Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 1

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Monopoly and Oligopoly

November 3, 1999

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 2

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Announcements

See web page for all exam information. Please get to exam rooms on time and have

your CU ID ready to show the proctor. For room assignments, see the web page Check the web page over the weekend for

problem set #7 sometime on Sunday, maybe. Otherwise we’ll have it in class on Monday. How are the projects going??????

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 3

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Themes of Today’s Lecture

Monopoly

Oligopoly

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 4

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Monopoly - Structure

single firm no close substitutes barriers to entry full and symmetric

information

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 5

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oSources of Monopoly Entry Barriers

Natural monopoly: the most efficient scale of production is so large, relative to market demand, that a single firm dominates the market.

Patents, copyrights, licenses, franchises: government protection of a firm’s right to produce a unique product.

Economic and/or legal restrictions, strategies or situations that make entry more difficult for new competitors than for the existing monopoly firm.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 6

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o“Other” Monopolies - Good? Bad?

Input Ownership– DeBeer’s and diamonds

Industry Secret or Know-how– IBM and mainframes?

Strategic Behavior– buy ‘em up– blow’ em up– let’s make a deal– Microsoft and operating systems?

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 7

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Caveats

monopoly does not => big big does not => monopoly monopoly does not => absolute and unlimited

control over price monopoly does not => must have economic

profit short run profit does not => monopoly power monopoly does not => badly behaved firm

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 8

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Classic Simple Monopoly

Polar extreme from perfect competition. Monopolist is a “price maker.” Cost curves are pretty much the same

(except in the case of natural monopoly).

The big change from before is in the demand side of the profit function.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 9

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oThe Simple Monopolist - Conduct

The simple monopolist abides by the “law of one price.” Everyone pays the same market price for all units purchased.

A monopolist faces the declining market demand curve for its product and simultaneously chooses price and quantity.

Now P>MR (before P=MR) because the simple monopolist must lower the price on all preceding units to sell an additional unit.

A monopolist has no “supply curve.”

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 10

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oThe Simple Monopolist: Rules for Profit Maximization

Suppose we are in the short run. Rules for profit maximization are the same as

before. If QSM maximizes profit, then

– MR(QSM ) = MC(QSM )» very important note: for a simple monopolist

P>MR at all positive levels of Q.

– QSM is a max and not a min. – at QSM it’s worth operating.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 11

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Simple Monopoly Economic profits equal

total revenue minus total costs.

Marginal revenue is the rate of change of total revenue (just like marginal cost is the rate of change of total cost) as quantity increases.

Economic profits are maximized when marginal revenue equals marginal costs

Monopoly Selling in a Single Market at a Single Price

Quantity

Market Demand

PriceTotal Costs

Marginal Cost

(midpoint formula)

Average Total Cost

Total Revenue

Marginal Revenue (midpoint formula)

Economic Profits

0 100.00 800 0.00 -80010 95.00 1,500 82.50 150.00 950.00 90.00 -55020 90.00 2,450 65.00 122.50 1,800.00 80.00 -65030 85.00 2,800 42.50 93.33 2,550.00 70.00 -25040 80.00 3,300 32.50 82.50 3,200.00 60.00 -10050 75.00 3,450 20.50 69.00 3,750.00 50.00 30060 70.00 3,710 18.50 61.83 4,200.00 40.00 49070 65.00 3,820 9.50 54.57 4,550.00 30.00 73080 60.00 3,900 9.00 48.75 4,800.00 20.00 90090 55.00 4,000 10.00 44.44 4,950.00 10.00 950

100 50.00 4,100 12.50 41.00 5,000.00 0.00 900110 45.00 4,250 17.50 38.64 4,950.00 -10.00 700120 40.00 4,450 20.00 37.08 4,800.00 -20.00 350130 35.00 4,650 25.00 35.77 4,550.00 -30.00 -100140 30.00 4,950 30.00 35.36 4,200.00 -40.00 -750150 25.00 5,250 35.00 35.00 3,750.00 -50.00 -1,500160 20.00 5,650 45.00 35.31 3,200.00 -60.00 -2,450170 15.00 6,150 60.00 36.18 2,550.00 -70.00 -3,600180 10.00 6,850 75.00 38.06 1,800.00 -80.00 -5,050190 5.00 7,650 100.00 40.26 950.00 -90.00 -6,700200 0.00 8,850 44.25 0.00 -8,850

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 12

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oGraphical Display of Monopolist’s Solution

The monopolist sets marginal revenue equal to marginal cost at MR=MC and considers producing Q=90.

The monopolist then gets the price off the demand curve. This implies a market price of $55/unit.

The monopoly profits (light blue in the graph) are the difference between price ($55) and average total cost ($44.44) times the number of units sold.

Notice that our monopolist is a “natural monopoly” since the average total costs decline over the entire relevant range of production.

Notice that if our monopolist operated at the competitive equilibrium (Price=MC=$30, Quantity=140), the firm would make a loss (ATC>Price).

Natural Monopolist's Market

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Market Demand Price

Exact Marginal Revenue

Marginal Cost

Average Total Cost

Monopoly Profits

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 13

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oImplications of the Monopolist’s Profit Maximum

Price will exceed the competitive price. Quantity will be less than the competitive quantity. The monopolist sells the output at a price greater than marginal

costs but the monopoly price can be above or below average total costs. Thus, the monopolist need not always make a profit. In the long run, of course, unprofitable monopolists will either stop production or raise the price further above marginal cost until it covers average total costs.

The monopolist will always try to operate on the elastic portion of the demand curve because when the elasticity of demand is greater than -1 (inelastic, between 0 and 1 in absolute value), marginal revenue is negative and, necessarily, less than marginal cost.

Since there is no entry to consider monopolists can have persistent long run economic profit.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 14

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oSimple Monopoly- Performance

Efficiency:– Is the monopoly equilibrium Pareto Efficient?

That is, at QSM is net social surplus maximized? Does $MB=$MC at QSM?

– Is the monopolist productively efficient? Does the monopolist operate at minimum efficient scale?

Equity: – Is the outcome of monopoly fair? Equitable?

Just?

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 15

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oSimple Monopoly- Performance Answers

The simple monopoly equilibrium is not Pareto Efficient. – The simple monopolist creates “dead-weight-loss.”– At QSM, $MB>$MC . Recall: $MR=$MC at QSM while

$PSM>$MR at all Q. So $PSM>$MC. Since $P=$MB, then $MB>$MC.

The simple monopolist may or may not be productively efficient.

Compared to the competitive equilibrium, there is a transfer of surplus from consumers to producers.