replied, “Roche … fully intends to remain the sole manufacturer of Tamiflu.”

Show the consumer surplus, producer surplus and total surplus in the diagram and discuss why WHO made such suggestion.

Why government still grant patent?

Page 16

Regulation of Monopoly

Optimal price regulation (price ceiling): MC Pricing

p($)

QD

Qm

pm

MRr

MC

pc

Qc

MR

Price Ceiling

Page 17

Regulation of Monopoly

There are two problems in regulating monopoly by price ceiling:- How to determine the optimal price?

Discussion Question 4: Describe the effects on output and welfare if the government regulates a monopoly so that it may not charge a price above , which lies between the unregulated monopoly price and the optimally regulated price.

- MC pricing to regulate a natural monopoly?

p($)

QD

AC

MRMC

Qc

pc

pm

Qm

Page 18

Barriers to Entry: Natural Monopoly

Natural Monopoly

- If one firm can produce the total output of the market at lower cost than several firms could, the market is a natural monopoly.

p($)

QD

AC

MRMC

Q1

AC1

Q1/2

AC2

Total cost of producing Q1 with 1 firm = AC1 x Q1

Total cost of producing Q1 with 2 firms = AC2 x Q1

Page 19

Price Discrimination

In some circumstances a monopoly may be able to increase profits by departing from a single-price policy for its output. (Why?)

A monopoly engages in price discrimination if it sells otherwise identical units of output at different prices and the price differential is not reflecting the cost differential.

Certain features must be present for a firm to exercise price discrimination:

- The firm must have some market power

- The firm must have some information about the consumers’ willingness to pay differ among consumers

- The firm must be able to prevent resale:

Page 20

First-Degree (Perfect) Price Discrimination

p($)

QD = MRd

Qm

pm

A

B

D

C

MR

MC

pc

Qc

E

Competition Monopoly Perfect Price Discrimination

CS A + B + C A 0

PS D + E B + D A + B + C + D + E

W = CS + PS A + B + C + D + E A + B + D A + B + C + D + E

DWL 0 C + E 0

The monopoly sells each unit at a price = maximum willingness to pay

Page 21

Third-Degree (Multimarket) Price Discrimination

Exercising first-degree price discrimination is usually difficult (why?). However, the firm may know which groups of consumers are likely to be more willing to pay than others.

Firms use two approaches to divide consumers into groups:

- Directly based on observable characteristics

• Age, gender, student status, country, …

- Allows consumers to self-select the group to which they belong (usually based on their willingness to spend time to obtain a lower price)

• E.g. Coupons,…

Page 22

Second-Degree (Quantity) Discrimination

In many markets each consumer buys more than one unit of the good in a given time period. As a typical consumer’s demand curve is typically downward sloping, the consumer’s willingness to pay decreases as successive units are purchased.

Quantity Discount: The consumer pays one price for units consumed in the first block (up to a given quantity) and a different price for subsequent blocks.

p($)

QD

Q2

pm

A

B

D

C

MR

MCpc

Qc

E

G H I

F

J

p1

p2

Q1 Qm

2nd block: Qm – Q1

3rd block: Q2 – Qm

Page 23

Discussion Question 5

The HK supermarket giant, ParknShop are issuing “MoneyBack Rewards Card,” which are needed to take advantage of discounts.

Supermarkets can then set consumer-specific prices to willing customers and collecting information on their purchases. Ideally, supermarkets can use that data to offer customized discount coupons to individuals. What type of price discrimination – first-degree, second-degree, or third-degree – are these personalized discounts.

Page 24

Discussion Question 5

While the supermarket is exercising price discrimination, which type of price discrimination they are using depends on how they use the card:

- If the supermarket can obtain perfect information from the discount card, it may be able to exercise perfect (or close to perfect) price discrimination.

- If the supermarket only records the amount the consumers have bought and offers quantity discount, it is an example of second-degree price discrimination.

- If the (so-called “personalized”) discount offers are actually the same to everyone who are willing to use the discount card, it is actually a mechanism to classify the customers into price-sensitive group and non-sensitive group. This is an example of third-degree price discrimination.