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Monopoly
Firm that is the sole seller of a product
Product does not have close substitutes
Firm is Price maker
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A firm is a monopoly if it is the sole seller of its product and if its product
does not have close substitutes.
The marginal cost of Windowsthe extra cost that Microsoft would incur
by printing one more copy of the program on a CDis only a few dollars.
Competitive firm
Price taker
Demand horizontal line at market price
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Demand curves for competitive and monopoly firms
(a) A Competitive Firms Demand Curve (b) A Monopolists Demand Curve
Price Price
Demand
Demand
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Competitive firms are price takers: they face
horizontal demand curve
The price effect is the loss of revenue from selling the original quantity at
the lower price; the quantity effect is the added revenue earned at the
new price on the newly induced units sold.
So, if the area of the rectangle giving the price effect is greater than the
area of the rectangle giving the quantity effect, demand is inelastic:
Ed < 1
If the reverse is true, demand is elastic: Ed > 1
If the sizes are equal, demand is unit elastic (or unitary elastic)
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A monopolists total, average, and marginal revenue
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Monopolists Production& Pricing Decisions
Monopolists revenue
Total revenue = price times quantity
Average revenue
Revenue per unit sold
average revenue always equals the price of the good
Marginal revenue
Revenue for each additional unit of output
Change in total revenue when output increases by 1 unit
Can be negative
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Monopolists Production& Pricing
Decisions
A monopolists marginal revenue is less than the price of its good: MR < P
When a monopoly increases the amount it sells, it has two effects on total
revenue (P x Q): Output effect ( Q increases) and Price effect (P is lower)
Note: A competitive firm can sell all it wants at the market price, there is
no price effect.
MR = P
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By contrast, when a monopoly increases production by 1 unit, it must
reduce the price it charges for every unit it sells
this cut in price reduces revenue on the units it was already selling.
MR < P
MR curve is below the demand curve
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Demand and marginal-revenue curves for a monopoly
Price
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10
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4
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Demand
2 (average revenue)
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0
-1 1 2 3 4 5 6 7 8 Quantity
of water
-2
-3
Marginal revenue
-4
The marginal-revenue curve shows how the firms revenue changes when the quantity increases
by 1 unit.
Because the price on all units sold must fall if the monopoly increases production, marginal
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revenue is always less than the price.
How Monopolies Make Production& Pricing Decisions
Profit maximization
If MR > MC increase production
If MC > MR produce less
Maximize profit
Produce quantity where MR=MC
Intersection of the marginal-revenue curve and the
marginal-cost curve
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How does the monopoly find the profit-maximizing price for its product?
the demand curve relates the price that customers are willing to pay for
the profit maximizing quantity
Thus, after the monopoly firm chooses the quantity of output that
equates MR and MC, it uses the demand curve to find the price consistent
with that quantity
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Profit maximization for a monopoly
Costs 2. . . . and then the demand curve shows the
price consistent with this quantity.
and
Revenue Marginal cost
Demand
Marginal revenue
0 Q1 QMAX Q2 Quantity
A monopoly maximizes profit by choosing the quantity at which marginal revenue equals
marginal cost (point A). It then uses the demand curve to find the price that will induce
consumers to buy that quantity (point B). 21
How Monopolies Make Production& Pricing Decisions
key difference :
In competitive markets, price equals marginal
cost.
In monopolized markets, price exceeds marginal
cost
Profit maximization
Perfect competition: P=MR=MC
Price equals marginal cost
Monopoly: P>MR=MC
Price exceeds marginal cost
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The monopolists Profit = TR TC = (P ATC) Q
Costs
and
Revenue Marginal cost
Monopoly E B
Average total cost
price
Monopoly
profit
Average Demand
total
cost D C
Marginal revenue
0 QMAX Quantity
The area of the box BCDE equals the profit of the monopoly firm. The height of the box
(BC) is price minus average total cost, which equals profit per unit sold. The width of the
box (DC) is the number of units sold. 23
Monopoly drugs versus generic drugs
When a pharmaceutical firm discovers a new drug, patent laws give the
firm a monopoly on the sale of that drug for 20 years.
Eventually the firms patent expires and any company can make and sell
the drug.
Q. What would happen to the price of a drug when the patent expires?
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New drug, patent laws monopoly
Produce Q where MR=MC
P>MC
Price
during
patent life
Demand
Marginal revenue
When a patent gives a firm a monopoly over the sale of a drug, the firm charges the
monopoly price, which is above the marginal cost of making the drug. When the patent on a
drug runs out, new firms enter the market, making it more competitive. As a result, the price
falls from the monopoly price to marginal cost. 26
The Welfare Cost of Monopolies
Is monopoly a good way to organize a market?
P> MC
From the standpoint of consumers, this high price
makes monopoly undesirable.
At the same time, the monopoly is earning profit
from charging this high price. From the standpoint
of the owners of the firm, the high price makes
monopoly desirable.
The Welfare Cost of Monopolies
Total surplus
Economic well-being of buyers & sellers in a
market
Sum of consumer surplus & producer surplus
Consumer surplus
Consumers willingness to pay for a good
Minus the amount they actually pay for it
Producer surplus
Amount producers receive for a good
Minus their costs of producing it
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The Welfare Cost of Monopolies
Suppose the monopoly firm were run by a benevolent planner /govt.
The social planner cares not only about the profit earned by the firms
owners but also about the benefits received by the firms consumers.
The planner tries to maximize total surplus, which equals producer surplus
plus consumer surplus
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The efficient level of output
Costs
and
Revenue
Marginal cost
Value Cost to
to monopolist
buyers
Value
to Demand
Cost to
buyers (value to buyers)
monopolist
0 Quantity
Value to buyers is greater Efficient Value to buyers is less
than cost to sellers quantity than cost to sellers
Charge P>MC
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The Welfare Cost of Monopoly
Note: a monopolist charges P > MC
There are some potential consumers who value the good at more than
its marginal cost, but that value less than the monopolists price.
However, the value these consumers place on the good is greater than
the marginal cost
Demand
Marginal revenue
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Take Away points:
-Leads to inefficiency
Price Discrimination
So far we have been assuming that the monopoly firm charges the same
price to all customers.
Price discrimination
the business practice of selling the same good at different prices to
different customers
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Price Discrimination
2) hardcover books and paperbacks:
publisher initially releases an expensive hardcover edition and
later releases a cheaper paperback edition
3) Train tickets: charge low price for students and senior citizens
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Price Discrimination
Perfect price discrimination
describes a situation in which the monopolist knows exactly the willingness
to pay of each customer and can charge each customer a different price.
Deadweight loss =?
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Welfare with and without price discrimination
(a) Monopolist with Single Price (b) Monopolist with Perfect Price Discrimination
Price Price
Consumer
surplus
Deadweight
Monopoly
loss
price
Profit
Profit
Marginal cost Marginal cost
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Panel (a) shows a monopolist that charges the same price to all
customers.
Consumer surplus = 0
Comparison:
perfect price discrimination raises monopolists profit,
raises total surplus,
and lowers consumer surplus.
1st Degree Price Discrimination
This type of discrimination,
also known as perfect price
discrimination.
Really impossible?
2nd Degree Price Discrimination
In this type of discrimination the companies
are actually not able to differentiate
between the different types of consumers.
In order for this form of discrimination to work the firm must be able to
predict the elasticity of demand in various consumers.
Third degree price discrimination relies on the firm being able to separate
the segments.
Example: Consider the total market for public transport journeys during peak
office hours 8 am to 9 am.
The total market demand (Dm) is the sum of the demand of two segments,
adults (Da) and students (Ds).
For adults the price of a bus ticket is only a small part of their income and this
means that their demand (Da) is more inelastic than that of students for whom
a bus ticket is a larger part of their income.
In this example, the firm once again decides on their output by equating MC with
MR. However there is not just one price.
By drawing a horizontal line through the MC=MR point until it intersects with the MR
curves for adults and students and then reading the price off the respective demand
curves Da and Dr the price in each segment is determined, Pa and Pr.
Not surprisingly the price in the adult market is higher. This discrimination allows
the firm to appropriate more, but not all, of the consumer surplus as seen below.
Price Discrimination
1. Rational strategy for monopolist
Increase profit
Charge each customer a price closer to his or her willingness to
pay
Sell more output than it is possible with a single price
Note:
In reality, a monopolist may not practice perfect price discrimination
Monopolist may not have exact information regarding consumers
willingness to pay.
Hence, firms often practice price discrimination by dividing customers into
different groups
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Price Discrimination
2. Requires the ability to separate customers according to their willingness
to pay
Certain market forces can prevent firms from price discriminating
Arbitrage: buy a good in one market, sell it in other market at a
higher price
Eg. Often books cannot be sold outside the countries mentioned on
cover
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Is price discrimination possible in a competitive market?
There are many firms selling the same good at the market price.