Chapter 14: Microeconomics

Deadweight Loss in a Monopoly Market Graphic

-A monopoly, however, will produce the quantity found at point B in panel B of Figure 14-5, where marginal revenue intersects marginal cost -This quantity is lower than the efficient quantity that would prevail in a competitive market, which tells us that total surplus is not maximized -It also tells us that producer surplus is higher than the level in a competitive market, while consumer surplus is lower -Monopolies earn profit, while consumers lose surplus (Panel B represents the loss of total surplus as a deadweight loss) -There can be cases in which people believe that the advantages to maintaining a particular monopoly outweigh the total welfare costs due to lost surplus

Vertical Splits

-Another common response to natural monopolies is to look for ways to split an industry "vertically" and introduce competition into parts of it -Rather than splitting a monopolist "horizontally" into multiple companies that compete to sell the same product, a "vertical" split divides the original firm into companies that operate at different points in the production process -For example, the supply of electricity is a natural monopoly, but the generation of electricity is not -Firms in NZ compete to generate electricity, but then all use the same wires to supply the electricity to people's homes and businesses -One of the five main public policy responses for a monopoly

How can a firm charge different customers different amounts for the same good?

-As we move away from the model of perfect competition, price discrimination becomes possible and whenever firms gain a degree of market power, they look for ways to exploit customers' varied willingness to pay

Quantity of Output Above/Below Intersection of Marginal Revenue

-At any quantity of output below the intersection of the marginal revenue and marginal cost curves, MR is higher than MC -At that point, De Beers could earn more profits by offering an additional diamond for sale -At any quantity of output above the intersection, the company loses profits on each additional diamond offered for sale -At that point, De Beers could earn more profits by offering fewer diamonds for sale -Therefore, De Beers should increase the quantity of output up to the point where it can no longer earn more profits by increasing output (That is where MR = MC, shown at point B in Figure 14-3) -It should then stop producing output, before it starts losing money

Average Revenue in a Monopoly Market

-Average revenue is equal to price at any quantity sold -In other words, the average revenue curve is the same as the market demand curve -The marginal revenue curve lies below the average revenue curve, because marginal revenue is always less than price after the very first unit sold -Table 14-1 and Figure 14-2 show that marginal revenue can sometimes be negative

Forms of Barriers to Entry

-Barriers to entry take four main forms: scarce resources, economies of scale, government intervention, and aggressive business tactics on the part of market-leading firms

Pros and Cons of Intellectual Property Protection

-Creating monopolies through intellectual property protection has costs and benefits for society -On the plus side, it gives firms an incentive to invest in research and creative activities that lead to products that enrich people's lives -On the negative side, monopolies drive down consumer surplus by setting higher prices than would be charged in a competitive market -In most cases, they reduce total surplus

Relationship Between Quantity and Price Effect

-Depending on which of these effects is larger, total revenue might increase or decrease when De Beers increases the quantity of diamonds it sells -But the price effect always works in the opposite direction of the quantity effect—it decreases revenue -Thus, marginal revenue in a monopoly market is always less than the price, except for the very first unit sold -For that first unit, average revenue and marginal revenue are both equal to the price

Government and Intellectual Property Rights

-Governments can also create or support private monopolies through regulation of intellectual property rights -Patents and copyrights give people who invent or create something the exclusive right to produce and sell it for a given period of time -For instance, by forbidding the use of a chemical formula by other manufacturers, patents allow pharmaceutical companies to act temporarily as monopolists in the market for a particular drug -When the patent expires, government protection of the monopoly ends; competitors can then drive down prices by producing a generic version of the same drug -Creative works like art, movies, and music are also frequently protected by intellectual property laws -Governments grant movie-making companies a legal monopoly over selling downloads of the movies they make -The result is that downloads of movies are more expensive than they would be if anyone could legally copy the movie and sell it

Government Intervention

-Governments may create or sustain monopolies where they would not otherwise exist -In many U.S. states, for example, the government has created a monopoly on the sale of alcoholic beverages -Governments usually say they are creating monopolies in the public interest -Sometimes governments create monopoly power for state-owned firms -They can do this through a legal prohibition on other firms entering the market, or by subsidizing a state-owned enterprise so heavily that private companies effectively cannot compete -Not all state-owned enterprises are monopolies, though (government and private-owned airlines compete) -One of the four forms of barriers to entry in a monopoly market

Aggressive Tactics

-How could De Beers prevent those new companies from undercutting its prices? -It offered to buy up the companies that discovered new sources of diamonds -It entered into exclusive agreements with diamond-producing countries -De Beers punished anyone who did business with independent diamond producers (could be deadly for a smaller player in the diamond market) -One of the four forms of barriers to entry in a monopoly market

Issues of Public Ownership

-However, public ownership of a natural monopoly has its problems -Politicians may feel pressure to lower prices even further, below the level they would be in a competitive market (will create shortages and people will demand more than it makes sense for the producer to supply at that price) -Publicly owned companies may also make business decisions—such as where to locate or what types of products to offer—on the basis of political concerns -Perhaps most importantly, the loss of the profit motive could reduce the publicly-owned monopolist's motivation to improve efficiency and to provide better service or lower costs (has to cover losses with tax revenue)

Profit Without Price Discrimination Graphic

-If Microsoft can pick only one price, it should pick $150 to maximize its profits. -However, by charging $150 Microsoft loses the business of students, who have a lower willingness to pay and it also misses out on the extra $75 that business customers would have been willing to pay -Microsoft does best if it can find a way to charge these three groups the exact price they are willing to pay

Regulation

-If policy-makers don't want to go all the way to public ownership, one common intermediate step is to regulate the behavior of natural monopolies -Such regulation takes the form of controls on the prices natural monopolies are allowed to charge (frequently in utility markets) -In theory, such controls could have the same effect as public ownership: By capping the price at ATC, regulators can force natural monopolies to earn zero economic profits, reducing deadweight loss as much as possible without causing the firm to incur losses and exit the market (not so simple in practice) -Firms have an incentive to avoid giving regulators useful information about their true costs of production, making it difficult for regulators to determine the appropriate price level -One of the five main public policy responses for a monopoly

Economies of Scale Example

-Imagine what would be needed to create competition in the electricity-supply industry, for example: Multiple firms would have to build power plants and huge systems of distribution poles and wires to serve the same area -The firm that can sell the most electricity can spread its fixed costs more widely and can achieve a lower cost per unit than a firm with the same fixed costs but lower output (large cost advantage in providing all of the electricity for a given region)

Quantity and Price Effect

-In a market dominated by a monopoly, however, the monopoly's choice to produce an additional unit drives down the market price -Because of this effect, producing an additional unit of output has two separate effects on total revenue: -Quantity effect: First, total revenue increases due to the money brought in by the sale of an additional unit -Price effect: Second, total revenue decreases, because all units sold now bring in a lower price than they did before

How a Monopolist Can Maintain a Price Higher than Average Total Cost

-In a monopoly market, however, other firms can't enter the market, due to the barriers to entry that allowed the firm to become a monopolist in the first place -The result is that a monopolist is able to maintain a price higher than average total cost

Monopolists and The Demand Curve

-In a perfectly competitive market, each individual firm faces a horizontal demand curve, even though the demand curve for the market as a whole slopes downward -This is because each firm is assumed to be too small for its production decisions to affect the market price -It can sell as much as it wants at the market price, but, if it tries to charge more, it will be undercut by competitors and won't be able to sell anything -In contrast, as the only producer in the market, a monopolist faces the downward- sloping market demand curve, shown in panel B -The monopolist can choose to sell at any price it wants without fear of being undercut, because there are no other firms to do the undercutting (However, it is still constrained by market demand) -The monopoly can choose any price-quantity combination on the demand curve, but is unable to choose points that are not on the curve (It can't force customers to buy more or less than the quantity they demand at any given price) -Only by increasing demand would it be able to sell a higher quantity of diamonds at a higher price

Economies of Scale

-In some industries, economies of scale are so powerful that competition between two or more firms simply doesn't make much sense; in these cases, the required infrastructure is too costly to replicate -One of the four forms of barriers to entry in a monopoly market

Antitrust laws

-In the late nineteenth century, massive corporations called "trusts" were beginning to dominate entire industries -To check their growing power, Congress passed the Sherman Antitrust Act in 1890 -The act requires the federal government to investigate and prosecute corporations that engage in anti-competitive practices (This includes practices such as price-fixing and bid-rigging) -In recent years, however, the government has only infrequently used the power to block mergers -More often, the government investigates a potential merger and allows it to go forward -Further, the mergers were seen as actually generating benefits for customers due to cost savings in airport operations and the organization of plane fleets -One of the five main public policy responses for a monopoly

No Response

-Looking at the pros and cons of various interventions in monopoly markets, some economists conclude that the best response to a monopoly is sometimes no response at all -Doing nothing might be preferable if regulation is too difficult to create or manage effectively -If government interventions in the market are subject to corruption or political mishandling, it might be better not to act -One of the five main public policy responses for a monopoly

Public Ownership

-Natural monopolies pose a particular problem for policy-makers -On the one hand, the monopolist is able to achieve lower costs of production than multiple competing producers would -On the other hand, even a natural monopoly chooses to produce at a price that is higher than marginal cost, causing deadweight loss -One possible solution for governments is to run natural monopolies as public agencies -Examples of public ownership of natural monopolies include the U.S. Postal Service to deliver mail and Amtrak to provide train services -The rationale behind public ownership of natural monopolies is that governments are supposed to serve the public interest rather than maximize profit -For example, a government-supported monopoly might deliver mail to any postal address in the country; a private monopolist might prefer not to deliver to remote addresses that are more expensive to reach -A publicly owned monopoly could also set prices lower than an unregulated monopolist would -One of the five main public policy responses for a monopoly

What does it mean when marginal revenue drops below zero?

-Negative marginal revenue means that the price effect has become bigger than the quantity effect, and so each additional unit of output decreases total revenue -Thus, the point at which the MR curve crosses the x-axis represents the revenue-maximizing quantity (7 in this example)

Positive Side of Monopoly Tactics

-Not all tactics to maintain monopoly power are so unwelcome to smaller competitors, however -For example, although Google controls around four-fifths of the world's Internet searches, it knows that a new company with a better search algorithm could overtake it -It tries to preserve its dominant position by buying promising-looking inventions in search technology -Many web entrepreneurs set up in business actively hoping that one of the giants of the industry will offer to buy them out

Price Discrimination Graphic

-Panel C shows what would happen if Microsoft were able to price discriminate perfectly (The area representing Microsoft's profits becomes even bigger) -There is no consumer surplus at all anymore; all customers are charged at the exact level of their willingness to pay (transformed into producer surplus) -Instead, all possible mutually beneficial trades take place—meaning the market is efficient -Remember that efficiency doesn't say anything about the distribution of surplus—including whether it goes to consumers or producers—but only whether total surplus is maximized

Public Policy Responses

-Policy-makers have developed a range of policy responses to monopolies -These tools aim to break up existing monopolies, prevent new ones from forming, and ease the effect of monopoly power on consumers -Each comes with costs as well as benefits; some economists argue that the best response is often to do nothing at all -Antitrust Laws -Public Ownership -Regulation -Vertical Splits -No Response

Price Discrimination in The Real World

-The first problem with price discrimination in the real world is defining categories of customers -Microsoft's price-discrimination strategy would not work very well if anyone could simply say "I'm a student" and be charged the lower price (need a way to verify who is a student) -The second problem facing the firm that tries to price discriminate is that many products can easily be resold -To prevent this, there needs to be some way of punishing people who cheat the system -Hence, Microsoft can use legal enforcement against anyone who uses student version of Office for their business -Many goods do not lend themselves to this kind of tracking as easily as software or theater tickets

Monopolist's Revenue Graphic

-The first step in understanding a monopolist's quest for profits is to map out the revenues it can bring in -Because it is constrained by demand, DeBeers has to accept the quantity that American consumers are willing to buy at a given price -Total revenue increases on sections of the demand curve where demand is price-elastic; it decreases on sections of the curve where demand is price-inelastic

Idea Behind Privatizing Natural Monopolies

-The idea behind privatizing natural monopolies relates to incentives: A private firm should be more motivated than a public one to increase its profits by innovating and reducing costs, and those savings should result in lower prices for consumers -But if the regulator sets a price so low that all of the cost savings go to consumers, the firm will have no incentive to reduce costs -If the regulator sets the price at a level insufficient to cover the monopolist's costs, it could even drive the firm out of business

Barriers to Entry

-The key characteristic of a monopoly market is that there are barriers that prevent firms other than the monopolist from entering the market (allow the monopolist to set prices and quantities) -Barriers to entry contradict the free entry and exit feature that characterizes perfectly competitive markets

Scarce Resources

-The most straightforward cause of barriers to entry is scarcity in some key resource or input into the production process -A new diamond firm cannot simply enter the market without somehow gaining control of a mine -Sometimes a single country, rather than a single firm, controls scarce resources with no close substitutes -One of the four forms of barriers to entry in a monopoly market

Monopolist's Cost Curves Graphic

-The only relevant difference between the curves for a monopoly and the equivalent ones for a firm in a competitive market is that marginal and average revenue slope downward for the monopolist (In a competitive market, those curves are horizontal at the market-price level) -Just as in a competitive market, the profit-maximizing quantity of output for a monopoly is the point at which the marginal revenue curve intersects the marginal cost curve

Purpose of Stockpiling

-The purpose of this stockpiling was to ensure that the quantity of diamonds for sale was always the quantity that maximized De Beers's profits

Competitive vs Monopoly Market in Relation to Marginal Revenue and Price

-There is an important difference between a firm in a competitive market that produces at the point where MR = MC and a monopoly that does the same thing -In a competitive market, marginal revenue is equal to price -For a monopolist, price is greater than marginal revenue; therefore price is also greater than marginal cost at the optimal production point -The profit-maximizing price is the price on the demand curve that corresponds to the profit-maximizing quantity of output

Marginal Revenue and Price in a Monopoly Market

-Unlike a firm in a competitive market, however, a monopolist's marginal revenue is not equal to price (Marginal revenue is the revenue generated by selling each additional unit) -We calculate marginal revenue by taking total revenue at a certain quantity and subtracting the total revenue when quantity is one unit lower -For instance, based on Table 14-1, total revenue from five diamonds is $20,000, and total revenue from four diamonds is $18,000 -So, the marginal revenue from selling a fifth diamond is $20,000 − $18,000 = $2,000

Sherman Act and Clayton Act

-Using the Sherman Act, Teddy vigorously prosecuted corporations that used monopolistic practices to stifle competition -Over the years, the government has used the Sherman Act to break up monopolies in various industries, including railroads, oil, aluminum, tobacco, and telecommunications -The U.S. government has also used the Sherman Antitrust Act and its partner the Clayton Antitrust Act of 1914 to prevent monopolies from forming in the first place -The Justice Department can block two firms from merging if the merger would result in a company with too much market power -An example is a proposed merger between office-supply giants Office Depot and Staples

Predatory Pricing

-Walmart has been sued on several occasions for predatory pricing—that is, temporarily slashing prices until rival local stores are forced out of business -Predatory pricing is a way for a large company, which can sustain short-term losses, to force smaller rivals out of the market -By doing so it can create monopoly power, which then enables the company to dictate its own prices

Demand for Microsoft Office Graphic

-With no variable cost, the profit that Microsoft earns is simply TR − FC (Note, too, that if variable costs are zero, marginal costs also are zero)

Monopoly

A firm that is the only producer of a good or service with no close substitutes -A firm is a perfect monopoly if it controls 100 percent of the market in a product -Firms can still have a large degree of monopoly power if they control slightly less than 100 percent of the market -The lack of a close substitute for a product is an essential part of the definition of monopoly (can set own price)

Natural Monopoly

A market in which a single firm can produce, at a lower cost than multiple firms, the entire quantity of output demanded -Drinking-water supply and natural gas are other examples of natural monopolies; these depend on a network of pipes that would be immensely expensive for new market entrants to duplicate (or public transport) -An electricity supplier or a railway company doesn't have to worry about new firms entering the market to compete because high fixed costs create an effective barrier to entry -Governments often get involved in natural monopolies to try to protect the public from abuse of monopolistic power

Price Discrimination

The practice of charging customers different prices for the same good -It involves "discriminating" between customers on the basis of their willingness to pay -Example is using your student ID card to claim discounts on public transport or theater tickets -The more monopoly power a firm has, the more it is able to price discriminate -For example, college students are often pleasantly surprised to find that they can buy computer software through their colleges for significantly lower prices than they could in a store or online -While Microsoft Office does have substitutes, such as the open source OpenOffice suite, for many people these are not close enough substitutes