Economics - Monopolist

8/8/2019 Economics - Monopolist

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Chapter 9. Profit

Maximization by aMonopolist

OPEC and Output Quotas

The Organization of the Petroleum Export-

ing Countries (OPEC) regularly have meet-ings to restrict their output and allocate quo-

tas among member nations. For example, in

1982,

OPEC set an overall output limit of 18million barrels per day, down from 31 mil-

lion barrels per day in 1979.

Each member nation had an individual

production quota.

Saudi Arabia adjusted its output to main-

tain oil price at $34 per barrel.


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The average cost per barrel is about $2$4 among member nations.

The current oil price is ? . The most re-

cent production allocation can be found

on OPECs website.

Why would OPEC restrict its output? How

would the restriction in output affect oil prices?

How would OPEC choose output?

How would output restriction affect various

countries, including oil importing countries

(e.g., U.S.), and exporting countries (e.g.,

Saudi Arabia vs. Russia)?


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1. Profit Maximization by aMonopolist

Monopoly is the industry structure when thereis only one firm in the industry the oppo-site to perfect competition. We call this firmthe monopolist.

A firm in perfectly competitive markets hasa negligible impact on the market price andthus takes the price as given. By contrast,a monopolist sets the market price for itsproduct.

In doing so, the monopolist must take ac-count of the market demand. The higher itsets its price, the fewer units it will sell. Themonopolists demand curve is the market de-mand curve. See Figure 9.1.

The profit-maximizing monopolists problem

is to find the optimal trade-off between vol-ume (the number of units it sells) and margin(the difference between price and marginalcost).


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Figure 9.1 The Monopolists DemandCurve Is the Market Demand Curve


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A Monopolist Does Not Have a Sup-

ply Curve

A perfectly competitive firm takes the mar-

ket price as given and chooses a profit-maximizing

quantity. The resulting s(p) is the firms sup-

ply curve.

However, for a monopolist, there is no such

thing as given market price, since how much

output the monopoly produces will affect the

market price.

As a result, the firm can choose either price

or output. But it does not have the freedom

to choose both at the same time.

For example, if monopolist chooses price,

then consumers decide how much they are

willing to buy at this price, and the monop-

olist should supply this much.


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The Profit-Maximization Condition

Suppose a monopolist faces the demand

p = 12 Q,

where Q is measured in millions of ounces,

and p in dollar per ounce. To sell more, themonopolist has to cut its price.

Monopolists total revenue is

T R = pQ = (12Q)Q = 12Q Q2.

The monopolists cost function is

T C =1

2Q2.

Figure 9.2(a) illustrates total revenue (T R),total cost (T C) and profit graphically.


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Figure 9.2 Profit Maximization by aMonopolist


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We can find thatT C

always increases withQ, T R and profit first rises as Q increases

but then falls.

Profit is maximized at the peak of the profit

hill, which occurs at Q = 4 million.

For quantities less than Q = 4 million, in-

creasing Q increases T R more than it in-

creases T C, which moves the firm up its

profit hill.

As Figure 9.2(b) shows, when Q < 4 mil-

lion, the monopolists marginal revenue ex-

ceeds its marginal cost (M R > M C ).

For Q > 4 million, producing less output in-

creases its profit, as now M R < M C .


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A Closer Look at Marginal Revenue

In the case of perfect competition, M R = p.

However, for a monopolist, M R = p. In fact,

if Q > 0, we have M R < p. To see why,

consider the following example.

Q = 1, p = $4, T R = $4.

Q = 2, p = $3 (price reduction applies to

both units of output), T R = $6.

Marginal revenue of the second unit is

$6$4 = $2, which is less than the price

p = $3.

A comparison between perfect competition

and monopoly in terms of marginal revenue

is illustrated in Figure 9.3.


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Price

Price

CompetitiveFirm

Monopolist

Demandfacingfirm

De

mandfacingfirm

0

0P1

C A

B

A

B

Q0

Q0+1

qq+1

Firm

output

Firm

output

Figure9.3

Marginal

Revenue:Competitionvs.Monopoly


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An Example with Linear Demand

Suppose that the monopolist faces a linear

demand curve

p = 12 Q.

The cost function is

c(Q) =1

2Q2 M C = Q.

Derive the monopolists profit-maximizing out-

put, the corresponding price and profit.

Solution: We will go over it in class.

Next, we compare the demand curve with

marginal revenue curve. The demand curvehas the equation

p = 12 Q.


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It can be shown that the marginal revenuehas the equation

M R = 12 2Q.

The two curves are shown in Figure 9.4.

Comparing them, we can find that:

(1) They have the same vertical intercept.

This is because when Q = 0, p = M R = 12.

(2) The horizontal intercept of demand curveis twice that of the M R curve, or M R curve

is twice as steep as the demand curve.

0 = p = 12Q Q = 12 .

0 = M R = 12 2Q Q = 6 .


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Figure 9.4 Demand Curve and MarginalRevenue Curve


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Figure 9.5 Monopoly vs. Competition


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Monopoly Deadweight Loss

How does the difference between the monopoly

and competitive equilibria affect economic

benefits in this market?

From Figure 9.5, the consumer surplus (CS)in monopoly is area A. The monopolists

producer surplus is the accumulation of the

difference between the monopolists price and

its marginal cost. This corresponds to area

B + E + H. Thus the net economic ben-

efit (or social surplus SS) in the monopoly

equilibrium is A + B + E + H.

In the perfectly competitive equilibrium, con-

sumer suplus is area A + B + F. Producer

surplus is area E + G + H. Social surplus isA + B + E + F + G + H.


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The table in Figure 9.5 compares the con-

sumer surplus, producer surplus (profit) and

net economic benefit (social surplus) under

monopoly and perfect competition. It shows

that consumers surplus and social surplus is

higher under perfect competition than monopoly.

The difference is area F + G. This differ-

ence is the deadweight loss (DW L) due to

monopoly.

The DWL arises because the monopolist does

not produce the socially optimal output level.

When 600 < Q < 1000, consumers willing-

ness to pay (social benefit) exceeds firms

marginal cost (social cost), but the monopo-

list chooses not to produce because marginal

revenue (firms benefit) is less than marginalcost (firms cost).


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Example

Consider a market where demand is charac-

terized by p = 2Q. The monopolists cost

function is c(Q) = 12Q2. Then M C = Q.

We want to compare two cases. Case 1

is monopoly. In case 2, the monopolist is

forced to behave competitively (i.e., p =

M C). The two cases are shown in Figure

9.6 and 9.7 respectively. The following ta-

ble summarizes the results. We will go over

the details in class.

Variable Competition Monopoly

Price 1 43Quantity 1 23

Profit 12 1Consumer surplus 12

29

Social surplus 1 89


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Figure 9.6 Monopoly


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Figure 9.7 Monopolist Forced to Behave

Competitively


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Rent-Seeking Activities

Question: Is the DWL listed in Figure 9.5

the true monopoly DWL loss?

Because a monopolist often earns above nor-

mal economic profits, you might expect that

firms would have an incentive to acquire monopoly

power.

For example, during the 1990s, cable televi-

sion companies spent millions lobbying Congressto preserve regulations that limit the ability

of satellite broadcasters to compete with tra-

ditional cable service.

Activities aimed at creating or preserving monopoly

power are called rent-seeking activities.


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Expenditures on rent-seeking activities can

represent an important social cost of monopoly

that the table in Figure 9.5 does not reflect.

What is the maximum amount that a firm is

willing to spend to become such a monopo-list as in Figure 9.5?

Suppose that a competitive firm earns zero

profit, than a firm would be willing to spend

up to B + E+ H to become the monopolist.

The upper bound of social waste of monopoly

is (B+E+H)+(F+G), if all the rent-seeking

activities does not generate any net benefit

to the society.


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3. Why Do Monopoly MarketsExist?

Now we have seen that monopoly equilibrium

can create a deadweight loss. But how do

monopolies arise in the first place?

Natural Monopoly

A market is a natural monopoly if, for rel-

evant output levels, a single firm can sup-

ply the market more efficiently than multiple

firms.

Figure 9.8 shows a natural monopoly market.Suppose that the industry is to supply Q =

9000. If supplied by a single firm, AC = $1.

If supplied equally by two firms, AC = $1.2.

If one firm can serve a market at lower cost

than two or more firms, we would expectthat, without government interference, the

market would eventually become monopo-

lized.


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Figure 9.8 Natural Monopoly Market


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Barriers to Entry

A natural monopoly is an example of a more

general phenomenon known as barriers to entry.

Barriers to entry are factors that allow an in-

cumbent firm to earn positive economic prof-

its, while at the same time making it unprof-

itable for newcomers to enter the industry.

Barriers to entry are essential for a firm to

remain a monopolist. Barriers to entry can

be structural, legal, or strategic.

Structural barriers to entry exist when incum-

bent firms have cost or marketing advan-

tage that would make it unattractive for a

new firm to enter the industry and compete

against them.

We will look at two of such factors.


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(1) Economies of scale.

When new firm enters, each firm (incumbent

and entrant) both have to produce fewer

outputs, and AC would be higher due to

economies of scale, and the market becomesless profitable.

(2) Network externality.

The auction site Ebay is attractive to both

buyers and sellers because of its volume. The

more buyers there are, the more attractive

Ebay is to sellers. More sellers will do busi-

ness on Ebay, making Ebay more attractive

to buyers, in turn luring more buyers there.


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Legal barriers to entry exist when an incum-

bent firm is legally protected against compe-

tition. Patents are an important legal barrier

to entry. Government regulation can also

create legal barriers to entry.

Strategic barriers to entry result when an in-

cumbent firm takes explicit steps to deter

entry.

An example would be the development of

a reputation over time as a firm that will

aggressively defend its market against en-

croachment by new entrants (e.g., by start-

ing a price war if a new firm chooses to come

into the market).


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Summary

In this chapter, we have

Analyzed production and pricing decisionsin a market with a monopolist.

Compared market equilibrium in monopoly

markets and perfectly competitive mar-

kets.

Seen why monopoly markets arise and

explored the notion of barriers to entry.

Economics - Monopolist

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