Monopoly : Monopoly Four Basic Market Structures : Four Basic Market Structures Perfectly Competitive: many firms, identical products, free entry and exit, full and symmetric info
Monopoly: single firm, no close substitutes, barriers to entry, full and symmetric info
Oligopoly: several firms, similar products, degree of product differentiation varies depending upon the market, might be barriers, full and symmetric info
Monopolistic competition: many firms, similar products, slightly differentiated products, free entry and exit, full and symmetric info Competitive Market : Competitive Market This is the classic “textbook” market structure.
Firms in a competitive market all make a product that is perfectly substitutable: all demanders are equally satisfied with any supplier’s product. Monopoly : Monopoly The single seller makes a product that has no “good” substitute.
Other firms may be able to produce the good or service but choose not to enter the market or are barred from it. Oligopoly : Oligopoly A few sellers make products that are good, but not perfect, substitutes.
Consumers can be induced to change suppliers but have only a limited number of choices. Monopolistic Competition : Monopolistic Competition The market has many firms but each supplier’s product is differentiated.
Consumers can be induced to change brands but they have brand preferences. Question : Question What is the market structure for each of these products or firms: competitive, monopoly, oligopoly, monopolistic competition?
The Food Bazar
Pepperidge Farm’s Whole Wheat Bread
VSNL Broadband Simple Monopoly : Simple Monopoly single firm
no close substitutes
barriers to entry
full and symmetric information Pricing and Output Decisions in Monopoly Markets : Pricing and Output Decisions in Monopoly Markets A monopoly market consists of one firm.
The firm is the market.
Power to establish any price it wants.
The firm’s ability to set price is limited by the demand curve for its product and the price elasticity of demand. Nature of Demand Curve: : Nature of Demand Curve: No. of units Price [AR] TR MR
1 Rs.10 Rs. 10 -
2 9 18 2
3 8 24 6
4 7 28 4
5 6 30 2
6 5 30 0
7 4 28 -2 Pricing and Output Decisions in Monopoly Markets : Pricing and Output Decisions in Monopoly Markets Graphically, demand is linear which implies that MR is linear and twice as steep
How much should the firm produce to maximize profit? Pricing and Output Decisions in Monopoly Markets : Pricing and Output Decisions in Monopoly Markets Graphically set output where MR=MC
At this output, read the price to set off of the demand curve.
Profits = rectangle ABCD The Simple Monopolist : The Simple Monopolist The simple monopolist abides by the “law of one price.” Everyone pays the same market price for all units purchased.
A monopolist faces the declining market demand curve for its product and simultaneously chooses price and quantity.
Now P>MR (before P=MR) because the simple monopolist must lower the price on all preceding units to sell an additional unit.
A monopolist has no “supply curve.” Implications of the Monopolist’s Profit Maximum : Implications of the Monopolist’s Profit Maximum Price will exceed the competitive price.
Quantity will be less than the competitive quantity.
The monopolist sells the output at a price greater than marginal costs but the monopoly price can be above or below average total costs. Thus, the monopolist need not always make a profit. In the long run, of course, unprofitable monopolists will either stop production or raise the price further above marginal cost until it covers average total costs.
The monopolist will always try to operate on the elastic portion of the demand curve because when the elasticity of demand is greater than -1 (inelastic, between 0 and 1 in absolute value), marginal revenue is negative and, necessarily, less than marginal cost.
Since there is no entry to consider monopolists can have persistent long run economic profit. Sources of Monopoly Entry Barriers : Sources of Monopoly Entry Barriers Natural monopoly: the most efficient scale of production is so large, relative to market demand, that a single firm dominates the market.
Patents, copyrights, licenses, franchises: government protection of a firm’s right to produce a unique product.
Economic and/or legal restrictions, strategies or situations that make entry more difficult for new competitors than for the existing monopoly firm. Natural Monopolies : Natural Monopolies Goods and services whose delivery requires the construction of a physical network (wires, pipes, etc..)
In such industries (local phone service, water, sewage removal, electricity, gas) the physical networks display decreasing marginal cost over essentially all quantities.
Thus, average total cost is always declining and the minimum efficient scale is much larger than the size of the market.
Natural monopolies are often regulated: they cannot charge a higher price without government approval. “Good” Monopolies : “Good” Monopolies The granting of patent protection (legal monopoly) gives firms a strong incentive to invest in new product development.
Would firms make the R&D investments if they could not protect them through patents and trade secrets?
Probably not because competitors could steal the design at a fraction of the cost after the product is brought to market. “Other” Monopolies - Good? Bad? : “Other” Monopolies - Good? Bad? Input Ownership
DeBeer’s and diamonds
Industry Secret or Know-how
IBM and mainframes?
let’s make a deal
Microsoft and operating systems? Caveats : Caveats monopoly does not => big
big does not => monopoly
monopoly does not => absolute and unlimited control over price
monopoly does not => must have economic profit
short run profit does not => monopoly power
monopoly does not => badly behaved firm Slide 20: The practice of charging unequal prices or fees to different buyers (or classes of buyers) is called price discrimination Price discrimination Examples of price discrimination : Examples of price discrimination Physicians charge more for an office visit if the patient has health insurance.
Magazines such as Sports Illustrated offer gifts and discounts to new subscribers.
Senior citizens may enjoy discounted rates at motels and restaurants.
Cinemas charge higher ticket prices for adults than for kids.
Japanese steel and Canadian timber producers earn sharply lower profit margins on products sold in the U.S. compared to the domestic market. Slide 22: “Sizing up their income” pricing by plumbers, auto mechanics, . . . A Mercedes driver can pay more, so why not charge them more? When is price discrimination feasible? : When is price discrimination feasible? Price-discrimination (PD) can be a very lucrative proposition from the seller’s point of view. However, PD will not be feasible or possible unless:
The seller possesses market power—meaning, the seller faces a downward sloping demand curve.
The seller is capable of segregating buyers into groups based on differential willingness to pay, or elasticity of demand .
The seller can prevent arbitrage or resale of the product. Price Discriminating Monopolists : Price Discriminating Monopolists A monopolist might be able to charge different prices for different units sold and enhance its profits.
charge different people different prices
charge the same person different prices for different units
charging different prices for different units with no cost basis
charging the same price for different units when there are cost differences Price Discrimination : Price Discrimination Under certain conditions, a firm with market power is able to charge different customers different prices. This is called price discrimination. The Price-Discriminating Monopolist* : The Price-Discriminating Monopolist* In order to price discriminate, a monopolist must be able to: Identify groups of customers who have different elasticities of demand;
Separate them in some way; and
Limit their ability to resell its product between groups. Importance of price discrimination : Importance of price discrimination Price discrimination occurs very frequently
Roughly defined, price discrimination happens when units of the same product are sold at different prices
Producer’s objective: extract (some of) the consumer surplus 27 Slide 28: Different types, classified by Pigou (1920):
First-degree price discrimination = perfect price discrimination
Second-degree price discrimination = selling larger quantities of a same product at a lower unit price
Third-degree price discrimination = different prices are charged for the same product to different consumers The Price-Discriminating Monopolist : The Price-Discriminating Monopolist A price-discriminating monopolist can increase both output and profit. It can charge customers with more inelastic demands a higher price.
It can charge customers with more elastic demands a lower price. Necessary Conditions for Price Discrimination : Necessary Conditions for Price Discrimination For price discrimination to work, the firm must be able to set the price.
The firm must be able to “segment the market” That is, the firm must be able to:
Separate the customers
Prevent resale of the product The Early Bird Gets a Lower Price : The Early Bird Gets a Lower Price Early Bird Specials—Restaurants charge special, lower prices for early diners.
Matinees—Theaters charge less for earlier shows.
Air Fares—Airlines charge less for flyers willing to fly “off peak,” i.e. early morning and late night. Monopoly vs. competition : Monopoly vs. competition Monopoly produces less than a competitive market .
Monopoly price is higher .
The monopoly extracts some of the consumer surplus, and imposes a deadweight loss to the society 32 Requirements for Price Discrimination : Requirements for Price Discrimination Some amount of monopoly power.
An ability to prevent resale.
Detailed information about who is buying what unit and what demanders are willing to pay. Two classic forms of Price Discrimination : Two classic forms of Price Discrimination Perfect or First Degree Price Discrimination
charge a different price for each unit sold
the most extreme form of price discrimination
Third Degree Price Discrimination
segment market and then charge a different price in each market
exploit the observation that at the simple monopoly price the own price elasticity of demand differs across the defined segmented markets
Price discrimination comes in many other “flavors” Slide 35: 1st Degree Price Discrimination This is referred to as “perfect” PD. The seller charges every buyer their “reservation price”—that is, the maximum price they are willing to pay rather then go without the marginal unit of the good or service First Degree Price Discrimination : First Degree Price Discrimination The monopolist charges the demand price for each unit sold.
In this case the market demand curve becomes the monopolist’s marginal revenue curve.
The monopolist sets MR=MC to get max. profit
The monopolist charges a different price for each unit according to the demand curve.
Performance is Pareto Efficient and all the net social surplus goes to the monopolist as producer surplus. Consumer surplus = $0! Perfect Price Discrimination : Perfect Price Discrimination By discriminating, a monopoly firm makes greater profits than it would make by charging both groups the same price.
A firm with market power could collect the entire consumer surplus if it could charge each customer exactly the price that that customer was willing and able to pay. This is called perfect price discrimination. Equilibrium of the first-degree price discriminating monopoly : Equilibrium of the first-degree price discriminating monopoly 38 P Q MC D = MR Q*F = QCM Producer surplus = Total surplus Imperfect First Degree … : Charging a few different prices based on the estimates of customer’s reservation prices. Imperfect First Degree … Doctors : Doctors Lawyers : Lawyers Accountants : Accountants Architects : Architects Scholarships : Scholarships Car salesperson : Car salesperson Second-degree price discrimination : Second-degree price discrimination Prices vary across units, but not across people: larger quantities are sold at a lower unit price
Consumers self select themselves into consumption groups
Consumers seek the largest surplus 46 Second Degree … : Quantity $/Q P0 Q0 P1 Q1 1st Block P2 Q2 P3 Q3 2nd Block 3rd Block Second-degree price
discrimination is pricing
according to quantity
consumed--or in blocks. Second Degree … Example: Water Bills : Example: Water Bills Example: Telephone or mobile Bills : Example: Telephone or mobile Bills Example: electricity bills : Example: electricity bills Third Degree … : This form of price discrimination divides consumers (with different demand curves) into two or more groups. It is the most prevalent form of price discrimination.
Consumer groups can be made based on some observable characteristics. Third Degree … Third-degree price discriminating monopoly : Third-degree price discriminating monopoly Total marginal revenue function is continuous, and kinked at Qk
Candidate equilibrium is unique since marginal cost intersects total marginal cost only once
Total output is determined first by equating marginal cost and total marginal revenue
Allocation of total output is made in order to equalize marginal revenues with the equilibrium value of the marginal cost
Prices are determined by the demands of each consumer group 52 Slide 53: Equilibrium of the third-degree price discriminating monopoly DN DS MRN MRS MRTOT MC Q*N Q*S Q* P*N P*S MC* 53 aN aS Examples : Examples Discounts to students and senior citizens
Publishers charging a higher rate to libraries than to individuals
Different airline and train fairs
Different labels like premium/non-premium, supermarket label etc. From the simple to the discriminating monopoly : From the simple to the discriminating monopoly When moving from a single price to third-degree price discrimination:
Total output remains unchanged or increases
Monopoly’s profit increases necessarily (old equilibrium can still be achieved)
Price increases (decreases) for consumers with a more inelastic (elastic) demand
Consumers with a more elastic demand are always better off with price discrimination
Consumers with a more inelastic demand are generally worse off, but could also be better off with price discrimination… How? 55 Summary : Summary Price discrimination consists in charging different prices to different consumers
Price discrimination requires more conditions than what is needed by a simple monopoly
Compared to a simple monopoly price discrimination allows producers to further increase their profits, by extracting some of the consumer surplus
Marginal revenues of a single-price monopoly and a price-discriminating monopoly are different
Output is always equal or greater when price discrimination is practiced
If producer’s marginal cost is decreasing, third-degree price discrimination increases the welfare of every market agent. 56 Should the Government Regulate Monopolies? : Should the Government Regulate Monopolies? Essentially all monopolies are regulated.
Natural monopolies are regulated by price commissions that determine the rates the monopolies may charge.
Patent, copyright and license protections are a form of ex ante regulation: firms that follow the rules for establishing the validity of their innovations receive the protection of the patent, copyright or license.
Should the government do more? Good question.