Managerial Economics BUSI 2050U Chapter 9: Monopoly

Managerial Economics (BUSI 2050U) - Chapter 9: Monopoly

• Monopoly: A market served by only one firm. A monopolist is the sole supplier and price setter of a good within a market. Firms with market power behave differently than those in perfect competition. Examples are rare in the real world.

Table of Contents

• 9.1 Source of Monopoly and Monopoly Profit Maximization
• 9.2 Market Power
• 9.3 Market Failure & Monopoly Pricing
• 9.5 Advertising
• 9.6 Networks & Behavioral Economics

Introduction

• Firms often have market power, the ability to influence the market price of a product.
• A monopoly is the most extreme example of market power.

Sources of Market Power

• The key difference between perfect competition and a market with pricing power is the existence of barriers to entry.
• Factors preventing entry into markets with large producer surpluses.
• Normally, positive producer surplus will induce more firms to enter the market.
• Barriers to entry allow firms to maintain positive producer surplus indefinitely.

Extreme Scale Economies: Natural Monopoly

• A major entry barrier is economies of scale.
• Long-run average total cost curve is downward sloping.
• Diseconomies of scale are never present.
• This leads to a natural monopoly, where it's more efficient for a single firm to produce the entire industry output, rather than splitting it across multiple firms. Splitting output across multiple firms increases average cost of production.

Absolute Cost Advantages or Control of Key Inputs

• Many production processes depend on scarce inputs (i.e. natural resource products).
• Example: Saudi Aramco (a Saudi Arabian state-run oil company) controls a large portion of global oil supply with relatively low extraction costs.
• Firms establish absolute cost advantages through long-term contracts with intermediate suppliers.
• Apple's relationship with Foxconn (a Chinese company that assembles Apple products) is an example.

Government Regulation

• Government regulations limit entry into a market.
• Patents
• Licensing requirements (i.e., medical board certification)
• Prohibition of competition (i.e., U.S Postal Service)

9.1 A Single-Price Monopoly's Output and Price Decision

• Price and Marginal Revenue: A monopoly is a price setter, not a price taker, unlike a firm in perfect competition. A monopoly's product demand is the market demand. To achieve higher output, a monopoly must set a lower price.
• Total revenue = price × quantity
• Marginal revenue (MR) is the change in total revenue from a one-unit increase in quantity sold
• For a single-price monopoly, marginal revenue is always less than price at any output level (MR < P).

9.1 A Single-Price Monopoly's Output and Price Decision (Figure Examples)

• Illustrates the relationship between price and marginal revenue.
• Example: Given a particular price (e.g. $16) the corresponding output (quantity) and thus price are shown on the graph. As price decreases (and demand increases) the relationship and marginal revenue is calculated.

A Single-Price Monopoly's Output and Price Decision

• The monopoly produces the profit maximizing output, where MR = MC.
• Prices are set at the highest possible level, for the profit maximizing quantity.

A Single-Price Monopoly's Output and Price Decision (Figure 13.4)

• Illustrates the profit maximizing choices for a single price monopoly.
• In a specific example (a), the monopoly produces the quantity that maximizes total revenue minus total cost.

A Single-Price Monopoly's Output and Price Decision (Figure 13.4) and (b) - Demand and Marginal Revenue and Cost Curves

• In part (b) of a graph, the firm produces the quantity where MR = MC. It sets the price where customers will buy that quantity.
• The ATC curve illustrates average total cost. Economic profit is profit per unit multiplied by quantity produced.

A Single-Price Monopoly's Output and Price Decision (Long-Run Considerations)

• A monopoly may still make an economic profit in the long-run if barriers to entry prevent competitors from entering the market.

9.2 Markup Formula for Companies with Market Power: The Lerner Index

• Starting with the definition of marginal revenue & setting it equal to marginal cost.
• Calculating the left-hand side using P/P (doesn't change anything), with AP/AQ (and P)
• Final formula for markup: (P – MC)/P = 1/│ε│

9.2 Market Power

• The Lerner Index or Price Markup The Lerner Index measures market power. The larger the difference between price and marginal cost, the higher the Lerner Index. This index can be calculated for any firm.
• Lerner Index and Elasticity The formula for The Lerner Index or price markup for a monopoly range from 0 up to 1. -If ɛ = -1.01, only slightly elastic, the monopoly markup is ~0.99 (99%) -If ɛ = -3, more elastic, the monopoly markup is ~0.33 (33%) -If ɛ = - ∞, perfectly elastic, the monopoly markup is zero.

9.2 Market Power (Sources of Market Power and examples)

• Market power derives from the availability of substitutes, the number of firms, and the proximity of competitors.
• Less power with better substitutes: When better substitutes enter the market.
• Less power with more firms: When more firms enter the market, choices increase.
• Less power with closer competitors: When companies offering similar services move closer together.

9.3 Single-Price Monopoly and Competition Compared (Graph Examples)

• Comparing Price and Output: Illustrates the price and quantity for perfect competition versus monopolies.
• Market Demand Curve (D): The demand curve that the firm in a monopoly faces.
• Market Supply Curve (S = MC): The horizontal sum of individual firms' marginal cost curves.

9.3 Single-Price Monopoly and Competition Compared

• Perfect Competition Equilibrium: The quantity demanded equals the quantity supplied at Qc, and the price is Pc.

9.3 Single-Price Monopoly and Competition Compared (Analysis of Differences)

• Monopoly Equilibrium: The output is at Qm, where marginal revenue equals marginal cost(MR = MC) .
• The price(PM) is set at the point on the demand curve that corresponds to the profit maximizing quantity.
• Compared to perfect competition, a monopoly produces a smaller quantity at a higher price.

9.3 Single-Price Monopoly and Competition Compared (Efficiency Comparison)

• Figure 13.6(a): Perfect competition is efficient because the market demand curve (MSB) equals the supply curve (MSC).

9.3 Single-Price Monopoly and Competition Compared (Total Surplus)

• Total surplus is maximized when quantity produced in perfect competition.

9.3 Single-Price Monopoly and Competition Compared (Inefficiencies)

• Figure 13.6(b): Monopoly results in inefficiency as price exceeds marginal social cost, marginal social benefit exceeds marginal social cost and deadweight loss arises.

9.3 Single-Price Monopoly and Competition Compared (Redistribution of Surpluses)

• Some of the lost consumer surplus in a monopoly environment becomes part of the producer surplus.

9.3 Single-Price Monopoly and Competition Compared (Rent-Seeking)

• Rent seeking refers to the pursuit of wealth by capturing economic rent.
• Rent-seekers try two ways buy a monopoly.
• create a monopoly by using resources in political activity.

9.3 Single-Price Monopoly and Competition Compared (Rent-Seeking Equilibrium)

• The area shows potential producer surplus if there is no rent seeking. Rent seeking can eliminate producer surplus.

9.3 Single-Price Monopoly and Competition Compared (Rent-Seeking Costs)

• Rent-seeking costs increase ATC curve, reduce producer surplus and increases deadweight loss.

9.5 Advertising

• Advertising and Net Profit: Successful advertising shifts the market demand curve outward.
• Deciding Whether to Advertise: Advertise only if expected net profit (gross profit minus advertising cost) increases.
• How Much to Advertise: Advertise until marginal benefit (gross profit or marginal revenue) equals marginal cost.

9.6 Networks & Behavioral Economics

• Network Externalities: A good has a network externality if one person's demand depends on others' consumption.
• Positive network externality: A good's value to a consumer increases as more people use it (i.e. telephones, fax machines)
• Networks need to reach a critical mass of users to succeed.
• Bandwagon and Snob Effects:
  • Bandwagon effect: Value of a good increases with more people using it.
  • Snob effect: Value of a good increases with fewer people using it.

9.6 Networks & Behavioral Economics (Monopoly Implications)

• Positive network externalities can lead to monopolies as consumers favor firms with large user bases (e.g., Windows).

9.6 Networks & Behavioral Economics (Managerial Implications: Introductory Pricing)

• Managers should consider using introductory pricing to accelerate critical mass (e.g., products being sold at low prices to encourage consumers to adopt them)

Explore the critical concepts of monopoly within Managerial Economics in this quiz. Understand the sources of monopoly, market power, and the implications of monopoly pricing. Dive into key topics like market failure, advertising, and behavioral economics as they relate to monopolistic structures.