Chapter 8 McGrawHillIrwin Copyright 2015 by McGrawHill Education Asia All rights reserved Learning Objectives Distinguish among three types of imperfectly competitive industries and describe how imperfect competition differs from perfect competition ID: 647487
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Slide1
Monopoly, Oligopoly, and Monopolistic Competition
Chapter 8
McGraw-Hill/Irwin
Copyright ©
2015
by
McGraw-Hill Education (Asia).
All rights reserved.Slide2
Learning Objectives
Distinguish among three types of imperfectly competitive industries and describe how imperfect competition differs from perfect competitionIdentify the five sources of monopoly power and describe why economies of scale are the most enduring of the various sources of market powerApply the concepts of marginal cost and marginal revenue to find the output and price that maximizes a monopolist's profitsExplain why the profit-maximizing output level for a monopolist is too small from society's perspectiveDiscuss why firms offer discounts to buyers who are willing to jump a hurdleDiscuss public policies that are often applied to natural monopoliesSlide3
Imperfect Competition
Imperfectly competitive firms have some ability to set their own price: they are price settersLong-run economic profits possibleReduce economic surplusThree types: Monopoly has only one seller, no close substitutesMonopolistic competition has many firms producing slightly differentiated products that are reasonably close substitutesOligopoly has a small number of large firms producing products that are close substitutesSlide4
Monopolistic Competition
Monopolistic Competition
Number of Firms
Many firms
Price
Limited flexibility
Entry and Exit
Free
Product
Differentiated
Economic Profits
Zero in long run
Decisions
P, Q, product differentiation
Perfect CompetitionMany firmsPrice takerFreeStandardizedZero in long runQ onlySlide5
Oligopoly
Oligopoly
Number of Firms
Few firms,
each large
Price
Some flexibility
Entry and Exit
Difficult
Product
Differentiated or standardized
Economic Profits
Possible
DecisionsP, Q, differentiation, advertising
Perfect CompetitionMany firmsPrice takerFreeStandardizedZero in long runQ onlySlide6
Imperfect Competition
Examples of monopolyElectricity and Magic CardsExamples of monopolistic competitionRetail gas stationsConvenience storesExamples of oligopolyWireless phone serviceCementAutomobiles and tobaccoSlide7
The Essential Difference
Market power is the firm's ability to raise its price without losing all its salesAny firm facing a downward sloping demand curveFirm picks P and Q on the demand curveMarket power comes from factors that limit competition
Quantity
Price
Imperfectly
Competitive Firm
D
Quantity
Price
Perfectly
Competitive Firm
DSlide8
Five Sources of Market Power
Exclusive control over inputsPatents and copyrightsGovernment licenses or franchisesEconomies of scale (natural monopolies)Network economiesSlide9
Market Power: Economies of Scale
Returns to scale refers to the percentage change in output from a given percentage change in ALL inputsLong-run ideaConstant returns to scale: doubling all inputs doubles outputIncreasing returns to scale: output increases by a greater percentage than the increase in inputsAverage costs decrease as output increasesNatural monopoly: a monopoly that results from economies of scaleSlide10
Market Power: Network Economies
Network economies occur when the value of the product increases as the number of users increasesVHS format for video tapes, Blu-ray for DVDsTelephonesWindows operating systemeBayFacebook and WhatsappSlide11
Economies of Scale and Start-Up Costs
New products can have a large fixed development costVariable cost: sum of payments made to the variable factors, such as laborFixed cost: sum of payments made to the fixed factors, such as capitalStart-up costs can be thought of as a fixed costAverage total cost (ATC): total cost divided by outputA good whose production has a large start-up cost and low variable cost is subject to economies of scaleATC declines sharply as output increasesSlide12
Economies of Scale and Start-Up Costs
Consider an example:Assume marginal cost (M) is constantVariable cost is M*QTotal cost is fixed cost (F) plus variable costTC = F + M*QTotal cost increases as output increasesAverage total cost is ATC = F / Q + MAverage total cost decreases as output increasesAverage fixed cost = F/QSlide13
Economies of Scale
QuantityTotal cost ($/year)
F
TC = F + M Q
Average cost ($/unit)
Quantity
ATC = F/Q + M
MSlide14
Example: Video Game Producers – Different Volumes
Nintendo
Playstation
Annual Production (000s)
1,000
1,200
Fixed Cost ($000s)
$200
$200
Variable Cost ($000s)
$800
$960
Total Cost ($000s)
$1,000$1,160
ATC per game$1.00$0.97Slide15
Example: Video Game Producers – Lower Marginal Costs
Nintendo
Playstation
Annual Production (000s)
1,000
1,200
Fixed Cost ($000s)
$200
$200
Variable Cost ($000s)
$200
$240
Total Cost ($000s)
$400
$440ATC per game$0.40$0.37Slide16
Example: Video Game Producers – Higher Fixed Cost
Nintendo
Playstation
Annual Production (000s)
1,000
1,200
Fixed Cost ($000s)
$10,000
$10,000
Variable Cost ($000s)
$200
$240
Total Cost ($000s)
$10,200$10,240
ATC per game$10.20$8.53Slide17
Example: Video Game Producers – Different Production Levels
Nintendo
Playstation
Annual Production (000s)
500
1,700
Fixed Cost ($000s)
$10,000
$10,000
Variable Cost ($000s)
$100
$340
Total Cost ($000s)
$10,100$10,240
ATC per game$20.20$6.08Slide18
Intel's Advantage
Development cost of a new chip $2 billionMarginal cost of making a chip PenniesDominating the market PricelessIntel supplies more than 80% of the processors for PCsSlide19
Profit Maximization for the Monopolist
Like all other firms, a monopolist:Maximizes profitsApplies the Cost-Benefit Principle:Increase output if marginal benefit > marginal costDecrease output is marginal benefit < marginal costMarginal benefit is called marginal revenue:Change in total revenue from a one-unit change in outputEqual to price for the perfectly competitive firmLess than price for the monopolistSlide20
Price ($/unit)
Quantity (units/week)
Profit Maximization for the Monopolist
To sell another unit the monopolist must lower price
Total revenue from 2 units = $12Total revenue from 3 units = $15
Marginal revenue = $3
D
2
6
3
5Slide21
Monopolist's Marginal Revenue
Total Revenue$12
$15
$16
$15
Price
Quantity
$6
2
$5
3
$4
4
$3
5Price & marginal revenue ($/unit)88DQuantity (units/week)MR
3
2
3
1
4
-1
5
Marginal Revenue
3
1
-1Slide22
Monopoly Demand and Marginal Revenue
The monopolist's marginal revenue curve:Has the same intercept as the straight-line demand curveHas twice the slope of the demand curveLies below the demand curve
Price
Quantity
a
D
Q
0
Q
0
/2
a/2
MRSlide23
Deciding Quantity
Profit is maximized at the level of output where marginal cost equals marginal revenueAt P = $3 and Q = 12, MC > MRDecrease outputAt Q = 8, MC = MR = 2The demand curve sets the price at P = $4At any output below 8, MC < MR
Price ($/unit of output)
Quantity (units/week)
3
MC
2
6
D
12
MR
4
8Slide24
Monopoly Profit
Profit = Total revenue – total costTotal cost = ATC x QProfit = P x Q – ATC x QProfit = (P-ATC) x QIf P > ATC then the firm earns a profitIf P < ATC then the firm suffers a lossThis can be graphically illustratedSlide25
Monopoly Losses and Profits
Price ($/minute)Minutes (millions/day)
20
0.12
0.10
ATC
Economic loss
= $400,000/day
D
0.05
MC
MR
24
Price ($/minute)Minutes (millions/day)2420
0.080.10ATCD0.05MCMREconomic profit= $400,000/daySlide26
The Invisible Hand Fails
Price ($/unit of output)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
424D3126Marginal CostDeadweight loss from monopoly = $4Slide27
Monopoly and Perfect CompetitionSlide28
Managing Monopoly: The Breakdown of the Invisible Hand
Monopolies exist for economic reasonsPatents, copyrights, and innovationEconomies of scaleNetwork economiesAnti-trust laws attempt to limit deadweight lossLimiting monopoly has costsPatents encourage innovationEconomies of scale minimize ATCNetwork economies increase benefitsSlide29
Price Discrimination
Price discrimination means charging different buyers different prices for essentially the same good or serviceSeparate the groupsNo side trades among buyersMany forms of price discriminationHurdle method: discounts for identifiable groups (e. g., students, AARP)Perfect discrimination: negotiate separate deals with each customerSlide30
Carla the Editor: Social Optimum
Opportunity cost of Carla's time is $29What is the social optimum?What if Carla is a profit maximizer? What is Carla's total revenue?Student
Reservation Price
A
$40
B
38
C
36
D
34
E
32
F
30G 28Total Revenue $40 $76 $108
$136
$160
$180
$196
6 papers with an economic profit of $6Slide31
Carla the Editor: Marginal Revenue
Opportunity cost of Carla's time is $29What is Carla's marginal revenue?Student
Reservation Price
A
$40
B
38
C
36
D
34
E
32
F
30G 28MR$40 $36 $32
$28
$24
$20
$16
Total Revenue
$40
$76
$108
$136
$160
$180
$196
3 papers with an
economic profit of $21Slide32
Carla the Editor: Price Discriminator
Opportunity cost of Carla's time is $29What if Carla is a perfect price discriminator?What is Carla's total revenue?Student
Reservation Price
A
$40
B
38
C
36
D
34
E
32
F
30G 28Total Revenue $40 $78 $114
$148
$180
$210
$238
6 papers with
an economic
profit of $36Slide33
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 salesHard cover and paperback booksMultiple car models from one manufacturerCommercial air carriers, e.g. CX, JAL, SQMovie producers, 2D and 3D versionsDiscount coupons with min spending requirementsSlide34
Carla Offers a Rebate
If reservation price < $36, student will mail in rebateStudentReservation Price
Total Revenue
A
$40
$40
B
38
76
C
36
108
Discounted Price Submarket
D
$34$34E3264F3090
MR
$40
36
32
$34
30
26
5 papers, price $36, rebate $4, economic profit $27Slide35
Carla's Choices
Program Social Optimum
Papers Edited
6
Price
$30
Total Revenue
$180
Carla's Time
$174
Economic Profit
$6
Total Surplus
$26
Hurdle 5 = (3 + 2) $36, $4 rebate$172$145
$27
$35
Perfect Discriminator
6
Reservation
$210
$174
$36
$36
Single Price
3
$36
$108
$87
$21
$27Slide36
Monopoly and Public Policy
Challenge: create the greatest increase in total surplusPolicy optionsGovernment ownership and operationRegulationCompetitive bids for natural monopoly servicesBreak upSlide37
State-Owned Natural Monopoly
Marginal cost is always less than average costMarginal cost pricing produces lossesOptionsFund losses from tax revenuesFixed monthly fee plus usage fee Fixed fee covers lossesLimited incentives to innovate and cut costsCommonly used for water, Post Office, and some electricitySlide38
Regulated Monopolies
Cost-plus regulation sets price at per unit explicit costs plus a mark-up for implicit costsUsed for electricity, telephone, and cablePolicies vary by stateDisadvantagesHigh administrative costReduced incentive for cost-saving innovationPrice is greater than marginal costSlide39
Exclusive Contracting for Natural Monopolies
Government awards contract to low bidder for natural monopoly servicesGarbage collection, fire protection, road construction, Department of DefenseCould achieve marginal cost pricing IF government pays the resulting lossesAsset transfer for large fixed investment is complexSlide40
Enforcement of Anti-Trust Laws
Two landmark laws in the United StatesSherman Act of 1890Declared conspiracy to create a monopoly illegalClayton Act of 1914Outlawed transactions that would "substantially lessen competition"Applies to mergers and acquisitions todayIBM avoided break-up; AT&T did notMicrosoft survivedSlide41
Another Policy Option: Ignore Monopoly
Two objections to monopoliesRestrict output, decrease total surplusRaise price, earn economic profitsAnalysisDiscount offers allow some customers to pay less than average cost, though more than marginal costEconomic profits generated by customers who pay list price – their choiceAbout two-thirds of economic profits are taxed awayRemainder accrues to shareholdersSlide42
Imperfect Competition
Imperfect CompetitionMonopolistic Competition
and Oligopoly
Sources of Market Power
Monopoly
Public PolicySlide43
Chapter 8 Appendix
The Algebra of Monopoly MaximizationSlide44
From Demand to Marginal Revenue
Given a demand curve such as P = 15 – 2 QWe can write the marginal revenue curve as MR = 15 – 4 Q Suppose marginal cost is a line with zero intercept and a slope of 1MC = QThe remaining step is to set marginal revenue equal to marginal costSlide45
MR = MC
Let Q* be the profit maximizing level of outputMC = MRQ* = 15 – 4 Q*5 Q* = 15Q* = 3To find P, substitute Q = 3 into the demand equationP = 15 – 4 Q*P = 15 – 4 (3)P = 3