AF1605 Introduction to Economics

Topic 5: Market Structure

Part 2: Monopoly and Oligopoly

Lecturer: Chau Tak Wai

School of Accounting and Finance

 Market Structure: Part 2

v Monopoly

v Oligopoly

v A Very Brief Introduction of Game Theory

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 Monopoly

v A pure monopoly is a firm which is the only seller in the market with
no close substitutes.

v A firm with monopoly power is the firm which has the ability to set
its product price (i.e., the demand is not perfectly elastic).

v Source of monopoly power: barrier to entry to the industry.

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 Why there are Barriers to Entry

1. Exclusive control of inputs in terms of resources or technology.

2. Legal barrier: patents, franchise, etc.

3. Network economies
v Network economies (or network externality) occurs when the
value of the product increases as the number of users increases.
v Example: Microsoft Office software.

4. Natural monopoly arises due to economies of scale (decreasing long

run average cost) in the production process even when its scale can
satisfy the whole market demand.

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 Electric Power Company as a Natural Monopoly

v One firm can distribute 4

million kilowatt hours at a cost
of 5 cents a kilowatt-hour.

v This same total output costs

10 cents a kilowatt-hour with
two firms, and 15 cents a
kilowatt-hour with four firms.

v One firm can meet the market

demand at a lower cost than
two or more firms can, and
the market has the
characteristics of natural
The price that
monopoly. consumers are willing
to pay for 4 millions of
kilowatt-hours

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6
 Price Setting Strategies of Monopoly

v The demand curve faced by a monopoly is the market demand curve

which is downward sloping.

v Note: Thus, the market-level diagram is the same as firm-level diagram.

v A monopoly has two price-setting possibilities:

v Single price: A single-price monopoly sells each unit of its output for
the same price to all its customers at all quantities.
v Price discrimination: A price-discriminating monopoly sells different
units of a good or service for different prices not related to cost
differences.

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 Monopoly’s Marginal Revenue – Single Price

v Using the marginal approach, the optimal output is determined by MR =

MC. So, how does the MR curve look like for a single-price monopolist?
v 1. The monopolist must charge the price on the demand curve for its
chosen quantity.
v 2. The marginal revenue (MR) curve of a single-price monopoly is no
longer a flat one, but is below its demand curve. Why?

v The monopolist has to sell at a lower price to attract consumers for the
extra sales.
v MR = size of increase due to selling one more unit (p)
– size of decrease due to selling at a lower price for all units
<p
v Since the price is charged on the demand curve, the MR curve is below
the demand curve.

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Monopoly’s Marginal Revenue – Single Price

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 Marginal Revenue and Elasticity

v Marginal revenue can be negative.

v Marginal revenue is positive only

when demand is elastic. Why?
When P¯,
TR­, MR ¯
v Since a profit maximizing single-price
monopoly will make MR equals MC
and MC must be positive, the
monopoly never profitably produces
an output in the inelastic range of its
demand curve.

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 It chooses the combination of
Single-Price Monopoly price and quantity of output
along the market demand curve
that maximizes its profit.

v The monopoly choose its quantity to

produce where MR = MC and MC is No supply curve!
increasing.

v After finding its output level, the

monopoly set its price according to
the demand curve.

v There is no supply curve relationship

independent of the demand curve.
Two different demand curves can
lead to the same quantity with
different prices.

v The profit earned by the monopoly

equals (P – ATC) × Q (which equals
the blue area).

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Self-assessment: Profit-maximizing Price and Output for Monopoly

1. The figure shows demand, marginal revenue,

marginal cost, and average total cost curves for
a monopolist. What is the monopolist's profit-
maximizing output and price?

(a) Q2, P5
(b) Q3, P4
(c) Q1, P1
(d) Q1, P6

2. The monopoly is earning a (positive/negative)

profit and it is equal to the area of _______.

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 Profit-maximization for Monopoly in a discrete case
• If the monopoly face the following demand curve with discrete
adjustment (integers only) for price and quantity, calculate the total
and marginal revenue schedule.

• If the marginal cost is constant at 4, what are the profit maximizing

quantity and price?

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 Monopoly and Competition Compared

v In perfect competition, the market sum of all MC curves of firms in the industry
demand curve is D, the market supply
curve is S, and the competitive
industry produces the quantity QC at
price PC.

v The competitive market’s supply

curve, S, is the monopoly’s MC curve.
A single-price monopoly produces the
quantity QM at price PM.

v Compared to firms in perfect

competition, a single-price monopoly
produces a smaller output and
charges a higher price.

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 Monopoly and Perfect Competition Compared

v In a single-price monopoly, the

equilibrium quantity, QM, is allocative
inefficient because the price, PM, which
equals marginal benefit to consumers,
exceeds marginal cost. (i.e. MB > MC, or
P > MC.)

v Underproduction creates a deadweight

loss.

v Deadweight loss is the decrease in

social surplus and that results from an
inefficient underproduction or
overproduction.

v Monopoly is inefficient because it Inefficient level of

Efficient level of
output
creates a deadweight loss. output

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 Monopoly and Perfect Competition Compared
• In which market structure the following is larger, given the same
demand and industry marginal cost curves?
Perfect Competition Single-Price
Monopoly
Market Price
Market Quantity
Consumer Surplus
Producer Surplus
Social Surplus

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 Price Discrimination

v A price-discriminating monopoly sells different units of a good or service

for different prices not because of the difference in production cost.

v These pricing strategies can also be applied when the firm has some
monopoly power. Not just for a pure monopoly.

v To be able to price discriminate, a firm must:

v Identify and separate different types of buyers with different
willingness to pay or elasticity of demand
v Sell a product that cannot be resold.
Discriminating among Discriminating among
groups of buyers: Third units of goods: Second
v Example: Haircut, Medical services … degree price degree price
discrimination discrimination
v The key idea behind price discrimination is to increase economic profit by
capturing part of consumer surplus (and perhaps also deadweight loss):
selling at a higher price to those who are more willing to pay and selling at
a lower price to those who are less willing to pay (but still higher than the
MC) to sell more.
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 Discriminating Among Groups of Buyers

v The firm offers different prices to different types of buyers (separating the
markets), based on things like age, employment status, or some other
easily distinguished characteristics.
v This is known as the third-degree price discrimination.
v This type of price discrimination works when each group has a different
average willingness to pay (or demand elasticities) for the commodity.
v For example, business travelers have higher marginal benefit of a trip and
are willing to pay a higher price. (Business class, or with booking little time
in advance)
In contrast, for vacation travelers, any of several different trips or even no
vacation trip are options. They have lower marginal benefit and are willing
to pay a lower price. (Economy class, and with booking months in
advance.)

v For a standard case of a third-degree price discrimination, one can simply

search for the profit maximizing price and quantity market as separate
markets, taking appropriately the marginal cost into account.
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 Discriminating Among Groups of Buyers

v Question: Why is it more common to have half-price for the elderly

and children/students for movie tickets or public transport services,
but not for buying in supermarkets?

v The elderly and children do have lower ability and willingness to pay
for many different goods and services.
v Their identity can be easily verifiable on the spot of purchase.
v It is much easier to prevent reselling of movie tickets and public
transport services, as these services have to be enjoyed on spot.
v However, it is harder to prevent reselling of goods purchased from
supermarkets. They can be resold, or at least, they can buy goods for
other family members and friends who are not eligible for the
discount.

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 Example of Discriminating among Groups of Buyers

v First consider an airline company that

charge a single price to all customers flying
from city A to city B.

v The company maximizes profit by selling

8,000 trips a year at $1,200 a trip.

v Consumers enjoy a consumer surplus of the

upper triangle.
($1,200-$600)*8,000

v The company earns a profit of $4.8 million

per year (the lower rectangle).

v This airline can also price discriminate by

offering different prices to different groups
of customers.

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 Example of Discriminating among Groups of Buyers

v $1,800 fare: No restrictions.

v $1,600 fare: 7-day advance purchase.

v $1,400 fare:14-day advance purchase.

v $1,200 fare:14-day advance purchase and

passenger has to stay over a weekend.

v The company sells 2,000 units at each of its

four new fares.
($1,200-$600)*8,000

v Economic profit increases from $4.8 million

to $7.2 million per year, shown by the original
blue rectangle plus the blue steps.
(1,800 + 1,600 + 1,400 + 1,200)*2,000 - (1,200-$600)*8,000 = 7,200,000
v Consumer surplus shrinks to the sum of the
green triangles.

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 Perfect Price Discrimination
(For travelers who are willing to pay between $1,200 and
$2,000 and $900-$1,200, all CS are captured)
v In the extreme case known as perfect (or
first-degree) price discrimination, the
monopoly can charge each customer exactly
the price they are willing to pay for each
unit, reflected by the demand curve.
v The demand curve becomes marginal
revenue (MR) curve.
v Profit maximizing output occurs at MC = MR
which is equivalent to MC equals demand.
v Output increases from 8,000 trips to 11,000
trips and the monopoly earns even larger
profits.
v The output level is efficient and there is no
deadweight loss.
v But the monopoly captures all the surplus Because a different price — the maximum price each customer is
willing and able to pay — is set for each unit of the good, each unit
and there is no consumer surplus. adds its price to total revenue. So, marginal revenue, the change in
total revenue, equals the price determined from the demand curve.
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 Perfect Price Discrimination

v It is hard to have a real-life example to satisfy these ideal situation.

v It is hard to have the information on the demand for each single
consumer and force them to pay a different price than other
customers.
v Some services with more heterogeneous elements may allow a
customer-by-customer pricing, like legal services, accounting
services.
v Sales with more rooms for bargaining can also help the seller to have
more information about consumer’s actual willingness to pay. (e.g.
car, apartment purchase).

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 Profit-maximization for Monopoly in a discrete case
• If the monopoly face the following demand curve with discrete
adjustment (integers only) for price and quantity, and can practice
perfect price discrimination, calculate the total and marginal
revenue schedule.

• If the marginal cost is constant at 4, what is the revenue the firm can
receive and what quantity will it produce?

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 Oligopoly

v Oligopoly is a market type in which there is a small number of firms (because of

barrier to entry) and each firm has a large market share.

v Interdependence of firms
v Firms are interdependent in the sense that the profit earned by each firm
depends on the firm’s own actions as well as on the actions of the other firms.
v Before making a decision, each firm must consider how the other firms will
react to its decision and influence its profit.

v Temptation to collude
v When a small number of firms share a market, they can increase their profit
by forming a cartel and acting like a monopoly.
v A cartel is a group of firms acting together to limit output, raise price, and
increase economic profit.
v However, firms have incentive to deviate from collusion.

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 Game Theory

v Game theory is the tool used to analyze strategic behavior.

v Strategic behavior is the behavior that recognizes mutual

interdependence and considers the expected behavior of others.

v A game involves three features:

v Rules
v Strategies
v Payoffs

v Prisoners’ dilemma is a game between two prisoners that shows why it

is hard to cooperate, even when it would be beneficial to both players to
do so.

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 Prisoners’ Dilemma

v Art and Bob have been caught stealing a car: sentence is 2 years in jail.

v The police wants to convict them of a big bank robbery: sentence is 10 years in jail.

v The police has no evidence and to get the conviction, he makes the prisoners play
a game.

v Rules:
v Players cannot communicate with one another and have to make their
decision without knowing the decision of the other.
v If both confess to the larger crime (bank robbery), each will receive a sentence
of 3 years for both crimes.
v If one confesses to the larger crime and the accomplice does not, the one who
confesses will receive a 1-year sentence, while the accomplice receives a 10-
year sentence.
v If neither confesses to the larger crime, both receive a 2-year sentence.

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 Prisoners’ Dilemma

v Strategies
v The strategies of a game are all the possible actions of each player.

v The strategies in the prisoners’ dilemma are:

v Confess to the bank robbery.
v Deny the bank robbery.

v Payoff
v A payoff matrix is a table that shows the payoffs for every possible action by
each player given every possible action by the other player.
v 4 possible outcomes: (a) Both confess, (b) Both deny, (c) Art confesses and
Bob denies, (d) Bob confesses and Art denies.
v The two players are interdependent as the payoff depends on the strategy
played by the other player(s).

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 Prisoners’ Dilemma

v Nash equilibrium (NE) is an equilibrium in

which each player takes the best possible Payoff Matrix
action given the action of the other
player(s) in this equilibrium.
v Specifically, (Art confesses, Bob confesses)
is a Nash Equilibrium if
1. Given Art confesses, Bob’s best
response is to confess.
2. Given Bob confesses, Art’s best
response is to confess.
v In the NE, no player would like to
unilaterally deviate from it.
v To find the NE, one should always
determine the best response of one player
by each of other’s strategies.

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 Prisoners’ Dilemma

v To find the NE: (note they prefer a shorter

sentence.) Payoff Matrix

v Given that Bob confesses, the best action

for Art is to confess. (3 < 10)
v Given that Bob denies, the best action for
Art is to confess. (1 < 2)
v Given that Art confesses, the best action
for Bob is to confess. (3 < 10)
v Given that Art denies, the best action for
Bob is to confess. (1 < 2)
v The only combination of strategy of each
player that constitutes the best response
of each other is (A confesses, B confesses).
v The Nash equilibrium is (Art confesses,
Bob confesses).
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 Prisoners’ Dilemma

v The Nash Equilibrium of the prisoners’

dilemma is not the best outcome for the Payoff Matrix
players.
v If they can commit to (A denies, B denies),
both can be better off.
v But if one knows that the other would
commit to deny, one is better to choose
confess.
v Thus, (A denies, B denies) is not stable and
is not an equilibrium.

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 Game Theory

v Be careful what “best” means.

v The inference used in game theory is to analyze by each of the other player’s
strategy.
v The best strategy may not be the same if other player’s strategy is not the
same.

v Caution: Don’t claim that a strategy is the best because it contains an

outcome which is highest among the four cases.
v The other player may not want to attain this outcome.

v Not all games are in the Prisoner’s Dilemma payoff structure.

v It can be a happy ending: the NE can be the one with highest absolute
outcome.
v There can be more than one NE in a game.

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Self-Assessment
• What is the Nash Equilibrium of the following games?

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 The Duopolists’ Dilemma

v The dilemma of Boeing and Airbus is similar to that of Art and Bob.

v Each firm has two strategies. It can produce airplanes at the rate of:
v 3 a week
v 4 a week

v Because each firm has two strategies, there are four possible combinations of
actions:
v Both firms produce 3 a week (monopoly outcome).

v Both firms produce 4 a week.

v Airbus produces 3 a week and Boeing produces 4 a week.
v Boeing produces 3 a week and Airbus produces 4 a week.

v The payoff matrix shows the economic profits for each firm in each possible
outcome.

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 The Duopolists’ Dilemma
v Notice that when each firm produces
more, the price will be lower to attract Payoff Matrix
buyers to buy more, which can make the
profit lower.
v Given that Boeing produces 4 a week, the
best action for Airbus is to produce 4 a
week.
v Given that Boeing produces 3 a week, the
best action for Airbus is to produce 4 a
week.
v Similar reasoning applies to the best
action of Boeing.
v The Nash equilibrium: (4 a week, 4 a
week).
v Similar to the prisoners’ dilemma, the
Nash equilibrium does not give the best
outcome to both companies.
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 Collusion is Profitable but Difficult to Achieve

v If Airbus and Boeing agree to collude and produce 3 a week, their profits
will be higher than that in Nash equilibrium.

v However, it would be individually rational for each firm to cheat on a

collusive agreement and increase output to earn a higher profit.

v The duopolists’ dilemma explains why it is difficult for firms to collude

and achieve the maximum monopoly profit.

Example:
qThe Organization of the Petroleum Exporting Countries (OPEC) is an international cartel of oil-
producing nations that was created in 1960.
qMembers meet from time to time and set a production limit for each member nation.
qAlmost always, within a few months of a decision to restrict production, some members of the
cartel break their quotas and increase production, and the price sags below the cartel’s desired
target.

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 Is Oligopoly Efficient?

v In oligopoly, price usually exceeds marginal cost.

v Similar to the case of monopoly, the quantity produced in the

oligopolistic market is less than the efficient quantity.

v Because the oligopolistic market is inefficient, antitrust laws and

regulations are used to try to reduce market power and move the
outcome closer to that of competition and efficiency.

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Self-assessment: The Duopolists’ Dilemma

Intel and AMD are a duopoly that produces CPU chips. Intel and AMD can conduct
R&D or they cannot conduct R&D. The table below shows the payoff matrix for
the two firms. The numbers are millions of dollars of profit. The Nash equilibrium
is for Intel to ________ and for AMD to ________ .

(a) conduct R&D; conduct R&D

(b) conduct R&D; not conduct R&D
(c) not conduct R&D; conduct R&D
(d) not conduct R&D; not conduct R&D

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 Market Structure: Part 2

v Monopoly

v Oligopoly

v A Very Brief Introduction of Game Theory

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