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Monopoly:Elasticity of Demand and Price Markup, Sources of Monopoly Power

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Microeconomics ­ECO402
VU
Lesson 32
Monopoly
The Multiplant Firm
­ For many firms, production takes place in two or more different plants whose operating
cost can differ.
­ Choosing total output and the output for each plant:
·  The marginal cost in each plant should be equal.
·  The marginal cost should equal the marginal revenue for each plant.
­ Algebraically:
Q1 & C1 Output & Cost for Plant 1
Q2 & C2 Output & Cost for Plant 2
Total Output = QT = Q1 + Q2
­
­ Algebraically:
š = PQ T - C  1 ( Q  1 ) - C 2 ( Q  2 )
Δš
Δ ( PQ T )  Δ C  1
=0
-
=
Δ Q1
Δ Q1
Δ Q1
Δ C1
Δ ( PQ  T )
- ( MC )
=0
( MR )
Δ Q1
Δ Q1
MR =
MC  1
- MC
MR
1
= MC
MR
2
= MC
= MC
MR
1
2
$/Q
MC1
MC2
MCT
P*
D = AR
MR*
MR
Quantity
Q1
Q
Q
149
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Microeconomics ­ECO402
VU
Observations:
1)
MCT = MC1 + MC2
2)
Profit maximizing
output:
·
$/Q
MCT = MR at QT and P *
MC1  MC2
·
MCT
MR = MR*
MR* = MC1 at Q1, MR*
·
= MC2 at Q2
P*
·
MC1 + MC2 = MCT, Q1 +
Q2 = QT,
and MR =MC1+MC2
D = AR
MR*
MR
Q1
Q2
QT
Quantity
Monopoly Power
Monopoly is rare.
However, a market with several firms, each facing a downward sloping demand curve will
produce so that price exceeds marginal cost.
Scenario:
­ Four firms with equal share (5,000) of a market for 20,000 toothbrushes at a price of
$1.50.
The Demand for Toothbrushes
$/Q
$/Q
The demand curve for
At a market price
2.00
2.00
Firm A
of $1.50, elasticity of
depends on how much
demand is -1.5.
their product differs, and
how the firms compete.
1.60
1.50
1.50
1.40
Market
Deman
1.00
1.00
QA
30,000 Quantity
10,000
20,000
3,000
5,000
7,000
150
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Microeconomics ­ECO402
VU
Firm A sees a much more
$/Q
$/Q
elastic demand curve due to
At a market price
competition--Ed = -.6. Still
2.00
2.00
of $1.50, elasticity of
Firm A has some monopoly
demand is -1.5.
power and charges a price
which exceeds MC.
1.60
MC
1.50
1.50
1.40
DA
Market
Demand
MR
1.00
1.00
QA
30,000 Quantity
10,000
20,000
3,000
5,000
7,000
Measuring Monopoly Power
­ In perfect competition: P = MR = MC
­ Monopoly power: P > MC
Lerner's Index of Monopoly Power
­ L = (P - MC)/P
·  The larger the value of L (between 0 and 1) the greater the monopoly power.
­ L is expressed in terms of Ed
·  L = (P - MC)/P = -1/E
d
·  E  is elasticity of demand for a firm, not the market
d
Monopoly power does not guarantee profits.
Profit depends on average cost relative to price.
The Rule of Thumb for Pricing
MC
=
P
1 + (
)
E
1
­ Pricing for any firm with monopoly power
d
·  If E
is large, markup is small
d
·  If E
is small, markup is large
d
Elasticity of Demand and Price Markup
$/Q
$/Q
The more elastic is
demand, the less the
markup.
P*
M
M
P*
P*-MC
A
M
A
M
Q*
Q*
Quantity
Quantity
151
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Microeconomics ­ECO402
VU
Markup Pricing: Supermarkets to Designer Jeans
Supermarkets
­
Several firms
­
Similar product
­
Ed = -10 for individual stores
MC
MC
­
P=
=
= 1.11(MC )
1 + (1 -.1)  0.9
­
Prices set about 10 ­ 11% above MC.
Convenience Stores
­
Higher prices than supermarkets
­
Convenience differentiates them
­
Ed = -5
MC
MC
­
P=
=
= 1.25(MC )
1 + (1 -5)  0.8
­
Prices set about 25% above MC.
­ Convenience stores have more monopoly power.
­ Question:
·  Do convenience stores have higher profits than supermarkets?
­ Designer jeans
Ed = -3 to -4
·  Price 33 - 50% > MC
·  MC = $12 - $18/pair
·  Wholesale price = $18 - $27
Sources of Monopoly Power
Why do some firm's have considerable monopoly power, and others have little or none?
A firm's monopoly power is determined by the firm's elasticity of demand.
The firm's elasticity of demand is determined by:
1) Elasticity of market demand
2) Number of firms
3) The interaction among firms
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Table of Contents:
  1. ECONOMICS:Themes of Microeconomics, Theories and Models
  2. Economics: Another Perspective, Factors of Production
  3. REAL VERSUS NOMINAL PRICES:SUPPLY AND DEMAND, The Demand Curve
  4. Changes in Market Equilibrium:Market for College Education
  5. Elasticities of supply and demand:The Demand for Gasoline
  6. Consumer Behavior:Consumer Preferences, Indifference curves
  7. CONSUMER PREFERENCES:Budget Constraints, Consumer Choice
  8. Note it is repeated:Consumer Preferences, Revealed Preferences
  9. MARGINAL UTILITY AND CONSUMER CHOICE:COST-OF-LIVING INDEXES
  10. Review of Consumer Equilibrium:INDIVIDUAL DEMAND, An Inferior Good
  11. Income & Substitution Effects:Determining the Market Demand Curve
  12. The Aggregate Demand For Wheat:NETWORK EXTERNALITIES
  13. Describing Risk:Unequal Probability Outcomes
  14. PREFERENCES TOWARD RISK:Risk Premium, Indifference Curve
  15. PREFERENCES TOWARD RISK:Reducing Risk, The Demand for Risky Assets
  16. The Technology of Production:Production Function for Food
  17. Production with Two Variable Inputs:Returns to Scale
  18. Measuring Cost: Which Costs Matter?:Cost in the Short Run
  19. A Firm’s Short-Run Costs ($):The Effect of Effluent Fees on Firms’ Input Choices
  20. Cost in the Long Run:Long-Run Cost with Economies & Diseconomies of Scale
  21. Production with Two Outputs--Economies of Scope:Cubic Cost Function
  22. Perfectly Competitive Markets:Choosing Output in Short Run
  23. A Competitive Firm Incurring Losses:Industry Supply in Short Run
  24. Elasticity of Market Supply:Producer Surplus for a Market
  25. Elasticity of Market Supply:Long-Run Competitive Equilibrium
  26. Elasticity of Market Supply:The Industry’s Long-Run Supply Curve
  27. Elasticity of Market Supply:Welfare loss if price is held below market-clearing level
  28. Price Supports:Supply Restrictions, Import Quotas and Tariffs
  29. The Sugar Quota:The Impact of a Tax or Subsidy, Subsidy
  30. Perfect Competition:Total, Marginal, and Average Revenue
  31. Perfect Competition:Effect of Excise Tax on Monopolist
  32. Monopoly:Elasticity of Demand and Price Markup, Sources of Monopoly Power
  33. The Social Costs of Monopoly Power:Price Regulation, Monopsony
  34. Monopsony Power:Pricing With Market Power, Capturing Consumer Surplus
  35. Monopsony Power:THE ECONOMICS OF COUPONS AND REBATES
  36. Airline Fares:Elasticities of Demand for Air Travel, The Two-Part Tariff
  37. Bundling:Consumption Decisions When Products are Bundled
  38. Bundling:Mixed Versus Pure Bundling, Effects of Advertising
  39. MONOPOLISTIC COMPETITION:Monopolistic Competition in the Market for Colas and Coffee
  40. OLIGOPOLY:Duopoly Example, Price Competition
  41. Competition Versus Collusion:The Prisoners’ Dilemma, Implications of the Prisoners
  42. COMPETITIVE FACTOR MARKETS:Marginal Revenue Product
  43. Competitive Factor Markets:The Demand for Jet Fuel
  44. Equilibrium in a Competitive Factor Market:Labor Market Equilibrium
  45. Factor Markets with Monopoly Power:Monopoly Power of Sellers of Labor