12 monopoly kusom slides.

In This Lecture…

The Theory of MonopolyMonopoly Pricing and

Output in Short Run and Long Run

Social Costs of Monopoly Sources of Monopoly

PowerMonopoly and

Consumer’s SurplusPrice Discrimination

Monopoly

A theory of market structure based on three assumptions:

There is one sellerIt sells a product for which no close

substitutes existThere are extremely high barriers to

entry

Barriers to Entry

Legal barriersEconomies of scaleExclusive ownership of a necessary

resource

Legal Barriers to Entry

Public franchises - A right granted to a firm by government that permits the firm to provide a particular good or service and excludes all others from doing the same. Thus eliminating potential competition by law.

The US Postal Service has been granted the exclusive franchises to deliver first class mail.

Legal Barriers to Entry

Patents Rights are granted to inventors of a product or process for a period of 20 years. During these years, the patent holder is shielded from competitors; no one else can legally produce and sell the patented product or process.

The rationale behind patents is that they encourage innovation in the economy.

Legal Barriers to Entry

Government licenses – required to carry on a business or occupation

Radio and television stations cannot operate without a license from the government.

In some states a person needs to be licensed to be a physician, dentist, nurses etc.

Economies of Scale Economies of scale – In some industries low

ATC are only obtained through large sale production. If new entrants are to be competitive in the industry they must enter in large scale. But having to produce on this scale is risky and costly and therefore acts as a barrier to entry.

If economies of scale are so pronouncedin an industry that only one firm can survive in the industry it is called a natural monopoly.

Monopolist’s Demand Curve

The monopoly firm is the industry, and the industry is the monopoly firm—they are the same.

It follows that the demand curve for the monopoly firm is the market demand curve, which is downward sloping.

A downward-sloping demand curve posits an inverse relationship between price and quantity demanded:

More is sold at lower prices than at higher prices, ceteris paribus.

Unlike Perfectly Competitive firm, the monopolist can raise its price and still sell its product (though not as much).

Monopolist is a Price Searcher

A seller that has the ability to control to some degree the price of the product it sells.

The monopolist seeks a price which maximizes profit.

Demand and Marginal Revenue Curves

The demand curve plots price and quantity.

The marginal revenue curve plots marginal revenue and quantity.

For a monopolist, P > MR, so the marginal revenue curve must lie below the demand curve.

Monopolist’s Profit-Maximizing

Price and Quantity of OutputThe monopolist produces

the quantity of output (Q1) at which MR= MC, and charges the highest price per unit at which this quantity of output can be sold (P1).

Notice that at the profit-maximizing quantity of output, price is greater than marginal cost, P >MC.

Monopoly Profits and Losses

A monopoly seller is not guaranteed any profits. Here, price is at above average total cost at Q1, the quantity of output at which MR = MC.

Therefore, TR (the area 0P1BQ1) is greater than TC (the area 0CAQ1), and profits equal the area CP1BA.

Monopoly Profits and Losses

Here, price is below average total cost at Q1.

Therefore, TR (the area 0P1AQ1) is less than TC (the area 0CBQ1) and losses equal the area P1CBA.

Perfect Competition and Monopoly

For the perfectly competitive firm, P = MR; for the monopolist, P > MR.

The perfectly competitive firm’s demand curve is its marginal revenue curve; the monopolist’s demand curve lies above its marginal revenue curve.

The perfectly competitive firm charges a price equal to marginal cost; the monopolist charges a price greater than marginal cost.

Perfect competition: P = MR and P = MC

Monopoly: P > MR and P > MC

Consumer Surplus

The difference between the maximum price a buyer is willing and able to pay and the actual price paid.

CS = Maximum Buying Price - Price Paid

Monopoly, Perfect Competition,and Consumers’ Surplus

If the market in the exhibit is perfectly competitive, the demand curve is the marginal revenue curve. The profit maximizing output is QPC and price is PPC.

Consumers’ surplus is the area PPCAB.

If the market is a monopoly market, the profit-maximizing output is QM and price is PM.

Consumers’ surplus is the area PMAC.

Consumers’ surplus is greater in perfect competition than in monopoly; it is greater by the area PPCPMCB.

Social Costs of Monopoly

Dead Weight LossThe loss of not producing the

competitive quantity of output.

Rent Seeking

Actions of individuals and groups who spend resources to influence public policy in the hope of redistributing (transferring) income to themselves from others.

X-Inefficiency

The increase in costs and organizational slack in a monopoly resulting from the lack of competitive pressure to push costs down to their lowest possible level.

Deadweight Loss and Rent Seeking as Costs of Monopoly

The monopolist produces QM, and the perfectly competitive firm produces the higher output level QPC.

The deadweight loss of monopoly is the triangle (DCB) between these two levels of output.

Rent-seeking activity is directed to obtaining the monopoly profits, represented by the area PPCPMCD.

Rent seeking is a socially wasteful activity because resources are expended to transfer income rather than to produce goods and services.

Price DiscriminationWhen the seller charges different prices for

the product it sells and the price differences do not reflect cost differences.

Perfect Price Discrimination - seller charges the highest price each consumer would be willing to pay for the product rather than go without it.

Second-Degree Price Discrimination - seller charges a uniform price per unit for one specific quantity, a lower price for an additional quantity, and so on.

Third-Degree Price Discrimination - seller charges different prices in different markets or charges a different price to different segments of the buying population.

Conditions of Price Discrimination

To price discriminate, the following conditions must hold:

The seller must exercise some control over price; that is, it must be a price searcher.

The seller must be able to distinguish among buyers who would be willing to pay different prices.

It must be impossible or too costly for one buyer to resell the good to other buyers. The possibility of arbitrage*, or “buying low and selling high,” must not exist.

*Buying a good at a low price and selling the good for a higher price.

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