ECON EXAM #3 - Teacher: Thomas Patrick McGahee PDF

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Teacher: Thomas Patrick McGahee...

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.ECON EXAM #3 Chapter 13: Monopoly Monopoly and How it Arises ● A monopoly is a market: ○ That produces a good or service with no close substitutes ■ If a good has a close substitute, even if only one firm produces it, that firm faces competition from producers of the substitute ○ That has one supplier, protected by barriers to entry ■ Barriers to entry prevent new firms from entering the market ■ Three types of barriers to entry: ● Natural ○ EX) SiriusXM (no one else wants to go into space and plant it) or Natural Gas company ● Ownership ○ EX) Diamond industry owns every single mine ● Legal ○ EX) Government grants you exclusive right → patent drug ● Natural Barriers to Entry ○ Natural barriers to entry create natural monopoly ■ LRAC sloping down (economies of scale), Demand increasing ■ Whereas LRAC rising → More firms serving ○ A natural monopoly is a market in which economies of scale enable one firm to supply the entire market at the lowest possible cost ○ EX) One firm can produce 4 million units of output at 5 cents per unit ■ Two firms can produce 4 million units--2 million units each--at 10 cents per unit ○ In a natural monopoly, economies of scale are so powerful that they are still being achieved even when the entire market demand is met ○ The LRAC curve is still sloping downward when it meets the demand curve ● Ownership Barriers to Entry ○ An ownership barrier to entry occurs if one firm owns a significant portion of a key resource ● Legal Barriers to Entry ○ Legal barriers to entry create a legal monopoly ■ Public franchise (like U.S. Postal Service, a public franchise to deliver first-class mail) ■ Government license (like a license to practice law or medicine) ■ Patent or copyright ● Monopoly Price-Setting Strategies ○ A monopoly is a price setter

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For a monopoly firm to determine the quantity it sells, it must choose the appropriate price There are two types of monopoly price-setting strategies: ■ A single-price monopoly is a firm that must sell each unit of its output at the same price to all its customers ■ Price discrimination is the practice of selling different units of a good or service for different prices

A Single-Price Monopoly’s Output and Price Decision ● A single-price monopoly maximizes profit by choosing the quantity where MR=MC But a monopolist’s marginal revenue depends on quantity ○ Competitive market doesn’t depend on Q ● To sell a larger quantity, a monopoly must set a lower price ● This is because the demand for monopoly’s output is the market demand ● Determining Marginal Revenue ○ Recall that total revenue is price times quantity sold ■ TR=P x Q ○ Marginal revenue, MR, is the change in total revenue that results from a one-unit increase in the quantity sold ■ If Q goes up, P goes down ○ For a single-price monopoly, marginal revenue is less than price at each level of output ■ MR < P (MR under demand curve) ● EX) Suppose the monopoly sells a price of $16 and sells 2 units ○ TR= $32 ○ Now suppose the firm cuts the price to $14 to sell 3 units ■ TR= $42 ○ It loses $4 of total revenue on the 2 units it was selling at $16 each ○ And it gains $14 of total revenue in the 3rd unit ○ So total revenue increases by $10, which is marginal revenue ○ The marginal revenue curve, MR, passes through the red dot midway between 2 and 3 units and at $10 ○ For a monopoly, MR < P at each quantity ● Marginal Revenue and Elasticity ○ If demand is elastic: ■ A fall in price brings an increase in total revenue ■ The increase in revenue from the greater quantity sold outweighs the decrease in revenue from the lower price per unit ■ MR is positive ○ If demand is inelastic: ■ A fall in price brings a decrease in total revenue ■ The rise in revenue from the increase in quantity sold is outweighed by the fall in revenue from the lower price per unit

■ MR is negative If demand is unit elastic (=1): ■ A fall in the price does not change total revenue ■ The rise in revenue from the greater quantity sold equals the fall in revenue from the lower price per unit ■ MR=0 ■ Total revenue is maximized when MR=0 ■ *Firms objective is to maximize profit not MR* ■ Pink area (bad) ● Lowered revenue ● Increase costs A single-price monopoly never produces an output at which demand is inelastic If it did produce such an output, the firm could increase total revenue, decrease total cost, and increase economic profit by decreasing output Price and Output Decision ○ The monopoly chooses the profit-maximizing quantity, where MR=MC ($10) ○ The monopoly sets price at the highest price at which the profit-maximizing quantity will sell (where demand curve is above= $14) ○ The monopoly earns profit of (P-ATC) x Q The monopoly can earn an economic profit, even in the long run, because barriers to entry protect the firm from market entry by competitor firms A monopoly that incurs an economic loss can shut down temporarily in the short run or exit in the long run Perfect Competition ○ Equilibrium occurs where the quantity demanded equals quantity supplied at quantity QC and price PC Monopoly ○ Equilibrium output, QM, occurs where marginal cost, MR=MC ○ Equilibrium price, PM, occurs on the demand curve at the profit-maximizing quantity ○ Compared to perfect competition, monopoly produces a smaller output and charges a higher price ■ Deadweight loss Efficiency Comparison ○ If the market demand curve is the marginal social benefit curve, MSB ○ And the market supply curve is the marginal cost curve, MSC, ○ The competitive equilibrium is efficient: MSB=MSC ○ Total surplus, the sum of consumer surplus and producer surplus, is maximized under perfect competition Inefficiency of monopoly: ○ Because price exceeds marginal social cost, MSB>MSC ○ And a deadweight loss arises Redistribution of Surpluses ○

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○ Some of the lost consumer surplus goes to the monopoly as producer surplus Rent Seeking ○ Any surplus--consumer surplus, producer surplus, or economic profit--is called economic rent ○ Rent seeking is the pursuit of wealth by capturing economic rent ○ Rent seekers pursue their goals in two main ways: ■ Buy a monopoly ■ Create a monopoly Rent-Seeking Equilibrium ○ The blue area shows the potential producer surplus with no rent seeking ○ The resources used in rent seeking can wipe out the monopoly producer’s surplus ○ Rent-seeking costs can shift the ATC curve upward, causing ○ Producer surplus to disappear (like search costs) ○ The deadweight loss would increase to the gray area

Price Discrimination ● Price descrimination is the practice of selling different units of a good or service for different prices ● To be able to price discriminate, a monopoly must: ○ Identify and separate different buyer types ○ Sell a product that cannot be resold ● Price differences that arise from cost differences are not price discrimination ○ EX) Airplane different prices for different seats/times ○ EX) Movie theaters ● Two Ways of Price Discriminating ○ A monopoly can discriminate ■ Among groups of buyers ■ Among units of a good ● Increasing Profit and Producer Surplus ○ By price discriminating, a monopoly captures consumer surplus and converts it into producer surplus ○ More producer surplus means more economic profit ○ Economic profit= Total revenue - Total cost ○ Producer surplus is total revenue minus the area under the marginal cost curve, which is total variable cost ○ Producer surplus= Total Revenue - Total variable cost ○ Economic profit= Producer surplus - Total fixed costs ● Discriminating Between Two Types of Travelers ○ Suppose graph (a) shows the market for business travel. The airline sells 8,000 business trips at $120 per trip. ○ The airline expands into the leisure market in graph (b)

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Leisure travelers will not pay $120 per trip, so the demand for leisure travel is the curve DL ○ The airline sells 4,000 (where MR=MC) leisure trips at $80 (where demand curve hits) per trip. ○ The airline increases its output to 12,000 trips per week. ○ Consumers surplus increases and the airline’s producer surplus increases. Perfect Price Discrimination ○ Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price someone is willing to pay ○ Marginal revenue now equals the price, so.... ○ The demand curve is also the marginal revenue curve ○ EX) Uber ○ The perfect price discriminating monopoly… ○ Increases its output until the price of the last trip equals marginal cost ○ Producer surplus is maximized when the lowest fair is $40 and 16,000 trips are bought ○ Consumer surplus= 0 ○ The monopoly makes the maximum possible profit Efficiency and Rent Seeking with Price Discrimination ○ The more perfectly a monopoly can price discriminate, the closer its output is to the competitive output P=MC and the more efficient is the outcome ○ But this outcome differs from the outcome of perfect competition in two ways: ■ The monopoly captures the entire consumer surplus ■ The increase in economic profit attracts even more rent-seeking activity that leads to inefficiency Disney Example ○ The more days you spend at Disney the lower your willingness to pay ■ Marginal day price declines, as demand declines (MB)

Monopoly Regulation ● Regulation: rules administrated by a government agency to influence prices, quantities, entry, and other aspects of economic activity ● Two theories about how regulation works are social interest theory and capture theory. ● Social interest theory: is that the political and regulatory process relentlessly seeks out inefficiency and regulates to eliminate deadweight loss ● Capture theory: is that regulation serves the self-interest of the producer, who captures the regulator and maximizes economic profit ● Rate of Return Regulation ○ Under rate of return regulation, a firm must justify its price by showing that its return on capital doesn’t exceed a specified target rate ○ This type of regulation can end up serving the self-interest of the firm than the social interest because… ○ The firm

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The firm’s managers have an incentive to inflate costs and use more capital than the efficient amount A Price Cap Regulation ○ A price cap regulation is a price ceiling ○ The rule specifies the highest price that the firm is permitted to charge ○ This type of regulation gives the firm an incentive to operate efficiently and keep costs under control Efficient Regulation of a Natural Monopoly ○ How can the government regulate natural monopoly so that it produces the efficient quantity? ○ Marginal cost pricing rule sets price equal to marginal cost ○ The quantity demanded at a price equal to marginal cost is the efficient quantity ○ Unregulated the natural monopoly produces the quantity at which MR=MC… ○ And charges the highest price at which that quantity will be bought ○ Regulating a natural monopoly in the societal interest sets the quantity where MSC=MSB ○ The demand curve is the MSB curve ○ The marginal cost is the MSC curve ○ Efficient regulation sets the price equal to marginal cost ○ With marginal cost pricing, the quantity produced is efficient ○ But the average cost exceeds the price, so the firm incurs an economic loss ■ ATC > P=MC ○ The natural monopoly might charge a fixed fee to cover its fixed costs and then charge a price equal to marginal cost ○ Or a regulated natural monopoly might be permitted to price discriminate to over the loss form marginal cost pricing. Average Cost Pricing Rule ○ Another alternative is to permit the firm to produce the quantity at which price equals average cost and to set the price equal to average cost ○ The firm breaks even, but produces less than the efficient quantity

Chapter 14: Monopolistic Competition What is Monopolistic Competition? ● Monopolistic competition is a market structure in which ○ A large number of firms compete ○ Each firm produces a differentiated product ○ Firms compete on product quality, price, marketing ○ Firms are free to enter and exit the industry ●

Large Number of Firms ○ The large number of firms in the market implies that:

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Each firm has a small market share and thus limited market power to influence the price of its product ■ Each firm is sensitive to the average market price but pays no attention to the actions of others ■ Collusion or conspiring to fix prices is impossible Product Differentiation ○ A firm in monopolistic competition practices product differentiation if the firm makes a product that is slightly different from the products of competing firms Competing on Quality, Price, and Marketing ○ Product differentiation enables firms to compete in three areas: quality, price, and marketing ■ Quality includes design, reliability, and service ■ Because firms produce differentiated products, the demand for each firm’s products is downward sloping ■ Because products are differentiated, a firm must market its product. Two main forms of marketing: advertising and packaging. Entry and Exit ○ There are no barriers to entry in monopolistic competition, so firms cannot make an economic profit in the long run. Examples of Monopolistic Competition ○ Producers oc clothing, jewelry, computers, smartphones, televisions, books, frozen foods, and sporting goods operate in monopolistic competition

Price and Output in Monopolistic Competition ● Example of economic profit in the short run ○ The firm in monopolistic competition decides the quality of its product and its marketing program and then operates like a single-price monopoly ■ MR below demand curve b/c smaller price means more customers ○ The firm produces the quantity at which MR equals MC and sells that quantity for the highest price possible ○ P-ATC x Q (NOT INTERSECTION DOT BELOW) ○ It makes an economic profit when P > ATC ○ Has to be short run b/c in long run firms would enter ○ Demand shift left after enter ● Example of an economic loss in the short run ○ At the profit-maximizing quantity in this example, P < ATC and the firm incurs an economic loss ○ In the long run you should exit ○ Demand shift right after exit ● Long Run: Zero Economic Profit ○ In the long run, economic profit induces entry ○ Entry continues as long as firms in the industry make an economic profit--as long as P > ATC

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As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases ○ The decrease in demand decreases the quantity at which MR=MC and lowers the maximum price that the firm can charge to sell this quantity ○ As new firms enter, the firm’s price and quantity fall until P = ATC and each firm earns zero economic profit ○ Example of a firm in monopolistic competition in long-run equilibrium ■ Once profit hits zero (P=ATC) firms stop entering Monopolistic Competition and Perfect Competition ○ Two key differences between monopolistic competition and perfect competition are ■ Excess capacity ■ Markup ● Firms charge ○ A firm has excess capacity if it produces less than the quantity at which ATC is minimized (efficient scale) ○ A firm’s markup is the amount by which its price exceeds marginal cost ○ In the long-run equilibrium, firms in monopolistic competition produce less than the efficient scale--the quantity at which ATC is a minimum ○ They operate with excess capacity ○ The downward-sloping demand curve for their products drives this result ○ Firms in monopolistic competition operate with positive markup ○ Again, the downward-sloping demand curve for their products drives this result ○ In contrast, firms in perfect competition have no excess capacity and no markup ○ The perfectly elastic demand curve for their product drives this result Is monopolistic competition efficient? ○ Because price exceeds marginal cost, marginal social benefit exceeds the marginal social cost, so… ○ In the long-run, the firm in monopolistic competition produces less than the efficient quantity Why Monopolistic Competition Might Be Efficient ○ The markup (price minus marginal cost) arises from product differentiation ○ People value product variety, but product variety is costly ○ The efficient degree of product variety is the one for which the marginal social benefit from product variety equals the marginal social cost ○ The loss arises from the markup and excess capacity is offset by the gain that arises from having a greater degree of product variety

Product Development and Marketing ● Product Development ○ To keep making an economic profit, a firm in monopolistic competition must be in a state of continuous product development

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New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation Efficiency of Product Development ○ The amount of product development is efficient if the marginal social benefit from an innovation equals the marginal social cost that firms incur to make the innovation Advertising ○ A firm with a differentiated product needs to ensure that customers know that its product differs from its competitors ○ Advertising expenditures affect the firm’s profit in two ways: They increase costs, and they change demand Selling Costs and Total Costs ○ Selling costs, such as advertising and expenditures, retail buildings, etc are fixed costs ■ More ad $ → higher ATC ○ So selling costs increase average total cost at any given quantity but do not change marginal cost Selling Costs and Demand ○ Advertising increases the demand for the firm’s product ○ (But if all firms advertise and it enables more firms to survive, the demand for any firm’s product will decrease.) Advertising increases the ATC curve but might reduce the ATC of the actual quantity produced ○ ATC could decrease (point on the curve) because you are spending more fixed costs, but your quantity increase allows fixed costs to be spread across more units. Advertising might also shrink the markup (if all firms advertise). ○ Make demand flatter Using Advertising to Signal Quality ○ Firms use advertising to signal high quality of their products ○ A signal is an action taken by an informed person or firm to send a message to uninformed people Brand Names ○ Brand name and image provide information about quality and consistency ○ EX) Coca-Cola is much higher quality b/c of its known name Efficiency of Advertising and Brand Names ○ To the extent that advertising and selling costs provide consumers with information and services that they value more highly than their cost, these activities are efficient

Chapter 15: Oligopoly What Is Oligopoly?

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Oligopoly is a market structure in which ○ Natural or legal barriers prevent the entry of new firms ○ A small number of firms compete Examples include PC processors (Intel and AMD), batteries (Energizer and Duracell), aircraft (Boeing and Airbus) Some industries have many firms but only a few serve the vast majority of the market (E.g., wireless networks At&T and Verizon). The dominant firms behave similarly to an oligopoly. Barriers to Entry ○ Either natural or legal barriers to entry can create oligopoly ○ This figure shows a natural duopoly-- a market with two firms ○ This figure shows a natural oligopoly with three firms ○ A legal oligopoly might arise even where the demand and costs leave room for a larger number of firms (e.g. a city might license only two taxi companies) Small Number of Firms ○ Because an oligopoly market has only a few firms, they are interdependent and face a temptation to cooperate ○ Interdependence: With a small number of firms, each firm’s profit depends on every firm’s actions ○ Temptation to Cooperate: Firms in oligopoly face the temptation to form a cartel ○ A cartel is a group of firms acting together to limit output, raise the price, and increase profit. Cartels are i...