Lecture 12 - Monopolies and Monopolistic Competition PDF

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Introduction to Microeconomics Lecture 12: Monopolies and Monopolistic Competition

Monopoly 

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One extreme of competition spectrum: o Perfect competition:  An individual firm takes the market price for its own output as given  On its own, its too small to influence the price Other extreme of competition spectrum: o Monopoly:  The single firm in the market is a “price maker”  It can set market price (subject to some constraints)

Market Power  

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Economic jargon: when a firm is able to influence the market price, it is said to have market power Pure monopolies (only one firm) are rare o Firms are categorized as monopolies if they can significantly affect the market price (or by market share) A firm will have some degree of market power whenever it faces a downward sloping demand for its output o PC firms face a horizontal demand curve so the lack any market power

Monopoly 

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A monopoly is a market: o That produces a good or service for which no close substitute exists o In which there is one supplier that is protected from competition by a barrier preventing the entry of new firms Barriers to entry – constraints limiting competition o Natural monopoly  A natural monopoly is a market in which economies of scale enable one firm to supply the entire market at the lowest possible cost  Usually characterized by large initial set up costs:  Electrical lines  Telephone lines  Water pipes o Ownership barriers to entry  An ownership barrier to entry occurs if one firm owns a significant portion of a key resource  During the last century, De Beers owned 90 percent of the world’s diamonds  Individual talents o Legal barriers to entry

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A legal monopoly is a market in which competition and entry are restricted by the granting of a…  Public franchise o like the U.S. Postal Service, a public franchise to deliver firstclass mail  Government license o license to practice law or medicine Patent or copyright

Single price monopolist  

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A PC firm can sell as much as it wants at the going market price A single-price monopolist charges a single price for all the unit it sells o If this monopoly wants to sell more, it must lower the price on all units o The monopoly is constrained by the market demand curve: price determines quantity sold A monopolist’s goal is to maximize profits Profit maximization condition is MR = MC Need to understand how MR behaves for monopolies (and for any firm facing downward-sloping demand curves) Selling one more unit requires lowering the price of all units: o Initially: TR = 16x2=$32 o To sell a third unit, P needs to fall to $14 o Revenue of third unit is $14 o But lowering the price reduces revenue from first to units by (16-14)2=$4 o Marginal revenue is $10, lower than $14 Hence, MR < P Due to the loss of revenue on ‘inframarginal’ units, the MR curve of a downward-sloping demand is below the demand curve Each demand curve has its own MR curve If demand shifts up or down, MR curve shifts in tandem MR revenue for a monopolist facing a linear demand curve o Recall elasticity falls as we move down a linear demand curve:  As price falls in the elastic region, TR rises  At the unit elastic point, TR is maximized  As price falls in the inelastic region, TR falls A monopolist will never produce in the inelastic region of a linear demand: o If a firm is in the inelastic region it will always prefer to raise the price because:  total revenue will increase

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 total cost will fall  so profits will rise Recall we derived costs without reference to market structure o The cost structure of the monopoly is the same as the one for the perfectly competitive firm

Profit maximization    

Table form: optimal output is determined by MR = MC Direct approach: optimal output is determined where difference between TR and TC is the greatest Marginal approach : optimal output is determined by MR = MC rule Once we know Q, D determine the profit-maximizing price

Monopoly in SR and LR 

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In the short-run (with some fixed inputs) o Firm will operate as long as TR ≥ TVC (P ≥ AVC) o Profits may be zero, positive or negative In the long-run (all inputs are variable) o Firm will operate only if TR ≥ TC (P ≥ AC) o Profits are zero or positive (no losses) o Note, a monopoly can sustain positive profits in LR due to barriers to entry

Monopolist Supply curve?  

Monopolies do not have a supply curve Monopolies are price-makers o They set the price depending on the market demand they face o For each market demand, monopolists are only willing to supply one level of output  The one where MR = MC

Monopolist vs. Perfect Competition   

Monopolist produce where MR = MC PC equilibrium occurs where D = S (=MC) Monopolies produce less output and charge a higher price than competitive markets

Recap: single price monopolist       

A single-price monopolist serves the whole market and charges a single price for all the units it sells Monopolists face a downward-sloping demand curve To sell more, a monopolist needs to lower the price for all units. Hence, MR < P The profit-maximizing output occurs where MR=MC Given the output, the demand curve determines the price Monopoly can earn positive profits in the long-run due to barriers to entry Compared to PC, monopolies produce less output and charge a higher price

Discriminating Monopolist

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Price discrimination is the practice of charging different prices to different customers for the same good To be able to price discriminate, a monopoly must: 1) Identify and separate different buyer types o The monopolist knows each consumer’s willingness to pay 2) Sell a product that cannot be resold. o Price differences that arise from cost differences are not price discrimination Degrees of discrimination o 1st degree: Perfect price discrimination: each consumer is charged his willingness to pay  A discriminating monopolist can sell more output without having to lower the price for previously-sold units  Selling one more unit increases revenue by an amount equal to P  The demand curve becomes the MR curve!  By discriminating the monopolist can increase its profits even further  Now the optimal output occurs where MR = MC, i.e., where  D = MC  Note: this is the same output that would be produced under perfect competition  Perfect price discrimination is not realistic  Firms do not know customers valuations  Hence, use of 3rd degree price discrimination nd o 2 degree: Quantity discounts: consumers are offered a lower price if they buy larger quantities o 3rd degree: Customer segmentation  Different prices are offered to different groups  e.g. students, seniors, etc.  Goods are sold under different conditions; consumers choose conditions themselves  e.g. Sat.-night stay: separate business travelers from tourists  e.g. Coupons/Sales: weekend vs weekday shoppers A monopoly will try to charge a higher price to customers with a lower price elasticity Below, the profits from each segment is higher than the profits from setting a single price for all consumers Recap o Price discrimination occurs when a different price is charged for the same product o If the monopolist knows each consumers willingness to pay it can practice perfect price discrimination o Discrimination allows a monopoly to sell more by lower the price on marginal units without sacrificing revenue from the previously sold units o For a discrimination monopoly, MR = D o Profit maximization occurs where D = MC (as in PC) o Without knowledge of willingness to pay, firm devises alternative to let customers sort themselves into groups o The goal is to charge a higher price to consumers whose demand is more inelastic

Monopolistic Competition  

Firms face competition Firms retain some market power

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Assumptions o A large number of firms compete o Each firm produces a differentiated product  Goods are similar but not identical o Firms are free to enter and exit the market

Product Differentiation     

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The firm makes a product that is slightly different from the products of competing firms Or tries to convince that its product is different even if in fact it is not Firms compete on quality/design, price and marketing Firms have only a small share of the market But product differentiation creates a degree of market power o Individual firms face a downward-sloping demand curve o They are able to set their own price (subject to the demand for their product) (There is no overall market demand since goods are not identical) Individual firms face a downward-sloping demand curve, granting them a certain degree of market power

Profit Maximization in the SR 

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Firm behaves like a monopolist over its own product o MR = MC determines output o D determines price In the SR firms may earn positive profits, may earn losses

LR equilibrium 

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Recall ‘free entry’ assumption o In the long-run, new firms will enter whenever profits are positive o In the long-run, firms exit if suffering losses In a long-run equilibrium, we must have the zero profit condition o Only when profits are zero (i.e., P = AC) does no firm want to enter or exit the market

Profit Maximization in LR 

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As new firms enter the industry, each existing firm loses some of its market share o The demand for its product decreases and the demand curve for its product shifts leftward (and becomes more elastic) o 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 LR equilibrium adjustment o As more firms enter, each firm has a lower market share:  The demand for its product falls  Its degree of market power falls  Its optimal price and quantity falls  Its profits fall o Firms enter until profits vanish LR equilibrium

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The long-run equilibrium occurs when P = AC so that the zero profit condition is satisfied The downward-sloping demand curve is tangent to the AC curve No more firms want to enter as that would result in a loss Monopolistically competitive firms  produce less output  charge a higher price  offer more variety than PC firms

Recap: Monopolistic Competition o o o

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Under monopolistic competition firms compete against many other firms producing similar but not identical products By differentiating their product, monopolistically competitive firms can create a degree of market power: they face a downward-sloping demand curve for their own product The degree of market power is determined by the number of firms in the market: as more firms enter each firm’s market power falls o its market share falls and its demand becomes more elastic Monopolistic competition is characterized by free entry Hence, the LR equilibrium must satisfy the zero profit condition o Firms enter or exit until economics profits are zero Compared to PC firms, MC firms produce less and charge a higher price MC firms compete on dimensions other than price: design, innovation, marketing MC firms do provide more variety to the market...