Market Structures: MonopolyMonopoly AssumptionsLimits to MonopolyProduction DecisionsA Monopoly’s RevenueTable 1 A Monopoly’s Total, Average, and Marginal RevenueFigure 2 Demand Curves for Competitive and Monopoly FirmsFigure 3 Demand and Marginal-Revenue Curves for a MonopolyProfit MaximizationPowerPoint PresentationFigure 4 Profit Maximization for a MonopolyFigure 5 The Monopolist’s ProfitFigure 6 The Market for DrugsWelfare Costs of MonopolySlide 15Figure 7 The Efficient Level of OutputFigure 8 The Inefficiency of MonopolySlide 18Public Policy and Monopolies Working towards P=MCPrice-Discriminating MonopolistBasis for Price DescriminationSummaryFigure 10 Welfare with and without Price DiscriminationSlide 24Market Structures: MonopolyMonopolyAssumptions•One seller and many buyers–Implication: The seller is a price maker and the buyers are price takers.•Barriers to Entry –Ownership of a unique resource (Diamonds)–Government granted rights for exclusive production (e.g. patents, copyrights, licenses, concessions)–Economies of scale and declining long-run average costs–Implication: Monopolist faces the entire market demand curve and profits can persist in the short and long-run.Limits to Monopoly•Size of the market (Pavarotti versus Joe, uncongested bridge)•Definition of market and close substitutes (ornamental versus industrial diamonds, bottled water).•Potential competitionProduction Decisions•Monopolist versus competitive firm.–CF is a price taker who faces a perfectly elastic demand curve  MR=P–M is a price maker who faces the entire market demand curve  MR<P•Intuitive proof – to sell another unit the monopolist must lower the price. This means lowering the price not only on the extra unit sold, but also all the other units the monopolist was selling. So MR = Price of the additional unit – the sum of the decreases in all the units previously sold ( e.g. selling 4 units @$100, to sell the 5 unit the price must be lowered to $90, so the monopolist’s MR = $90 – 4X$10=$50)•Tabular proof – see next table and handout•Graphical proofA Monopoly’s Revenue•Total RevenueP  Q = TR•Average RevenueTR/Q = AR = P•Marginal RevenueTR/Q = MRTable 1 A Monopoly’s Total, Average, and Marginal RevenueCopyright©2004 South-WesternFigure 2 Demand Curves for Competitive and Monopoly FirmsCopyright © 2004 South-WesternQuantity of OutputDemand(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve0PriceQuantity of Output0PriceDemandFigure 3 Demand and Marginal-Revenue Curves for a MonopolyCopyright © 2004 South-WesternQuantity of WaterPrice$11109876543210–1–2–3–4Demand(averagerevenue)Marginalrevenue1 2 3 4 5 6 7 8Profit Maximization•A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.•It then uses the demand curve to find the price that will induce consumers to buy that quantity.•Profit Maximization ––Set MR = MC to find Q that maximizes profits.–Use the market demand curve to find the P that the Q brings–Find ATC and AVC cost to determine profits, losses, or shutdown.•Difference between the monopolist decision and the competitive firms decision–The monopolist does not have a supply curve like the CF, rather they pick a single price and quantity–Monopolists produce where P>MR and P>MCversus CFs who produce where P=MR and P=MC.Figure 4 Profit Maximization for a MonopolyCopyright © 2004 South-WesternQuantityQ Q0Costs andRevenueDemandAverage total costMarginal revenueMarginalcostMonopolypriceQMAXB1. The intersection of themarginal-revenue curveand the marginal-costcurve determines theprofit-maximizingquantity . . .A2. . . . and then the demandcurve shows the priceconsistent with this quantity.Figure 5 The Monopolist’s ProfitCopyright © 2004 South-WesternMonopolyprofitAveragetotalcostQuantityMonopolypriceQMAX0Costs andRevenueDemandMarginal costMarginal revenueAverage total costBCEDFigure 6 The Market for DrugsCopyright © 2004 South-WesternQuantity0Costs andRevenueDemandMarginalrevenuePriceduringpatent lifeMonopolyquantityPrice afterpatentexpiresMarginalcostCompetitivequantityWelfare Costs of Monopoly•In competitive markets, firms produce whereP=MCAnd sinceP=MB=willingness to budAndMC=willingness to sellP=MC  MB=MC orMaximum total surplus•In monopoly,P>MR soP>MCOrMB>MCOutput falls short of the efficient amount Deadweight Welfare LossFigure 7 The Efficient Level of OutputCopyright © 2004 South-WesternQuantity0PriceDemand(value to buyers)Marginal costValue to buyersis greater thancost to seller.Value to buyersis less thancost to seller.CosttomonopolistCosttomonopolistValuetobuyersValuetobuyersEfficientquantityFigure 8 The Inefficiency of MonopolyCopyright © 2004 South-WesternQuantity0PriceDeadweightlossDemandMarginalrevenueMarginal costEfficientquantityMonopolypriceMonopolyquantity•Monopoly profit is not usually a social cost but a transfer of surplus from consumer to producer.•Profit can be a social cost if extra costs are incurred to maintain it, such as political lobbying, or if the lack of competition leads to costs not being minimized (X-inefficiency again!)Public Policy and MonopoliesWorking towards P=MC•Attempts to increase competition through anti-trust legislation –Sherman Antitrust Act of 1890 –Examples: Breakup of Standard Oil and turning MA Bell into Baby Bells •Regulation – Natural Monopolies–P=MC doesn’t work with extensive economies of scale–Regulated forms have little incentive to minimize costs•Public Ownership –Public utilities and the Postal Service•Hands-off Approach•Monopolies contribute to inefficiency because:–P>MC –Less than the socially optimal level of output is produced–Incentives for cost reduction may diminish–Too many resources may be spent on political protection.Price-Discriminating Monopolist•Price discrimination occurs when different prices are charged to different consumer that do no reflect differences in the cost of providing th good•Perfect Price Discrimination – charging each customer their maximum willingness to pay.•Imperfect Price Discrimination – segmenting the market into different consumer groups.–Parable – Hardcopy versus paperback copy –Allows firms to increase profits–Requires separating customers into different groups and minimize arbitrage–Results in greater economic welfare than single-pricing