Monopoly handout

# Monopoly handout - Monopoly Handout Spectrum of market...

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Unformatted text preview: Monopoly Handout Spectrum of market structures: competitive markets (many firms, price takers) monopolistic competition (many firms, price makers) oligopoly (few firms, price makers) monopoly (single firm, price maker) A firm is a monopolist if it is the only seller of a good or service with no close substitutes. A monopolist’s profit‐maximization problem: Maxy p(y)y – c(y) First‐order condition: MC(y) = MR(y) = p + p’(y)y Can re‐express as: MC(y) = p[1 + (dp/dy) (y/p)] = p[1 + 1 / (dy/dp) (p/y)] = p[1 + 1/εd] Increasing output has two effects on revenue: increases revenue because firm gets p for marginal unit of output, but decreases revenue because p falls for inframarginal units of output. (This 2nd effect was absent in perfectly competitive market.) For a monopolist, the MR curve is steeper than the market demand curve. Remarks: (1) Perfect competition is a special case where demand facing a firm has εd=‐∞, so MC = p. (2) There are few pure monopolies where there are literally no substitutes at all. The real issue is how much market power a firm has, which depends on the degree of substitutability of its product. To be precise, its elasticity of demand. Market power means that the firm can influence the output price (here, by choosing its level of output). (3) Since the market demand curve gives a 1‐to‐1 relationship between price and output, it is equivalent to think of the firm as choosing a price and then selling as much as it can at the posted price. This is the usual case in reality, but sometimes, it will be analytically convenient to think of the firm as setting output. (4) There is no “supply function / supply curve” because the firm is simply choosing a level of output / price on the demand curve; supply curve presupposes price‐taking (5) Can’t be an optimum when |εd|<1, because MC is always positive. Intuition: If demand is inelastic, firm can increase revenue by cutting output. Hence at the firm’s optimum, it must be that |εd|>1: Monopolist always operates at an elastic part of the demand curve. (6) Optimal price is a markup over MC, where extent of markup depends on elasticity: p = MC / [1 + 1/εd]. Empirically, regulatory agencies use Lerner Index as a measure of monopoly power = (p – MC) / p. Rubber: .049, Retail gasoline: .100, Pepsi: .560, Coca‐Cola: .640. Coca‐Cola sells for 64% more than marginal cost of production. (7) Since p > MC, firm earns positive profit (as long as fixed costs aren’t too big) (more accurately, monopoly rents because earned by the fixed factor (e.g., patent) and possibly purchased) (8) Since output is less than the competitive level, there is DWL 1 What causes monopoly? Barriers to entry. Five main sources (1st three are “artificial”): (1) Collusion (2) Government enforced barriers a. Exclusive franchise granted by government. Ex.: U.S. Postal Service. b. Licensing. Ex.: quality standards for physicians, taxi medallions. c. Patent (temporary grant of monopoly right over a new product or scientific discovery), copyright (grant of exclusive rights to sell a literary, musical, or artistic work). (3) Control of scarce inputs (4) Natural monopoly: A single firm can supply a good or service to an entire market at a smaller cost than could 2 or more firms. Exs.: utilities, railroads, local monopolies (e.g., Ithaca’s 1 gas station). (5) Network economies: On the demand side of many markets, a product becomes more valuable as greater numbers of consumers use it. Exs.: popular bar or club, Microsoft Windows. In the analysis above, we’ve assumed that firms with market power post a single price and charge that price to all consumers. But need not be true when the firm is a price maker. Price discrimination: Selling output to different consumers at different prices. First‐degree (perfect) price discrimination: Firm charges each person a different price. Exs.: haggling in a traditional market, college financial aid. Although all social surplus goes to profit, can lead to a Pareto efficient outcome! Third‐degree price discrimination (a.k.a. market segmentation): Firm has a different posted price for observably different types of consumers. Ex.: student discounts. Second‐degree price discrimination: Firm makes price depend on other choices made by the buyer. Ex.: quantity discounts, coupons. (A firm is a monopsonist if it is the only buyer of a factor of production.) 2 ...
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