2. Announcements
• Problem Set 1 is due! Pass to end of aisle.
• Thanks for clicking to ``follow’’ class website!
(now 90 are signed up.)
• Thanks for registering your clickers! Now ____
people are really cool.
• Today is the beginning of our discussion of
imperfections. (New material for nearly
everyone.)
3. Last Class
• Studied how marginal revenue and marginal
cost are calculated in simple examples.
• We will apply this basic knowledge to study
how monopolies profit-maximize.
4. Learning Goals for Today
• List the sources of market power that make a
firm a monopoly.
– We will study how monopolies gain special
privilege in the market place, and what this
means.
• Show how a given monopoly will behave in
the market place
– Use marginal revenue and marginal cost to predict
profit-maximizing behavior.
5. What is a perfectly competitive
market?
• Firms have no influence over what the going
price in the market is.
– ``Price-takers.’’
• Characteristic of perfectly competitive
markets:
– All firms sell the same (really the same!) product.
– There are many buyers and sellers.
– There are no costly barriers to starting a business.
– Both consumers and firms are well-informed.
6. What is individual firm demand under
perfect competition?
N firms
P (Whole Market) P One Firm Demand
S=MC S=MC
P*
D
D
NQ* Q*
Q Q
7. Geometry of Profits
• Individual firm profits:
– ∏=PDQ*-TC(Q*)
– ATC=TC/Q* implies ∏=(PD-ATC)Q*.
• Recall: Why does MC intersect ATC at its trough?
P One Firm Profit
ATC
S=MC
PD
Q* Q
8. Putting it together: perfect competition.
• Individual profits must be zero.
• If profits were negative, firms would shut down.
• If profits were positive, more firms would enter market
P N firms P One Firm Demand P One Firm Profit
ATC
S=MC S=MC S=MC
D
D
NQ* Q* Q*
Q Q Q
9. Why does firm entry squeeze out profits?
A. An entering firm can steal all unmet demand.
B. An entering firm causes quantity sold by each
original firm to decrease.
10. Answer: B
• Assume profits (red rectangle) are positive and the market quantity is is
NQ*.
• If another firm enters market, NQ* quantity now shared amongst N+1 firms.
• In this case, Q* being produced by each firm reduces to N(N+1)Q* being
produced by each firm, so red rectangle gets smaller.
P One Firm Profit
ATC
S=MC
PD
Q
N/(N+1)Q* Q*
11. Market Power
• Another interpretation of ``price takers’’ is
that they have no market power.
• Conversely, but equivalently, market power is
the ability of an individual firm to set the
going price in the market place.
• What are some sources of market power?
12. Some sources of market power
1 Exclusive control of inputs.
2 Patents and copyrights.
3 Government licenses.
4 Network economies.
When market power allows one firm to take over the
market, that firm is called a monopoly.
13. Fifth type: Natural monopolies
• Average production cost falls as output
increases
• One source: Economies of scale
• Another source: High fixed costs
14. High Fixed Costs
• FC = fixed cost (start-up cost)
• MC=marginal cost (assume constant: Example is one
more unit takes one more laborer which costs one more
wage)
• TC=FC + VC
• ATC=FC/Q + VC/Q where VC/Q=MC
ATC=FC/Q+MC
MC
Q
15. High Fixed Costs Due to R&D
• Approximate cost of building a state-of-the-art manufacturing
plant for microprocessors in Asia: $3 billion.
• Average cost of bringing a new drug to market: $1.3 billion.
• Annual R&D expenditures
– Google: 5.2 billion
– Microsoft: 9.4 billion
– Apple: 2.6 billion
– Pfizer: 8.4 billion
16. Recall what a perfectly competitive
market is
• Characteristic of perfectly competitive
markets:
– All firms sell the same (really the same!) product.
– There are many buyers and sellers.
– There are no costly barriers to starting a business.
– Both consumers and firms are well-informed.
• Which do monopolies contradict?
17. The Essential Difference Between Perfectly and
Imperfectly Competitive Firms
P P
D
D
Q Q
Perfectly Competitive Imperfectly Competitive
Firm Firm
18. Under perfect competition, P* is the
market price. What price would a
profit-maximizing firm charge if there
were no competition, ie, one firm?
P
A. PA PA MC
B. PB
PB
C. PC P*
D. PD(=0) PC
E. P* PD
PD
Q*
Q
MR
20. Deciding Price
$
• Q=6, P=5 8
MC=2=MR, optimal Q 7
MC
Q determined by setting MC=MR 6
5
• Don’t charge $2! Trace up to
4
demand curve; consumers willing
3
to pay $5 when Q=6, so charge
2
them that.
1 D
2 4 6 8 10 12 14 16
MR
21. Again: Under perfect competition, P*
is the market price. What price would
a profit-maximizing firm charge if
there were no competition, ie, one
P firm?
A. PA PA MC
B. PB
PB
C. PC P*
D. PD(=0) PC
E. P* PD
PD
Q*
Q
MR
22. The Invisible Hand Fails
P
The socially optimal
amount occurs where
MC = MB S=MC
PM
The monopolist's optimal
amount occurs where
MC = MR
D
QM MR Q
22
24. Which Monopoly should shut down?
A B
$ $
8 8
7 ATC 7
MC MC
6 6
5 ATC
5
4 4
3 3
2 2
D 1 D
1
2 4 6 8 10 12 14 16 2 4 6 8 10 12 14 16
MR MR
24
25. Answer: A. Recall: Profits=(P-
ATC)Q
A: LOSS B: PROFIT
$ $
8 8
7 ATC 7
MC MC
6 6
5 ATC
5
4 4
3 3
2 2
D 1 D
1
2 4 6 8 10 12 14 16 2 4 6 8 10 12 14 16
MR MR
25
26. Summary: Comparing Monopoly
and Perfect Competition
Monopoly Perfect Competition
MC = MR MC = MR
P >MR P = MR
P > MC P = MC
Deadweight No Deadweight
Loss Loss
26
27. Price Discrimination
• Price discrimination: the practice of charging different buyers
different prices for essentially the same good.
• How does price discrimination affect output and profits?
• Simple model
– Assume fixed costs=0 and that marginal costs are constant.
– Implies that marginal costs equal average costs
– Example: If marginal cost=5, then if Q=5, TC=25 and ATC
(=TC/Q)=5.
28. Output With and Without Price
Discrimination
P P
CS
DWL
PS
MC=ATC MC=ATC
MR D D
Q Q
Can charge each
Perfectly Price buyer exactly
Single-Price Monopolist
Discriminating Monopolist his or her
reservation
price.
29. Example
• Rebates: The assumption is that people with high reservation
prices are wealthy and that the opportunity cost of their time
is too high to be bothered to fill out the paperwork to get the
rebate.
30. What type of monopoly is Verizon /
what is the source of its market
power?
1 Exclusive control of inputs.
2 Patents and copyrights.
3 Government licenses.
4 Network economies.
A. Natural monopoly.
31. Which of the following is price
discrimination in this case?
A. Good
B. Bad
C. Can’t Say
