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1 Chapter 11 Monopoly Key issues 1. monopoly profit maximization: MR = MC 2. market power 3. monopoly welfare effects: p > MC ⇒ DWL 4. cost advantages that create monopolies 5. government actions that create monopolies 6. government actions that reduce market power 7. dominant firm and competitive fringe Applications and problems 1.granting TV monopoly rights 2.monopolizing by merging 3.Botox: patent monopoly 4.controlling key ingredient 5.price of textbooks 6.Chinese monopoly becomes dominant firm Monopoly • monopoly: only supplier of a good for which there is no close substitute • monopoly's output is the market output: q = Q • monopoly's demand curve is market demand curve • its demand curve is downward sloping • it doesn't lose all its sales if its raises its price • it is a price setter Profit maximization all firms maximize profits by choosing quantity such that marginal revenue = marginal cost MR(Q) = MC(Q) Marginal revenue •firm's MR curve depends on its demand curve • monopoly's MR curve • lies below its demand curve at any positive quantity • because its demand curve is downward sloping • demand curve shows price, p, it receives for selling a given quantity, Q • price = p = average revenue 2 Marginal revenue, MR • change in revenue from selling one more unit • MR = ∆R/∆Q (Calculus: MR = dR(Q)/dQ) • if firm sells exactly one more unit, ∆Q = 1, • its marginal revenue is MR = ∆R • ∆R = R 2 –R 1 • MR < p at any given Q for a monopoly (but not for a competitive firm) Figure 11.1a Average and Marginal Revenue Price, p, $ per unit qq+ 1 Quantity, q, Units per year p 1 (a) Competitive Firm Demand curve AB R 1 = A R 2 = A + B ∆R = R 2 –R 1 = B = p 1 Figure 11.1b Average and Marginal Revenue QQ+ 1 Quantity, Q, Units per year p 1 p 2 Price, p, $ per unit (b) Monopoly Demand curve AB C R 1 = A + C R 2 = A + B ∆R = R 2 –R 1 = B – C = p 2 -C Deriving monopoly’s MR curve • monopoly increases its output by ∆Q, • by lowering its price per unit by ∆p/∆Q (slope of demand curve) • so monopoly loses (∆p/∆Q) × Q on units originally sold at higher price: area C • but earns an additional p on extra output: area B • thus: MR = p + (∆p/∆Q) × Q = p + a negative term < p Calculus derivation • monopoly’s revenue is R(Q) = p(Q)Q • differentiating with respect to Q: • thus: MR = p + a negative term < p () () () dR Q dp Q MR p Q Q dQ dQ ==+ Figure 11.2 Elasticity of Demand and Total, Average, and Marginal Revenue p, $ per unit Demand ( p = 24 – Q) Perfectly elastic Perfectly inelastic Elastic, ε < –1 Inelastic, –1 < ε < 0 ε = –1 ∆ p = –1 ∆ Q = 1 ∆ Q = 1 ∆ MR = –2 Q, Units per day 24 12 01224 MR = 24 – 2Q 3 Linear MR curve • for all linear demand curves, p = a - bQ • MR curve is a straight line, MR = a -2bQ • MR curve hits vertical (price) axis where demand curve does • slope of MR curve = 2 × slope of demand curve • MR curve hits horizontal axis at half the quantity as the demand curve In our example • p = 24 – Q •so a = 24 and b = 1 • ∆p /∆Q = -1 • hence MR = p + (∆p/∆Q) × Q = (24 – Q) + (-1) × Q = 24 – 2Q Using calculus R(Q) = p(Q)Q if linear: R(Q) = [a - bQ]Q = aQ - bQ 2 MR = dR/dQ = a -2bQ MR and elasticity of demand • MR at any given quantity depends on • demand curve's height (price) • demand curve's shape (elasticity) • thus, it depends on its elasticity Derive MR/elasticity formula • demand elasticity: ε = (∆Q/Q)/(∆p/p) = (∆Q/∆p)(p/Q) • MR = p + (∆p/∆Q) × Q = p + (∆p/∆Q)(Q/p)p 1 1p ε =+ MR and price • MR • MR closer to p the more elastic is demand • where demand curve hits price axis (Q = 0), demand curve is perfectly elastic ⇒ MR = p • MR = 0 where demand elasticity is ε = -1 • MR < 0 where demand is inelastic: 0 0 ε > -1 1 1p ε =+ 4 Table 11.1 Quantity, Price, Marginal Revenue, and Elasticity for the Linear Inverse Demand Curve p=24-Q Figure 11.2 Elasticity of Demand and Total, Average, and Marginal Revenue p, $ per unit Demand ( p = 24 – Q) Perfectly elastic Perfectly inelastic Elastic, ε < –1 Inelastic, –1 < ε < 0 ε = –1 ∆ p = –1 ∆ Q = 1 ∆ Q = 1 ∆ MR = –2 Q, Units per day 24 12 01224 MR = 24 – 2Q Choosing price or quantity • monopoly can set p or Q to maximize its profit, π • monopoly is constrained by market demand curve • it cannot set both Q and p (cannot pick a point above demand curve) • if monopoly sets p, demand curve determines Q • if monopoly sets Q, demand curve determines p • because monopoly wants to maximize π, it chooses same profit-maximizing solution whether it sets p or Q Profit maximization all firms, including monopolies, use a two- step analysis 1. firm determines output, Q*, at which it makes highest π, where • MR = MC • in elastic portion of demand curve 2. firm decides whether to produce Q* or shut down: p 0 AVC Figure 11.3 Maximizing Profit 12 18 24 8 6 108 144 60 601224 R, π , $ 012624 AC AVC e Demand π = 60 MC MR Q, Units per day Revenue, R Profit, π Q , Units per day p, $ per unit (a) Monopolized Market (b) Profit, Revenue SR cost in our example • C(Q) = Q 2 + 12 • MC = dC(Q)/dQ = 2Q • AVC = VC/Q = Q 2 /Q = Q • AC = C/Q = (Q 2 + 12)/Q = Q + 12/Q 5 Profit is maximized where • MR = 24 – 2Q = 2Q = MC ⇒ Q = 6 • inverse demand: p = 24 – Q = 24 – 6 = 18 • AVC = Q = 6 < p = 18 so produce • π > 0 because AC = Q + 12/Q = 8 < p = 18 Market power ability of a firm to charge a price above marginal cost profitably No check on bank market power banks exercise substantial market power on the rate for bounced checks • although you had no idea that a check wouldn't clear, your bank charges you an average of $4.75 to $7.50 (up to $10) • large banks charge more than small ones • bad check writer also pays an average of $15 to $19.50 (up to $30) Bank costs • bank's handling fees for bad checks = $1.32 • most checks eventually clear (check writer merely miscalculated balances) • even including losses from fraud, total MC = $2.70 (Center for the Study of Responsive Law) • thus, banks are exercising substantial market power: price > MC Market power and shape of demand curve • market power depends on shape of demand curve (elasticity) • at profit-maximizing quantity: 1 1 M Rp MC ε =+= () 1 11/ p MC ε = + Lerner index (price markup) 1pMC p ε − =− • Lerner index is (p – MC)/p • if firm profit maximizes, • Lerner index ranges from 0 to 1 • p 0 MC •0/ p – MC / p •0/ (p – MC)/p / p/p = 1 6 Causes of market power monopoly's demand curve is relatively inelastic if • consumers are willing to pay "virtually anything" for it • no close substitutes for firm's product exist • other firms can't enter market • other similar firms are located far away • other firms’ products very different Welfare effects of monopoly • welfare = consumer surplus + producer surplus • W = CS + PS • welfare is < under monopoly than under competition • monopoly sets p > MC, causing deadweight loss (DWL) = 18 Figure 11.5 Deadweight Loss of Monopoly p, $ per unit Demand Q , Units per day MR MC p c = 16 B= $12 D=$60 C=$2 E = $4 MR= MC= 12 A= $18 p m 24 Q m = 6 Q c = 8 24120 e m e c Solved problem • in our linear example, • how does subjecting a monopoly to a specific tax of τ = $8 per unit affect • monopoly optimum • welfare of consumers, the monopoly, and society? • what is tax incidence on consumers? Solved Problem 11.1 p, $ per unit Demand Q, Units per day MR MC 1 (before tax) MC 2 (after tax) p 1 = 18 D E C F G B A τ = $8 0 8 p 2 = 20 24 Q 2 = 4 Q 1 = 6 2412 e 1 e 2 7 Competitive vs. monopoly sugar tax incidence • incidence of a tax on consumers may be less for a monopolized than a competitive market • in 1996, Florida voted on (and rejected) a one-cents-per- pound excise tax on refined cane sugar in the Florida Everglades Agricultural Area • given linear supply (or marginal cost) and demand curves the tax incidence on consumers from this tax is • 70% if the market is competitive • 41% if monopolistic • thus, a competitive Florida sugar industry passes on substantially more of the tax to demanders than it would if the industry were monopolized Welfare effects of taxes • governments use ad valorem taxes (αp per unit) more often than specific taxes (τ per unit) – why? • suppose both taxes cut output by the same amount • which one raises the most government tax revenue? Figure 11.6 Ad Valorem Versus Specific Tax p, $ per unit A B Before-tax demand, D Q, Units per year MR MC e 1 e 2 p 2 p 1 p a = (1 – α )p 2 p s = p 2 – τ Q 2 Q 1 MR a D a MR s D s Why monopolies? • firm has cost advantage over others firms • government created monopoly • merger of several firms into a single firm • firms act collectively: cartel • strategies - such as threats of violence - that discourage other firms from entering market Sources of cost advantages • firm controls a key input: • essential facility: scarce resource that rival needs to use to survive • firm knows of superior technology, or • has better way of organizing production Natural monopoly • market has a natural monopoly if one firm can produce total market output at lower cost than could several firms • if cost for Firm i to produces q i is C(q i ), condition for a natural monopoly is C(Q) < C(q 1 ) + C(q 2 ) + + C(q n ), • where Q = q 1 + q 2 + + q n is sum of output of any n > 2 firms 8 Sufficient condition natural monopoly if • AC curve falls at any observed quantity for all firms • economies of scale Electricity example • F = $60 (build plant & connect houses) • MC = m = $10 (constant) • AC = m + F/Q = 10 + 60/Q, declines as output rises Costs of producing Q = 12 $240$2062 $180$15121 CAC = 10+60/Qoutput# of firms having only one firm produce avoids a second fixed cost (MC doesn’t vary with number of firms) Figure 11.7 Natural Monopoly 15 20 40 10 601215 AC = 10 + 60/Q MC =10 Q, Units per day AC, MC, $ per unit Public utilities apparently believing they’re natural monopolies, governments grant monopoly rights for essential good or service “public utilities” • water •gas • electric power • mail delivery Electric power utilities • AC curve for U.S electric-power-producing firms in 1970 •was U-shaped • reached its minimum at 33 billion kWh per year • whether an electric power utility is a natural monopoly depends on demand it faces 9 Economies of scale • natural monopolies: most electric companies operated in regions of substantial economies of scale • Newport Electric produced 0.5 billion kWh/year • Iowa Southern Utilities: 1.3 billion kWh/year • not natural monopolies: a few operated in upward- sloping section of AC curve • Southern produced 54 kWh/year • 2 firms could produce that quantity at 3¢ less per thousand kWh than could a single firm Application Electric Power Utilities 4.85 5.10 4.79 Cost, $ per thousand kWh 03366 Q, Billion kWh per year AC D Government created monopolies • barriers to entry (e.g, patents) • own and manage many monopolies • postal services • garbage collection • utilities • electricity • water •gas • phone services Barriers to entry governments prevent other firms from entering a market in 3 ways • by making it difficult for new firms to obtain a license to operate • by granting a firm rights to be a monopoly • by auctioning rights to be a monopoly Granting rights • the United States, granted exclusive (monopoly) rights to portions of the electromagnetic spectrum (TV) • thereby gave broadcast television stations at least $40 billion in present value terms for the first 30 years of television Patents • grants an inventor right to be monopoly provider of good for a number of years • stimulates research 10 Iceland’s government creates genetic monopoly • starting in 874, Viking crews from western Norway grabbed young Celtic women from Ireland and took them to Iceland • 11 centuries later, the descendents of these 10,000 to 15,000 pirates and their about five-times-as-many slave wives form an unusually isolated population with a relatively homogeneous gene pool • Iceland has tissue samples dating back to the 1940s and meticulous records on every citizen since 1915 • careful genealogic records have been kept that allows researchers to trace disease genes back more than 10 generations deCODE Genetics • Dr. Kari Stefansson believed that the unique genetic dataset of the 286,000 current Icelanders (and their forbearers) would help pinpoint genetics of some serious common diseases • he formed a firm, deCODE Genetics • in 1998, deCODE acquired 12 years of monopoly rights to the genetic, medical, and genealogical records of Iceland for about $200 million • the firm agreed to provide Icelanders for free with drugs and diagnostic tools stemming from their research • the firm has collected voluntary blood samples from tens of thousands of people to augment their databases • by 2002, deCODE announced findings for a number of diseases and had revenues of $13.4 million Drug patent: Botox • Dr. Alan Scott turned a deadly poison, botulinum toxin, into a miracle drug to treat • strabismus, or cross-eyes, which affects about 4% of children • blepharospasm, an uncontrollable closure of the eyes, which left about 25,000 Americans functionally blind before his discovery • his patented drug, Botox, is sold by Allergan Inc. Other uses • Dr. Scott has been amused to see several of the unintended beneficiaries of his research at the Academy Awards • even before it was explicitly approved for cosmetic use, many doctors were injecting Boxtox into the facial muscles of actors, models, and other people to smooth out their wrinkles • ideally for Allergan, the treatment is only temporary, lasting up to 120 days, so repeated injections are necessary Profits • Allergan had expected to sell $400 million worth of Botox in 2002 • however, in April 2002, the FDA approved Botox for cosmetic purposes—allows Allegran to advertise the drug widely • The firm expects Botox to eventually earn a $1 billion a year (becoming another Viagra) Compare • Mattel sold $1.4 billion worth of Barbie dolls over 37 years [...]... marginal cost curves, MR = 775 – 750Q = 25 = MC, • determines the monopoly equilibrium at the profit-maximizing quantity of 1 million vials per year and a price of $400 per vial • strikes the price axis at $775 • has twice the slope, -750, as the demand curve p, $ per vial 775 Botox Benefits • SR relief from eye problems and wrinkles (CS at monopoly price): A = $187.5 million per year • LR CS after patent... demand it faces is only slightly elastic Linear demand Monopoly optimum • if the demand curve is linear and elasticity of demand is -1.067 at 2002 monopoly optimum (1 million vials sold at $400 each), Allergan’s inverse demand function is p = 775 – 375Q • demand curve: • slope is -375 • hits price axis at $775 • hits quantity axis at 2.07 million vials per year • corresponding marginal revenue curve... per year • Patent monopoly profit (ignoring fixed costs): B = $375 million per year A= $187.5 million em 400 Demand B= $375 million C= $187.5 million ec 25 1 MR MC= AVC 2 2.07 Q, Millions vials of Botox per year 11 Auctions Mergers • Oakland cable TV • SF auctioned monopoly rights to store cars towed for illegal parking • if all firms in a market merge (and no new ones enter), then a monopoly is formed... regulated p is < minimum of monopoly' s AVC, monopoly shuts down • if regulated price is between shut-down point and monopoly price but not equal to competitive price • too little is produced • welfare is below competitive level 12 Figure 11.9 Regulating an Electric Utility Solved problem 11.3 p, Yen (¥) per hundred KWH 53 MC AC e1 30.3 What's the effect of a price regulation on a monopoly that is below... Solved Problem 11.3 Creation and destruction of an aluminum monopoly p, $ per unit MC Market demand B A p1 p2 C D • cost advantages and government actions gave Aluminum Company of America (Alcoa) a U.S monopoly in aluminum • monopoly lasted for decades e1 Regulated demand e2 E MR Q 2 Q1 MR r Qd Q, Units per day Excess demand Alcoa becomes a monopoly • Alfred Hall invented and patented a new process... MC • closer is Lerner Index, (p - MC)/p, to zero (competitive level) 3 Welfare effects of monopoly • • • • • because a monopoly' s p > MC too little output is produced society suffers a DWL consumers are worse off monopoly' s profit > competitive level 16 4 Cost advantages that create monopolies firm may become a monopoly if it • controls a key input • has superior knowledge about producing or distributing... natural monopoly 5 Government actions that create monopolies • governments may establish • government-owned and operated monopolies • private monopolies by • establishing barriers to entry • patents 6 Government actions that reduce market power • government can eliminate welfare harm of a monopoly by forcing firm to set its price at competitive level • government can eliminate or reduce harms of monopoly. .. Firm-Competitive Fringe Equilibrium p, $ per unit D 1 Monopoly profit maximization Sf p2 p* f d MC d e • chooses p or Q • maximizes profit where MR = MC • operates if p AVC Dr p1 MR r Q* f * qd Q* d Q, Units of output per year 2 Market power • ability of a firm to charge a price above MC and earn a positive profit • more elastic is demand at Q where monopoly maximizes its profit • closer is its p to its...Justification Botox profit maximization • patent monopoly profits spur new research • people benefit greatly from many inventions (new drugs) • Dr Scott can produce a vial of Botox in his lab for about $25 • Allergan sells a vtal to doctors for about $400 • assuming that the firm is setting its price to maximize... a market merge (and no new ones enter), then a monopoly is formed • US Dept of Justice and FTC challenge such mergers • monopoly, City Tow, collects $40 per car, of which $15.03 goes to the city • losing company's bid promised the city only $7.50 • ASUC tried to create a bookstore monopoly without holding an auction Government actions that reduce market power • antitrust laws prohibit monopolization, . problems 1.granting TV monopoly rights 2.monopolizing by merging 3.Botox: patent monopoly 4.controlling key ingredient 5.price of textbooks 6.Chinese monopoly becomes dominant firm Monopoly • monopoly: only. = MC, • determines the monopoly equilibrium at the profit-maximizing quantity of 1 million vials per year and a price of $400 per vial 25 400 p, $ per vial Q, Millions vials of Botox per year 1 A=. gave broadcast television stations at least $40 billion in present value terms for the first 30 years of television Patents • grants an inventor right to be monopoly provider of good for a