©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 8: Monopoly, Oligopoly, and...

©2012 The McGraw-Hill Companies, All Rights Reserved

1

Chapter 8: Monopoly, Oligopoly, and

Monopolistic Competition


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Learning Objectives

1. Define imperfect competition and compare it to perfect competition

2. Define market power and explain how it affects the firm's demand curve

3. Explain how start-up costs affect economies of scale and market power

4. Understand and use marginal cost and marginal revenue to maximize monopolist's profit

5. Show how monopoly alters economic surplus compared to perfect competition

6. Describe price discrimination and its effects7. Discuss public policies applied to natural

monopolies


3

Imperfect Competition

Millions of people around the world suffer from allergies

The symptoms can be treated using over-the-counter or prescription medication Over-the-counter medication is affordable Prescription medication is expensive

Prescription medication costs no more to manufacture than over-the-counter medication their producer earns an enormous profit

In a perfectly competitive market if an economic profit exists firms enter the market and prescription medication would sell for roughly its cost of production


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But prescription medication has been on the market for years now and that hasn’t happened The reason is that prescription medication

is patented, which means the government has granted the creator of the medication an exclusive license to sell it

The holder of a patent is an example of an imperfectly competitive firm, or price setter A firm with some liberty to set its own price


5


Imperfectly competitive firms have some control of price Long-run economic profits possible / Reduce

economic surplusThree types

1.Monopoly has only one seller, no close substitutes

Farthest from perfectly competitive markets2.Monopolistic competition has many firms

with differentiated products These products are all close substitutes No significant barriers preventing firms from

entering or leaving the market


6


Three types 3. Oligopoly is a small number of firms

producing close substitutes Oligopoly is typically a consequence of cost

advantages that prevent small firms from being able to compete effectively


7

Monopoly

Monopoly

Number of Firms

One firm

Price Price setter

Entry and Exit

Not free

Product Unique

Economic Profits

Possible

DecisionsP, Q, product differentiation

Perfect Competition

Many firms

Price taker

Free

Standardized

Zero in long run

Q only


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Number of Firms

Many firms

Price Limited flexibility

Entry and Exit

Free

Product Differentiated

Economic Profits

Zero in long run

DecisionsP, Q, product differentiation

Perfect Competition

Many firms

Price taker

Free

Standardized

Zero in long run

Q only


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Oligopoly

Oligopoly

Number of Firms

Few firms, each large

Price Some flexibility

Entry and Exit

Large size firm

ProductDifferentiated or

standardized

Economic Profits

Possible

DecisionsP, Q,

differentiation, advertising

Perfect Competitio

n

Many firms

Price taker

Free

Standardized

Zero in long run

Q only


10

The Essential Difference

Whereas the perfectly competitive firm faces a perfectly elastic demand curve for its product, the imperfectly competitive firm faces a downward-sloping demand curve Why is the demand curve different?

• Market Power

Quantity

Pric

e

Imperfectly Competitive Firm

DQuantity

Pric

e

Perfectly Competitive Firm

D


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The Essential Difference

Market power is the firm's ability to raise its price without losing all its sales Perfectly competitive firm:

Raise the price loses all its sales No incentive to lower price since it can sell

as many units as it wants at the market price Imperfectly competitive firm:

Has incentive to charge a higher price lose some customers but keep some and maybe gain more


12

Five Sources of Market Power

A firm with a down-ward sloping demand curve is said to enjoy market power Referring to its ability to set the prices of its

productsFive Sources of Market Power

1.Exclusive control over inputs2.Patents and copyrights3.Government licenses or franchises4.Economies of scale (natural monopolies)5.Network economies


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Exclusive Control over Inputs

If a single firm controls an input essential to the production of a given product, that firm will have market power For example, to the extent that some

tenants are willing to pay a premium for office space in the world’s tallest building, Burj Khalifa, the owner of that building has market power


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Patents and Copyrights

Patents give the inventors or developers of new products the exclusive right to sell those products for a specified period of time

By insulating sellers from competition for an interval, patents enable innovators to charge higher prices to recoup their product’s development costs Pharmaceutical companies in the US are given

20 years patents During that time, these companies can charge a

price above their marginal cost


15

Government Licenses or Franchises

Example: The Tourism Development &

Investment Company (TDIC) has an exclusive license from the Abu Dhabi government to manage all operational aspects of eight islands off the western coast of Abu Dhabi One of the government’s goals in granting

this monopoly was to preserve the wilderness character of the area to the greatest degree possible


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Market Power: Economies of Scale

Returns to scale refers to the percentage change in output from a given percentage change in ALL inputs

Long–run idea Constant returns to scale: doubling all

inputs doubles output Increasing returns to scale: output

increases by a greater percentage than the increase in inputs Average costs decrease as output increases Natural monopoly: a monopoly that results

from economies of scale


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Market Power: Network Economies

Network economies occur when the value of the product increases as the number of users increases VHS format for video tapes, Blu-ray for DVDs Windows operating system Facebook and MySpace

Network economies can also be seen as a source of natural monopolies A product’s quality increases as the number

of users increases Any given quality level can be produced at

lower cost as sales volume increases


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Market Power

The most important and enduring of these sources of market power are economies of scale and network economies

Other sources are weak Lured by economic profit, firms almost always

find substitutes for exclusive inputs Firms can often evade patent laws by making

slight changes in design of products Patent protection is only temporary in any case

Governments grant very few franchises each year


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Economies of Scale and Start-Up Costs

New products can have a large fixed development cost

If marginal cost is constant, Marginal cost = Average variable cost

Total cost is fixed cost (F) plus variable cost

TC = F + (M)*(Q) Total cost increases as output increases

Average total cost is ATC = (F/Q) + M

Average total cost decreases as output increases


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Economies of Scale

Quantity

Tot

al c

ost (

$/ye

ar)

F

TC = F + M*Q

Ave

rage

cos

t ($/

unit)

Quantity

ATC = F/Q + M

M


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Video Game – Different Volumes

Nintendo Playstation

Annual Production (000s)

1,000 1,200

Fixed Cost ($000s) $200 $200

Variable Cost ($000s)

$800 $960

Total Cost ($000s) $1,000 $1,160

ATC per game $1.00 $0.97


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Video Game – Lower Marginal Costs



1,000 1,200

Fixed Cost ($000s) $200 $200


$200 $240

Total Cost ($000s) $400 $440



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Video Games – Higher Fixed Cost



1,000 1,200

Fixed Cost ($000s) $10,000 $10,000


$200 $240

Total Cost ($000s) $10,200 $10,240



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Video Games – Different Production Levels



500 1,700

Fixed Cost ($000s) $10,000 $10,000


$100 $340

Total Cost ($000s) $10,100 $10,240



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Intel's Advantage

In 1984, 80 percent of the cost of a computer was in its hardware (which has relatively high marginal cost) The remaining 20 percent was in its software

By 1990 those proportions were reversed Fixed cost now accounts for about 85 percent

of total costs in the computer software industry

Development cost of a new chip $2 billion Marginal cost of making a chip Pennies Dominating the market Priceless!

• Intel supplies more than 80% of the processors for PCs!!!


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Profit Maximization for a Price Setter

Regardless of whether a firm is a price taker or a price setter its basic goal is to maximize its profit

In both cases: The firm expands output as long as the

benefit of doing so exceeds the cost Further, the calculation of marginal cost

is also the same for the monopolist as for the perfectly competitive firm

Difference is in the calculation of the marginal revenue


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Monopolist

Pure monopoly: the only seller of a unique product which has no close substitutes

Like all other firms, a monopolist Maximizes profits Applies the Cost-Benefit Principle

Increase output if marginal benefit > marginal cost Decrease output is marginal benefit < marginal cost

Marginal benefit (marginal revenue) for a monopolist is different than for a perfectly competitor


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Pric

e ($

/uni

t)

Quantity (units/week)

Profit Maximization for the Monopolist

For the monopolist, selling one more unit Decreases market price Reduces marginal revenue by more than the

price Lower price applied to all units

D

2

6

3

5


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Monopolist's Marginal Revenue

Total Revenue

$12

$15

$16

$15

Price Quantity

$6 2

$5 3

$4 4

$3 5

Pric

e &

mar

gina

l rev

enue

($/

unit)

8

8

D


MR

32

3

1

4-1 5

Marginal Revenue

3

1

-1


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Monopoly Demand and Marginal Revenue

In general, the monopolist's marginal revenue curve Has the same

intercept as demand

Has twice the slope of demand

Lies below demand

Pric

e

Quantity

a

D

Q0Q0/2

a/2

MR


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Deciding Quantity

A monopolist knows his demand and marginal revenue curves

Marginal cost is also known

If he operates at P = $3 and Q = 12, MC > MR Decrease output

If the firm operates at Q = 8, then MC = MR = 2 The demand curve sets

the price, P = $8 At any output below 8,

MC < MR

Pric

e ($

/uni

t of o

utpu

t)


3

MC

2

6

D

12

MR

4

8


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Does being a Monopolist Guarantee Profits?

Being a monopolist does not guarantee positive profits The question comes down to:

At MR = MC, is the P larger or smaller than ATC?

• If P > ATC positive profits• If P < ATC negative profits (losses)


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Monopoly Losses and ProfitsP

rice

($/m

inut

e)

Minutes (millions/day)20

0.12

0.10ATC

Economic loss= $400,000/day

D

0.05 MC

MR

24P

rice

($/m

inut

e)

Minutes (millions/day)2420

0.08

0.10

ATC

D

0.05 MC

MR

Economic profit= $400,000/day


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The Invisible Hand Fails

Pric

e ($

/uni

t of o

utpu

t)


The socially optimalamount occurs where

MC = MB, Q = 12 units and P = $3

The monopolist's optimalamount occurs where

MC = MR, Q = 8 units and P = $4

2MR

8

4

24

D

3

12

6 Marginal Cost


35


Since the monopolist’s marginal revenue is always less than price, the monopolist’s profit-maximizing output level is always below the socially efficient level

Under perfect competition, by contrast, profit maximization occurs when marginal cost equals the market price (MB = Demand) - the same criterion that must be satisfied for social efficiency This difference explains why the invisible

hand of the market is less evident in monopoly markets than in perfectly competitive markets


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The source of inefficiency in monopoly markets is the fact that the benefit to the monopolist of expanding output is less than the corresponding benefit to society MR < MB = Demand

From the monopolist’s point of view, the price reduction the firm must grant existing buyers to expand output is a loss

From the point of view of those buyers, each dollar of price reduction is a gain—one dollar more in their pockets


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Monopoly and Perfect Competition


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Managing Monopoly

Monopolies exist for economic reasons Patents, copyrights and innovation Economies of scale Network economies

Anti-trust laws attempt to limit deadweight loss Limiting monopolies has costs

Patents encourage innovation Economies of scale minimize ATC Network economies increase benefits


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Price Discrimination

Price discrimination means charging different buyers different prices for essentially the same good or service Separate the groups No side trades among buyers

Many forms of price discrimination Perfect discrimination: negotiate

separate deals with each customer Hurdle method: discounts for identifiable

groups (e. g., students, senior citizens)


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Price Discrimination

Whenever a firm offers a discount, the goal is to target that discount to buyers who would not purchase the product without it People with low incomes generally have

lower reservation prices for museum tickets than people with high incomes

Because students generally have lower disposable incomes than working adults, museum owners can expand their visitors by charging lower prices to students than to adults


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Carla the Editor: Example

Carla is a teaching assistant supplementing her income by editing term papers for undergraduates

There are eight students per week (A,B,C,D,E,F,G and H) for whom she might edit, each with a different reservation price

If the opportunity cost of her time to edit each paper is $29 (also equal to her MC) and she must charge the same price to each student (no price discrimination) How many papers should she edit?

How much economic profit will she make? How much accounting profit?


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Carla the Editor

Opportunity cost of Carla's time is $29Student

Reservation Price

A $40 B 38C 36D 34E 32F 30G 28H 26

Total Revenue

$40 $76 $108 $136 $160 $180 $196 $208


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Carla the Editor


Reservation Price

A $40 B 38C 36D 34E 32F 30G 28H 26

MR

$40 $36 $32 $28 $24 $20 $16 $12

Total Revenue

$40 $76 $108 $136 $160 $180 $196 $208


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Carla the Editor: Ordinary Monopolist

Carla is a profit maximizer Carla should keep expanding the number

of students she serves as long as her MR exceeds the opportunity cost of her time (MC)

Carla should stop at 3 papers since MR = 32 > MC = 29

Total opportunity cost = 3 * 29 = $87 Economic profit = 108 – 87 = $21 Accounting profit = $108 (since no explicit

costs) = TR


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Carla the Editor: Social Optimum

What is the socially efficient number of papers for Carla to edit? Students A to F are willing to pay more than

her opportunity cost ($29) Students G and H are unwilling to pay at least

$29 Socially efficient outcome is to edit 6 papers To be able to achieve that she has to charge

a price no higher to $30 (the lowest willing price, here of student F)

TR = 6 * 30 = $180 and Opportunity Cost = 6 * 29 = $174 Economic profit = $6

Accounting profit = TR = $180


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Carla the Editor: Price Discrimination


Reservation Price

A $40 B 38C 36D 34E 32F 30G 28H 26

Total Revenue

$40 $78 $114 $148 $180 $210 $238 $264


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What if Carla knew exactly the reservation price of each student? How many papers should she edit, and how much economic and accounting profit will she make? She will edit papers for students A to F again But this time charge each their reservation

price Carla is a perfectly discriminating monopolist

TR = 40 + 38 + 36 + 34 + 32 + 30 = $210 Opportunity cost = 6 * 29 = $174 Economic profit = $36


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Notice that the profit-maximizing level of output under perfect price discrimination was exactly the same as the socially efficient level of output

With a perfectly discriminating monopoly, there is no loss of efficiency

Note that although total economic surplus is maximized by a perfectly discriminating monopolist, consumers would have little reason to celebrate Consumer surplus is exactly zero for the perfectly

discriminating monopolist Total economic surplus and producer surplus are

one and the same


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In practice, of course, perfect price discrimination can never occur because no seller knows each and every buyer’s precise reservation price

Also in many markets the seller could not prevent buyers who bought at low prices from reselling to other buyers at higher prices, capturing some of the seller’s business in the process

In general imperfect price discrimination is more prevalent Imperfect price discrimination: at least some

buyers are charged less than their reservation prices


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The profit-maximizing seller’s goal is to charge each buyer the highest price that buyer is willing to pay Two primary obstacles prevent sellers from

achieving this goal First, sellers don’t know exactly how much each

buyer is willing to pay Second, they need some means of excluding

those who are willing to pay a high price from buying at a low price

One way is to follow the hurdle method of price discrimination


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Hurdle Method of Price Discrimination

The hurdle method of price discrimination is the practice of offering a discount to all buyers who overcome some obstacle

Hard cover and paperback books Commercial air carriers Temporary sales

A perfect hurdle is one that separates buyers precisely according to their reservation prices


52


Carla offers a rebate coupon that gives a discount to any student who takes the trouble to mail it back to her Suppose further that students whose

reservation prices are at least $36 never mail in the rebate coupons

Those whose reservation prices are below $36 always do so

What should her list price be, and what amount should she offer as a rebate? Will her economic profit be larger or smaller than when she lacked the discount option?


53

Carla Offers a Rebate

If reservation price < $36, mail in rebateStudent

Reservation Price

Total Revenue

A $40 $40

B 38 76

C 36 108

Discounted Price Submarket

D $34 $34

E 32 64

F 30 90

G 28 112

H 26 130

MR

$40

36

32

$34

30

26

22

18


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Carla will divide the market into two groups and act as an ordinary monopolist compare MR and MC 1st group = list price submarket: A,B and C

Charge $36 and serve all three students 2nd group = discount price submarket: D,E,F,G

and H Charge $32 and serve D and E only (discount = $4)

Combined TR from both submarkets = 3 * 36 + 2 * 32 = $172

Opportunity cost = 5 * 29 = $145Economic profit = 172 – 145 = $27


55

Carla's Choices

Program Social

Optimum

Papers Edited 6

Price $30

Total Revenue $180

Carla's Time $174

Economic Profit $6

Total Surplus $26

Hurdle

5 = (3 + 2)

$36, $4 rebate

$172

$145

$27

$35

Perfect Discriminator

6

Reservation

$210

$174

$36

$36

Single Price

3

$36

$108

$87

$21

$27


56

Is Price Discrimination a Bad Thing?

Although we might think so, but it is not necessary

Total surplus was actually enhanced by the monopolist’s use of the hurdle method of price discrimination TS = CS+PS

CS = reservation price minus price actually paid PS = charged price minus reservation price ($29)

Ordinary monopoly: TS = $27 CS = 4 + 2 + 0 = $6 ; PS = 3(36 – 29) = $21

Hurdle price discriminate: TS = $35 CS = 4 + 2 + 0 + 2 + 0 = $8; PS = 3(36 – 29) + 2(32 –

29) = $27


57

Monopoly and Public Policy

Monopoly is problematic: Loss in efficiency associated with

restricted output Monopolist earns an economic profit at

the buyer’s expenseGoal of people is to control monopolies

Policy options Government ownership and operation Regulation Competitive bids for natural monopoly services Break up


58

State-Owned Natural Monopoly

Marginal cost is always less than average cost Marginal cost pricing produces losses

Options Fund losses from tax revenues Fixed monthly fee plus usage fee

Fixed fee covers losses

Limited incentives to innovate and cut costs

Commonly used for water, Post Office and electricity


59

Regulated Monopolies

Cost-plus regulation sets price at per unit explicit costs plus a mark-up for implicit costs

Used for electricity, telephone and cable Policies vary by state

Disadvantages High administrative cost Reduced incentive for cost-saving

innovation Price is greater than marginal cost


60

Bid for Contract

Government awards contract to low bidder for natural monopoly services Garbage collection, fire protection, road

construction, Department of DefenseCould achieve marginal cost pricing IF

government pays the resulting lossesAsset transfer for large fixed

investment is complex


61

Anti-Trust Laws

Two landmark laws Sherman Act of 1890

Declared conspiracy to create a monopoly illegal

Clayton Act of 1914 Outlawed transactions that would

"substantially lessen competition"

Applies to mergers and acquisitions today IBM avoided break-up; AT&T did not Microsoft survived


62

Another Policy Option: Ignore Monopoly

Two objections to monopolies Restrict output, decrease total surplus Raise price, earn economic profits

Analysis Discount offers allow some customers to

pay less than average cost, though more than marginal cost

Economic profits generated by customers who pay list price – their choice

About two-thirds of economic profits are taxed away

Remainder accrues to shareholders

Chapter 9 Appendix

The Algebra of Monopoly Maximization


64

From Demand to Marginal Revenue

Given a demand curve such as P = 15 – 2 Q

We can write the marginal revenue curve as

MR = 15 – 4 QSuppose marginal cost is a line with zero

intercept and a slope of 1MC = Q

The remaining step is to set marginal revenue equal to marginal cost


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MR = MC

Let Q* be the profit maximizing level of output

MC = MRQ* = 15 – 4 Q*5 Q* = 15Q* = 3

To find P, substitute Q = 3 into the demand equation

P = 15 – 4 Q*

P = 15 – 4 (3)

P = 3

©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 8: Monopoly, Oligopoly, and...

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