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Topic
3.
Monopoly
Bibliography: Pindyck and Rubinfeld.
Chapter 10 (pages 357-398)
Microeconomics. Antoni Cunyat
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Assumptions of Monopoly
The model of monopoly rests on three basic assumptions:(1) One seller, many buyers
(2) Product homogeneity, and
(3) Barriers to entry.
Barriers to entry
Condition that impedes entry by newcompetitors.
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
Demand curve faced by a monopolist
As the sole producer of a product, monopolists
demand is equal to market demand (downwardsloping). d=D, q=Q
dP/dq
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Total Revenue, Average Revenue and Marginal Revenue
Total Revenue: R(Q)=P(Q)Q
Average Revenue:
Marginal Revenue:
RQ RQ
Q
PQ
Q PQ
MRQ dRQ
dQ
dPQQ
dQ P Q dP
dQ
AR is the market demand function MR < P (as opposed to a competitive market)
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
Why the price is greater than Marginal Revenue?
TABLE 10.1 Total, Marginal, and Average Revenue
Total Marginal Average
Price (P) Quantity (Q) Revenue (R) Revenue (MR) Revenue (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
Consider a firm facing the following demand curve:
P = 6 Q
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
Average Revenue and Marginal Revenue
Average and marginalrevenue are shown forthe demand curveP = 6 Q.
Average and MarginalRevenue
Figure 10.1
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3.1
Relationship between Marginal Revenue and theElasticity of Demand
MRQ PQ QPQ
dP
dQ PQ PQ 1 1
Ed
Where is the absolute value of the elasticity of demand.|Ed|
If|Ed| 1 MR 0
If|Ed| 1 MR 0
If|Ed| 1 MR 0
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3.1
Relationship between Marginal Revenue and theElasticity of Demand
If|Ed| MR P (Perfectly Competitive Market)
If|Ed| MR P (Market Power)
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
The Monopolists output decision
Marginal revenue equals marginal cost at a point at which the
marginal cost curve is rising.
MR=MC
At this output level, the price is determined by the intersect atthe market demand.
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
The Monopolists Output Decision
Q* is the output level at whichMR = MC.
If the firm produces a smalleroutputsay, Q1it sacrificessome profit because the extra
revenue that could be earnedfrom producing and selling theunits between Q1 and Q*exceeds the cost of producingthem.
Similarly, expanding output from
Q* to Q2 would reduce profitbecause the additional costwould exceed the additionalrevenue.
Profit Is Maximized When MarginalRevenue Equals Marginal Cost
Figure 10.2
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
An Example
Part (a) shows total revenue R, total cost C,
and profit, the difference between the two.
Part (b) shows average and marginalrevenue and average and marginal cost.
Marginal revenue is the slope of the totalrevenue curve, and marginal cost is the
slope of the total cost curve.The profit-maximizing output is Q* = 10, thepoint where marginal revenue equalsmarginal cost.
At this output level, the slope of the profitcurve is zero, and the slopes of the total
revenue and total cost curves are equal.
The profit per unit is $15, the differencebetween average revenue and averagecost. Because 10 units are produced, totalprofit is $150.
Example of Profit Maximization
Figure 10.3
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
Monopolists profits
MC
AC
Q
D = ARMRP*
Q
*
MC
AC
Q
D = ARMR
P*
Q*
P P
SHUT-DOWN CONDITION
Short-run: P AVC
Long-run: P ATC
P*
Monopolist with positive profitsMonopolist with zero profits
Monopolist can have long-runeconomic profits (monopoly rents).
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A Rule of Thumb for Pricing
We want to translate the condition that marginal revenue shouldequal marginal cost into a rule of thumb that can be more easily
applied in practice.To do this, we first remember the former expression for marginalrevenue:
MR PQ 1 1Ed
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A Rule of Thumb for Pricing
(Q/P)(P/Q) is the reciprocal of the elasticity of demand,1/Ed, measured at the profit-maximizing output, and
Now, because the firms objective is to maximize profit, wecan set marginal revenue equal to marginal cost:
which can be rearranged to give us
(10.1)
Equivalently, we can rearrange this equation to expressprice directly as a markup over marginal cost:
(10.2)
MR PQ1
1
Ed
P P 1Ed
C
PMC
P
1Ed
P MC
1
1
Ed
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
Remember the important distinction between a perfectly competitivefirm and a firm with monopoly power: For the competitive firm, price
equals marginal cost; for the firm with monopoly power, price exceedsmarginal cost.
Measuring Monopoly Power
Lerner Index of Monopoly PowerMeasure of monopoly power calculated asexcess of price over marginal cost as a
fraction of price.
Mathematically:
This index of monopoly power can also be expressed in terms of the elasticityof demand facing the firm.
L PMCP
1Ed
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The Rule of Thumb for Pricing
The markup (P MC)/P is equal to minus the inverse of the elasticity of demand facing the firm.
If the firms demand is elastic, as in (a), the markup is small and the firm has little monopoly power.
The opposite is true if demand is relatively inelastic, as in (b).
Elasticity of Demand and Price Markup
Figure 10.8
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Although the elasticity of market demand for foodis small (about 1), no single supermarket can
raise its prices very much without losingcustomers to other stores.
The elasticity of demand for any one supermarketis often as large as 10.We find P = MC/(1 0.1) = MC/(0.9) = (1.11)MC.
The manager of a typical supermarket should set prices about 11 percentabove marginal cost.
Small convenience stores typically charge higher prices because its customersare generally less price sensitive.
Because the elasticity of demand for a convenience store is about 5, themarkup equation implies that its prices should be about 25 percent abovemarginal cost.
With designer jeans, demand elasticities in the range of 2 to 3 are typical.
This means that price should be 50 to 100 percent higher than marginal cost.
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TABLE 10.2 Retail Prices of VHS and DVDs
2007
Title Retail Price DVD
Purple Rain $29.88
Raiders of the Lost Ark $24.95
Jane Fonda Workout $59.95
The Empire Strikes Back $79.98An Officer and a Gentleman $24.95
Star Trek: The Motion Picture $24.95
Star Wars $39.98
1985
Title Retail Price VHS
Pirates of the Caribbean $19.99
The Da Vinci Code $19.99
Mission: Impossible III $17.99
King Kong $19.98Harry Potter and the Goblet of Fire $17.49
Ice Age $19.99
The Devil Wears Prada $17.99
Source (2007): Based on http://www.amazon.com. Suggested retail price.
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Between 1990 and 1998, lowerprices induced consumers to buymany more videos.
By 2001, sales of DVDs overtook
sales of VHS videocassettes.High-definition DVDs wereintroduced in 2006, and areexpected to displace sales ofconventional DVDs.
Video Sales
Figure 10.9
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
Three factors determine a firms elasticity of demand.
1. The elasticity of market demand. Because the firms owndemand will be at least as elastic as market demand, theelasticity of market demand limits the potential for monopolypower.
2. The number of firms in the market. If there are many firms, itis unlikely that any one firm will be able to affect pricesignificantly.
3. The interaction among firms. Even if only two or three firms
are in the market, each firm will be unable to profitably raiseprice very much if the rivalry among them is aggressive, witheach firm trying to capture as much of the market as it can.
Sources of monopoly power
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If there is only one firma pure monopolistits demand curve is themarket demand curve.
Because the demand for oil is fairly inelastic (at least in the short run),OPEC could raise oil prices far above marginal production cost duringthe 1970s and early 1980s.
Because the demands for such commodities as coffee, cocoa, tin, andcopper are much more elastic, attempts by producers to cartelizethese markets and raise prices have largely failed.
In each case, the elasticity of market demand limits the potentialmonopoly power of individual producers.
The Elasticity of Market Demand
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When only a few firms account for most of the sales in a market, wesay that the market is highly concentrated.
The Number of Firms
barrier to entry Condition thatimpedes entry by new competitors.
Firms might compete aggressively, undercutting one anothers pricesto capture more market share.
This could drive prices down to nearly competitive levels.
Firms might even collude (in violation of the antitrust laws), agreeingto limit output and raise prices.
Because raising prices in concert rather than individually is more likelyto be profitable, collusion can generate substantial monopoly power.
The Interaction Among Firms
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
A monopolistic market has no supply curve.
Monopolists supply curve
There is no-one-to-one relationshipbetween price and the quantityproduced.
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Shifts in Demand
Shifting the demand curve shows
that a monopolistic market has nosupply curvei.e., there is noone-to-one relationship betweenprice and quantity produced.
In (a), the demand curve D1 shiftsto new demand curve D2.
But the new marginal revenuecurve MR2 intersects marginalcost at the same point as the oldmarginal revenue curve MR1.
The profit-maximizing output
therefore remains the same,although price falls from P1 to P2.
In (b), the new marginal revenuecurve MR2 intersects marginalcost at a higher output level Q2.
But because demand is now more
elastic, price remains the same.
Shifts in Demand
Figure 10.4
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THE MONOPOLIST OUTPUT DECISION.MONOPOLY POWER3.1
The Effect of a Tax
With a tax t per unit, the firmseffective marginal cost isincreased by the amount t toMC + t.
In this example, the increase inprice P is larger than the tax t.
Effect of Excise Tax on Monopolist
Figure 10.5
Suppose a specific tax of t dollars per unit is levied, so that themonopolist must remit t dollars to the government for every unit itsells. If MC was the firms original marginal cost, its optimal production
decision is now given by
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The social costs of monopoly power3.3
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The social costs of monopoly power3.3
The shaded rectangle and trianglesshow changes in consumer and
producer surplus when moving fromcompetitive price and quantity, Pcand Qc,
to a monopolists price and quantity,Pm and Qm.
Because of the higher price,
consumers loseA + B
and producer gainsA C. Thedeadweight loss is B + C.
Deadweight Loss from Monopoly Power
Figure 10.10
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The social costs of monopoly power3.3
Rent Seeking
rent seeking Spending money insocially unproductive efforts to acquire,maintain, or exercise monopoly.
In 1996, the Archer Daniels Midland Company (ADM) successfullylobbied the Clinton administration for regulations requiring that theethanol (ethyl alcohol) used in motor vehicle fuel be produced from
corn.Why? Because ADM had a near monopoly on corn-based ethanolproduction, so the regulation would increase its gains from monopolypower.
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Price regulation3.4
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Price regulation3.4
Price Regulation
If left alone, a monopolist
produces Qm and charges Pm.When the governmentimposes a price ceiling of P1the firms average andmarginal revenue are constantand equal to P1 for output
levels up to Q1.For larger output levels, theoriginal average and marginalrevenue curves apply.
The new marginal revenue
curve is, therefore, the darkpurple line, which intersectsthe marginal cost curve at Q1.
Price Regulation
Figure 10.11
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Price regulation3.4
Price Regulation
When price is lowered to
Pc, at the point wheremarginal cost intersectsaverage revenue, outputincreases to its maximumQc. This is the output thatwould be produced by a
competitive industry.Lowering price further, toP3 reduces output to Q3and causes a shortage,Q3 Q3.
Price Regulation
Figure 10.11
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Price regulation3.4
Natural Monopoly
A firm is a natural monopoly
because it has economies ofscale (declining average andmarginal costs) over its entireoutput range.
If price were regulated to be Pcthe firm would lose money and
go out of business.
Setting the price at Pryields thelargest possible output consistentwith the firms remaining inbusiness; excess profit is zero.
natural monopoly Firm that can produce theentire output of the market at a cost lower thanwhat it would be if there were several firms.
Regulating the Price of a NaturalMonopoly
Figure 10.12
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Price regulation3.4
Regulation in Practice
rate-of-return regulation Maximum priceallowed by a regulatory agency is based on the
(expected) rate of return that a firm will earn.
The difficulty of agreeing on a set of numbers to be used in rate-of-return calculations often leads to delays in the regulatory response tochanges in cost and other market conditions.
The net result is regulatory lagthe delays of a year or more usuallyentailed in changing regulated prices.