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Lecture 19: Imperfect Competition and Monopoly Lecture 19: Imperfect Competition and Monopoly EC101 DD & EE / Manove Rent-Seeking p 1 EC101 DD & EE / Manove Clicker Question p 2 Perfect and Imperfect Competition Perfect Competition a) One homogeneous product b) Many buyers and sellers c) Voluntary exchange d) Perfect information e) Rational self-interested agents Competition is imperfect when one or more of these features doesn’t apply. Various forms/degrees of imperfect competition can be defined as a) to e) are modified in different ways. EC101 DD & EE / Manove Imperfect Competition p 3 Imperfect competition from a small number of sellers or from product differences. Monopoly (one dominant firm) Duopoly (two dominant firms) Soft drinks: Coke and Pepsi EC101 DD & EE / Manove Imperfect Competition>Types p 4 Oligopoly (a few firms) Automobile market EC101 DD & EE / Manove Imperfect Competition>Types>Oligopoly p 5 Monopolistic Competition (many firms with differentiated products) restaurants etc… These firms can raise prices above the competitive equilibrium. EC101 DD & EE / Manove Imperfect Competition>Types>Monopolistic Competition p 6 EC101 DD & EE / Manove Clicker Question p 7 Imperfect Competition from Limited Information Adverse Selection: bad products or bad customers that cannot be identified. Moral Hazard: customers with unknown WTP buy too much when others are paying the bill. Example: Used cars [adverse selection] Used cars often have hidden problems. So buyers have low WTP. Equilibrium prices are low. Owners won’t sell good cars. Vicious circle—market works poorly. EC101 DD & EE / Manove Imperfect Competition>Incomplete Information p 8 Example: Health Insurance Buyers of health insurance tend to be less healthy than average. [adverse selection]. Insured people may see the doctor too often [moral hazard]. Insurance companies respond with high prices. Healthy people don’t want to buy insurance. Vicious circle—market works poorly. EC101 DD & EE / Manove Imperfect Competition>Incomplete Information p 9 Imperfect competition in markets with less-than-voluntary exchange: college textbooks healthcare EC101 DD & EE / Manove Imperfect Competition>Involuntary Exchange p 10 Imperfect competition in markets with irrational consumers: wishful thinking stupidity temptation These imperfections can lead to high prices or inefficiency or both. EC101 DD & EE / Manove Imperfect Competition>Irrational Consumers p 11 Market Power A firm has market power if it can raise its prices without losing all of its customers. This happens when no other firm is producing the same (or very similar) product. EC101 DD & EE / Manove Imperfect Competition>Market Power p 12 Differences in products (real or apparent) that create market power often come from: minor product characteristics location customer service marketing Most real-world firms obtain some degree of market power through a deliberate strategy of product differentiation. Firms with market power can raise prices and increase profits. EC101 DD & EE / Manove Imperfect Competition>Market Power p 13 EC101 DD & EE / Manove Clicker Question p 14 Monopoly A firm is a monopoly when it is the only firm producing a given product. i.e. when no other firm produces a good substitute for its product. Because the monopoly is the only firm in the market,… …the monopoly faces the entire market demand curve. The monopoly can create an artificial scarcity by restricting production. Then, the monopoly can move up the demand curve and charge a higher price (as we shall see). EC101 DD & EE / Manove Monopoly p 15 What factors allow monopolies to exist? Patents and Copyrights (Intellectual Property Rights) Product Patents: New products Process Patents: Production processes that lower costs Copyrights: Protects the expression of an idea EC101 DD & EE / Manove Monopoly p 16 Control over important inputs Government Licenses and Franchises Decreasing Costs (Natural Monopolies) Network economies EC101 DD & EE / Manove Monopoly p 17 Monopoly: Restricting Production The monopoly faces the market demand curve. Monopoly To sell quantity Q, the Rent monopoly sets price P on Price CS Lost P CS Lost the demand curve. PS P Social surplus would be M MC maximized producing Q* P* and setting price P*. PS D, WTP Restricted But by restricting Production production, Q Q QM Q* the monopoly can sell at a The monopoly loses some PS higher price, because of reduced production, and obtain monopoly but at QM, monopoly rents are rents (taken from CS). larger than the lost PS. EC101 DD & EE / Manove Monopoly>Restricting Production p 18 Monopoly and Social Surplus When monopolies raise price and restrict production,… consumer surplus is transferred to the monopoly in the form of monopoly rents,… but the output reduction decreases total social surplus. Monopoly behavior also affects surplus in other more important ways. These behaviors will be analyzed in the next lecture. EC101 DD & EE / Manove Monopoly>Social Surplus p 19 EC101 DD & EE / Manove Clicker Question p 20 Marginal Revenue and Market Power Total Revenue (TR) is the money a firm obtains by selling its output. Marginal revenue (MR) is the additional revenue obtained from selling another unit of output. In a perfectly competitive market, a firm’s output does not affect the price,… so a competitive firm obtains the same added revenue (the price) for each additional unit sold. Therefore, MR = P. EC101 DD & EE / Manove Monopoly>Marginal Revenue p 21 But any firm with market power (including a monopoly), faces a downward-sloping demand curve. Suppose the firm cannot price-discriminate [charge different prices to different consumers]. Then, if it lowers the price of an additional unit in order to sell it, it must lower its price for ALL units that it sells. To find the marginal revenue, you start with the price it receives for the additional unit… and then subtract the revenue loss on its other units caused by the price drop. Therefore, MR < P. EC101 DD & EE / Manove Monopoly>Marginal Revenue p 22 Marginal Revenue Suppose a firm facing P demand D produces q − 1 units. D If the firm produces one more (q−1)∆p unit… ∆p p it cannot sell it for more than price p,… so revenue increases by p×1 p×1 = p. MR = p − (q−1)∆p 1 Q But the price on the other q−1 q q−1 units drops by ∆p, [For those who like calculus:] so revenue drops back by If goods are perfectly divisible, (q−1)∆p . we can use calculus and write, Therefore, MR = p − (q−1)∆p . EC101 DD & EE / Manove Monopoly>Marginal Revenue p 23 Example: Diamonds EC101 DD & EE / Manove Monopoly>Example: Diamonds p 24 Example: Monopoly Profit Maximization (with no price discrimination) De Beers Diamonds Total Marginal Price Quantity Revenue Revenue (P) (Q) (TR=PxQ) (MR) 1000 1 1000 1000 MR = 1800 – 1000, or 900 2 1800 800 MR = 900 – 1×100 800 3 2400 600 MR = 2400 – 1800, or MR = 800 – 2×1002 700 4 2800 400 600 5 3000 200 QM*: MR > MC 500 6 3000 0 MR < MC 400 7 2800 –200 How many diamonds should At what price? DeBeers sell if the cost (MC) of each additional diamond is $150? EC101 DD & EE / Manove Monopoly>Profit Maximization p 25 $ Price and Marginal Revenue 1100 900 P, W TP 700 Demand 500 MR Curve 300 MC = 150 100 -100 12345678910 Unit -300 Monopoly earns profits But society would have (MR − MC) on every unit benefited from units 6 to 9,… up to and including 5,… because WTP > MC. but he would lose profits on units 6, 7, 8, etc. Social surplus would have been positive on those units. So he will sell 5 units. EC101 DD & EE / Manove Monopoly>Profit Maximization p 26 $ Price and Marginal Revenue In our example, 1100 the monopolist 900 P, W TP sells 5 units for 700 P $600 each. M Demand Cost of each unit 500 MR Curve (MC = ATC) is 300 MC = 150 $150. 100 -100 12345678910 Unit -300 Hence monopoly profits are 5(600 – 150) = $2250 . In this example, we have so far assumed that the monopolist cannot price-discriminate [sell to different consumers at different prices]. What if he could? EC101 DD & EE / Manove Monopoly>Profit Maximization p 27 EC101 DD & EE / Manove Clicker Question p 28 End of File EC101 DD & EE / Manove End of File p 29.
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