Introduction: Thinking Like an Economist CHAPTER 2 CHAPTER 14 12 1 Monopoly and Monopolistic Competition Monopoly is business at the end of its journey. — Henry Demarest Lloyd McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Monopoly and Monopolistic Competition 14 1 Chapter Goals Summarize how and why the decisions facing a monopolist differ from the collective decisions of competing firms Determine a monopolist’s price, output, and profit graphically and numerically Show graphically the welfare loss from monopoly Explain why there would be no monopoly without barriers to entry Explain how monopolistic competition differs from monopoly and perfect competition 14-2 Monopoly and Monopolistic Competition 14 1 A Monopolistic Market Monopoly is a market structure in which one firm makes up the entire market Barriers to entry into the market prevent competition Barriers to entry can be: • Legal • Sociological • Natural • Technological There are no close substitutes for the monopolist’s product 14-3 Monopoly and Monopolistic Competition 14 1 The Key Difference Between a Monopolist and a Perfect Competitor A monopolistic firm’s marginal revenue is not its price • Marginal revenue is always below its price • Marginal revenue changes as output changes and is not equal to the price A monopolistic firm’s output decision can affect price There is no competition in monopolistic markets so monopolists see to it that monopolists, not consumers, benefit 14-4 Monopoly and Monopolistic Competition 14 1 Determining the Monopolist’s Price and Output Numerically The goal of the monopolistic firm is to maximize profits, the difference between total revenue and total cost The monopoly maximizes profit when marginal revenue equals marginal cost Marginal revenue (MR) is the change in total revenue associated with a change in quantity Marginal cost (MC) is the change in total cost associated with a change in quantity 14-5 Monopoly and Monopolistic Competition 14 1 Determining the Monopolist’s Price and Output Numerically The profit-maximizing condition of a monopolistic firm is: • MR = MC For a monopolistic firm, MR < P A monopolistic firm maximizes total profit, not profit per unit If MR > MC, • The monopoly can increase profit by increasing output If MR < MC, • The monopoly can increase profit by decreasing its output 14-6 Monopoly and Monopolistic Competition Monopolistic Profit Maximization Table Q P ($) TR ($) MR ($) TC ($) MC ($) ATC ($) Profit ($) 0 36 0 1 33 33 2 30 60 3 27 81 4 24 96 5 21 105 6 18 108 7 15 105 8 12 96 9 9 81 33 27 21 15 9 3 -3 -9 -15 47 48 50 54 62 78 102 142 198 278 1 2 4 8 16 54 40 56 80 --- -47 48.00 -15 25.00 10 18.00 27 15.50 34 15.60 27 17.00 6 20.29 -37 24.75 -102 30.89 -197 14 1 The profitmaximizing condition is: MR = MR If MC < MR, increase production Profit maximizing quantity is where MC = MR If MC > MR, decrease production 14-7 Monopoly and Monopolistic Competition 14 1 Finding the Monopolist’s Price and Output Draw the marginal revenue, marginal cost, and demand curves P $36 Monopolist Price: D at Qprofit max MC Find the profit maximizing level of output, where MR and MC curves intersect $24 $20.50 MC = MR D MR Qm (profit max) Find how much consumers will pay where Qm intersects demand; this is the price the monopolist will charge Q 14-8 Monopoly and Monopolistic Competition 14 1 Comparing Monopoly and Perfect Competition • In a monopoly, P>MR, • In perfect competition, P=MR=D • MR=MC is the profit max rule for both P MC First find the monopoly Q and P PM PPC DPC= MRPC DM MRM QM QPC Q Then find the perfectly competitive Q and P Outcome: Monopoly output is lower and price is higher than perfect competition 14-9 14 1 Monopoly and Monopolistic Competition Find output where MC = MR, this is the profit maximizing Q Determining Profits Graphically: A Firm with Profit P Find how much consumers will pay where the profit max Q intersects demand, this is the monopolist price Find profit per unit where the profit max Q intersects ATC MC D at Qprofit max P ATC ATC Profits ATC at Qprofit max MC = MR Since P>ATC at the profit maximizing quantity, this firm is earning profits D MR Qprofit max Q 14-10 Monopoly and Monopolistic Competition Determining Profits Graphically: A Firm with Zero Profit or Losses 14 1 Find output where MC = MR, this is the profit maximizing Q P Find how much consumers will pay where the profit max Q intersects demand, this is the monopolist price MC ATC D at Qprofit max P =ATC ATC at Qprofit max Find profit per unit where the profit max Q intersects ATC MC = MR D MR Qprofit max Q Since P=ATC at the profit maximizing quantity, this firm is earning zero profit or loss 14-11 14 1 Monopoly and Monopolistic Competition Find output where MC = MR, this is the profit maximizing Q Determining Profits Graphically: A Firm with Losses P Find how much consumers will pay where the profit max Q intersects demand, this is the monopolist price Find profit per unit where the profit max Q intersects ATC Since P<ATC at the profit maximizing quantity, this firm is earning losses ATC at Qprofit max ATC P MC ATC D at Qprofit max Losses MC = MR D MR Qprofit max Q 14-12 Monopoly and Monopolistic Competition 14 1 Welfare Loss from a Monopoly: The Normal Monopolist P • The welfare loss from a monopoly is represented by the triangles B and D MC PM PPC C • The rectangle C is a transfer of surplus from the consumer to the monopolist D B A QM QPC D MR Q • The area A represents the opportunity cost of diverted resources, which is not a loss to society 14-13 Monopoly and Monopolistic Competition 14 1 The Price-Discriminating Monopolist When a monopolist price discriminates, it charges different prices to different individuals or groups of individuals • Consumers with less elastic demands are charged higher prices. • Consumers with more elastic demands are charged lower prices Price discrimination increases output and profits 14-14 Monopoly and Monopolistic Competition 14 1 The Price-Discriminating Monopolist • A price-discriminating monopolist produces the same output as the combination of all firms in a competitive market MC PC • All firms in the perfectly competitive market capture only area B A B D QPM = QC • The price-discriminating monopolist captures all the surplus represented by areas A and B 14-15 Monopoly and Monopolistic Competition 14 1 The Price-Discriminating Monopolist Examples of price discrimination • Movie discounts to senior citizens and children • Airline charge more to fly on Fridays and Sundays • Tracking consumer information and pricing accordingly It might seem unfair for a monopolist to charge different people different prices, but doing so eliminates welfare loss from monopoly For a price-discriminating monopolist, because it can charge what consumers are willing to pay, all consumer surplus is captured by the monopolist 14-16 Monopoly and Monopolistic Competition 14 1 Barriers to Entry Natural Ability • A firm is better at producing the good than anyone else Natural Monopolies • Natural monopoly is when a single firm can produce at a lower cost than can two or more firms Government-Created Monopolies • Patents If there were no barriers to entry, profit-maximizing firms would always compete away monopoly profits 14-17 Monopoly and Monopolistic Competition 14 1 Average Cost for Natural Monopolist Average Cost • One firm producing Q1 has average cost C1 • If two firms share the market, each produces Q1/2 and has average cost C2 • If three firms share the market, each produces Q1/3 has average cost C3 C3 C2 C1 Q 1/3 Q 1/2 Q1 ATC Q 14-18 Monopoly and Monopolistic Competition 14 1 Profit of Natural Monopolist • A natural monopolist produces QM and charges PM, therefore earning a profit Average Cost • If there is government regulation and a competitive solution where P = MC is required, the monopolist produces QC and charges PC, therefore earning a loss PM CM CC PC Profits Losses MR QM QC ATC MC D Q 14-19 Monopoly and Monopolistic Competition 14 1 Government Policy and Monopoly: AIDS Drugs A few companies have patents for AIDS drugs that enable them to charge high prices because demand is inelastic Policy Options • Government regulation where price = marginal cost benefits society, but discourages research • Government purchase of the patents and allowing anyone to produce the drugs so their price = marginal cost. This is expensive for taxpayers. 14-20 Monopoly and Monopolistic Competition 14 1 Characteristics of Monopolistic Competition Four distinguishing characteristics: 1. Many sellers that do not take into account rivals’ reactions 2. Product differentiation where the goods that are sold aren’t homogenous 3. Multiple dimensions of competition make it harder to analyze a specific industry, but these methods of competition follow the same two decision rules as price competition 4. Ease of entry of new firms in the long run because there are no significant barriers to entry 14-21 Monopoly and Monopolistic Competition 14 1 Output, Price, and Profit of a Monopolistic Competitor Like a monopoly, • The monopolistic competitive firm has some monopoly power so the firm faces a downward sloping demand curve • Marginal revenue is below price • At profit maximizing output, marginal cost will be less than price Like a perfect competitor, zero economic profits exist in the long run 14-22 Monopoly and Monopolistic Competition 14 1 Monopolistic Competition P MC ATC PMC D MR QMC Q • You can see that a monopolistically competitive firm prices in the same manner as a monopolist, setting quantity where marginal revenue equals marginal cost • But the firm is also a competitor; competition implies zero economic profit in the long run (determined by ATC) 14-23 Monopoly and Monopolistic Competition 14 1 Comparing Monopolistic Competition with Monopoly It is possible for the monopolist to make economic profit in the long run because of the existence of barriers to entry No long-run economic profit is possible in monopolistic competition because there are no significant barriers to entry For a monopolistic competitor in long-run equilibrium, (P = ATC) ≥ (MC = MR) 14-24 Monopoly and Monopolistic Competition 14 1 Monopolistic Competition Compared with Perfect Competition Graph P MC ATC PMC PPC DPC DMC MRMC QMC QPC Q • In monopolistic competition in the long run, P > min ATC • In perfect competition in the long run, P = min ATC Outcome: Monopolistic competition output is lower and price is higher than perfect competition 14-25 Monopoly and Monopolistic Competition 14 1 Advertising and Monopolistic Competition Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do The goals of advertising are to increase demand and make demand more inelastic Advertising increases ATC The increase in cost of a monopolistically competitive product is the cost of “differentness” 14-26 Monopoly and Monopolistic Competition 14 1 Chapter Summary A monopolist maximizes profit or minimizes losses where MR=MC To determine a monopolist’s profit or loss: Find output where MR=MC; Determine price and ATC at that output; Profit or loss = (P – ATC) * Q Because monopolies reduce output and charge P > MC, monopolies create a welfare loss for society Monopoly output is lower and price is higher than in competitive markets Natural monopolies exist in industries with strong economies of scale 14-27 Monopoly and Monopolistic Competition 14 1 Chapter Summary A price-discriminating monopolist earns more profit than a normal monopolist by charging a higher price to those with less elastic demand and a lower price to those with more elastic demand Three important barriers to entry are natural ability, economies of scale, and government restrictions Monopolistic competition is characterized by many sellers, differentiated products, multiple dimensions of competition, and ease of entry for new firms A monopolistic competitor differs from a monopolist in that a monopolistic competitor makes zero economic profit in long-run equilibrium 14-28