10-1 copyright 2007 mcgraw-hill australia pty ltd ppts t/a principles of microeconomics by frank,...

10-1 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and JenningsSlides prepared by Nahid Khan

Chapter 10

Monopoly and other forms of imperfect competition


Imperfect competition

• Perfect competition– Firms have no control over price.– Firms produce homogenous products.– Price equal the marginal cost of production.– Long-run economic profits are not possible due to free

entry and exit.– An ideal market that maximises economic surplus.– A situation that does not always exist.



• Imperfectly competitive firms– Have some control over price.– Price may be greater than the cost of production.– Long-run economic profits are possible.– Face a downward-sloping demand curve.– Contribute to loss of efficiency. – Are very common in every economy.– Reduce economic surplus to varying degrees by

restricting output.



• Different forms of imperfect competition– Pure monopoly– Oligopoly– Monopolistic competition



• Various forms of imperfect competition– Pure monopoly (most inefficient)

The only supplier of a unique product with no close substitutes, examples

• City power provider• Only petrol station in a small town• AFL football league



• Various forms of imperfect competition– Oligopoly (more efficient than a monopoly)

A firm that produces a product for which only a few rival firms produce close substitutes, examples

• Major banks in Australia• BP, Shell, Mobil• Airlines



• Different forms of imperfect competition– Monopolistic competition (closest to perfect competition)

A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another, examples

• Restaurants in Lygon Street• Novels, films, CDs



• The essential difference between perfectly and imperfectly competitive firms comes from possible substitutability of products– The perfectly competitive firm faces a perfectly elastic

demand for its product.– The imperfectly competitive firm faces a downward-

sloping demand curve.



• In perfect competition – Supply and demand determine equilibrium price. The firm

has no market power.– At the equilibrium price, the firm sells all it wishes.



• With perfect competition – If the firm raises its price, sales will be zero.– If the firm lowers its price, sales will not increase.– The firm’s demand curve is the horizontal line at the

market price.



• With imperfect competition – The firm has some control over price or some market

power.– The firm faces a downward-sloping demand curve.– In the case of a monopoly, the firm’s demand curve is the

market demand curve.


The demand curves facing perfectly and imperfectly competitive firms

Quantity

$/u

nit

of

ou

tpu

t

DMarket

price Pri

ce

QuantityD

Perfectly competitive firm Imperfectly competitive firm


Five sources of market power

• Exclusive control over inputs A singer with gifted talent

• Government-created monopolies A new pharmaceutical drug Taxi licenses

• Economies of scale (natural monopolies) City water supply

• Network economies Microsoft Windows


Economies of scale and the importance of fixed costs

• Firms with large fixed costs and low variable costs – Have low marginal costs– Average total cost declines sharply as output increases– Have higher proportion of fixed cost than variable cost in

average total cost– Economies of scale will exist


Total and average total costs for a production process with economies of scale

Quantity

To

tal c

ost

($/

year

)

F

Q0

F + Q0

TC = F + MQ

Total cost rises at a constant rate as output rises

Ave

rag

e co

st (

$/u

nit

)Quantity

ATC = F/Q + M

M

Average costs decline and isalways higher than marginal cost


Costs for two computer game producers (1)

Nintendo PlayStation

Annual production1,000 000 1,200 000

Fixed cost $200 000 $200 000

Variable cost $800 000 $960 000

Total cost $1,000 000 $1,160 000

Average total cost per game $1.00 $0.97

Observations• Fixed costs are a relatively small share of total cost.• Cost/game is nearly the same.



Annual production 1,000 000 1,200 000

Fixed cost $10,000 000 $10,000 000

Variable cost $200 000 $240 000

Total cost $10,200 000 $10,240 000



Observations• Fixed costs are a relatively large share of total cost.• PlayStation has a $1.67 average cost advantage.• PlayStation can lower prices, cover cost and attract customers.


Annual production 500 000 1,700 000

Fixed cost $10,000 000 $10,000 000

Variable cost $100 000 $340 000

Total cost $10,100 000 $10,340 000




• Shift of 500,000 units to PlayStation.• Nintendo’s average cost increases to $20.20/unit.• PlayStation average cost falls to $6.08.• A large number of firms cannot survive when the cost differential is

high.


Economies of scale and the importance of fixed costs

• Fixed investment in research and development has been increasing as a share of production costs.

1984 20% 80%1990 80% 20%

Cost of producing a computerFixed cost Variable cost

Software Hardware


Economies of scale and the importance of fixed costs (cont.)

• Thinking as an economist– Why does Intel sell the overwhelming majority of

microprocessors used in personal computers?

• As fixed costs become more important, the perfectly competitive pattern becomes less common.


Profit maximisation for the monopolist

• A price taker (perfect competition) and a price setter (imperfect competition) share two economic goals. They want– to maximise profits– to select the output level that maximises the difference

between TR and TC, where MR = MC.



• Marginal revenue for the monopolist– Firms in perfect competition and monopoly firms

(assuming a single price firm) Both increase output when MR > MC. Calculate MC the same way. Do not have the same MR at a given price.

• In perfect competition: MR = P• In monopoly: MR < P


The monopolist’s benefit from selling an additional unit

Pri

ce (

$/u

nit

)

Quantity (units/week)

D

8

8

2

6

3

5

• If P = $6, then TR = $6 x 2 = $12• If P = $5, then TR = $5 x 3 = $15• The MR of selling the 3rd unit = $3 (15-12)• For the 3rd unit, MR = $3 < P = $5


• Observations– MR declines as quantity

increases.– MR is the change between two

quantities.– MR < P because price must be

lowered to sell an additional unit.

P Q TR MR

3

1

-1

Marginal revenue in graphical form

6 2 12

5 3 15

4 4 16

3 5 15


Pri

ce &

mar

gin

al r

even

ue

($/u

nit

)


8

8

D

432-1

3

5

1

MR

Marginal revenue in graphical form

P Q TR MR

3

1

-1

6 2 12

5 3 15

4 4 16

3 5 15


The marginal revenue curve for a monopolist with a straight-line demand curve

Pri

ce

QuantityObservations• The vertical intercept, a, is the same for MR and D.• The horizontal intercept for MR, Q0/2, is one half the demand

intercept, Q0..

D

Q0

a

Q0/2

a/2

MR



• Profit maximising decision rule:– When MR > MC, output should be increased.– When MR < MC, output should be reduced.– Profits are maximised at the level of output for which

MR = MC.– Set the price that consumers are willing to pay at that

level of output.


The monopolist’s profit-maximising output level

Pri

ce (

$/u

nit

of

ou

tpu

t)


6

D

3

12 24

Marginal cost

2

4

MR

8

Observations• If P = $3 & Q = 12 MR < MC

and output should be reduced.

• Profits are maximised at 8 units where MR = MC.

• The maximum single price at which 8 units can be sold is P=$4.


Even a monopolist may suffer an economic loss

Pri

ce (

$/m

inu

te)

Minutes (millions/day)

Pri

ce (

$/m

inu

te)

Minutes (millions/day)

2420

0.12

0.10ATC

20

0.08

0.10

ATC

Economic loss= $400 000/day

Economic profit= $400 000/day

D

0.05 MC

MR

D

0.05 MC

MR

Being a monopolist doesn’t guarantee an economic profit


D

3

12

6

24

Marginal cost

The socially optimalamount occurs whereMC = D(MR) at 12 units

The demand and marginal cost curves for a monopolist

Pri

ce (

$/u

nit

of

ou

tpu

t)


Why the invisible hand breaks down under monopoly


2

4

MR

8

• The profit maximising level of output of 8 units, where MR = MC, is less than the socially optimal output of 12.

• Between 8 and 12, MB to society > MC to society.

• Single-price monopolist will not increase output because MR<MC.

The demand and marginal cost curves for a monopolist (cont.)

Pri

ce (

$/u

nit

of

ou

tpu

t)


D

12

6

24


3

Marginal cost


2

4

MR

8

• Because MR < P, the monopoly produces less than the socially optimal amount

• The deadweight loss of the monopoly to society = (1/2)($2/unit)(4units/wk) = $4/wk.

Deadweight loss

The demand and marginal cost curves for a monopolist (cont.)

Pri

ce (

$/u

nit

of

ou

tpu

t)


D

12

6

24


3

Marginal cost



• Monopoly– Profits are maximised

where MR = MC– P > MR– P > MC– Deadweight loss

• Perfect competition– Profits are maximised

where MR = MC– P = MR– P = MC– No deadweight loss


Why the invisible hand breaks down under monopoly (cont.)

• Difficulties in reducing the deadweight loss of monopolies– Enforcing competition and anti-monopoly laws– Patents, copyrights and innovation– Natural monopolies


• Price discrimination– The practice of charging different buyers different prices

for essentially the same good or service, where differences do not simply reflect differences in costs of supplying different buyers.

• Examples of price discrimination– Senior citizens and student discounts on movie tickets– Supersaver discounts on air travel– Rebate coupons

Using discounts to expand the market


Using discounts to expand the market (cont.)

• Thinking as an economist– Why do many movie theatres offer discount tickets to

students?– Why do most airlines have peak and off-peak rates?– Why do fitness clubs have a membership fee and per unit

price?


• Example– Rosie can edit term papers for eight students each

with a different reservation price. If Rosie’s opportunity cost of her time to edit each paper is $29 and she must charge a single price to each student, how many term papers should Rosie edit? How much economic profit would she make?



Total and marginal revenue from editing

Reservation price Total revenue Marginal revenueStudent ($ per paper) ($ per week) ($ per paper)

A 40 40

B 38 76

C 36 108

D 34 136

E 32 160

F 30 180

G 28 196

H 26 208

40

36

32

28

24

20

16

12



• Example– How many manuscripts should Rosie edit when

she must charge all buyers the same amount? Opportunity cost = $29 TR = P x Q, or for 4 papers, 4 x $34 = $136/wk MR is the difference in TR from adding another

student If MR > MC: increase output



• Example– How many manuscripts should Rosie edit?

Rosie edits 3 papers• TC = 3 x $29 = $87

• TR = $108

• Economic profit = $108 - $87 = $21/wk

• Accounting profit = $108


Why the invisible hand breaks down under monopoly• Example

– How many manuscripts should Rosie edit? Opportunity cost = $29 Must charge the same price Reservation price > opportunity cost for student

A to F Socially efficient number is 6

• TR = 6 x $30 = $180

• TC = 6 x $29 = $174

• Economic profit = $180- $174 = $6

• Accounting profit = $180



• Example– If Rosie can price discriminate, how many papers

should she edit? Assume Rosie can charge each student their

reservation price.


Example

ReservationStudent

price

A 40

B 38

C 36

D 34

E 32

F 30

G 28

H 26

• Rosie would edit A to F• TR = $40 + $38… = $210• TC = 6 x $29 = $174• Economic Profit = $210 -

$174 = $36/wk• Economic profit is $30

more than when she had to charge a single price.



• Perfectly discriminating monopolist– Charging each buyer exactly their reservation price

Economic surplus is maximised Consumer surplus is zero Economic surplus = producer surplus No deadweight loss



• Limitations to perfect price discrimination– Seller will not know each buyer’s reservation price.– Low price buyers could resell to other buyers at a higher

price.



• Group pricing– A form of price discrimination where different discounts

are offered in different submarkets, while members of particular submarket all receive the same discount.

– Group pricing essentially allows a firm to divide its market into two submarkets in which it can charge two different prices.

– In each market the firm can charge the same price to every buyer like an ordinary monopolist.

– Therefore the firm should keep expanding output in each submarket as long as MR in that submarket exceeds MC.



• Group pricing– Question: Suppose Rosie knows that students whose

reservation prices are at least $34 are science students, while those whose reservation prices are below $34 are commerce students. How much should Rosie charge for editing if she uses group pricing?



• The hurdle method of price discrimination– The practice by which a seller offers a discount to all

buyers who overcome some obstacle.– Examples:

Rebate coupon Bundling of goods Foregoing extras that come with a higher price



• The hurdle method of price discrimination is used to solve two problems:– Seller does not know the reservation prices.– Seller must separate high and low price buyers.


Using discounts to expand the market (cont.)• A perfect hurdle

– Completely segregates buyers whose reservation prices lie above it from others whose reservation prices lie below it, imposing no cost on those who jump the hurdle.

• What do you think?– Is a perfect hurdle possible?



• Question– How much should Rosie charge for editing if she uses a

perfect hurdle?

• Assume – Rosie offers a mail in rebate coupon.– Students with at least a $36 reservation price never use

the coupon.– Students with a reservation price below $36 use the

coupon.– Opportunity cost = $29.– Discount coupon = $4.


Price discrimination with a perfect hurdle

Reservation price Total revenue Marginal revenueStudent ($ per paper) ($ per week) ($ per paper)

A 40 40

B 38 76

C 36 108

D 34 34

E 32 64

F 30 90

G 28 112

H 26 130

40

36

32

List price submarket

Discount price submarket

34

30

26

22

18



• Solution– TR = (3)(36) + (2)(32) = $172– MC = ($5)($29) = $145– Economic profit = $27/wk

• Question– Is price discrimination a desirable thing?

The hurdle method raised economic surplus.


• Producer surplus– Single price = 3(36 - 29) = $21/wk– Discount price = 3(36 - 29) = $21/wk

2(32 - 29) = $6/wk

$27/wk

Calculating economic surplusConsumer surplus Reservation price Actual price Consumer surplus

A $40 $36 $4

B $38 $36 $2

C $36 $36 $0

BothSingle price& discount

Without discount $6

D $34 $22 $2

With discount $8




• Question– Is Rosie’s discount rebate socially efficient?



• Examples of price discrimination– Temporary sales– Book publishers and paperback books– Automobile producers offer various models– Commercial air carriers– Movie producers



• Thinking as an economist– Why might an appliance retailer instruct its salespeople

to hammer dents into the sides of its stoves and refrigerators?



• Summary– Single price monopolies are inefficient because P > MR.– The hurdle method of price discrimination reduces the

inefficiency.– Hurdles are not perfect, therefore, there will be some

efficiency loss.– The more finely the seller can discriminate, the smaller

the efficiency loss.


Public policy towards competition

• National competition policy– Competitive markets will generally serve the interests of

consumers.– Wider community can provide strong incentives for

suppliers.– Promote efficiency and innovation.


• The Trade Practices Act and the ACCC– Promotion of competition and fair trading– Provision of consumer protection

• Thinking as an economist– How does the ACCC use cost-benefit thinking in applying

the Act’s authorisation and notification processes?

Public policy towards competition (cont.)


• Regulating natural monopolies– State ownership, marginal cost pricing versus the cost of

less incentive for innovation– Exclusive contracting for natural monopoly

Competition for the contract sets P = MC Difficulty when fixed costs are high such as electric utilities

Public policy towards competition (cont.)


Public policy toward natural monopoly

• Regulating natural monopolies in Australia• Abandoned direct regulation• Incentive compatible regulatory regimes such as

price caps


• What do you think?– Should we regulate natural monopolies?

Public policy toward natural monopoly (cont.)

10-1 copyright 2007 mcgraw-hill australia pty ltd ppts t/a principles of microeconomics by frank,...

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