Monopoly1. Types of market structure2. The diamond market3. Monopoly pricing4. Why do monopolies exist?5. The social cost of monopoly power6. Government regulation7. Price discrimination1Announcements• We are going to cover sections 10.1-10.4, sections 11.1-11.2, and for allpractical purposes skip chapter 12.• Ben Friedman will speak in class on March 23 on his book The MoralConsequences of Economic Growth2Types of Market StructureIn the real world there is a mind-boggling array of different markets.• In some markets, producers are extremely competitive (e.g. grain)• In other markets, producers somehow coordinate actions to avoid di-rectly competing with each other (e.g. breakfast cereals)• In others, there is no competition (e.g. flights out of Tweed-New Havenairport).In general we classify market structures into four types:• perfect competition – many producers of a single, unique good.• monopoly - single producer of an unique good (e.g. cable TV, diamonds,particular drugs)• monopolistic competition – many producers of slightly differentiatedgoods (e.g. fast food)• oligopoly – few producers, with a single or only slightly differentiatedgood (e.g. cigarettes, cell phones, BDL to ORD flights)3What determines market structure?• It really depends on how difficult it is to enter the market. That dependson control of the necessary resources or inputs, government regulations,economies of scale, network externalities, or technological superiority.It also depends on how easy it is to differentiate goods:• Soft drinks, economic textbooks, breakfast cereals can readily be madeinto different varieties in the eyes and tastes of consumers.• Red roses are less easy to differentiate4The Diamond Market• Geologically diamonds are more common than any other gem-qualitycolored stone. But if you price them, they seem a lot rarer ...• Why? Diamonds are rare because The De Beers Company, the world’smain supplier of diamonds, makes them rare. The company controlsmost of the worlds diamond mines and limits the quantity of diamondssupplied to the market.• The De Beers monopoly of South Africa was created in the 1880s byCecil Rhodes, a British businessman. In 1880 mines in South Africadominated the world’s supply of diamonds. There were many producersuntil Rhodes bought them up.• By 1889 De Beers controlled almost all the world’s diamond production.• Since then large diamond deposits have been discovered in other Africancountries, Russia, Australia, and India. De Beers has either bought outnew producers or entered into agreements with local governments• For example, all Russian diamonds are marketed through De Beers.5Monopoly• A monopolist is a firm that is the only producer of a good that has noclose substitutes. An industry controlled by a monopolist is know asmonopoly.• In practice, true monopolies are hard to find in the U.S. today becauseof legal barriers. If today someone tried to do what Rhodes did, s/hewould be accused of breaking anti-trust laws.• Oligopoly, a market structure in which there is a small number of largeproducers, is much more common.6Monopoly Pricing• A monopolist, unlike a producer in a perfectly competitive market, facesa downward sloping demand curve.• Average revenue isP (Q) × QQ= P (Q)is just the market demand curve.• Recall from before break, the profit maximizing production conditionwasMR = MC• Table 10.1• Figure 10.17• Recall a firm’s profit is the difference between its revenue and its costs:π(Q) = R(Q) − C(Q)whereπ(Q) = profitsR(Q) = total revenueC(Q) = total economic cost• Since a monopolist faces a downward-sloping demand curve, At higherprices, the monopolist sells less output. The price it can charge dependsnegatively on the quantity it sells.In this case R(Q) = P (Q) × Q and the revenue function is curved.• Marginal revenue is the change in total revenue generated by an addi-tional unit of output. It is the slope of the revenue curve.8• Profits are maximized where the slope of the profit function is zero∆π(Q)∆Q=∆R(Q)∆Q−∆C(Q)∆Q= 0• This implies that the firm maximizes profits when the marginal revenueis equal to marginal cost.∆R(Q)∆Q=∆C(Q)∆QMR = MC• Profit is maximized by producing the quantity of output at whichmarginal revenue of the last unit produced is equal to its marginalcost.• Figure 10.39• Note:MR =∆R(Q)∆Q=∆(P Q)∆Q• An increase in production by a monopolist has two opposing effects onrevenue1. A quantity effect: One more unit is sold, increasing total revenueby the price at which the unit is sold: (1) × P = P2. A price effect: In order to sell the last unit, the monopolist mustcut the market price on all units sold. This decreases total revenue:Q × (∆P/δQ).10• Thus,MR = P + Q∆P∆Q= P + Q∆P∆QPP= P + PQP∆P∆Q•Q∆Q∆PPis the reciprocal of the elasticity of demand, soMR = P + P1²d.• Since the profit maximizing production decision is set MR = MC,MC = P (1 +1²d)orP =MC1 +1²dSince ²dis a negative number, the denominator is less than one.• A monopolist charges a price greater than marginal cost, but by anamount that depends inversely on the elasticity of demand.11• If demand is very elastic, the mark-up of price over marginal cost willbe small.– Example: Amtrak and its inter-city fares• If demand is very inelastic, the mark-up of price over marginal cost willlarge.– Example: pharmaceutical drugs for life-threatening illnesses• What if marginal cost is zero? Well rewrite the pricing equation asP − MCP= −1²dSo if MC = 0, it must mean ²d= −1. If marginal cost is zero,maximizing profits is equivalent to maximizing revenue. Revenue ismaximized when ²d= −1.12A monopolist has no supply curve• Since the price charged depends on the elasticity of demand there is noone-to-one relationship between price and quantity produced.• Figure 10.4 (a) and (b)• A monopolist always operates on the elastic region of the market de-mand curve.– That is, the region in which the price elasticity of demand is between-1 and −∞.– Suppose the firm was operating in inelastic region of the demandcurve. It could raise price, reduce quantity, but the price effect woulddominate the quantity effect and total revenue would increase. Sincequantity goes down, total cost goes down.– If revenue goes up and costs go down with a price increase in theinelastic region of the demand curve, keep doing it until you are inthe