What is Economics? 9
Chapter
12 / monopolyWhat is Economics? 9
monopoly 293
Chapter Key Ideas
The Only Game in Town
A. Most buyers use e-Bay for auctions because most sellers use e-Bay for auctions. Most companies and organizations list their websites on Google because most internet browsing customers use Google to search the web.
1. These firms clearly have little competition and enjoy significant market power (ability to influence market price), so these firms can’t be operating in a perfectly competitive market.
2. Is there anything different about how firms with market power operate? Do industries with a singularly dominant firm behave differently than competitive ones?
B. Students get lots of price breaks—at the movies. Seniors get price breaks at restaurants. Business travelers tend to pay higher prices for tickets on the airlines.
1. How do firms get different people to pay different prices?
2. How can it be profit maximizing to offer lower prices to some customers but higher prices to others?
Outline
I. Market Power
A. Market power and competition are the two forces that influence the market structure of most markets.
1. Market power is the ability to influence the market, and in particular the market price, by influencing the total quantity offered for sale.
2. A monopoly is a firm that produces a good or service for which no close substitute exists and which is protected by a barrier that prevents other firms from selling that good or service.
B. How a Monopoly Arises
1. A monopoly market has two key features:
a) No close substitutes. The absence of any firms making close substitute goods or services allows the monopolist to avoid competition in the market.
b) Barriers to entry. Legal or natural constraints that protect a firm from potential competitors are called barriers to entry.
2. There are two types of barriers to entry:
a) Legal barriers to entry create a legal monopoly—a market in which competition and entry are restricted by the granting of a public franchise, a government license, a patent, or a copyright.
i) A public franchise exists when an exclusive right is granted to a firm to supply a good or service. For example, the U.S. Postal Service has a public franchise to deliver first-class mail.
ii) A government license exists when the government controls entry into particular occupations, professions and industries. For example, a license is required to practice law. Licensing doesn’t always create a monopoly, but it does restrict competition.
iii) A patent is an exclusive right granted to the inventor of a product or service, and a copyright is an exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work. Patents and copyrights don’t always create a monopoly, but because these rights can be sold, they do restrict competition.
b) Natural barriers to entry create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can. Figure 12.1 shows the LRAC curve for an electrical power company that is a natural monopoly.
C. Monopoly Price-Setting Strategies
1. Monopolies face a tradeoff between the price it charges and the quantity it can sell. For a monopoly firm to determine the quantity it sells, it uses its market power to choose the appropriate price.
2. There are two types of monopoly price-setting strategies:
a) Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.
b) A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers.
3. Although the practice of price discrimination appears to be for the benefit some consumers, it is really an attempt by the firm to receive the maximize price for each unit sold to maximize its economic profit.
II. A Single-Price Monopoly’s Output and Price Decision
A. Price and Marginal Revenue
1. The demand curve facing a monopoly firm is the entire market demand curve.
2. This demand curve relates the market price at which the monopoly firm can sell the corresponding quantity of output.
a) Total revenue, TR, is the price, P, multiplied by the quantity sold, Q.
b) Marginal revenue, MR, is the change in total revenue resulting from a one-unit increase in the quantity sold. The key feature of a single-price monopoly is that at each level of output, marginal revenue is less than the price, that is, MR < P.
c) MR < P at every level of output because the single–price monopoly firm must lower its price on all units sold to sell an additional unit of output. This fact means that the extra revenue received equals the price of the additional unit sold minus the decrease in price for each of the previous units it would have sold at the higher price. As a result, the net increase to firm’s revenue, that is, its MR, is less than the price of the last unit sold.
d) Figure 12.2 uses a demand curve to show how these offsetting influences on total revenues.
B. Marginal Revenue and Elasticity
1. A single-price monopoly’s MR is related to the elasticity of demand for its good.
a) If demand is elastic, a fall in price brings an increase in total revenue. The rise in revenue from the increase in quantity sold outweighs the fall in revenue from the lower price per unit, and so the MR is positive.
b) If demand is inelastic, a fall in price brings a decrease in total revenue. The rise in revenue from the increase in quantity sold is outweighed by the fall in revenue from the lower price per unit, and so the MR is negative.
c) If demand is unit elastic, a fall in price does not change the firm’s total revenues. The rise in revenue from the increase in quantity sold equals the fall in revenue from the lower price per unit, and so the MR is zero.
2. Figure 12.3 shows the relationship between elasticity of demand and total revenues for all three cases.
3. A single-price monopoly will never produce at an output for which demand is inelastic. If it did so, the firm could decrease output, increase total revenue while decreasing total cost, and thereby enjoy higher economic profits. So a single price monopoly will always maximize its economic profit by producing in the elastic range of its demand.
C. Price and Output Decisions
1. The monopoly faces the same types of technology and cost constraints as does a competitive firm, so its costs behave the same as the costs of a perfectly competitive firm. But the monopoly faces a different type of market constraint.
a) The monopoly selects the profit-maximizing level of output in the same manner as a competitive firm, choosing the level of output where: MR=MC.
b) The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity. Table 12.1 uses a numerical example to illustrate the monopoly firm’s output and price decision.
2. The monopoly might earn an economic profit—even in the long run—because the barriers to entry protect the firm from market entry by competitor firms.
a) Figure 12.4 illustrates the profit-maximizing choices of a single-price monopolist.
b) A monopoly is not guaranteed an economic profit. An economic profit is received only when PATC.
III. Single-Price Monopoly and Competition Compared
A. Comparing the same industry under perfect competition and monopoly reveals the significant differences in these two types of markets.
B. Comparing Output and Price
1. Figure 12.5 shows the market outcomes under perfect competition and under monopoly.
2. The market demand curve, D, in perfect competition is the same demand curve that the firm faces in monopoly.
3. The market supply curve, S, in perfect competition is the horizontal sum of the individual firm’s marginal cost curves (S = sum of MC for each firm). This supply curve is also the monopoly’s marginal cost curve.
4. Equilibrium in perfect competition occurs where the quantity demanded equals the quantity supplied at quantity QC and market price PC.
5. The profit-maximizing equilibrium output for a monopoly QM occurs where MR = MC. Equilibrium price for the monopoly, PM, is obtained from the demand curve, at the profit-maximizing quantity.
6. The monopoly firm produces less output and charges a higher price than a perfectly competitive market.
B. Efficiency and Comparison
1. The monopoly output decision is inefficient. Figure 12.6 shows why this result is so.
a) The demand curve, D, is the marginal benefit curve for society, MB, and the competitive market supply curve, S, is the marginal cost curve for society, MC. So competitive equilibrium is efficient because output is produced where MB = MC.
b) Monopoly is inefficient because output occurs where MB > MC.
c) For all output levels at which MB > MC, a deadweight loss is incurred. So, an increase in output would generate additional MB for society that would exceed the additional MC to society.
C. Redistribution of Surpluses
Monopoly redistributes a portion of consumer surplus by changing it to producer surplus.
D. Rent Seeking
1. The social cost of monopoly may exceed the deadweight loss through an activity called rent seeking, which is any attempt to capture a consumer surplus, a producer surplus, or an economic profit. Rent seeking is not confined to a monopoly.
2. There are two forms of rent seeking:
a) Buy a monopoly—expend resources by seeking out the opportunity to buy monopoly rights for a price below the value of the economic profit earned by the monopoly. Example: The buying of taxi cab medallions (a government license) in New York City.
b) Create a monopoly—expend resources seeking political influence, such as lobbying legislators to provide preferential market status by restricting domestic competition or enacting tariffs on imports. Example: U.S. steel firms successfully seeking large tariffs placed against imported steel from foreign firms.
E. Rent-Seeking Equilibrium
1. There are no barriers to entry in the activity of rent seeking. This fact means that the resources used up in rent seeking are costs which can exhaust the monopoly’s potential economic profit and leave the monopoly owner with only a normal profit.
2. However, the outcome is still not efficient, because output does not occur where MB=MC. Figure 12.7 shows the normal profit outcome that results from rent seeking.
IV. Price Discrimination
A. Price discrimination is the selling of different units of a good or service for different prices.
1. To be able to price discriminate, a firm must:
a) Identify and separate different buyer types
b) Sell a product that cannot be resold
2. Price discrimination occurs because of different consumer’s willingness to pay for the good.
a) Price discrimination does not occur because of cost differences between units produced.
b) Not all observed price differences are the result of price discrimination.
B. Price Discrimination and Consumer Surplus
1. Price discrimination converts consumer surplus into economic profit.
2. A monopoly firm can price discriminate in different ways:
a) Monopoly firms can charge the same buyer a different price for each unit sold. Quantity discounts are an example. However, quantity discounts that reflect lower costs at higher volumes are not price discrimination.
b) Monopoly firms can charge different buyers different prices for the same good or service. Giving a lower price on advance purchase airline tickets is an example of this form of price discrimination.
C. Profiting by Price Discriminating
Figure 12.8 and Figure 12.9 show the same market with a single price monopoly firm and monopoly firm practicing price discrimination, respectively. Comparing these two diagrams shows how price discrimination converts consumer surplus into economic profit for the firm.
D. Perfect Price Discrimination
1. Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price anyone is willing to pay for it. The outcome of perfect price discrimination is characterized by:
a) Economic profit increases above that earned by a single-price monopoly firm.
b) Output increases to the quantity at which P=MC.
c) Deadweight loss is eliminated.
2. Figure 12.10 shows the outcome of perfect price discrimination.
E. Efficiency and Rent Seeking with Price Discrimination
1. The more perfectly a monopoly can price discriminate, the closer its output gets to the competitive output where P = MC and the outcome is more efficient.
2. However, this outcome differs from the outcome of perfect competition in two important ways:
a) The monopoly firm captures the entire consumer surplus.
b) The increase in economic profit attracts even more rent-seeking activity that leads to an inefficient use of resources for society.
V. Monopoly Policy Issues
A. Gains from Monopoly
1. Monopolies create inefficiency:
a) Both single-price and price-discriminating monopolies create deadweight loss. And a price discriminating monopoly converts consumer surplus into producer surplus and economic profit.
b) Both types of monopoly also encourage rent-seeking activity, which wastes resources.
2. However, monopoly also brings benefits to society: