Monopoly

8

Monopoly

Definition of Monopoly

Market: A monopoly is an industry in which there is only one firm (seller).

Firm: A firm is considered a monopolist if . . . it is the only seller of its product. its product does not have close substitutes.

Why Do Monopolies Arise?

Why is there only one firm in the market? Because there are barriers to entry in the market.

Why Do Monopolies Arise? Barriers to entry have three sources:

1. Government restricts entry by giving a single firm the exclusive right to sell a particular good, service, idea

Land phone service is given to Türk Telekom, postal services given to PTT, natural gas given to İGDAŞ, tap water to İSKİ in İstanbul.

Patents, copyrights, intellectual property rights.

Government-Created Monopolies

Patents, copyrights and intellectual property rights laws creates a monopoly to increase social welfare. Purpose is to encourage research and development. If there were no such laws, then it would be free to copy inventions (ideas, films, books, formulas...), then nobody does research & development.

Ex: Aspirin is patented to Bayer for 5 years and no other firm can use the same formula without purchasing patent rights during 5 years. After 5 years, “generic drugs” can sell the same formula.

Why Do Monopolies Arise?

2. Natural Monopoly: Cost structure of production make a single producer

more efficient than multiple producers. Natural monopolies arise when there are very large

fixed costs but low marginal costs. Ex: High technology products, research&

development, inventions (Ex:light bulb, microwave oven), software, energy, telecom, etc.

“İSKİ” and tap water production, Türk Telekom (Cable TV & Land Phones), Tüpraş, İGDAŞ (Natural Gas Distributor), etc.

Natural Monopolies

An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller average cost than can two or more firms. (i.e. when there are economies of scale over the entire market size)

Figure 1 Economies of Scale as a Cause of Monopoly

Copyright © 2004 South-Western

Quantity of Output

Averagetotalcost

0

Cost

Why Do Monopolies Arise?

3. Ownership of a key resource:Diamonds (De Beers), Hazelnuts & Boraks (Turkey as a country), İGDAŞ (Natural Gas Distributor), etc.

How Does a Monopolist Choose its Quantity and its Price? Monopoly versus Competition

Monopoly Is the sole producer Faces a downward-sloping demand curve Has market power (power to choose the price).

Competitive Firm Is one of many producers Faces a horizontal demand curve Is a price taker Can sell much or little at the same price

Property of a Monopoly

While a competitive firm is a price taker, a monopoly firm is a price maker. Monopolist can choose its own price. Does this mean that it chooses the maximum possible price? No.

Figure 2 Demand Curves for Competitive and Monopoly Firms

Copyright © 2004 South-Western

Quantity of Output

Demand

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve

0

Price

Quantity of Output0

Price

Demand

A Monopoly’s Revenue

Total RevenueP Q = TR

Average RevenueTR/Q = AR = P

Marginal RevenueTR/Q = MR

Table 1 A Monopoly’s Total, Average, and Marginal Revenue

Copyright©2004 South-Western

Figure 3 Demand and Marginal-Revenue Curves for a Monopoly

Copyright © 2004 South-Western

Quantity of Water

Price

$1110

9876543210

–1–2–3–4

Demand(averagerevenue)

Marginalrevenue

1 2 3 4 5 6 7 8

A Monopoly’s Revenue

A Monopoly’s Marginal Revenue A monopolist’s marginal revenue is always less

than the price of its good. The demand curve is downward sloping. When a monopoly drops the price to sell one more unit,

the revenue received from all previously sold units also decreases.

How Does a Monopolist Choose its Quantity and its Price? A monopolist maximizes profit by producing

the quantity at which marginal revenue equals marginal cost.

After choosing optimal qty, monopolist uses the demand curve to find the price of the good. At that price, consumers will buy the optimal quantity that maximizes firm’s profit.

Figure 4 Profit Maximization for a Monopoly

Copyright © 2004 South-Western

QuantityQ Q0

Costs andRevenue

Demand

Average total cost

Marginal revenue

Marginalcost

Monopolyprice

QMAX

B

1. The intersection of themarginal-revenue curveand the marginal-costcurve determines theprofit-maximizingquantity . . .

A

2. . . . and then the demandcurve shows the priceconsistent with this quantity.

How Does a Monopolist Choose its Quantity and its Price? 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

A Monopoly’s Profit

Profit equals total revenue minus total costs. Profit = TR - TC Profit = (TR/Q - TC/Q) Q Profit = (P - ATC) Q

Figure 5 The Monopolist’s Profit

Copyright © 2004 South-Western

Monopolyprofit

Averagetotalcost

Quantity

Monopolyprice

QMAX0

Costs andRevenue

Demand

Marginal cost

Marginal revenue

Average total cost

B

C

E

D

A Monopolist’s Profit

The monopolist will receive economic profits as long as price is greater than average total cost.

Figure 6 The Market for Drugs

Copyright © 2004 South-Western

Quantity0

Costs andRevenue

DemandMarginalrevenue

Priceduring

patent life

Monopolyquantity

Price afterpatent

expires

Marginalcost

Competitivequantity

THE WELFARE COST OF MONOPOLY In contrast to a competitive firm, the

monopoly charges a price above the marginal cost.

From the perspective of consumers, this high price makes monopoly undesirable.

However, from the perspective of the firm, the high price makes monopoly very desirable.

Figure 7 The Efficient Level of Output

Copyright © 2004 South-Western

Quantity0

Price

Demand(value to buyers)

Marginal cost

Value to buyersis greater thancost to seller.

Value to buyersis less thancost to seller.

Costto

monopolist

Costto

monopolist

Valueto

buyers

Valueto

buyers

Efficientquantity

The Deadweight Loss

Because a monopoly sets its price above marginal cost, it places a difference between the consumer’s marginal benefit and the producer’s marginal cost. This difference causes the quantity sold to be less

than the socially optimal qty where MB=MC.

Figure 8 The Inefficiency of Monopoly

Copyright © 2004 South-Western

Quantity0

PriceDeadweight

loss

DemandMarginalrevenue

Marginal cost

Efficientquantity

Monopolyprice

Monopolyquantity

The Deadweight Loss of Monopoly

The Inefficiency of Monopoly The monopolist produces less than the socially

efficient quantity of output AND Charges a price that is greater than socially

efficient MC.

PUBLIC POLICY TOWARD MONOPOLIES Government responds to the problem of

monopoly in one of four ways. Making monopolized industries more competitive. Regulating the behavior of monopolies: control

price. Turning some private monopolies into public

enterprises. Doing nothing at all.

Increasing Competition with Antitrust Laws Antitrust laws aim to decrease monopoly power. Antitrust laws give government various ways to

increase competition. If necessary, They allow government to prevent mergers. They allow government to break up companies. They prevent companies from performing activities that

make markets less competitive: Predatory pricing. Large firm prevents other firms from

entering the market by setting a very low price. Collusion: firms get together and arrange prices and share the

market. Ex: OPEC, intercity travel companies.

Regulation

Government may regulate the prices that the monopoly charges. The allocation of resources will be efficient if price

is set to equal marginal cost.

Figure 9 Marginal-Cost Pricing for a Natural Monopoly

Copyright © 2004 South-Western

Loss

Quantity0

Price

Demand

Average total cost

Regulatedprice Marginal cost

Average totalcost

Govt. Policy Against Monopoly

In practice, regulators allow monopolists to make some positive profits by allowing price>MC. This is because if price is forced to be equal to MC in a natural monopoly, profit is always negative and the firm cannot survive.

Ex: research & development, new ideas. Price of Stata is $500 but MC is only $20, but initial research effort is $1million.

Public Ownership

Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself (Ex: in the US and in Turkey, government runs the Postal Service. In Turkey, government runs the distribution of natural gas).

PRICE DISCRIMINATION

Price discrimination is the business 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.

PRICE DISCRIMINATION Price discrimination is not possible when a good is

sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power.

Perfect Price Discrimination Perfect price discrimination takes place when the

monopolist knows exactly the marginal benefit (willingness to pay) of each customer and can charge each buyer a different price equal to that buyer’s willingness to pay.

PRICE DISCRIMINATION

Three important effects of price discrimination: Show on graph: It increases the monopolist’s producer surplus. It decreases consumer surplus. It decreases deadweight loss, therefore increases

total surplus of the society.

PRICE DISCRIMINATION

Examples of Price Discrimination Movie tickets Airline prices Discount coupons New publications: novels, films, etc. Financial aid Quantity discounts

CONCLUSION: THE PREVALENCE OF MONOPOLY How prevalent are the problems of

monopolies? Monopolies are common. Most firms have some control over their prices

because of differentiated products. Firms with substantial monopoly power are rare. Few goods are truly unique. There are usually

substitutes, but they may be poor substitutes. Ex: natural gas. Substitute?