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ECON 201 Chapter 15 Notes

by: Kathryn Catton

ECON 201 Chapter 15 Notes ECON 2010

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Kathryn Catton

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These notes cover the affects and characteristics of monopolistic firms, how they price, their welfare, price discrimination, and its public policies.
Principles of Economics: Microeconomics
Dr. Zegeye
Class Notes
Economics, price, discrimination, publicpolicy, monopoly
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This 8 page Class Notes was uploaded by Kathryn Catton on Thursday April 21, 2016. The Class Notes belongs to ECON 2010 at a university taught by Dr. Zegeye in Winter 2016. Since its upload, it has received 33 views.


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Date Created: 04/21/16
ECON 201 Chapter 15: Monopoly Monopolies have the power to influence the market price of its product. A competitive firm is a price taker and a monopoly is a price maker. A monopoly charges prices that exceeds marginal costs. Monopolies generally charge high prices and customers might have little choice but to pay whatever the monopoly charges. A monopoly firm can control the price of the good it sells, but because a high price reduces the quantity that its customers buy, the monopoly’s profits are not unlimited. The goal is to maximize profit as well but it has a few ramifications that are different, because monopoly firms are unchecked by competition, the outcome in a market with a monopoly is often not in the best interest of society. Why Monopolies Arise: A firm is a monopoly if it is the sole seller of its product and if its product does not have close substitutes. The fundamental cause of monopoly is barriers to entry: a monopoly remains the only seller in its market because other firms cannot enter the market and compete with it. Barriers to entry, in turn, have three main sources. 1. Monopoly resources: a key resource required for production is owned by a single firm. Examples: ALCOA, DeBeers, and Nickel Company of Canada. 2. Government regulation: the government gives a single firm the exclusive right to produce some good or service. Government enforced barriers such as patent laws, copyright laws and public franchises. 3. The production process: a single firm can produce output at a lower cost than can a larger number of firms. Monopoly Resources: The simplest way for a monopoly to arise is for a single firm to own a key resource. Regardless of marginal cost, some monopolies like water wells in local areas command a high price no matter what. Government-Created Monopolies: Sometimes the monopoly arises from the sheer political sheer political clout of that would be monopolist. At other times the government grants a monopoly because doing so is viewed to be in the public interest. The patent and copyright laws are two important examples. The effects of patent and copyright laws are easy to see. Because these laws give on producer a monopoly, they lead to higher prices than would occur under competition. The laws create incentives. Natural Monopolies: An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output. In this case, a single firm can produce any amount of output at the least cost. That is for any given amount of output, a larger number of firms lead to less output per firm and higher average total cost. Club goods- are excludable but not rival in consumption. Example: a bridge that gets used so infrequently it is never congested. It is excludable because a toll collector can prevent someone from using it, and not rival because use of the bridge by one person does not diminish the ability of others to use it. Because there is a large fixed cost of the building and a negligible marginal cost of additional users, the ATC of a trip across the bridge (TC/Q) falls as the number of trips rises. When a firm is a natural monopoly, it is less concerned about new entrants eroding its monopoly power. There is trouble maintaining a monopoly position without ownership of a key resource or protection from the government. Monopolist’s profit attracts entrants into the market, and these entrants make the market more competitive. Sometimes size of market can determine being a monopoly or not. How Monopolies Make Production and Pricing Decisions Monopoly vs. Competition: the key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output. A competitive firm is small relative to the market in which it operates, and therefore, has no power to influence the price of its output. It takes the price as given by market conditions. By contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market. Noticing the demand curve can show the differences. Profit maximization by competitive firms creates a horizontal line at the price. Since a competitive firm can sell as much or as little as it wants at this price, the firm faces a horizontal demand curve. NOW, since a monopoly is the sole proprietor in its market, its demand curve is the market demand curve. It demand slopes downward for many reasons; if you raise the price, consumers buy less of it. If the monopolist reduces the quantity of output it produces and sells, the price will increase. Monopolists prefer to charge a high price and sell a large quantity at a high price. That demand curve makes that outcome impossible. The market demand curve describes the combinations of price and quantity that are available to a monopoly firm. By adjusting the quantity, the monopolist can choose any point ON THE DEMAND CURVE not off it though! A Monopoly’s Revenue: A table with a monopoly’s total, average and marginal revenue. Quantity of Price Total Revenue Average Marginal Water (P*Q) Revenue Revenue (Ch (TR/Q) in TR/ Ch in Q) 0 11 0 - 10 1 10 10 10 8 2 9 18 9 6 3 8 24 8 4 4 7 28 7 2 5 6 30 6 0 6 5 30 5 -2 7 4 28 4 -4 8 3 24 3 The first two columns represent the monopolist’s demand schedule. This produces the down-ward sloping demand curve. The third column represent the monopolist’s total revenue. Quantity sold times the price. The fourth column computes the firm’s average revenue, the amount of revenue the firm receives per unit sold. Last column is the marginal revenue. It is important to understand the marginal revenue is ALWAYS less than the price of its good. Marginal revenue for monopolies is very different from marginal revenue for competitive firms. When a monopoly increases the amount it sells, there are two effects on total revenue: 1) the output effect: more output is sold, so Q is higher, which tends to increase total revenue 2) the price effect: the price falls, so P is lower, which tends to decrease total revenue. Because a competitive firm can sell all it wants at the market price, there is no price effect. That is why it is a price taker, and marginal revenue EQUALS the price. But, when a monopoly increases production by 1 unit, it must reduce the price it charges for every unit it sells, and this cut in price reduces revenue on the units it was already selling. MR is less than its price. Marginal revenue is negative when the price effect on revenue is greater than the output effect. Profit Maximization: Rational people think at the margin. Here we apply the logic of marginal analysis to the monopolist’s decision about how much to produce. The demand curve, marginal revenue curve and the cost curves for a monopoly firm are shown. These determine the profit maximization. The monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B). In the end the firm adjusts its level of production until the quantity reaches Qmax, at which marginal revenue equals marginal cost. Thus, the monopolist’s profit-maximizing quantity of output is determined by the intersection of the marginal revenue curve and the marginal cost curve. MR < PRICE. PRICE > MR = MC. The equality of MR and MC determines the profit maximizing quantity for both types of firm. What differs is how the price is related to MR and MC. After the monopoly chooses the quantity of output that equates MR and MC, you use the demand curve to find the maximum price it can charge for that quantity. PRICE EXCEEDS MC. A Monopoly’s Profit: Profit: TR-TC, rewrite as: (TR/Q-TC/Q) TIMES Q. or (P-ATC) TIMES Q. E >1, MR > 0, TR INCREASES. E=1, MR=0, TR AT MAX. E< 1, MR< 0, TR DECREASES The Welfare Cost of Monopolies The Deadweight Loss: The social planner cares not only about the profit earned by the firm’s owners but also about the benefits received by the firm’s consumers. The planner tries to maximize total surplus, which equals producer surplus (profit) plus consumer surplus. Keep in mind that total surplus equals the value of the good to consumers minus the costs of making the good incurred by the monopoly producer. The demand curve reflects the value of the good to consumers, as measured by their willingness to pay for it. The MC curve reflects the costs of the monopolist. Thus, the socially efficient quantity is found where the demand curve and the marginal cost curve intersect. Monopolists choose to produce and sell the quantity of output at which the MR and MC curves intersect; the social planner would choose the quantity at which the demand and MC curves intersect. Here, the monopolist produces less than the socially efficient quantity of output. You can also see the inefficiency of monopoly at their price. A quantity that is inefficiently low is equivalent to a price that is inefficiently high. When a monopolist charges a price above MC, some potential consumers value the good at more than its MC but less than the monopolist’s price, then they don’t buy the good since the value is greater than the cost. Thus, monopoly pricing prevents some mutually beneficial trades from taking place. The inefficiency can be measured with a deadweight loss triangle, which is represented by the area of the triangle between the demand curve and the MC curve. It is almost like a tax deadweight loss, a monopolist is like a private tax collector. The difference is that the government gets the revenue from the tax, whereas the private firm gets the monopoly profit. The Monopoly’s Profit: A Social Cost? Welfare in a monopolized market includes the welfare of both consumers and producers. The monopoly profit itself represents not a reduction in the size of the economic pie but merely a bigger slice for producers and a smaller slice for consumers, therefore the monopoly profit is not a social problem. The actual problem is when the firm produces and sells a quantity of output below the level that maximizes total surplus, this connects to the reason for high prices: Consumers buy fewer units when the firm raises its price above marginal cost. The profit earned isn’t the problem, it is how inefficiently low the quantity of output is. Said differently, if the high monopoly price did not discourage some consumers from buying the good, it would raise producer surplus by exactly the amount it reduced consumer surplus, leaving total surplus the same as could be achieved by a benevolent social planner. The social loss from monopoly includes both these costs and the deadweight loss resulting from reduced output. Price Discrimination: Some firms sell the same good to different customers for different prices, even though the costs of producing for the two customers are the same. It is not possible when a good is sold in a competitive market. In order to price discriminate, the firm must have some market power. Moral of the Story: 1 lesson: Price discrimination is a rational strategy for a profit- maximizing monopolist- by charging different prices to different customers, a monopolist can increase its profit. A price discriminating monopolist charges each customer a price closer to their willingness to pay than is possible with a single price. 2ndlesson: It requires the ability to separate customers according to their willingness to pay, such as geographic, age, income, and more. Certain market forces can prevent firms from price discriminating= arbitrage- the process of buying a good in one market at a low price and selling it in another market at a higher price to profit from the price difference. 3 lesson: price discrimination can raise economic welfare, outcome and output is efficient. The Analytics of Price Discrimination: Assume that a firm can price discriminate perfectly. Perfect price discrimination- describes a situation in which the monopolist knows exactly each customer’s willingness to pay and can charge each customer a different price, here they charge the exact willingness to pay and the monopolist gets the entire surplus in every transaction. There are differences between producer and consumer surplus (welfare) with and without price discrimination. Without: the firm charges a single price above MC. Because some potential customers who value the good at more than the MC do not buy it at this high price, the monopoly causes a deadweight loss. With: each customer who values the good at more than marginal cost buys the good and is charged her willingness to pay. All mutually beneficial trades take place, no deadweight loss occurs, and the entire surplus derived from the market goes to the monopoly producer in the form of profit. How does this affect welfare? The analysis of these pricing schemes is complicated and it turns out that there is no general answer. Compared to the monopoly outcome with a single price, imperfect price discrimination can raise, lower, or leave unchanged total surplus in a market. The only certain conclusion is that it can raise the monopoly’s profit. Examples of Price Discrimination: Movie Tickets, discount coupons, financial aid and quantity discounts. Public Policy toward Monopolies: Monopolies produce less than the socially desirable quantity of output and charge prices above MC. Policy makers in the government can respond to the problem of monopoly ¼ ways. 1) Trying to make monopolized industries more competitive 2) Regulating the behavior of the monopolies 3) Turning some private monopolies into public enterprises 4) doing nothing at all. Increasing Competition with Anti-Trust Laws: Sherman Antitrust Act- reduces the market power of the large and powerful “trusts” that were viewed as dominating the economy at the time. Clayton Antitrust Act- strengthens the government’s powers and authorized private lawsuits. The laws are a “comprehensive charter of economic liberty aimed at preserving free and unfettered competition as the rule of trade”. They mostly promoted competition, government prevents mergers and break up companies. They have both costs as well as benefits. Sometimes companies merge to lower costs not to reduce competition. These benefits from mergers are sometimes called synergies. Regulation: There are two problems with the MC Pricing as a regulatory system. 1= logic of cost curves. There is a declining ATC, when ATC is declining, MC is less than ATC. If regulators were to set price = to MC, that price would be less than the firm’s ATC and the firm would lose money. Instead of charging such a low price, the monopoly firm would just exit the industry. Regulators can respond but not perfectly, one way is to subsidize the monopolist. The government picks up the losses inherent in MC pricing. Yet to pay for the subsidy, the government needs to raise money through taxation, which involves deadweight loss. The regulators can allow the monopolist to charge a price higher than MC. If the regulated price = ATC, the monopolist earns exactly 0 economic profit. Yet ATC pricing leads to deadweight losses because the monopolist’s price no longer reflects the MC of producing the good. In all, ATC pricing is like a tax on the good that the monopolist is selling. 2= The MC pricing as a regulatory system gives the monopolist no incentive to reduce costs. Each firm in a competitive market tries to reduce its costs because lower costs mean higher profits. But if a regulated monopolist knows that regulators will reduce prices whenever costs fall, the monopolist will not benefit from lower costs. Regulators deal with this problem by allowing monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from MC pricing. Public Ownership: Rather than regulating a natural monopoly, it is run by a private firm, the government can run the monopoly itself. In Europe, government owns telephone, water and electronic companies. In the US, the government runs the Postal Service. Economists prefer private to public ownership of natural monopolies. The key issue is how the ownership of the firm affects the costs of production. Private owners have an incentive to minimize costs as long as the reap part of the benefit in the form of higher profit. If the firm’s managers are doing a bad job of keeping costs down, the firm’s owners will fire them. As a way of ensuring that firms are well run, the voting booth is less reliable than the profit motive. Doing Nothing: Each policy has drawbacks. Some economists argue that it is best for the government not to try to remedy the inefficiencies of the monopoly pricing.


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