11. MonopolyMonopoly Profit MaximizationMonopoly Profit MaximizationMonopoly Profit MaximizationThe Inverse Elasticity Pricing Rule (IEPR)ExampleMonopoly ExampleMonopoly Shut-down DecisionMarket PowerMarket PowerSources of Market PowerWelfare Effects of MonopolyWelfare Effects of MonopolyCost Advantages that Create MonopoliesSlide Number 15Slide Number 16Government Actions that Create MonopoliesSlide Number 18Government Actions that Reduce Market PowerMonopoly Decisions Over Time and Behavioral EconomicsSlide Number 2111. Monopoly • Monopoly Profit Maximization • Market Power • Welfare Effects of Monopoly • Cost Advantages that Create Monopolies • Government Actions that Create Monopolies • Government Actions that Reduce Market Power • Monopoly Decisions Over Time and Behavioral Economics 1Monopoly Profit Maximization • A monopoly is the only supplier of a good for which there is no close substitute. • Monopolies are not price takers like competitive firms • Monopoly output is the market output • Monopoly demand curve is the market demand curve • Monopolists can set their own price given market demand • Because demand is downward sloping, monopolists set price above marginal cost to maximize profit. • Like all firms, monopolies maximize profits by setting price or output so that marginal revenue (MR) equals marginal cost (MC). 2Monopoly Profit Maximization • Monopolies maximize profits by setting price or output so that marginal revenue (MR) equals marginal cost (MC). • Profit function to be maximized by choosing output, Q: • π(Q) = R(Q) – C(Q), where • R(Q) is the revenue function • C(Q) is the cost function • The necessary condition for profit maximization: • The sufficient condition for profit maximization: 3Monopoly Profit Maximization • A firm’s MR curve depends on its demand curve. • MR is also downward sloping and lies below D • If p(Q) is the inverse demand function, which shows the price received for selling Q, then the marginal revenue function is: • Given a positive value of Q, MR lies below inverse demand. • Selling one more unit requires the monopolist to lower the price • Monopoly profit maximization implies: ()() ()dp QMR Q p Q MC QdQ=+=4The Inverse Elasticity Pricing Rule (IEPR) • We can rewrite MR function so that it is stated in terms of the inverse elasticity: • This makes the relationship between MR, D, and elasticity quite clear. • The quantity at which MR = 0 corresponds to the unitary elastic portion of the demand curve. • Everywhere that MR > 0, demand is elastic. • Since MC>0, the monopolist will always operate on the elastic region of the market demand curve 5Example • Inverse demand function: • Can be used to find the marginal revenue function: • SR cost function: • Can be used to find the marginal cost function: • Profit-maximizing output Q* is determined by: • Solving we have the profit-maximizing output Q*=6, and the monopolistic price p = 24 - 6 = $18. 6Monopoly Example • The monopolist’s profit maximizing choice of output is found where MR=MC and p comes from the demand curve. 7Monopoly Shut-down Decision • Should a profit-maximizing monopoly produce at Q* or shut down? • As with competitive firms, a monopoly should shut down in the monopolist’s price is less than its AVC. • In our example, AVC at Q* of 6 is $6. • Because p = $18 is clearly above $6, the monopoly in this example should produce in the SR. 8Market Power • Market power is the ability of a firm to charge a price above marginal cost and earn a positive profit. • Monopoly has market power; competitive firms do not. • Market power is related to the price elasticity of demand • Recall that • Rewrite as • Thus, the ratio of price to MC depends only on the elasticity of demand at the profit maximizing quantity. • The more elastic the demand curve, the less a monopoly can raise its price without losing sales (and vice versa). 9Market Power • The Lerner Index (or price markup) is another way to examine the way in which elasticity affects a monopoly’s price relative to its MC. • The Lerner Index ranges from 0 to 1 for a profit-maximizing firm. • Competitive firms have a Lerner Index of 0. • The Lerner Index gets closer to 1 as a firm has more market power (and faces less elastic demand). 10Sources of Market Power • Elasticity of the market demand curve depends on consumers’ tastes and options. • Demand becomes more elastic (which implies less market power for the firm): • as better substitutes for the firm’s product are introduced • as more firms enter the market selling a similar product • as firms that provide the same service locate closer to the firm • As a profit-maximizing monopoly faces more elastic demand, it has to lower its price. • Examples: Xerox, USPS, McDonald’s 11Welfare Effects of Monopoly • Recall from Chapter 9 that competition maximizes welfare, which is the sum of consumer surplus and producer surplus, because price equals marginal cost. • By contrast, a monopoly • sets price above marginal cost (and above the competitive price) • causes consumers to buy less than the competitive level of output • generates deadweight loss 12Welfare Effects of Monopoly • The competitive equilibrium, ec, has no DWL, while the monopoly equilibrium, em, has DWL = C+E. 13Cost Advantages that Create Monopolies • Sources of cost advantages: 1. Control of an essential facility, a scarce resource that a rival firm needs to use to survive • Example: owning the only quarry in a region generates a cost advantage in the production of gravel 2. Use of superior technology or a better way of organizing production • Example: Henry Ford’s assembly lines and standardization 3. Protection from imitation through patents or informational secrets • Secrets are more common in new and improved processes; patents more common with new products 14• A market has a natural monopoly if one firm can produce the total output of the market at lower cost than several firms could. • where Q = q1 + q2 +… + qn for n > 1 firms • Examples: public utilities such as water, gas, electric, and mail delivery • Natural monopolies may have high fixed costs, but low and fairly constant marginal costs. 15• A natural monopoly has economies of scale at all levels of output, so average costs fall as output increases.