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EKONOMI PERINDUSTRIAN II

EKONOMI PERINDUSTRIAN II. MARKET POWER AND WELFARE - Pricing. Introduction. Firm with market power is often called the price maker. Price maker is aware that its output decisions will affect their prices. To sell more they have to reduce price and vise versa.

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EKONOMI PERINDUSTRIAN II

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  1. EKONOMI PERINDUSTRIAN II MARKET POWER AND WELFARE - Pricing

  2. Introduction • Firm with market power is often called the price maker. • Price maker is aware that its output decisions will affect their prices. • To sell more they have to reduce price and vise versa. • The demand curve is downward sloping (in contrast to the horizontal demand curve – of the price taking firm.

  3. MARKET POWER AND PRICING • E.g. a firm is a monopolist – not in competition with other firm. • Not worry whether other firms will respond to its price. • Profits depends on the behavior of the customers- summarized in the demand function, cost function (that accounts for technology and prices of inputs) and price or outputs.

  4. MARKET POWER AND PRICING • The firm will be monopolist if there is no close substitutes • Cross-price elasticities of demand between the monopolist products of other producers are small. • Cross-price elasticity : • εij= ∆qi • ∆pj

  5. MARKET POWER AND PRICING • If the cross price elasticities between monopolist and other firms are small changes in price charged by monopolist has very little effect on the demand of the product supplied by other firms. • The effect of any response of the monopolist product will probably trivial.

  6. MONOPOLY PRICING • If, •  = PQ-C(Q) • Where C(Q) is the cost function, • P is price • PQ is the total revenue • P and Q is not independent. • Feasible combination of P and Q is given by the inverse demand function P = P(Q). • Function which shows maximum price that can be charged on consumers and have them voluntarily purchase Q.

  7. MONOPOLY PRICING • Substituting into the definition of profits, •  = P(Q)Q - C(Q) , • Therefore profits depends on the level of output the monopolist selects. • Profit maximizing output equates MR and MC.

  8. MONOPOLY PRICING • The revenue function of the monopolist depends on Q directly, since increase in Qincrease sales volume ( same as competitive firm). • Unlike competitive firm, increase in Q(indirectly) requires change in P.

  9. MONOPOLY PRICIif it sold onG • If monopolist sold 1000 units, how will the revenue change if it sold 1 more unit? • Monopolist’s MR will consists of 2 components: • Direct effect. • Indirect effect.

  10. MONOPOLY PRICING • Direct effect: • Monopolist revenue will increase because he receives the price for the 1001th unit. • Indirect effect: • To sell the 1001th unit monopolist must lower the price – moving down the demand curve (the price he has to charge for the first 1000 units as well). • Hence, revenue goes down because revenue receives for the marginal unit (1unit) declines. • Preceding 1000 unit are “below” the margin, or inframarginal.

  11. MONOPOLY PRICING • Therefore, marginal revenue of the monopolist is equal the sum of the direct and indirect effects. • MR(Q) = P(Q) + dP(Q) Q • d(Q) • Where: • dP(Q)/d(Q) = rate of ∆ in P with respect to Q(slope of the demand curve at Q) showing how much price must fall in order to sell 1 more unit given the existing production equals to Q. • dP(Q)/d(Q) has negative sign indicating MR < P.

  12. MONOPOLY PRICING • Graphical relationship: Loss on infra-marginal units P(Q1) Gain on marginal unit P(Q1+1) Q1 Q1+1

  13. MONOPOLY PRICING • To get profit maximizing volume, monopolist will set its MR function = MC function. • Qm; profit maximizing output level is defined as: • P(Qm) + dP(Qm) Qm= MC(Qm) • dQ

  14. EFFICEINCY EFFECTS OF MONOPOLY PRICING • Socially optimum quantity Qsis where MC = MB of consumption. • Monopoly pricing is inefficient since it produce too few uits. • At Qm shows consumer willingness to pay for another unit of output, Pm. • Difference between total surplus and under monopoly and maximum total surplus is the DWL –representing opportunity costs to society. P Consumer Surplus Pm Monopoly Profit DWL Qm Qs

  15. EFFICEINCY EFFECTS OF MONOPOLY PRICING • The second effect of monopoly power is the transfer of surplus from consumers to the fir as profits. • Under competitive pricing both monopoly profits and DWL will have gone to the consumers as surplus.

  16. GAINS FROM TRADE • Many ways gains from trade represented by DWL can be realized. • E.g. consumers could band together by forming society action. • Society could propose to the monopolist that it sets its price = MC. • In return society will pay a lump sum of m + t, where t is small.

  17. GAINS FROM TRADE • As the result monopolist profit will increase by amount t. • Surplus of the consumers will also increase by DWL – t. • The only problem, cost of organizing the consumer may be large.

  18. Monopoly Pricing – Problem. • Assume: • MC is Constant and is equal to c. • Demand curve is linear – P(Q) = A – bQ • Where both A and b are positive parameters. • Question : Find the monopoly price and output.

  19. Monopoly Pricing – Problem • Solution: • Slope of the inverse demand function is b. • Therefore, if monopolist wants to sell 1 more unit of his product he will lower his price by b.

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