Lecture notes 9

MARKET STRUCTURE :

MONOPOLY

Unit 9

Monopoly or Price Maker

• _{A Monopoly is a firm that is}

• _{A single seller producing a product with no close substitutes.}

• _{You either buy the product or go without.}

• _{Effective barriers to entry into the market (legal,} technological, economic).

• _{These barriers block new firms from entering the industry, blocking}

potential competition.

• _{The firm is a price maker; faces a downward sloping} demand curve for its product (this demand curve is the market demand curve).

• _{The firm has considerable control over price since it controls} the quantity supplied and can cause price to change by

Monopoly

• _{One special type of monopoly is a natural monopoly, a}

monopoly that arises because of the existence of economies of scale over the entire relevant range of output and competition is impractical, e.g., water, electricity.

• _{Natural monopolies have low MC and it is to their}

Barriers to Entry

• _{Economies of scale: efficient, low cost producers are usually large firms}

operating under conditions of economies of scale, where AC falls over a range of output. (natural monopoly)

• _{Legal barriers: Patents and Licences - government creates legal} barriers in giving patents and licences.

• _{Ownership of critical raw materials/ resources: a firm that owns a critical} raw material can block the creation of rival firms.

Monopoly Demand, AR, MR, TR, and elasticity

• _{The demand curve facing a monopoly firm is the market}

demand curve (firm is the market).

• _{Since the market demand curve is a downward sloping}

curve, marginal revenue will be less than the price of the good.

• _{The monopolist MR curve is downward sloping and below}

Monopoly Demand, AR, MR, TR, and elasticity

• _{The monopolist can only increase sales if it reduces price,}

this causes MR < P (AR) for all output except the first.

• _{The falling MR means that TR will increase at a}

decreasing rate. Since it must lower price to sell more, the firm’s MR lies below its demand curve.

• _{When a monopoly drops the price to sell one more unit,}

the revenue received from previously sold units also decreases.

• _{TR is maximized at the level of}

output at which demand is unit elastic (and MR = 0).

• _{Since the objective is to}

maximize its profit, the firm will look at its costs and

revenue in determining its output level.

• As long as TR is increasing, MR

is positive.

• When TR is at its maximum,

MR = 0 and when TR is

Profit Maximization of a Monopoly

Marginal revenue Marginal

cost

B

1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity...

A

2. ...and then the demand curve shows the price

The price-quantity combination depends not only on the MR and demand data, but also on costs.

Profit-maximising firms produce the level of output where:

MC = MR (as long as P > AVC).

For the monopoly firm, MR = MC at an output level of Qo and firm will charge Po.

Since Po > ATCo at this level of output, the firm receives economic profit.

• _{A monopoly firm may}

experience losses if P < ATC. The economic

losses equal to the

shaded area. Since price is above AVC, it will

A monopoly firm will shut down in the short run if the price falls below AVC.

It is widely viewed that a monopolist can

charge any price, but the firm is constrained by the demand for its product. If a monopoly firm wishes to

• _{Firms operating in markets other than those of perfect}

competition are able to increase their profits by engaging in price discrimination,

• _{where higher prices are charged to those customers who have the}

Degrees of Price Discrimination

• _{1st degree -Firm charges each customer the most the customer}

would be willing to pay for each unit he or she buys. (i.e. they charge the reservation price)

• _{Example: Negotiating prices with dealers for second hand cars}

• _{2nd degree - Practice of charging different prices per unit for}

different quantities of the same good or service. Price varies

according to quantity sold. Larger quantities are available at a lower unit price.

• _{Example: sales to industrial customers, where bulk buyers enjoy higher}

discounts.

• _{3rd degree - this type of discrimination occurs when each customer}

faces a single price at which they can buy as much as they want, but the price differs by type of customer.

Necessary conditions for price discrimination include:

• _{Monopoly power: the firm control output and price (not be}

a price taker)

• _{Separation of buyers - the firm must be able to sort}

customers according the their elasticity of demand or willingness to pay for the product

• _{No reselling - resale of the product must not be feasible –}

price discrimination may be used in the market for airline travel

Vacation travelers are likely to have a more elastic

demand than business travelers.

The optimal price is higher for business travelers than for vacation travelers. Airlines engage in price discrimination by offering low price "super saver" fares that require a

weekend stay and tickets to be purchased 2-4 weeks in advance.

• _{When countries practice price discrimination by charging}

different prices in different countries, they are often accused of dumping in the low-price countries.

• _{Predatory dumping occurs if a country charges a low price}

Price Discrimination and Dumping

Consequences of discrimination

• _{The monopolist will be able to increase profits by}

engaging in discriminatory price practices.

• _{Monopolist will produce a larger output than a}

The Welfare Cost of Monopoly

• _{A monopoly leads to an inefficient allocation of resources}

and a failure to maximize total economic well-being.

• _{Another way of stating this is that monopolies are}

usually considered bad.

• _{The monopolist produces less than the socially efficient}

quantity of output.

• _{Because a monopoly charges a price above marginal}

cost, consumers who value the good at more than its marginal cost but less than the monopolist’s price won’t buy it.

• _{Monopoly pricing prevents some mutually beneficial}

Economic Effects of a Monopoly

• _{It will be profitable for the monopolist to sell a smaller}

quantity and charge a higher price than would a competitive producer.

• _{The profit maximizing output will result in an under}

allocation of resources since the restricted output uses fewer resources.

• _{Given the same costs, a monopolist will find it profitable}

to charge a higher price, produce a smaller output and misallocate resources compared with a perfectly

Competition VS Monopoly

The introduction of a monopoly firm causes the price to rise from P(pc) to P(m), while the quantity of output falls from Q(pc) to Q(m). The higher price and reduced quantity in the

Regulation of Natural

Monopoly

If the government leaves the

monopolist alone, it will maximize its profits by

producing Q(m) units of output and charging a price of P(m).

Suppose the gov’t attempts to emulate a perfectly

competitive market by setting the P = MC .

Natural Monopoly

An alternative

pricing strategy is to ensure that the owners of the

monopoly receive only a "fair rate of return" on their investment rather than monopoly profits.