Chapter 10

1. Chapter 10 Market Power: Monopoly and Monopsony

2. Perfect Competition • Review of Perfect Competition • P = LMC = LRAC • Normal profits or zero economic profits in the long run • Large number of buyers and sellers • Homogenous product • Perfect information • Firm is a price taker Chapter 10

3. D S LMC LRAC P0 P0 D = MR = P q0 Q0 Perfect Competition Market Individual Firm P P Q Q

4. Monopoly • Monopoly 1) One seller - many buyers 2) One product (no good substitutes) 3) Barriers to entry Chapter 10

5. Monopoly • The monopolist is the supply-side of the market and has complete control over the amount offered for sale. • Profits will be maximized at the level of output where marginal revenue equals marginal cost. Chapter 10

6. Total, Marginal, and Average Revenue Total Marginal Average Price Quantity Revenue Revenue Revenue P Q R MR AR $6 0 $0 --- --- 5 1 5 $5 $5 4 2 8 3 4 3 3 9 1 3 2 4 8 -1 2 1 5 5 -3 1 Chapter 10

7. Average Revenue (Demand) Marginal Revenue Average and Marginal Revenue $ per unit of output 7 6 5 4 3 2 1 Output 0 1 2 3 4 5 6 7 Chapter 10

8. MC P1 P* AC P2 Lost profit D = AR Lost profit MR Q1 Q* Q2 Maximizing Profit When Marginal Revenue Equals Marginal Cost $ per unit of output Quantity Chapter 10

9. C t' R c’ t Profits c Example of Profit Maximization $ 400 300 200 150 100 50 Quantity 0 5 10 15 20 Chapter 10

10. MC AC Profit AR MR Example of Profit Maximization $/Q 40 30 20 15 10 0 5 10 15 20 Quantity Chapter 10

11. Monopoly • Monopoly pricing compared to perfect competition pricing: • Monopoly P > MC • Perfect Competition P = MC Chapter 10

12. Monopoly • Monopoly pricing compared to perfect competition pricing: • The more elastic the demand the closer price is to marginal cost. • If Ed is a large negative number, price is close to marginal cost and vice versa. Chapter 10

13. Monopoly • Shifts in Demand • In perfect competition, the market supply curve is determined by marginal cost. • For a monopoly, output is determined by marginal cost and the shape of the demand curve. Chapter 10

14. MC P1 P2 D2 D1 MR2 MR1 Q1= Q2 Shift in Demand Leads toChange in Price but Same Output $/Q Quantity Chapter 10

15. MC P1 = P2 D2 MR2 D1 MR1 Q1 Q2 Shift in Demand Leads toChange in Output but Same Price $/Q Quantity Chapter 10

16. Monopoly Power • Monopoly is rare. • However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost. Chapter 10

17. Monopoly Power • Scenario: • Four firms with equal share (5,000) of a market for 20,000 toothbrushes at a price of $1.50. Chapter 10

18. At a market price of $1.50, elasticity of demand is -1.5. The demand curve for Firm A depends on how much their product differs, and how the firms compete. Market Demand The Demand for Toothbrushes $/Q $/Q 2.00 2.00 1.60 1.50 1.50 1.40 1.00 1.00 QA Quantity 10,000 20,000 30,000 3,000 5,000 7,000

19. Firm A sees a much more elastic demand curve due to competition--Ed = -6.0. Still Firm A has some monopoly power and charges a price which exceeds MC. MCA DA MRA The Demand for Toothbrushes $/Q $/Q At a market price of $1.50, elasticity of demand is -1.5. 2.00 2.00 1.60 1.50 1.50 1.40 Market Demand 1.00 1.00 QA Quantity 10,000 20,000 30,000 3,000 5,000 7,000

20. Monopoly Power • Measuring Monopoly Power • In perfect competition: P = MR = MC • Monopoly power: P > MC Chapter 10

21. Monopoly Power • Lerner’s Index of Monopoly Power • L = (P - MC)/P • The larger the value of L (between 0 and 1) the greater the monopoly power. • L is expressed in terms of Ed • L = (P - MC)/P = -1/Ed • Ed is elasticity of demand for a firm, not the market Chapter 10

22. Monopoly Power • Monopoly power does not guarantee profits. • Profit depends on average cost relative to price. Chapter 10

23. Monopoly Power • The Rule of Thumb for Pricing • Pricing for any firm with monopoly power • If Ed is large, markup is small • If Edis small, markup is large Chapter 10

24. The more elastic is demand, the less the markup. P* MC MC P* AR P*-MC MR AR MR Q* Q* Elasticity of Demand and Price Markup $/Q $/Q Quantity Quantity

25. Markup Pricing:Supermarkets • Supermarkets Chapter 10

26. Markup Pricing:Supermarkets • Convenience Stores Chapter 10

27. Markup Pricing:Supermarkets Convenience Stores • Convenience stores have more monopoly power. • Question: • Do convenience stores have higher profits than supermarkets? Chapter 10

28. Sources of Monopoly Power • Why do some firm’s have considerable monopoly power, and others have little or none? • A firm’s monopoly power is determined by the firm’s elasticity of demand. Chapter 10

29. Sources of Monopoly Power • The firm’s elasticity of demand is determined by: 1) Elasticity of market demand 2) Number of firms 3) The interaction among firms Chapter 10

30. The Social Costs of Monopoly Power • Monopoly power results in higher prices and lower quantities. • However, does monopoly power make consumers and producers in the aggregate better or worse off? Chapter 10

31. Because of the higher price, consumers lose A+B and producer gains A-C. Lost Consumer Surplus MC Deadweight Loss Pm A B PC C AR MR Qm QC Deadweight Loss from Monopoly Power $/Q Quantity Chapter 10

32. The Social Costs of Monopoly Power • Rent Seeking • Firms may spend to gain monopoly power • Lobbying • Advertising • Building excess capacity Chapter 10

33. The Social Costs of Monopoly Power • The incentive to engage in monopoly practices is determined by the profit to be gained. • The larger the transfer from consumers to the firm, the larger the social cost of monopoly. Chapter 10

34. The Social Costs of Monopoly Power • Example • 1996 Archer Daniels Midland (ADM) successfully lobbied for regulations requiring ethanol be produced from corn • Question • Why only corn? Chapter 10

35. The Social Costs of Monopoly Power • Price Regulation • Recall that in competitive markets, price regulation created a deadweight loss. • Question: • What about a monopoly? Chapter 10

36. If left alone, a monopolist produces Qm and charges Pm. Marginal revenue curve when price is regulated to be no higher that P1. If price is lowered to P3 output decreases and a shortage exists. MR MC Pm P1 If price is lowered to PC output increases to its maximum QC and there is no deadweight loss. P2 = PC AC P3 P4 AR Any price below P4 results in the firm incurring a loss. Qm Q1 Q3 Q’3 Qc For output levels above Q1 , the original average and marginal revenue curves apply. Price Regulation $/Q Quantity Chapter 10

37. The Social Costs of Monopoly Power • Natural Monopoly • A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms. Chapter 10

38. Unregulated, the monopolist would produce Qm and charge Pm. If the price were regulate to be PC, the firm would lose money and go out of business. Pm Setting the price at Pr yields the largest possible output; profit is zero. AC Pr MC PC AR MR Qm Qr QC Regulating the Priceof a Natural Monopoly $/Q Quantity Chapter 10

39. The Social Costs of Monopoly Power • Regulation in Practice • It is very difficult to estimate the firm's cost and demand functions because they change with evolving market conditions Chapter 10

40. The Social Costs of Monopoly Power • Regulation in Practice • An alternative pricing technique---rate-of-return regulation allows the firms to set a maximum price based on the expected rate or return that the firm will earn. Chapter 10

41. The Social Costs of Monopoly Power • Regulation in Practice • Using this technique requires hearings to arrive at the respective figures. • The hearing process creates a regulatory lag that may benefit producers (1950s & 60s) or consumers (1970s & 80s). Chapter 10

42. Monopsony • A monopsony is a market in which there is a single buyer. • An oligopsony is a market with only a few buyers. • Monopsony power is the ability of the buyer to affect the price of the good and pay less than the price that would exist in a competitive market. Chapter 10

43. Monopsony • Competitive Buyer • Price taker • P = Marginal expenditure = Average expenditure • D = Marginal value Chapter 10

44. MC ME = AE AR = MR P* P* MR = MC P* = MR P* = MC ME = MV at Q* ME = P* P* = MV D = MV Q* Q* Competitive BuyerCompared to Competitive Seller Buyer Seller $/Q $/Q Quantity Quantity

45. The market supply curve is the monopsonist’s average expenditure curve ME • Monopsony • ME > P & above S S = AE PC P*m • Competitive • P = PC • Q = Qc MV Q*m QC Monopsonist Buyer $/Q Quantity Chapter 10

46. Monopoly Note: MR = MC; AR > MC; P > MC MC P* PC AR MR QC Q* Monopoly and Monopsony $/Q Quantity Chapter 10

47. ME Monopsony Note: ME = MV; ME > AE; MV > P S = AE PC P* MV Q* QC Monopoly and Monopsony $/Q Quantity Chapter 10

48. Monopsony Power • A few buyers can influence price (e.g. automobile industry). • Monopsony power gives them the ability to pay a price that is less than marginal value. Chapter 10

49. Monopsony Power • The degree of monopsony power depends on three similar factors. 1) Elasticity of market supply • The less elastic the market supply, the greater the monopsony power. Chapter 10

50. Monopsony Power • The degree of monopsony power depends on three similar factors. 2) Number of buyers • The fewer the number of buyers, the less elastic the supply and the greater the monopsony power. Chapter 10