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A theory of market structure based on three assumptions:
->There is one seller
-> It sells a product for which no close substitutes exist
-> There are extremely high barriers to entry
-> Public franchises - A right granted to a firm by government that permits the firm to provide a particular good or service and excludes all others from doing the same
->Patents – granted to inventors of a product or process for a period of 20 year
-> Government licenses – required to carry on a business or occupation
->Economies of scale – Exist when inputs are increased by some percentage and outputs increase by a greater percentage causing unit costs to fall.
->Natural monopoly - The condition where economies of scale are so pronounced that only one firm can survive.
There are always some close substitutes for the product any firm sells; therefore, the theory of monopoly (which assumes no close substitutes) cannot be useful. Comment.
Let’s assume the statement is right—that there are always some close substitutes for the product a firm sells. The question, however, is how close does the substitute have to be before the theory of monopoly is not useful? For example, a slightly close substitute for a seller’s product may not be close enough to matter. The theory of monopoly may still be useful in predicting a firm’s behavior.
How do economies of scale act as a barrier to entry?
Economies of scale exist when a firm doubles inputs and its output more than doubles, lowering its unit costs (average total costs) in the process. If economies of scale exist only when a firm produces a large quantity of output and one firm is already producing this output, then new firms (that initially produce less output) will have higher unit costs than those of the established firm. Some economists argue that this will make the new firms uncompetitive when compared to the established firm. In other words, economies of scale act as a barrier to entry, effectively preventing firms from entering the industry and competing with the established firm.
How is a movie superstar like a monopolist?
In a monopoly, there is a single seller of a good for which there are no close substitutes, and there are extremely high barriers to competing with the single seller. If a movie superstar has so much talent that the movie going public puts her in a class by herself, she might be considered a monopolist. Can anyone compete with her? They can try, but she may have such great talent (relative to everyone else) that no one will be able to effectively compete with her. Her immense talent acts as a barrier to entry in the sense that even if others try to compete with her, they won’t be a close enough substitute for her.
The monopoly firm is the industry, and the industry is the monopoly firm—they are the same.
It follows that the demand curve for the monopoly firm is the market demand curve, which is downward sloping.
A downward-sloping demand curve posits an inverse relationship between price and quantity demanded:
More is sold at lower prices than at higher prices, ceteris paribus.
The monopolist can raise its price and still sell its product (though not as much).
->To sell an additional unit of its good, a monopolist needs to lower price.
->This price reduction both gains revenue and loses revenue for the monopolist.
->In the exhibit, the revenue gained and revenue lost are shaded and labeled.
->Marginal revenue is equal to the larger shaded area minus the smaller shaded area.
->The demand curve plots price and quantity.
->The marginal revenue curve plots marginal revenue and quantity.
->For a monopolist, P > MR, so the marginal revenue curve must lie below the demand curve.
->The monopolist produces the quantity of output (Q1) at which MR= MC, and charges the highest price per unit at which this quantity of output can be sold (P1).
->Notice that at the profit- maximizing quantity of output, price is greater than marginal cost,
->A monopoly seller is not guaranteed any profits. Here, price is at above average total cost at Q1, the quantity of output at which MR = MC.
->Therefore, TR (the area 0P1BQ1) is greater than TC (the area 0CAQ1), and profits equal the area CP1BA.
->Here, price is below average total cost at Q1.
->Therefore, TR (the area 0P1AQ1) is less than TC (the area 0CBQ1) and losses equal the area P1CBA.
->The perfectly competitive firm is a price taker; it has no control over the price of the product it sells. The monopoly firm is a price searcher; it has some control over the price of the product it sells.
->Essentially, what determines whether a firm is a price taker or a price searcher is the demand curve that it faces. The perfectly competitive firm faces a horizontal demand curve. The monopoly firm faces a downward-sloping demand curve
-> If a firm faces a horizontal (or flat) demand curve, then it is a price taker. A horizontal (or flat) demand curve implies that the firm can sell its good at only one price: the price determined by the market.
->If a firm faces a downward sloping demand curve, then it is a price searcher because of what each demand curve implies about the firm’s ability to control price.
->For the perfectly competitive firm, P = MR; for the monopolist, P > MR.
->The perfectly competitive firm’s demand curve is its marginal revenue curve; the monopolist’s demand curve lies above its marginal revenue curve.
-> The perfectly competitive firm charges a price equal to marginal cost; the monopolist charges a price greater than marginal cost.
Perfect competition: P = MR and P = MC Monopoly: P > MR and P > MC
->The difference between the maximum price a buyer is willing and able to pay and the actual price paid.
->CS = Maximum Buying Price - Price Paid
If the market in the exhibit is perfectly competitive, the demand curve is the marginal revenue curve. The profit maximizing output is QPC and price is PPC.
Consumers’ surplus is the area PPCAB.
If the market is a monopoly market, the profit-maximizing output is QM and price is PM.
Consumers’ surplus is the area PMAC.
Consumers’ surplus is greater in perfect competition than in monopoly; it is greater by the area PPCPMCB.
->We start with the demand and marginal revenue curves and with MC1=ATC1. Because cost is “so high, ”no firm produces the good.
->Later, a single firm figures out how to lower cost to MC2=ATC2. This firm produces QM and charges the monopoly price of PM per unit.
->Is monopoly preferable to no firm producing the good? From a consumer’s perspective, the answer is yes. Consumers’ surplus is zero when no firm produces the good.
-> Consumers’ surplus is area PM AB when the monopoly firm produces the good.
Why does the monopolist’s demand curve lie above its marginal revenue curve?
The single-price monopolist has to lower price to sell an additional unit of its good (as a downward-sloping demand curve necessitates). As long as it has to lower price to sell an additional unit, its marginal revenue will be below its price. A demand curve plots price (P) and quantity (Q), and a marginal revenue curve plots marginal revenue (MR) and quantity (Q). Because P MR for a monopolist, its demand curve will lie above its marginal revenue curve.
Is a monopolist guaranteed to earn profits?
No. Profit depends on whether price is greater than average total cost. A monopolist can produce the quantity of output at which MR MC, charge the highest price per unit possible for the output, and still have its unit costs (ATC) greater than price. If this is the case, the monopolist incurs losses; it does not earn profits.
Is a monopolist resource allocative efficient?
Why or why not?
No. A firm is resource allocative efficient when it charges a price equal to its marginal cost (P = MC). The monopolist does not do this; it charges a price above marginal cost. Profit maximization (MR = MC ) does not lead to resource allocative efficiency (P = MC ) because for the monopolist P > MR. This is not the case for the perfectly competitive firm, where P = MR.
A monopolist is a price searcher. Why do you think it is called a price searcher? What is it searching for?
A monopolist is searching for the highest price at which it can sell its product. In contrast, the perfectly competitive firm doesn’t have to search; it simply takes the equilibrium price established in the market.For example, suppose Nancy is a wheat farmer. She gets up one morning and wants to know at what price she should sell her wheat. She simply turns on the radio, listens to the farm report, and finds out that the equilibrium price per bushel of wheat is, say, $5. Being a price taker, she knows she can’t sell her wheat for a penny more than this ($5 is the highest price), and she won’t want to sell her wheat for a penny less. The monopoly firm doesn’t know the highest price for its product. It has to search for it; it has to experiment with different prices before it finds the so-called highest price.
->The net value (value to buyers over and above costs to suppliers) of the difference between the monopoly quantity of output (where P> MC) and the competitive quantity of output (where P = MC).
-> The loss of not producing the competitive quantity of output.
->Monopoly produces a quantity of output that is too small in comparison to the quantity of output produced in perfect competition. This difference in output results in a welfare loss to society.
->The monopolist produces QM, and the perfectly competitive firm produces the higher output level QPC.
->The deadweight loss of monopoly is the triangle (DCB) between these two levels of output.
->Rent-seeking activity is directed to obtaining the monopoly profits, represented by the area PPCPMCD.
->Rent seeking is a socially wasteful activity because resources are expended to transfer income rather than to produce goods and services.
->Actions of individuals and groups who spend resources to influence public policy in the hope of redistributing (transferring) income to themselves from others.
-> If firm A tries to get the government to transfer income in the form of consumers' surplus from buyers to itself, it is undertaking a transfer-seeking activity. In economics, such activities are usually called rent seeking. In other words, firm A is rent seeking.
->An example of rent seeking is influencing the government to grant the firm monopoly power.
->The increase in costs and organizational slack in a monopoly resulting from the lack of competitive pressure to push costs down to their lowest possible level.
->The monopolist benefits if it can and does lower its costs, but it doesn’t have to in order to survive (with the proviso that average total costs cannot be higher than price).
When the seller charges different prices for the product it sells and the price differences do not reflect cost differences.
seller charges the highest price each consumer would be willing to pay for the product rather than go without it.
seller charges a uniform price per unit for one specific quantity, a lower price for an additional quantity, and so on.
seller charges different prices in different markets or charges a different price to different segments of the buying population.
->The seller must exercise some control over price; that is, it must be a price searcher.
->The seller must be able to distinguish among buyers who would be willing to pay different prices.
->It must be impossible or too costly for one buyer to resell the good to other buyers. The possibility of arbitrage*, or “buying low and selling high,” must not exist.
*Buying a good at a low price and selling the good for a higher price.
What are some of the “costs,” or shortcomings, of monopoly?
There are three in particular: (1) A monopoly firm produces too little output relative to a perfectly competitive firm; this causes the deadweight loss of monopoly. (2) The profits of the monopoly are sometimes subject to rent-seeking behavior. Rent seeking, while rational for an individual firm, wastes society’s resources. Society receives no benefit if one firm expends resources to take over the monopoly position of another firm. Resources that could have been used to produce goods (e.g., computers, software, shoes, houses, etc.) are instead used to transfer profits from one firm to another. (3) A monopolist may not produce its products at the lowest possible cost. Again, this wastes society’s resources.
What is the deadweight loss of monopoly?
As an example, suppose a perfectly competitive firm would produce 100 units of good X, but a monopoly firm would produce only 70, for a difference of 30 units. Buyers value these 30 units by more than it would cost the monopoly firm to produce them, yet the monopoly firm chooses not to produce them. The net benefit (benefits to buyers minus costs to the monopolist) of producing these 30 units is said to be the deadweight loss of monopoly. It represents how much buyers lose because the monopolist chooses to produce less than the perfectly competitive firm
Why must a seller be a price searcher (among other things) before he can price discriminate?
A seller who is not a price searcher is a price taker. A price taker can sell a product at only one price, the market equilibrium price.
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