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Chapter Twenty-Four Monopoly Pure Monopoly A monopolized market has a single seller. The monopolist’s demand curve is the (downward sloping) market demand curve. So the monopolist can alter the market price by adjusting its output level. Pure Monopoly $/output unit

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Chapter Twenty-Four

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Chapter twenty four l.jpg

Chapter Twenty-Four

Monopoly


Pure monopoly l.jpg

Pure Monopoly

  • A monopolized market has a single seller.

  • The monopolist’s demand curve is the (downward sloping) market demand curve.

  • So the monopolist can alter the market price by adjusting its output level.


Pure monopoly3 l.jpg

Pure Monopoly

$/output unit

Higher output y causes alower market price, p(y).

p(y)

Output Level, y


Pure monopoly4 l.jpg

Pure Monopoly

  • Suppose that the monopolist seeks to maximize its economic profit,

  • What output level y* maximizes profit?


Profit maximization l.jpg

Profit-Maximization

$

R(y) = p(y)y

c(y)

y*

y

P(y)


Profit maximization6 l.jpg

Profit-Maximization

$

R(y) = p(y)y

c(y)

y*

y

P(y)


Profit maximization7 l.jpg

Profit-Maximization

$

R(y) = p(y)y

c(y)

y*

y

P(y)


Profit maximization8 l.jpg

Profit-Maximization

$

R(y) = p(y)y

c(y)

y*

y

At the profit-maximizingoutput level the slopes of

the revenue and total costcurves are equal; MR(y*) = MC(y*).

P(y)


Marginal revenue l.jpg

Marginal Revenue

E.g. if p(y) = a - by then

R(y) = p(y)y = ay - by2

and so

MR(y) = a - 2by < a - by = p(y) for y > 0.

p(y) = a - by

a

y

a/b

a/2b

MR(y) = a - 2by


Marginal cost l.jpg

Marginal Cost

Marginal cost is the rate-of-change of totalcost as the output level y increases;

E.g. if c(y) = F + ay + by2 then


Marginal cost11 l.jpg

Marginal Cost

$

c(y) = F + ay + by2

F

y

$/output unit

MC(y) = a + 2by

a

y


Profit maximization an example l.jpg

Profit-Maximization; An Example

At the profit-maximizing output level y*,MR(y*) = MC(y*). So if p(y) = a - by andc(y) = F + ay + by2 then


Profit maximization an example13 l.jpg

Profit-Maximization; An Example

$/output unit

a

p(y) = a - by

MC(y) = a + 2by

a

y

MR(y) = a - 2by


Monopolistic pricing own price elasticity of demand l.jpg

Monopolistic Pricing & Own-Price Elasticity of Demand

  • Suppose that market demand becomes less sensitive to changes in price (i.e. the own-price elasticity of demand becomes less negative). Does the monopolist exploit this by causing the market price to rise?


Monopolistic pricing own price elasticity of demand15 l.jpg

Monopolistic Pricing & Own-Price Elasticity of Demand

Own-price elasticity of demand is

so


Monopolistic pricing own price elasticity of demand16 l.jpg

Monopolistic Pricing & Own-Price Elasticity of Demand

Suppose the monopolist’s marginal cost ofproduction is constant, at $k/output unit.For a profit-maximum

which is


Monopolistic pricing own price elasticity of demand17 l.jpg

Monopolistic Pricing & Own-Price Elasticity of Demand

Notice that, since

That is,

So a profit-maximizing monopolist alwaysselects an output level for which marketdemand is own-price elastic.


Markup pricing l.jpg

Markup Pricing

  • Markup pricing: Output price is the marginal cost of production plus a “markup.”

  • How big is a monopolist’s markup and how does it change with the own-price elasticity of demand?


Markup pricing19 l.jpg

Markup Pricing

is the monopolist’s price. The markup is


A profits tax levied on a monopoly l.jpg

A Profits Tax Levied on a Monopoly

  • A profits tax levied at rate t reduces profit from P(y*) to (1-t)P(y*).

  • Q: How is after-tax profit, (1-t)P(y*), maximized?


A profits tax levied on a monopoly21 l.jpg

A Profits Tax Levied on a Monopoly

  • A profits tax levied at rate t reduces profit from P(y*) to (1-t)P(y*).

  • Q: How is after-tax profit, (1-t)P(y*), maximized?

  • A: By maximizing before-tax profit, P(y*).


A profits tax levied on a monopoly22 l.jpg

A Profits Tax Levied on a Monopoly

  • A profits tax levied at rate t reduces profit from P(y*) to (1-t)P(y*).

  • Q: How is after-tax profit, (1-t)P(y*), maximized?

  • A: By maximizing before-tax profit, P(y*).

  • So a profits tax has no effect on the monopolist’s choices of output level, output price, or demands for inputs.

  • I.e. the profits tax is a neutral tax.


Quantity tax levied on a monopolist l.jpg

Quantity Tax Levied on a Monopolist

  • A quantity tax of $t/output unit raises the marginal cost of production by $t.

  • So the tax reduces the profit-maximizing output level, causes the market price to rise, and input demands to fall.

  • The quantity tax is distortionary.


Quantity tax levied on a monopolist24 l.jpg

Quantity Tax Levied on a Monopolist

$/output unit

p(y)

p(y*)

MC(y)

y

y*

MR(y)


Quantity tax levied on a monopolist25 l.jpg

Quantity Tax Levied on a Monopolist

$/output unit

p(y)

MC(y) + t

p(y*)

t

MC(y)

y

y*

MR(y)


Quantity tax levied on a monopolist26 l.jpg

Quantity Tax Levied on a Monopolist

$/output unit

p(y)

p(yt)

MC(y) + t

p(y*)

t

MC(y)

y

yt

y*

MR(y)


Quantity tax levied on a monopolist27 l.jpg

Quantity Tax Levied on a Monopolist

The quantity tax causes a dropin the output level, a rise in theoutput’s price and a decline in

demand for inputs.

$/output unit

p(y)

p(yt)

MC(y) + t

p(y*)

t

MC(y)

y

yt

y*

MR(y)


The inefficiency of monopoly l.jpg

The Inefficiency of Monopoly

  • A market is Pareto efficient if it achieves the maximum possible total gains-to-trade.

  • Otherwise a market is Pareto inefficient.


The inefficiency of monopoly29 l.jpg

The Inefficiency of Monopoly

$/output unit

The efficient output levelye satisfies p(y) = MC(y).

p(y)

MC(y)

p(ye)

y

ye


The inefficiency of monopoly30 l.jpg

The Inefficiency of Monopoly

$/output unit

The efficient output levelye satisfies p(y) = MC(y).Total gains-to-trade ismaximized.

p(y)

CS

MC(y)

p(ye)

PS

y

ye


The inefficiency of monopoly31 l.jpg

The Inefficiency of Monopoly

$/output unit

p(y)

p(y*)

MC(y)

y

y*

MR(y)


The inefficiency of monopoly32 l.jpg

The Inefficiency of Monopoly

$/output unit

p(y)

CS

p(y*)

MC(y)

PS

y

y*

MR(y)


The inefficiency of monopoly33 l.jpg

The Inefficiency of Monopoly

$/output unit

MC(y*+1) < p(y*+1) so bothseller and buyer could gainif the (y*+1)th unit of outputwas produced. Hence the market is Pareto inefficient.

p(y)

CS

p(y*)

MC(y)

PS

y

y*

MR(y)


The inefficiency of monopoly34 l.jpg

The Inefficiency of Monopoly

$/output unit

Deadweight loss measures

the gains-to-trade not

achieved by the market.

p(y)

p(y*)

MC(y)

DWL

y

y*

MR(y)


The inefficiency of monopoly35 l.jpg

The Inefficiency of Monopoly

The monopolist produces less than the efficient quantity, making the market price exceed the efficient market price.

$/output unit

p(y)

p(y*)

MC(y)

DWL

p(ye)

y

y*

ye

MR(y)


Natural monopoly l.jpg

Natural Monopoly

  • A natural monopoly arises when the firm’s technology has economies-of-scale large enough for it to supply the whole market at a lower average total production cost than is possible with more than one firm in the market.


Natural monopoly37 l.jpg

Natural Monopoly

$/output unit

ATC(y)

p(y)

MC(y)

y


Natural monopoly38 l.jpg

Natural Monopoly

$/output unit

ATC(y)

p(y)

p(y*)

MC(y)

y*

y

MR(y)


Entry deterrence by a natural monopoly l.jpg

Entry Deterrence by a Natural Monopoly

  • A natural monopoly deters entry by threatening predatory pricing against an entrant.

  • A predatory price is a low price set by the incumbent firm when an entrant appears, causing the entrant’s economic profits to be negative and inducing its exit.


Entry deterrence by a natural monopoly40 l.jpg

Entry Deterrence by a Natural Monopoly

  • E.g. suppose an entrant initially captures one-quarter of the market, leaving the incumbent firm the other three-quarters.


Entry deterrence by a natural monopoly41 l.jpg

Entry Deterrence by a Natural Monopoly

$/output unit

ATC(y)

p(y), total demand = DI + DE

DE

DI

MC(y)

y


Entry deterrence by a natural monopoly42 l.jpg

Entry Deterrence by a Natural Monopoly

$/output unit

An entrant can undercut theincumbent’s price p(y*) but ...

ATC(y)

p(y), total demand = DI + DE

DE

p(y*)

DI

pE

MC(y)

y


Entry deterrence by a natural monopoly43 l.jpg

Entry Deterrence by a Natural Monopoly

$/output unit

An entrant can undercut theincumbent’s price p(y*) but

ATC(y)

p(y), total demand = DI + DE

the incumbent can then lower its price as far as pI, forcing the entrant to exit.

DE

p(y*)

DI

pE

pI

MC(y)

y


Inefficiency of a natural monopolist l.jpg

Inefficiency of a Natural Monopolist

  • Like any profit-maximizing monopolist, the natural monopolist causes a deadweight loss.


Inefficiency of a natural monopoly l.jpg

Inefficiency of a Natural Monopoly

$/output unit

ATC(y)

p(y)

p(y*)

MC(y)

y*

y

MR(y)


Inefficiency of a natural monopoly46 l.jpg

Inefficiency of a Natural Monopoly

$/output unit

ATC(y)

Profit-max: MR(y) = MC(y) Efficiency: p = MC(y)

p(y)

p(y*)

MC(y)

p(ye)

y*

ye

y

MR(y)


Inefficiency of a natural monopoly47 l.jpg

Inefficiency of a Natural Monopoly

$/output unit

ATC(y)

Profit-max: MR(y) = MC(y) Efficiency: p = MC(y)

p(y)

p(y*)

DWL

MC(y)

p(ye)

y*

ye

y

MR(y)


Regulating a natural monopoly l.jpg

Regulating a Natural Monopoly

  • Why not command that a natural monopoly produce the efficient amount of output?

  • Then the deadweight loss will be zero, won’t it?


Regulating a natural monopoly49 l.jpg

Regulating a Natural Monopoly

$/output unit

At the efficient outputlevel ye, ATC(ye) > p(ye)

ATC(y)

p(y)

MC(y)

ATC(ye)

p(ye)

ye

y

MR(y)


Regulating a natural monopoly50 l.jpg

Regulating a Natural Monopoly

$/output unit

At the efficient outputlevel ye, ATC(ye) > p(ye)so the firm makes aneconomic loss.

ATC(y)

p(y)

MC(y)

ATC(ye)

Economic loss

p(ye)

ye

y

MR(y)


Regulating a natural monopoly51 l.jpg

Regulating a Natural Monopoly

  • So a natural monopoly cannot be forced to use marginal cost pricing. Doing so makes the firm exit, destroying both the market and any gains-to-trade.

  • Regulatory schemes can induce the natural monopolist to produce the efficient output level without exiting.


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