CHAPTER 2 MONOPOLY

PART I GOVERNMENT AND ECONOMIC EFFICIENCY MARKET FAILURE 17/08/11 Public Economics - Hoang Phu LY - FTU CHAPTER MONOPOLY: A MARKET FAILURE 17/08/11 Public Economics - Hoang Phu LY - FTU Introduction Free Market 17/08/11 Competitive Forces Market Efficiency Market Failure Regulation Regulation Equitable Distribution Public Economics - Hoang Phu LY - FTU Introduction  Market failure occurs when freely functioning markets, operating without government intervention, fail to deliver an efficient or optimal allocation of resources  Therefore economic and social welfare may not be maximized  This leads to a loss of economic efficiency 17/08/11 Public Economics - Hoang Phu LY - FTU Monopoly Definition of monopoly 17/08/11 Public Economics - Hoang Phu LY - FTU Definition While a competitive firm is a price taker, a monopoly firm is a price maker 17/08/11 Public Economics - Hoang Phu LY - FTU Monopoly  A firm is considered a monopolist if   17/08/11  Public Economics - Hoang Phu LY - FTU Monopoly power occurs when the seller of a product can influence prices    it is the sole seller of its product its product does not have close substitutes A single seller is a monopolist There is oligopoly if there are several sellers Monopsony power occurs when the buyer of a product can influence price  17/08/11 A single buyer is a monopsonist Public Economics - Hoang Phu LY - FTU Monopoly Causes of monopoly 17/08/11 Public Economics - Hoang Phu LY - FTU Why Monopoly?? The fundamental cause of monopoly is barriers to entry 17/08/11 Public Economics - Hoang Phu LY - FTU 10 Barriers to Entry   The reason a monopoly exists is that other firms find it unprofitable or impossible to enter the market Barriers to entry are the source of all monopoly power  there are two general types of barriers to entry   17/08/11 technical barriers legal barriers Public Economics - Hoang Phu LY - FTU 11 Technical Barriers to Entry  The production of a good may exhibit decreasing marginal and average costs over a wide range of output levels  in this situation, relatively large-scale firms are low-cost producers    17/08/11 firms may find it profitable to drive others out of the industry by cutting prices this situation is known as natural monopoly once the monopoly is established, entry of new firms will be difficult Public Economics - Hoang Phu LY - FTU 12 Technical Barriers to Entry  Another technical basis of monopoly is special knowledge of a low-cost productive technique   it may be difficult to keep this knowledge out of the hands of other firms Ownership of unique resources may also be a lasting basis for maintaining a monopoly 17/08/11 Public Economics - Hoang Phu LY - FTU 13 Legal Barriers to Entry  Many pure monopolies are created as a matter of law   17/08/11 with a patent, the basic technology for a product is assigned to one firm the government may also award a firm an exclusive franchise to serve a market Public Economics - Hoang Phu LY - FTU 14 Creation of Barriers to Entry  Some barriers to entry result from actions taken by the firm     research and development of new products or technologies purchase of unique resources lobbying efforts to gain monopoly power The attempt by a monopolist to erect barriers to entry may involve real resource costs 17/08/11 Public Economics - Hoang Phu LY - FTU 15 Economies of Scale as a Cause of Monopoly Cost Average total cost 17/08/11 Public Economics - Hoang Phu LY - FTU Quantity of Output 16 Monopoly Recap about monopoly 17/08/11 Public Economics - Hoang Phu LY - FTU 17 a, Monopoly versus Competition Monopoly  Is the sole producer  Has a downwardsloping demand curve  Is a price maker  Reduces price to increase sales 17/08/11 Competitive Firm Is one of many producers Has a horizontal demand curve Is a price taker Sells as much or as little at same price Public Economics - Hoang Phu LY - FTU 18 Comparing Monopoly and Competition  For a competitive firm, price equals marginal cost P = MR = MC  For a monopoly firm, price exceeds marginal cost P > MR = MC 17/08/11 Public Economics - Hoang Phu LY - FTU 19 b, A Monopoly’s Revenue  Total Revenue P x Q = TR  Average Revenue  Marginal Revenue TR/Q = AR = P TR/Q = MR 17/08/11 Public Economics - Hoang Phu LY - FTU 20 Monopoly’s Marginal Revenue A monopolist’s marginal revenue is always less than the price of its good The demand curve is downward sloping a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases When 17/08/11 Public Economics - Hoang Phu LY - FTU 21 A Monopoly’s Total, Average, and Marginal Revenue Quantity (Q) Price (P) $11.00 $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 17/08/11 Total Revenue (TR=PxQ) $0.00 $10.00 $18.00 $24.00 $28.00 $30.00 $30.00 $28.00 $24.00 Average Revenue (AR=TR/Q) Marginal Revenue (MR= TR / Q ) $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 -$2.00 -$4.00 22 Public Economics - Hoang Phu LY - FTU Demand and Marginal Revenue Curves for a Monopoly Price $11 10 -1 -2 -3 17/08/11 -4 Demand (average revenue) Marginal revenue Quantity of Water 23 Public Economics - Hoang Phu LY - FTU Profit-Maximization for a Monopoly .and then the demand curve shows the price consistent with this quantity Costs and Revenue B Monopoly price The intersection of the marginal-revenue curve and the marginalcost curve determines the profit-maximizing quantity Average total cost A Demand Marginal cost Marginal revenue 17/08/11 QMAX Public Economics - Hoang Phu LY - FTU Quantity 24 c, The Monopoly’s Profit Profit equals total revenue minus total costs Profit = TR - TC Profit = (TR/Q - TC/Q) x Q Profit = (P - ATC) x Q 17/08/11 25 Public Economics - Hoang Phu LY - FTU The Monopolist’s Profit The monopolist will receive economic profits as long as price is greater than average total cost 17/08/11 26 Public Economics - Hoang Phu LY - FTU The Monopolist’s Profit Costs and Revenue Marginal cost Average total cost D B y ol op it on f M pro Monopoly E price Average total cost C Demand Marginal revenue 17/08/11 QMAX Public Economics - Hoang Phu LY - FTU Quantity 27 Monopoly = market failure Deadweight welfare loss under monopoly 17/08/11 £ Public Economics - Hoang Phu LY - FTU 28 A monopolist producing less than the social optimum MC P1 MC1 AR MR O £ Q Q1 Monopoly output 17/08/11 29 Public Economics - Hoang Phu LY - FTU A monopolist producing less than the social optimum MC = MSC P1 P2 = MSB = MSC MC1 AR = MSB MR O Monopoly output 17/08/11 Q1 Q Q2 30 Perfectly competitive output Public Economics - Hoang Phu LY - FTU 10 £ Deadweight loss under monopoly MC (= S under perfect competition) Consumer surplus Ppc a Producer surplus AR = D O Qpc Q 17/08/11 Public Economics - Hoang Phu LY - FTU (a) Industry equilibrium under perfect competition £ Pm Ppc Deadweight loss under MC (= S under perfect competition) monopoly Deadweight welfare loss Consumer surplus b a Producer surplus AR = D MR O 17/08/11 £ 31 Qpc Qpc Q Economics - Hoang Phu LY - FTU (b) Industry Public equilibrium under monopoly Deadweight loss under monopoly 32 MC (= S under perfect competition) Perfect competition Consumer surplus Ppc a Producer surplus AR = D O Qpc Q 17/08/11 Public Economics - Hoang Phu LY - FTU (a) Industry equilibrium under perfect competition 33 11 Deadweight loss under monopoly MC £ (= S under perfect competition) Monopoly Consumer surplus Pm Ppc Deadweight welfare loss b a Producer surplus AR = D MR O 17/08/11 Qpc Qpc Q Economics - Hoang Phu LY - FTU (b) Industry Public equilibrium under monopoly 34 Monopoly Public Policy Toward Monopolies 17/08/11 Public Economics - Hoang Phu LY - FTU 35 5.1 Public Policy Toward Monopoly Government responds to the problem of monopoly in one of four ways     17/08/11 Making monopolized industries more competitive Regulating the behavior of monopolists Turning some private monopolies into public enterprises Doing nothing at all Public Economics - Hoang Phu LY - FTU 36 12 Regulation of Monopoly   The natural policy is to encourage competition This can be done directly by enforcing division of monopolists US antitrust legislation applied to Standard Oil (1911) and Bell System (1984) => division into separate competing firms    It can be done indirectly by reducing barriers to entry Legal barriers can be removed by changing the law But why were they imposed initially?  17/08/11 Public Economics - Hoang Phu LY - FTU 37 Regulation of Monopoly  Technological barriers can be reduced insistence on knowledge sharing US insists Microsoft provides information   Patents are also a barrier to entry Optimum length trades reward for innovation against stifling of competition   Advertising and excess capacity can be part of an entry deterrence strategy Advertising expenditure can be limited (e.g tobacco) Proving excess capacity is held to deter entry is difficult   17/08/11 Public Economics - Hoang Phu LY - FTU 38 5.2 Regulation of a Natural Monopoly  Natural monopolies such as the utility, communications, and transportation industries are highly regulated in many countries 17/08/11 Public Economics - Hoang Phu LY - FTU 39 13 Regulation of a Natural Monopoly   Many economists believe that it is important for the prices of regulated monopolies to reflect marginal costs of production accurately An enforced policy of marginal cost pricing will cause a natural monopoly to operate at a loss  natural monopolies exhibit declining average costs over a wide range of output 17/08/11 40 Public Economics - Hoang Phu LY - FTU Regulation of a Natural Monopoly Because natural monopolies exhibit decreasing costs, MC falls below AC Price An unregulated monopoly will maximize profit at Q1 and P1 If regulators force the monopoly to charge a price of P2, the firm will suffer a loss because P2 < C2 P1 C1 C2 AC MR P2 MC Q1 17/08/11 Q2 D Quantity 41 Public Economics - Hoang Phu LY - FTU a, Marginal-Cost Pricing for a Natural Monopoly Price Average total cost Regulated price Average total cost Loss Marginal cost Demand 17/08/11 Public Economics - Hoang Phu LY - FTU Quantity 42 14 b, Pricing for a Natural Monopoly as AC Price Price as AC Average total cost Average total cost Marginal cost MR 17/08/11 Demand Q1 Q2 Q0 Quantity Public Economics - Hoang Phu LY - FTU 43 c, Price Discrimination Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same In order to this, the firm must have market power 17/08/11 Public Economics - Hoang Phu LY - FTU 44 Price Discrimination  Two important effects of price discrimination:  It can increase the monopolist’s profits  It can reduce deadweight loss  But in order to price discriminate, the firm must  Be able to separate the customers on the basis of willingness to pay  Prevent the customers from reselling the product 17/08/11 Public Economics - Hoang Phu LY - FTU 45 15 Regulation of Monopoly Suppose that the regulatory commission allows the monopoly to charge a price of P1 to some users Price Other users are offered the lower price of P2 The profits on the sales to highprice customers are enough to cover the losses on the sales to low-price customers P1 C1 C2 AC MC P2 Q1 17/08/11 Q2 D Quantity Public Economics - Hoang Phu LY - FTU 46 Regulation of Monopoly  Another approach followed in many regulatory situations is to allow the monopoly to charge a price above marginal cost that is sufficient to earn a “fair” rate of return on investment  17/08/11 if this rate of return is greater than that which would occur in a competitive market, there is an incentive to use relatively more capital than would truly minimize costs Public Economics - Hoang Phu LY - FTU 47 Regulation of Oligopoly   Collusion among firms allowed price to rise and profit to increase Tacit collusion may be difficult for a regulator to detect   Does a high price represent lack of substitutes or price collusion? This question is answered by calculating price elasticities and using these to construct Lerner index with and without collusion    17/08/11 Breakfast cereal: collusion implies Lerner of 65-75% Competition implies Lerner of 40-44% Actual index about 45%, implying no collusion Public Economics - Hoang Phu LY - FTU 48 16 Regulation of Oligopoly      Mergers can damage economic efficiency by increasing monopoly power Mergers are regulated by governments A merger is not permitted if it is judged to harm the public interest Estimated demand elasticities can be used to predict the outcome of a merger The predicted price changes favor the merger 17/08/11 49 Public Economics - Hoang Phu LY - FTU Monopsony  A monopsonist is a single buyer      Such as the only firm using a specialized form of labor Monopsony results in price (or wage) being below the competitive level The monopsonist takes account of the fact that a higher price (or wage) must be paid to all units purchased This provides a disincentive to raising the wage to the competitive level Monopsony causes a deadweight loss 17/08/11 50 Public Economics - Hoang Phu LY - FTU Monopsony     Labor demand is given by the marginal revenue of labor (MRL) The competitive wage is wc The marginal cost for the monopsonist is w plus additional payment to existing workers Monopsony wage is wm Wage Marginal Cost Labor Supply w(L) wc wm Labor Demand MRL Lm Lc Quantity of Labor Monopsony in the labor market 17/08/11 Public Economics - Hoang Phu LY - FTU 51 17 Next CHAPTER…  EXTERNALITIES 17/08/11 Public Economics - Hoang Phu LY - FTU 52 18 ... unregulated monopoly will maximize profit at Q1 and P1 If regulators force the monopoly to charge a price of P2, the firm will suffer a loss because P2 < C2 P1 C1 C2 AC MR P2 MC Q1 17/08/11 Q2 D Quantity... $24 .00 $28 .00 $30.00 $30.00 $28 .00 $24 .00 Average Revenue (AR=TR/Q) Marginal Revenue (MR= TR / Q ) $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $10.00 $8.00 $6.00 $4.00 $2. 00 $0.00 - $2. 00... -$4.00 22 Public Economics - Hoang Phu LY - FTU Demand and Marginal Revenue Curves for a Monopoly Price $11 10 -1 -2 -3 17/08/11 -4 Demand (average revenue) Marginal revenue Quantity of Water 23