Chapter 4 Monopoly

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Chapter 4Monopoly
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Outline.

• What is a monopoly?
• The profit maximising monopolist
• Price discrimination
• The efficiency loss from monopoly
• Public policy toward natural monopoly

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Definition of a monopoly

• A monopoly is a situation in which the market is
  served by only one seller, the product of which
  has no close substitute on the market.
• Although this definition looks very simple, it is
  not that simple to apply in practice.
• Examples cinema, train tickets
• The key factor that differentiates the monopoly
  from the competitive firm is the elasticity of
  demand facing the firm.
• Perfectly competitive firm infinite
• Monopoly finite
• One practical measure examine the cross-price
  elasticity of demand for the closest substitute

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Five sources of monopoly

• Exclusive control over important inputs
• Examples Perrier, DeBeers
• Economies of scale when the long-run AC curve is
  downward sloping the least costly way to serve
  the market is to concentrate production in one
  single firm this is a natural monopoly.

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Five sources of monopoly (ctd)

• Patents they confer the right to exclusive
  benefit from the invention to which it applies.
• Costs higher prices for consumers
• Benefits they make possible many inventions that
  would not be so otherwise
• Network economies on many markets, a product
  becomes more valuable as the number of customers
  that use it increases.
• Example telephones
• May give rise to a monopoly. Example Microsoft
• Government licenses or franchising in many
  markets, only those firms that get a license from
  the government can set up a business.

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Outline

• The profit maximising monopolist
• Price discrimination
• The efficiency loss from monopoly
• Public policy toward natural monopoly

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Total revenue

• Perfectly competitive firm horizontal demand
  curve
• So, firms total revenue is given by

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• The monopolist
• Faces a downward
• sloping demand
• If he wants to sell
• more, he needs to
• cut his price

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Total revenue, total cost and economic Profit
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Marginal revenue

• The marginal revenue is the change in total
  revenue generated by a very small change in the
  amount of output produced.
• The monopolist will choose its production level
  in order to maximise its profit
• P TR TC
• Profit is maximum when

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Marginal revenue (ctd)

• In the case of the monopoly firm, marginal
  revenue is always going to be less than the
  price.

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Marginal revenue (ctd)

• The monopolist wants to increase production from
  Q0 to (Q0 DQ).
• ? Needs to lower its price from P0 to (P0 - DP)
  where DP gt 0.
• The new total revenue is
• (Q0 DQ).(P0 - DP) P0Q0 P0DQ - DPQ0 - DP DQ
• MR (P0DQ - DPQ0 - DP DQ)/ DQ
• MR P0 - (DP/ DQ).Q0 DP
• MR 60 10 (10/50).100 30

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Marginal revenue and price elasticity

• The price elasticity of demand at a point (Q,P)
  is given by
• The marginal value is given by

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Marginal revenue and demand

• Notice that
• When 8 (for Q 0), MR P
• When gt 1, MR gt 0
• When 1, MR 0
• When lt 1, MR lt 0
• When the demand curve is a straight line
• P a bQ where a,b gt 0
• Then
• TR P.Q aQ bQ2

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Marginal revenue and demand (ctd)
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The short-run profit maximisation condition

• MR MC

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The short-run profit maximisation condition (ctd)

• The profit-maximising mark-up
• Given that
• and MR MC
• It follows that

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The monopolist shut-down condition

• The monopolist should stop production when
  average revenue is less than average variable
  costs at any level of output

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Monopoly versus perfect competition

• Both choose an output level by weighing the
  benefits of expanding (resp. contracting) output
  against the corresponding costs
• Both compare MC and MR
• The main difference is that for the perfectly
  competitive firm, the marginal revenue is equal
  to the market price whereas for the monopolist,
  it is less than the price
• The output level chosen by the monopolist is
  lower than the output level chosen by the perfect
  competitor

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Monopoly versus perfect competition (ctd)
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Adjustments in the long run
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Outline

• Price discrimination
• The efficiency loss from monopoly
• Public policy toward natural monopoly

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Sales in different markets

• Suppose the monopolist has two completely
  distinct markets what quantity should it sell
  and what price should it charge in both markets?

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Sales in different markets (ctd)

• The monopolist will charge a higher price in the
  market where demand is less elastic to price.
• This is called third-degree price discrimination.
  
• This is feasible only when it is impossible for
  buyers to trade among themselves.
• If trading is feasible arbitrage
• ? Example train tickets

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Perfect discrimination

• First-degree or perfect discrimination is a
  situation in which each unit of product is sold
  at each customer at the highest price the
  customer is willing to pay for it.

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Perfect discrimination (ctd)

• How much output will the monopolist produce?

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Second-degree price discrimination

• It is a practice according to which sellers do
  not post a single price but a schedule along
  which price declines with the quantity one buys .

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The hurdle model of price discrimination

• It consists in inducing the most price-elastic
  buyers to identify themselves.
• The seller sets up a hurdle an offers a discount
  to those buyers who jump over it.
• The underlying idea is that those buyers who are
  most sensitive to price will be more likely than
  others to jump the hurdle
• Examples.
• The rebate included in a product package.
• Airlines offering restricted fares

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Outline

• The efficiency loss from monopoly
• Public policy toward natural monopoly

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The lost surplus
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The deadweight loss

• If the firm would behave like a perfect
  competitor, the whole triangle above the LAC
  curve would be consumer surplus
• If the firm perfectly discriminates, the whole
  triangle becomes producer surplus
• If the firm is a non-discriminating monopolist,
  part of the consumer surplus is lost .
• ? This is the deadweight loss from monopoly

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Outline

• Public policy toward natural monopoly

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Fairness and efficiency objections

• How does monopoly compare with alternatives?
• Let's consider a technology in which total costs
  are given by
• TC F MQ
• There are 2 main objections to the equilibrium
  reached by the monopoly
• The fairness objection the producer earns a
  profit which is higher than it would under
  perfect competition (P).
• The efficiency objection the price is above the
  marginal cost ? loss in consumer surplus (S).

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State ownership and management

• One solution in that case is to have the state
  take over the industry.
• Advantage the government is not as much
  constrained as a private firm.
• ? Can set the price equal to the marginal cost
  and absorb the corresponding economic losses out
  of general tax revenues.
• Drawbacks it often reduces the incentives for
  cost-conscious efficient management, thus
  generating X-inefficiency.

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State regulation of private monopolies

• The most frequent regulation consists in setting
  a price that allows the firm to earn a
  pre-defined rate of return on its invested
  capital.
• Ideally this rate of return should allow the firm
  to recover exactly the opportunity cost of its
  capital ? be equal to the competitive rate of
  return on investment.
• However, in practice, regulatory commissions lack
  information on what the competitive rate of
  return should be.

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Exclusive contracting for natural monopolies

• Accept that the product be produced by only one
  firm but to create strong competition in order to
  determine who will be the supplier.
• Specify in detail the service that is wanted and
  then call for private companies to make bids to
  supply this service.
• This should be better than state management in
  terms of keeping cost down if X-inefficiency is
  lower in private than in public firms.
• But the advantages of such systems are often more
  apparent than real.

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Antitrust laws

• The most famous antitrust laws
• The Sherman Act (1890). It makes it illegal to
  "monopolise or attempt to monopolise any part of
  the trade or commerce among the several States".
• The Clayton Act (1914) prevents companies from
  buying shares in a competitor where the effect
  would be to "substantially lessen competition or
  create monopoly
• The U.S. Justice Department prohibits mergers
  between competing companies whose combined market
  share would exceed some predetermined fraction of
  total industry output.

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Laissez-faire policy

• A last possibility for dealing with natural
  monopolies is laissez-faire, or doing nothing.
• ? The main objections to this policy are those
  with started with, namely the fairness and
  efficiency objections
• Efficiency objection the monopolist charges a
  price above the marginal cost which excludes many
  potential buyers from the market.
• But in the case of a two-price monopolist, the
  deadweight loss is limited
• The more finely the monopolist can partition her
  market under the hurdle model, the smaller the
  efficiency loss will be.

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Laissez-faire policy (ctd)
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Laissez-faire policy (ctd)

• The fairness problem It consists in the fact
  that the monopolist transfers resources from
  consumers to firms.
• Raises a distributional problem
• One argument in favour of the hurdle model of
  price discrimination is that most of the profit
  earned by the monopolist comes from the high
  price elasticity consumers
• Overall, each of the policy options for dealing
  with natural monopolies has problems.
• None completely eliminates the problem of having
  only one producer serving a market.