Lecture Principles of economics (Brief edition, 2e): Chapter 7 - Robert H. Frank, Ben S. Bernanke

Chapter 7 - Monopoly, oligopoly, and monopolistic competition. Our agenda in chapter 7 is to develop more carefully and fully the concept of economic surplus introduced in part 1 and to investigate the conditions under which unregulated markets generate the largest possible economic surplus. We will also explore why attempts to interfere with market outcomes often lead to unintended and undesired consequences.

Chapter 7: Monopoly, Oligopoly, and

Monopolistic Competition

1 Distinguish among three types of imperfectly

competitive industries

2 Define imperfect competition and describe how it

differs from perfect competition

3 Describe why economies of scale are the most

enduring source of monopoly power

4 Apply the concepts of marginal cost and marginal

revenue to find the output and price that maximizes

a monopolist's profits

5 Explain why the profit-maximizing output level for a

monopolist is too small from society's perspective

6 Discuss why firms offer discounts to buyers who are

willing to jump a hurdle

Imperfect Competition

• Imperfectly competitive firms have some ability

to set their own price: they are price setters

– Long-run economic profits possible

– Reduce economic surplus

• Three types:

1.Monopoly has only one seller, no close substitutes 2.Monopolistic competition has many firms

producing slightly differentiated products that are

reasonably close substitutes

3.Oligopoly has a small number of large firms

producing products that are close substitutes

Monopolistic Competition

Monopolistic Competition

Number of

Price Limited flexibility

Entry and Exit Free

Economic

Profits Zero in long run

Decisions differentiation P, Q, product

Perfect Competition

Many firms

Price taker

Free Standardized Zero in long run

Q only

Oligopoly

Number of

Entry and

Product Differentiated or standardized

Economic

Decisions P, Q, differentiation, advertising

Perfect Competition

Many firms Price taker

Free Standardized Zero in long run

Q only

The Essential Difference

• Market power is the firm's ability to raise its price

without losing all its sales

• Any firm facing a downward sloping demand curve

– Firm picks P and Q on the demand curve

• Market power comes from factors that limit

competition

Quantity

Imperfectly Competitive Firm

D

Quantity

Perfectly Competitive Firm

D

Market Power: Economies of

Scale

• Returns to scale refers to the percentage

change in output from a given percentage

change in ALL inputs

– Long-run idea

– Constant returns to scale: doubling all inputs

doubles output

– Increasing returns to scale: output increases by

a greater percentage than the increase in inputs

• Average costs decrease as output increases

• Natural monopoly: a monopoly that results from

economies of scale

Market Power: Network

Economies

• Network economies occur when the value of

the product increases as the number of users

increases

– VHS format for video tapes, Blu-ray for DVDs

– Telephones

– Windows operating system

– eBay

– Facebook and MySpace

Economies of Scale and

Start-Up Costs

• New products can have a large fixed development

cost

• Variable cost: sum of payments made to the variable

factors, such as labor

• Fixed cost: sum of payments made to the fixed

factors, such as capital

• Start-up costs can be thought of as a fixed cost

• Average total cost (ATC): total cost divided by output

• A good whose production has a large start-up cost and low variable cost is subject to economies of scale

– ATC declines sharply as output increases

Economies of Scale and

Start-Up Costs

• Consider an example:

• Assume marginal cost (M) is constant

• Variable cost is M*Q

• Total cost is fixed cost (F) plus variable cost

TC = F + M*Q

– Total cost increases as output increases

• Average total cost is

ATC = F / Q + M

– Average total cost decreases as output increases

– Average fixed cost = F/Q

Economies of Scale

Quantity

F

TC = F + M Q

Quantity

ATC = F/Q +

M

M

Profit Maximization for the

Monopolist

• Like all other firms, a monopolist:

– Maximizes profits

– Applies the Cost-Benefit Principle:

• Increase output if marginal benefit > marginal cost

• Decrease output is marginal benefit < marginal cost

• Marginal benefit is called marginal revenue:

– Change in total revenue from a one-unit change in output

– Equal to price for the perfectly competitive firm

– Less than price for the monopolist

Quantity (units/week)

Profit Maximization for the

Monopolist

• To sell another unit the monopolist must lower price

– Total revenue from 2 units = $12

– Total revenue from 3 units = $15

• Marginal revenue = $3

D

2

6

3 5

Deciding Quantity

• Profit is maximized at the

level of output where

marginal cost equals

marginal revenue

• At P = $3 and Q = 12,

MC > MR

• Decrease output

– At Q = 8, MC = MR = 2

• The demand curve sets the

price at P = $4

– At any output below 8,

MC < MR

Quantity (units/week)

3

MC

2

6

D

12

MR

4

8

The Invisible Hand Fails

Quantity (units/week)

The socially optimal amount occurs where

MC = MB, Q = 12 units

and P = $3

The monopolist's optimal amount occurs where

MC = MR, Q = 8 units

and P = $4

2

MR

8

4

24

D

3

12

Deadweight loss from monopoly = $4

Monopoly and Perfect

Competition

Managing Monopoly

• Monopolies exist for economic reasons

– Patents, copyrights, and innovation

– Economies of scale

– Network economies

• Anti-trust laws attempt to limit deadweight loss

– Limiting monopoly has costs

• Patents encourage innovation

• Economies of scale minimize ATC

• Network economies increase benefits

Price Discrimination

• Price discrimination means charging different

buyers different prices for essentially the same

good or service

– Separate the groups

– No side trades among buyers

• Many forms of price discrimination

– Hurdle method: discounts for identifiable groups

(e g., students, AARP)

– Perfect discrimination: negotiate separate deals

with each customer

Hurdle Method of Price

Discrimination

• The hurdle method of price discrimination is the

practice of offering a discount to all buyers who

overcome some obstacle.

– Temporary sales

– Hard cover and paperback books

– Multiple car models from one manufacturer

– Commercial air carriers

– Movie producers and phased releases

– Scratch and Dent appliance sales

Imperfect Competition

Imperfect Competition

Monopolistic Competition

and Oligopoly Sources of Market Power Monopoly