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Chapter 15

ECO1104 Chapter 15: ECO1104 - Chapter 15

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Gordon Lenjosek

ECO1104: Microeconomics Chapter 15: Monopoly  Monopoly o 2 Characteristics 1. A firm that is the sole seller of a product 2. The product it sells has no close substitutes o The key difference between monopoly and perfect competition is that:  A monopolist has market power – the ability to influence the market price of the product it sells  A competitive firm has no market power o Why monopolies Arise:  The main cause of monopolies is barriers to entry  Other firms cannot enter the market  There are 3 types of barriers to entry: 1. A single firm owns a key resource 2. The government gives a single firm the exclusive right to produce the good a. Ex. Via patents or copyright laws 3. Natural monopoly – A single firm can produce the entire market Q at lower cost than could several firms  Example: Suppose 1000 homes need electricity o ATC is lower if one firm services all 1000 homes (ATC = $50000) than if two firms each service 500 homes (ATC = $80000) o Q is the number of homes that are provided with electricity. Cost is the ATC of providing electricity per home.  Monopoly vs. Competition: Demand Curves o In a competitive market, the market demand curve slopes downward, but any individual firm’s demand curve is effectively horizontal at the market price o Thus, the firm can increase Q without lowering P, so MR = P for the competitive firm. It can sell as much as it likes at the market price. o It is a price-taker. Its product has many perfect substitutes, so demand is perfectly elastic. Were it to raise its price above P, demand for its product would fall to zero. o A monopolist is the only seller, so it faces the market demand curve. To sell a larger Q, the firm must reduce P. Thus, MR ≠ P. The next slide defines the exact relationship between MR and P. This is what distinguishes a competitive firm from a monopoly, in terms of both firm behaviour and welfare implications.  Monopoly Revenue o Gaia Java is the only seller of cappuccinos in town. The table shows the market demand for its cappuccinos. Fill in the missing spaces of the table. What is the relation between P and AR? Between P and MR? o P = AR  The same as for a competitive firm o MR = P  For a competitive firm  Understanding the Monopolist’s MR o Increasing Q has two effects on revenue:  Output effect: Higher output raises revenue  Price effect: Lower price reduces revenue o To sell a larger Q, the monopolist must reduce the price on all the units it sells  Hence, MR < P o MR could even be negative if the price effect exceeds the output effect (e.g., when Gaia Java increases Q from 5 to 6) o Note: A competitive firm has an output effect, but not a price effect  It does not need to reduce its price in order to sell a larger quantity, so MR = P  Profit-Maximization o Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC o Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity o It finds this price from the demand curve  The next slide demonstrates how 1. Profit-maximizing Q is where MR = MC 2. Find P from the demand curve at this Q  The Monopolist’s profit o As with a competitive firm, the monopolist’s profit equals  (P – ATC) x Q  A monopoly does not have a supply curve o A supply curve shows the relationship between P & Q o A competitive firm  Takes P as given  Has a supply curve that shows how its Q depends on P o A monopoly  Rather, Q and P are determined jointly by MC, MR and the demand curve o So there is no supply curve for monopoly  Case Study: Monopoly vs. Generic Drugs o Patents on new drugs give a temporary monopoly to the seller. When the patent expires, the market becomes competitive, and generics appear. o For simplicity, we assume constant marginal cost  The Welfare Cost of Monopoly o Recall: In a competitive market equilibrium, P = MC and total surplus is maximized o In the monopoly equilibrium, P > MR = MC  The value to buyers of an additional unit (P) exceeds the cost of the resources needed to produce that unit (MC)  The monopoly Q is too low – total surplus would be larger with a larger Q  Thus, monopoly results in a deadweight loss o By charging higher prices, the monopoly gets more surplus and consumers get less surplus o But the monopoly also reduces the size of the economic pie – by producing less than the socially efficient quantity and causing a deadweight loss o Competitive Equilibrium  Quantity = Qc  P = MC  Total surplus is maximized o Monopoly equilibrium:  Quantity = Qm  P > MC  A deadweight loss arises  Price Discrimination o Discrim
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