Second Edition Chapter 11 Chapter 11 Costs and Profit Maximization Under Competition Competition
Mar 26, 2015
Second Edition
Chapter 11 Chapter 11 Costs and Profit Maximization Under
CompetitionCompetition
Costs and Profit Maximization Under
CompetitionCompetition
Chapter OutlineChapter Outline
What price to set? What quantity to produce? Profits and the average cost curve Entry, exit, and shutdown decisions Entry, exit, and industry supply curves
2
IntroductionIntroduction
Imagine that you are the owner of a stripper oil well. You must answer three questions:• What price to set?• What quantity to produce?• When to enter and exit the industry?
In this chapter will answer these questions for a competitive industry
3
What Price to Set?What Price to Set?
In a competitive market you are a “price-taker”• As an oil producer your price is the world
price. If you set the price higher, no one will buy your oil. Why would you set the price lower?
Elasticity of demand for your oil is perfectly elastic
Let’s see what this means.
4
What Price to Set?What Price to Set?
World Market for Oil Demand for Your Oil
P ($/barrel)P ($/barrel)
Quantity
(millions of barrels)
Quantity
Demanddemand
Marketsupply
$50
(barrels)
Demandfor your
oil
82
5
The Perfectly Elastic Demand CurveThe Perfectly Elastic Demand Curve
A perfectly elastic demand curve is a reasonable assumption under the following conditions:• Product being sold is similar across sellers.• There are many buyers and sellers, each
small relative to the total market.• There are many potential sellers.
6
The Perfectly Elastic Demand Curve The Perfectly Elastic Demand Curve
Demand curves are most elastic in the long run
Long run – the time after all exit or entry has occurred.
Short run – the time period before exit or entry can occur
7
Try it!Try it!
To next To next Try it! Try it!
In a competitive market, what happens when a firm prices its product above the market price? Below the market price?
What kind of demand elasticity does the competitive firm face?
How can a firm that produces oil face a very elastic demand curve when the demand for oil is inelastic?
What Quantity to Produce?What Quantity to Produce?
We assume the objective is to maximize profit.
Total revenue is price x quantity = P x Q
Total cost is the cost of producing a given quantity of output
9
Profit = = Total Revenue – Total Cost
Don’t Forget: Opportunity Cost!Don’t Forget: Opportunity Cost!
Total cost = Explicit cost + Implicit cost Explicit cost is cost that requires a money
outlay Implicit cost is an opportunity cost that does
not require an outlay of money Economic profit includes implicit costs Accounting profit = Total revenue – explicit
costs Output decisions should be based on
economic profit 10
Maximizing ProfitMaximizing Profit
From now on our measure of total costs includes implicit costs.
• Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)
• Fixed Costs are costs that do not vary with output (Q)
• Variable Costs are costs that do vary with output (Q)
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Maximizing ProfitMaximizing Profit
Marginal revenue (MR) = Change in TR from selling one more unit.
Marginal cost (MC) = Change in TC from producing one more unit.
Profits are maximized at the level of output where MR = MC• If MR > MC → ↑profits from ↑Q• If MR < MC → ↓profits from ↑Q
Let’s look at some hypothetical data12
Profit MaximizationProfit Maximization
Let’s show this with our model. 13
Maximizing ProfitMaximizing Profit
P($/barrel)
Quantity(barrels)0 102 3 4 5 6 7 8 91
100
$150
50
0
MR = P
Marginalcost
At Q = 8: P = MR = MCProfits are maximized
WorldMarketprice→
Note: In a competitive market, price does not vary with the firm’s output. This implies:
PΔQ
ΔQP
ΔQ
Q)Δ(P
ΔQ
ΔTRMR
14
Maximizing Profit: Effect of an Increase in Maximizing Profit: Effect of an Increase in the Market Pricethe Market Price
P($/barrel)
Quantity(barrels)0 102 3 4 5 6 7 8 91
100
$150
50
0
MR = P
Marginalcost
As P↑, the firm expands production along its MC curve
WorldMarketprice→ MR = P
15
Profits and the Average Cost CurveProfits and the Average Cost Curve
Average cost is the cost per unit of output, i.e. the total cost divided by Q
We can now add a column to our table showing AC at each level of output.• At the profit maximizing quantity, is AC at its
lowest value?
Q
TCAC
16
Profits and the Average Cost CurveProfits and the Average Cost Curve
Let’s see how profits are measured in our model. 17
Maximizing ProfitMaximizing Profit
P($/barrel)
Quantity(barrels)0 102 3 4 5 6 7 8 91
100
$150
50
0
MR = P
Marginalcost
WorldMarketprice→
AverageCost (AC)
17
P = AR = $50Profits are maximized at Q = 8At Q = 8, AC = $25.75Profit = (P – AC) x Q or,Profit = ($50 - $25.75) x 8 = $194Maximizing profits ≠ minimum AC
25.75
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Maximizing ProfitMaximizing Profit
P($/barrel)
Quantity(barrels)0 102 3 4 5 6 7 8 91
100
$150
50
0
Marginalcost
AverageCost (AC)
17
MR = MC doesn’t necessarily mean the firm makes a profit
P = $17 is the minimum price the firm will accept
P > $17 → P > AC → Profits P < $17 → P < AC → Losses
Let’s look at this a little closer. 19
Maximizing ProfitMaximizing Profit
P($/barrel)
Quantity(barrels)0 102 3 4 5 6 7 8 91
50
25
0
Marginalcost
AverageCost (AC)
17
Loss
P = MR
P < ACis a profit
P < ACis a loss
20
Try it!Try it!
If a firm is earning positive economic profit, it must be the case that
a)price is less than average cost.
b)price is equal to average cost.
c)price is equal to total cost.
d)price is greater than average cost.
To next To next Try it! Try it!
Marginal and Average Cost CurveMarginal and Average Cost Curve
The MC curve intersects the AC curve at its minimum point.• When marginal cost is just below average cost, the AC curve
is falling.• When marginal cost is just above average cost, the AC curve
is rising.• So, AC and MC curves must meet at the minimum of the AC
curve.
Entry, Exit, and Shutdown DecisionsEntry, Exit, and Shutdown Decisions
When should a firm enter or exit an industry?
Long run• Firms will enter the industry when P > AC• Firms will exit the industry when P < AC
When P = AC• Profits are zero• No incentive to either leave or enter the
industry
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Entry, Exit, and Shutdown DecisionsEntry, Exit, and Shutdown Decisions
Why would firms remain in an industry if profits are zero?
Zero profits – means at the market price the firm is covering all of its costs including enough to pay labor and capital their ordinary opportunity cost.
When economists say zero profits, they mean what people mean by normal profits.
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The Short-Run Shutdown DecisionThe Short-Run Shutdown Decision
Sometimes it makes sense to continue running a business even if P < AC.
A ski resort is an example• If it shuts down during the summer…
Revenue = 0, but… They still have fixed costs to cover
• Insurance, security, payments to the bank…
• If it stays open Revenue is positive
• Ski lift for hikers and bikers• Restaurants and hotel
• If TR > VC they are better off staying open
The following table provides some numbers to help us.25
The Short-Run Shutdown DecisionThe Short-Run Shutdown Decision
Note: By staying open, the firm still loses money, but it loses less than if it shuts down for the summer
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Entry and Exit with Uncertainty and Entry and Exit with Uncertainty and Sunk CostsSunk Costs
In the real world firms must modify the entry and exit rules.• P > AC → Firm should enter only if the price is
expected to be above AC for a long time.• P < AC → Firm should exit only if the price is
expected to below AC for a long time.
Let’s return to our oil firm as an example.
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Entry and Exit with Uncertainty and Entry and Exit with Uncertainty and Sunk CostsSunk Costs
Entry means drilling an oil well. Costs of drilling an oil well are sunk costs. Sunk costs – A cost that once incurred can
never be recovered. Unless
• long enough to cover sunk costs, the well won’t be drilled.
($17) ACminPExpectedOil
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Entry and Exit with Uncertainty and Entry and Exit with Uncertainty and Sunk CostsSunk Costs
It doesn’t always make sense to exit an industry immediately when P < AC• High entry and exit costs• Long-term it may be best to “weather the
storm”
Only if • For an extended period of time will the firm
exit
($17) ACmin PExpectedOil
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Entry and Exit with Uncertainty and Entry and Exit with Uncertainty and Sunk CostsSunk Costs
Firms must base their exit or entry decisions on lifetime expected profit when…• It is costly to enter or exit• There is uncertainty about future prices
Uncertainty about the national economy can cause many firms to reduce investment simultaneously.
30
Entry, Exit, and Industry Supply CurvesEntry, Exit, and Industry Supply Curves
Industry supply curve depends on how costs change as industry output ↑ or ↓• Constant cost industry – Industry costs do not
change with greater output• Increasing cost industry - Industry costs ↑ with
greater output• Decreasing cost industry – Industry cost ↓ with
greater output
We discuss each of these in turn.
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Constant Cost IndustriesConstant Cost Industries
Domain name registration industry has two characteristics:• Satisfies all the conditions for a competitive
industry• Major input , bank of computers, is small
compared to the world supply of computers.
Implications1)Price is quickly driven down to AC ($6.99).
2)Price doesn’t change much.
Let’s see how this works.32
Constant Cost IndustryConstant Cost Industry
Market FirmPP
$6.99
SSA
DA
AC
MC
QA qA
A
↑ Market demand → ↑ market price → ↑ profits ↑ profits → Existing firms ↑ q → ↑ Q ↑ profits → Firms enter → Short-run supply shifts right → ↓ P, ↑Q Profits return to normal
$7.99
DB
A
QB qB
SSBBB
C C
QC
LRS
33
Increasing Cost IndustriesIncreasing Cost Industries
Industry costs rise as industry output increases.
The oil industry is an increasing cost industry• Greater quantities of oil can only be obtained
by using more expensive methods Drilling deeper Drilling in more inhospitable spots Extracting oil from tar sands
We can use the following example to illustrate.34
Increasing Cost IndustriesIncreasing Cost Industries
Firm 1 – oil is near the surface Firm2 – oil is located deeper
Firm 2 IndustryFirm 1 P PP
q2 Qq1
MC1 MC2AC2
AC1
$50
$17
$29
4 5 76 8 4 11 15
SIndustry
P < $17 → Q = 0 P = $17 → Q = q1 + q2 = 4 P = $29 → Q = q1 + q2 = 11 P = $50 → Q = q1 + q2 = 15 35
Increasing Cost IndustriesIncreasing Cost Industries
Any industry that buys a large fraction of the output of and increasing cost industry will also be an increasing cost industry.
Three examples:• Gasoline industry - ↑demand for gas → ↑ price
of oil → ↑ price of gas• Electricity - ↑ demand → ↑ demand for coal• Coal – for the same reasons as oil
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Decreasing Cost Industry: A Special CaseDecreasing Cost Industry: A Special Case
Industry clusters can create decreasing cost industries• As one industry grows, suppliers of inputs
move to be close → ↓ costs• Examples:
Dalton Georgia – “Carpet Capital of the World” Silicon Valley – Computer technology Hollywood – Movies Aalsmeer, Holland – Flower distribution
Cost reductions are temporary37
Try it!Try it!
Is the automobile manufacturing industry a constant cost, increasing cost, or decreasing cost industry? Why?
Where are most U.S. films made? Why do you think the film industry is concentrated in such a small town?
To next To next Try it! Try it!
Industry Supply: SummaryIndustry Supply: Summary
Constant cost industry• Industry is small relative to its input markets…• It can expand without ↑ costs → flat supply curve.
(Constant cost industry) Increasing cost industry
• Expansion → ↑ costs → supply curve slopes upward
Decreasing cost industry• Expansion → ↓ costs → supply curve slopes
downward• Rare and temporary
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TakeawayTakeaway
We answered the following 3 questions• What price to set?: P = market price• What quantity to produce?: P = MC• When to enter and exit an industry?
In the long-run • Enter if P > AC• Exit if P < AC
Increasing cost industry: LRS slopes up Constant cost industry: LRS flat Decreasing cost industry: LRS slopes down
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Second Edition
End of Chapter 11End of Chapter 11
Second Edition
Chapter 12 Chapter 12 Competition and The InvisibleInvisibleHandHand
Competition and The InvisibleInvisibleHandHand
IntroductionIntroduction
In this chapter we return to the “invisible hand”
With the right institutions, individuals acting in their self-interest can generate outcomes that…• are neither part of their intention nor design.• have desirable properties.
43
Chapter OutlineChapter Outline
Invisible Hand Property 1:The minimization of total industry costs of production
Invisible Hand Property 2: The balance of industries
Creative destruction The invisible hand works with
competitive markets44
IntroductionIntroduction
We will show that:• Competitive markets balance production
across firms in a given industry so that… total industry costs are minimized.
• Entry (P > AC) and exit (P < AC) result in balanced production across different industries so that… Total value of production is maximized.
45
Invisible Hand Property 1: The Minimization ofInvisible Hand Property 1: The Minimization ofTotal Industry Costs of ProductionTotal Industry Costs of Production
In a competitive market with N firms…• All firms face the same market price• To maximize profits each firm adjusts its
output until P = MC
Therefore, the following will be true:
This results in minimizing total costs for the industry
N21 MC...MCMCP
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To see how, lets use an example
Invisible Hand Property 1: The Minimization ofInvisible Hand Property 1: The Minimization ofTotal Industry Costs of ProductionTotal Industry Costs of Production
Assume:• You own two farms.• Each has a different MC curve.• You wish to produce a total of 200 bushels of
wheat.
You should produce all 200 bushels on the farm with the lowest MC. Right?
Not necessarily.
47
To see why, lets use a diagram.
Invisible Hand Property 1: The Minimization ofInvisible Hand Property 1: The Minimization ofTotal Industry Costs of ProductionTotal Industry Costs of Production
48
$$
Bushelsof corn
Bushelsof corn
Farm 2Farm 1
200200
MC2
MC1
Total cost of producing 200 bushels on farm 2
Total cost of producing 200 bushels on farm 1
It costs less to produce all 200 bushels on farm 2.
Net result: ↓total cost of producing 200bushels
Invisible Hand Property 1: The Minimization ofInvisible Hand Property 1: The Minimization ofTotal Industry Costs of ProductionTotal Industry Costs of Production
49
$$
Bushelsof corn
Bushelsof corn
200
MC2
MC1
What if we produce a little less on farm 2 and a little more on farm 1?
↑ Cost due to producingMore on farm 1
↓ Cost due to producingless on farm 2
Invisible Hand Property 1: The Minimization ofInvisible Hand Property 1: The Minimization ofTotal Industry Costs of ProductionTotal Industry Costs of Production
50
$$
Bushelsof corn
Bushelsof corn
200
MC2
MC1
Only when MC1 = MC2 is it not possible to reallocate production and reduce costs.
75 125
Less
More
MC
Invisible Hand Property 1: The Minimization ofInvisible Hand Property 1: The Minimization ofTotal Industry Costs of ProductionTotal Industry Costs of Production
Summary:
• If MC1 > MC2 → ↓Q1, ↑Q2 → ↓ Total Costs
Costs saved by ↓Q1 > costs increased by ↑Q2
• If MC1 < MC2 → ↑Q1, ↓Q2 → ↓Total Costs
Costs increased by ↑Q1 < costs saved by ↓Q2
• If MC1 = MC2 → Total costs are minimized.
Costs increased by ↑Q1 = Costs decreased by ↓Q2
Costs increased by ↓Q1 = Costs decreased by ↑Q2
51
Invisible Hand Property 1: The Minimization ofInvisible Hand Property 1: The Minimization ofTotal Industry Costs of ProductionTotal Industry Costs of Production
The “really important part”:
• As owner of the farms you can allocate your production across farms so that MC1 = MC2.
• What if the farms are owned by different people in different states? Each farmer faces the same market price.
Each maximizes profits by producing where: P = MC
Therefore, P = MC1 = MC2
52
Invisible Hand Property 2: The Balance Invisible Hand Property 2: The Balance of Industriesof Industries
Entry or exit work to ensure that…• Labor and capital move across industries
• Production is optimally balanced
• Greatest use is made of our limited resources.
It is possible to minimize the cost of producing any given level of output but…
To minimize cost across industries:• Each industry should produce the “right” quantity.
• Invisible Hand Property 2 makes this happen.
53Let’s see how markets do this.
Invisible Hand Property 2: The Balance Invisible Hand Property 2: The Balance of Industriesof Industries
Profit is the signal that allocates capital and labor among industries.• They need to flow from low-profit industries to
high industries. If P > AC, profits are above normal.
• Capital and labor enter the industry. If P < AC, profits are below normal.
• Capital and labor exit the industry.
Profit rate in all competitive industries tends toward the same level.
54
Creative DestructionCreative Destruction
Elimination Principle – above-normal profits are eliminated by entry, and below-normal profits are eliminated by exit.• Resources move toward an increase in the value
of production.• Entrepreneurs move resources from unprofitable
industries to profitable industries. Implication of this principle:
• Above normal profits are temporary.• To earn above-normal profits, entrepreneurs must
innovate.
55
Creative DestructionCreative Destruction
Joseph Shumpeter (1883-1950)• “This process of creative
destruction is the essential fact about capitalism”
• The kind of competition that counts: “…the new commodity,
56
the new technology, the new source of supply, the new type of organization…which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives”
The Invisible Hand Works with The Invisible Hand Works with Competitive MarketsCompetitive Markets
The invisible hand will not work if…• Prices do not accurately signal costs and
benefits. Result: no optimal balance between industries
• Markets are not competitive. Result:
• Monopolists and oligopolists produce less than the ideal amount
• Firms make above normal profits, and entry is limited.
• Commodities are public goods. Result: Self interest does not align with social
interest
57
TakeawayTakeaway
Invisible Hand Property 1• P = MC results in minimization of total industry
cost. Invisible Hand Property 2
• Entry and exit result in the best use of limited resources.
Elimination principle• Above normal profits are temporary. • To earn above normal profits, a firm must
innovate
58
Second Edition
End of Chapter 12End of Chapter 12
Second Edition
Chapter 13 Chapter 13
MonopolyMonopoly
Chapter OutlineChapter Outline
Market Power How a Firm Uses Market Power to Maximize
Profit The Costs of Monopoly: Deadweight Loss The Costs of Monopoly: Corruption and
Inefficiency The Benefits of Monopoly: Incentives for
Research and Development Economies of Scale and the Regulation of
Monopoly Other Sources of Market Power
61
IntroductionIntroduction
Price of one pill is about 25 times higher than cost. Why?• Market power
In the U.S, deaths from AIDS dropped by 50% due to drugs like Combivir.
AIDS has killed more than 28 million people.
62
• The “you can’t take it with you” effect• The “other people’s money” effect
Market PowerMarket Power
Market Power – the power to raise price above marginal cost without fear that other firms will enter the market.
GlaxoSmithKline owns the patent on Combivir.• Monopoly – a firm with market power.
A simple test:• India does not recognize the patent• Price of the drug in India = $0.50 per pill = MC.
63
Sources of market power:• Patents• Government regulations other than patents• Economies of scale• Exclusive access to an important input• Technological innovation
We look at these later
64
Market PowerMarket Power
Marginal revenue (MR) – the change in total revenue from selling an additional unit of output.
Marginal cost (MC) – the change in total cost from producing an additional unit.
To maximize profit, firms produce at the level of output where:
65
How a Firm Uses Market Power to How a Firm Uses Market Power to Maximize ProfitMaximize Profit
MCMR
Firm with market power:• Faces a downward sloping demand curve.• If it sells an additional unit…
It had to lower the price. Additional revenue per unit < current price.
In other words:
66
How a Firm Uses Market Power to How a Firm Uses Market Power to Maximize ProfitMaximize Profit
PMR
Let’s show this.
MR < PMR < P
Price
Quantity2 3 4 6 751
$20
18
16
14
12
10
8
6
4
2
Demand
MR
Revenue loss = $2 x 2 = $4
At P = 16:•TR = $16 x 2 = $32At P = 14:•TR = $14 x 3 = $42Marginal Revenue equals:•Revenue loss = - $4 +•Revenue gain = $14 x 1 = $14MR = $14 -$4 = $10
RevenuegainMR
=$10
67
Short-Cut for Finding MRShort-Cut for Finding MR
MR begins at same point on the vertical axis. MR has twice the slope
68
Price
Quantity
a
P = a – bQMR = a – 2bQ
MR Demand
a/ba/2b
Let’s lookat someexamples.
Short-Cut for Finding MRShort-Cut for Finding MR
Short-cut for finding MR
69
PricePrice
aa
500 250 QuantityQ
250 125
DemandDemandMRMR
The value of Q where MR= 0 is one half of that where P = 0.
How a Firm Uses Market Power to How a Firm Uses Market Power to Maximize ProfitMaximize Profit
Quantity(millions of pills)
Price($/pill)
MR
Demand
AC
MC
Profit maximizing output = 80Profit maximizing price = $12.50Profit per pill = $10.00Total profit = $10 x 80 = $800 m
80
$12.50
0.50
2.50
Profit
//
70
The Elasticity of Demand and the The Elasticity of Demand and the Monopoly MarkupMonopoly Markup
The two effects can make the elasticity of demand for pharmaceuticals more inelastic:• The “you can’t take it with you” effect
People with serious illnesses are relatively insensitive to the price of life saving medicine.
• The “other people’s money” effect If third parties are paying for the medicine, people
are less sensitive to price.
71
Let’s see how this effects the monopoly markup.
The Elasticity of Demand and the The Elasticity of Demand and the Monopoly MarkupMonopoly Markup
72
PricePrice
QuantityQuantity
Demand
MRMR
Demand
MCMC
Relatively inelastic demandbig markup
Relatively elastic demandsmall markup
QI
PI
QE
PE
Largemarkup
Smallmarkup
Try it!Try it!
As a firm with market power moves down the demand curve to sell more units, what happens to the price it can charge on all units?
What type of demand curve does a firm with market power prefer to face for its products: elastic or inelastic? Why?
To next To next Try it! Try it!
The Cost of Monopoly: Deadweight LossThe Cost of Monopoly: Deadweight Loss
Compared to competition monopolies reduce total surplus (CS+ PS)
This implies a deadweight loss. Let’s use a model of a constant cost
industry to show this.
74
Because the profit maximizing monopolist will produce where:
And because P > MR:
Result: deadweight loss (inefficiency)
75
How a Firm Uses Market Power to How a Firm Uses Market Power to Maximize ProfitMaximize Profit
MCP
MCMR
To show this we will use the monopoly model.
The Cost of Monopoly: Deadweight LossThe Cost of Monopoly: Deadweight Loss
76
PP MonopolyCompetition
QC = Optimalquantity
PC
Monopolist gets this
Supply
MR
Demand Demand
MC = AC
PM
QC
CS
QM
Profit
Consumers getthis
DWL
No one gets this(deadweight loss)
Consumers getthis
P > MCP = MC
The Cost of Monopoly: Deadweight LossThe Cost of Monopoly: Deadweight Loss
Deadweight loss in practice• GlaxoSmithKline prices Combivir at $12.50 a
pill• MC = $0.50• Deadweight loss = value of the sales that do
not occur because P > MC.
77
The Costs of Monopoly: Corruption and The Costs of Monopoly: Corruption and InefficiencyInefficiency
In Indonesia Tommy Suharto, the presidents son, was given the clove monopoly.
He bought the entireLamborghini company with his monopoly profits.
78
Many monopolies are born of government corruption
The Costs of Monopoly: Corruption and The Costs of Monopoly: Corruption and InefficiencyInefficiency
Monopolies are especially harmful if they control a good that is used to produce other goods.
In Algeria a dozen or so army generals each control a key good• People refer to these men as General wheat,
General tire….• Each general tries to get a larger share of the
economic pie. Result: greater DWL and the “pie” shrinks
79
The Benefits of Monopoly: Incentives for The Benefits of Monopoly: Incentives for Research and DevelopmentResearch and Development
Drug prices are lower in India and Canada• India does not offer strong patent protection.• Canada’s government controls drug prices.
Should the U.S. government limit patents?• It costs $1billion to develop a new drug.• Patents are one way of rewarding R&D.• Without patents why would firms spend on
R&D?• Result: Fewer new drugs will be developed.
80
The Benefits of Monopoly: Incentives for The Benefits of Monopoly: Incentives for Research and DevelopmentResearch and Development
What the U.S. government opened up the pharmaceutical industry to competition?
81
Competition will drive price down to MC.• R&D costs are not
included in MC• Firms can not cover
their R&D costs.• Result: Fewer drugs will be created.
The Benefits of Monopoly: Incentives for The Benefits of Monopoly: Incentives for Research and DevelopmentResearch and Development
Other goods have high development costs.• Information goods – goods that are valuable for
their content. Examples: Music, movies, computer files, books. Typically MC is very low.
• High development costs and low MC of production → Need for patent or copyright protection.
Policy trade-off:• Lower prices today
• Fewer new ideas in the future
82
The Benefits of Monopoly: Incentives for The Benefits of Monopoly: Incentives for Research and DevelopmentResearch and Development
Nobel Prize winner Douglas North, economic historian:
“The failure to develop systematic property rights in innovation up until fairly modern times was a major source of the slow pace of technological change.”
83
Patent Buyouts: A Potential SolutionPatent Buyouts: A Potential Solution
The government could buy the patent for a little more than monopoly profits … then rip it up.
Competitors would enter and drive the price of the drug to its MC.
What’s the downside?• Higher taxes – they also create DWL• Difficulty in determining the right price• Possible corruption
84
Economies of Scale and the Regulation Economies of Scale and the Regulation of Monopolyof Monopoly
Economies of scale – the advantages of large-scale production that reduce AC as quantity increases.
Natural monopoly – is said to exist when a single firm can supply the entire market at a lower cost than two or more firms.
85
Let’s use a model to learn the economics of natural monopoly.
Natural MonopolyNatural Monopoly
86
P
Quantity
MR
Demand
Competitiveprice PC
Averagecosts forsmall firms
AC
MC
QC Competitivequantity
QM
PM
Monopolyquantity
Monopolyprice
Optimalquantity
It is possible for PM < PCIf economies of scale are large enough
Natural MonopolyNatural Monopoly
A price control can increase output. What price should the government choose?
• P = MC → Optimal level of output At P = MC, P < AC due to economies of scale The firm’s profit is less than the normal level.
• P = AC, is a compromise Profits are normal There is a deadweight loss.
Let’s go to our model to take a closer look.
Price Control and Natural MonopolyPrice Control and Natural Monopoly
88
P
Quantity
MR
Demand
Competitiveprice PC
Averagecosts forsmall firms
AC
MC
QC Competitivequantity
QM
PM
Monopolyquantity
Monopolyprice
Optimalquantity
If the government sets:•P = MC
Firm loses money
Loss if P = MC
Price Control and Natural MonopolyPrice Control and Natural Monopoly
89
P
Quantity
MR
Demand
Competitiveprice PC
Averagecosts forsmall firms
AC
MC
QC Competitivequantity
QM
PM
Monopolyquantity
Monopolyprice
Optimalquantity
If the government sets:P = AC
• Profit = normal• Results in DWL
P = AC
Electric ShockElectric Shock
Government ownership is another solution to natural monopoly.
Worked well until 1970s when new technologies reduced average costs at small scales.
Result: Electric generation
was no longer a natural monopoly. 90
California’s Perfect StormCalifornia’s Perfect Storm
California deregulated wholesale electricity prices in 1998.
Problems: • Transmission and distribution remained natural
monopolies.• Electricity is difficult to store.• Booming economy required importing electricity from
other states.• Inelastic demand curves
Summer-winter 2008• Several factors quadrupled wholesale prices• Generators of electricity could exploit market power.
91
Other Sources of Monopoly PowerOther Sources of Monopoly Power
Barriers to entry – factors that increase the cost to new firms of entering an industry.
92
Try it!Try it!
Consider ticket prices at major league baseball and professional football parks. How does the term “barrier to entry” help explain their pricing?
How permanent are barriers to entry in the following cases: NBA basketball franchises, U.S. Postal Service delivery of first class mail, U.S. Postal Service delivery of parcels?
To next To next Try it! Try it!
TakeawayTakeaway
You should be able to:
• Find MR given either a demand curve or a table of prices and quantities.
• Given demand and MC curves, find and label monopoly price and quantity, and DWL.
• With the addition of the AC curve Find and label monopoly profit
Demonstrate that the markup of price over MC is larger the more inelastic the demand.
94
TakeawayTakeaway
Monopolies involve trade-offs between DWL and innovation.
Natural monopolies involve trade-offs between DWL and economies of scale.
Regulation of monopolies is a challenge• Regulation of Cable TV kept prices low but also
quality• Deregulation of electricity in California left them at
the mercy of firms with market power. Many monopolies are created to transfer
wealth to politically powerful elites.95
Second Edition
End of Chapter 13End of Chapter 13