Unit 4
Unit 4
Unit 4
Efficiency: No, Monopolies price above marginal cost and do not produce at the lowest
average cost so they are not allocatively or productively efficient and they have
deadweight loss.
Economies of Scale: Monopolies usually capture economies of scale because the
profit maximizing quantity is on the downward sloping portion of their long-run average
total cost curve.
Graph: Since there is only one firm, the market is the firm. As a result, the firms
demand curve is downward sloping. The average revenue, and price will also be the
demand curve (DARP). If the firm is a single price monopoly, the marginal revenue
curve is below demand.
Note: The cost curves for a monopoly are the same as a perfectly competitive firm and
monopolistically competitive firm. The AVC and AFC are rarely needed in this graph.
Why is the marginal revenue below demand?
For a perfectly competitive firm (and a perfect price discriminating monopoly as seen
below), marginal revenue is equal to demand. But for a single price monopoly (one that
does not price discriminate), the marginal revenue is less than demand. That is because
when the firm produces more output, it must lower the price of not just the last unit
produced, but on all units produced. Take a look at the chart which shows the quantities
of candy bars I could sell at each price (the demand is equal to the price). If I have one
candy bar, I might be able to sell it for $3. But if I want to sell 2 candy bars, I must lower
the price to $2.50; and since I am not a price discriminator, I charge the same price for
both candy bars. As a result, the marginal revenue for that second candy bar isn’t the
$2.50 I charged for it but just $2.00.
Total Revenue: As long as the marginal revenue curve is positive (above the x axis),
total revenue is increasing as output increases. Since the marginal revenue curve is
downward sloping, total revenue will increase at a decreasing rate. When marginal
revenue is negative (below the x axis), total revenue decreases. So as output increases,
a monopoly’s total revenue will increase at a decreasing rate, then decrease.
Marginal Revenue and Elasticity of Demand
The monopoly’s marginal revenue curve reveals the elasticity of the demand curve
above. The total revenue test tells us a demand curve is elastic when a decrease in
price causes an increase in total revenue. At lower quantities monopoly’s marginal
revenue curve is positive. That means as price falls with each additional unit produced,
total revenue increases. Therefore, the demand curve is elastic at those quantities.
When marginal revenue is zero (where it intersects the x axis), the demand curve is unit
elastic at that quantity because the decrease in price causes no change in total
revenue. Finally, at higher quantities, the marginal revenue curve is negative which
indicates total revenue decreases with the price decrease. As a result, that portion of
the demand curve is inelastic. Profit maximizing monopolies will always produce in the
elastic region of their demand curve.
Surplus and deadweight loss: Single price monopolies have both consumer and
producer surplus. But since they do not produce the allocatively efficient quantity (where
P=MC), they create deadweight loss and are inefficient.
A fair return price is one which enforces a price ceiling where economic profits are zero
(P=ATC). At the fair return price, there is less deadweight loss than an unregulated
monopoly and the firm breaks even.
Compared to perfectly competitive markets: Unlike perfectly competitive firms,
monopolies (as well as oligopolies and monopolistic competition) produce less, and
price higher. Monopolies can also earn an economic profit in the long run.
Higher Prices Lower Quantities
Price Discrimination: All of the monopolies above are called single price monopolies.
That means they sell all units of output for the same price. Some monopolies are able to
price discriminate and charge different prices for different units of output. Price
discrimination occurs when a firm is able to charge different customers different prices
for the same product. Like letting kids eat free or giving senior citizens discounts at
restaurants. Firms charge lower prices to people with a lower willingness to pay and
higher prices to people with a higher willingness to pay. If the firm is able to figure out
the maximum price each customer is willing to pay and charge them that price, the firm
would be a perfect price discriminator. That would cause the MR curve to be the same
curve as the Demand, Average Revenue, and Price (MRDARP). Perfect price
discriminators are allocatively efficient. The last unit produced will be priced at the
marginal cost.
Everything you need to know
about Oligopoly, Duopoly, and
Game Theory
Below you will find a breakdown of the oligopoly market structure. Make sure you
practice the skills required to answer questions about this market structure with
the Game Theory flash review when you finish reading.
Number of Sellers: A Few (ten or less). A Duopoly is an oligopoly with 2 firms.
Product Difference: Either. Products may be homogeneous or differentiated.
Market Structures
Ability to Affect Price: Yes. With oligopolies, there is usually a mutual
interdependence between firms. The actions of one firm impact the actions (and profit)
of other firms. Oligopolies are prone to collusion or the formation of cartels which set
production quantities low and prices high. When cartels are successful oligopolies
function as monopolies. Governments often regulate oligopolies and attempt to prevent
collusion and cartels while encouraging competition through anti-trust laws. These anti-
trust policies reduce monopoly power among firms. Fortunately, since there is an
incentive to cheat, collusive agreements often break down even without anti-trust laws.
Barriers to Entry: High barriers which make it difficult for new firms to enter the market.
Barriers include high start-up costs, government regulations, customer loyalty, etc.
Long-run Profit: Oligopolies often earn an economic profit in the long run due to high
barriers to entry which prevent new firms from entering the market.
Efficiency: No, Oligopolies price above marginal cost and do not produce at the lowest
average cost so they are not allocatively or productively efficient.
Graph: While there is a graph for oligopolies these firm’s behavior is better understood
through game theory. As a result, a payoff matrix is used to determine outcomes.
Take a look at the payoff matrix for the prisoners’ dilemma (see figure 1). In this classic
game theory example two criminals are caught for stealing a car. The police also think
they robbed a bank but they don’t have any evidence against them. The police separate
the prisoners and question them individually. If they both confess to the bank robbery
they both go to prison for 5 years. If they both deny robbing the bank, they both go to
prison for 2 years. If one confesses while the other does not, the one who confesses will
only go to prison for 1 year while the other will go to prison for 10 years. This scenario
creates 4 possible outcomes illustrated in the 4 quadrants of the payoff matrix below.
Figure 1
Figure 2
Let’s look at prisoner A first. If prisoner A thinks prisoner B will confess, then prisoner A
is deciding between confessing as well and getting 5 years in prison or denying and
getting 10 years in prison (see figure 2). Confessing is a better option for Prisoner A.
If, on the other hand, prisoner A thinks prisoner B will deny, then prisoner A is deciding
between confessing and getting 1 year in prison or denying and getting 2 years in prison
(see figure 3). Again, confessing is the better option for prisoner A.
Figure 3
Figure 4
Now let’s look at prisoner B (see figure 4). If prisoner B thinks prisoner A will confess,
then prisoner B is deciding between 5 years in prison (confessing also) or 10 years in
prison (denying). Confessing is a better option for prisoner B.
If prisoner B thinks prisoner A will deny (see figure 5), then prisoner B is deciding
between 1 year in prison (confessing) and two years in prison (denying). Again denying
is the better option for prisoner B.
Figure 5
Figure 6
One thing you must know for these problems is the Nash Equilibrium. This is the most
likely outcome if there is no collusion. It is also the quadrant containing two likely
choices (upper left quadrant with 2 green triangles in figure 6 ). You should note, there
is not always just one Nash Equilibrium; there could be two. Officially a Nash
Equilibrium is defined as an outcome where neither firm has an incentive to change
their behavior. In the prisoner’s dilemma above, the Nash Equilibrium is for both
prisoners to confess. If either prisoner (not both) confesses, that prisoner would serve
10 years instead of 5. As a result, neither prisoner is likely to deviate from the Nash
Equilibrium.
Occasionally you get a question asking about a Collusion outcome. This is much
easier to figure out. For that you just look at all the quadrants in the pay off matrix and
decide where the two entities would choose to end up if they could talk it out and come
to some negotiated agreement. In our example that is the lower right quadrant where
both prisoners deny and only spend two years in prison.
You also need to know what a Dominant Strategy is. This is the choice one of the
players will make regardless of the other player’s action. In our prisoners’ dilemma, both
prisoners have a dominant strategy to confess. That is both prisoners should confess
regardless of what the other player does. You should note, there is not always a
dominant strategy for a particular player. If there is not, it is because the actions of that
player are dependent on the actions of the other player.