MODERN PRINCIPLES OF ECONOMICSThird Edition

Monopoly

Chapter 13

Outline

Market Power How a Firm Uses Market Power to Maximize Profit The Costs of Monopoly: Deadweight Loss The Costs of Monopoly: Corruption and Inefficiency The Benefits of Monopoly: Incentives for Research

and Development Economies of Scale and the Regulation of Monopoly Other Sources of Market Power

2

Introduction

Since 1981 AIDS has killed over 36 million people.

In the U.S., deaths from AIDS dropped 50% due to drugs like Combivir.

3

A Combivir pill costs $0.50 to produce, but sells for 25 times higher - $12.50.

INGRAM PUBLISHING/VETTA/GETTY IMAGES

Definition

Market power:

the power to raise price above marginal cost without fear that other firms will enter the market.

4

Monopoly:

a firm with market power.

5

Market Power

GlaxoSmithKline owns the patent on Combivir. A patent gives exclusive rights to make, use, or

sell the product. GSK’s patent prevents competition. This gives GSK market power. India does not recognize the Combivir patent. In India, an equivalent drug sells for $0.50, or

the marginal cost.

Definition

Marginal revenue (MR):

the change in total revenue from selling an additional unit.

6

Marginal cost (MC):

the change in total cost from selling an additional unit.

7

Self-Check

Market power allows a firm to raise price:

a. Above average cost.

b. Above marginal cost.

c. Above marginal revenue.

Answer: b – market power allows a firm to raise price above marginal cost, without fear that other firms will enter the market.

8

Market Power

To maximize profit, firms produce at the level of output where:

A firm with market power faces a downward sloping demand curve.

It must lower price to sell an additional unit. The additional revenue per unit < current price,

or:

MC = MR

MR < P

9

Marginal Revenue

When price ↓ from $16 to $14, quantity ↑ from 2 to 3 units

Total revenue ↑ from $32 to $42.

MR, or the change in total revenue, is $10.

Marginal Revenue

10

Price

Quantity2 3 4 6 751

$20

18

16

14

12

10

8

6

4

2

Demand

MR

Revenue loss$2 x 2 = $4

Revenue gain14 x $1 = $14

MR =$10

Price ↓ $16 to $14

Short-Cut for Finding MR

MR begins at same point on the vertical axis as demand. MR has twice the slope.

11

Price

Quantity

a

MR = a – 2b x Q

Demand: P = a – b x Q

a/ba/2b

2b

1 b1

12

Self-Check

For a firm with market power, marginal revenue is:

a. Higher than price.

b. Equal to price.

c. Lower than price.

Answer: c – A firm with market power must drop its price to sell more units, so the marginal (additional) revenue is lower than price.

Using Market Power to Maximize Profit

13

Quantity(millions of pills)

Price($/pill)

MR

Demand

ACMC

Profit maximizing output: MR = MC at 80 million pillsProfit maximizing price = $12.50Profit per pill = $10.00Total profit = $10 x 80 = $800 m

80

$12.50

0.50

2.50//

Profit

Elasticity of Demand and Markup

Two effects make demand for pharmaceuticals inelastic:• The “you can’t take it with you” effect:

People with serious illnesses are relatively insensitive to the price of life saving drugs.

• The “other people’s money” effect: If third parties are paying for the medicine,

people are less sensitive to price. The more inelastic the demand curve, the more

a monopolist will raise price above MC.

14

Elasticity of Demand and Markup

15

PricePrice

QuantityQuantity

Demand

MRMR

Demand

MCMC

Relatively inelastic demand → big markup

Relatively elastic demand→ small markup

Q

P

QE

P

Costs of Monopoly: Deadweight Loss

Monopolies charge a higher price and produce less than competitive firms.

Monopolies reduce total surplus (consumer surplus + producer surplus).

This implies a deadweight loss - sales that do not occur because the monopoly price is above the competitive price.

16

Costs of Monopoly: Deadweight Loss

17

PP

Competition: P = MC

QC

PC

Monopolist gets this

Supply

MRDemand Demand

MC = AC

PM

QCQM

Consumers get this

No one gets this(deadweight loss)

QQ

Consumers get this

Monopoly: P > MR

18

Self-Check

A monopolist’s price is:

a. Lower than a competitive firm’s.

b. Higher than a competitive firm’s.

c. The same as a competitive firm’s.

Answer: b – a monopolist’s price is higher than a competitive firm’s.

Costs of Monopoly: Corruption and Inefficiency

19

Many monopolies are the result of government corruption.

Tommy Suharto, the Indonesian president’s son, was given the clove monopoly.

He bought the Lamborghini company with the monopoly profits.

PETER HARHOLDT/SUPERSTOCK

Costs of Monopoly: Corruption and Inefficiency

20

Monopolies are especially harmful if they control a good that is used to produce other goods.

In Algeria a dozen or so army generals each control a key good• People refer to these men as General wheat,

General tire….• Each general tries to get a larger share of the

economic pie. The result is greater deadweight loss, and the

“pie” shrinks.

Benefits of Monopoly: Incentives for R&D

Drug prices are lower in India and Canada. • India does not offer strong patent protection.• Canada’s government controls drug prices.

It costs $1 billion to develop a new drug. Patents are one way of rewarding research and

development (R&D). Without patents firms would not spend on R&D,

fewer new drugs would be developed.

21

Benefits of Monopoly: Incentives for R&D

Prizes can reward research and development without creating monopolies.

Patent buyouts are another alternative. • Reduce price without reducing R&D. • Must raise taxes to pay for the patent. • May be difficult to determine a price.

22

Definition

Economies of Scale:

the advantages of large-scale production that reduce average cost as quantity increases.

23

Natural Monopoly:when a single firm can supply the entire market at a lower cost than two or more firms.

Natural Monopoly

Monopolies can arise naturally when economies of scale allow a single firm to produce at lower cost than many small firm.

Utilities such as water, natural gas, and cable television are often natural monopolies.

If economies of scale are large enough, price can be lower under natural monopoly than under competition.

24

Natural Monopoly

25

P

Q

MR

Demand

Competitiveprice PC

Average costs for small firms

AC

MC

CompetitiveQuantity QC

MonopolyQuantity QM

Monopolyprice PM

It is possible for PM < PC

If economies of scale are large enough

26

Self-Check

Which of the following is most likely to be a natural monopoly:

a. A home builder.

b. A restaurant.

c. A railroad company.

Answer: c – a railroad company is most likely to be a natural monopoly, due to economies of scale and the high cost of duplicating tracks.

Price Control and Natural Monopoly

A price control can increase output. Price = MC is the optimal level of output.

At P = MC, P < AC. The firm is operating at a loss and will exit

the industry. Price = AC is the lowest price the firm will accept.

Firm is earning zero (normal) profit. Output is higher than at monopoly price.

27

Loss (P < AC)

Price Control and Natural Monopoly

28

Price

Quantity

MR

Demand

AC

MC

QM

PM

Monopolyquantity

Monopolyprice

Optimalquantity

• PM and QM are set where MR = MC• Optimal quantity is where P = MC • At optimal Q, firm suffers a loss

P = MC

Price Control and Natural Monopoly

29

Price

Quantity

MR

Demand

AC

MC

QM

PM

Monopolyquantity

Monopolyprice

Optimalquantity

P = MC

• At P = AC, firm has normal profit • Results in some deadweight loss

P = AC

Deadweight Loss

30

Self-Check

A monopolist will have normal profit when its price is set equal to:

a. Marginal cost.

b. Average cost.

c. Total cost.

Answer: a – a monopolist will have normal profit when P = AC.

Definition

Barriers to entry:

factors that increase the cost to new firms of entering an industry.

31

Other Sources of Monopoly Power

32

33

Takeaway

For a monopolist, marginal revenue is less than market price (MR < P).

Monopolies: • Charge a higher price than competitive firms. • Reduce total. • Create a deadweight loss. • Use market power to earn above normal profits.

The markup of price over marginal cost is larger the more inelastic the demand.

34

Takeaway

Patent monopolies involve a trade-off between deadweight loss and innovation,

Natural monopolies involve a trade-off between deadweight loss and economies of scale.

Outcomes can be improved by: • Opening the industry up to competition. • Regulating the monopolist.