Chapter 15: Monopoly - University of Minnesota...

Monopolistic Market Monopolistic Pricing Inefficiency Price Discrimination Public Policy

Econ 1023 Introduction to Economics: Micro

Chapter 15: Monopoly

Instructor: Hiroki WatanabeSpring 2013

Watanabe Econ 4935 15 Monopoly 1 / 83


1 Monopolistic Market

2 Monopolistic Pricing

3 Inefficiency of Monopoly

4 Price Discrimination

5 Public Policy

6 Summary



1 Monopolistic MarketQuestionsWhy Monopolies AriesNatural Monopoly




5 Public Policy

6 Summary


Notes

Notes

Notes


Questions

Question 1.1 (Agenda for Chpt 13-17)1 Where does the supply curve come from?2 What do firms do?3 How does the market structure affect the firms’

decision making?

1 Chpt 13: Preparation2 Chpt 14: Deriving the supply curve, perfect

competition3 Chpt 15: Monopoly4 Chpt 17: Oligopoly5 Chpt 16(?): Monopolistic competition



Why Monopolies Aries

Definition 1.2 (Monopolist)

is a firm that is the sole seller of a product without closesubstitutes.

Price setter.Major cause: barriers to entry.




Barriers to entry:1 Government regulation2 Monopoly resources3 The production process


Notes

Notes

Notes



1 Government regulationGovernment gives a single firm the exclusive rightto produce some good or serviceGovernment-created monopoliesPatent and copyright lawsE.g., new drugs, postal services (legal fiat)




2 Monopoly resourcesA key resource required for production is owned bya single firm.E.g., DeBeers, toll highway




3 The production processA single firm can produce output at a lower totalcost than can a larger number of producers.E.g., local utility companies


Notes

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Natural Monopoly

Definition 1.3 (Natuaral Monopoly)

is a monopoly that arises because a single firm cansupply a good or service to an entire market at asmaller cost than could two or more firms.

Increasing returns to scale in a relevant region.



Natural Monopoly

Example 1.4 (Natural Monopoly and IRS)

Suppose production function takes the form

ƒ () = 2.

To produce y = 4, which economy produces withfewer inputs?

1 Jack and Dotcom splitting the production.2 Jack producing all.



Natural Monopoly

0 1.4142 2 2.82840

2

4

Che

esec

akes

y [s

lices

]

Number of Chefs xC [persons]

y=fJ(xC)

y=fD(xC)

0 1.4142 2 2.82840

2

4

Che

esec

akes

y [s

lices

]

Number of Chefs xC [persons]


Notes

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Notes


Natural Monopoly

1 Split: JC =p2, DC =

p2. 2

p2 chefs in total.

2 Single firm: JC = 2(< 2p2).



Natural Monopoly

In natural monopoly,The average number of chefs you need to bake aslice decreases as y increases.Accordingly, the average total cost decreaseswith y.



Natural Monopoly

0 1 2 3 40

0.5

1

1.5

2

2.5

3

3.5

4

Cheesecakes y [slices]

Cos

ts [$

]

TC(y)ATC(y)Co−ProductionSingle−Firm Production

0 1 2 3 40

0.5

1

1.5

2

2.5

3

3.5

4


Cos

ts [$

]


Notes

Notes

Notes



2 Monopolistic PricingMonopolist vs Competitive FirmMonopolistic PricingMR(y) ,MWTP(y)



5 Public Policy

6 Summary



Monopolist vs Competitive Firm

Monopolists face a different demand curve thancompetitive firms do.Optimal pricing rule for competitive firms (c.f.

Proposition 2.2 in Ch 14):

MR(y∗)(= p) = MC(y∗).




Does the same pricing rule (p = MC(y)) still apply toa monopolist?

Example 2.1 (Monopolistic Pricing)

Listen to Marketplace Clip .


Notes

Notes

Notes

http://www.marketplace.org/topics/life/coca-cola-set-raise-prices



0 20 40 60 80 1000

2

4

6

8

10


MC

, MW

TP

[$]

MC(y)Demand the Firm Faces

0 20 40 60 80 1000

2

4

6

8

10


MC

, MW

TP

[$]




0 20 40 60 80 1000

2

4

6

8

10


MC

, MW

TP

[$]

MC(y)Demand the Firm Faces

0 20 40 60 80 1000

2

4

6

8

10


MC

, MW

TP

[$]




1 Monopoly1 price setter2 sole producer3 faces downward sloping demand.

2 Competitive firm1 price taker2 lots of infinitesimally small producers3 faces flat demand curve


Notes

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Notes


Monopolistic Pricing

Definition 2.2 (Competitive Frim’s PMP)

maxyπ(y) = py − TC(y).

Definition 2.3 (Monopolist’s PMP)

maxyπ(y) = MWTP(y)y − TC(y).

Total revenue is not linear for a monopolist.Recall Ch 5 Elasticity:

1 State lawmakers: Increase in revenue because theycan collect larger tax from each tourist.

2 Bill Connors: Reduction in revenue becauseincreased tax reduces the number of tourists.




Example 2.4 (Preview)

Metrolink’s total cost function is given by

TC(y) = y2 + 1,

where y is the # of passengers.Inverse demand for the train service is

MWTP(y) = −y + 12.

1 Competitive firms’ profit: π(y) = 6y − TC(y).2 Monopolist’s profit: π(y) = (−y + 12)y − TC(y).




0 2 4 6 8 100

5

10

15

20

25

30

35

40

Passengers y [people]

TC

, MW

TP

, TR

, π [$

]

TC(y)MWTP(y)TR(y)π(y)

0 2 4 6 8 100

5

10

15

20

25

30

35

40


TC

, MW

TP

, TR

, π [$

]


Notes

Notes

Notes



0 2 4 6 8 100

5

10

15

20

25

30

35

40


TC

, MW

TP

, TR

, π [$

]

TC(y)MWTP(y)TR(y)π(y)

0 2 4 6 8 100

5

10

15

20

25

30

35

40


TC

, MW

TP

, TR

, π [$

]




Different from perfect competition: Total revenue isnot linear.Similar to perfect competition: At the optimal level,additional increase in revenue (MR) is cancelled byadditional decrease in total cost (TC) of the equalsize.




How do monopolists find the optimal output levely∗?


Notes

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Notes



Instead of plugging in random y’s in π(y), we ask:If Jack sells one more slice, does it increasehis profit?

1 If it does, go ahead.2 If it decreases the profit, downsize.3 If it doesn’t change, then that’s the y he’s looking

for.




Change in profit from an additional unit sold hastwo sources:

1 MR(y): additional revenue that the additional unitbrings in (just p in a perfectly competitive market,but not anymore here)

Breaks further down into two components (next slide)2 MC(y): additional cost that the additional unit

inflicts (varies with y)




Monopolists still follow Proposition 2.2 in Ch 14:

Proposition 2.5 (Finding the Optimal ProductionScale)

The output level y∗ that maximizes Jack’s profitsatisfies:

MR(y) = MC(y).

except that MR(y) does not coincide with MWTP(y)anymore.


Notes

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Notes


MR(y) ,MWTP(y)

Two effects by producing one more y:1 ☹ : If Metrolink carries one more passenger, it will

cost them ΔTC(y)Δy = MC(y).

2 ☺ : If Metrolink carries one more passenger, theyget

MR(y) = quantity effect︸︷︷︸

>0

+ price effect︸︷︷︸

<0



MR(y) ,MWTP(y)

Break down the marginal effect of quantity changeover the total revenue:

1 Price-change effect (Bill Connors)☹: the marginal revenue lost by reduced price: haveto sell everything for a dollar less.ΔMWTP(y)

Δy y

2 Quantity-change effect (State lawmakers)☺: the marginal revenue gained by increased output:can sell one more slice.MWTP(y)

1

1Note Metrolink can’t increase output and price at the sametime. Also note that the problem Metrolink faces is PMP, not totalrevenue maximization.



MR(y) ,MWTP(y)

The additional profit is

Δπ(y)Δy = MR(y) − MC(y)

= MWTP(y) + ΔMWTP(y)Δy − MC(y).

At y∗ π(y) does not increase nor decrease

i.e., Δπ(y)Δy = 0.

MR(y∗) = MC(y∗).So, set p = MR(y∗)?


Notes

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Notes


MR(y) ,MWTP(y)

Example 2.6 (Finding the Price)

Metrolink’s marginal revenue (additional revenuefrom one more passenger):

MR(y) = −2y + 12.

Their marginal cost:

MC(y) = 2y

a

aYou’re not responsible for deriving two equations above.

At the optimal level, MR offsets MC:

MR(y) = MC(y).

y∗ = 3.Watanabe Econ 4935 15 Monopoly 34 / 83


MR(y) ,MWTP(y)

0 1 2 3 4 5 6 7 80

1

2

3

4

5

6

7

8

9

10

11

12


MW

TP

, MR

, MC

[$]

MWTP(y)MR(y)MC(y)

0 1 2 3 4 5 6 7 80

1

2

3

4

5

6

7

8

9

10

11

12


MW

TP

, MR

, MC

[$]



MR(y) ,MWTP(y)

The most common mistake:p∗ = MR(y∗ = 3) = 6.If they charge p = 6, demand is 6 rather than 3.Setting MR(y) = MC(y) finds the optimalquantity but not the optimal price.Price corresponds to y∗ = 3 is MWTP(y = 3) = 9.NOT 6. (what is the point of selling tickets for $6when you can sell them for $9 anyway?).


Notes

Notes

Notes


MR(y) ,MWTP(y)

Another common mistake: (y, p) = (4,8) istempting,where marginal cost meets marginal willingness topay.Why does Metrolink choose (y, p) = (3,6) instead?(y, p) = (4,8) ignores Bill Connors’ effect. Confirm:

π(y = 4) = 32 − 17 = 15.π(y∗ = 3) = 27 − 10 = 17(> 15).



MR(y) ,MWTP(y)

Exercise 2.7 (Monopolistic Pricing)

Find Metrolink’s profit maximizing service level (y∗) andcorresponding price (p∗) for the following:

Inverse demand: MWTP(y) = − 12y + 6 withMR(y) = −y + 6.MC(y) = 2.

Steps:1 Use MR(y) = MC(y) to find y∗.2 Plug y∗ in MWTP(y) to find p∗.



MR(y) ,MWTP(y)

0 1 2 3 4 5 6 7 80

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]

MWTP(y)MR(y)MC(y)

0 1 2 3 4 5 6 7 80

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]


Notes

Notes

Notes




3 Inefficiency of MonopolyEfficiency Loss due to Monopolistic Pricing


5 Public Policy

6 Summary



Efficiency Loss due to Monopolistic Pricing

A monopolist sets p higher than their marginal cost.In perfect competition, p is exactly = MC(y).Monopoly sounds good for a producer and bad forconsumers.What is total surplus (social economic welfare)?The allocation is efficient if it achieves themaximum possible social economic welfare.




The first fundamental theorem: When RP(y) meetsMWTP(y), the market outcome is efficient.Monopoly: RP(y) is lower than MWTP(y), i.e., theset price > MC(y).Is a monopolistic market still efficient?


Notes

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Notes



0 1 2 3 4 5 6 7 80

1

2

3

4

5

6

7

8

9

10

11

12


MW

TP

, MR

, MC

[$]

CSPSMWTP(y)MR(y)MC(y)

0 1 2 3 4 5 6 7 80

1

2

3

4

5

6

7

8

9

10

11

12


MW

TP

, MR

, MC

[$]




0 1 2 3 4 5 6 7 80

1

2

3

4

5

6

7

8

9

10

11

12


MW

TP

, MR

, MC

[$]


0 1 2 3 4 5 6 7 80

1

2

3

4

5

6

7

8

9

10

11

12


MW

TP

, MR

, MC

[$]




Due to the price-change effect, the monopolist stopproduceing before y reaches the pointMC(y) = MWTP(y) but rather MC(y) = MR(y).Reduced total surplus as a result.Creates deadweight loss.


Notes

Notes

Notes



Exercise 3.1 (Finding DWL)

For MWTP(y) = −12 y + 6, MR(y) = −y + 6 and MC(y) = 2,find passengers’ surplus, Metrolink’s surplus anddeadweight loss.




0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]

CSMWTP(y)MR(y)MC(y)

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]




0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]


0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]


Notes

Notes

Notes



What can we do about the deadweight loss?1 price discrimination2 government fixes (public policy)






4 Price DiscriminationPrice Discrimination

5 Public Policy

6 Summary



Price Discrimination

Does a monopolist really charge the uniform price?


Notes

Notes

Notes






Definition 4.1 (Price Discrimination)is the business practice of selling the same good atdifferent prices to different customers.

Doesn’t sound fair but it can eliminate the DWL.




Perfect price discrimination:Charge each customer a different priceCharge exactly his or her willingness to pay.The monopolist gets the entire surplus (Profit)No deadweight loss.

How?


Notes

Notes

Notes



Example 4.2 (Perfect Price Discrimination)

Metrolink hasInverse demand: MWTP(y) = − 12y + 6 withMR(y) = −y + 6.MC(y) = 2.

If Metrolink sets the price as p(y) = MWTP(y), what istheir surplus?




0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]

CSMWTP(y)MR(y)MC(y)

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]




0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]


0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]


Notes

Notes

Notes



0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]

PSMWTP(y)MR(y)MC(y)

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

[$]




Why don’t they stop producing at y = 4?




Examples of price discriminationMovie ticketsAirline pricesDiscount couponsFinancial aidQuantity discounts


Notes

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Notes






5 Public PolicyTypes of RegulationsAntitrust LawsPublic OwnershipPrice Regulation

6 SummaryWatanabe Econ 4935 15 Monopoly 61 / 83


Types of Regulations

1 Antitrust laws2 Public Ownership3 Price regulation



Antitrust Laws

Increasing competition with antitrust lawsSherman Antitrust Act, 1890Clayton Antitrust Act, 1914Prevent mergersBreak up companiesPrevent companies from coordinating their activitiesto make markets less competitive


Notes

Notes

Notes


Public Ownership

Private ownersMaximize producer surplus

Public owners (government)Maximize total surplusWeak incentive to minimize costPossible efficiency loss due to inefficient production



Price Regulation

Why don’t we simply ask the firm to produce moreand set the price down to p = MC(y)?We can, but problematic for natural monopoly.



Price Regulation

Example 5.1 (Marginal Cost Pricing)

Consider the following environment:

MWTP(y) = −.5y + 6MR(y) = −y + 6TC(y) = 2y + 6MC(y) = 2.

What happens to the monopolist if the governmentimposes marginal cost pricing?


Notes

Notes

Notes


Price Regulation

Ask Metrolink to serve y = 8 at p = 2.The total surplus will be maximized.



Price Regulation

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

, AT

C [$

]

CSMWTP(y)MR(y)MC(y)ATC(y)

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

, AT

C [$

]



Price Regulation

But then Metrolink will stop its operation in the longrun.Then the whole total surplus will be gone.


Notes

Notes

Notes


Price Regulation

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

, AT

C [$

]

−πMWTP(y)MR(y)MC(y)ATC(y)

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

, AT

C [$

]



Price Regulation

Unfortunately, this result is inevitable.Natural monopoly happens when the firm isoperating in the region where the ATC is decreasing.



Price Regulation

Note that Metrolink does not have to stop itsoperation if there were no government intervention.


Notes

Notes

Notes


Price Regulation

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

, AT

C [$

]

π (Long Run)MWTP(y)MR(y)MC(y)ATC(y)

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

, AT

C [$

]



Price Regulation

1 We don’t want monopolistic pricing (inflictsDWL).

2 We want to but can’t impose marginal costpricing (eliminates DWL but the firm exitseventually).

3 Second best solution: average cost pricing.



Price Regulation

If we impose the price where MWTP(y) = ATC(y),y increases, andπ(y) won’t be negative.DWL still exists but not worse than monopolisticpricing.


Notes

Notes

Notes


Price Regulation

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

, AT

C [$

]

DWLAverted DWLMWTP(y)MR(y)MC(y)ATC(y)

0 1 2 3 4 5 6 7 8 9 100

1

2

3

4

5

6


MW

TP

, MR

, MC

, AT

C [$

]



Price Regulation

y CS PS TS π(y) DWL

Laissez-Faire 4 4 8 12 2 4MC Pricing 8 16 0 16 -6 0AC Pricing 6 9 6 15 0 1



Price Regulation

Discussion 5.2 (Average-Cost Pricing)

Is average cost pricing implementable?

1 Can a government force average cost pricing?2 What’s the long-term effect?


Notes

Notes

Notes


Price Regulation

1 Who would tell the true average cost?2 What’s worse, in the long term, Metrolink won’t get

motivated to reduce its cost (no innovation occurs).







5 Public Policy

6 Summary



Monopolist’s pricing ruleEfficiency lossPrice discriminationPrice regulation


Notes

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Notes


Airline du Jour

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Index

antitrust laws, 63average cost pricing, 74barriers to entry, 6deadweight loss, 45increasing returns to scale,10marginal cost, 29marginal cost pricing, 66,74marginal revenue, 29monopolist, 5monopolistic pricing, 74

natural monopoly, 10, 65perfect pricediscrimination, 54price effect, 31price setter, 5price-change effect, 32profit maximizationproblem, 22public ownership, 64quantity effect, 31quantity-change effect, 32


Notes

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Notes

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