Chapter 11A/24

1. MONOPOLY Chapter 11A/24 Prof. Charles Fusi

2. Introduction In New York City, a taxicab requires a medallion as legal possession of a license to operate the taxi business. Thus, the medallion constitutes a barrier to entry to New York City’s taxicab industry. In this chapter, you will learn how governmentally imposed and other types of barriers to entry give rise to monopolies, or single-firm industries.

3. Learning Objectives Identify situations that can give rise to monopoly Describe the demand and marginal revenue conditions a monopolist faces Discuss how a monopolist determines how much output to produce and what price to charge Evaluate the profits earned by a monopolist Understand price discrimination Explain the social cost of monopolies

4. Chapter Outline Definition of a Monopolist Barriers to Entry The Demand Curve a Monopolist Face Elasticity and Monopoly Cost and Monopoly Profit Maximization Calculating Monopoly Profit On Making Higher Profits: Price Discrimination The Social Cost of Monopolies

5. Definition of a Monopolist Monopolist A single supplier of a good or service for which there is no close substitute The monopolist therefore constitutes the entire industry

6. Barriers to Entry Question How does a firm obtain monopoly power? • Answer • Barriers to entrythat allow the firm to make long-run economic profits • Barriers to entry are restrictions on who can start as well as stay in business.

7. Barriers to Entry (cont'd) Barriers to entry include: Ownership of resources without close substitutes Economies of scale Legal or governmental restrictions

8. Barriers to Entry (cont'd) Ownership of resources without close substitutes The Aluminum Company of America (ALCOA) at one time owned most of of the world’s bauxite

9. Barriers to Entry (cont'd) Economies of scale Low unit costs and prices drive out rivals The largest firm can produce at the lowest average total cost

10. Barriers to Entry (cont'd) Natural Monopoly A monopoly that arises from the peculiar production characteristics in an industry It usually arises when there are large economies of scale One firm can produce at a lower average cost than can be achieved by multiple firms

11. Figure 11a/24-1 The Cost Curves That Might Lead to a Natural Monopoly

12. Barriers to Entry (cont'd) Legal or governmental restrictions Licenses, franchises, and certificates of convenience Examples include Electrical utilities Radio and television broadcasting

13. Barriers to Entry (cont'd) Legal or governmental restrictions Patents Intellectual property Tariffs Taxes on imported goods Regulation Government enforcement of safety and quality

14. The Demand Curve a Monopolist Faces The monopolist faces the industry demand curve because the monopolist is the entire industry

15. Recall that under perfect competition Firm faces perfectly elastic demand curve, it is a price taker The forces of supply and demand establish the price per unit Marginal revenue, average revenue, and price are all the same The Demand Curve a Monopolist Faces (cont'd)

16. The Demand Curve a Monopolist Faces (cont'd) Marginal revenue equals the change in total revenue due to a one-unit change in the quantity produced and sold

17. The Demand Curve a Monopolist Faces (cont'd) Perfect competition versus monopoly The perfect competitor doesn’t have to worry about lowering price to sell more In a purely competitive situation, the firm accounts for a small part of the market It can sell its entire output, whatever that may be, at the same price

18. The Demand Curve a Monopolist Faces (cont'd) Perfect competition versus monopoly The more the monopolist wants to sell, the lower the price it has to charge on the last unit sold To sell the last unit, the monopolist has to lower the price because it is facing a downward sloping demand curve

19. Figure 11a/24-2 Demand Curves for the Perfect Competitor and the Monopolist

20. The Demand Curve a Monopolist Faces (cont'd) Monopoly Perfect Competition Single seller Faces entire industry demand Must lower price to sell more Not all units sold for same price (MR < P) Many sellers Faces perfectly elastic demand Must produce moreto sell more All units sold for same price (P = MR)

21. Figure 11a/24-3 Marginal Revenue: Always Less Than Price

22. Elasticity and Monopoly The monopolist faces a downward-sloping demand curve (its average revenue curve) That means that it cannot charge just any price with no changes in quantity (a common misconception) because, depending on the price charged, a different quantity will be demanded

23. Elasticity and Monopoly (cont'd) Question If a monopoly raises price, what will happen to quantity demanded? • Hint • Remember how consumers respond to a change in price

24. Elasticity and Monopoly (cont'd) Recall A monopolist is a single seller of a well-defined good or service with no close substitute Think of some imperfect substitutes. The demand curve slopes downward because individuals compare marginal satisfaction to cost

25. Elasticity and Monopoly (cont'd) After all, consumers have limited incomes and unlimited wants The market demand curve, which the monopolist alone faces in this situation, slopes downward because individuals compare the marginal satisfaction they will receive to the cost of the commodity to be purchased

26. Costs and Monopoly Profit Maximization We assume profit maximization is the goal of the pure monopolist, just as it is for the perfect competitor

27. Costs and Monopoly Profit Maximization (cont'd) Perfect competitor has only to decide on the profit-maximizing output rate because price is given The perfect competitor is a price taker For the pure monopolist, we must seek a profit-maximizing price outputcombination The monopolist is a price searcher

28. Costs and Monopoly Profit Maximization (cont'd) Price Searcher A firm that must determine the price-output combination that maximizes profit because it faces a downward-sloping demand curve

29. Costs and Monopoly Profit Maximization (cont'd) We can determine the profit-maximizing price-output combination with either of two equivalent approaches: By looking at total revenues and total costs or By looking at marginal revenues and marginal costs

30. Costs and Monopoly Profit Maximization (cont'd) Total revenues-total costs approach Maximize the positive difference between total revenues and total costs Marginal revenue-marginal cost approach Profit maximization will also occur where marginal revenue equals marginal cost

31. Costs and Monopoly Profit Maximization (cont'd) Question Why produce where marginal revenue equals marginal cost? Answer This is where the greatest positive difference between total revenue and total cost occurs

32. Figure 11a/24-4 Monopoly Costs, Revenues, and Profits, Panel (a)

33. Figure 11a/24-4 Monopoly Costs, Revenues, and Profits, Panels (b) and (c)

34. Costs and Monopoly Profit Maximization (cont'd) Producing past where MR = MC Result is that incremental cost will exceed incremental revenue Producing less than where MR = MC The monopolist is not maximizing profits through this approach either

35. Figure 11a/24-5 Maximizing Profits

36. Cost and Monopoly Profit Maximization (cont’d) Real-World Informational Limitations Price searching by a less-than perfect competitor is a process A monopolist can only estimate the actual demand curve and make an educated guess when it sets its profit-maximizing profit For the perfect competitor, price is given already by the intersection of market demand and supply

37. Calculating Monopoly Profit Monopoly profit is given by the shaded area in Figure 24-6, which is equal to total revenues (P  Q) minus total costs (ATC  Q)

38. Figure 11a/24-6 Monopoly Profit

39. Calculating Monopoly Profit (cont'd) No guarantee of profits The term monopoly conjures up the notion of a greedy firm ripping off the public If ATC is everywhere above AR, or demand No price-output combination allows the monopolist to cover costs

40. Figure 11a/24-7 Monopolies: Not Always Profitable

41. International Example: A Mexican Cement Monopoly Finds a Way to Incur Losses In Mexico, a single company, Cemex, accounts for almost 80 percent of the nation’s cement production and sales. Thus, Cemex sells cement to Mexican consumers at almost twice the market price in the United States, where a number of firms make and sell cement. Recently, Cemex has been incurring losses as a result of falling demand in 2008 and its debt costs from short-term loans that the company had borrowed during periods of expansion.

42. On Making Higher Profits: Price Discrimination Price Discrimination Selling a given product at more than one price, with the difference being unrelated to differences in cost

43. On Making Higher Profits: Price Discrimination (cont'd) Price Differentiation Establishing different prices for similar products to reflect differences in marginal cost in providing those commodities to different groups of buyers

44. On Making Higher Profits: Price Discrimination (cont'd) Necessary conditions for price discrimination The firm must face a downward-sloping demand curve The firm must be able to readily (and cheaply) identify buyers or groups of buyers with predictably different elasticities of demand The firm must be able to prevent resale of the product or service

45. Example: Why Students Pay Different Prices to Attend College Out-of-pocket tuition rates for any two college students can differ by considerable amounts, even if the students happen to major in the same subjects and enroll in many of the same courses. The reason for this is that colleges offer students diverse financial aid packages depending on their “financial need.” To document their “need” for financial aid, students must provide detailed information about family income and wealth. This information helps the college determine the prices that different families are most likely to be willing and able to pay, so that it can engage in price discrimination.

46. Figure 11a/24-8 Toward Perfect Price Discrimination in College Tuition Rates

47. The Social Cost of Monopolies Comparing monopoly with perfect competition Let’s assume a monopolist comes in and buys up every single perfect competitor Notice the monopolist produces a smaller quantity and sells at a higher price

48. The Social Cost of Monopolies (cont'd) Comparing monopoly with perfect competition Monopolists raise the price and restrict production compared to a perfectly competitive situation Consumers pay a price that exceeds the marginal cost of production and resources are misallocated in such a situation

49. Figure 11a/24-9 The Effects of Monopolizing an Industry

50. You Are There: A Texas Veterinary Board Whittles Down Vets’ Competition The Texas Board of Veterinary Medical Examiners has determined that horse-teeth floaters, who provide basic dental services for horses, must be certified or else they must work under the supervision of a licensed veterinarian. This way, many skilled horse-teeth floaters without a license will no longer able to compete with licensed veterinarians in the market for horse dental services.