Managerial Economics (BUSI 2050U) Chapter 9 Monopoly PDF

Managerial Economics (BUSI 2050U) Chapter#9 Monopoly 9-1 © 2014 Pearson Education, Inc. All rights reserved.  Table of Contents 9.1 Source of M...

Managerial Economics (BUSI 2050U) Chapter#9 Monopoly 9-1 © 2014 Pearson Education, Inc. All rights reserved.  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 9-2 © 2014 Pearson Education, Inc. All rights reserved.  Introduction In the real world, there are very few examples of perfectly competitive industries Firms often have market power, or an ability to influence the market price of a product The most extreme example is a monopoly, or 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 in different ways than those in perfect competition 9-3 © 2014 Pearson Education, Inc. All rights reserved.  Sources of Market Power 9 The key difference between perfect competition and a market structure in which firms have pricing power is the presence of barriers to entry Factors that prevent entry into markets with large producer surpluses Normally, positive producer surplus in the long run will induce additional firms to enter the market The presence of barriers to entry means firms may be able to maintain positive producer surplus indefinitely 9-4 © 2014 Pearson Education, Inc. All rights reserved.  Sources of Market Power 9 Extreme Scale Economies: Natural Monopoly One common barrier to entry results from a production process that exhibits economies of scale at every quantity level Long-run average total cost curve is downward sloping; diseconomies never emerge Results in a situation called a natural monopoly More efficient for a single firm to produce the entire industry output Splitting output across multiple firms raises the average cost of production http://dividendmonk.com/7-companies-with-unrivaled-economi es-of-scale/ 9-5 © 2014 Pearson Education, Inc. All rights reserved.  Sources of Market Power 9 Absolute Cost Advantages or Control of Key Inputs Many production processes rely on scarce inputs (e.g., natural resource products) For instance, Saudi Aramco (Saudi Arabia’s state-run oil company) maintains control over a vast oil supply, with relatively low extraction costs In other circumstances, firms may develop absolute cost advantages by engaging in long-term contracts with intermediate suppliers Apple has developed this type of relationship with Foxconn, a Chinese company that assembles many of Apple’s products 9-6 © 2014 Pearson Education, Inc. All rights reserved.  Sources of Market Power 9 Government Regulation A final important barrier is the presence of government regulation that limits entry to a market Patents Licensing requirements (e.g., medical board certification) Prohibition of competition (e.g., U.S. Postal Service) 9-7 © 2014 Pearson Education, Inc. All rights reserved.  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 like a firm in perfect competition. – The reason is that the demand for the monopoly’s output is the market demand. – To sell a larger output, a monopoly must set a lower price. 9-8 © 2014 Pearson Education, Inc. All rights reserved.  9.1 A Single-Price Monopoly’s Output and Price Decision – Total revenue, TR, is the price, P, multiplied by the quantity sold, Q. – Marginal revenue, MR, is the change in total revenue that results from a one-unit increase in the quantity sold. – For a single-price monopoly, marginal revenue is less than price at each level of output. That is, – MR < P. 9-9 © 2014 Pearson Education, Inc. All rights reserved.  9.1 A Single-Price Monopoly’s Output and Price Decision – Figure 13.2 illustrates the relationship between the price and marginal revenue and derives the marginal revenue curve. – Suppose the monopoly sets a price of $16 and sells 2 units. 9-10 © 2014 Pearson Education, Inc. All rights reserved.  9.1 A Single-Price Monopoly’s Output and Price Decision – Now suppose the firm cuts the price to $14 to sell 3 units. – It loses $4 of total revenue on the 2 units it was selling at $16 each. – And it gains $14 of total revenue on the 3rd unit. – So total revenue increases by $10, which is marginal revenue. 9-12 © 2014 Pearson Education, Inc. All rights reserved.  A Single-Price Monopoly’s Output and Price Decision – The marginal revenue curve, MR, passes through the red dot midway between 2 and 3 units and at $10. – For a monopoly, MR < P at each quantity. 9-13 © 2014 Pearson Education, Inc. All rights reserved.  A Single-Price Monopoly’s Output and Price Decision Price and Output Decision – The monopoly produces the profit-maximizing quantity, where MR = MC. – The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity. 9-14 © 2014 Pearson Education, Inc. All rights reserved.  A Single-Price Monopoly’s Output and Price Decision – Figure 13.4 illustrates the profit- maximizing choices of a single-price monopoly. – In part (a), the monopoly produces the quantity that maximizes total revenue minus total cost. 9-15 © 2014 Pearson Education, Inc. All rights reserved.  A Single-Price Monopoly’s Output and Price Decision – In part (b), the firm produces the quantity at which MR = MC and sets the price at which it can sell that quantity. – The ATC curve tells us the average total cost. – Economic profit is the profit per unit multiplied by the quantity produced—the blue rectangle. 9-17 © 2014 Pearson Education, Inc. All rights reserved.  A Single-Price Monopoly’s Output and Price Decision – The monopoly might make an economic profit, even in the long run, because barriers to entry protect the firm from market entry by competitor firms. – But a monopoly that incurs an economic loss might shut down temporarily in the short run or exit the market in the long run. 9-19 © 2014 Pearson Education, Inc. All rights reserved.  Market Power 9.2 A Markup Formula for Companies with Market Power: The Lerner Index Starting with the definition of marginal revenue, and setting it equal to marginal cost Multiply the left-hand side by P/P (doesn’t change anything) And finally, or, as demand becomes more elastic, the optimal markup falls 9-20 © 2014 Pearson Education, Inc. All rights reserved.  9.2 Market Power The Lerner Index or Price Markup: (p - MC)/p – The Lerner Index measures a firm’s market power: the larger the difference between price and marginal cost, the larger the Lerner Index. – This index can be calculated for any firm, whether or not the firm is a monopoly. Lerner Index and Elasticity: (p – MC)/p = - 1/ε – The Lerner Index or price markup for a monopoly ranges between 0 and 1. – If ε = -1.01, only slightly elastic, the monopoly markup is 0.99 (99%) – If ε = -3, more elastic, the monopoly markup is 0.33 (33%) – If ε = - ∞, perfectly elastic, the monopoly markup is zero 9-21 © 2014 Pearson Education, Inc. All rights reserved.  Table 9.2 Elasticity of Demand, Price, and Marginal Cost 9-22 © 2014 Pearson Education, Inc. All rights reserved.  9.2 Market Power Sources of Market Power – Availability of substitutes, number of firms and proximity of competitors determine market power. Less Power with … – Less power with better substitutes: When better substitutes are introduced into the market, the demand becomes more elastic (Xerox pioneered plain-paper copy machines until …) – Less power with more firms: When more firms enter the market, people have more choices, the demand becomes more elastic (USPS after FedEx and UPS entered the market). – Less power with closer competitors: When firms that provide the same service locate closer to this firm, the demand becomes more elastic (Wendy’s, Burger King, and McDonald’s close to each other). 9-23 © 2014 Pearson Education, Inc. All rights reserved.  9.3 Single-Price Monopoly and Competition Compared Comparing Price and Output – Figure 13.5 compares the price and quantity in perfect competition and monopoly. – The market demand curve, D, in perfect competition is the demand curve that the firm in monopoly faces. 9-24 © 2014 Pearson Education, Inc. All rights reserved.  9.3 Single-Price Monopoly and Competition Compared – The market supply curve in perfect competition is the horizontal sum of the individual firms’ marginal cost curves, S = MC. – This curve is the monopoly’s marginal cost curve. 9-25 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared – Perfect Competition – Equilibrium occurs where the quantity demanded equals the quantity supplied at quantity QC and price PC. 9-26 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared – Monopoly – Equilibrium output, QM, occurs where marginal revenue equals marginal cost, MR = MC. – Equilibrium price, PM, occurs on the demand curve at the profit-maximizing quantity. 9-27 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared – Compared to perfect competition, monopoly produces a smaller output and charges a higher price. 9-28 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared Efficiency Comparison – Figure 13.6(a) shows the efficiency of perfect competition. – The market demand curve is the marginal social benefit curve, MSB. – The market supply curve is the marginal social cost curve, MSC. – So competitive equilibrium is efficient: MSB = MSC. 9-29 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared – Total surplus, the sum of consumer surplus and producer surplus, is maximized. – The quantity produced in perfect competition is efficient. 9-31 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared – Figure 13.6(b) shows the inefficiency of monopoly. – Because price exceeds marginal social cost, marginal social benefit exceeds marginal social cost, … – and a deadweight loss arises. 9-32 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared Redistribution of Surpluses – Some of the lost consumer surplus goes to the monopoly as producer surplus. 9-34 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared Rent Seeking – Any surplus—consumer surplus, producer surplus, or economic profit—is called economic rent. – Rent seeking is the pursuit of wealth by capturing economic rent. – Rent seekers pursue their goals in two main ways:  Buy a monopoly—transfers rent to creator of monopoly.  Create a monopoly—uses resources in political activity. 9-35 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared Rent-Seeking Equilibrium – The blue area shows the potential producer surplus with no rent seeking. – The resources used in rent seeking can wipe out the monopoly’s producer surplus. 9-36 © 2014 Pearson Education, Inc. All rights reserved.  Single-Price Monopoly and Competition Compared – Rent-seeking costs shifts the ATC curve upward, – Producer surplus disappears. – The deadweight loss increases to the larger gray area. 9-38 © 2014 Pearson Education, Inc. All rights reserved.  9.5 Advertising Advertising and Net Profit – A successful advertising campaign shifts the monopolist market demand curve outward. In Figure 9.7, D2 is the new demand curve after advertisement i.e. to the right of D1. Deciding Whether to Advertise – Do it only if firm expects net profit (gross profit minus the cost of advertising) to increase. In Figure 9.7, gross profit is B. How Much to Advertise – Do it until its marginal benefit (gross profit or marginal revenue) equals its marginal cost 9-39 © 2014 Pearson Education, Inc. All rights reserved.  9.5 Advertising Figure 9.7 Advertising 9-40 © 2014 Pearson Education, Inc. All rights reserved.  9.6 Networks & Behavioral Economics Network Externalities – A good has a network externality if one person’s demand depends on the consumption of a good by others. – If a good has a positive network externality, its value to a consumer grows as the number of units sold increases. A telephone and fax are classical examples. – For a network to succeed, it has to achieve a critical mass of users— enough adopters that others want to join. Network Externalities & Behavioral Economics – Bandwagon effect: A person places greater value on a good as more and more other people possess it – Snob effect: A person places greater value on a good as fewer and fewer other people possess it 9-41 © 2014 Pearson Education, Inc. All rights reserved.  9.6 Networks & Behavioral Economics Network Externalities & Monopoly – Because of the need for a critical mass of customers in a market with a positive network externality, we sometimes see only one large firm surviving. – The Windows operating system largely dominates the market—not because it is technically superior to Apple’s operating system or Linux— but because it has a critical mass of users. Managerial Implication: Introductory Pricing – Managers should consider initially selling a new product at a low introductory price to obtain a critical mass. By doing so, the manager maximizes long-run but not short-run profit. 9-42 © 2014 Pearson Education, Inc. All rights reserved.