ECONOMICS Twelfth Edition, Global Edition Michael Parkin 13

ECONOMICS Twelfth Edition, Global Edition Michael Parkin 13

ECONOMICS Twelfth Edition, Global Edition Michael Parkin 13 MONOPOLY After studying this chapter, you will be able to:

Explain how monopoly arises Explain how a single-price monopoly determines its output and price Compare the performance and efficiency of single-price monopoly and competition Explain how price discrimination increases profit Explain how monopoly regulation influences output, price, economic profit, and efficiency 2016 Pearson Education, Ltd.

Monopoly and How It Arises A monopoly is a market: That produces a good or service for which no close substitute exists In which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

2016 Pearson Education, Ltd. Monopoly and How It Arises How Monopoly Arises A monopoly has two key features: No close substitute Barriers to entry No Close Substitutes If a good has a close substitute, even if it is produced by

only one firm, that firm effectively faces competition from the producers of the substitute. A monopoly sells a good that has no close substitutes. 2016 Pearson Education, Ltd. Monopoly and How It Arises Barriers to Entry A constraint that protects a firm from potential competitors is called a barrier to entry.

Three types of barriers to entry are Natural Ownership Legal 2016 Pearson Education, Ltd. Monopoly and How It Arises Natural Barriers to Entry

Natural barriers to entry create natural monopoly. A natural monopoly is a market in which economies of scale enable one firm to supply the entire market at the lowest possible cost. Figure 13.1 illustrates a natural monopoly.

2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. Monopoly and How It Arises One firm can produce 4 million units of output at 5 cents per unit. Two firms can produce 4 million units2 units

eachat 10 cents per unit. 2016 Pearson Education, Ltd. Monopoly and How It Arises In a natural monopoly, economies of scale are so powerful that they are still being achieved even

when the entire market demand is met. The LRAC curve is still sloping downward when it meets the demand curve. 2016 Pearson Education, Ltd. Monopoly and How It Arises Ownership Barriers to Entry

An ownership barrier to entry occurs if one firm owns a significant portion of a key resource. During the last century, De Beers owned 90 percent of the worlds diamonds. 2016 Pearson Education, Ltd. Monopoly and How It Arises Legal Barriers to Entry Legal barriers to entry create a legal monopoly.

A legal monopoly is a market in which competition and entry are restricted by the granting of a: Public franchise (like the U.S. Postal Service, a public franchise to deliver first-class mail) Government license (like a license to practice law or medicine) Patent or copyright

2016 Pearson Education, Ltd. Monopoly and How It Arises Monopoly Price-Setting Strategies For a monopoly firm to determine the quantity it sells, it must choose the appropriate price. There are two types of monopoly price-setting strategies: A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers.

Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and Price Decision Price and Marginal Revenue A monopoly is a price setter, not a price taker like a firm in

perfect competition. The reason is that the demand for the monopolys output is the market demand. To sell a larger output, a monopoly must set a lower price. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and Price Decision Total revenue, TR, is the price, P, multiplied by the

quantity sold, Q. Marginal revenue, MR, is the change in total revenue that results from a one-unit increase in the quantity sold. For a single-price monopoly, marginal revenue is less than price at each level of output. That is, MR < P. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and

Price Decision Figure 13.2 illustrates the relationship between the price and marginal revenue and derives the marginal revenue curve. Suppose the monopoly sets a price of $16 and sells 2 units.

2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and Price Decision Now suppose the firm cuts the price to $14 to sell 3 units. It loses $4 of total revenue

on the 2 units it was selling at $16 each. And it gains $14 of total revenue on the 3rd unit. So total revenue increases by $10, which is marginal revenue. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and

Price Decision The marginal revenue curve, MR, passes through the red dot midway between 2 and 3 units and at $10. For a monopoly, MR < P at each quantity. 2016 Pearson Education, Ltd.

A Single-Price Monopolys Output and Price Decision Marginal Revenue and Elasticity A single-price monopolys marginal revenue is related to the elasticity of demand for the good. If demand is elastic, a fall

in the price brings an increase in total revenue. MR is positive. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and Price Decision

The increase in revenue from the greater quantity sold outweighs the decrease in revenue from the lower price per unit. So MR is positive. As the price falls, total revenue increases. 2016 Pearson Education, Ltd.

2016 Pearson Education, Ltd. A Single-Price Monopolys Output and Price Decision If demand is inelastic, a fall in the price brings a decrease in total revenue. The rise in revenue from the increase in quantity

sold is outweighed by the fall in revenue from the lower price per unit. So MR is negative. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and

Price Decision As the price falls, total revenue decreases. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and Price Decision

If demand is unit elastic, a fall in the price does not change total revenue. The rise in revenue from the greater quantity sold equals the fall in revenue from the lower price per unit. MR = 0. Total revenue is maximized

when MR = 0. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and Price Decision In Monopoly, Demand Is Always Elastic A single-price monopoly never produces an output at which demand is inelastic.

If it did produce such an output, the firm could increase total revenue, decrease total cost, and increase economic profit by decreasing output. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and Price Decision Price and Output Decision The monopoly faces the same types of technology

constraints as the competitive firm, but the monopoly faces a different market constraint. The monopoly produces the profit-maximizing quantity, where MR = MC. The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and

Price Decision Figure 13.4 illustrates the profit-maximizing choices of a single-price monopoly. In part (a), the monopoly produces the quantity that maximizes total revenue minus total cost.

2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. A Single-Price Monopolys Output and Price Decision In part (b), the firm produces the quantity at which MR = MC and sets the price at which it can

sell that quantity. The ATC curve tells us the average total cost. Economic profit is the profit per unit multiplied by the quantity produced the blue rectangle. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd.

A Single-Price Monopolys Output and Price Decision The monopoly might make an economic profit, even in the long run, because barriers to entry protect the firm from market entry by competitor firms. But a monopoly that incurs an economic loss might shut down temporarily in the short run or exit the market in the long run.

2016 Pearson Education, Ltd. Single-Price Monopoly and Competition Compared Comparing Price and Output Figure 13.5 compares the price and quantity in perfect competition and monopoly. The market demand curve,

D, in perfect competition is the demand curve that the firm in monopoly faces. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. Single-Price Monopoly and Competition Compared

The market supply curve in perfect competition is the horizontal sum of the individual firms marginal cost curves, S = MC. This curve is the monopolys marginal cost curve. 2016 Pearson Education, Ltd.

Single-Price Monopoly and Competition Compared Perfect Competition Equilibrium occurs where the quantity demanded equals the quantity supplied at quantity QC and price PC. 2016 Pearson Education, Ltd.

Single-Price Monopoly and Competition Compared Monopoly Equilibrium output, QM, occurs where marginal revenue equals marginal cost, MR = MC. Equilibrium price, PM, occurs on the demand

curve at the profitmaximizing quantity. 2016 Pearson Education, Ltd. Single-Price Monopoly and Competition Compared Compared to perfect competition, monopoly produces a smaller output and charges a higher

price. 2016 Pearson Education, Ltd. Single-Price Monopoly and Competition Compared Efficiency Comparison Figure 13.6(a) shows the efficiency of perfect competition.

The market demand curve is the marginal social benefit curve, MSB. The market supply curve is the marginal social cost curve, MSC. So competitive equilibrium is efficient: MSB = MSC. 2016 Pearson Education, Ltd.

2016 Pearson Education, Ltd. Single-Price Monopoly and Competition Compared Total surplus, the sum of consumer surplus and producer surplus, is maximized. The quantity produced in perfect competition is

efficient. 2016 Pearson Education, Ltd. Single-Price Monopoly and Competition Compared Figure 13.6(b) shows the inefficiency of monopoly. Because price exceeds marginal social cost,

marginal social benefit exceeds marginal social cost, and a deadweight loss arises. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd.

Single-Price Monopoly and Competition Compared Redistribution of Surpluses Some of the lost consumer surplus goes to the monopoly as producer surplus. 2016 Pearson Education, Ltd.

Single-Price Monopoly and Competition Compared Rent Seeking Any surplusconsumer surplus, producer surplus, or economic profitis called economic rent. Rent seeking is the pursuit of wealth by capturing economic rent. Rent seekers pursue their goals in two main ways:

Buy a monopolytransfers rent to creator of monopoly. Create a monopolyuses resources in political activity. 2016 Pearson Education, Ltd. Single-Price Monopoly and Competition Compared Rent-Seeking Equilibrium The blue area shows the

potential producer surplus with no rent seeking. The resources used in rent seeking can wipe out the monopolys producer surplus. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd.

Single-Price Monopoly and Competition Compared Rent-seeking costs shifts the ATC curve upward, Producer surplus disappears. The deadweight loss increases to the larger gray area.

2016 Pearson Education, Ltd. Price Discrimination Price discrimination is the practice of selling different units of a good or service for different prices. To be able to price discriminate, a monopoly must: 1. Identify and separate different buyer types. 2. Sell a product that cannot be resold. Price differences that arise from cost differences are not

price discrimination. 2016 Pearson Education, Ltd. Price Discrimination Two Ways of Price Discriminating A monopoly can discriminate Among groups of buyers. (Advance purchase and other restrictions on airline tickets are an example.)

Among units of a good. (Quantity discounts are an example. But quantity discounts that reflect lower costs at higher volumes are not price discrimination.) 2016 Pearson Education, Ltd. Price Discrimination Increasing Profit and Producer Surplus By price discriminating, a monopoly captures consumer

surplus and converts it into producer surplus. More producer surplus means more economic profit. Why? Economic profit = Total revenue Total cost Producer surplus is total revenue minus the area under the marginal cost curve, which is total variable cost. Producer surplus = Total revenue Total variable cost Economic profit = Producer surplus Total fixed cost 2016 Pearson Education, Ltd.

Price Discrimination A Price-Discriminating Airline Figure 13.8 shows the market demand and the airlines marginal cost of $40 a trip. Single-Price Profit Maximization The airline sells 8,000 trips a week at $120 a trip.

Travelers enjoy a consumer surplus. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. Price Discrimination The airline has a producer surplus of $640,000. Can the airline increase its

producer surplus by price discriminating? 2016 Pearson Education, Ltd. Price Discrimination Discriminating Between Two Types of Travelers In Figure 13.9, part (a) shows the market for business travel. The airline expands into the leisure market in part (b).

2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. Price Discrimination Leisure travelers will not pay $120 a trip, so the demand for leisure travel is the curve DL. The airline sells 4,000 leisure trips at $80 a trip. 2016 Pearson Education, Ltd.

Price Discrimination The airline increases its output to 12,000 trips a week. Consumer surplus increases and the airlines producer surplus increases. 2016 Pearson Education, Ltd. Price Discrimination Perfect Price Discrimination

Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price someone is willing to pay. Marginal revenue now equals the price, so the demand curve is also the marginal revenue curve.

2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd. Price Discrimination Figure 13.10 shows that the perfect price discriminating monopoly increases its output until the price of the last trip equals

marginal cost. Producer surplus is maximized when the lowest fare is $40 and 16,000 trips are bought. The monopoly makes the maximum possible profit. 2016 Pearson Education, Ltd. Price Discrimination

Efficiency and Rent Seeking with Price Discrimination The more perfectly a monopoly can price discriminate, the closer its output is to the competitive output (P = MC) and the more efficient is the outcome. But this outcome differs from the outcome of perfect competition in two ways: 1. The monopoly captures the entire consumer surplus. 2. The increase in economic profit attracts even more rent-seeking activity that leads to inefficiency.

2016 Pearson Education, Ltd. Monopoly Regulation Regulation: rules administrated by a government agency to influence prices, quantities, entry, and other aspects of economic activity. Two theories about how regulation works are social interest theory and capture theory. Social interest theory is that the political and regulatory process relentlessly seeks out inefficiency and regulates to

eliminate deadweight loss. Capture theory is that regulation serves the self-interest of the producer, who captures the regulator and maximizes economic profit. 2016 Pearson Education, Ltd. Monopoly Regulation Efficient Regulation of a Natural Monopoly When demand and cost conditions create natural monopoly, the quantity produced is less than the efficient

quantity. How can government regulate natural monopoly so that it produces the efficient quantity? Marginal cost pricing rule is a regulation that sets the price equal to the monopolys marginal cost. The quantity demanded at a price equal to marginal cost is the efficient quantity. 2016 Pearson Education, Ltd.

Monopoly Regulation Figure 13.11 illustrates the marginal cost pricing rule. Unregulated, the natural monopoly maximizes economic profit by producing the quantity at which marginal revenue equals marginal cost and charging the highest

price at which that quantity will be bought. 2016 Pearson Education, Ltd. Monopoly Regulation Regulating a natural monopoly in the social interest sets the quantity where MSB = MSC. The demand curve is the

MSB curve. The marginal cost curve is the MSC curve. Efficient regulation sets the price equal to marginal cost. 2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd.

Monopoly Regulation With marginal cost pricing, the quantity produced is efficient, but the average cost exceeds price, so the firm incurs an economic loss. How can the firm cover its costs and at the same time obey the marginal

cost pricing rule? 2016 Pearson Education, Ltd. Monopoly Regulation Where possible, a regulated natural monopoly might be permitted to price discriminate to cover the loss from marginal cost

pricing. Or the natural monopoly might charge a one-time fee to cover its fixed costs and then charge a price equal to marginal cost. 2016 Pearson Education, Ltd. Monopoly Regulation

Second-Best Regulation of a Natural Monopoly Another alternative is to permit the firm to produce the quantity at which price equals average cost and to set the price equal to average costthe average cost pricing rule. Or the government might

pay a subsidy equal to the monopolys loss. 2016 Pearson Education, Ltd. Monopoly Regulation Implementing average cost pricing can be a problem because it is not possible for the regulator to be sure what the firms costs are. Regulators use one of two practical rules:

Rate of return regulation Price cap regulation 2016 Pearson Education, Ltd. Monopoly Regulation Rate of Return Regulation Under rate of return regulation, a firm must justify its price by showing that its return on capital doesnt exceed a specified target rate.

This type of regulation can end up serving the self-interest of the firm rather than the social interest because the firms managers have an incentive to inflate costs and use more capital than the efficient amount. 2016 Pearson Education, Ltd. Monopoly Regulation Price Cap Regulation A price cap regulation is a price ceiling.

The rule specifies the highest price that the firm is permitted to charge. This type of regulation gives the firm an incentive to operate efficiently and keep costs under control. Figure 13.12 shows how a price cap works. 2016 Pearson Education, Ltd. Monopoly Regulation Unregulated, a natural

monopoly profit-maximizes. A price cap sets the maximum price. The firm has an incentive to minimize cost and produce the quantity on the demand curve at the price cap. The price cap regulation lowers the price and increases the quantity.

2016 Pearson Education, Ltd. 2016 Pearson Education, Ltd.

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