BUSS1040 W5 - Lecture notes PDF

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BUSS1040 – Economics for BusinessDecision Making, Semester 2, 2019Lecture 5: Pricing with Market Power ISchool of Economics, Faculty of Arts and Social SciencesDr. Kadir AtalayThe story so far...Demand SupplyConsumer preferences and constraints Costs objectivesFirmMarket outcome: price, quantity, we...

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BUSS1040 – Economics for Business Decision Making, Semester 2, 2019 Lecture 5: Pricing with Market Power I

Dr. Kadir Atalay School of Economics, Faculty of Arts and Social Sciences

The story so far…

Consumer preferences and constraints

Costs

Demand

Firm objectives

Supply

Market outcome: price, quantity, welfare

BUSS1040 - Lecture 4

Market Structure

Outline › Outline 1. Monopoly 2. Market Power 3. Monopolist’s Marginal Revenue 4. Profit Maximation by a Monopolist 5. Welfare and Deadweight Loss 6. Governmental Regulations

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Learning Objectives › 1. Explain what a monopoly market is and what conditions might cause a market to be a monopoly. › 2. What is market power? › 3. Discuss relationship between price and revenue for monopolist: derive the monopolist’s marginal revenue (MR) curve. › 4. Understand what is supply by a monopolist: show how a monopolist maximises its profit (MR = MC) – and use graphs to show a firm’s profit (or loss). › 4. Explain why a monopolist causes a loss in surplus (a deadweight loss) in the market. › 5. Explain possible option to regulate a monopolist, and outline their strengths and weaknesses.

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Characteristics of a Monopoly › A market with a single seller o The market is a monopoly, and that seller is a monopolist. o One seller but many buyers o Because the monopolist is the only firm in the market, it has market power to determine the price in the market – that is, it is a price maker. o In perfect competition, firms are price takers.

› Barriers to entry to potential entrants o Think of it as a cost that must be incurred by a new entrant in the market that incumbents do not bear o Barriers to entry are legal or `natural constraints’ that protect a firm from potential competitors. o Recall that in perfect competition, there is free entry and exit of firms - no barriers to entry.

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Why Are There Monopolies? › Competition and entry is restricted by various mechanisms including: o Legal Barriers to Entry • Exclusive right over a goods production (patent, copyright) • Public franchise (Australia Post); government licences (taxis, practice of medicine) o Natural Barriers to Entry • Control over an essential input not available to other firms e.g. Esso/BHP and natural gas fields in Victoria; know-how, distribution network • The monopolist might simply have a lower cost of production that effectively allows them to prevent other firms from entering the market e.g. favourable access to raw materials, favourable geographic location, learning curve advantages • Technology/level of demand make one producer more efficient than a number of producers RMIT University©5/09/2019

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Natural Monopoly › A natural monopoly results from a situation where a single firm can supply an entire market at lower cost than two or more firms could supply that market. › E.g. Telecommunications network, electricity transmission, (tap) water provision › Declining (long run) average total cost implies natural monopoly o Substantial economies of scale ( a `natural’ barrier to entry) o Often large capital costs (infrastructure), but low marginal cost of supply

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Government regulation › Patents or copyrights - In Australia, patent lasts for 20 years - Encourages research and development - Copyright: 70 years

› Granting a public franchise to a firm - Only legal provider of a good or service

Control of key input › Alcoa in the US, pre-1940s - Alcoa owned or had long-term contracts to buy almost all existing bauxite - Key input to aluminium production - So, Alcoa had substantial monopoly power in aluminium production

› De Beers - Used to control ~90% of diamond sales

Network externalities › The value of a good or service increases with the number of consumers using it - Mobile phones

- Computer operating systems

- Social media platforms

Costs (cents per kilowatt-hour)

Declining Average Costs

Asoutputincreasesaveragecostof productiondecreases.Hence,asingle firmcansupplythemarketquantity(Q=4) atalowercostthantwoindividualfirms supplying2each(or4 individualfirms supplying1each).

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10

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ATC 0

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4 Quantity (millions of kilowatt-hours)

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Market Power

› A monopoly is an industry comprised of a single firm o No close substitutes for the firm’s product o The firm is protected from competition by some barrier to entry which prevents and or inhibits entry of other firms

› In the absence of close competition ... o A monopolist has market power – the ability to affect price

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Market Power – competitive market • • •

Individual firms and consumers cannot affect the market price All economic agents are price takers Individual firms face a horizontal demand curve, that is perfectly elastic demand

Price and revenue

Market price

Individual firm demand curve

Demand = average revenue = marginal revenue

Quantity

Market Power › Whereas, a firm that has a LOW price elasticity of demand for its output can raise price and not lose all its customers. › Market power captures the idea that a firm can raise its prices above the level that would exist in a perfectly competitive industry and not lose all its customers.

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Market Power › A competitive firm has to take the price as determined in the market (price taker) o No market power o Faces a perfectly elastic demand curve for its good

› A monopolist instead is a price maker o Has market power o Faces a downward-sloping Demand Curve for its good

› Monopolists are not the only type of firm with marker power. Whenever there is imperfect competition in the market, there will be market power e.g. a firm in a monopolistically competitive market or a firm in a oligopoly

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Monopoly Pricing Strategies

› A single-price monopolist is a firm that must sell each unit of output for the same price. o Monopolist chooses quantity (and thus price) to maximise profits

› Price discrimination is the practice of selling different units of a good or service for different prices. o Monopolist sets a variety of prices to maximise profits o e.g. haircuts, movies, toll prices

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Single-Price Monopolist › Here we examine a monopolist who charges the same price to all of its consumers, also known as a single-price monopolist. › As the monopolist is the sole producer, it faces all the demand in the market. o Faces the downward-sloping market demand curve. o Firm has market power (or monopoly power) – it can raise price and not have the quantity demanded drop to zero o Monopolist has to choose the price (or the quantity it wants to sell).

› A monopolist can alter the price in the market by changing q o If produces more, price for all units falls o If it produces less, price for all units rises o This causes a trade off for the monopolist: sell less q for higher price or sell more q for lower price RMIT University©5/09/2019

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Monopolist: Output and Price Effect

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Monopolist and Marginal Revenue › Marginal revenue (MR) is the additional revenue that the firm received from selling one extra unit of a good. › For a monopolist, the marginal revenue incorporates two effects: (i) Output effect: as you sell more units, you obtain extra revenue from the additional units sold; and (ii) Price effect: as you sell more units, price falls and you lose revenue on the existing units sold › Hence, for a monopolist, MR is not the same as the market price: MR is always below P › Note, there is no price effect for a competitive firm, only an output effect o For a competitive firm, price is invariant to the quantity it sells: MR=P=AR is constant for any q supplied

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A Monopolist’s Marginal Revenue – An Example

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A Monopolist’s Marginal Revenue – An Example

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A Monopolist’s Marginal Revenue – An Example

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A Monopolist’s Marginal Revenue – An Example

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Deriving MR from Monopolist’s Demand Curve › MR is the change in total revenue when the firm sells one more unit › Can obtain the MR by differentiating TR with respect to q:

› Example: consider when the demand curve is linear and given by P = a – bq (inverse D-curve; where a and b are constants) Then, TR = P(q)*q = (a – bq)*q = (aq – bq2) Differentiate TR with respect to q:

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Deriving MR from Monopolist’s Demand Curve

› For example, if P = 100 – 2q, then MR = 100 – 4q › Note two things about MR curve when demand is a straight line: o MR curve has the same vertical intercept as the demand curve (at a); and o MR curve is linear and has twice the slope of the demand curve: the MR curve has a slope of -2b whereas the demand curve has a slope of –b.

› This is a rule you can choose to remember (or you can derive it as above)

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Deriving MR from Monopolist’s Demand Curve

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Deriving MR from Monopolist’s Demand Curve

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Marginal Revenue and Elasticity

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Monopoly and Profit Maximisation › Profits will be maximized when a monopolist sets marginal revenue equal to marginal cost: MR = MC o If MR > MC, the monopolist can increase its profit by selling one extra unit. o If MR < MC, profit falls from selling the last unit, so it would be better off from not selling that unit.

› For a competitive firm

–

P = MR = MC

› For a monopolist

–

P > MR = MC

› Note – this means that for a (single-price) monopoly P > MC at the optimal quantity supplied (while competitive firms produce until P = MC)

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Profit Maximisation: MC = MR

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Profit Maximisation: MC = MR

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Monopoly Price

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Monopoly Profits • The monopolist’s profit is:

π = TR – TC π = (TR/q – TC/q)*q • As before TR/q = AR = P; TC/q = ATC,so π = (AR – ATC)*q = (P – ATC)*q

• (P – ATC) is the profit per unit sold, q is the quantity sold; profit is then the average profit per unit output times by the quantity sold RMIT University©5/09/2019

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Monopoly Profits

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Monopoly Profits

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Monopoly Profits

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Monopoly Profits

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Monopoly Profits

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Monopoly Profits

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Welfare/ Efficiency with a Monopoly • Thesociallyefficientlevelofoutputiswherethemarginal value/benefittoconsumers(MB)equalsthemarginalcostof production(MC) o MB=MC:allgainsfromtradeareexhausted o Welfare(totalsurplus)maximum,competitivemarketoutput Q*

• MonopolistproduceswhereMR= MC o Weknowthatforeverylevelofoutput(excepttheeveryfirstunitsold):MRMC;P> MR o Barrierstoentry o Restrictsoutput,chargesahigher priceandcanearneconomicprofits o CreatesaDWLinmarket

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Example of a Monopoly Problem › Consider a monopolist whose demand curve and marginal cost are given by the below. Calculate the monopolist’s price, quantity, profit and DWL.

› How do you go about this problem? 1. Draw the demand and MC curves 2. In a monopoly, the monopolist produces Qm to satisfy MR=MC (profit maximisation condition). o Rearrange demand curve where by P=f(Q), and derive MR from the demand curve by differentiation. Draw MR curve o Set MR = MC to find and indicate Qm ; from this, determine and indicate Pm by looking at the demand curve

3.

DWL of monopoly?

o DWL = loss in welfare because of under or overproduction relative to competitive market outcome o Indicate DWL in figure + calculate area RMIT University©5/09/2019

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Example of a Monopoly Problem › Consider a monopolist whose demand curve and marginal cost are given by the below. Calculate the monopolist’s price, quantity, profit and DWL.

› How do you go about this problem? 2. In a monopoly, the monopolist produces Qm to satisfy MR=MC (profit maximisation condition). o Rearrange demand curve where by P=f(Q), and derive MR from the demand curve by differentiation. Draw MR curve. o P = 20 – 2Q, thus MR = 20 – 4Q o Set MR = MC to find and indicate Qm ; from this, determine and indicate Pm by looking at the demand curve o Profit-maximisaton: MR=MC, thus Qm =3, Pm =14 RMIT University©5/09/2019

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Example of a Monopoly Problem › Consider a monopolist whose demand curve and marginal cost are given by the below. Calculate the monopolist’s price, quantity, profit and DWL.

› How do you go about this problem? 3. DWL of monopoly? o DWL = loss in welfare because of under or overproduction relative to competitive market outcome o Here, loss in welfare because monopoly (market power) restricts output below efficient output (Q*).

o Indicate DWL in figure + calculate area › DWL = 1⁄2 * (Pm – MC at Qm) * (Q* - Qm) o Find Q* by setting P = 20 – 2Q equal to MC = 5 + Q ; Q* = 5 o MC at Qm is found by substituting Qm into the MC function; MC = 8

› DWL = 1⁄2 * (14 - 8) * (5 - 3) = 6. RMIT University©5/09/2019

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Alternative Method for Profit Maximisation ProfitmaximisationoccurswhenMC= MR π(q)=q*P(q)– c(q) whereP(q)isthedemandcurveandc(q)isthecostcurve dπ(q)/dq = 0

(alsocheckthesecond‐order condition) RMIT University©5/09/2019

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Public Policies Towards Monopolies

• Given it creates a DWL, governments might try to regulate a monopoly. • Goal: Increase competition in monopolised industries • Australian Competition and Consumer Commission (ACCC) o Cartels (price-fixing agreements) illegal o Oppose mergers o Misuse of market power

• Price regulation o Regulate price of a monopolist (typically monopolist with declining ATC – a ‘natural monopoly’) o Two basic forms: MC-price regulation; ATC-price regulation

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Natural Monopoly Example

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Marginal-Cost Price Regulation › Under marginal-cost price regulation, the government sets the monopoly price at P=MC (assuming constant MC for simplicity). › This means that the DWL = 0. › However, this means that the monopolist makes a loss equal to the greyshaded area (that is, its fixed costs), and will exit the market when it can. › To prevent this, the government will need to subsidize the monopolist that amount to prevent them from leaving the market, o These funds will typically have a DWL associated with them (from taxation). o Such a subsidy could also be politically unpopular.

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Marginal-Cost Price Regulation

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Average-Cost Price Regulation › Under average-cost price regulation, the government sets the monopoly price at P= ATC. › However, the monopolist will produce less than the efficient quantity (the monopolist does not produce where MB = MC), so there is still some DWL. › However, regulation typically decreases DWL relative to the situation with no regulation at all.

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Average-Cost Price Regulation

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Regulating natural monopolies Price and cost

Monopoly price

MC

PM Profit

ATC

MR 0

QM

Demand Quantity

Regulating natural monopolies Price and cost

Monopoly price

MC

PM Profit

ATC

PE

Efficient price

Loss

Demand

MR 0

QM

QE

Quantity

Regulating natural monopolies Price and cost

Monopoly price

MC

PM Regulated price

Profit

ATC PR PE

Efficient price

Loss

Demand

MR 0

QM

QE

Quantity

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