Ch 8

Monopoly

Features of Monopoly
1. 2. 3. 4. Imperfect information One seller in the market Entry Barrier Differentiated Goods

Features of Monopoly
1. Only one seller
No Close Substitute in the Market
Not close substitute

Not in the same market

Features of Monopoly
2. Entry Barrier
a. Government regulation:
Licenses The Jockey Club Patents Panadol Copyright Movies, songs

b. Monopolized inputs.

Features of Monopoly
c. Natural Monopoly
The total cost for a single firm to produce a certain level of output is lower than the combined total costs of two or more firms. Example: C
Firm 1 and firm 2 have 10 the same AC. If only firm 1 produces 5 Q = 2, TC = $5x2 =$10 If both firm 1 & 2 produce 1 2 Q = 1, TC = $10x2 =$20

AC1 =AC2
Q

Features of Monopoly
c. Natural Monopoly
Necessary condition for a natural monopoly producing in the range of downward sloping LAC. The firm is enjoying economies of scale. This usually arises in industries that involve a huge initial investment in indivisible inputs. Telecommunications, electricity, water supply.

Profit Maximization
The monopolist targets at maximize its Economic Profit. To know how it meet this target, we need to know how
How much should it produce? What price should it set?

We need to look at the demand facing the monopolist and its costs.

Demand Facing a Monopolist

The monopolist is the only firm producing this good. To buy this good, consumers have to buy the good produced by this particular firm. Demand for this good = Demand for this firms good It is the same as the market demand for the product. The firms demand curve is also Downward-Sloping.

Demand Facing a Monopolist

The demand curve of a monopoly
P

Market

Dmarket = DMonopoly Q

Demand Facing a Monopolist

Properties of a Monopolys demand curve: 1. Downward Sloping
There is no such thing as market price for the firm to observe. It has to set its own price Price Searcher.

2. If the firm needs to lower the price in order to sell more. 3. Price = Average Revenue (AR) > Marginal Revenue (MR)

Demand Facing a Monopolist

If the firm produces Q1, its TR = P1xQ1 = A+B P If the firm produces Q2, its has to lower the price to P2, P1 and TR = P2xQ2 = B+C A -P TR = C A P2 = P2(Q) + Q1(P) B C MR = TR/Q P2(Q) + Q1(P) Q1 Q2 =
Q P2 + Q1(P) = Q
Q

D Q

Demand Facing a Monopolist

MR = P + Q (P) Q

If Q = 0, MR = P. MR curve and the demand curve have the same intercept. As P/Q < 0 (the law of demand), MR < P as Q > 0. MR curve is steeper than the demand curve. If the demand curve is linear, the MR curve will be twice as steep as the

TR & MR Curve
P Q = 0, TR = 0 Ed > 1 Q = Q2, TR increases (Ed>1) Mid-pt: Ed =1 Q = Qm, TR increases Ed < 1 (Ed>1) D Q2 Qm Q 3 Q4 Q Q = Q3, TR decreases TR (Ed<1) MR>0 MR<0 MR=0 Q = Q4, TR =0 MR TR
Q2 Qm Q3 Q4

TR & MR Curve
Question: Will a monopolist sell more than Qm(middle level of output)? No! Because Q > Qm, MR < 0. The monopolist will set a price higher than the mid-pt of the demand curve. The monopolist will set a price at the elastic range of the demand curve.

SR Profit Maximization
How much should the firm facing demand D produce in the Short Run? Equilibrium condition: MR = MC P
SMC1 ATC1 AVC1 MR Qe

Pe

D
Q

SR Profit Maximization
Is the monopolist making Economic Profit? E. Profit > 0, if TR > TC, P > ATC

SMC1

Pe E. profit ATC

ATC1 AVC1
MR

D Q

Qe

SR Profit Maximization
1. E. Profit > 0
TR > Explicit Costs +Implicit Costs

2. Break-Even
TR = Explicit Costs + Implicit Costs

3. Loss but stay

TR < Explicit Costs + Implicit Costs, but TR > Explicit Costs

4. Shut down
TR < Explicit Costs + Implicit Costs, and TR < Explicit Costs

Supply Curve
Question: Will the MC curve of the firm be the supply curve for a Monopoly? Not on There is no such thing SMC SMC as supply curve for a Pe monopoly.
MR Qe D

LR Profit Maximization
If the monopolist makes E. Profit in the SR, what will it do in the LR? Expand increases capital investment
LMC SMC ATC P1 P2 E. profit E. profit LAC

MR Q1 Q2

LR Profit Maximization
Question Will the monopoly be able to keep this E. Profit in the LR? Yes! There is Entry Barrier. Although there is an incentive for potential entrants to enter the market, they cannot do so. Unlike perfect competition, it is possible for a monopolist to earn positive E. profit in the

Comparative Static
Question If there is an increase in market demand, how will the monopoly be affected? Market demand increases, Firms demand increases P
SMC1

P2 ATC P1 E. profit

ATC1
MR2 MR1 D2 D1

Q1Q2

Market Efficiency
Question: Is a monopoly allocating resources efficiently? To answer this question, we can compare the output produced by the monopolist and that produced under perfect competition. But, to do this comparison, we need an assumption the monopolist takes over all the firms in the competitive market without changing their cost curves.

Market Efficiency
The sum of all the MC curves of each competitive firms becomes the MC of the monopolist. As the sum of all the MC curves of each competitive firms is the market supply. The supply curve becomes the MC curve of the monopolist.

Market Efficiency
Under perfect competition, P = PPC, and Q = QPC. At E, Demand = Supply, P the market is efficient. If the monopolist takes PM over all the competitive PPC firms, S = MC of the monopoly. The monopolist produces at MR = MC, P = PM, Q = QM. At F, Demand > Supply, the monopoly is inefficient.
MCMono =

DWL
F

MR QM QPC

Market Efficiency
The monopolist sells at a higher price (PM > PPC) but smaller quantities (QM < QPC). Consumer surplus shrink. The monopolist will create a Dead-WeightLoss. At QM, Demand > Supply (consumers willing to pay > producers need to pay). From the society point of view, output should be raised to improve efficiency. An example of Market failure.

Regulating Monopoly
To improve efficiency, the government may need to intervene the market. One of the way is MC pricing, which is a price ceiling forcing the monopolist to set a price not higher than the MC of its last unit of production. Because of this regulation, the firm can set the price PMC only, which implies the price is fixed at PMC for every unit. MR = PMC

Regulating Monopoly
Originally, the monopolist produces Qm and sells at P PM. To improve efficiency, the government should set a PM PPC price ceiling at PMC which PMC is the same as PPC. With MR = PMC, the monopolist produces at QPC. The DWL is captured.
= MCMono =

DWL
F

S MR D

MR QM QPC

Regulating Monopoly
Question: Is it possible to adopt the MC pricing regulation for a natural monopoly? No! As the natural monopoly is producing in the downward-sloping part of the AC curve, MC curve lies below the AC curve. The MC pricing will render the monopolist to make loss.

Price Discrimination
Except traditional pricing, a monopoly can adopt Price Discrimination, which allows the firm to capture the consumer surplus. Price discrimination refers the practice of charging different prices for different units of the same product when there is no cost difference in selling those units. There are 3 basic types of P.D.: 1. 1st degree (Perfect) 2. 2nd degree 3. 3rd degree

Price Discrimination
Conditions for P.D.:
The firm must have some market power.
The firm must be a price searcher. The firm is producing differentiated good.

The firm must have some information about the consumers demand. The amount of information a monopolist holds determines the type of P.D. The firm must be able to prevent resale. Otherwise, consumers will trade amount themselves which renders only one single price in the market.

1st degree P.D.

With 1st degree (perfect) P.D., a firm attempts to charge the price of each unit at a price that is equal to the consumers maximum willingness to pay. Example:
The consumer is willing to pay $10 for the 1st unit and $8 for the 2nd unit. The firm sells at $10 and $8 for the 1st and 2nd unit respectively.

1st degree P.D.

Assumption:
The firm knows the Demand curve. The firm MC is constant at $2 Traditional pricing: P = 6, Q = 2 CS = $4 + $2 = $6 DWL = $2 1st degree P.D.: 1st unit: P = $8, CS = $0 2nd unit: P = $6, CS = $0 3rd unit: P = $4, CS = $0 4th unit: P = $2, CS = $0 All the CS are captured
$8 $6 $4 $2 1 2 3 4

CS

DWL

MC D

1st degree P.D.

Effects of adopting 1st degree P.D.:
All the CS will be captured (ie. CS =$0) and becomes PS.
Total Gain = PS

The monopoly is as efficient as under perfect competition.

The Demand curve becomes the MR curve The firm produces the same output level as under perfect competition, where MR = Demand = MC DWL = $0

1st degree P.D.

Problem: the firm needs to know the consumers maximum willingness to pay. The firm need to have Perfect knowledge on Consumers demand. Otherwise, it cannot charge the price of each unit at a price that is equal to the consumers maximum willingness to pay. In reality, it is impossible for a firm to have perfect knowledge on Consumers demand; 1st degree P.D. is not common.

2nd Degree P.D.

2nd Degree P. D. = Quantity Discount
Q = 1, P = $10 Q = 2, P = $18 Q = 3, P = $24

If you buy a larger quantity, the per unit price of the following units will be cheaper.
P1st = $10 P 2nd = $8 P3rd = $6

2nd Degree P.D.

Yesterday, when I walked by a boutique, I saw a promotion like this: 9 8 Yes! Is this 2nd degree P.D.? 1st unit: 10% off 2nd unit: 28% off Buy more; cheaper

2nd Degree P.D.

Yesterday, when I walked by a boutique, I saw a promotion like this: 8 Is this 2nd degree P.D.? Yes! Assume that the price is $100 for each unit. Q = 1: P = $100 (No Discount!) Q = 2: P = $200 (with discount: net price = $160)

2nd Degree P.D.

More examples of 2nd degree P.D.:
Bulk Purchase:
A can of coke VS a pack of coke (8 cans)

Individual ticket VS group ticket

2nd Degree P.D.

Effects on 2nd Degree P.D.:
Some of the CS will be captured. As the producer does not have perfect knowledge on consumers demand The firm produces less than the optimal output level. DWL > 0

3rd Degree P.D.

When the firm charge different groups with different prices, the firm is practicing 3rd degree P.D.
MTR: Student discount. Karaoke: Student discount. Bus: senior and children discount DVD and Book: Chinese discount Festival walk: CityU offers

3rd Degree P.D.

The general rule for practicing 3rd degree P.D. is charging lower price to the more price elastic group.
As students, children and the senior usually have a higher own price elasticity, they get discount from the sellers. Q (P)
P(1 + Q(P) ) MR = P(Q) 1 MR = P(1 + Ed )

MR = P + Q Why the lower Ed groups should pay more?

3rd Degree P.D.

To maximize profit, the firm will produce up to MR = MC.
P(1 + 1 ) = MC MR = Ed

As the costs of providing to the two groups are the same, MC is fixed. To keep MR = MC, a larger Ed has to be associated with a smaller P.

3rd Degree P.D.

There are two markets: 1 & 2 The two markets show different Ed: Ed1<Ed2 The firm has a constant MC. In market 1: P = P1, Q = Q1 Uniformed pricing will discourage the consumers in market 2.
P P1

Market 1

Market 2

P2 MR1
Q1 D1 Q Q2 MR2 D2

MC Q

Conclusion
A monopoly is a price searcher its demand curve is downward sloping. The MR curve is steeper than the demand curve. An unregulated monopoly will produce up to MR = MC, but not D = MC. This render the firm producing less than the optimal output level, the level being produced under perfect competition.

Conclusion
A monopoly is usually said to be inefficient in allocating resources. This is an example of Market Failure. If the monopolist is provided with perfect knowledge on consumer preference, it can practice Perfect price discrimination and becomes efficient.

Concept Map
Competition Price Competition Market Economy How market work?
P P1 D Q1 Q Qe S

Non-Price Competition
(Order)

Command Economy
SMC1 ATC1 D MR Q

P
Pe

Market failure