Monopoly

A monopoly is the sole producer of a commodity that has no close substitutes and faces many buyers.
The firm and the industry are identical. The demand curve faced by the firm is the downward-sloping industry demand curve. A monopoly acts as a price-maker

Monopoly
The existence of the downward-sloping demand curve sets a constraint on the monopolists actions The monopolist can either set the price and then sell the quantity indicated by the demand curve Or determine the quantity to be sold and then find the price at which this quantity can be sold

Market power
A monopolist, as we shall see, has market power That is, it can set a price above marginal cost Whether a market is a monopoly market or not depends on the definition of the market The market must be such that the monopolists product has no close substitutes If we define the market too broadly, a monopolist may appear to have rivals If we define it too narrowly, we may identify a firm as a monopoly when it is not

Where Do Monopolies Come From?

1 Government blocks the entry of more than one firm into a market. (Why?) 2 One firm has control of a key resource y to p produce a good. g necessary 3 Economies of scale are so large that one firm has a natural monopoly. 4 Being first to produce a new product (iPod)

Where Do Monopolies Come From?

Entry Blocked by Government Action
The government blocks entry in two main ways: 1 By granting a patent or copyright to an individual or firm, giving it the exclusive right to produce a product. 2 By granting a firm a public franchise, making it the exclusive legal provider of a good or service.

Where Do Monopolies Come From?

Entry Blocked by Government Action

Patents and Copyrights Patent The exclusive right to a product for some period from the date the product is invented. Copyright A government-granted exclusive right to produce and sell a creation. Public Franchises Public franchise A designation by the government that a firm is the only legal provider of a good or service.

Where Do Monopolies Come From?

Control of a Key Resource
Another way for a firm to become a monopoly is by controlling a key resource. To produce aluminium you need bauxite the ALCOA example

Are Diamond Profits Forever? The De Beers Diamond Monopoly

De Beers promoted the sentimental value of diamonds as a way to maintain its position in the diamond market.
http://edwardjayepstein.com/diamond/pro logue.htm

Scale Economies and Monopoly

Monopolist can make a profit because AC lies below the demand curve at some quantities Two firms cannot make positive profits
AC lies above Dhalf for all quantities

Profit-maximization
Let the equation of the (inverse) demand curve facing the monopolist be P = P(Q), where dP/dQ < 0. The total cost function is C = C(Q) C(Q). The monopolist tries to maximize = TR C, where TR = P(Q).Q and TC = C(Q).

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Profit-maximization
The first order condition is d/dQ = dTR/dQ dC/dQ = 0, i.e., dTR/dQ = dC/dQ. => MR = MC. The second order condition is d2/dQ2 = dMR/dQ dMC/dQ < 0
$

Profit Maximization
C t' R 400

300 c 200 150 100 50 0 c 5 t Profits

10

15

20 Quantity

Maximizing Profit When Marginal Revenue Equals Marginal Cost

$ per unit of output

Marginal Revenue
For a straight line demand curve P = a bQ, what is the MR equation? TR = PQ = aQ bQ2 Then MR = dTR/dQ = a 2bQ AR = TR/Q = a bQ for Q > 0.

MC P1 P* AC P2
Lost profit

D = AR MR Q1 Q* Q2
Lost profit

Quantity

Average and Marginal Revenue

$ per unit of output

P and MR
Note: MR = dTR/dQ. But TR = PXQ. Hence MR = P + Q(dP/dQ) = P(1 1/e)

7 6 5 4 3 2 1 0
Marginal Revenue

Average Revenue (Demand)

7 Output

Profit-maximization
For e > 1, MR < P; for e < 1, MR will be negative So long as MC > 0, 0 profit-maximization requires MR > 0, i.e. e > 1.

The Monopolists Output Decision

An Example C(Q) (Q) = 50 + Q2 P(Q) = 40 Q Then MC = 2Q, MR = 40 2Q MR = MC => Q = 10, P = 30

The monopolist will operate on the elastic portion of the demand curve.

Profit Maximization
$/Q

Miscellaneous
The Monopolist does not face a Supply

40

MC

30
Profit

Curve The Lerner Index

AC AR

20 15 10 MR 0 5 10 15 20
Quantity

- Th The elasticity l ti it of f demand d d affects ff t a monopolists price relative to its marginal cost - Check the price-marginal cost margin: (p MC)/p

The Lerner Index

MR = p(1 1/e) Then MR = MC implies L = (p MC)/p = 1/e For a competitive firm, p = MC => L = 0 The smaller e, the larger the Lerner index and the greater the monopolists ability to set price above marginal cost.

Monopoly
If demand is very elastic, there is little benefit to being a monopolist The larger the elasticity, the closer to a perfectly competitive market

Perfect competition vs. Monopoly

Monopoly is inferior to perfect competition in two respects. (1) In perfect competition, the long run equilibrium is when price is driven down to the point of the minimum average cost curve productive efficiency is attained. Monopolist is not forced to produce at the lowest point of the average cost.

Perfect competition vs. Monopoly

(2) Perfect competition leads to a situation where the potential gains from trade between buyers and sellers are fully realized allocative efficiency p = MC The monopoly charges a price that is higher than marginal cost and there is a deadweight loss under monopoly.

Does Monopoly Reduce Economic Efficiency?

Comparing Monopoly and Perfect Competition
What Happens If a Perfectly Competitive Industry Becomes a Monopoly?

The Social Costs of Monopoly Power

Monopoly power results in higher prices and lower quantities However, does monopoly power make consumers and producers in the aggregate better or worse off? We can compare producer and consumer surplus when in a competitive market and in a monopolistic market

Does Monopoly Reduce Economic Efficiency?

Measuring the Efficiency Losses from Monopoly

Taxation of a monopolist
What happens if a tax is imposed on a monopolist? If the tax is a lump-sum tax T, it is clear that there will be no effect on either monopoly price or quantity, because the monopolist will now be maximizing T.

The Inefficiency of Monopoly

Taxation of a monopolist
Suppose that a specific tax of t per unit is imposed. Consider linear demand and cost curves: P = a Q, Q C = cQ, Q a > c. Then Q* = (a c)/2 and P* = (a + c)/2. Next, let the tax be imposed on quantity at the rate t, a > (c+t).

Taxation of a monopolist
The total cost curve facing the monopolist becomes C = (c+t)Q. Quantity is now Q** = (a c t)/2 and price P** = (a+c+t)/2 (a+c+t)/2. Hence, P** - P* = t/2, which shows that price has increased by only half the amount of the tax per unit.

Taxation of a monopolist
However, it is not generally true that the price increases by less than the tax. Suppose that the demand curve is a constantelasticity demand curve. MR = P(1 1/e). Equating this to MC = c and solving, we get P = c/(1 1/e). After the tax is imposed, price is P = (c+t)/(1 1/e). P P = t/(1 1/e). Since e > 1, 1 1/e is a fraction and therefore the increase in price exceeds t.

MONOPOLY
The Effect of a Tax
Suppose a specific tax of t dollars per unit is levied, so that the monopolist must remit t dollars to the government for every unit it sells. If MC was the firms original marginal cost, its optimal production decision is now given by

Effect of Excise Tax on Monopolist

With a tax t per unit, the firms effective marginal cost is increased by the amount t to MC + t. In this example, the increase in price P is larger than the tax t.

Nonprice Effects of Monopoly: Investments

Firms can make investments in an effort to become a monopolist Example: cable TV firms lobbying government officials to award them franchises If firms compete to become a monopolist, they will spend up to the full monopoly profit (Richard Posner) If they spend on socially wasteful things (e.g., golf outings for local officials) the loss from monopoly may be larger than deadweight loss and include all monopoly profit

Response to Changes in Cost

How do monopolies and perfectly competitive markets differ in their response to changes in costs? Consider the case of a marginal cost increase by a given amount at every level of output
Example: a specific tax, T, on firms

The pass pass-through through rate is the increase in price that occurs in response to a small increase in marginal cost, measured per dollar of increase in marginal cost In a competitive market, the pass-through rate is never greater than one The monopolists pass-through rate depends on the shape of the demand curve
Can be greater than one with a constant-elasticity demand curve

Nonprice Effects of Monopoly: Investments Rent seeking is socially useless effort devoted to securing a monopoly position Welfare effects of monopoly need not always be so bad Expenditures firms make to gain monopoly positions can be socially valuable (e.g., R&D spending in the search for patentable drugs)

Regulating Monopoly Power

Since monopoly leads to a higher price and a lower output than a comparable competitive industry, governments try to restrict monopoly power in various ways. ways

Regulating Monopoly Power

Price ceiling - Changes the demand curve facing the firm - The profit-maximizing output for monopoly becomes the same as the perfectly competitive output

If price is lowered to PC output increases to its maximum QC and there is no deadweight loss.
$/Q Pm

Price Regulation
MC

MR

P2 = PC

AC

AR If left alone, a monopolist produces Qm and charges Pm.

Qm Qc Quantity

The Social Costs of Monopoly Power Natural Monopoly

A firm that can produce the entire output of an industry y at a cost lower than what it would be if there were several firms. C(Q) < C(q1) + C(q2) + C(q3) + .. + C(qn), where Q = q1+q2+ ..+qn If the average cost curve is downward sloping, then there is natural monopoly Sufficient, not necessary condition

Natural Monopoly
Suppose that the total cost function is C = 50 + 10Q. If output per day is 25, one firm can produce this amount at an average cost of Rs.12 and total cost of Rs Rs.300. 300 On the other hand, if there are two firms and one produces 12 units while the other produces 13 units, the total cost of production is 170 + 180 = Rs.350 which is greater than the cost of production of a single firm.

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Regulating the Price of a Natural Monopoly

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$/Q

Regulating the Price of a Natural Monopoly

Unregulated, the monopolist would produce Qm and charge Pm. If the price were regulate to be PC, the firm would lose money and go out of business.

Pm

Natural N t l monopolies li occur because of extensive economies of scale

Setting g the price p at Pr yields the largest possible output;excess profit is zero.

Pr PC MR
Quantity Qm Qr

AC MC AR

QC

Quantity

First-Best vs. Second-Best Price Regulation

Under regulation, ideally prices will be set at the competitive price Price at which demand and supply curves intersect Aggregate surplus will be maximized First-best solution to problem of price regulation Two T problems bl with ith achieving hi i this thi lead l d to t second-best db t regulation Regulator may not know the firms marginal costs First-best solution would cause the monopolist to lose money If P < AC Best the regulator can do is set a price that makes aggregate surplus as large as possible, allow the firm to break even Set P = AC
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Regulatory Failure
Difficulties associated with price regulation:

It is very difficult to estimate the firm's cost and demand functions because they change with evolving market conditions Regulated monopolists make many decisions other than about price regulation may lead to inefficiencies wrt these decisions

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Regulatory Goals
Regulators may pursue goals other than the maximization of aggregate surplus - Official mandate may include other objectives, j , e.g. g provision p of services to poor consumers - Regulators may be appointed/elected they can try to improve chances of repeat appointment or reelection - Regulators may be captured by the regulated firm

Government ownership
If the government owns the monopoly, - There is no need for elaborate regulatory hearings saves resources - Managers have no incentive to overstate costs But there is no focus on profits which leads to efficiency - the politicians and bureaucrats have their own agendas

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