Eco Chap 11

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Chapter 11 This week, we'll examine how price and output is determined in a monopoly market. A monopoly market is characterized by: ã ã ã a single seller, no close substitutes, and effective barriers to entry. Monopoly markets Barriers to entry may exist for three reasons: economies of scale, actions by firms, and/or actions by the government. If economies of scale exist throughout the relevant range of output, large firms can produce output at a lower cost than can smaller firms. The diagram b
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  Chapter 11 This week, we'll examine how price and output is determined in a monopoly market. A monopoly market is characterized by: ã a single seller, ã no close substitutes, and ã effective barriers to entry. Monopoly markets Barriers to entry may exist for three reasons:economies of scale,actions by firms, and/or actions by the government.If economies of scale exist throughout the relevant range of output, large firms can produce output at a lower cost than can smaller firms.The diagram below illustrates this possibility. When an industry of this sort begins to develop, there may be many small firms. Suppose,for example that all of the firms have the average total cost curve labeled ATCo. If one of them becomes larger than the others, though,it can produce output at a lower cost per unit (as illustrated by the curve ATC'). This allows the larger firm to sell its output at a lower  price (such as P') at which smaller firms will experience economic losses. (Note that the smaller firms would receive zero economic profit if the price were Po. At a price of P' the smaller firms would receive economic losses and the larger firm would receive zeroeconomic profits.)In this situation, the smaller firms will eventually be forced to either leave the industry or merge with other firms to become at least aslarge as the current largest firm. As firms keep growing (either through internal expansion or by buying up smaller firms), their averagecosts continue to decline. Smaller firms continue to disappear until eventually only one large firm remains. Such an industry is referred toas a natural monopoly since the long-run outcome of the competitive process is the creation of a monopoly industry.The concept of natural monopoly in the U.S. was first used to explain the early development of the telephone industry in the U.S. In theearly years, most cities had several telephone companies competing to offer telephone service. To call all of the other people who had phones in a given city, people might have to subscribe to 3 or 4 telephone services (since they were not initially interconnected). Byvirtue of its patents and head start, though, the Bell Company was larger than most of its competitors. To see why this provided anadvantage, note that once a company pays for the right-of-way and places telephone poles and wires on a given street, the cost of addingan additional customer (on that street) is fairly small. The company that acquires the most customers faces lower average costs. This iswhy AT&T was able to offer lower prices then its competitors. AT&T bought up these companies when they were no longer profitable.Since the government recognized that it would be more costly to have many small telephone companies, it chose to allow AT&T tooperate as a regulated monopoly in which the government regulated the prices that could be charged for telephone services. (Thegovernment chose to break up AT&T in the latter part of the 20th century because the introduction of microwave and satellite  transmissions of telephone signals and digital switching networks were believe to have eliminated some of the economies of scale thatwere present under the earlier technology.)One way in which firms may acquire monopoly power is by acquiring exclusive ownership of a raw material. As your text notes, a singlefamily in New Mexico controls most of the known supply of desiccant clay. Firms can also raise the sunk costs associated with entry intoan industry to help discourage entry by new firms. Sunk costs are costs that cannot be recovered upon exit from an industry. These sunk costs include things like the advertising expenditures needed to ensure brand-name recognition. If a firm spends a large amount of moneyon advertising, new firms in the industry will have to spend a similar amount to counteract this advertising spending. While investmentsin buildings can be (at least partly) recovered if a firm leaves the industry, it cannot recover it's sunk costs. These costs represent a cost of exit that must be taken into account by firms considering entry into an industry. If all costs were recoverable on exit, firms would bequite willing to enter to receive even just temporary short-run profits. If they know that they'd lose a large amount in the form of sunk costs, though, they'd be much more cautious about entering an industry. Large sunk costs are also difficult to finance. (A problemexperienced by John DeLorean when he attempted to enter the automotive manufacturing industry.... His method of financing the highsunk costs of this industry were not well received by the legal authorities...)Patents and licenses provide two types of barriers to entry that are created by the government. While patent protection is necessary toensure that there are sufficient incentives for firms to engage in research and development expenditures, it also provides the patent holder with some degree of monopoly power. This is how Polaroid has been able to maintain it's long-term monopoly of the instant film business.A local monopoly is a monopoly that exists in a specific geographical area. In many regions, there is only a single company providinglocal newspapers (at least on a daily basis). In Syracuse, for example, the Syracuse Newspapers company is the only local newspaper (note that this company publishes both the Post-Standard, a morning newspaper, and the Herald American, an afternoon paper). Demand, AR, MR, TR, and elasticity The demand curve facing a monopoly firm is the market demand curve (since the firm is the only firm in the market). Since the marketdemand curve is a downward sloping curve, marginal revenue will be less than the price of the good (this relationship was discussed insome detail in Chapter 9). As noted earlier, marginal revenue is: ã  positive when demand is elastic, ã equal to zero when demand is unit elastic, and ã negative when demand is inelastic.These relationships are illustrated in the diagram below. As this diagram illustrates, total revenue is maximized at the level of output atwhich demand is unit elastic (and MR = 0). It might be tempting to assume that this is the best output level for the firm to produce. Thiswould be the case, though, only if the firm's goal is to maximize it's revenue. A profit- maximizing firm must take its costs as well as itsrevenue into account in determining how much output to produce.  As in all other market structures, average revenue (AR) is equal to the price of the good. (To see this note that AR = TR/Q = (PxQ)/Q =P.) Thus, the price given by the demand curve is the average revenue that the firm receives at each level of output.As discussed in Chapter 9, any firm maximizes its profits by producing at the level of output at which marginal revenue equals marginalcost (as long as P > AVC). For the monopoly firm described by the diagram below, MR = MC at an output level of Qo. The price thatthis firm will charge is Po (the price that the firm can charge for this level of output given by the demand curve). Since the price (Po)exceeds average total cost (ATCo) at this level of output, the firm receives economic profit. These monopoly profits, though, differ fromthose received by a perfectly competitive firm in that these profits will persist in the long run (due to the barriers to entry thatcharacterize a monopoly industry).  Of course, it is possible that a monopoly firm may experience losses. The diagram below illustrates this possibility. In this diagram, thefirm receives economic losses equal to the shaded area. Since price is above AVC, though, it will continue operations in the short run, but will leave the industry in the long run. Note that the ownership of a monopoly does not guarantee the existence of economic profits. Itis quite possible to have a monopoly in the production of a good that few people want....A monopoly firm will shut down in the short run if the price falls below AVC. This possibility is illustrated in the diagram below.
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