AP Econ PURE MONOPOLY
Can the perfectly competitive firm earn short-run economic profit? What happens in the long run? What about the monopolist?
-Yes; however, in the long run, the profit motive draws other firms into the industry. ✎This results in a lower price/MR for the firm until economic profit is reduced to 0. -The monopolist can sustain economic profit in the long run due to the barriers to entry. ✎Because no new firms are able to enter the industry, no long-run adjustment occurs for monopolies.
In short, what is the MOST important reason as to why MR is lower than P?
*In order for the firm to sell more products, it must lower the price on all of the products sold.*
The government can also create barriers to entry by granting patents/licenses. Describe what effect(s) it would have on the monopoly.
*PATENT: Protects an inventor's ownership rights -Government grants a patent in order to encourage investment in research & development. -For the life of the patent, the owner has monopoly control of the product and can use revenues to regain research & development costs. -The owner may also use revenues to possibly support further development of other products. *LICENSE: In many cases, in order to enter a profession, a government either sets licensing requirements, or empowers some other body to set such conditions. In many cases, this is generally approved of by the public: We like knowing that our doctors know what they are doing, and that our accountants are certified as competent. (Source: Penn State) -Government can create licenses as barriers to entry by licensing producers (anyone from taxi drivers and cosmetologists to teachers and electricians).
Demand, MR, & TR for a pure monopolist:
-As MR falls, the growth in TR slows down. -As long as MR is positive, the sale of additional products adds to TR for the firm, but each additional sale adds less and less revenue. -At the point where MR of the next product = 0, TR peaks. -TR is maximized at the output where the MR curve crosses through the bottom axis of the graph. ✎After this point, each additional product sold results in a negative MR. ✎The product price is positive, but the reduction in price for all earlier units overwhelms that price; thus, the MR curve falls through the bottom of the graph. -At the output where MR becomes negative, TR starts to fall.
Give some examples of pure monopolies.
-Local natural gas -Electricity -Water companies -Pharmaceutical companies that hold patents (copyrights) on certain medications
If per-unit (variable) costs decrease, such as lower wages or lower-cost resources, what would happen to the MC, AVC, and ATC?
-MC, AVC, and ATC would all shift downward -The firm would increase production -The price would fall
Economies of scale
-One important barrier to entry is economies of scale. -The larger the firm's output, the more efficient the firm becomes. -Natural monopolies achieve economies of scale, as their ATC curves continue to fall over a large range of output.
Describe what a pure monopoly's graph looks like.
-The MR curve is LOWER than the P (price) curve. -For the firm to sell more products, it must lower the price for ALL goods it sells, not simply the last one. -Because of this, MR will be lower than the price charged for that product.
(Con.) Regulated monopoly:
-The firm incurs a loss and will have to decide whether to even stay in the short run. -In the long run, if the firm cannot raise its price or lower its costs, it will NOT remain in business. →The government could offer the firm a subsidy to cover these costs, in order to encourage the firm to remain in operation. The government could also allow the firm to engage in price discrimination in order to charge a higher price to those customers with the most INELASTIC demand for the product.
Regulated monopoly:
-The firm maximizes its profit by setting an output at the first Q and a price at the highest P. -In order to achieve allocative efficiency, the government may set a price ceiling at the point where MC = D (=P). At that price ceiling of the lowest P, the MR curve becomes the price (as in perfect comp.) and the monopoly firm will produce the highest Q units of output (where MR now = MC but at a lower price and higher output than it would have produced as an UNREGULATED monopoly). →MC = price at this output, signifying allocative efficiency. *Note: This arrangement leaves this particular firm producing at a price LOWER than ATC at this output.
If a lump-sum (fixed) cost decreases (a firm receiving a subsidy or lower property tax), what happens to AFC and ATC?
AFC and ATC would shift down. While the price/output do NOT change, the firm's profit INCREASES.
Profit maximization by a pure monopolist:
-The monopolist maximizes profit at the output where MR = MC. -As long as the firm receives revenue ≥ the cost of producing the next unit of output, the firm should produce it. -If the cost to produce the next unit is > the revenue the firm would receive from selling it, the firm should NOT produce it. ☆Look at the quantity where MR = MC; this will show you the profit-maximizing output. -To find the monopoly's price, extend the line at the selected output up to the demand curve. Because consumers are willing AND able to pay that price, that is the price that the firm will charge.
Inefficiency of a pure monopoly relative to a purely competitive industry:
-The perfectly competitive model and the monopoly model, the extremes of the 4 market structures, demonstrate significant differences in efficiency, output, and price. 1. While both productive/allocative efficiency are achieved in the perfectly competitive industry (because firms produce at the lowest cost where MC = ATC and the product's value to society = the cost of making it where P = MC), neither is achieved for the monopoly. ✎The monopolist produces where MR = MC in order to maximize profit, at an output lower than that required to achieve productive efficiency. -Price > MC AND minimum ATC ✎Because productive efficiency is not met, allocative efficiency cannot be met by the monopoly. ✎Deadweight loss is illustrated by the triangle to the left of the point where MC = D for the monopoly. This is the loss of efficiency due to monopoly output and represents the loss of consumer/producer surplus.
Why do monopolists cut their prices?
-To undercut the competition -Make deals with retailers in order to reinforce their monopoly status -To find other ways to make the competitor's product more expensive or less desirable
Loss minimization and the shutdown decision:
-While the monopoly can earn a profit, it is also possible for the firm to sustain a loss. -A loss occurs when the firm's ATC is > the price on the demand curve at the MR = MC output.
List the steps used to show that the firm earns an economic profit in the monopoly model.
1. Draw the demand, MR, and MC curves. 2. Draw a point on the MC curve between the demand and MR curves. Make this point the LOWEST point on your ATC curve. ✎This step ensures that you'll demonstrate MC crossing ATC at its lowest point (productive efficiency), as well as show that the ATC is lower than the price on the demand curve.
(Con.) Inefficiency of a pure monopoly relative to a purely competitive industry:
2. A monopoly produces fewer products and charges a higher price than a perfectly competitive industry. ✎Monopolists maximize profit at the output where MR = MC, which is less than the allocatively efficient output of MC = D. -The monopolist then sets the price on the demand curve, which is higher than what the perfectly competitive firm would charge.
(Con.) Inefficiency of a pure monopoly relative to a purely competitive industry:
3. A monopoly can sustain long-run profit because the price is higher than ATC and barriers prevent firms from entering in order to bring the price down. ✎Perfectly competitive firms may enjoy a short-run profit, but in the long run, the entry of new firms lowers the price until economic profit returns to 0. -This translates to a lower MR for the firm.
Give an example of HOW the MR curve is lower than the P (price) curve.
A firm sells 5 gumdrops for $10 each (those are some expensive gumdrops) and TR = $50. -If the firm wants to sell the 6th gumdrop, it must lower its price of gumdrops to $9- for all of them. -Now, the firm sells 6 gumdrops for $9 each and TR = $54. -So while the price of the gumdrop is $9, MR for the firm is only $4 (TR increased from $50 to $54). -This means that MR is LESS THAN the price, and AR (average revenue), price, & demand are all shown on the higher curve.
Why does a monopoly have only one graph unlike the side-by-side graphs for perfect competition?
A monopoly has only one graph because the monopoly is the only firm in the industry; therefore, the monopoly IS the industry.
Define a pure monopoly.
A pure monopoly is a market structure with: -Only ONE producer -NO close substitutes -COMPLETE barriers to entry
Describe the analysis of the pure monopoly.
Analysis of the pure monopoly assumes that: -no firms can enter the industry -the government does not regulate the firm -the firm charges the same price for every product
What are barriers to entry?
Barriers to entry are factors that prevent competitors from entering the industry.
How does a monopoly's demand curve differ from a perfectly competitive demand curve?
Because the monopoly is the one and only producer, industry demand = firm's demand. So, a monopoly faces a downward-sloping demand curve, with Qd increasing as price falls. -This difference has important effects in price/output.
How do changes in costs for the monopoly shift the cost curves? Why?
Changes in costs for the monopoly shift the cost curves directly up and down, because the curves represent the costs at EACH output (see next notecard for more info).
True or False: The firm is focused on maximizing profit per unit.
FALSE!! The firm is focused on maximizing TOTAL PROFIT, not profit per unit. *Note: The monopoly is limited in the price it can charge. Many believe that a monopoly can charge any price that it wants to, but keep in mind that it is still constrained by the demand curve. -The firm will set the price at the point on the demand curve at the output where MR = MC.
True or False: Monopolies cannot completely prevent potential competitors from entering the industry.
False; monopolies CAN keep other competitors away from the industry.
Why does government have an interest in intervening in some monopoly markets?
Government has an interest in intervening in some monopoly markets because of the inefficiency, higher prices, and lower output associated with monopolies.
Because the monopolist reduces output in order to maximize profit, sets a higher price, and does not achieve productive or allocative efficiency, what do governments attempt to do?
Governments attempt to improve the outcome for society through regulation.
While perfectly competitive firms face no barriers and are free to enter/exit the industry, what must imperfectly competitive firms deal with?
Imperfectly competitive firms must deal with BARRIERS.
Is it more or less cost-effective to have one large producer? What do these economies of scale also serve as?
It is MORE cost-effective to have one large producer, because the ATC would increase with more firms producing less units. These economies of scale also serve as a barrier to entry for new firms, which face those higher costs as smaller producers.
Why do monopolies hold market power (power to determine prices)?
Monopolies hold market power as a result of barriers to entry.
What are natural monopolies (such as public utilities) regulated by? Why?
Natural monopolies are regulated by state & local governments in order to limit prices and ensure product quality.
When do near monopolies exist?
Near monopolies exist where a single firm provides the majority of sales in a certain industry.
Does the perfectly competitive firm have any power over prices in the marketplace? What about the monopoly?
No; however, the monopoly does have the power needed for determining the product's price/output.
When determining profit, what should you be extremely careful about?
ONLY look at the distance between the price and ATC at the MR = MC output. ☆Do NOT measure the distance between the demand curve and the MR = MC point, viewing this point as the profit per unit (it's not). -Remember, profit = TR - TC.
If a lump-sum (fixed) cost increases, what else increases?
Only AFC and ATC increase; all else stays the same. -Because MC does not change, price/output do not change. -With a higher ATC, the firm's profit is lower; however, everything else stays the same.
How can other firms create barriers to entry?
Other firms may control the resources necessary to produce the product.
Often, where do regulatory commissions set the price ceiling at?
Regulatory commissions set the price ceiling at the fair-return price, where ATC = D. ✎At this output, the firm achieves a normal profit but not an economic profit. -The price is lower and the output is higher than it would be under an unregulated monopoly but not as much as if the regulators set the price ceiling at the socially optimal price of P = MC. →However, this solution avoids the need for a subsidy to keep the firm in business.
What happens when a per-unit (variable) cost increases?
The MC, AVC, and ATC all increase. -Because the new MR = MC is at a lower output, the firm will produce fewer products at the higher cost. -The price set on the demand curve above where MR = MC will be HIGHER as a result of the LOWER output.
What is the MOST important difference between the competitive firm and the pure monopoly?
The demand curve! -The perfectly competitive firm is a price-taker, accepting the price set in the industry. -In this case, the individual firm has a perfectly elastic/horizontal demand curve, with MR = P.
Because there is no long-run adjustment of other firms leaving the industry, what does the firm alone have to decide on?
The firm has to make its own decision of whether to shut down in the long run. -If the firm is convinced that losses will persist in the long run, the firm will likely shift its resources to a more profitable opportunity or simply shut down altogether.
Another important conclusion drawn from a downward-sloping demand curve:
The firm is a price MAKER, not a price TAKER (as firms are in pure competition). Monopolies control the supply/product price through their OWN output decisions. -Another effect of a downward-sloping demand curve is that the firm will set its price/output in the ELASTIC portion of the demand curve since the monopoly seeks to MAXIMIZE PROFIT. ✎The firm will NEVER chose to produce where MR is negative because that output would result in a lower TR for the firm at the same time that TC is rising. So, the firm would experience LOWER profit in that range of production.
Under what condition can the government file charges under anti-trust laws?
The government can file charges under anti-trust laws (IF a firm engages in anti-competitive behavior) by prohibiting the firm from continuing the behavior or breaking it into several competing firms.
In the case of a natural monopoly, where society benefits from a monopoly due to economies of scale, what can the government regulate?
The government may regulate the firm's price/product quality in a natural monopoly. -Other monopolies that do not cause significant economic problems (ie. the only ice skating rink in town) may be allowed to continue in operation WITHOUT regulation.
What happens as a result of the downward-sloping demand curve in a monopoly?
The monopoly can restrict output in order to raise the product price.
Why is the monopoly model important?
The monopoly model helps us to understand monopolistic competition/oligopolies later on!
What does the monopoly model show us?
The monopoly model shows us important differences from perfect competition in terms of efficiency and effects on producer and consumer surplus.
How is a pure monopoly mainly different from a perfectly competitive firm?
The pure monopoly is a price MAKER, while the perfectly competitive firm is a price TAKER. In a pure monopoly, the firm determines its own price/output for its product.
To calculate the profit that the firm earns from the chosen output, you must compare the price at that output to the ATC at that same output. How can you find profit?
There are 2 ways to calculate the profit: 1) TR - TC ✎TR = Price x Output ✎TC = ATC x Output 2) Profit per Unit x Output ✎Profit per unit = Price - ATC
Describe price discrimination.
Up to this point, we have assumed that the firm charges all customers the same price for the product. →However, monopolists are able to discriminate, increasing profit by charging different customers different prices for the same good. ✎You have likely seen price discrimination, such as a special price for movie tickets for children and senior citizens or discount cards for frequent shoppers at a store. ✎Price-discriminating monopolists charge a lower price for consumers who are more sensitive to price (elastic demand), while customers who are less sensitive to price are charged the full higher price. ✎Price discrimination is common and legal in the U.S. as long as it is not used to prevent entry of firms into the industry.
As is the case for a perfectly competitive model, what type of industry do we assume a pure monopoly is in?
We assume that the monopoly is in a constant-cost industry (an increase of firms entering an industry does not affect the price of resources needed for that industry). -The monopoly firm is such a small part of the market for resources that increased demand will NOT push up the cost of those resources.
When determining the price, be EXTRA careful to go ALL the way up to the demand curve...
☆Do NOT treat the MR = MC point similarly to a supply and demand equilibrium (setting the price at that same point). ☆Consumers are willing AND able to pay for the higher price, and charging that higher price maximizes the firm's profit.
If the firm incurs a loss, should it remain in operation?
✎If the price is > the firm's AVC, the firm should remain in operation. ✎If the firm cannot even cover the variable costs needed to produce the additional output, the firm should shut down.
