GEN 315 Week four chapter eight ppt lecture

1. Chapter 8
Monopoly, Oligopoly, and
Monopolistic Competition
© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
distribution without the prior written consent of McGraw-Hill Education.

2. © 2019 McGraw-Hill Education. 2
Learning Objectives
1. Distinguish among three types of imperfectly competitive
industries and describe how imperfect competition differs from
perfect competition.
2. Identify the five sources of market power.
3. Describe how economies of scale are affected by how large fixed
costs are in relation to marginal cost.
4. Apply the concepts of marginal cost and marginal revenue to find
the output level and price that maximize a monopolist's profits.
5. Explain why the profit-maximizing output level for a monopolist is
too small from society's perspective.
6. Discuss why firms often offer discounts to buyers who are willing
to jump some form of hurdle.
7. Discuss public policies that are often applied to natural
monopolies.

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Imperfect Competition1
Imperfectly competitive firms have some ability
to set their own price: they are price setters
• Long-run economic profits possible
• Reduce economic surplus
Three types:
1. Monopoly has only one seller, no close substitutes
2. Monopolistic competition has many firms
producing slightly differentiated products that are
reasonably close substitutes
3. Oligopoly has a small number of large firms
producing products that are close substitutes

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Monopoly
Monopoly
Perfect
Competition
Number of Firms One firm Many firms
Price Complete flexibility Price taker
Entry and Exit Difficult or impossible Free
Product Unique Standardized
Economic Profits Possible Zero in long run
Decisions P, Q Q only

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Monopolistic Competition
Monopolistic
Competition
Perfect
Competition
Number of Firms Many firms Many firms
Price Limited flexibility Price taker
Entry and Exit Free Free
Product Differentiated Standardized
Economic Profits Zero in long run Zero in long run
Decisions
P, Q, product
differentiation
Q only

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Oligopoly
Oligopoly
Perfect
Competition
Number of Firms
Few firms,
each large
Many firms
Price Some flexibility Price taker
Entry and Exit Difficult Free
Product
Differentiated or
standardized
Standardized
Economic Profits Possible Zero in long run
Decisions
P, Q, differentiation,
advertising
Q only

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Imperfect Competition2
Examples of monopoly
• Electricity and Magic Cards
Examples of monopolistic competition
• Retail gas stations
• Convenience stores
Examples of oligopoly
• Wireless phone service
• Cement
• Automobiles and tobacco

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The Essential Difference between Perfectly
and Imperfectly Competitive Firms
Market power is the firm's ability to raise its price
without losing all its sales
Any firm facing a downward sloping demand curve
• Firm picks P and Q on the demand curve
Market power comes from factors that limit competition

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Five Sources of Market
Power
1. Exclusive control over inputs
2. Patents and copyrights
3. Government licenses or franchises
4. Economies of scale (natural
monopolies)
5. Network economies

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Market Power: Economies
of Scale
Returns to scale refers to the percentage
change in output from a given percentage
change in ALL inputs
• Long-run idea
• Constant returns to scale: doubling all inputs
doubles output
• Increasing returns to scale: output increases by a
greater percentage than the increase in inputs
• Average costs decrease as output increases
• Natural monopoly: a monopoly that results from
economies of scale

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Market Power: Network
Economies
Network economies occur when the
value of the product increases as the
number of users increases
• Blu-Rays vs. DVDs
• Telephones
• Windows operating system
• eBay
• Facebook and Instagram

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Economies of Scale and
Start-Up Costs1
New products can have a large fixed development cost
Variable cost: sum of payments made to the variable
factors, such as labor
Fixed cost: sum of payments made to the fixed
factors, such as capital
Start-up costs can be thought of as a fixed cost
Average total cost (ATC): total cost divided by output
A good whose production has a large start-up cost and
low variable cost is subject to economies of scale
• ATC declines sharply as output increases

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Economies of Scale and
Start-Up Costs2
Consider an example:
Assume marginal cost (M) is constant
Variable cost is M*Q
Total cost is fixed cost (F) plus variable cost
TC = F + M*Q
• Total cost increases as output increases
Average total cost is
ATC = F / Q + M
• Average total cost decreases as output increases
• Average fixed cost = F/Q

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Economies of Scale

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Example: Video Game
Producers – Different Volumes
Nintendo Sony
Annual Production
(1000s)
1,000 1,200
Fixed Cost ($1000s) $200 $200
Variable Cost
($1000s)
$800 $960
Total Cost ($1000s) $1,000 $1,160
ATC per game $1.00 $0.97

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Example: Video Game Producers
– Lower Marginal Costs
Nintendo Sony
Annual Production
(1000s)
1,000 1,200
Fixed Cost ($1000s) $200 $200
Variable Cost
($1000s)
$200 $240
Total Cost ($1000s) $400 $440
ATC per game $0.40 $0.37

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Example: Video Game Producers
– Higher Fixed Cost
Nintendo Sony
Annual Production
(1000s)
1,000 1,200
Fixed Cost ($1000s) $10,000 $10,000
Variable Cost
($1000s)
$200 $240
Total Cost ($1000s) $10,200 $10,240
ATC per game $10.20 $8.53

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Example: Video Game Producers
– Different Production Levels
Nintendo Sony
Annual Production
(000s)
500 1,700
Fixed Cost ($000s) $10,000 $10,000
Variable Cost
($000s)
$100 $340
Total Cost ($000s) $10,100 $10,240
ATC per game $20.20 $6.08

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Intel's Advantage
Intel can spend $2 billion to develop a
new chi
Once developed, the marginal cost of
each one is pennies
Intel supplies more than 80% of the
processors for PCs
And before anyone can even try to
compete, they need to spend billions too!

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Profit Maximization for the
Monopolist1
Like all other firms, a monopolist:
• Maximizes profits
• Applies the Cost-Benefit Principle:
• Increase output if marginal benefit > marginal cost
• Decrease output is marginal benefit < marginal cost
Marginal benefit is called marginal revenue:
• Change in total revenue from a one-unit change in
output
• Equal to price for the perfectly competitive firm
• Less than price for the monopolist

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Profit Maximization for the
Monopolist2
To sell another unit the monopolist must lower price
• Total revenue from 2 units = $12
• Total revenue from 3 units = $15
• Marginal revenue = $3

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Monopolist's Marginal
Revenue
Price Quantity
$6 2
$5 3
$4 4
$3 5
Total Revenue
$12
$15
$16
$15
Marginal Revenue
3
1
-1

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Monopoly Demand and
Marginal Revenue
The monopolist's
marginal revenue
curve:
• Has the same intercept
as the straight-line
demand curve
• Has twice the slope of
the demand curve
• Lies below the demand
curve

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Deciding Quantity
Profit is maximized at the
level of output where
marginal cost equals
marginal revenue
At P = $3 and Q = 12,
MC > MR
• Decrease output
• At Q = 8, MC = MR = 2
• The demand curve sets
the price at P = $4
• At any output below 8,
MC < MR

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Monopoly Profit
Profit = Total revenue – total cost
Total cost = ATC × Q
Profit = P × Q – ATC × Q
Profit = (P−ATC) × Q
If P > ATC then the firm earns a profit
If P < ATC then the firm suffers a loss
This can be graphically illustrated

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Monopoly Losses and Profits
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The Invisible Hand Fails
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Monopoly and Perfect
Competition

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Managing Monopoly: The
Breakdown of the Invisible Hand
Monopolies exist for economic reasons
• Patents, copyrights, and innovation
• Economies of scale
• Network economies
Anti-trust laws attempt to limit deadweight
loss
• Limiting monopoly has costs
• Patents encourage innovation
• Economies of scale minimize ATC
• Network economies increase benefits

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Price Discrimination
Price discrimination means charging different
buyers different prices for essentially the same
good or service
• Separate the groups
• No side trades among buyers
Many forms of price discrimination
• Hurdle method: discounts for identifiable groups
(e. g., students, AARP)
• Perfect discrimination: negotiate separate deals
with each customer

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Carla the Editor: Social
Optimum
Opportunity cost of Carla's time is $29
Student
Reservation
Price
Total
Revenue
A $40 $40
B 38 $76
C 36 $108
D 34 $136
E 32 $160
F 30 $180
G 28 $196
What if Carla
is a profit
maximizer?
What is
Carla's total
revenue?

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Carla the Editor: Marginal
Revenue
What is Carla's marginal
revenue?
3 papers with an
economic profit of $21
Opportunity cost of Carla's time is $29
Student
Reservation
Price
Total
Revenue
MR
A $40 $40 $40
B 38 $76 $36
C 36 $108 $32
D 34 $136 $28
E 32 $160 $24
F 30 $180 $20
G 28 $196 $16

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Carla the Editor: Price
Discriminator
Opportunity cost of Carla's time is $29 6 papers with
an economic
profit of $36
Student
Reservation
Price
Total
Revenue
Marginal
Revenue
A $40 $40
B 38 $78 38
C 36 $114 36
D 34 $148 34
E 32 $180 32
F 30 $210 30
G 28 $238 28

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Hurdle Method of Price
Discrimination
The hurdle method of price discrimination is
the practice of offering a discount to all
buyers who overcome some obstacle.
• Temporary sales
• Hard cover and paperback books
• Multiple car models from one manufacturer
• Commercial air carriers
• Movie producers and phased releases
• Scratch and Dent appliance sales

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Carla Offers a Rebate
If reservation price < $36, student will mail in rebate
Student Reservation Price
Total
Revenue
MR
A $40 $40 $40
B 38 76 36
C 36 108 32
Discounted Price Submarket
D $34 $34 $34
E 32 64 30
F 30 90 26

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Carla's Choices
Program
Social
Optimum
Single
Price
Perfect
Discriminator
Hurdle
Papers Edited 6 3 6 5 = (3 + 2)
Price $30 $36 Reservation
$36, $4
rebate
Total Revenue $180 $108 $210 $172
Carla's Time $174 $87 $174 $145
Economic Profit $6 $21 $36 $27
Total Surplus $26 $27 $36 $35

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Monopoly and Public Policy
Challenge: create the greatest increase in
total surplus
Policy options
• Government ownership and operation
• Regulation
• Competitive bids for natural monopoly
services
• Break up

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State-Owned Natural
Monopoly
Marginal cost is always less than average cost
• Marginal cost pricing produces losses
Options
• Fund losses from tax revenues
• Fixed monthly fee plus usage fee
• Fixed fee covers losses
Limited incentives to innovate and cut costs
Commonly used for water, Post Office, and
some electricity

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Regulated Monopolies
Cost-plus regulation sets price at per
unit explicit costs plus a mark-up for
implicit costs
Used for electricity, telephone, and cable
• Policies vary by state
Disadvantages
• High administrative cost
• Reduced incentive for cost-saving innovation
• Price is greater than marginal cost

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Exclusive Contracting for
Natural Monopolies
Government awards contract to low
bidder for natural monopoly services
• Garbage collection, fire protection, road
construction, Department of Defense
Could achieve marginal cost pricing IF
government pays the resulting losses
Asset transfer for large fixed investment is
complex

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Enforcement of Anti-Trust
Laws
Two landmark laws
• Sherman Act of 1890
• Declared conspiracy to create a monopoly illegal
• Clayton Act of 1914
• Outlawed transactions that would "substantially
lessen competition"
Applies to mergers and acquisitions today
• IBM avoided break-up; AT&T did not
• Microsoft survived; will Google?

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Another Policy Option:
Ignore Monopoly
Two objections to monopolies
• Restrict output, decrease total surplus
• Raise price, earn economic profits
Analysis
• Discount offers allow some customers to pay less
than average cost, though more than marginal cost
• Economic profits generated by customers who pay list price –
their choice
• About two-thirds of economic profits are taxed away
• Remainder accrues to shareholders

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Imperfect Competition

44. Chapter 8
Appendix
The Algebra of Monopoly Maximization
© 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or
distribution without the prior written consent of McGraw-Hill Education.

45. © 2019 McGraw-Hill Education. 45
From Demand to Marginal
Revenue
Given a demand curve such as
P = 15 − 2 Q
We can write the marginal revenue curve as
MR = 15 − 4 Q
• Suppose marginal cost is a line with zero intercept
and a slope of 1
MC = Q
The remaining step is to set marginal revenue
equal to marginal cost

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MR = MC
Let Q* be the profit maximizing level of output
MC = MR
Q* = 15 − 4 Q*
5 Q* = 15
Q* = 3
To find P, substitute Q = 3 into the
demand equation
P = 15 − 4 Q*
P = 15 − 4 (3)
P = 3