Ch 15: MonopolySunday, November 16, 20147:02 PM -While a competitive firm is a price taker, a monopoly is a price maker.-A monopoly charges a price that exceeds marginal cost. -A monopoly firm can control that price of the good it sells, but because a high price reduces quantity that its customers buy, the monopoly's profits are not unlimited. -Monopoly firms, like competitive firms, aim to maximize profit. -Because monopoly firms are unchecked by competition, the outcome in a market with a monopoly is often not in the best interest of society. Why Monopolies Arise-Monopoly: a firm that is the sole seller of a product without close substitutes-The fundamental cause of monopoly is barriers to entry: a monopoly remains the only seller in its market because other firms cannot enter the market and compete with it. -Barriers to entry, in turn, have three main sources: 1. Monopoly resources: a key resource required for production is owned by a single firm -Ex: if there is only one water well in a town and it is impossible to get water fromanywhere else, then the owner of the well has a monopoly on water.2. Government regulation: The government gives a single firm the exclusive right to produce some good or service-The patent and copyright laws are two important examples-Because these laws give one producer a monopoly, they lead to higher prices than would occur under competition. But by allowing these monopoly producers to charge higher prices and earn higher profits, the laws also encourage some desirable behavior-The benefits of the patent and copyright laws are the increased incentives for creativity. These benefits are offset, to some extent, by the costs of monopoly pricing. 3. The production process: A single firm can produce output at a lower cost than can a larger number of producers. -Natural monopoly: a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms-Arises when there are economies of scale over the relevant range of output. -Ex: the distribution of water. To provide water to residents of a town, a firm must build a network of pipes throughout the town. If two or more firms were to compete in the provision of this service, each firm would have to pay the fixed cost of building a network. Thus, the average total cost of water is lowest if a single firm serves the entire market. -When a firm's average total cost curve continually declines, the firm has whats iscalled a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce ant given amount at the smallest cost.How Monopolies Make Production and Pricing Decisions-Monopoly versus CompetitionoBecause a monopoly is the sole producer in its market, it can alter the price of its food by adjusting the quantity it supplies to the marketoBecause a competitive firm can sell as much or as little as it wants at the market price, the competitive firm faces a horizontal demand curve. -Because the competitive firm sells a produce with many perfect substitutes (the products of all the other firms in its market), the demand curve that any one firm facesis perfectly elastic. oBecause monopoly is the sole producer in its market, its demand curve is the market demand curve. -The monopolist's demand curve slopes downward for all the usual reasons. If the monopolist raises the price of its good, consumers buy less of it. If the monopolist reduces quantity of output it produces and sells, the price of its output increases. oThe market demand curve provides a constraint on a monopoly's ability to profit from itsmarket power. A monopolist would prefer to charge a high price and sell a large quantity at that high price. The market demand curve makes that outcome impossible. oThe monopolist can choose any point on the demand curve, but it cannot choose a pointoff of it. -A Monopoly's RevenueoTotal revenue = P*QoAverage revenue = TR / Q (the amount of revenue the firm receives per unit sold)oAverage revenue always equals the price of the good. (this is true for both monopolies and competitive firms)oMarginal revenue: the amount of revenue that the firm receives for each additional unit of output-MR = ΔTR / ΔQoA monopolists marginal revenue is always less than the price of its good-This is because a monopoly faces a downward sloping demand curveoTo increase the amount sold, a monopoly firm must lower the price it charges to all customers. oWhen a monopoly increases the amount it sells, this action has two effects on total revenue (P*Q):-The output effect: More output is sold, so Q is higher, which tends to increase total revenue-The price effect: The price falls, so P is lower, which tends to decrease total revenueoBecause a competitive firm can sell all it wants at the market price, there is no price effect. -When it increase production by 1 unit, it receives the market price for that unit, and it does not receive any less for the units it was already selling-By contrast, when a monopoly increase production by 1 unit, it must reduce the price it charges for every unit it sells, and this cut in price reduces revenue on the unitsit was already selling. -A monopoly's marginal revenue is less than its price. oA monopoly's marginal-revenue curve lies below its demand curve. oMarginal revenue is negative when the price effect on revenue is greater than the output effect-Profit MaximizationoWhen marginal cost is less than marginal revenue, the firm can increase profit by producing more units. oIf marginal cost is greater than marginal revenue, the firm can raise profit by reducing production. oThe monopolist's profit maximizing quantity of output is determined by the intersection of the marginal-revenue curve and the marginal-cost curve. oCompetitive firms also choose this quantity of output for profit maximization but there isan important difference:-For a competitive firm: P = MR = MC-For a monopoly firm: P > MR = MCoAfter the monopoly firm chooses the quantity of output that equates marginal revenue and marginal cost, it uses the demand curve to find the highest price it can charge for that quantity. E B Costs & RevenueMarginal costThe area of box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus average total cost. The width of the box (DC) is the number of units sold.