Chapter 9 Monopoly, Oligopoly, and Monopolistic Competition 6 additional Questions Even-numbered Qs.
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Transcript of ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 8: Monopoly, Oligopoly, and...
©2012 The McGraw-Hill Companies, All Rights Reserved
1
Chapter 8: Monopoly, Oligopoly, and
Monopolistic Competition
©2012 The McGraw-Hill Companies, All Rights Reserved
2
Learning Objectives
1. Define imperfect competition and compare it to perfect competition
2. Define market power and explain how it affects the firm's demand curve
3. Explain how start-up costs affect economies of scale and market power
4. Understand and use marginal cost and marginal revenue to maximize monopolist's profit
5. Show how monopoly alters economic surplus compared to perfect competition
6. Describe price discrimination and its effects7. Discuss public policies applied to natural
monopolies
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3
Imperfect Competition
Millions of people around the world suffer from allergies
The symptoms can be treated using over-the-counter or prescription medication Over-the-counter medication is affordable Prescription medication is expensive
Prescription medication costs no more to manufacture than over-the-counter medication their producer earns an enormous profit
In a perfectly competitive market if an economic profit exists firms enter the market and prescription medication would sell for roughly its cost of production
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Imperfect Competition
But prescription medication has been on the market for years now and that hasn’t happened The reason is that prescription medication
is patented, which means the government has granted the creator of the medication an exclusive license to sell it
The holder of a patent is an example of an imperfectly competitive firm, or price setter A firm with some liberty to set its own price
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Imperfect Competition
Imperfectly competitive firms have some control of price Long-run economic profits possible / Reduce
economic surplusThree types
1.Monopoly has only one seller, no close substitutes
Farthest from perfectly competitive markets2.Monopolistic competition has many firms
with differentiated products These products are all close substitutes No significant barriers preventing firms from
entering or leaving the market
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Imperfect Competition
Three types 3. Oligopoly is a small number of firms
producing close substitutes Oligopoly is typically a consequence of cost
advantages that prevent small firms from being able to compete effectively
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Monopoly
Monopoly
Number of Firms
One firm
Price Price setter
Entry and Exit
Not free
Product Unique
Economic Profits
Possible
DecisionsP, Q, product differentiation
Perfect Competition
Many firms
Price taker
Free
Standardized
Zero in long run
Q only
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Monopolistic Competition
Monopolistic Competition
Number of Firms
Many firms
Price Limited flexibility
Entry and Exit
Free
Product Differentiated
Economic Profits
Zero in long run
DecisionsP, Q, product differentiation
Perfect Competition
Many firms
Price taker
Free
Standardized
Zero in long run
Q only
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9
Oligopoly
Oligopoly
Number of Firms
Few firms, each large
Price Some flexibility
Entry and Exit
Large size firm
ProductDifferentiated or
standardized
Economic Profits
Possible
DecisionsP, Q,
differentiation, advertising
Perfect Competitio
n
Many firms
Price taker
Free
Standardized
Zero in long run
Q only
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10
The Essential Difference
Whereas the perfectly competitive firm faces a perfectly elastic demand curve for its product, the imperfectly competitive firm faces a downward-sloping demand curve Why is the demand curve different?
• Market Power
Quantity
Pric
e
Imperfectly Competitive Firm
DQuantity
Pric
e
Perfectly Competitive Firm
D
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The Essential Difference
Market power is the firm's ability to raise its price without losing all its sales Perfectly competitive firm:
Raise the price loses all its sales No incentive to lower price since it can sell
as many units as it wants at the market price Imperfectly competitive firm:
Has incentive to charge a higher price lose some customers but keep some and maybe gain more
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Five Sources of Market Power
A firm with a down-ward sloping demand curve is said to enjoy market power Referring to its ability to set the prices of its
productsFive Sources of Market Power
1.Exclusive control over inputs2.Patents and copyrights3.Government licenses or franchises4.Economies of scale (natural monopolies)5.Network economies
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Exclusive Control over Inputs
If a single firm controls an input essential to the production of a given product, that firm will have market power For example, to the extent that some
tenants are willing to pay a premium for office space in the world’s tallest building, Burj Khalifa, the owner of that building has market power
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Patents and Copyrights
Patents give the inventors or developers of new products the exclusive right to sell those products for a specified period of time
By insulating sellers from competition for an interval, patents enable innovators to charge higher prices to recoup their product’s development costs Pharmaceutical companies in the US are given
20 years patents During that time, these companies can charge a
price above their marginal cost
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Government Licenses or Franchises
Example: The Tourism Development &
Investment Company (TDIC) has an exclusive license from the Abu Dhabi government to manage all operational aspects of eight islands off the western coast of Abu Dhabi One of the government’s goals in granting
this monopoly was to preserve the wilderness character of the area to the greatest degree possible
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Market Power: Economies of Scale
Returns to scale refers to the percentage change in output from a given percentage change in ALL inputs
Long–run idea Constant returns to scale: doubling all
inputs doubles output Increasing returns to scale: output
increases by a greater percentage than the increase in inputs Average costs decrease as output increases Natural monopoly: a monopoly that results
from economies of scale
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Market Power: Network Economies
Network economies occur when the value of the product increases as the number of users increases VHS format for video tapes, Blu-ray for DVDs Windows operating system Facebook and MySpace
Network economies can also be seen as a source of natural monopolies A product’s quality increases as the number
of users increases Any given quality level can be produced at
lower cost as sales volume increases
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Market Power
The most important and enduring of these sources of market power are economies of scale and network economies
Other sources are weak Lured by economic profit, firms almost always
find substitutes for exclusive inputs Firms can often evade patent laws by making
slight changes in design of products Patent protection is only temporary in any case
Governments grant very few franchises each year
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Economies of Scale and Start-Up Costs
New products can have a large fixed development cost
If marginal cost is constant, Marginal cost = Average variable cost
Total cost is fixed cost (F) plus variable cost
TC = F + (M)*(Q) Total cost increases as output increases
Average total cost is ATC = (F/Q) + M
Average total cost decreases as output increases
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Economies of Scale
Quantity
Tot
al c
ost (
$/ye
ar)
F
TC = F + M*Q
Ave
rage
cos
t ($/
unit)
Quantity
ATC = F/Q + M
M
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Video Game – Different Volumes
Nintendo Playstation
Annual Production (000s)
1,000 1,200
Fixed Cost ($000s) $200 $200
Variable Cost ($000s)
$800 $960
Total Cost ($000s) $1,000 $1,160
ATC per game $1.00 $0.97
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Video Game – Lower Marginal Costs
Nintendo Playstation
Annual Production (000s)
1,000 1,200
Fixed Cost ($000s) $200 $200
Variable Cost ($000s)
$200 $240
Total Cost ($000s) $400 $440
ATC per game $0.40 $0.37
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Video Games – Higher Fixed Cost
Nintendo Playstation
Annual Production (000s)
1,000 1,200
Fixed Cost ($000s) $10,000 $10,000
Variable Cost ($000s)
$200 $240
Total Cost ($000s) $10,200 $10,240
ATC per game $10.20 $8.53
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Video Games – Different Production Levels
Nintendo Playstation
Annual Production (000s)
500 1,700
Fixed Cost ($000s) $10,000 $10,000
Variable Cost ($000s)
$100 $340
Total Cost ($000s) $10,100 $10,240
ATC per game $20.20 $6.08
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Intel's Advantage
In 1984, 80 percent of the cost of a computer was in its hardware (which has relatively high marginal cost) The remaining 20 percent was in its software
By 1990 those proportions were reversed Fixed cost now accounts for about 85 percent
of total costs in the computer software industry
Development cost of a new chip $2 billion Marginal cost of making a chip Pennies Dominating the market Priceless!
• Intel supplies more than 80% of the processors for PCs!!!
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Profit Maximization for a Price Setter
Regardless of whether a firm is a price taker or a price setter its basic goal is to maximize its profit
In both cases: The firm expands output as long as the
benefit of doing so exceeds the cost Further, the calculation of marginal cost
is also the same for the monopolist as for the perfectly competitive firm
Difference is in the calculation of the marginal revenue
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Monopolist
Pure monopoly: the only seller of a unique product which has no close substitutes
Like all other firms, a monopolist Maximizes profits Applies the Cost-Benefit Principle
Increase output if marginal benefit > marginal cost Decrease output is marginal benefit < marginal cost
Marginal benefit (marginal revenue) for a monopolist is different than for a perfectly competitor
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Pric
e ($
/uni
t)
Quantity (units/week)
Profit Maximization for the Monopolist
For the monopolist, selling one more unit Decreases market price Reduces marginal revenue by more than the
price Lower price applied to all units
D
2
6
3
5
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Monopolist's Marginal Revenue
Total Revenue
$12
$15
$16
$15
Price Quantity
$6 2
$5 3
$4 4
$3 5
Pric
e &
mar
gina
l rev
enue
($/
unit)
8
8
D
Quantity (units/week)
MR
32
3
1
4-1 5
Marginal Revenue
3
1
-1
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Monopoly Demand and Marginal Revenue
In general, the monopolist's marginal revenue curve Has the same
intercept as demand
Has twice the slope of demand
Lies below demand
Pric
e
Quantity
a
D
Q0Q0/2
a/2
MR
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Deciding Quantity
A monopolist knows his demand and marginal revenue curves
Marginal cost is also known
If he operates at P = $3 and Q = 12, MC > MR Decrease output
If the firm operates at Q = 8, then MC = MR = 2 The demand curve sets
the price, P = $8 At any output below 8,
MC < MR
Pric
e ($
/uni
t of o
utpu
t)
Quantity (units/week)
3
MC
2
6
D
12
MR
4
8
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Does being a Monopolist Guarantee Profits?
Being a monopolist does not guarantee positive profits The question comes down to:
At MR = MC, is the P larger or smaller than ATC?
• If P > ATC positive profits• If P < ATC negative profits (losses)
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Monopoly Losses and ProfitsP
rice
($/m
inut
e)
Minutes (millions/day)20
0.12
0.10ATC
Economic loss= $400,000/day
D
0.05 MC
MR
24P
rice
($/m
inut
e)
Minutes (millions/day)2420
0.08
0.10
ATC
D
0.05 MC
MR
Economic profit= $400,000/day
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The Invisible Hand Fails
Pric
e ($
/uni
t of o
utpu
t)
Quantity (units/week)
The socially optimalamount occurs where
MC = MB, Q = 12 units and P = $3
The monopolist's optimalamount occurs where
MC = MR, Q = 8 units and P = $4
2MR
8
4
24
D
3
12
6 Marginal Cost
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The Invisible Hand Fails
Since the monopolist’s marginal revenue is always less than price, the monopolist’s profit-maximizing output level is always below the socially efficient level
Under perfect competition, by contrast, profit maximization occurs when marginal cost equals the market price (MB = Demand) - the same criterion that must be satisfied for social efficiency This difference explains why the invisible
hand of the market is less evident in monopoly markets than in perfectly competitive markets
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The Invisible Hand Fails
The source of inefficiency in monopoly markets is the fact that the benefit to the monopolist of expanding output is less than the corresponding benefit to society MR < MB = Demand
From the monopolist’s point of view, the price reduction the firm must grant existing buyers to expand output is a loss
From the point of view of those buyers, each dollar of price reduction is a gain—one dollar more in their pockets
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Monopoly and Perfect Competition
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Managing Monopoly
Monopolies exist for economic reasons Patents, copyrights and innovation Economies of scale Network economies
Anti-trust laws attempt to limit deadweight loss Limiting monopolies has costs
Patents encourage innovation Economies of scale minimize ATC Network economies increase benefits
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Price Discrimination
Price discrimination means charging different buyers different prices for essentially the same good or service Separate the groups No side trades among buyers
Many forms of price discrimination Perfect discrimination: negotiate
separate deals with each customer Hurdle method: discounts for identifiable
groups (e. g., students, senior citizens)
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Price Discrimination
Whenever a firm offers a discount, the goal is to target that discount to buyers who would not purchase the product without it People with low incomes generally have
lower reservation prices for museum tickets than people with high incomes
Because students generally have lower disposable incomes than working adults, museum owners can expand their visitors by charging lower prices to students than to adults
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Carla the Editor: Example
Carla is a teaching assistant supplementing her income by editing term papers for undergraduates
There are eight students per week (A,B,C,D,E,F,G and H) for whom she might edit, each with a different reservation price
If the opportunity cost of her time to edit each paper is $29 (also equal to her MC) and she must charge the same price to each student (no price discrimination) How many papers should she edit?
How much economic profit will she make? How much accounting profit?
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Carla the Editor
Opportunity cost of Carla's time is $29Student
Reservation Price
A $40 B 38C 36D 34E 32F 30G 28H 26
Total Revenue
$40 $76 $108 $136 $160 $180 $196 $208
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Carla the Editor
Opportunity cost of Carla's time is $29Student
Reservation Price
A $40 B 38C 36D 34E 32F 30G 28H 26
MR
$40 $36 $32 $28 $24 $20 $16 $12
Total Revenue
$40 $76 $108 $136 $160 $180 $196 $208
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Carla the Editor: Ordinary Monopolist
Carla is a profit maximizer Carla should keep expanding the number
of students she serves as long as her MR exceeds the opportunity cost of her time (MC)
Carla should stop at 3 papers since MR = 32 > MC = 29
Total opportunity cost = 3 * 29 = $87 Economic profit = 108 – 87 = $21 Accounting profit = $108 (since no explicit
costs) = TR
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Carla the Editor: Social Optimum
What is the socially efficient number of papers for Carla to edit? Students A to F are willing to pay more than
her opportunity cost ($29) Students G and H are unwilling to pay at least
$29 Socially efficient outcome is to edit 6 papers To be able to achieve that she has to charge
a price no higher to $30 (the lowest willing price, here of student F)
TR = 6 * 30 = $180 and Opportunity Cost = 6 * 29 = $174 Economic profit = $6
Accounting profit = TR = $180
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Carla the Editor: Price Discrimination
Opportunity cost of Carla's time is $29Student
Reservation Price
A $40 B 38C 36D 34E 32F 30G 28H 26
Total Revenue
$40 $78 $114 $148 $180 $210 $238 $264
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Carla the Editor: Price Discrimination
What if Carla knew exactly the reservation price of each student? How many papers should she edit, and how much economic and accounting profit will she make? She will edit papers for students A to F again But this time charge each their reservation
price Carla is a perfectly discriminating monopolist
TR = 40 + 38 + 36 + 34 + 32 + 30 = $210 Opportunity cost = 6 * 29 = $174 Economic profit = $36
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Carla the Editor: Price Discrimination
Notice that the profit-maximizing level of output under perfect price discrimination was exactly the same as the socially efficient level of output
With a perfectly discriminating monopoly, there is no loss of efficiency
Note that although total economic surplus is maximized by a perfectly discriminating monopolist, consumers would have little reason to celebrate Consumer surplus is exactly zero for the perfectly
discriminating monopolist Total economic surplus and producer surplus are
one and the same
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Carla the Editor: Price Discrimination
In practice, of course, perfect price discrimination can never occur because no seller knows each and every buyer’s precise reservation price
Also in many markets the seller could not prevent buyers who bought at low prices from reselling to other buyers at higher prices, capturing some of the seller’s business in the process
In general imperfect price discrimination is more prevalent Imperfect price discrimination: at least some
buyers are charged less than their reservation prices
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Carla the Editor: Price Discrimination
The profit-maximizing seller’s goal is to charge each buyer the highest price that buyer is willing to pay Two primary obstacles prevent sellers from
achieving this goal First, sellers don’t know exactly how much each
buyer is willing to pay Second, they need some means of excluding
those who are willing to pay a high price from buying at a low price
One way is to follow the hurdle method of price discrimination
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Hurdle Method of Price Discrimination
The hurdle method of price discrimination is the practice of offering a discount to all buyers who overcome some obstacle
Hard cover and paperback books Commercial air carriers Temporary sales
A perfect hurdle is one that separates buyers precisely according to their reservation prices
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Carla the Editor: Price Discrimination
Carla offers a rebate coupon that gives a discount to any student who takes the trouble to mail it back to her Suppose further that students whose
reservation prices are at least $36 never mail in the rebate coupons
Those whose reservation prices are below $36 always do so
What should her list price be, and what amount should she offer as a rebate? Will her economic profit be larger or smaller than when she lacked the discount option?
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Carla Offers a Rebate
If reservation price < $36, mail in rebateStudent
Reservation Price
Total Revenue
A $40 $40
B 38 76
C 36 108
Discounted Price Submarket
D $34 $34
E 32 64
F 30 90
G 28 112
H 26 130
MR
$40
36
32
$34
30
26
22
18
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Carla the Editor: Price Discrimination
Carla will divide the market into two groups and act as an ordinary monopolist compare MR and MC 1st group = list price submarket: A,B and C
Charge $36 and serve all three students 2nd group = discount price submarket: D,E,F,G
and H Charge $32 and serve D and E only (discount = $4)
Combined TR from both submarkets = 3 * 36 + 2 * 32 = $172
Opportunity cost = 5 * 29 = $145Economic profit = 172 – 145 = $27
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Carla's Choices
Program Social
Optimum
Papers Edited 6
Price $30
Total Revenue $180
Carla's Time $174
Economic Profit $6
Total Surplus $26
Hurdle
5 = (3 + 2)
$36, $4 rebate
$172
$145
$27
$35
Perfect Discriminator
6
Reservation
$210
$174
$36
$36
Single Price
3
$36
$108
$87
$21
$27
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56
Is Price Discrimination a Bad Thing?
Although we might think so, but it is not necessary
Total surplus was actually enhanced by the monopolist’s use of the hurdle method of price discrimination TS = CS+PS
CS = reservation price minus price actually paid PS = charged price minus reservation price ($29)
Ordinary monopoly: TS = $27 CS = 4 + 2 + 0 = $6 ; PS = 3(36 – 29) = $21
Hurdle price discriminate: TS = $35 CS = 4 + 2 + 0 + 2 + 0 = $8; PS = 3(36 – 29) + 2(32 –
29) = $27
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Monopoly and Public Policy
Monopoly is problematic: Loss in efficiency associated with
restricted output Monopolist earns an economic profit at
the buyer’s expenseGoal of people is to control monopolies
Policy options Government ownership and operation Regulation Competitive bids for natural monopoly services Break up
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State-Owned Natural Monopoly
Marginal cost is always less than average cost Marginal cost pricing produces losses
Options Fund losses from tax revenues Fixed monthly fee plus usage fee
Fixed fee covers losses
Limited incentives to innovate and cut costs
Commonly used for water, Post Office and electricity
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Regulated Monopolies
Cost-plus regulation sets price at per unit explicit costs plus a mark-up for implicit costs
Used for electricity, telephone and cable Policies vary by state
Disadvantages High administrative cost Reduced incentive for cost-saving
innovation Price is greater than marginal cost
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Bid for Contract
Government awards contract to low bidder for natural monopoly services Garbage collection, fire protection, road
construction, Department of DefenseCould achieve marginal cost pricing IF
government pays the resulting lossesAsset transfer for large fixed
investment is complex
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Anti-Trust Laws
Two landmark laws Sherman Act of 1890
Declared conspiracy to create a monopoly illegal
Clayton Act of 1914 Outlawed transactions that would
"substantially lessen competition"
Applies to mergers and acquisitions today IBM avoided break-up; AT&T did not Microsoft survived
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Another Policy Option: Ignore Monopoly
Two objections to monopolies Restrict output, decrease total surplus Raise price, earn economic profits
Analysis Discount offers allow some customers to
pay less than average cost, though more than marginal cost
Economic profits generated by customers who pay list price – their choice
About two-thirds of economic profits are taxed away
Remainder accrues to shareholders
Chapter 9 Appendix
The Algebra of Monopoly Maximization
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From Demand to Marginal Revenue
Given a demand curve such as P = 15 – 2 Q
We can write the marginal revenue curve as
MR = 15 – 4 QSuppose marginal cost is a line with zero
intercept and a slope of 1MC = Q
The remaining step is to set marginal revenue equal to marginal cost
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MR = MC
Let Q* be the profit maximizing level of output
MC = MRQ* = 15 – 4 Q*5 Q* = 15Q* = 3
To find P, substitute Q = 3 into the demand equation
P = 15 – 4 Q*
P = 15 – 4 (3)
P = 3