Lecture 14Lecture 14

MonopolyMonopoly The definition of monopolyThe definition of monopoly

– From the Latin: “single seller”From the Latin: “single seller”

A structural viewA structural view– Unique product — famous athleteUnique product — famous athlete– Large relative to market — Michelin tiresLarge relative to market — Michelin tires

A theoretical viewA theoretical view– Must lower price to sell more unitsMust lower price to sell more units– Must find best price for output, so often Must find best price for output, so often

called “price searcher” or “price maker”called “price searcher” or “price maker”

Sources of monopolySources of monopoly

Unique talentUnique talent– Beatles, Bono, Yao MingBeatles, Bono, Yao Ming

Patent or copyrightPatent or copyright– Pentium chipPentium chip

LocationLocation– Magazine stand at airportMagazine stand at airport

RegulationRegulation– TaxicabsTaxicabs

CollusionCollusion– OPECOPEC

Consider this Price Maker Consider this Price Maker MarketMarket

You think so hard in econ class youYou think so hard in econ class youhave a headache!have a headache!

You go to buy a bottle of 100You go to buy a bottle of 100generic aspirin. Consider thesegeneric aspirin. Consider theseoptions: Wal-Martoptions: Wal-Mart

Grocery StoreGrocery Store Convenience storeConvenience store

Which is highest price and lowestWhich is highest price and lowestprice? Is the market competitive?price? Is the market competitive?What does monopoly mean in practice?What does monopoly mean in practice?

How can the seller get the How can the seller get the consumer surplus?consumer surplus?

How about an auction?How about an auction? English auction: seller lets demanders bid English auction: seller lets demanders bid

against each other (moving up the demand against each other (moving up the demand curve) so the demander who has the curve) so the demander who has the highest value pays close to that highest value pays close to that (volunteering to give the seller the (volunteering to give the seller the consumer surplus).consumer surplus).

Dutch auction: seller starts at a very high Dutch auction: seller starts at a very high price and comes down until a demander price and comes down until a demander makes a bid.makes a bid.

This works in some markets, but in many This works in some markets, but in many markets the seller must choose one price.markets the seller must choose one price.

The winner of an auction is said to suffer The winner of an auction is said to suffer from a “winners curse.” Why is that? from a “winners curse.” Why is that?

Marginal Revenue scheduleMarginal Revenue schedule

Marginal revenue (MR) is the change in Marginal revenue (MR) is the change in total revenue (TR) when there is a change total revenue (TR) when there is a change in quantity (Q) sold. To sell more, you must in quantity (Q) sold. To sell more, you must cut price (P) – move down the demand cut price (P) – move down the demand curve – so MR is always less than P. Price curve – so MR is always less than P. Price to the seller is the revenue received.to the seller is the revenue received.

Because a price cut to sell more units Because a price cut to sell more units reduces revenue on “earlier” units, extra reduces revenue on “earlier” units, extra revenue (the marginal revenue) is less revenue (the marginal revenue) is less than price. Assuming all sales at the same than price. Assuming all sales at the same price — P is Average Revenue — measured price — P is Average Revenue — measured by the Demand Curve.by the Demand Curve.

Anatomy of a Demand Anatomy of a Demand CurveCurve

Demand reflects what consumers pay for a Demand reflects what consumers pay for a good.good.

They pay a price, P’, whichThey pay a price, P’, whichis Average Revenue to theis Average Revenue to theseller (AR). Total revenue inseller (AR). Total revenue ina given time period isa given time period isP’ x Q’ = TR. MarginalP’ x Q’ = TR. MarginalRevenue (MR) is the Revenue (MR) is the change in TR given achange in TR given achange in Q sold, whichchange in Q sold, whichrequires P to change. requires P to change.

Q

$

MR

D = AR

P’

Q’

Madonna’s problem:Madonna’s problem:

How many songs?How many songs? TC Q Price TR MCTC Q Price TR MC

3.5 1 $10m/song 10 3.53.5 1 $10m/song 10 3.5 7 2 9 18 3.57 2 9 18 3.5 10.5 3 8 24 3.510.5 3 8 24 3.5 14 4 7 28 3.514 4 7 28 3.5 17.5 5 6 30 3.517.5 5 6 30 3.5 21 6 5 30 3.521 6 5 30 3.5 24.5 7 4 28 3.524.5 7 4 28 3.5 28 8 3 24 3.528 8 3 24 3.5

At each price, recording company demands (will buy) At each price, recording company demands (will buy) the number of songs shown, Qthe number of songs shown, Q-- Price-quantity combinations shown are points on -- Price-quantity combinations shown are points on demand curvedemand curve

What is the best price; or how many songs?What is the best price; or how many songs?Is maximum total revenue the best solution?Is maximum total revenue the best solution?

Marginal revenue is less than Marginal revenue is less than priceprice

TC MR Q Price TR MCTC MR Q Price TR MC 3.5 10 1 $10m/song 10 3.53.5 10 1 $10m/song 10 3.5

7 8 2 9 18 3.57 8 2 9 18 3.5 10.5 6 3 8 24 3.510.5 6 3 8 24 3.5 14 4 4 7 28 3.514 4 4 7 28 3.5 17.5 2 5 6 30 3.517.5 2 5 6 30 3.5 21 0 6 5 30 3.521 0 6 5 30 3.5 24.5 -2 7 4 28 3.524.5 -2 7 4 28 3.5 28 -4 8 3 24 3.528 -4 8 3 24 3.5

What is the most profitable P and Q?What is the most profitable P and Q?

New

The solution: marginal revenue = The solution: marginal revenue = marginal costmarginal cost

TC TC Profit MR Q Price/song TR Profit MR Q Price/song TR MCMC

3.5 6.5 10 1 $10m 10 3.53.5 6.5 10 1 $10m 10 3.5 7 11 8 2 9 18 3.57 11 8 2 9 18 3.5 10.5 13.5 6 3 8 24 3.510.5 13.5 6 3 8 24 3.5 14 14 4 4 7 28 3.514 14 4 4 7 28 3.5 17.5 12.5 2 5 6 30 3.517.5 12.5 2 5 6 30 3.5 21 9 0 6 5 30 3.521 9 0 6 5 30 3.5 24.5 3.5 -2 7 4 28 3.524.5 3.5 -2 7 4 28 3.5

28 -4 -4 8 3 24 3.528 -4 -4 8 3 24 3.5

Find the price that maximizes profits for Madonna (the Find the price that maximizes profits for Madonna (the seller)seller)

The solution: Choose Q such that MR = MCThe solution: Choose Q such that MR = MC

Note that P > MC at best QNote that P > MC at best Q

New

The solution graphicallyThe solution graphically

The profit-maximizing price is the one that induces The profit-maximizing price is the one that induces demanders to choose Q such that MR = MCdemanders to choose Q such that MR = MC

At any higher price,At any higher price,

MR > MCMR > MC

lost profitslost profits

At any lower price, At any lower price,

MR < MCMR < MC

lost profitslost profits

Only at P* is MR = MCOnly at P* is MR = MC

maximum profitsmaximum profits

MC = S

DMR

MC=3.5

P*=7

Quantity

$

1 2 3 4 5 6 7 8

The Price Maker: Common The Price Maker: Common in Highly Competitive in Highly Competitive MarketsMarketsSetting price at movie theaterSetting price at movie theater that has 1,000 seats in it.that has 1,000 seats in it.

Assume fixed costs of $2,000 for Assume fixed costs of $2,000 for movie rental, $250 for labor, & movie rental, $250 for labor, & $250 for building per night.$250 for building per night.

You know your customers from You know your customers from experience—what price do you experience—what price do you charge if only one price can be set?charge if only one price can be set?

Highly competitive market for Highly competitive market for entertainment dollars.entertainment dollars.

$

D

Q

MR

$6

$5

$4

400 500 600

Setting PricesSetting Prices

What is Marginal Cost in this situation?What is Marginal Cost in this situation?All costs are fixed, so MC = $0All costs are fixed, so MC = $0

At what quantity does MC = MR?At what quantity does MC = MR?500 seats500 seats

What price can be charged?What price can be charged?$5$5

What is Total Revenue?What is Total Revenue?TR = P * Q = $5 x 500 = $2500TR = P * Q = $5 x 500 = $2500

Can we do better?Can we do better?

There are unsold seats — and it costs nothing There are unsold seats — and it costs nothing to service another customer — so should to service another customer — so should we cut the price to $4 to fill more seats? we cut the price to $4 to fill more seats? Look at change in Total Revenue.Look at change in Total Revenue.

We can gouge some customers for more as We can gouge some customers for more as many value the movie more than $5 — so many value the movie more than $5 — so can we do better by charging a higher can we do better by charging a higher price, say $6?price, say $6?Look at change in Total Revenue.Look at change in Total Revenue.

Nothing beats the golden rule of MC = MRNothing beats the golden rule of MC = MR

Same example with positive Same example with positive MCMC

Now presume movie distributorNow presume movie distributor

charges a rental fee of $2 percharges a rental fee of $2 per

customer let into the theater.customer let into the theater.

Building cost of $250 and labor costBuilding cost of $250 and labor cost

Of $250 per night are still fixed.Of $250 per night are still fixed.

What is profit maximizing price toWhat is profit maximizing price to

charge? Same rule: MC = MRcharge? Same rule: MC = MR

Compare this to if you cut price toCompare this to if you cut price to

$5 and get 500 patrons or raise price$5 and get 500 patrons or raise price

to $7 and get 300 patrons.to $7 and get 300 patrons.

D

Q

$

$6

$2

MR

MC

400

Questions to PonderQuestions to Ponder

This is called the monopoly pricing This is called the monopoly pricing model or price maker model.model or price maker model.

The market for movie theaters is The market for movie theaters is competitive —between theaters as competitive —between theaters as well as with substitutes such as well as with substitutes such as DVDs.DVDs.

The market is competitive, but firms The market is competitive, but firms act act as ifas if they are a monopoly. they are a monopoly.

It Depends What You Are It Depends What You Are SellingSelling

Parker Hannifin: Industrial parts maker:Parker Hannifin: Industrial parts maker:$9.4 billion revenue 2006; 800,000 parts $9.4 billion revenue 2006; 800,000 parts

sold. Traditional policy: “cost” plus 35% sold. Traditional policy: “cost” plus 35% (the “strategy” used by (the “strategy” used by ~ 60% US ~ 60% US manufacturers)manufacturers)

Net income in 2002: $130 millionNet income in 2002: $130 millionNet income in 2006: $673 millionNet income in 2006: $673 millionReturn on invested capital up from 7% to Return on invested capital up from 7% to

21% in same time.21% in same time.How: Be a “monopolist” when possibleHow: Be a “monopolist” when possible

Some things are Some things are “monopolistic” Some are “monopolistic” Some are not.not.New Strategy: 4 Basic Categories of productsNew Strategy: 4 Basic Categories of productsA.A. Ones in highly competitive markets—Ones in highly competitive markets—

charge the market price; no price charge the market price; no price changeschanges

B.B. Partially differentiated products—Partially differentiated products—common products changed a bit for a common products changed a bit for a customer; prices up 0-9%customer; prices up 0-9%

C.C. Differentiated products—engineered for a Differentiated products—engineered for a customer; up 0-25%customer; up 0-25%

D.D. Specials—custom designed; no close Specials—custom designed; no close substitutes; prices up over 25%substitutes; prices up over 25%

The cartel solution…The cartel solution…

The completive outcome is at (Pc, Qc) with P = MCThe completive outcome is at (Pc, Qc) with P = MC But for the industry as a whole, MR < MC But for the industry as a whole, MR < MC lost lost

profitsprofits

Cartel solution is MR = MC Cartel solution is MR = MC (Pm, Qm) and max. (Pm, Qm) and max. profitsprofits S=∑MCiS=∑MCi

To achieve Qm, each firm must restrict its output To achieve Qm, each firm must restrict its output to qmto qm

BUT—the incentive to cheat is hugeBUT—the incentive to cheat is huge

D

Pm

Pc

MCi

MR

qcqm Qm Qc

How to enforce?How to enforce?

Techniques to prevent cheatingTechniques to prevent cheating– Require posting of pricesRequire posting of prices– Central officeCentral office

DeBeers and diamondsDeBeers and diamonds OPECOPEC

– ViolenceViolence Government is best at this Government is best at this

Cheating temptation enormousCheating temptation enormous

Monopoly QuestionMonopoly Question

Suppose only one train company Suppose only one train company (a private company) that (a private company) that operates between Beijing and operates between Beijing and Shanghai. Is the train company a Shanghai. Is the train company a monopoly? Can it charge any monopoly? Can it charge any price it wishes?price it wishes?

Ending MonopoliesEnding Monopolies

Suppose you have industries that Suppose you have industries that have been protected by the have been protected by the government against competition government against competition for many years. If the protection for many years. If the protection is removed and the industries is removed and the industries become competitive, what will become competitive, what will happen?happen?

Effect of Ending Protection Effect of Ending Protection from Competitionfrom Competition

Price Reductions in the U.S. Following Price Reductions in the U.S. Following DeregulationDeregulation

Billions of 1995 DollarsBillions of 1995 Dollars

IndustryIndustry Price Reduction after:Price Reduction after: AnnualAnnual 2 yrs. 5 yrs. 10 yrs.2 yrs. 5 yrs. 10 yrs. SavingsSavings

Natural Gas 10-38% 34-45% 27-57%Natural Gas 10-38% 34-45% 27-57% n.a. n.a.Long Distance 5-16% 23-41% 40-47% $5Long Distance 5-16% 23-41% 40-47% $5Airlines Airlines 13% 12% 29% $19.4 13% 12% 29% $19.4TruckingTrucking n.a. 3-17% 28-56% $19.6 n.a. 3-17% 28-56% $19.6RailroadsRailroads 4% 20% 44% $9.1 4% 20% 44% $9.1