“I don’t think it’s fair that only one company is allowed to make the Monopoly game.” Stephen Wright

1. 12 Monopoly CHAPTER “Competition is a sin.” J. D. Rockefeller “I don’t think it’s fair that only one company is allowed to make the Monopoly game.” Stephen Wright

2. C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • 1Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly. • 2Explain how a single-price monopoly determines its output and price. • 3Compare the performance of a single-price monopoly with that of perfect competition.

3. C H A P T E R C H E C K L I S T • 4Explain how price discrimination increases profit. • 5Explain why natural monopoly is regulated and the effects of regulation.

4. MARKET CHARACTERISTICS

5. 12.1 MONOPOLY AND HOW IT ARISES • No Close Substitutes • If a good has a close substitute, even though only one firm produces it, that firm effectively faces competition from the producers of substitutes. • Barriers to Entry • Anything that protects a firm from the arrival of new competitors is a barrier to entry. • There are three types of barriers to entry: • Natural • Ownership • Legal

6. 12.1 MONOPOLY AND HOW IT ARISES • Natural Barrier to Entry • Natural monopoly – when one firm is able to meet the entire market demand at a lower price than two or more firms could (long downward-sloping ATC). • Ex - Duke Power can meet the market demand for electricity at a lower cost than two or more firms could.

7. 12.1 MONOPOLY AND HOW IT ARISES Figure 12.1 shows a natural monopoly. 1.Economies of scale exist over the entire LRAC curve. 2.One firm can distribute 4 million kilowatt hours at acost of 5 cents a kilowatt-hour.

8. 12.1 MONOPOLY AND HOW IT ARISES 3.This same total output costs 10 cents a kilowatt-hour with two firms, 4.and15 cents a kilowatt-hour with four firms. One firm can meet the market demand at a lower cost than two or more firms can, and the market is a natural monopoly.

9. 12.1 MONOPOLY AND HOW IT ARISES • Ownership Barrier to Entry • A monopoly market in which competition and entry are restricted by the concentration of ownership of a natural resource. • Ex - DeBeers created barrier to entry by buying control over most of the world’s diamonds.(DeBeers is no longer a monopoly)

10. 12.1 MONOPOLY AND HOW IT ARISES • Legal Barrier to Entry • A legal barrier to entry creates legal monopoly. • Legal monopoly - competition and entry are restricted by granting of a public franchise, government license, patent, or copyright.

11. 12.1 MONOPOLY AND HOW IT ARISES • Public Franchise- exclusive right granted to a firm to supply a good or service. (ex, U.S. Postal Service) • Government license - controls entry into particular occupations, professions, and industries (ex, CPA). • Patent- exclusive right granted to the inventor of a product or service (must be registered, usually 20 years) • Copyright- exclusive constitutional right automatically granted to the author or composer of a literary, musical, dramatic, or artistic work. (work created from 1978 on, copyright last 70 years plus life of author. Time for work prior to 1978 varies, often 28 years)

12. 12.1 MONOPOLY AND HOW IT ARISES • Monopoly Price-Setting Strategies • A monopolist faces a tradeoff between price and the quantity sold. • To sell a larger quantity, the monopolist must set a lower price. • There are two price-setting possibilities that create different tradeoffs: • Single price • Price discrimination

13. 12.1 MONOPOLY AND HOW IT ARISES • Single-price monopoly - firm that must sell each unit of its output for the same price to all its customers. • DeBeers sell diamonds (quality given) at a single price. • Price-discriminating monopoly - firm that is able to sell different units of a good or service for different prices. • Airlines offer different prices for the same trip. (Though there are multiple airlines, one may have monopoly over certain routes)

14. 12.2 SINGLE-PRICE MONOPOLY • Price and Marginal Revenue • Firm demand curve = market demand curve (because there is only one seller, the firm IS the market). • Total revenue (TR) P x Q. • Marginal revenue (MR) ∆TR / Q.

15. 12.2 SINGLE-PRICE MONOPOLY The table shows the demand schedule and the graph shows the demand curve.

16. 12.2 SINGLE-PRICE MONOPOLY The table also calculates total revenue and marginal revenue.

17. 12.2 SINGLE-PRICE MONOPOLY When the price is $16, the quantity demanded is 2 haircuts an hour.

18. 12.2 SINGLE-PRICE MONOPOLY When the price falls to $14, the quantity demanded increases to 3 haircuts an hour.

19. 12.2 SINGLE-PRICE MONOPOLY 1.Total revenue lost on the 2 haircuts previously sold is $4.

20. 12.2 SINGLE-PRICE MONOPOLY 2. Total revenue gained on 1 additional haircut is $14.

21. 12.2 SINGLE-PRICE MONOPOLY 3.Marginal revenue is $10 ($14 gain minus $4 loss).

22. 12.2 SINGLE-PRICE MONOPOLY The marginal revenue curve slopes downward and is below the demand curve. Marginal revenue is less than price.

23. 12.2 SINGLE-PRICE MONOPOLY • Marginal Revenue and Elasticity • 1. If a price cut increases TR, demand is elastic. • 2. If a price cut decreases TR, demand is inelastic.

24. 12.2 SINGLE-PRICE MONOPOLY Figure 12.3(a) illustrates this relationship. 1. Over the range from zero to 5 haircuts an hour, marginal revenue is positive. A price fall increases total revenue, so demand is elastic. MR=ZERO

25. 12.2 SINGLE-PRICE MONOPOLY 2. At 5 haircuts an hour, marginal revenue is zero, so demand is unit elastic. MR=ZERO 3. Over the range 5 to 10 haircuts an hour, marginal revenue is negative. A price fall decreases total revenue, so demand is inelastic.

26. 12.2 SINGLE-PRICE MONOPOLY Over the range from zero to 5 haircuts an hour, marginal revenue is positive and total revenue increases as output increases. Figure 12.3(b) shows the same information about marginal revenue as steps running along the total revenue curve.

27. 12.2 SINGLE-PRICE MONOPOLY MR=ZERO Over the range from 5 to 10 haircuts an hour, marginal revenue is negative and total revenue decreases as output increases. The blue line is the total revenue curve. Total revenue is maximized at 5 haircuts an hour.

28. 12.2 SINGLE-PRICE MONOPOLY 4. Total revenue is maximized at 5 haircuts an hour, where marginal revenue is zero and demand is unit elastic. MR=ZERO • The relationship between MR and elasticity implies that a monopoly never profitably produces an output in the inelastic range of its demand curve.

29. 12.2 SINGLE-PRICE MONOPOLY • Output and Price Decision • Monopolists (like perfectly competitive firms) set profit maximizing output where MC=MR. Corresponding price is then found on demand curve.

30. 12.2 SINGLE-PRICE MONOPOLY Figure 12.4(b) shows the firm’s profit-maximizing output and price decision. The average total cost curve is ATC. The marginal cost curve is MC. The demand curve is D. The marginal revenue curve is MR.

31. 12.2 SINGLE-PRICE MONOPOLY Economic profit is maximized when MC=MR. The profit-maximizing quantity is 3 haircuts an hour. Profit-maxprice = $14 (determined by the demand curve (D). Average total cost = $10 (determined by ATC curve at profit max output)

32. 12.2 SINGLE-PRICE MONOPOLY 2.Economic profit, the blue rectangle, is $12. Profit per unit = P – ATC = $ 4. Profit per unit x Q = Total profit = $12. P-ATC

33. 12.3 MONOPOLY AND COMPETITION COMPARED • Output and Price • Compared to a firm in perfect competition, a single-price monopoly produces a smaller output and charges a higher price.

34. 12.3 MONOPOLY AND COMPETITION COMPARED Figure 12.5 illustrates this outcome. In perfect competition, the market demand curve is D. The market supply curve is S. 1. The competitive industry produces the quantity QC at price PC.

35. 12.3 MONOPOLY AND COMPETITION COMPARED The competitive market’s supply curve, S, is the monopoly’s marginal cost curve, MC. The market demand curve, D, is the demand for the monopoly’s output. The monopoly’s marginal revenue curve is MR.

36. 12.3 MONOPOLY AND COMPETITION COMPARED 2. A single-price monopoly produces the quantity QM where MC=MR and sells that quantity for the price PM.

37. 12.3 MONOPOLY AND COMPETITION COMPARED • Is Monopoly Efficient? • Resources are used efficiently in perfect competition because surplus is max when MB=MC. • Monopolists produce lower quantity at higher price, under-producing relative to efficient output. • Underproduction yields deadweight losses, not efficient.

38. 12.3 MONOPOLY AND COMPETITION COMPARED Figure 12.6 shows the inefficiency of monopoly. 1. In perfect competition, the quantity, QC, is the efficient quantity because at that quantity, MB=MC=PC. The sum of 2.consumer surplus and 3.producer surplus is maximized.

39. 12.3 MONOPOLY AND COMPETITION COMPARED 4. In a single-price monopoly, the equilibrium quantity, QM, is inefficient because MB(PM)>MC at that output. Underproduction creates a deadweight loss.

40. 12.3 MONOPOLY AND COMPETITION COMPARED 5.Consumer surplus shrinks. 6. Part of the producer surplus is lost as deadweight loss, but 7. Producer surplus expands to accrue part of consumer surplus, so producer is better off, consumer is worse off, society is worse off.

41. 12.4 PRICE DISCRIMINATION • Price discrimination - selling a good or service to different buyers at different prices, even though cost of providing the good is not different. • To price discriminate, a firm must • Identify and separate different types of buyers. • Sell a product that cannot be resold.

42. 12.4 PRICE DISCRIMINATION • Price Discrimination and Consumer Surplus • The key idea behind price discrimination is to convert consumer surplus into economic profit. • To extract every dollar of consumer surplus from every buyer, the monopoly would have to offer each individual customer a separate price schedule based on that customer’s own willingness to pay. • Remember: consumer surplus is the difference between what I’m willing to pay and what I have to pay. Price discriminators find ways to charge customers what they are willing to pay.

43. 12.4 PRICE DISCRIMINATION Figure 12.8 shows a single price of air travel. As a single-price monopoly, Global Air maximizes profit by selling 8,000 trips a year at $1,200 a trip. 1. Global’s customers enjoy a consumer surplus—the green triangle—and 2.Global’s economic profit is $4.8 million a year—the blue rectangle.

44. 12.4 PRICE DISCRIMINATION Figure 12.9 shows how Global can profit from price discrimination. The $1,200 fare is available only with a 14-day advance purchase and a stay over a weekend. The price of other 14-day advance purchase tickets is $1,400. The price of a 7-day advance purchase ticket is $1,600.

45. 12.4 PRICE DISCRIMINATION A ticket with no restrictions costs $1,800. Economic profit increases by $2.4 million to $7.2 million a year, shown by the original blue rectangle plus the blue steps. Global sells 2,000 units at each of its four new fares. Consumer surplus shrinks to the sum of the green triangles.

46. 12.4 PRICE DISCRIMINATION • Perfect Price Discrimination • Perfect price discrimination extracts the entire consumer surplus by charging the highest price that consumers are willing to pay for each unit.

47. 12.4 PRICE DISCRIMINATION Figure 12.10 illustrates perfect price discrimination. With perfect price discrimination, the demand curve becomes the marginal revenue curve. 1.Output increases to 11,000 trips a year, and ... 2.Global’s economic profit increases to $9.35 million a year.

48. 12.5 MONOPOLY REGULATION • Efficient Regulation (First Best) of Natural Monopoly • Regulation achieves an efficient allocation of resources if MC=MB(and price). • Called “first best” method because it is most efficient, but causes monopoly firm to earn negative economic profits (losses). • Marginal cost pricing rule- sets P=MC to achieve an efficient output.

49. 12.5 MONOPOLY REGULATION 1.Price is set equal to marginal cost of $10 a month. 2. At this price, the efficient quantity (8 million households) is served. 3. Consumer surplus, the green triangle, is maximized. 4.The firm incurs a loss on each household served, shown by the red arrow.

50. 12.5 MONOPOLY REGULATION • Inefficient Regulation (Second-Best) of a Natural Monopoly • Two possible ways of enabling a regulated monopoly to avoid an economic loss are • Average cost pricing • Government subsidy