Outline The Profits of Generosity

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Chapter 12



The Profits of Generosity

A. Most of us use Microsoft Windows to run our computers. Microsoft isn’t a price taker like the firms in perfect competition. How does a firm like Microsoft decide the quantity to produce and the price to charge?

B. Students get lots of price breaks—at the movies, hairdresser, and on the airlines. Why? How can it be profit maximizing to offer lower prices to some customers?

I. Market Power

A. Market power and competition are the two forces that operate in most markets.

1. Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale.

2. A monopoly is an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.

B. How Monopoly Arises

1. A monopoly has two key features:

a) No close substitutes. The absence of any firms making close substitutes allows the monopolist to avoid competition in the market.

b)Barriers to entry. Legal or natural constraints that protect a firm from potential competitors are called barriers to entry.

2. There are two types of barriers to entry:

a) Legal barriers to entry create a legal monopoly, a market in which competition and entry are restricted by the granting of:

i) Public franchise. The exclusive right granted to a firm to supply a good or service is called a public franchise. For example, the U.S. Postal Service has a public franchise to deliver first-class mail.

ii) Government license. The government controls entry into particular occupations, professions and industries by requiring a government license. For example, a license is required to practice law. Licensing doesn’t always create a monopoly, but it does restrict competition.

iii) Patent and copyright. A patent is an exclusive right granted to the inventor of a product or service. A copyright is an exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work. Because these rights can be sold, patents and copyrights don’t always create a monopoly, but they do restrict competition.

b) Natural barriers to entry create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can. Figure 12.1 (page 259) shows the average total cost curve for an electrical power company that is a natural monopoly.

C. Monopoly Price-Setting Strategies

1. For a monopoly firm to determine the quantity it sells, it must choose the appropriate price.

2. There are two types of monopoly price-setting strategies:

a) Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.

b) A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers.

II. A Single-Price Monopoly’s Output and Price Decision

A. Price and Marginal Revenue

1. The demand curve facing a monopoly is the market demand curve.

2. This demand curve relates the market price at which the monopoly firm can sell the corresponding quantity of output. This allows the firm to calculate revenue measures:

a) Total revenue, TR, is the price, P, multiplied by the quantity sold, Q.

b) Marginal revenue, MR, is the change in total revenue resulting from a one-unit increase in the quantity sold. The key feature of a single-price monopoly is that marginal revenue is less than price at each level of output: that is, MR < P.

c) Marginal revenue is less than the price at all levels of output because the single–price monopoly firm must lower its price on all units sold to sell an additional unit of output. The extra revenue equals the price of that unit sold less the decrease in price for each of the units it would have sold at the higher price. The net increase to revenues amounts to something less than the price of the last unit sold. Figure 12.2 (page 260) uses a demand curve to show how these offsetting influences on total revenues.

B. Marginal Revenue and Elasticity

1. A single-price monopoly’s marginal revenue is related to the elasticity of demand for its good:

a) If market demand is elastic, a fall in price brings an increase in total revenue. The rise in revenue from the increase in quantity sold outweighs the fall in revenue from the lower price per unit, and MR is positive.

b) If market demand is inelastic, a fall in price brings a decrease in total revenue. The rise in revenue from the increase in quantity sold is outweighed by the fall in revenue from the lower price per unit, and MR is negative.

c) If market demand is unit elastic, a fall in price brings total revenue does not change. The rise in revenue from the increase in quantity sold equals the fall in revenue from the lower price per unit, and MR = 0.

2. Figure 12.3 (page 261) shows the relationship between elasticity of demand and total revenues for all three cases.

3. A single-price monopoly never produces an output at which demand is inelastic. If it did produce such an output, the firm could increase total revenue, decrease total cost, and increase economic profit by decreasing output.

C. Output and Price Decisions

1. The monopoly faces the same types of technology constraints as the competitive firm, but the monopoly faces a different market constraint.

a) The monopoly selects the profit-maximizing level of output in the same manner as a competitive firm, where MR = MC.

b) The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity. Table 12.1 (page 262) uses a numerical example to illustrate the profit-maximizing output and price decision.

2. The monopoly may earn an economic profit, even in the long run, because the barriers to entry protect the firm from market entry by competitor firms.

a) Figure 12.4 (page 263) illustrates the profit-maximizing choices of a single-price monopolist.

b) Monopoly is not guaranteed an economic profit. A profit is received only when price exceeds average total cost.

III. Single-Price Monopoly and Competition Compared

A. Comparing the same industry under perfect competition and monopoly reveals the differences in the two types of market.

B. Comparing Output and Price

1. Figure 12.5 (page 264) shows the outcomes of perfect competition and monopoly.

2. The market demand curve, D, in perfect competition is the demand curve that the firm faces in monopoly.

3. The market supply curve in perfect competition is the horizontal sum of the individual firm’s marginal cost curves, S = MC. This curve is the monopoly’s marginal cost curve.

4.Equilibrium in perfect competition occurs where the quantity demanded equals the quantity supplied at quantity QC and price PC.

5. Equilibrium output for a monopoly, QM, occurs where marginal revenue equals marginal cost, MR = MC. Equilibrium price for a monopoly, PM, occurs on the demand curve at the profit-maximizing quantity.

6. Because marginal revenue is less than price at each output level, QM < QC and PM > PC

7. Compared to perfect competition, monopoly restricts output and charges a higher price.

B. Efficiency and Comparison

1. Monopoly is inefficient, and Figure 12.6 (page 265) shows why.

a) The demand curve is the marginal benefit curve, MB, and the competitive market supply curve is the marginal cost curve, MC. So competitive equilibrium is efficient because MB = MC.

b) Monopoly is inefficient because price exceeds marginal cost so MB > MC.

c) On all output levels for which MB > MC, a deadweight loss is incurred.

C. Redistribution of Surpluses

Monopoly redistributes a portion of consumer surplus by changing it to producer surplus.

D. Rent Seeking

1. The social cost of monopoly may exceed the deadweight loss through an activity called rent seeking, which is any attempt to capture consumer surplus, producer surplus, or economic profit.

2. Rent seeking is not confined to a monopoly. There are two forms of rent seeking activity to pursue monopoly:

a) Buy a monopoly—expend resources seeking out the opportunity to buy monopoly rights for a price below the value of the economic profit earned by the monopoly.

b) Create a monopoly—expend resources seeking political influence, such as lobbying legislators to provide preferential market status by restricting domestic competition or enacting tariffs on imports.

E. Rent-Seeking Equilibrium

1. The resources used in rent seeking can exhaust the monopoly’s economic profit and leave the monopoly owner with only a normal profit.

2. Figure 12.7 (page 267) shows the normal profit that result from rent seeking.

IV. Price Discrimination

A. Price discrimination is the practice of selling different units of a good or service for different prices.

1. To be able to price discriminate, a monopoly must:

a) Identify and separate different buyer types

b) Sell a product that cannot be resold

2. Price differences that arise from cost differences are not price discrimination.

B. Price Discrimination and Consumer Surplus

1. Price discrimination converts consumer surplus into economic profit.

2. A monopoly can discriminate

a) Among units of a good, charging a different price for each unit sold. Quantity discounts are an example. (But quantity discounts that reflect lower costs at higher volumes are not price discrimination.)

b) Among groups of buyers, charging different buyers different prices for the same good or service. (Advance purchase and other restrictions on airline tickets are an example.)

C. Profiting by Price Discriminating

Figure 12.8 (page 268) and Figure 12.9 (page 269) shows the same market with a single price and price discrimination and show how price discrimination converts consumer surplus into economic profit.

D. Perfect Price Discrimination

1. Perfect price discrimination extracts the entire potential consumer surplus and converts it to economic profit. With perfect price discrimination:

a) Economic profit increases above that earned by a single-price monopoly.

b) Output increases to the quantity at which price equals marginal cost

c) Deadweight loss is eliminated

2. Figure 12.10 (page 270) shows the outcome with perfect price discrimination.

E. Efficiency and Rent Seeking with Price Discrimination

1. The more perfectly a monopoly can price discriminate, the closer its output gets to the competitive output (P = MC) and the more efficient is the outcome.

2. But this outcome differs from the outcome of perfect competition in two ways:

a) The monopoly captures the entire consumer surplus.

b) The increase in economic profit attracts even more rent-seeking activity that leads to an inefficient use of resources.

V. Monopoly Policy Issues

A. Gains from Monopoly

1. A single-price monopoly creates inefficiency and price discriminating monopoly captures consumer surplus and converts it into producer surplus and economic profit.

2. And monopoly encourages rent-seeking, which wastes resources. But monopoly brings benefits.

a) Product innovation. Patents and copyrights provide protection from competition and let the monopoly enjoy the profits stemming from innovation for a longer period of time.

b) Economies of scale and scope. Where economies of scale or scope exist, a monopoly can produce at a lower average total cost than what a large number of competitive firms could achieve.

B. Regulating Natural Monopoly

1. When demand and cost conditions create natural monopoly, government agencies regulate the monopoly.

a) Figure 12.11 (page 273) shows a natural monopoly and compares two types of regulation with no regulation.

b) Left alone, the natural monopoly will charge a price and produce at a quantity where MR = MC. Price will exceed marginal cost and quantity will be less than under perfect competition.

2. Regulating a natural monopoly in the public interest sets output where MB = MC and the price equal to marginal cost. This regulation is the marginal cost pricing rule, and it results in an efficient use of resources.

a) With price equal to marginal cost, ATC exceeds price and the monopoly incurs an economic loss. If the monopoly receives a subsidy to cover its loss, taxes must be imposed on other economic activity, which create deadweight loss.

b) Where possible, a regulated natural monopoly might be permitted to price discriminate to cover the loss from marginal cost pricing.

3. Another alternative is to produce the quantity at which price equals average total cost and to set the price equal to average total cost—the average cost pricing rule.
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