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Textbook Notes - Nov 21.docx

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Economics 1021A/B
Michael Parkin

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Economics – Textbook Notes Monopoly and How is Arises A monopoly is a market with a single firm that produces a good or service for which no close substitutes exist and that is protected by a barrier that prevents other firms from selling that good or service. How Monopoly Arises Monopoly arises for two key reasons:  No Close Substitute o A monopoly sells a good or service that has no good substitute  Tap water for washing a car or having a shower  Barrier to Entry o A constraint that protects a firm from potential competitors is called a barrier to entry o Types:  Natural  Natural Monopoly: an industry in which economies of scale enable one firm to supply the entire market at the lowest possible price o The firms that deliver gas, water, and electricity to our homes  Economies of scale prevail over the entire length of the LRAC curve  One firm can supply the entire market at a lower cost than two or more firms can  Ownership  An ownership barrier to entry occurs if one firm owns a significant portion of a key resource  Legal  A legal barrier to entry creates a legal monopoly: a market in which competition and entry are restricted by the granting of a public franchise, government license, patent, or copyright o A public franchise is an exclusive right granted to a firm to supply a good or service o A government licence controls entry into particular occupations, professions, and industries o A patent is an exclusive right granted to the inventor of a product or service o A copyright is an exclusive right granted to the author of composer of a literary, musical, dramatic, or artistic work.  Patents and copyrights are valid for a limited time period that varies from country to countryMonopoly Price-Setting Strategies A monopoly sets its own price. In doing so, the monopoly faces a market constraint: To sell a larger quantity, the monopoly must set a lower price. There are two monopoly situations that create two pricing strategies:  Single Price o A single price monopoly is a firm that must sell each unit of its output for the same price to all its customers  Price Discrimination o Price discrimination is when a firm sells different units of a good or service for different prices  When a firm price discriminates, it looks as though it is doing its customers a favour. In fact, it is charging the highest possible price for each unit sold and making the largest possible profit A Single-Price Monopoly’s Output and Price Decision Price and Marginal Revenue The marginal revenue curve lies below the demand curve. When the price is lowered to sell one more unit, two opposing forces affect total revenue. The lower price results in a revenue loss, and the increased quantity sold results in a revenue gain. Marginal Revenue and Elasticity A single-price monopoly’s marginal revenue is related to the elasticity of demand for its good.  If demand is elastic, a fall in price brings an increase in total revenue  If demand is inelastic, a fall in price brings a decrease in total revenue  If demand is unit elastic, total revenue does not change  In Monopoly, Demand is Always Elastic o A profit maximizing monopoly never produces an output in the inelastic range of the market demand curve Price and Output Decision A monopoly sets its price and output at the levels that maximize economic profit. A monopoly faces the same types of technology and cost constraints as a competitive firm, so its costs behave just like those of a firm in perfect competition  Maximizing Economic Profit o Total cost (TC) and the total revenue (TR) both rise as output increases, but TC raises at an increasing rate and TR rises at a decreasing rate  Marginal Revenue Equals Marginal Cost o The greatest economic profit is made at the quantity when MR=MC  Maximum Price the Market Will Bear o A monopoly influences the price of what it sells. But a monopoly doesn’t set the price at the maximum possible price  At the maximum possible price, the firm would be able to sell only one unit of output, which in general is less than the profit maximizing quantity o For a monopoly, price exceeds marginal revenue, so price also exceeds marginal cost o Barriers to entry prevent new firms from entering the market, so a monopoly can make a positive economic profit and might continue to do so indefinitely Single-Price Monopoly and Competition Compared Comparing Price and Output The supply and the equilibrium are different in monopoly and competition  Perfect Competition o In perfect competition, equilibrium, occurs where the supply curve and the demand curve intersect  Each firm take the price and maximizes its profit by producing the output at which its own marginal cost equals the price. Because each firm is a small part of the total industry, there is no incentive for any firm to try to manipulate the price by varying its output  Monopoly o The monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost  This output is less than the competitive output  Compared to a perfectly competitive industry, a single- price monopoly produces a smaller output and charges a higher price Efficiency Comparison Perfect Competition (with no external costs and benefits) is efficient. A monopoly produces a certain quantity and sells its output for a high price. The smaller output and higher price drive a wedge between marginal social benefit and marginal social cost and create a deadweight loss  Consumer surplus shrinks for two reasons: o They have to pay more for the good  This loss to consumer is a gain for monopoly and increases the producer surplus o Consumers lose by getting less of the good, and this loss is part of the deadweight loss  Although monopoly gains from a higher price, it loses some producer surplus because it produces a smaller output. That loss is another part of the deadweight loss A monopoly produces a smaller output than perfect competition and faces no competition, so it does not produce at the minimum possible long run average costRedistribution of Surpluses Monopoly also brings a redistribution of surpluses. Some of the lost consumer surplus goes to the monopoly. This portion of the loss of consumer surplus in not a loss to society. It is redistribution from consumers to the monopoly producer. Rent Seeking Any surplus – consumer surplus, producer surplus, or economic profit – is called economic rent. And rent seeking is the pursuit of wealth by capturing economic rent. Rent seekers pursue their goals in two main ways. They might:  Buy A Monopoly o To rent seek by buying a monopoly, a person searches for a monopoly that is for sale at a lower price than the monopoly’s economic profit o People rationally devote time and effort to seeking out profitably monopoly businesses to buy. In the process, they use up scarce resources that could otherwise have been used to produce goods and services  The value of this lost production is part of the social cost of monopoly  The amount paid for a monopoly is not a social cost because the payment is just a transfer of an existing producer surplus from the buyer to the seller  Create A Monopoly o Rent seeking by creating a monopoly is mainly a political activity. It takes the form of lobbying and trying to influence the political process  Such influence might be sought by making contributions to a political party in exchange for legislative support or by indirectly
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