Monopoly Review & Exercises

Review & Exercises  The Welfare Cost of Monopoly The monopolist sells less and at a higher price P($) than the perfectly competitive industry. MC The welfare loss from a monopoly is B +...

Review & Exercises  The Welfare Cost of Monopoly The monopolist sells less and at a higher price P($) than the perfectly competitive industry. MC The welfare loss from a monopoly is B + D PM DWL C is a transfer of surplus from the consumer C D to the monopolist B A is the opportunity cost of diverted A resources, which is not a loss to society (Not MR D QM QPC Q DWL) 26  Public Policy Toward Monopolies i. Antitrust laws: Break up the firm ii. Regulation: Government determines price and quantity iii. Public ownership: State enterprise iv. Do nothing: Let time and markets get rid of monopoly 27  Two Pricing Choices for Regulation Socially optimal price = perfect competition price – Set P = MC (i.e., where D intersects MC) – Most efficient but may result in losses for the firm – So, the government would have to subsidize the firm to survive. Fair-return price = breakeven price – Set P = ATC (i.e., where D intersects ATC) – Does not achieve allocative efficiency but does insure a fair return (break even) for the firm. Can a natural monopolist achieve productive Efficiency? 28 Exercise 1: Monopoly A natural monopoly firm has the following data (in $). Fill in the table below. Q P TR MR LRATC TC MC 1 $14 $14 $14 $11 $11 $11 2 12 10 10.5 21 10 3 10 10 9 4 8 38 5 6 45 29 Exercise 1: Monopoly A natural monopoly firm has the following data (in $). Fill in the table below. Q P TR MR LRATC ATC TC MC 1 $14 $14 $14 $11 $11 $11 2 12 24 10 10.5 21 10 3 10 30 6 10 30 9 4 8 32 2 9.5 38 8 5 6 30 -2 9 45 7 30  Exercise 1: Monopoly What will be the price that the firm charges if there is no government market intervention? How much profit or loss it will make? Q P TR MR LRATC TC MC 1 $14 $14 $14 $11 $11 $11 2 12 24 10 10.5 21 10 3 10 30 6 10 30 9 4 8 32 2 9.5 38 8 5 6 30 -2 9 45 7 With no government market intervention => Charge monopoly price At MR = MC, Q* = 2 units and P* = $12 Profit = $24 – $21 = $3 or ($12 – $10.5) x 2 31 Exercise 1: Monopoly What is the fair return price? How much will the firm make if it charges a fair return price? Q P TR MR LRATC TC MC 1 $14 $14 $14 $11 $11 $11 2 12 24 10 10.5 21 10 3 10 30 6 10 30 9 4 8 32 2 9.5 38 8 5 6 30 -2 9 45 7 – Fair return price is break even price, P = ATC – P = LRATC = $10 at Q = 3 units – Firm breaks even (profit = $0). 32 Exercise 1: Monopoly What is the socially optimum price? How much will the firm make? Q P TR MR LRATC TC MC 1 $14 $14 $14 $11 $11 $11 2 12 24 10 10.5 21 10 3 10 30 6 10 30 9 4 8 32 2 9.5 38 8 5 6 30 -2 9 45 7 – Socially optimum price is where P = MC. – P = MC = $8 at Q = 4 units – Profit = 32 – 38 = - $6 or (8 – 9.5) x 4 33 Review  Measuring Industry Concentration Concentration ratio: The % of industry’s total sales obtained by the 4 largest firms. Output of 4 largest firms CR4 = x 100 Total output of the industry Herfindahl index: The sum of the squared value of the individual market shares of all firms in the industry. HI = (%S1)2 + (%S2)2 + (%S3)2 + …. + (%Sn)2 45  Demand and Marginal Revenue Demand is downward sloping. MR is below D. That is, P > MR = MC. P ($) P ($) dPC MR d DMONOPOLY d q A B C q MC AB = BC = 0.5 x AC Imperfect competitive firms face downward sloping demand curve 46  The Marginal Approach P ($) MC Find output where MR = MC, D at q* this is the profit maximizing q P* = $24 Find how much consumers will pay where the profit max q* intersects demand curve, dMC this is the chosen price MR = MC MR q 4 = q* 47  Possible Outcomes Short run has 4 possible scenarios 1. Make profits (P > ATC) 2. Breakeven (P = ATC) 3. Continue with losses ATC > P > AVC) 4. Shutdown (P < AVC) Long run has only 1 possible scenario Breakeven (zero economic profit) Because relatively easy entry and exit into and out of the industry 48  Efficiency Inefficiency 1. Does not achieve productive efficiency P > min. ATC and P > min. LRATC There are lots of underutilized firms in the industry. The existing firms are not operating at optimal capacity. 2. Does not achieve allocative efficiency P > MC instead of P = MC 49 Review & Exercises  Monopoly vs. Perfect Competition Characteristic Pure/Perfect Competition Monopoly Number of firms A very large number One Type of product Standardized Unique; no close substitutes Control over price None Considerable Conditions of entry Very easy, no obstacles Blocked 58  Monopoly vs. Perfect Competition Characteristic Pure/Perfect Competition Monopoly MR vs. P P = MR P > MR Influence over price Price taker Price maker Productive Yes No efficiency: (even breakeven where P = min LRATC P = LRATC) Conditions of entry Very easy, no obstacles Blocked Beneficiaries Consumers (because of Monopolist (because of intense competition) no competition) 59  Demand and Marginal Revenue P ($) Demand is downward sloping. MR is below D. That is, P > MR. To maximize profit, monopolist produces at output where MR = MC. MR D Since P > MR, P > MC too. B Q A C AB = BC = 0.5 x AC “MR is twice as steep as demand curve” 60  Monopolist’s Profit Maximization Price, Costs and Revenue MC As with a P ATC competitive firm, ATC the monopolist’s profit equals D (P – ATC) x Q MR Q*M Q 61  Marginal Approach Step 1 Determine the profit-maximizing output by finding where MR = MC. Determine the profit-maximizing price by extending a vertical line upward from the Step 2 output determined in step 1 to the pure monopolistʼs demand curve. Step 3 Determine the pure monopolistʼs economic profit by using one of two methods: Method 1. Find profit per unit by subtracting the ATC of the profit-maximizing output from the profit-maximizing price. Then multiply the difference by the profit- maximizing output to determine economic profit (if any).  (P-ATC)Q Method 2. Find TC by multiplying the ATC of the profit-maximizing output by that output. Find TR by multiplying the profit-maximizing output by the profit- maximizing price. Then subtract TC from TR to determine the economic profit (if any).  TR - TC If the firm makes a loss, need to check P against AVC. If P < AVC, then the firm shuts Step 4 down instead of producing any output. 62  Some Observations about Monopoly 1. No supply curve for a monopolist. 2. Always sets prices in the elastic region of the demand curve. 3. Does not charge the highest possible price. 4. Interests in total profit, not per unit profit. 5. There is a possibility of losses. 63 Exercise 1: Monopoly Q P = AR TC Is the market structure here perfect or 0 $34 $20 imperfect competition? Why? 1 32 36 – Imperfect competition because price is 2 30 46 not constant. 3 28 50 4 26 54 5 24 56 6 22 68 7 20 80 64 Exercise 1: Monopoly Q P = AR TC Find profit maximizing output and 0 $34 $20 price using the total and marginal 1 32 36 approaches. 2 30 46 3 28 50 4 26 54 5 24 56 6 22 68 7 20 80 65 Exercise 1: Monopoly Total approach: Max profit = $64 gives Q* = 6 and P* = $22. Q P = AR TC TR MR MC Profit/Loss 0 $34 $20 $0 - - -$20 1 32 36 32 $32 $16 -4 2 30 46 60 28 10 +14 3 28 50 84 24 4 +34 4 26 54 104 20 4 +50 5 24 56 120 16 2 +64 6 22 68 132 12 12 +64 7 20 80 140 8 12 +60 66  Exercise 1: Monopoly Marginal approach: MR = MC = $12 gives Q* = 6 and P* = $22 > ATC = $11.33 Q P = AR TC TR MR MC Profit/Loss 0 $34 $20 $0 - - -$20 1 32 36 32 $32 $16 -4 2 30 46 60 28 10 +14 3 28 50 84 24 4 +34 4 26 54 104 20 4 +50 5 24 56 120 16 2 +64 6 22 68 132 12 12 +64 7 20 80 140 8 12 +60 67 Exercise 1: Monopoly We have the following graph. P, Cost, and Revenue ($) MC D at Q* ATC P* = 22 Economic Profit = $64 MR=MC 12 D ATC = 11.33 ATC at Q* MR Q Q*= 6 68 Review  Kinked Demand Curve Model P, Cost ($) A gap in the MR curve exists A large shift in marginal cost If P increases, others will not go is required before firms will along, so D is elastic. change their price (and output) MC1 P If P decreases, other firms MC2 match the decrease, so D Gap is inelastic. MR D Q Q 55  Collusive Pricing Model Firms collude (cooperate with rivals) in this model. The oligopolies act as if they were a monopoly and set a price to maximize joint profit or group profit. Output quotas are assigned to individual member firms so that total output is consistent with joint profit maximization. 56  Price Leadership Model Implicit or informal collusion Dominant firm initiates price changes – The firm has to take into account the followers’ action at any price it sets. Other firms follow the leader. Use limit pricing to block entry of new firm. 57  Oligopoly Is Inefficient Productive inefficient because P > min. ATC and P > min. LRATC Allocative inefficient because P > MC. 58  Market Structure Comparison Monopolistic Perfect Monopoly Oligopoly Competition Competition No. of Firms One Few Many Almost infinite Barriers to Entry Significant Significant Few None Pricing Decisions MR = MC Strategic pricing MR = MC P = MR = MC Output restricted, Most output No output Output Decisions restriction Output restricted product restriction differentiation Interdependent Each firm is Each firm is Interdependence No competitors decisions independent independent None None Long-Run Profit Possible Possible P = LRATC P = min. LRATC P and MC P > MC P > MC P > MC P = MC 59 Review & Exercise  Price Discrimination Selling the same product at different prices to different buyers. – Consumers with lower elastic demands are charged higher prices – Consumers with higher elastic demands are charged lower prices Price differences are not based on cost differences. 20  Price Discrimination Price discrimination can raise the firm’s profit and economic welfare (perfect price discrimination) The deadweight loss of monopoly is completely eliminated under the perfect price discrimination - consumer surplus = 0 - No deadweight loss (at QM: P = MC) - produce at output level as in perfect competition (QM = QPC) 21  Conditions for Price Discrimination Not all firms can price discriminate. To be able to do so, all following conditions must be satisfied. 1. Monopoly power 2. Market segregation  classify customers into groups 3. No resale (or no arbitrage)  so normally found in services 22 Exercise 1: Price Discrimination Local-Daily, a monopolistic newspaper producer, has two major groups of readers: business employees and students. Each group has 1,000 readers. Willingness to purchase is as follows. – Business employees: maximum price of $5. – Students: if the prices are not more than $2. Assume that Local-Daily has a constant average total cost of $1 per copy of newspaper. 23 Exercise 1: Price Discrimination Recap: – Business employees: maximum price of $5 – Students: if the prices are not more than $2 – 1,000 readers for each group – Constant average total cost of $1 What would be the profit of Local Daily if they charge a single price of $2? – Both groups buy. – Profit = (P-ATC) x (q1 +q2) = (2 – 1) x (1,000 + 1,000) = $2,000. 24 Exercise 1: Price Discrimination Recap: – Business employees: maximum price of $5 (or P1) – Students: if the prices are not more than $2 (or P2) – 1,000 readers for each group – Constant average total cost of $1 What would be the profit of Local Daily if they charge a single price of $5? – Only business employees would buy. (Students would not buy.) – Profit = (P1- ATC) x q1 = (5 – 1) x 1,000 = $4,000. 25 Exercise 1: Price Discrimination Recap: – Business employees: maximum price of $5 (or P1) – Students: if the prices are not more than $2 (or P2) – 1,000 readers for each group – Constant average total cost of $1 If Local-Daily somehow found a way to engage in price discrimination, what prices should be charged? And what will be profit of Local-Daily? – Charge $5 for business employees and $2 for students. – Profit = [(P1- ATC) x q1] + [(P2- ATC) x q2] = [(5 – 1) x 1,000] + [(2 – 1) x 1,000] = $5,000 26 Exercise 1: Price Discrimination What is the major obstacle for Local-Daily to engage in price discrimination? – Must prevent resales. – Must effectively prevent the students purchase newspaper and resell to the business employees, or to prevent students purchase the newspaper for business employees or their parents. 27