Ka-fu Wong University of Hong Kong

1. Ka-fu WongUniversity of Hong Kong Monopoly and Other Forms of Imperfect Competition

2. The Perfectly Competitive Firm Is a Price Taker (Recap) • The perfectly competitive firm has no influence over the market price. It can sell as many units as it wishes at that price. • Typically, a “perfectly” competitive industry is one that consists of a large number of sellers, each of which makes a highly standardized product.

3. Profit-maximization for the perfectly competitive firm • Profit = Total revenue - total cost Q.How much output should a perfectly competitive firm produce if its goal is to earn as much profit as possible? • It should keep expanding output as long as the marginal benefit of doing so exceeds the marginal cost. • The marginal benefit of expanding output by one unit is the market price. • The marginal cost of expanding production by one unit is the firm's marginal cost at its current production level.

4. Example 10.1. • If this grower can sell as many bushels of corn as he chooses to at a price of $5 per bushel, how many bushels should he sell in order to maximize profit? The profit-maximizing quantity for the perfectly competitive firm is the one for which price = MC.

5. Imperfect Competition Monopoly = "single seller" Oligopoly = "few sellers" Monopolistic competition: Many sellers, each with a differentiated product

6. Monopoly = “single seller” Towngas (The Hong Kong and China Gas Company Limited)supplies cooking fuel to households in Hong Kong An electronic payment system using a contactless smartcard. The sole supplier of electricity in Kowloon and New Territories. The sole supplier of electricity on Hong Kong Island.

7. Oligopoly = “few sellers” Six mobile service providers in Hong Kong

8. Monopolistic competition: Convenience stores

9. Five Sources of Monopoly 1. Exclusive control over important inputs Perrier’s mineral spring

10. Five Sources of Monopoly 2. Economies of Scale (Natural monopoly) The average cost of production declines as the number of unit s produced increases. Example: domestic cooking fuel

11. Five Sources of Monopoly 3. Patents Example: Prescription drugs

12. Five Sources of Monopoly 4. Government licenses or franchises Example: Postal services

13. Five Sources of Monopoly 5. Network Economies Example: Microsoft Windows

14. Five Sources of Monopoly 5. Network Economies Sony Playstation library: Over 1000 games that will not play on other formats

15. Five Sources of Monopoly 5. Network Economies Network economies may be thought of as a kind of economy of scale. Most enduring source of monopoly is economies of scale. With growth of research and development expenses, economies of scale are becoming more important.

16. The Old Economy • Two widget producers, Acme and Ajax • Each has fixed costs of $200,000, and variable costs of $0.80 per widget. Ajax, the high volume producer, has only a small cost advantage. Widget: 1. A small mechanical device or control. 2. An unnamed or hypothetical manufactured article.

17. The New Economy • In the new economy, fixed costs are $800,000, reflecting the growing importance of the information and ideas in the product. Variable costs are only $0.20/widget. Ajax, the high volume producer, has a much larger cost advantage. Note: Capital can substitute for labor in production. Thus, higher fixed cost is likely associated with lower variable cost.

18. The New Economy • This cost advantage becomes self reinforcing, as more and more of the market goes to Ajax:

19. Demand curves facing Monopoly, oligopoly, and monopolistically competitive firms • Monopoly, oligopoly, and monopolistically competitive firms have in common the fact that the demand curves for their goods are downward sloping. For convenience, we will refer to any of these three types of imperfectly competitive firms as monopolists.

20. Demand curves facing perfectly a competitive firm • The demand curve facing a perfectly competitive firm is a straight line at the market price.

21. The marginal benefit to a competitive firm of selling an additional unit of output is the market price. By contrast, the marginal benefit to a monopolist of selling an additional unit of output is less than the market price. Marginal Revenue The reason MR < P for the monopolist is that it must cut its price in order to sell an extra unit of output. This means that is will earn less on the output it was selling thus far.

22. Price 10 7 6 Quantity 3 4 10 Example 10.2. • If this monopolist is currently selling 3 units of output at a price of $7 per unit, what is its marginal benefit from selling an additional unit? TR from the sale of 3 units = $7x3 = $21 TR from the sale of 4 units = $6x4 = $24 So MR from the fourth unit = $24 - $21 = $3, which is less than both the original price and the new price.

23. Price 10 6 5 Quantity 4 5 Example 10.3. • If this monopolist is currently selling 4 units of output at a price of $6 per unit, what is its marginal benefit from selling an additional unit? TR from the sale of 4 units = $6x4 = $24 TR from the sale of 5 units = $5x5 = $25 So MR from the fifth unit = $25 - $24 = $1, which is less than both the original price and the new price. 10

24. Price 10 5 4 Quantity 5 6 10 Example 10.4. • If this monopolist is currently selling 5 units of output at a price of $5 per unit, what is its marginal benefit from selling an additional unit? TR from the sale of 5 units = $5x5 = $25 TR from the sale of 6 units = $4x6 = $24 So MR from the sixth unit = $24 - $25 = - $1,

25. Price 10 5 D Quantity 5 10 MR Marginal Revenue Curve • The Marginal Revenue Curve for the monopolist in the preceding examples:

26. Price a a/2 D Quantity Q0/2 Q0 MR Marginal Revenue Curve • More generally, MR for any monopolist with a straight-line demand curve: For a straight-line demand curve: P = a - bQ The corresponding MR curve: MR = a - 2bQ

27. Price a a/2 D Quantity Q0/2 Q0 MR Marginal Revenue Curve • More generally, MR for any monopolist with a straight-line demand curve: For calculus-trained students: Demand: P = a - bQ MR = dTR/dQ TR = PQ = aQ-bQ2 so MR = a - 2bQ

28. Price 8 4 Demand: P=8-0.5Q Quantity 8 16 MR Example 10.5 • Find this monopolist’s marginal revenue curve. For calculus-trained students: MR = dTR/dQ TR = PQ = 8Q-0.5Q2 so MR = 8 - Q

29. Profit-maximization for the monopolist • Profit = total revenue - total cost Q. How much output should a monopolist produce if its goal is to earn as much profit as possible? It should keep expanding output as long as the marginal benefit of doing so exceeds the marginal cost. The marginal benefit of expanding output by one unit is the marginal revenue at the current output level. The marginal cost of expanding production by one unit is the firm's marginal cost at the current output level. So the monopolist should expand output until MR = MC.

30. Example 10.6. • True or False: The profit-maximizing level of output for this monopolist is 9 units. Price MC At Q=9, MC=6 > MR=0. Thereis net gain from producing one less unit at the proposed output. So the monopolist cannot be maximizing profit at Q=9. 12 6 Demand: P=12-0.67Q = 12 – (2/3)Q Quantity 9 18 MR

31. Example 10.6. • True or False: The profit-maximizing level of output for this monopolist is 9 units. The profit-maximizing quantity for the monopolist is the one for which MR = MC, in this case 6 units of output. At that level of output the monopolist will charge a price of $8/unit. Price MC 12 8 MR = 12 – (4/3)Q and MC = (2/3)Q Hence Q = 6, P=8. 6 4 Demand: P=12-0.67Q = 12 – (2/3)Q Quantity 9 6 18 MR

32. Example 10.7. • Consider the profit-maximizing monopolist in Example 10.6. At Q=6, what is the benefit to society of an additional unit of output? • What is the cost to society of an additional unit? • Is this situation efficient from society's point of view? Price MC 12 At Q=6, the marginal benefit to society of an additional unit of output is $8. The MC of an additional unit is only $4. That is, the society would gain a net benefit of $4 per unit of output if output were expanded by 1 unit from the profit-maximizing level. 8 6 4 D Quantity 9 6 18 MR

33. Social efficiency: • For social efficiency, production should expand as long as the marginal benefit to society exceeds the marginal cost. • Marginal social benefit of an extra unit of output = the amount people are willing to pay for it = the amount given by the demand curve. • Thus, social efficiency occurs where the demand curve intersects the marginal cost curve.

34. Social efficiency of monopoly • Undermonopoly: MC = MR < P, so output produced by monopoly is too low for social efficiency. Price MC P* Social efficient point MC, MR D Quantity Q* MR

35. Social efficiency of perfect competition • Under perfect competition: MC = P, so output produced by perfectly competitive industry is socially efficient.

36. Social efficiency of monopoly • Note that the monopolist would gladly expand output if it could do so without having to sell the current output at a lower price. Price MC P* MC, MR D Quantity Q* MR

37. Example 10.8 • If this monopolist maximizes profit, by how much will total economic surplus be smaller than the maximum possible economic surplus? Price MC 12 8 6 4 D Quantity 9 6 18 MR

38. Example 10.8 • The maximum possible economic surplus = CS + PS Price Consumer surplus MC 12 6 D Producer surplus Quantity 9 18

39. Example 10.8 • Loss in economic surplus from Monopoly Consumer surplus Price MC 12 8 Loss in surplus =0.5*(9-6)*(8-4)=6 6 4 D Producer surplus Quantity 9 6 18 MR

40. Example (loss in economic surplus) • Rebecca is a single-price, profit-maximizing monopolist in the sale of singing lessons. If her demand and marginal cost curves are as shown, by how much does total economic surplus fall short of the maximum achievable surplus in this market if Rebecca charges the profit-maximizing price? a. $8 per week. b. $16 per week. c. $32 per week d. $56 per week. e. None of the above. MR

41. Should we outlaw monopoly? • Does the fact that perfect competition is socially efficient and monopoly is not mean that we should outlaw monopoly? • Suppose the monopoly in question is the result of a patent that prevents all but one firm from manufacturing a highly valued product. • Would we be better off without patents?

42. Should we outlaw monopoly? • Suppose the monopolist is a natural monopolist. • For the natural monopolist, MC < AC

43. Should we outlaw monopoly? • Efficiency requires P=MC • But if MC<AC, setting P=MC means losing money

44. Should we outlaw monopoly? • What do you prefer? • A natural monopolist to maximize profit and stay in business • Force the monopolist to charge MC and go out of business.

45. Source of efficiency loss from a monopoly • The efficiency loss from single-price natural monopoly stems from the fact that the profit-maximizing price is above marginal cost, thereby excluding many buyers who "should" be in the market (because they are willing to pay a price greater than or equal to marginal cost).

46. Should we outlaw monopoly? • Recall that the monopolist would gladly expand output if it could do so without having to sell the current output at a lower price.

47. Price discrimination • Can the monopolist find ways of lowering prices to some buyers while keeping price high for others? • Price discrimination: charging different buyers different prices for the same good or service.

48. Example 10.9. • Ram is a monopolist in the market for carved sisalwood bowls in his village, a minor tourist stop in Northern India.

49. Example 10.9. • Each day 8 tourists visit his shop, and each has a different reservation price for Ram's standard bowl. If these reservation prices are as listed in the table below, draw the demand curve Ram faces each day.

50. Example 10.9.