Monopoly

1. Monopoly and monopoly behavior Alexandre Mateus Sara Levy Tiago Ratinho

2. Monopoly • We’ve seen the behaviour of a competitive industry, a market structure characterised by a great number of small firms • Now, we consider the opposite extreme and study the behaviour of a market structure with only one firm in the industry  MONOPOLY • The level of price is chosen in order to maximize its profits • The monopolist can choose the price and let the consumers pick the quantity or it can choose the quantity and see what price the consumers wish to pay for it.

3. Maximizing Profits • Inverse demand curve - p(y) • Inverse cost curve – c(y) • Inverse revenue curve – r(y) = p(y).y max  = max (r(y) - c(y)) • The optimal choice we must equal marginal costs with marginal revenue: • If Marginal Revenue were less than Marginal Costs, it would pay the firm to decrease output; • If Marginal Revenue were greater than Marginal Costs, it would pay the firm to increase output

4. Maximizing Profits • MR=MC  • The condition is the same for competitive firms: the marginal revenue equals the market price, constant and unaffected by any actions of the individual firms • Monopolist: marginal revenue is not constant • When output is increased by : • More output, extra revenue, • Increase of output, prices reduce, less revenue for every unit sold,

5. Maximizing Profits • The total effect will be • The effects are contradictory: if the monopolist produces more, it sells more but at lower prices for all units sold, thus reducing its revenue

6. Maximizing Profits • The expression can be re-written • This implies that: • In a competitive market, the firm faces an horizontal demand curve, infinitely elastic, so optimal condition is price equals marginal costs • The monopolist will never position itself where elasticity since in this case reducing output will increase revenue, raising profits • For a monopolist, maximization of profits occurs for

7. Linear Demand Curve and Monopoly • Suppose the monopolist faces a linear inverse demand curve p(y) = a-by Revenue: r(y)=p(y)y=ay-by2 Marginal Revenue: MR(y)=a-2by

8. Linear Demand Curve and Monopoly P a MC AC p* MR Slope=-2b Demand Slope=-b y* Q

9. Markup Pricing • Rewriting the optimal condition where is the markup. • Since , the markup is greater than one, the price will be higher than the Marginal Costs

10. P MC p* D y* Q Markup Pricing

11. The Impact of Taxes on a Monopolist • Consider a firm with constant marginal costs and a tax levied: • The marginal costs increase • Price? • The optimal condition now yields • The change in the output is • The demand curve is so the price will change by a factor of a half.

12. The Impact of Taxes on a Monopolist • This factor cannot be assumed as true in general. • Considering the monopolist facing a constant-elasticity demand curve, we have and , which is greater than one. Hence, the monopolist passes on more than the amount of tax.

13. The Impact of Taxes on a Monopolist • Another kind of tax could be a profits tax • In this case, the monopolist is levied on a fraction  of its profits • The maximization of profit becomes • Thus, a pure profits tax will have no effect on a monopolist’s choice of output

14. Inefficiency of Monopoly • The monopolist operates with prices greater than Marginal Costs  prices higher and output lower than in a competitive environment  consumers typically be worse • In contrast, firms will be better under monopoly, as they can manipulate the price in order to increased profits • An economic arrangement is Pareto efficient if there is no way to make anyone better without making anyone worse, so Is the monopoly Pareto Efficient?

15. P pm MC pc D MR ym yc Q Inefficiency of Monopoly • NO!

16. Inefficiency of Monopoly • Since p > Marginal Costs  extra output could be sold at a price lower than the market price, but still higher than MC  each side gets better • The monopoly is not Pareto efficient because the monopolist cannot lower the price of the extra units without lowering the prices of all units

17. Deadweight Loss of the Economy • Measure how inefficient is a monopoly  variations of producers’ and consumers’ surpluses by imposing a perfect competition to a monopoly situation

18. C Deadweight Loss of the Economy P MC p* B A pc D MR y* Q

19. Deadweight Loss of the Economy • The consumers’ surplus goes up for: • Paying less for the same units than under monopoly (A) • Getting the same surplus on the extra units that are being sold • The producers’ surplus is affected in contradictory ways: • Profits are driven downwards due to a lower price (A) • Extra profits by selling more (C)

20. Deadweight Loss of the Economy • Hence: • The area A is just a transfer from the monopolist to the consumer  total surplus remains the same • The area B+C represents the gain from moving from a monopoly to perfect competition, measuring the value that consumers and producers place on extra units • Thus, the area A+B measures the deadweight loss due to the monopoly  the cost of monopoly • Example: The optimal life of a Patent

21. Natural Monopoly

22. Natural Monopoly • Pareto efficiency occurs when price equals MC; • Monopolist firms produce where MR equals MC: • Too little output. • Government intervention: • Set the price equal to the Marginal Cost. • The monopolist might make negative profit!

23. price Demand AC MC Losses due to marginal cost pricing pMC yMC output Natural Monopoly

24. Natural Monopoly • Often arises with public utilities: • Gas / electricity / telecom companies; Very large fixed costs; Very small marginal costs; Natural Monopoly

25. Problem • Monopolist price: • Pareto inefficiency; • Forcing competitive price: • Negative profits; • Government options: • Regulate the monopoly; • Operate the monopoly; • Most natural monopolies are regulated or operated by governments.

26. Government regulation • Regulation without subsidy: • The regulated firm must make nonnegative profits; • On or above the AC curve; • Provide service to all that are willing to pay for it; • On the Demand curve. • Too little output relative to the efficient output level.

27. MC Government regulation price Demand AC pAC yAC output

28. Government regulation • Solution adopted as second best pricing policy: • Government regulators set prices that the public utility is allowed to charge: • Ideally prices that allow the firm to break even (p = AC); • Difficulty: • Determine the firm’s true costs.

29. Government operation • Operate at the point where the price equals the marginal costs (p=MC); • Provide a lump-sum subsidy to keep the firm in operation. • Difficulty: • Determine the firm’s true costs;

30. price Demand AC MC Government lump-sum subsidy pMC yMC output Government operation

31. What causes monopolies?

32. What causes monopolies? • When is an industry competitive and when is it monopolized? • In general it depends on the relationship between the Demand and the Average Cost curves; • Crucial factor: • Size of the Minimum Efficient Scale (MES) relative to the size of demand. MES = level of output that minimizes average cost

33. AC Monopolized industry price price Demand Demand AC p* p* output output MES Competitive industry MES Competitive / Monopolized

34. Competitive / Monopolized • Average Cost curve: • Shape determined by the underlying technology; • Important to determine if the industry is competitive or monopolized: • Relation between the MES and the size of the market; • Economic policy: • Can influence the size of the market;

35. Other reasons • Cartel: • Different firms in the same industry collude; • Restrict output; • Raise prices; • Generate more profit; • Illegal! • Historical accident: • One large firm that entered the market first; • Cost advantage to discourage other firms to enter the market.

36. Monopoly behavior

37. Introduction • Competitive market: • A firm raises the price above the market price: • Costumers desert it in favor of its competitors; • Monopolized market: • Monopolist firm raises the price: • Looses some customers, but not all. • Most firms stand somewhere between these extremes. • Firm with some degree of monopoly has more options: • More complex pricing and marketing strategies; • Some degree of differentiation.

38. Price discrimination

39. Price discrimination • Monopoly has an inefficient level of output: • People are willing to pay more for extra output that it costs to produce it; • Monopolist does not want to produce the extra output: • Force down the price of all the output. • Can the monopolist sell different units at different prices? • Price discrimination. • First-degree (perfect) price discrimination; • Second-degree price discrimination; • Third-degree price discrimination.

40. First-degree price discrimination

41. First-degree price discrimination • Each unit of the good is sold to the person that values it the most: • At the maximum price that individual is willing to pay for it. • No consumer surplus generated; • The producer is able to appropriate it to itself. • Producer’s goal: • Maximize its surplus; • As long as customers are willing to purchase; • Pareto efficiency: • Producer’s profits are at maximum; • Consumer’s surplus can’t increase without reducing producer’s profits;

42. willingnessto pay willingnessto pay MC quantity MC quantity Reservation price Producer’s surplus

43. Perfect price discriminator producer • Produces at an output level where price equals Marginal Cost; • Price  MC • someone willing to pay more for an extra unit than it costs to produce it; • Price < MC • Negative profit;

44. Different perspective • So far: • “selling each unit as the maximum price someone is willing to pay for it” • Another perspective: • Selling a fixed amount of the good at a “take it or leave it” price.

45. Producer’s surplus willingnessto pay willingnessto pay MC MC x01 quantity x02 quantity Sell x01 units at price equal to area Sell x02 units at price equal to area Linear demand

46. Second degree price discrimination

47. Second degree price discrimination • Price per unit is not constant but depends on how much is bought; • Non-linear pricing; • Commonly used by public utilities; • Price per unit of electricity; • Sometimes available in other industries; • Bulk discounts for great quantities.

48. Hard to discriminate • In perfect price discrimination: • To set the right prices the monopolist has to know the demand curves of the consumers. • Not enough: • Consumers of one type may pretend to be consumers of another type; • No effective way to tell them apart! • Construct price-quantity packages that will induce the consumer to choose the package meant for him: • Self-selection.

49. willingnessto pay Quantity: x02 Price: A+B+C B Quantity: x01 Price: A A C x01 x02 quantity Self-selection problem High end customer would choose to buy x01 at price A with a surplus of B instead of x02 with no surplus. One solution: Offer x02 at price A+C

50. willingnessto pay Profits increase: The decrease of A is smaller than the increase of C. B Decreasing x01: A decreases; C increases A C x01 x02 quantity Reduce of output for consumer 1