Econ 201Spring 2009

Lecture 6.1b

Market Failure:

Monopoly – cont’d

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What’s Different?

• The profit maximizing rule for both a monopolist and a competitive firm is the same– Choose output level such that MRev = MCost

• Difference is:– For a competitive firm: price = MRev

• As it takes price as given

– For a monopolist:• Each successive unit supplied/sold lowers the

price (avg rev) and marginal revenue (MRev)

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What’s the Impact on Market Efficiency?

• DWLoss as higher P; lower Q

• Transfer from CS to PS

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Monopolies and Market Efficiency

• A monopolist will sell:– a lower quantity of goods – at a higher price than firms would in a

purely competitive market.

• Monopoly will secure monopoly profits by appropriating some or all of the consumer surplus

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3 Questions to Ponder?

• Does a monopolist earn “excess” profits, or economic rent?

• At what demand elasticity will a monopolist operate at, i.e., what is the demand elasticity at the monopolists profit maximizing output?

• Can a monopoly persist over time?

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Monopoly Rents

• Is the monopolist earning an economic, or excess, profit?

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Persistence of the Monopoly

• Unique Costs– High fixed costs

• Generally industrial: e.g., automotive (“big 3” before globalization), airlines, telecomm and energy

– Economies-of-scale are so large• “natural monopolies” – public utilities (telecomm, electricity,

energy) • Scale economies are so large, that it is efficient for only 1

firm to exist

– High costs of switching to a substitute• E.g., Windows XP to LINUX

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More Complex Monopoly Pricing Schemes

• Classic categorization of monopolies– 3 levels of price discrimination

• First degree (Perfect Price Discrimination)– Extract almost all of the Consumer Surplus

» Able to get a different price for each unit sold

» Moves consumer along the Demand Curve

• Second degree– Provide quantity discounts; but have to buy in blocks, with each

larger block having a lower price than the last

• Third degree– Different prices for same good in different markets

• In all cases, it is necessary to prevent resale!8

Price Discrimination orDifferences in Cost?

• A Simple Example:– Shell’s pricing of gasoline

• Madison Park and Montlake - $3.25 per gal• Genesee and Ballard - $3.15

– Charging different prices for the same good in different markets

– Alternative hypotheses/explanations?

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Alternative Hypotheses

• Hypo A:– Shell is performing 3rd degree price discrimination

• Based on different incomes in the two areas; Shell knows that higher income areas will have higher demand for a normal good (higher opportunity costs of time, fewer substitutes)

• Hypo B:– Higher costs in Madison Park

• Transport, labor and materials are similar, but• Maybe (space) rental is higher?

• Could try and get rental data and compare!

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Pricing Models for Retail Gas• Price Optimization Models (Price Net)

If a retailer has 100 stations that each sell three grades of gasoline, Stein pointed out, and that each have four competitors who also sell three gasoline grades — then each day the chain must gather 1,500 prices. “Try to put all of that data into an Excel spreadsheet,” he continued, “and it becomes very unwieldy. Our system handles all that — and it keeps working on weekends and holidays.”

PriceNet is designed to automate that process, discern competitors’ pricing patterns, develop models of how consumers react, and then automate the retailer’s competitive response—according to the pricing rules, volume targets, and margin goals that the retailer establishes. The need to automate these functions, Stein believes, is seen in the fact that “marketers’ behavior isn’t the same seven days a week, and many of your competitors are already changing their prices more than once a day.”

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And Then Add Game Theory

• Also in looking ahead to the future, Stein foresaw the day when it may be possible “not only to develop models of your competitors’ pricing patterns, but to take those models and predict what your competitors will do in response to a given condition.”

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Empirical Evidence

• NBER Working Paper No. 12530Issued in September 2006NBER Program(s):   IO    EEE

• In this paper, we compare the price and income elasticities of gasoline demand in two periods of similarly high prices from 1975 to 1980 and 2001 to 2006.

• The short-run price elasticities differ considerably: and range from -0.034 to -0.077 during 2001 to 2006, versus -0.21 to -0.34 for 1975 to 1980.

• The estimated short-run income elasticities range from 0.21 to 0.75 and when estimated with the same models are not significantly different between the two periods.

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Some Additional Research

• Retail Gasoline Pricing: What Do We Know?• Daniel S. Hosken1• Federal Trade Commission• Robert S. McMillan• Federal Trade Commission• Christopher T. Taylor• Federal Trade Commission• October 30, 2006

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Their Findings• find that stations do not appear to use simple static pricing rules:

– Stations do not charge a fixed mark-up over their wholesale costs, – nor do they simply maintain their relative position in the pricing

distribution over time. • Instead, a particular gasoline station frequently changes its relative

position in the pricing distribution, often dramatically. • Also find differences in the pricing strategies of gasoline stations.

– Stations that charge very high or very low prices in one period are much more likely to charge high or low prices in subsequent periods.

– Interestingly, there appears to be an asymmetry in this behavior.• Stations charging low prices appear to remain low priced stations for much

longer periods than high priced stations.• My observation: Madison Park station appears to maintain its rank

(as one of the highest priced) and relatively large price differential over time

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Journal of Marketing Research588 Vol. XLIII (November 2006), 588–604

• Two important trends in this context are micromarketing and “demand-based management,”which emphasize tailoring supermarket retail chain prices to each store’s clientele, environment, and performance conditions

• Micromarketing represents a manager’s interest to combine the advantages of large operations with the flexibility of independent, yet “customized,” neighborhood stores.

• Iyer and Seetharaman (2003) provide empirical evidence for such micromarketing strategies governing prices and service decisions in gasoline retailing.

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Other Monopolist Pricing Strategies

• Predatory Pricing

• Dumping

• Zone Pricing

• Block Pricing

• Tie-in Sales

• All aimed at extracting Consumer Surplus

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Predatory Pricing• Predatory pricing (also known as destroyer pricing) is the

practice of a firm selling a product at very low price with the intent of driving competitors out of the market, or create a barrier to entry into the market for potential new competitors. If the other firms cannot sustain equal or lower prices without losing money, they go out of business. The predatory pricer then has fewer competitors or even a monopoly, allowing it to raise prices above what the market would otherwise bear.

• In many countries, including the United States, predatory pricing is considered anti-competitive and is illegal under antitrust laws. However, it is usually difficult to prove that a drop in prices is due to predatory pricing rather than normal competition, and predatory pricing claims are difficult to prove due to high legal hurdles designed to protect legitimate price competition.

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The Standard Oil Case• Rockefeller’s Standard Oil Monopoly• Predatory pricing through sharp discounting is not beneficial to a

business in the short run, as it may result in a price war and will cause loss of revenue and/or profits. Yet businesses may engage in predatory pricing because it may pay dividends in the long run.

• This is because competitors who are not as financially strong as the predator will suffer even more, either due to loss of business or reduced profit margin caused by the aggressive price competition. The predation continues until the competitor is driven to failure and forced to leave the market. After the weaker competition has been driven out, the surviving business can raise prices above competitive levels (to "supra competitive pricing"). The business hopes to thereby reap revenues and profits that will more than offset the losses during the predatory pricing period.

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Another Explanation

• McGee, John, "Predatory Price Cutting: The Standard Oil (N.J.) Case," Journal of Law and Economics Vol 1 (April 1958)

• Buy out other gas stations at a price higher than the competitive value, based on possible future monopolistic value

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Game Theory and Predatory Pricing Models

• Since the early 1980s, economic models based on game theory and the theory of imperfect information have suggested that predatory pricing can be rational and profitable under certain circumstances. For instance, by increasing production and lowering price below costs, a firm may convince its competitors that it has achieved a lower cost of production than them—the competitors will see the firm's high volume and low price and may believe that the firm's price is not below its costs but rather the firm's costs are low because of its high volume—causing them to leave the market based on the conclusion that it would not be profitable for them to compete; this is known as low-cost signalling. Also, by pricing aggressively the incumbent firm will acquire a reputation for being "tough", this may deter potential entrants in the future.

• Another explanation for predatory pricing may be where long term success will require a large market share from early on (e.g. market for computer operating systems), usually markets with significant switching costs. By pricing aggressively to start with, even pricing below cost, firms can ensure a base of customers in the future from whom to make a profit. Moreover, the criticism of predatory pricing theory suggests that competition will come flooding back in to profit from the irrational market pricing. This view is based on conventional market economics, but it overlooks that there may barriers to entry or other significant transaction costs that cannot be borne by smaller competitors in the short run or in some cases even in the long run.

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More Game Theory• Moreover, most criticism of predatory pricing is based on oversimplified

models and demonstrably fallacious assumptions, which disregard the the fact that businesses which engage in predatory pricing (1) are typically able to buy in sufficient volume to negotiate lower costs and/or bypass one or more levels of the distribution chain through which their competitors must operate, (2) are typically diversified retailers, able to subsidize losses in some departments with profits in others, and (3) are typically chain retailers, able to subsidize a temporary overall loss at one location with profits from other locations. Once all competitors for a given product line are driven out of an area, prices on that product line can be raised to a point that is profitable (particularly with reduced costs), yet low enough to serve as a barrier to entry, at least for independent specialty merchants. Also frequently overlooked by critics is the fact that predatory retailers typically locate their stores far enough away from established local merchants to discourage their customers from patronizing the local merchants in the same trip. As local independent merchants are driven out of business, customer traffic in established retail areas (both traditional downtowns and shopping centers of various sizes and types) decreases, leaving the remaining merchants more vulnerable to being driven out.

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Upside to Monopolies?

• Dumping– Some argue that it can be good to allow a firm to attempt to

monopolize a market, since practices such as dumping can benefit consumers in the short term; and once the firm grows too big, it can be dealt with via regulation

• Natural Monopolies (monopolies of scale)– When monopolies are not broken through the open market, often

a government will step in, • regulate the monopoly, turn it into a publicly owned monopoly, • forcibly break it up (see Antitrust law). Public utilities, • Natural monopolies are less susceptible to efficient breakup,

– strongly regulated or publicly owned.– AT&T and Standard Oil are debatable examples of the breakup of a

private monopoly. When AT&T was broken up into the "Baby Bell" components, MCI, Sprint, and other companies were able to compete effectively in the long distance phone market and began to take phone traffic from the less efficient AT&T.

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Factors Working Against Persistence

• Monopoly rents attract entry of other firms– First mover advantage

• monopolies tend to become less efficient and innovative over time, – complacent giants", do not have to be efficient or innovative to compete

in the marketplace• One of the arguments advanced by AT&T for deregulating the Telecomm

industry in 1996• Availability in the longer term of substitutes in other markets. For example, a

canal monopoly, while worth a great deal in the late eighteenth century United Kingdom, was worth much less in the late nineteenth century because of the introduction of railways as a substitute.

• However, loss of efficiency can raise a potential competitor's value enough to overcome market entry barriers, or provide incentive for research and investment into new alternatives.

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Does a Single Supplier Always Mean There is a Monopoly?

• The theory of contestable markets argues that in some circumstances (private) monopolies are forced to behave as if there were competition because of the risk of losing their monopoly to new entrants.

• This is likely to happen where a market's barriers to entry are low.

• Single supplier does not necessarily mean there is a monopoly– Firm may behave as though its in a competitive

market

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