ppa 723: managerial economics lecture 15: monopoly the maxwell school, syracuse university professor...
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PPA 723: Managerial Economics
Lecture 15:
Monopoly
The Maxwell School, Syracuse UniversityProfessor John Yinger
Managerial Economics, Lecture 15: Monopoly
Outline
Monopoly Pricing
Welfare Effects of Monopoly
How Do Monopolies Arise?
Monopolies and Public PolicyAnti-trust laws and regulationPublic monopolies
Managerial Economics, Lecture 15: Monopoly
Monopoly
A monopoly is the only supplier of a good for which there is no close substitute.
A monopoly's output is the market output. A monopoly's demand curve is market
demand curve. Its demand curve is downward sloping. It doesn't lose all its sales if it raises its price.
A monopoly is a price setter, not a price taker.
Managerial Economics, Lecture 15: Monopoly
Monopoly Profit Maximization
Monopolies, like other firms, maximize profits by choosing quantity such that:
marginal revenue = marginal cost
MR(Q) = MC(Q)
But with a monopoly, MR(Q) ≠ P.
Managerial Economics, Lecture 15: Monopoly
Marginal Revenue, MR
MR = the change in revenue from selling one more unit.
MR = R/Q (=R when Q =1)
For a competitive firm, MR = P.
For a monopoly, MR < P.
Managerial Economics, Lecture 15: Monopoly
Figure 11.1a Average and Marginal Revenue
Price, p,$ per unit
q q + 1Quantity, q, Units per year
p 1
(a) Competitive Firm
Demand curve
A B
R1 = A R2 = A + B
R = R2 – R1 = B = p 1
Managerial Economics, Lecture 15: Monopoly
Figure 11.1b Average and Marginal Revenue
Q Q + 1Quantity, Q, Units per year
p1
p2
Price, p,$ per unit
(b) Monopoly
Demand curve
A B
C
R1 = A + CR2 = A + BR = R2 – R1 = B – C = p2 - C
Managerial Economics, Lecture 15: Monopoly
Deriving a Monopoly’s MR CurveA monopoly increases its output by Q,
by lowering its price per unit by P/Q (=slope of demand curve).
So monopoly loses (p/Q) Q on units originally sold at higher price (area C)but earns an additional P on extra output
(area B).Thus: MR = P + (p/Q) Q = P + a negative term < P
Managerial Economics, Lecture 15: Monopoly
Figure 11.2 Elasticity of Demandand Total, Average,
and Marginal Revenue
p, $ per unit
Demand ( p = 24 – Q)
Perfectly elastic
Perfectlyinelastic
Elastic, < –1
Inelastic, –1 < < 0
= –1
p = –1
Q = 1Q = 1
MR = –2
Q, Units per day
24
12
0 12 24MR = 24 – 2Q
Managerial Economics, Lecture 15: Monopoly
Linear MR CurveIf demand curve is linear, P = a - bQ,
Then MR curve is linear, MR = a - 2bQ.MR curve hits vertical (price) axis where
demand curve does.Slope of MR curve = 2 slope of
demand curve.MR curve hits horizontal axis at half the
quantity as the demand curve.
Managerial Economics, Lecture 15: Monopoly
Choosing Price or Quantity• A monopoly can set P or Q to maximize its
profit, . • A monopoly is constrained by market demand.
– It cannot set both Q and P.– If a monopoly sets p, demand curve determines Q. – If a monopoly sets Q, demand curve determines P.
• Because a monopoly wants to maximize , it chooses same profit-maximizing solution whether it sets P or Q
Managerial Economics, Lecture 15: Monopoly
Profit Maximization All firms, including monopolies, use a
two-step analysis:
1. The firm determines output, Q*, at which it makes highest , i.e., where
– MR = MC
2. The firm decides whether to produce Q* or shut down (if P ≤ AVC)
Managerial Economics, Lecture 15: Monopoly
Figure 11.3 Maximizing Profit
12
18
24
8
6
108
144
60
60 12 24
R, , $
0 126 24
AC
AVCe
Demand
= 60
MC
MR
Q, Units per day
Revenue, R
Profit,
Q, Units per day
p, $ per unit
(b) Profit, Revenue
Managerial Economics, Lecture 15: Monopoly
Market PowerA monopolist’s ability to set the price is
an example of a more general phenomenon called market power.
Market power is defined as the ability of a firm to charge a price above marginal cost without losing all its business.
Market power exists when a firm faces a demand curve with an elasticity < -∞.
Managerial Economics, Lecture 15: Monopoly
Causes of Market Power A firm gains market power if
Consumers are willing to pay "virtually anything" for its product.
There exist no close substitutes for the firm's product.
Other firms can't enter the market.
Managerial Economics, Lecture 15: Monopoly
The Welfare Effects of Monopoly Define welfare as consumer surplus +
producer surplus.
Then welfare is lower under monopoly than under competition.
A monopoly sets P > MC, causing deadweight loss (DWL).
Managerial Economics, Lecture 15: Monopoly
= 18
Figure 11.5 Deadweight Loss of Monopolyp, $ per unit
Demand
Q , Units per day
MR
MC
pc = 16B = $12
D =$60
C =$2
E = $4MR = MC = 12
A = $18pm
24
Qm = 6 Q c = 8 24120
em
ec
Managerial Economics, Lecture 15: Monopoly
How Do Monopolies Arise?A firm has a cost advantage over other
firms (e.g. due to better technology). Government regulation prevents entry.Several firms merge into a single firm. Firms act collectively = a cartel.Firms use strategies - such as threats of
violence - that discourage other firms from entering market.
Managerial Economics, Lecture 15: Monopoly
Natural MonopolyA market has a natural monopoly if one
firm can produce total market output at lower cost than could several firms.
If cost for Firm i to produce qi is C(qi), the condition for a natural monopoly is
C(Q) < C(q1) + C(q2) + ... + C(qn),
where Q = q1 + q2 + .. + qn is sum of output of any n > 2 firms
Managerial Economics, Lecture 15: Monopoly
Natural Monopoly, 2
Equivalently, natural monopoly arises if the long-run AC curve is declining.
This corresponds to a technology characterized by economies of scale.
Managerial Economics, Lecture 15: Monopoly
Figure 11.7 Natural Monopoly
15
20
40
10
60 12 15
AC = 10 + 60/Q
MC = 10
Q, Units per day
AC, MC,$ per unit
Managerial Economics, Lecture 15: Monopoly
Government Actions that Reduce Market Power
Antitrust laws prohibit monopolization, price fixing, and so forth.
Regulations prevent monopolies from exercising all of their market power.
Managerial Economics, Lecture 15: Monopoly
Optimal Price Regulation
Price regulation can eliminate DWL.
Regulation is optimal if it leads to the "competitive" outcome.
Managerial Economics, Lecture 15: Monopoly
Figure 11.8 Optimal Price Regulationp , $ per unit
Regulated demand
Market demand
Q , Units per day2412860
MRMR r
MC
18
24
16
DE
CB
A em
eo
Managerial Economics, Lecture 15: Monopoly
Government Created Monopoly
Governments create monopoly through
Barriers to entry (e.g., patents, licenses)
Government provision (e.g. utilities, public safety, education, lotteries)
Managerial Economics, Lecture 15: Monopoly
Government MonopolyP
Q
AC
MR
D=MB
Peff
Peven
Government monopoly can raise revenue by setting price anywhere between the break-even price (Peven) and the private monopoly price (Pmon). It loses money at the efficient price (Peff).
MC
Pmon
Managerial Economics, Lecture 15: Monopoly
Government Monopoly Pricing
If a government monopoly uses the private monopoly price it:
Maximizes its revenue.
Causes the same distortion as the private monopoly!
Transforms monopoly profits into government revenue.