Frank & Bernanke rd 3 edition, 2007 Ch. 10: Monopoly and Other Forms of Imperfect Competition 1 Perfect Competition An ideal market that maximizes economic surplus A situation that does not always exist 2 Imperfectly Competitive Firms Have some control over price Price may be greater than the cost of production Reduce economic surplus to varying degrees Long-run economic profits are possible Are very common Reduce economic surplus to varying degrees Are very common 3 Different Forms of Imperfect Competition Pure Monopoly (most inefficient) Monopolistic Competition (closest to perfect competition) The only supplier of a unique product with no close substitutes A large number of firms that produce slightly differentiated products that are reasonably close substitutes for one another Long-run adjustment to zero economic profits Importance of differentiation Oligopoly (more efficient than a monopoly) Industry structure in which a small number of large firms produce products that are either close or perfect substitutes Cost advantages from large size may prevent the long-run adjustment to zero economic profit Undifferentiated and differentiated products 4 Perfectly and Imperfectly Competitive Firms The perfectly competitive firm faces a perfectly elastic demand for its product. Supply and demand determine equilibrium price. The firm has no market power. At the equilibrium price, the firm sells all it wishes. The imperfectly competitive firm faces a downward-sloping demand curve. The firm has some control over price or some market power. The firm faces a downward sloping demand curve. 5 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. 6 The Demand Curves D Market price Imperfectly competitive firm Price $/unit of output Perfectly competitive firm D Quantity Quantity 7 Five Sources of Market Power Exclusive control over inputs Patents and Copyrights Government Licenses or Franchises Economies of Scale (Natural Monopolies) Network Economies 8 Economies of Scale and the Importance of Start-Up Costs Firms with large fixed costs and low variable costs: Have low marginal costs Average total cost declines sharply as output increases Economies of scale will exist 9 Constant Returns to Scale A production process is said to have constant returns to scale if, when all inputs are changed by a given proportion, output changes by the same proportion. 10 Increasing Returns to Scale A production process is said to have increasing returns to scale if, when all inputs are changed by a given proportion, output changes by more than that proportion; also called economies of scale. 11 TC and ATC with Economies of Scale Average cost ($/unit) Total cost ($/year) TC = F + MQ F + MQ0 F ATC = F/Q + M M Q0 Quantity Total cost rises at a constant rate as output rises Quantity Average costs decline and is always higher than marginal cost 12 Costs for Two Computer Game Producers (1) Nintendo Playstation Annual production 1,000,000 1,200,000 Fixed cost $200,000 $200,000 Variable cost $800,000 $960,000 $1,000,000 $1,160,000 $1.00 $0.97 Total cost Average total cost per game Observations •Fixed costs are a relatively small share of total cost •Cost/game is nearly the same 13 Costs for Two Computer Game Producers (2) Annual production Fixed cost Variable cost Total cost Average total cost per game Nintendo Playstation 1,000,000 1,200,000 $10,000,000 $10,000,000 $200,000 $240,000 $10,200,000 $10,240,000 $10.20 $8.53 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 14 Costs for Two Computer Game Producers (3) Annual production Fixed cost Variable cost Total cost Average total cost per game Nintendo Playstation 500,000 1,700,000 $10,000,000 $10,000,000 $100,000 $340,000 $10,100,000 $10,340,000 $20.20 $6.08 • 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 15 Economies of Scale and the Importance of Fixed Costs Fixed investment in research and development has been increasing as a share of production costs. Cost of producing a computer Fixed Cost Software 1984 1990 20% 80% Variable Cost Hardware 80% 20% 16 Economic Naturalist How big will Playstation’s unit cost advantage be if it sells 2,000,000 units per year, while Nintendo sells only 200,000? Why does Intel sell the overwhelming majority of all microprocessors used in personal computers? 17 Profit Maximization Perfect competition and monopolies 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 18 The Monopolist’s Benefit from Selling an Additional Unit • 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 = $5 Price ($/unit) 8 6 5 D 2 3 8 Quantity (units/week) 19 Marginal Revenue P Q TR 6 2 12 5 3 15 4 4 16 3 5 15 MR Observations 3 1 -1 MR < P MR declines as quantity increases MR is the change between two quantities MR < P because price must be lowered to sell an additional unit 20 P Q TR 6 2 12 5 3 15 4 4 16 3 5 15 MR 3 1 -1 Price & marginal revenue ($/unit) Marginal Revenue in Graphical Form 8 3 D 1 -1 2 3 4 8 5 MR Quantity (units/week) Demand: P = 8 – Q MR = 8 – 2Q 21 Monopolist with a Straight-Line Demand Curve Price a a/2 D MR Q0/2 Q0 Quantity Observations • The vertical intercept, a, is the same for MR and D • The horizontal intercept for MR, Q0/2, is one half the demand intercept, Q0. 22 Profit Maximizing Decision Rule When MR > MC, output should be increased. When MR < MC, output should be reduced. Profits are maximized at the level of output for which MR = MC. 23 The Monopolist’s ProfitMaximizing Output Level Marginal Cost Price ($/unit of output) 6 Observations • If P = $3 & Q = 12 MR < MC and output should be reduced • Profits are maximized at 8 units where MR = MC • P = $4 where quantity demanded = quantity supplied 4 3 2 MR 8 12 D 24 Quantity (units/week) Demand: P = 6 – 0.25Q MR = 6-0.5Q MC = 0.25Q 24 Even a Monopolist May Suffer an Economic Loss Being a monopolist doesn’t guarantee an economic profit 0.12 0.10 ATC MC 0.05 D 20 MR Minutes (millions/day) Economic profit = $400,000/day Price ($/minute) Price ($/minute) Economic loss = $400,000/day 0.10 0.08 ATC MC 0.05 D 20 24 MR Minutes (millions/day) 25 Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) 6 Marginal cost The socially optimal amount occurs where MC = D(MB) @ 12 units 3 D 12 24 Quantity (units/week) 26 Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) 6 Marginal cost • The profit maximizing level of output of 8 units, where MR = MC, is less than the socially optimal output of 12 • Between 8 and 12, MB to society > MC to society • Cannot increase output because MR to the firms is less than MC 4 3 2 MR 8 12 D 24 Quantity (units/week) 27 Invisible Hand Breaks Down Under Monopoly Price ($/unit of output) 6 Marginal cost Deadweight loss • 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. 4 3 2 MR 8 12 D 24 Quantity (units/week) 28 Why the Invisible Hand Breaks Down Under Monopoly Monopoly Profits are maximized where MR = MC. P > MR P > MC Deadweight loss Perfect Competition Profits are maximized where MR = MC. P = MR P = MC No deadweight loss 29 Difficulties in Reducing the Deadweight Loss of Monopolies Enforcing antitrust laws Patents, copyrights, and innovation Natural monopolies 30 Price Discrimination The practice of charging different buyers different prices for essentially the same good or service Examples of Price Discrimination Senior citizens and student discounts on movie tickets Supersaver discounts on air travel Rebate coupons 31 Price Discrimination Profit-maximizing seller’s goal is to charge each buyer his/her reservation price. There are two problems to implementing this pricing strategy. Seller does not know the reservation prices Seller must separate high and low price buyers The hurdle method of price discrimination is used to solve these problems. 32 The Hurdle Method The practice of offering a discount to all buyers who overcome some obstacle. Example Offering a rebate to those who mail in a coupon 33 Examples of Price Discrimination Temporary Sales Book publishers and paperback books Automobile producers offer various models Commercial air carriers Movie producers 34 Price Discrimination and Economic Surplus P MC P* World Price D MR Q* Q** Q 35 Controlling Natural Monopolies State ownership and management Weighing the benefit of marginal cost pricing versus the cost of less incentive for innovation State regulation of private monopolies Cost-plus regulation Exclusive contracting for natural monopoly High administrative cost Less incentive for innovation P does not equate to MC Competition for the contract sets P = MC Difficulty when fixed costs are high such as electric utilities Vigorous enforcement of anti-trust laws Helps prevent cartels May prevent economies of scale 36