Chapter 28: Theory of the firm monopoly (1.5)

Transcription

1 Chapter 28: Theory of the firm monopoly (1.5) Assumptions of the monopoly model Barriers to entry Revenue and costs in the unit cost picture Profit maximising price and output Revenue maximising price and output Assumptions of the Describe, using examples, the assumed characteristics of a monopoly: model a single or dominant firm in the market; no close substitutes, and significant barriers to entry Barriers to entry Describe, using examples, barriers to entry including economies of scale, branding and legal barriers Revenue curves Explain that the average revenue curve for a monopolist is the market demand curve, which will be downward-sloping Explain, using a diagram, the relationship between demand, average revenue and marginal revenue in a monopoly Explain why a monopolist will never choose to operate on the inelastic portion of its average revenue curve Profit maximization Revenue maximisation Explain, using a diagram, the short and long run equilibrium output and pricing decision of a profit maximizing (loss minimising) monopolist, identifying the firm s economic profit (or losses) Explain the role of barriers to entry in permitting the firm to earn economic profit Explain, using a diagram, the output and pricing decision of a revenue maximizing monopoly firm Compare and contrast, using a diagram, the equilibrium positions of a profit maximizing monopoly firm and a revenue maximizing monopoly firm Calculate from a set of data and/or diagrams the revenue maximizing level of output I think it's wrong that only one company makes the game Monopoly. Steven Wright The perfectly competitive market model is a rather theoretical extreme of firms as price takers operating on a market where no long run profits are possible. Monopoly firms are quite the opposite! Assumptions of the monopoly model The assumptions of the monopoly market model are markedly different from the competitive model: 1. There is one firm supplying the market. 2. There are very high barriers to entry. One assumption, however, remains the same: 3. The firm is a short run profit maximiser, just like the perfectly competitive market firm.

2 In fulfilling the assumptions above, a monopoly firm will have a great deal of power on the market, often at the expense of the consumer. A single monopoly firm is able to choose to produce at any point along the market demand curve. Therefore the firm is a price-setter. This power is a consequence of the lack of available consumer substitutes. A monopoly must per definition be supplying a good which is quite unique in terms of perceived utility, and therefore cannot be replaced. Postal service has long been an example of monopoly power, but (as seems to be the case in the long run) this power has been eroded over time as private delivery firms and increasingly encroach this market. Barriers to entry Firms attempting to enter a market could experience technical barriers, where the monopoly firm enjoys decreasing marginal costs over the span of market demand (see natural monopolies, below), for example special techniques and production methods involved in production, or ownership of unique factors of production (e.g. raw material). An example of the former would be Pilkington Glass of England which in the early 1950 s invented a revolutionary process for producing sheet glass used in windows and then licensed the technology to firms around the world. As for controlling a vital factor input, ALCOA (Aluminum Company of America) of USA controlled most of the world s bauxite (from which aluminium is produced) until the 1940 s. There could also be legal barriers to entry, for example intellectual property rights such as patents and copyrights. The firm could also enjoy government-granted production rights in public utilities such as postal service and telecommunication. Microsoft Corporation has a monopoly on both DOS and Windows and many countries will have legislation in place governing which companies are allowed to supply electrical power and telecom cables to the market. 1 It is also quite common even likely, according to some studies that firms which are able to will attempt to create barriers in the aims of constructing a monopoly-like market situation. The monopoly firm s activities on the market could dissuade other firms from entering the market. A monopoly might engage in predatory pricing, whereby the a firm seeking to uphold monopoly power sets the price lower than smaller rivals and potential entrants see Chapter 32. Additionally, a monopoly firm could aim to control the supply on the market by buying up the output of other firms in order to control end-user supply. The diamond merchant de Beers previously controlled via a cartel some 70% of the market for diamonds (depending, once again, on how the market is defined) which it has consistently tried to uphold by controlling not only the mines but also the wholesaling chain via purchasing and stockpiling diamonds from mines not under company control. A final key barrier to entry is the existence of economies of scale. An incumbent (= existing) firm enjoying large benefits of scale will dissuade potential entrants simply by having far lower average costs than any newcomer can attain. This often creates a so-called natural monopoly which will be looked at in Chapter 29. Revenue and costs in the unit cost picture Picture the market demand curve. Now cross out Market demand and replace the title with Monopoly demand. You re finished; the demand curve for the market is the demand curve facing the monopolist, as there are no other providers of the good. The main difference compared to a PCM firm, as shown in the chapter on marginal revenue, is the marginal revenue curve for the monopolist firm. Figure returns to the demand, average and marginal revenue curves for a monopoly firm. 1 Have you noticed that all Microsoft product names are accepted by the automatic spell-checker in Word?! Just try writing MSWord and then MSNerd!

3 Fig Demand, AR and for a monopoly The market demand is the same as the monopolist firm s demand. AR = (P x Q) / Q, which means that AR is equal to demand. = TR / Q. As the single-price monopoly will lose revenue as well as gain revenue by lowering price, the curve will fall twice as fast as AR. Qrev-max TR is maximised at output level where = 0 which is where PED = 1. Profit maximising price and output As the monopoly firm faces a market where no other goods are substitutes, the market demand will be satisfied by the monopoly firm. And since we retain the assumption of the firm being a short run profit maximiser, the firm will produce where equals. By drawing the marginal cost curve of the monopoly firm we get the profit-maximising level of output seen in figure The single-price monopolist sets output at the profitmax point ( = ) which is shown by Q Π-max in the diagram. The price can of course be set anywhere below the demand curve at the profitmax point of output, but the monopoly will set the maximum price denoted by the boundary of demand at Q Π-max, which is at P Π-max. Fig Profit-maximising level of output in a monopoly P Π-max Q Π-max = (Q Π-max ) The monopoly operates under the same set of criteria as the PCM firm; output is set at the level where = ; Q Π-max. However, since the monopoly has price-setting power, the price is set above but within the boundary of the demand curve. Price is set at the highest possible point on the demand curve; P Π-max. Conclusion: P >. The unit-cost picture and the market picture meld (= join) in the case of monopolies. The demand curve is a given but since there is only one supplier, the assumption of profitmax and the entailing = condition turns the monopoly firm s curve into the market supply curve. I actually recommend

4 avoiding the use of supply curve in conjunction with monopoly output. WARNING! Drawing the monopoly diagram The two most common mistakes in dealing with monopoly diagrams are 1) drawing faulty curves, and 2) confusing revenue maximum with the point where the curve intersects with the demand curve. Faulty curves: The diagram on the left below illustrates the first problem. As the must lie halfway between the demand curve and the price-axis, all the curves in blue are incorrect! Only the orange curve is correct. It is amazing how many times one sees this mistake in both economic literature and official exam papers. It s the sort of mistake that, when done by a student, is taken to show sloppiness, lack of understanding, or both. Like drugs, just don t do it. Fig Good diagrams to illustrate monopolies Correct curve curve and unit PED Incorrect curves! Correct curve! No correlation between the two points! Q rev-max The other common mistake is to arrive at the conclusion that the unit elastic point on the demand curve is where the curve will intersect. The diagram on the right shows that while this is possible, shown by the blue curve, any number of curves are also possible which do not intersect the D-curve at the point where PED equals 1. I recommend drawing diagrams that distinctly show that you have not confused this by making sure that your curve passes through the demand curve above or below unit elasticity of demand. Revenue maximising price and output While the profit maximising decision for a monopolist is not different from that of the competitive firm, the pricing decision leads to a higher price than marginal cost, as explained above. In many but far from all cases, the monopoly firm will have an average cost level that is below the price, as shown in figure below, giving the firm an abnormal profit (grey area).

5 Fig Abnormal profits and LR in monopoly Profit-maximising monopoly Revenue-maximising monopoly Abnormal profit P Π-max AC AC Q Π-max Q rev-max Output: Q is set at Q π-max. This is the level where =. Price: The monopoly will set the highest possible price allowed by market demand P π- max. Profit: Entry barriers and lack of substitutes enable the monopoly to reap abnormal profits in the long run. This is shown by the blue area in the diagram; P π-max x (AR AC). The monopoly can forego short run profits in order to maximise revenue. Revenue is maximised when output is set at the unit elastic point on the demand curve which will also be where = 0. Price decreases and output increases compared to profitmax price and output. Revenue increases and profit decreases compared to profitmax price and output. Question: How well do the monopoly firms illustrated above fulfil the criteria for productive efficiency? Since a basic assumption is that there are no competitors i.e. there are no substitute goods and that market entry is severely limited, the firm will be able to enjoy abnormal profits in the long run in addition to short run profits. Firms will be attracted to the market but will be unable to overcome the entry barriers, allowing the existing monopoly to continue to reap abnormal profits. (TYPE 3 MEDIUM HEADING) NORMAL PROFITS AND LOSS IN A MONOPOLY It is possible that the monopoly firm faces market demand that yields less than abnormal profits. Figure shows two possibilities. In the case where the AC curve is tangential to the demand curve (AC 0 ) the monopoly will make a normal profit, as AR equals AC. If average costs are pictured by AC 1, then the total cost per unit is higher than total revenue per unit; the firm will run at a total loss represented by the grey area in the diagram. In keeping with the truism of profitmax and loss-min, the firm with an average cost curve of AC 1 cannot set the price at any other level in order to lower losses; = will render the lowest possible loss to the firm.

6 Fig Normal profit and loss in monopoly P Π-max = P loss-min Loss (AR < AC) Normal profit (AR = AC) AC 1 AC 0 Q Π-max = Q loss-min Output is set according to profitmax/ loss-min criteria, resulting in Qπ-max. AC0: The firm makes a normal profit. AC1: The firm makes a loss. Note that the loss is minimised at Qπ-max and P Π-max at any other level of output and price, the loss would be greater. Hence the use of loss minimum Q loss-min and P loss-min in the diagram.

7 Summary and 1. The assumptions in the monopoly market are: 1) One firm controls the market; 2) There are very high barriers to entry; 3) The firm is a short run profit maximiser 2. Entry barriers include the possibility of technical barriers (proprietary production methods), control of vital factor inputs (raw material such as bauxite for aluminium), legal barriers (intellectual property rights or a state monopoly on tobacco), huge economies of scale (natural monopolies) and the possibility of predatory pricing and/or cartels. 3. As the monopoly enjoys protection from market entry via barriers to entry the firm can make abnormal profits in the long run. 4. In a monopoly, average revenue equals price thus, the demand curve is also the average revenue curve. P = AR = D P π-max AC Q π-max Q rev-max 5. Total revenue is maximised where average revenue is zero this is the same quantity where the price elasticity of demand is unitary. 6. Profit maximising level of output is where marginal costs equal marginal revenue. = ; Q Π-max. Thus, any profit maximising price will always be set along the elastic portion of the demand curve. 7. Quantity at revenue maximising output will always be greater than the profit maximising level of output. Q revmax > Q Π-max