chapter 16 monopoly
link between Price and Marginal Revenue
Firm's Output = Market Demand Total Revenue = Price x Quantity sold Marginal revenue = Change in Total Revenue / Change in one-unit increase MR relates to change in quantity sold
MONOPOLY REGULATION
Natural monopoly presents a dilemma— to operate in the self-interest of the monopoly and not in the social interest.
almost 15 percent of seats fly empty. The marginal cost of filling an empty seat is close to zero, so a ticket sold at a few dollars would be profitable.
Online booking sites facilitate competition among airlines (low fares)
Second-Best Regulation of a Natural Monopoly
Two possible ways of enabling a regulated monopoly to avoid an economic loss are: 1— Average cost pricing 2— Government subsidy
Legal Monopoly—
a market in which competition an entry or restricted by granting a public franchise, government license, patent or Copyright
barrier to entry
any constraint that protects a firm from competitors 3 types: #1— Natural #2— Legal #3— Ownership
Example of a rent created by lobbying to politicians with campaign contributions
the law that restricts the quantities of textiles that can be imported into the United States the law that limits the number of tomatoes that can be imported into the United States These laws restrict competition--> decreasing the quantity for sale + increasing prices.
2 theories about how regulation actually works:
the social interest theory the capture theory.
Is Monopoly Fair? Not always fair or unfair Fair BC/ if... --- Redistribution from the rich to the poor is consistent with the fair-result view (depends on whether monopoly or consumer is richer) --- if everyone is free to acquire the monopoly, then the rules are fair ^^^ rules are fair depends on whether the monopoly has benefited from a protected position that is not available to anyone else
they redistribute consumer surplus in a way that transfers it to the producer's surplus Redistriubtion==> difference between Pc - Pm is transferred from consumers surplus to producer's surplus
To determine the output level and price that maximize a monopoly's profit...
we study the behavior of both revenue and costs as output varies.
Monopoly—
when one firm sells a good or service that has no close substitutes and in which a barrier to entry prevents competition from new firms.
What happens when Rent-seeking costs exhaust economic profit?
#1— Rent-seeking costs exhaust economic profit #2— Rent-seeking costs total fixed cost and average total cost BC it is a FC #3— Rent-seeking costs ATC curve shifts upward until, at the profit-maximizing price, the firm breaks even #4— Rent-seeking costs doesn't shrink consumer surplus any further #5— deadweight loss increases ==>> now includes the original deadweight loss plus the economic profit consumed by rent-seeking
#1 public franchise— is an exclusive right granted to a firm to supply a good or service, an example of which is the U.S. Postal Service's exclusive right to deliver first-class mail
#2 government license— controls entry into particular occupations, professions, and industries. Ex: Michael's Texaco in Charleston, Rhode Island— the only firm in the area licensed to test for vehicle emissions
#3 Patent— it is an exclusive right granted to the inventor of a product or service. Benefits: *** Encourages the invention of new products and production methods *** stimulates innovation by encouraging inventors to publicize their discoveries and offer them for use under license ——— innovation in soybean seeds, pharmaceuticals, memory chips, and video games
#4 copyright— is an exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work. ***Patents and copyrights are valid for a limited time period that varies from country to country. (US- patent is vaild for 20 years)
Examples of monopolies
- market for PC operating systems (Microsoft) - water supplied by a local public utility (no substitutes for doing the laundry, taking a shower, or washing a car, but substitutes for water bottles) - Technological change can create substitutes and weaken a monopoly ---- FedEx, UPS, and e-mail are close substitutes for the services provided by the U.S. Postal Service and have weakened its monopoly - arrival of a new product ----- Google + Microsoft
MONOPOLY characteristics
- one firm - no substitutes - high barriers of entry - no competition - profit-maxmizing = P > MR = MC
relationship between marginal revenue and elasticity implies that...
-- a monopoly never profitably produces along with the inelastic range of its demand curve (right-side) ---->> but, one could increase total revenue by raising its price and selling a smaller quantity (when on inelastic side) -->>> by producing less, TC falls + Profits increases
2 differences between perfect competition and perfect price discrimination.
1st— the distribution of the total surplus is different. It is shared by consumers and producers in perfect competition while the producer gets it all with perfect price discrimination 2nd— rent-seeking becomes profitable BC the producer grabs all the total surplus
Does a monopoly face a tradeoff between price and the quantity sold? Yes, the monopoly must set a lower price to sell a larger quantity
2 price-setting possibilities that create different tradeoffs: #1— Single price #2— Price discrimination
MR has twice the slope of the demand curve
A fall in price of $10 increases the quantity demanded by 5, but marginal revenue falls by $10 when the quantity increases by 2.5.
Why can a monopoly make a positive economic profit and continue to do so indefinitely?
A positive economic profit is an incentive for firms to enter a market. But barriers to entry prevent that from happening in a monopoly.
Compare the performance of a single-price monopoly with that of perfect competition.
A single-price monopoly price is higher and quantity produced is smaller than in a perfectly competitive market and a deadweight loss arises. Monopoly imposes a loss on society that equals its deadweight loss plus the cost of the resources devoted to rent seeking.
Which is the better option, average cost pricing or marginal cost pricing with a government subsidy? The answer turns on the relative magnitudes of the two deadweight losses. ****The smaller deadweight loss is the second-best solution to regulating a natural monopoly.***
Average cost pricing generates a deadweight loss in market (served by natural monopoly) subsidy generates deadweight losses in the markets (for the items that are taxed to pay the subsidy) AC pricing accepted more than subsidy BC calculation is difficult
2 ways in which a person might become the owner of a monopoly: Buy a monopoly. Create a monopoly.
Buy a Monopoly— try to make a monopoly profit by buying a firm (or a right) that is protected by a barrier to entry ex: taxicab medallion in New York City (uber left them with normal profit: 1 mill to 250,000) Create a monopoly— creating a monopoly by rent-seeking is an attractive alternative to buying one BC buying one is costly ex: lobbying to politicians + campaign contributions
Information-Age Monopolies
Created 3 big natural monopolies— 1. Google = internet search 88% 2. Microsoft = Operating Systems 78% 3. Facebook = Social media 74% these firms have large fixed plant costs but almost zero marginal cost that experience economies of scale.
Is Monopoly Efficient? NO
Deadweight loss from underproduction *** BC Price (MB) > MC Consumer surplus shrinks *** BC consumers receive less of the product Producer surplus expands *** BC producers Lose by selling less products but gain by selling output for a higher price
Discriminating Among Groups of Buyers— firms offers different prices to different types of buyers based on... - age - employment status - some other easily distinguished characteristic works when each group has a different average willingness to pay for the good or service. ex: business travelers are willing to pay more than vacation travelers—— airlines price discrimination against the two Or flyers who book tickers earlier
Discriminating Among Units of a Good— firms charges the same prices to all its customers but offers a lower price per unit for a larger number of units bough ex: BOGO
total revenue test for the price elasticity of demand
Fall in price increases total revenue = demand is elastic =>> MR+ Maximum TR = demand is unit elastic =>> MR is 0 Fall in price decreases total revenue = demand is inelastic =>> MR-
Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly.
In monopoly, a single producer of a good or service that has no close substitutes operates behind a natural, legal, or ownership barrier to entry. A monopoly can price discriminate when there is no resale possibility. Where resale is possible, a firm charges a single price.
perfect competition vs single-price monopoly *** after monopoly buy ALL small firms-->> Consumers don't change, so the demand curve doesn't change
Initially — many small firms: - Price = MR = MC - larger quantity than 2nd After monopoly buy ALL small firm— one firm: - Price > MR = MC - smaller quantity than 1st Qc Output > Qm Output Pc Price < Pm Price
To be able to price discriminate, a firm must #1— Identify and separate different types of buyers. #2—Sell a product that cannot be resold.
NOT ALL price discriminators are monopolies Not all price differences are price discrimination. *** some goods that are similar but not identical have different prices because they have different production costs
Explain how price discrimination increases profit.
Perfect price discrimination captures the entire consumer surplus. Prices are the highest that each consumer is willing to pay for each unit. With perfect price discrimination, the monopoly is efficient but rent seeking uses some or all of the producer surplus.
Total Revenue and Total Cost graph Economic profit = vertical distance between the TR and TC curves Economic Profit maximized when TR - TC is greatest.
Price and Cost graph— Economic profit = MC = MR - represented by the blue rectangle Price => depends on demand curve-- uses the highest price at which it can sell profit-maximizing output
marginal cost pricing rule— a rule that says price equal to marginal cost to achieve an efficient output How can FPL be regulated to produce the efficient quantity of electric power? with MCPR
Problem: the Firm will incur an economic loss BC ATC > MC, so frim will go out of business
Perfect Competition Vs Monopoly
Qc > Qm Pc < Pm Deadweight Loss < Deadweight Loss Consumer surplus > Consumer surplus Producer surplus < Producer surplus Profit < Profit ??
Explain why natural monopoly is regulated and the effects of regulation.
Regulation might achieve an efficient use of resources or help the monopoly to maximize economic profit. A natural monopoly is efficient if its price equals marginal cost, but a second-best outcome is for price to equal average total cost. A price cap supported by earnings sharing regulation is the most effective practical method of regulating a natural monopoly.
Implementing average cost pricing presents the regulator with a challenge because it is not possible to be sure of a firm's costs
So regulators use one of two practical rules: 1— Rate of return regulation 2—Price cap regulation
Price discrimination (monopoly)
Some people pay less with price discrimination, but others pay more - monopolies have a high incentive to find ways of discriminating and charging each buyer the highest possible price
Explain how a single-price monopoly determines its output and price.
The demand for a monopoly's output is the market demand, and a single-price monopoly's marginal revenue is less than price. A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost and by charging the maximum price that consumers are willing to pay for that quantity.
Rent seekers use resources in pursuit of monopoly, and the bigger the rents, the greater is the incentive to use resources to pursue those rents.
With free entry into rent seeking, the long-run equilibrium outcome is that rent seekers use up the entire producer surplus.
average cost pricing rule— a rule that sets price equal to average total costs to enable a regulated firm to avoid economic losses
results in... -- firm makes zero economic profit—breaking even - quantity produced < efficient quantity ==> a deadweight loss arises
social interest theory— the theory that regulation achieves an efficient allocation of resources ***political and regulatory process relentlessly seeks out inefficiency and introduces regulation that eliminates deadweight loss and allocates resources efficiently.
capture theory— the theory that regulation serves the self-interest of the producer and results in maximum profit, under production, and deadweight loss No individual consumer has an incentive to oppose the regulation, but the producer has a big incentive to lobby for it
two-part tariff or two-part price
charge a fee that covers its fixed cost and then charge a price per hour used that is equal to marginal cost.
regulation— (not 100% effective) rules administrated by a government agency to influence prices, quantities, entry, and other aspects of economic activity in a firm or industry -- government establishes agencies to oversee and enforce the rules Ex: Surface Transportation Board
deregulation— the process of removing regulation of prices, quantities, entry, and other aspects of economic activity in a firm or an industry deregulation has occurred in domestic air transportation, telephone service, interstate trucking, and banking and financial services ( + Cable TV was deregulated and regualted)
Government Subsidy
direct payment to the firm equal to its economic loss. But to pay a subsidy, the government must raise the revenue by taxing some other activity.
Price cap regulation is often combined with earnings sharing regulation to combat issue when the regulator might set the cap too high
earnings sharing regulation— a regulation that requires the firm to make refunds to customers when its profits rise above a target level.
Profiting by Price Discriminating
economic profit increase consumer surplus shrinks
rate of return regulation— a regulation that sets a price at a level that enables a firm to earn a specified target rate of return on its capital -- rate of return on capital is regulated -- total return on capital is not regulated -- greater the amount of capital = greater the total return
end up serving the self-interest of the firm rather than the social interest BC -- incentive to inflate costs by spending on items such as private jets, free baseball tickets (disguised as public relations expenses), and lavish entertainment -- incentive to use more capital than the efficient amount
outcome of perfect price discrimination
extracted the entire consumer surplus from specific group and converted it into economic profit ++ Demand curve becomes MR curve +++ Economic profit is maximized when lowest price = MC +++ output + economic profit increases
Can monopolies incur an economic loss?
if monopoly's fixed costs increase to the point where TFC exceeds TR BC profit-maximizing level doesn't change, since MR and MC didn't change - might have to exit industry
Price Discrimination and Efficiency
increase output to where P = MC ==> identical to Prefect Competition "perfect price discrimination" ... - pushes consumer surplus to zero but increases producer surplus to equal the sum of consumer surplus and producer surplus in perfect competition - Deadweight loss with perfect price discrimination is zero. So perfect price discrimination produces zero DWL too
Rent seeking
is the lobbying for special treatment from the government to create an economic profit or to divert consumer surplus or producer surplus away from others. does not always create a monopoly, but it always restricts competition and often creates a monopoly ***political activity = lobbying and trying to influence the political process to get laws that create legal barriers to entry (campaign contributions inexchange for influence in political outcomes)
Price Discrimination and Consumer Surplus
key idea: convert consumer surplus into economic profit **do not have enough information about consumer's demand curve to know what price to offer each individual customer **so, they discriminate in two broad ways: #1— Among groups of buyers #2— Among units of a good
price cap regulation— a rule that specifies the highest price that a firm is permitted to set a price ceiling (replaced rate of return regulation) permitted to sell any quantity it chooses at that price or at a lower price
lowers the price and gives the firm an incentive to minimize its costs natural monopoly a price ceiling increases output MR =P > MC ==> profit-maximizing quantity becomes Quantity demanded at Price Ceiling price cap regulation lowers the price and increases the number of households served. price cap delivers average cost pricing
Ownership Barrier to Entry
monopoly arises in a market in which competition and entry are restricted by a concentration of ownership Ex: global wholesale market in sunglasses— Luxottica, an Italian firm
Natural Barrier to Entry
natural monopoly — When economies of scale enable a single firm to meet the entire market demand at a lower average total cost than two or more firms could Economies of scale exist when market demand is met (D = LRAC= 1 firm's output) - only room from one firm in market ex: electric power utility
Rent seeking is..
potentially profitable for the rent seeker but costly to society because... it uses scarce resources purely to transfer wealth from one person or group to another person or group rather than to produce the things that people value.
Single price monopoly— a monopoly that must sell each unit of its output for the same price to all its customers ex: Luxottica is a single-price monopoly
price discriminating monopoly— a monopoly that sells different units of a good or service for different price not related to cost differences very common amongst firms - airlines (airfares) -pizza producers (bargain price for 2nd item) appears to be doing its customers a favor
Why is price-discrimination limited to certain monopolies?
price discrimination is limited to monopolies that sell goods and services that cannot be resold because of resale possibilities (customers who buy for a low price, then sell it for a higher price earning a profit )
How can the firm cover its costs and, at the same time, obey a marginal cost pricing rule?
price discrimination or two-part tariff or two-part price
Perfect Price Discrimination
price discrimination that extracts the entire consumer surplus by charging the highest price that consumers are willing to pay for that each unit MR = P == increase output to point where MR = P = MC ==== increased profits ** people willing to pay MR + people willing to pay highest price
Rent-Seeking Equilibrium
rent-seeking is a competitive activity Rent-seeking competition raises the cost of rent-seeking to the point where monopoly earns a zero economic profit after rent-seeking costs Rent-Seeking are considered Fixed costs - ATC curve shifts upwards until it touches the Demand curve - Consumer Surplus is unaffected - Deadweight loss of monopoly now includes deadweight loss plus economic profit consumed by rent-seeking (enlarged grey area)