Intermediate Microeconomics - Purdue Universitybvankamm/Files/340 Notes/ECON 301 Notes 10 -...
Transcript of Intermediate Microeconomics - Purdue Universitybvankamm/Files/340 Notes/ECON 301 Notes 10 -...
Intermediate Microeconomics
MONOPOLYBEN VAN KAMMEN, PHDPURDUE UNIVERSITY
Price makingA monopoly seller in a goods market is the conceptual opposite from perfectly competitive firms.ā¦ The monopolist does not face competition from other
firms because he is the only seller.ā¦ He is still constrained in his behavior, however, by
consumersā willingness to pay for his output, i.e., by the demand curve.
A monopolist faces the entire market demand for his good, though, so when he chooses an output level, he implicitly determines the price.ā¦ Thus the term āprice makerā.
Competitive firmās demand curve
Monopolistās demand curve
Total revenueCompetitive firms get the same price for all units sold, so: šššš = ššššā.If a monopolist wants to sell more, he has to cut the price on all units sold.
TR is still equal to ššššā, but P* is now a function of Q.ā¦ Note: Q as market quantity as distinct from q for firmās quantity.
Specifically the demand curve tells you P* as a function of Q.
ExampleSay that market demand is given by:
šš = 10 ā1
20šš
2
. . . and the inverse demand you see on Marshallās diagram: šš =200ā 20šš
12.
šššš = šššš, where P is given by the inverse demand function.
šššš = šš 200 ā 20šš12 .
šššš = 200ššā 20šš32.
Taking the partial derivative to get MR:
šššš = 200 ā 30šš12.
MR is below the price
q*
The product rule in calculusThe basic reason that šššš < šš for a firm facing downward-sloping demand has to do with the product rule in calculus.
The product rule is as follows: when you multiply two functions of the same variable together, the differential of the product is:
ā(š„š„) ā” šš(š„š„) ā šš(š„š„)ššāššš„š„
= šš š„š„ ļ潚šššššš„š„
+ šš š„š„ ļ潚šššššš„š„
The product rule in calculusSo if šš(šš) = šš, and šš(šš) = [š¼š¼š¼š¼š¼š¼š¼š¼š¼š¼š¼š¼š¼š¼ š·š·š¼š¼š·š·š·š·š¼š¼š·š·] = šš(šš),
šššš = šš šš ā šš šš , and
šššš =ššāšššš
= šš šš ļ潚ššššššš
+ šš šš ļ潚ššššššš
.
The first term in MR is the quantity effect that comes from selling an additional unit. The second term is the price effect that comes from cutting the price in order to sell the extra unit.ā¦ Since Demand curves slope downward,
šššššššš
is negative, so the price effect has to be negative.
The difference between monopoly and competition
Perfect Competition is like having a price effect that equals zero. If āg/āq = 0 (no price effect), the 2nd term in the MR drops out, and you have only a quantity effect:
MR = (āf/āq)g(q) + 0 = 1*g(q).
Since g(q) is the inverse demand curve, g(q) gives the market price, so MR = 1*P . . . MR = P.In almost any other scenario, however, there is a negative price effect from increasing output.ā¦ This is particularly true of monopolies.
MC Intersects MR at Q*
A monopolist chooses optimal output the same, though, finding where MC=MR.
Monopoly price exceeds MC
P*
MC = MR dictates the optimal Q, but the monopolist would be foolish not to āmark upā its output by charging consumers the price from the demand curve.
Monopoly profitsThe result of the monopolistās profit maximizing Q is that its output gets āmarked upā beyond its marginal cost.ā¦ The monopolist makes a profit of (šš ā š“š“š“š“) per unit, and a total
profit: Ī = šš(šš ā š“š“š“š“).ā¦ If the monopolist has constant marginal cost, as in the previous
graph, AC = MC, so Ī = šš(šš āššš“š“).Since no firms enter the market to compete them away, the monopoly profits persist even in the long run.
Example (continued)The previous graph contains the MR and Demand curves from the example.ā¦ In the graph I have set the MC to a constant ($120).
To solve for optimal Q, set šššš = 120 and solve for Q: 120 = 200 ā 30šš
12 ā 80 = 30šš
12
83
= šš12 ā ššā =
649
= 719
.
To solve for the Price, substitute Q* into the inverse Demand:
šš = 200 ā 20649
12ā ššā = $146.67.
Ī = šš ššāš“š“š“š“ = (146.67 ā 120) ā649
= $189.63.
Efficiency loss from monopolyMonopolies create an efficiency loss because they charge a price greater than the marginal cost. ā¦ This is good for the monopolist because they get profits, and itās bad
for consumers because they pay higher prices and do not get to enjoy as much of the good.
ā¦ But the welfare loss to consumers is larger than the gain to monopolist, so the net effect is negative for welfare.
The lost welfare is called a deadweight loss.
Why do monopolies arise?There are several reasons monopolies arise, but they can be grouped into two categories:
1. Net welfare improving.2. Net welfare damaging.
Both can be broken down further into two sub categories: natural monopoly and legal monopoly.
In any case the general explanation for a monopoly is a barrier to entry. Any market can be monopolized if an effective barrier to prevent competition is erected.
Natural barriers to entryNew firms could be prevented from entering a market because the cost would be prohibitive.
Some cost functions prohibit more than one firm from operating profitably in a market.ā¦ Specifically when there are very large sunk costs and low marginal
cost, natural monopolies are common.
A natural monopoly
Market with one seller. Monopolist maximizes profits.Q*
P*
If a 2nd seller enters, demand is split between them
Pink Curves are the firmsā individual demand curves.
Losses after entry
Q*
š“š“š“š“ > šš at ššā
If the market is split between 2 firms, neither can make a profit.
Reasoning: natural monopolySince both firms incur the large fixed costs and face a lower price than the monopoly did, neither can make a profit.ā¦ So eventually at least one will go out of business.ā¦ Then the market will go back to being a monopoly, hence, its natural
state is monopoly.
āUnā natural monopolyEvery firm would love to eliminate its competitors, increase its market power, and earn monopoly profits.Consequently we often see attempts to create artificial barriers to entry that raise competitorsā costs and keep them out of a market.The most conspicuous example of this is the creation of a legal monopoly.ā¦ A legal barrier to entry consists of an enforced penalty for competing
with the existing firm in a market.
But the idea of government granting monopoly powers by punishing competitors sounds like unfair favoritism to most people.ā¦ So the firms seeking such legal protection have to create a
justification for their greed.
Artificial monopolyA common device for creating a legal monopoly is a licensure requirement.Combine it with a penalty for operating without a license and you have a legal monopoly for the license holder.The justification for the license? Thatās where they have to get a little creative.ā¦ If they can convince the public that the licensure scheme is to
protect consumers, that will usually appease them.ā¦ E.g., convince Congress that unlicensed hair dressers are the biggest
threat to consumer safety since the Corvair, and they might support a licensure regulation that āprotectsā consumers from this peril.
Legal barriers to entryMany licensure requirements may genuinely make goods or services safer by excluding scammers and quacks (think about Doctor Nick Riviera on The Simpsons, for example) from the market.ā¦ But it is equally sure that many such requirements and regulations
are spurious. Instead many are thinly veiled attempts by existing firms to keep out competition and make monopoly profits.
In contrast there is another class of legal monopolies that includes some of the most efficient monopolies in existence: the patent system.
Patents, copyrights, and trademarksThis system of legal barriers is considered one of the most valuable for improving welfare. Inventors engage in expensive and time-consuming research to develop new products.ā¦ They would be much less inclined to do so if, upon discovery,
everyone could simply copy their technology and compete their profits away.
As an incentive for research and development, the patent system grants temporary monopolies to the discoverers of new inventions as a reward.
This increases the overall pace of technological advancement and income growth in the economy.
Regulating natural monopoliesFor legal monopolies, the critical question for economic efficiency is: whether to grant them or not?
For a natural monopoly, the monopolistās incentives still create a deadweight loss that regulations could mitigate.
The basic problem is that monopolists charge too high a price and produce too little output.
RegulationsIf the price were restricted to the marginal cost, consumers would be happy, but for a natural monopoly this would drive them out of business.ā¦ Since MC<AC for the natural monopolist, this would force him to sell
below AC and incur losses.
A common solution for this is to allow the monopolist to mark up the output he sells to some consumers but make him sell to other consumers at a low price.ā¦ Particularly they let him charge a high price to āinelasticā demanders
and make him charge a low price to āmarginalā or āelasticā demanders. This enables the monopolist to stay in business andproduce a more efficient level of output.
Market segmentation
šš1 = ššš“š“
šš2 > ššš“š“
If inelastic consumers can be segregated from inelastic ones, the monopolist can offset losses from elastic consumers with profits from inelastic consumers.
Price discriminationThe regulation policy in which the monopolist charges different groups of consumers different prices is an example of price discrimination.
So far we have confined ourselves to talking about firms that charge the same price to all consumers.
If a firm with market power (like a monopolist) can tell consumers apart on the basis of their willingness to pay, it has an incentive to price discriminate.
Perfect price discriminationThe demand curve reveals each consumersā willingness to pay for a good.ā¦ But not which consumers have high willingness and which have low
willingness to pay.ā¦ If the seller is confident that side transactions will not be made
between consumers with different valuations, he will attempt to charge the high-valuing consumer a higher price and the low-valuing consumer a lower price (as long as itās above MC).
If the seller knew every consumerās willingness to pay, he could charge each of them that full amountā¦ Thereby getting all the consumer surplus for himself as
monopoly profit.
No DWL for perfect price discriminationIronically if a monopolist could perfectly price discriminate, he would not create a deadweight loss.ā¦ Instead of excluding consumers that would pay more than the
marginal cost, he can now sell to them and make a profit. This gets rid of the deadweight loss from a single-price monopolist.
ā¦ Even if perfect price discrimination may be more efficient in an overall sense, there may be objections because all the āsurplusā is in the hands of the monopolist.
SummaryMonopolies exist because there is are barriers to entry in some markets.ā¦ Since competition is prevented either by law or by production
characteristics, there is only one seller in a monopoly market.
Monopolists follow the same objective of profit maximization that competitive firms do.ā¦ The primary difference is that a monopolistās demand curve is the
whole market demandāand is consequently downward sloping.ā¦ MR < P.
SummaryMonopolies earn profits that do not get competed away in the long run.They create a deadweight loss (and efficiency loss) by raising the price above MC and restricting output.Competitive firms have an incentive to try to establish spurious barriers to entry to protect their own profits.Some legal barriers to entry are welfare improving because they encourage research and development.
SummaryIf a monopolist can identify consumersā willingness to pay and prevent secondary transactions, it can price discriminate.ā¦ Charge each consumer a different price based on his willingness to
pay.
Market segmentation is an example of price discrimination in which the monopolist charges different prices to elastic and inelastic demanders.ā¦ Deliberate market segmentation is a method for regulating natural
monopolies to get their markets to be more efficient.
ConclusionMonopoly and perfect competition are two extreme market structures.
Most real markets are neither monopolized nor perfectly competitive and have features of both.
The last market structure we will examine is imperfect competitionā¦ A case in which a small number of firms interact strategically
by influencing (and being influenced by) the othersā decisions.