13
CHAPTER
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Monopoly
1
CHAPTER OUTLINE
Market Power
How a Firm Uses Market Power to Maximize Profit
The Costs of Monopoly: Deadweight Loss
The Costs of Monopoly: Corruption and Inefficiency
The Benefits of Monopoly: Incentives for Research
and Development
Economies of Scale and the Regulation of
Monopoly
Other Sources of Market Power
To Try it!
questions
To
Video
2
Food for Thought….
Some good blogs and other sites to get the juices flowing:
3
HIV Drugs: $10,000/year
Cost per pill (to produce): $.50
Cost to AIDS patient: $12.50/ pill
Why?
HIV
1. Market Power
2. The “you can’t take it with you
effect”
3. The “other people’s money”
effect
BACK TO
Market Power
Competitive forces tend to drive price
down to the average cost of production.
Sometimes competitive forces are
prevented from operating.
Market Power = the power to raise price
above marginal cost without fear that
other firms will enter the market
Monopoly = a firm with market power
BACK TO
How a Firm Uses Market Power to Maximize Profit
Recall the profit-maximizing rule:
p is maximized by producing where MR = MC
Marginal Revenue, MR = the change in total
revenue from selling an additional unit.
Example: if total revenue increases from $100 to
$150 when a firms sells another unit, MR = $50
Marginal Cost, MC = the change in total cost
from producing an additional unit.
BACK TO
Demand and Marginal Revenue for Monopoly
Firms
Price
20
Marginal Revenue is the Change in Total Revenue When
Quantity Increases by One Unit
16
P
Q
TR
(P*Q)
14
18
1
18
16
2
32
14
14
3
42
10
12
4
48
6
10
5
50
2
8
6
48
-2
TR when
P = 16 is
10 $32
TR when
P = 14 is
$42
MR
(Change in TR)
Demand
Quantity
2
3
5
Marginal Revenue
10
BACK TO
Demand and Marginal Revenue for Monopoly
Firms
Price
Marginal Revenue is the Loss in
Revenue on Previous Sales plus the
Gain in Revenue on New Sales when
Quantity Increases by One Unit
20
Revenue
Loss = $4
16
-$4
Revenue
Gain = $14
14
Marginal Revenue
= (-$4 + $14) = $10
10
+$14
Demand
Quantity
2
8
3
5
Marginal Revenue
10
BACK TO
Demand and Marginal Revenue for Monopoly
Firms
Shortcut for finding MR:
For a straight line demand curve, the marginal
revenue curve is a straight line that begins at the
same point on the vertical axis as the demand
curve but with twice the slope.
If Demand = a – bxQ, then MR = a – 2bxQ
P
P
P
MR
MR
250
D
500
D
Q
4
8
D
MR
Q
a/2b
a/b
Q
BACK TO
Try it!
Suppose that a monopolist can sell 5
units of output at a price of $5 or 6 units
of output at a price of $4. What is the
marginal revenue of the sixth unit?
a)
b)
c)
d)
$24
$49
–$1
$10
To next
Try it!
Profit Maximization for a Monopoly
Profit maximization consists of two steps:
1.Choosing a Quantity
Rule: choose Q where MR = MC
2.Choosing a Price
Choose the highest price you can get away
with… which is the highest price
consumers will pay for that Quantity
Rule: once you’ve picked your Quantity, then
follow the graph to the Demand curve,
which shows you how much consumers
will pay.
BACK TO
The Elasticity of Demand and the Monopoly
Markup
Price
Profit Maximizing
Price
Monopoly Profit Maximization
(Note: Marginal Cost
is simplified here to
be constant at $.50)
Profit
b
$12.50
c
$2.50
Average Cost
a
$.50
Demand
80
Profit Maximizing
Quantity
Marginal Cost
Quantity
Marginal Revenue
BACK TO
Try it!
What is the monopolist's price and output level here?
a)
b)
c)
d)
P
P
P
P
=
=
=
=
$3.00; Q = 40
$16.50; Q = 40
$6.00; Q = 40
$6.00; Q = 80
To next
Try it!
Try it!
The monopolist earns a profit of:
a)
b)
c)
d)
$600.
$420.
$240.
$480.
To next
Try it!
The Elasticity of Demand and the Monopoly
Markup
A competitive firm cannot markup its
goods:
It charges a price for its goods equal to
marginal cost (P = MC) and earns zero or
normal profits.
A firm with monopoly power can markup:
It charges a price greater than marginal cost
(P > MC) and earns positive or above normal
profits.
BACK TO
Try it!
If a monopolist faces a very inelastic
demand curve, its mark-up over
marginal cost will likely be
a)
b)
c)
d)
zero.
very low.
rather high.
Impossible to tell.
To next
Try it!
The Elasticity of Demand and the Monopoly
Markup
Remember, we have argued that the
price of AIDS drugs is high because of
market power. There are two other effects
at work which make demand for AIDS
drugs inelastic (and therefore subject to
higher markup!)
17
BACK TO
The Elasticity of Demand and the Monopoly
Markup
1. The “you can’t take it with you effect”
Consumers are insensitive to the price of lifesaving drugs.
2. The “other people’s money” effect
The majority of Americans are covered by
insurance, which pays for these drugs.
BACK TO
The Elasticity of Demand and the Monopoly
Markup
The More Inelastic the Demand Curve the More the Monopolist Raises Price
Above Marginal Cost
P
P
Relatively Inelastic Demand
Big Markup
Pi
Relatively Elastic Demand
Small Markup
Big
Markup
Pe
MC
Small
Markup
MC
D
D
Qi
MR
Q
Q
Qe
MR
BACK TO
The Costs of Monopoly:
Deadweight Loss
By charging a price greater than marginal cost, a
firm with monopoly power reduces total surplus, or
the gains from trade to society.
A firm with monopoly power produces a lower level of
output and charges a higher price than that of a
competitive firm.
Some consumer surplus is transferred to the firm as profit.
But some consumer surplus is not transferred at all. This
portion goes to no one, neither the consumer nor the firm
(deadweight loss).
BACK TO
The Costs of Monopoly:
Deadweight Loss
Competition Maximizes Social Surplus, Monopolies Do Not Maximize
Social Surplus
P
P
Competition
Pm
Consumer
Surplus
Pc
Monopoly
Consumer
Surplus
Deadweight Loss
Profit
D
Quantity
MC
Pc
Supply
Qc = Optimal
DWL
D
Q
Qm
Q
Qc= Optimal
MR
Quantity
BACK TO
The Costs of Monopoly:
Corruption and Inefficiency
Many monopolies are created by corrupt
politicians.
In these cases, self-interest is channeled toward
social destruction through poor institutions,
instead of toward social prosperity through good
institutions.
Cigarettes and fast cars go together for Tommy Suharto
(who bought Lamborghini with the profits from the clove monopoly his
father, Indonesian President Suharto gave him.)
BACK TO
The Benefits of Monopoly: Incentives for Research
and Development
Would AIDS drugs exist without Monopoly
Profits?
Average cost for developing a new drug?
$1 billion
Profit fuels the fire of invention and protects
innovation.
Would Edison have tried so long without incentives?
BACK TO
Patent Buyouts: a Solution to the Deadweight Loss
Problem?
Is there a way to eliminate the deadweight
loss without reducing the incentives to
innovate?
Patent Buyouts
If the government were to compensate
patent holders the value of their patents
(and then allow competition), prices
could be driven down- eliminating the
deadweight loss without eliminating the
incentive to innovate.
BACK TO
Larry Lessig, the Net’s most celebrated lawyer’s gives a TED talk titled
“Laws that choke creativity”. He cites John Philip Sousa, celestial
copyrights and the "ASCAP cartel" in his argument for reviving our
creative culture. (18:59 minutes)
http://www.ted.com/talks/lang/eng/larry_lessig_says_the_law_is_strangling_
creativity.html
BACK TO
Economies of Scale and the Regulation of
Monopoly
A Natural Monopoly = when a single firm can
supply the entire market at a lower cost than
two or more firms.
A natural monopoly can emerge when
economies of scale are present over the relevant
range of output.
The largest firm will be able to produce its goods
at a lower per unit cost than smaller firms, so only
one firm tends to exist.
BACK TO
Economies of Scale and the Regulation of
Monopoly
Price
A Monopoly with Large Economies of Scale can
have a lower price than competitive firms
Average costs for small
firms
Pc
Pm
AC of monopoly
MC of monopoly
Market Demand
Quantity
Qcompetitive Qmonopoly
Qoptimal
Marginal Revenue
BACK TO
Economies of Scale and the Regulation of
Monopoly
Government Regulation or
ownership can solve the
Natural Monopoly
problem.
Hoover Dam, a Natural
Monopoly
BACK TO
California’s Perfect Storm
California deregulated electricity prices with
disastrous results.
High demand pushed generators to capacity
Utilities’ demand for electricity is inelastic when
supply is critically low.
Firms that generate electricity found a way to
increase profit by shutting down some of their
generators “for maintenance and repair.”
When supply decreased, the price rose rapidly.
Enron and others “gamed” the system for their benefit.
BACK TO
Regulation – A Different Viewpoint
• Many assume that market failure can be
corrected via regulation
• Implicitly presume that regulation is done
competently if not perfectly
• “Nirvana” fallacy - the fallacy of
comparing actual things with unrealistic,
idealized alternatives. It can also refer to
the tendency to assume that there is a
perfect solution to a particular problem.
BACK TO
Regulation – A Different Viewpoint
• Nirvana fallacy – a view that now
pervades much public policy economics
implicitly presents the relevant choice as
between an ideal norm and an existing
'imperfect' institutional arrangement. This
differs considerably from a comparative
institution approach in which the relevant
choice is between alternative real
institutional arrangements.
• “The perfect is the enemy of the good’”
BACK TO
Regulation – A Different Viewpoint
• Sometimes regulatory action are hardly
“solutions” (i.e. Calif elec deregulation)
Many believe Dodd-Frank FinReg bill has
made things worse
• What matters is the effectiveness of the
regulation in terms of costs/benefits,
including potential opportunity costs
• i.e. over-regulation can stifle market forces
for cost reduction and/or innovation
BACK TO
A Price Control on a Monopoly Can Increase
Output
Without regulation, the monopoly
maximizes profit by choosing Pm, Qm.
Price
If the government imposes a price
control at PR, the monopolist chooses
QR, a larger quantity.
Old marginal
revenue curve
The optimal price is at P = MC, but at
this price the monopolist is making a
loss and will exit the industry.
New marginal
revenue curve
Pm
A lower
Price…
a
Pr
P = MC
The lowest price that will keep the
monopolist in the industry is P = AC at
point a. At that price, the monopolist
makes a zero (normal) profit.
AC of monopoly
Loss if P = MC
Marginal Cost
Demand
Qm
QR
Optimal
Quantity
Quantity
…leads to higher
output
BACK TO
Other Sources of Market Power
Summary of Sources of Monopoly Power
Source of Market Power
Example
Patents
GlaxoSmith Kline’s Patent on Combivir
Laws Preventing Entry
The Indonesian Clove Monopoly, The
Algerian Wheat Monopoly, The U.S.
Post Office
Economies of Scale
Subways, Cable TV, Electricity
Transmission, Major Highways
Hard to Duplicate Inputs
Oil, Diamonds, Rolex Watches
Innovation
Apple’s iPod, Mathematica Software,
eBay
BACK TO
Try it!
If the market for some good were converted
from a competitive industry to a monopoly,
which of the following would occur as a result?
a)
b)
c)
d)
Prices would fall on the output produced
by the monopolist.
Some consumer surplus would be
reallocated to the monopolist as profit.
The overall level of profit earned in the
industry would decrease.
More output would be produced by the
monopolist.
To next
Try it!
Try it!
Which of the following reasons explains why telephone
service is no longer considered a natural monopoly?
a) The government regulated the industry and forced
competitors into the market.
b) Advances in communications technology
reduced the cost of providing phone service,
allowing new firms to enter the industry.
c) Consumers stopped using phones and began
using other means of communication.
d) Existing phone companies were unprofitable and
went out of business, allowing new companies to
enter.
To next
Try it!
Try it!
In the following diagram, ______ represents the profit -maximizing
price, while _____ represents the profit-maximizing quantity.
Point
Point
Point
Point
A; Point E
B; Point E
A; Point D
B; Point D
To next
Try it!
Try it!
The
a)
b)
c)
d)
monopolist's markup here is:
a – b.
b – d.
d.
a – d.
BACK TO