Chapter 14 Monopoly BEFORE YOU READ THE CHAPTER. Goldwasser AP Microeconomics

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1 Goldwasser AP Microeconomics Chapter 14 Monopoly BEFORE YOU READ THE CHAPTER Summary This chapter develops the model of monopoly, a situation in which there is a single producer of the good. This chapter explores how the monopolist determines its profit-maximizing price and output. In addition, the chapter compares perfect competition and monopoly and examines how these two different market structures result in different outcomes with respect to social welfare. The chapter also discusses how policymakers address the problems posed by monopoly. The chapter discusses price discrimination and the effects of price discrimination on a market. Chapter Objectives Objective #1. A monopoly is a market characterized by having a single producer of the good, when the good has no close substitutes. Monopolists, unlike perfectly competitive firms, know that their actions affect the market price, and they take this fact into account when deciding how much to produce. Objective #2. There are four principal models of market structure: perfect competition, monopoly, oligopoly, and monopolistic competition. These four types of market structure are distinguished by the number of firms in the market and whether the goods offered in the market are identical or differentiated. In monopoly, a single producer produces a single, undifferentiated product. In oligopoly, a few producers sell products that mayor may not be differentiated. In monopolistically competitive markets, many producers sell differentiated products. In perfect competition, many producers produce identical products. The number of firms in the market is determined by the long-run conditions that make it difficult for new firms to enter the market: these conditions include government regulations that limit entry, the presence of increasing returns to scale in production, technological superiority that limits potential competition, or the control of necessary resources or inputs. When these conditions are present, the market structure tends to be monopolistic or oligopolistic. Objective #3. In contrast to perfect competition, a monopolist produces a smaller quantity and charges a higher price for its product. The monopolist is able to charge a price that is greater than the competitive price because it has market power: it is the only producer of the good and the good has no close substitutes. By charging a higher price and restricting output, the monopolist is able to increase its profit while maintaining positive profits in the long run.

2 Objective #4. Positive economic profits earned by the monopolist continue in the long run because effective barriers to entry prevent new firms from entering the industry. There are four principal barriers to entry: (1) the monopoly controls a scarce resource or input that prevents new firms from being able to compete in the industry; (2) the monopolist enjoys increasing returns to scale and therefore can spread its fixed cost over a larger volume of output, resulting in the monopolist having lower average total costs than potential competitors; (3) the monopolist enjoys technological superiority over its potential competitors; and (4) the monopolist is protected from competition due to government created barriers. Increasing returns to scale results in lower costs of production as the size of the firm increases. In the case of a monopoly with increasing returns to scale, the single firm finds that its cost of production falls throughout the relevant range of production. Any potential competitor would face higher costs per unit. Natural monopolies are an example of a monopoly that benefits from increasing returns to scale. With technological superiority some monopolists also experience network externalities, which is a condition that arises when the value to a consumer of a good increases as the number of people who use the good increases. This advantage may allow the producer to become a monopolist. The most important government-created barrier to entry takes the form of patent protection. A similar type of protection afforded producers is the copyright. Objective #5. The monopolist's demand curve for its product is the market demand curve, since it is the only provider of the good in the market. Since the monopolist's demand curve is downward sloping, this implies that the monopolist can only sell additional units of the good by lowering the price on all the units it sells: this results in the monopolist's marginal revenue (MR) curve being beneath the monopolist's demand curve. An increase in production by a monopolist has two opposing effects on revenue: a quantity effect and a price effect. When the monopolist sells one more unit of the good, this increases its revenue by the price at which the unit is sold: this is the quantity effect. When the monopolist sells one more unit of the good, it must reduce the price on all units sold, which decreases revenue: this is the price effect. A firm with market power will find that its MR curve always lies beneath its demand curve due to the price effect. At low levels of output the quantity effect is stronger than the price effect, and the monopolist will find that its total revenue increases as it increases its level of production. At high levels of output the price effect is stronger than the quantity effect, and the monopolist will find that its total revenue decreases as it increases its level of production.

3 Figure 14.1 illustrates a linear demand curve for a monopolist as well as the monopolist's MR curve. Notice that the MR curve bisects the distance between the origin and the horizontal intercept of the demand curve. This implies that the slope of the MR curve is twice the slope of the demand curve. Notice also that the y-intercept for the demand curve and the MR curve are the same. Objective #6. The monopolist maximizes profit by producing the output at which marginal revenue equals marginal cost (MR = MC) for the last unit produced while charging the price consumers are willing to pay for this output. The profitmaximizing price-quantity combination is always a point on the demand curve. Figure 14.2 illustrates this concept.

4 Objective #7. Just as with perfect competition, the monopolist's profits are equal to total revenue minus total cost (TR - TC). However, the monopolist can earn profits in the short run as well as the long run since there are effective barriers to entry that protect the monopolist from competition. Figure 14.3 illustrates a monopolist's profit: note that when the price the monopolist charges is greater than its average total cost, then the monopolist earns positive economic profit. Objective #8. In a perfectly competitive industry, each firm equates the marginal cost to the price of the good; in contrast, in a monopoly the price of the good is always greater than the marginal cost at the profit-maximizing level of output. This tells us that the monopolist is not producing the efficient level of output, since the price consumers are willing to pay for the last unit produced is greater than the cost of producing the last unit. Too few resources are being devoted to the production of the monopolist product. A monopoly, compared with a perfectly competitive industry, restricts output, charges a higher price for the product, and earns a profit that is not eliminated through the entry of new firms in the long run.

5 Objective #9. Monopoly causes a net loss to the economy because the cost to the consumer is greater than the gain to the monopolist. The existence of a monopoly creates a deadweight loss due to the monopolist's restriction of output and its ability to charge a higher price for its product relative to the quantity and price decision made by a perfectly competitive firm. The deadweight loss created by the monopolist occurs because some mutually beneficial transactions do not occur: this is evident when we recall that for the last unit produced by the monopolist, the marginal cost of producing that unit is less than the price consumers are willing to pay for that unit. Because monopoly is inefficient, government policy often is used to offset some of the undesired effects of monopoly. Figure 14.4 indicates for a monopolist the areas that correspond to consumer surplus, producer surplus, and deadweight loss. Objective #10. If an industry is not a natural monopoly, then the best method for avoiding monopoly outcomes is to prevent monopoly from arising or to break up the monopoly if it already exists. Government policies used to prevent or eliminate monopolies are known as antitrust policy. Objective #11. If an industry is a natural monopoly, then breaking up the monopoly is not a clearly beneficial idea since large-scale producers have lower average total cost than smaller scale producers. Two policy methods are used for regulating natural monopolies: public ownership and regulation. With public ownership, the government establishes a public agency to provide the good and to protect consumers' interests. With public ownership, it is possible to set the price at the efficient level so that P = MC for the last unit being produced by the natural monopoly. Unfortunately, publicly owned natural monopolies are not always successful at minimizing their costs or at providing high-quality products. Publicly owned companies may also end up serving political interests.

6 Regulation typically takes the form of price regulation, where the private company is regulated with regard to what prices it can charge for the product. Local utilities are frequently regulated in this way. With price regulation the monopolist produces a higher level of output and sells this output at a lower price, provided that the regulated price is set at a level greater than the firm's marginal cost and is high enough that the firm at least breaks even on total output. Price regulation increases the area of consumer surplus because the regulation reduces the monopolist's profit and results in more output at lower prices. The price set by regulators is ideally set so that price equals average total cost, but monopolies have an incentive to exaggerate their costs to regulators, making it difficult for regulators to ascertain this ideal price. Additionally, regulated monopolies often provide inferior quality to consumers. Objective #12. Price discrimination refers to a situation in which a firm with market power charges different prices to different customers. Instead of offering the good at a single price, the firm with market power offers the good at multiple prices depending on the characteristics of the consumer. The firm will find that its profit increases if it charges a higher price to the consumers of the good who have price inelastic demand, and a lower price to the consumers of the good who have price elastic demand. Common techniques for price discrimination include: Advance purchase restrictions-the earlier you purchase, the lower the price you pay. Volume discounts-the larger the quantity you buy, the lower the price per unit. Two-part tariffs-you pay an annual fee plus the cost of whatever items you purchase, thereby effectively creating a volume discount. Objective #13. Perfect price discrimination occurs when the monopolist is able to capture the entire consumer surplus. The greater the number of prices the monopolist charges, the more money it extracts from consumers. In addition, the greater the number of prices the monopolist charges, the closer the lowest price will get to the marginal cost of producing the last unit of the good. A monopolist who practices perfect price discrimination does not cause any inefficiency, since the marginal cost of producing the last unit exactly equals the price of this last unit. But with perfect price discrimination, the consumer's surplus is equal to zero since this entire surplus is captured by the producer.

7 Key Terms Notes monopolist a firm that is the only producer of a good that has no close substitutes. monopoly an industry controlled by a monopolist. market power the ability of a producer to raise prices. barrier to entry something that prevents other firms from entering an industry. Crucial in protecting the profits of a monopolist. There are four types of barriers to entry: control over scarce resources or inputs, increasing returns to scale, technological superiority, and government created barriers such as licenses. natural monopoly a monopoly that exists when increasing returns to scale provide a large cost advantage to having all output produced by a single firm. patent a temporary monopoly given by the government to an inventor for the use or sale of an invention. copyright the exclusive legal right of the creator of a literary or artistic work to profit from that work; like a patent, it is a temporary monopoly. public ownership when goods are supplied by the government or by a firm owned by the government to protect the interests of the consumer in response to natural monopoly. price regulation a limitation on the price a monopolist is allowed to charge. single-price monopolist a monopolist that offers its product to all consumers at the same price. price discrimination charging different prices to different consumers or the same good. perfect price discrimination when a monopolist charges each consumer the maximum that the consumer is willing to pay.

8 AFTER YOU READ THE CHAPTER Tips Tip #1. It is important that you understand why the monopolist has a downwardsloping MR curve that lies beneath the monopolist's demand curve and how to find this MR curve. When the monopolist thinks about increasing the amount of the good it supplies to the good. But it also knows that to sell more units of the good it will need to lower the price on all the units of the good it sells, so the decision to sell a larger amount of the good has two effects-one effect adds to the monopolist's revenue, but the second effect decreases the monopolist's revenue. Review this analysis until you understand it and can express it clearly. Tip #2. To find the monopolist's MR curve is a relatively simple matter if the demand curve for the monopolist is linear. For a linear demand curve, the MR curve has the same y-intercept as the demand curve and twice the slope of the demand curve. For example, if the demand curve is expressed as P = 1,000-2Q, then the MR curve is MR = 1,000-4Q. Another way of expressing this idea is to realize that the MR curve bisects the horizontal distance between the origin and the x-intercept of the demand curve. Figure 14.5 illustrates this concept. Tip #3. Notice the relationship between the elasticity of the linear demand curve and its MR curve. Marginal revenue is positive in the elastic portion of the demand curve, marginal revenue equals 0 at the unit-elastic point (the midpoint) of the demand curve, and marginal revenue is negative in the inelastic portion of the demand curve. Tip #4. This chapter continues the use of cost curves and marginal analysis. If you are still having trouble with the terminology related to cost curves, or with your understanding and use of these concepts, you should return to Chapter 12 on production and cost and review this material. To work successfully with this material, you must have a very strong understanding (and not just memorization) of these underlying concepts.