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Chapter Twenty-Four
Monopoly
Pure Monopoly
A monopolized market has a single
seller.
The monopolist’s demand curve is
the (downward sloping) market
dem...
Pure Monopoly
$/output unit
p(y)

Higher output y causes a
lower market price, p(y).

Output Level, y
Why Monopolies?
What causes monopolies?
– a legal fiat; e.g. US Postal Service
Why Monopolies?
What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
Why Monopolies?
What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
– sole ownershi...
Why Monopolies?
What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
– sole ownershi...
Why Monopolies?
What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
– sole ownershi...
Pure Monopoly
Suppose that the monopolist seeks
to maximize its economic profit,

Π( y) = p( y)y − c( y).
What output leve...
Profit-Maximization
Π( y) = p( y)y − c( y).
At the profit-maximizing output level y*

dΠ( y)
d
dc( y)
=
=0
( p( y)y) −
dy
...
Profit-Maximization
$

R(y) = p(y)y

y
Profit-Maximization
$

R(y) = p(y)y
c(y)

y
Profit-Maximization
$

R(y) = p(y)y
c(y)

y
Π(y)
Profit-Maximization
$

R(y) = p(y)y
c(y)

y*

y
Π(y)
Profit-Maximization
$

R(y) = p(y)y
c(y)

y*

y
Π(y)
Profit-Maximization
$

R(y) = p(y)y
c(y)

y*

y
Π(y)
Profit-Maximization
$

R(y) = p(y)y
c(y)

y*

y

At the profit-maximizing
output level the slopes of
Π(y)
the revenue and ...
Marginal Revenue
Marginal revenue is the rate-of-change of
revenue as the output level y increases;
d
dp( y)
MR( y) =
.
( ...
Marginal Revenue
Marginal revenue is the rate-of-change of
revenue as the output level y increases;
d
dp( y)
MR( y) =
.
( ...
Marginal Revenue
E.g. if p(y) = a - by then
R(y) = p(y)y = ay - by2
and so
MR(y) = a - 2by < a - by = p(y) for y > 0.
Marginal Revenue
E.g. if p(y) = a - by then
R(y) = p(y)y = ay - by2
and so
MR(y) = a - 2by < a - by = p(y) for y > 0.
a

p...
Marginal Cost
Marginal cost is the rate-of-change of total
cost as the output level y increases;
dc( y)
MC( y) =
.
dy
E.g....
$

Marginal Cost
c(y) = F + αy + βy2

F
$/output unit

y
MC(y) = α + 2βy

α
y
Profit-Maximization; An Example
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and
c(y) = ...
Profit-Maximization; An Example
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and if
c(y)...
Profit-Maximization; An Example
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and if
c(y)...
Profit-Maximization; An Example
$/output unit
a

p(y) = a - by
MC(y) = α + 2βy

α
y
MR(y) = a - 2by
Profit-Maximization; An Example
$/output unit
a

p(y) = a - by
MC(y) = α + 2βy

α
y* =
a−α
2(b + β )

y
MR(y) = a - 2by
Profit-Maximization; An Example
$/output unit
a

p(y) = a - by

p( y*) =
a−α
a −b
2(b + β )

MC(y) = α + 2βy

α
y* =
a−α
2...
Monopolistic Pricing & Own-Price
Elasticity of Demand
Suppose that market demand
becomes less sensitive to changes
in pric...
Monopolistic Pricing & Own-Price
Elasticity of Demand
d
dp( y)
MR( y) =
( p( y)y) = p( y) + y
dy
dy
y dp( y) 

= p( y) ...
Monopolistic Pricing & Own-Price
Elasticity of Demand
d
dp( y)
MR( y) =
( p( y)y) = p( y) + y
dy
dy
y dp( y) 

= p( y) ...
Monopolistic Pricing & Own-Price
Elasticity of Demand
d
dp( y)
MR( y) =
( p( y)y) = p( y) + y
dy
dy
y dp( y) 

= p( y) ...
Monopolistic Pricing & Own-Price
Elasticity of Demand
1 + 1  .
MR( y) = p( y) 
ε



Suppose the monopolist’s margina...
Monopolistic Pricing & Own-Price
Elasticity of Demand
p( y*) =

k
1
1+
ε

.

E.g. if ε = -3 then p(y*) = 3k/2,
and if ε = ...
Monopolistic Pricing & Own-Price
Elasticity of Demand
1 + 1  = k,
Notice that, since MR( y*) = p( y*) 
ε


1 + 1  ...
Monopolistic Pricing & Own-Price
Elasticity of Demand
1 + 1  = k,
Notice that, since MR( y*) = p( y*) 
ε


1 + 1  ...
Monopolistic Pricing & Own-Price
Elasticity of Demand
1 + 1  = k,
Notice that, since MR( y*) = p( y*) 
ε


1 + 1  ...
Monopolistic Pricing & Own-Price
Elasticity of Demand
1 + 1  = k,
Notice that, since MR( y*) = p( y*) 
ε


1 + 1  ...
Monopolistic Pricing & Own-Price
Elasticity of Demand
1 + 1  = k,
Notice that, since MR( y*) = p( y*) 
ε


1 + 1  ...
Markup Pricing
Markup pricing: Output price is the
marginal cost of production plus a
“markup.”
How big is a monopolist’s ...
Markup Pricing
1 + 1  = k
p( y*) 
ε



kε
⇒ p( y*) =
=
1 1+ ε
1+
ε

is the monopolist’s price.

k
Markup Pricing
1 + 1  = k
p( y*) 
ε



kε
⇒ p( y*) =
=
1 1+ ε
1+
ε
k

is the monopolist’s price. The markup is
kε
k
...
Markup Pricing
1 + 1  = k
p( y*) 
ε



kε
⇒ p( y*) =
=
1 1+ ε
1+
ε
k

is the monopolist’s price. The markup is
kε
k
...
A Profits Tax Levied on a Monopoly
A profits tax levied at rate t reduces
profit from Π(y*) to (1-t)Π(y*).
Q: How is after...
A Profits Tax Levied on a Monopoly
A profits tax levied at rate t reduces
profit from Π(y*) to (1-t)Π(y*).
Q: How is after...
A Profits Tax Levied on a Monopoly
A profits tax levied at rate t reduces
profit from Π(y*) to (1-t)Π(y*).
Q: How is after...
Quantity Tax Levied on a Monopolist
A quantity tax of $t/output unit raises
the marginal cost of production by $t.
So the ...
Quantity Tax Levied on a Monopolist
$/output unit
p(y)
p(y*)

MC(y)

y

y*
MR(y)
Quantity Tax Levied on a Monopolist
$/output unit
p(y)
MC(y) + t

p(y*)

t

MC(y)

y

y*
MR(y)
Quantity Tax Levied on a Monopolist
$/output unit
p(y)
p(yt)
p(y*)

MC(y) + t
t

MC(y)

y

yt y*
MR(y)
Quantity Tax Levied on a Monopolist
$/output unit
p(y)
p(yt)
p(y*)

The quantity tax causes a drop
in the output level, a ...
Quantity Tax Levied on a Monopolist
Can a monopolist “pass” all of a $t
quantity tax to the consumers?
Suppose the margina...
Quantity Tax Levied on a Monopolist
The tax increases marginal cost to $
(k+t)/output unit, changing the profitmaximizing ...
Quantity Tax Levied on a Monopolist
(k + t ) ε
kε
tε
p( y ) − p( y*) =
−
=
1+ε
1+ ε 1+ ε
t

is the amount of the tax passe...
The Inefficiency of Monopoly
A market is Pareto efficient if it
achieves the maximum possible total
gains-to-trade.
Otherw...
The Inefficiency of Monopoly
$/output unit

The efficient output level
ye satisfies p(y) = MC(y).

p(y)
MC(y)

p(ye)
ye

y
The Inefficiency of Monopoly
$/output unit

The efficient output level
ye satisfies p(y) = MC(y).

p(y)
CS

MC(y)

p(ye)
y...
The Inefficiency of Monopoly
$/output unit

The efficient output level
ye satisfies p(y) = MC(y).

p(y)
CS
p(ye)

MC(y)

P...
The Inefficiency of Monopoly
$/output unit
p(y)
CS
p(ye)

The efficient output level
ye satisfies p(y) = MC(y).
Total gain...
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)

MC(y)

y

y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)

CS
MC(y)

y

y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)

CS
MC(y)

PS

y

y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)

CS
MC(y)

PS

y

y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)

CS
MC(y)

PS

y

y*
MR(y)
The Inefficiency of Monopoly
$/output unit
p(y)
p(y*)

CS
PS

MC(y*+1) < p(y*+1) so both
seller and buyer could gain
if th...
The Inefficiency of Monopoly
$/output unit

Deadweight loss measures
the gains-to-trade not
achieved by the market.

p(y)
...
The Inefficiency of Monopoly
The monopolist produces
less than the efficient
quantity, making the
market price exceed the
...
Natural Monopoly
A natural monopoly arises when the
firm’s technology has economies-ofscale large enough for it to supply
...
Natural Monopoly
$/output unit
ATC(y)
p(y)

MC(y)

y
Natural Monopoly
$/output unit
ATC(y)
p(y)
p(y*)

MC(y)
y*

MR(y)

y
Entry Deterrence by a Natural
Monopoly
A natural monopoly deters entry by
threatening predatory pricing against
an entrant...
Entry Deterrence by a Natural
Monopoly
E.g. suppose an entrant initially
captures one-quarter of the market,
leaving the i...
Entry Deterrence by a Natural
Monopoly
$/output unit
ATC(y)
p(y), total demand = DI + DE
DE
DI
MC(y)

y
Entry Deterrence by a Natural
Monopoly
$/output unit
ATC(y)

An entrant can undercut the
incumbent’s price p(y*) but ...

...
Entry Deterrence by a Natural
Monopoly
$/output unit
ATC(y)

An entrant can undercut the
incumbent’s price p(y*) but

p(y)...
Inefficiency of a Natural Monopolist
Like any profit-maximizing
monopolist, the natural monopolist
causes a deadweight los...
Inefficiency of a Natural Monopoly
$/output unit
ATC(y)
p(y)
p(y*)

MC(y)
y*

MR(y)

y
Inefficiency of a Natural Monopoly
$/output unit
ATC(y)
p(y)

Profit-max: MR(y) = MC(y)
Efficiency: p = MC(y)

p(y*)

p(y ...
Inefficiency of a Natural Monopoly
$/output unit
ATC(y)
p(y)

Profit-max: MR(y) = MC(y)
Efficiency: p = MC(y)

p(y*)

DWL
...
Regulating a Natural Monopoly
Why not command that a natural
monopoly produce the efficient
amount of output?
Then the dea...
Regulating a Natural Monopoly
$/output unit

At the efficient output
level ye, ATC(ye) > p(ye)

ATC(y)
p(y)

ATC(ye)
p(ye)...
Regulating a Natural Monopoly
$/output unit
ATC(y)
p(y)

ATC(ye)
p(ye)

At the efficient output
level ye, ATC(ye) > p(ye)
...
Regulating a Natural Monopoly
So a natural monopoly cannot be
forced to use marginal cost pricing.
Doing so makes the firm...
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Transcript of "Ch24"

  1. 1. Chapter Twenty-Four Monopoly
  2. 2. Pure Monopoly A monopolized market has a single seller. The monopolist’s demand curve is the (downward sloping) market demand curve. So the monopolist can alter the market price by adjusting its output level.
  3. 3. Pure Monopoly $/output unit p(y) Higher output y causes a lower market price, p(y). Output Level, y
  4. 4. Why Monopolies? What causes monopolies? – a legal fiat; e.g. US Postal Service
  5. 5. Why Monopolies? What causes monopolies? – a legal fiat; e.g. US Postal Service – a patent; e.g. a new drug
  6. 6. Why Monopolies? What causes monopolies? – a legal fiat; e.g. US Postal Service – a patent; e.g. a new drug – sole ownership of a resource; e.g. a toll highway
  7. 7. Why Monopolies? What causes monopolies? – a legal fiat; e.g. US Postal Service – a patent; e.g. a new drug – sole ownership of a resource; e.g. a toll highway – formation of a cartel; e.g. OPEC
  8. 8. Why Monopolies? What causes monopolies? – a legal fiat; e.g. US Postal Service – a patent; e.g. a new drug – sole ownership of a resource; e.g. a toll highway – formation of a cartel; e.g. OPEC – large economies of scale; e.g. local utility companies.
  9. 9. Pure Monopoly Suppose that the monopolist seeks to maximize its economic profit, Π( y) = p( y)y − c( y). What output level y* maximizes profit?
  10. 10. Profit-Maximization Π( y) = p( y)y − c( y). At the profit-maximizing output level y* dΠ( y) d dc( y) = =0 ( p( y)y) − dy dy dy so, for y = y*, d dc( y) . ( p( y)y) = dy dy
  11. 11. Profit-Maximization $ R(y) = p(y)y y
  12. 12. Profit-Maximization $ R(y) = p(y)y c(y) y
  13. 13. Profit-Maximization $ R(y) = p(y)y c(y) y Π(y)
  14. 14. Profit-Maximization $ R(y) = p(y)y c(y) y* y Π(y)
  15. 15. Profit-Maximization $ R(y) = p(y)y c(y) y* y Π(y)
  16. 16. Profit-Maximization $ R(y) = p(y)y c(y) y* y Π(y)
  17. 17. Profit-Maximization $ R(y) = p(y)y c(y) y* y At the profit-maximizing output level the slopes of Π(y) the revenue and total cost curves are equal; MR(y*) = MC(y*).
  18. 18. Marginal Revenue Marginal revenue is the rate-of-change of revenue as the output level y increases; d dp( y) MR( y) = . ( p( y)y) = p( y) + y dy dy
  19. 19. Marginal Revenue Marginal revenue is the rate-of-change of revenue as the output level y increases; d dp( y) MR( y) = . ( p( y)y) = p( y) + y dy dy dp(y)/dy is the slope of the market inverse demand function so dp(y)/dy < 0. Therefore dp( y) MR( y) = p( y) + y < p( y ) dy for y > 0.
  20. 20. Marginal Revenue E.g. if p(y) = a - by then R(y) = p(y)y = ay - by2 and so MR(y) = a - 2by < a - by = p(y) for y > 0.
  21. 21. Marginal Revenue E.g. if p(y) = a - by then R(y) = p(y)y = ay - by2 and so MR(y) = a - 2by < a - by = p(y) for y > 0. a p(y) = a - by a/2b a/b y MR(y) = a - 2by
  22. 22. Marginal Cost Marginal cost is the rate-of-change of total cost as the output level y increases; dc( y) MC( y) = . dy E.g. if c(y) = F + αy + βy2 then MC( y) = α + 2βy.
  23. 23. $ Marginal Cost c(y) = F + αy + βy2 F $/output unit y MC(y) = α + 2βy α y
  24. 24. Profit-Maximization; An Example At the profit-maximizing output level y*, MR(y*) = MC(y*). So if p(y) = a - by and c(y) = F + αy + βy2 then MR( y*) = a − 2by* = α + 2βy* = MC( y*)
  25. 25. Profit-Maximization; An Example At the profit-maximizing output level y*, MR(y*) = MC(y*). So if p(y) = a - by and if c(y) = F + αy + βy2 then MR( y*) = a − 2by* = α + 2βy* = MC( y*) and the profit-maximizing output level is a−α y* = 2( b + β )
  26. 26. Profit-Maximization; An Example At the profit-maximizing output level y*, MR(y*) = MC(y*). So if p(y) = a - by and if c(y) = F + αy + βy2 then MR( y*) = a − 2by* = α + 2βy* = MC( y*) and the profit-maximizing output level is a−α y* = 2( b + β ) causing the market price to be a−α p( y*) = a − by* = a − b . 2(b + β )
  27. 27. Profit-Maximization; An Example $/output unit a p(y) = a - by MC(y) = α + 2βy α y MR(y) = a - 2by
  28. 28. Profit-Maximization; An Example $/output unit a p(y) = a - by MC(y) = α + 2βy α y* = a−α 2(b + β ) y MR(y) = a - 2by
  29. 29. Profit-Maximization; An Example $/output unit a p(y) = a - by p( y*) = a−α a −b 2(b + β ) MC(y) = α + 2βy α y* = a−α 2(b + β ) y MR(y) = a - 2by
  30. 30. Monopolistic Pricing & Own-Price Elasticity of Demand Suppose that market demand becomes less sensitive to changes in price (i.e. the own-price elasticity of demand becomes less negative). Does the monopolist exploit this by causing the market price to rise?
  31. 31. Monopolistic Pricing & Own-Price Elasticity of Demand d dp( y) MR( y) = ( p( y)y) = p( y) + y dy dy y dp( y)   = p( y) 1 + .  p( y) dy 
  32. 32. Monopolistic Pricing & Own-Price Elasticity of Demand d dp( y) MR( y) = ( p( y)y) = p( y) + y dy dy y dp( y)   = p( y) 1 + .  p( y) dy  Own-price elasticity of demand is p( y) dy ε= y dp( y)
  33. 33. Monopolistic Pricing & Own-Price Elasticity of Demand d dp( y) MR( y) = ( p( y)y) = p( y) + y dy dy y dp( y)   = p( y) 1 + .  p( y) dy  Own-price elasticity of demand is p( y) dy 1 + 1  . ε= so MR( y) = p( y)  y dp( y)  ε 
  34. 34. Monopolistic Pricing & Own-Price Elasticity of Demand 1 + 1  . MR( y) = p( y)  ε   Suppose the monopolist’s marginal cost of production is constant, at $k/output unit. For a profit-maximum 1 + 1  = k MR( y*) = p( y*)  which is  k ε  p( y*) = . 1 1+ ε
  35. 35. Monopolistic Pricing & Own-Price Elasticity of Demand p( y*) = k 1 1+ ε . E.g. if ε = -3 then p(y*) = 3k/2, and if ε = -2 then p(y*) = 2k. So as ε rises towards -1 the monopolist alters its output level to make the market price of its product to rise.
  36. 36. Monopolistic Pricing & Own-Price Elasticity of Demand 1 + 1  = k, Notice that, since MR( y*) = p( y*)  ε   1 + 1  > 0 p( y*)  ε  
  37. 37. Monopolistic Pricing & Own-Price Elasticity of Demand 1 + 1  = k, Notice that, since MR( y*) = p( y*)  ε   1 + 1  > 0 ⇒ 1 + 1 > 0 p( y*)  ε ε  
  38. 38. Monopolistic Pricing & Own-Price Elasticity of Demand 1 + 1  = k, Notice that, since MR( y*) = p( y*)  ε   1 + 1  > 0 ⇒ 1 + 1 > 0 p( y*)  ε ε   1 That is, ε > −1
  39. 39. Monopolistic Pricing & Own-Price Elasticity of Demand 1 + 1  = k, Notice that, since MR( y*) = p( y*)  ε   1 + 1  > 0 ⇒ 1 + 1 > 0 p( y*)  ε ε   1 > −1 ⇒ ε < −1. That is, ε
  40. 40. Monopolistic Pricing & Own-Price Elasticity of Demand 1 + 1  = k, Notice that, since MR( y*) = p( y*)  ε   1 + 1  > 0 ⇒ 1 + 1 > 0 p( y*)  ε ε   1 > −1 ⇒ ε < −1. That is, ε So a profit-maximizing monopolist always selects an output level for which market demand is own-price elastic.
  41. 41. Markup Pricing Markup pricing: Output price is the marginal cost of production plus a “markup.” How big is a monopolist’s markup and how does it change with the own-price elasticity of demand?
  42. 42. Markup Pricing 1 + 1  = k p( y*)  ε   kε ⇒ p( y*) = = 1 1+ ε 1+ ε is the monopolist’s price. k
  43. 43. Markup Pricing 1 + 1  = k p( y*)  ε   kε ⇒ p( y*) = = 1 1+ ε 1+ ε k is the monopolist’s price. The markup is kε k p( y*) − k = −k = − . 1+ ε 1+ ε
  44. 44. Markup Pricing 1 + 1  = k p( y*)  ε   kε ⇒ p( y*) = = 1 1+ ε 1+ ε k is the monopolist’s price. The markup is kε k p( y*) − k = −k = − . 1+ ε 1+ ε E.g. if ε = -3 then the markup is k/2, and if ε = -2 then the markup is k. The markup rises as the own-price elasticity of demand rises towards -1.
  45. 45. A Profits Tax Levied on a Monopoly A profits tax levied at rate t reduces profit from Π(y*) to (1-t)Π(y*). Q: How is after-tax profit, (1-t)Π(y*), maximized?
  46. 46. A Profits Tax Levied on a Monopoly A profits tax levied at rate t reduces profit from Π(y*) to (1-t)Π(y*). Q: How is after-tax profit, (1-t)Π(y*), maximized? A: By maximizing before-tax profit, Π(y*).
  47. 47. A Profits Tax Levied on a Monopoly A profits tax levied at rate t reduces profit from Π(y*) to (1-t)Π(y*). Q: How is after-tax profit, (1-t)Π(y*), maximized? A: By maximizing before-tax profit, Π(y*). So a profits tax has no effect on the monopolist’s choices of output level, output price, or demands for inputs. I.e. the profits tax is a neutral tax.
  48. 48. Quantity Tax Levied on a Monopolist A quantity tax of $t/output unit raises the marginal cost of production by $t. So the tax reduces the profitmaximizing output level, causes the market price to rise, and input demands to fall. The quantity tax is distortionary.
  49. 49. Quantity Tax Levied on a Monopolist $/output unit p(y) p(y*) MC(y) y y* MR(y)
  50. 50. Quantity Tax Levied on a Monopolist $/output unit p(y) MC(y) + t p(y*) t MC(y) y y* MR(y)
  51. 51. Quantity Tax Levied on a Monopolist $/output unit p(y) p(yt) p(y*) MC(y) + t t MC(y) y yt y* MR(y)
  52. 52. Quantity Tax Levied on a Monopolist $/output unit p(y) p(yt) p(y*) The quantity tax causes a drop in the output level, a rise in the output’s price and a decline in demand for inputs. MC(y) + t t MC(y) y yt y* MR(y)
  53. 53. Quantity Tax Levied on a Monopolist Can a monopolist “pass” all of a $t quantity tax to the consumers? Suppose the marginal cost of production is constant at $k/output unit. With no tax, the monopolist’s price is kε p( y*) = . 1+ ε
  54. 54. Quantity Tax Levied on a Monopolist The tax increases marginal cost to $ (k+t)/output unit, changing the profitmaximizing price to (k + t ) ε p( y ) = . 1+ ε t The amount of the tax paid by buyers is t p( y ) − p( y*).
  55. 55. Quantity Tax Levied on a Monopolist (k + t ) ε kε tε p( y ) − p( y*) = − = 1+ε 1+ ε 1+ ε t is the amount of the tax passed on to buyers. E.g. if ε = -2, the amount of the tax passed on is 2t. Because ε < -1, ε /(1+ ε ) > 1 and so the monopolist passes on to consumers more than the tax!
  56. 56. The Inefficiency of Monopoly A market is Pareto efficient if it achieves the maximum possible total gains-to-trade. Otherwise a market is Pareto inefficient.
  57. 57. The Inefficiency of Monopoly $/output unit The efficient output level ye satisfies p(y) = MC(y). p(y) MC(y) p(ye) ye y
  58. 58. The Inefficiency of Monopoly $/output unit The efficient output level ye satisfies p(y) = MC(y). p(y) CS MC(y) p(ye) ye y
  59. 59. The Inefficiency of Monopoly $/output unit The efficient output level ye satisfies p(y) = MC(y). p(y) CS p(ye) MC(y) PS ye y
  60. 60. The Inefficiency of Monopoly $/output unit p(y) CS p(ye) The efficient output level ye satisfies p(y) = MC(y). Total gains-to-trade is maximized. MC(y) PS ye y
  61. 61. The Inefficiency of Monopoly $/output unit p(y) p(y*) MC(y) y y* MR(y)
  62. 62. The Inefficiency of Monopoly $/output unit p(y) p(y*) CS MC(y) y y* MR(y)
  63. 63. The Inefficiency of Monopoly $/output unit p(y) p(y*) CS MC(y) PS y y* MR(y)
  64. 64. The Inefficiency of Monopoly $/output unit p(y) p(y*) CS MC(y) PS y y* MR(y)
  65. 65. The Inefficiency of Monopoly $/output unit p(y) p(y*) CS MC(y) PS y y* MR(y)
  66. 66. The Inefficiency of Monopoly $/output unit p(y) p(y*) CS PS MC(y*+1) < p(y*+1) so both seller and buyer could gain if the (y*+1)th unit of output was produced. Hence the MC(y) market is Pareto inefficient. y y* MR(y)
  67. 67. The Inefficiency of Monopoly $/output unit Deadweight loss measures the gains-to-trade not achieved by the market. p(y) p(y*) MC(y) DWL y y* MR(y)
  68. 68. The Inefficiency of Monopoly The monopolist produces less than the efficient quantity, making the market price exceed the efficient market $/output unit p(y) p(y*) p(ye) MC(y) DWL y* price. y ye MR(y)
  69. 69. Natural Monopoly A natural monopoly arises when the firm’s technology has economies-ofscale large enough for it to supply the whole market at a lower average total production cost than is possible with more than one firm in the market.
  70. 70. Natural Monopoly $/output unit ATC(y) p(y) MC(y) y
  71. 71. Natural Monopoly $/output unit ATC(y) p(y) p(y*) MC(y) y* MR(y) y
  72. 72. Entry Deterrence by a Natural Monopoly A natural monopoly deters entry by threatening predatory pricing against an entrant. A predatory price is a low price set by the incumbent firm when an entrant appears, causing the entrant’s economic profits to be negative and inducing its exit.
  73. 73. Entry Deterrence by a Natural Monopoly E.g. suppose an entrant initially captures one-quarter of the market, leaving the incumbent firm the other three-quarters.
  74. 74. Entry Deterrence by a Natural Monopoly $/output unit ATC(y) p(y), total demand = DI + DE DE DI MC(y) y
  75. 75. Entry Deterrence by a Natural Monopoly $/output unit ATC(y) An entrant can undercut the incumbent’s price p(y*) but ... p(y), total demand = DI + DE DE p(y*) pE DI MC(y) y
  76. 76. Entry Deterrence by a Natural Monopoly $/output unit ATC(y) An entrant can undercut the incumbent’s price p(y*) but p(y), total demand = DI + DE DE p(y*) pE pI MC(y) the incumbent can then lower its price as far as pI, forcing DI the entrant to exit. y
  77. 77. Inefficiency of a Natural Monopolist Like any profit-maximizing monopolist, the natural monopolist causes a deadweight loss.
  78. 78. Inefficiency of a Natural Monopoly $/output unit ATC(y) p(y) p(y*) MC(y) y* MR(y) y
  79. 79. Inefficiency of a Natural Monopoly $/output unit ATC(y) p(y) Profit-max: MR(y) = MC(y) Efficiency: p = MC(y) p(y*) p(y ) e MC(y) y* MR(y) ye y
  80. 80. Inefficiency of a Natural Monopoly $/output unit ATC(y) p(y) Profit-max: MR(y) = MC(y) Efficiency: p = MC(y) p(y*) DWL p(y ) e MC(y) y* MR(y) ye y
  81. 81. Regulating a Natural Monopoly Why not command that a natural monopoly produce the efficient amount of output? Then the deadweight loss will be zero, won’t it?
  82. 82. Regulating a Natural Monopoly $/output unit At the efficient output level ye, ATC(ye) > p(ye) ATC(y) p(y) ATC(ye) p(ye) MC(y) MR(y) ye y
  83. 83. Regulating a Natural Monopoly $/output unit ATC(y) p(y) ATC(ye) p(ye) At the efficient output level ye, ATC(ye) > p(ye) so the firm makes an economic loss. MC(y) Economic loss MR(y) ye y
  84. 84. Regulating a Natural Monopoly So a natural monopoly cannot be forced to use marginal cost pricing. Doing so makes the firm exit, destroying both the market and any gains-to-trade. Regulatory schemes can induce the natural monopolist to produce the efficient output level without exiting.
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