Monopoly

Market Power

• Market power is the ability of a firm to affect the market price of a good to their advantage. In declining order. • Monopoly – A single producer without competition • Oligopoly Power – A small number of producers sometimes acting in concert.

• Monopolistic Competition – Firms selling differentiated products.

Price effects

• There is a demand curve relating the quantity of a product that can be sold at a given price. • Invert the concept: For each quantity, there is a price that the market may bare.

• Change the quantity and change that price • Marginal revenue

Marginal Revenue • For price taking firm, marginal revenue is equal to price.

• For a firm with market power, marginal revenue must include the change in the price that results from a change in quantity.

MR



P



Q Q



P MR



P P



Q Q P



P

(1  1

Demand Elasticity

) 

P

(1  1

e D

)

Example Demand, Revenue, Marginal Revenue

Output 10,000.00

Price 33.0

Revenue 330,000.0

Marginal Revenue 13.7

20,000.00

23.3

466,690.5

10.5

30,000.00

19.1

571,576.8

8.8

40,000.00

16.5

660,000.0

7.8

50,000.00

14.8

737,902.4

7.0

60,000.00

13.5

808,331.6

6.5

70,000.00

12.5

873,097.9

6.0

80,000.00

11.7

933,381.0

5.7

90,000.00

11.0

990,000.0

5.4

100,000.00

10.4 1,043,551.6

P

35.0

30.0

25.0

20.0

15.0

10.0

Demand MR

5.0

0.0

10 20 30 Price 40 50 60 70 80 Marginal Revenue 90

Q

Example

Monopolist • Maximize Revenues by choosing an output level such that marginal revenue equals marginal cost.

• Price will exceed marginal cost. Monopolists will make greater profits than a competitive firm. – Monopolists will charge higher prices and produce less output than a competitive industry. • Profits should attract new entrants to the market.

– Monopoly can only survive if there are some

barriers to entry

.

Monopolist: Constant Cost

Price

P* Q Mono

ATC

Q PC

MC = ATC

D MR

Output

Price

P*

Monopolist: Revenue

Revenues Q*

ATC MC = ATC

D MR

Output

Monopolist: Profits

Price

P* Profit Q*

ATC MC = ATC

D MR

Output

10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 Price

33.0

Revenue

330000

Marginal Revenue

13.66905

23.3 466690.5

10.48863

19.1 571576.8

8.842323

16.5

660000

7.790243

14.8 737902.4

7.042918

13.5 808331.6

6.476632

12.5 873097.9

6.028302

11.7

933381 5.661905

11.0

990000

Cost

80000 160000 240000

320000

400000 480000 560000 640000 720000

Marginal Cost

8 8 8 8 8 8 8 8

Profit

250000 306690.5

331576.8

340000

337902.4

328331.6

313097.9

293381 270000

Monopolist: General Case

MC

Price

ATC

P* MR

Output

D Q*

Price

Monopolist: Revenue

MC ATC

P* Revenues Q* MR

Output

D

Price

Monopolist: Costs

MC ATC

P* Costs Q* MR

Output

D

Price

Monopolist: Profits

MC ATC

P* Profits Q* MR

Output

D

Markups • If a market is competitive, then price will equal marginal cost.

• Degree of market power is often measured as markup over marginal cost

P



MC P

Lerner Index

• Net markups are a measure of the market power of a firm or industry. Referred to as the Lerner index.

P



MC P

• Rule of thumb for a monopolist,

MC



MR



P

(1  1

e D

) 

P



P MC e D

– If markups are below this level, raise prices.

– If markups are above this level, lower prices.

Monopolist’s Schedule

• The more elastic the demand curve, the higher the market power.

• The greater the market power, the greater the markup.

• Firm has more pricing power if good has fewer substitutes.

Barriers to Entry • Total Control over Vital Resource – Alcoa in the aluminum market – DeBeers in Diamond market • Patents or Secret Formula: – Xerox: Controlled photocopying • Regulations: Jockey Club, SDTM – Gambling is a legally restricted monopoly • Returns to Scale: – TownGas is an regulated monopoly supplier of a particular type of piped natural gas (may have competition from LNG)

Natural Monopoly

• In markets with a natural monopoly there may be one firm.

• Economies of scale indicate that at marginal cost pricing firms make a loss.

• Efficient production involves 1 firm. Firm will naturally charge markup and earn profits.

Monopolist: High Fixed Costs

Price

P* Q Mono

ATC

Q PC

ATC

MR

Output

MC

D

.

Regulation

• Government may step in, usually to put a maximum price level. Should be minimum amount necessary to get the firm to operate small decisions that lead to a competitive outcome. • Average cost pricing • Information Problem. A single decision maker may not have full access to enough information.

Monopoly Average Cost Pricing Competition

P

600 500 400

MC

300 200 100 0 0 D MR

ATC

50 100 150 200 250

Q

Monopolistic Competition and Product Differentiation

Monopolistic Competition

• Most firms produce a good that is (to a certain extent) unique. No other good has the exact same properties.

– Coke, Pepsi, President’s Choice • To the extent that you are a unique producer, you will have some market power.

• Price elasticity of individual products are larger than total category. But not infinite as in the case of commodity goods.

Price

Monopolistic Competition: Short-term

MC ATC

P* Q* MR

Output

D

Characteristics of Monopolistically Competitive Markets • Differentiated Products Download • Free Entry into very similar markets.

• Fixed costs of setting up production • Individual firms face downward sloping demand curve and a falling average total cost curve.

– They would sell more if they could at the going rate but lowering their prices to sell more would lead to losses.

No Barriers to Entry

• What happens if new firms can enter?

• If there are profits to be had, entrepreneurs will enter markets to provide close substitutes for profit making goods.

• New goods splitting the market and better substitutes means lower, flatter demand curve.

Price

Monopolistic Competition: Entry of Competitors

MC ATC

Q* D D ′ MR ′

Output

MR

Monopolistic Competition vs. Perfect Competition • On a market-by-market basis, perfect competition will offer greater efficiency both in terms of minimizing deadweight losses and encouraging an efficient production scale. • Monopolistic Competition only occurs with differentiated products. – Greater variety generated by this market may compensate for loss of efficiency.

Price

Monopolistic Competition: Long-term

MC ATC

P* Q* MR D

Output

Monopolistic Competition vs. Perfect Competition • Similar: Both have many firms, both have zero profits and P = ATC. • Different: – P > MC : On the margin, monopolistically competitive firms want more customers. Greater variety generated by this market may compensate for loss of efficiency. – MC < ATC: Firm is operating at a level that does not minimize total costs.

Variety and Monopolistic Competition • Given that most markets have the “feel” of monopolistic competition, do we have too many firms or is variety it’s own reward?

• Does advertising create phony differentiation or provide information?

Monopolistic Competition and Entrepreneurship • New markets are frequently developed. • For many goods, the only barriers to entry is imagination. • Entrepreneurs develop new ideas for new goods. The pay-off for entrepreneurship are short-run monopoly profits. (Ted Turner and CNN). Only in rare cases will firms be able to make long-term monopolistic profits.

Unprofitable Monopolistic Competition: Short-term

Price

MC ATC

P* Q* MR D

Output

Consequences of Market Power • One clear consequence of the existence of market power is that prices are higher than marginal cost and output is smaller than perfect competition.

• Additional consequences of the presence of market power may be: – Complacency by firms managers (i.e. standard corporate governance measures do not generate efficiency) – Rent-seeking: Firms may put effort into constructing artificial barriers to entry rather than producing goods.

Learning Outcomes

• Define marginal revenue. • Characterize the relationship between price, marginal revenue, marginal cost, average total cost, and profits in a monopolistic market. • Measure the degree of market power with the Lerner index. • Describe 4 barriers to entry that may enable monopoly power.

Final Exam

• Date: Saturday, October 25 • Time: 2:30pm • Place: 3007 (L2) & 3008 (L1) • Coverage: Lecture notes covered in class, semi-open book.

• Bring writing instruments, calculator, 1 A4 sized paper with written notes. • Office Hours: 7-8Thur. 15 th Building, 10-12Sat. 2346, Floor HK Club