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Monopoly

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  • 1. Monopoly
  • 2. Four Basic Market Structures
    • Perfectly Competitive : many firms, identical products, free entry and exit, full and symmetric info
    • Monopoly : single firm, no close substitutes, barriers to entry, full and symmetric info
    • Oligopoly : several firms, similar products, degree of product differentiation varies depending upon the market, might be barriers, full and symmetric info
    • Monopolistic competition : many firms, similar products, slightly differentiated products, free entry and exit, full and symmetric info
  • 3. Competitive Market
    • This is the classic “textbook” market structure.
    • Firms in a competitive market all make a product that is perfectly substitutable: all demanders are equally satisfied with any supplier’s product.
  • 4. Monopoly
    • The single seller makes a product that has no “good” substitute.
    • Other firms may be able to produce the good or service but choose not to enter the market or are barred from it.
  • 5. Oligopoly
    • A few sellers make products that are good, but not perfect, substitutes.
    • Consumers can be induced to change suppliers but have only a limited number of choices.
  • 6. Monopolistic Competition
    • The market has many firms but each supplier’s product is differentiated.
    • Consumers can be induced to change brands but they have brand preferences.
  • 7. Question
    • What is the market structure for each of these products or firms: competitive, monopoly, oligopoly, monopolistic competition?
      • The Campus Store
      • Kinko’s
      • Pepperidge Farm’s Whole Wheat Bread
      • PowerMac computer
      • Windows computer
      • NYSEG (electricity utility)
      • Morton salt
      • AT&T long distance
  • 8. Answer
    • The Campus Store: most products competitive, textbooks oligopoly, but location is very important.
    • Kinko’s: monopolistic competition (differentiated service)
    • Pepperidge Farm’s Whole Wheat Bread: competition or monopolistic competition (slightly differentiated recipes)
    • PowerMac computer and clones: monopoly, under license.
    • Windows computer: monopolistic competition (differentiated features)
    • NYSEG (electricity utility): monopoly
    • Morton salt: competitive
    • AT&T long distance: oligopoly
  • 9. Monopoly
    • single firm
    • no close substitutes
    • barriers to entry
    • full and symmetric information
  • 10. Sources 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.
  • 11. Natural Monopolies
    • Goods and services whose delivery requires the construction of a physical network (wires, pipes, etc..)
    • In such industries (local phone service, water, sewage removal, electricity, gas) the physical networks display decreasing marginal cost over essentially all quantities.
    • Thus, average total cost is always declining and the minimum efficient scale is much larger than the size of the market.
    • Natural monopolies are often regulated: they cannot charge a higher price without government approval.
  • 12. Patents: Are There “Good” Monopolies?
    • Consider the protease inhibitor Crixivan from Merck.
    • A very effective AIDS therapy.
    • Development costs were more than one billion dollars.
    • Annual revenue now from treating around 90,000 patients is $500,000,000.
  • 13. What is a “Good” Monopoly?
    • Why is Merck given a monopoly?
    • The granting of a patent on the drug Crixivan guarantees that Merck can earn monopoly profits on its sale.
    • These monopoly profits provide the incentive to invest in the research and development required to create the new drug.
  • 14. “Good” Monopolies
    • The granting of patent protection (legal monopoly) gives firms a strong incentive to invest in new product development.
    • Would firms make the R&D investments if they could not protect them through patents and trade secrets?
    • Probably not because competitors could steal the design at a fraction of the cost after the product is brought to market.
  • 15. “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?
  • 16. 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
  • 17. 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.
  • 18. The Simple Monopolist
    • 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.”
  • 19. The Simple Monopolist: Rules for Profit Maximization
    • Suppose we are in the short run.
    • Rules for profit maximization are the same as before.
    • If X SM maximizes profit, then
      • MR(X SM ) = MC(X SM )
        • very important note: for a simple monopolist P>MR at all positive levels of X.
      • X SM is a max and not a min.
      • at X SM it’s worth operating.
  • 20. 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
  • 21. Graphical Display of Monopolist’s Solution
    • The monopolist sets marginal revenue equal to marginal cost at MR=MC=$10.
    • The optimal quantity is thus 90 units, which 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” the average total costs decline over the entire relevant range of production and the minimum efficient scale (150) is bigger than the entire market.
    • Notice that if our monopolist operated at the competitive equilibrium (Price=MC=$30, Quantity=140), the firm would make a loss (ATC>Price).
  • 22. Implications 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.
  • 23. Simple Monopoly- Performance
    • Efficiency:
      • Is the monopoly equilibrium Pareto Efficient? That is, at X SM is net social surplus maximized? Does $MB=$MC at X SM ?
      • Is the monopolist productively efficient? Does the monopolist operate at minimum efficient scale?
    • Equity:
      • Is the outcome of monopoly fair? Equitable? Just?
  • 24. Simple Monopoly- Performance Answers
    • The simple monopoly equilibrium is not Pareto Efficient.
      • The simple monopolist creates “dead-weight-loss.”
      • At X SM , $MB>$MC . Recall: $MR=$MC at X SM while $P SM >$MR at all X. So $P SM >$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.
  • 25. Price Discriminating Monopolists
    • A monopolist might be able to charge different prices for different units sold and enhance its profits.
      • charge different people different prices
      • charge the same person different prices for different units
    • price discrimination
      • charging different prices for different units with no cost basis
      • charging the same price for different units when there are cost differences
  • 26. Requirements for Price Discrimination
    • Some amount of monopoly power.
    • An ability to prevent resale.
    • Detailed information about who is buying what unit and what demanders are willing to pay.
  • 27. Believe It Or Not
    • What would you do to prevent resale???
    • when: 1940’s
    • market: plastic molding powder
      • industrial users: .85/pound
      • denture manufacturers: $22/pound
    • firm: Rohm and Haas
    • problem: resale from industrial users to denture manufacturers
    • solution: rumor you are mixing arsenic in the powder sold to industrial users!
  • 28. Two classic forms of Price Discrimination
    • Perfect or First Degree Price Discrimination
      • charge a different price for each unit sold
      • the most extreme form of price discrimination
    • Third Degree Price Discrimination
      • segment market and then charge a different price in each market
      • exploit the observation that at the simple monopoly price the own price elasticity of demand differs across the defined segmented markets
    • Price discrimination comes in many other “flavors”
  • 29. Question
    • The data on your handout show the demand curves for movie tickets of adults and seniors. The market described has only one movie theatre.
      • Find the best single price.
      • If the movie theater can charge separate prices for adults and seniors, what are the best two prices?
  • 30. Two Prices are Better than One for Movie Tickets
    • The best single price in this market is $7.50/ticket, which makes economic profits of $4,225 (blue entries). Set marginal cost = marginal revenue with the single price.
    • The price discriminating monopolist can make more economic profits by charging adults $8.50 (yellow entries) and seniors $6.50 (green entries). Set marginal cost = marginal revenue separately for each market.
  • 31. Summary of Price Discrimination Example
    • Calculating economic profits separately for the two markets (adult and senior) shows that the total is greater than with the best single price.
    • Taking advantage of different elasticities of demand.
  • 32. Believe It Or Not
    • when: early 1990’s
    • market: contact lenses
    • firm: Bausch & Lomb
    • Lenses:
      • Optima @ $70/pair - wash and keep 1 year
      • Medalist @ $15/pair - wash and keep 2 months
      • SeeQuence 2 @ $8/pair - wash and keep 2 weeks
      • Occasions @ $3/pair - daily and disposable each day
    • Guess what?
  • 33. Believe It Or Not
    • They were all the same lenses!
    • Just packaged differently!
    • What would you pay for a year?
      • Optima = $70/pair - wash and keep 1 year
      • Medalist = $15x6=$90 (last 2 months)
      • SeeQuence 2 = $8x26=$208 (last 2 weeks)
      • Occasions = $3x365 = $1095
    • What would I do? Buy the Occasions and wash and wear until my eyes hurt.
    • Class action suits were eventually settled.
  • 34. First Degree Price Discrimination
    • The monopolist charges the demand price for each unit sold.
    • In this case the market demand curve becomes the monopolist’s marginal revenue curve.
    • The monopolist sets MR=MC to get X FDPD .
    • The monopolist charges a different price for each unit according to the demand curve.
    • Performance: X FDPD is Pareto Efficient and all the net social surplus goes to the monopolist as producer surplus. Consumer surplus = $0!
  • 35. Should the Government Regulate Monopolies?
    • Essentially all monopolies are regulated.
    • Natural monopolies are regulated by price commissions that determine the rates the monopolies may charge.
    • Patent, copyright and license protections are a form of ex ante regulation: firms that follow the rules for establishing the validity of their innovations receive the protection of the patent, copyright or license.
    • Should the government do more? Good question.

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