Chapter 8 McGraw-Hill/Irwinpeople.tamu.edu/~aglass/econ202/Chap008Lecture.pdf · 2016-08-05 · –...
Transcript of Chapter 8 McGraw-Hill/Irwinpeople.tamu.edu/~aglass/econ202/Chap008Lecture.pdf · 2016-08-05 · –...
08/26/2013
1
Monopoly, Oligopoly, and Monopolistic Competition
Chapter 8
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
8-2
Learning Objectives1. Distinguish among three types of imperfectly
competitive industries and describe how imperfect competition differs from perfect competition
2. Identify the five sources of monopoly power and describe why economies of scale are the most enduring of the various sources of market power
3. Apply the concepts of marginal cost and marginal revenue to find the output and price that maximizes a monopolist's profits
4. Explain why the profit-maximizing output level for a monopolist is too small from society's perspective
5. Discuss why firms offer discounts to buyers who are willing to jump a hurdle
6. Discuss public policies that are often applied to natural monopolies
08/26/2013
2
8-3
Imperfect Competition
• Imperfectly competitive firms have some ability to set their own price: they are price setters– Long-run economic profits possible
– Reduce economic surplus
• Three types: 1. Monopoly has only one seller, no close
substitutes
2. Monopolistic competition has many firms producing slightly differentiated products that are reasonably close substitutes
3. Oligopoly has a small number of large firms producing products that are close substitutes
8-4
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
08/26/2013
3
8-5
Oligopoly
Oligopoly
Number of Firms
Few firms, each large
Price Some flexibility
Entry and Exit
Difficult
ProductDifferentiated or
standardized
Economic Profits
Possible
DecisionsP, Q, differentiation,
advertising
Perfect Competition
Many firms
Price taker
Free
Standardized
Zero in long run
Q only
8-6
Imperfect Competition
• Examples of monopoly– Electricity and Magic Cards
• Examples of monopolistic competition– Retail gas stations
– Convenience stores
• Examples of oligopoly– Wireless phone service
– Cement
– Automobiles and tobacco
08/26/2013
4
8-7
The Essential Difference• Market power is the firm's ability to raise its price
without losing all its sales
• Any firm facing a downward sloping demand curve
– Firm picks P and Q on the demand curve
• Market power comes from factors that limit competition
Quantity
Pri
ce
Imperfectly Competitive Firm
D
Quantity
Pri
ce
Perfectly Competitive Firm
D
8-8
Five Sources of Market Power
1. Exclusive control over inputs
2. Patents and copyrights
3. Government licenses or franchises
4. Economies of scale (natural monopolies)
5. Network economies
08/26/2013
5
8-9
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
8-10
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
– Telephones
– Windows operating system
– eBay
– Facebook and MySpace
08/26/2013
6
8-11
Economies of Scale and Start-Up Costs
• New products can have a large fixed development cost
• Variable cost: sum of payments made to the variable factors, such as labor
• Fixed cost: sum of payments made to the fixed factors, such as capital
• Start-up costs can be thought of as a fixed cost
• Average total cost (ATC): total cost divided by output
• A good whose production has a large start-up cost and low variable cost is subject to economies of scale
– ATC declines sharply as output increases
8-12
Economies of Scale and Start-Up Costs
• Consider an example:
• Assume marginal cost (M) is constant
• Variable cost is M*Q
• 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
– Average fixed cost = F/Q
08/26/2013
7
8-13
Economies of Scale
Quantity
Tota
l cos
t ($/
year
)
F
TC = F + M Q
Ave
rage
cos
t ($/
unit)
Quantity
ATC = F/Q + M
M
8-14
Example: Video Game Producers – 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
08/26/2013
8
8-15
Example: Video Game Producers – 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
8-16
Example: Video Game Producers – 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
08/26/2013
9
8-17
Example: Video Game Producers –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
8-18
Intel's Advantage
• Development cost of a new chip $2 billion
• Marginal cost of making a chip Pennies
• Dominating the market Priceless
• Intel supplies more than 80% of the processors for PCs
08/26/2013
10
8-19
Profit Maximization for the Monopolist
• Like all other firms, a monopolist:– Maximizes profits
– Applies the Cost-Benefit Principle:• Increase output if marginal benefit > marginal cost
• Decrease output is marginal benefit < marginal cost
• Marginal benefit is called marginal revenue:– Change in total revenue from a one-unit change in
output
– Equal to price for the perfectly competitive firm
– Less than price for the monopolist
8-20
Pric
e ($
/uni
t)
Quantity (units/week)
Profit Maximization for the Monopolist
• To sell another unit the monopolist must lower price– Total revenue from 2 units = $12
– Total revenue from 3 units = $15
• Marginal revenue = $3
D
2
6
3
5
08/26/2013
11
8-21
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
8-22
Monopoly Demand and Marginal Revenue
• The monopolist's marginal revenue curve:– Has the same
intercept as the straight-line demand curve
– Has twice the slope of the demand curve
– Lies below the demand curve
Pri
ce
Quantity
a
D
Q0Q0/2
a/2
MR
08/26/2013
12
8-23
Deciding Quantity
• Profit is maximized at the level of output where marginal cost equals marginal revenue
• At P = $3 and Q = 12,
MC > MR• Decrease output
– At Q = 8, MC = MR = 2
• The demand curve sets the price at P = $4
– At any output below 8, MC < MR
Pric
e ($
/uni
t of
out
put)
Quantity (units/week)
3
MC
2
6
D
12
MR
4
8
8-24
Monopoly Profit
• Profit = Total revenue – total cost
• Total cost = ATC x Q
• Profit = P x Q – ATC x Q
• Profit = (P-ATC) x Q
• If P > ATC then the firm earns a profit
• If P < ATC then the firm suffers a loss
• This can be graphically illustrated
08/26/2013
13
8-25
Monopoly Losses and ProfitsP
rice
($/m
inut
e)
Minutes (millions/day)20
0.12
0.10ATC
Economic loss= $400,000/day
D
0.05 MC
MR
24
Pric
e ($
/min
ute)
Minutes (millions/day)
2420
0.08
0.10
ATC
D
0.05 MC
MR
Economic profit= $400,000/day
8-26
The Invisible Hand Fails
Pric
e ($
/uni
t of
out
put)
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
Deadweight loss from monopoly = $4
08/26/2013
14
8-27
Monopoly and Perfect Competition
Monopoly
MC = MR
P >MR
P > MC
Deadweight Loss
Perfect Competition
MC = MR
P = MR
P = MC
No Deadweight Loss
8-28
Managing Monopoly: The Breakdown of the Invisible Hand• Monopolies exist for economic reasons
– Patents, copyrights, and innovation
– Economies of scale
– Network economies
• Anti-trust laws attempt to limit deadweight loss– Limiting monopoly has costs
• Patents encourage innovation
• Economies of scale minimize ATC
• Network economies increase benefits
08/26/2013
15
8-29
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– Hurdle method: discounts for identifiable groups
(e. g., students, AARP)
– Perfect discrimination: negotiate separate deals with each customer
8-30
Carla the Editor: Social Optimum
• Opportunity cost of Carla's time is $29
What is the social optimum?
What if Carla is a profit maximizer? What is Carla's total revenue?
Student Reservation
Price A $40 B 38C 36D 34E 32F 30G 28
Total Revenue
$40 $76
$108 $136 $160 $180 $196
6 papers with an economic profit of $6
08/26/2013
16
8-31
Carla the Editor: Marginal Revenue
• Opportunity cost of Carla's time is $29
What is Carla's marginal revenue?
Student Reservation
Price A $40 B 38C 36D 34E 32F 30G 28
MR
$40 $36 $32 $28 $24 $20 $16
Total Revenue
$40 $76
$108 $136 $160 $180 $196
3 papers with an economic profit of $21
8-32
Carla the Editor: Price Discriminator
• Opportunity cost of Carla's time is $29
What if Carla is a perfect price discriminator?
What is Carla's total revenue?
Student Reservation
Price A $40 B 38C 36D 34E 32F 30G 28
Total Revenue
$40 $78 $114 $148 $180 $210 $238
6 papers with an economicprofit of $36
08/26/2013
17
8-33
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.– Temporary sales
– Hard cover and paperback books
– Multiple car models from one manufacturer
– Commercial air carriers
– Movie producers and phased releases
– Scratch and Dent appliance sales
8-34
Carla Offers a Rebate
• If reservation price < $36, student will mail in rebate
StudentReservation
PriceTotal
Revenue
A $40 $40
B 38 76
C 36 108
Discounted Price Submarket
D $34 $34
E 32 64
F 30 90
MR
$40
36
32
$34
30
26
5 papers, price $36, rebate $4, economic profit $27
08/26/2013
18
8-35
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
8-36
Monopoly and Public Policy
• Challenge: create the greatest increase in total surplus
• Policy options– Government ownership and operation
– Regulation
– Competitive bids for natural monopoly services
– Break up
08/26/2013
19
8-37
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 some electricity
8-38
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
08/26/2013
20
8-39
Exclusive Contracting for Natural Monopolies
• Government awards contract to low bidder for natural monopoly services– Garbage collection, fire protection, road construction,
Department of Defense
• Could achieve marginal cost pricing IF government pays the resulting losses
• Asset transfer for large fixed investment is complex
8-40
Enforcement of 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
08/26/2013
21
8-41
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
8-42
Imperfect Competition
Imperfect Competition
Monopolistic Competition and Oligopoly
Sources of Market Power
Monopoly
Public Policy
08/26/2013
22
Chapter 8 Appendix
The Algebra of Monopoly Maximization
8-44
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 Q• Suppose marginal cost is a line with zero intercept
and a slope of 1
MC = Q
• The remaining step is to set marginal revenue
equal to marginal cost
08/26/2013
23
8-45
MR = MC
• Let Q* be the profit maximizing level of outputMC = MR
Q* = 15 – 4 Q*
5 Q* = 15
Q* = 3
• To find P, substitute Q = 3 into the demand equation
P = 15 – 4 Q*
P = 15 – 4 (3)P = 3