HE191

Principles of Economics
Lecture 6

N.Chapters
GREGO 16,
RY 17,M18
ANKIW

Principles of Economics, Fourth Edition

PowerPoint® Slides
N. Gregory Mankiw
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 In this lecture, look for the answers
to these questions:
ƒ Why is MR < P for a monopolist?
ƒ How do monopolies choose their P and Q?
ƒ How do monopolies affect society’s well-being? What can
the government do about monopolies?
ƒ What outcomes are possible under oligopoly?
ƒ Why is it difficult for oligopoly firms to cooperate? How do
monopolistically competitive firms choose price and
quantity? Do they earn economic profit?
ƒ In what ways does monopolistic competition affect society’s
welfare?

1
 Monopoly
ƒ A monopoly is a firm that is the sole seller of a
product without close substitutes.
ƒ Monopoly firm vs competitive firm:
• A monopoly firm has market power, the ability
to influence the market price of the product it
sells. A competitive firm has no market power;
• A monopoly firm is the only seller, so it faces
the downward-sloping market demand curve. A
competitive firm is a price taker and has a
horizontal demand curve.

2
 Why Monopolies Arise
The main cause of monopolies is barriers
to entry – other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right to
produce the good.
E.g., patents, copyright laws
3. Natural monopoly: a single firm can produce the
entire market Q at lower ATC than could several
firms. 3
A C T I V E L E A R N I N G 1:
Answers

Q P TR AR MR
Here, P = AR,
same as for a 0 $4.50 $0 n.a.
$4
competitive firm. 1 4.00 4 $4.00
3
Here, MR < P, 2 3.50 7 3.50
whereas MR = P 2
for a competitive 3 3.00 9 3.00
1
firm. 4 2.50 10 2.50
0
5 2.00 10 2.00
–1
6 1.50 9 1.50

4
Moonbuck’s D and MR Curves

P, MR
$5
4
Demand curve (P)
3
2
1
0
-1 MR
-2
-3
0 1 2 3 4 5 6 7 Q

5
 Profit-Maximization

Costs and
1. The profit- Revenue MC
maximizing Q
is where P
MR = MC.
2. Find P from
D
the demand
curve at this Q. MR

Q Quantity

Profit-maximizing output
6
 The Monopolist’s Profit
ƒ The profit-
maximizing Q Costs and
is where Revenue MC
MR = MC.
P
ƒ Find P from ATC
ATC
the demand
curve at this Q.
D
ƒAs with a
MR
competitive firm,
the monopolist’s Q Quantity
profit equals
(P – ATC) x Q 7
A Monopoly Does Not Have an S Curve
A competitive firm
ƒ takes P as given
ƒ has a supply curve that shows how its Q depends
on P
A monopoly firm
ƒ is a “price-maker,” not a “price-taker”
ƒ Q does not depend on P;
rather, Q and P are jointly determined by
MC, MR, and the demand curve.
So there is no supply curve for monopoly.
8
 The Welfare Cost of Monopoly
Competitive eq’m:
Price Deadweight
quantity = QE loss MC
P = MC
total surplus is P
P = MC
maximized
MC
Monopoly eq’m:
D
quantity = QM
P > MC MR
deadweight loss QM QE Quantity

9
 Natural Monopoly
•Monopolist supplies
Cost
only QM
•QC is socially efficient.
Demand
•At P=MC, monopolist
PM suffers a loss

ATCM
ATCC
ATC
PC MC
Q
QM Qc

MR
10
 Public Policy Toward Monopolies
ƒ Increasing competition
• US has antitrust laws banning certain anticompetitive
practices.
• Singapore does not have antitrust laws but it could allow
more competition in the market e.g. Telecom, Postal
Services, power generation, bus and taxis
ƒ Regulation
• Govt agencies set the monopolist’s price
• For natural monopolies, MC < ATC at all Q,
so marginal cost pricing would result in losses.
• If so, regulators might subsidize the monopolist or set P =
ATC for zero economic profit.
• SBS, SMRT, Singapore Power
11
 Public Policy Toward Monopolies
ƒ Public ownership
• Example: US Postal Service
• Problem: Public ownership is usually less
efficient since no profit motive to minimize costs
ƒ Doing nothing
• The foregoing policies all have drawbacks,
so the best policy may be no policy.

12
 Price Discrimination
ƒ Discrimination is the practice of treating people
differently based on some characteristic, such as
race or gender.
ƒ Price discrimination is the business practice of
selling the same good at different prices to
different buyers.
ƒ The characteristic used in price discrimination
is willingness to pay (WTP):
• A firm can increase profit by charging a higher
price to buyers with higher WTP.

13
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist Consumer
Price
charges the same surplus
price (PM) to all Deadweight
buyers. PM loss
A deadweight loss
results. MC
Monopoly
profit D
MR

QM Quantity

14
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist
produces the Price
Monopoly
competitive quantity,
profit
but charges each
buyer his or her WTP.
This is called perfect
MC
price discrimination.
D
The monopolist
captures all CS MR
as profit.
Quantity
But there’s no DWL. Q
15
 Price Discrimination in the Real World
ƒ In the real world, perfect price discrimination is not
possible:
• no firm knows every buyer’s WTP
• buyers do not announce it to sellers
ƒ So, firms divide customers into groups
based on some observable trait
that is likely related to WTP, such as age.
ƒ Examples
• Movie tickets
• Airline prices
• Discount coupons 16
 The Prevalence of Monopoly
ƒ In the real world, pure monopoly is rare.
ƒ Yet, many firms have market power, due to
• selling a unique variety of a product
• having a large market share and few significant
competitors
ƒ In many such cases, the results we discussed
apply, including
• markup of price over marginal cost
• deadweight loss

17
 Between Monopoly and Competition

Two extremes
• Competitive markets: many firms, identical
products
• Monopoly: one firm
In between these extremes
• Oligopoly: only a few sellers offer similar or
identical products.
• Monopolistic competition: many firms sell
differentiated products.

18
The percentage of the market’s total output supplied by its
four largest firms (concentration ratio) in U.S. Industries
Industry Concentration ratio
Video game consoles 100%
Tennis balls 100%
Credit cards 99%
Batteries 94%
Soft drinks 93%
Web search engines 92%
Breakfast cereal 92%
Cigarettes 89%
Greeting cards 88%
Beer 85%
Cell phone service 82%
Autos 79%
19
 EXAMPLE: Cell Phone Duopoly in Smalltown

P Q ƒ Smalltown has 140 residents

$0 140
ƒ The “good”:
5 130
cell phone service with unlimited
10 120 anytime minutes and free phone
15 110
20 100
ƒ Smalltown’s demand schedule
25 90 ƒ Two firms: Cingular, Verizon
30 80 (duopoly: an oligopoly with two firms)
35 70 ƒ Each firm’s costs: FC = $0, MC = $10
40 60
45 50
20
 EXAMPLE: Cell Phone Duopoly in Smalltown

P Q Revenue Cost Profit Competitive

Competitive
$0 140 $0 $1,400 –1,400 outcome:
outcome:
P
P == MC
MC == $10
$10
5 130 650 1,300 –650
QQ == 120
120
10 120 1,200 1,200 0
Profit
Profit == $0
$0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000
25 90 2,250 900 1,350
Monopoly
Monopoly
30 80 2,400 800 1,600 outcome:
outcome:
35 70 2,450 700 1,750 PP == $40
$40
40 60 2,400 600 1,800 Q
Q == 6060
45 50 2,250 500 1,750 Profit
Profit == $1,800
$1,800
21
EXAMPLE: Cell Phone Duopoly in Smalltown
ƒ One possible duopoly outcome: collusion
ƒ Collusion: an agreement among firms in a
market about quantities to produce or prices to
charge
ƒ Cingular and Verizon could agree to each produce
half of the monopoly output:
• For each firm: Q = 30, P = $40, profits = $900
ƒ Cartel: a group of firms acting in unison,
e.g., Cingular and Verizon in the outcome with
collusion

22
Collusion vs. self-interest

If both firms stick to agreement,

P Q
each firm’s profit = $900
$0 140
If Cingular reneges on agreement and
5 130
produces Q = 40:
10 120
Market quantity = 70, P = $35
15 110
Cingular’s profit = 40 x ($35 – 10) = $1000
20 100
Cingular’s profits are higher if it reneges.
25 90
Verizon will conclude the same, so
30 80
both firms renege, each produces Q = 40:
35 70
Market quantity = 80, P = $30
40 60
Each firm’s profit = 40 x ($30 – 10) = $800
45 50 23
 Collusion vs. Self-Interest
ƒ Both firms would be better off if both stick to the
cartel agreement.
ƒ But each firm has incentive to renege on the
agreement.
ƒ Lesson:
It is difficult for oligopoly firms to form cartels and
honor their agreements.

24
The Oligopoly Equilibrium

P Q Is it in Cingular’s or Verizon’s interest to

$0 140
increase its output further, to Q = 50?
5 130 If each firm produces Q = 40,
10 120 then each firm’s profit = $800.
15 110 If Cingular increases output to Q = 50:
20 100 Market quantity = 90, P = $25
25 90 Cingular’s profit = 50 x ($25 – 10) = $750
30 80
Cingular’s profits are higher at Q = 40
35 70 than at Q = 50.
40 60
The same is true for Verizon.
45 50 25
 The Equilibrium for an Oligopoly
ƒ Nash equilibrium: a situation in which
economic participants interacting with one another
each choose their best strategy given the strategies
that all the others have chosen
ƒ Our duopoly example has a Nash equilibrium
in which each firm produces Q = 40.
• Given that Verizon produces Q = 40,
Cingular’s best move is to produce Q = 40.
• Given that Cingular produces Q = 40,
Verizon’s best move is to produce Q = 40.

26
 A Comparison of Market Outcomes
P Q Revenue Cost Profit Competitive
Competitive outcome:
outcome:
$0 140 $0 $1,400 –1,400 PP == MC
MC == $10
$10
5 130 650 1,300 –650 Q
Q == 120;
120; Profit
Profit == $0
$0
10 120 1,200 1,200 0
15 110 1,650 1,100 550 Nash
Nash Equilibrium:
Equilibrium:
20 100 2,000 1,000 1,000 PP == $30;
$30; Q Q == 80;
80;
Profit
Profit == $1,600
$1,600
25 90 2,250 900 1,350
30 80 2,400 800 1,600
Monopoly
Monopoly outcome:
outcome:
35 70 2,450 700 1,750
PP == $40;
$40; Q Q == 60;
60;
40 60 2,400 600 1,800
Profit
Profit == $1,800
$1,800
45 50 2,250 500 1,750
27
 The Output & Price Effects
ƒ Increasing output has two effects on a firm’s profits:
• output effect:
If P > MC, selling more output raises profits.
• price effect:
Raising production increases market quantity,
which reduces market price and reduces profit
on all units sold.
ƒ If output effect > price effect,
the firm increases production.
ƒ If price effect > output effect,
the firm reduces production.
28
 The Size of the Oligopoly
ƒ As the number of firms in the market increases,
• the price effect becomes smaller
• the oligopoly looks more and more like a
competitive market
• P approaches MC
• the market quantity approaches the socially
efficient quantity

29
 Game Theory
ƒ Game theory: the study of how people behave
in strategic situations
ƒ Dominant strategy: a strategy that is best
for a player in a game regardless of the
strategies chosen by the other players
ƒ Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial

30
 Prisoners’ Dilemma Example
ƒ The police have caught Bonnie and Clyde,
two suspected bank robbers, but only have
enough evidence to imprison each for 1 year.
ƒ The police question each in separate rooms,
offer each the following deal:
• If you confess and implicate your partner,
you go free.
• If you do not confess but your partner implicates
you, you get 20 years in prison.
• If you both confess, each gets 8 years in prison.

31
 Prisoners’ Dilemma Example
Confessing is the dominant strategy for both players.
Nash equilibrium:
Bonnie’s decision
both confess
Confess Remain silent
Bonnie gets Bonnie gets
8 years 20 years
Confess
Clyde Clyde
Clyde’s gets 8 years goes free
decision Bonnie goes Bonnie gets
Remain free 1 year
silent Clyde Clyde
gets 20 years gets 1 year

32
 Prisoners’ Dilemma Example
ƒ Outcome: Bonnie and Clyde both confess,
each gets 8 years in prison.
ƒ Both would have been better off if both remained
silent.
ƒ But even if Bonnie and Clyde had agreed before
being caught to remain silent, the logic of self-
interest takes over and leads them to confess.

33
 Oligopolies as a Prisoners’ Dilemma
ƒ When oligopolies form a cartel in hopes
of reaching the monopoly outcome,
they become players in a prisoners’ dilemma.
ƒ Our earlier example:
• Cingular and Verizon are duopolists in
Smalltown.
• The cartel outcome maximizes profits:
Each firm agrees to serve Q = 30 customers.
ƒ Here is the “payoff matrix” for this example…

34
 Cingular & Verizon in Prisoners’ Dilemma
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
Cingular
Q=30 Q=40
Cingular’s Cingular’s
profits =$900 profits=$1000
Q=30
Verizon’s Verizon’s
Verizon profits = $900 profit=$750
Cingular’s Cingular’s
profits=$750 profits=$800
Q=40
Verizon’s Verizon’s
profits=$1000 profits=$800

35
Other Examples of the Prisoners’ Dilemma
Ad Wars
Two firms spend millions on TV ads to steal business from
each other. Each firm’s ad cancels out the effects of the
other, and both firms’ profits fall by the cost of the ads.
Organization of Petroleum Exporting Countries
Member countries try to act like a cartel, agree to limit oil
production to boost prices & profits. But agreements
sometimes break down when individual countries renege.
Arms race between military superpowers
Each country would be better off if both disarm, but each
has a dominant strategy of arming.
Common resources
All would be better off if everyone conserved common
resources, but each person’s dominant strategy is overusing
the resources.
36
Prisoners’ Dilemma and Society’s Welfare
ƒ The non-cooperative oligopoly equilibrium
• bad for oligopoly firms:
prevents them from achieving monopoly profits
• good for society:
Q is closer to the socially efficient output
P is closer to MC
ƒ In other prisoners’ dilemmas, the inability to
cooperate may reduce social welfare.
• e.g., arms race, overuse of common resources

37
 Why People Sometimes Cooperate
ƒ When the game is repeated many times,
cooperation may be possible.
ƒ Strategies which may lead to cooperation:
• If your rival reneges in one round,
you renege in all subsequent rounds.
• “Tit-for-tat”
Whatever your rival does in one round
(whether renege or cooperate),
you do in the following round.

38
 Public Policy Toward Oligopolies
ƒ Recall one of the Ten Principles from Chap.1:
Governments can sometimes
improve market outcomes.
ƒ In oligopolies, production is too low and prices
are too high, relative to the social optimum.
ƒ Role for policymakers:
promote competition, prevent cooperation
to move the oligopoly outcome closer to
the efficient outcome.

39
 Monopolistic Competition
ƒ Monopolistic competition:
a market structure in which many firms sell
differentiated products. Firms can freely exit or
enter the market.
ƒ Examples:
• apartments
• books
• bottled water
• clothing
• fast food
• night clubs
40
 A Monopolistically Competitive Firm
Earning Profits in the Short Run
The firm faces a
downward-sloping
D curve. Price
profit MC
At each Q, MR < P. ATC
P
To maximize profit,
ATC
firm produces Q D
where MR = MC.
The firm uses the MR
D curve to set P.
Q Quantity

41
 A Monopolistically Competitive Firm
With Losses in the Short Run

For this firm,

P < ATC
Price
at the output where MC
MR = MC.
losses ATC
The best this firm ATC
can do is to
P
minimize its losses.
D
MR
Q Quantity

42
 Monopolistic Competition and Monopoly
ƒ Short run: Under monopolistic competition,
firm behavior is very similar to monopoly.
ƒ Long run: In monopolistic competition,
entry and exit drive economic profit to zero.
• If profits in the short run:
New firms enter market,
taking some demand away from existing firms,
prices and profits fall.
• If losses in the short run:
Some firms exit the market,
remaining firms enjoy higher demand and prices.

43
A Monopolistic Competitor in the Long Run

Entry and exit

occurs until
P = ATC and Price
profit = zero. MC

Notice that the ATC

firm charges a P = ATC
markup of price markup
over marginal
D
cost, and does MC MR
not produce at
minimum ATC. Q Quantity

44
 Why Monopolistic Competition Is
Less Efficient than Perfect Competition
1. Excess capacity
• The monopolistic competitor operates on the
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.
• Under perfect competition, firms produce the
quantity that minimizes ATC.
2. Markup over marginal cost
• Under monopolistic competition, P > MC.
• Under perfect competition, P = MC.

45
 Monopolistic Competition and Welfare
ƒ Monopolistically competitive markets do not
have all the desirable welfare properties of
perfectly competitive markets.
ƒ Because P > MC, the market quantity is below
the socially efficient quantity.
ƒ Yet, not easy for policymakers to fix this problem:
Firms earn zero profits, so cannot require them
to reduce prices.

46
 Monopolistic Competition and Welfare
ƒ Number of firms in the market may not be optimal,
due to external effects from the entry of new firms:
• the product-variety externality:
surplus consumers get from the introduction
of new products
• the business-stealing externality:
losses incurred by existing firms
when new firms enter market
ƒ The inefficiencies of monopolistic competition are
subtle and hard to measure. No easy way for
policymakers to improve the market outcome.

47
 Advertising
ƒ Critics of advertising believe:
• Society is wasting the resources it devotes to advertising.
• Firms advertise to manipulate people’s tastes.
• Advertising impedes competition –
it creates the perception that products are
more differentiated than they really are,
allowing higher markups.
ƒ Defenders of advertising believe:
• It provides useful information to buyers.
• Informed buyers can more easily find and exploit price
differences.
• Thus, advertising promotes competition and reduces
market power.
ƒ Advertising as a signal of quality
48
 Brand Names
ƒ Critics of brand names believe:
• Brand names cause consumers to perceive differences that
do not really exist.
• Consumers’ willingness to pay more for brand names is
irrational, fostered by advertising.
• Eliminating govt protection of trademarks would reduce
influence of brand names, result in lower prices.
ƒ Defenders of brand names believe:
• Brand names provide information about quality to
consumers.
• Companies with brand names have incentive
to maintain quality, to protect the reputation of their brand
names.
49
 CONCLUSION
ƒ Differentiated products are everywhere;
examples of monopolistic competition abound.
ƒ The theory of monopolistic competition
describes many markets in the economy,
yet offers little guidance to policymakers looking
to improve the market’s allocation of resources.

50