Profit Maximization
Kate2310
4748713_88462790_e201ch13.pptxThe significance of monopoly, where a single monopolist is the only producer of a good
How a monopolist determines its profit-maximizing output and price
The difference between monopoly and perfect competition, and the effects of that difference on society’s welfare
How policy makers address the problems posed by monopoly
What price discrimination is, and why it is so prevalent when producers have market power
What you will learn in this chapter
1
TYPES OF MARKET STRUCTURE
In order to develop models and make predictions about how producers will behave, we have developed four principal models of market structure:
perfect competition
monopoly
oligopoly
monopolistic competition
2
TYPES OF MARKET STRUCTURE
Are products differentiated?
How many producers are there?
Oligopoly
Perfect competition
No
One
Few
Many
Yes
Monopolistic competition
Not applicable
Monopoly
THE MEANING OF MONOPOLY
Monopolist: a firm that is the only producer of a good with no close substitutes.
(An industry controlled by a monopolist is known as a monopoly)
Market power: the ability of a firm to raise prices.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
4
WHAT A MONOPOLIST DOES
M
C
S
D
QC
QM
Quantity
Price
PM
PC
2. … and raises price.
1. Compared to perfect competition, a monopolist reduces output…
A monopolist reduces the quantity supplied to QM and moves up the demand curve from C to M, raising the price to PM.
WHY DO MONOPOLIES EXIST?
How do they get away with this and protect their profit from new firms?
Profits will not persist in the long run unless there is a barrier to entry.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
6
BARRIERS TO ENTRY
Barriers to entry are essential for monopolies. They generate profit for the monopolist in the short run and long run.
This can take the form of:
control of natural resources or inputs.
increasing returns to scale.
technological superiority.
government-made barriers, including patents and copyrights.
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1. CONTROL OF A SCARCE RESOURCE OR INPUT
If De Beers owned nearly all of the diamond mines in the world, it would have a monopoly in diamond production.
Image courtesy of Corbis
8
NEWLY EMERGING MARKETS: A DIAMOND MONOPOLIST’S BEST FRIEND
DeBeers (the original diamond monopoly) has, since 1990
Lost control of many mines
Agreed to stop monopolizing and fixing prices in the US diamond market (2013)
Been faced with high-quality synthetic diamond alternatives
BUT… demand is growing in China and India… and mines are being depleted
ECONOMICS
IN ACTION
Image © Abenaa/Getty Images
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2. INCREASING RETURNS TO SCALE
A natural monopoly exists when increasing returns to scale (economies of scale) provide a large cost advantage to a single firm.
Hoover Dam, a natural monopoly
10
2. INCREASING RETURNS TO SCALE
A given quantity of output is produced more cheaply by one large firm than by two or more smaller firms.
D
ATC
Quantity
Price, cost
Relevant output range
Natural monopoly. Average total cost is falling over the relevant output range
Natural monopolist’s break-even price
3. TECHNOLOGICAL SUPERIORITY
A firm that maintains a consistent technological advantage over potential competitors can establish itself as a monopolist.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
12
4. NETWORK EXTERNALITY
Network externality: the value of a good or service to an individual increasing as more others use the same good or service.
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13
2010: Should Macmillan have let Amazon sell its e-books at $9.99 (a loss after paying for the copyright)?
How are network externalities related to this issue?
Were publishers right to be fearful of Amazon.com’s pricing policy even though it probably generated higher book sales?
Do you support Amazon’s response: removal of all Macmillan books from the website? (Policy was reversed after bad press.)
LEARN BY DOING: DISCUSS
14
5. GOVERNMENT-CREATED BARRIER
A patent gives an inventor a temporary monopoly in the use or sale of an invention.
A copyright gives the creator of a literary or artistic work sole rights to profit from that work.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
15
GLOBAL COMPARISON
Different prices in different countries reflect willingness to pay; they also reflect that governments in other countries regulate drug prices more actively than the U.S. government does
How much profit is necessary to stimulate research and development? It’s hard to know.
Source: International Federation of Health Plans, 2012 Comparative Price Report
WHY IS YOUR BROADBAND SO SLOW? AND WHY DOES IT COST SO MUCH?
American cable consumers face companies with significant monopoly power and little oversight.
In the few locations where there are competing cable companies, bills are typically 15% lower and service is better.
ECONOMICS
IN ACTION
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HOW A MONOPOLIST MAXIMIZES PROFIT
(a)
Demand curve of an individual perfectly competitive producer
DC
Price
(b)
Demand curve of a monopolist
DM
Market price
Quantity
Quantity
Competitive firms cannot choose price.
Price
Monopolists can.
HOW A MONOPOLIST MAXIMIZES PROFIT
All firms face the same rule: Profit is maximized at the Q where MR = MC.
So what does MR look like?
MR = ∆TR/ ∆Q.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
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HOW A MONOPOLIST MAXIMIZES PROFIT
MR is below the demand curve…
An increase in production by a monopolist has two opposing effects on revenue:
A quantity effect: One more unit is sold, increasing total revenue by the price at which the unit is sold.
A price effect: To sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue.
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DEMAND, TOTAL REVENUE, AND MARGINAL REVENUE
21
YOUR TURN: FILL IN THE MISSING MR
22
Suppose that a monopolist can sell 5 units of output at a price of $5 or 6 units of output at a price of $4. What is the marginal revenue of the sixth unit?
$24
$49
–$1
$10
LEARN BY DOING: PRACTICE QUESTION
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A MONOPOLIST’S DEMAND, TOTAL REVENUE, AND MARGINAL REVENUE CURVES
A
MR
TR
D
(a)
9
20
$1,000
–200
–400
500
550
0
50
Quantity of diamonds
(b)
0
10
20
$5,000
4,000
3,000
2,000
1,000
Total Revenue
B
C
Demand and marginal revenue
Total Revenue
Price, cost, marginal revenue of demand
Price effect = –$450
Quantity effect =
+$500
Marginal revenue = $50
Quantity effect dominates price effect.
Price effect dominates quantity effect.
10
Quantity of diamonds
PROFIT MAXIMIZATION FOR A MONOPOLY
Profit maximization consists of two steps:
Choosing a quantity
Rule: Choose Q where MR = MC.
Choosing a price
Choose the highest price you can get away with, which is the highest price consumers will pay for that quantity.
Rule: Once you’ve picked your quantity, follow the graph to the demand curve, which shows you how much consumers will pay.
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THE MONOPOLIST’S PROFIT-MAXIMIZING OUTPUT AND PRICE
The price De Beers can charge per diamond is found by going to the point on the demand curve directly above point A, (point B here)—$600 per diamond. It makes a profit of $400 × 8 = $3,200.
B
C
MR
Monopoly profit
MC
=
ATC
D
$1,000
200
600
–200
–400
0
Quantity of diamonds
8
10
20
16
A
PC
PM
QM
QC
Price, cost, marginal revenue of demand
Monopolist’s optimal point
Perfectly competitive industry’s optimal point
FINDING THE MONOPOLY PRICE
In order to find the profit-maximizing quantity of output for a monopolist, you look for the point where the MR curve crosses the MC curve.
But this isn’t the price the monopolist will choose. The firm will want to charge as much as it can. Why stop at MR if it can charge up to what the demand curve says people will pay?
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THE MONOPOLIST’S PROFIT
QM
Quantity
PM
ATCM
C
D
MR
A
B
MC
ATC
Price, cost, marginal revenue
Monopoly profit
As long as the monopoly has strong barriers to entry, profit will stay.
What are the monopolist's profit-maximizing price and output level here?
P = $3.00; Q = 40
P = $16.50; Q = 40
P = $6.00; Q = 40
P = $6.00; Q = 80
LEARN BY DOING: PRACTICE QUESTION
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LEARN BY DOING: PRACTICE QUESTION
30
IS THERE A MONOPOLY SUPPLY CURVE?
You might be tempted to ask about the supply curve of a monopolist. But this is a meaningless question:
Monopolists don’t have supply curves- since they control prices there is no set relationship between Price and Quantity supplied.
31
If the market for some good were converted from a competitive industry to a monopoly, which of the following would occur as a result?
Prices would fall on the output produced by the monopolist.
Some consumer surplus would be reallocated to the monopolist as profit.
The overall level of profit earned in the industry would decrease.
More output would be produced by the monopolist.
LEARN BY DOING: PRACTICE QUESTION
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MONOPOLY CAUSES INEFFICIENCY
(a)
Total surplus with perfect competition
(b)
Total surplus with monopoly
D
MC =
ATC
MC =
ATC
Quantity
QC
PC
QM
PM
D
MR
Quantity
Price, cost
Profit
Deadweight loss
Consumer surplus with perfect competition
Consumer surplus with monopoly
Price, cost, marginal revenue
MONOPOLY AND PUBLIC POLICY
Monopoly profit comes at consumers’ expense:
When a monopoly raises prices and lowers Q, consumer surplus falls and deadweight loss is created.
To avoid deadweight loss, government policy attempts to prevent monopoly behavior.
The government policies used to prevent or eliminate monopolies are known as antitrust policy.
34
Ponder this:
With a partner, list three to five important monopoly firms in the United States.
Would we be better off if they were split into more competitive firms? Why or why not?
LEARN BY DOING: DISCUSS
35
DEALING WITH NATURAL MONOPOLY
Natural monopolies are a different story: They bring lower costs…
…but there’s no guarantee the firm will voluntarily pass along its cost savings to consumers.
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
36
DEALING WITH NATURAL MONOPOLY
What can public policy do about this? Two common answers:
Public (government) ownership: But publicly owned companies are often poorly run.
Price regulation: A price ceiling imposed on a monopolist does not create shortages if it is not set too low.
37
UNREGULATED AND REGULATED NATURAL MONOPOLY
If the monopoly’s price is regulated at PR, consumer surplus rises (and profits fall).
(a)
Total surplus with an unregulated natural monopolist
(
b
)
Total surplus with a regulated natural monopolist
QM
QR
PM
D
MC
MR
ATC
Quantity
Consumer surplus
QR*
D
MC
MR
ATC
Quantity
PR*
Price, cost, marginal revenue
Price, cost, marginal revenue
Profit
Consumer surplus
SHOCKED BY THE HIGH PRICE OF ELECTRICITY
2000-2001: California energy “crisis”: blackouts and higher prices
Ingredients for the crisis:
Deregulation (away from government-regulated rates) became popular as a way to increase competition and reduce electricity prices
Large up-front fixed costs deterred many would-be new generators
Incumbent firms could now manipulate the market- and did! Plants were shut down during peak demand hours to raise prices.
Proof of manipulation? Prices rose more in deregulated states.
ECONOMICS
IN ACTION
All photo credits unless otherwise noted from Freeimages.com (Formerly Stockxchange) or Morguefile.com
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PRICE DISCRIMINATION
¿Qué pasa?
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40
PRICE DISCRIMINATION
So far we’ve been assuming our firms is a single-price monopolist: It offers its product to all consumers at the same price.
Some firms practice price discrimination: They charge different prices to different consumers for the same good.
41
PRICE DISCRIMINATION AND PROFIT MAXIMIZATION
Recall the profit-maximizing rule for firms with monopoly power:
Produce the Q at which MR = MC.
Based on that Q, charge as much as the market will bear (found by the position of the demand curve).
But what if you sell to more than one market, each with its own demand curve?
E.g., senior citizens and young people, business travelers and leisure travelers.
42
PRICE DISCRIMINATION
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
43
PRICE DISCRIMINATION
Students Get
10% Off!
55+
Discount
From the Slate online: L.A. Boutique Opens Only When It Wants To
In a hurry to find that perfect Christmas present? Then don't go to the Never Open Store, an L.A. boutique where the owner sets her hours—and her prices—based on what kind of mood she's in. The Never Open Store doesn't have official hours. The hands have been ripped off the miniature "Will Return At ..." clock on the front door, and owner Stephanie Mata lets people in when she wants to. None of the funky clothing or art is priced, either. Mata says she knows it's "unethical," but she sizes people up and names a price that she thinks fits the client. Hollywood set designers with lavish budgets will pay more for the syringe-studded dartboard or recycled chandelier than students looking to decorate their first apartment. In an era of consumer belt-tightening and retail door-shutting (the Never Open Store is on a street with lots of vacant storefronts), the unorthodox strategy seems to be working. Mata has created a buzz, and she's won't be changing the way she operates. "I'm the boss," Mata says. "And I don't like bad vibes."
Read original story in The Los Angeles Times | Saturday, Dec. 12, 2009.
44
Is it right for consumers to face different prices based on their age?
Yes
No
LEARN BY DOING: DISCUSS
No right answer…. Just a stepping stone for discussion.
45
A New York politician has suggested making gasoline “zone pricing” (price discrimination) illegal here. (1 minute)
LEARN BY DOING: APPLICATION VIDEO
http://www.dailymotion.com/video/xi6rlu_gas-price-discrimination_news
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TWO TYPES OF AIRLINE CUSTOMERS
Quantity of tickets
Price, cost of ticket
D
MC
2,000
4,000
$550
150
0
B
S
125
Profit from sales to business travelers
Profit from sales to student travelers
If your consumers have low price elasticity, charge them more!
Who probably has more elastic demand for a Hertz rental car? Person A reserves a car online weeks before a trip; person B walks up to a Hertz counter after he walks off an airplane after a four-hour flight? Who probably gets charged more?
Person B a more elastic demand and will be charged less.
Person B has a more elastic demand and will be charged more.
Person A has a more elastic demand and will be charged more.
Person A has a more elastic demand and will be charged less.
LEARN BY DOING: PRACTICE QUESTION
48
Do you expect prices to be higher or lower near the pirate dens in Somalia?
Pirates pay $5 for a shoeshine, everyone else $0.50. Full article here.
LEARN BY DOING: DISCUSS
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
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PRICE DISCRIMINATION INCREASES SALES AND PROFITS
Quantity
Price, cost
(a) Discrimination with two prices
(b) Discrimination with three prices
Phigh
MC
D
Plow
Sales to consumers with a high willingness to pay
Quantity
Phigh
MC
D
Plow
Sales to consumers with a medium willingness to pay
Sales to consumers with a low willingness to pay
Pmedium
Profit with two prices
Profit with three prices
Sales to consumers with a low willingness to pay
Sales to consumers with a high willingness to pay
Price, cost
PERFECT PRICE DISCRIMINATION
When perfect price discrimination can be employed, a firm will charge each customer a different price, the maximum price each is willing to pay.
Under perfect price discrimination, the firm captures all consumer surplus as profit.
Haggling at the flea market: Perfect price discrimination.
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All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
PRICE DISCRIMINATION
There is no deadweight loss, because all mutually beneficial transactions are exploited.
There is zero consumer surplus: The entire surplus is captured by the monopolist in the form of profit.
Quantity
MC
D
Profit with perfect price discrimination
(c)
Perfect price discrimination
Price, cost
PRICE DISCRIMINATION
Common techniques for price discrimination:
Advance purchase restrictions
Volume discounts
Two-part tariffs
Your Costco card: a two-part tariff
All image credits courtesy of Morgue File and/or FreeImages.com unless otherwise specified
53
Larry Lessig, the Net’s most celebrated lawyer, gives a TED talk here titled “Laws That Choke Creativity.” He cites John Philip Sousa, Celestial Copyrights and the "ASCAP cartel" in his argument for reviving our creative culture. (18:59 minutes)
LEARN BY DOING: APPLICATION VIDEO
http://www.ted.com/talks/lang/eng/larry_lessig_says_the_law_is_strangling_creativity.html
54
Sales, Factory Outlets, and Ghost Cities: Evidence of Price Discrimination?
Necessities: (sheets, towels) go on sale rarely
Outlets: lower prices but further away
Airline tickets: often cheaper to fly longer distances to major cities than short distances to small cities
Can you explain the pricing in light of differences in price elasticity of demand?
ECONOMICS
IN ACTION
All photo credits unless otherwise noted from Freeimages.com (Formerly Stockxchange) or Morguefile.com
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Amazon and Hachette Go to War
May 2014: in a dispute over the increase in Amazon’s fees to Hachette publishers (30% to 50%) Amazon slowed delivery of Hachette books, removed ordering options and suggested alternatives to customers.
QUESTIONS FOR THOUGHT
1. What is the source of surplus in this industry? Who generates it? How is it divided among the various agents (author, publisher, and retailer)?
2. What are the various sources of market power here? What is at risk for the various parties?
LEARN BY DOING: BUSINESS CASE
Image courtesy of David Ryder/Getty Images
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