hall and lieberman, 3 rd edition, thomson south-western, chapter 9 monopoly

Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 9

Monopoly

2

Overview

What you will learn in this lecture What is a monopoly? Why does a monopoly exist? How is monopolized optimal output / price

level determined? How is a monopoly different from a perfect

competitive firm? What happens when things change?

3

Part I. Monopoly Negative reputation of monopoly is in

many ways deserved Unfairly prices, extraordinary power, etc This negative characterization goes too far

Monopolies should be avoided in many markets, but in some it may be best to organize the production

We do better by managing monopoly problem, rather than eliminating it

4

What Is A Monopoly? A monopoly firm is the only seller of a good or

service with no close substitutes Monopoly market is the one where the monopoly firm

operates Key concept is notion of substitutability Example

How “close” are the substitutes in the real world? Depends on how broadly or how narrowly we define a

market when trying to decide if it is a monopoly Example

the only doctor, attorney or food market in a small town

5

Figure 1 What A Monopolist Does?

P2

D

M

P1C

Q2 Q1

S

Quantity

Price

6

What A Monopolist Does? Compared with a firm in perfectly

competitive market, a monopolist moves along the demand curve to produce less but charge a higher price To earn higher profit rather than zero profit The ability of a monopolist to raise its price

above the competitive level by reducing output is known as market power

Example Why don’t profit get competed away?

7

The Sources of Monopoly

Existence of a monopoly means that something is causing other firms to stay out of the market

What barrier prevents additional firms from entering the market? Several possible answers

Economies of scale Legal barriers Network externalities

8

I. Economies of Scale

Economies of scale: the higher output, the lower LRATC or the lower unit cost Example

If economies of scale persist to the point where the monopoly is producing for entire market, the market is a natural monopoly one firm can operate at lower average

cost than can two or more firms

9

Figure 2: A Natural Monopoly from Economy of Scale

M

Q

P

Quantity

Dollars

LRATC

DMarket

Natural monopolist’s break-even price

Relevant output range

10

I. Economies of Scale Why natural monopoly may exist?

Incumbent advantages Example: dry cleaning in a small town,

Figure 2 Small local monopolies are often natural

monopolies Because they continue to enjoy economies

of scale up to point at which they are serving entire market

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II. Legal Barriers

Sometimes public interest is best served by having a single seller in a market Purposely creating barriers leading to monopoly

Many monopolies arise because of legal barriers including Protection of intellectual property Government franchise

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II. Legal Barrier -- Protection of Intellectual Property

Most important kinds of legal protection for intellectual property are Patents

Temporary grant of monopoly rights over a new product or scientific discovery

CopyrightsGrant of exclusive rights to sell a literary,

musical, or artistic work

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II. Legal Barrier -- Protection of Intellectual Property

Government strikes a compromise Allows creators of intellectual property to enjoy a

monopoly and earn economic profit, but only for a limited period of time

Once time is up, other sellers are allowed to enter the market, and it is hoped that competition among them will bring down prices

Free usage if not having purpose of making profit

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II. Legal Barrier -- Government Franchise

Large firms we usually think of as monopolies have their monopoly status guaranteed through government franchise Grant of exclusive rights over a product

Governments usually grant franchises when they think market is a natural monopoly

Example?

15

III. Network Externalities Exist when an increase in network’s

membership increases its value to current and potential members

Advantages of joining a large network more beneficial than joining a small network

The value to consumers of a good rises as the number of people who also use the good rises Example: computer operating systems

Microsoft Windows

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Monopoly Goals & Constraints

Goal of a monopoly—Maximize profit like that of any firm

Noncompetitive firms make ONE decision Once firm determines its output level, it has also

determined its price Constraints

Cost constraint for any level of possible Q Technology of production Price it must pay for its inputs

Demand constraint maximum price monopolist can charge, given Q

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Demand Constraints and MR

Monopoly firm faces a downward sloping demand curve, marginal revenue is less than price of output Graphically, marginal revenue curve will lie below

demand curve (figure 3a) Why?

By Intuition By Mathematics

Monopoly will always produce at an output level where marginal revenue is positive

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Figure 3a: Demand and Marginal Revenue

5,000

BA

18

MR6,00020,000

21,00030,000

20

3038

4850

$60

Demand

F G

C

Number of Subscribers

Monthly Price per

Subscriber

15,000

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Figure 3b:Profit Maximization by Monopoly-- MC curve crosses MR curve from below

E

MR10,000

MC

D

30,000


Monthly Price per

Subscriber

40

$60

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Profit And Loss

A monopoly earns a profit whenever P > ATC Profit is the shadow area in the Figure 4(a)

Height equal to P - ATC Width equal to level of output

A monopoly suffers a loss whenever P < ATC Loss is the shadow area in the Figure 4(b)

Height equal to ATC - P Width equal to level of output

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Figure 4: Monopoly Profit and Loss

E

MR10,000

$40

MC

32

Total Profit

ATC

D

E

Total Loss

AVCATC

MR10,000

40

MC

D

$50

Dollars(a)


Dollars(b)


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Part II. Equilibrium in Monopoly Markets

A monopoly market is in equilibrium when this only firm in market is maximizing profit

For monopoly—as for perfect competition—we have different expectations about equilibrium in short-run and equilibrium in long-run

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Short-Run Equilibrium

Monopoly may earn an economic profit or suffer an economic loss

What if a monopoly suffers a loss in short-run? Any firm should shut down if P < AVC at output

level where MR = MC If monopoly suddenly finds that P < AVC,

government will usually not allow it to shut down, Instead use tax revenue to make up for firm’s

losses

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Long-Run Equilibrium Remember that perfectly competitive

firms earn zero profit in the long-run equilibrium

However, monopolies may earn economic profit in the long-run May still benefit from economies of scale

A privately owned monopoly suffering an economic loss in long-run will exit the industry

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Part III. Comparing Monopoly to Perfect Competition In perfect competition, economic profit is relentlessly

reduced to zero by entry of other firms In monopoly,

economic profit can continue indefinitely have a higher price and lower output than an

otherwise similar perfectly competitive market earns economic profit due to this reason

Consumers lose in two ways Pay more for output they buy Due to higher prices they buy less output

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Figure 5a/b: Comparing Monopoly and Perfect Competition

100,000

E$10

D

S

1,000

ATCMC

d$10

Quantity of Output

Price per

Unit

(a) Competitive Market (b) Competitive FirmDollars

per Unit

Quantity of Output

2. and each firm produces 1,000 units, where P = MC.

1. In this competitive market of 100 firms, equilibrium price is $10

3. When monopoly takes over, the old market supply curve . . .

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Figure 5c: Comparing Monopoly and Perfect Competition

100,000 Quantity of Output

Price per

Unit

E10

D

(c) Monopoly

S = MC

60,000

MR

$15F

6. with a higher price and lower market output than under perfect competition.

4. becomes the monopoly's MC curve.

5. The monopoly produces where MR = MC,

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MC

MR

Demand

Figure 5d Comparison of the social loss between Monopoly and Perfect Competition

Competitive Competitive equilibriumequilibrium

Monopolistic Monopolistic equilibriumequilibriumPM

PC

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Comparing Monopoly to Perfect Competition

Perfect Competition Monopoly

Firm’s choice Q P or Q

Profit maximization

P = MC MR=MC

Maximized Profit

Zero in the long runProfit / loss in the short run

Profit / loss in short run / long run with lower Q and

higher P than those in perfect competitive market

Characteristics Many firms; free entry & exit; undifferentiated goods

Entry barrier; only one firm; differentiated goods;

Technology’s effect

Still zero profit; usually P goes down and Q goes up

Generate higher profits; P and Q change is not

determined

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Why Monopolies Often Earn Zero Economic Profit ?

Government regulation Rent-seeking activity

Any costly action a firm undertakes to establish or maintain its monopoly status

Example: Bribes to government officials in corrupt bureaucracies

Or time and money spent lobbying legislators and public for favorable polices in less corrupt governments

Rent-seeking activity is part of firm’s costs. It can reduce economic profit of a monopoly, even reduce it to zero.

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Part IV. What Happens When Things Change? Once a monopoly is maximizing profit, it

has no incentive to change its price or its level of output Unless something that affects these

decisions changes Possible events

Change in demand for monopolist’s product Change in its costs

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I. An Increase in Demand

Monopolist’s reactions Producing more output Charging a higher price Earning a larger profit Figure 6

It will react to a decrease of demand by Reducing output Lowering price Suffering a reduction in profit

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Figure 6: A Change in Demand

A

MR110,000

$40

MC

D1

30,000

(a)


Monthly Price per

Subscriber

MR211,000

D2

$47B

A

D1

MR1

(b)

10,000

40

MC

Monthly Price per

Subscriber


34

II. Cost-Saving Technological Advance

Benefits perspective: Monopoly’s profits will be higher after adoption

Only part of benefits are passed to consumers In perfect competitive market, all of the benefits are

passed to consumers Costs perspective:

After its cost increase, monopoly’s profits will be lower Only part of a cost increase onto consumers in form of a

higher price In perfect competitive market, all of the costs are passed

to consumers – have to pay higher prices

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Figure 7: Monopoly Profit and Loss-- Increased Cost


Dollars

ED

MR10,00012,000

$40MC2

MC1

D

38

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Summary Monopoly has market power Possible reasons for existence of monopoly:

Economies of scale – natural monopolyLegal barriersNetwork externalities

Standard profit maximization approach (MR =MC) Profit or loss both in short run and long run

Rent seeking activity and zero profit Increase in demand / technology adoption

effects on monopolist’s decision

hall and lieberman, 3 rd edition, thomson south-western, chapter 9 monopoly

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