Chapter 24

1. Chapter 24 Monopoly

2. Introduction In New York City, a taxicab requires a medallion as legal possession of a license to operate the taxi business. Thus, the medallion constitutes a barrier to entry to New York City’s taxicab industry. In this chapter, you will learn how governmentally imposed and other types of barriers to entry give rise to monopolies, or single-firm industries.

3. Learning Objectives Identify situations that can give rise to monopoly Describe the demand and marginal revenue conditions a monopolist faces Discuss how a monopolist determines how much output to produce and what price to charge Evaluate the profits earned by a monopolist Understand price discrimination Explain the social cost of monopolies

4. Chapter Outline Definition of a Monopolist Barriers to Entry The Demand Curve a Monopolist Face Elasticity and Monopoly Cost and Monopoly Profit Maximization Calculating Monopoly Profit On Making Higher Profits: Price Discrimination The Social Cost of Monopolies

5. Did You Know That ... Today the activities of 35 percent of U.S. employees of private businesses are licensed, certified, or regulated by government agencies, up from just 3 percent five decades ago? In this chapter, you will learn that a consequence of such government-established barriers to entry can be a situation called monopoly.

6. Definition of a Monopolist Monopolist A single supplier of a good or service for which there is no close substitute The monopolist therefore constitutes the entire industry

7. Barriers to Entry Question How does a firm obtain monopoly power? Answer Barriers to entrythat allow the firm to make long-run economic profits Barriers to entry are restrictions on who can start as well as stay in business.

8. Barriers to Entry (cont'd) Barriers to entry include: Ownership of resources without close substitutes Economies of scale Legal or governmental restrictions

9. Barriers to Entry (cont'd) Ownership of resources without close substitutes The Aluminum Company of America (ALCOA) at one time owned most of of the world’s bauxite

10. Barriers to Entry (cont'd) Economies of scale Low unit costs and prices drive out rivals The largest firm can produce at the lowest average total cost

11. Barriers to Entry (cont'd) Natural Monopoly A monopoly that arises from the peculiar production characteristics in an industry It usually arises when there are large economies of scale One firm can produce at a lower average cost than can be achieved by multiple firms

12. Figure 24-1 The Cost Curves That Might Lead to a Natural Monopoly

13. Barriers to Entry (cont'd) Legal or governmental restrictions Licenses, franchises, and certificates of convenience Examples include Electrical utilities Radio and television broadcasting

14. Why Not … stop erecting government barriers to entry? Despite the understanding that government-established entry barriers reduce competition, vested interests often promote insincere public safety rationales for licensing and certification rules. On example is the requirement in some states for all qualified people to arrange furniture and accessories in office buildings to be American Society of Interior Designers members, who must earn a college degree in interior design, complete a 2-year apprenticeship, and pass a licensing exam.

15. Policy Example: Congress Decides to License Tax Preparers Many firms offering tax preparation services are unlicensed and uncertified by any governmental authorities. The Internal Revenue Service (IRS), however, has convinced Congress to require all tax preparers to reregister with the federal government and to satisfy government-defined minimum competency standards. The government-erected entry barriers essentially make tax preparation firms public utilities.

16. Barriers to Entry (cont'd) Legal or governmental restrictions Patents Intellectual property Tariffs Taxes on imported goods Regulation Government enforcement of safety and quality

17. The Demand Curve a Monopolist Faces The monopolist faces the industry demand curve because the monopolist is the entire industry

18. Recall that under perfect competition Firm faces perfectly elastic demand curve, it is a price taker The forces of supply and demand establish the price per unit Marginal revenue, average revenue, and price are all the same The Demand Curve a Monopolist Faces (cont'd)

19. The Demand Curve a Monopolist Faces (cont'd) Marginal revenue equals the change in total revenue due to a one-unit change in the quantity produced and sold

20. The Demand Curve a Monopolist Faces (cont'd) Perfect competition versus monopoly The perfect competitor doesn’t have to worry about lowering price to sell more In a purely competitive situation, the firm accounts for a small part of the market It can sell its entire output, whatever that may be, at the same price

21. The Demand Curve a Monopolist Faces (cont'd) Perfect competition versus monopoly The more the monopolist wants to sell, the lower the price it has to charge on the last unit sold To sell the last unit, the monopolist has to lower the price because it is facing a downward sloping demand curve

22. Figure 24-2 Demand Curves for the Perfect Competitor and the Monopolist

23. The Demand Curve a Monopolist Faces (cont'd) Monopoly Perfect Competition Single seller Faces entire industry demand Must lower price to sell more Not all units sold for same price (MR < P) Many sellers Faces perfectly elastic demand Must produce moreto sell more All units sold for same price (P = MR)

24. Figure 24-3 Marginal Revenue: Always Less Than Price

25. Elasticity and Monopoly The monopolist faces a downward-sloping demand curve (its average revenue curve) That means that it cannot charge just any price with no changes in quantity (a common misconception) because, depending on the price charged, a different quantity will be demanded

26. Elasticity and Monopoly (cont'd) Question If a monopoly raises price, what will happen to quantity demanded? Hint Remember how consumers respond to a change in price

27. Elasticity and Monopoly (cont'd) Recall A monopolist is a single seller of a well-defined good or service with no close substitute Think of some imperfect substitutes. The demand curve slopes downward because individuals compare marginal satisfaction to cost

28. Elasticity and Monopoly (cont'd) After all, consumers have limited incomes and unlimited wants The market demand curve, which the monopolist alone faces in this situation, slopes downward because individuals compare the marginal satisfaction they will receive to the cost of the commodity to be purchased

29. Costs and Monopoly Profit Maximization We assume profit maximization is the goal of the pure monopolist, just as it is for the perfect competitor

30. Costs and Monopoly Profit Maximization (cont'd) Perfect competitor has only to decide on the profit-maximizing output rate because price is given The perfect competitor is a price taker For the pure monopolist, we must seek a profit-maximizing price outputcombination The monopolist is a price searcher

31. Costs and Monopoly Profit Maximization (cont'd) Price Searcher A firm that must determine the price-output combination that maximizes profit because it faces a downward-sloping demand curve

32. Costs and Monopoly Profit Maximization (cont'd) We can determine the profit-maximizing price-output combination with either of two equivalent approaches: By looking at total revenues and total costs or By looking at marginal revenues and marginal costs

33. Costs and Monopoly Profit Maximization (cont'd) Total revenues-total costs approach Maximize the positive difference between total revenues and total costs Marginal revenue-marginal cost approach Profit maximization will also occur where marginal revenue equals marginal cost

34. Costs and Monopoly Profit Maximization (cont'd) Question Why produce where marginal revenue equals marginal cost? Answer This is where the greatest positive difference between total revenue and total cost occurs

35. Figure 24-4 Monopoly Costs, Revenues, and Profits, Panel (a)

36. Figure 24-4 Monopoly Costs, Revenues, and Profits, Panels (b) and (c)

37. Costs and Monopoly Profit Maximization (cont'd) Producing past where MR = MC Result is that incremental cost will exceed incremental revenue Producing less than where MR = MC The monopolist is not maximizing profits through this approach either

38. Figure 24-5 Maximizing Profits

39. Cost and Monopoly Profit Maximization (cont’d) Real-World Informational Limitations Price searching by a less-than perfect competitor is a process A monopolist can only estimate the actual demand curve and make an educated guess when it sets its profit-maximizing profit For the perfect competitor, price is given already by the intersection of market demand and supply

40. Calculating Monopoly Profit Monopoly profit is given by the shaded area in Figure 24-6, which is equal to total revenues (P  Q) minus total costs (ATC  Q)

41. Figure 24-6 Monopoly Profit

42. Calculating Monopoly Profit (cont'd) No guarantee of profits The term monopoly conjures up the notion of a greedy firm ripping off the public If ATC is everywhere above AR, or demand No price-output combination allows the monopolist to cover costs

43. Figure 24-7 Monopolies: Not Always Profitable

44. International Example: A Mexican Cement Monopoly Finds a Way to Incur Losses In Mexico, a single company, Cemex, accounts for almost 80 percent of the nation’s cement production and sales. Thus, Cemex sells cement to Mexican consumers at almost twice the market price in the United States, where a number of firms make and sell cement. Recently, Cemex has been incurring losses as a result of falling demand in 2008 and its debt costs from short-term loans that the company had borrowed during periods of expansion.

45. On Making Higher Profits: Price Discrimination Price Discrimination Selling a given product at more than one price, with the difference being unrelated to differences in cost

46. On Making Higher Profits: Price Discrimination (cont'd) Price Differentiation Establishing different prices for similar products to reflect differences in marginal cost in providing those commodities to different groups of buyers

47. On Making Higher Profits: Price Discrimination (cont'd) Necessary conditions for price discrimination The firm must face a downward-sloping demand curve The firm must be able to readily (and cheaply) identify buyers or groups of buyers with predictably different elasticities of demand The firm must be able to prevent resale of the product or service

48. Example: Why Students Pay Different Prices to Attend College Out-of-pocket tuition rates for any two college students can differ by considerable amounts, even if the students happen to major in the same subjects and enroll in many of the same courses. The reason for this is that colleges offer students diverse financial aid packages depending on their “financial need.” To document their “need” for financial aid, students must provide detailed information about family income and wealth. This information helps the college determine the prices that different families are most likely to be willing and able to pay, so that it can engage in price discrimination.

49. Figure 24-8 Toward Perfect Price Discrimination in College Tuition Rates

50. The Social Cost of Monopolies Comparing monopoly with perfect competition Let’s assume a monopolist comes in and buys up every single perfect competitor Notice the monopolist produces a smaller quantity and sells at a higher price