CHAPTER 2 MONOPOLY

17/08/11 Public Economics - Hoang Phu LY - FTU 11 Barriers to Entry  The reason a monopoly exists is that other firms find it unprofitable or impossible to enter the market  Barriers t

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17/08/11 Public Economics - Hoang Phu LY - FTU 1

PART I

GOVERNMENT AND

ECONOMIC EFFICIENCY

MARKET FAILURE

CHAPTER 1

MONOPOLY: A MARKET

FAILURE

Introduction

Free Market Competitive

Forces

Market Efficiency

Market

Failure Regulation

Regulation Equitable

Distribution

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 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

Introduction

Monopoly

1 Definition of monopoly

While a competitive firm is a price taker ,

a monopoly firm is a price maker

1 Definition

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Monopoly

 A firm is considered a monopolist if

 it is the sole seller of its product.

 its product does not have close substitutes.

 Monopoly power occurs when the seller of a

product can influence prices

 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

 A single buyer is a monopsonist

Monopoly

2 Causes of monopoly

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Why Monopoly??

The fundamental cause of monopoly is

barriers to entry

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

 technical barriers

 legal barriers

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

 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

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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

Legal Barriers to Entry

 Many pure monopolies are created as a

matter of law

 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

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

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Economies of Scale as a Cause of Monopoly

Average total cost Quantity of Output

Cost

0

Monopoly

3 Recap about monopoly

a, Monopoly versus Competition

Monopoly

 Is the sole producer

 Has a

downward-sloping demand

curve

 Is a price maker

 Reduces price to

increase sales

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

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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

b, A Monopoly’s Revenue

 Total Revenue

P x Q = TR

 Average Revenue

TR/Q = AR = P

 Marginal Revenue

 TR/  Q = MR

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

previously sold units also decreases.

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A Monopoly’s Total, Average, and

Marginal Revenue

Quantity

(Q)

Price

(P)

Total Revenue (TR=PxQ)

Average Revenue (AR=TR/Q)

Marginal Revenue

0 $11.00 $0.00

1 $10.00 $10.00 $10.00 $10.00

2 $9.00 $18.00 $9.00 $8.00

3 $8.00 $24.00 $8.00 $6.00

4 $7.00 $28.00 $7.00 $4.00

5 $6.00 $30.00 $6.00 $2.00

6 $5.00 $30.00 $5.00 $0.00

7 $4.00 $28.00 $4.00 -$2.00

8 $3.00 $24.00 $3.00 -$4.00

Q

TR 

 /

Demand and Marginal Revenue Curves for

a Monopoly

Quantity of Water

Price

$11

10

9

8

7

6

5

4

3

2

1

0

-1

-2

-3

-4

Marginal

revenue

Demand (average revenue)

Profit-Maximization for a Monopoly

Monopoly

price

Costs and

Revenue

Demand Average total cost

Marginal revenue

Marginal

cost

A

1 The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity

B

2 .and then the demand curve shows the price consistent with this quantity.

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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

The Monopolist’s Profit

The monopolist will receive economic

profits as long as price is greater than

average total cost.

M

on

op

oly

pro

fit

The Monopolist’s Profit

Costs and

Revenue

Demand Marginal cost

Marginal revenue

B Monopoly

price

E

Average

total cost D

Average total cost

C

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Monopoly = market failure

4 Deadweight welfare loss under

monopoly

MC1

Q1

MC

MR AR

A monopolist producing less than the

social optimum

O

P1

£

Monopoly output

Q

O

P1

MC1

MC = MSC

Q

P2= MSB

= MSC

£

Q

A monopolist producing less than the

social optimum

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O

£

Q

P pc

Q pc

AR = D

Consumer

surplus

Producer

surplus

Deadweight loss under

(= S under perfect competition)

(a) Industry equilibrium under perfect competition

a

MR

O

£

Q

Ppc

Qpc

AR = D

a

Pm Consumer surplus b

Producer

surplus

Deadweight welfare loss

Deadweight loss under

monopoly (= S under perfect competition) MC

(b) Industry equilibrium under monopoly

O

£

Q

P pc

Q

AR = D

Consumer

surplus

Producer

surplus

Deadweight loss under monopoly

MC

a

Perfect

competition

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MR

O

£

Q

Ppc

Qpc

AR = D

a

Pm Consumer surplus b

Producer

surplus

Deadweight welfare loss

MC

(b) Industry equilibrium under monopoly

Monopoly

Deadweight loss under monopoly

Monopoly

5 Public Policy Toward Monopolies

5.1 Public Policy Toward Monopoly

Government responds to the problem of

monopoly in one of four ways.

 Making monopolized industries more competitive.

 Regulating the behavior of monopolists.

 Turning some private monopolies into public

enterprises.

 Doing nothing at all.

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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?

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

5.2 Regulation of a Natural Monopoly

 Natural monopolies such as the utility,

communications, and transportation

industries are highly regulated in many

countries

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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

Regulation of a Natural Monopoly

Quantity Price

D MR

AC MC

Because natural monopolies exhibit

decreasing costs, MC falls below AC

C1

P1

Q1

An unregulated monopoly will

maximize profit at Q 1 and P 1

C2

P2

Q2

If regulators force the monopoly to charge a

price of P 2 , the firm will suffer a loss because

P 2 < C 2

a, Marginal-Cost Pricing for a Natural

Monopoly

Regulated

price

Loss

Price

Demand Marginal cost Average total cost

Average

total cost

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Q1

b, Pricing for a Natural Monopoly as AC

Quantity

0

Price

Demand Marginal cost Average total cost

Average

total cost

MR

Q2 Q0

Price as AC

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 do this, the firm

must have market power.

Price Discrimination

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.

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cover the losses on the sales to low-price customers

The profits on the sales to high-price customers are enough to Regulation of Monopoly

Quantity Price

D

AC MC

Suppose that the regulatory commission allows the

monopoly to charge a price of P 1 to some users

P1

Q1

C1

Other users are offered the lower price

of P 2

P2

Q2

C2

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

 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

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

 Breakfast cereal: collusion implies Lerner of 65-75%

 Competition implies Lerner of 40-44%

 Actual index about 45%, implying no collusion

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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

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

Monopsony

 Labor demand is given by

the marginal revenue of

labor (MRL)

 The competitive wage is w c

 The marginal cost for the

monopsonist is w plus

additional payment to

existing workers

 Monopsony wage is w m

Wage

Quantity

of Labor

Labor Supply

w(L)

Marginal Cost

Labor Demand

MRL c

L m L

m w

c w

Monopsony in the labor market

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Next CHAPTER…

 EXTERNALITIES

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