Unformatted text preview: Lecture 14 Lecture 14 Monopoly The definition of monopoly – From the Latin: “single seller” A structural view – Unique product — famous athlete – Large relative to market — Michelin tires A theoretical view – Must lower price to sell more units – Must find best price for output, so often called “price searcher” or “price maker” Sources of monopoly Sources of monopoly Unique talent – Beatles, Bono, Yao Ming Patent or copyright
– Pentium chip Location – Magazine stand at airport Regulation
– Taxicabs Collusion
– OPEC Consider this Price Maker Market Consider this Price Maker Market
You think so hard in econ class you have a headache! You go to buy a bottle of 100 generic aspirin. Consider these options: WalMart Grocery Store Convenience store Which is highest price and lowest price? Is the market competitive? What does monopoly mean in practice? How can the seller get the How can the seller get the consumer surplus? How about an auction? English auction: seller lets demanders bid against each other (moving up the demand curve) so the demander who has the highest value pays close to that (volunteering to give the seller the consumer surplus). Dutch auction: seller starts at a very high price and comes down until a demander makes a bid. This works in some markets, but in many markets the seller must choose one price. The winner of an auction is said to suffer from a “winners curse.” Why is that? Marginal Revenue schedule Marginal Revenue schedule Marginal revenue (MR) is the change in total revenue (TR) when there is a change in quantity (Q) sold. To sell more, you must cut price (P) – move down the demand curve – so MR is always less than P. Price to the seller is the revenue received. Because a price cut to sell more units reduces revenue on “earlier” units, extra revenue (the marginal revenue) is less than price. Assuming all sales at the same price — P is Average Revenue — measured by the Demand Curve. Anatomy of a Demand Curve Anatomy of a Demand Curve
Demand reflects what consumers pay for a good. They pay a price, P’, which $ is Average Revenue to the seller (AR). Total revenue in D = AR a given time period is P’ P’ x Q’ = TR. Marginal Revenue (MR) is the MR change in TR given a change in Q sold, which Q’ Q requires P to change. Madonna’s problem: Madonna’s problem:
How many songs? TC Q Price TR MC 3.5 1 $10m/song 10 3.5 7 2 9 18 3.5 10.5 3 8 24 3.5 14 4 7 28 3.5 17.5 5 6 30 3.5 21 6 5 30 3.5 24.5 7 4 28 3.5 28 8 3 24 3.5 At each price, recording company demands (will buy) the number of songs shown, Q Pricequantity combinations shown are points on demand curve What is the best price; or how many songs? Is maximum total revenue the best solution? Marginal revenue is less than price Marginal revenue is less than price
New TC MR Q Price TR MC 3.5 10 1 $10m/song 10 3.5 7 8 2 9 18 3.5 10.5 6 3 8 24 3.5 14 4 4 7 28 3.5 17.5 2 5 6 30 3.5 21 0 6 5 30 3.5 24.5 2 7 4 28 3.5 28 4 8 3 24 3.5 What is the most profitable P and Q? The solution: marginal revenue = marginal cost The solution: marginal revenue = marginal cost
New TC Profit MR Q Price/song TR MC 3.5 6.5 10 1 $10m 10 3.5 7 11 8 2 9 18 3.5 10.5 13.5 6 3 8 24 3.5 14 14 4 4 7 28 3.5 17.5 12.5 2 5 6 30 3.5 21 9 0 6 5 30 3.5 24.5 3.5 2 7 4 28 3.5 28 4 4 8 3 24 3.5 Find the price that maximizes profits for Madonna (the seller) The solution: Choose Q such that MR = MC Note that P > MC at best Q The solution graphically The solution graphically
The profitmaximizing price is the one that induces demanders to choose Q such that MR = MC $ At any higher price, MR > MC lost profits P*=7 At any lower price, MC=3.5 MC = S MR < MC lost profits D MR Only at P* is MR = MC maximum profits Quantity 1 2 3 4 5 6 7 8 The Price Maker: Common in The Price Maker: Common in Highly Competitive Markets
Setting price at movie theater that has 1,000 seats in it.
Assume fixed costs of $2,000 for movie rental, $250 for labor, & $250 for building per night. $ $6 $5 MR 400 500 600 Q D You know your customers from $4 experience—what price do you charge if only one price can be set? Highly competitive market for entertainment dollars. Setting Prices Setting Prices
What is Marginal Cost in this situation? All costs are fixed, so MC = $0 At what quantity does MC = MR? 500 seats What price can be charged? $5 What is Total Revenue? TR = P * Q = $5 x 500 = $2500 Can we do better? Can we do better?
There are unsold seats — and it costs nothing to service another customer — so should we cut the price to $4 to fill more seats? Look at change in Total Revenue. We can gouge some customers for more as many value the movie more than $5 — so can we do better by charging a higher price, say $6? Look at change in Total Revenue. Nothing beats the golden rule of MC = MR Same example with positive MC Same example with positive MC
Now presume movie distributor charges a rental fee of $2 per customer let into the theater. $ Building cost of $250 and labor cost $6 Of $250 per night are still fixed. What is profit maximizing price to charge? Same rule: MC = MR Compare this to if you cut price to $5 and get 500 patrons or raise price to $7 and get 300 patrons. MR $2 D M C 400 Q Questions to Ponder Questions to Ponder
This is called the monopoly pricing model or price maker model. The market for movie theaters is competitive —between theaters as well as with substitutes such as DVDs. The market is competitive, but firms act as if they are a monopoly. It Depends What You Are Selling It Depends What You Are Selling
Parker Hannifin: Industrial parts maker: $9.4 billion revenue 2006; 800,000 parts sold. Traditional policy: “cost” plus 35% (the “strategy” used by ~ 60% US manufacturers) Net income in 2002: $130 million Net income in 2006: $673 million Return on invested capital up from 7% to 21% in same time. How: Be a “monopolist” when possible Some things are “monopolistic” Some things are “monopolistic” Some are not.
New Strategy: 4 Basic Categories of products A. Ones in highly competitive markets—charge the market price; no price changes B. Partially differentiated products—common products changed a bit for a customer; prices up 09% C. Differentiated products—engineered for a customer; up 025% D. Specials—custom designed; no close substitutes; prices up over 25% The cartel solution… The cartel solution… The completive outcome is at (Pc, Qc) with P = MC But for the industry as a whole, MR < MC lost profits Cartel solution is MR = MC (Pm, Qm) and max. profits MCi S=∑MCi Pm Pc D MR qm qc Qm Qc To achieve Qm, each firm must restrict its output to qm BUT—the incentive to cheat is huge How to enforce? How to enforce? Techniques to prevent cheating
– Require posting of prices – Central office – Violence DeBeers and diamonds OPEC Cheating temptation enormous Government is best at this Monopoly Question Monopoly Question Suppose only one train company (a private company) that operates between Beijing and Shanghai. Is the train company a monopoly? Can it charge any price it wishes? Ending Monopolies Ending Monopolies Suppose you have industries that have been protected by the government against competition for many years. If the protection is removed and the industries become competitive, what will happen? Effect of Ending Protection from Effect of Ending Protection from Competition
Price Reductions in the U.S. Following Deregulation Billions of 1995 Dollars Industry Price Reduction after: Annual 2 yrs. 5 yrs. 10 yrs. Savings Natural Gas 1038% 3445% 2757% n.a. Long Distance 516% 2341% 4047% $5 Airlines 13% 12% 29% $19.4 Trucking n.a. 317% 2856% $19.6 Railroads 4% 20% 44% $9.1 ...
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- Fall '07
- Monopoly, OPEC