EC 100 Week 10

1. EC 100 Week 10

2. Overview • This week: Market Power. • Firms Profit: Revenue – Cost • Where Revenue = Price * Quantity • Cost = Fixed Cost + Marginal Costs * Quantity • Under perfect Competition: Price is fixed, so a firms supply decision is optimal when P=MC • For a monopolist: equilibrium price is a function of the Quantity that is sold on market – so a monopolist can control prices by choosing quantity.

3. Question 1(Preliminary) Name the 3 sources of monopoly

4. Question 1(Preliminary) • “Natural monopoly”. Increasing returns to scale everywhere, meaning falling AC. Gives initial firm a competitive advantage over all others. Happens in industries with high fixed costs, low marginal costs (hence falling AC). E.g. water pipes, electricity distribution, roads. • Firm actions. Firm can try to “corner a market” (buy all the stock – e.g. ram man). Firm may own all natural resources, e.g. a diamond monopoly. • Government actions. Government can create a monopoly for political or “economic” reasons (e.g. Royal Mail, BT – note that this is now less common in UK). Governments give patents to new inventions (to provide incentives to entrepreneurs, but controversial – e.g. drug patents).

5. Question 1 • Which of the Following Answers Are Reasons Why An Industry May Tend towards a Monopoly?

6. Question 2

7. Question 2(Preliminary) What is important about average revenue (AR)? AR = TR/Q Where TR = P*Q This implies that AR = P i.e. Average revenue is the price consumers are willing to pay: it is the demand curve for a monopolist

8. Question 2 Question 2: If firm produces 3 units of output, what is average revenue?

9. Question 3 Question 3: If firm increases output from 3 to 4 units, what is its marginal revenue? Why is MR curve below AR curve?

10. Question 4 If the marginal cost of every unit of output is 5, what is the profit maximizing level of output? • Firm will carry on producing until change in profits from one more unit is zero • i.e. MR = MC

11. “Textbook” Monopolist diagram Price, P Choose quantity by setting MR = MC (understand why). At that quantity, find price by using demand curve P* Marginal Revenue Marginal Cost Demand Curve (Average Revenue) Q* Quantity, Q

12. “Textbook” Monopolist diagram Price, P Note that monopolist makes profits If constant MC, then MC = AC (if fixed cost=0. Footballer example) Profits = (P-AC)*Q and so the box denotes profits Consumer Surplus P* Producer Surplus (profit) Marginal Cost Demand Curve (Average Revenue) Marginal Revenue Q* Quantity, Q

13. Question 5 • Suppose there are two markets. In both there are constant returns to scale and marginal costs of output are the same. But demand is less sensitive to price in market A than market B. if both markets are perfectly competitive will the price be higher or lower or the same in A or B? What if the markets are monopolies? • Select one:

14. Question 5 • Suppose there are two markets. In both there are constant returns to scale and marginal costs of output are the same. But demand is less sensitive to price in market A than market B. • Remember: under perfect competition, p=MC – since MC the same, prices the same • Shape of the demand curve matters for the extent to which a monopolist can push up prices.

15. Consider the following two market demand curves Which one has more elastic demand? In which one will price be higher? A Price, P Price, P B Marginal Cost Marginal Cost Demand Curve (Average Revenue) Demand Curve (Average Revenue) Marginal Revenue Marginal Revenue Quantity, Q Quantity, Q

16. The Gap Between Price and Marginal Cost • The ability of a monopoly to raise prices above marginal cost depends on the price elasticity of the demand curve • If demand is inelastic then prices will be higher • If demand is very elastic then prices will be lower • See diagrams above

17. Question 6 • If an industry goes from being perfectly competitive to being a monopoly, what happens to consumer and producer surplus?

18. Consumer and Producer Surplus with Perfect Competition Price, P Note that this is perfect competition industry diagram (not firm) Marginal cost curve is supply curve under perfect competition (because firms set P = MC so MC determines how much is supplied at each price) Consumer Surplus Producer Surplus (profit) Marginal Cost P Demand Curve (Average Revenue) Q* Quantity, Q

19. Consumer and Producer Surplus with Monopoly Price, P Important results: Prices are higher (make profits) Quantity is lower Consumer Surplus P* DWL Producer Surplus (profit) Marginal Cost Demand Curve (Average Revenue) Marginal Revenue Q* Quantity, Q

20. Question 7 The following Table gives total labour supply to a monopsonist for different wages a firm might pay: • What numbers should go in the final column? • Total cost of labour = wage * labour supply

21. Question 8 The following Table gives total labour supply to a monopsonist for different wages a firm might pay: What is the marginal cost of labour in going from 2 to 3 workers?12 Marginal cost of labour = ∆ cost of labour

22. Question 9 If the marginal revenue product of a worker is 10, what will be the profit maximising level of employment for the monopsonist?

23. Question 9 • Marginal Revenue Product of Labour • Additional revenue from hiring one more worker • Equals marginal product * price (because marginal product is the additional output of the worker) • Firm keeps hiring as long as MRP>MC • Because this means hiring one extra worker adds to profits • So if MRP = 10, a firm should hire two workers. • Hiring a third worker reduces profits as MRP < MC = 12.

24. Question 10 • If the marginal revenue product of a worker is 10 what will be the profit maximizing level of the wage for the monopsonist? • Firm optimally hires two workers, which supply their labour at a wage of 6 (from table)

25. Question 11 • If the marginal revenue product of a worker is 10 and the government imposes a minimum wage of 9 what level of employment will the firm choose? • Now have a minimum wage, i.e. government intervenes.

26. Question 11 • Previous table: • New table: Note: total cost of labour is different and marginal cost of labour is different

27. Question 11 • Again, firm hires an additional worker as long as MRP>marginal cost • Hence, firm hires 3 workers • Hiring a fourth worker would have a marginal cost of 13, and bring in revenue of just 10

28. Question 12 • With minimum wage = 11, no employment.