Monopoly Here we see what a monopoly is and its revenue potential.
Overview Monopoly means one seller. In perfect competition many sellers were price takers. Any one seller could not influence the price of the product in the market. The competitive firm could only choose what amount to sell. A monopoly firm will have to determine both how much to sell and at what price. Let’s look at these ideas a little more on the following few slides.
p Review D Market Q In a market, consumers as a group are thought to want to buy a greater quantity the lower the price. We see this as a downward sloping demand curve.
p $ Review S p* P=MR=D D Market Q Firm Q In a competitive market, the market demand from consumers interacts with market supply from many sellers and we get an equilibrium price, like p* in the graph. At this point, since any one firm is a small part of the market, when we look at a firm it is a price taker. Thus, when the firm thinks about selling another unit it can sell that unit at the same price as the previous unit and thus MR = P for a competitive firm.
Analogy: To think about the marginal revenue for a competitive firm I like to think about a pop machine. Say the price of a pop is $1.25. Say the machine has been refilled and the pops are no chilled to perfection and you are the first one to make a purchase. What is the total revenue in the machine after you make your purchase? $1.25! Since the total revenue was zero before you bought, the change in total revenue from the sale of another unit (in this case the first one), was $1.25. This is exactly what we mean by marginal revenue. Marginal revenue is the change in total revenue from changing output by 1 unit. Now say I buy a pop right after you. The total revenue in the machine is 1.25(2) = 2.50 and the marginal revenue is 1.25. SO, MR = P for a competitive firm.
Monopoly For a monopoly firm the demand is the same as the market demand we see in competition. The demand is downward sloping to the right, what is called less than perfectly elastic. Since the monopolist is the only seller, it is natural they face the market demand curve. The situation of monopoly is often called imperfect competition.
Maximize profit Since the monopolist is the only seller in the market, the monopolist must decide what price to charge and how much to sell. When the monopolist sells, she is worried about profit. The goal is to maximize profit. But, in order to maximize profit, the pattern of revenues and costs at various output levels must be understood. The pattern of cost was the topic of an earlier chapter. Now we look at the pattern of revenue.
p Monopoly 6 5 D 2 3 Market Q Here the monopoly is the only firm in the market. When the price is 6, in this example the consumers want 2 units. Total revenue would be 12. But, this firm, if it wants to sell 3 units has to lower the price on all units to 5. The competitive firm didn’t have to worry about another price like the monopoly firm.
Monopoly – marginal revenue So, because the way consumers are in this example on the previous screen, when P = 6, 2 units will be sold and when the P = 5, 3 units will be sold. Total revenue would move from 12 to 15 when the quantity moves from 2 to 3. So, the additional revenue from the 3rd unit is $3. This is the marginal revenue of the 3rd unit. Note, the price to get the third unit sold is $5, but the marginal revenue is only $3. SO, P>MR at a quantity.
Interpretation When the price is lowered from 6 to 5 the amount sold rises. In fact, the 3rd unit sold brings in 5 in revenue. But this isn’t all we need to look at to have MR. Since the monopolist must sell to all consumers at the same price, the first 2 units now get sold at 5 as well. That means revenue on those 2 units will not include $6 per unit when the price is lowered. Continuing with the example, MR(of the 3rd unit) = 5 - (6-5) 2 = 3
interpretation P 6 area c is the gain in revenue from selling more area a is the loss in revenue from selling at a lower price. a 5 b c Q 2 3 Area a + b = 6 times 2= 12 = TR when P = 6 Area b + c = 5 times 3 = 15 = TR when P = 5 MR = c - a = 5 - 2 = 3
Let’s do another example P Q 5 0 4 1 3 2 2 3 1 4 0 5 Say this is the demand from consumers in the market. If the price is 5 consumers want nothing, for instance. Let’s TR on the next slide.
Let’s do another example P Q TR 5 0 0 4 1 4 3 2 6 2 3 6 1 4 4 0 5 0 Total revenue is just P times Q, so you should check what I have here. Next let’s add MR to the table.
Let’s do another example P Q TR MR 5 0 0 ---- 4 1 4 4 3 2 6 2 2 3 6 0 1 4 4 -2 0 5 0 -4 MR, marginal revenue, is the change in TR when we add a unit of output. Note at Q = 0 I have the line --- because we have not had a change yet. The MR = 4 for a Q = 1 because TR went from 0 to 4 when Q went from 0 to 4. The MR = 2 for Q = 2 because TR went from 4 to 6 when Q went from 1 to 2. Note: MR can become negative, in theory. Also note that P > MR at each Q (except Q = 1, but we usually ignore this.)
MR from areas to height P In the above diagram we think of MR as area c - a and we get a number. a In the bottom graph we can think of the number as a height. Note still the MR is lower than the price on the demand curve. On the next screen we will see the whole MR curve. D b c Q P height = MR D Q
Monopoly MR in a graph $ I do not have a proof for you, but you can see in this diagram that MR is also a straight line that starts at the same place as demand in the upper left, but is always below demand because P>MR. Like at Q = 3, MR = 3 and P = 5. 5 3 D Q 3 Note that a good way to draw in MR is to first draw demand and then put MR through the Q axis halfway out to the demand curve. I put an X at that point.
Monopoly Pricing and Output We study the pricing and output decision of the monopoly firm.
Price and output decision for the monopolist in the short run The amount of output the monopolist should sell in the short run is the amount where MR = MC(as long as P>AVC), just as in the case of the competitive firm. The price charged would then be the price on the demand curve above the quantity where MR = MC.
Logic of MR = MC rule $ The Q = b is the Q where MR = MC. But look at Q = a. At that point, Q could be increased and more would be added to revenue than to cost and thus profit would rise. We know this because the MR > MC for these Q (Compare the heights of the curves). MC D Q a b c MR Now let’s look at a Q greater than where MR = MC, like at point c. More has been added to cost than to revenue and thus profit would fall. We know this because MC > MR at this Q.
What price? $ MC At Q*, where MR = MC, P* is the price on the demand curve consumers are willing to pay for Q* and thus this is the price charged by the monopolist. P* D Q Q* MR
Qualification ATC = .12 $ ATC Note that the ATC is above the demand curve, so the firm will lose money. In the short run, the question is whether the firm should shutdown or continue to operate. Let’s go to the next screen and say more about this. MC AVC1 =.11 AVC1 AVC2 P*= .10 AVC2 = .08 D 20 MR
continue Note that the Q where MR = MC = 20. So, if the firm operates at all it should make 20. Note at Q = 20, the price on the demand curve is .10 but the ATC = .12 Now, remember ATC = TC/Q so ATC times Q = TC. TR = P Q = .1(20) = 2 TC = ATC Q = .12(20) = 2.4 Profit = TR – TC = 2 – 2.4 = - .4 Or Profit = (P – ATC)Q = (1 - .12)20 = -.4 The firm is losing money.
continue 2 If the AVC curve is AVC2 for the firm then at Q = 20 the AVC = .08. This means the TVC = AVC Q = .08(20) = 1.6. Thus the TR = 2 can cover the 1.6 of TVC and what is left of TR, .4 can go to paying some of the total fixed costs. If the firm shuts down it would have nothing going to fixed cost. So the firm should operate. Thus, operate if at the Q where MR = MC the P > AVC. Note if the AVC is AVC 1 = .11 the P < AVC. The firm should shut down. TR of 2 falls short of TVC of 2.2 and covers none of fixed while if the firm shuts down it only has to cover the fixed cost.
Quiz 1 – not a real quiz $ MC Is this monopoly firm earning a profit? If so, draw in the graph the rectangle that represents the profit. ATC P* D Q* MR
Quiz 2 not a real quiz $ ATC MC Is it possible for a monopoly to lose money? Indicate in the graph how much this monopoly is losing by indicating the loss rectangle. AVC P* D Q* MR
Is a monopoly guaranteed a profit. I have a monopoly – I make a pizza fork (not really, but listen up). Look at the palm of your right hand, thumb up. When you wrap your hand around the fork your thumb is next to a button on the fork (sorry, only right handed version.). When you press the button Thumb Palm of hand A razor blade edge comes out here and you move your hand so your thumb is now pointing left and you cut your pizza real easily. The demand for my item is much lower than where my costs are.
Can Monopolies charge whatever price they want? The answer is yes, but with a qualification. Remember consumers have a demand for the product and have prices they are willing to pay. As long as the monopoly is charging a price the consumers are willing to pay then they can charge whatever they like. But if the monopoly charges too high a price consumers will not buy at all.
Compare monopoly with competition The main results here are the ideas that ----1) a monopoly firm will charge a higher price than would occur in competition and ----2) a monopoly will sell less output than would occur in competition. There seems to be a notion in the world that monopolies will charge us outrageous prices. Economics does not settle this claim, but the science of Economics does tell us that we get higher prices than in competition. But, there are some willing to pay the higher price.
P S Pc D Q Qc
On the previous slide we have the competitive market. Note the demand is coming from many consumers in the market. The demand from each person is essentially the marginal benefit curve of each person. Note the supply is coming from many suppliers. The supply from each firm is basically the marginal cost curve (that part above AVC). Because there are so many players in the market, none has an influence on price, so the “market” determines the price and each buyer and seller takes the price. Now, if the industry is monopolized, one seller would meet all the consumers. Thus, the monopolist would see a MR curve and treat S as a MC curve.
Comparison continued If you focus your eyes on the point where S = D you see the competitive point with Pc and Qc. If you focus on the point where MR = MC you see the monopoly point with Qm and Pm (Note Pm is on demand curve above where MR and MC cross.). Assume that a monopolist comes in and buys up all the firms. It then operates $ S = MC Pm Pc D Q Qm Qc MR where MR=MC and charges the price on the demand curve at that Q.
P The graph reproduced a b c d e f g h Pm Pc Q Qm Qc
Referring to the previous slide: comp monop con surp a b c d e a b Prod surp f g h c d f g So, consumers lose surplus of b, c, and e due to monopoly. Producers gain c and d from the consumers, but lose h. Overall, there is a deadweight loss of e and h. This loss is a major reason why we have laws against monopoly. The Sherman Act of 1890 is the first law in US to be against monopoly. We have had revisions since, but basically this law is the driving force.
Problems of monopoly The problems of monopoly are higher price and less output than in competition. Moreover, 1) The higher price means those who still buy have less money to spend on other things – c and d are surplus areas that consumer used to have for other things but now pays to monopoly. 2) Those who no longer buy must be worse off because they get less than what they were at their liberty to purchase under competition – area e represents the value of lost output to the consumers and is part of the deadweight loss of monopoly.