A monopoly is the sole producer of a commodity that has no close substitutes and faces many buyers.
The firm and the industry y are identical. The demand curve faced by the firm is the downward-sloping industry demand curve. A monopoly l acts as a price-maker i k

• The existence of the downward-sloping downward sloping demand curve sets a constraint on the monopolist’s monopolist s actions • The monopolist can either set the price and then sell the quantity indicated by the demand curve • Or O determine d t i the th quantity tit t to b be sold ld and d then find the price at which this quantity can be b sold ld

Market power
• A monopolist, as we shall see, has market power • That is, it can set a price above marginal cost • Whether a market is a monopoly market or not depends on the definition of the market • The market must be such that the monopolist monopolist’s s product has no close substitutes • If we define the market too broadly, a monopolist may appear to have rivals • If we define it too narrowly, y, we may y identify ya firm as a monopoly when it is not

Where Do Monopolies p Come From?
1 Government blocks the entry of more than one firm fi i into t a market. k t (Wh (Why?) ?) 2 One firm has control of a key y resource necessary to produce a good. 3 Economies of scale are so large that one firm has a natural monopoly. 4 Being first to produce a new product (iPod)

Where Do Monopolies p Come From?
Entry Blocked by Government Action
The government blocks entry in two main ways: 1 By granting a patent or copyright to an individual or firm, giving it the exclusive right to produce a product. 2 By granting a firm a public franchise, making it the exclusive legal provider of a good or service.

Where Do Monopolies Come From? Entry Blocked by Government Action Patents and Copyrights Patent The exclusive right to a product for some period from the date the product is invented. . ti Public Franchises Public franchise A designation by the government that a firm is the only legal provider of a good or service. invented Copyright A government-granted exclusive right t produce to d and d sell ll a creation.

To produce aluminium you need bauxite – the ALCOA example .Where Do Monopolies p Come From? Control of a Key Resource Another way for a firm to become a monopoly is by controlling a key resource.

htm . http://edwardjayepstein.•Are Diamond Profits Forever? The De Beers Diamond Monopoly De Beers promoted the sentimental value of diamonds as a way to maintain its position in the diamond http://edwardjayepstein com/diamond/pro logue.

Scale Economies and Monopoly • Monopolist can make a profit because AC lies below the demand curve at some quantities • Two firms cannot make positive profits – AC lies li above b Dhalf for f all quantities 17-9 .

• The Th monopolist li t tries t i to t maximize i i = TR – C. where dP/dQ < 0 0.Q and TC = C(Q). . where TR = P(Q).Profit maximization Profit-maximization • Let the equation of the (inverse) demand curve facing the monopolist be P = P(Q). • The total cost function is C = C(Q).

Profit maximization Profit-maximization The first order condition is d/dQ = dTR/dQ – dC/dQ = 0. i i. dTR/dQ = dC/dQ. dC/dQ => MR = MC..e. The second order condition is d2/dQ2 = dMR/dQ – dMC/dQ < 0 .

P fit Maximization Profit M i i ti $ C t' R 400 300 c’ 200 150 100 50 0 c 5 t Profits 10 15 20 Quantity .

.Marginal Revenue For a straight line demand curve P = a – bQ. what h ti is the th MR equation? ti ? TR = PQ = aQ – bQ2 Then MR = dTR/dQ = a – 2bQ AR = TR/Q = a – bQ for Q > 0.

Average g and Marginal g Revenue $ per unit it of f output 7 6 5 4 3 2 1 0 Marginal Revenue Average Revenue (Demand) 1 2 3 4 5 6 7 Output .

P and MR Note: MR = dTR/dQ. Hence MR = P + Q(dP/dQ) = P(1 – 1/e) . dTR/dQ But TR = PXQ.

Maximizing Profit When Marginal Revenue q Marginal g Cost Equals $ per unit it of f output MC P1 P* AC P2 Lost profit D = AR MR Q1 Q* Q2 Lost profit Quantity .

Profit maximization Profit-maximization • For e > 1. MR will be negative So long as MC > 0.e. The monopolist will operate on the elastic portion of the demand curve. . • for e < 1. e > 1. 0 i. 1 MR < P. profit-maximization requires MR > 0.

MR = 40 – 2Q • MR = MC => Q = 10.The Monopolist’s Output Decision • An Example • C(Q) = 50 + Q2 • P(Q) = 40 – Q • Then MC = 2Q 2Q. P = 30 .

P fit M Profit Maximization i i ti $/Q 40 MC 30 P fit Profit AC AR 20 15 10 MR 0 5 10 15 20 Quantity .

Check the price-marginal cost margin: (p – MC)/p )/p .Miscellaneous • The Monopolist does not face a Supply Curve • The Lerner Index .The elasticity of demand affects a monopolist’s li t’ price i relative l ti to t its it marginal i l cost .

the larger the Lerner index and the greater the monopolist’s ability to set price above marginal cost cost. .The Lerner Index • MR = p(1 – 1/e) • Then MR = MC implies L = (p ( – MC)/p MC)/ = 1/e 1/ • For a competitive firm. p = MC => L = 0 The smaller e e.

there is little benefit to being a monopolist • The larger the elasticity elasticity.Monopoly • If demand is very elastic elastic. the closer to a perfectly competitive market .

Taxation of a monopolist • What happens if a tax is imposed on a monopolist? • If the tax is a lump lump-sum sum tax T. . T it is clear that there will be no effect on either monopoly price or quantity. quantity because the monopolist will now be maximizing  – T.

• Next. . let the tax be imposed p on quantity q y at the rate t. • Then Q* = (a – c)/2 and P* = (a + c)/2. C = cQ. • Consider linear demand and cost curves: • P = a – Q. .Taxation of a monopolist • Suppose that a specific tax of t per unit is imposed. a > c. a > (c+t).

which hi h shows h that th t price has increased by only half the amount t of f th the t tax per unit.P* = t/2 t/2. • Quantity is now Q** = (a – c – t)/2 and price P** = (a+c+t)/2. it . H P** .Taxation of a monopolist • The total cost curve facing the monopolist becomes C = (c+t)Q. • Hence.

.Taxation of a monopolist • However. . • Equating q g this to MC = c and solving. . • Suppose that the demand curve is a constantelasticity demand curve. curve • MR = P(1 – 1/e). 1/e) • P” – P’ = t/(1 – 1/e). • After the tax is imposed. price is P” = (c+t)/(1 – 1/e). g. it is not generally g y true that the price p increases by less than the tax. 1 – 1/e / is a fraction and therefore the increase in price exceeds t. we get g P’ = c/(1 – 1/e). • Since e > 1.

its optimal production decision is now given by Effect of Excise Tax on Monopolist With a tax t per unit. In this example.MONOPOLY • The Th Effect Eff of faT Tax Suppose a specific tax of t dollars per unit is levied. so that the monopolist must remit t dollars to the government for every unit it sells. . the increase in price ΔP is larger than the tax t. the firm’s effective marginal cost is increased by the amount t to MC + t. If MC was the firm’s original marginal cost.

t on firms fi • The pass-through rate is the increase in price that occurs in response to a small increase in marginal cost.Response p to Changes g in Cost • How do monopolies and perfectly competitive markets differ in their response to changes in costs? • Consider the case of a marginal cost increase by a given amount at every level of output – Example: E l a specific ifi tax. measured d per dollar d ll of f increase in marginal l cost • In a competitive market. the pass-through rate is never greater than one g • The monopolist’s pass-through rate depends on the shape of the demand curve – Can be greater than one with a constant-elasticity demand curve . t t.

(1) In perfect competition competition. M Monopolist li t is i not t forced f d to t produce d at t the th lowest point of the average cost.Perfect competition vs. Monopoly • Monopoly is inferior to perfect competition in two respects. . the long run equilibrium is when price is driven down to the point of the minimum average cost curve – productive efficiency is attained.

Perfect competition vs. Monopoly (2) Perfect competition leads to a situation where the potential gains from trade between buyers and sellers are fully realized – allocative efficiency • p = MC • The monopoly charges a price that is hi h than higher th marginal i l cost t and d there th is i a “deadweight loss” under monopoly. .

Does Monopoly Reduce Economic Efficiency? Comparing Monopoly and Perfect Competition What Happens If a Perfectly Competitive Industry Becomes a Monopoly? .

The Social Costs of Monopoly Power • Monopoly power results in higher prices and lower quantities • However. However does monopoly power make consumers and producers in the aggregate better or worse off? • We can compare producer and consumer surplus l when h in i a competitive titi market k t and d in a monopolistic market .

Does Monopoly Reduce Economic Efficiency? Measuring the Efficiency Losses from Monopoly The Inefficiency of Monopoly .

they will spend up to the full monopoly profit (Richard P Posner) ) – If they spend on socially wasteful things (e.g.Nonprice Effects of Monopoly: Investments • Firms can make investments in an effort to become a monopolist – Example: cable TV firms lobbying government officials to award them franchises • If firms compete to become a monopolist. golf outings for local officials) the loss from monopoly may be larger than deadweight loss and include all monopoly profit ..

g.. ( R&D spending di in i the th search for patentable drugs) .Nonprice Effects of Monopoly: Investments • Rent seeking is socially useless effort devoted to securing a monopoly position • Welfare effects of monopoly need not always be so bad – Expenditures E dit firms fi make k to t gain i monopoly positions can be socially valuable l bl (e.

Regulating Monopoly Power • Since monopoly leads to a higher price and a lower output than a comparable competitive industry industry. . governments try to restrict monopoly power in various ways.

Ch Changes the th demand d d curve facing f i the th firm fi .Regulating Monopoly Power Price ceiling .The profit-maximizing output for monopoly becomes the same as the perfectly competitive output .

If price is lowered to PC output increases to its maximum QC and th there i is no d deadweight d i ht loss. l $/Q Pm Price Regulation MC MR P2 = PC AC AR If left alone. a monopolist produces Qm and charges Pm. Qm Qc Quantity .

Th Social The S i l Costs C t of f Monopoly M l Power P • Natural Monopoly – A firm that can produce the entire output of an industry at a cost lower than what it would be if there were several firms.. .+qn – If th the average cost t curve i is d downward d sloping. + C(qn). then there is natural monopoly Sufficient not necessary condition – Sufficient. – C(Q) < C(q1) + C(q2) + C(q3) + …………. where Q = q1+q2+ ………..

12 R 12 and d total l cost of Rs.350 which is greater than the cost of production of a single firm. • On the other hand. the total cost of production is 170 + 180 = Rs. . • If output per day is 25. one firm can produce this amount at an average cost of f Rs.Natural Monopoly • Suppose pp that the total cost function is C = 50 + 10Q.300. hand if there are two firms and one produces 12 units while the other produces 13 units.

Regulating the Price p y of a Natural Monopoly $/Q Natural monopolies occur because of extensive economies of scale Quantity .

Pr PC MR Qm Qr AC MC AR QC Quantity .excess profit is zero. the monopolist would produce Qm and charge Pm.Regulating the Price p y of a Natural Monopoly $/Q Unregulated. Pm Setting the price at Pr yields the largest possible output. the firm would lose money and go out of business. If the price were regulate to be PC.

First-Best vs. ideally prices will be set at the competitive price i – Price at which demand and supply curves intersect – Aggregate gg g surplus p will be maximized – First-best solution to problem of price regulation • Two problems with achieving this lead to second-best regulation • Regulator may not know the firm’s marginal costs • First-best solution would cause the monopolist to lose money – If P < AC • Best the regulator can do is set a price that makes aggregate surplus as large as possible. allow the firm to break even – Set P = AC 17-43 . Second-Best Pi R Price Regulation l i • Under regulation.

Regulatory Failure • Difficulties associated with price regulation: – – It is very difficult to estimate the firm's firm s cost and demand functions because they change with t e evolving o g market a et co conditions dto s Regulated monopolists make many decisions other than about p price – regulation g may y lead to inefficiencies wrt these decisions .

Regulatory Goals • Regulators may pursue goals other than the maximization of aggregate surplus .Official mandate may include other objectives.g. provision of services to poor consumers p .Regulators may be appointed/elected – y can try y to improve p chances of repeat p they appointment or reelection .Regulators g may y be “captured” p by y the regulated firm . e.

Managers have no incentive to overstate costs • But there is no focus on profits which leads to efficiency .Government ownership • If the government owns the monopoly. .There is no need for elaborate regulatory hearings – saves resources .the politicians and bureaucrats have their own agendas .

Dorfman-Steiner Dorfman Steiner model Advertising .But B t shifts hift d demand d curve Let p = price a = advertising expenditure q = q(a. q/p < 0.Adds to cost . p). q/a > 0. C( ) = other C(q) th costs t .

q + (p – C/q)(q/p) = 0 [p – C/q]/p = -(q/p)/(q/p) = 1/ep Lerner condition (1) (2) ( ) (3) . C[ ( p)] )] – a To maximize profit: /p = q + pq/p – (C/q)(q/p) = 0 /a = pq q/a – (C/q)(q q/a) )–1=0 From (1). ( p) ) – C[q(a.Dorfman-Steiner model Consider a profit-maximizing monopolist:  = pq(a.

(4) we get [(a/q)/ea][1/p] = 1/ep a/pq / = ea/e / p (4) . (p – C/ q)(q/ a) = 1 (p ( – C/q) ) = 1/(q/ /a) ) (p – C/q) = (a/q)/(a/q)(q/a) (p – C/q) = (a/q)/(1/ea) From (3) and (4).Dorfman-Steiner model From (2) (2).

Dorfman-Steiner Dorfman Steiner model a/pq = | Advertising expenditure as a proportion of sales revenue ea/ep | Ratio of elasticities If ep is large. then less will be spent on advertising the product .

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