Chapter 14

Monopoly

Introduction to Monopoly

  • The monopolistic market will be the second scenario where we will study how firms behave in order to maximize profit.

-Monopoly: a market where there is only one firm supplying one particular good to many small customers. This gives the firm control over the price. The buyers are price-takers while the monopoly is a price-maker. Firms can not freely enter (open up shop) this market.

(e.g.: public utilities, software industry, medical drugs)

-Firms will be able to determine their level of output and then charge the maximum price that consumers will be willing to pay for that quantity of the good.

  • Although monopolies are harmful to consumer interests they are not “evil” and arise due to many different reasons. Monopolies created to corner a particular market are illegal.

Why Monopolies Arise (Barriers to Entry)

  • Monopolistic markets can be closed to additional competition for any of the following reasons:

-Monopoly resources; exclusive ownership of a key resource such as raw materials. This is actually quite infrequent in the age of extensive international trade when resources are global.

(e.g.: diamonds and The DeBeers,)

-Government intervention; there are some activities that require government approval or protection (i.e.: patents) in order for the market to operate properly. Of course, there are also rent-seeking motivated monopolies that use the law to fence off competition.

(e.g.: TV and radio stations, medical drugs, music and movies)

-Natural barriers; some activities display economies of scale and so the company that first starts the industry -or the largest one- can offer low prices that keep away competition.

(e.g.: power, gas, and water utilities, software development)

  • Monopolies can also arise as a result of natural business competition or by exercising exclusionary business practices (the later are illegal and this is why all the big corporate mergers have to be cleared by the Justice Dept.)

The Monopolist's Output Decision

  • Monopolists are rational people. They want to maximize profit and so "think at the margin" (like consumers and perfectly competitive firms) using the marginal principle.

"A monopolist will produce up to the point where marginal cost equals marginal revenue"

  • But now marginal revenue is not the market price, so how do we set the quantity to produce and the selling price?
  • Since a monopoly is the only firm in the market, that firm is facing the whole demand curve.

-A demand curve represents the maximum price that consumers are willing and able to pay for any given amount of the good or service being sold.

-The monopoly can charge that price and be sure that consumers will pay.

-Total revenue, then, is Quantity x Selling Price (as determined by the demand curve)

-Marginal revenue is by how much total revenue increases when output produced increases by one unit (this will be a straight line that lies halfway through the demand line.)

-Therefore, applying the marginal principle concludes the following:

Marginal benefit (MB) = Marginal cost (MC)

Marginal revenue (MR) = Marginal cost (MC)

and now

Price (P) = determined by the Demand Curve (D)

  • Then, the equilibrium quantity is set by MC = MR and the selling price P is determined by the demand curve. For a monopoly price is always higher than marginal cost. This is a markup.

A Monopoly’s Profit

  • Monopolies do not necessarily make a profit because there is a limit, set by the demand curve of the market in which they operate, to the maximum price that they can charge.
  • As with perfectly competitive firms:

-If P < Minimum of SATC: the monopoly does not collect enough revenue to cover its costs, it will eventually go out of business -exit the market.

-If P > Minimum of SATC: the monopoly is collecting enough revenue to cover its costs and even generates an extraordinary profit -attracting new firms to a market with barriers to entry.

-If P = Minimum of SATC = P*: the monopoly collects enough revenue just to cover its economic cost (both explicit and implicit costs.)

The Welfare Cost of the Monopoly

  • Monopolies are inefficient(i.e.: they create a welfare loss) for a number of reasons:

-Their prices have a mark-up over marginal cost (i.e.: the extraordinary profit they collect) that perfectly competitive firms can not apply to their customers.

-Their output is always lower than that of perfectly competitive firms that will produce where marginal cost equals price.

-They collect a positive economic profit although they could increase output to the point where their MC intercepts D, lower prices and still collect an economic profit (albeit a smaller one.)

-They generate a welfare loss because output is below the socially optimal quantity and price is above the socially optimal. They also create a deadweight loss (due to market distortions.)

  • Additionally, monopolies can keep on collecting positive economic profits in the long run because the existence of barriers to entry prevents new firms to compete in that market.

-If competition were possible economic profit would be zero; output would be determined by the intercept of SATC and D (i.e.: lower prices and higher output than before.)

  • A monopoly does not have a supply curve (the MC curve above the minimum of the SAVC curve) in fact it only has a supply point.
  • Monopolies can extracta large fraction of consumer surplus because they charge the maximum price that consumers are willing to pay for the good or service.

Public Policy toward Monopolies

  • Because monopolies are socially inefficient there is always public pressure to force them to modify their business practices.
  • Nonetheless, forcing monopolies to set the selling price equal to the MC (as firms in perfectly competitive markets would do) reduces their profits. Monopolies will oppose such regulation.
  • Antitrust lawsare enacted to prevent the creation of monopolies by mergers and acquisitions and to preserve competition as a rule of trade, although that by itself may not be optimal:

-Microsoft was forced to separate the Internet browser division from the operating system.

-The Bell Corporation was forced to open long-distance phone lines to other operators.

-Illinois Power will be required to separate the power generation from the distribution divisions.

  • Regulationof natural monopolies by means of direct government setting of price and quantity. In this particular type of monopolies forcing companies to produce where MC intercepts D will cause the monopoly to operate at a loss and eventually go out of business.

-Public utilities receive government subsidies in order to keep prices low.

  • Nationalizationof monopolies would guarantee that the collected economic profits end up as government revenue. The problem is that bureaucrats make very bad business managers.

-Most European utility companies are public. In the US the government owns the Mail Service.

  • Doing nothing may be the best course of action given that all the above interventions are associated with negative side-effects.

Price Discrimination

  • Monopolies normally use their price-setting capacity to charge different prices for the same good or service according to the characteristics of the market.
  • This is called price discrimination and it is not illegal because it normally takes the form of discounts or special offers to specific groups of consumers (e.g.: students, seniors, children)

-At each independent market segment the monopolist applies the marginal principle of equalizing MC with MR. The optimal output amounts change across markets.

-Since demand curves are different in each market the resulting selling price changes according to the consumer at hand (e.g.: students are offered discounts because their low income levels reduce their demand for movies.)

  • There is a number of advantages to this pricing strategy for the monopolist:

-It gives the monopolist access to "secondary markets" that would normally not be accessible to its products at the prevailing general prices.

(e.g.: free seats on airplanes for children allow families to buy regular adult tickets.)

-It allows the extraction of the largest possible fraction of the consumer's surplus from each different type of consumer.

-It maximizes profits in each segment of the market, so total profits are also maximized.

  • This type of price discrimination is possible because the monopolist can keep the marketsseparated, identifying each type of consumer and charging the appropriate price.

(e.g.: nobody can get a student discount at the movies without showing the school's ID.)