Monopolies: Production, Pricing and Public Policies, Study notes of Economics

Download Monopolies: Production, Pricing and Public Policies and more Study notes Economics in PDF only on Docsity! LEARNING OBJECTIVES: By the end of this chapter, students should understand:  why some markets have only one seller.  how a monopoly determines the quantity to produce and the price to charge.  how the monopoly’s decisions affect economic well-being.  why monopolies try to charge different prices to different customers.  the various public policies aimed at solving the problem of monopoly. 262 © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 5 MONOPOLY Chapter 15/Monopoly ❖ 263 CONTEXT AND PURPOSE: Chapter 15 is the third chapter in a five-chapter sequence dealing with firm behavior and the organization of industry. Chapter 13 developed the cost curves on which firm behavior is based. These cost curves were employed in Chapter 14 to show how a competitive firm responds to changes in market conditions. In Chapter 15, these cost curves are again employed, this time to show how a monopolistic firm chooses the quantity to produce and the price to charge. Chapters 16 and 17 will address the decisions made by monopolistically competitive, and oligopolistic firms. A monopolist is the sole seller of a product without close substitutes. As such, it has market power because it can influence the price of its output. That is, a monopolist is a price maker as opposed to a price taker. The purpose of Chapter 15 is to examine the production and pricing decisions of monopolists, the social implications of their market power, and the ways in which governments might respond to the problems caused by monopolists. KEY POINTS:  A monopoly is a firm that is the sole seller in its market. A monopoly arises when a single firm owns a key resource, when the government gives a firm the exclusive right to produce a good, or when a single firm can supply the entire market at a lower cost than many firms could.  Because a monopoly is the sole producer in its market, it faces a downward-sloping demand curve for its product. When a monopoly increases production by one unit, it causes the price of its good to fall, which reduces the amount of revenue earned on all units produced. As a result, a monopoly’s marginal revenue is always below the price of its good.  Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost. The monopoly then chooses the price at which that quantity is demanded. Unlike a competitive firm, a monopoly firm’s price exceeds its marginal revenue, so its price exceeds marginal cost.  A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus. That is, when the monopoly charges a price above marginal cost, some consumers who value the good more than its cost of © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 266 ❖ Chapter 15/Monopoly 2. Government-Created Monopolies a. Monopolies can arise because the government grants one person or one firm the exclusive right to sell some good or service. b. Patents are issued by the government to give firms the exclusive right to produce a product for 20 years. c. Patents involve trade-offs; they restrict competition but encourage research and development. 3. Natural Monopolies a. Definition of natural monopoly: a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. b. A natural monopoly occurs when there are economies of scale, implying that average total cost falls as the firm's scale becomes larger. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Figure 1 Chapter 15/Monopoly ❖ 267 c. Other examples of natural monopolies are club goods – goods that are excludable but not rival in consumption. III. How Monopolies Make Production and Pricing Decisions A. Monopoly versus Competition 1. The key difference between a competitive firm and a monopoly is the monopoly's ability to influence the price of its output. 2. The demand curves that each of these types of firms faces is different as well. a. A competitive firm faces a perfectly elastic demand at the market price. The firm can sell all that it wants to at this price. b. A monopoly faces the market demand curve because it is the only seller in the market. If a monopoly wants to sell more output, it must lower the price of its product. B. A Monopoly's Revenue 1. Example: sole producer of water in a town. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Figure 2 268 ❖ Chapter 15/Monopoly Quantit y Price Total Revenue Average Revenue Marginal Revenue 0 $11 $0 ---- ---- 1 10 10 $10 $10 2 9 18 9 8 3 8 24 8 6 4 7 28 7 4 5 6 30 6 2 6 5 30 5 0 7 4 28 4 -2 8 3 24 3 -4 2. A monopoly's marginal revenue will always be less than the price of the good (other than at the first unit sold). a. If the monopolist sells one more unit, his total revenue (P × Q) will rise because Q is getting larger. This is called the output effect. b. If the monopolist sells one more unit, he must lower price. This means that his total revenue (P × Q) will fall because P is getting smaller. This is called the price effect. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Table 1 Chapter 15/Monopoly ❖ 271 D. FYI: Why a Monopoly Does Not Have a Supply Curve 1. A supply curve tells us the quantity that a firm chooses to supply at any given price. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Figure 4 272 ❖ Chapter 15/Monopoly 2. But a monopoly firm is a price maker; the firm sets the price at the same time it chooses the quantity to supply. 3. It is the market demand curve that tells us how much the monopolist will supply because the shape of the demand curve determines the shape of the marginal revenue curve (which in turn determines the profit-maximizing level of output). E. A Monopoly's Profit 1. We can find profit using the following equation: Profit = TR – TC. 2. Because TR = P × Q and TC = ATC × Q, we can rewrite this equation: Profit = (P – ATC) × Q. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Figure 5 Chapter 15/Monopoly ❖ 273 F. Case Study: Monopoly Drugs versus Generic Drugs 1. The market for pharmaceutical drugs takes on both monopoly characteristics and competitive characteristics. 2. When a firm discovers a new drug, patent laws give the firm a monopoly on the sale of that drug. However, the patent eventually expires and any firm can make the drug, which causes the market to become competitive. 3. Analysis of the pharmaceutical industry has shown us that prices of drugs fall after patents expire and new firms begin production of that drug. IV. The Welfare Cost of Monopolies A. The Deadweight Loss 1. The demand curve represents the value that buyers place on each additional unit of a good or service. The marginal-cost curve represents the additional cost of producing each unit of a good or service. 2. The socially efficient quantity of output is found where the demand curve and the marginal cost curve intersect. This is where total surplus is maximized. 3. Because the monopolist sets marginal revenue equal to marginal cost to determine its output level, it will produce less than the socially efficient quantity of output. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Figure 6 Figure 7 276 ❖ Chapter 15/Monopoly 4. How should the firm set its price? a. If the firm sets its price equal to $30, it will sell 100,000 copies of the book, receive total revenue of $3 million, and earn $1 million in profit. b. If the firm sets its price equal to $5, it will sell 500,000 copies, receive total revenue of $2.5 million, and earn only $500,000 in profit. c. It will choose to set its price at $30 and sell 100,000 books. Note that there is a deadweight loss from this decision because there are 400,000 other customers willing to pay $5, which is more than the marginal cost of producing the book ($0). 5. Since it would be difficult for Australian readers to buy a copy of the book in the United States, the company could make even more profit by selling 100,000 copies to the die-hard fans at $30 each, and then selling 400,000 copies to the other readers for $5 each. a. The total revenue from selling 100,000 copies at $30 each is $3 million. b. The total revenue from selling 400,000 copies at $5 each is $2 million. c. Because the firm's costs are $2 million, profit will be $3 million. C. The Moral of the Story 1. By charging different prices to different customers, a monopoly firm can increase its profit. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 15/Monopoly ❖ 277 2. To price discriminate, a firm must be able to separate customers by their willingness to pay. 3. Arbitrage (the process of buying a good in one market at a low price and then selling it in another market at a higher price) will limit a monopolist's ability to price discriminate. 4. Price discrimination can increase economic welfare. Producer surplus rises (because price exceeds marginal cost for all of the units sold) while consumer surplus is unchanged (because price is equal to the consumers’ willingness to pay). D. The Analytics of Price Discrimination 1. Perfect price discrimination describes a situation where a monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price. 2. Without price discrimination, a firm produces an output level that is lower than the socially efficient level. 3. If a firm perfectly price discriminates, each customer who values the good at more than its marginal cost will purchase the good and be charged his or her willingness to pay. a. There is no deadweight loss in this situation. b. Because consumers pay a price exactly equal to their willingness to pay, all surplus in this market will be producer surplus. E. Examples of Price Discrimination © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Figure 9 278 ❖ Chapter 15/Monopoly 1. Movie Tickets 2. Airline Prices 3. Discount Coupons 4. Financial Aid 5. Quantity Discounts F. In the News: TKTS and Other Schemes 1. Every night in New York City, about 25,000 people attend Broadway shows (on average). 2. This is an article written by economist Hal Varian that describes the level of price discrimination that occurs in this market. VI. Public Policy toward Monopolies A. Increasing Competition with Antitrust Laws 1. Antitrust laws are a collection of statutes that give the government the authority to control markets and promote competition. a. The Sherman Antitrust Act was passed in 1890 to lower the market power of the large and powerful "trusts” that were viewed as dominating the economy at that time. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.