Intermediate Microeconomics Module 15 Monopoly

MONOPOLY 339 CHAPTER 15 Monopoly by Zach Armstrong is licensed under THE POLICY QUESTION SHOULD THE GOVERNMENT GIVE PATENT PROTECTION COMPANIES THAT MAKE DRUGS ?

In 1993 , pharmaceutical company , received a patent for the medication calcium , better known by its brand name , is used to treat high cholesterol and related heart and cardiovascular diseases . has become one of the drugs of all time . In 2016 , the patent protection will expire , and , the manufacturer of , will cease to be a monopolist , and generic versions of the drug will flood the market . The patent created a monopoly in the market , for which has enjoyed enormous profits the company recorded billion in sales in 2015 alone . 339

340 PATRICK EMERSON Providing a company the exclusive rights to sell a popular and medically important drug creates the potential for enormous profits , which gives pharmaceutical companies a very strong incentive to invest in the research and development of new drugs . But it also creates a situation in which medically drugs are very expensive for consumers . EXPLORING THE POLICY QUESTION . Does the societal benefit from the advent of new drugs outweigh the cost to society from the creation of monopolies ?

What other way could society promote the development of new medicines ?

LEARNING OBJECTIVES Conditions for Monopoly Learning Objective Explain the conditions that lead to monopolies , Profit Maximization for Learning Objective Explain how maximize profits and solve for the optimal monopolist solution from a demand curve and a marginal cost curve , Market Power and the Demand Curve Learning Objective Describe the relationship between demand elasticity and a monopolist ability to price above marginal cost . Monopoly and Welfare Learning Describe how create deadweight loss and explain how deadweight loss affects societal fare . Policy Example Should the Government Give Patent Protection to Companies That Make Drugs ?

Learning Objective Explain the effect of patent protection on drug markets and the society makes to promote the development of new drugs . CONDITIONS FOR MONOPOLY Learning Objective Explain the conditions that lead to monopolies . A monopoly is the sole supplier of a good for which there does not exist a close substitute . In the policy example above , a firm that makes the only drug with which to treat or cure a disease is a monopolist if there is no other drug available to treat or cure the disease or if the only other drugs are not nearly as effective . Many drug makers continue to hold on to their trademarked drug names even patents

MONOPOLY 341 run out and generic drugs enter the market , but the presence of the means that the original companies are no longer in the market for that particular drug . As we learned in chapter 13 , the characteristics of monopoly markets are a single firm , a unique , and barriers to entry . But what are those barriers to entry , and where do they come from ?

There are two main sources of these barriers ( cost conditions that make it cheaper for one firm to produce and ( government regulations that create legal barriers to entry that prevent other firms from competing in the same market . Cost advantages can come from a number of sources . A firm might control an essential input for example , one company might control the only source of a rare earth element used in batteries for automobiles . A firm might have better technology for or a better method of producing a good or service that gives it a cost advantage . Of course , this advantage only lasts as long as the firm is the only one with the technology or method . For this reason , many firms keep their production processes a closely guarded secret . Another source ofa monopoly is large fixed costs associated with production . If the fixed costs of duction are large enough relative to the demand for a product , it may be true that only one firm can make economic profits . This is referred to as a natural one firm can supply the market more cheaply than two or more firms . For example , suppose an entrepreneur wants to start a service in her isolated small town to provide concrete for places that normal concrete trucks are unable to access . trucks are very large and very expensive . The town might have enough demand to justify the cost of one such truck , and so the entrepreneur will attract enough business to cover the cost of the truck itself and the other accounting and opportunity costs ofthe business . But there might not be enough demand the purchase of a second truck if another business decided to start up . Thus the monopoly that results is a natural result of the large fixed cost relative to the limited demand . We can express the example more formally with a simple model . Suppose the cost of supplying pumped concrete is fixed at and the cost of the truck itself , the fixed cost , is The truck is a fixed cost because it costs to acquire the truck , and this does not depend on the amount of concrete sold , or The firms total cost function is therefore Average cost is AC This is the same for any firm that enters the market . Let say that the cost of the truck , is per year , and the marginal cost is per cubic foot of concrete , Now suppose that the demand is such that at , cubic feet of concrete is sold per year . If there is one firm , the average cost of pumped concrete is AC 500 , 000 , or AC . If there were two firms , the average cost of the industry would be Note that at a constant , the cost ofa single cubic foot of concrete is always , no matter which company it however , with two firms , there are two fixed costs because each one has to pay for a truck . So AC , 000 , 000 , or AC 11 . If the maximum willingness to pay for at cubic feet a year in this town is , the town can only support one firm . One firm would make in economic profit in this business , while two firms would each lose in economic profit . Another important source of monopoly power is government . The government itself owns and ages monopolies for example , the federal government runs the US Postal Service , and local are often the sole provider of utilities such as water and sewer services . The government also provides protection from competition for individual firms , guaranteeing their monopoly status . The most common protection the government offers is patent protection , but the government can also require licenses to operate example , a local issue only one per market . The

342 PATRICK EMERSON can also grant a firm the right to operate as a monopoly for example , a municipality might grant one company the right to collect residential trash . A patent is an exclusive right to an invention that excludes others from making , using , selling , or importing it into the country for a limited time . In other words , the inventor is granted protection from any direct competition for a period of time , generally twenty years from the time an application is filed , and in exchange , the invention becomes public knowledge when the patent is granted . Why does the government offer patent protection ?

As we will see in the next section , being a monopolist often allows companies to collect positive economic return on investment . So patents give companies a reward for investing in new technologies , new drugs , and new methods that are able to society as an incentive . PROFIT MAXIMIZATION FOR Learning Objective Explain how maximize profits and solve for the optimal list solution from a demand curve and a marginal cost curve . All profit maximizing firms , regardless ofthe structure ofthe markets in which they sell , maximize its by setting the output so that marginal revenue equals marginal cost , as we learned in chapter . ter demonstrated how to find a marginal cost curve from the firm total cost curve . What is different in the case ofa monopoly is the marginal revenue curve . Perfectly competitive firms take prices as given their output decisions do not change market prices , and so the marginal revenue for a perfectly firm is simply the market price . on the other hand , are price makers in the sense that they can set their prices by picking a point on the demand curve . Note that they are not free of straint the demand curve dictates the maximum price they can charge for every quantity level . The task for the profit maximizing monopolist is to determine which point on the demand curve maximizes their profits . A demand curve will mean that the firm faces a they can sell more but must lower their price to do so . This means that the marginal revenue of a monopolist will depend on their output decision . The total revenue for a firm is the number of goods they sell , multiplied by the price at which they sell the goods , Note that is both the firms output and the market output , as there is only one firm supplying the market . The firm marginal revenue is the change in total revenue from the sale of one more unit ofits output . Thus in a firm that earns extra revenue from the sale of , more units have a marginal of ' Therefore , if the firm sells one more unit , and . Because of the from the demand curve , the revenue of a monopolist will depend on its output . Unlike a Calculus competitive firm whose product sells for a constant price and therefore has a constant price for its marginal revenue , a monopolist Ma a eVe Ca who wants to sell one more unit must lower its price to do so . Thus a ' a ' bY a monopolist marginal revenue is a constantly declining function It also derivative declines at a rate greater than the demand curve because to sell more ,

MONOPOLY 343 the monopolist must lower the price ofall its goods . Figure the marginal revenue . 10 , per unit , Figure Monopoly , revenue , and marginal review At price , the total revenue is , which is represented by the areas A . At price , the total revenue is , which is represented by the areas A Area A is the same for both , so the revenue is the difference between and , or . Note that area is the price , 122 , times the change in quantity , or , and area is the quantity , times the change in price , or . Since is negative , the change in total revenue is , or . Dividing both sides by gives us an expression for marginal revenue A ( This expression has an intuitive interpretation . The first part , is the extra revenue the firm gets from selling an extra unit of the good . The second part , which IS negative , IS the decrease in revenue from the fact that increasing output marginally lowers the price the firm receives for all of its output .

344 PATRICK EMERSON Since the second part is negative , we know that the curve is below the demand curve for every since the demand curve relates price and quantity . Figure shows the relationship between a linear demand curve and the marginal revenue curve in the top panel and the total revenue in the bottom panel .

MONOPOLY 345 , per unit Total Revenue , Figure Demand , marginal revenue , and total revenue Since marginal revenue is the rate of change in total revenue for a marginal increase in quantity , when marginal revenue is positive , the total revenue curve has a positive slope , and when marginal revenue is

346 PATRICK EMERSON negative , the total revenue curve has a negative slope . Note that this means the total revenue is at the point where marginal revenue is zero . A profit maximizing firm chooses an output so that the marginal cost of producing that output exactly matches the marginal revenue it gets from selling that output . Now that we have the marginal revenue , all that remains is to add the marginal cost . Figure shows that the optimal output for the list is where marginal revenue and marginal cost intersect . per unit Figure Profit maximization for a The intersection of the marginal revenue and marginal cost curves occurs at point , and the highest price at which the monopolist can sell exactly is . At , the total revenue is simply ( and total cost is ( AC ) since AC is just . Therefore , the shaded area is the difference between total revenue and total cost or profit . Mathematically , profit maximization for a monopolist is the same as for any firm find the output level for which marginal revenue equals marginal cost . Let start with a general example . Suppose the demand for a good produced by a monopolist is A . Note that this is an inverse demand curve , a demand curve written with price as a function of quantity . We could easily solve it for to get it back in normal form . We can find the marginal revenue curve by first noting that (

MONOPOLY 347 The marginal revenue from a linear demand curve is a curve with the same vertical intercept as the demand curve ( in this case , A ) and a slope twice as steep ( in this case , In other words , for an inverse Calculus demand curve , and the marginal revenue curve is A . Let consider a specific example suppose that Tesla is a monopolist he in the manufacture of luxury electric cars . For its electric Model cars , A let say it faces an annual demand curve of 200 ( in sands ) Its marginal cost of producing a Model is ( also in thousands ) First , we will solve for the monopolist profit maximizing level of output and the profit maximizing price . Second , we will graph the solution . To solve the problem , we need to proceed in four steps ( find the inverse demand curve ( find the marginal revenue curve ( set marginal revenue equal to marginal cost and solve for , the profit maximizing output level ( find , the monopolist profit maximizing price . Find the inverse demand curve by solving for demand curve for . Find the marginal revenue curve by doubling the slope coefficient ( 100 ( 100 . Set equal to and solve for 100 100 50 or 50 , 000 . Find from the inverse demand curve 100 ( 50 ) 100 25 75 or

348 PATRICK EMERSON So the optimal output of Model cars for Tesla is fifty thousand cars , and the optimal price is per car . Figure Solution to problem In order to determine Tesla profit , we need the total cost function . Suppose total cost is . In this case , with 50 and 75 , the total revenue is 75 50 , 750 , or cost is ( 50 ) 250 , or million . So profit , which is , equals , or 25 million . MARKET POWER AND THE DEMAND CURVE Learning Objective Describe the relationship between demand elasticity and a monopolist ability to price above marginal cost . A firm that faces a demand curve has market power the ability to choose a price above marginal cost . face demand curves because they are the only plier ofa particular good or service , and the market demand curve is therefore the monopolist demand curve . How much market power a firm has is a function of the shape of the demand curve . A market in which customers are price sensitive is one with a highly elastic demand curve , or one that is relatively flat . A market in which customers are very price insensitive is one with a highly inelastic demand curve , or one that is relatively steep . What makes customers more or less price sensitive ?

This could be caused by a number of factors , but the most important one is the availability of good substitutes . A drug company MONOPOLY 349 that has a patent for a drug that is the only cure for a serious disease is likely to face an inelastic demand curve , as those who have the disease will be likely to buy at any price they can afford , since there is no other choice . However , a smartphone company that has a patent for its unique technologies would ably face a highly elastic demand curve because customers are likely to switch to a different smartphone with slightly different capabilities if the price is too high . Consider Tesla , the example from Tesla arguably has a monopoly on luxury cars . But there are many other cars and luxury hybrid cars with both gas and electric motors . demand curve is probably somewhere in between the two examples above . There are substitutes , but they are quite a bit different from the Tesla , and so customers are probably fairly price insensitive . The relationship between the elasticity of the demand curve that a monopolist faces and the list ability to price above its marginal cost can be derived by using the marginal revenue equation ( AP ?

Profit maximization implies that , so If we multiply by , we do change the value , since , but we can rearrange to get Ap ) or AC ?

Notice that the term in the parentheses is the inverse of the elasticity , from chapter ( Rearranging terms yields ( We call the side of this equation the markup the percentage of the price is above marginal cost . The side of the equation says that the markup is inversely related to the elasticity of the demand . As consumers are more price sensitive , the absolute value of the elasticity increases , causing the side of the equation to decrease , meaning the markup are not able to charge as high a price as if they faced customers . Equation ( has a special name , the index , and it measures the firm optimal markup . This is also a measure of market power , as firms with more market power are more able to charge prices above marginal cost . Notice that when the demand curve is perfectly elastic , or horizontal , the monopolist is in the same situation that a perfectly competitive firm is . Perfect elasticity implies that oo , or that the side of the index is essentially zero , meaning the monopolist sets price equal to marginal cost , just as if they were a perfectly competitive firm . On the other extreme , a perfectly inelastic demand curve has an close to zero . In this case , the markup is infinitely high .

350 PATRICK EMERSON We know from figure that a monopolist firm will never want to operate on the inelastic part of the demand curve , and the index confirms that if , the index is greater than one , and this implies that , which can only be true if marginal cost is negative , and marginal cost can never be negative . The relationship between markup and demand elasticity can be seen graphically , as in figure . Figure The markup and shape ofthe demand curve In the figure above , is the demand curve , which is much more elastic than . This means that if the monopolist tries to charge higher prices , it loses more sales than if it faced . This constrains the monopolist , and therefore is significantly lower than . As an example , using the index , pose that at the elasticity from is and the elasticity from is . The index for is Ma , or a 25 percent markup . The index for is , or a 50 percent markup . MONOPOLY AND WELFARE Learning Objective Describe how create deadweight loss and explain how weight loss affects societal welfare . In chapter 10 , we learned that welfare is defined as the sum of consumer and producer surplus . competitive markets that meet a set of criteria maximize welfare and achieve efficiency . Monopoly markets do not . To understand why not , think about the marginal revenue relationship to the demand

MONOPOLY 351 curve , as explained in section . The incentive is to limit output in order to keep prices high for all its goods . Figure Monopoly and deadweight loss In figure , the monopolist output , and the price , create an area of consumer surplus of A . The producer surplus is area , and the total surplus is A We can compare this outcome to the perfectly competitive outcome , which is shown as and , or where price equals marginal cost , which is what we know is the perfectly competitive firm outcome . In this case , the consumer surplus is A , and the producer surplus is , for a total surplus of A The difference in total surplus between the perfectly competitive outcome and the monopoly outcome is This is the deadweight loss that results from the presence of a monopoly in this market . Again , the deadweight loss is the potential surplus not realized due to the lower level of output . As an example , suppose that a drug company has a patent for a drug that makes it a monopolist on the market for that drug . The demand for that drug is described by the inverse demand curve 30 and the firm marginal cost is where is in thousands . The profit maximizing

352 PATRICK EMERSON level of output is where equals and marginal revenue is a line with the same vertical cept , 30 , and twice the slope , 30 . So 30 or 30 , or , and therefore , since 20 . That is the profit maximizing solution . What is the perfectly competitive market solution ?

It is where ) equals 30 and 15 . Graphically , this looks like figure . Figure Deadweight Loss from Monopoly We can see from figure that the deadweight loss is a triangle with a base of 10 , because at 10 , 10 and 20 therefore , the distance between the two is 10 with a height of , the difference between and . Using the formula for the area of a triangle of base times height , we get ( 25 . POLICY EXAMPLE

MONOPOLY 353 SHOULD THE GOVERNMENT GIVE PATENT PROTECTION TO COMPANIES THAT MAKE DRUGS ?

Learning Objective Explain the effect of patent protection on drug markets and the makes to promote the development of new drugs . Providing companies like patent protection for drugs like gives them a profit incentive to invest in the research and development of new , medically important drugs . However , from section , we also know that monopoly power creates deadweight loss . Figure shows the weight loss that results from monopoly power , but it is important to understand what the deadweight loss represents this is the loss to society that results from the reduction in output of these medically important drugs . By restricting output , monopolies keep prices high and , in so doing , exclude a segment of consumers who would purchase the drugs if the price were at marginal cost , as would be the case in a perfectly competitive market . Deadweight loss from monopoly power However , there would be an even larger deadweight loss if the drug was never discovered and the ket never created . The total surplus , the combination of the and areas in figure , would be lost .

354 PATRICK EMERSON The most basic policy question is therefore whether the benefit to society is greater than the weight loss . Given the diagram in figure , the answer is almost certainly yes . Another policy question is whether there is an alternate policy that could achieve the same objective of developing new medicines at a lower societal most obvious is to fund the research of new medicines directly by the and then allow new discoveries to be produced by many firms . This would lead to more duction and lower costs of new drugs but might not be as efficient at promoting new discoveries . A final question is whether the patent protections promote the discovery the most profitable drugs , such as those often associated with aging in countries . Malaria , a disease that remains one ofthe most lethal in the world , has not generated a lot of funding for the creation of a new drug to combat it , and many critics believe this is because it is a disease most commonly found in countries and thus the potential profits are low because the market could not support high prices . Supporters of the current system like the fact that it is private enterprise , not the government , that decides in which areas to invest resources , thus ensuring that the drugs with the highest expected benefits are invested in most heavily . REVIEW TOPICS AND RELATED LEARNING OUTCOMES Conditions for Monopoly Learning Objective Explain the conditions that lead to monopolies , Profit Maximization for Learning Objective Explain how maximize profits and solve for the optimal monopolist solution from a demand curve and a marginal cost curve , Market Power and the Demand Curve Learning Objective Describe the relationship between demand elasticity and a monopolist ability to price above marginal cost . Monopoly and Welfare Learning Describe how create deadweight loss and explain how deadweight loss affects societal fare . Policy Example Should the Government Give Patent Protection to Companies That Make Drugs ?

Learning Objective Explain the effect of patent protection on drug markets and the society makes to promote the development of new drugs .

MONOPOLY 355 LEARN KEY TOPICS Terms Monopoly The sole supplier of a good for which there does not exist a close substitute . Natural monopoly When one can supply the market more cheaply than two or more . Patent An exclusive right to an invention that excludes others from making , using , selling , or importing it into the country for a limited time . Inverse demand curve A demand curve written with price as a function of quantity . See . Markup The percentage of the price above marginal cost . Market power The ability to choose a price above marginal cost . The index Measures the optimal markup . This is also a measure of market power , as with more market power are more able to charge prices above marginal cost . Graphs Monopoly , revenue , and marginal revenue

356 PATRICK EMERSON , per unit Figure Monopoly , revenue , and marginal Demand , marginal revenue , and total revenue MONOPOLY 357 Total Revenue , Figure 752 Demand , marginal revenue , and total revenue maximization for a monopolist 358 PATRICK EMERSON , per unit Figure Profit for a monopolist Solution to maximization problem Figure Solution to Tesla problem The markup and shape of the demand curve MONOPOLY 359 Figure 155 The markup and shape ofthe demand curve Monopoly and deadweight loss 360 PATRICK EMERSON Figure Monopoly and loss Deadweight loss from monopoly power

MONOPOLY 361 Figure monopoly power Equations Marginal revenue A The index Measures the optimal markup . Also measures market power , as with more market power are more able to charge prices above cost . Marginal revenue curve produced by an inverse demand curve The marginal revenue from a linear demand curve is a curve with the same vertical intercept as the demand curve and a slope twice as steep . The demand for a particular good is ( or the inverse demand curve , or the demand curve solved as a function of price ) The marginal revenue curve is found by noting that Total revenue equals times output , and therefore ,

362 PATRICK EMERSON ( or and if , then A In other words , for an inverse demand curve of the marginal revenue curve is The Tesla example Optimizing a output and is a process . The first part is solving for the maximizing level and the second is solving for their maximizing price . The results are usually afterwards . Solving for the monopolist maximizing level of output A four step process . Find the inverse demand curve Find the inverse demand curve by solving for the demand for . Find the marginal revenue curve Find the marginal revenue curve by doubling the slope coefficient 100 ( 100 . Solve for Set marginal revenue equal to and solve for

MONOPOLY 363 iv . Find Find from the inverse demand curve 100 100 ( 50 ) 100 25 75 OI Solving for Tesla maximizing price Requires the total cost function . A theoretical total cost equation for Tesla Previously variables ( 75 ) and ( 50 ) are now substituted into total cost function and the total revenue equation 75 50 , 750 ( 50 ) This the variables of total cost and total revenue as and , respectively . Substituting into the equation gives us or in this case , we have sliced zeroes off for ease of calculation , so the exact total is million . The solution to the Tesla example 100 100 200 Figure Solution to profit maximization problem