Three Questions

1
Three Questions

• What is wrong with monopoly
• Does monopoly result in an inefficient outcome
• And why
• Why does monopoly exist
• State monopoly
• Natural monopoly
• Artificial monopoly
• cartel
• What to do about it?
• May depend on why it exists and what the
  alternatives are
• And on the explanation for behavior such as
• Tie-in sales
• Vertical integration
• Resale price maintainance

2
Whats Wrong with Monopoly?

• Why do property and trade lead to efficient
  outcomes?
• You use something if and only if its value to you
  is greater than its cost to you
• The price you pay is the cost of producing it
• So you use things if their value to you is
  greater than the cost to the producer, and
  similarly
• Greater than the value to anyone else, since you
  were willing to pay a higher price than anyone
  who didnt get it
• Similarly for inputs least cost production in
  money is also least cost in human values
• Why does price correspond to cost?
• If it costs me 10 to produce one more widget
• And they sell for 11
• It is in my interest to produce more
• And the process continues until price driven
  down, or cost up, so they are equal

3
Suppose there is only one producer

• I can produce as many widgets as I want at
  10/widget
• Currently, I sell 1000 widgets/year _at_12/w
• Revenue 12,000, cost 10,000
• Profit 2,000
• I could sell 1100 _at_11/widget
• Revenue 12,100. Cost 11,000
• Profit 1,100
• Or 1200 _at_10/widget. Profit?
• The argument for pricecost
• Assumed I can sell more without driving down the
  price
• A reasonable assumption if there are many firms
• But not if there is only one
• So a monopoly will sell at pricegtmarginal cost

4
What is Wrong with Monopoly

• PricegtMC means that
• A consumer who values the good at gtMC
• But ltP doesnt get it
• Although producing it for him produces a net gain
  in efficiency
• Since value to him is more than cost to produce
• Also a rent seeking problem
• If there is only room for one firm
• And the first firm gets the monopoly
• There is an incentive to enter inefficiently
  early
• So as to make sure your firm gets the monopoly
• Just like the homesteading problem discussed
  earlier

5
The second efficiency conditon

• One requirement for efficiency is
• That everyone who values the good at at least its
  cost gets it
• And PMC produces that result
• The other is that the product only be produced if
  the total valuegttotal cost
• Consider a computer program
• MC1.00 (to copy a CD, package it)
• Fixed cost of writing the program10,000,000
• If you sell it at MC, 10,000 are sold
• And you somehow know that at 10 none would be
  sold
• Benefit to consumer is from 0-9
• Total benefit from 0-90,000
• It wasnt worth writing the program
• How do we arrange to satisfy both conditions?

6
Why is Monopoly?

• State Monopoly
• Natural Monopoly
• Cartel
• Artificial Monopoly

7
State Monopoly

• The original meaning of the word
• Illegal for others to compete
• Salt monopoly, say, used to raise revenue
• Modern versions include
• Government monopoly Post Office
• Regulated industries Several firms but
• New firms not free to join
• Existing firms not free to compete on price and
  service
• More nearly a cartel (see shortly) than a
  monopoly
• Examples
• Airlines before deregulation
• Trucking
• Barbers where the city licenses them
• Taxicabs

8
Natural Monopoly

• Due to economies of scale and the size of the
  market
• The more you produce the more cheaply you can
  produce?
• Sometimes, for some range of output
• Your design costs get spread over more units, but
  
• More layers of control between the president and
  the factory floor
• So cost falls and then eventually rises again
• Natural monopoly if a firm big enough to produce
  for the entire market has lower costs than any
  smaller firm
• That might be a big firm in an industry with a
  lot of economies of scale
• Or a small firm in a very small market
• Geographically small General store in small town
• Niche market Me as a public speaker
• In either case, the economic analysis of monopoly
  applies.

9
Cartel

• Suppose economies of scale are not quite big
  enough
• Big firms beat small firms
• But there is room for several big firms
• And ones even bigger dont beat them
• The firms make a deal
• Ill keep price up, quantity down, if you do
• Multiple firms functioning like a monopoly
• What problems arise for the cartel?

10
Problems for a cartel

• Problem 1
• It is in each firms interest to cheat on the
  deal
• Sell a little more at the high price
• Solutions
• An enforceable contract--not legal in the U.S.
• Government regulators controlling output and
  price
• Watch each other very carefully
• A legal substitute for an enforceable
  contract--such as
• Problem 2 Preventing entry of new firms
• Problem 3 The smallest members have the most
  power
• If the Saudis increase output, the cartel breaks
• If Venezuela does, will anyone believe Saudi
  threats to do the same?
• So the biggest members have to bear most of the
  cost of holding down output

11
Artificial Monopoly

• Suppose I have a very big firm
• I am not a natural monopoly--my costs are not
  lower. But
• Since I have more money than the small firms
• I can sell below cost to drive them out
• And become a monopoly

What is wrong with this story?

• Suppose I am ten times as big and as rich
• Selling below cost I lose money ten times as fast
• Probably faster--I have to sell as much as people
  want to buy at the low price
• My competitors dont.
• Who goes broke first?
• And if I somehow outlast the competitor
• What keeps him from selling out his plant to a
  new competitor
• At a point when I am almost out of money?

12
What can be done about monopoly?

• By the government
• Regulate? How
• Government ownership (Post Office)
• General legal rules
• Such as not enforcing cartel agreements
• Or not permitting merger to monopoly
• By the monopoly
• Consumers with Pgtvaluegtcost
• Are not only a problem for efficiency
• They are lost revenue for the monopoly
• Price discrimination might solve that
• Find a way of selling at a high price to those
  willing to pay it
• But at a lower price to those who arent
• Discriminate both among customers and among units
  bought by a single customer

13
Regulation

• Order the monopoly to sell at marginal cost?
• How does the government know what MC is?
• There are fixed costs as well if the firm cannot
  cover them it goes broke
• If the government offers to subsidize them, how
  does it make the monopoly minimize its costs?
• Or know if the firm and product should exist?
• If government is willing to subsidize the fixed
  cost
• The firm covers its cost even if the good is not
  worth producing
• So how do we take care of the second efficiency
  condition?
• Order it to sell at average cost?
• Standard utility rate regulation
• Price is still inefficiently high, and
• Either regulator has to know what AC should be
• Or observes costs, lets firm set price to cover
  them
• So why should the firm hold costs down?
• At least, firm will not exist if total
  valuelttotal cost (why?)
• But might not exist even though total valuegttotal
  cost (why?)
• And if the regulator could produce efficiency,
  why would he?
• We can predict that the firm will try to maximize
  its profit
• What makes it in the interest of the regulator to
  maximize efficiency?

14
Government Ownership

• With the best of intentions
• How does the firm get the information to know
• If its existence satisfies the second condition?
• It sets PMC, makes up fixed cost from taxes
• It observes how many consumers valuegtMC
• But not by how much more
• So doesnt know if the taxes are buying a benefit
  worth the cost
• Why should it have the best of intentions?
• Post office jobs can reward political supporters
• Contracts can be sold for campaign donations
• How do we make it in the interest of a government
  run firm to try to maximize economic efficiency?
• Or shut it down if it isnt worth running?

15
Problem with Both

• Consider a private natural monopoly
• As things change, it may cease to be a natural
  monopoly
• And lose market share to new competitors
• Suppose it is a regulated monopoly?
• It may be able to get the regulators
• To keep out the competitors
• Airlines, Railroads, Trucks
• Suppose it is a government run monopoly?
• Likely to be a monopoly in the old sense too
• The people running it believe in what they are
  doing
• Post Office

16
Preventing Cartels

• Not enforcing cartel agreements
• Indeed, trying to punish them
• If detected
• Firms might merge--perhaps lose some efficiency
  but solve the cartel problem
• So restrictions on merger to monopoly
• But what about mergers for efficiency?
• One elegant but impractical solution is

• Ask other firms if they approve of the merger
• If they do, forbid it
• If they dont, approve it
• Because?

17
Price Discrimination

• Ideally, a monopoly wants to
• Sell every unit for which valuegtMC
• At the highest price the customer will pay
• One approach is to separate markets
• Sell book for a high price in U.S., low in U.K.
• Offer cheap standby tickets only to youths
• Sell hardcovers for more than paperbacks
• By substantially more than the cost difference
• The real fans will want the higher quality
• And the earlier publication
• Baen's pricing of Electronic Advance Review
  Copies of SF
• Another is different prices for one customer
• Customer values tenth cookie less than the first
• So 1/cookie up to five, .50/cookie beyond that
• Suppose cost is all fixed (Disneyland rides at
  below capacity)
• Charge an entry fee, make rides free
• PMC0, entry fee up to total value to customer
• If done perfectly, this meets both efficiency
  conditions

18
Problems

• For the seller
• Seller must know enough to charge the right
  prices, and
• Be able to prevent resale
• I buy 100 cookies, sell five each to 20 people
  for .80/cookie
• Harder to do the equivalent for the Disney ride!
• So price discrimination is easier for services
  consumed on the spot
• For the economist
• How do we distinguish price discrimination from
• Different prices due to different costs
• Coming from non-obvious causes
• For example
• Cheaper airline fares for standby, or
  non-refundable early purchases, or
• Gasoline price differences for unleaded
• Based not on wholesale cost for the gasoline, but
  
• On larger tanks in older vehicles using leaded
  gasoline
• Meaning lower transaction cost/gallon for the
  seller
• Any joint cost problem
• Consider the economics of mining ore, producing
  silver and gold, or
• Flying a plane to Miami at the beginning of
  spring break, vs flying it back

19
Why is Price Discrimination Interesting?

• It provides a possible solution to the problem of
  efficient outcomes
• Can be used to get closer to everyone buys it
  who values it at its cost
• But whether PD increases efficiency turns out to
  be ambiguous
• How does it increase efficiency?
• How might it decrease efficiency?
• Perfect PD solves that problem, imperfect could
  make it worse
• And PD increases the rent seeking problem (why?)
• It provides a possible explanation for why firms
  do things
• Consider tie-in sales
• If you buy our printer, you must use our paper
• (IBM card sorter and IBM cards in a later case)
• Such terms have been found illegal under
  antitrust
• Before deciding if they should be illegal, first
  question is
• Why does the firm want to do it?

20
Why Tie-in Sales?

• Old theory Leverage your monopoly
• IBM makes the only (?) card sorters
• Use that monopoly to get a monopoly on cards
• Problem
• Purchaser needs sorter and cards what matters to
  him is the total cost
• So the more IBM charges for cards
• The less they will be able to get for the sorter
• IBM should let card producers compete down price
  to MC
• And collect the whole profit off a single
  monopoly
• How does the price they can sell the sorter on
  depend on the cost of cards?
• Consumer surplus shows the value to a consumer of
  being able to buy a good at a price
• For instance cards to be sorted
• So anything that increases consumer surplus to
  the customers
• Increases by the same amount what they will pay
  for the sorter

21
Why IBM Should Sell Cards at Cost

• IBM Gets
• Net Revenue from cards
• (P-MC)Q
• Consumer Surplus
• (In price of sorters)
• The sum is maximized
• At PMC
• No net from cards
• All in higher price of sorters
• It doesn't have to make cards
• Just let customers buy them
• On a competitive market

22
This Also Explains the Cookie Club

• Cookie company collects
• Net revenue from sales
• Club membership fee
• Net revenue equals
• Price - marginal cost
• Times quantity
• Highest membership fee they can charge
• consumer surplus
• At the price they charge
• Sum is maximized at PMC
• Note that this only works if customers all have
  the same demand curve
• Otherwise the fee
• Is more than CS for some
• Less for others

23
So Why Tie-in Sales?

• We have just shown that the tie-in lowers IBM's
  profit!
• So the old explanation about extending a monopoly
• Is wrong
• Two monopolies are worth less than one
• So why do they insist on the tie-in?

• Solution Price Discrimination
• Firms that use the sorter a lot use lots of cards
• And probably get lots of value from the sorter
• So high priced cards are an indirect way of
• Charging more to the high value users
• A point made explicitly in the much older printer
  case

24
Vertical Integration

• You have a monopoly of steel production
• So use it to get a monopoly of autos
• In order to extend your monopoly
• Get two monopoly profits
• But you could push up the price of autos
• By what you charged auto producers for steel
• Let them compete down their margin
• While you collect the monopoly profit
• If autos not a natural monopoly, that makes you
  more money
• So why does vertical integration exist?
• Because it is sometimes less costly to produce
  in-house
• Because it can reduce the inefficiency from
  monopoly pricing
• Suppose steel costs you 10/ton to produce, you
  sell it to auto firms for 20/ton monopoly price
• In deciding how much to use, they compare costs
  at 20
• Which means inefficient substitution of aluminum
  etc.
• If you make the autos, do internal calculations
  at 10
• Produce at minimum cost--then sell cars at a
  monopoly price

25
Retail Price Maintainance

• Producer sets a minimum price
• Retailers may not sell for less
• If they do, they dont get the product any more
• Legally restricted but forms still exist
• Again, conventional argument is
• Producer is getting a second monopoly
• On retailing
• By preventing competition between outlets
• Again, it doesnt work, because
• Producer can force up retail price via his price
• Let retailers compete down their margins
• And so he gets all the monopoly profit
• Why does it happen?

26
Why?

• Perhaps to encourage rent seeking?
• Pgtcost, pays to spend money on advertising,
  support
• Even though some of it benefits other stores
• And all of it would if they were free to cut
  their price instead
• This leaves open another question
• Why not sell support separately?
• 20/hour to visit our stereo showroom, talk to
  experts
• 50/hour for the auto equivalent
• And we'll throw in free advice on the cheapest
  way to buy the stereo or car you choose.
• Suppose you wanted to defend Homesteading
• Is there an analogous argument
• For why you want the land settled
• "inefficiently early?"

27
The Real Problem Is

• Not the existence of a (natural) monopoly
• Breaking it up would just raise costs
• Regulation has problems similar to those of
  monopoly
• But the existence of conditions inconsistent with
  a competitive market
• I.e. economies of scale
• That run up to the full size of the market
• Without competition, only bad answers
• Private single price monopoly
• Private monopoly with price discrimination
• Regulated monopoly
• Government owned monopoly
• But better answers to
• Government created monopoly or
• Cartel
• Since there competition may be an option

28
Network Externalities

• The idea
• The value of a good to me might depend
• On how many other people are using it
• Querty keyboard, MS Word, English language
• So once one version somehow becomes dominant
• Everyone wants to use that
• Even if an alternative would be better for
  everyone
• Consider driving on the left in England
• So outcomes could be path dependent
• Some random factor early in a technology
• Puts us on the wrong path
• Perhaps we could avoid that, or
• Switch paths--as Sweden switched to the right

29
Is it a real issue?

• Example used to be the Qwerty keyboard
• Until Liebowitz and Margolis looked into the
  history
• And found that all the asserted facts were false
• It wasnt
• Designed to slow typist down
• Successful due to one typing contest
• Hard to switch keyboards
• Much inferior to the later Dvorak layout
• Similar criticisms have been made of other
  supposed examples
• Of inefficiency due to path dependence
• By Liebowitz and Margolis in their book

30
How can One Tell?

• If network externalities are large
• The dominant product should still be dominant at
  a higher price
• Giving its seller more profit
• So MSWord, Excel, should sell at a higher price
  than competing software with similar features but
  lower sales
• That doesnt seem to be how sellers act
• Liebowitz Margolis argue that the actual
  economics of software
• Is a natural monopoly of the currently best
• With sequential competition
• As better competitors appear, become dominant
• Visicalc, Lotus, Excel
• WordStar, WordPerfect, Word
• They graphed the pattern of reviews in the
  magazines against the pattern of sales
• When a new product started getting consistently
  favorable reviews
• In comparison to the dominant one
• Dominance shifted quickly