Chapter 15: Monopoly
Economies of Scale as a Cause of Monopoly
When a firm's ATC curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and ATC rises. As a result, a single firm can produce any given amount at the least cost
The Market for Drugs (Fig. 6)
When a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug. When the patent on the drug runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost (this, however, might not always happen and the price differential may persist if consumers of the formerly monopolized/patented drug feel a strong loyalty to the brand)
Summary Part 1
1) A monopoly is a firm that is the sole seller in its market. A monopoly arises when a single firm owns a key resource, when the government gives a firm the exclusive right to produce a good, or when a single firm can supply the entire market at a lower cost than many firms could. 2) Because a monopoly is the sole producer in its market, it faces a downward-sloping demand curve for its product. When a monopoly increases production by 1 unit, it causes the price of its good to fall, which reduces the amount of revenue earned on all units produced. As a result, the monopoly's MR is always below the price of its good. 3) Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which MR=MC. The monopoly then sets the price at which that quantity is demanded. Unlike a competitive firm, a monopoly firm's price exceeds its MR, so its price exceeds MC. 4) A monopolist's profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus. That is, when the monopoly charges a price above marginal cost, some consumers who value the good more than its cost of production do not buy it. As a result, monopoly causes deadweight losses similar to those caused by taxes.
Policymakers can respond to problems from monopolies in several ways;
1) By trying to make monopolized industries more competitive 2) By regulating the behavior of the monopolies 3) By turning some private monopolies into public enterprises 4) By doing nothing at all
Sources of barriers to entry
1) Monopoly resources: A key resource required for production is owned by a single firm 2) Government regulation: The government gives a single firm the exclusive right to produce some good or service 3) The production process: A single firm can produce output at a lower cost than can a larger number of firms
Examples of Price Discrimination
1) Movie Tickets- charging lower price for children and senior citizens 2) Airline Prices- charging lower price for travelers who stay over Saturday night 3) Discount coupons 4) Financial Aid 5) Quantity Discounts
When a monopoly increases the amount it sells, this action has two effects on total revenue (P*Q)
1) The output effect: More output is sold, so Q is higher, which tends to increase total revenue 2) The price effect: The price falls, so P is lower, which tends to decrease total revenue
Monopoly versus Competition
1) key difference between a competitive firm and a monopoly is the monopoly's ability to influence the price of its output. Because a monopoly is the sole produce in its market, it can alter the price of its good by adjusting the quantity it supplies to the market 2) Competitive firm can sell as much or as little as it wants at a price, so it faces a horizontal demand curve. Because the competitive firm sells a product with many perfect substitutes (the products of all the other firms in its market), the demand curve that any one firm faces is perfectly elastic 3) Monopoly's demand curve is the market demand curve. If the monopolist reduces the quantity of output it produces and sells, the price of its output increases
Behavior of Price-discriminating monopolist
1) price discrimination is a rational strategy for a profit-maximizing monopolist 2) price discrimination requires the ability to separate customers according to their willingness to pay. In our example, customers were separated geographically. But sometimes, monopolists choose other differences such as age or income, to distinguish among customers. 3) price discrimination can raise economic welfare. Ex: When Readalot price discriminates, all readers get the book, and the outcome is efficient. Thus, price discrimination get eliminate the inefficiency inherent in monopoly pricing
Summary Part 2
5) A monopolist can often increase profits by charging different prices for the same good based on a buyer's willingness to pay. This practice of price discrimination can raise economic welfare by getting the good to some consumers who otherwise would not buy it. In the extreme case of perfect price discrimination, the deadweight loss of monopoly is completely eliminated and the entire surplus in the market goes to the monopoly producer. More generally, when price discrimination is imperfect, it can either raise or lower welfare compared to the outcome with a single monopoly price 6) Policymakers can respond to the inefficiency of monopoly behavior in four ways. They can use the antitrust laws to try to make the industry more competitive. They can regulate the prices that the monopoly charges. They can turn the monopolist into a government-run enterprise. Or, if the market failure is deemed small compared to the inevitable imperfections of policies, they can do nothing at all
Key Fact about Monopoly behavior
A monopolist's marginal revenue is always less than the price of its good
Profit Maximization for a Monopoly
A monopoly maximizes profit by choosing the quantity at which MR=MC. It then uses the demand curve to find the price that will induce consumers to buy that quantity (Fig. 4- Pg. 307) Fig 4 Explanation- The intersection of the MR curve and the MC curve determines the profit-maximizing quantity and the demand curve shows the price consistent with this quantity
Public Ownership
Another policy used by the government to deal with monopoly is public ownership. Rather than regulating the natural monopoly that is run by a private firm, the government can just run the monopoly itself. This solution is common in many European countries where the government owns and operates utilities such as telephone, water and electric companies. In the US, the government runs the postal service.
Market Force that prevents firms from price discriminating
Arbitrage- the process of buying a good in one market at a low price and selling it in another market at a higher price to profit from the price difference. In our example, if Australian bookstores could buy the book in the USA and resell it to Australian readers, the arbitrage would prevent Readalot from price discriminating, because no Australian would buy the book at the higher price
Monopoly Resources Example
DeBeers, the South African diamond company the market for water in a small town in the Old West
The Inefficiency of Monopoly (Fig. 8)
As we have seen, the monopolist chooses to produce and sell the quantity of output at which the MR and MC curves intersect; the social planner would choose the quantity at which the demand and marginal-cost curves intersect. Because a monopoly charges a price above MC, not all consumers who value the good at more than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the MC curve (which reflects the costs of the monopoly producer). Thus, the monopolist produces less than the socially efficient quantity of output
Fundamental Cause of Monopoly
Barriers to entry
Why does a monopoly fail to maximize total economic well-being?
Because a monopoly leads to an allocation of resources different from that in a competitive market and must fail to maximize total economic well-being
Marginal-Cost Pricing for a Natural Monopoly (Fig.10)
Because a natural monopoly has declining ATC, marginal cost is less than ATC. Therefore, if regulators require a natural monopoly to charge a price equal to marginal cost, price will be below ATC, and the monopoly will lose money.
Demand Curves for Competitive and Monopoly Firms (Fig. 2)
Because competitive firms are price takers, they in effect face horizontal demand curves. Because a monopoly firm is the sole producer in its market, it faces the downward-sloping market demand curve. As a result, the monopoly has to accept a lower price if its wants to sell more output
Why does a Monopoly not have a Supply Curve?
Because the firm is a price maker, not a price taker. It is not meaningful to ask what amount such a firm would produce at any price because the firm sets the price at the same time it chooses the quantity to supply. In a competitive market, supply decisions can be analyzed without knowing the demand curve, but that is not true in a monopoly market. Therefore, we never talk about a monopoly's supply curve
Size is a determinant of whether an industry is a natural monopoly- Example
Consider a bridge across a river. When the population is small, the bridge may be a natural monopoly. A single bridge can satisfy the entire demand for trips across the river at lowest cost. Yet as the population grows and the bridge becomes congested, satisfying the entire demand may require two or more bridges across the same river. Thus, as a market expands, a natural monopoly can evolve into a more competitive market
Natural Monopoly Example
Distribution of water. To provide water to residents of a town, a firm must build a network of pipes throughout the town. If two or more firms were to compete in the provision of this service, each firm would have to pay the fixed cost of building a network. Thus, the average total cost of water is lowest if a single firm serves the entire market
Doing Nothing
Due to aforementioned problems with government intervention, some economists argue that is often best for the government not to try to remedy the inefficiencies of monopoly pricing.
Key Difference Between a competitive firm and a monopoly firm
For a competitive firm: P=MR=MC For a monopoly firm: P>MR=MC Takeaway- In competitive markets, price equals marginal cost. In monopolized markets, price exceeds marginal cost
Welfare with and without Price Discrimination
For a monopolist who charges the same price to all customers (no price discrimination), total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. For a monopolist who can perfectly price discriminate, total surplus now equals the firm's profit because consumer surplus equals zero. Comparing the two, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus. Moreover, a monopoly with a single price will have deadweight loss
Regulation of Monopolies
Government agencies often regulate prices of natural monopolies, such as water and electric companies. (marginal-cost pricing as a regulatory system) Two problems with this; 1) If regulators were to set price equal to the MC, that price would be less than the firm's ATC and the firm would lose money. Instead of charging such a low price, the monopoly firm would just exit the industry 2) Regulation gives the monopolist no incentive to reduce costs. Each firm in a competitive market tries to reduce its cost because lower costs mean higher profits. But if a regulated monopolist knows that regulators will reduce prices whenever costs fall, the monopolist will not benefit from lower costs.
The Efficient Level of Output (Fig. 7)
Key- The socially efficient quantity is found where the demand curve and the marginal-cost curve intersect. Explanation- A benevolent social planner maximizes total surplus in the market by choosing the level of output where the demand curve and the marginal-cost curve intersect. Below this level, the value of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good. Above this level, the value to the marginal buyer is less than the marginal cost
When is MR negative?
MR is negative when the price effect on revenue is greater than the output effect
Government-Created Monopolies Examples
Patent and Copyright laws Drug companies are allowed to be monopolists in the drugs they discover to encourage research
A Monopoly's Profit
Profit= TR-TC Profit= (TR/Q-TC/Q)*Q Profit= (P-ATC)*Q Figure 5 (Pg. 309) shows graphic depiction of Monopolist's Profit
Increasing Competition with Antitrust Laws
Sherman Antitrust Act and Clayton Antitrust Act laid the foundation Antitrust laws give the government various ways to promote competition; they can block mergers, they allow the government to break up companies (in 1984, the government split up AT&T), they allow the government to prevent companies from coordinating their activities in ways that make markets less competitive Cost of Antitrust- Sometimes companies merge not to reduce competition but to lower costs through more efficient joint production (these benefits from mergers are sometimes called synergies) Critics are also skeptical that government can perform the necessary cost-benefit analysis with sufficient accuracy
Table 2- Competition vs. Monopoly
Summary Comparison- Review (Pg. 322)
Monopolist Deadweight Loss as a Tax
The deadweight loss caused by monopoly is similar to the deadweight loss caused by a tax. Indeed, a monopolist is like a private tax collector. Because a monopoly exerts its market power by charging a price above marginal cost, it creates a similar wedge. In both cases, the wedge causes the quantity sold to fall short of the social optimum. The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit
Demand and MR Curves for a Monopoly
The demand curve shows how the quantity affects the price of the good. The MR curve shows how the firm's revenue changes when the quantity increase by 1 unit. Because the price on all units sold must fall if the monopoly increases production, MR is always less than the price (Fig. 3)
Why do Economists prefer private to public ownership of natural monopolies?
The key issue is how the ownership of the firm affects the costs of production. Private owners have an incentive to minimize costs as long as they reap part of the benefit in the form of higher profit. If the firm's managers are doing a bad job of keeping costs down, the firm's owners will fire them. By contrast, if the government bureaucrats who run a monopoly do a bad job, the losers are the customers and taxpayers, whose only recourse is the political system. The bureaucrats may become a special-interest group and attempt to block cost-reducing reforms. As a way of ensuring that firms are well run, the voting booth is less reliable than the profit motive
What constrains a monopoly's ability to profit from its market power?
The market demand curve
Is there price effect for competitive firm?
There is no price effect because a competitive firm can sell all it wants at the market price
Monopoly's Total, Average and Marginal Revenue
Total Revenue: TR=P*Q Average Revenue: AR=TR/Q Marginal Revenue: Change in TR/Change in Q
Monopoly
a firm that is the sole seller of a product without close substitutes
Natural Monopolies
a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms
Perfect Price Discrimination
a situation in which the monopolist knows exactly each customer's willingness to pay and can charge each customer a different price. In reality, of course, price discrimination is not perfect. Customers do not walk into stores with signs displaying their willingness to pay. Instead, firms price discriminate by divide customers into groups: young vs. old, week-day vs. weekend shoppers, Americans vs. Australians, etc
Price Discrimination
the business practice of selling the same good at different prices to different customers