Lecture 5 27.02.13


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  • See section 4-2 and Figure 4-4 in the main text.
  • See Section 8-6 in the main text, and Figure 8-12.
  • Lecture 5 27.02.13

    1. 1. EC-103Semester 2Lecture 5Market structure, perfect competition,monopoly and imperfect competition(cont’d)
    2. 2. MonopolyThe market structure of monopoly is at the opposite end ofperfect competition – exists when an industry is in the hands of asingle producer.A firm is viewed as a monopoly if•it is the sole seller of its product and the only potential supplier•it produces a product which does not have close substitutes
    3. 3. A monopoly arises due to barriers to entryThese have three major sources:•ownership of a key resource•a government gives just one firm the right to produce a product•may arise from patent and copyright laws•cost of production make a single producer more efficient than alarge number of producersone firm can supply market cheaper than two or more firms
    4. 4. While a competitive firm is a price taker, a monopoly is a pricemaker.As it is the only producer and supplier of the product, its demandcurve is the market demand curve for the product.As this curve is downward sloping each extra sale pushes downthe price at which all units are sold.As a result the marginal revenue arising from an increase insales will be less than the price at which the unit is sold.
    5. 5. Demand and Marginal Revenue for MonopolyD=ARUnit elasticityElasticInelasticQuantityPrice•DQuantityTotalRevenue(+)TR< (-)TR(+)TR< (-)TRMR©The McGraw-Hill Companies
    6. 6. Profit maximization by a monopolistProfits are maximizedwhere MC = MR at Q1P1.It then uses the demandcurve to find the price.In this position, AR isgreater than ACso the firm makesprofits above theopportunity cost ofcapital shown by theshaded area.Entry barriers preventnew firms joining theindustry.AC1OutputMC=MR£P1Q1MCACD = ARMR©The McGraw-Hill Companies
    7. 7. Comparing a Monopoly with Perfect CompetitionEquilibrium in a competitive industry occurs at the intersection of thesupply curve (MC) and demand curve. Output is QC and price PC.Monopolist sets MC = MR output falls to QM, given output level QM price isPM. Monopolist reduces output and increases price.Monopolist does not operate where price is equal to MC and so the levelof output is not allocatively efficient and leads to a welfare loss.If the cost structures of themonopoly and thecompetitive industry arethe same, then themarginal cost curve, MC isthe competitive industry’ssupply curve.
    8. 8. Welfare loss of MonopolyIn perfect competition equilibrium occurs at PC and QC and consumersurplus is given by areas 1, 4 and 3.When a monopolist runs the industry price increases to PM and consumersurplus is now only area 3. Area 1 is lost due to reduction in output. Area4 is lost due to increase in price and transferred to the monopolist.
    9. 9. In perfect competition producer surplus is given by areas 2 and 5.When a monopolist runs the industry price rises and producersurplus area 2 is lost, but the monopolist has gained area 4. Area 4is greater than area 2 as output QM and price PM maximizes profit.Society, however, loses areas 1 and 2 as a result of the monopolyand this is the deadweight loss arising from allocative inefficiency.Public policy makers have attempted to deal with the problem ofmonopoly through a number of channels.i.Making industries more competitiveii.Regulating monopoliesiii.Turning them into public enterprisesHowever others have suggested doing nothing as ‘Political Failure’ isusually greater than ‘Market Failure’.
    10. 10. Discriminating MonopolyIf a monopolist supplies two separate groups of customers•with differing elasticities of demandIt can be shown that a monopolist can increase profits by charging differentprices to different individuals.•business travellers may be less sensitive to price levels than touristsMonopolist may increase profits by charging higher prices to businessmenthan touristsDiscrimination is more likely to be possible for goods that cannot be resold•dental treatment•train and airline travel•private medical treatment
    11. 11. Perfect price discrimination occurs where a monopolist chargeseach individual exactly what they are willing to pay. Therefore thediscriminating monopolist collects the surplus on each transaction.Because consumer surplus is zero for the perfectly discriminatingmonopolist, the total surplus is equal to profit. This case has beendescribed as first degree price discrimination.
    12. 12. THIRD DEGREE PRICE DISCRIMINATIONThis takes place where different prices are charged to different groups ofconsumers for the same product.For this to take place the firm must be able to separate consumers into twosub-markets and the demand curve for consumers in these two sub-groupsmust be different.
    13. 13. For simplicity assume the MC curve is constant (equal to 5).The profit maximising firm will equate marginal revenue with marginal cost.Output will equal 10 and price charged will equal 10.Profit = TR – TCProfit = P.Q – AC.Q= (10 x 10) – (5 x 10)= 50As marginal revenue differs across submarkets the monopolist could re-allocate its output and increase its profit by charging a lower price toconsumers with a higher elasticity of demand – lower willingness to pay.Profit = (TRA– TCA) + (TRB– TCB)Profit = [(14 x 4) – (5 x 4) + (9 x 6) – (5 x 6)]= 56 – 20 + 54 – 30= 60By exploiting the different elasticities of demand in the two markets profitshave increased from 50 to 60.
    14. 14. SummaryA monopoly compared with perfect competition implies•higher price•lower outputMonopolist can increase profits by price discriminatingMonopoly results in welfare loseThe firm by exploiting economies of scale may imply theconsumer doesn’t always lose from monopolyPolicy makers can respond to inefficiencies of monopolybehaviours through competitive legislation, regulation of prices,or by turning the monopoly into a government-run enterpriseIf the market failure is viewed to be small, policy makers maydecide to do nothing at all