Lecture 1-MP

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Monopoly

Lecture 1 - Connan Snider

Econ 101

March 28 2011


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Monopoly

A Monopoly is a single supplier of a market

How can a monopoly persist in the long run?

Recall the long run supply in the competitive model Suppose there is one firm in the short run Assume for now that the firm behaves competitively in the

sense of price taking (well show this isnt the way an actual

monopolist would behave soon) Industry supply is then just the marginal cost curve of the firm


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Monopoly

What do we expect to happen in the long run?


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Monopoly

What do we expect to happen in the long run?

Other firms see there are positive profits to be had and enterthe market

New firms will enter until profits are driven to zero,i.e. price =minimum ATC = MC.


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Monopoly

A Monopoly is a single supplier of a market

How can a monopoly persist in the long run?

Barriers to Entry are the source of all monopoly power

There are two general types of barriers to entry:

1. Technical barriers

2. Legal barriers


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Technical Barriers to Entry

Technical barriers to entry arise because production mayexhibit decreasing marginal and average costs over a widerange of output

Economies of Scale

In some industries, large fixed costs mean that the large scaleproducers are the low cost producers

E.g. A cable company has to make a huge upfront investmentto serve any customers but after the investment is made themarginal cost of an additional customer is small

This situation is known as Natural Monopoly

Once monopoly is established entry of new firms is difficult


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Technical Barriers to Entry

Technical barriers can take many forms, the simplest is the

high fixed cost, low marginal cost as in the cable companyexample

Another common example: Network externalities in high techindustries

Why did the Blu-Ray/HD DVD battle have to have a winner? Why did Microsoft have a monopoly on operating systems?

Network externalities means a product is more valuable to mewhen a lot of other people also buy the product.

If half of all titles are only on Blu-Ray and half are on HDDVD, I might only be able to get a fraction of the movies Iwant if I dont buy both types of player.

Other examples of technical barriers to entry?


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Legal Barriers to Entry

Often monopolies are created as a matter of law Patents and copyrights assign a monopoly for a (long) period

of time to the discoverer/creator of a product

Governments may want to limit competition and thus award afirm an exclusive franchise to serve a market: toll roads?

Examples?


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Monopoly Pricing

In either case, a firm is choosing output to maximize profits:

(q) = R(q) C(q) = qP(q) C(q) (1)

The optimal output is found from the first order condition:

d

dq=

dR

dq

dC

dq= 0 (2)

MR(q) = qP(q) + P(q) = MC(q) (3)

In the competitive case P(q) = 0 (i.e. the inverse demand

curve is flat) so P= MC(q), but for the monopolist P

(q) < 0

P(q) is the revenue a monopolist earns from selling to themarginal customer, qP(q) is the amount the monopolist loseson the inframarginal customers from lowering price to attract

the marginal customer


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The Inverse Elasticity Rule

A firms markup- The gap between its price and marginalcost- is inversely related to the price elasticity of demandfacing the firm.

PMC

P=

1

eQ,P(4)

or

P =

MC

1 + 1/eQ,P (5) Exercise: Derive this relationship using the definition of

elasticity and the condition for firm optimization

The more sensitive consumers are to price, the less themonopolist will choose to mark up above cost.

The condition implies firm will never choose output on theinelastic part of the demand curve since

eQ,P < 1 PMC> P MC< 0


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Example: Linear Demand and Constant AC-MC

Assume:

P(Q) = a bQ (6)

C(Q) = cQ (7)

Then

TR = PQ= aQ bQ2 (8)

MR = a 2bQ (9)


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Example: Linear Demand and Constant AC-MC

Profit maximization requires:

MR= a 2bQ = c= MC (10)

Or

Q =

a c

2b (11)

Plugging back into the inverse demand function

P = a bQ (12)

= a (a

c)2

(13)

=a + c

2(14)


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Example: Constant Elasticity Demand and ConstantMarginal Cost

Suppose demand is given by: Q= aPe

eQ,P =dQ

dP

P

Q(15)

= aePe1P

Q(16)

= e (17)

We could solve this directly by solving the profit maximizationproblem of a monopolist or we could use the inverse elasticityrule.

E l C El i i D d d C


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Example: Constant Elasticity Demand and ConstantMarginal Cost

From the markup equation we derived earlier we know:

P =MC

1 + 1/eQ,P(18)

SoP = e

e+ 1c (19)

Plugging into the demand equation

Q

= a ee+ 1c

e

(20)

Exercise: Verify this by solving the monopolists problem(hint: use the same tricks as you do in deriving the markup

relationship)

I M l G d B d?


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Is Monopoly Good or Bad?

U.S. Antitrust laws (and competition laws in other countries)are designed to keep firms from scheming themselves into amonopoly

Monopoly is bad?

Intellectual property laws grant monopolies to inventors andartists

Monopoly is good?

What is going on here?

I M l G d B d?


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Is Monopoly Good or Bad?

U.S. Antitrust laws (and competition laws in other countries)

are designed to keep firms from scheming themselves into amonopoly Monopoly is bad?

Intellectual property laws grant monopolies to inventors and

artists Monopoly is good?

Balancing static versus dynamic considerations:

Monopolies distort market allocations away from the efficientallocations if we think only about the world right now, i.e.prices are too high today

The promise of future monopoly profits give incentive toinvest, e.g. Im not going to sit in my lab/studio for 16 hours aday unless I can get rich

M l d ( t ti ) R All ti


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Monopoly and (static) Resource Allocation

Compare a monopoly to a benchmark perfectly competitiveeconomy

Assume firms have identical constant cost technology so thelong run supply curve in the perfectly competitive world isinfinitely elastic with price equal to both marginal and averagecost

Later we will think about dynamic incentives


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Lecture 1-MP

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