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Chapter 14 Full Notes

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Boston College
ECON 1131

Chapter 14 Pure Monopoly  Market power (monopoly power): a market situation in which an individual firm faces a downward-sloping demand curve for its product  Pure monopoly: a market situation in which an individual firm faces a downward- sloping demand curve for its product  Pure monopoly exists when the industry consists of a single firm.  The model of pure monopoly allows us to explore the effects of market power in and of itself without having to consider the endless possibilities associated with strategic interaction among firms  Economists assume that oligopolists aspire to the life of a pure monopolist- they would love to isolate themselves from competitions with other firms in their industry o The reason is that profits for the industry as a whole are never higher than when the market is structured as a pure monopoly  Pure monopoly is the natural analytical counterpoint to perfect competition- if perfect competition is the best of all market structures for a society committed to the pursuit of efficiency and equity, then pure monopoly is in many respects the worst of all market structures o Pure monopoly is unlikely to be efficient or equitable Profit Maximization Under Pure Monopoly  All firms, whether they have market power or not, maximize profit by following the same general principle: Produce the output at which marginal revenue equals marginal cost Implications of Downward-Sloping Demand Curve  Price setting behavior versus price-taking behavior: o Afirm with market power does not have a supply curve o It does not consider how much it would be willing to supply at each possible market price- instead, a firm with market power sets the price of the product itself  The demand curve and the total revenue frontier: o The firm cannot set price or quantity independently o Having chosen price or quantity, the demand curve defines the total revenue frontier for the firm (just as the total cost curve defines the total cost frontier for the firm and the production possibilities frontier defines the output frontier for society) o The point q ,1P o1 the demand curve has 2 interpretations  1: q1is the maximum quantity the firm can sell if it sets price at 1  or, 2: P is the maximum price the firm can charge it if chooses to 1 sell output q1  Demand and marginal revenue o The final important implication of a downward sloping demand curve is that the marginal revenue from selling additional output is less than the price of the product o Marginal revenue: the increase in total revenue from selling one more unit of output o Marginal revenue is less than price in pure monopoly because the firm has to lower its price in order to increase the quantity sold o Price is average revenue, the amount of revenue received per unit of output- therefore, the firms demand curve is its average revenue curve o In perfect competition, average rev is neither inc. or dec., so marginal rev and price are equal o In pure monopoly, avg revenue decreases along the downward sloping demand cruve of a firm with market power, so marginal rev is below avg revenue, pulling the avg revenue down  MR curve is below demand curve Average and Marginal Cost  Assume that pure monopoly has the same cost as perfect competition o Not unrealistic since the presence or absence of market power relates to a firm’s demand curve, not to it’s costs  Main difference between a pure monopoly and a perfectly competitive firm is a matter of scale: a pure monopolist is likely to be a much larger firm than a perfectly competitive firm  Given that entry and exit are impossible, the only important difference between the short runs and the long runs is that pure monopolies can adjust previously fixed factors of production in the long run Maximizing Profit  This analysis of profit maximization applies to any firm with market power o 1: Which output should the firm produce? They should select the output at which marginal revenue equals marginal cost. MR=MC at the intersection of the MR and MC curves o 2: Which price should the firm charge? They should choose the highest possible price- get this by finding the price on the demand curve up from where MC and MR intersect. o 3: Does the firm make a profit or incur a loss? Use graphical analysis- profit is the rectangle between the point on theAC curve where MC and MR intersect and the same point on the demand curve.  Total revenue increases whenever marginal revenue is positive, and reaches its peak when marginal revenue is zero  Profit is the vertical distance between the total revenue and total cost curves at each output  Profit is maximized when MR equals MC Evaluation of Pure Monopoly  Pure monopoly’s market outcome fails all four efficiency and equity norms Allocational Efficiency  Price is far greater than MC  This is not unique to pure monopoly, price is greater than marginal cost whenever a firm has market power o This is because firm with market power set marginal revenue equal to marginal cost in order to maximize profit  Contrived scarcity: market situation generat
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