Chapter 23. Monopoly

Chapter 23Monopoly23-1Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesThe graph of the monopolistHow monopolist’s profits are calculatedThe monopolist in the short run and long runBarriers to entryLimits to monopoly powerEconomies of scale and natural monopolyWhat makes bigness bad?23-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Monopoly DefinedA monopoly is the ONLY firm in an industryNo one else sells what the monopolist is producingThere are local monopolies Some examples are a hardware store, a dry cleaners, and a drugstoreThere are national/regional monopoliesSome examples are diamonds dealers, gas and electric companies, and local phone companies A monopoly produces ALL the output in an industryThere are no close substitutes for the product or service23-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Graph of the MonopolistMonopoly is the first of three types of imperfect competitionThe other two are monopolistic competition and oligopolyThe distinguishing characteristic of imperfect competition is that the firm’s demand curve slopes downward to the rightThis means the imperfect competitor has to lower price to sell more23-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Graph of the MonopolistThe imperfect competitor has to lower price to sell more23-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.DQ2Q1P2P123-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Demand & Cost Schedule for a MonopolyOutput Price TR MR TC ATC MC 1 $16 2 15 3 14 4 13 5 12 6 11 7 1023-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Demand & Cost Schedule for a MonopolyOutput Price TR MR TC ATC MC 1 $16 $16 2 15 30 3 14 42 4 13 52 5 12 60 6 11 66 7 10 7023-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Demand & Cost Schedule for a MonopolyOutput Price TR MR TC ATC MC 1 $16 $16 $16 2 15 30 14 3 14 42 12 4 13 52 10 5 12 60 8 6 11 66 6 7 10 70 423-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Demand & Cost Schedule for a MonopolyOutput Price TR MR TC ATC MC 1 $16 $16 $16 $20 $20 2 15 30 14 30 15 3 14 42 12 36 12 4 13 52 10 42 10.50 5 12 60 8 50 10 6 11 66 6 63 10.50 7 10 70 4 84 1223-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Demand & Cost Schedule for a MonopolyOutput Price TR MR TC ATC MC 1 $16 $16 $16 $20 $20 ---- 2 15 30 14 30 15 $10 3 14 42 12 36 12 6 4 13 52 10 42 10.50 6 5 12 60 8 50 10 8 6 11 66 6 63 10.50 13 7 10 70 4 84 12 2123-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(This is the graph of the previous schedule)The monopolist will make a profit if for some range of output her ATC lies below the demand curve23-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(This is the graph of the previous schedule)In this instance, the monopolist maximizes her profit at five units of output charging a price of $1223-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(Calculating the Monopolist’s Profit)In this instance, the monopolist maximizes her profit at five units of output charging a price of $12This is where MC=MR23-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(Calculating the Monopolist’s Profit)PriceThe ATC at five units of output is about $9.90ATC23-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(Calculating the Monopolist’s Profit)PriceATCTotal Profit = (Price – ATC) X Output= ($12 - $9.90) X 5 ($2.10 X 5)= $10.5023-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(Calculating the Monopolist’s Profit)PriceATCEvery firm produces where MC=MR. The perfect competitor produced at the most profitable output, which in the long run always happened to be the most efficient output23-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(Calculating the Monopolist’s Profit)PriceATCThe monopolist has no competition and does not have to produce where output is at its most efficient level (the minimum point on the ATC).23-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(Calculating the Monopolist’s Profit)PriceATCThe perfect competitor will produce at the most efficient output level which is the minimum point on the ATC23-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(Calculating the Monopolist’s Profit)PriceATCThe perfect competitor’s P=MR=D=$9.80 and its ATC is equal to price.23-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit(Calculating the Monopolist’s Profit)PriceATCPerfect competitor Monopoly Price $9.80 Price $12.00 Output $5.45 units Output 5 units ATC $9.80 ATC 9.90 SummaryThe monopolist makes a profit (economic), whereas in the long run the perfect competitor makes no profit (economic)The monopolist operates at less than peak efficiency, while the perfect competitor operates at peak efficiency (the lowest point on the ATC)The perfect competitor(s) charges a lower price and produces a larger output than the monopolist23-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.23-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a Profit Output is 5Price is $17ATC is $14TP = (P – ATC) X OutputTP = ($17 – $14) X 5TP = ($3) X 5TP = $1523-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist Making a ProfitOutput is 5Price is $17ATC is $14TP = (P – ATC) X OutputTP = ($17 – $14) X 5TP = ($3) X 5TP = $15The output at which the firm would produce most efficiently is 5.1 The perfect competitor would produce at an output of 5.1 The perfect competitor would charge23-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Monopolist in the Short Run and the Long RunThere is no distinction between the short run and the long run for the monopolistsIf there is a demand for their product or service they make a profit (economic profits)If there is not enough demand for their product for them to make a profit they go out of business 23-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Demand and Supply under MonopolyBecause the monopolist is the ONLY seller in the industry, her individual demand curve is also the Market Demand curve. Likewise her supply curve is the Market Supply curve.The monopolist’s supply curve is her MC curve. Her supply curve begins at the break-even point (that is, the minimum point of the ATC) Break even point23-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Are All Monopolies Big CompaniesNo . . . many monopolies are tiny firms operating in a very small marketWhat matters is size relative to the market - the proverbial big fish in a small pondChances are there is only one book store on your campusIt is not nearly as big as Barnes and nobleThe only video store in a very small community would be a monopolyThere are tens of thousands of gas stations, convenience stores, restaurants, cleaners, and repair shops that have monopolies in their communities23-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Barriers to EntryControl over an essential resourceEconomies of scaleLegal barriersRequired scale for innovationEconomies of being established 23-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Control over an Essential ResourceIn economics the basic resources are land, labor and capitalSome examples areThe Metropolitan Opera has most of the world’s opera stars under contractThe NFL had virtually all the top football stars under contract until the early 1960sDeBeers Diamonds own four fifths of the world’s diamond minesThe International Nickel Company of Canada owns ninety percent of the world’s nickel reserves23-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economies of ScaleTypically, heavy industry - iron, steel, copper, aluminum, and automobiles - has high start up costOnce the plant and equipment are in place, you can take advantage of economies of scale with high volumes of output23-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal BarriersLegal barriers include licensing, franchises, and patentsLicensing prevents just anybody from driving a taxi, cutting hair, peddling on the street, practicing medicine, burying bodies, etcOften the licensing procedure is designed to hold down the number of people going into the fieldThis tends to keep prices high in that field23-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal BarriersLegal barriers include licensing, franchises, and patentsGovernment franchises are the most important legal barrierWhen the number is large, for example radio stations, usually there is no big problemHowever, government franchises can be, (illegally) obtained through bribesThe most important form of local franchise is the public utility gas and electric companies23-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Legal BarriersLegal barriers include licensing, franchises, and patentsPatents are granted to investors so they can have a chance to get rich before some one else can use their ideas (Patents are granted for 17 years)Some times firms buy up patents to prevent competitionSome times, just before the 17 years are up, a firm makes a slight improvement and gets a patent for another 17 yearsRequired Scale for InnovationMost inventors don’t have the wherewithal to produce and market their ideasMost inventors would probably be quite happy to hand their ideas and innovations over to one of the big guys for a share of the profitsWhile individuals come up with all the great ideas, only large firms have the money and know-how to bring them to the marketplace23-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.23-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economies of Being EstablishedCompanies that have been in business for a number of years have certain advantagesRecognizable brand namesThe sales reps have established territoriesThe sellers and buyers have long-standing relationshipsSometimes these companies can set the standard for the industry, i.e.,Microsoft in software, Matsushita-VCR format23-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Limits to Monopoly PowerThe ultimate limit to monopoly power may come from the government or from the market itselfIf a firm gets too big or too bad, or both, the government may decide to step in using antitrust lawsThe market limits monopoly power basically through the development of substitutes23-36Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economies of Scale and Natural MonopolyThere are only two justifications for monopolyEconomies of Scale justify bigness because sometime only a firm with the capability of a very large output can produce anywhere close to the minimum point of its ATCNatural Monopoly is a situation where one firm is able to provide a service at a lower cost than could several competing firms23-37Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.ABOne electric Company Is Better than FourPanel A shows a single electric transmission feeder cable serving all the homes in one block. Panel B shows four cables serving that same block. It is a lot more efficient (and cheaper) to have one cable than four.23-37The Rationale for Natural MonopolyToday the rationale for natural monopoly is disappearingIn more than half the states the electric power industry has been deregulated, so that local electric monopolies are getting a great deal of competitionOnce the transmission cables had been laid, it became possible under deregulation for competition to develop, and the rationale for monopoly no longer was validThe original local phone or electric company was a natural monopoly, but once we’re all connected, then let the competition begin 23-38Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.When Is Bigness Bad?Monopolies tend to be inefficient because they do not produce at the minimum point on their ATCThis prevents resources from being allocated in the most efficient mannerBig business always has great political powerEconomic power is easily converted into political powerThe monopolist may engage in price discrimination 23-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.When Is Bigness Good?Natural monopolies can take advantage of economies of scale and deliver services much more cheaply than a multitude of competing firmsIt is probably all right if a firm is big because it is very goodIf a firm is big because it is bad is another story23-40Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.23-41Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Corporate HierarchyBecause there is no competition, there is no great incentive to control cost or to use resources efficientlyThere is no need to spend much money on research and development, to improve processes, to develop new products, or to be responsive to customer needsA monopolist can charge higher prices and provide poorer quality and service23-42Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Economic Case Against Bigness23-43Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Two Policy AlternativesTwo ways to prevent public utilities from charging outrageous pricesgovernment regulationgovernment ownership23-44Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.ConclusionNatural Monopolies are probably all right, but only if they do not abuse their powerMonopolies based on other factors must be looked on with suspicionThey may be up to no goodThey may even be illegalAny monopoly must pass the test of whether or not there are close substitutes