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INDUSTRIAL ECONOMICS I

INDUSTRIAL ECONOMICS I. Monopoly – Cost and Benefit. The Cost and Benefit. When monopoly restricted output and raises prices, society suffers deadweight loss. In certain circumstances monopoly is preferable to competition. The Cost and Benefit. Deadweight loss of Monopoly

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INDUSTRIAL ECONOMICS I

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  1. INDUSTRIAL ECONOMICS I Monopoly – Cost and Benefit

  2. The Cost and Benefit • When monopoly restricted output and raises prices, society suffers deadweight loss. • In certain circumstances monopoly is preferable to competition.

  3. The Cost and Benefit • Deadweight loss of Monopoly • To maximize profit, output is set where MR curve intersect MC curve. • The gap between monopoly price and MC represents the difference between the value or price the consumer puts on the product and the MC of producing it.

  4. The Cost and Benefit • Suppose for a competitive industry the gap represents government tax – where price and output differ from their competitive price and there is a deviation between demand price and (given by demand curve) supply price (given by MC curve). • For the monopoly the DWL is area below D curve and above MC curve – to the right of the monopoly equilibrium. • Therefore the monopoly efficiency effect and inefficient tax are the same i.e. there is DWL.

  5. The Cost and Benefit • In terms who keeps the transfers from consumer to the monopoly or to the government – the effect is different. • Monopoly keeps monopoly profits. • Tax revenue goes to the government • Many researchers have estimated the DWL imposes on the economy. • E.g. Harberger (1954) calculated that the DWL is about 0.1 % of the US GNP. • Jenny and Weber (1983) DWL in France is about 7.4%.

  6. Deadweight Loss - Tax DWL – cost to society if the market is not operating efficiently – consumers’ surplus + producers’ surplus. It is the deviation from the competitive equilibrium. E.g. the competitive equilibrium is at p0 and quantity Q0. At Q0 the value the consumer places on additional consumption equals the MC of producing the goods. Suppose government collect tax of T per unit of the goods sold. Consumer pays p government collects T. Therefore firms receives p-T. Thus, T creates the wedge between the value the marginal demander places on the good, (demand curve) and the marginal supplier is willing to supply the goods (supply curve). $ DWL S p* A B p0 T D C D p* - T Q Q* Q0

  7. Deadweight Loss - Tax Thus, imposition of tax reduce quantity sold from Q0to Q*. Price consumer pays raise to p*. The price firm receives p* - T.

  8. Deadweight Loss - Tax • In the after tax equilibrium, the amount sold is Q* - less than competitive equilibrium Q0. • The value consumers place on consuming additional unit, p* now exceeds MC of producing by t. • Consumers suffer a loss of consumers surplus equals to areas A and B.

  9. Deadweight Loss - Tax • Suppliers loss a producers surplus equal to areas C and D. • Government receives revenue TQ*; (A+C). • Hence, there is a transfer from consumers and producers to the government –the tax revenue = boxes A and C – less than the combined loss of the consumers and the producers. • The extra cost to society is the reduced output due to DWL – the sum of triangle B and D.

  10. Deadweight Loss - Tax • In this case the DWL is an efficiency loss to the society because MC of producing a good is less than the marginal willingness of the consumer to pay for it. • However, as long as the government makes efficient use of the revenue, it is not an efficiency loss, • It rather reflects a redistribution of income from buyers and sellers to those who benefits from the fund.

  11. DWL vary with Elasticity of Demand • Monopoly profits and the DWL portion is dependent on the shape of the demand curve. – can be explained through its elasticity. • Assume linear demand curve, • p = a – bQ • Assume a = $60, b = 0.5 • Constant MC = AC = $10

  12. DWL vary with Elasticity of Demand Assume that monopoly sells pm = $35, elasticity of D is -1.4. Monopoly profit area is A = $1,250. Rotate D curve, so elasticity varies. It is rotated where it crosses MC line at 100 units. MR is also linear and crosses at MC line half the distance.= of D curve. Hence, profit-maximizing monopoly equilibrium at 50 units is unchanged – when d curve is rotated. 90 Rotated D Rotated MR 60 50 Original D B C 35 A D MC 10 MR Q 0 100 50

  13. DWL vary with Elasticity of Demand • Monopoly price axis, a is $90, sells the same quantity Qm = 50 units at pm = $50. but d elasticity falls to -1.25 (less elastic). • Monopoly profits raises to A + B = $2,000. Monopoly Profits and DWL with Price Elasticity of D Monopoly Profit Intercept of D-curve with Price axis Elasticity of Demand at Q = 50 Monopoly Price DWL $ 30 60 90 120 150 -2.00 -1.40 -1.25 -1.18 -1.14 $20 35 50 65 80 $ 250 625 1000 1375 1750 $ 500 1,250 2,000 2,750 3,500

  14. DWL vary with Elasticity of Demand • As D curve becomes less elastic, it reflects that consumers are less willing to do without the goods. • Hence, when monopoly realized that the opportunity exist, will increase equilibrium price and earns larger monopoly profit. • As D curve becomes steeper at a given quantity (more inelastic) the DWL becomes bigger. • Thus the transfer from the consumer goes to the monopoly (unlike tax it is redistributed).

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