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# I. Monopoly Revenue II. Cournot’s Costless Monopoly III. Monopoly with Costs IV.Consumer Surplus.

Dec 22, 2015

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I. Monopoly Revenue

II. Cournot’s Costless Monopoly

III. Monopoly with Costs

IV. Consumer Surplus

V. The liberal Case: RegulationVI. Schumpeter and ConservativesVII.Monopoly Regulation

How does his Total Revenue (TR) curve differ?

The monopolist’s Total Cost (TC )curve is like that of the competitive firm.

Total Cost

Q

P

0

Because the D = AR curve slopes down to the right, MR is below AR and is falling. MR falls when TR rises at a decreasing rate.

\$

0 Q

TR

The monopolist is a “ price maker,” not a “ price taker.” So his AR > MR. TR no longer has a constant slope.

Now, we just put TC and TR together.

• This is a profit maker. Where MC = MR, NR >0.

• Pure profit can be used:

• 1. Higher than opp cost returns to factors

• 2. Growth of the firm

\$

Q0

TC

TR

NR

This monopolist is “enjoying “ losses. TR < TC, so NR< 0. Losses are minimized where MC = MR (The distance between TC and TR is minimal).

\$

0

TC

TRTR

NR

Q

This monopolist is breaking even. Any other output than the one shown would bring losses.

\$

0

TC

TR

Q

NR

We discover mineral water. The demand is as shown, and there is no cost.

Should we charge a very high price and go for a killing? Or….

Charge a much lower price and go for the mass market?

P

0 Q

D=AR

You got it! Neither. You’re already an expert on this question, and TR is at a max when MR=0, or when Elasticity of demand equals 1.

Without cost, profit max is the same as revenue max.

TR

MR

P

P

0 Q

D=AR

E=1

But in the real world...

MR

P

0 Q

D=AR

And what output level should we choose?

What price?

MCMC MRMR

PP

00 QQ

D=ARD=AR

ACAC

And what output level should we choose?

What price?

Choose the output at which MC = MR and sell it for the price read off the demand curve.

(Charge “what the traffic will bear”)

P

0 Q

D=AR

ACMC

MR

Will this monopoly make a profit ?

MR

P

0 Q

D=ARMC

Pm

C

AC

What is the profit here?

NR = TR - TC

= AR(Q) -AC(Q)

is shown by the shaded area

MR

P

0 Q

D=ARMC

ACPm

C

Here is a monopoly breaking even.

The best that can be done here is to equate MC and MR, and not lose money.

Any other Q and P would mean losses.

MCMR

P

0 Q

D=AR

ACPm

Qm

Here is a monopoly enjoying losses.

The best that can be done here is to

minimize losses where MC=MR.

What are losses here?

MR

P

0 Q

D=AR

AC

MC

Where MC = MR, losses are minimal

MR

P

0 Q

D=AR

ACMC

What the consumer would pay rather than go without

-What the consumer actually does pay

= Consumer Surplus

Quantity D (Would Pay) - P(Does Pay) = Cons Surplus1

2

3

4

\$5

4

3

2

\$2

2

2

2

\$3

2

1

0\$6

\$5

\$2 P

Q0

The whole shaded area is what individual 1 would be willing to pay rather than go without. (\$5)

This is what consumer 1 actually does pay (\$2)

This is consumer surplus for individual 1 (\$3)

\$4

\$2 P

Q0

The whole shaded area is what individual 2 would be willing to pay rather than go without. (\$4)

This is consumer surplus for individual 2 (\$2)

This is what consumer 2 actually does pay (\$2)

\$3\$2 P

Q0

The whole shaded area is what individual 3 would be willing to pay rather than go without. (\$3)

This is what consumer 3 actually does pay (\$2)

This is consumer surplus for individual 3 (\$1)

\$2 P

Q0

The whole shaded area is what individual 4 would be willing to pay rather than go without. (\$2)

This is what consumer 4 actually does pay (\$2)

THERE IS NO CONSUMER SURPLUS FOR CONSUMER 4

\$2 P

Q0

This area represents total expenditures

This area represents consumer surplus (\$6)

\$2 Price

Q0

D

In general, Consumer Surplus is the area below the demand curve and above the price line

For simplicity, assume a constant cost industry, so that the firm has the following

appearance.

P AC=MC=MR=P

Q0

\$

Assume that the industry is initially a case of pure competition. Each firm would have these costs and as price takers, their revenue curve would simply rest on the horizontal cost curves, so...

Industry Demand

Here, S=D

Now consider the industry. Assume that someone organizes a set of small fishermen into a successful monopoly. As a competitive industry before the monopoly is organized, we have...

Qc

AC=MC=SPc

After the monopoly is organized the central planning office must now consider the MR. We draw in the MR curve...

Industry Demand=AR

AC=MCPc

Qc

MR

When we have the MR curve, we can find the industry (monopoly) profit maximum by equating MR with MC and producing that output (Qm).

Industry Demand=AR

AC=MCPc

Qc

MR

Qm

Industry Demand=AR

Sell this output, Qm, at the price buyers are willing to pay, which we read off the demand curve to get Pm.

AC=MCPc

Qc

MR

Qm

Pm

Just extend the output line up to the demand curve for Pm.

Industry Demand=AR

Add a little labeling and note the differences after the monopoly is organized: under competition there was no net revenue (), now we have...

AC=MCPc

Qc

MR

Qm

Pm

With output Qm: TR=OPmaQm

TC=oPc bQm

o

b

a

c

Industry profit as the shaded area. It is the result of restricted output

AR

Add a little labeling and note the differences after the monopoly is organized: under competition there was no net revenue (), now we have...

AC=MCPc

Qc

MRQm

Pm

But the consumers lose because of the restricted output and higher price. Their loss is of consumer surplus.

AR

AC=MCPc

Qc

MRQm

o

b

a

c

The difference? Its as simple as... abc

Under monopoly we now have

NOTE: This was the loss in consumer surplus

AR

AC=MCPc

Qc

MRQm

o

b

a

c

This was the gain in profit

AR

AC=MCPc

Qc

MRQm

o

b

a

c

AR

AC=MCPc

Qc

MRQm

o

b

a

c

THIS IS THE DIFFERENCE: A NET SOCIAL WELFARE LOSS OF

ABC!

Why must monopoly, instrument of social evil, be regulated?

1. By blocking entry, monopoly profit of the short run can be maintained in the long run. Entry is blocked by:

a. controlling raw materials,

b. controlling patents,

Why must monopoly, instrument of social evil, be regulated?

c. receiving a government franchise,

Note: More modest profit returns can be maintained in the long run. Take a low profile and sell larger outputs at lower prices than profit

2. Monopoly must be controlled because it has “quasi-governmental powers of taxation.” An excise tax raises the price of a commodity and turns the extra revenue over to a government body. What is profit?

In monopoly, “quasi-governmental power” is exerted by the producer in raising the price above the competitive level, just like a tax, and using ;the excess revenues for private purposes.

Note the abuses of the “robber barons,” anti-trust regulation, the development of social consciousness, non-profit corporations, taxation without representation.

P

LAC

3. Monopoly is inefficient:

Note that in competition average cost is just covered by the price. The firm operates at the optimal scale of plant.

Competition:

3. Monopoly is inefficient:

In monopoly, what would cause the firm to operate at the optimal scale of plant?

Monopoly:

LAC

MR

An mr curve that cuts the LAC at its lowest point!

3. Monopoly is inefficient:

The mr curve might just as easily cut LAC at an infinite number of other places! For example...

LAC

MR

None of these mr curves would cause the monopolist to select the optimal scale.

MR

MR MR

And if, by remote chance, we did have the mr curve cut the LAC at it’s lowest point, so that the output would be at minimal LRAC, would the result be as pleasing as in competition?

Monopoly:

LAC

MR

An mr curve that cuts the LAC at its lowest point!

and there would be a pure monopoly profit.

Pc

No! The output would be right, but the price would be much higher...

LAC

Pm

AR

MR

Pm

True, monopoly might operate without pure profit, but if it does, other aspects of the outcome are poor!

Here, no pure profit, but we still get higher p and lower.

But note! Competition is not viable.

Pc

QcQm

o Q

Josef Schumpeter, appreciated more with the passing years, is now considered one of history’s greatest economists. He was not at all concerned as were the liberals. His attitude regarding monopoly might be described as...

WHAT, ME WORRY?

Let us consider now some of the reasons why monopoly may not be so deadly. Some of these reasons we owe to Schumpeter.

First, our entire comparison of monopoly and competition to this point has assumed they both have the some cost curves. What if the cost curves of the monopoly were lower?

Note: for the same output, monopoly can produce at a lower cost level.

MCACc

ACmMCm

This could be due to the monopolist’s better finance possibilities or R&D capabilities. The result would be...

MCcACc

ACm

MCm

Pc=Pm

cm

Q

just as large a monopoly output, and no higher price! Even lower monopoly costs would mean Pm<Pc, Qm>Qc.

Moreover, with these lower costs, and favorable outcomes for quantity and price, the monopoly...

MCcACc

ACm

MCm

cm

Q

earns the pure profit shown. This pure profit can also be used to promote further R&D, product improvements, etc.

Pc=Pm

Consider the potential for lower costs (how can one prove that monopoly costs could be lower?) as the first item on a list of reasons not to worry about monopoly. We could add other reasons to the list.

1. Lower costs.

2. Schumpeter’s “Creative Destruction”

3. Foreign competition: tariff and trade policy.

Consider the potential for lower costs (how can one prove that monopoly costs could be lower?) as the first item on a list of reasons not to worry about monopoly. We could add other reasons to the list.

4. Anti-trust activity

5. Potential Entrants (Contestable Markets)

6. General Equilibrium Substitution.

Creative DestructionCreative Destruction

Refers to the DESTRUCTION of static monopolies over time through the CREATIVE, dynamic activity of the heroes of society, the entrepreneurs.

Entrenched monopoly positions, with high prices, restricted outputs, and pure profits cannot be maintained when the monopolized commodity becomes obsolete.

Creative DestructionCreative Destruction

New sources of supply, new production technologies, new product design, and other innovations are at the heart of dynamic social progress.

Business managers are the leaders of society because they bear the risk of pursuing new and creative market possibilities. They are the heroes of economic development.

Foreign CompetitionForeign CompetitionExcept for goods that are non-tradable in world markets, competition can be imported from abroad by exposing domestic producers to the wares of foreign workers and managers. This can be done through avoiding protectionism.Tariff protection can be comforting in the short run, but it is destructive of creativity and progress in the long run. It provides for lethargic, domestic monopoly.

Anti-Trust ActivityAnti-Trust Activity

For some reason, legislators are more inclined to smile on monopoly bashing when there are not foreign producers involved. Around the turn of the century it was apparent that industry would have to be regulated. US antitrust regulation was the first of its kind in the world

2. Clayton Act, 1914: outlaws specific practices not covered by the Sherman Act. It hoped to restrain the growth of monopoly “in its incipiency.” It prohibited price discrimination lessening competition or creating a monopoly, forbids interlocking directorates, etc.

1. Sherman Act, 1890: prohibits contracts, combinations, and conspiracies in restraint of trade.

MAJOR US ANTI-TRUST LEGISLATION

3. Federal Trade Commission Act, 1914: established a panel of five full-time commissioners with substantial quasi-judicial powers. It outlawed “unfair methods of competition,” leaving the commission and the Supreme Court to judicate relevant offenses.

Potential EntrantsPotential EntrantsIn contestable markets entry and exit by new firms is completely free. New firms will be able to produce at the same costs as firms already in the industry, and customers will respond to the first firm to set a lower price

The Nature of CompetitionThe Nature of Competition

Michael Porter, HBS, has now written several books on the topic of the pervasiveness of competitive forces and how the firm should respond strategically to the competitive environment.

There are two types of Monopoly Regulation:There are two types of Monopoly Regulation:

1. Price regulation.a. Average-cost pricing.b. Marginal-cost pricing.

2. Taxation.a. Specific (excise) tax.b. Lump-sum tax

1a. Average-Cost Pricing. Instruct the regulated monopolist to set the price = to AC. (Unit production costs are calculated, and a normal return to stockholders, 6% or so, will be added to that cost.)

ACMC

MR

Q

\$

0

P=CAR

1a. Average-Cost Pricing. Instruct the regulated monopolist to set the price = to AC. (Unit production costs are calculated, and a normal return to stockholders, 6% or so, will be added to that cost.)

AC

MC

MRQ

\$

0

P=CAR

Qm

BUT, the regulatory authority must also regulate output at Q (now Qr), or the monopolist will...

AC

MC

MRQ

\$

0

P=CAR

Qr

regard the regulated price line as hisdemand curve and equate his MC to that to gain net revenues.

1b. Marginal-Cost Pricing is generally favored. The regulatory authority sets the price equal to the point where mc crosses the demand curve. Then P=mc, which means society is getting an efficient outcome.

AC

MC

MRQ

\$

0

P=C

AR

Q

The cost of the last unit produced = the amount paid for it. Price is lower, output is greater, consistent with costs and demand.

Compare this with...

…the monopoly solution! The price is still lower set at MC = AR than for the monopolist, who chooses to work where MC=MR

AC

MC

MRQ

\$

0

P=C

AR

This is the monopolist’s solution. Note the higher price and the lower output than we had before.

Qm

2a. Regulation by Taxation. Specific (excise) tax. A specific or per unit tax on output shifts all cost curves up, since such a tax is a variable cost. Result...

AC

MC

MRQ

\$

0

AR

2a. Regulation by Taxation. Specific (excise) tax.

ACMC

MRQ

\$

0

AR

The higher costs induce the monopolist to reduce output and increase price. Some of the tax costs are passed on and profit is reducedP

P'

Q' Q

MC'AC'

The specific (or excise) tax can be considered a variable cost, attached to each unit of sales. It shifts cost curves up from ac and mc to ac' and mc'.

ACMC

MRQ

\$

0

AR

P

P'

Q' Q

MC'AC'

ACMC

MRQ

\$

0

AR

P

P'

Q' Q

MC'AC'

2a. Regulation by Taxation. Specific (excise) tax.

ACMC

MRQ

\$

0

AR

'

2b. Regulation by Taxation. Lump-sum tax. This type of tax (a good example would be a license tax) shifts only the ac curve. A lump-sum tax is a fixed cost, which cannot be passed on to the consumer.

Before the tax

2b. Regulation by Taxation. Lump-sum tax.

Cost curves shift up to ac' but mc is unchanged.

After the taxNote what happens to profit when the tax is imposed...

AC

MC

MRQ

\$

0

AR

AC'

2b. Regulation by Taxation. Lump-sum tax.

The tax merely shifts up TC by the amount of the increase in TFC.

\$

Q0

TRTC

TFC

NR’

TC'

TFC'

NR

2b. Regulation by Taxation. Lump-sum tax.

All profit can be eliminated by setting the tax high enough. Here, the profit is reduced from the initial level shown...

AC

MC

MRQ

\$

AR

AC'

c

P

Q0

2b. Regulation by Taxation. Lump-sum tax.

…to the reduced level associated with ac' (c').AC

MC

MRQ

\$

AR

AC'

c'P

Q0

Price DiscriminationPrice DiscriminationObjective:Increase profit by selling in more than one market.

1. Marginal Revenues must be equal from each market. MR1 = MR2 = MR3 = …= MRn

Necessary Conditions:

Price DiscriminationPrice Discrimination

2. Markets must be kept separated.

3.Elasticities of demand at each price level must differ.

Necessary Conditions:

Since MR = P(1+1/E)Since MR = P(1+1/E)

As noted above, MR must be equal to maximize revenues from separate markets. But if MRs in separate markets and Elasticities (E) are also the same, P cannot be different. We would be talking about just one demand curve, not two. The same price would maximize returns for both identical demands.

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