Chapter24 puremonopoly

CHAPTER 24

PURE MONOPOLY

PURE MONOPOLY

Pure Monopoly: Exists when a single firm is the sole producer of a product for which there are no close substitutes.

There are a number of products where the producers have substantial amount of monopoly power, and they are called “near” monopolies.

CHARACTERISTICS OF PURE MONOPOLY

1. There is a single seller so that firm and industry are synonymous.

2. There are no close substitutes for the firm’s product.

3. The firm is a “price maker” (it has considerable control over the price because it can control the quantity supplied.

CHARACTERISTICS OF PURE MONOPOLY

4. Entry into the industry by other firms is blocked.

5. A monopolist may or may not engage in non-price competition. Depending on the nature of its product, a monopolist may advertise to increase demand.

EXAMPLES OF MONOPOLIES AND “NEAR” MONOPOLIES

1. Public utilities – gas, electric, water, cable TV, and telephone companies – are pure monopolies.

2. Western Union, Frisbees, and DeBeers diamond syndicate are examples of “near” monopolies.

3. Professional sports leagues grant team monopolies to cities.

EXAMPLES OF MONOPOLIES AND “NEAR” MONOPOLIES

4. Manufacturing monopolies are virtually non-existent in the U.S. manufacturing industries.

5. Monopolies may be geographic. If a town is small, it may have only one bank, airline, etc.

USING THE MONOPOLY MODEL

As with pure competition, analysis of monopolies helps us understand monopolistic competition and oligopoly, the more common types of market situations.

BARRIERS TO ENTRY

1. Economies of Scale

2. Legal barriers

3. Ownership or control of essential resources

4. Pricing, selective price-cutting, and advertising.

ECONOMIES OF SCALE

Economies of scale are one major barrier. This occurs where the lowest unit costs, and therefore, the lowest unit prices for consumers, depend on the existence of a small number of large firms, or in the case of a monopoly, only one firm. Because a large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale.

ECONOMIES OF SCALE

1. Public utilities are know as natural monopolies because they have economies of scale in the extreme case where one firm is most efficient in satisfying existent demand.

2. Government usually gives one firm the right to operate a public utility industry in exchange for government regulation of its power.

ECONOMIES OF SCALE

3. The explanation of why more than one firm would be inefficient involves the description of the maze of wires or pipes that would result if there were competition among water companies, electricity utility companies, etc.

LEGAL BARRIERS Legal barriers to entry into a monopolist industry

also exist in the form of patents or licenses.

1. Patents grant the inventor the exclusive right to produce or license a product for 20 years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits.

2. Licenses are another form of barrier. Radio and TV stations, taxi companies are examples of government granting a set number of licenses to allow only a set number of firms to offer the service.

OWNERSHIP OF RESOURCES

Ownership or control of essential resources is another barrier to entry.

1. A monopoly may control mineral reserves, such as nickel or diamonds.

2. Alcoa once controlled all basic resources of bauxite, the ore used to produce aluminum.

3. Professional sports leagues control player contracts and leases on city stadiums.

PRICING

Monopolists may use pricing or other strategic barriers, such as selective price-cutting and adverstising.

3 ASSUMPTIONS OF MONOPOLY DEMAND

3 assumptions in monopoly demand:

1. The monopoly is secured by patents, economies of scale, or resource ownership.

2. The firm is not regulated by any unit of government.

3. The price will exceed marginal revenue.

WHY DOES PRICE EXCEED MARGINAL REVENUE?

The price exceeds marginal revenue because the monopolist must lower the price to sell the additional unit. The added revenue will be the price of the last unit minus the sum of the price cuts which must be taken on all prior units of output.

The marginal-revenue curve is below the demand curve, and when it becomes negative, the total-revenue curve turns downward as total-revenue falls.

MONOPOLIST IS A PRICE MAKER

The monopolist is a price maker. The firm controls output and price but is

not free of market forces, since the combination of output and price that can be sold depends on demand.

MONOPOLY DEMAND AND ELASTICITY

Price elasticity also plays a role in monopoly price setting.

The total revenue test shows that the monopolists will avoid the inelastic segment of its demand schedule. As long as demand is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true when demand becomes inelastic.

Therefore, the monopolist will expand output only in the elastic portion of its demand curve.

MONOPOLY DEMAND AND ELASTICITY

At the point when demand becomes inelastic, total revenue falls as output expands, and since total costs rise with output, profits will decline as demand becomes inelastic.

Therefore, the monopolist will expand output only in the elastic portion of its demand curve.

OUTPUT AND PRICE DETERMINATION

Cost data is based on hiring resources in competitive markets.

The MR = MC rule will tell the monopolist where to find its profit-maximizing output level. The same outcome can be determined by comparing total revenue and total costs incurred at each level of production.

OUTPUT AND PRICE DETERMINATION

The pure monopolist has no supply curve because there is no unique relationship between price and quantity supplied. The price and quantity supplied will always depend on location of the demand curve.

MISCONCEPTIONS ABOUT MONOPOLY PRICES

1. Monopolists cannot charge the highest price it can get, because it will maximize profits where total revenue minus total cost is the greatest. This depends on quantity sold as well as on price and will never be the highest price possible.

MISCONCEPTIONS ABOUT MONOPOLY PRICES

2. Total, not units, profits is the goal of the monopolist. Quantity must be considered as well as unit profit.

3. Unlike the purely competitive firm, the pure monopolist can continue to receive economic profits in the long run. Although losses can occur in a pure monopoly in the short run (PATC), the less-than-profitable monopolist will shut down in the long run.

ECONOMIC EFFECTS OF A MONOPOLY

2. Monopoly price will exceed marginal cost, because it exceeds marginal revenue and the monopolist produces where marginal revenue and marginal cost are equal. The monopolist charges the price that consumers will pay for that output level.


3. Allocative efficiency is not achieved because price (what the product is worth to consumers) is above marginal cost (opportunity cost of the product). Ideally, output should expand to a level where price = marginal revenue = marginal cost, but this will occur only under pure competitive conditions where price = marginal revenue.


4. Productive efficiency is not achieved because the monopolist’s output is less than the output at which average total cost is minimum.


Income distribution is more unequal than it would be under a more competitive situation. The effect of the monopoly power is to transfer income from the consumers to the business owners.

This will result in a redistribution of income in favor of higher-income business owners, unless the buyers of monopoly products are wealthier than the monopoly owners.

COST IMPLICATIONS

1. Economies of scale may result in one or two firms operating in an industry experiencing lower ATC than many competitive firms. These economies of scale may be the result of spreading large initial capital cost over a large number of units of output (natural monopoly) or spreading product development costs over units of output, and a greater specialization of inputs.

COST IMPLICATIONS

2. X-inefficiency may occur in monopoly since there is no competitive pressure to produce at the minimum possible costs.

3. Rent-seeking behavior often occurs as monopolies seek to acquire or maintain government-granted monopoly privileges. Such rent-seeking may entail substantial costs (lobbying, legal fees, public relations advertising, etc.) which are inefficient.

TECHNOLOGICAL PROGRESS AND DYNAMIC EFFICIENCY

Technological progress and dynamic efficiency may occur in some monopolistic industries but not in others.

1. Some monopolies have shown little interest in technological progress.

2. On the other hand, research can lead to lower unit costs, which help monopolies as much as any other type of firm. Also, research can help the monopoly maintain its barriers to entry against new firms.

ASSESSMENT AND POLICY OPTIONS

1. Although there are legitimate concerns of the effects of monopoly power on the economy, monopoly power is not widespread. While research and technology may strengthen monopoly power, over time it is likely to destroy monopoly position.

2. When monopoly power is resulting in an adverse effect on the economy, the government may choose to intervene on a case-by-case basis.

PRICE DISCRIMINATION Conditions needed for a successful price

discrimination:

1. Monopoly power is needed with the ability to control output and price.

2. The firm must have the ability to segregate the market, to divide buyers into separate classes that have a different willingness or ability to pay for the product (usually based on elasticities of demand)

3. Buyers must be unable to resell the original product or service.

EXAMPLES OF PRICE DISCRIMINATION

1. Airlines charge high fares to executive travelers (inelastic demand) then vacation travelers (elastic demand).

2. Electric utilities frequently segment their markets by end uses, such as lighting and heating (lack of substitutes for lighting makes this demand inelastic).


3. Long-distance phone service has higher rates during the day, when businesses must make their calls (inelastic demand) and lower rates at night and on weekends, when less important calls are made (elastic demand).

4. Movie theaters and golf courses vary their charges on the basis of time and age.


5. Discount coupons are a form of price discrimination, allowing firms to offer a discount to price-sensitive customers.

6. International trade has examples of firms selling at different prices to customers in different countries.

CONSEQUENCES OF PRICE DISCRIMINATION

1. More profits can be earned by the seller, since the price charged is what each buyer is willing to pay in perfect discrimination. The marginal revenue will be equal to price in the perfect discrimination.

CONSEQUENCES OF PRICE DISCRIMINATION

2. More production will occur with discrimination because as output expands, the reduced price applies to the additional unit sold and not to prior units. Marginal revenue can now be equated to marginal cost to find the profit-maximizing level of output, and price of the last unit sold will equal that marginal revenue.

REGULATED MONOPOLY

This occurs where a natural monopoly or economies of scale makes one firm desirable.

As a result of changes in technology and deregulation in some utility providers industry, some states are allowing new entrants to compete in previously regulated markets.

REGULATED MONOPOLY

A regulatory commission may attempt to establish the legal price for the monopolist that is equal to marginal cost at the quantity of output chosen. This is called the “socially optimal price”.

REGULATED MONOPOLY

However, setting price to equal marginal cost may cause losses, because public utilities must invest in enough fixed plant to handle peak loads. Much of this fixed plant goes unused most of the time, and a P=MC would be below ATC. Regulators often choose a P=AC rather than MC, so that the monopoly firm can achieve a “fair return” (normal profit) and avoid losses.

REGULATED MONOPOLY

The dilemma for regulators is whether to choose a socially optimal price, where P=MC, or a fair return price, where P=AC. P=MC may be more efficient, but may result in losses for the monopoly firm, and government would then have to subsidize the firm for it to survive. P=AC does not achieve allocative efficiency, but it does insure a fair return (normal profit) for the firm.

LAST WORD: De Beers’ Diamonds: Are Monopolies

Forever? De Beers Consolidated Mines of South

Africa has been one of the world’s strongest and most enduring monopolies. It produces about 50% of all rough-cut diamonds in the world and buys for resale many of the diamonds produced elsewhere, for a total of about 80% of the world’s diamonds.


Forever? Its behavior and results fit the monopoly

model. It sells a limited quantity of diamonds that yield an “appropriate” monopoly price.

The “appropriate” price is well over production costs and has earned substantial economic profits.


Forever? How has De Beers controlled the production of

mines it doesn’t own?

1. It convinces producers that “single channel” monopoly marketing is in their best interests.

2. Mines that don’t use De Beers may find the market flooded from De Beers stockpiles of the particular kind of diamond they produce, which causes price declines and loss of profits.

3. Finally, De Beers purchases and stockpiles diamonds produced by independents.


Forever? Threats and problems face De Beers

monopoly power.

1. New diamond discoveries have resulted in more diamonds outside their control.

2. Russia, which has been a part of De Beers’ monopoly, has been allowed to sell a part of its stock directly into the world market.


Forever? In mid 2000, De Beers abandoned its

attempt to control the supply of diamonds.

The company is transforming itself into a company that sells “premium” diamonds and luxury goods, under the De Beers label.

De Beers plans to reduce its stockpile of diamonds and increase the demand for diamonds through advertising.

Chapter24 puremonopoly

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