Monopoly

Extra Reading

• Product Differentiation Download

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

• 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. P

MR P Q PQ

1 1(1 ) (1 )D

PPMR P P P P eQ Demand ElasticityQ

Theoretical Note: Monopolies and Inelastic Demand

• Monopolist will not operate where demand elasticity is between 0 and -1. Why?

• Raising prices/cutting production will increase revenues. MR < 0

• When facing an inelastic demand, monopolist raises prices until demand becomes inelastic.

Example Demand, Revenue, Marginal Revenue

Output Price Revenue Marginal Revenue

10,000.00 33.0 330,000.013.7

20,000.00 23.3 466,690.510.5

30,000.00 19.1 571,576.88.8

40,000.00 16.5 660,000.07.8

50,000.00 14.8 737,902.47.0

60,000.00 13.5 808,331.66.5

70,000.00 12.5 873,097.96.0

80,000.00 11.7 933,381.05.7

90,000.00 11.0 990,000.05.4

100,000.00 10.4 1,043,551.6

Example

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

10 20 30 40 50 60 70 80 90

Q

P

Price Marginal Revenue

Demand

MR

Monopolist• Maximize Profits 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

MC = ATC

MR

D

QMono

P*

QPC

Price

Output

Monopolist: Revenue

MC = ATC

MR

D

Q*

P*

Revenues

Price

Output

Monopolist: Profits

MC = ATC

ATC MR

D

Q*

P*

Profit

Price

Output

Marginal MarginalPrice Revenue Revenue Cost Cost Profit

10,000 33.0 330000 80000 25000013.66905 8

20,000 23.3 466690.5 160000 306690.510.48863 8

30,000 19.1 571576.8 240000 331576.88.842323 8

40,000 16.5 660000 320000 3400007.790243 8

50,000 14.8 737902.4 400000 337902.47.042918 8

60,000 13.5 808331.6 480000 328331.66.476632 8

70,000 12.5 873097.9 560000 313097.96.028302 8

80,000 11.7 933381 640000 2933815.661905 8

90,000 11.0 990000 720000 270000

Monopolist: General CaseMC

ATC

MR

D

Q*

P*

Price

Output

Monopolist: RevenueMC

ATC

MR

D

Q*

P*

Revenues

Price

Output

Monopolist: CostsMC

ATC

MR

D

Q*

P*

Costs

Price

Output

Monopolist: Profits

MC

ATC

MR

D

Q*

P*

Profits

Price

Output

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

Rule of thumb for a monopolist,

– If markups are below this level, raise prices.– If markups are above this level, lower prices.

1 1(1 ) 1(1 )DD

PMC MR P e MC e

Monopolist’s Schedule

• The less 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)

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.

• Products may vary by type, scale, or location.

Characteristics of Monopolistically Competitive Markets

• Differentiated Products• 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.

Profitable Monopolistic Competition:Short-term

MC

ATC

MR

D

Q*

P*

Price

Output

Unprofitable Monopolistic Competition:Short-term

MC

ATC

MR

D

Q*

P*

Price

Output

Monopolistic Competition:Entry of Competitors

MC

ATC

MR

D

Q*

MR′

D′

Price

Output

Monopolistic Competition:Long-term

MC

ATC

MR D

Q*

P*

Price

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.

Learning Outcomes

• Define marginal revenue. • Characterize the relationship between price,

marginal revenue, marginal cost, average total cost, and profits in a monopolistic market.

• Use the rule of thumb to calculate optimal markups.

• Describe 4 barriers to entry that may enable monopoly power.

• Characterize the relationship between price, marginal revenue, marginal cost, average total cost, and profits in a monopolistically competiive market.

Closed Book Final

• Date: Sunday, October 28th

• Time: 2:00-5:00

• Place: Room 3007, 3008

• Coverage: Material in Notes to date

• Bring Calculator, Writing Instruments

–Good Luck!