Monopoly Chapter 8

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MonopolyChapter 8

• LIPSEY CHRYSTAL
• ECONOMICS 12e

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Learning Outcomes

• A monopolist sets marginal cost equal to marginal
  revenue, but marginal cost is less than price.
• Output is lower under monopoly than under perfect
  competition.
• Profit can be increased for a monopolist if it is
  possible to charge different prices to different
  customers or in separate markets.

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• Pure profits exist in the long run under
  monopoly, so long as there are entry barriers.
• Cartel can increase the profits of colluding
  firms, but individual members have incentives to
  break away.

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INTRODUCTION - MONOPOLY

• A Single-Price Monopolist price discrimination
• A monopoly is an industry containing a single
  firm.
• The monopoly firm maximises its profits by
  equating marginal cost to marginal revenue, which
  is less than price.
• Production under monopoly is less than it would
  be under perfect competition, where marginal cost
  is equated to price.

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INTRODUCTION - MONOPOLY

• The Allocative Inefficiency of Monopoly
• Monopoly is allocatively inefficient.
• By producing less than the perfectly competitive
  output it transfers some consumers surplus to
  its own profits and also causes deadweight loss
  of surplus that would have resulted from the
  output that is not produced.

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INTRODUCTION - MONOPOLY

• A Multi-Price Monopolist
• If a monopolist can discriminate among either
  different units or different customers, it will
  always sell more and earn greater profits than if
  it must charge a single price.
• For price discrimination to be possible, the
  seller must be able to distinguish individual
  units bought by a single buyer or to separate
  buyers into classes among whom resale is
  impossible.

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INTRODUCTION - MONOPOLY

• Long-run Monopoly Equilibrium
• A monopoly can earn positive profits in the long
  run if there are barriers to entry.
• These may be man-made, such as patents or
  exclusive franchises, or natural, such as
  economies of large-scale production.

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INTRODUCTION - MONOPOLY

• Cartels as Monopolies
• The joint profits of all firms in a perfectly
  competitive industry can always be increased if
  they agree to restrict output.
• After agreement is in place, each firm can
  increase its profits by violating the agreement.
  If they all do this, profits are reduced to the
  perfectly competitive level.

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Total, Average and Marginal Revenue
Price pAR () 9.10 9.00 8.90
Quantity q () 9 10 11
Total Revenue TRpq () 81.90 90.00 97.90
Marginal Revenue MR ?TR/?q () 8.10 7.90
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The Effect on Revenue of an Increase in Quantity
Sold
Price
p0
p1
q1
q0
Quantity
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Total, Average and Marginal Revenue

• Marginal revenue is less than price because price
  must be lowered to sell an extra unit.
• For example, consider the marginal revenue of the
  eleventh unit.
• It is total revenue when eleven units are sold
  (97.90) minus total revenue when 10 units are
  sold (90.00) which is 7.90.
• This is less than the 8.90 at which the eleventh
  unit is sold because the price on all previous 10
  units must be cut by 0.10 to raise sales by one
  unit.

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The Effect on Revenue of an Increase in Quantity
Sold

• Because the demand curve has a negative slope,
  marginal revenue is less than price.
• A reduction of price from p0 to p1 increases
  sales by one unit from q0 to q1 units.
• The revenue from the extra unit sold is shown as
  the medium blue area.
• To sell this unit, it is necessary to reduce the
  price on each of the q0 units previously sold.
• The loss in revenue is shown as the dark blue
  area.
• Marginal revenue of the extra unit is equal to
  the difference between the two areas.

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Revenue curves and demand elasticity
Elasticity greater than one ?gt1
10
Unity elasticity ?1
Elasticity between zero and one 0 lt ? lt1
per unit
AR
5
50
100
MR
-10
Quantity
250
TR

50
Quantity
100
0
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Revenue curves and demand elasticity

• Rising TR, positive MR, and elastic demand all go
  together.
• In this example, for outputs from 0 to 50 units,
  marginal revenue is positive, elasticity is
  greater than unity, and total revenue is rising.
• Falling TR negative MR and inelastic demand all
  go together. In this example, for outputs from 50
  to 100 units, marginal revenue is negative,
  elasticity is less than unity, and total revenue
  is falling. (All elasticities refer to absolute
  not algebraic values.)

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The Equilibrium of a Monopoly
MC
per unit
ATC
p0
c0
AVC
MR
D AR
q0
0
Quantity
Profit-maximizing quantity
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The Equilibrium of a Monopoly

• The monopoly produces the output q0 where
  marginal revenue equals marginal cost (rule 2).
• At this output, the price of p0 (which is
  determined by the demand curve) exceeds the
  average variable cost (rule 1).
• Total profit is the profit per unit of p0-c0
  multiplied by the output of q0, which is the
  yellow area.

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No Supply Curve under Monopoly
per unit
D
MC
p1
p0
D
MR
MR
q0
0
Quantity
The same output at different prices
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No Supply Curve under Monopoly

• The demand curves D and D both have marginal
  revenue curves that intersect the marginal cost
  curve at output q0.
• But because the demand curves are different, q0
  is sold at
• p0 when the demand curve is D and at p1 when the
  demand curve is D.
• Thus under monopoly there is no unique relation
  between price and the quantity sold.

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The deadweight loss of monopoly
MC monopoly S competition
Price
Em
pm
Ec
Competitive price
p0
D
MR
0
q0
qm
Quantity
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The deadweight loss of monopoly

• At the perfectly competitive equilibrium Ec
  consumers surplus is the sum of the areas 1, 5,
  and 6.
• When the industry is monopolized, price rises to
  pm, and consumers surplus falls to area 5.
• Consumers lose area 1 because that output is not
  produced.
• They lose area 6 because the price rise has
  transferred it to the monopolist.
• Producers surplus in the competitive equilibrium
  is the sum of the areas 7 and 2.

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The deadweight loss of monopoly

• When the market is monopolized and price rises to
  pm, the surplus area 2 is lost because the output
  is not produced.
• However the monopolist gains area 6 from
  consumers. Area 6 is known to be greater than 2
  because pm maximizes the monopolist profits.
• Thus although the monopolist gains, society loses
  areas 1 and 2.
• Areas 1 and 2 are the deadweight loss resulting
  from monopoly and account for its allocative
  inefficiency.

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A Price-discriminating Monopolist
D
Price
MR
pm
pd
S MC
0
qd
qm
qc
Quantity
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A Price-discriminating Monopolist

• Initially the monopolist produces output qm which
  it sells at pm where MC MR instead of the
  competitive output qc where MC equals demand
  (which is consumers marginal utility).
• The deadweight loss is the sum of the three areas
  labelled 1, 2, and 3.
• A second group of consumers is then isolated from
  the first (the first group continue to buy qm at
  pm).

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• This new group who would buy nothing at the
  original price of pm, will buy an amount that
  would increase total output to qd at a price of
  pd.
• The monopoly firms profits now rise by the area
  2, which is the difference between its cost curve
  and the price pd that is charged to the new group
  who buy the amount between qm and qd.
• Consumers surplus rises by the area labelled 1
  and total deadweight loss falls to the area
  labelled 3.

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Conflicting forces affecting cartels
MR
ATC
p1
MC
S
p1
E
per unit
E
per unit
p0
p0
D
0
q1
q2
q0
Q0
Q1
Quantity thousands of tons
Quantity tons
i. Market equilibrium
ii. Firm equilibrium
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Conflicting forces affecting cartels (i) the
market

• Initially the market is in competitive
  equilibrium, with price p0 and quantity Q0.
• The cartel is formed and enforces quotas on
  individual firms that are sufficient to reduce
  the industrys output to Q1, the output that
  maximizes the joint profits of the cartel
  members.
• Price rises to p1.

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Conflicting forces affecting cartels (ii) an
individual firm

• (Note the change in scale from figures (i) and
  (ii).
• Initially the individual firm is producing output
  q0 and is just covering its total costs at price
  p0.
• When the cartel restricts production the typical
  firms quota is q1.
• The firms profits rise from zero to the amount
  shown by the dark blue area.

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Conflicting forces affecting cartels (ii) an
individual firm

• Once price is raised to p1 however, the
  individual firm would like to increase output to
  q2, where marginal cost is equal to the price set
  by the cartel.
• This would allow the firm to earn profits shown
  by the blue hatched area.
• But if all firms violate their quotas in this
  way, industry output will rise above Q1, market
  price will fall, and the profit earned by each
  and every firm will fall.