Demand, AR, MR, AR and elasticity The demand curve facing of monopoly firm is market demand curve.. Considered Example A rule of thumb for pricing We know that price and output
Trang 1Chapter 10 Market Power: Monopoly and Monopsony
Topics to be discussed
1 Monopoly
2 Monopoly Power
3 Sources of Monopoly Power
4 The Social Cost of Monopoly Power
5 Monopsony
6 Monopsony Power
7 Limiting Market Power: The Anti-trust Law
A monopoly is a market that has only one seller but many buyers
A monopsony is just the opposite: a market with many sellers but only one buyer
Pure monopoly is rare, but in many markets only a few firms compete with each other
Market power: Ability of a seller of buyer to affect the price of a good
10.1 Monopoly
A monopoly market is characterized by:
A single seller
No close substitutes and
Effective barriers entry
The barriers entry may exist for three reasons
Economies of scale
Actions by firm and/or
Actions by government
There are three kinds of monopoly in economy
Natural monopoly
Regulated monopoly (by government regulation)
Local monopoly
Explain natural monopoly
Trang 2 The monopolist is the market and completely controls the amount of output offered for sale
Demand, AR, MR, AR and elasticity
The demand curve facing of monopoly firm is market demand curve
Since the market demand curve is a downward sloping curve, the marginal revenue will be less than the price of the goods
Marginal revenue is
Positive when demand is elastic
Zero when demand is unit elastic
Negative when demand is inelastic
Trang 3 Average Revenue and Marginal Revenue
Marginal revenue: Change in revenue resulting from a one unit increase in output
Trang 4 The monopolist’s Output Decision
Maximization condition
MR = MC
Output 0
1 2 3
$ per unit of output
4 5 6 7
Average Revenue (Demand)
Marginal Revenue
Marginal Revenue
Lost profit
Lost profit
P 1
Q 1
Lost profit
P 1
Q 1
Lost profit
MC
AC
MC
AC
Quantity
$ per unit of
output
D = AR MR
D = AR MR
P*
Q*
P*
Q*
P 2
Q 2
P 2
Q 2
Trang 5 Considered Example
A rule of thumb for pricing
We know that price and output should be chosen so that marginal revenue equals marginal cost, but how can the manager of a firm find the correct price and output level in practice? We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in
practice
A rule of thumb for pricing
Q* is the output level at which MR = MC If the firm produces a smaller output-say, Q1 – it sacrifices some profit because the extra revenue that could be earned from producing and
selling the units between Q1 and Q* exceeds the cost of producing them Similarly, expanding output from Q* to Q2 would reduce profit because the addition cost would exceed the
additional revenue
P
Q Q
P E
Q
P P
Q P P Q
P Q P MR
Q
PQ Q
R MR
d
3
2
) (
1
d
d
E P
P MR
E Q
P P
Q
1
5
1
4
D
D D
E 1 1
MC P
E E
1 P P
MC MR
@ maximized is
1
.
6
= the markup over MC as a percentage of price (P-MC)/P
d
E
1
7
8 The markup should equal the inverse of the elasticity of demand
Trang 6 Discussion Example and Example 10.1
Shifts in demand
o In the competitive market
The supply curve is determined by marginal cost
o In the monopoly market
The output is determined depend not only on marginal cost but alsi on the shape of the demand curve
9 4
1 1
9
9 4
1 1
9
P
MC E
Assume
E
MC P
d
d
D 2
MR 2
D 2
MR 2
D 1
MR 1
D 1
MR 1
Quantity
MC
$/Q
P 2
P 2
P 1
Q = Q
P 1
Q = Q
D 1
MR 1
D 1
MR 1
MC
$/Q
MR 2
D 2
MR 2
D 2
P 1 = P 2
P 1 = P 2
Trang 7 The effect of a Tax
o Under monopoly, however, price can sometimes rise by more than the amount of the tax
o MC = MC + t
o MR = MC + t optimal production decision
o Question
Suppose Ed = -2
How much would the price change?
Shifting the demand curve shows that a monopolistic market has no supply curve – i.e., there
is no one-to-one relationship between price and quantity produced In (a), the demand curve
D1 shifts to new demand curve D2 But the new marginal revenue curve MR2 intersects marginal cost at the same point that the old marginal revenue curve MR1 did The profit-maximizing output therefore remains the same, although price falls from P1 to P2 In (b), the new marginal revenue curve MR2 intersects marginal cost at a higher output level Q2 But because demand is now more elastic, price remains the same
Quantity
$/Q
MC
D = AR
MR
D = AR
MR
Q 0
P 0
Q 0
t
MC + tax
t
Q 1
P 1
P
Increase in P: P 0 P 1 > increase in tax
Q 1
P 1
P
Increase in P: P 0 P 1 > increase in tax
tax.
the
by twice increases
Price
2 2
) (
2
to increases If
2 2
If
1 1
t MC t
MC P
t MC MC
MC P
E
E
MC P
d
d
Trang 8 The Multiplant Firm
o For many firms, production takes place in two or more different plants whose operating costs can differ What should its total output be and how much of that output should each plant produce?
o We can find the answer intuitively in two steps
Step 1: Whatever the total output, it should be divided between the two plants so that marginal cost is the same in each plant
Step 2: We know that total output must bu such that marginal revenue equals marginal cost
o We ca also derive this result algebraically
Similarly, we can set incremental profit from output at plant 2 to zero,
MR = MC2
o Putting these relation together, we see that the firm should produce so that
MR = MC1 = MC2
2 1
2 2
1 1
Output Total
2 Plant for
Cost
&
Output
&
1 Plant for
Cost
&
Output
&
Q Q Q
C Q
C Q
T
0 )
(
) ( )
(
1
1 1
1
2 2 1
1
Q
C Q
PQ Q
Q C Q
C PQ
T
T
Algebraically:
1
1
1 1
0 )
( ) ( ) (
MC MR
Q
C MC Q
PQ
Quantity
$/Q
D = AR
MR
D = AR
MR
MC 1 MC 2
MC 1 MC 2
MC T
MR*
Q 1 Q 2 Q 3
P*
MC T
MR*
Q 1 Q 2 Q 3
P*
Trang 910.2 Monopoly power
Monopoly is rare Markets in which several forms compete with one another are much more common
However, a market with several firms, each facing a downward sloping demand curve will produce so that price exceeds marginal cost
Measuring Monopoly power
o In perfect competitive market P = MC
o In monopoly market P > MC
o This measure of monopoly power, introduced by economist Abba Lerner in
1934, is called the Lerner Index of Monopoly Power
Production with two plants A firm with two plants maximizes profits by choosing output levels Q 1 and Q 2 so that marginal revenue MR (which depends on total output) equals marginal costs for each plant, MC 1 and
MC 2.
At a market price
of $1.50, elasticity of demand is -1.5.
Quantity 10,000
2.00
Q A
1.50
1.00
2.00
1.50
1.00
1.40 1.60
D A
MR A
D A
MR A
Market Demand
Firm A sees a much more
elastic demand curve due to
competition E d = -.6 Still
Firm A has some monopoly power and charges a price
which exceeds MC.
Firm A sees a much more
elastic demand curve due to
competition E d = -.6 Still
Firm A has some monopoly power and charges a price
which exceeds MC.
MC A
MC A
Part (a) shows the market demand for toothbrushes Part (b) shows the demand for toothbrushes as seen by firm A.
At a market price of 1.50 $, elasticity of market demand is -1.5 Firm A, however, sees a much more elastic demand curve D A because of competition from other firms At a price of 1.50$, firm A’s demand elasticity is -6 Still, firm A has some monopoly power: Its profit-maximizing price is 1.50$, which exceeds marginal cost.
Trang 10 Lerner’s Index of Monopoly Power
The larger the value of L (between 0 and 1) the greater the
monopoly power
Monopoly power does not guarantee profits
Profit depends on average cost relative to price
Question:
Can you identify any difficulties in using the Lerner Index (L) for
public policy?
10.3 Sources of Monopoly Power
Why do some firms have considerable monopoly power while other firms have little
or none?
The Rule of Thumb for Pricing
If E d is large, markup is small
If E d is small, markup is large
Ed
MC P
1 1
Quantity Quantity
AR
MR
MR
AR
AR
MR
MR
AR
P*
P*
P*-MC
The more elastic is demand, the less the markup.
P*
P*
P*-MC
The more elastic is demand, the less the markup.
The markup (P-MC)/P is equal to minus the inverse of the elasticity of demand facing the firm If the firm’s demand is elastic as in (a), the markup is small and the firm has little monopoly power The opposite is true if demand is relatively inelastic, as in (b)
Trang 11 Thus, monopoly power depends on a firm’s elasticity of demand Three factors determine a firm’s elasticity of demand
o The elasticity of market demand
o The number of firms in the market
o The interaction among firms
10.4 The Social Costs of Monopoly Power
Monopoly power results in higher prices and lower quantities
However, does monopoly power make consumers and producers in the aggregate better or worse off?
Rent Seeking
o Firms may spend to gain monopoly power
Lobbying
Advertising
Building excess capacity
o The incentive to engage in monopoly practices is determined by the profit to
be gained
o The larger the transfer from consumers to the firm, the larger the social cost
of monopoly
Price Regulation
o Recall that in competitive markets, price regulation created a deadweight loss
o Question:
What about a monopoly?
B A
Lost Consumer Surplus
Deadweight Loss
Because of the higher price, consumers lose
A+B and producer gains A-C.
C B A
Lost Consumer Surplus
Deadweight Loss
Because of the higher price, consumers lose
A+B and producer gains A-C.
C
Quantity
AR MR
AR MR
MC
Q C
P C
Q C
P C
P m
Q m
P m
Q m
$/Q
AR
MR
AR
MR
MC
P m
Q
AC
MC
P m
Q
AC
P 1
Q
Marginal revenue curve when price is regulated
to be no higher that P 1 .
P 1
Q
Marginal revenue curve when price is regulated
to be no higher that P 1 .
$/Q
Quantity
P 2 = P C
Q
P 2 = P C
Q
P 3
P 3
Trang 12 Natural Monopoly
o Natural monopoly: Firm that can produce the entire output of the market at a cost lower than what it would be if there were several firms
Regulation in practice
o It is often difficult to determine these prices accurately in practice because the firm’s demand and cost curves may shift as market conditions evolve
If left a lone, a monopolist produces Q m and charges P m When the government imposes a price ceiling of P 1 the firm’s average and marginal revenue are constant and equal to P 1 for output levels up to Q 1 For larger output levels, the original average and marginal revenue curves apply The new marginal revenue curve is, therefore, the dark purple line, which intersects the marginal cost curve at Q 1 When price is lowered to P c , at the point where marginal cost intersect average revenue, output increases to its maximum Q c This is the output that would be produced by a competitive industry Lowering price further, to P 3 , reduces output to Q 3 and causes a shortage, Q’ 3
– Q 3
MC
AC MC AC
AR MR
AR MR
$/Q
Quantity
Setting the price at P r
yields the largest possible output;excess profit is zero.
Q r
P r
Setting the price at P r
yields the largest possible output;excess profit is zero.
Q r
P r
P C
Q C
If the price were regulate to be P C, the firm would lose money and go out of business.
P C
Q C
If the price were regulate to be P C, the firm would lose money and go out of business.
P m
Q m
Unregulated, the monopolist
would produce Q mand
charge P m
P m
Q m
Unregulated, the monopolist
would produce Q mand
charge P m
A firm is a natural monopoly because it has economies of scale (declining average and marginal costs) over its entire output range If price were regulated to be P c , the firm would lose money and go out of business Setting the price at P r yields the largest possible output consistent with the firm’s remaining in business; excess profit is zero.
Trang 13o Rate-of-Return Regulation
The maximum price allowed by a regulatory agency is based on the (expected) rate of return that a firm will earn
Unfortunately, difficult problems arise when implementing rate-of-return regulation
First, although it is a key element in determining the firm’s rate of return, a firm’s capital stock is difficult to value
Second, while a “fair” rate of return must be based on the firm’s actual cost
of capital, that cost depends in return on the behavior of the regulatory agency (and on investors’ perceptions of what future allowed rates of return will be)
o An alternative pricing technique -rate-of-return regulation allows the firms
to set a maximum price based on the expected rate or return that the firm will earn
P = AVC + (D + T + sK)/Q, where
P = price, AVC = average variable cost
D = depreciation, T = taxes
s = allowed rate of return, K = firm’s capital stock
o Using this technique requires hearings to arrive at the respective figures
o The hearing process creates a regulatory lag that may benefit producers (1950s & 60s) or consumers (1970s & 80s)
o Question
Who is benefiting in the 1990s?
10.5 Monopsony
Monopsony refers to a market in which there is a single buyer
An oligopsony is a market with only a few buyers
Monopsony power: Buyer’s ability to affect the price of a good
Marginal value: additional benefit derived from purchasing one more unit of a good
Marginal expenditure: additional cost of buying one more unit of a good
Average expenditure: Price paid per unit of a good
Quantity Quantity
AR = MR
D = MV
ME = AE
P*
Q*
ME = MV at Q*
ME = P*
P* = MV
ME = AE
P*
Q*
ME = MV at Q*
ME = P*
P* = MV
P*
Q*
MC
MR = MC P* = MR P* = MC
P*
Q*
MC
MR = MC P* = MR P* = MC
In (a), the competitive
buyer takes market price P *
as given ME & AE are
constant & equal; quantity
purchased is found by
equating price to marginal
value (demand) In (b), the
competitive seller also
takes price as given MR
and AR are constant and
equal; quantity sold is
found by equating price to
S = AE
The market supply curve is the monopsonist’s
average expenditure curve
ME
S = AE
The market supply curve is the monopsonist’s
average expenditure curve
Quantity
$/Q
MV
Q*
P* m
Monopsony
•ME > P & above S
Q*
P* m
Monopsony
•ME > P & above S
P C
Q
Competitive
•P = P C
•Q = Q+C
P C
Q
Competitive
•P = P C
•Q = Q+C
Trang 14 Monopsony and Monopoly Compared
10.6 Monopsony Power
The market supply curve is the monopsonist’s average expenditure curve AE Average expenditure is rising,
so ME lies above it The monopsonist purchases quantity Q m*, where ME and marginal value (demand) intersect The price paid per unit P m* is then found from the AE (supply) curve In a competitive market, price and quantity, P c and Q c , are both higher They are found at the point where AE (supply) and marginal value (demand) intersect.
Quantity
AR MR
AR MR
MC
$/Q
Q C
P C
Monopoly Note: MR = MC;
AR > MC; P > MC
Q C
P C
Monopoly Note: MR = MC;
AR > MC; P > MC
P*
Q*
P*
$/Q
MV
ME
S = AE
ME
S = AE
Q*
P*
Q*
P*
P C
Q C
Monopsony Note: ME = MV;
ME > AE; MV > P
P C
Q C
Monopsony Note: ME = MV;
ME > AE; MV > P
Monopoly
MR < P
P > MC
Q m < Q C
P m > PC
Monopsony
ME > P
P < MV
Q m < Q C
P m < P C