10. monopoly - schneider.wiwi.uni-wuppertal.de · 10. monopoly . literature: pindyck ......

10. Monopoly

Literature: Pindyck and Rubinfeld, Chapter 10, 12

Varian, Chapter 24

Chapter Outline

• Monopoly

• Monopoly Power

• Sources of Monopoly Power

• The Social Costs of Monopoly Power

• Monopolistic Competition

Perfect Competition

• Review of perfect competition

– P = LMC = LAC.

– In the long-run, firms earn normal profit, i.e., zero economic

profit.

– Large number of buyers and sellers.

– Homogeneous products.

– Complete information.

– The firm is a price-taker.

Perfect Competition

P P Market Single Firm D S

P0 P0 D = LMC = P

LAC LMC

Monopoly

• Monopoly

1) One seller – many buyers.

2) One product (no good substitutes).

3) Barriers for market entry.

Monopoly

• The monopolist covers the supply side of the market and has

market power over the amount of goods produced.

• The profits are maximized when marginal cost is equal to

marginal revenue.

• Marginal revenue : Change in revenue resulting from a one-unit

increase in output.

Monopoly

• Determining the marginal revenue

– The monopolist, being the only supplier in the market, uses

market demand to determine output and price.

– Consider a firm facing following demand curve:

P = 6 – Q.

Total, Marginal, and Average Revenue

€6 0 €0 --- --- €5 1 €5 €5 €5 €4 2 €8 €3 €4 €3 3 €9 €1 €3 €2 4 €8 -€1 €2 €1 5 €5 -€3 €1

Total Marginal Average Price Quantity Revenue Revenue Revenue P Q R MR AR

Average and Marginal Revenue

Output 0

Price (€ per unit of output)

1 2 3 4 5 6 7

Average Revenue (demand)

Marginal Revenue

Monopoly

• Note that:

1) The price has to fall for sales to increase.

2) MR < P.

3) In comparison to perfect competition:

• No change in prices when sales change.

• MR = P.

Monopoly

The Monopolist‘s Output Decision

• Profits are maximized at the production level where

MR = MC.

( ) ( ) ( )

/ 0Q R Q C Q

d dQ MR MCor MC MR

= −= − ==

Profits are Maximized when Marginal Revenue Equals Marginal Cost

• When switching to output levels below MR = MC, the

decrease in revenue is greater than the decrease in costs

(MR > MC).

• When switching to output levels above MR = MC, the

increase in cost is greater than the increase in revenue

(MR < MC).

Profits are Maximized when Marginal Revenue Equals Marginal Cost

Lost Profits

Quantity

D = AR

Price (€ per unit of output)

Monopoly

• An Example:

2( ) 50

Cost C Q QdCMC QdQ

Monopoly

( ) 40

2( ) ( ) 40

Demand P Q Q

R R Q P Q Q Q Q

= = −

= = = −

Monopoly

40 2 210

When 10, 30.

MR MC or Q QQ

= − ==

Example of Profit Maximization

Quantity

0 5 10 15 20

Profits r

Example of Profit Maximization

Profit

Quantity

0 5 10 15 20

Monopoly

A Rule of Thumb for Pricing

• We would like to convert the condition MC = MR into a

simple rule of thumb, which will be easier to apply in

practice.

• This can be demonstrated using the following steps:

( )( )

dR d PQMRdQ dQ

dP Q dPMR P Q P PdQ P dQ

dQPE Q dP

= + = +

( )( ) 1

Q dPP dQ E

MR P PE

4. is maximized when MR MC

1 P P MCE

MC P1 (1 E )

The price markup rate (as a percentage of price) is

equal to the reciprocal of the elasticity of demand!

Assume the following is given: 4 9

9 9 €120.7511 4

= − =

= = =+ −

An Example

Monopoly

Pricing in a Monopoly Compared to Pricing in Perfect

Competition

• Monopoly:

P > MC.

• Perfect competition:

P = MC.

Monopoly

Pricing in a Monopoly Compared to Pricing in Perfect

Competition

• The more elastic the demand is, the closer the price is to

the marginal cost.

• If Ed is a large negative number, the price is closer to

marginal costs and vice versa.

Example: Astra-Merck Prices Prilosec

• The drug, Prilosec, represented a new generation of

antiulcer medication.

• Price P = €3.50 /daily dose.

• MC = 30 to 40 cents/daily dose.

• is in the range of -1 to -1.2.

Astra-Merck Prices Prilosec

[ ] [ ]

0.351 1 1 1 1.1

0.35 3.891 0.91 0.09

MC Euro

= = =+ + −

= =+ −

•The price of €3.50 is almost equal to our rule of thumb for pricing.

Monopoly

• The effect of a tax

– The monopolist can sometimes increase his price by more than

the amount of the tax (see chapter 9).

• Analyzing the effect of a tax:

– t = specific tax.

– MC = MC + t.

– MR = MC + t: optimal production decision.

Effect of an Excise Tax on a Monopolist

Quantity

MC D = AR

P0 MC + tax

Increase in P: P0 to P1 > tax

• Question

– Suppose for example that Ed = -2.

– How much would the change in price be?

• Answer

When 2 2

MC increases to MC2( ) 2 2

The price rises by twice the amount of the tax.

EdE P MCd

tP MC t MC t

= − → =

+= + = +

Monopoly Power

• Pure monopolies are rare.

• However, a market with many firms, all of whom are facing a

negative (downward sloping) demand function, can also produce

at a quantity where price exceeds marginal cost.

• Scenario:

– Four firms with the same market share of 5,000 units

produce 20,000 tooth-brushes for a price of €1.50 each.

The Demand for Toothbrushes

Quantity 10,000

€/Q €/Q

20,000 30,000 3,000 5,000 7,000

At a market price of €1.50, elasticity of market demand is -1.5.

Market Demand

The demand curve of firm A depends on the extent to which its product differs from others and how other firms compete.

The Demand for Toothbrushes

At a market price of €1.50, elasticity of market demand is -1.5.

Quantity 10,000

€/Q €/Q

20,000 30,000 3,000 5,000 7,000

Market Demand

Firm A, however, has a much more elastic demand curve, DA, because of competition from other firms: Ed = -6. Still, firm A has some monopoly power: its profit-maximizing price is €1.50, which exceeds its marginal cost.

Monopoly Power

•Profit is not guaranteed by monopoly power.

•Profit depends on average cost in comparison to prices.

• Remember the rule of thumb for pricing:

• Pricing for a firm with market power:

If Ed is large, the mark-up rate is small.

If Ed is small, the mark-up rate is large.

( )1 1 d

Elasticity of Demand and Price Markup

€/Q €/Q

Quantity Quantity

P* - MC

The more elastic the demand is, the less the price markup.

Markup Pricing: Supermarkets to Designer Jeans

Supermarkets

1. Supermarket chain several supermarkets .2. Similar product.3. 10 for each supermarket.

4. 1.11( ).1 1/ 10 0.9

5. Price should be almost 10-11% above MC.

EdMC MCP MC

= = =+ −

Small Convenience Stores

1. Higher prices than supermarkets.2. Customers are less price sensitive.3. 5.

4. 1.25( ).1 1 5 0.8

5. Prices should be almost 25% above MC.

dEMC MCP MC

= = =+ −

Designer Jeans

1. Ed = -2 to -3.

2. Prices should be 50 – 100% higher than

3. MC = €15 - €20/piece.

4. Wholesale price = €20 - €50.

5. How can you explain this price?

Sources of Monopoly Power

• What are the sources of monopoly power, and why do some

firms have more monopoly power than others?

• The monopoly power of a firm is determined through the

elasticity of demand.

• The elasticity of demand is determined by three factors:

1) The elasticity of market demand.

2) The number of firms in the market.

3) The interaction among firms.

The Social Costs of Monopoly Power

• Monopoly power results in higher prices and lower quantities

being produced.

• However, does monopoly power make consumers and

producers better or worse off?

Deadweight Loss from Monopoly Power

Lost Consumer Surplus

Deadweight Loss

Because of the higher price, consumers lose A + B and the producer gains A – C.

Quantity

• Rent seeking: spending money in socially unproductive efforts to

acquire, maintain, or exercise monopoly power.

― Lobbying

― Advertising

― Creation of additional product capacities

• The incentive for the implementation of such monopoly power

depends on the targeted profits.

• The higher the rent transfer from consumer to monopoly, the

higher are the social costs of the monopoly.

• Price regulation

– Recall that price regulation in perfect competition leads to

welfare loss.

• Question:

– What happens in the case of a monopoly?

Price Regulations

If left alone, a monopolist produces Qm and charges Pm.

Quantity

If we decrease price to PC, Output increases to its maximum QC and we do not face welfare loss.

P2 = PC

Every price below P4 causes the firm to incur losses.

Marginal revenue curve when price is regulated to be no higher than P1.

Q3 Q’3

If price decreases to P3, the output decreases. We then have a shortage of supply: Q’3 - Q3.

The Social Cost of Monopoly Power

• Natural monopoly

– A firm that can produce the entire output of a market at a

cost lower than what it would be if there were several

firms.

Economies of scale may make it too costly for more

than a few firms to supply the entire market. In some cases, economies of scale may be so large that it is most efficient for a single firm—a natural monopoly—to supply the entire market.

Regulating the Price of a Natural Monopoly

Quantity

Setting the price at Pr yields the largest possible output consistent with the firm’s remaining in business. Excess profit is zero.

If price were regulated to PC the firm would lose money and go out of business.

Without price regulation the producer produces Qm for a price of Pm .

Monopolistic Competition

• Characteristics

1) Many companies

2) Free market entry and exit

3) Differentiated products

• The degree of monopoly power depends on the extent of

differentiation.

• Examples for such common market structures:

– Toothpaste

– Soap

– Cold remedies (i.e. remedies for catching a cold)

• The assumptions for having monopolistic competition

– Two important assumptions

Differentiated goods that are highly substitutable but are not

perfect substitutes.

Free market entry and exit.

A Monopolistic Competitive Firm in the Short and Long Run

Quantity

€/Q MC

Short Run Long Run

Deadweight Loss MC AC

Quantity

D = MR

Quantity

Perfect Competition Monopolistic Competition

Comparison of Competitive Equilibrium: Monopolistic and Perfect Competition

• Monopolistic competition and economic efficiency

– If monopoly power exists (differentiation), a higher price will be

charged in the market in comparison to perfect competition. If

the price is lowered to the point where MC = D, the total rent

increases by the yellow triangle.

– Although, in the long-run economic profit is equal to zero, firms

still do not produce the cost minimizing quantity; rather, they

operate with excess capacity.

10. monopoly - schneider.wiwi.uni-wuppertal.de · 10. monopoly . literature: pindyck ......

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