Maximizing Profit under Monopoly
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0:00 - 0:03♪ [music] ♪
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0:09 - 0:12- [Prof. Alex Tabarrok] Monopoly.
It's not just a game. -
0:12 - 0:14In this video
we'll talk about how a firm -
0:14 - 0:17uses market power
to maximize profit. -
0:18 - 0:20We'll begin with
a controversial example. -
0:25 - 0:27This is the AIDS virus.
-
0:27 - 0:30Worldwide, it has killed
more than 36 million people. -
0:30 - 0:32In the United States, however,
-
0:32 - 0:35AIDS is no longer
the death sentence that it once was. -
0:35 - 0:37Beginning in the mid-1990s,
-
0:37 - 0:39death rates from AIDS
began to fall dramatically -
0:39 - 0:43with the introduction
of new drugs such as Combivir. -
0:43 - 0:46These new drugs are great,
but they're expensive, -
0:46 - 0:47and they're expensive
-
0:47 - 0:51not because it costs a lot
to manufacture these drugs. -
0:51 - 0:54The per-pill costs of production
are actually quite low. -
0:54 - 0:57Instead, these drugs are expensive
-
0:57 - 1:01because they're the subject matter
of this chapter -- Monopoly. -
1:02 - 1:04GlaxoSmithKline, or GSK,
-
1:04 - 1:07owns the patent on Combivir
-
1:07 - 1:10and that means that it has
the right to exclude competitors. -
1:10 - 1:14Only GSK can legally sell Combivir.
-
1:14 - 1:17The patent gives GSK a monopoly,
-
1:17 - 1:20or more generally we say
it gives them market power. -
1:20 - 1:25Market power is the power
to raise price above marginal cost -
1:25 - 1:29without fear that other firms
will enter the market. -
1:29 - 1:32Now how do we know the price
is above marginal cost? -
1:32 - 1:34Here's a simple test --
-
1:34 - 1:35in the United States,
-
1:35 - 1:39Combivir costs
around $12 to $13 per pill. -
1:39 - 1:43India, however, does not
recognize the patent on Combivir. -
1:44 - 1:45So in India,
-
1:45 - 1:49there are many producers of Combivir
who sell in a competitive market. -
1:49 - 1:52As we know,
in a competitive market, -
1:52 - 1:54price will fall to marginal cost
-
1:54 - 1:59and in India the price of Combivir
is about 50 cents per pill. -
1:59 - 2:02Thus, in the United States,
-
2:02 - 2:03the price of Combivir
-
2:03 - 2:07is about 25 times higher
than the marginal cost. -
2:09 - 2:12Let's say a few words
about the sources of market power. -
2:12 - 2:15The basic idea
is that a firm has market power -
2:15 - 2:17when it's selling a unique good
-
2:17 - 2:20and there are barriers to entry,
-
2:20 - 2:23forces which prevent competitors
from entering the market. -
2:23 - 2:25Barriers to entry
could include patents, -
2:25 - 2:27as we've already discussed.
-
2:27 - 2:29There may also be other
government regulations -
2:29 - 2:32creating barriers to entry,
such as exclusive licenses. -
2:33 - 2:34Economies of scale
-
2:34 - 2:37can mean that a single big firm
-
2:37 - 2:41can sell at lower cost
than any of many small firms, -
2:41 - 2:44making it difficult
to establish a competitive market -
2:44 - 2:46even with free entry.
-
2:47 - 2:50Exclusive access
to an important input. -
2:50 - 2:51Diamonds, for example,
-
2:51 - 2:54are found in only
a few places in the world. -
2:54 - 2:56If you control a number
of these diamond mines, -
2:56 - 2:59you can monopolize
the market for diamonds, -
2:59 - 3:02where you will have market power
in the market for diamonds. -
3:03 - 3:05Technological innovations
-
3:05 - 3:07can give a firm
temporary market power. -
3:07 - 3:11A firm with knowledge or abilities
that other firms don't yet have -
3:11 - 3:13will have some market power,
for example. -
3:14 - 3:16Now we'll say a little bit more
about these later. -
3:16 - 3:17What we want to do now
-
3:17 - 3:20is to focus on how
a firm with market power -
3:20 - 3:23chooses to set its price.
-
3:23 - 3:26What is the profit
maximizing price? -
3:28 - 3:31So how does a monopolist
maximize profit? -
3:31 - 3:33By producing at the level of output
-
3:33 - 3:36where marginal revenue
is equal to marginal cost. -
3:36 - 3:36Great!
-
3:36 - 3:39That's the same rule
as for a competitive firm -- -
3:39 - 3:40choose a level of output
-
3:40 - 3:43where marginal revenue
is equal to marginal cost. -
3:43 - 3:45The only difference
is that for a competitive firm, -
3:45 - 3:48marginal revenue
was the same as price, -
3:48 - 3:51and that's not true
for a monopolist. -
3:52 - 3:55A monopolist is not
a small share of the market. -
3:55 - 3:58Since it's selling a unique good,
-
3:58 - 3:59the monopolist
-
3:59 - 4:03faces the entire downward
sloping market demand curve. -
4:03 - 4:04As a result,
-
4:04 - 4:07marginal revenue
is going to be less than price. -
4:07 - 4:11Let's show how to calculate
marginal revenue for a monopolist. -
4:13 - 4:14Let's start with the demand curve,
-
4:14 - 4:17and suppose that
we're initially selling two units. -
4:17 - 4:20We can sell those
two units for $16 apiece. -
4:20 - 4:25Total revenue therefore
is $16 times 2 units, or $32. -
4:26 - 4:29Now, remember that marginal revenue
-
4:29 - 4:33is the change in total revenue
from selling an additional unit. -
4:33 - 4:35So suppose
that we sell an additional unit -- -
4:35 - 4:37three units in total.
-
4:37 - 4:40We can sell three units for $14 --
-
4:40 - 4:46$14 is the maximum per unit price
we can get when selling three units. -
4:46 - 4:49So when the quantity sold is three,
-
4:49 - 4:52total revenue
is 14 times three, or $42. -
4:52 - 4:55That means marginal revenue,
-
4:55 - 4:59the change in revenue
from selling that additional unit, -
4:59 - 5:00is $10.
-
5:00 - 5:03Now we can actually
arrive at the same conclusion -
5:03 - 5:06in another revealing way.
-
5:06 - 5:09Marginal revenue
can be broken down into two parts. -
5:09 - 5:13First is the revenue gain
from selling an additional unit. -
5:13 - 5:15That's just this area right here.
-
5:15 - 5:19We can sell an additional unit,
the third unit for $14. -
5:19 - 5:21That's the revenue gain.
-
5:21 - 5:24But, in order to sell
that additional unit, -
5:24 - 5:26we had to lower the price
-
5:26 - 5:29on the previous units
that we were selling, -
5:29 - 5:32so there's also a revenue loss.
-
5:32 - 5:37We were receiving $16 per unit
when we sold just two units. -
5:37 - 5:42When we sell three units,
we have to lower the price to $14, -
5:42 - 5:46so we lose $2 per unit
on these previous units -
5:46 - 5:48or a total loss of $4.
-
5:48 - 5:53So marginal revenue
is just the revenue gained -- $14, -
5:53 - 5:58minus the revenue loss, $4,
or $10 just as before. -
5:58 - 6:01Notice also that the revenue gain
-
6:01 - 6:03is just the price of the third unit,
-
6:03 - 6:08so since it's the revenue gain
minus the revenue loss, -
6:08 - 6:12we can also see right away
that for a monopolist, -
6:12 - 6:16marginal revenue
must be less than the price. -
6:16 - 6:19Okay, let's remember
where we're going. -
6:19 - 6:22We want to find
the profit maximizing price, -
6:22 - 6:24which is the level of output
-
6:24 - 6:26where marginal revenue
is equal to marginal cost. -
6:26 - 6:30But do we need to go through
this tedious process -
6:30 - 6:33to find marginal revenue
for each unit? -
6:34 - 6:34No.
-
6:34 - 6:35There's a shortcut,
-
6:35 - 6:37and that's what
I'm going to show you next. -
6:39 - 6:41Here's the shortcut
for finding marginal revenue, -
6:41 - 6:44and this will work
for any linear demand curve, -
6:44 - 6:46and those are the only ones
we're really going to be working with -
6:46 - 6:49in this class,
so it'll work just fine for us. -
6:49 - 6:51Take a linear demand curve,
-
6:51 - 6:53then the marginal revenue curve
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6:53 - 6:56begins at the same point
on the vertical axis -
6:56 - 6:57as the demand curve,
-
6:57 - 6:59and it has twice the slope.
-
6:59 - 7:02So if we were to write
the demand curve in inverse form, -
7:02 - 7:06as P is equal to A minus B times Q,
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7:06 - 7:12then the marginal revenue curve
is equal to A minus 2B times Q. -
7:12 - 7:14That's it.
Pretty simple. -
7:14 - 7:16Let's give a few more examples.
-
7:17 - 7:20Let's use our shortcut
on these two different demand curves. -
7:20 - 7:22In the first case,
the marginal revenue curve -
7:22 - 7:25begins at the same point
on the vertical axis. -
7:25 - 7:27It has twice the slope.
-
7:27 - 7:28So notice what that means
-
7:28 - 7:33is that if the demand curve
hits the horizontal axis at 500, -
7:33 - 7:38the marginal revenue curve
must hit the horizontal axis at 250. -
7:38 - 7:41More generally,
since it has twice the slope, -
7:41 - 7:44the marginal revenue curve
splits the distance -
7:44 - 7:49between the vertical axis
and the demand curve in half. -
7:49 - 7:51So the distance
from the vertical axis -
7:51 - 7:54to the marginal revenue curve
-
7:54 - 7:57is half the total distance
to the demand curve, -
7:57 - 8:00throughout the length
of the marginal revenue curve. -
8:00 - 8:02Okay, what about
our second demand curve? -
8:02 - 8:06Notice that it hits
the horizontal axis at 200, -
8:06 - 8:08therefore
the marginal revenue curve -
8:08 - 8:12must hit
the horizontal axis at 100. -
8:12 - 8:13Pretty simple, and again,
-
8:13 - 8:15this will work
for any linear demand curve, -
8:15 - 8:18any demand curve which
we're going to see in this course. -
8:18 - 8:19Great.
-
8:21 - 8:23We're now ready
for the big payoff -- -
8:23 - 8:26how a firm uses market power
to maximize profit. -
8:26 - 8:30So here is our demand curve
and our marginal revenue curve -
8:30 - 8:31with twice the slope.
-
8:31 - 8:33Let's introduce
the marginal cost curve. -
8:33 - 8:36We're going to make it flat
at 50 cents per pill. -
8:36 - 8:38How does the firm maximize profit?
-
8:38 - 8:40Well it compares for each unit
-
8:40 - 8:43the revenue
for selling that additional unit -
8:43 - 8:46compared to the cost
of selling that unit. -
8:46 - 8:50If the marginal revenue
is bigger than the marginal cost, -
8:50 - 8:52then that's a profitable unit to sell,
-
8:52 - 8:54so the firm keeps producing
-
8:54 - 8:58so long as marginal revenue
is bigger than marginal cost. -
8:58 - 9:01That is, it produces
until marginal revenue -
9:01 - 9:03is equal to marginal cost.
-
9:03 - 9:08That point tells us the profit
maximizing quantity of output, -
9:08 - 9:11in this case, 80 million pills.
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9:11 - 9:14Now what is
the maximum amount per pill -
9:14 - 9:17that we can sell
these 80 million pills for? -
9:18 - 9:19Where do we find that?
-
9:19 - 9:23We find that by looking up
to the demand curve. -
9:23 - 9:25Remember the demand curve tells us
-
9:25 - 9:27the maximum willingness to pay.
-
9:27 - 9:32So the maximum willingness
to pay for a pill is $12.50. -
9:32 - 9:33Eighty million units --
-
9:33 - 9:36that's the profit
maximizing quantity, -
9:36 - 9:41$12.50 -- that's that profit
maximizing price per unit. -
9:41 - 9:42One more curve --
-
9:42 - 9:45let's remember
our average cost curve. -
9:45 - 9:46If we introduce this curve
-
9:46 - 9:49we can now show
profits on the diagram, -
9:49 - 9:51just as we did
with a competitive firm. -
9:51 - 9:56The profit is the price
minus the average cost -- -
9:56 - 9:59in this case that's $10 per pill --
-
9:59 - 10:03times the quantity --
in this case 80 million units -- -
10:03 - 10:07so profit is the shaded area
given right here. -
10:07 - 10:09So now we've got everything.
-
10:09 - 10:10Whenever we have
a monopoly question, -
10:10 - 10:13we have a demand curve,
we draw the marginal revenue curve, -
10:13 - 10:16we draw a marginal cost curve
if it's not given. -
10:16 - 10:20We can then find the profit
maximizing output quantity -- -
10:20 - 10:23that's given when marginal revenue
is equal to marginal cost. -
10:23 - 10:27We go up to the demand curve
to find the profit maximizing price. -
10:27 - 10:30The difference between
the price and average cost -
10:30 - 10:33gives us the profit per unit,
-
10:33 - 10:37times the total number
of units gives us total profit. -
10:37 - 10:40Okay.
That's our big lesson for today. -
10:40 - 10:43What we're going to do next time
is look at -- -
10:43 - 10:46how does the difference
between price and marginal cost -- -
10:46 - 10:48how does the mark-up vary?
-
10:48 - 10:49And what we're going to show
-
10:49 - 10:52is the mark-up varies
with the elasticity of demand. -
10:52 - 10:55Remember, I told you elasticity
of demand would come back. -
10:55 - 10:57Well, here we're going to
use it again in our next lecture. -
10:58 - 11:00- [Narrator]
If you want to test yourself -
11:00 - 11:02click "Practice Questions."
-
11:02 - 11:06Or, if you're ready to move on
just click "Next Video." -
11:06 - 11:09♪ [music] ♪
- Title:
- Maximizing Profit under Monopoly
- Description:
-
AIDS has killed more than 36 million people worldwide. There are drugs available to treat AIDS, but the price of one pill is incredibly high in the U.S. — coming in at 25 times higher than its cost. Why is that? In this video, we show how patent rights have created a monopoly in the U.S. market for AIDS medication, causing pills to be very expensive. In other countries, however, such as India, which does not recognize patents on AIDS medication, prices remain low. Using this example, we go over how monopolies use market power to increase prices.
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- Video Language:
- English
- Team:
- Marginal Revolution University
- Project:
- Micro
- Duration:
- 11:11
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