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Principles of Microeconomics – Mr. Lilly Topic 10 Skills
1. Know the meaning of the words and expressions monopoly, barriers to entry, market power, and price maker. Know the four types of barrier to entry and be able to recognize a description of each one. Know what useful purpose patents and copyrights serve. Know whether a monopoly is a price-taker or a price-maker. (241) monopoly = one firm in an industry selling a product for which there are no close substitutes. (241) barriers to entry = anything that prevents firms from entering a market. (241) market power = a firm’s power to set its price without losing its entire share of the market (241) price market = a firm that has the power to set its price rather than taking the price set by the market (slide 2) Monopoly: An industry consisting of only one firm (or) a firm that sells a product for which there are no close substitutes (Slide 4) Market power: Any firm that can raise its price without losing its entire share of the market has some market power. Price maker: Any firm that can raise its price without losing its entire share of the market. (Slide 3) Barriers to entry: Anything that prevents Type of Barrier Example Patents and copyrights Intel, Pfizer (Viagra) Network effects Ebay, Microsoft Ownership of unique and essential inputs De Beers (diamonds) High fixed costs plus uncertainty The Big 3 automakers before Japanese competition
2. Know why the perfectly competitive firm cannot raise its price, and why it faces a horizontal demand curve. Know what will happen to the quantity of product demanded from the perfectly competitive firm if it raises its price by a penny. Know what will happen to the market price of the product if the perfectly competitive firm cuts its output in half. (Slide 5) Why the Perfectly Competitive Firm Cannot Raise Its Price Because there is always another seller nearby who will undercut that price. Because all products are assumed to be homogenous. Because buyers are assumed to have perfect information about the prices and quality of available goods. All buyers will simply ignore that seller. 3. Understand that the demand curve facing the monopolist is the market demand curve. (See Figure 10.1 on page 243.) Know that the demand curve facing the monopolist could also be thought of as its average revenue curve. (See discussion of Average Revenue on page 246.) Know that we will generally assume that the market demand curve is downward sloping, and that in order to sell an additional unit, the monopolist must lower its price on all units. Understand why this implies that marginal revenue will always be less than price for a monopolist, and that therefore the monopolist’s marginal revenue curve will always be below its demand curve. ok 4. Know that when marginal revenue is positive, total revenue will rise as output is increased, but that when marginal revenue is negative, total revenue will fall as output is increased. Know that when elasticity of market demand is greater than one, marginal revenue for the monopolist will be positive; therefore any increase in quantity will increase the monopolist’s total revenue. Know that when elasticity of demand is less than one, marginal revenue for the monopolist will be negative; therefore any increase in quantity will decrease the monopolist’s total revenue. Total revenue = price x quantity. ok 5. Know that the profit-maximizing rule for the monopolist is to expand output until marginal revenue equals marginal cost. Know that because marginal cost will always be assumed to be greater than zero in this class, that this means that marginal revenue will also be greater than zero when the monopolist is producing at the profit-maximizing output level. Know that, in general, total revenue will not be maximized at the same output level that total profit is maximized. Know also that, in general, average revenue (which is the same thing as price) will not be maximized at the same output level that total profit is maximized. Know that if marginal revenue is greater than marginal cost at the current level of output, that the monopolist should increase output in order to maximize profits. Know that if marginal revenue is less than marginal cost at the current level of output, that the monopolist should decrease output in order to maximize profits. (Slide 21) The Profit Maximization Rule for the Monopolist Regardless whether a firm is a perfect competitor or a monopolist: •Their goal is to maximize profits •And their rule for doing so is… • Expand output when MR > MC • Decrease output when MC > MR • Sell the quantity of output where marginal revenue equals marginal cost, MR = MC
6. Be able to draw from memory the
generic diagram of a monopoly and its profits shown in Figure 10.6. Given such
a diagram, be able to find the monopolist’s profit-maximizing output and price,
and the rectangular area that represents its profit per period. 7. Know that, in the absence of significant internal economies of scale, a profit-maximizing monopolist will charge a higher price and produce a smaller quantity than an equivalent number of profit-maximizing perfectly competitive firms. Given a generic diagram of a monopoly and its profits such as that shown in either Figure 10.6 or Figure 10.8, be able to identify the equilibrium price and quantity that would occur if this market were served by many perfectly competitive firms, the deadweight loss caused by this market being served by a monopolist, and the amount of consumer surplus that would be converted into profit (producer surplus) if this industry changed from perfect competition to monopoly. Know that monopoly causes resources to be under-allocated to an industry because marginal benefit is greater than marginal cost at the level of output chosen by the monopolist. ok 8. Know that, as long as the barriers to entry that made a firm a monopolist in the first place remain effective, a monopolist can continue to earn positive economic profits forever! ok 9. Know the meaning of the expression “natural monopoly.” Know that there is some benefit to society in permitting a natural monopoly to exist, because one firm can produce the product or service more cheaply than two or more firms could. Understand why water service, telephone service to the home, and electricity service to the home all exhibit the steeply declining average total cost curve that is characteristic of natural monopolies. (See pages 300-301.) (slide 28) Natural monopoly: A single firm in an industry in which average total cost is declining over the entire range of production and the minimum efficient scale is larger than the size of the market. 10. Understand the marginal cost pricing and average total cost pricing schemes for regulating a natural monopoly. Understand the problem with trying to use marginal cost pricing to regulate a natural monopoly, and know how the average total cost pricing method avoids this problem. Know that using the average total cost pricing method to regulate a natural monopoly will generally produce far less deadweight loss for society than if the monopolist is allowed to set the price itself. Know the four problems with using the average total cost pricing method to regulate a natural monopoly. (Slide 31) Marginal cost pricing: A regulatory method that stipulates that the firm charge a price that equals marginal cost. Average total cost pricing: A regulatory method that stipulates that the firm charge a price no higher than the average total cost of production, including opportunity costs. (slide 33) Problems with Average Total Cost Pricing (cont.)
– In fact, if they are paid a 10% return on their explicit costs, they actually have an incentive to be inefficient!
3. The firm has no
incentive to provide excellent customer service because there is no competition. 11. Know what the “deregulation movement” is. Know that in the United States, the following industries have been fully or partially deregulated: airlines, railroads, trucking, telecommunications, and cable television. Know that deregulation was in part an attempt to address the problems with using the average total cost pricing method to regulate a monopoly referred to in skill 10. Know that deregulation in these industries has reduced deadweight loss in the American economy by at least 42 billion dollars per year! (See Table 12.4 on page 307.) (306) deregulation movement = begun in the late 170s, the drive to reduce the government regulations controlling prices and entry in many industries. 12. Know the three kinds of firms that participate in the process of providing (selling) electricity to California homes and businesses today. Know that the goals of deregulation in the California electricity market were to harness the forces of competition to lower prices and increase service quality in two of the three markets that represent the process of providing electricity, but that the third market would have to remain regulated. Know why it would have to remain regulated. Know that the price caps on wholesale electricity were removed but the price caps on retail electricity were not. Know that the plan worked reasonably well from 1996 to 1999. Know what happened in the summer of 2000, why it happened, and what the costs were. (Slide 37) Electricity Deregulation in California: Background Three kinds of firms participate in the electricity market: •Power generation companies build power plants, generate electricity, and sell it on the wholesale electricity market. •Retail electricity providers buy electricity at wholesale prices and sell it to consumers at retail prices. •The regulated utilities that own both the high voltage intercity power transmission lines and the low voltage lines that deliver power to individual homes and businesses. (Slide 38-39) Electricity Deregulation in California: Results •The plan worked reasonably well from 1996 to 1999 –Wholesale prices averaged 2 cents per kWh and retail prices 6-7 cents per kWh in 1999 –Demand for power almost doubled in that time, while supply declined slightly •However, in the summer of 2000, the wholesale price of electricity skyrocketed. The utilities were forced to implement rolling blackouts, and the retail electricity providers began to accumulate big losses. Electricity Deregulation in California: What Went Wrong? •The Northwest had a drought. •The private electricity companies used various schemes to get the “spot rate” of wholesale electricity to spike throughout the day. •But the main problem was that demand increased sharply but no new power generating facilities were built. –Since the retail price was fixed, consumers had no incentive to conserve. –Also, the power generators may have been concerned about their customers’ ability to pay.
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