The Monopoly Market power Monopoly equilibrium Welfare aspects.

The Monopoly

Market powerMonopoly equilibrium

Welfare aspects

The Monopoly

As we concluded last week, perfect competition is not really a realistic outcome It is an ideal situation which serves as a

benchmark for evaluating competition So “real-life” competition suffers from

imperfection But how can be characterise “imperfectness”?

1st step is to define the opposite benchmark The most imperfect form of competition

imaginable: the Monopoly

The Monopoly

Market power

The market equilibrium under a monopoly

Welfare aspects of the monopoly

The monopsony

The 5 conditions of perfect competition

Reminder: Perfect competition is defined by the following 5 conditions:

1. Large number of agents (Atomicity) 2. Homogeneous products3. Free entry and exit from the market4. Perfect information5. Perfect mobility of inputs

All 5 are required for perfect competition to occur

Market power

Reminder: When one of these 5 assumptions fails to hold, the market is in an imperfectly competitive situation.

Two main consequences for firms:1: Their production decisions influence

the market price of their products

2: Their profits can depend on how competitors react to these decisions

Market power

1st consequence: Their production decisions influence the market price of their products Firms are big enough to start influencing the

price of the market when they change their level of production

This is market power This does not occur under perfect competition

because of the atomicity assumption It is of course maximal for in the monopoly

Market power

2nd consequence: Their profits can depend on how competitors react to these decisions Because a change in the production decision of

a firm will change the price, competitors will probably react. The firm will have to take this into account.

This is known as strategic behaviour, and is a central focus of game theory.

Not really relevant for monopolies. There are no competitors !!

This 2nd aspect will be covered in the next 2 weeks

Market power

Market power of firms

Perfect competition

Many firms with a homogeneous product

Oligopoly

A few producers with high market power

Monopoly

A single producer

Monopolistic competition

Many firms with differentiated products

The “competition continuum”

Market power

Market power refers to the ability of a firm (a monopoly here) to influence the price

How can one measure this power ? In perfect competition we have p =mC One could expect a firm with market power to

try and push the price above the marginal cost so that p >mC

This divergence is known as a mark-up and can be measured,

This gives us our measure of market power.

Market power

Profit of the firm:

The profit maximisation condition finds output q such that :

This is valid for any firm, with or without market power

But what it mR equal to when a firm has market power?

TR TC

mR mC

Market power

Total revenue is simply equal to the quantity sold times the price at which the output is sold:

The derivative of total revenue is the sum of: The extra quantity produced ∂q times the price The effect of the increase on the market price

This 2nd effect is equal to zero in perfect competition, but not when a firm has market power...

TR p q p q

TR p q

Market power

Dividing through by ∂q gives marginal revenue

The income generated by an extra unit of output is equal to the price minus the negative impact of the extra output on prices

Factorising price:

TR p q p q

TR pmR p q

q q

1p q

mR pq p

Market power

11 1

Dp

p qmR p p

q p

One can see that the “complicated” term inside the brackets is the inverse of the price elasticity of demand:

The term in brackets is our mark-up. This is also sometimes called the Lerner index, and is the measure of market power

The profit maximising condition mR = mC can be written as:

1 1

Dp

mR mC p mC

Market power

Price

Quantity

Demand

mR

Graphical construction of mRDp

1Dp

0Dp

The slope of the mR curve is twice that of the demand curve

11

Dp

mR p

The Monopoly

Market power

The market equilibrium under a monopoly

Welfare aspects of the monopoly

The monopsony

The market equilibrium under a monopoly

The monopoly is an extreme case. It corresponds to the following market structure :

1. A single producer2. Homogeneous products3. No entry of competing producers on the

market4. Perfect information5. Perfect mobility of inputs

The market equilibrium under a monopoly

mC

AC

Price Price

S

D

Reminder: Perfect competition equilibrium

Firm level Market level

Quantityquantity

d=mRp

q Q

D2

Q2

p2

q2

d2=mR2

Total Cost

p q TC

Positive profits in SR

The market equilibrium under a monopoly

Price

Quantity

mC AC

Demand

mR

q

p

Monopoly equilibrium

1st

2nd 1st : mC=mR gives q

2nd : given q, the demand curve gives p

The market equilibrium under a monopoly

pq = TR

ACq = TC

Price

Quantity

mC AC

Demand

mR

q

p

RT CT

The Monopoly

Market power

The market equilibrium under a monopoly

Welfare aspects of the monopoly

The monopsony

Welfare aspects of the monopoly

Unsurprisingly, the monopoly is inefficient compared to perfect competition:

Positive economic profit in the LRP ≠ mC: there is a mark-up on marginal

costNot producing at minimal AC

Welfare aspects of the monopoly

mC

AC

Price

Monopoly equilibrium

Quantity

mR

p

q

Demand

1st element p ≠ mC This is due to the

existence of market power

The monopoly can push prices above the perfect competition outcome

Prices are a mark-up over marginal cost

mC

Welfare aspects of the monopoly

mC

AC

Price

Quantity

mR

p

q

Demand

p q TC

2nd element The monopoly

makes positive economic products in the LR

This is due to the existence of barriers to entry

Competitors cannot enter to compete away the profit

Monopoly equilibrium

Welfare aspects of the monopoly

mC

AC

Price

Quantity

mR

p

q

Demand

3rd element The monopoly does

not produce at the minimum point of the AC curve

Some IRS opportunities are not used up

This market does not produce at the most cost-efficient point

Monopoly equilibrium

min AC

AC

Welfare aspects of the monopoly

There are therefore different sources of inefficiency in the monopolyThe existence of market powerThe existence of barriers to entry

How can we measure the overall inefficiency of the monopoly compared to perfect competition ??We use the surplus as a measure of

welfare

Welfare aspects of the monopoly

Consumer surplus

Producersurplus

Deadweight loss

Price

Quantity

mC AC

Demand

mR

q

p

Welfare aspects of the monopoly

This is why competition policy often regulates existing monopolies and attempts to prevent the emergence of new ones

Examples : US Antitrust legislation Sherman Act (1890) Clayton

Act (1914) 1911: John Rockefeller's Standard Oil is split US 1934 Airmail Act splits United Aircraft and

Transport Corporation into Boeing, United Aircraft (Pratt Whitney, Sikorsky) and United Airlines.

EU vs. Microsoft on Internet Explorer (aka “the browser wars”)

Welfare aspects of the monopoly

There are different ways of regulating a monopoly, based on the different inefficiencies

The typical instrument is the price ceiling Regulate at p = AC

Pro: Zero-profits. The average cost is known Con: not the most efficient regulation (deadweight

loss) Regulate at p = mC

Pro: Most efficient regulation (no deadweight loss) Con: Some positive profits remain. Difficult to

calculate the marginal cost !!

Welfare aspects of the monopoly

Consumer surplus

Producersurplus

Deadweight loss

Price

Quantity

mC AC

Demand

mR

q2

p2

q

p Regulate at p= mC

Welfare aspects of the monopoly

Consumer surplus

Producersurplus

Deadweight loss

Price

Quantity

mC AC

Demand

mR

q2

p2

q

p Regulate at p= AC

Welfare aspects of the monopoly

“Schumpeterian” argument: Monopoly profits are a reward for a risky

investment decision by an entrepreneur If these potential rewards are denied (through

a tough competition policy), no entrepreneur will be willing to take risks.

Therefore, monopoly regulation has a negative effect on innovation

See the Patent argument (Varian, chap 24)

The Monopoly

Market power

The market equilibrium under a monopoly

Welfare aspects of the monopoly

The monopsony

The monopsony

Opposite situation to the monopolyA single buyer instead of a single

producer

Similar aspects in terms of market power and welfareThe buyer’s market power pushes the

price below the marginal costThere is a deadweight loss ⇒ inefficient

structure

The monopsony

The monopsony corresponds to the following market structure, similar to the monopoly case :

1. A single buyer2. Homogeneous products3. No entry of competing buyers on the

market4. Perfect information5. Perfect mobility of inputs

The monopsony

Price

Quantity

mC Supply

Marginal Product

q

p

Monopsony equilibrium

1st

2nd

1st : mC=mP gives q

2nd : given q, the supply curve gives p

mC

The monopsony

How likely is this market structure ? Actually important for some agricultural

products Coffee, cocoa, bananas, etc...

Another situation can be the labour market There are many more suppliers of labour

(individual workers) than buyers (firms) Firms will have monopsony power on the labour

market. This will distort the market outcome ! We shall examine this again when we talk about

the labour market (week 14)