Monopoly

Monopoly and
and
imperfect
imperfect competition
competition

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Announcements

 Ellie Colema?
 Assignment due dates
 Syllabus: Health care?

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Imperfect Competition

 Imperfectly Competitive Firms

 Have some control over price
 Price may be greater than the marginal
cost of production
 Long-run economic profits are possible

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Imperfect Competition

 Imperfectly Competitive Markets

 Reduce economic surplus to varying
degrees
 Are very common

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Forms of Imperfect Competition

 Pure Monopoly (most inefficient)

 The only supplier of a unique product with
no close substitutes
 This is the one we’ll pay most attention to

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Forms of imperfect Competition

 Oligopoly (theoretically more efficient than
a monopoly)
 A firm that produces a product for which only
a few rival firms produce close substitutes
 Many major economic sectors
 Food, media, banking, energy, garbage,
pharmaceuticals, electricity, water, hospitals, etc.
 Collusion is a big problem
 Oil, Electricity, Vitamins, Archer-Daniels Midland

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Forms of imperfect Competition

 Monopolistic Competition (closest to

perfect competition)
 A large number of firms that produce
slightly differentiated products that are
reasonably close substitutes for one
another

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Imperfect Competition

 The Essential Difference Between

Perfectly and Imperfectly Competitive
Firms
 The perfectly competitive firm faces a
perfectly elastic demand for its product.
 The imperfectly competitive firm faces a
downward-sloping demand curve.

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Imperfect Competition

 In perfect competition
 Supply and demand determine equilibrium
price. The firm has no market power.
 At the equilibrium price, the firm sells all it
wishes.
 If the firm raises its price, sales will be
zero.
 The firm’s demand curve is the horizontal
line at the market price.

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Imperfect Competition

 With imperfect competition

 The firm has some control over price or
some market power.
 The firm faces a downward sloping
demand curve.

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The Demand Curves Facing Perfectly
and Imperfectly Competitive Firms

Perfectly competitive firm Imperfectly competitive firm

$/unit of output

Market D

Price
price

Quantity Quantity

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Five Major Sources of Market Power

Market power = barriers to entry

 Exclusive control over inputs

 Patents and copyrights

 Government licenses or franchises

 Economies of scale (natural monopolies)

 Networked economies

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Economies of Scale and the
Importance of Fixed Costs

 Natural Monopolies: Firms with large

fixed costs and low variable costs
 e.g. telephones, electric utilities, sewage,
etc.
 Have low marginal costs
 Average total cost declines sharply as
output increases
 Economies of scale will exist

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 Total and Average Total Costs for a
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Production Process with Economies of Scale

TC = F + MQ

Average cost ($/unit)

Total cost ($/year)

F + Q0

F ATC = F/Q + M

M
Q0 Quantity Quantity

Total cost rises at a constant Average costs decline and is

rate as output rises always higher than marginal cost

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Costs for Computers
(Hardware+software): Scenario 1

Mac OSX Windows XP

Annual production 1,000,000 1,200,000

Fixed cost $2,000,000 $2,000,000
Variable cost $8,000,000 $9,600,000
Total cost $10,000,000 $11,600,000
Average total cost per system $10.00 $9.70

Observations
•Fixed costs are a relatively small share of total cost
•Variable costs are identical
•Cost/system is nearly the same
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Costs for for Computers
(Hardware+software): Scenario 2

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Costs for for Computers: scenario 2
after time passes

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Economies of Scale and the
Importance of Fixed Costs

 Fixed investment in research and

development has been increasing as a
share of production costs.
Cost of producing a computer
Fixed Cost Variable Cost
Software Hardware

1984 20% 80%

1990 80% 20%

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Profit Maximization for
the Monopolist

 A price taker (perfect competition) and a

price setter (imperfect competition)
share two economic goals. They want
 To maximize profits
 To select the output level that maximizes
the difference between TR and TC, where
MB= MC.

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Profit Maximization for
the Monopolist

 For any producer

 MB = Marginal Revenue (MR) or a change
in a firm’s total revenue that results from a
one-unit change in output
 Increase output when MR > MC.

 For competitive producer

 MR=P
 For a monopolist
 MR<P
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The Monopolist’s Benefit
from Selling an Additional Unit

• If P = $6, then TR = $6 x 2 = $12

• If P = $5, then TR = $5 x 3 = $15
8 • The MR of selling the 3rd unit = $3 (15-12)
• For the 3rd unit, MR = $3 < P = $5
Price ($/unit)

6
5

2 3 8

Quantity (units/week)

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Marginal Revenue

 Observations
 MR < P
P Q TR MR
 MR declines as quantity
6 2 12 increases
3
5 3 15  MR is the change between
1
4 4 16 two quantities
-1
3 5 15  MR < P because price must
be lowered to sell an
additional unit

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Marginal Revenue in
Graphical Form

Price & marginal revenue ($/unit)

P Q TR MR

6 2 12
3
5 3 15 3
1 D
4 4 16
-1 1
3 5 15
-1 2 3 4 5 8

MR
Quantity (units/week)

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Profit Maximization for
the Monopolist

 Profit Maximizing Decision Rule

 When MR > MC, output should be increased.
 When MR < MC, output should be reduced.
 Profits are maximized at the level of output
for which MR = MC.
 What’s the marginal revenue for a
competitive firm?

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The Monopolist’s Profit-
Maximizing Output Level

6 Marginal Cost
Observations
Price ($/unit of output)

• If P = $3 & Q = 12 MR < MC
and output should be
4 reduced
• Profits are maximized at 8
3 units where MR = MC
• P = $4 where quantity
2 demanded = quantity
supplied
D
MR
8 12 24
Quantity (units/week)

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The Demand and Marginal Cost
Curves for a Monopolist
Why the Invisible Hand Breaks Down Under Monopoly

6 Deadweight loss Marginal cost

Price ($/unit of output)

• Because MR < P, the monopoly

4 produces less than the socially
optimal amount
3 • The deadweight loss of the
monopoly to society = (1/2)
($2/unit)(4units/wk) = $4/wk.
2

D
MR
8 12 24
Quantity (units/week)

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Why the Invisible Hand Breaks
Down Under Monopoly

 Monopoly  Perfect Competition

 Profits are  Profits are
maximized where maximized where
MR = MC. MR = MC.
 P > MR  P = MR
 P > MC  P = MC
 Deadweight loss  No deadweight loss

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Why the Invisible Hand Breaks
Down Under Monopoly

 Difficulties in Reducing the Deadweight

Loss of Monopolies
 Enforcing antitrust laws
 Growing concentration in food, media, energy,
pharmaceuticals, etc.
 Patents, copyrights, and innovation
 Natural monopolies

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Price Discrimination

 The practice of charging different buyers

different prices for essentially the same
good or service
 E.g. textbooks, medicine
 What about re-importing medicine?
 Theoretically maximizes economic surplus,
but reduces consumer surplus to zero

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 MB MC Public Policy Toward
Natural Monopoly

 Methods of Controlling Natural

Monopolies
 State ownership and management
 Weighing the benefit of marginal cost pricing
versus the cost of less incentive for innovation
 Is it true that there is less incentive for
innovation? Burlington Electric and VEIC
 In a democracy, politicians have to provide
public services and keep taxes low to get re-
elected

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 MB MC Methods of Controlling
Natural Monopolies

 State regulation of private monopolies

 Cost-plus regulation
 High administrative cost
 Less incentive for innovation

 P does not equate to MC

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 MB MC Methods of Controlling
Natural Monopolies

 Exclusive contracting for natural

monopoly
 Competition for the contract theoretically
sets P = MC
 Example of water in Buenos Aires
 Difficulty when fixed costs are high
 No incentive to maintain infrastructure
when contract nears termination

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 MB MC Methods of Controlling
Natural Monopolies

 Vigorous enforcement of anti-trust laws

 Helps prevent cartels
 May prevent economies of scale

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