Monopoly

1. Monopoly

2. Four Basic Market Structures • Perfectly Competitive: many firms, identical products, free entry and exit, full and symmetric info • Monopoly: single firm, no close substitutes, barriers to entry, full and symmetric info • Oligopoly: several firms, similar products, degree of product differentiation varies depending upon the market, might be barriers, full and symmetric info • Monopolistic competition: many firms, similar products, slightly differentiated products, free entry and exit, full and symmetric info

3. Competitive Market • This is the classic “textbook” market structure. • Firms in a competitive market all make a product that is perfectly substitutable: all demanders are equally satisfied with any supplier’s product.

4. Monopoly • The single seller makes a product that has no “good” substitute. • Other firms may be able to produce the good or service but choose not to enter the market or are barred from it.

5. Oligopoly • A few sellers make products that are good, but not perfect, substitutes. • Consumers can be induced to change suppliers but have only a limited number of choices.

6. Monopolistic Competition • The market has many firms but each supplier’s product is differentiated. • Consumers can be induced to change brands but they have brand preferences.

7. Question • What is the market structure for each of these products or firms: competitive, monopoly, oligopoly, monopolistic competition? • The Campus Store • Kinko’s • Pepperidge Farm’s Whole Wheat Bread • PowerMac computer • Windows computer • NYSEG (electricity utility) • Morton salt • AT&T long distance

8. Answer • The Campus Store: most products competitive, textbooks oligopoly, but location is very important. • Kinko’s: monopolistic competition (differentiated service) • Pepperidge Farm’s Whole Wheat Bread: competition or monopolistic competition (slightly differentiated recipes) • PowerMac computer and clones: monopoly, under license. • Windows computer: monopolistic competition (differentiated features) • NYSEG (electricity utility): monopoly • Morton salt: competitive • AT&T long distance: oligopoly

9. Monopoly • single firm • no close substitutes • barriers to entry • full and symmetric information

10. Sources of Monopoly Entry Barriers • Natural monopoly: the most efficient scale of production is so large, relative to market demand, that a single firm dominates the market. • Patents, copyrights, licenses, franchises: government protection of a firm’s right to produce a unique product. • Economic and/or legal restrictions, strategies or situations that make entry more difficult for new competitors than for the existing monopoly firm.

11. Natural Monopolies • Goods and services whose delivery requires the construction of a physical network (wires, pipes, etc..) • In such industries (local phone service, water, sewage removal, electricity, gas) the physical networks display decreasing marginal cost over essentially all quantities. • Thus, average total cost is always declining and the minimum efficient scale is much larger than the size of the market. • Natural monopolies are often regulated: they cannot charge a higher price without government approval.

12. Patents: Are There “Good” Monopolies? • Consider the protease inhibitor Crixivan from Merck. • A very effective AIDS therapy. • Development costs were more than one billion dollars. • Annual revenue now from treating around 90,000 patients is $500,000,000.

13. What is a “Good” Monopoly? • Why is Merck given a monopoly? • The granting of a patent on the drug Crixivan guarantees that Merck can earn monopoly profits on its sale. • These monopoly profits provide the incentive to invest in the research and development required to create the new drug.

14. “Good” Monopolies • The granting of patent protection (legal monopoly) gives firms a strong incentive to invest in new product development. • Would firms make the R&D investments if they could not protect them through patents and trade secrets? • Probably not because competitors could steal the design at a fraction of the cost after the product is brought to market.

15. “Other” Monopolies - Good? Bad? • Input Ownership • DeBeer’s and diamonds • Industry Secret or Know-how • IBM and mainframes? • Strategic Behavior • buy ‘em up • blow’ em up • let’s make a deal • Microsoft and operating systems?

16. Caveats • monopolydoes not => big • big does not => monopoly • monopoly does not => absolute and unlimited control over price • monopoly does not => must have economic profit • short run profit does not => monopoly power • monopoly does not => badly behaved firm

17. Classic Simple Monopoly • Polar extreme from perfect competition. • Monopolist is a “price maker.” • Cost curves are pretty much the same (except in the case of natural monopoly). • The big change from before is in the demand side of the profit function.

18. The Simple Monopolist • The simple monopolist abides by the “law of one price.” Everyone pays the same market price for all units purchased. • A monopolist faces the declining market demand curve for its product and simultaneously chooses price and quantity. • Now P>MR (before P=MR) because the simple monopolist must lower the price on all preceding units to sell an additional unit. • A monopolist has no “supply curve.”

19. The Simple Monopolist: Rules for Profit Maximization • Suppose we are in the short run. • Rules for profit maximization are the same as before. • If XSM maximizes profit, then • MR(XSM ) = MC(XSM ) • very important note: for a simple monopolist P>MR at all positive levels of X. • XSM is a max and not a min. • at XSM it’s worth operating.

20. Simple Monopoly • Economic profits equal total revenue minus total costs. • Marginal revenue is the rate of change of total revenue (just like marginal cost is the rate of change of total cost) as quantity increases. • Economic profits are maximized when marginal revenue equals marginal costs

21. Graphical Display of Monopolist’s Solution • The monopolist sets marginal revenue equal to marginal cost at MR=MC=$10. • The optimal quantity is thus 90 units, which implies a market price of $55/unit. • The monopoly profits (light blue in the graph) are the difference between price ($55) and average total cost ($44.44) times the number of units sold. • Notice that our monopolist is a “natural monopoly” the average total costs decline over the entire relevant range of production and the minimum efficient scale (150) is bigger than the entire market. • Notice that if our monopolist operated at the competitive equilibrium (Price=MC=$30, Quantity=140), the firm would make a loss (ATC>Price).

22. Implications of the Monopolist’s Profit Maximum • Price will exceed the competitive price. • Quantity will be less than the competitive quantity. • The monopolist sells the output at a price greater than marginal costs but the monopoly price can be above or below average total costs. Thus, the monopolist need not always make a profit. In the long run, of course, unprofitable monopolists will either stop production or raise the price further above marginal cost until it covers average total costs. • The monopolist will always try to operate on the elastic portion of the demand curve because when the elasticity of demand is greater than -1 (inelastic, between 0 and 1 in absolute value), marginal revenue is negative and, necessarily, less than marginal cost. • Since there is no entry to consider monopolists can have persistent long run economic profit.

23. Simple Monopoly- Performance • Efficiency: • Is the monopoly equilibrium Pareto Efficient? That is, at XSM is net social surplus maximized? Does $MB=$MC at XSM? • Is the monopolist productively efficient? Does the monopolist operate at minimum efficient scale? • Equity: • Is the outcome of monopoly fair? Equitable? Just?

24. Simple Monopoly- Performance Answers • The simple monopoly equilibrium is not Pareto Efficient. • The simple monopolist creates “dead-weight-loss.” • At XSM,$MB>$MC . Recall: $MR=$MC at XSM while $PSM>$MR at all X. So $PSM>$MC. Since $P=$MB, then $MB>$MC. • The simple monopolist may or may not be productively efficient. • Compared to the competitive equilibrium, there is a transfer of surplus from consumers to producers.

25. Price Discriminating Monopolists • A monopolist might be able to charge different prices for different units sold and enhance its profits. • charge different people different prices • charge the same person different prices for different units • price discrimination • charging different prices for different units with no cost basis • charging the same price for different units when there are cost differences

26. Requirements for Price Discrimination • Some amount of monopoly power. • An ability to prevent resale. • Detailed information about who is buying what unit and what demanders are willing to pay.

27. Believe It Or Not • What would you do to prevent resale??? • when: 1940’s • market: plastic molding powder • industrial users: .85/pound • denture manufacturers: $22/pound • firm: Rohm and Haas • problem: resale from industrial users to denture manufacturers • solution: rumor you are mixing arsenic in the powder sold to industrial users!

28. Two classic forms of Price Discrimination • Perfect or First Degree Price Discrimination • charge a different price for each unit sold • the most extreme form of price discrimination • Third Degree Price Discrimination • segment market and then charge a different price in each market • exploit the observation that at the simple monopoly price the own price elasticity of demand differs across the defined segmented markets • Price discrimination comes in many other “flavors”

29. Question • The data on your handout show the demand curves for movie tickets of adults and seniors. The market described has only one movie theatre. • Find the best single price. • If the movie theater can charge separate prices for adults and seniors, what are the best two prices?

30. Two Prices are Better than One for Movie Tickets • The best single price in this market is $7.50/ticket, which makes economic profits of $4,225 (blue entries). Set marginal cost = marginal revenue with the single price. • The price discriminating monopolist can make more economic profits by charging adults $8.50 (yellow entries) and seniors $6.50 (green entries). Set marginal cost = marginal revenue separately for each market.

31. Summary of Price Discrimination Example • Calculating economic profits separately for the two markets (adult and senior) shows that the total is greater than with the best single price. • Taking advantage of different elasticities of demand.

32. Believe It Or Not • when: early 1990’s • market: contact lenses • firm: Bausch & Lomb • Lenses: • Optima @ $70/pair - wash and keep 1 year • Medalist @ $15/pair - wash and keep 2 months • SeeQuence 2 @ $8/pair - wash and keep 2 weeks • Occasions @ $3/pair - daily and disposable each day • Guess what?

33. Believe It Or Not • They were all the same lenses! • Just packaged differently! • What would you pay for a year? • Optima = $70/pair - wash and keep 1 year • Medalist = $15x6=$90 (last 2 months) • SeeQuence 2 = $8x26=$208 (last 2 weeks) • Occasions = $3x365 = $1095 • What would I do? Buy the Occasions and wash and wear until my eyes hurt. • Class action suits were eventually settled.

34. First Degree Price Discrimination • The monopolist charges the demand price for each unit sold. • In this case the market demand curve becomes the monopolist’s marginal revenue curve. • The monopolist sets MR=MC to get XFDPD. • The monopolist charges a different price for each unit according to the demand curve. • Performance: XFDPD is Pareto Efficient and all the net social surplus goes to the monopolist as producer surplus. Consumer surplus = $0!

35. Should the Government Regulate Monopolies? • Essentially all monopolies are regulated. • Natural monopolies are regulated by price commissions that determine the rates the monopolies may charge. • Patent, copyright and license protections are a form of ex ante regulation: firms that follow the rules for establishing the validity of their innovations receive the protection of the patent, copyright or license. • Should the government do more? Good question.