12/10/2008
Reviewing Monopoly Profits
Monopoly Output Levels
20
Price
(Demand)
Costs / Revenue (Dollars)
15
Marginal
Revenue
($)
10
5
Average
Total
Cost ($)
0
0
1
2
3
4
5
6
7
8
Monopoly profits are
generated when
profits are maximized
at a level ABOVE the
average total cost!
A monopoly with low
costs can potentially
enjoy massive profits
indefinitely!
9
-5
Marginal
Costs ($)
-10
Output (Units Produced)
X-Inefficiency
Factors Influencing Monopoly
Profits and Revenue
Monopolies can grow
inefficient due to lack
of competition.
Monopoly Output Levels
12
• x-inefficiency
• price discrimination
• excise taxes
C osts / R even ue (D ollars)
• elasticity of demand
MC
10
X-inefficiency will
increase costs, which
will in turn reduce
profits.
ATC
AVC
8
6
PROFIT
4
2
0
0
1
2
3
4
5
6
7
8
9
-2
X-Inefficiency:
Inefficiency: Is the
failure to use
resources in the most
economically efficient
way.
-4
Output (Units Produced)
Inefficiency
Monopolies can grow
inefficient due to lack
of competition.
Monopoly Output Levels
12
MC
C osts / R even ue (D ollars)
10
ATC
AVC
8
Inefficiency will
increase costs, which
will in turn reduce
profits.
PROFIT
6
4
2
0
0
1
2
3
4
5
6
-2
-4
Output (Units Produced)
7
8
9
X-Inefficiency
Inefficiency:: Is the
failure to use
resources in the most
economically efficient
way.
X-efficiency is the effectiveness with which a given
set of inputs are used to produce outputs. If a firm is
producing the maximum output it can with its given
resources, and the best technology available, then it
is said to be x-efficient.
X-inefficiency occurs when xefficiency is not achieved. The
concept of x-efficiency was
introduced by Harvey Leibenstein
in his paper Allocative efficiency v.
"x-efficiency" in American
Economic Review 1966.
Note: This is different than standard
Note:
inefficiency.
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12/10/2008
In a perfectly competitive market, x-inefficiency
cannot occur because if a firm is less efficient than its
competition then it will not survive in the market.
X-inefficiency is not the only type of inefficiency in economics. Other types
of efficiencies we can consider include:
• Pareto Efficiency: Pareto efficiency is achieved when no party can
be made better off without another party being made worse off.
However, it may be possible for a monopoly to be xinefficient, because the lack of competition makes it
possible to use inefficient production techniques and
still stay in business.
• Allocative Efficiency: Occurs where marginal benefit is equal to
marginal cost. Since price is always based on “marginal benefit”
(consider the “water-diamond” paradox), price always represents
marginal benefit. Therefore, allocative efficiency is attained when price
is equal to marginal cost.
• Productive Efficiency: At the macroeconomic level, this considers
how close a society is to producing the most output that it can with its
resources (closest to the PPC); at a microeconomic level, this
considers whether a firm is producing at the bottom of its average total
cost curve.
• Economic Efficiency: Producing the most value of output for the
least value of input.
Thus, we needed a new term to describe the distinct phenomenon of Xinefficiency.
x-inefficiency
Elasticity
Monopoly Output Levels
12
Any cost that is higher than it needs to be because a firm
is not operating efficiently.
NOTE: This is different than productive economic
inefficiency where a firm fails to produce at the lowest
point of the ATC curve.
M
C A
A
T
V
C
C
8
PROFIT
6
4
Cool Rule #1:
Monopoly Output Levels
If marginal revenue is
positive, total revenue
will increase as output
is increased.
12
2
10
0
0
1
2
3
4
5
6
7
8
9
-2
-4
Output (Units Produced)
C o s ts / R e v e n u e (D o lla rs )
X-inefficiency is most often seen for firms that have a
12
great deal of market control, especially monopoly.
10
The lack of competition allows a business to pad it's x-inefficiency
8
expenses, hire unneeded employees (like relatives),
6
goof off instead of working, and all sorts of other
things that lessen production and increase cost. The
4
business is not penalized for these actions, because
2
market control allows the company to extract
0
0
whatever price is needed to cover cost.
Monopoly Output Levels
MC
ATC
AVC
PROFIT
C o sts / R e ven u e (D o lla rs)
C o s ts / R ev e n u e (D o lla rs )
productive 10
inefficiency
8
Cool Rule #2:
6
If demand is elastic, a
reduction in price will
increase total revenue!
4
2
0
0
1
2
3
4
5
6
7
8
9
-2
1
2
3
4
5
6
7
8
9
If marginal revenue is
positive, then demand
must be elastic!
-4
-2
Output (Units Produced)
-4
Output (Units Produced)
Price Discrimination
Monopoly Demand & Marginal Revenue
12
Monopoly Output Levels
10
12
9
Costs / Revenue (Dollars)
8
8
7
6
6
MR=
10
4
5
MR=
8
2
3
MR=
4
0
0
1
2
3
4
5
6
MR=
7
-2
8
MR=
-4
-4
Old TR = 30.00
8
30.00
MR = 0.00
MR=
2
-2
10
New TR=
4
MR=
6
9
MC
6 units @ 5.00
C osts / R even ue (D ollars)
10
ATC
AVC
MORE
PROFIT
PROFIT
6
A monopoly loses
potential profits as
output is increased
because it lowers its
price for ALL units
produced. (Thus, it
loses the value of the
consumer surplus.)
4
D
2
0
0
1
2
3
4
5
6
7
8
9
-2
-4
Output (Units Produced)
Cool Rule #3:
Output (Units Produced)
MR
A monopoly could earn
a lot more if it could
charge different prices
to different consumers!
This is called price
discrimination!
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12/10/2008
Price Discrimination
MC
C osts / R even ue (D ollars)
10
8
MORE
PROFIT MORE
PROFIT
ATC
AVC
MORE PROFIT
PROFIT
6
If a monopolist could
discriminate perfectly
(charge everyone as
much as they are willing
to pay) then their
marginal revenue would
not fall any faster than
their demand curve.
4
D
2
0
0
1
2
3
4
5
6
7
8
9
-2
-4
Thus their demand
curve would become
their marginal revenue
curve…
Monopoly Output Levels
12
MC
10
C o sts / R e ven u e (D o lla rs)
Monopoly Output Levels
12
Price Discrimination
PROFIT
6
4
D = MR
2
0
0
1
2
3
12
MC
C o sts / R e ven u e (D o lla rs)
10
8
MORE
PROFIT MORE
PROFIT MORE
PROFIT
6
ATC
AVC
MORE
PROFIT
PROFIT
D = MR
0
0
1
2
3
4
5
6
7
8
9
-2
-4
5
6
If a monopolist could
discriminate perfectly
(charge everyone as
much as they are willing
to pay) then their
marginal revenue would
not fall any faster than
their demand curve.
1st degree:
Thus their demand
curve would become
their marginal revenue
curve… and their
equilibrium would shift
to the right.
This is also known as “perfect” price discrimination, where
each customer pays their own personal maximum price.
In perfect price discrimination the consumer surplus is
completely eliminated.
2nd degree:
Price varies based on quantity sold.
Quantity discounts ensure that customers who are willing
and able to buy more product will pay a lower per unit price.
3rd degree:
Price varies based on market segment.
Examples:
age segmentation in movies, public transport, and
admissions to parks;
gender segmentation for haircuts;
segmentation based on business versus private
citizens for phone and banking services.
6
This would shift the
equilibrium price up
slightly, and reduce the
equilibrium output.
4
D
2
0
0
1
2
3
4
5
6
7
8
9
-2
-4
Output (Units Produced)
MR
Note that the increase in
price is far less than the tax!
Q: Why not just
increase the price by
the amount of the tax?
A: If you do this, then
demand will fall to a
non--profit maximizing
non
level!
Monopoly Output Levels MCt
12
10
MC
8
tax
price
C osts / R even ue (D ollars)
MC
8
Excise Tax
If an excise tax of 4.00
was placed on a
monopoly’s product,
then it would shift the
marginal costs up by
4.00 across all levels of
output.
tax
C osts / R even ue (D ollars)
10
9
Price varies on a customer by customer basis
(ie.
ie. car dealers).
Excise Tax
12
8
Degrees of Price Discrimination
Output (Units Produced)
Monopoly Output Levels MCt
7
Thus their demand
curve would become
their marginal revenue
curve… and their
equilibrium would shift
to the right.
Output (Units Produced)
4
2
4
-4
Price Discrimination
Monopoly Output Levels
ATC
AVC
MORE PROFIT
-2
MR
Output (Units Produced)
8
MORE
PROFIT MORE
PROFIT
If a monopolist could
discriminate perfectly
(charge everyone as
much as they are willing
to pay) then their
marginal revenue would
not fall any faster than
their demand curve.
6
You will sell less, and
anything you do sell will
have higher marginal
costs!
4
D
2
0
0
1
2
3
4
5
6
7
8
9
-2
-4
Output (Units Produced)
MR
Hey, if you have to pay
tax, then it’s far better to
pay the tax out of
maximum profits!
3