MONOPOLY BEN VAN KAMMEN, PHD PURDUE UNIVERSITY Outline of Objectives 1

Intermediate Microeconomics

MONOPOLY BEN VAN KAMMEN, PHD PURDUE UNIVERSITY Outline of objectives 1. Solve a mathematical model of an monopolist's profit maximization problem. 2. Apply simple differential calculus, to solve economic models. 3. Compare consumer utility, firm profit, tax revenue, output, and price in equilibrium to competition. 4. Classify monopoly according to net welfare improving or net welfare detrimental. 5. Modify a monopolist’s profit function to show the effect of different forms of regulation. 6. Compare consumer utility, profit, output, and price across regulatory regimes. Competitive firm’s demand curve Monopolist’s demand curve Example Market demand: 1 = 10 20 2

= 200𝑄𝑄 20 − 𝑃𝑃= – 20 . 1 3 = 2002 30 . 2 𝑇𝑇𝑇𝑇 𝑄𝑄 − 𝑄𝑄 ⇔ 𝑇𝑇𝑇𝑇 1 200𝑄𝑄 𝑄𝑄 2 𝑀𝑀𝑀𝑀 − 𝑄𝑄 MR is below the price The product rule in calculus ( ) ( ) ( )

= ℎ 𝑥𝑥 ≡ 𝑓𝑓 𝑥𝑥+∗ 𝑔𝑔 𝑥𝑥 𝜕𝜕� 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕 𝑔𝑔 𝑥𝑥 � 𝑓𝑓 𝑥𝑥 � 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕 The product rule in calculus If ( ) = , and ( ) = = ( ) 𝑓𝑓 𝑞𝑞 𝑞𝑞 , = , and 𝑔𝑔 𝑞𝑞 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑃𝑃 𝑄𝑄 = 𝑇𝑇𝑇𝑇= 𝑓𝑓 𝑞𝑞 ∗ 𝑔𝑔 𝑞𝑞+ . 𝜕𝜕𝑇𝑇𝑇𝑇 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕 𝑀𝑀𝑀𝑀 𝑔𝑔 𝑞𝑞 � 𝑓𝑓 𝑞𝑞 � 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕 MC Intersects MR at Q*

A monopolist chooses optimal output the same, though, finding where MC=MR. Monopoly price exceeds MC

MC = MR dictates the optimal Q, but the monopolist would be foolish not to “mark up” its output by charging consumers the price from the demand curve. Example (continued) 120 = 200 30 80 = 30 8 164 1 1 = =2 = 7 . 2 3 1 − 𝑄𝑄 ⇔9 9 𝑄𝑄 2 ∗ 𝑄𝑄 →64𝑄𝑄 = 200 20 1 = $146.67. 9 2 ∗ 𝑃𝑃 − → 𝑃𝑃 64 = – = (146.67 120) = $189.63. 9 Π 𝑄𝑄 𝑃𝑃 𝐴𝐴𝐴𝐴 − ∗ Efficiency loss from monopoly Monopolies create an efficiency loss because they charge a price greater than the marginal cost. The lost welfare is called a deadweight loss. Summary Monopolies exist because of barriers to entry in markets. Monopolists follow the same objective of profit maximization that competitive firms do. ◦ MR < P. Outline of objectives 1. Solve a mathematical model of an monopolist's profit maximization problem. 2. Apply simple differential calculus, to solve economic models. 3. Compare consumer utility, firm profit, tax revenue, output, and price in equilibrium to competition. 4. Classify monopoly according to net welfare improving or net welfare detrimental. 5. Modify a monopolist’s profit function to show the effect of different forms of regulation. 6. Compare consumer utility, profit, output, and price across regulatory regimes. Why do monopolies arise? 1. Net welfare improving. 2. Net welfare damaging. Natural monopoly and legal monopoly. Barriers to entry. A natural monopoly

Q* Market with one seller. Monopolist maximizes profits. Entry

Pink Curves are the firms’ individual demand curves. Losses after entry

> at ∗ 𝐴𝐴𝐴𝐴 𝑃𝑃 𝑄𝑄

Q* If the market is split between 2 firms, neither can make a profit. “Un” natural monopoly Legal monopoly. Legal barrier to entry consists of an enforced penalty for competing with the existing firm in a market. As bad as it sounds. Licensing for example. Artificial monopoly The justification for the license? ◦ Convince the public that licensure is to protect consumers. ◦ E.g., convince Congress that unlicensed hair dressers are threaten consumer safety. Legal barriers to entry Some licensure requirements may make goods or services safer. It’s equally sure that many are spurious. ◦ Thinly veiled attempts by existing firms to keep out competition. Patents, copyrights, and trademarks Valuable for improving welfare. Research to develop new products. ◦ Less incentive if you’re immediately exposed to competition. Patent system grants temporary monopolies as incentive to do research and development. ◦ Increases the pace of technological advancement and income growth in the economy. Outline of objectives 1. Solve a mathematical model of an monopolist's profit maximization problem. 2. Apply simple differential calculus, to solve economic models. 3. Compare consumer utility, firm profit, tax revenue, output, and price in equilibrium to competition. 4. Classify monopoly according to net welfare improving or net welfare detrimental. 5. Modify a monopolist’s profit function to show the effect of different forms of regulation. 6. Compare consumer utility, profit, output, and price across regulatory regimes. Regulations Make price equal MC like competition? ◦ MC

𝑃𝑃2 𝑀𝑀𝑀𝑀

𝑃𝑃1 𝑀𝑀𝑀𝑀

If inelastic consumers can be segregated from inelastic ones, the monopolist can offset losses from elastic consumers with profits from inelastic consumers. Perfect price discrimination If the seller knew every consumer’s willingness to pay, he could charge each of them that full amount, ◦ Thereby getting all the consumer surplus for himself as monopoly profit. No DWL for perfect price discrimination Ironically if a monopolist could perfectly price discriminate, he would not create a deadweight loss. Summary & conclusions If a monopolist can identify consumers’ willingness to pay and prevent secondary transactions, it can price discriminate. Market segmentation is price discrimination in which the monopolist charges different prices to elastic and inelastic demanders. ◦ Deliberate market segmentation is a method for regulating natural monopolies to get their markets to be more efficient.