Chapter 13: Monopoly

Barriers to entry

can also generate monopoly power. Barriers to entry are factors that increase the cost to new firms of entering an industry. Barriers to entry can also be more subtle. Texas Instruments (TI), the maker of the TI-84 Plus, spent a lot of time and effort training high-school teachers to use their calculator and many math textbooks even include exact instructions for solving problems using the TI-84. So teachers assign the TI-84 for their classes. And since the parents, not the teachers, are paying, the teachers don't care much about the price. As a result, the graphing calculator division of Texas Instruments is very profitable. Market entry will eventually break down TI's barrier to entry but sometimes small advantages can mean big profits.

Brands and Trademarks

can also give a firm market power because the prestige of owning the real thing cannot be easily duplicated. Timex watches tell the time as well as a Rolex, but only the Rolex signals wealth and status.

There are are three reasons why HIV drugs are priced well above cost:

1. Market Power 2. The "you can't take it with you effect" 3. The "other people's money" effect

Government Ownership:

Electric Shock: Government ownership is another potential solution to the natural monopoly problem. In the United States, there are some 3,000 electric utilities, and two-thirds of them are government-owned (the remainder are heavily regulated). The system of government ownership and regulation of electricity worked reasonably well for several decades in providing the United States with cheap power. Without the discipline of competition or a profit motive, however, there is a tendency for a government-run or government-regulated monopoly to become inefficient. multibillion-dollar cost overruns for the construction of nuclear power plants drew attention to industry inefficiencies. Historically, a single firm handled the generation, long-distance transmission, and local distribution of electricity. In the 1970s, however, new technologies reduced the average cost of generating electricity at small scales Although the transmission and distribution of electricity remained natural monopolies, the new technologies meant that the generation of electricity was no longer a natural monopoly. Economists began to argue that unbundling generation from transmission and distribution could open up electricity generation to competitive forces, thereby reducing costs. California's Perfect Storm Hoping to benefit from lower costs and greater innovation, California deregulated wholesale electricity prices in 1998. All appeared well in the first two years after deregulation. Then in 2000, a hot summer and an earlier dry winter (low snowfall meant low lake levels and less opportunity for hydroelectric power) led to massive increases in the price of electricity. Worse yet, when not enough power was available to meet the demand, blackouts threw more than 1 million Californians off the grid and into the dark. The combination of increased demand, reduced supply, and a poorly designed deregulation plan had created the perfect opportunity for electricity generators to exploit market power. he effect on the price would have been minimal because the power from those generators could easily have been replaced with imports or power from other generators. In 1999, then, each generator faced an elastic demand curve. In 2000, however, every generator was critical because nearly every generator needed to be up and running just to keep up with demand. Electricity is an unusual commodity because it is expensive to store; and, if demand and supply are ever out of equilibrium, the result can be catastrophic blackouts Thus, in early 2000, the demand curve facing each generator was becoming very inelastic. A firm that owned only one generator couldn't do much to exploit its market power: If it shut down, the price of electricity would rise but the firm wouldn't have any power to sell! Because many firms owned more than one generator, however, a terrible incentive was created in 2000. A firm with four generators could shut down one generator, say, for "maintenance and repair," and the price of electricity would rise by so much that the firm could make more money selling the power produced by its three operating generators than it could if it ran all four! California was not the only state to restructure its electricity market in the late 1990s. Texas and Pennsylvania had opened up generation to competition and both have seen modestly lower electricity prices. California's experience has demonstrated that unbundling generation from transmission and distribution, which remain natural monopolies, is tricky.

Takeaway

After reading this chapter, you should be able to find marginal revenue given either a demand curve or a table of prices and quantities (as in Figure 13.1). Given a demand and marginal cost curve, you should be able to find and label the monopoly price, the monopoly quantity, and deadweight loss. With the addition of an average cost curve, you should be able to find and label monopoly profit. You should also be able to demonstrate why the markup of price over marginal cost is larger the more inelastic the demand—this relationship will also be useful in the next chapter. What makes monopoly theory interesting and a subject of debate among economists is that it's not always obvious whether monopolies are good or bad. Instead, we are faced with a series of trade-offs. Patent monopolies, such as the one on Combivir, create a trade-off between deadweight loss and innovation. The monopolist prices its product above marginal cost, but without the prospect of monopoly profits, there might be no product at all. Natural monopolies also involve trade-offs, this time between deadweight loss and economies of scale. Deadweight loss means that monopoly is not optimal, but when economies of scale are large, competitive outcomes aren't optimal either. Regulating monopoly seems to offer an escape from this trade-off, but as we saw in our analysis of cable TV and electricity regulation, the practice of regulation is much more complicated than the theory. Cable TV regulation kept prices low but it kept quality low as well. Overall, deregulation of cable television rates worked surprisingly well, at least according to the consumers who flocked to cable even as rates rose. In contrast, electricity deregulation left California at the mercy of firms wielding market power. Antitrust laws like the Sherman Act and the Clayton Act give the U.S. government the legal authority to prosecute monopolies or attempts to monopolize. Mergers between large firms are often challenged by the government, and they typically create a difficult trade-off between increases in market power and reductions in cost. Economists don't always agree on the best way to navigate the trade-offs between market power, innovation, and efficiency. Many monopolies, however, perhaps most on a world scale, are "unnatural"—they neither support innovation nor efficiency. They are instead created to transfer wealth to politically powerful elites. For these monopolies, economics does offer guidance—open the field to competition! Alas, economics offers less clear guidance about how to convince the elites to follow the advice of economists.

Price Controls

But surprisingly, when the market price is set by a monopolist, a price control can increase output. But suppose that the government imposes a price control at level PR. To avoid a loss, the monopolist must charge a price greater than or equal to average cost. But at the price PR the only quantity that lets the monopolist avoid a loss is QR. Thus, if the government sets PR = AC at point a, where the AC curve intersects the demand curve, the monopolist chooses QR and just breaks even. Most importantly, notice that when the government lowers the price from PM to PR output increases from QM to QR and consumer surplus increases from the light green area to the light green plus dark blue area. When a monopolist's profits are regulated, it doesn't have much incentive to increase quality with innovative new products or to lower costs. A price control on pharmaceutical monopolies could lower prices and increase the output of currently existing drugs. But reduced profits mean a reduced incentive to invest in research and development, and that would result in fewer new drugs. A price control is equivalent, in this context, to reducing the power of patents and, as we discussed earlier, this could end up harming patients through reduced innovation. Cable TV is a natural monopoly—at least it was in its early years, before satellite and Internet TV—and it has long been regulated in the United States. But if subscription rates were fixed at the low levels, thereby limiting profit rates, the cable operators would have little incentive to add channels. Deregulation of cable TV rates led to higher prices, just as the theory of natural monopoly predicts, but something else happened—the number of television stations and the quality of programming increased dramatically. Even as prices rose, more people signed up for cable television. First with cable and subscription television and now with services such as Netflix and Hulu, it can pay to produce shows that appeal to a smaller number of people, so long as enough of them are willing to pay the subscription fee to support the show. despite increases in prices and in part because of the increase in prices, the deregulation of cable TV appears to have created a much more dynamic and exciting market in entertainment.

How a Firm Uses Market Power to Maximize Profit

Even a firm with no competitors faces a demand curve, so as it raises its price, it will sell fewer units. Higher prices, therefore, are not always better for a seller—raise the price too much and profits will fall. Lower the price and profits can increase. To maximize profit, a firm should produce until the revenue from an additional sale is equal to the cost of an additional sale. This is the same condition that we discovered in Chapter 11: produce until marginal revenue equals marginal cost(MR=MC). For a small firm, therefore, the revenue from the sale of an additional unit is the market price(MR=Price). But when a firm's output of a product is large relative to the entire market's output of that product (or very close substitutes), a significant increase in the firm's output will cause the market price of that product to fall. Thus, for a firm that produces a large share of the market's total output of a product, the revenue from the sale of an additional unit is less than the current market price(MR<Price) In contrast, a firm with monopoly power is a price maker; when this firm changes the quantity it produces, it also changes the price at which it can sell. Thus, we can always calculate MR by looking at the change in total revenue when production changes by 1 unit. The right panel of Figure 13.1 shows another way of thinking about marginal revenue. When the monopolist lowers its price from $16 to $14, it makes one additional sale, which increases revenues by the price of 1 unit, $14—the green area. But to make that additional sale, the monopolist had to lower its price by $2, so it loses $2 on each of the 2 units that it was selling at the higher price for a revenue loss of $4—the red area. Notice that MR ($10) is less than price ($14)—once again, this is because to sell more units, the monopolist must lower the price so there is a loss of revenue on sales the firm would have made at the higher price. If the demand curve is a straight line, then the marginal revenue curve is a straight line that begins at the same point on the vertical axis as the demand curve but with twice the slope Notice that if the demand curve cuts the horizontal axis at, say, Z, then the marginal revenue curve will always cut the horizontal axis at half that amount, Z/2 To find the maximum that consumers will pay for 80 million units, remember that we read up from the quantity supplied of 80 million units to the demand curve at point b (By the way, the fixed costs of producing a new pharmaceutical are very large so the minimum point of the AC curve occurs far to the right of the diagram.) Recall that a competitive firm earns zero or normal profits but a monopolist uses its market power to earn positive or above-normal profits.

The Benefits of Monopoly: Incentives for Research and Development

If GSK didn't have a monopoly, competition would push prices down, more people could afford to buy Combivir, and total surplus would increase (i.e., deadweight loss would decline). Firms must be compensated for these expenses if people expect them to invest in the discovery process. But if competition pushes the price of a pill down to the marginal cost, nothing will be left over for the cost of invention. And he who has no hope of reaping will not sow. Patents are one way of rewarding research and development. It's precisely the expectation (and hope) of enjoying that monopoly profit that encourages firms to research and develop new drugs. If pharmaceutical patents are not enforced, the number of new drugs will decrease. But if the United States were to limit pharmaceutical patents significantly or to control pharmaceutical prices, the number of new drugs would decrease significantly.9 But new drugs save lives. We should be careful that in pushing prices closer to marginal cost, we do not lose the new drug entirely. In evaluating pharmaceutical patents, you should keep in mind that patents don't last forever. Once the drug goes off patent, generic equivalents appear quickly and the deadweight loss is eliminated as price falls. Pharmaceuticals are not the only goods with high development costs and low marginal costs. Information goods of all kinds often have the same cost structure. Since prices exceed marginal costs, there is a deadweight loss, which in theory could be reduced by a price control. Reducing prices, however, would reduce the incentive to research and develop new games. lower prices today at the expense of fewer new ideas in the future is a central one in modern economies. In fact, modern theories of economic growth emphasize that monopoly—when it increases innovation—may increase economic growth. Nobel prize-winning economic historian Douglass North argues that economic growth was slow and sporadic until laws, including patent laws, were created to protect innovation:

Patent Buyouts - A Potential Solution?

If the government ripped up the patent, competitors would enter the field, drive the price down to the marginal cost of production, and eliminate the deadweight loss. In other words, Combivir would fall from $12.50 a pill to 50 cents a pill, and more of the world's poor could afford to be treated for AIDS. Indeed, by offering more than the potential profit, the government could even increase the incentive to innovate! As usual, however, there is no such thing as a free lunch. To buy the patent, the government must raise taxes, and we know from Chapter 6 that taxes, just like monopolies, create deadweight losses. Also determining the right price to buy the patent is not easy and some people worry that corruption could be a problem. economists are becoming increasingly interested in patent buyouts and the closely related idea of prizes as a way to encourage innovation without creating too much deadweight loss.

The Costs of Monopoly: Deadweight Loss

It turns out, however, that the monopolist gains less from monopoly pricing than the consumer loses. So monopolies are bad—they are bad because, compared with competition, monopolies reduce total surplus, the total gains from trade (consumer surplus plus producer surplus). Some of the consumer surplus has been transferred to the monopolist as profit, the green area. But some of the consumer surplus is not transferred; it goes to neither the consumers nor the monopolist; it goes to no one and is lost. We call the lost consumer surplus deadweight loss. To better understand deadweight loss, remember that the height of the demand curve tells you how much consumers are willing to pay for the good, and the height of the marginal cost curve tells you the cost of producing the good. In other words, consumers value the units between Qm and Qc more than their cost; so if these units were produced, total surplus would increase. But the monopolist does not produce these units. Why not? Because to sell these units, the monopolist would have to lower its price; and if it did so, the increase in revenue would not cover the increase in costs, that is, MR would be less than MC, so the monopolist's profit would decrease. Deadweight loss is the value of the Combivir sales that do not occur because the monopoly price is above the competitive price.

The Elasticity of Demand and the Monopoly Markup(the 2 effects in first flashcard...)

Market power for pharmaceuticals can be especially powerful because of the two other effects we mentioned earlier: the "you can't take it with you" effect and the "other people's money" effect. Consumers with serious diseases, therefore, are relatively insensitive to the price of life-saving pharmaceuticals. Moreover, if you are willing to spend your money on pharmaceuticals, how do you feel about spending other people's money? Thus, both the "you can't take it with you" and the "other people's money" effects make consumers with serious diseases relatively insensitive to the price of life-saving pharmaceuticals—that is, they will continue to buy in large quantities even when the price increases. The "you can't take it with you" effect and the "other people's money" effect make the demand curve more inelastic. Thus, we say that the more inelastic the demand curve, the more a monopolist will raise its price above marginal cost. Since travelers flying from Washington to San Francisco have many substitutes, their demand curve is more elastic, like the one in the left panel of Figure 13.4. As a result, travelers flying from Washington to Dallas (inelastic demand) are charged more than those flying from Washington to San Francisco (elastic demand). As a matter of contract, most airlines prohibit this and similar practices—their profit is at stake!

Network Effects

Network effects are another source of monopoly power. Because everyone wants to be on the site that their friends use, there is a tendency for people to gravitate toward the same site. Thus, Facebook does not have many direct competitors. Similarly, there are only a handful of credit card companies (MasterCard, Visa, American Express). Customers want to have a card that is widely accepted and firms want to accept cards that are widely used, so there is a tendency to gravitate toward one or a handful of credit card companies. We take up the economics of network goods in Chapter 16.

Market Power

Patent: Govt grant that gives owner exclusive rights to make, use, or sell the patented product. Market Power: the power to raise price above marginal costs without fear that other competitors will enter the market. Monopoly: a firm with market power. Patents are not the only source of market power. Government regulations other than patents, as well as economies of scale, exclusive access to an important input, and technological innovation can all create firms with market power.

Sources of Market Power

Patents and government regulation are not the only source of market power. Monopolies may be created by economies of scale, significant barrier to entry, network effects or innovation.

The Costs of Monopoly: Corruption and Inefficiency

Sadly, around the world today, many monopolies are government-created and born of corruption. Monopolies are especially harmful when the goods that are monopolized are used to produce other goods. Steel is an input into automobiles, so when General Steel tries to take advantage of his market power by raising the price of steel, this increases costs for General Auto. General Auto responds by raising the price of automobiles even more than he would if steel were competitively produced. Similarly, General Steel raises the price of steel even more than he would if automobiles were competitively produced. Throw in a General Tire, a General Computer, and, let's say, a General Electric and we have a recipe for economic disaster. Each general tries to grab a larger share of the pie, but the combined result is that the pie gets much, much smaller. Cost savings in one sector are spread throughout the economy, resulting in economic growth. In a monopolized economy, in contrast, the entire process is thrown into reverse. Each firm wants to raise its prices, and the resulting cost increases are spread throughout the economy, resulting in poverty and stagnation. One of the great lessons of economics is to show that good institutions channel self-interest toward social prosperity, whereas poor institutions channel self-interest toward social destruction. It's because competitive markets channel the self-interest of business leaders toward social prosperity, whereas the political structure of Algeria channels self-interest toward social destruction.

Regulating Monopoly

The government has many tools to regulate monopolies. We will examine price controls, government ownership, and antitrust law.

Antitrust Law + Merger Policy

Two of the most important U.S. antitrust laws are the Sherman Act, passed in 1890, and the Clayton Act, passed in 1914. (The word "trust" can be thought of as another term for monopoly, so the antitrust laws are antimonopoly laws.) Together, these two acts give the federal government legal authority to prosecute monopolies or firms' attempts to monopolize. It's important to understand that most of these acts are not illegal in every circumstance. It's not illegal to be a monopolist, for example; it's only illegal to become a monopoly using illegal means. Mergers can be legal, even if they reduce competition. Predatory pricing is always illegal—if proven, but it is difficult to prove moreover, however defined, pricing below cost can be legal if it's not intended to drive a competitor out of business (think, for example, of sharp discounts on clothing that is no longer in fashion). What all of this means is that the government cannot simply declare that an action is illegal—it must prove it in a court of law. Let's now take a closer look at mergers. In a dynamic, capitalist economy, firms grow, shrink, split, and merge all the time. Prices, technology, and market conditions are constantly changing, and firms must adjust to remain competitive. Together, the two firms can reduce costs and better serve both markets. When two small firms merge, there is little chance that they will gain market power and be able to significantly raise prices. But, when two large firms merge, there is a potential trade-off between increased market power (and thus higher prices) and lower costs. When a merger is likely to increase market power but also to increase efficiency, the antitrust authorities must try to balance higher prices with lower costs. In 2015, for example, Staples, the office supply store, offered to buy one of its rivals, Office Depot. The two companies argued that competition from Costco, Amazon, and Walmart had cut into their traditional market and made it difficult for both firms to survive. By merging, the companies hoped to close some stores that were too close to one another and reduce their input costs by buying even more paper and pens in bulk. The firms argued that their costs would fall but competition would still be fierce because of all the other firms in the industry. The government, however, disagreed and argued that the merger would increase market power and increase prices by too much to be justified. A federal judge agreed with the government and blocked the merger. Was the judge correct? It's hard to know for certain. If Staples and Office Depot slowly close some stores over the next few years, then we will have fewer firms, as the antitrust authorities feared, but without the cost savings that might have come with a merger. On the other hand, if both firms continue to compete vigorously, then the government's position is more likely to be vindicated. Antitrust law is a very contested area of law and it is not uncommon to find economists testifying on both sides of an antitrust trial. Merger or no merger, therefore, the economists usually end up profiting from hefty consulting fees—another reason why it's good to be an economist.

Economies of Scale

advantages of large-scale production that reduce average cost as quantity increases If economies of scale are large relative to the size of the market, then one large firm can produce at lower cost than many small firms. When a single firm can supply the entire market at lower cost than two or more firms, we say that the industry is a natural monopoly. A subway is a natural monopoly because one subway system could serve the entire market at a lower cost than two systems. Why build two parallel subway tunnels when one is enough? Utilities such as water, natural gas, and cable television are typically natural monopolies because in each case it's much cheaper to run one pipe or cable than to run multiple pipes or cables to the same set of homes. we compared competitive firms with an equal cost monopoly and showed that total surplus was higher under competition. The comparison between competitive firms and natural monopoly is more difficult. Even though natural monopolies produce less than the optimal quantity, competitive firms would also produce less than the optimal quantity because they could not take advantage of economies of scale. If the economies of scale are large enough, it's even possible for price to be lower under a natural monopoly than it would be under competition. Figure 13.6 shows just such a situation. Notice that the average cost curve for the monopoly is so far below the average cost curves of the competitive firms that the monopoly price is below the competitive price. More generally, however, when economies of scale are important we have a trade-off—costs are lower with one or a handful of firms but market power and prices are greater.

Copyrights + harder to duplicate inputs

another kind of barrier of entry. The Tanya Grotter series sold well in Russia but is not available in English because J. K. Rowling and the other copyright holders to the Harry Potter series successfully sued for copyright infringement. In the information age, copyrights are becoming an important source of monopoly power. Finally, monopolies may also arise when a firm innovates, producing a product that no other firm can immediately duplicate. Apple's high market share, however, isn't guaranteed and has come under increasing threat as other firms improve their products. iPhones are priced higher than they would be if Apple had better competitors, but Apple would have less incentive to innovate if it didn't expect to earn some monopoly profits.