ECO101— PRINCIPLES OF MICROECONOMICS—Notes
Perfect Competition and Monopoly
Overview Having examined the production and costs side of the firm’s decision-making in Chapters 6 and 7, we will now integrate costs and revenues to examine how firms determine prices and output levels under different market structures, starting out with perfect competition and monopoly – the two extreme cases of market structure. We develop a framework for categorising both market structures in both short run and long run periods. Then we represent the demand curve as the average revenue curve, and examine its relationship with the MR curve. Finally price discrimination is introduced in the context of monopoly production. Comparative Characteristics of Different Market Structures: An Overview We have determined in previous chapters that in the long-run firms primarily strive to maximise profits, though we examined situations where the objective of the firm may be sales maximization, market share maximization, revenue growth maximization, or some other objective. We have also determined that if firms want to achieve these optimum targets (sales or profits), they need to follow some accepted economic principles or “rules”—for example, that in order to maximize profits, firms must equate MR to MC. Yet, as we will examine in this chapter, the outcome (result) of decisions by firms, with respect to price and output levels, operating under different market structures/conditions, may well be different. In order to examine these various outcomes economists have developed and adopted certain analytical frameworks, or models. Remember that models necessarily abstract from reality by simplifying things in order to see the broad picture. For instance, perfect competition and monopoly as we describe them below do not exist in real life; still these features are very helpful in illustrating / approximating real-life business practices. The table below lists the comparative characteristics of the four broad market structures:
C o m p a r a tiv e C h a r a c te r is tic s o f M a r k e ts
P e rfe c t C o m p e titio n N u m b e r & N a tu re o f S e lle rs P r ic e N a tu re o f P ro d u c t B a r r ie r s to e n tr y P r o fit P o te n tia l P ro d u c t P r o m o tio n & A d v e r tis in g •M a n y (s m a ll s e lle rs ) •In d e p e n d e n t N o c o n tro l H o m o g e n e o u s (n o d iffe r e n tia tio n ) N o n e N o r m a l P r o fits in L R N o n e o r m in im a l M o n o p o lis tic C o m p e titio n M a n y (s m a ll to m e d iu m ) S o m e c o n tro l S o m e d iffe r e n tia tio n L o w S o m e p r o fits in S R & L R C o n s id e r a b le O lig o p o ly • F e w (la r g e ) • In te r -d e p e n d e n t C o n s id e r a b le c o n tro l S o m e tim e s b u t n o t a lw a y s C o n s id e r a b le C o n s id e r a b le P r o fits in S R & L R H e a vy M o n o p o ly O n e
A b s o lu te c o n tro l N o s u b s titu te s E n tr y is b lo c k e d L a r g e P r o fits in S R & L R S o m e b u t n o t d ir e c te d to c o m p e titio n , b u t to in c r e a s e s a le s
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
1
PERFECT COMPETITION
Price and Output Determination Under Perfect Competition
The first two characteristics / attributes in the table above are perhaps the most important in determining whether or not firms are operating under perfect competition. Since there is a very large number of sellers (and buyers), each one is producing/selling a very small amount of the total market output and therefore each one cannot affect the price (have no control on price). We say in this case that firms in perfect competition are price takers. How are prices then determined in a perfectly competitive market? The answer is: by the forces of market supply and market demand! In other words, by the total of all buyers demanding different quantities of goods at various prices (willing and able to buy) interacting with the sellers who are willing and able to supply these quantities at the various prices—refer back to Chapter 3 to review how the markets clear (reach equilibrium)! The conclusion that under perfect competition sellers are price takers, means that each perfectly competitive firm faces a horizontal (perfectly elastic) demand (AR) curve. If firms attempt to raise their prices they will risk losing ALL their customers since they will all go “next door” to the other seller of products, which are assumed to be identical (homogeneous or standardised), and which are sold at the lower market price. Also, firms will not sell below the market price because given the relatively small amount of output they produce compared to the total, they can sell all their output at the market price, without engaging in “price wars”. Since each additional unit is sold at the same price, it means that the additional revenue (MR) is equal to the average revenue (total revenue divided by the number of units sold). Thus, AR = MR = P. Let’s see this from the point of view of simple algebra: TR = P * Q AR = TR / Q MR = ?TR / ?Q AR = (P * Q ) / Q = P Thus, AR = P = ?(P * Q) / ?Q Thus MR = P
Since price does not change with output, (firms are price takers), = P ( ?Q / ?Q) = P
Therefore, we conclude that under perfect competition, the demand curve is horizontal, and since the demand curve is equal to the average revenue (AR), it is also equal to AR ( = MR = P). We represent the demand curve of a perfectly competitive firm in the graph below: Perfectly Competitive MARKET Price S Price MC Perfectly Competitive FIRM
P*
P*
d=MR=AR
D Q* Total Market Quantity Q* Firm Quantity
The firm accepts the price, as determined by the market, as given (the firm is a price taker), and decides what output to produce according to the rule for profit maximization, that is, where MR = MC. Therefore, each firm will decide to produce a level of profit-maximizing output depending on its cost structure, that is, the total costs that the firm pays for its inputs (wages, raw materials, etc) as represented above by the firm’s MC curve, which of course may be different for different firms. In other words, in the case of convenience stores (periptera), which we may assume that they come close to satisfying the conditions of perfect competition, some may decide to rent a less expensive shop, employ their children, etc in an attempt to keep their costs low, whereas another periptero may decide to rent a very large shop, in a new building paying high rent, hire full time people who get paid higher salaries, etc, therefore having relatively higher unit costs.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
2
Deriving the Firm’s Short Run Supply Curve We have determined above that the optimum (best) level of output for each firm is where MR = MC. We also determined that in perfect competition the firm’s MR is equal to the market price (P). If we assume that we have a set of different prices (and therefore a set of different MR curves) we can find a set of different points where MR = MC (points E0 to E3) as in the graph below. At each point of equality of MR and MC we have alternative sets of prices (P’s) and quantities produced (Q’s). In other words, we have a schedule of prices and quantities, which represent nothing more than the supply schedule we examined in Chapter 3. We can conclude then that the upward-sloping portion of the firm’s MC curve above the shut-down point is the firm’s short-run supply curve! This is shown in the graph below.
M C = S
P, A C , M C P3 E
3
SR
P
E
3
= M R
3
P
2
2
P P
2
= M R = M R = M R
2
E P P
1
1
1
1
E
0
0
AV C
P
0
0
S h u t-d o w n p o in t Q
Profits or Losses in the Short-Run Once we find the point where MR = MC, we can determine whether at this optimum level of output and price the firm is making profits or losses. In the graph below, MR = MC at Q =4 and P=$45. At this level of output, ATC1 = $35. Thus the firm makes a per unit profit of $10, or total profits of $40 (= 4 units X $10 per unit profit). If on the other hand, the per unit costs of the firm are as those represented by ATC2, then at the price of $45 per unit, the firm is obviously not covering its per unit cost which is $55 (ATC2 =$55). The firm then is making a loss in the short and would have to decide whether to stay in operation or whether to close down. As we discussed in Chapter 7, as long as the firm is covering its average variable costs – that is P > AVC – it should continue to operate in the short-run because by doing so it is recovering part of its overhead expenses (fixed costs). Price Losses
MC AC2
D=AR=P=MR
AC1
Profits
Quantity Long Run Equilibrium In the figure below we illustrates the long run supply decisions of the perfectly competitive firm. The market settles in long-run equilibrium when the typical firm just makes “normal” profits by setting LMC=MR at the minimum point of LAC. Long-run industry supply is horizontal (it exhibits constant returns to scale). If, on the other hand, by increasing industry output input prices rise (in other words, the industry faces decreasing returns to scale), then the long-run supply curve will not be horizontal, but upward sloping (see Chapter 7). Thus it can be seen that the price corresponding to the lowest point on the LAC curve is the entry or exit price – firms making only normal profit at this point.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
3
S
D
FIRM: Long Run Equilibrium
Q MARKET: Long Run Equilibrium
MONOPOLY
We now proceed to examine how a monopoly behaves in deciding what price to charge and how much output to produce. Remember that one of the key conditions (characteristics) for the monopolist (as described in the beginning of this chapter), was that the firm is a price maker. To be regarded as a pure monopoly, a firm must have absolute control on the market price and face no threat of possible entry by new comers into the market. Barriers to Entry One of the pre-conditions for monopoly to exist is that, as mentioned above, the firm face no threat of new competitors entering the market. That is, entry must be blocked. We will see in the next chapter that barriers (or obstacles) to entry exist also in the case of Oligopoly, but they are not as absolute as for monopoly. There are various forms of barriers. Here we briefly describe the major ones: Economies of Scale: In some situations, in order to be economical (efficient) to produce a good or service, the scale of operation must be very large to cover the entire market. This is especially true for small markets. In Cyprus, for example, we have the utilities companies (the Telecommunications Authority and the Electricity Authority), which control the whole market. These are called natural monopolies. Ownership / Control of Key Resources or Sales Outlets: Some companies may own or control the raw materials (such as mineral resources) for the production of certain goods, or control the wholesale or retail distribution outlets whereby goods are brought to the market and sold to consumers. Legal Protection: The firm may be protected from new competitors entering the market by patents (for new inventions), copyrights (for intellectual properties such as books, software programs, etc), licensing agreements (such as licences to operate TV stations, Taxis, Z-cars, etc), or even tariffs and barriers imposed by governments to protect local producers. Substantial Capital Outlay Requirements: For certain goods / activities to be offered, they require a very large investment to built for instance a power plant to produce electricity and set up the network to provide it to all homes and businesses. Similar is the case to Telephone companies to have all the cabling to provide service across the entire market. The size of the investment is an obstacle to entry. Brand Loyalty: In some situations, firms are able to develop such a strong customer loyalty for their brand that it becomes very difficult for new-comers to compete on the same terms.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
4
Demand Conditions under Monopoly By definition, the monopolist is the only seller in the industry. Therefore, it follows that the monopolist’s demand curve is the industry demand curve. We know by now that the shape of the standard demand curve faced by any industry is downward sloping, which derives from the law of demand. This means that in order to sell more firms have to lower their prices. We conclude, therefore, that the monopolist faces a downwardsloping demand curve: in order to sell more the monopolist has to lower the price in order to attract new business. This is always true even though the monopolist does not have competitors. Given the necessity of lowering price to sell more, the MR curve must also slope down and lie below the Demand curve (or Average Revenue curve). This relationship between AR and MR is shown in the graph below.
Price
MR
D = AR =P
Quantity
Here is a quick rule to find the relationship between the demand curve and the respective MR curve. When the demand (AR) curve is a downward sloping straight line, the MR curve starts from the same place on the Price axis, and cuts the quantity axis exactly half way between the origin and where the Demand (AR) curve cuts the quantity axis (in other words the MR curve is twice as steep as the AR curve). At this point the MR curve becomes negative, representing a situation where the revenue loss from the existing output exceeds the revenue gain from the extra unit itself.
Profit Maximization Under Monopoly Once again, using the familiar optimization rule by setting MR = MC will identify the profit maximising output At this optimum point, the monopolist must compare AR with ATC to see whether it is making profits or losses. If it is making losses, the firm must check further whether price (or AR) cover AVC. If P >AVC the firm should stay in business in the short run. If P < AVC, the monopolist should close down.
Price
MC ATC AR ATC
MR
Q*
D = AR
Quantity
As in other market structures, profits under monopoly are maximized where MR = MC. This is at Q*. As drawn here in the graph, the firm is making profits, since AR are greater than ATC at the optimum (best level) of output. AR – ATC is average profit. Obviously, the monopolist is a price-maker. This is the result of the market power that the firm has because it is able to block the entry of new comers in the industry.
Comparison of Monopoly and Perfect Competition A useful way to make the comparison is to assume that a monopolist takes over an industry composed of a number of identical perfectly competitive firms. We can assume that the monopolist continues to produce the same products as before, but now the decisions for prices and output levels are made centrally by the monopolist, whereas previously, under competitive conditions, prices were determined by the forces of supply and demand where the industry supply curve intersected the industry demand curve. The industry S becomes the monopolist’s short run MC curve, and the industry D becomes the firm’s D. With the monopolist gaining control of the individual firms, it will run the industry like an individual firm and in order to maximize profits, it will set its (short run) MC curve equal to the MR curve. The result is that compared to previously, the prices will be forced up and production will be reduced. This outcome is shown graphically below. From Q1 and P1 under perfect competition where demand = supply (as represented by the upward-sloping portion of the MC curve), the new situation is at Q2 and P2 where the monopolistic firm’s MR = MC.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
5
Price
MC (=SSR)
P2 P1
MR
SLR D = AR
Q2
Q1
Quantity
Discriminating Monopolist Price discrimination refers to the charging of different prices for different quantities of the product, to different segments (groups) of the population (market), to different markets (local vs. international), or even at different times. Price discrimination should be distinguished from price differentiation, which refers to the charging of different prices, which are justified as a result of changes in the costs of production of firms. We have seen that under the strict conditions of perfect competition, the small perfectly competitive firm is not in a position to charge higher prices than its competitors, nor it makes sense for the firm to charge a lower price in order to increase its sales, since it can sell all the output it produces at the going market price. The monopolist, however, having absolute control on prices, can decide to charge different prices to different segments of the population as long as three conditions are met: • • • The firm must have control over the price of the product The price elasticity for each segment (group) of the market must be different The monopolist must be able to isolate (separate) the market segments in order to prevent resale of goods from the low price marker (or group) to the higher price group or market.
Remember that when demand is inelastic (elasticity less than one), a price increase would result in an increase in total revenues (TR), since the percentage decrease in sales due to the higher prices would be proportionately less than the percentage increase in the prices, thus resulting at the end in higher total revenues. The lower the elasticity, the larger the final increase in TR. A classic example to make the concept of price discrimination clear is the pricing policies of airline companies, which charge different prices for the same trip to different customer segments (business class, economy class, student fares, excursion fares, etc). The primary reason that they are able to do this is due to the different price elasticities of the different groups of customers (also the resale of a ticket is not possible)! For instance, the business traveller who is on a tight time schedule and needs to catch his or her airplane to an important business meeting is not price sensitive (that is, his/her price elasticity is low)—in most cases, it is the company that pays for the ticket anyway!!--and can therefore be charged more for the service , compared to a student traveller who can spend some time examining the cheapest way to travel which may involve various routes, or even consider to travel by train. Time is not such a pressing element for the student over the summer holidays. There are many other examples of price discrimination, most of them in services which are consumed at the point of sale (on the spot) and there is no danger of resale: • • • • • • The charging of different rates by telephone companies during “peak periods” compared to “off-peak” periods (such as at night or on week-ends). The charging of different rates by electricity companies to commercial users compared with residential users The charging of different prices by doctors to lower-income than to high-income people The charging of different prices by movie theatres for evening than for matinees (morning) shows The charging of different fares by bus and train companies to the elderly, students, soldiers, etc The charging of lower rates by hotels for tourists or for conventions, groups than for locals.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
6
References for further reading: Bade, R. and Parkin, (2007). Foundations of Economics 3rd edition (Pearson Education). Begg, D., Fischer, S. and Dornbusch, R. (2005). Economics 8th edition (McGraw-Hill). Mankiew N. Gregory (2007). Principles of Economics 4th edition (Thomson, South-Western). McConnel C. and S. Brue (2005). Economics 16th edition (McGraw-Hill). Miller, R.L (2006). Economics Today 13th edition (Pearson Addison Wesley). Sloman John (2006). Economics 6th edition (Prentice Hall).
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
7
doc_834050895.pdf
Perfect Competition and Monopoly
Overview Having examined the production and costs side of the firm’s decision-making in Chapters 6 and 7, we will now integrate costs and revenues to examine how firms determine prices and output levels under different market structures, starting out with perfect competition and monopoly – the two extreme cases of market structure. We develop a framework for categorising both market structures in both short run and long run periods. Then we represent the demand curve as the average revenue curve, and examine its relationship with the MR curve. Finally price discrimination is introduced in the context of monopoly production. Comparative Characteristics of Different Market Structures: An Overview We have determined in previous chapters that in the long-run firms primarily strive to maximise profits, though we examined situations where the objective of the firm may be sales maximization, market share maximization, revenue growth maximization, or some other objective. We have also determined that if firms want to achieve these optimum targets (sales or profits), they need to follow some accepted economic principles or “rules”—for example, that in order to maximize profits, firms must equate MR to MC. Yet, as we will examine in this chapter, the outcome (result) of decisions by firms, with respect to price and output levels, operating under different market structures/conditions, may well be different. In order to examine these various outcomes economists have developed and adopted certain analytical frameworks, or models. Remember that models necessarily abstract from reality by simplifying things in order to see the broad picture. For instance, perfect competition and monopoly as we describe them below do not exist in real life; still these features are very helpful in illustrating / approximating real-life business practices. The table below lists the comparative characteristics of the four broad market structures:
C o m p a r a tiv e C h a r a c te r is tic s o f M a r k e ts
P e rfe c t C o m p e titio n N u m b e r & N a tu re o f S e lle rs P r ic e N a tu re o f P ro d u c t B a r r ie r s to e n tr y P r o fit P o te n tia l P ro d u c t P r o m o tio n & A d v e r tis in g •M a n y (s m a ll s e lle rs ) •In d e p e n d e n t N o c o n tro l H o m o g e n e o u s (n o d iffe r e n tia tio n ) N o n e N o r m a l P r o fits in L R N o n e o r m in im a l M o n o p o lis tic C o m p e titio n M a n y (s m a ll to m e d iu m ) S o m e c o n tro l S o m e d iffe r e n tia tio n L o w S o m e p r o fits in S R & L R C o n s id e r a b le O lig o p o ly • F e w (la r g e ) • In te r -d e p e n d e n t C o n s id e r a b le c o n tro l S o m e tim e s b u t n o t a lw a y s C o n s id e r a b le C o n s id e r a b le P r o fits in S R & L R H e a vy M o n o p o ly O n e
A b s o lu te c o n tro l N o s u b s titu te s E n tr y is b lo c k e d L a r g e P r o fits in S R & L R S o m e b u t n o t d ir e c te d to c o m p e titio n , b u t to in c r e a s e s a le s
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
1
PERFECT COMPETITION
Price and Output Determination Under Perfect Competition
The first two characteristics / attributes in the table above are perhaps the most important in determining whether or not firms are operating under perfect competition. Since there is a very large number of sellers (and buyers), each one is producing/selling a very small amount of the total market output and therefore each one cannot affect the price (have no control on price). We say in this case that firms in perfect competition are price takers. How are prices then determined in a perfectly competitive market? The answer is: by the forces of market supply and market demand! In other words, by the total of all buyers demanding different quantities of goods at various prices (willing and able to buy) interacting with the sellers who are willing and able to supply these quantities at the various prices—refer back to Chapter 3 to review how the markets clear (reach equilibrium)! The conclusion that under perfect competition sellers are price takers, means that each perfectly competitive firm faces a horizontal (perfectly elastic) demand (AR) curve. If firms attempt to raise their prices they will risk losing ALL their customers since they will all go “next door” to the other seller of products, which are assumed to be identical (homogeneous or standardised), and which are sold at the lower market price. Also, firms will not sell below the market price because given the relatively small amount of output they produce compared to the total, they can sell all their output at the market price, without engaging in “price wars”. Since each additional unit is sold at the same price, it means that the additional revenue (MR) is equal to the average revenue (total revenue divided by the number of units sold). Thus, AR = MR = P. Let’s see this from the point of view of simple algebra: TR = P * Q AR = TR / Q MR = ?TR / ?Q AR = (P * Q ) / Q = P Thus, AR = P = ?(P * Q) / ?Q Thus MR = P
Since price does not change with output, (firms are price takers), = P ( ?Q / ?Q) = P
Therefore, we conclude that under perfect competition, the demand curve is horizontal, and since the demand curve is equal to the average revenue (AR), it is also equal to AR ( = MR = P). We represent the demand curve of a perfectly competitive firm in the graph below: Perfectly Competitive MARKET Price S Price MC Perfectly Competitive FIRM
P*
P*
d=MR=AR
D Q* Total Market Quantity Q* Firm Quantity
The firm accepts the price, as determined by the market, as given (the firm is a price taker), and decides what output to produce according to the rule for profit maximization, that is, where MR = MC. Therefore, each firm will decide to produce a level of profit-maximizing output depending on its cost structure, that is, the total costs that the firm pays for its inputs (wages, raw materials, etc) as represented above by the firm’s MC curve, which of course may be different for different firms. In other words, in the case of convenience stores (periptera), which we may assume that they come close to satisfying the conditions of perfect competition, some may decide to rent a less expensive shop, employ their children, etc in an attempt to keep their costs low, whereas another periptero may decide to rent a very large shop, in a new building paying high rent, hire full time people who get paid higher salaries, etc, therefore having relatively higher unit costs.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
2
Deriving the Firm’s Short Run Supply Curve We have determined above that the optimum (best) level of output for each firm is where MR = MC. We also determined that in perfect competition the firm’s MR is equal to the market price (P). If we assume that we have a set of different prices (and therefore a set of different MR curves) we can find a set of different points where MR = MC (points E0 to E3) as in the graph below. At each point of equality of MR and MC we have alternative sets of prices (P’s) and quantities produced (Q’s). In other words, we have a schedule of prices and quantities, which represent nothing more than the supply schedule we examined in Chapter 3. We can conclude then that the upward-sloping portion of the firm’s MC curve above the shut-down point is the firm’s short-run supply curve! This is shown in the graph below.
M C = S
P, A C , M C P3 E
3
SR
P
E
3
= M R
3
P
2
2
P P
2
= M R = M R = M R
2
E P P
1
1
1
1
E
0
0
AV C
P
0
0
S h u t-d o w n p o in t Q
Profits or Losses in the Short-Run Once we find the point where MR = MC, we can determine whether at this optimum level of output and price the firm is making profits or losses. In the graph below, MR = MC at Q =4 and P=$45. At this level of output, ATC1 = $35. Thus the firm makes a per unit profit of $10, or total profits of $40 (= 4 units X $10 per unit profit). If on the other hand, the per unit costs of the firm are as those represented by ATC2, then at the price of $45 per unit, the firm is obviously not covering its per unit cost which is $55 (ATC2 =$55). The firm then is making a loss in the short and would have to decide whether to stay in operation or whether to close down. As we discussed in Chapter 7, as long as the firm is covering its average variable costs – that is P > AVC – it should continue to operate in the short-run because by doing so it is recovering part of its overhead expenses (fixed costs). Price Losses
MC AC2
D=AR=P=MR
AC1
Profits
Quantity Long Run Equilibrium In the figure below we illustrates the long run supply decisions of the perfectly competitive firm. The market settles in long-run equilibrium when the typical firm just makes “normal” profits by setting LMC=MR at the minimum point of LAC. Long-run industry supply is horizontal (it exhibits constant returns to scale). If, on the other hand, by increasing industry output input prices rise (in other words, the industry faces decreasing returns to scale), then the long-run supply curve will not be horizontal, but upward sloping (see Chapter 7). Thus it can be seen that the price corresponding to the lowest point on the LAC curve is the entry or exit price – firms making only normal profit at this point.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
3
S
D
FIRM: Long Run Equilibrium
Q MARKET: Long Run Equilibrium
MONOPOLY
We now proceed to examine how a monopoly behaves in deciding what price to charge and how much output to produce. Remember that one of the key conditions (characteristics) for the monopolist (as described in the beginning of this chapter), was that the firm is a price maker. To be regarded as a pure monopoly, a firm must have absolute control on the market price and face no threat of possible entry by new comers into the market. Barriers to Entry One of the pre-conditions for monopoly to exist is that, as mentioned above, the firm face no threat of new competitors entering the market. That is, entry must be blocked. We will see in the next chapter that barriers (or obstacles) to entry exist also in the case of Oligopoly, but they are not as absolute as for monopoly. There are various forms of barriers. Here we briefly describe the major ones: Economies of Scale: In some situations, in order to be economical (efficient) to produce a good or service, the scale of operation must be very large to cover the entire market. This is especially true for small markets. In Cyprus, for example, we have the utilities companies (the Telecommunications Authority and the Electricity Authority), which control the whole market. These are called natural monopolies. Ownership / Control of Key Resources or Sales Outlets: Some companies may own or control the raw materials (such as mineral resources) for the production of certain goods, or control the wholesale or retail distribution outlets whereby goods are brought to the market and sold to consumers. Legal Protection: The firm may be protected from new competitors entering the market by patents (for new inventions), copyrights (for intellectual properties such as books, software programs, etc), licensing agreements (such as licences to operate TV stations, Taxis, Z-cars, etc), or even tariffs and barriers imposed by governments to protect local producers. Substantial Capital Outlay Requirements: For certain goods / activities to be offered, they require a very large investment to built for instance a power plant to produce electricity and set up the network to provide it to all homes and businesses. Similar is the case to Telephone companies to have all the cabling to provide service across the entire market. The size of the investment is an obstacle to entry. Brand Loyalty: In some situations, firms are able to develop such a strong customer loyalty for their brand that it becomes very difficult for new-comers to compete on the same terms.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
4
Demand Conditions under Monopoly By definition, the monopolist is the only seller in the industry. Therefore, it follows that the monopolist’s demand curve is the industry demand curve. We know by now that the shape of the standard demand curve faced by any industry is downward sloping, which derives from the law of demand. This means that in order to sell more firms have to lower their prices. We conclude, therefore, that the monopolist faces a downwardsloping demand curve: in order to sell more the monopolist has to lower the price in order to attract new business. This is always true even though the monopolist does not have competitors. Given the necessity of lowering price to sell more, the MR curve must also slope down and lie below the Demand curve (or Average Revenue curve). This relationship between AR and MR is shown in the graph below.
Price
MR
D = AR =P
Quantity
Here is a quick rule to find the relationship between the demand curve and the respective MR curve. When the demand (AR) curve is a downward sloping straight line, the MR curve starts from the same place on the Price axis, and cuts the quantity axis exactly half way between the origin and where the Demand (AR) curve cuts the quantity axis (in other words the MR curve is twice as steep as the AR curve). At this point the MR curve becomes negative, representing a situation where the revenue loss from the existing output exceeds the revenue gain from the extra unit itself.
Profit Maximization Under Monopoly Once again, using the familiar optimization rule by setting MR = MC will identify the profit maximising output At this optimum point, the monopolist must compare AR with ATC to see whether it is making profits or losses. If it is making losses, the firm must check further whether price (or AR) cover AVC. If P >AVC the firm should stay in business in the short run. If P < AVC, the monopolist should close down.
Price
MC ATC AR ATC
MR
Q*
D = AR
Quantity
As in other market structures, profits under monopoly are maximized where MR = MC. This is at Q*. As drawn here in the graph, the firm is making profits, since AR are greater than ATC at the optimum (best level) of output. AR – ATC is average profit. Obviously, the monopolist is a price-maker. This is the result of the market power that the firm has because it is able to block the entry of new comers in the industry.
Comparison of Monopoly and Perfect Competition A useful way to make the comparison is to assume that a monopolist takes over an industry composed of a number of identical perfectly competitive firms. We can assume that the monopolist continues to produce the same products as before, but now the decisions for prices and output levels are made centrally by the monopolist, whereas previously, under competitive conditions, prices were determined by the forces of supply and demand where the industry supply curve intersected the industry demand curve. The industry S becomes the monopolist’s short run MC curve, and the industry D becomes the firm’s D. With the monopolist gaining control of the individual firms, it will run the industry like an individual firm and in order to maximize profits, it will set its (short run) MC curve equal to the MR curve. The result is that compared to previously, the prices will be forced up and production will be reduced. This outcome is shown graphically below. From Q1 and P1 under perfect competition where demand = supply (as represented by the upward-sloping portion of the MC curve), the new situation is at Q2 and P2 where the monopolistic firm’s MR = MC.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
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Price
MC (=SSR)
P2 P1
MR
SLR D = AR
Q2
Q1
Quantity
Discriminating Monopolist Price discrimination refers to the charging of different prices for different quantities of the product, to different segments (groups) of the population (market), to different markets (local vs. international), or even at different times. Price discrimination should be distinguished from price differentiation, which refers to the charging of different prices, which are justified as a result of changes in the costs of production of firms. We have seen that under the strict conditions of perfect competition, the small perfectly competitive firm is not in a position to charge higher prices than its competitors, nor it makes sense for the firm to charge a lower price in order to increase its sales, since it can sell all the output it produces at the going market price. The monopolist, however, having absolute control on prices, can decide to charge different prices to different segments of the population as long as three conditions are met: • • • The firm must have control over the price of the product The price elasticity for each segment (group) of the market must be different The monopolist must be able to isolate (separate) the market segments in order to prevent resale of goods from the low price marker (or group) to the higher price group or market.
Remember that when demand is inelastic (elasticity less than one), a price increase would result in an increase in total revenues (TR), since the percentage decrease in sales due to the higher prices would be proportionately less than the percentage increase in the prices, thus resulting at the end in higher total revenues. The lower the elasticity, the larger the final increase in TR. A classic example to make the concept of price discrimination clear is the pricing policies of airline companies, which charge different prices for the same trip to different customer segments (business class, economy class, student fares, excursion fares, etc). The primary reason that they are able to do this is due to the different price elasticities of the different groups of customers (also the resale of a ticket is not possible)! For instance, the business traveller who is on a tight time schedule and needs to catch his or her airplane to an important business meeting is not price sensitive (that is, his/her price elasticity is low)—in most cases, it is the company that pays for the ticket anyway!!--and can therefore be charged more for the service , compared to a student traveller who can spend some time examining the cheapest way to travel which may involve various routes, or even consider to travel by train. Time is not such a pressing element for the student over the summer holidays. There are many other examples of price discrimination, most of them in services which are consumed at the point of sale (on the spot) and there is no danger of resale: • • • • • • The charging of different rates by telephone companies during “peak periods” compared to “off-peak” periods (such as at night or on week-ends). The charging of different rates by electricity companies to commercial users compared with residential users The charging of different prices by doctors to lower-income than to high-income people The charging of different prices by movie theatres for evening than for matinees (morning) shows The charging of different fares by bus and train companies to the elderly, students, soldiers, etc The charging of lower rates by hotels for tourists or for conventions, groups than for locals.
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
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References for further reading: Bade, R. and Parkin, (2007). Foundations of Economics 3rd edition (Pearson Education). Begg, D., Fischer, S. and Dornbusch, R. (2005). Economics 8th edition (McGraw-Hill). Mankiew N. Gregory (2007). Principles of Economics 4th edition (Thomson, South-Western). McConnel C. and S. Brue (2005). Economics 16th edition (McGraw-Hill). Miller, R.L (2006). Economics Today 13th edition (Pearson Addison Wesley). Sloman John (2006). Economics 6th edition (Prentice Hall).
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
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