Production: The Case of One Producer

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1 Production: The Case of One Producer Economics II: Microeconomics VŠE Praha November 2009 Aslanyan (VŠE Praha) Monopoly 11/09 1 / 27

2 Microeconomics Consumers: Firms: People. Households. Optimisation Now Monopoly. Oligopoly. Perfect competition. Equilibrium: Holds. Does not hold. Aslanyan (VŠE Praha) Monopoly 11/09 2 / 27

3 Optimisation Assumption: Firms maximise their pro t π = revenue cost Aslanyan (VŠE Praha) Monopoly 11/09 3 / 27

4 Optimisation Assumption: Firms maximise their pro t π = revenue max π cost Aslanyan (VŠE Praha) Monopoly 11/09 3 / 27

5 Optimisation Assumption: Firms maximise their pro t π = revenue max π π 0 = 0 cost Aslanyan (VŠE Praha) Monopoly 11/09 3 / 27

6 Optimisation Assumption: Firms maximise their pro t π = revenue cost max π π 0 = 0 MR MC = 0 Aslanyan (VŠE Praha) Monopoly 11/09 3 / 27

7 Optimisation Assumption: Firms maximise their pro t π = revenue cost max π π 0 = 0 MR MC = 0 MR = MC Aslanyan (VŠE Praha) Monopoly 11/09 3 / 27

8 Optimisation Assumption: Firms maximise their pro t π = revenue cost max π π 0 = 0 MR MC = 0 MR = MC Aslanyan (VŠE Praha) Monopoly 11/09 4 / 27

9 Microeconomics Consumers: Firms: People. Households. Optimisation. Monopoly Now Oligopoly. Perfect competition. Equilibrium: Holds. Does not hold. Aslanyan (VŠE Praha) Monopoly 11/09 5 / 27

10 Monopolist Market Structure De nition A situation where a market is dominated by a single seller of a product is known as a monopoly. Fact The monopolist (the sole producer) faces market demand, and thus, has to choose the price and produce the demanded quality (or vice versa). Aslanyan (VŠE Praha) Monopoly 11/09 6 / 27

Fact The monopolist (the sole producer) faces market demand, and thus, has to

11 Monopolist Assumption: Perfect discrimintaion ability Aslanyan (VŠE Praha) Monopoly 11/09 7 / 27

12 Monopolist Assumption: Arbitrage pricing MR = MC Aslanyan (VŠE Praha) Monopoly 11/09 8 / 27

13 Monopolist Assumption: Arbitrage pricing MR = MC R = p(q) q Aslanyan (VŠE Praha) Monopoly 11/09 8 / 27

14 Monopolist Assumption: Arbitrage pricing MR = MC R = p(q) q MR = p (q) q p (q) + q q q = p (q) + q p q = p (q) 1 + q p p q Aslanyan (VŠE Praha) Monopoly 11/09 8 / 27

15 Monopolist Assumption: Arbitrage pricing MR = MC R = p(q) q MR = p (q) q p (q) + q q q = p (q) + q p q = p (q) 1 + q p p q MR = p (q) = p (q) 1 ε p (q) 1 = MC jε p (q)j Aslanyan (VŠE Praha) Monopoly 11/09 8 / 27

(q) 1 + q p p q MR = p (q) 1 + 1 = p (q) 1 ε p (q) 1 =

16 Monopolist Pricing rules h i 1 MC = p (q) 1 jε p (q)j p (q) = MC 1 1 jεp (q)j Lemma (Pricing Rule 1: The Elasticity Rule for Monopoly Pricing) Never price on the inelastic portion of the demand curve. Lemma (Pricing Rule 2: Markup Pricing) The optimal price for a monopolist is the price that is on the demand curve at the optimal quantity point. Aslanyan (VŠE Praha) Monopoly 11/09 9 / 27

17 Monopoly Pricing Rule Linear demand example Aslanyan (VŠE Praha) Monopoly 11/09 10 / 27

18 Monopoly Pricing Rule Linear demand example Aslanyan (VŠE Praha) Monopoly 11/09 11 / 27

19 Monopoly Pricing Pro t π = p (q ) q C (q ) = p (q ) q AC q = (p (q ) AC ) q π > 0 () p > AC Aslanyan (VŠE Praha) Monopoly 11/09 12 / 27

20 Monopoly Pricing Pro t The producer cannot operate pro tably as p < AC. The pro t is negative and is represented by the rectangle edgp Aslanyan (VŠE Praha) Monopoly 11/09 13 / 27

21 Monopoly Market Structure Problem Why do monopolies emerge? Aslanyan (VŠE Praha) Monopoly 11/09 14 / 27

22 Monopoly Market Structure Problem Why do monopolies emerge? Solution Among others: Minimum e ciency scale and Natural monopoly Inertia shopping and Contestable markets Governmental licences and historical reasons Cartels Aslanyan (VŠE Praha) Monopoly 11/09 15 / 27

23 Monopoly Natural Monopoly De nition A natural monopoly is a monopoly that develops because the cheapest way to produce any given level of output in this market is to have one rm to do it. De nition A cost function is subadditive if C (q) < C q 0 + C q 00 for all levels q, q 0 and q 00, such that q = q 0 + q 00. Aslanyan (VŠE Praha) Monopoly 11/09 16 / 27

24 Monopoly Natural Monopoly and MInimum e ciency scale De nition Minimum e ciency scale (MES) is the level of output that minimizes average cost. Fact For the monopoly to emerge the MES should be small relative to the size of demand. Aslanyan (VŠE Praha) Monopoly 11/09 17 / 27

25 Monopoly Sustainable Monopoly Aslanyan (VŠE Praha) Monopoly 11/09 18 / 27

26 Monopoly Sustainable Monopoly De nition A Natural monopoly that has a cost function C (q) and faces demand function of D (p) is sustainable if there is a price of p and an output of q such that 1 at any price the rm satis es all the demand in the market: q = D (p) 2 covers its cost: p q = C (q) 3 a competing rm will incur loss if enters to the market: p 0 q 0 < C q 0 for all p 0 < p and q 0 D (p 0 ) Aslanyan (VŠE Praha) Monopoly 11/09 19 / 27

27 Monopoly Sustainable Monopoly Fact (technical) A natural monopoly is sustainable if, for an output of q, average costs are declining at every level up to that quantity. Fact (intuitive) A sustainable price-output combination must be a point at which the demand curve intersects the average cost curve. Problem Why do monopolies price the commodities higher than the average costs? Aslanyan (VŠE Praha) Monopoly 11/09 20 / 27

28 Monopoly Historical incumbant and Inertia-shopping rule Example There is an incumbant in the market. The potential entrant will su er sunk costs once enters the market. And the consumers follow the inertia shopping rule. Incumbent has to decide whether to set monopolistic or sustainable price. Potential entrant decides. Incumbent, observing entrant s decision chooses new price or keeps the same. De nition (Inertia-shopping Rule) Buy from the rm that charges the lowest price, but if you are already buying from a rm and another rm enters the market and o ers you a lower price, give your current rm a chance to meet the entrant s price before shifting. Aslanyan (VŠE Praha) Monopoly 11/09 21 / 27

29 Monopoly Historical incumbant and Inertia-shopping rule Aslanyan (VŠE Praha) Monopoly 11/09 22 / 27

30 The rest is not covered! Aslanyan (VŠE Praha) Monopoly 11/09 23 / 27

31 Monopoly The Contestable Markets Example There is an incumbent in a contestable market. The consumers have no loyalty to sellers. The entrants can use hit-and-run strategy, i.e. enter with lower price, make pro t, and go out of the market (with little costs) once the incumbent decreases his price. De nition A market that competitors can easily enter and leave is known as a contestable market. Aslanyan (VŠE Praha) Monopoly 11/09 24 / 27

32 Monopoly The Contestable Markets Aslanyan (VŠE Praha) Monopoly 11/09 25 / 27

33 Monopoly Deadweight loss and Government regulation De nition Deadweight loss occurs when the consumers demand commodity with higher price than the costs of production, however it is not produced (area lba). Aslanyan (VŠE Praha) Monopoly 11/09 26 / 27

34 Monopoly Deadweight loss and Government regulation Fact (( rst-) best result) Social wealfare maximisation requires marginal-cost pricing. Fact (second-best result) Average-cost pricing is used to cover the total costs. Aslanyan (VŠE Praha) Monopoly 11/09 27 / 27

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