Chapter 12 Monopoly

Chapter Summary
According to the text, "the key feature that differentiates monopoly from competition is the price elasticity of demand." The five sources of monopoly power are (1) exclusive control over important inputs, (2) economies of scale, (3) patents, (4) government licenses, and (5) the network economy. The first section discusses profit-maximizing strategy for a monopolist. It explores the revenue of the firm showing how the total, average and marginal revenue functions relate to each other. Marginal revenue is falling while total revenue rises and when it peaks margainal revenue is zero. begins with a discussion of the relation between the demand curve facing the monopolist and the total revenue curve. Next marginal revenue is defined, including the fact that total revenue is maximized where marginal revenue equals zero. The revenue functions and demand elasticity show that firms will profit maximize when demand is elastic which is where marginal revenue is positive. The amount of markup over marginal cost will demand on the elasticity of demand at the profit maximizing output. One can identify the shut down point in any given situation as the loss minimizing output level which can not provide a price high enough to cover average variable cost. Because monopolists alter their price as demand changes it is impossible to identify a specific supply curve for the firm. In the long run, monopolists equate long run marginal cost to marginal revenue producing as long as price equals or exceeds average costs. The three types of price diecrimination illustrate ways in which monopolists try to capture some of the consumer surplus. Monopolists underproduce except when they perfectly price discriminate. The chapter concludes with a discussion of five different ways that public policy can deal with monopolies. The method used will depend on the nature of a market and the type of output being produced. Finally, the concern that monopolies suppress innovation is most likely overplayed because profits from innovation will often exceed profits from maintaining the staus quo.

Chapter Outline
Chapter Preview Defining Monopoly Five Sources of Monopoly The Profit-Maximizing Monopolist A Monopolist Has No Supply Curve Adjustments in the Long Run Price Discrimination The Efficiency Loss from Monopoly Public Policy toward Natural Monopoly Monopolies and Innovation Summary

Teaching Suggestions
1. In one sense monopoly is easier than other market forms because the demand of the market is the demand of the firm. This advantage will disappear fast, however, if the derivation of the marginal revenue function is not understood well. As always, the graphical, mathematical, and intuitive understanding is necessary before one can start drawing MR simply at twice the slope of the straight line demand functions. I find it helpful to introduce at the very beginning of this chapter the idea of price discrimination

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CHAPTER 12: Monopoly because students live with it enough to have a good grasp of it, and because the absence of price discrimination is the reason that marginal revenue is less than demand. Start by showing why a perfect price discriminating monopolist has a marginal revenue function that is equal to demand. Then ask what happens if you cannot segregate markets and must charge a single price. Good students will recognize that there will be a loss on all previous units sold if the price on all of them must be reduced to sell more. With this intuitive understanding, take TR = PQ and substitute demand for P. Then take the first derivative to get the marginal function, and it will clearly show that MR has twice the slope of the demand curve. If the TR = PQ is differentiated with respect to Q, the resulting components of the derivative show that MR = P (the price of the last unit) plus the change in P as Q changes times the amount of Q (the amount lost on all previous units sold). Finally, show these two areas as the text does in Figure 12-5 and the job should be complete. Students who fail to grasp this MR concept for monopoly are in the fog throughout most of the monopoly model chapter. 2. Refer back to the Chapter 2 graph on welfare analysis and add several letters to the graph as shown below. P

A C

B D E G F K I J Q H MC

Use this graph to illustrate the welfare effects of a single price monopoly, a perfectly price discriminating monopolist, and perfect competition. Give the following quiz to the class. a. List the letters of the total welfare generated in the market if it is perfectly competitive. b. List the letters of the total welfare generated in the market if it is perfectly price discriminating. c. List the letters of the total welfare generated if the market is a single price monopoly market. d. What letters show the deadweight loss due to monopoly? e. Using letters from the graph above, explain why consumers prefer single price monopoly over perfect price discrimination even if perfect discrimination is more efficient. . f. If there are no fixed costs, what letters represent single price monopoly profits? g. If there are no fixed costs, what letters represent a perfect price discriminator's profit?

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3. Most colleges price discriminate. I get 20% off all bookstore items. Students pay vastly differing effective tuition fees. Campus people get cheaper concert, sports, and musical tickets. Have students try to figure out why. Is the school simply being nice even if it loses some profit? Why don't faculty buy books and sell them to students at a price generating mutual gain? 4. The networked economy is a fascinating concept and it has enormous implications for economic analysis. Perhaps some stories about how the interconnectedness of economic agents will help to see how concentration in industry is a logical result of the plunging marginal costs of some economic activity. For example, a farmers corn planter can now have an onboard computer which communicates through a satellite to pinpoint exactly where it is in the field and how much fertilizer is needed for that particular location. This is a cost saving process that is possible because the planter is really information chips with wheels and fertilizer bins. When we start seeing airplanes that fly without pilots we have chips with wings. While networking may offer some opportunities for decentralization it also often involves challenges where huge fixed costs and low marginal costs abound moving an industry toward centralization and perhaps monopoly in some cases.

Stumbling Blocks for Students

1. Many students seem puzzled by the fact that monopolists stop producing where marginal cost equals marginal revenue. It seems logical to the students that if price is above marginal cost, additional profits are possible. This is not surprising since they have just come through perfect competition where price did not exceed marginal cost at the profitmaximizing output. This will occur more often when the declining marginal revenue function is not understood. To clear up this point, illustrate again what happens if one more unit is produced, emphasizing that the marginal revenue is less than the price because of all the lost revenue from previous units sold when price is lowered on all sales. 2. The comparison of perfect competition and monopoly is confusing when one observes the relationship between the long-run average cost curve and the market demand curve. If the entire market is served over the range of output where declining costs occur, then many sellers operating at the low cost point of the LATC would not be possible. Consequently, no comparison can be made between the monopolist and the competitive structure. In the text the cost functions are all downward-sloping natural monopoly type functions. Consequently, the welfare issues focus more on whether the monopolist is producing where ATC = demand, whether it is producing at the profit- maximizing restricted output, or whether it is required to price at the MC point where a subsidy is required. 3. Price discriminating concepts are not difficult except that the three kinds of discrimination need to be differentiated. Taking all of one person's consumer surplus is quite different from charging two different prices in two separate markets. Students do not always pick up these distinctions unless they are pointed out explicitly.

Answers to Questions for Review

1. The five factors include, exclusive control over inputs, economies of scale, patents, a network economy, and government licensing or franchising, Economies of scale derive from technological conditions rather than institutional arrangements that can change anytime.

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2. Yes if the transportation costs of cement from the next town make the competing cement more expensive than the monopoly price of the local cement. 3. Since the demand curve slopes downward, marginal revenue will always be less than price; because for each additional unit sold one must lower the price for all other goods sold. 4. On the inelastic portion of the curve, raising price will always increase revenue and (since output will be lower) it also lowers costs. Therefore the firm should always move up the demand curve to where it is not inelastic if profit maximization is a goal. 5. If MR intersects MC from below, then MC must be downward sloping; more output will lower MC. 6. No effect. The same P and Q that maximize also maximize /2 . 7. Price would be 50% higher than marginal cost. (P MC) /P = 1 MC/P = 1/3 or MC/P = 1 1/3 2/3 or P/MC = 3/2. 8. The price-quantity pair that maximizes profits will also maximize the profits minus a lump sum tax. Such a tax is equivalent to any other fixed cost since it leaves the optimal price-quantity pair unaffected. 9. With a perfectly horizontal market demand curve, there will be no deadweight loss. So true. 10. Whoever owns the firm will want to increase profits by reducing x-efficiency. 11. The hurdle model gives the lower price only to those willing to jump the hurdle so the markets are more easily segregated. Deadweight losses are reduced.

Answers to Chapter 12 Problems

2) 3) 4) 5) 1. 1) Increase output because MR > MC and P > AVC. Reduce output because MR < MC (we know that MR < P and P = MC here). Remain at current output. MR = MC, and P = TR/Q = 11 > AVC. Figures can't be right (P < MR). Figures can't be right (P = TR/Q = 3.99, which is clearly not equal to 35.00). 2. MC = 2Q = MR = 100 - 2Q; 100 - 2Q = 2Q, so Q* = 25, P* = 75. TR = 1875; TC = 641 = TR - TC = 1234

3. The profit maximizing level of output for a single-price monopolist occurs where MR = MC. The linear demand curve P = 100 Q has a marginal revenue of MR = 100 2Q. By equating marginal revenue and marginal cost (100 2Q = 2Q) we get a quantity of 25. The price charged for this quantity is read off the demand curve so P = 100 Q = 100 25 = 75. The monopolists price and quantity are unaffected by fixed costs. However, the monopolist earns lower profits: = TR TC = 75Q (32 + Q2) = 1875 657 = 1218. The difference in profits equals the increase in fixed costs.

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4. The profit-maximizing level of output for a single-price monopolist occurs where MR = MC. The linear demand curve P = 100 Q has associated marginal revenue of MR = 100 2Q. Setting marginal revenue equal to marginal cost , MC = 8Q, we have 100 2Q = 8Q, which solves for Q = 10. The price charged for this quantity is read off the demand curve: P = 100 Q = 100 10 = 90. The monopolists price rises and quantity falls due to the increase in marginal costs. The monopolist earns lower profit than before: = TR TC = 90Q (16 + 4Q2) = 900 416 = 484. Price 100 90 MC ATC

D 42 MR 0 10 20 Quantity 30 40 50

5. MR should be equal in both markets. Since the price is fixed at 60 in the foreign market, MR is also fixed at 60 in that market. This means that MR at home should also be 60. We have MRhome = 100-2Q=60, which solves for Qhome = 20. Also MC should be equal to 60. MC = 2Q = 60 solves for Qtotal = 30. Therefore Qforeign = Qtotal-Qhome = 10. Price in the home market = 100 - 20 = 80.

P 100 80 60 MC MR

20 30 50

100

Q Foreign Market

Home Market

6. The profit-maximizing level of output for a single-price monopolist occurs where MR = LMC, The linear demand curve P = 100 Q has associated marginal revenue of MR = 100

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CHAPTER 12: Monopoly 2Q. Setting marginal revenue equal to marginal cost, LMC = 20, we have 100 2Q = 20, which solves for Q = 40. The price charged for this quantity is read off the demand curve: P = 100 Q = 100 40 = 60. A perfectly competitive industry would produce the quantity such that P = LMC = 20 so that Q = 100 20 = 80. The total surplus generated by perfect comptition would be TS = (1/2)80(100 20) = 3200. By comparison, the monopoly generates producer surplus PSm = 40(60 20) = 1600 and consumer surplus CSm = (1/2)40(100 60) = 800 for a total surplus of TSm = 160 = 80 = 2400. The efficiency loss due to monopoly is the amount by which total surplus under monopoly falls short of the total surplus under perfect competition. (TS = 2400 3200 = 800) The efficiency loss is the triangular area between the demand curve and marginal cost (supply) with base equal to quantity by which ouput under perfect competition exceeds output under monopoly. Price 100

60 MC MR 0 40 50 Quantity 100 D

7. A perfectly discriminating monopolist sells the quantity where marginal cost intersects the demand curve P = MC or 100 10Q = 20 or 10Q = 80 or Q* = 8. The monopolists economic profit is the area under the demand curve down to average cost out to quantity. PS = (1/2) (100 20)8 = 320. The government could charge the firm any fixed fee up to 320. Price 100

20 D 0 Quantity 8. MR = P(1 - 1/||) = MC, which implies that P = MC/(1 - 1/||) Senior citizens: PS* = 1/(1-1/4) = 4/3 8 10

MC

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Adults: PA* = 1/(1-1/2) = 2. 9. Iraq: P=400-0.5Q => MR=400-Q, or Q=400-MR. Iran: P=300-Q => MR=300-2Q, or Q=150 - MR/2. When we add these horizontally, we get Q=QIraq+QIran = 400-MR for 0<Q<100, 550-(3/2)MR for Q>100. MC=Q will intersect MR when Q>100. In equilibrium, MR=MC=1100/3 - (2/3)Q = Q, which solves for Q=220 and MR=220. Iraq: Q=400-MR=180 ; P=400-0.5Q=310. Iran: Q=150-MR/2=40 and P=300-Q=260. 10. Since they have lower income, their demand is more price elastic than regular customers'. So they are more willing to jump the hurdle to get a lower price. The hurdle is the coupon in this case, and it is used to sort people according to their price elasticities of demand. 11. || =2, so MR = P(1-1/||) = 10(1-1/2) = 5. 12. If demand is inelastic at the price ceiling, we know the monopolist could increase its profits by raising its price. So false. 13. First look at how the Times prices its ads to outside advertisers, who have a downwardsloping demand curve for ad space. When the Times sets its price for outside ads, its rule is to equate marginal revenue to marginal cost. Marginal cost is simply the cost of expanding the paper to accommodate the extra ad. When the paper maximizes profit, the price it charges outsiders for ads will thus be higher than the marginal cost of producing another ad. When the Times advertises for its own features, its rule should be to continue placing more ads until the marginal benefits (in terms of increased sales or higher prices) just equal the cost of producing an extra ad. The opportunity cost to the Times of running another ad is thus the marginal cost of producing the ad, which in general will be lower than the price it charges outside advertisers. 14. See footnote in text associated with this problem. = PH QH + PL QL - 5(QH + QL) - 15 14. a) PH = 20 - 5QH, PL = 20 - 5QH - 5QL

max [(20 - 5QH) QH + (20 - 5QH - 5QL) QL - 5QH - 5QL - 15] QH,QL First-order conditions: (1) / QH = 20 - 10QH - 5QL - 5 = 0 (2) / QL = 20 - 5QH - 10QL - 5 = 0, which may be restated as (1') 15 - 10QH = 5QL, so 3 - 2QH = QL (2') 15 - 5QH - 10 (3 - 2QH) = 0, so -15 + 15QH = 0 Thus QH = 1; QL = 3 - 2QH = 1; PH = 15; PL = 10

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P 20 P =15 H P =10 L 5 QH 0
14. b) = 15 + 10 - 5(2) - 15 = 0 14. c) MR = 20 - 10Q = MC = 5, so Q* = 1.5 P* = 20 - 5(1.5) = 12.5 = (12.5)(1.5) - 5(1.5) - 15 = -3.75 14. d) With a single price, Harry would be forced out of business in the long run, and consumers would lose the surplus they enjoy under the two-price arrangement. 15. The publisher's net income from the project comes when it sets the price that corresponds to the quantity for which marginal revenue and marginal cost are equal. The author's net income from the project is maximized when the price is set at the level that maximizes total revenue. The author's best price thus corresponds to the quantity for which marginal revenue equals zero. As long as marginal production costs are positive, it follows that the publisher will prefer a higher price than the author. So false. 16. The studio's maximum net income from the project comes when it sets the rental price that corresponds to the quantity for which marginal revenue and marginal cost are equal. The director's net income from the project is maximized when the price is set at the level that maximizes total revenue. The director's best price thus corresponds to the quantity for which marginal revenue equals zero. As long as marginal production costs are zero (which follows from the assumption that all costs are fixed), it follows that the studio will also prefer the price that equates marginal revenue to zero. So false.

MC =5 QL 1 2 4 Q

Additional Problems
1. The demand curve for a monopolist is given by P = 350 - 7Q, and the short-run total cost curve is given by TC = 500 + 70Q. What is the profit-maximizing price and quantity? Find the monopolist's economic profit. 2. A monopolist faces two separate demand curves: P1 = 65 - 2Ql and P2 = 35 - 3Q2. The total cost curve is TC = 7 + 5Q. Find Q1, Q2, P1, P2. 3. Find the price elasticities at the profit maximizing points for Problem 2. 4. The price elasticity of demand for popsicles on a beach in a small east coast resort town is -5 in the month of May, while in July the elasticity falls to -1.5. A single vendor supplies

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the popsicles to the beachcombers. If the marginal cost per popsicle is $0.60, how much should the vendor charge per popsicle in May and July? 5. Premium gasoline costs a few more pennies a gallon to refine, yet costs much more at the pump. Can you think of a good explanation? 6. Stores often have sales to get rid of excess inventory and overstock. Yet they often have only recently ordered the overstock. Can you think of another explanation?

Answers to Additional Problems

1. Marginal cost is equal to the slope of the straight line total cost curve: MC = 70 Marginal revenue has a slope which is twice as large as the slope of the demand curve. MR = 350- 14Q Set MC = MR: 70 = 350- 14Q Q = 280/14 = 20 P = 350 - 7(20) = 350 - 140 = 210 Profit = PQ - TC = 210(20) - [500 + 70(20)] Profit = 4200 _ 1900 = 2300 2. MC = slope of TC = 5 MR1 = 65 - 4Q1 MR2 = 35 - 6Q2 Set MR1 = MR2 = MC First solve for Q1 and P1: 65 - 4Q1 = 5 4Q1 = 60 Q1 = 60/4 = 15 P1 = 65 - 2(15) = 35 Next solve for Q2 and P2: 35 - 6Q2 = 5 6Q2 = 30 Q2 =30/6=5 P2 = 35 - 3(5) = 20 3. elasticity l = Q1/P1 (P1/Q1) = (-15/30) (35/15) = -1.167 elasticity 2 = (-5/15)(20/5) = -1.333 Check: MR= P(1 - 1/n) MR1 = 35(1 - 1/1.1671) = 5 MR2 = 20(1 - 1/133) = 5 4. Set MC = MR = $0.60 MR= P(1 - 1/elasticity) P1 (May): $0.60 = P1[1 - (1/5)]: $0.60 = 0.80 P1: P1 = $0.75 P2 (July): $0.60 = P2[ 1 - (1/1.5)]: $0.60 = 0.333P2: P2 = $0.60/0.333 = $1.80

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5. Price discrimination. People who use premium are most likely the wealthiest and the least price sensitive. 6. Price discrimination. People with higher elasticities of demand are willing to wait for sales.

Answers to Homework Assignment

HOMEWORK ASSIGNMENT KEY:______Chapter 12_____________

1. A resort island 10 miles off the mainland has enough daily traffic to fill either one large ship or 15 small boats. Vacationers have the same preferences for time of travel, so having many small boats at differing times is no advantage. The ATC of the small boats is $35 when they run at capacity. Unfortunately, there is not enough business for both types of operation to succeed. The large shipping company estimates the demand to be P = 100 0.1Q and has a total cost function TC = 10,000 + 15Q. The island council has a petition before it to outlaw the large shipping operation. The petition says that the island citizens can not be held hostage to a monopoly. Analyze this petition by answering the following questions. a. What would the shipping company be inclined to do in order to secure its monopoly status if there were no governmental action? The shipping firm would maximize profit at 100 .2Q = 15: 2Q = 85: Q = 425 b. Once the monopoly was established, what would keep the small boats from coming back into the market if the shipping price went above $35? Small boats would fear that the large ship would lower its prices below the costs of the small boats and drive them out of business, since the large ship would still be operating above costs. c. What would be the ship's profit-maximizing price and what would its profits be? By inserting the 425 quantity into demand equation the price of $57.50 results. Profit is equal to ($57.50)(425) $10,000 (15)(425) = $24,437.50 16.375 = $8,062.50 d. Is the petition the best solution? What options does the island have in addition to passing the petition? (A numerical answer is not required.) 1) The island officials could regulate the industry by requiring the price = marginal cost which is 15, in which case a $1000 subsidy would be needed to keep the ship operating. 2) The regulated price could be set at the point where ATC and demand intersect. This would mean the ship would cover all costs but not have economic profits. 2. Use the graph below to explore answers to questions a-g. Answer with letters except where indicated. J P ATC (short run) MC A B J C I H D E F G Demand Quantity

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a. What is the consumer surplus if the monopolist is a single price profit maximizer? A+B b. This industry controlled by a single price monopolist will provide ___E+F+G____ less total benefit to consumers than firms in a competitive industry. use __G+F______ less resources than firms in a competitive industry, cause a ___E________ deadweight loss to society.

c. A single price monopoly firm would need to go out of business in the long run if its ATC was as shown. However, a price discriminating monopolist might make a profit under certain circumstances. Describe with letters what would need to be true for the price discriminating firm to stay in business in the long run _(A+B)>J__. d. If the dotted ATC is eliminated and the variable costs are the only costs, how much profit will a single price monopolist make _C+D+I_____? Also with no fixed costs, how much profit will a perfect price discriminator make _A+B+C+D+E+I_? (Remember: the sum of all the marginal costs = the total variable cost.) e. If a 10% tax is put on all profit, a single price monopolist will do what to his price _no change_______? (direction of change if any) A perfect price discriminator will do what to his quantity produced if the same tax is imposed _no change_______? (direction of change if any) f. Answer the following questions for the single priced monopolist sketched on the previous page if the demand curve shown above is P = 21 .5Q and the marginal cost curve is MC = .5Q. Fixed costs are 20. What are the numerical values of: the single price monopolists profit ___127__________? What is the deadweight loss imposed on society __49/2 =24.5__? What is the value of the consumer surplus that is generated ___49_________? g. Given the same information as in (f) above except that the firm is now a perfect price discriminator. What is the profit of the firm ___220.5_____? What are its total cost of production __130.25__________? How much output does it produce __21___________?