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Chapter 17
Monopoly
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Main Topics
Market powerMonopoly pricingWelfare effects of monopoly pricingDistinguishing monopoly from perfect
competitionNonprice effects of monopolyMonopsonyRegulation of monopolies
17-2
Market Power
In many situations, competition is not intense A firm has market power when it can profitably charge
a price that is above its marginal cost Most firms have some market power, though it may be
very slight Depends on whether their competitors’ products are close
substitutes Two market structures in which firms have market
power: A monopoly market has a single seller An oligopoly market has a few, but not many, producers
Determining what is and is not a monopoly market can be trickier than simple definitions might suggest
17-3
How Do Firms Become Monopolists?
Firms get to be monopolists in various ways:Government grants a monopoly position to a firm
(cable TV companies in local communities, drug patents)
Economies of scale (concrete supply in a small town)
Being first to produce a new product (iPod)Owning all of an essential input (De Beers diamond
producer)Many of these ways of initially capturing market
power tend to erode over time
17-4
Figure 17.1: Scale Economies and Monopoly
Monopolist can make a profit because AC lies below the demand curve at some quantities
Two firms cannot make positive profitsAC lies above Dhalf for
all quantities
17-5
Monopoly Pricing
Monopolist will choose the price that maximizes its profit, given the demand for its product Whenever the firm’s profit-maximizing sales quantity is
positive, marginal revenue equals marginal cost at that sales quantity
Marginal cost curve applies as usual Need to examine the shape of the marginal revenue
curve Recall that a firm’s marginal revenue curve captures
the additional revenue it gets from the marginal units it sells, measured on a per-unit basis
17-6
Marginal Revenue for a Monopolist
An increase in sales quantity (Q) changes revenue in two ways
Firm sells Q additional units of output, each at a price of P(Q), the output expansion effect
Firm also has to lower price as dictated by the demand curve; reduces revenue earned from the original (Q-Q) units of output, the price reduction effect
The overall effect on marginal revenue is:
So the price reduction effect makes the monopolist’s marginal revenue less than price
PQPMR
17-7
Figure 17.2: Marginal Revenue and Price
17-8
Sample Problem 1 (17.2):
Suppose that Noah and Naomi have a monopoly in the garden bench market. Their weekly demand is D(P) = 500 – 4P. What is their marginal revenue when they sell 100 garden benches a week? Graph their inverse demand and marginal revenue curves.
Monopoly Profit Maximization When a monopolist maximizes its profit by selling a
positive amount, its marginal revenue must equal its marginal cost at that quantity If marginal revenue exceeded marginal cost the firm would be
better off selling more If marginal revenue were less than marginal cost the firm would
be better off selling less
Two-step procedure for finding the profit-maximizing sales quantity
Step 1: Quantity Rule Identify positive sales quantities at which MR=MC If more than one, find one with highest profit
Step 2: Shut-Down Rule Check whether the quantity from Step 1 yields higher profit than
shutting down 17-10
Figure 17.4: Monopoly Profit Maximization
17-11
Markup
A monopolist facing a downward sloping demand curve will set its price above marginal cost Firm in a perfectly competitive market sets price equal to
marginal cost, meaning that the firm has no market power
Extent to which price exceeds marginal cost is a measure of monopolist’s market power
A firm’s markup, price-cost margin, or Lerner index equals the difference between its price and its marginal cost, as a percentage of its price
dEP
MCP 1
17-12
Markup
A monopolist’s markup at its profit-maximizing price always equals the reciprocal of the elasticity of demand, times negative one
The less elastic the demand curve, the greater the firm’s markup over its marginal cost
When demand is less elastic, raising the price is more attractive because fewer sales are lost
This also implies that demand must be elastic at the profit-maximizing price
17-13
Sample Problem 2 (17.4):
Suppose KCC has faces an annual demand function Q = 16,000 – 200P, where P is the price, in dollars, of a cubic yard of concrete and Q is the number of cubic yards sold per year. Its marginal cost of $20 per cubic yard and an avoidable fixed cost of $100,000 per year. What is its profit-maximizing sales quantity and price?
Welfare Effects ofMonopoly Pricing
By charging a price above marginal cost, the monopolist makes consumers worse off than under perfect competition Consumers who buy the product pay more for it Some who would have bought it under perfect competition will
not buy it at the higher price Welfare effects of monopoly pricing:
Firm gains Consumers lose Deadweight loss incurred
Deadweight loss from monopoly pricing is the amount by which aggregate surplus falls short of its maximum possible level, which is attained in a competitive market
17-15
Figure 17.5: Welfare Effects of Monopoly Pricing
17-16
Distinguishing Monopoly from Perfect Competition
Existence of more than one firm in a market does not guarantee perfect competition
How can we tell whether multiple firms in a market are behaving like price takers or colluding and acting like a monopoly?Easy to answer if we could observe marginal costs
and compare to priceMonopolists and perfectly competitive
industries behave differently in responses to changes in demand and changes in costs
17-17
Response to Changes in Demand
Monopolist’s profit-maximizing price depends on elasticity of demand
Price in perfectly competitive market depends on level of demand
If elasticity of demand changes but level of demand does not, provides a way to distinguish between market structures
Can investigate this through data collection over time and statistical analysis
17-18
Figure 17.7: Response to a Change in Demand
17-19
Response to Changes in Cost
How do monopolies and perfectly competitive markets differ in their response to changes in costs?
Consider the case of a marginal cost increase by a given amount at every level of output Example: a specific tax, T, on firms
The pass-through rate is the increase in price that occurs in response to a small increase in marginal cost, measured per dollar of increase in marginal cost
In a competitive market, the pass-through rate is never greater than one
The monopolist’s pass-through rate depends on the shape of the demand curve Can be greater than one with a constant-elasticity demand
curve
17-20
Nonprice Effects of Monopoly: Product Quality
Product quality is a decision firms make Raising a product’s quality increases the consumer’s
willingness to pay Producing a higher-quality product usually costs more
The firm must decide whether the extra benefit is worth the extra cost
How does the quality provided by a monopolist compare to the level that would maximize aggregate surplus?
If different consumers value quality differently, the monopolist may not choose to offer the quality that maximizes aggregate surplus May over- or under-produce quality
17-21
Product Quality: Car Wash Example
Suppose the only car wash in town is deciding whether to provide hand washing Without hand washing the firm maximizes profit by selling 100 washes at
$15 each, profit is $1,000 Hand washing costs $5 more per wash
Consumers whose willingness to pay is above $22 value a car wash $15 more if done by hand All other consumers value a hand wash $5 more
With hand washes, firm’s profit-maximizing quantity is 100 washes at $20 each, with profit of $1,000
Aggregate surplus: Without hand washes: $1,500 With hand washes: $1,800
Firm is indifferent between providing and not providing the higher quality product If cost of hand washing were $5.01, monopolist would choose not to
provide it even though aggregate surplus would be greater with it
17-22
Figure 17.9: Monopolist and Product Quality
17-23
Sample Problem 3 (17.20):
The only gas station in a small town sells bothregular and premium gasoline. The weekly demandfunctions for the two gasolines are:QReg = 10,000 – 1,000PReg +50PPrem and QPrem = 350 + 50PReg – 100PPrem where the quantities are measured in gallons andprices in dollars per gallon. Are these products substitutes or complements? If the price of regular gas is $3.00 per gallon, its marginal cost is $2.95, and the marginal cost of premium is $3.05, what is the profit-maximizing price of premium gas?
Nonprice Effects of Monopoly: Advertising
Spending on advertising is another important decision for many firms
Because the monopolist’s marginal cost is less than the price, each additional sale increases its profit
Firms in perfectly competitive markets have no individual incentive to advertise Each firm perceives itself as capable of selling as much as its desires
at the market price Marginal benefit of advertising equals the increase in sales times
the firm’s profit on additional sales At the profit-maximizing level of advertising, this marginal benefit
must equal the extra dollar expended For a monopolist, the ratio of the amount spend on advertising to
the firm’s total sales revenue, the advertising-sales ratio, equals the advertising elasticity divided by the elasticity of demand, times negative one
17-25
Nonprice Effects of Monopoly: Investments
Firms can also make investments in an effort to become a monopolist Example: cable TV firms lobbying government officials to award them
franchises If firms compete to become a monopolist, they will spend up to the
full monopoly profit less avoidable fixed costs If spend on socially wasteful things (e.g., golf outings for local
officials) the loss from monopoly may be larger than deadweight loss and include all monopoly profit
Rent seeking is socially useless effort devoted to securing a monopoly position
Welfare effects of monopoly need not always be so bad Expenditures firms make to gain monopoly positions can be socially
valuable (e.g., R&D spending in the search for patentable drugs)
17-26
Monopsony
Market power isn’t limited to the sellers of a product: it also can be held by buyers
A monopsony market has a single buyer Analysis of monopsony parallels the analysis of
monopoly A monopsonist faces an upward-sloping supply curve
By lowering the quantity he buys, can pay less Monopsonist can think either in terms of what price to
pay or in terms of how many units to employ
17-27
Marginal Expenditure
A monopsonist’s marginal expenditure, ME, is the extra cost per marginal unit of an input
Consider a small city in which the hospital is the only employer of nurses
The hospital’s marginal expenditure has two parts The input expansion effect: the marginal nurse costs W Given the upward-sloping supply curve, the hospital must
increase the wage by (W/Q) to hire another nurse Since the hospital must pay Q nurses this higher wage, the
wage increase raises nursing costs by (W/Q) Q So ME is larger than W since the total effect is:
QQWWME / 17-28
Monopsony Profit Maximization
The monopsonist’s profit-maximizing choice equates its marginal benefit with its marginal costMaximizes its profit by choosing the quantity at
which its demand and ME curves crossResult is lower price and quantity than if the
firm was a price takerCan solve for the equilibrium algebraically by
setting marginal benefit equal to marginal expenditure and solving for quantity
17-29
Figure 17.10: Monopsony
Profit-maximizing outcome:Occurs where
marginal expenditure curve crosses the demand curve
Firm hires 200 nursesWage is $50,000
Deadweight loss is red-shaded area
17-30
Welfare Effects ofMonopsony Pricing
Like with monopoly, monopsony price setting creates deadweight loss
Monopsonist uses too little of the inputPotential net benefits from the input are lost
Deadweight loss is created between the marginal benefit and market supply curvesSee the red-shaded region in Figure 17.10
Can compute the dollar value of the deadweight loss using algebra
17-31
Sample Problem 4 (17.15):
The Happyland Hospital is a monopsonist employer of nurses in the small city of Happyland. The supply function of nurses is S(W) = 0.1W – 100, where W is the nurses’ weekly wage. What is the hospital’s marginal expenditure, ME? If the hospital’s marginal benefit is $2,000 per week no matter how many nurses it hires, what is the profit-maximizing number of nurses for the hospital to hire? What will the nurses’ wage be? What is the deadweight loss?
Regulation of Monopolies
Deadweight loss from monopoly pricing provides a justification for government intervention
Government actions that keep prices closer to marginal cost can protect consumers and increase economic efficiency
Intervention can take many forms Antitrust legislation (see Chapter 19) Direct regulation of prices
Price regulation not common in U.S. today More prevalent in the past Still used for electricity, natural gas, local telephone service More common in some other countries
17-33
Why Are Some Monopolies Regulated?
Regulation arises out of political pressure and economic concern about market dominance
When governments create monopolies they may then regulate them to deal with the negative consequences
May create a monopoly to ensure that goods are produced at least cost
A market is a natural monopoly when a good is produced most economically through a single firm Average cost falls as quantity increases Second firm may enter but this would cause costs to rise
Government can designate one firm to be the provider Institute price regulation to protect consumers
17-34
Figure 17.11: A Natural Monopoly
17-35
First-Best vs. Second-Best Price Regulation
Under regulation, ideally prices will be set at the competitive price Price at which demand and supply curves intersect Aggregate surplus will be maximized First-best solution to problem of price regulation
Two problems with achieving this lead to second-best regulation
Regulator may not know the firm’s marginal costs First-best solution would cause the monopolist to lose
money If P < AC
Best the regulator can do is set a price that makes aggregate surplus as large as possible, allow the firm to break even Set P = AC
17-36