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Chapter 11

Chapter 11. Monopoly. Key issues. monopoly profit maximization: MR = MC market power monopoly welfare effects: p > MC  DWL cost advantages that create monopolies government actions that create monopolies government actions that reduce market power

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Chapter 11

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  1. Chapter 11 Monopoly

  2. Key issues • monopoly profit maximization: MR = MC • market power • monopoly welfare effects: p > MC  DWL • cost advantages that create monopolies • government actions that create monopolies • government actions that reduce market power • dominant firm and competitive fringe

  3. Monopoly • monopoly: only supplier of a good for which there is no close substitute • monopoly's output is the market output: q = Q • monopoly's demand curve is market demand curve • its demand curve is downward sloping • it doesn't lose all its sales if its raises its price • it is a price setter

  4. Profit maximization all firms maximize profits by choosing quantity such that marginal revenue = marginal cost MR(Q) = MC(Q)

  5. Marginal revenue • firm's MR curve depends on its demand curve • monopoly's MR curve • lies below its demand curve at any positive quantity • because its demand curve is downward sloping • demand curve shows price, p, it receives for selling a given quantity, Q • price = p = average revenue

  6. Marginal revenue, MR • change in revenue from selling one more unit • MR = R/Q (Calculus: MR = dR(Q)/dQ) • if firm sells exactly one more unit, Q = 1, • its marginal revenue is MR = R • R = R2 – R1 • MR < p at any given Q for a monopoly (but not for a competitive firm)

  7. Figure 11.1a Average and Marginal Revenue R1 = A R2 = A + B (a) Competitive Firm Price, p , R = R2 – R1 = B = p 1 $ per unit Demand curve p 1 A B q q + 1 Quantity, q , Units per year

  8. Figure 11.1b Average and Marginal Revenue (b) Monopoly R1 = A + C R2 = A + B Price, p , $ per unit R = R2 – R1 = B – C = p2 - C p 1 C p 2 Demand curve A B Q Q + 1 Quantity, Q , Units per year

  9. Deriving monopoly’s MR curve • monopoly increases its output by Q, • by lowering its price per unit by p/Q (slope of demand curve) • so monopoly loses (p/Q)Q on units originally sold at higher price: area C • but earns an additional p on extra output: area B • thus: MR = p + (p/Q) Q = p + a negative term < p

  10. Calculus derivation • monopoly’s revenue is R(Q) = p(Q)Q • differentiating with respect to Q: • thus: MR = p + a negative term < p

  11. Figure 11.2 Elasticity of Demand and Total, Average, and Marginal Revenue p , $ per unit Perfectly elastic 24 Elastic, < – 1 e MR = – 2 D p = – 1 D Q = 1 Q = 1 D D = – 1 e 12 Inelastic, – 1 < < 0 e Demand ( p = 24 – Q ) Perfectly inelastic 0 12 24 Q , Units per day MR = 24 – 2 Q

  12. Linear MR curve • for all linear demand curves, p = a - bQ • MR curve is a straight line, MR = a - 2bQ • MR curve hits vertical (price) axis where demand curve does • slope of MR curve = 2  slope of demand curve • MR curve hits horizontal axis at half the quantity as the demand curve

  13. In our example • p = 24 – Q • so a = 24 and b = 1 • p /Q = -1 • henceMR = p + (p/Q) Q = (24 – Q) + (-1)  Q = 24 – 2Q

  14. Using calculus R(Q) = p(Q)Q if linear: R(Q) = [a - bQ]Q = aQ - bQ2 MR = dR/dQ = a - 2bQ

  15. MR andelasticity of demand • MR at any given quantity depends on • demand curve's height (price) • demand curve's shape (elasticity) • thus, it depends on its elasticity

  16. Derive MR/elasticity formula • demand elasticity:  = (Q/Q)/(p/p) = (Q/p)(p/Q) • MR = p + (p/Q) Q = p + (p/Q)(Q/p)p

  17. MR and price • MR • MR closer to p the more elastic is demand • where demand curve hits price axis (Q = 0), demand curve is perfectly elastic  MR = p • MR = 0 where demand elasticity is  = -1 • MR < 0 where demand is inelastic: 0   > -1

  18. Table 11.1 Quantity, Price, Marginal Revenue, and Elasticity for the Linear Inverse Demand Curve p=24-Q

  19. Figure 11.2 Elasticity of Demand and Total, Average, and Marginal Revenue p , $ per unit Perfectly elastic 24 Elastic, < – 1 e MR = – 2 D p = – 1 D Q = 1 Q = 1 D D = – 1 e 12 Inelastic, – 1 < < 0 e Demand ( p = 24 – Q ) Perfectly inelastic 0 12 24 Q , Units per day MR = 24 – 2 Q

  20. Choosing price or quantity • monopoly can set p or Q to maximize its profit,  • monopoly is constrained by market demand curve • it cannot set both Q and p (cannot pick a point above demand curve) • if monopoly sets p, demand curve determines Q • if monopoly sets Q, demand curve determines p • because monopoly wants to maximize , it chooses same profit-maximizing solution whether it sets p or Q

  21. Profit maximization all firms, including monopolies, use a two-step analysis • firm determines output, Q*, at which it makes highest , where • MR = MC • in elastic portion of demand curve 2. firm decides whether to produce Q* or shut down: p  AVC

  22. (a) Monopolized Market Figure 11.3 Maximizing Profit MC p , $ per unit 24 AC AVC e 18 p = 60 12 8 6 Demand MR 0 6 12 24 Q , Units per day (b) Profit, Revenue R , p , $ 144 Revenue, R 108 60 Profit, p 0 6 12 24 , Units per day Q

  23. SR cost in our example • C(Q) = Q2+ 12 • MC = dC(Q)/dQ = 2Q • AVC = VC/Q = Q2/Q = Q • AC = C/Q = (Q2 + 12)/Q = Q + 12/Q

  24. Profit is maximized where • MR = 24 – 2Q = 2Q = MC  Q = 6 • inverse demand: p = 24 – Q = 24 – 6 = 18 • AVC = Q = 6 < p = 18 so produce •  > 0 because AC = Q + 12/Q = 8 < p = 18

  25. Market power ability of a firm to charge a price above marginal cost profitably

  26. No check on bank market power banks exercise substantial market power on the rate for bounced checks • although you had no idea that a check wouldn't clear, bank charges you an average of $4.75 to $7.50 (up to $10) • large banks charge more than small ones • bad check writer also pays an average of $15 to $19.50 (up to $30)

  27. Bank costs • bank's handling fees for bad checks = $1.32 • most checks eventually clear (check writer merely miscalculated balances) • even including losses from fraud, total MC = $2.70 (Center for the Study of Responsive Law) • thus, banks are exercising substantial market power: price > MC

  28. Market power and shape of demand curve • market power depends on shape of demand curve (elasticity) • at profit-maximizing quantity:

  29. Lerner index (price markup) • Lerner index is (p – MC)/p • if firm profit maximizes, • Lerner index ranges from 0 to 1 • p MC • 0  p – MC  p • 0  (p – MC)/p  p/p = 1

  30. Causes of market power monopoly's demand curve is relatively inelastic if • consumers are willing to pay "virtually anything" for it • no close substitutes for firm's product exist • other firms can't enter market • other similar firms are located far away • other firms’ products very different

  31. Welfare effects of monopoly • welfare = consumer surplus + producer surplus • W = CS + PS • welfare is < under monopoly than under competition • monopoly sets p > MC, causing deadweight loss (DWL)

  32. Figure 11.5 Deadweight Loss of Monopoly p , $ per unit 24 MC e m A = $18 C =$ 2 p = 18 m B = $12 e c p = 16 c = $4 E D =$60 MR = MC = 12 Demand MR 0 Q = 6 Q = 8 12 24 m c , Units per day Q

  33. Solved problem • in our linear example, • how does subjecting a monopoly to a specific tax of  = $8 per unit affect • monopoly optimum • welfare of consumers, the monopoly, and society? • what is tax incidence on consumers?

  34. Solved Problem 11.1 p , $ per unit 2 MC (after tax) 24 1 MC (before tax) e A t = $ 8 2 p = 20 2 e B C 1 p = 18 1 E F D 8 G Demand MR 0 Q = 4 Q = 6 12 24 2 1 Q , Units per day

  35. Competitive vs. monopoly sugar tax incidence • incidence of a tax on consumers may be less for a monopolized than a competitive market • in 1996, Florida voted on (and rejected) a one-cents-per-pound excise tax on refined cane sugar in the Florida Everglades Agricultural Area • given linear supply (or marginal cost) and demand curves the tax incidence on consumers from this tax is • 70% if the market is competitive • 41% if monopolistic • thus, a competitive Florida sugar industry passes on substantially more of the tax to demanders than it would if the industry were monopolized

  36. Welfare effects of taxes • governments use ad valorem taxes (p per unit) more often than specific taxes ( per unit) – why? • suppose both taxes cut output by the same amount • which one raises the most government tax revenue?

  37. Figure 11.6 Ad Valorem Versus Specific Tax p , $ per unit e 1 p 2 A e 2 p 1 p = p – t s 2 B p = (1 – ) p a a 2 MC Before-tax demand, D MR s a D D Q Q Q , Units per year s a MR MR 2 1

  38. Why monopolies? • firm has cost advantage over others firms • government created monopoly • merger of several firms into a single firm • firms act collectively: cartel • strategies - such as threats of violence - that discourage other firms from entering market

  39. Sources of cost advantages • firm controls a key input: • essential facility: scarce resource that rival needs to use to survive • firm knows of superior technology, or • has better way of organizing production

  40. Natural monopoly • market has a natural monopoly if one firm can produce total market output at lower cost than could several firms • if cost for Firm i to produces qi is C(qi), condition for a natural monopoly is C(Q) < C(q1) + C(q2) + ... + C(qn), • where Q = q1 + q2 + .. + qn is sum of output of any n > 2 firms

  41. Sufficient condition natural monopoly if • AC curve falls at any observed quantity for all firms • economies of scale

  42. Electricity example • F = $60 (build plant & connect houses) • MC = m = $10 (constant) • AC = m + F/Q = 10 + 60/Q, declines as output rises

  43. Costs of producing Q = 12 • having only one firm produce avoids a • second fixed cost (MC doesn’t vary with • number of firms)

  44. Figure 11.7 Natural Monopoly AC , MC , $ per unit 40 20 = + AC 60/ Q 10 15 10 MC = 10 0 6 12 15 Q, Units per day

  45. Public utilities apparently believing they’re natural monopolies, governments grant monopoly rights for essential good or service “public utilities” • water • gas • electric power • mail delivery

  46. Electric power utilities • AC curve for U.S electric-power-producing firms in 1970 • was U-shaped • reached its minimum at 33 billion kWh per year • whether an electric power utility is a natural monopoly depends on demand it faces

  47. Economies of scale • natural monopolies: most electric companies operated in regions of substantial economies of scale • Newport Electric produced 0.5 billion kWh/year • Iowa Southern Utilities: 1.3 billion kWh/year • not natural monopolies: a few operated in upward-sloping section of AC curve • Southern produced 54 kWh/year • 2 firms could produce that quantity at 3¢ less per thousand kWh than could a single firm

  48. Application Electric Power Utilities Cost, $ per thousand kWh 5.10 D AC 4.85 4.79 0 33 66 Q , Billion kWh per year

  49. Government created monopolies • barriers to entry (e.g, patents) • own and manage many monopolies • postal services • garbage collection • utilities • electricity • water • gas • phone services

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