Transcript Chapter 1
Chapter 10
Market Power: Monopoly
Topics to be Discussed
Monopoly Monopoly Power Sources of Monopoly Power The Social Costs of Monopoly Power
Chapter 10 Slide 2
Perfect Competition
Review of Perfect Competition
P = LMC = LRAC
Normal profits or zero economic profits in the long run Large number of buyers and sellers Homogenous product Perfect information Firm is a price taker
Chapter 10 Slide 3
Perfect Competition
P D Market S P Individual Firm LMC LRAC P 0 P 0 D = MR = P q 0 Q 0 Q Q
Monopoly
Monopoly 1) One seller - many buyers 2) One product (no good substitutes) 3) Barriers to entry
Chapter 10 Slide 5
Monopoly
The monopolist is the supply-side of the market and has complete control over the amount offered for sale.
Profits will be maximized at the level of output where marginal revenue equals marginal cost.
Chapter 10 Slide 6
Monopoly
Finding Marginal Revenue As the sole producer, the monopolist works with the market demand to determine output and price.
Assume a firm with demand:
P =
6 -
Q
Chapter 10 Slide 7
Total, Marginal, and Average Revenue Price
P
$6 5 4 3 2 1
Quantity
Q
0 1 2 3 4 5
Total Revenue
R
$0 5 8 9 8 5
Marginal Revenue
MR
-- $5 3 1 -1 -3
Average Revenue
AR
-- $5 4 3 2 1
Chapter 10 Slide 8
Average and Marginal Revenue
$ per unit of output 7 6 5 4 3 Chapter 10 0 2 1 Marginal Revenue 1 2 3 4 Average Revenue (Demand) 5 6 7 Output Slide 9
Monopoly
Observations 1) To increase sales the price must fall 2)
MR < P
3) Compared to perfect competition No change in price to change sales
MR = P
Chapter 10 Slide 10
Monopoly
Monopolist’s Output Decision 1) Profits maximized at the output level where
MR = MC
2) Cost functions are the same (
Q
)
R
(
Q
)
C
(
Q
) /
Q
R
/
Q
C
/
Q
0
MR
MC or MC
MR
Chapter 10 Slide 11
Maximizing Profit When Marginal Revenue Equals Marginal Cost $ per unit of output
P 1 P* P 2
Lost profit Chapter 10
MC AC Q 1 Q* Q 2 MR D = AR
Lost profit Quantity Slide 12
Maximizing Profit When Marginal Revenue Equals Marginal Cost The Monopolist’s Output Decision
At output levels below
MR = MC
the decrease in revenue is greater than the increase in cost (MR > MC).
At output levels above
MR = MC
the increase in cost is greater than the decrease in revenue (MR < MC)
Chapter 10 Slide 13
Monopoly
The Monopolist’s Output Decision
An Example
Cost MC
C
(
Q
) 50
Q
2
C
Q
2
Q
Chapter 10 Slide 14
Monopoly
The Monopolist’s Output Decision
An Example
Demand
P
(
Q
) 40
Q R
(
Q
)
P
(
Q
)
Q
40
Q
Q
2
MR
R
Q
40 2
Q
Chapter 10 Slide 15
Monopoly
The Monopolist’s Output Decision
An Example
MR
MC or
40 2
Q
2
Q Q
10 When
Q
10,
P
30
Chapter 10 Slide 16
Monopoly
The Monopolist’s Output Decision
An Example By setting marginal revenue equal to marginal cost, it can be verified that profit is maximized at
P =
$30 and
Q
= 10.
This can be seen graphically:
Chapter 10 Slide 17
Example of Profit Maximization
Observations Slope of
rr’
= slope of
cc’
and they are parallel at 10 units Profits are maximized at 10 units P = $30, Q = 10, TR = P x Q = $300 TC = $ 150 AC = $15, Q = 10 Profit = TR - TC $150 = $300 - $150
Chapter 10 $ 400 300 200 150 100 50 0
r c
5
r'
C R
c ’
Profits 10 15 20 Quantity Slide 18
Example of Profit Maximization
Observations AC = $15, Q = 10, TC = AC x Q = 150 Profit = TR -TC = $300 - $150 = $150 or Profit = (P - AC) x Q = ($30 - $15)(10) = $150
$/Q 40 30 20 15 10 0 Chapter 10 MC 5 Profit MR 10 15 20 Quantity Slide 19 AR AC
Monopoly
A Rule of Thumb for Pricing We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in practice.
This can be demonstrated using the following steps:
Chapter 10 Slide 20
A Rule of Thumb for Pricing
1 .
MR
R
Q
(
PQ
)
Q
2 .
MR
3 .
E d
P
Q
P Q
P
P
Q P
P
Q
P Q
Q
P
Chapter 10 Slide 21
A Rule of Thumb for Pricing
4 .
Q P
P
Q
5 .
MR
P
P
1
E d
1
E d
Chapter 10 Slide 22
A Rule of Thumb for Pricing
6 .
is maximized @ MR
MC P
P
1 E
D
MC
P
1
MC
1 E
D
Chapter 10 Slide 23
A Rule of Thumb for Pricing
7 .
(P MC)/P 1
E d
(P-MC)/P: the markup over MC as a percentage of price 8. The markup should equal the inverse of the elasticity of demand.
Chapter 10 Slide 24
A Rule of Thumb for Pricing
9 .
P
1
MC
1
E d Assume E d
4
MC
9
P
1 9 4 9 .
75 $ 12
Chapter 10 Slide 25
Monopoly
Monopoly pricing compared to perfect competition pricing: Monopoly P > MC Perfect Competition P = MC
Chapter 10 Slide 26
Monopoly
Monopoly pricing compared to perfect competition pricing: The more elastic the demand the closer price is to marginal cost.
If
E d
is a large negative number, price is close to marginal cost and vice versa.
Chapter 10 Slide 27
Monopoly
Shifts in Demand In perfect competition, the market supply curve is determined by marginal cost.
For a monopoly, output is determined by marginal cost and the shape of the demand curve.
Chapter 10 Slide 28
Shift in Demand Leads to Change in Price but Same Output $/Q MC P 1 P 2 Chapter 10 Q 1 = Q 2 MR 1 D 2 D 1 MR 2 Quantity Slide 29
Shift in Demand Leads to Change in Output but Same Price $/Q MC P 1 = P 2 MR 2 D 1 D 2 Chapter 10 Q 1 Q 2 MR 1 Quantity Slide 30
Monopoly
Observations Shifts in demand usually cause a change in both price and quantity.
A monopolistic market has no supply curve.
Monopolist may supply many different quantities at the same price.
Monopolist may supply the same quantity at different prices.
Chapter 10 Slide 31
Monopoly Power
Monopoly is rare.
However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost.
Chapter 10 Slide 32
Monopoly Power
Scenario: Four firms with equal share (5,000) of a market for 20,000 toothbrushes at a price of $1.50.
Chapter 10 Slide 33
The Demand for Toothbrushes
$/ Q 2.00
At a market price of $1.50, elasticity of demand is -1.5.
$/ Q 2.00
1.50
1.00
10,000 20,000 1.60
1.50
1.40
Market Demand 1.00
30,000 Quantity The demand curve for Firm A depends on how much their product differs, and how the firms compete.
3,000 5,000 7,000 Q A
The Demand for Toothbrushes
$/ Q 2.00
At a market price of $1.50, elasticity of demand is -1.5.
$/ Q 2.00
1.50
1.00
10,000 20,000 1.60
1.50
1.40
Market Demand 1.00
30,000 Quantity Firm A sees a much more elastic demand curve due to competition--E
d
= -.6. Still Firm A has some monopoly power and charges a price which exceeds MC. MC A D A 3,000 5,000 7,000 MR A Q A
Monopoly Power
Measuring Monopoly Power In perfect competition:
P = MR = MC
Monopoly power:
P > MC
Chapter 10 Slide 36
Monopoly Power
Lerner’s Index of Monopoly Power
L = (P - MC)/P
The larger the value of
L
(between 0 and 1) the greater the monopoly power.
L
is expressed in terms of
E d
L
=
(P - MC)/P = -1/E d
E d
is elasticity of demand for a firm, not the market
Chapter 10 Slide 37
Monopoly Power
Monopoly power does not guarantee profits.
Profit depends on average cost relative to price.
Question: Can you identify any difficulties in using the Lerner Index (
L
) for public policy?
Chapter 10 Slide 38
Monopoly Power
The Rule of Thumb for Pricing
P
1
MC
1
E d
Pricing for any firm with monopoly power If
E d
If
E d
is large, markup is small is small, markup is large
Chapter 10 Slide 39
$/ Q Elasticity of Demand and Price Markup The more elastic is demand, the less the markup.
MC $/ Q
P*
MC
P*
MR AR
P*-MC
AR
Q*
Quantity
Q*
MR Quantity
Sources of Monopoly Power
Why do some firm’s have considerable monopoly power, and others have little or none?
A firm’s monopoly power is determined by the firm’s elasticity of demand.
Chapter 10 Slide 41
Sources of Monopoly Power
The firm’s elasticity of demand is determined by: 1) Elasticity of market demand 2) Number of firms 3) The interaction among firms
Chapter 10 Slide 42
The Social Costs of Monopoly Power
Monopoly power results in higher prices and lower quantities.
However, does monopoly power make consumers and producers in the aggregate better or worse off?
Chapter 10 Slide 43
Deadweight Loss from Monopoly Power $/Q
P m P C A
Lost Consumer Surplus Deadweight Loss Because of the higher price, consumers lose A+B and producer gains A-C.
MC B C AR
Chapter 10
Q m MR Q C
Quantity Slide 44
The Social Costs of Monopoly Power
Price Regulation Recall that in competitive markets, price regulation created a deadweight loss.
Question: What about a monopoly?
Chapter 10 Slide 45
Price Regulation
If price is lowered to P
3
output decreases and a shortage exists. $/Q
MR
For output levels above Q
1
the original average and , marginal revenue curves apply.
Marginal revenue curve when price is regulated to be no higher that P
1 .
MC P m P 1 P 2 = P C AC P 3 P 4
Any price below P
4
results in the firm incurring a loss. If left alone, a monopolist produces Q
m
and charges P
m
.
AR Q m Q 1 Q 3 Q c Q’ 3
Quantity If price is lowered to P
C
output increases to its maximum Q
C
and there is no deadweight loss.
The Social Costs of Monopoly Power
Natural Monopoly A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms.
Chapter 10 Slide 47
Regulating the Price of a Natural Monopoly $/Q Natural monopolies occur because of extensive economies of scale Chapter 10 Quantity Slide 48
Regulating the Price of a Natural Monopoly $/Q
P m P r P C
Chapter 10 Unregulated, the monopolist would produce Q charge P
m .
m
and If the price were regulate to be P
C
, the firm would lose money and go out of business.
Setting the price at P
r
yields the largest possible output;excess profit is zero.
AC MC AR MR Q m Q r Q C
Quantity Slide 49
Summary
Market power is the ability of sellers or buyers to affect the price of a good.
Market power can be in two forms: monopoly power and monopsony power.
Monopoly power is determined in part by the number of firms competing in the market.
Chapter 10 Slide 50
Summary
Market power can impose costs on society.
Sometimes, scale economies make pure monopoly desirable.
We rely on the antitrust laws to prevent firms from obtaining excessive market power.
Chapter 10 Slide 51