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Chapter 8 Monopoly

The document discusses monopoly, how firms obtain market power through legal and natural barriers to entry, and how monopolists determine the optimal price and quantity to maximize profits. It provides examples using a hypothetical monopolist producing a drug to illustrate revenue curves and how changing price affects total revenue and marginal revenue.

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76 views

Chapter 8 Monopoly

The document discusses monopoly, how firms obtain market power through legal and natural barriers to entry, and how monopolists determine the optimal price and quantity to maximize profits. It provides examples using a hypothetical monopolist producing a drug to illustrate revenue curves and how changing price affects total revenue and marginal revenue.

Uploaded by

Feb
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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EK0007

MICRO AND MACRO ECONOMIC


CHAPTER 8
Monopoly

ACCOUNTING PROGRAM
Overview
This chapter discuss about monopoly, barriers to
entry, government and how control of key resources.
Objectives
• legal market power
• Natural Market Power
• Revenue Curves
• Price, Marginal Revenue, and Total Revenue
• Producing the Optimal Quantity
• Setting the Optimal Price
Contents
• New Market Structure
• Sources of Market Power
• The Monopolist’s Problem
• The Cost of Monopoly
• Restoring Efficiency
New Market Structure
• Competitive markets: identical goods are produced by many
different sellers and sold at the market-determined price
• A price-maker—a seller that sets the price of a good
• has the ability to set the price of the good because it has market
power
• A monopoly is an industry structure in which only one seller
provides a good or service that has no close substitutes
• The price chosen by the monopolist is the one that makes the
company the highest profit
Sources of Market Power
• market power arises because of barriers to entry
• Barriers to entry are obstacles that prevent potential
competitors from entering the market
• provide the seller protection against competition
• Barriers to entry range from complete exclusion of market entrants
to prevention of a new firm from entering and competing on an
equal footing with an incumbent firm
• There are two types of market power that arise from
barriers to entry
• legal market power
• natural market power
legal market power
• occurs when a firm obtains market power through barriers
to entry created not by the firm itself, but by the
government
• These barriers can take the form of patents and copyrights
that are issued to innovative companies
• With a patent, the government grants an individual or company the
sole right to produce and sell a good or service
• With a copyright, the government grants an individual or company
an exclusive right to intellectual property
• Such exclusivity laws represent a significant benefit for the
innovator-turned-monopolist
Natural Market Power
• occurs when a firm obtains market power through
barriers to entry created by the firm itself
• two main sources of monopoly power
• Control of Key Resources
• Key resources are those materials that are essential for
the production of a good or service
• The way for a firm to develop market power naturally is
to control the entire supply of such resources
• Another key resource is individual expertise
• Network externalities occur when a product’s value
increases as more consumers begin to use it
Natural Market Power
• two main sources of monopoly power
• Economies of Scale
• A natural monopoly arises because the economies of
scale of a single firm make it efficient to have only one
provider of a good or service
• such firms are the first suppliers in a given market, and
the cost advantages they achieve through producing a
large number of goods preclude would-be competitors
from entering the market
• natural monopolies arise because of economies of scale
The Monopolist’s Problem
• The monopolist’s problem shares two important
similarities with the perfectly competitive seller’s
problem
• the monopolist must understand how inputs combine to
make outputs
• the monopolist must know the costs of production
• difference between the perfectly competitive
seller’s decision problem and the monopolist’s
decision problem
• to maximize profits the perfectly competitive firm expands
production until marginal cost (MC ) equals price (P ), where price is
determined by the intersection of the market demand and market
supply curves
• marginal revenue equals price for a perfectly • the monopolist can increase price
competitive firm because the firm faces a and not lose all of its business
perfectly elastic demand curve (a horizontal • If the monopolist chooses a price of
demand curve)
$100, it can sell 1,000 units. If the
• At the market price, the perfectly competitive
firm can sell as many units as it wishes price is increased to $200, then the
• If it charges a bit more, it will lose all of its monopolist can sell only 400 units
business because consumers can buy an • A monopoly is powerful, but it
identical good from another seller who is cannot sell at a point above the
ready to sell at a lower price market demand curve
• if it charges a bit less, it sells the same
number of units but does not raise as much
revenue, so that would not be profit
optimizing
Revenue Curves
• total revenue changes with price changes
• A first step in this process is to understand how much
money you will bring in at various price levels
• total revenue of a firm is the amount of money it brings in from
the sale of its outputs
• Marginal revenue is the change in total revenue associated
with producing and selling one more unit of output
• After a thorough market analysis, you determine that a
reasonable estimate of the market demand curve
• From this demand curve, can calculate the total revenue
and marginal revenue at each price level
Illustration : CEO of Schering-Plough Corporation,
want to figure out how can make the
most money possible from the drug

• how much money you will bring in at various


price levels
• assume that you have to charge each
customer the same price
• determining total and marginal revenue
• at a price of $5 per pill, you can sell 200
million units of Claritin
• at a price of $3, you can sell 600 million
units
• the important trade-off between price
and quantity sold that the monopolist
faces: a higher price yields more revenue
per unit sold, but fewer number of units
sold
Illustration : the relationship
between price
• Assume that you lower the price from $5 to $4
and total • you bring in $600 million more in total
revenue revenues
• This additional arises from two effects
• a quantity effect: the lower price allows you
to sell 200 million more units of Claritin
• The increase in revenues because of this
increased number of sales is shown as the
green-shaded region
• But there is a flip side, Those people who
were buying at the old price of $5 now only
have to pay $4. This loss in revenues is
known as the price effect; it is shaded pink
• With price decreases— moving down the demand
curve—when the quantity effect dominates the
price effect, then total revenue increases
• If the price effect dominates the quantity effect,
then total revenue falls

table summarizes the effect


Price, Marginal Revenue, and Total Revenue

information

• The curves begin at the same point on the price


axis because the price of Claritin is the marginal
revenue from selling the first unit of Claritin
• marginal revenue lies below the demand curve,
and as quantity expands the difference
between the demand curve and the marginal
revenue curve grows larger
• the marginal revenue curve is twice as steep as
the demand curve, causing it to reach the
quantity axis at 600 million units, whereas the
demand curve reaches it at 1.2 billion units
• important aspect reveals is the relationship
between marginal revenue and total revenue
• total revenue curve for Claritin,
which is hill-shaped
• when total revenue is rising,
marginal revenue is positive
• total revenue is at its maximum
when the marginal revenue
curve crosses the x-axis
(quantity axis)—that is the point
where an additional unit of
output causes marginal revenue
to equal zero
Choosing the Optimal Quantity and Price
• Assume that you choose to produce at quantity
Producing the Optimal Quantity level QL which is 300 million
• MR > MC, specifically, $3 > $1
• you produce one more unit of Claritin, your
additional revenue exceeds the additional cost
of making the allergy pill
• should continue to expand production
provided that MR > MC
• You stop increasing production when you
reach the point of MR = MC, or at 500 million
units
• profit-maximizing level of output produced is given
by the intersection of the MR and MC curves
• monopolists are price-makers—they set the price
for their goods or services because there are no
competitors
• In this sense, after you determine how much
to produce, you as a monopolist need to
determine where to set Claritin’s price
Setting the Optimal Price
• if millions of people desperately want goods, you
should set a very high price
• if only a few thousand people are vaguely
interested in goods, you should set a low price
• pricing decision, critically linked to the nature of
the market demand curve
• the firm in a competitive industry does not set its
price (the market does), whereas the monopolist
sets price based on the market demand curve
Illustration

• the demand curve


• the MR curve
• the MC curve
• determine Claritin’s price by looking at the
demand curve to see what price consumers are
willing to pay for the quantity you put on the
market
• maximize your firm’s profits by setting a
price of $3.50 because this is the highest
price that you can charge and still sell the
500 million pills that you have produced
• price is set at a level higher than marginal cost for
a monopolist, whereas price is equal to marginal
cost for a perfectly competitive firm
• the monopolist sets a price that is on the elastic
portion of the demand curve
The Cost of Monopoly
• One important factor that can “break” the powerful
result of the invisible hand is market power
• A firm that exercises market power causes a
reallocation of resources toward itself, thereby
sacrificing social surplus
Restoring Efficiency
• One way to restore social efficiency (that is,
maximize social surplus) is to have a social planner
choose the monopolist’s quantity and price
• This “all-knowing” social planner would need to know
both the monopolist’s marginal cost and the buyer’s
willingness to pay
• the social planner could choose the same outcome as
that which results in the perfectly competitive
equilibrium because that outcome maximizes social
surplus
Restoring Efficiency
• Three Degrees of Price Discrimination
• Price discrimination occurs when firms charge different
consumers different prices for the same good or service
• First-degree, or perfect price discrimination, in which
consumers are charged the maximum price they are
willing to pay
• Second-degree price discrimination, in which consumers
are charged different prices based on characteristics of
their purchase, such as the quantity they purchase
• Third-degree price discrimination, in which different
groups of consumers are charged different prices based
on their own attributes (such as age, gender, location,
and so on)

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