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Monopoly

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OverviewMonopoly means one seller.

In perfect competition many sellers were price takers. Any one seller could not influence the price of the product in the market. The competitive firm could only choose what amount to sell.

A monopoly firm will have to determine both how much to sell and at what price. Let’s look at these ideas a little more on the following few slides.

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Review p

Market Q

In a market, consumers as a group are thought to want to buy a greater quantity the lower the price. We see this as a downward sloping demand curve.

D

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Review p $

Market Q Firm Q

P=MR=D

In a competitive market, the market demand from consumers interacts with market supply from many sellers and we get an equilibrium price, like p* in the graph. At this point, since any one firm is a small part of the market, when we look at a firm it is a price taker. Thus, when the firm thinks about selling another unit it can sell that unit at the same price as the previous unit and thus MR = P for a competitive firm.

D

S

p*

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Analogy: To think about the marginal revenue for a competitive firm I like to think about a pop machine. Say the price of a pop is $1.25.

Say the machine has been refilled and the pops are not chilled to perfection and you are the first one to make a purchase. What is the total revenue in the machine after you make your purchase? $1.25! Since the total revenue was zero before you bought, the change in total revenue from the sale of another unit (in this case the first one), was $1.25. This is exactly what we mean by marginal revenue. Marginal revenue is the change in total revenue from changing output by 1 unit.

Now say I buy a pop right after you. The total revenue in the machine is 1.25(2) = 2.50 and the marginal revenue is 1.25.

SO, MR = P for a competitive firm.

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MonopolyFor a monopoly firm the demand is the same as the market demand we see in competition. The demand is downward sloping to the right, what is called less than perfectly elastic.

Since the monopolist is the only seller, it is natural they face the market demand curve.

The situation of monopoly is often called imperfect competition.

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Maximize profitSince the monopolist is the only seller in the market, the monopolist must decide what price to charge andhow much to sell.

When the monopolist sells, she is worried about profit. The goal is to maximize profit. But, in order to maximize profit, the pattern of revenues and costs at various output levels must be understood. The pattern of cost was the topic of an earlier chapter. Now we look at the pattern of revenue.

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Monopoly p

Market Q

Here the monopoly is the only firm in the market. When the price is 6, in this example the consumers want 2 units. Total revenue would be 12. But, this firm, if it wants to sell 3 units has to lower the price on all units to 5. The competitive firm didn’t have to worry about another price like the monopoly firm.

D

6

5

2 3

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Monopoly – marginal revenue

So, because the way consumers are in this example on the previous screen, when P = 6, 2 units will be sold and when the P = 5, 3 units will be sold. Total revenue would move from 12 to 15 when the quantity moves from 2 to 3.

So, the additional revenue from the 3rd unit is $3. This is the marginal revenue of the 3rd unit.Note, the price to get the third unit sold is $5, but the marginal revenue is only $3.SO, P>MR at a quantity.

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InterpretationWhen the price is lowered from 6 to 5 the amount sold rises. In fact, the 3rd unit sold brings in 5 in revenue. But this isn’t all we need to look at to have MR. Since the monopolist must sell to all consumers at the same price, the first 2 units now get sold at 5 as well. That means revenue on those 2 units will not include $6 per unit when the price is lowered.

Continuing with the example,

MR(of the 3rd unit) = 5 - (6-5) 2 = 3

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interpretationP

Q

6

5

2 3

a

bc

Area a + b = 6 times 2= 12 = TR when P = 6Area b + c = 5 times 3 = 15 = TR when P = 5

MR = c - a = 5 - 2 = 3

area c is the gain in revenue from sellingmorearea a is the loss inrevenue from selling at a lower price.

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Let’s do another exampleP Q 5 04 13 22 31 40 5

Say this is the demand from consumers in the market. If the price is 5 consumers want nothing, for instance. Let’s add TR on the next slide.

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Let’s do another exampleP Q TR 5 0 04 1 43 2 62 3 61 4 40 5 0

Total revenue is just P times Q, so you should check what I have here.

Next let’s add MR to the table.

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Let’s do another exampleP Q TR MR 5 0 0 ----4 1 4 43 2 6 22 3 6 01 4 4 -20 5 0 -4

MR, marginal revenue, is the change in TR when we add a unit of output. Note at Q = 0 I have the line --- because we have not had a change yet.

The MR = 4 for a Q = 1 because TR went from 0 to 4 when Q went from 0 to 4. The MR = 2 for Q = 2 because TR went from 4 to 6 when Q went from 1 to 2.

Note: MR can become negative, in theory. Also note that P > MR at each Q (except Q = 1, but we usually ignore this.)

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MR from areas to heightP

Q

a

b c

P

Q

In the above diagram we think ofMR as area c - a and we get a number.

height = MR

In the bottom graph we can think of the numberas a height. Note still theMR is lower than the priceon the demand curve.

On the next screen we will see the whole MRcurve.

D

D

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Monopoly MR in a graph$

Q

D

3

5

3

I do not have a prooffor you, but you can see in this diagramthat MR is also a straight line that startsat the same place asdemand in the upperleft, but is always below demand becauseP>MR. Like at Q = 3, MR = 3 and P = 5.

Note that a good way to draw in MR is to first draw demand and then put MR through the Q axis halfway out to the demand curve. I put an X at that point.

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Monopoly Pricing and Output

We study the pricing and output decision of the

monopoly firm.

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Price and output decision for the monopolist in the short run

The amount of output the monopolist should sell in the short run is the amount where MR = MC(as long as P>AVC), just as in the case of the competitive firm.

The price charged would then be the price on the demand curve above the quantity where MR = MC. ************some students miss this above point**********IN competition since P = MR and since firms make the Q where MR = MC, the firms make the Q where P = MC. But we will see for a monopoly since P > MR and since it will make Q where MR = MC, then P > MC.

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Logic of MR = MC rule$

Q

D

MR

MC

a b c

The Q = b is the Q whereMR = MC. But look at Q = a. Atthat point, Q could be increased and more would be added torevenue than to cost and thus profit would rise. We know this because the MR > MC for these Q (Compare the heights of the curves).

Now let’s look at a Q greater than where MR = MC, like at point c. More has been added to cost than to revenue and thus profit would fall. We know this because MC > MR at this Q.

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What price?$

Q

MC

D

MR

P*

Q*

At Q*, where MR = MC, P* is the price on the demand curveconsumers are willing to pay for Q* and thus this is the price charged by the monopolist.

So, make Q where MR = MC and charge the P on the demand curve at this Q.

Go all the way up to the demand curve to find the price!!!

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Qualification$

MC

D

MR

P*= .10

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ATC

AVC1

AVC2

AVC1=.11

AVC2= .08

Note that the ATCis above the demandcurve, so the firm will lose money. In the short run, the question is whetherthe firm should shutdown or continue to operate. Let’s go to the next screen and say moreabout this.

ATC = .12

Q

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continueNote that the Q where MR = MC is 20. So, if the firm operates at all it should make 20.

Note at Q = 20, the price on the demand curve is .10 but the ATC = .12Now, remember ATC = TC/Q so ATC times Q = TC.

TR = P Q = .1(20) = 2TC = ATC Q = .12(20) = 2.4Profit = TR – TC = 2 – 2.4 = - .4OrProfit = (P – ATC)Q = (1 - .12)20 = -.4 The firm is losing money.

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continue 2If the AVC curve is AVC2 for the firm then at Q = 20 the AVC = .08. This means the TVC = AVC Q = .08(20) = 1.6.

Thus the TR = 2 can cover the 1.6 of TVC and what is left of TR, .4 can go to paying some of the total fixed costs. If the firm shuts down it would have nothing going to fixed cost. So the firm should operate.

Thus, operate if at the Q where MR = MC the P > AVC.

Note if the AVC is AVC 1 = .11 the P < AVC. The firm should shut down. TR of 2 falls short of TVC of 2.2 and covers none of fixed while if the firm shuts down it only has to cover the fixed cost.

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Quiz 1 – not a real quiz$

MC

D

MR

P*

Q*

ATC

Is this monopoly firmearning a profit? If so,draw in the graph therectangle that represents the profit.

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Quiz 2 not a real quiz

MC

D

MR

P*

Q*

AVC

$ ATC

Is it possible for a monopoly to lose money?

Indicate in the graphhow much thismonopoly is losing byindicating the lossrectangle.

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Palm of hand

Thumb

Is a monopoly guaranteed a profit. I have a monopoly – I make a pizza fork (not really, but listen up). Look at the palm of your right hand, thumb up. When you wrap your hand around the fork your thumb is next to a button on the fork (sorry, only right handed version.). When you press the button

a razor blade edge comes out here and you move your hand so your thumb is now pointing left and you cut your pizza real easily.

The demand for my item is much lower than where my costs are.

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Can Monopolies charge whatever price they want? The answer is yes, but with a qualification.

Remember consumers have a demand for the product and have prices they are willing to pay. As long as the monopoly is charging a price the consumers are willing to pay then they can charge whatever they like. But if the monopoly charges too high a price consumers will not buy at all.

Keep this a secret – monopolies can charge whatever they want, but since a monopoly wants to maximize profit it will only charge the price on the demand curve above the quantity where MR = MC.

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Compare Monopoly to Competition

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Compare monopoly with competition

The main results here are the ideas that----1) a monopoly firm will charge a higher price than would occur in competition and----2) a monopoly will sell less output than would occur

in competition.

There seems to be a notion in the world that monopolieswill charge us outrageous prices. Economics does not settle this claim, but the science of Economics does tell us that we get higher prices than in competition. But, there are some willing to pay the higher price.

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Q

P

D

S

Pc

Qc

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On the previous slide we have the competitive market. Note the demand is coming from many consumers in the market. The demand from each person is essentially the marginal benefit curve of each person.

Note the supply is coming from many suppliers. The supply from each firm is basically the marginal cost curve (that part above AVC).

Because there are so many players in the market, none has an influence on price, so the “market” determines the price and each buyer and seller takes the price.

Now, if the industry is monopolized, one seller would meet all the consumers. Thus, the monopolist would see a MR curve from the demand and treat S as a MC curve.

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Comparison continued$

Q

D

MR

S = MC

Pm

Pc

Qm Qc

If you focus your eyes on the point where S = D you see the competitive point with Pc and Qc. If you focus on the point where MR = MC you see themonopoly point with Qm and Pm (Note Pm is on demand curve above where MR and MC cross.). Assume that a monopolist comes in and buys up all the firms. It then operates

where MR=MC and charges the price on the demand curve at that Q.

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Pm

Pc

Qm Qc

P

Q

a b

c d e

f g h

The graph

reproduced

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Referring to the previous slide:

comp monop

con surp a b c d e a b

Prod surp f g h c d f g

So, consumers lose surplus of b, c, and e due to monopoly. Producers gain c and d from the consumers, but lose h.

Overall, there is a deadweight loss of e and h. This loss is a major reason why we have laws against monopoly. The Sherman Act of 1890 is the first law in US to be against monopoly. We have had revisions since, but basically this law is the driving force.

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Problems of monopolyThe problems of monopoly are higher price and less output than in competition. Moreover, 1) The higher price means those who still buy have less money to spend on other things – c and d are surplus areas that consumer used to have for other things but now pays to monopoly.

2) Those who no longer buy must be worse off becausethey get less than what they were at their liberty to purchase under competition – area e represents the value of lost output to the consumers and is part of the deadweight loss of monopoly.

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Monopoly Transfer

Note in the graph that the area c+d was part of consumer surplus under competition but is now part of monopoly revenue under monopoly.

Both producer and consumer are part of society. Area c+d is a transfer from one part of society to another.

The deadweight loss area e and h, though, are lost by society in total.

The real problem of monopoly is less output!!! Plus, we get a higher price than in competition.