BUSN 502

ECON 201CHAPTER 15 MONOPOLY

A monopoly is a firm that is the sole seller of a product without close substitutes. A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power. Sources of Monopoly Power

The main cause of monopolies is barriers to entry other firms cannot enter the market.

Three sources of barriers to entry:1.A single firm owns a key resource.

E.g., DeBeers owns most of the worlds diamond mines2.The government gives a single firm the exclusive right to produce the good.

E.g., patents, copyright laws3.Natural Monopoly: A single firm can produce the entire market Q at lower cost than could several firms (economies of scale over the relevant range of output).E.g., distribution of water or electricityMonopoly versus CompetitionIn a competitive market, the market demand curve slopes downward. But the demand curve for any individual firms product is horizontal at the market price. The firm can increase Q without lowering P, so MR = P for the competitive firm. A monopolist is the only seller, so it faces the market demand curve. To sell a larger Q, the firm must reduce P (thus, MR P). Note that the monopolist can choose a point along the market demand curve (combination of price and quantity) but cannot choose a point off (above) the market demand curve.

Monopolysts RevenueFor a monopolist MR MC increase production

If MC > MR produce less

To maximize profit the monopolist produces quantity where MR=MC (intersection of the marginal-revenue curve and the marginal-cost curve)

Once the monopolist identifies the quantity where MR=MC, he sets the highest price consumers are willing to pay for that quantity. The monopolist finds this price from the D curve. A monopolys Profit = TR TC = (P ATC) Q

Monopolized versus Competitive Markets The Case of Generic DrugsNote the difference between perfect competition and monopoly:

In perfect competition: P=MR=MC (Price equals Marginal Cost)A competitive firm takes P as given and has a supply curve that shows how its Q depends on P.In monopoly: P>MR=MC (Price exceeds Marginal Cost)A monopoly firm is a price-maker, not a price-taker. Q does not depend on P; rather, Q and P are jointly determined by MC, MR, and the demand curve.

So there is no supply curve for monopoly.

Patents on new drugs give a temporary monopoly to the seller. When the patent expires, the market becomes competitive, generic drugs appear.New drug, patent laws monopoly

Produce Q where MR=MC

P>MC

Generic drugs competitive market

Produce Q where MR=MC

And P=MC

The price of the competitively produced generic drug is below the price that the monopolist was able to charge due to the patent.

The Welfare Cost of Monopolies

A monopolist produces a quantity such that MC = MR. This quantity is less than the socially efficient quantity of output and corresponds to a price P>MC.Monopoly pricing prevents some mutual beneficial trades from taking place. There are in fact some consumers that value the good at more than the monopolists marginal cost but less than the monopolists price.

The deadweight loss is the triangle between the demand curve and the MC curve.

Its not the profit earned by the monopolist the problem in terms of social welfare, but rather the inefficiently low quantity of output.

Price DiscriminationIn competitive markets many firms sell the same good; therefore if one firm charges any consumer or group of consumers a higher price, it would not be able to sell the good. However, if a firm is a monopolist, it can try to sell the good to different customers at different prices.

The characteristic used in price discrimination is willingness to pay: a firm can increase profit by charging a higher price to buyers with higher willingness to pay.When the monopolist charges the same price to all buyers he obtains profits, however there is also a consumer surplus and a deadweight loss. The consumer surplus is due to the fact that some consumers would have been willing to pay a higher price that the price set by the monopolist. The deadweight loss is instead due to the fact that some consumers were willing to pay a price smaller than the price set by the monopolist, but still greater than the marginal cost for the monopolist.

If the monopolist can perfectly price discriminate, he will charge each customer exactly the price that the customer is willing to pay. Therefore the entire surplus goes to the monopolist and there is no consumer surplus and no deadweight loss.

In the real world, perfect price discrimination is not possible because firms dont know every buyers willingness to pay. Therefore firms divide customers into groups based on some observable trait that is likely related to their willingness to pay, such as age. Examples of Price Discrimination

Movie tickets: discounts for students, seniors and matinees.

Airline Prices: discounts for non-business travelers (Saturday stays over)

Discount Coupons: people who have time to clip and organize coupons are more likely to have lower income and lower willingness to pay than others. Need-based financial aid: low income families have lower willingness to pay for their childrens college education. Schools price-discriminate by offering need-based aid to low income families. Quantity discounts: a buyers willingness to pay often declines with additional units, so firms charge less per unit for large quantities than small ones. Public Policies toward Monopolies

Monopolies, in contrast to perfectly competitive markets, fail to allocate resources efficiently. Moreover, the monopoly related losses may be greater than just the deadweight losses as potential monopolies may spend resources on lobbying/lawyers and politicians and this implies that resources are not being spent on productive activities but being spent on increasing the probability of getting a monopoly position. This kind of expenditure is sometimes referred to as rent-seeking expenditure.

The basic objective of public policy in this context is to increase and encourage competition.

a) Anti-trust Laws: The government can intervene directly and break up monopolies, prevent collusive behavior and prevent mergers. Mergers result in reduced competition and this can potentially increase prices. However mergers may also result in increased cost efficiencies which result in lower prices. If the first negative effect is estimated to be stronger, then the government will not approve the merger. b) Price Regulation: The government can try and directly regulate the prices of natural monopolies such as Electricity Companies, Water Companies, Postal Systems etc. The ideal situation from the efficiency perspective is to enforce marginal cost pricing. Because these are situations of natural monopoly, the long run average total cost curve is downward sloping and the MC is below the Average cost. So if the price is restricted to be equal to MC then the price will be below the average cost and the firm will face losses. The firm then will exit the industry and there would be no provider for the service.

One way to solve the problem is to subsidize the natural monopolist. An alternative policy may be to enforce average cost pricing. In this case there will still be deadweight losses and the quantity produced will be below the socially efficient level. However in both policies the firm does not make profits and has no incentive to reduce costs.

c) Public Ownership: The government can take over the ownership of the monopoly and make it a public enterprise (U.S. Postal Service). Public ownership is usually less efficient since there is no incentive to minimize costs

d) Doing Nothing: The government can choose to do nothing and let the market forces dictate the outcome.ConclusionIn the real world, pure monopoly is rare. Yet, many firms have market power, due to selling a unique variety of a product or having a large market share and few significant competitors.

In many such cases, most of the results that we have studied apply, including markup of price over marginal cost and deadweight loss.

Competitive versus Monopoly Markets in Synthesis

Note however that although monopoly results in deadweight losses for the economy, the potential for positive economic profits creates an incentive for firms to invest and R&D and improve the quality of existing products or come up with new products.

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