Chapter 4 Monopoly

Chapter 4

Monopoly

Outline. What is a monopoly?

The profit maximising monopolist

Price discrimination

The efficiency loss from monopoly

Public policy toward natural monopoly

Definition of a monopoly A monopoly is a situation in which the market is

served by only one seller, the product of which has no close substitute on the market. Although this definition looks very simple, it is not that

simple to apply in practice. Examples: cinema, train tickets…

The key factor that differentiates the monopoly from the competitive firm is the elasticity of demand facing the firm. Perfectly competitive firm: infinite Monopoly: finite

One practical measure: examine the cross-price elasticity of demand for the closest substitute

Five sources of monopoly Exclusive control over important inputs

Examples: Perrier, DeBeers…

Economies of scale: when the long-run AC curve is downward sloping the least costly way to serve the market is to concentrate production in one single firm: this is a natural monopoly.

Five sources of monopoly (ctd) Patents: they confer the right to exclusive

benefit from the invention to which it applies. Costs: higher prices for consumers Benefits: they make possible many inventions that

would not be so otherwise

Network economies: on many markets, a product becomes more valuable as the number of customers that use it increases.

Example: telephones May give rise to a monopoly. Example: Microsoft

Government licenses or franchising: in many markets, only those firms that get a license from the government can set up a business.

Outline The profit maximising monopolist

Price discrimination

The efficiency loss from monopoly

Public policy toward natural monopoly

Total revenue

Perfectly competitive firm: horizontal demand curve So, firm’s total revenue is given by

The monopolist: Faces a downward

sloping demand

If he wants to sellmore, he needs tocut his price

Total revenue, total cost and economic Profit

Marginal revenue The marginal revenue is the change in total

revenue generated by a very small change in the amount of output produced.

The monopolist will choose its production level in order to maximise its profit

= TR – TC

Profit is maximum when:

dQ

dTRMR

MCMR0dQ

d

Marginal revenue (ctd)

In the case of the monopoly firm, marginal revenue is always going to be less than the price.

Marginal revenue (ctd)

The monopolist wants to increase production from Q0 to (Q0 + Q).

Needs to lower its price from P0 to (P0 - P) where P >

0.

The new total revenue is

(Q0 + Q).(P0 - P) = P0Q0 + P0Q - PQ0 - P Q

MR = (P0Q - PQ0 - P Q)/ Q

MR = P0 - (P/ Q).Q0 – P

MR = 60 – 10 – (10/50).100 = 30$

Marginal revenue and price elasticity The price elasticity of demand at a point (Q,P) is

given by:

The marginal value is given by:

Q

P.

P

Q

0Q

P.

P

Q

PQ.Q

PPMR

Q.Q

PPMR

)1

1(PQ..Q

PPMR

Marginal revenue and demand

Notice that : When = ∞ (for Q = 0), MR = P When > 1, MR > 0 When = 1, MR = 0 When < 1, MR < 0

When the demand curve is a straight line P = a – bQ where a,b > 0

Then:

TR = P.Q = aQ – bQ2

bQ2adQ

dTRMR

Marginal revenue and demand (ctd)

The short-run profit maximisation condition MR = MC :

The short-run profit maximisation condition (ctd) The profit-maximising mark-up:

Given that:

and MR = MC

It follows that:

)1

1(PMR

1

P

MCPPPMC

The monopolist shut-down condition The monopolist should stop production when

average revenue is less than average variable costs at any level of output

Monopoly versus perfect competition Both choose an output level by weighing the

benefits of expanding (resp. contracting) output against the corresponding costs Both compare MC and MR

The main difference is that for the perfectly competitive firm, the marginal revenue is equal to the market price whereas for the monopolist, it is less than the price

The output level chosen by the monopolist is lower than the output level chosen by the perfect competitor

Monopoly versus perfect competition (ctd)

Adjustments in the long run

Outline Price discrimination

The efficiency loss from monopoly

Public policy toward natural monopoly

Sales in different markets Suppose the monopolist has two completely distinct

markets: what quantity should it sell and what price should it charge in both markets?

Sales in different markets (ctd)

The monopolist will charge a higher price in the market where demand is less elastic to price.

This is called third-degree price discrimination. This is feasible only when it is impossible for buyers to

trade among themselves.

If trading is feasible: arbitrage

Example: train tickets

1

P

MCP

Perfect discrimination First-degree or perfect discrimination is a situation in which

each unit of product is sold at each customer at the highest price the customer is willing to pay for it.

Perfect discrimination (ctd)

How much output will the monopolist produce?

Second-degree price discrimination

It is a practice according to which sellers do not post a single price but a schedule along which price declines with the quantity one buys .

The hurdle model of price discrimination

It consists in inducing the most price-elastic buyers to identify themselves. The seller sets up a hurdle an offers a discount

to those buyers who jump over it. The underlying idea is that those buyers who

are most sensitive to price will be more likely than others to jump the hurdle

Examples. The rebate included in a product package. Airlines offering restricted fares

Outline The efficiency loss from monopoly

Public policy toward natural monopoly

The lost surplus

The deadweight loss

If the firm would behave like a perfect competitor, the whole triangle above the LAC curve would be consumer surplus

If the firm perfectly discriminates, the whole triangle becomes producer surplus

If the firm is a non-discriminating monopolist, part of the consumer surplus is lost . This is the deadweight loss from monopoly

Outline Public policy toward natural

monopoly

How does monopoly compare with alternatives?

Let's consider a technology in which total costs are given by:

TC = F + MQ

There are 2 main objections to the equilibrium reached by the monopoly The fairness objection: the producer earns a profit which

is higher than it would under perfect competition ().

The efficiency objection: the price is above the marginal cost loss in consumer surplus (S).

Fairness and efficiency objections

One solution in that case is to have the state take

over the industry.

Advantage: the government is not as much constrained as a private firm.

Can set the price equal to the marginal cost and absorb the corresponding economic losses out of general tax revenues.

Drawbacks: it often reduces the incentives for cost-conscious efficient management, thus generating X-inefficiency.

State ownership and management

The most frequent regulation consists in setting a

price that allows the firm to earn a pre-defined rate of return on its invested capital.

Ideally this rate of return should allow the firm to recover exactly the opportunity cost of its capital be equal to the competitive rate of return on investment.

However, in practice, regulatory commissions lack information on what the competitive rate of return should be.

State regulation of private monopolies

Accept that the product be produced by only one

firm but to create strong competition in order to determine who will be the supplier.

Specify in detail the service that is wanted and then call for private companies to make bids to supply this service. This should be better than state management in terms

of keeping cost down if X-inefficiency is lower in private than in public firms.

But the advantages of such systems are often more apparent than real.

Exclusive contracting for natural monopolies

The most famous antitrust laws:

The Sherman Act (1890). It makes it illegal to "monopolise or attempt to monopolise any part of the trade or commerce among the several States".

The Clayton Act (1914) prevents companies from buying shares in a competitor where the effect would be to "substantially lessen competition or create monopoly“

The U.S. Justice Department prohibits mergers between competing companies whose combined market share would exceed some predetermined fraction of total industry output.

Antitrust laws

A last possibility for dealing with natural

monopolies is laissez-faire, or doing nothing. The main objections to this policy are those with started with, namely the fairness and efficiency objections

Efficiency objection: the monopolist charges a price above the marginal cost which excludes many potential buyers from the market. But in the case of a two-price monopolist, the

deadweight loss is limited

The more finely the monopolist can partition her market under the hurdle model, the smaller the efficiency loss will be.

Laissez-faire policy

Laissez-faire policy (ctd)

The fairness problem: It consists in the fact that

the monopolist transfers resources from consumers to firms. Raises a distributional problem One argument in favour of the hurdle model of price

discrimination is that most of the profit earned by the monopolist comes from the high price elasticity consumers

Overall, each of the policy options for dealing with natural monopolies has problems. None completely eliminates the problem of having only

one producer serving a market.

Laissez-faire policy (ctd)