Chapter 7 - Monopoly, oligopoly, and monopolistic competition. Our agenda in chapter 7 is to develop more carefully and fully the concept of economic surplus introduced in part 1 and to investigate the conditions under which unregulated markets generate the largest possible economic surplus. We will also explore why attempts to interfere with market outcomes often lead to unintended and undesired consequences.
Chapter 7: Monopoly, Oligopoly, and Monopolistic Competition Distinguish among three types of imperfectly competitive industries Define imperfect competition and describe how it differs from perfect competition Describe why economies of scale are the most enduring source of monopoly power Apply the concepts of marginal cost and marginal revenue to find the output and price that maximizes a monopolist's profits Explain why the profit-maximizing output level for a monopolist is too small from society's perspective Discuss why firms offer discounts to buyers who are willing to jump a hurdle McGrawưHill/Irwin Copyrightâ2011byTheMcGrawưHillCompanies,Inc.Allrightsreserved Imperfect Competition Imperfectly competitive firms have some ability to set their own price: they are price setters – Long-run economic profits possible – Reduce economic surplus • Three types: 1.Monopoly has only one seller, no close substitutes 2.Monopolistic competition has many firms producing slightly differentiated products that are reasonably close substitutes 3.Oligopoly has a small number of large firms producing products that are close substitutes 72 Monopolistic Competition Monopolistic Competition Perfect Competition Many firms Many firms Price Entry and Exit Product Limited flexibility Free Differentiated Price taker Free Standardized Economic Profits Zero in long run Zero in long run Decisions P, Q, product differentiation Q only Number of Firms 73 Oligopoly Oligopoly Perfect Competition Few firms, each large Many firms Some flexibility Price taker Difficult Free Differentiated or standardized Standardized Economic Profits Possible Zero in long run Decisions P, Q, differentiation, advertising Q only Number of Firms Price Entry and Exit Product 74 The Essential Difference • Market power is the firm's ability to raise its price without losing all its sales • Any firm facing a downward sloping demand curve – Firm picks P and Q on the demand curve • Market power comes from factors that limit competition Perfectly Competitive Firm Price Price Imperfectly Competitive Firm D D Quantity Quantity 75 Market Power: Economies of Scale • Returns to scale refers to the percentage change in output from a given percentage change in ALL inputs – Long-run idea – Constant returns to scale: doubling all inputs doubles output – Increasing returns to scale: output increases by a greater percentage than the increase in inputs • Average costs decrease as output increases • Natural monopoly: a monopoly that results from economies of scale 76 Market Power: Network Economies • Network economies occur when the value of the product increases as the number of users increases – – – – – VHS format for video tapes, Blu-ray for DVDs Telephones Windows operating system eBay Facebook and MySpace 77 Economies of Scale and StartUp Costs • New products can have a large fixed development cost • Variable cost: sum of payments made to the variable factors, such as labor • Fixed cost: sum of payments made to the fixed factors, such as capital • Start-up costs can be thought of as a fixed cost • Average total cost (ATC): total cost divided by output • A good whose production has a large start-up cost and low variable cost is subject to economies of scale – ATC declines sharply as output increases 78 Economies of Scale and StartUp Costs • • • • Consider an example: Assume marginal cost (M) is constant Variable cost is M*Q Total cost is fixed cost (F) plus variable cost TC = F + M*Q – Total cost increases as output increases • Average total cost is ATC = F / Q + M – Average total cost decreases as output increases – Average fixed cost = F/Q 79 TC = F + M Q F Average cost ($/unit) Total cost ($/year) Economies of Scale ATC = F/Q + M M Quantity Quantity 710 Profit Maximization for the Monopolist • Like all other firms, a monopolist: – Maximizes profits – Applies the Cost-Benefit Principle: • Increase output if marginal benefit > marginal cost • Decrease output is marginal benefit < marginal cost • Marginal benefit is called marginal revenue: – Change in total revenue from a one-unit change in output – Equal to price for the perfectly competitive firm – Less than price for the monopolist 711 Profit Maximization for the Monopolist Price ($/unit) • To sell another unit the monopolist must lower price – Total revenue from units = $12 – Total revenue from units = $15 • Marginal revenue = $3 D Quantity (units/week) 712 Deciding Quantity • Decrease output – At Q = 8, MC = MR = • The demand curve sets the price at P = $4 – At any output below 8, MC < MR Price ($/unit of output) • Profit is maximized at the level of output where marginal cost equals marginal revenue • At P = $3 and Q = 12, MC > MR MC D MR 12 Quantity (units/week) 713 The Invisible Hand Fails Price ($/unit of output) The monopolist's optimal amount occurs where MC = MR, Q = units and P = $4 Deadweight loss from monopoly = $4 The socially optimal amount occurs where MC = MB, Q = 12 units and P = $3 Marginal Cost MR D 12 24 Quantity (units/week) 714 Monopoly and Perfect Competition 715 Managing Monopoly • Monopolies exist for economic reasons – Patents, copyrights, and innovation – Economies of scale – Network economies • Anti-trust laws attempt to limit deadweight loss – Limiting monopoly has costs • Patents encourage innovation • Economies of scale minimize ATC • Network economies increase benefits 716 Price Discrimination • Price discrimination means charging different buyers different prices for essentially the same good or service – Separate the groups – No side trades among buyers • Many forms of price discrimination – Hurdle method: discounts for identifiable groups (e g., students, AARP) – Perfect discrimination: negotiate separate deals with each customer 717 Hurdle Method of Price Discrimination • The hurdle method of price discrimination is the practice of offering a discount to all buyers who overcome some obstacle – – – – – – Temporary sales Hard cover and paperback books Multiple car models from one manufacturer Commercial air carriers Movie producers and phased releases Scratch and Dent appliance sales 718 Imperfect Competition Imperfect Competition Monopolistic Competition and Oligopoly Sources of Market Power Monopoly 719 ... – Maximizes profits – Applies the Cost-Benefit Principle: • Increase output if marginal benefit > marginal cost • Decrease output is marginal benefit < marginal cost • Marginal benefit is called... economies of scale 7 6 Market Power: Network Economies • Network economies occur when the value of the product increases as the number of users increases – – – – – VHS format for video tapes, Blu-ray... good whose production has a large start-up cost and low variable cost is subject to economies of scale – ATC declines sharply as output increases 7 8 Economies of Scale and StartUp Costs • • • •