Monopoly and Dominant Firms

Chapter 11
"Monopoly"conjuresimagesofhugeprofits,great
wealth,andindiscriminatepower,labeledrobber
barons.

Butsomemonopoliesarenotveryprofitable
Othersdominatetheirindustry
StillothersareregulatedbyStatePublicServiceor
UtilityCommissions,andmayhaveverylowratesof
returnoninvestedcapital.
Regulatedmonopoliesareknownasutilities.
2008 Thomson * South-Western

Slide 1

Sources of Market Power for a Monopolist

Legalrestrictionscopyrights&patents.
Controlofcriticalresourcescreatesmarketpower.
Governmentauthorizedfranchises,suchas
providedtocableTVcompanies.

Economiesofscaleallowlargerfirmstoproduceat
lowercostthansmallerfirms.

Increasingreturnsinnetworkbasedbusinesses
compatibilitiesincreasemarketpenetration.

Slide 2

Netscape vs. Microsoft

Internet Explorer
At one time, Netscape held 80% of the Internet browser
market
But rapidly, Microsoft Internet Explorer grew through
increasing returns and being packaged with other
Microsoft software taking 55% of the market.
Trying to avoid Apples mistake of not being compatible
with industry standard, Netscape made itself compatible,
but it found itself buried by the increasing returns in its
competitors.
Then Yahoo! and Google grew into the leading browsers
Slide 3

An Unregulated Monopoly
Monopoly is a single seller

The demand curve:

P = 100 - Q

where entry is prohibited and

there are no close substitutes

1. FIRM = INDUSTRY

TR1 = 6040 = 2400

TR2 = 5941 = 2419

19

60
59

40 41

So. MR = 19
where MR < P

Slide 4

3. At output where MR = MC,

profit is maximized
MC

Proof: Max = TR TC
Find where d/dQ = 0

PM

d/dQ = dTR/dQ - dTC/dQ = 0

MR MC = 0
So: MR = MC

4.

QM
Charge highest price
that the market will bear, PM

MR
Slide 5

If we use a linear demand curve:

MARGINAL REVENUE is twice as steep
as a linear demand curve

If P = a - bQ, then
TR = aQ - bQ2
so

MR = a - 2bQ
This is twice as steep
Slide 6

A MONOPOLY
PROBLEM
Find the monopoly quantity if: P = 100 - Q, and where
MC = 20.
Answer this by starting where MR = MC
TR = PQ = 100Q - Q2
MR = 100 - 2Q = 20
80 = 2Q
QM = 40

Find Monopoly Price:

PM = 100 - 40 = 60

The highest price

that the market will
bear.
Slide 7

The Importance of Price Elasticity of

Demand for a Monopoly
MONOPOLY has MR = MC
TR = QP(Q)
dTR/dQ = MR = P + (dP/dQ)Q = P [ 1 + (dP/dQ)(Q/P) ]
= P[ 1 + 1/ EP ]
As EP goes to
negative infinity,
MR approaches P

P [ 1 + 1/ EP ] = MC
Equation 11.2

Marginal Revenue
Slide 8

Optimal Markups
The optimal markup can be found using this same formula.
P = [ED /( ED+1)]MC.
The optimal markup m is: (1+m) = [ED /( ED+1)]
Hence: m = - 1 / ( ED + 1)
For example, if ED = -3, the markup is 50%, since = [-1/( -3
+1)] = .50
If ED = -4, the markup is 33.3%, since his is where [-1/( -4
+1)] = .333.
If the price elasticity is infinite, the markup is zero. This
occurs in competition, where m = -1/(- + 1) = 0.
Slide 9

Find the Monopoly Price in

these Problems

ANSWER

EP = - 3
& MC = 100
Whats PM ?
If

P[ 1 + 1/( - 3) ] = 100
P[ 2/3 ] = 100
So, P = $150.
If EP = -5, then optimal
monopoly price falls to
$125.
The more elastic is the
demand, the closer is
price to MC.
Slide 10

A Monopoly Pricing Problem

Regression results for Lands End Womens lightweight coats:
Log Q = - .4 -1.7 Log P + 1.2 Log Y
( 3 . 2)

( 4. 5)

Let MC of imported womens light-weight coats be

$19.50.
Find the Monopoly Price for a Lands End lightweight coats.
ANSWER: P( 1 + 1/EP ) = MC
P ( 1 + 1/(-1.7) ) = 19.50

P = $47.36

Slide 11

Components of Gross Profit Margin

Sometimes it is shortened to Profit Margin and is also called

Direct Cost of Goods Sold (DCOGS). It is defined as:

Gross Profit Margin = Revenue Variable Cost Direct Fixed Cost

Suppose a carpet firm makes 20 varieties, the Gross Profit Margin

of one of them is the Revenue earned, minus the cost of time and
materials to make it, minus the setup costs to produce that type of
carpet. The last is the direct fixed cost associated with that
product.
Gross Profit Margin varies across industries:
1. Because industries vary in capital intensity. Typically highly capital
intensive industries have larger gross profit margins
2. Because industries vary in selling costs such as advertising and promotional
expenses. Typically high selling costs lead to high gross profit margins.
3. Because industries vary in their overhead expense. Often high overhead
expense leads to high gross profit margins
Slide 12

Limit Pricing
An established firm considers the possibility
of new entrants with distaste.
Suppose a new entrant would have a Ushaped average cost curves.
Suppose also that the established firm has
created some brand loyalty, such that
entrants must under-price them to take away
their customers.

AC

Slide 13

The potential competitor (PC) has no demand at

limit price PL as DPC is below ACPC

Profit Profiles
ACPC

PL

II
D

ACestablished
DPC

I
time

Which profit profile (I or II) represents profit maximization?

Would a stockholder prefer profile I or II?
The profit profile of limit pricing is more like II than I.
Slide 14

Regulated Monopolies
Electric Power Companies
Natural Gas Companies
Communication Companies (telephone,
cable, radio, TV, etc.)

Often, Municipal Water Companies

All are examples of regulated companies or
Public Utilities.
They are all naturally monopolistic as they all
have significant declining cost curves.
Suppose we examine railroads before regulation
as an example of a nature monopoly.
Slide 15

Natural Monopolies
Declining Cost
Industries
economies in
distribution
economies of scale

Without Regulation
they face Cyclical
Competition with
prices gyrating
between PM and PC.
railroad history includes
periods of huge profits then
bankruptcies

DEMAND
PM

AC
MC

PR = AC
PC = MC

QM

Q R QC

MR
Slide 16

Solutions to the

Problem of Natural Monopolies

PREVENT ENTRY, set
P = MC and subsidize.

REGULATE, prevent
entry, & set P = AC

common in US for
subsidies require some form of
electricity, water
taxation, which will tend to distort
work effort.
FRANCHISE through
subsidies to AMTRAK
a bidding war, likely

NATIONALIZE, prevent entry,

set price typically low
governments find that changing its
price is a highly political event
once popular solution in Europe

P = AC
Cable T.V.
concessions at various
stadiums
Slide 17

Peak Load Pricing

Examples: Long Distance Calls,
Electrical Prices, Seasonally Pricing
at Amusement Parks
Conditions
Not Storable
Same Facilities
Demand Variation

Slide 18

Peak and Off-Peak Demand

What price
should we
charge for peak
and off-peak
users?

price

Pp
Po

Off Peak
Demand

Peak Load Demand

Q0 QP
Slide 19

General Solution
P(peak) = variable costs + capital costs
P(off-peak) = variable costs only
Some argue that off-peak users benefit from
capacity
Electrical Case: Less chance of a brown out
Amusement Park: Off peak users enjoy more space
Then off-peak users should pay for some part of the
capacity cost

Slide 20