Prinecomi lectureppt ch10
- 2. Previously • Profits and losses act as signals in a perfectly competitive market • For perfect competition to exist, two factors must be in place: – A competitive market – Easy entry and exit from the market • A price taker has no control over the price it pays, or receives, in the market • A firm that maximizes profits will expand output (Q) until MR = MC
- 3. Big Questions 1. How are monopolies created? 2. How much do monopolies charge, and how much do they produce? 3. What are the problems with, and solutions for, monopoly?
- 4. Defining Monopoly • Monopoly – Single seller who produces a good • How do monopolies persist? – Recall what happens in competitive markets with free entry… • Barriers to entry – Restrictions that make it difficult for new firms to enter a market – Allows many monopolists to enjoy long run economic profit
- 5. Natural Barriers to Entry • Control of resources – If a monopoly controls all of a resource (input) necessary for production, competitors cannot enter – ALCOA, De Beers • Inability of potential competitors to raise enough capital – Monopolies are often very established after years of growing. Can you raise $10 million of capital to compete?
- 6. Natural Barriers to Entry • Economies of scale – “Bigger is better” (more cost-efficient) – This is due to the ATC being downward- sloping over a large range of output – Lower costs lower prices – Car production, electricity production, mail delivery • Natural monopoly – A monopoly exists because a single large firm has lower costs than any potential competitor – In addition, breaking up the firm into multiple competitors may increase costs as well
- 7. Government Created Barriers • Licenses, qualifications – License to use certain radio or TV frequency (prevent the negative externality of interference) – Must be qualified to practice medicine or law • Patents and copyright law – Patent • Temporarily grants monopoly rights to a product • An incentive to innovate – However, copyrights (and higher resulting prices) sometimes create unintended consequences • File sharing, movie pirating
- 8. The Monopolist’s Pricing and Output Decisions • Perfectly competitive firms –Price takers, cannot affect the price –Each firm faces a horizontal demand • Monopoly firm –Price maker, sets the price by choosing output level –Faces the downward-sloping demand curve for the entire industry
- 10. Profit Maximizing Rule for Monopoly • Similarity between monopoly and competitive firms – Profit is maximized at output level (Q) where MR = MC • Difference between monopoly and competitive firms – In competition, P = MR – In monopoly, P > MR – To increase output, monopoly must lower the price. Competitive firms can sell as much as they want at the market price.
- 11. Monopoly Marginal Revenue Quantity of Customers (Q) Price (P) Total Revenue (TR) = Q × P Marginal Revenue per 1,000 Customers (MR) = ΔTR 0 $100 $0.00 1,000 90 90,000 $90,000 2,000 80 160,000 70,000 3,000 70 210,000 50,000 4,000 60 240,000 30,000 5,000 50 250,000 10,000 6,000 40 240,000 -10,000 7,000 30 210,000 -30,000 8,000 20 160,000 -50,000 9,000 10 90,000 -70,000 10,000 0 0.00 -90,000
- 12. Monopoly Marginal Revenue • When the monopoly decreases its price in order to sell more output units, two things happen: –The price effect • All units are now sold at a lower price. By itself, this is a loss for the firm. –The output effect • More units are sold. By itself, this is a gain for the firm.
- 13. Monopoly MR and Demand
- 14. Deciding How Much to Produce • For a monopoly, we can use the same three- step process to determine profits that we used for a competitive firm: 1. Find the profit maximizing point: MR = MC 2. Find output (Q) at this point: move down the vertical dashed line to the x axis at point q 3. The monopolist will charge a price P equal to the height of the demand curve at that quantity. The average costs will be the height of the ATC curve at that quantity. Average profit per unit is (P – ATC).
- 16. Contrasting Competition and Monopoly Competitive Markets Monopoly Many firms One firm Produces efficient level of output (since P = MC) Produces less than the efficient level of output (since P > MC) Cannot earn long run economic profits May earn long run economic profits Has no market power (is a price taker) Has significant market power (is a price maker)
- 17. The Problems with Monopoly • Monopolies can make societies worse off – Restricting output and charging higher prices compared to competitive markets – Operate inefficiently (deadweight loss). This is referred to as market failure. – Less choices for consumers – Unhealthy competition called “rent seeking”
- 19. Deadweight Loss of Monopoly
- 20. Monopoly versus Competition • Output (quantity) – QMonopoly < QCompetition • Price – PCompetition < PMonopoly • Deadweight loss – Monopoly DWL > 0 – Competition DWL = 0
- 21. Monopoly Problems • Few choices – Restricts consumer ability to put downward pressure on prices. No substitutes. – Cable companies and bundling. Monopolies can force you to buy more. • Rent seeking – Competition among rivals to secure monopoly profits – This type of competition produces one winner without the other usual benefits of competition – Inefficient: Resources used to monopolize rather than become a more competitive firm
- 22. Solutions to Monopoly • Harnessing benefits of competition – Splitting up a large company into smaller competing companies – AT&T (1982), Standard Oil (1911) – Sherman Act (1890) • Reduce trade barriers – Allow competitively priced goods to be transported over borders – This includes state and national borders
- 23. Economics in One Man Band • The introduction of competition gives producers incentives to work hard and create a better product • Consumers will have more choices
- 24. Solutions to Monopoly • Price regulation –Often, we don’t want to break up firms due to large economies of scale • Don’t need to have redundant water pipes, power lines –In this case, a monopoly may be desirable, but we may still need to regulate the firm to prevent market power abuse
- 25. Regulatory Solution for Natural Monopoly
- 26. Marginal Cost Pricing • At P = MC – The monopolist experiences a loss – MC < ATC, so P < ATC (results in losses) • Solutions? – Government subsidies given to the firm – Set P = ATC at the P = MC output level – Government ownership of the firm
- 27. Government Failure • Government intervention – Can eliminate the profit motive and the necessity to innovate and improve efficiency – Government employees are rarely fired, regardless of performance • Free market – Firms under MC pricing have no incentive to lower costs. – Often better than government intervention and changing incentives for a firm
- 28. Economics in Seinfeld • “Soup Nazi” (1995) – If a monopoly’s product is extremely popular, people will do just about anything to get the product since there is no substitute. – What happens to monopoly power if a substitute product can be introduced?
- 29. Conclusion • While competitive markets generally bring about welfare-enhancing outcomes for society, monopolies often do the opposite – Government seeks to limit monopoly outcomes and promote competitive markets • Perfectly competitive markets and monopoly are market structures at opposite extremes – Most economic activity takes place between these two alternatives
- 30. Summary • Monopolies – Market structure characterized by a single seller who produces a well-defined product with few good substitutes – Operate in a market with high barriers to entry, the chief source of market power. – May earn long run profits • Perfectly competitive firms are price takers. Monopolists are price makers.
- 31. Summary • Like perfectly competitive firms, a monopoly tries to maximize its profits. – Same profit maximizing rule of MR = MC is used. • From an efficiency standpoint, the monopolist charges too much and produces too little. • Since the output of the monopolist is smaller than would exist in a competitive market, the outcome also results in deadweight loss.
- 32. Summary • Government grants of monopoly power encourage rent seeking • There are four potential solutions to the problem of monopoly – First, the government may break up firms to restore a competitive market – Second, government can promote open markets by reducing trade barriers – Third, the government can regulate a monopolist’s ability to charge excessive prices – Finally, there are circumstances in which it is better to leave the monopolist alone
- 33. Practice What You Know Which of the following firms will most likely be a natural monopoly? A. A grocery store B. A cable TV company C. A gas station D. A barbershop
- 34. Practice What You Know Which of the following most accurately describes a patent? A. An incentive to innovate B. A profit-sharing mechanism C. A redistribution of wealth D. An original invention
- 35. Practice What You Know What is true for a profit-maximizing monopoly? A. P = MR = MC B. P = MR > MC C. P > MR = MC D. P > MR > MC
- 36. Practice What You Know What is the reason for monopoly deadweight loss (relative to perfect competition)? A. The monopolist faces a downward sloping demand curve B. People boycott monopolies more often C. The monopolist sells less output at a higher price D. The monopolist has no competitors
- 37. Practice What You Know A monopolist will have negative profits and exit the industry in the long run if: A. A new competitor enters the industry B. Demand becomes more elastic C. Price < ATC D. A monopolist never has negative profits
Editor's Notes
- #3: Lecture tip: Remind your students: Just because this is a new chapter, they can’t forget about old material. Parts of this chapter will involve comparing the market structures of monopoly and perfect competition.
- #5: Lecture notes: Note that the good produced by the monopoly has no good substitutes. In perfect competition, other firms entered the market during profitable times and high prices. Why don’t other firms join the monopoly’s industry and compete with it and take some of its profits? The answer is because of entry barriers. Entry barriers keep other potential competitors out of the market. As long as there are entry barriers, a monopolist can enjoy long run profits. However, just because a firm is a monopoly doesn’t guarantee profits. If demand for the monopoly product is low, it may shut down or go out of business in the long run. The trucking industry put an end to the railroad monopoly. (Increase in trucking and the interstate decreased demand for rail use).
- #6: Lecture notes: Control of resources: In the early 1900s, ALCOA (Aluminum Company of America) owned 90% of the world’s bauxite, the essential input in making aluminum. ALCOA just simply purchased all the bauxite mines around the world. De Beers diamonds did the same thing (around the same time period as well). In the early 1900s, De Beers owned over 90% of the world’s diamond supply. They just simply bought every diamond mine. Raising capital: Difficult to compete with an established monopoly that already has a huge amount of capital and equipment. A lender may not want to loan you $10 million to try and start a business. That’s a big loan!
- #7: Lecture notes: Economies of scale Recall this definition from Chapter 8. Average costs fall as output increases. Which do you think can be done at an OVERALL lower cost? One hundred car producers making 10 cars each or two car producers making 500 cars each? A total of 1,000 cars is made in each case, but due to the nature of the cost structure of car production which exhibits economies of scale, average costs fall with output increases and two firms producing more cars will have overall lower costs. Natural monopoly It’s just “natural” to have a monopoly since it provides the lowest (most efficient) costs. Realize however, that a monopoly (natural or not) will enjoy significant market power and may not pass cost savings to consumers in the form of lower prices. Natural monopolies (such as electric companies) are often regulated by the government to prevent abuse of market power.
- #8: Lecture notes: LicensesOften, you cannot broadcast unless you have a government-sponsored operating license. However, in certain places, corruption and bribery determine who gets the limited licenses. Not everyone can do brain surgery or judge a court case. We want to reserve these important duties for only qualified individuals with a medical license or JD. Patents Patents and copyrights create stronger incentives to find new drugs and make new music than would exist if market forces could immediately copy inventions. The result is that pharmaceutical companies invest heavily in researching and developing new drugs and musicians devote their time to writing new music. However, many economists wonder if patents and copyrights are necessary or have unintended consequence of their own. Justin Bieber was able to use his Internet fame to launch his career without his music being tightly controlled by music studio copyrights. For file sharing and music/movie pirating, see how many of your students are in favor of the MPAA or RIAA.
- #9: Lecture notes: If a firm faces a downward-sloping demand curve, it is indicative of the firm having at least some market power and the ability to set its price. In PC (Perfect Competition), there are hundreds of firms selling substitute products. No one firm can determine the price. The price is determined by market supply and demand. In monopoly, the one firm IS the market. Later, we will see that the monopoly does not have a supply curve. It simply chooses the output level where its MR = MC and charges a price based on the height of the demand curve at that level of output.
- #10: Image: Animated Figure 10.1 Lecture notes: Perfectly competitive firms have a demand curve that is horizontal. Since the monopolist is the sole provider of the good or service the demand for its product depends on the price that is charged. This is reflected in a downward-sloping demand curve. So while the perfectly competitive firm has no control over the price it charges, the monopolist must search for the price and output combination that maximizes its profits. The monopoly, while having market power, is still limited by what price it can charge. The demand curve shows the consumer willingness to pay for the product and guides the monopolist to what price it will charge.
- #11: Lecture notes: For any firm, profit is maximized at the output level where MR = MC. In competition, the demand curve (price) and the MR curve were the same horizontal line. In monopoly, the MR curve lies below the demand curve, so P &gt; MR. For monopoly, this results in P &gt; MC. If price is greater than marginal cost, the firm has market power. The size of the difference between P and MC illustrates the amount of market power. A higher price markup from MC indicates higher market power.
- #12: Lecture notes: Notice the inverse relationship between output (quantity) and price since the monopolist faces a downward-sloping demand curve. Total revenue is calculated by multiplying output by price, (TR = Q P). At first total revenue rises as the price falls, then, once the price becomes too low ($40), it begins to fall. As a result, the total revenue function rises to $250,000 before it falls off. The final column, marginal revenue (MR), shows the change in total revenue. Here we see positive (green text) (though falling) marginal revenue associated with prices above $50. Below $50, marginal revenue becomes negative. Negative marginal revenue (red text) means that total revenue decreases if the monopoly were to continue selling more units. Realize that in order to sell more units, the monopolist must lower its price.
- #13: Lecture notes: Thus, the monopoly firm has to make a decision at the margin. While lowering the price (and selling more) has a marginal gain and loss, the firm will only do this action if the marginal gain is bigger than the marginal loss. In the most simplistic form, you could imagine the following: “I’m a monopoly and have all the market power. Do I want to sell a small amount at very high prices, a lot of output at low prices, or something in between?” The firm would need to examine the marginal consequences of placing too high or too low of a price.
- #14: Image: Animated Figure 10.2 Lecture notes: Two separate effects that determine marginal revenue. First, there is a price effect, which refers to the impact that lower prices have on revenue. If the price drops from $70 to $60, each of the 3,000 existing customers will save $10. This represents a drop of $10 x 3,000, or $30,000 in lost revenue (the yellow shaded area). Second, dropping the price also has an output effect, which refers to the impact of lower prices on the quantity sold. Since 1,000 new customers buy the product when the price is lowered to $60, this represents $60 x 1,000, or $60,000 in additional revenue (the blue shaded area). Therefore, the output effect (gain from selling more) is greater ($60,000) than the price effect (loss from selling units at lower prices) ($30,000). As a consequence, marginal revenue is positive ($30,000) at an output level between 3,000 and 4,000 units. Since the lost revenues associated with the price effect are always subtracted from the revenue gains created by the output effect, the marginal revenue per customer can never exceed price.
- #15: Lecture notes: After finding the quantity at MR = MC, realize that any quantity greater than or less than q would result in lower profits. If MR &gt; MC, it means additional units produced will increase our profits, so we should produce more. If MC &gt;MR, it means that we’ve produced units in which the additional cost of production for those units was greater than the additional change in revenue we received from selling those units. This decreased our profit, and it means we’ve produced too much. Once we find the optimal output, we need to find the ATC of producing that output. P – ATC will give us average profit per unit.
- #16: Image: Animated Figure 10.3 Lecture notes: Remember that the demand function represents willingness to pay (WTP) of consumers. At the quantity q, the monopolist charges a price equal to the height of the demand, or equal to the WTP of the consumers at that quantity. Recall the area of a rectangle is length * height. Here, the length of the green profit rectangle is the number of units the monopoly sells. The height of the rectangle is average profit per unit. Thus, we get the following formula from the graph: Total profit = (number of units sold) * (average profit per unit)
- #17: Lecture notes: Really, you can just point out that perfect competition and monopoly are on polar opposite ends of the market structure spectrum. You may have realized that in real life, we don’t often see perfect competition or pure monopoly. Much of our economy lies somewhere between these two extremes. We call this “imperfect competition,” and we can discuss the market structures of oligopoly and monopolistic competition.
- #18: Lecture notes: The word “monopoly” often has a negative connotation. With a bad economy, we often hear people complaining about “greedy companies,” “Wall Street,” “banks”, etc. However, these entities are often not monopolies. Monopolies are often economically inefficient. This comes from the fact that P &gt; MC and that output is restricted compared to competitive markets.
- #19: Image: Animated Figure 10.4 Left: Typical firm in a competitive industry. Profits for each firm are zero due to free entry of other firms. (If there ARE profits, other firms will enter and cause the price to fall, decreasing profits.) Firms are efficient and produce output at the lowest point on their ATC curve. Right: A single monopoly firm. Profits are positive since P &gt; ATC at the level of output chosen. Output is less than the point at min(ATC), thus the firm is not economically efficient, and there is DWL. In monopoly, prices are higher and output is lower compared to competitive markets.
- #20: Image: Animated Figure 10.5 Lecture notes: From text: The monopolist charges too high a price and produces too little of the product, so some consumers who would benefit from a competitive market lose out. Since the demand curve, or the willingness to pay, is greater than the marginal cost between output levels QM and QC, society would be better off if output was expanded to QC. But a profit-maximizing monopolist will limit output to QM. The result, a deadweight loss equal to the area of the yellow triangle, is inefficient for society.
- #21: Lecture notes: In one sentence: A monopolist produces less output and charges a higher price than competitive markets.
- #22: Lecture notes: With fewer choices (no substitutes), consumers may be “forced” to pay higher prices for goods and services since they have no option to buy cheaper substitutes. In addition, multiproduct monopolies (cable companies, for example) may bundle other goods together that you must also buy. This raises prices and profits for the firm and may make consumers buy more goods than they want to. Rent seeking: think about this as spending time, effort, and resources in ways that attempt to gain monopoly or keep your existing monopoly. Rather than spending money on making a better product or improving production, you spend money on lobbyists and lawyers, and spend resources defending your monopoly. This is an economically inefficient use of resources in this market. The firm is attempting to eliminate competition, but this act doesn’t benefit consumers.
- #23: Lecture notes: 1982: AT&T was split up into eight smaller companies after spending over $300 million defending itself from lawsuits and antitrust legislation. 1911: Standard Oil controlled 91% of production and 85% of final sales of oil in the United States in 1904. In 1909, the Department of Justice sued the company for violating the Sherman Act. In 1911, the company was forced to break up into 34 independent companies with different boards of directors. The biggest two companies were Exxon and Mobil. Reducing trade barriers: Text: The Constitution reads, “No State shall, without the consent of Congress, lay any imposts or duties on imports or exports.” Rarely have so few words been more profound. With this simple law in place, states must compete on equal terms. In addition, if we eliminate trade quotas and tariffs, international firms may force domestic producers to become more competitive, which will reduce monopoly power.
- #24: Economics in the media Lecture tip: The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
- #25: Lecture notes: Breakup of a natural monopoly would actually be a bad idea. Due to economies of scale, there are some firms in which bigger really is better. If the ATC curve is downward-sloping over a large range of output, it means that a bigger firm can produce output at a lower cost than many smaller firms. While this monopoly may be desirable (compared to competition), we still want to make sure that the firm doesn’t abuse its monopoly power by charging exorbitantly high prices. This is where price regulation comes in.
- #26: Image: Animated Figure 10.6 Lecture notes: No regulation: Unregulated monopolist sets MR = MC and produces QM at a price of PM. Since PM is greater than the average cost of producing QM units, or CM, the monopolist earns the profit shown in the green rectangle. Regulation: If the firm is regulated, and the price is set at marginal cost, regulators can set P = MC and the output expands to QR. In this example, since the cost of production is subject to economies of scale, the cost falls from CM to CR. This is a large improvement in efficiency. The regulated price, PR, is lower than the monopolist’s price, PM, and production increases. As a result, consumers are better off. But what happens to the monopoly? It loses profits in the amount of the red rectangle. This occurs since the average costs under the marginal-cost pricing solution, CR, are higher than the price charged by regulators, PR.
- #27: Lecture notes: Why is this bad? Subsidies come from the government, which taxes YOU! So you now have lower prices, but now have to pay higher taxes to subsidize the firm! Government ownership creates many more problems, which we will see next.
- #28: Lecture notes: It all comes down to incentives. The government can always “bail itself out,” so it has no incentive to be efficient, keep costs down, or fire bad employees. A private firm has to take care of its own expenses and has the incentive to find and eliminate inefficiencies.
- #29: Economics in the media Lecture tip: The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
- #30: Lecture notes: You can think that we often talk about perfect competition (PC) and pure monopoly in the theoretical sense because they are very rare (by strict definition and assumptions) in real life. Many firms have some competitive characteristics and some monopolistic characteristics. This will be studied in the upcoming chapters.
- #33: Lecture notes: The government may want to leave a monopoly alone if the costs of intervention are greater than the benefits of intervention.
- #34: Clicker Question Correct answer: B Town utilities (cable, gas, electricity, water) usually are natural monopolies due to their cost structure.
- #35: Clicker Question Correct answer: A Be careful. The patent is not the invention itself. The patent protects your invention and allows you to gain temporary monopoly status on your invention.
- #36: Clicker Question Correct answer: C Any firm wants to sell output where MR = MC. However, in monopoly, P &gt; MR. In competition, we have P = MR = MC.
- #37: Clicker Question Correct answer: C With monopoly, we don’t maximize gains from trade by reaching the same equilibrium that a competitive market reaches.
- #38: Clicker Question Correct answer: C A monopolist can still earn negative profits. Maybe demand for the product is low, or the firm’s costs are too high.