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Unformatted text preview: PADP 6950: Founda1ons of Policy Analysis Perfect Compe,,on & Monopoly Angela Fer1g, PhD Perfect Compe11on Perfect compe11on is a type of market with: Large numbers of buyers and sellers Firms that produce a homogeneous good Free entry and exit Since firms are numerous and all produce the exact same good, no firm has the ability to charge anything but the prevailing market price Each firm is so small compared to the whole market that it cannot affect the market price no maKer how much it produces If any firm tried to charge more than the market price, it would lose all its customers to other firms Firms are "price takers" because they take the market price as given Likewise, each consumer is too small compared to the whole market to affect the market price, so the consumer is also a price- taker 1 Demand curve facing compe11ve firm Because each firm is a price taker, it views its demand curve as perfectly elas1c: P P* d = MR q Profit maximiza1on for compe11ve firm To find the profit-maximizing quan1ty, the firm compares MR and MC: P MC P* d=MR q* q 2 Short-run to long-run industry adjustment Assume a perfectly compe11ve firm earns posi1ve profit in the short-run P MC AC P* d=MR q q* Then, new firms enter the market P S P MC AC d=MR P1 P2 D Q1 Q2 Q q2 q1 Long run competitive equilibrium: q Industry Q increases Firm's q decreases Profit = 0 P = min. AC 3 Monopoly Monopoly is a type of market with: One seller No subs1tutes available for the good Barriers to entry Since there is only one firm, the firm's decisions about quan1ty affect the price of the good If the firm charges a high price, they will only sell a small quan1ty, and vice versa Monopolies are "price seKers" because their decisions affect the market price We assume, as before, that each consumer is too small compared to the whole market to affect the market price, so the consumer is s1ll a price-taker Demand curve facing monopoly Because a monopoly is the only firm in the market, it views its demand curve as the market demand curve: P d q 4 Marginal revenue for a monopoly Marginal revenue (MR) is defined as the change in total revenue that results from producing an addi1onal unit: MR = TR / Q For a monopoly that can only charge one price: If want to sell one more unit of Q , then must lower P for all units so: TR=P1-Q0(P0-P1) Marginal revenue curve for monopoly P MR d q 5 Profit maximiza1on for monopoly To find the profit-maximizing quan1ty, the firm compares MR and MC (same solu1on, different graph): P MC AC P* 2 1) Find Q* where MR=MC 2) Find P* such that demand would be Q* 1 MR Q* D d=MR q Profit, price, and quan1ty with monopoly Posi1ve profits in the long-run Eqbm monopoly price (P*) > eqbm compe11ve price (Pc) Eqbm monopoly Q* < eqbm compe11ve market Qc P MC AC P* Pc D MR Q* Qc Q 6 Why we don't like monopolies 1. They are Pareto inefficient There is someone willing to pay more for an extra unit of output than it costs to produce that extra unit there is room for Pareto improvement P MC P* D MR Q* Q Why we don't like monopolies 2. There is a deadweight loss P MC Comp CS A+B+C D+E Monop A B+E Diff -B-C +B-D A P* Pc B E C D D MR Q* Qc Q PS Total A thru E A+B+E -C-D 7 This is why we have An1trust Laws An1trust laws Ban prac1ces that restrict compe11on Regulate behavior of monopolists Supervise mergers and acquisi1ons which may lead to monopolies Some1mes we need monopolies When we want to encourage investments We give patents (creates temporary monopoly power) E.g. pharmaceu1cal industry: each drug requires years of investment and in order to get FDA approval must reveal produc1on secrets, so must have patents or no firm would produce drugs Natural monopolies When there are economies of scale so bigger is beKer for consumers Happens when there are high fixed costs and low marginal costs 8 Policy op1ons Grant a public franchise to a par1cular firm and regulate the price the firm charges to make sure the price does not get excessively high Because a really high price would create a large DWL And possibly restrict access to essen1al services like water, power, telephone, and cable TV Regulatory Op1on #1: An unregulated public franchise One possibility is to do nothing and simply let the firm maximize its profits P MC CS PM ATCM profit DWL ATC MR D Q QM QC 9 Regulatory Op1on #2: Average Cost Pricing We could let the firm charge a price just high enough to earn normal rate of return (profit = 0 and P = ATC). This is called average cost pricing P CS MC PAC=ATCAC ATC DWL MR QAC D Q Regulatory Op1on #3: Marginal Cost Pricing A third alterna1ve is to force the firm to charge the efficient price (P = MC) This is called marginal cost pricing P CS ATCMC PMC=MCMC losses losses MC ATC D QMC Q 10 Comparison of Regulatory Alterna1ves As you move from unregulated monopoly to AC pricing to MC pricing, outcomes get more efficient but regulatory costs increase: P M ACP MCP MR D MC ATC Q Measuring Monopoly Power A firm may have market power even if it is not literally a monopolist But the closer it is to being a monopolist, the more market power it will have There are many ways to measure the extent of market power in an industry One popular measure is called the Lerner Index: L = (P MC) / P L is the % markup of P above MC (higher L means less compe11ve) Note that L = 0 for perfect compe11on because P = MC 11 Herfindahl-Hirschman Index (HHI) Regula1ng mergers and acquisi1ons is part of federal an1-trust policy. In deciding whether or not to allow a merger, especially between two large firms, the government wants to make sure that compe11on in the industry will not be reduced too much by the merger To determine this, a numerical measure of the degree of compe11on in the industry (both before and
aser the proposed merger) is required. One possible measure is the Herfindahl-Hirschman index, which is the sum of squared market shares of the firms in the industry: HHI = s12 + s22 + ...+ sn2 Examples: (lower number is more compe11ve) 1 dominant firm: HHI = 852+52+52+52=7300 100 small firms: HHI = 12*100=100 A firm's "market share" is the percentage of total industry sales made by that firm. Thus, the HHHI measures the extent to which market share is concentrated in the top firms. If the HHI is already large (e.g., between 1000 and 1800), then the Jus1ce Department may block the merger if it would increase the HHI by more than 100 points. PRICE DISCRIMINATION Price discrimina1on is the prac1ce of charging different prices to different consumers of same good It is a tac1c that firms with market power some1mes use in order to increase their profits To be able to prac1ce PD, need: Market power (ability to set the price of your product) Ability to iden1fy and separate customers w/ different marginal benefits Ability to prevent resale of the good 12 Price Discrimina1on Examples of PD: Airlines (business vs. vaca1on travel) Colleges (tui1on discounts based on need/ability) Movies (students vs. non-students) Restaurants (senior ci1zens discounts) Coupons We will discuss 2 different types of price discrimina1on Regular and perfect Price Discrimina1on Price discrimina1on is where the firm is able to dis1nguish between groups of buyers with different marginal benefits, but is not able to discern every single buyer's marginal benefit The firm is able to convert some, but not all, of the consumer surplus into monopoly profits P P1 P2 P3 MR Q1 Q2 Q3 CS CS PS CS PS PS DWL D Q MC 13 Perfect Price Discrimina1on Perfect price discrimina1on is where you charge each customer the maximum he or she is willing to pay for the good (you charge them their marginal benefit) To sell a larger quan1ty, you only have to cut the price to the marginal buyer, not the inframarginal ones Therefore MR is equal to the consumer's MB on each unit sold, so the MR curve is the demand curve: P MC PS D = MR Q* Q 14 ...
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- Spring '11