MONOPOLY

1. MONOPOLY • Examines the sources of monopoly power • How monopolist maximizes profit • Differences between monopoly and perfect competition • why monopolist sometimes charges different prices for the same product

2. Topics • Barriers to entry • Price elasticity and marginal revenue • Profit maximization and loss minimization • Monopoly and resource allocation • Welfare cost of monopoly • Price discrimination

3. Characteristics of Monopoly Market Structure • Monopoly is the sole supplier of a product with no close substitutes • 2. A monopolized market is characterized by barriers to entry – restrictions on the entry of new firms into an industry such as • Legal restrictions • Economies of scale • Control of an essential resource

4. 1.Legal restrictions 1. Patents and invention incentives • Patents award an inventor the exclusive right to produce a good or service for 20 years • Provide the stimulus to turn an invention into a marketable product, a process called innovation 2. Licenses and other entry restrictions • Licenses can serve as an effective barriers against new competitors • Governments often confer monopoly status by awarding a single firm the exclusive right to supply a particular good or service

5. 2. Economies of Scale • Monopoly emerges when a firm experiences economies of scale as reflected by the downward-sloping, long-run average cost curve • In this case, a single firm can supply market demand at a lower AVC per unit than 2 or more firms each producing less • A monopoly that emerges from nature of costs is called natural monopoly $ t i n u r e p t s o C Long-run average cost Quantity per period

6. 3. Control of Essential Resources • Sometimes the source of monopoly power is a firm’s control over some nonreproducible resource critical to production • Alcoa was the sole U.S. maker of aluminum for a long period of time because it controlled the supply of bauxite • China is the monopoly supplier of pandas • DeBeers controls the world’s diamond trade

7. Revenue for the Monopolist 1.Demand, Average and Marginal Revenue • Because monopoly supplies the entire market, the demand for goods or services produced by a monopolists is also the market demand • The demand curve for monopolist slopes downward ( inverse relationship between P and Q) • The demand curve is also the monopolist’s average revenue (AR) curve

8. Revenue Schedule Example of De Beers Diamonds • As De Beers expands output, total revenue increases until Q = 15 diamonds when total revenue tops out • For all units of output except the first, MR < P and the gap widens as the price declines because the loss from selling all diamonds at the lower price increases • This also implies that the MR curve will be below the demand curve

9. Monopoly Demand and Marginal and Total Revenue • MR curve is below the demand curve and TR is maximized when MR = 0 • At any level of sales, P = AR so demand curve is also the monopolist’s AR curve • When demand is elastic, a decrease in price increases total revenue  MR is positive • When demand is inelastic, a decrease in price reduces total revenue  MR is negative • Profit-maximizing monopolist would never expand output where demand is inelastic because TR will be reduced (a) Demand and Marginal Revenue Elastic $ per diamond Unit elastic $3,750 Inelastic 0 D = Average revenue Marginal revenue 1-carat diamonds per day 16 32 (b) Total Revenue $60,000 Dollars Total revenue 1-carat diamonds per day 0 16 32

10. Firm’s Costs and Profit Maximization • Monopolist can choose either the price or the quantity, but choosing one determines the other • Because the monopolist can select the price that maximizes profit, we say the monopolist is a price maker • More generally, any firm that has some control over what price to charge is a price maker

11. Short-Run Revenues and Costs for the Monopolist Price (AR) TR MR Total MC ATC Profit or (MR = Cost ( MC = ( =TC/Q) Loss = (Q) (P) (TR = Q x p) TR / Q) (TC) TC / Q) TR - TC (1) (2) (3) =(1) x (2) (4) (5) (6) (7) (8) 0 $7,750 0 - $15,000 - - -$15,000 1 7,500 $7,500 $7,500 19,750 4,750 $19,750 -12,250 2 7,250 14,500 7,000 23,500 3,750 11,750 9,000 3 7,000 21,000 6,500 26,500 3,000 8,830 -5,500 4 6,750 27,000 6,000 29,000 2,500 7,750 -2,000 5 6,500 32,500 5,500 31,000 2,000 6,200 1,500 6 6,250 37,500 5,000 32,500 1,500 5,420 5,000 7 6,000 42,000 4,500 33,750 1,250 4,820 8,250 8 5,750 46,000 4,000 35,250 1,500 4,410 10,750 9 5,500 49,500 3,500 37,250 2,000 4,140 12,250 10 5,250 52,500 3,000 40,000 2,750 4,000 12,500 11 5,000 55,000 2,500 43,250 3,250 3,930 11,750 12 4,750 57,000 2,000 48,000 4,750 4,000 9,000 13 4,500 58,500 1,500 54,500 6,500 4,190 4,000 14 4,250 59,500 1,000 64,000 9,500 4,570 -4,500 15 4,000 60,000 500 77,500 13,500 5,170 -7,500 16 3,750 60,000 0 96,000 18,500 6,000 -36,000 17 3,500 59,500 -500 121,000 25,000 7,120 -61,500 1.Monopoly will expand output as long as MR >MC and stop at MC>MR 2. Profit maximized at $12,500 when Q = 10 (MR=$3,000 and MC = $2,750. Output exceeding 10 unit, the MC > MR

12. Monopoly Costs and Revenue • The intersection of the two marginal curves at point e in panel (a) indicates that profit is maximized when 10 diamonds are sold (MR=MC). • ATC of $4,000 is identified by point b: the average profit per diamond equals the price of $5,250 minus the ATC of $4,000 = $1,250 – the economic profit is the equal to $1,250 * 10 units sold = $12,500 • In panel (b), the firm’s profit or loss is measured by the vertical distance between the TR and TC: profit is maximized where 10 diamonds are produced per day • One common myth about monopolies is that they charge the highest price possible • However monopolist is interested in maximizing profit, not price (a) Per-Unit Cost and Revenue Marginal cost Average total cost a Dollars per unit $5,250 Profit b 4,000 e D = Average revenue MR Diamonds per day 0 32 10 16 (b) Total Cost and Revenue Total cost Maximum profit $52,500 40,000 Total dollars Total revenue 15,000 Diamonds per day 0 10 16 32

13. The Monopolist Minimizes Losses in the Short Run • Although monopolist are sole supplier of a good, the demand may not generate economic profit in the short run or the long run (because of rising costs and falling demand) • loss-minimizing monopolist must decide whether to produce or to shut down • If P covers AVC the firm will produce. If not firm will shut down at least in the short-run • MR =MC at point e. At quantity Q, price p (at point b) is < ATC (point a) – monopolist suffers loss • But the monopolist will continue to produce rather than shut down in the short run because P > AVC ( point c). Dollars per unit Marginal cost a Average total cost Loss b p Average variable cost c e Demand = Average revenue Marginal revenue Quantity per period 0 Q

14. Long-Run Profit Maximization • If a monopoly is insulated from competition by high barriers that block new entry, economic profit can persist in the long run • A monopolist that earns economic profit in the short-run may find that profit can be increased in the long run by adjusting the scale of the firm • Conversely, a monopoly that suffers a loss in the short run may be able to eliminate that loss in the long run by adjusting to a more efficient size

15. Monopoly and Allocation of ResourcesPerfect Competition and Monopoly • Start from LR equilibrium price and quantity • Equilibrium in perfect competition is at point c, where market demand and supply intersect to yield pricepc and quantity Qc . Consumer surplus = acpc (MB=MC) • Monopolist maximizes profit by equating MR with MC:point b and price pmand output Qm .Consumer surplus = ampm. (MR>MC ) • Because MR > MC, society would be better off if monopolist expand output beyond Qm Dollars per unit a LR market supply curve in perfect competition m pm b c Sc = MC = ATC pc D = AR MRm 0 Qm Qc Quantity per period

16. Perfect Competition and Monopoly Dollars per unit a • Consumer surplus under perfect competition is the large triangle acpc while under monopoly it shrinks to the smaller triangle ampm • Consumer surplus has been reduced by more than the profit triangle • Consumers have also lost the triangle mcb – the deadweight loss of monopoly – loss to the society when a firm uses it market power to restrict output and increase price • Monopoly lead to inefficient allocation of resources because of the higher price and reduced output Monopoly’s gain Deadweight loss m p m b c Sc = MC = ATC p c D = AR MRm 0 Qm Qc Quantity per period

17. Price Discrimination • Monopoly increases it profit by charging higher prices to those who value the product more. • The practice of charging difference prices to different customers is called price discrimination • Conditions: • Demand curve must slope downward – the firm has some market power and control over price • At least two groups of consumers for the product, each with a different price elasticity of demand • Ability, at little cost, to charge each group a different price for essentially the same product • Ability to prevent those who pay the lower price from reselling the product to those who pay the higher price

18. A Single Price of Air Travel Price Discrimination P ticket P ticket Increased economic profit from price discrimination Consumer Surplus 1,800 MC MC profit 1,600 1,400 ATC ATC ● ● 1,200 1,200 900 900 ● ● 600 600 ● ● D D MR MR 6 8 4 2 8 Passenger (‘000) Passenger (‘000) • Suppose Global revise its fare – 4 categories • No restrictions at $1,800 • 7-day advance purchase at $1,600 • 14-day advance - $1,400 • Others - $1,200 • 2. Economic profit increases by $2.4 million to $7.2 million • Suppose Global Air has a monopoly on air route • A single-price monopoly Global maximizes profit by selling 8,000 trips a year at $1,200 • Its profit =$4.8 million • Global’s customer enjoy a consumer surplus

19. Price Discrimination Less elastic More elastic • Suppose the consumer are sorted into 2 groups with different demand elasticities • Assume the firm produces at a constant LRAC and MC =$1.00 • At a given price, price elasticity of demand (panel b, elastic-more sensitive to price) is greater than in panel a (inelastic). • 4. The firm maximizes profit by finding the price in each market that equates MC=MR • 5. So consumers with lower price elasticity pay $3.00 and those with higher price elasticity pay $1.50

20. Perfect Price Discrimination • If a monopolist could charge a different price for each unit sold, the firm’s marginal revenue curve from selling one more unit would equal the price of that unit • the demand curve would become the marginal revenue curve (D=MR) • A perfectly discriminating monopolist charges a different price for each unit of the good • By charging a different price for each unit sold, the perfectly discriminating monopolist is able to convert every dollar of consumer surplus into economic profit

21. Increase in profit from perfect price discrimination 2,000 MC ● 1,200 ATC ● 900 600 ● ● D=MR Passenger (‘000) 5 8 11 1. With perfect price discrimination the DD curve becomes MR curve. 2. Economic profit is maximized when the lowest price equals marginal cost. 3. The Air Travel company sells 11,000 tickets at between $2,000 and $900 each and makes an economic profit of $9.35 million a year 4. The output is identical to perfect competition –however it pushes the consumer surplus to zero and increases producer surplus. 5. Deadweight loss with perfect price discrimination is zero

22. The more perfectly the monopoly can price discriminate, the closer its output gets to the competitive output and the achieves efficiency • There are differences between perfect competition and perfect price discrimination 1. the distribution of surplus in perfect competition is shared by consumers and producers, 2. producer grabs all the surplus with perfect price discrimination