Chapter 10: [ 10 Questions on Final] Monopoly – Absolute Market power by a single firm

 

Ø      Understand the meaning of each of the Key Terms in this chapter

Ø      Reasons for a monopoly: (there has to be a barrier to entry)

o       Natural Monopoly: Result of positive economies of scale

o       National Policy: Prior to “globalization” there were strong arguments for “national industries” (telecommunications, airlines, etc.)

§         Public utilities: government ownership - to set prices

§         Regulated utilities: private ownership - with regulated prices

o       Barriers to entry: (patents, gov’t policy)

 

The theoretical model of a monopoly is a market for a produce where there is only one firm supplying the product. That gives the firm absolute market power. Absolute market power does not mean that the firm can charge any price. It means that the firm faces the product demand curve, as well as its own costs curves, and selects a price/quantity combination (from the given demand curve) that maximizes its own profits.

 

Similar to the purely competitive firm the monopoly looks at:

Profits = Total Revenue – Total Cost

 

Look first at Total Revenue (e.g. Fig 10.2(a): At high prices (elastic portion of demand curve) price is high, but quantity is low, so lowering price (higher Q) increases total revenue. At low prices quantity is high, but price is low so raising prices (lower Q) increases total revenue (TR). If cost of produce was zero, the monopoly would maximize total revenue (TR), but cost of production is not zero, so profits are maximized when the marginal revenue (MR) from the last unit just covers the marginal cost (MC) of that last unit. The big difference between pure competition and monopoly is that the purely competitive firm takes price as given and MR = P. For the monopolist price is generated from the consumer demand curve so (a) as a monopolist picks the best (P,Q) it will never operate on the inelastic portion of the demand curve [right half of Fig 10.2(a)] since in that range higher Q means higher costs but with TR falling, MR is negative.

 

Demand, Marginal Revenue, Marginal Costs, and Profit Maximization: Figure 10.3

 

Get comfortable with Fig 10.3.It explains where the monopolist goes (P,Q) at point where MR = MC for profit maximization. Useful fact: The MR curve bisects the distance between the horizontal axis and the demand curve – always.

 

The Missing Supply Curve: In the purely competitive market the individual firm marginal cost curves are their individual supply curves and sum horizontally to be the industry supply curve. This is not the case for a monopoly. A monopoly has a profit maximizing pricing strategy give (a) its cost curves and (b) the industry demand curve it faces. (Figure 10.5).

 

The Monopolist’s long run supply decision: In the long run the industry demand curve may shift and the monopolist has to make a decision as to choice of plant size. Let’s keep it simple with a constant returns to scale industry (i.e., long run average cost curve flat).  For a competitive market the number of firms (and their optimum size) will be where the demand curve intersects the long run average cost LRAC) curve, and that will be the price of the product, i.e., P = MC.

 

For a monopoly the optimum size is where in the long run MR = MC. In Figure 10.(b) this is at Q₂ . Note and learn the differences between the monopoly solution here and a competitive solution.

Ø      In Figure 10(b) a purely competitive industry would yield a (P,Q) where the demand curve would intersect the horizontal Long Run Average Cost (LRAC) curve, (to the right on the figure) and where P = MC at minimum LRAC.

Ø      In contrast, a monopoly (at Q₂,P₂) would be a smaller industry (at Q₂ ), and a higher price ( at P₂ ) and where P > MC .

 

     IMPORTANT:

Recall Efficient Resource Allocation under Perfect/Pure Competition from Chapter 9:

a.        Each purely competitive firm produces where P = MC

b.        Each consumer buys products where P_x/P_y  =  MU_x/MU_y  (from eq 6.1 p 106)

c.        So:    Consumers’ MU_x/MU_y   =   P_x/P_y   =   firms’ MC_x/MC_y

d.        The subjective rate at which consumers substitute goods on the margin (given P_x/P_y ) is the same as the marginal costs of switching between producing the goods by producers. This efficient production-consumption outcome is the positive basis of economists’ support for pure competition.

Contrast this with the Monopoly outcome:

• Each monopoy firm produces where P > MC
• Each consumer buys products where P_x/P_y  =  MU_x/MU_y  (from eq 6.1 p 106)
• Consumers’ MU_x/MU_y   =   P_x/P_y  but  P_x/P_y  is not equal to the monopolist’s  MC_x/MC_y
• The subjective rate at which consumers substitute goods on the margin (given P_x/P_y ) is NOT the same as the marginal costs of switching between producing the goods by producers. This inefficient production-consumption outcome is the part of the basis of economists’ objections to unregulated monopoly.

i.          There is Dead Weight Loss ABF (Figure 10.7) from the existence of monopoly power.

 

Price Discrimination

If a monopoly can segment (divide up) a market into different sets of consumers who cannot trade products or services with each other,(and if the different markets have different demand elasticities) the monopolist can maximize profits further by charging different market segments (business, seniors, students, etc.) different prices. Segmenting the market allows the monopolist to extract more Consumer Surplus from different groups by charging them different prices.

In perfect price discrimination the monopolist charges the maximum price to each consumer, capturing all of the Consumer Surplus. There is no Dead Weight Loss, since production takes place up to where P = MC, but the entire surplus goes to the monopolist.

Microsoft & Linux (unfolding case study – p. 189)

Microsoft captured most all of the market for computer operating systems and has been accused (at various times) of abuse of monopoly power (in North America and Europe). Its dominant position in markets has been challenged from an interesting front, that being the open source software movement. Now the challenge is from “cloud computing” or the provision of applications as an online service.

 

Does Price Discrimination increase welfare?

P. 189 The book states that “price discrimination increases welfare” based on the fact that production takes place to where P = MC and those last buyers, willing to pay P > MC, get access to the product. It is only partially true since in the process the monopolist has transferred all of the Consumer Surplus into Producer Surplus. If equity is a consideration in “welfare” then the outcome is more complicated in terms of welfare implications.

 

Cartels: The Profits of Acting Like a Monopoly (and the incentive to cheat)

A group of companies, or oil producing countries like (OPEC) can gain greater profits if they treat their individual production capacity as though they are branches of the same monopoly, and behave like a monopoly. However, this leaves two problems. The first is that high cost producers may feel that they share of the profits is lower than if they sold more oil. The cartel could keep them happy by side-payments or giving them larger shares of the total quota. The second is that MC are less than Price (MC < P) so there is an incentive to “cheat” and supply additional goods to the market. This is always a problem in oil production. [Search Google for “smuggled oil, Nigeria, Iraq” and similar phrases]. These two factors contribute to cartel instability. As well, since cartel behaviour is monopoly behaviour it is frequently illegal under government regulations.

 

Monopolies and “Rent Seeking Behaviour”

Since the extent to which a monopoly can exist depends on political permission there is an active business of lobbying governments to permit monopoly-like behaviour. Such behaviour is called “rent seeking behaviour”. Resources are used (lobbying, bribes, etc.) to redistribute income and wealth, rather than using the resources to create output and value.

 

Who pays for Rent Seeking?

Any rent seeking behaviour uses resources to re-direct economic benefits. This is a non-productive use of society’s scarce resources. As well, it protects the inefficiencies of monopoly behaviour, a further cost to society.

 

Monopoly, Technology and Innovation

One of the arguments for monopolies has to do with the incentive to innovate and the financial benefits of a patent as the reward. This is a hotly contested issue in the medical drug industry. There are situations where monopoly can/may promote innovation and others (consider the history of the Big Three U.S. auto makers (Chrysler, Ford, GM).

 

Where do we go from here?

We now have two models of markets, the purely competitive market, and the monopoly market. Now (Chapter 11) we will look at markets between those two extremes:

Ø      A market in which there are a large number of small firms (monopolistic competition)  with some market power through modest product differentiation.

Ø      A market in which there are a small number of large firms (oligopoly) with considerable market power, but highly interdependent on the strategies of other firms.