Monopoly

00:01 Hello, and welcome back to your online presentation in Microeconomics.

00:04 My name is James DeNicco. This presentation is gonna be about Monopolies.

00:09 We're gonna find out what monopolies are and how they come about.

00:13 We're gonna look at the pricing of a monopoly versus pricing in perfect competition.

00:18 We're gonna look at the implications for a monopoly on profits in the short and long run.

00:23 We're gonna look at the implications for monopolies on economic well-being.

00:27 And then we're gonna take a look at price discrimination, how that plays into a monopoly and how that affects economic well-being as well.

00:35 So let's get started. First, what is a monopoly? A monopoly is when there's only one game in town.

00:40 It's the sole producer of a product, the only seller of a product without close substitutes.

00:47 So this is the opposite of perfect competition, right, where we had numerous firms selling identical products.

00:53 Here we have one seller, one producer of a product without close substitutes.

00:59 So how does a monopoly come about? It comes about with what we call barriers to entry like this castle here these walls that keep people out, monopoly has walls to keep people out.

01:10 So what are some of those walls? Monopoly resources, it could be government regulation, or just the production process, what we call a natural monopoly.

01:19 So first, monopoly resources, that's when the monopoly owns all the resources to produce a certain good or service.

01:26 An example would be if you're in the desert and you own the only water well, so then of course, everybody has to come to you to get that water.

01:35 Or, it could be a government created monopoly.

01:38 Sometimes it's in the best interest of the government to create monopolies for overall economic well-being.

01:44 You can take the example of the drug companies.

01:46 Oftentimes, you wanna incentivize research and development so that companies go out there and they make these new drugs of course to fight illness and disease and such.

01:56 So what you do is you grant exclusive rights to these companies that they come up with these new drugs through patents so that they can earn a profit.

02:04 It incentivizes them to go out and do the research and development, otherwise, they might not do it because companies could just take these drugs, reverse engineer them, use the technology and get profits for themselves.

02:16 This gives the company exclusive rights, that way they are willing to come out there and come up with these new drugs, do the research and development necessary to find these new drugs.

02:26 Also there's instances when you could have a natural monopoly.

02:29 That's the case we have a constantly falling average total cost, that comes about when you have high fixed cost to get your operations set-up but a small variable cost, so that fixed cost is always falling faster than that variable cost rises so you always have a constantly decreasing average total cost.

02:49 Like I said, it comes about with this large fixed cost.

02:51 It's a lot of money to set up the operation so you need a lot of customers to make it worth your time to cover those fixed costs.

03:00 Some examples might be a utility company where it takes a long time and a lot money to set up all the pipes to the different houses or all the lines to the different houses, but once you get set up, once you pay that fixed cost, the variable cost of just turning on the line to a new home is very, very small.

03:17 So that creates this natural monopoly where it's just not very attractive for people to enter that market, because to share the customers, will be detrimental because you couldn't cover your fixed cost.

03:29 For somebody to come into the market they would have to spend a lot of money to get themselves set up like the existing company, like the monopoly, but then you would have to share the market, you would have to share the consumers and it would be very difficult to cover your fixed cost to make that worth it, so we have an example of utility company where you could think of a toll bridge as well.

03:49 So here's graphs to show the difference a little bit between perfect competition and a monopoly.

03:56 So if you go back to the perfect competition, you remember the other price takers, they're numerous and they're selling identical products so that competition is gonna get prices all the way down to average total cost where there's no profits in the long run.

04:10 You have no incentive to raise your price cuz somebody will just go to another firm cuz you're selling an identical products , you lose all your market share.

04:17 You can't lower your price any further cuz then it'll be below average total cost and you'll have loses.

04:23 Now, I said it's totally different than monopoly, and you see here, a monopoly has a downward sloping demand curve.

04:30 They can make pricing decisions, they're the only game in town, there's no competition bringing in their price down to average total cost.

04:37 Just like in the monopoly in all other firms, they're gonna maximize profits when the marginal cost equals the marginal revenue, but you're gonna see here with this downward sloping demand curve, the results are gonna be a little bit different.

04:50 So let's look in the example of a monopoly's revenue.

04:53 So here we're gonna have an example of a company selling gallons of water.

04:57 So in our left hand column here we have gallons of water produced, they sold.

05:01 So zero all the way down to 8. Now we have our pricing in this column.

05:06 Right away you'll notice the difference between perfect competition, perfect competition will be the same price all the way down.

05:13 Here though, the monopoly has power over the market so they can control the price and that will determine the quantity they cell.

05:21 They wanna sell more, they have to lower that price.

05:24 Here in the third column we'll see total revenue.

05:27 The total revenue is just like any other firm, it's just price times quantity, 1 times 10 is 10, 2 times 9 is 18, 3 times 8 is 24, all the way down to 8 times 3 is 24. Then we go to average revenue.

05:40 You'll notice this is different from a perfect competition as well.

05:44 It's the same in one way it's just the price cuz the average revenue that's just the total revenue divided by the amount sold, so that'll be the price because you have to sell each good at the same price, however, it's constant when you're in perfect competition.

06:00 Here it's decreasing cuz the prices are decreasing in order to sell more units.

06:05 Now your marginal revenue.

06:07 In perfect competition again that's just your constant price, so if you sell each unit for $6, selling an additional unit brings in $6.

06:16 Here now let's take a look at our marginal revenue.

06:19 Remember how we calculate it, it's just total revenue for quantity 1 minus total revenue for quantity zero total revenue for quantity 2 minus total revenue for quantity 1 so that we have 10 minus zero is 10, 18 minus 10 is 8, 24 minus 18 is 6 and on down the line.

06:36 What you're gonna notice here and what drives a lot of these results is that our marginal revenue is always has to be lower than our average revenue.

06:44 The reason being in order to sell another unit, you have to lower your price so the revenue that you bring in for that next unit is gonna be lower than the average revenue.

06:55 So as the marginal revenue comes down, it's gonna bring that average down after it.

07:00 So as I said, the marginal revenue is always less than the price cuz in order to sell more, they have to lower the price which lowers it for each gallon of water sold.

07:10 So you're gonna have two effects on revenue here.

07:12 You're gonna have what we call the output effect and the price effect as you increase quantity.

07:17 The first effect, the output effect says, as you sell more that's gonna tend to an increase total revenue.

07:24 You're selling more units so your revenue goes up.

07:27 But you also have the price effect cuz in order to sell more units, you have to lower your prices, so as you lower your prices that tends to wanna bring total revenue down.

07:36 So you have these two competing effects when you have a monopoly or whenever you have a downwards sloping demand curve.

07:43 Now, let's take a look at the picture of the chart that we're going over.

07:46 So you notice we're gonna have our downward sloping demand curve and our downward sloping marginal revenue curve.

07:51 Here you can see that the marginal revenue is always less than the average revenue.

07:57 Again, because the price on all units has to fall as the monopoly increases production, so the marginal revenue is always less than the price.

08:06 Here, the demand is gonna be the price.

08:09 Price equals average revenue and the average revenue curve equals demand, so we have our downward sloping demand curve and our downward sloping marginal revenue curve.

08:19 Remember, we always maximize profits where marginal revenue equals marginal cost, so that's gonna have some implications here.

08:28 Alright, so let's look at how a monopoly maximizes their profit.

08:31 Again, as I said, it's always where marginal cost equals marginal benefit.

08:36 Remember, you only wanna sell an additional unit if it brings in more than it cost you, that's what's margins are about, they're about increments.

08:44 If I sell one more unit does it cost more than I bring in? If that's the case, you don't wanna do it, so you stop where marginal cost equals marginal revenue.

08:53 So here, I have this one point into the marginal revenue equals the marginal cost, so to find the demand from that point, you're gonna go straight up.

09:02 The demand curve shows the price consistent with this quantity, so this is our monopoly price.

09:08 We draw our monopoly price over here, so again, we have our marginal cost curve, we have our marginal revenue curve where they meet each other, that maximizes profits.

09:18 So you find the monopoly price for taking that quantity that maximizes profits, draw it up to the demand curve and you can over to our price on the vertical axis here and find our monopoly price.

09:31 What you're gonna end up seeing is the monopoly price is higher than the price in perfect competition and the quantity sold is gonna be less than the quantity sold in perfect competition.

09:44 So the monopoly profit, so it's gonna be your price minus your average total cost.

09:49 So for a monopoly you can actually have profits in the short and long run, unlike in perfect competition where you can only have profits in the short run to another firm manners, increases the supply and brings that profit down here.

10:03 Here you don't have that competition to bring the prices down so this profit can stand in the long run. So let's take a look at this.

10:10 We have our monopoly pricing, right, this is our quantity that maximizes profits, we draw it up to the demand curve, we can find our price.

10:18 Now our price minus our average total cost, that's our revenue per unit, so you multiply that times the number of units you sell, that's your total profit, right? Price, that's the average revenue you get per unit and then your average total cost that's your cost per unit so price minus cost, that's your profit per unit times the quantity that's your total profit, your total profit is the area of this triangle right here.

10:44 So, now let's go back to our example of the drug company.

10:48 Let's take a look at what happens when a patent expires.

10:50 Now you see a monopoly go from being the only game in town to people able to come in and now produce and compete against you.

10:58 What you're gonna see here is that prices is gonna come down and the quantity is gonna increase, right? So during the life of the patent the drug company operates as a monopoly, after the patent expires, firms enter with the generic drug and it becomes like perfect competition if enough firms enter, that will bring price down to average total cost and there will be no more revenues.

11:20 So you see at first here were a monopoly, this is our quantity for a monopoly.

11:24 You draw the line straight up you find your price, that's the price during the patent life, but then after that patent expires and companies are able to come in and compete, well, that's gonna pull that price down, it's gonna take away your profits, so you'll see the prices gonna come down and then the quantity is gonna increase, so still our marginal cost is gonna equal our marginal revenue, but our marginal revenue now is gonna equal our demand curve if we get to the point where it's like perfect competition and everybody has to sell for the same price, you don't have any power over the market anymore.

11:59 Alright, so what are the welfare cost of a monopoly? Well, the fact that prices are higher than perfect competition and the quantity sold is lower, it's gonna result in some inefficiencies, it's gonna result in some dead weight loses here, so because the allocation of resource is different from the competitive market, right? In some ways, the monopoly fails to maximize the total economic well-being.

12:22 So let's take a look here why we see some inefficiency in a market that's defined as a monopoly.

12:29 Well, we know from the free market, in the presentations we've done before, if you were a benevolent dictator or a social planner, you would maximize total surplus where the value to the marginal buyer equals the cost to the marginal seller. We don't get to that point here.

12:45 So in perfect competition we will be at this efficient quantity but prices don't get that low like they do in perfect competition for a monopoly and the quantity doesn't increase to the sufficient quantity, so what we're gonna have was gonna be instances where the quantity sold, you have value to the marginal buyer above the cost of the marginal seller, but those people aren't gonna be in the market because the price is too high so that creates an inefficiency what call a dead weight loss.

13:14 You can see that dead weight loss right here.

13:17 In perfect competition, we would get all the way over to this efficient quantity right here because competition would bring those prices down and increase that quantity.

13:28 We don't get to that point here.

13:29 Again, it's where marginal cost equals marginal revenue, but in perfect competition, the marginal revenue equals the average revenue over the demand curve.

13:38 We don't get to that point when we have some power over the market and we have downward sloping demand curves.

13:44 So on this area, you're gonna have your dead weight loss, alright? So this is gonna be less efficient than perfect competition.

13:53 So what's the problem? It's not profit. It's not that the firm makes profit.

13:57 That's not the problem, it's just this high prices discourage some consumers from buying the good, right? If the high price didn't discourage people from buying or consuming, it would raise producer surplus by the same amount it reduce consumer surplus, leaving total surplus the same as a social planner can achieve, but we're not getting to that point, right, this high prices are discouraging some of the consumers.

14:22 So how might we fix this? One way would be with price discrimination.

14:27 If a monopoly was able to price discrimination, so what's price discrimination? That's the business practice of selling the same good at different prices to different consumers.

14:36 So there's three facts about price discrimination, right.

14:40 First, price discrimination is a rational strategy for a profit maximizing monopolists, alright? If the firm increases the quantity sold with the extra units at a lower price but still earns a profit.

14:51 Yes, they would have to lower the price for some of those buyers but they will be earning more profit by selling more quantity, alright.

14:59 The second, price discrimination requires the ability to distinguish customers willingness to pay.

15:05 You have to be able to distinguish between your different customers how much they're willing to pay.

15:09 Perfect price discrimination, you would charge each person their willingness to pay, alright? The third, price discrimination can actually raise economic welfare.

15:20 So let me show you to how that works.

15:22 So here we have a monopolist with a single price, this is the graft we've been looking at, okay, so when you sell for a single price what you're gonna have, your marginal cost equals your marginal revenue, that's the quantity that maximizes our profit and so we draw the price all the way up here to the demand curve and that is our monopoly price, that's charging a single price.

15:46 But how about if the monopolist could sell to each consumer what they're willingness to pay is so they could set a price equal to the willingness to pay.

15:55 Well, then you could increase it all the way out here to the efficient quantity.

16:00 You'll see, there is no dead weight loss that increases the total surplus, however, the surplus is all gonna go to the producer, there will not be no consumer surplus, but total surplus will be maximized then, will be at that efficient quantity if we could discriminate perfectly with each one of our consumers.

16:21 So let's take a look at some examples of price discrimination, alright? The first will take a look at is movie tickets.

16:27 So if you sell movie tickets for just one price you might miss out on some people who might otherwise come to the movie.

16:34 You always see discounts for children and senior citizens.

16:37 You might have to lower the price in order to get people willing to take children to a movie cuz they just don't enjoy it all that much if they have the kids with them.

16:45 Senior citizens, they might be less likely to go to a movie unless you give them a discount.

16:50 So even though you're lowering the price for some people, you're increasing your profits because you're getting more people in the seats, you're getting more people to the movie theater.

17:00 Another example is with airline prices.

17:02 So they charge lower prices for a round trip tickets if it extends over Saturday night.

17:07 What you're trying to do is discriminate between people traveling for business and people travelling for pleasure.

17:14 So people traveling for business is more imperative, they have to go, they have business, they have to be there. So you try to charge that higher price.

17:22 The way you distinguish is whether you stay over on a Saturday night.

17:25 If you're staying over on a Saturday night, it's more likely, that it's for vacation or leisure time than it is for actually going on a business trip.

17:32 How about coupons, that's another example of price discrimination.

17:38 So you put coupons out there so if you go to the grocery store you can get some money off of your products.

17:44 Well, how's that price discrimination? Well, you're getting more people in there. Some people don't like coupons.

17:50 I never clip coupons I think it's just -- it's a pain, I hate doing it so I'm a sucker, I go in and I have to pay full price, so they get me to go in and pay full price for my groceries, however, some people might not be willing to go to the grocery store and buy the goods or they will buy less goods if they didn't get a discount.

18:08 So you put the coupons out there and you let people actually price discriminate themselves.

18:13 The people that are willing to cut the coupons, they cut them and they go in and they get a lower price but it's still more profit to the firm because otherwise those people might not come in or they might not buy as much as they otherwise do.

18:26 The last, how about financial aid? So less affluent students have a lower willingness to pay, right? So offering financial aid gets them in the door, so the people that don't need financial aid, the people who are more affluent, you charge them a higher price.

18:40 They're willing to pay it, they're gonna come to school you earn the profits off of them.

18:44 The less affluent people you can still earn profits off them, but you give them a discount, you earn less profits per student with the less affluent students but still adds to your total overall profit, so that's another example of price discrimination.

18:59 So what have we learned here? Well, we know the definition of a monopoly and then monopoly rises due to these barriers to entry.

19:06 We know the difference between pricing in a monopoly versus a competitive market.

19:11 We understand the implications of a monopoly for profit in a short and long run.

19:15 We know the implications for economic well-being, and we understand how monopolies can use price discrimination.

19:21 They can decrease some of those inefficiencies and raise overall total surplus.

19:27 That was your presentation on monopolies. Thank you.