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ECON 301 Notes 10 Intermediate Microeconomics MONOPOLY BEN VAN KAMMEN, PHD PURDUE UNIVERSITY Price making A monopoly seller in a goods market is the conceptual opposite from perfectly competitive firms. ◦ The monopolist does not face competition from other firms because he is the only seller. ◦ He is still constrained in his behavior, however, by consumers’ willingness to pay for his output, i.e., by the demand curve. A monopolist faces the entire market demand for his good, though, so when he chooses an output level, he implicitly determines the price. ◦ Thus the term “price maker”. Competitive firm’s demand curve Monopolist’s demand curve Total revenue Competitive firms get the same price for all units sold, so: = . ∗ If a monopolist wants to sell more, he has to cut the price on all units sold. TR is still equal to , but P* is now a function of Q. ◦ Note: Q as market quantity∗ as distinct from q for firm’s quantity. Specifically the demand curve tells you P* as a function of Q. Example Say that market demand is given by: 1 = 10 20 2 . and the inverse demand you see− on Marshall’s diagram: = 200– 20 . 1 2 = , where P is given by the inverse demand function. = 200 20 . 1 = – 20 2. − 3 2 Taking the partial derivative 200 to get MR: = 200 30 . 1 2 − MR is below the price q* The product rule in calculus The basic reason that < for a firm facing downward- sloping demand has to do with the product rule in calculus. The product rule is as follows: when you multiply two functions of the same variable together, the differential of the product is: ( ) ( ) ( ) = ℎ ≡ +∗ ℎ � � The product rule in calculus So if ( ) = , and ( ) = [ ] = ( ), = , and = = ∗ + . ℎ � � The first term in MR is the quantity effectthat comes from selling an additional unit. The second term is the price effect that comes from cutting the price in order to sell the extra unit. ◦ Since Demand curves slope downward, is negative, so the price effect has to be negative. The difference between monopoly and competition Perfect Competition is like having a price effect that equals zero. If ∂g/∂q = 0 (no price effect), the 2nd term in the MR drops out, and you have only a quantity effect: MR = (∂f/∂q)g(q) + 0 = 1*g(q). Since g(q) is the inverse demand curve, g(q) gives the market price, so MR = 1*P . MR = P. In almost any other scenario, however, there is a negative price effect from increasing output. ◦ This is particularly true of monopolies. MC Intersects MR at Q* A monopolist chooses optimal output the same, though, finding where MC=MR. Monopoly price exceeds MC P* 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. Monopoly profits The result of the monopolist’s profit maximizing Q is that its output gets “marked up” beyond its marginal cost. ◦ The monopolist makes a profit of ( ) per unit, and a total profit: = ( ). ◦ If the monopolist has constant marginal − cost, as in the previous graph, ACΠ = MC, so− = ( ). Since no firms enter the market to compete them away, the monopoly profits persistΠ even− in the long run. Example (continued) The previous graph contains the MR and Demand curves from the example. ◦ In the graph I have set the MC to a constant ($120). To solve for optimal Q, set = 120 and solve for Q: 120 = 200 30 80 = 30 8 164 1 1 = =2 = 7 . 2 3 1 − 9⇔ 9 2 ∗ To solve for the Price, substitute → Q* into the inverse Demand: 64 = 200 20 1 = $146.67. 9 2 ∗ 64 = – =− (146.67 →120 ) = $189.63. 9 Π − ∗ Efficiency loss from monopoly Monopolies create an efficiency loss because they charge a price greater than the marginal cost. ◦ This is good for the monopolist because they get profits, and it’s bad for consumers because they pay higher prices and do not get to enjoy as much of the good. ◦ But the welfare loss to consumers is larger than the gain to monopolist, so the net effect is negative for welfare. The lost welfare is called a deadweight loss. Why do monopolies arise? There are several reasons monopolies arise, but they can be grouped into two categories: 1. Net welfare improving. 2. Net welfare damaging. Both can be broken down further into two sub categories: natural monopoly and legal monopoly. In any case the general explanation for a monopoly is a barrier to entry. Any market can be monopolized if an effective barrier to prevent competition is erected. Natural barriers to entry New firms could be prevented from entering a market because the cost would be prohibitive. Some cost functions prohibit more than one firm from operating profitably in a market. ◦ Specifically when there are very large sunk costs and low marginal cost, natural monopolies are common. A natural monopoly P* Q* Market with one seller. Monopolist maximizes profits. If a 2nd seller enters, demand is split between them Pink Curves are the firms’ individual demand curves. Losses after entry > at ∗ Q* If the market is split between 2 firms, neither can make a profit. Reasoning: natural monopoly Since both firms incur the large fixed costs and face a lower price than the monopoly did, neither can make a profit. ◦ So eventually at least one will go out of business. ◦ Then the market will go back to being a monopoly, hence, its natural state is monopoly. “Un” natural monopoly Every firm would love to eliminate its competitors, increase its market power, and earn monopoly profits. Consequently we often see attempts to create artificial barriers to entry that raise competitors’ costs and keep them out of a market. The most conspicuous example of this is the creation of a legal monopoly. ◦ A legal barrier to entry consists of an enforced penalty for competing with the existing firm in a market. But the idea of government granting monopoly powers by punishing competitors sounds like unfair favoritism to most people. ◦ So the firms seeking such legal protection have to create a justification for their greed. Artificial monopoly A common device for creating a legal monopoly is a licensure requirement. Combine it with a penalty for operating without a license and you have a legal monopoly for the license holder. The justification for the license? That’s where they have to get a little creative. ◦ If they can convince the public that the licensure scheme is to protect consumers, that will usually appease them. ◦ E.g., convince Congress that unlicensed hair dressers are the biggest threat to consumer safety since the Corvair, and they might support a licensure regulation that “protects” consumers from this peril. Legal barriers to entry Many licensure requirements may genuinely make goods or services safer by excluding scammers and quacks (think about Doctor Nick Riviera on The Simpsons, for example) from the market. ◦ But it is equally sure that many such requirements and regulations are spurious. Instead many are thinly veiled attempts by existing firms to keep out competition and make monopoly profits. In contrast there is another class of legal monopolies that includes some of the most efficient monopolies in existence: the patent system. Patents, copyrights, and trademarks This system of legal barriers is considered one of the most valuable for improving welfare. Inventors engage in expensive and time-consuming research to develop new products. ◦ They would be much less inclined to do so if, upon discovery, everyone could simply copy their technology and compete their profits away. As an incentive for research and development, the patent system grants temporary monopolies to the discoverers of new inventions as a reward. This increases the overall pace of technological advancement and income growth in the economy. Regulating natural monopolies For legal monopolies, the critical question for economic efficiency is: whether to grant them or not? For a natural monopoly, the monopolist’s incentives still create a deadweight loss that regulations could mitigate. The basic problem is that monopolists charge too high a price and produce too little output. Regulations If the price were restricted to the marginal cost, consumers would be happy, but for a natural monopoly this would drive them out of business. ◦ Since MC<AC for the natural monopolist, this would force him to sell below AC and incur losses. A common solution for this is to allow the monopolist to mark up the output he sells to some consumers but make him sell to other consumers at a low price. ◦ Particularly they let him charge a high price to “inelastic” demanders and make him charge a low price to “marginal” or “elastic” demanders. This enables the monopolist to stay in business and produce a more efficient level of output. Market segmentation > 2 = 1 If inelastic consumers can be segregated from inelastic ones, the monopolist can offset losses from elastic consumers with profits from inelastic consumers. Price discrimination The regulation policy in which the monopolist charges different groups of consumers different prices is an example of price discrimination. So far we have confined ourselves to talking about firms that charge the same price to all consumers. If a firm with market power (like a monopolist) can tell consumers apart on the basis of their willingness to pay, it has an incentive to price discriminate. Perfect price discrimination The demand curve reveals each consumers’ willingness to pay for a good. ◦ But not which consumers have high willingness and which have low willingness to pay. ◦ If the seller is confident that side transactions will not be made between consumers with different valuations, he will attempt to charge the high-valuing consumer a higher price and the low-valuing consumer a lower price (as long as it’s above MC).
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