Microeconomics Claudia Vogel EUV Winter Term 2009/2010 Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 1 / 34 Market Power: Monopoly and Monopsony Lecture Outline Part III Market Structure and Competitive Strategy 10 Market Power: Monopoly and Monopsony Monopoly The Social Costs of Monopoly Power Monopsony Summary 11 Pricing with Market Power Capturing Consumer Surplus Price Discrimination Summary Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 2 / 34 Market Power: Monopoly and Monopsony Market Power: Monopoly and Monopsony monopoly: Market with only one seller monopsony: Market with only one buyer market power: Ability of a seller or buyer to aect the price of a good. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 3 / 34 Market Power: Monopoly and Monopsony Monopoly Monopoly marginal revenue: Change in revenue resulting from a from a one-unit increase in output. To see the relationship among total, average, and marginal revenue, consider a rm facing the following demand curve: P = 6 − Q Total Marginal Average Price (P) Quantity (Q) Revenue (R) Revenue (MR) Revenue (AR) $6 0 0 5 1 5 $5 $5 4 2 8 3 4 3 3 9 1 3 2 4 8 -1 2 1 5 5 -3 1 Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 4 / 34 Market Power: Monopoly and Monopsony Monopoly Average Revenue and Marginal Revenue Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 5 / 34 Market Power: Monopoly and Monopsony Monopoly The Monopolist's Output Decision 1/2 Prot is maximized when marginal revenue equals marginal cost. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 6 / 34 Market Power: Monopoly and Monopsony Monopoly The Monopolist's Output Decision 2/2 We can also see algebraically that Q∗ maximizes prot. Prot π is the dierence between revenue and cost, both of which depend on Q: π (Q) = R (Q) − C (Q) As Q is increased from zero, prot will increase until it reaches a maximum and then begin to decrease. Thus a prot-maximizing Q is such that the incremental prot resulting from a small increase in Q is just zero (i.e., 4π=4Q = 0). Then 4π 4R 4C = − = 0 4Q 4Q 4Q But 4R=4Q is marginal revenue and 4C=4Q is marginal cost. Thus the prot-maximizing condition is that: MR = MC Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 7 / 34 Market Power: Monopoly and Monopsony Monopoly Example of Prot Maximization Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 8 / 34 Market Power: Monopoly and Monopsony Monopoly Shifts in Demand Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 9 / 34 Market Power: Monopoly and Monopsony Monopoly The Eect of a Tax Suppose a specic tax of t dollars per unit is levied, so that the monopolist must remit t dollars for the government for every unit it sells. If MC was the rm's original marginal cost, its optimal production decision is now given by MR = MC + t Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 10 / 34 Market Power: Monopoly and Monopsony The Social Costs of Monopoly Power Sources of Monopoly Power When only few rms account for most of the sales in a market, we say that the market is highly concentrated. barrier to entry: Condition that impedes entry by new competitors. The elasticity of market demand limits the potential monopoly power of individual producers. Even if only two or three rms are in the market, each rm will be unable to protably raise price very much if the rivalry among them is aggressive, with each rm trying to capture as much of the market as it can. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 11 / 34 Market Power: Monopoly and Monopsony The Social Costs of Monopoly Power Deadweight Loss from Monopoly Power Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 12 / 34 Market Power: Monopoly and Monopsony The Social Costs of Monopoly Power Price Regulation Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 13 / 34 Market Power: Monopoly and Monopsony The Social Costs of Monopoly Power Natural Monopoly natural monopoly: Firm that can produce the entire output of the market at a cost lower than what it would be if there were several rms. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 14 / 34 Market Power: Monopoly and Monopsony Monopsony Monopsony oligopsony: Market with only a few buyers. monopsony power: Buyer's ability to aect the price of a good. marginal value: Additional benet derived from purchasing one more unit of a good. marginal expenditure: Additional cost of buying one more unit of a good. average expenditure: Price per unit of a good. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 15 / 34 Market Power: Monopoly and Monopsony Monopsony Competitive Buyer Compared to Competitive Seller Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 16 / 34 Market Power: Monopoly and Monopsony Monopsony Monopsonist Buyer Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 17 / 34 Market Power: Monopoly and Monopsony Monopsony Monopsony and Monopoly Compared Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 18 / 34 Market Power: Monopoly and Monopsony Monopsony Sources of Monopsony Power Elasticity of Market Supply If only one buyer is in the market - a pure monopsonist - its monopsony power is completely determined by the elasticity of market supply. If supply is highly elastic, monopsony power is small and there is little gain in being the only buyer. Number of Buyers When the number of buyers is very large, no single buyer can have much inuence over price. Thus each buyer faces an extremely elastic supply curve, so that the market is almost completely competitive. Interaction Among Buyers If few buyers in a market compete aggressively, they will bid up the price close to their marginal value of the product, and will thus have little monopsony power. On the other hand, if those buyers compete less aggressively, or even collude, prices will not be bid up very much, and the buyers' degree of monopsony power might be nearly as high as if there were only one buyer. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 19 / 34 Market Power: Monopoly and Monopsony Monopsony The Social Costs of Monopsony Power Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 20 / 34 Market Power: Monopoly and Monopsony Summary Summary Market power is the ability of sellers or buyers to aect the price of a good. Market power comes in two forms. When sellers charge a price that is above marginal cost, we say that they have monopoly power, which we measure by the extent to which price exceeds marginal cost. When buyers can obtain a price below their marginal value of the good, we say they have monopsony power, which we measure by the extent to which marginal value exceeds price. Market power can impose costs on society. Because monopoly and monopsony power both cause production to fall below the competitive level, there is a deadweight loss of consumer and producer surplus. There can be additional costs from rent seeking. Sometimes, scale economies make pure monopoly desirable. But the government will still want to regulate price to maximize social welfare. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 21 / 34 Pricing with Market Power Lecture Outline Part III Market Structure and Competitive Strategy 10 Market Power: Monopoly and Monopsony Monopoly The Social Costs of Monopoly Power Monopsony Summary 11 Pricing with Market Power Capturing Consumer Surplus Price Discrimination Summary Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 22 / 34 Pricing with Market Power Capturing Consumer Surplus Capturing Consumer Surplus If a rm can charge only one price for all its customers, that price will be P∗ and the quantity produced will be Q∗. Ideally, the rm would like to charge a higher price to consumers willing to pay more than P∗, thereby capturing some of the consumer sur- plus under region A of the demand curve. The rm would also like to sell to consumers willing to pay prices lower than P∗, but only doing so does not entail lowering the prive to other consumers. In that way, the rm could also capture some of the surplus under region B of the demand curve. price discrimination: Practice of charging dierent prices to dierent consumers for similar goods. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 23 / 34 Pricing with Market Power Price Discrimination First-Degree Price Discrimination reservation price: Maximum price that a customer is willing to pay for a good. rst-degree price discrimination: Practice of charging each customer her reservation price. variable prot: Sum of prots on each incremental unit produced by a rm; i.e. prot ignoring xed costs. Perfect Price Discrimination The additional prot from producing and selling an incremental unit is now the dierence between demand and marginal cost. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 24 / 34 Pricing with Market Power Price Discrimination Second-Degree Price Discrimination second-degree price discrimination: Practice of charging dierent prices per unit for dierent quantities of the same good or service. block pricing: Practice of charging dierent prices for dierent quantities or blocks of a good. Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 25 / 34 Pricing with Market Power Price Discrimination Third-Degree Price Discrimination 1/2 third-degree price discrimination: Practice of dividing consumers into two or more groups with separate demand curves and charging dierent prices to each group. Creating Consumer Groups π = P1Q1 + P2Q2 − (QT ) 4π 4P1Q1 4C = − = 0 4Q1 4Q1 4Q1 MR1 = MC MR2 = MC MR1 = MR2 = MC Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 26 / 34 Pricing with Market Power Price Discrimination Third-Degree Price Discrimination 2/2 Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 27 / 34 Pricing with Market Power Summary Summary Firms with market power are in enviable position because they have the potential to earn large prots.