monopoly and other forms of imperfect competition 1

Monopoly and Other Forms of Imperfect Competition

Monopoly and Other Forms of Imperfect Competition

1

Perfectly Competitive Market

An ideal market that maximizes economic surplus

A situation that does not always exist

Imperfect Competition

Imperfectly Competitive Firms Have some control over price Price may be greater than the marginal

cost of production Long-run economic profits are possible Reduce economic surplus to varying

degrees Are very common

1. Pure Monopoly The only supplier of a unique product with no

close substitutes

2. Monopolistic Competition A large number of firms that produce slightly

differentiated products that are reasonably close substitutes for one another

Long-run adjustment to zero economic profits Importance of differentiation

Forms of Imperfect Competition

3. Oligopoly Industry structure in which a small

number of firms produce products that are either close or perfect substitutes

Cost advantages from large size may prevent the long-run adjustment to zero economic profit

Undifferentiated and differentiated products

Forms of Imperfect Competition

The perfectly competitive firm faces a perfectly elastic demand for its product.

The imperfectly competitive firm faces a downward-sloping demand curve.

Essential Difference Between Perfectly and Imperfectly Competitive Firms

The Demand Curves Facing Perfectly and Imperfectly Competitive Firms

Quantity

$/u

nit

of

ou

tpu

t

Quantity

DMarket

price Pri

ce

D

Perfectly competitive firm Imperfectly competitive firm

Supply and demand determine equilibrium price. The firm has no market power.

At the equilibrium price, the firm sells all it wishes. If the firm raises its price, sales will be zero. If the firm lowers its price, sales will not

increase. The firm’s demand curve is the horizontal

line at the market price.

Perfectly competitive market

The firm has some control over price or some market power. A firm’s ability to raise the price of a

good without losing all its sales Sellers face a downward sloping

demand

Imperfectly Competitive Markets

Exclusive control over inputs Patents and Copyrights Government Licenses or Franchises Economies of Scale (Natural

Monopolies) Network Externalities

Sources of Market Power

Economies of Scale and the Importance of Start-Up Costs

Firms with large fixed costs and low variable costs: Have low marginal costs Average total cost declines sharply as

output increases Economies of scale will exist

Costs for Two Computer Game Producers (1)

Nintendo Playstation

Annual production 1,000,000 1,200,000

Fixed cost $200,000 $200,000

Variable cost $800,000 $960,000

Total cost $1,000,000 $1,160,000

Average total cost per game $1.00 $0.97

Observations•Fixed costs are a relatively small share of total cost•Cost/game is nearly the same


Annual production 1,000,000 1,200,000

Fixed cost $10,000,000 $10,000,000

Variable cost $200,000 $240,000

Total cost $10,200,000 $10,240,000



Observations•Fixed costs are a relatively large share of total cost•Playstation has a $1.67 average cost advantage•Playstation can lower prices, cover cost, and attract customers

Annual production 500,000 1,700,000

Fixed cost $10,000,000 $10,000,000

Variable cost $100,000 $340,000

Total cost $10,100,000 $10,340,000




• Shift of 500,000 units to Playstation• Nintendo’s average cost increases to $20.20/unit• Playstation average cost falls to $6.08• A large number of firms cannot survive when the cost differential is high

Economies of Scale and the Importance of Fixed Costs

Fixed investment in research and development has been increasing as a share of production costs.

1984 20% 80%1990 80% 20%

Cost of producing a computerFixed Cost Variable Cost

Software Hardware

Profit Maximization for the Monopolist

A price taker (perfect competition) and a price setter (imperfect competition) share the economic goal. They want: To maximize profits; i.e., To select the output level that maximizes

the difference between TR and TC, where MB= MC (when quantity is divisible and not producing at all is not optimal).

For a producer MB = Marginal Revenue (MR) or a

change in a firm’s total revenue that results from a one-unit change in output


Marginal Revenue for the Monopolist Perfect competition and monopolies

Both increase output when MR > MC. Calculate MC the same way. Do not have the same MR at a given

price. In perfect competition: MR = P In monopoly: MR < P


The Monopolist’s Benefit from Selling an Additional Unit

Pri

ce (

$/u

nit

)

Quantity (units/week)

D

8

8

2

6

3

5

• If P = $6, then TR = $6 x 2 = $12• If P = $5, then TR = $5 x 3 = $15• The MR of selling the 3rd unit = $3 (=15-12)• For the 3rd unit, MR = $3 < P = $5

Observations MR < P MR declines as quantity

increases MR is the change

between two quantities MR < P because price

must be lowered to sell an additional unit

6 2 12

5 3 15

4 4 16

3 5 15

P Q TR MR

3

1

-1

Marginal Revenue in Graphical Form

6 2 12

5 3 15

4 4 16

3 5 15

P Q TR MR

3

1

-1

Marginal Revenue in Graphical Form

Pri

ce &

mar

gin

al r

even

ue

($/u

nit

)


8

8

D

432-1

3

5

1

MR

The Marginal Revenue Curve for a Monopolist with a Straight-Line Demand Curve

Pri

ce

Quantity

Observations• The vertical intercept, a, is the same for MR and D• The horizontal intercept for MR, Q0/2, is one half the demand intercept, Q0.

D

Q0

a

Q0/2

a/2

MR


Profit Maximizing Decision Rule When MR > MC, output should be

increased. When MR < MC, output should be

reduced. Profits are maximized at the level of

output for which MR = MC.

The Monopolist’s Profit-Maximizing Output Level

Pri

ce (

$/u

nit

of

ou

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t)


6

D

3

12 24

Marginal Cost

2

4

MR

8

Observations• If P = $3 & Q = 12, MR < MC

and output should reduce• Profits are maximized at 8

units where MR = MC• P = $4 where quantity

demanded = quantity supplied

Even a Monopolist May Suffer an Economic Loss

Pri

ce (

$/m

inu

te)

Minutes (millions/day)

Pri

ce (

$/m

inu

te)

Minutes (millions/day)2420

0.12

0.10 ATC

20

0.08

0.10

ATC

Economic loss= $400,000/day

Economic profit= $400,000/day

D

0.05 MC

MR

D

0.05 MC

MR

Being a monopolist doesn’t guarantee an economic profit

D

3

12

6

24

Marginal cost

The socially optimalamount occurs whereMC = D(=MB) @ 12 units

The Demand and Marginal Cost Curves for a Monopolist

Pri

ce (

$/u

nit

of

ou

tpu

t)


Why the Invisible Hand Breaks Down Under Monopoly

2

4

MR

8

• The profit maximizing level of output of 8 units, where MR = MC, is less than the socially optimal output of 12

• Between 8 and 12, MB to society > MC to society

• Does not increase output because MR to the firms is less than MC

Pri

ce (

$/u

nit

of

ou

tpu

t)


D

12

6

24


3

Marginal cost


2

4

MR

8

• Because MR<P, the monopoly produces less than the socially optimal amount

• The deadweight loss of the monopoy to society = (1/2)($2/unit)(4 units/wk) = $4/wk.P

rice

($/

un

it o

f o

utp

ut)


D

12

6

24


3

Marginal cost


Deadweight loss


Monopoly Profits are

maximized where MR = MC.

P > MR P > MC Deadweight loss

Perfect Competition Profits are

maximized where MR = MC.

P = MR P = MC No deadweight

loss

Difficulties in Reducing the Deadweight Loss of Monopolies Enforcing antitrust laws Patents, copyrights, and innovation Natural monopolies


The practice of charging different buyers different prices for essentially the same good or service

Examples Senior citizens and student discounts

on movie tickets Supersaver discounts on air travel Rebate coupons

Price Discrimination

Why do many movie theaters offer discount tickets to students?

Food For Thought

How many manuscripts should Carla edit?

Example: Carla Edit

Total and MarginalRevenue from Editing

Reservation Price Total Revenue Marginal revenueStudent ($ per paper) ($ per week) ($ per paper)

A 40 40

B 38 76

C 36 108

D 34 136

E 32 160

F 30 180

G 28 196

H 26 208

40

36

32

28

24

20

16

12

How many manuscripts should Carla edit? Opportunity cost = $29 TR = P x Q, or for 4 papers, 4 x $34 =

$136/wk MR is the difference in TR from adding

another student If MR > MC: increase output

Example: Single Price Monopoly

How many manuscripts should Carla edit?

Carla edits 3 papers TC = 3 x $29 = $87 TR = $108 Economic profit = $108 - $87 =

$21/wk

Example: Single Price Monopoly

How many manuscripts should Carla edit? O.C. of her time per editing= $29 Must charge the same price Reservation price > opportunity cost for

student A to F Socially efficient number is 6

TR = 6 x $30 = $180 TC = 6 x $29 = $174 Economic profit = $180- $174 = $6

Example: Social Optimal

If Carla can do perfect price discriminate, how many papers should she edit?

Assume Carla can charge each student the reservation price.

Example: Perfect Price Discrimination

ReservationStudent

price

A 40

B 38

C 36

D 34

E 32

F 30

G 28

H 26

• Carla would edit A to F• TR = $40 + $38… = $210• TC = 6 x $29 = $174• Economic Profit = $210 - $174 = $36/wk

• Economic Profit is $30 more

Example: Perfect Price Discrimination

Perfectly Discriminating Monopolist Charging each buyer exactly their

reservation price Economic surplus is maximized Consumer surplus is zero Economic surplus = producer surplus

Perfect Price Discrimination

Seller will not know each buyer’s reservation price.

Low price buyers could resell to other buyers at a higher price.

Limitation to Perfect Price Discrimination

Profit-maximizing seller’s goal is to charge each buyer his/her reservation price. There are two problems to implementing

this pricing strategy. Seller does not know the reservation prices Seller must separate high and low price buyers

The hurdle method of price discrimination is used to solve these problems.

The Hurdle Method of Price Discrimination

The practice of offering a discount to all buyers who overcome some obstacle. Example

Offering a rebate to those who mail in a coupon


A Perfect Hurdle Separates buyers precisely according

to their reservation prices

What do you think? Is a perfect hurdle possible?


Question How much should Carla charge for

editing if she uses a perfect hurdle?

Example: Price Discriminationwith a Perfect Hurdle

Assume Carla offers a mail in rebate coupon Students with at least a $36

reservation price never use the coupon

Students with a reservation price below $36 use the coupon

Opportunity cost = $29 Discount coupon = $4


Price Discriminationwith a Perfect Hurdle

Reservation Price Total Revenue Marginal revenue

Student ($ per paper) ($ per week) ($ per paper)

A 40 40

B 38 76

C 36 108

D 34 34

E 32 64

F 30 90

G 28 112

H 26 130

40

36

32

List Price Submarket

Discount Price Submarket

34

30

26

22

18

Solution TR = (3)(36) + (2)(32) = $172 MC = ($5)($29) = $145 Economic Profit = $27/wk


Is price discrimination a bad thing? In fact, the hurdle method raised

economic surplus.

Price Discriminationwith a Perfect Hurdle

Producer Surplus Single price = 3(36 - 29) = $21/wk Discount price = 3(36 - 29) = $21/wk

2(32 - 29) = $6/wk$27/wk

Calculating Economic Surplus

Consumer Surplus Reservation Price Actual Price Consumer Surplus A $40 $36 $4

B $38 $36 $2

C $36 $36 $0

BothSingle price& discount

Without Discount $6

D $34 $22 $2

With Discount $8

Economic Surplus Under Price Discrimination with a Perfect Hurdle

Economic Surplus Single price = $6 + $21 = $27/wk Discount price = $8 + $27 = $35/wk

Calculating Economic Surplus

Consumer Surplus Reservation Price Actual Price Consumer Surplus A $40 $36 $4

B $38 $36 $2

C $36 $36 $0

BothSingle price& discount

Without Discount $6

D $34 $22 $2

With Discount $8

Economic Surplus Under Price Discrimination with a Perfect Hurdle

Is Carla’s discount rebate completely efficient?

Food For Thought

Temporary Sales Book publishers and paperback

books Automobile producers offer various

models Commercial air carriers Movie producers

Examples of Price Discrimination

Single price monopolies are inefficient because P > MR.

The hurdle method of price discrimination reduces the inefficiency. The more finely the seller can discriminate,

the smaller the efficiency loss. Hurdles are not perfect, therefore, there will

be some efficiency loss.

Summary

EndEnd

55

monopoly and other forms of imperfect competition 1

Documents

competitive market slide

common slide

average total cost

equilibrium price

total cost declines

competitive firms quantity

large fixed costs

competitive markets