Monopoly, Market Power

and Market Failures

Prof. Carlo Cambini

carlo.cambini@polito.it
Review of Perfect Competition

z Large number of buyers and sellers

z Homogenous product
z Perfect information
z Firm is a price taker
z Solution
P = (L)MC = (LR)AC
Normal profits or zero economic profits in the
long run

2
Review of Perfect Competition

3
Microeconomics: a review

4
Individual demand: consumer
behavior
z Under the local nonsatiation assumption, the optimal
consumer demanded bundle of goods (i = 1, .., n) is given by
the following problem:

v( p, m) = max u ( x)
x
s.t. px = m
where p is the vector of market prices and m the income level
of the consumer.
z v(p, m) is the maximum utility achievable at given prices and
income and is called indirect utility function. The optimal x(p,
m) is therefore the consumer’s demand function.

5
Individual demand: consumer
behavior

z The Lagrangian for the Utility maximization problem

can be written as:

L = u ( x) − λ ( px − m)
z The FOC is given by:
∂u ( x)
− λpi = 0 for i = 1,...n
∂xi
And it can be re-elaborated as:
⎛ ∂u ( x*) ⎞
⎜⎜ ⎟⎟
⎝ ∂xi ⎠ = pi for i, j = 1,...n
⎛ ∂u ( x*) ⎞ p j
⎜ ⎟
⎜ ∂x j ⎟
⎝ ⎠ 6
Individual demand: consumer
behavior

z The indirect utility, i.e. the maximum utility as

a function of p and m has the following
properties:

 It is non increasing in p, that is if p’ ≥ p, then

v(p’, m) ≤ v(p, m). Similarly, v(.,.) is non
decreasing in m.
 It is continuous and quasi-convex

7
The quasi-linear utility function
z Partial equilibrium analysis: analyse the market
functioning of a “good” that has a relatively low weight
on the global economy.
z Hence, we can introduce two simplifying assumptions:
 1. the impact of a change in consumers’ income on the
expenditure of the “good” is limited (no income effect);
 2. the substitution effect on the other goods is small too.
z The prices of the rest of goods can then be considered
as fixed and we can be assume them as a numeraire,
normalised to 1.
z We can then simplify our utility function in the following
way (yi is the “rest of goods”, i.e. the numeraire):

U ( x, y ) = u ( x ) + y
8
The quasi-linear utility function
z u(xi) is a continuous, increasing, twice-differentiable,
and convex function.
z The optimization problem becomes:
U ( x, y ) = u ( x ) + y
s.t. px + y = m
z FOCs: ∂L ∂u ( x)
= − λp = 0
∂x ∂x
∂L
= 1− λ = 0
∂y

z This leads to the following optimal condition:

∂u ( x)
= u ′( x ) = p
∂x
9
Surplus: a review

z Consumer surplus is the total benefit

or value that consumers receive beyond
what they pay for the good

z Producer surplus is the total benefit or

revenue that producers receive beyond
what it costs to produce a good

10
 Consumer and Producer
Surplus
Price
9 Consumer
Surplus
S

Between 0 and Q0
consumer A receives
a net gain from buying
the product--
5 consumer surplus.
Producer
Surplus
3 Between 0 and Q0
producers receive
a net gain from
selling each product--
D producer surplus.

QD QS Q0 Quantity
11
Marginal effects of a price/quantity
changes on Consumer Surplus
z Consumer surplus, as a function of price, is given by:
∞
CS = V ( p ) = ∫ q ( p )dp
p*

z Hence, it results:

dV ( p )
= −q( p)
dp
z Intutition: the demand has a negative slope, the minus
is needed to have a positve quantity

12
Marginal effects of a price/quantity
changes on Consumer Surplus

z Consumer surplus, as a function of quantity,

is given by:

CS = S ( q ) − p ( q ) q
q*
where S(q) = ∫0
p ( q ) dq

z Hence, it results:

dS (q )
= p(q)
dq
13
Perfect competition and Welfare

14
Welfare economics
z What are the welfare properties of the perfect
competitive equalibrium?
z The representative consumer approach: suppose
that the market demand, x(p), is generated by
maximizing the utility of a single representative
consumer who has a quasi linear utility function u(x)+y,
where x is the good under examination and y
“everything else”.
z Under this utility function, we know that: u ′( x) = p
z Hence, the direct demand function x(p) is simply the
inverse of the above condition
z Note that in case of a quasi-linear utility the demand
function is independent of income!!

15
Welfare economics
z Consider now a representative firm having a cost
function c(x), with c’ > 0, c’’ > 0 and c(0) = 0.
z In a perfect competitive market, the profit maximizing
(inverse) supply function of a representative firm is
given by p = c’(x).
z Hence, the equilibrium level of output of the x-good is
simply the solution to the equation:
u ′( x) = c′( x)
z This is the level of output at which the marginal
willingness to pay for the x-good just equals its marginal
cost of production.

16
Welfare analysis
z What is the optimal amount of output that maximizes the
representative consumer’s utility?
z Let w be the consumer’s initial endowment of the y-good. The
consumer’s problem is: max u ( x ) + y
x, y

s .t . y = w − c(x)
z Intuition: the welfare maximizing problem is simply to maximize
total utility consuming x-good and y-goods. Since x units of the x-
good means giving up – in a competitive market - c(x) units of the
y-good, our social objective function becomes:
max u ( x) + w − c( x)
x, y

z The Foc is given by (as before): u ′( x) = c′( x)

z The competitive market results in exactly the same level of
production and consumption as does maximizing utility directly.

17
Welfare analysis
z Another way to look at the same problem.
z Let CS(x) = u(x) - px be the consumer’s surplus and PS(x)
= px – c(x) be the producer’s surplus.
z The total surplus, or welfare, is:

W = max CS ( x) + PS ( x) =
x

= [u ( x) − px ] + px − c( x) =
= u ( x) − c( x)

z We can conclude saying that the competitive equilibrium

level of output maximizes total surplus!

18
Welfare analysis: a generalization

z Suppose there are i = 1,, n consumers and j = 1,…,m

firms. Each consumer has a quasi-linear utility function
ui(xi)+yi and each (perfectly competitive) firm has a cost
function cj(xj).
z An allocation describes how much each consumer
consumers of x-good and the y-good, (xi, yi), i = 1,, n,
and how much the firm produces of the x-good, zj, j =
1,…,m .
z The initial endowment of each consumer is taken to be
some given amount of the y-good and 0 of the x-good.
z The sum of utilities is given by:
n n

∑ u (x ) + ∑ y
i =1
i i
i =1
i

19
Welfare analysis: a generalization

z The total amount of the y-good is the sum of

initial endowments, minus the amount used up
in production: n n m
y = w − c (z )∑
i =1
i ∑
i =1
i ∑
j =1
j j

z Observing that the total amount of the x-good

produced must equal the total amount
consumed, we have
n n m
max ∑ ui ( xi ) + ∑ wi − ∑ c j ( z j )
xi , z j
i =1 i =1 j =1
n m
s.t.∑ xi =∑ z j
i =1 j =1
20
Welfare analysis: a generalization

z Let λ the Lagrangian multiplier on the

constraint, we have
u i '( xi ) = λ
c j '(z j ) = λ
where p* = λ since the market is perfectly
competitive!
z Hence, market equilibrium necessarily
maximizes welfare for a given pattern of initial
endowments (wi).

21
Consumer Equilibrium in a
Competitive Market

z First Theorem of Welfare Economics

If everyone trades in a competitive
marketplace, all mutually beneficial trades
will be completed and the resulting
equilibrium allocation of resources will be
economically efficient
Welfare economics involves the normative
evaluation of markets and economic policy

22
Consumer Equilibrium in a
Competitive Market
z Pareto Optimality
z An outcome is Pareto optimal if it is not possible
to make one person better off without making
one another worse off
z If this is possbile, we face a potential Pareto
improvement (PPI)
z The adoption of the PPI criterion means that we
can focus on what happens to total surplus.
z Hence an outcome that maximizes total surplus
is Pareto optimal.

23
Consumer Equilibrium in a
Competitive Market

z Difficult for efficient allocation with many

consumers and producers unless all
markets are perfectly competitive
z Efficient outcomes can also be achieved
by centralized system
z Competitive outcome preferred since
consumers and producers can better
assess their preferences and supplies

24
Equity and Efficiency
z Although there are many efficient
allocations, some may be more fair than
others
z The difficult question is, what is the most
equitable allocation?
z We can show that there is no reason to
believe that efficient allocation from
competitive markets will give an equitable
allocation

25
Equity and Perfect Competition
z Must a society that wants to be more
equitable necessarily operate in an
inefficient world?

Second Theorem of Welfare Economics

If individual preferences are convex, then
every efficient allocation is a competitive
equilibrium for some initial allocation of
goods

26
Equity and Perfect Competition

z Any equilibrium that is equitable can be

achieved by redistributing resources and
may be efficient
z Typical ways to redistribute goods,
however, are costly
Taxes lead to bad incentives
z Firms devote fewer resources to production in
order to avoid taxes
z Encourage individuals to work less

27
Market Failures

28
Why Markets Fail

z Market Power
Those with market power choose the price
and quantity
Less output is sold than in competitive
markets
Inefficiency
Can have market power as producers or as
inputs

29
Why Markets Fail

z Externalities
Market prices do not always reflect the
activities of either producers or consumers
Consumption or production has indirect
effect on other consumption or production
not reflected in market prices
May be impossible to get insurance because
suppliers of insurance lack information

30
Why Markets Fail

z Public Goods
Nonexclusive, nonrival goods that can be
made available cheaply but which, once
available, are difficult to prevent others from
consuming
Company thinking about researching a new
technology if can’t get patent
z Once it’s made pubic, others can duplicate it

31
Why Markets Fail

z Incomplete Information
Consumers must have accurate information
about market prices or production quality for
markets to operate efficiently
Lack of information can change supply
z Buy products with no value
z Don’t buy enough of products with value
Some markets may never develop

32
Market Failures
z Economic motivations
 Existence of market power (monopoly, natural
monopoly, collusive oligopoly)
 Externality (positive or negative)
 Market incompleteness (asymmetric information)
z Social motivations:
 Redistributive concerns (urban to rural areas; rich to
poor citizens)
 Merit goods (essential services should be provided to
everybody at affordable prices)
⇒ need of State policy in the form of ex ante
(regulation) or ex post (antitrust) interventions

33
Monopoly

z Monopoly
1. One seller - many buyers
2. One product (no good substitutes)
3. Barriers to entry
4. Price Maker

34
Monopolist’s Output Decision

1. Profits maximized at the output level

where MR = MC
2. Cost functions are the same

π (Q) = R(Q) − C(Q)

Δπ / ΔQ = ΔR / ΔQ − ΔC / ΔQ = 0 = MC − MR
or MC = MR

35
 Monopolist’s Output Decision
$ per
unit of
output MC

P1

P*
AC
P2
Lost
profit

D = AR

Lost
MR profit

Q1 Q* Q2 Quantity

36
Monopolist’s Output Decision

1. Profits maximized at the output level

where MR = MC
2. Cost functions are the same
ΔP ⎛ Q ⎞⎛ ΔP ⎞
MR = P + Q = P + P⎜ ⎟⎜⎜ ⎟⎟
ΔQ ⎝ P ⎠⎝ ΔQ ⎠
⎛ 1 ⎞
MR = P + P⎜⎜ ⎟⎟
⎝ ED ⎠

37
Equilibrium Pricing

π is maximized where MR = MC

P + P ⎡ 1 ⎤ = MC
⎢⎣ E D ⎥⎦
P − MC 1
=
P ED

38
 Elasticity of Demand and Price
Markup
The more elastic is $/Q
$/Q demand, the less the
markup.

MC P* MC

P*
P*-MC
D
P*-MC

MR

D
MR

Q* Quantity Q* Quantity
Measuring Monopoly Power
z Could measure monopoly power by the extent
to which price is greater than MC for each firm
z Lerner’s Index of Monopoly Power
L = (P - MC)/P
z The larger the value of L (between 0 and 1)
the greater the monopoly power
L is expressed in terms of Ed
z L = (P - MC)/P = 1/Ed
z Ed is elasticity of demand for a firm, not the
market

40
Monopoly Power
z Pure monopoly is rare
z However, a market with several firms,
each facing a downward sloping demand
curve, will produce so that price exceeds
marginal cost
z Firms often product similar goods that
have some differences, thereby
differentiating themselves from other
firms

41
Sources of Monopoly Power

z Why do some firms have considerable

monopoly power, and others have little or
none?
z Monopoly power is determined by ability
to set price higher than marginal cost
z A firm’s monopoly power, therefore, is
determined by the firm’s elasticity of
demand

42
Sources of Monopoly Power
z The less elastic the demand curve, the
more monopoly power a firm has
z The firm’s elasticity of demand is
determined by:
1) Elasticity of market demand
2) Number of firms in market: entry
barriers and entry deterrence
3) Strategic behaviour by incumbent
4) New Technology

43
Elasticity of Market Demand
z With one firm, their demand curve is market
demand curve
 Degree of monopoly power is determined completely
by elasticity of market demand (ex. OPEC)
 The presence of alternative suppliers or substitute
products reduces market power (supply and demand
side substitution)
z With more firms, individual demand may differ
from market demand
 Demand for a firm’s product is more elastic than the
market elasticity

44
Demand elasticity in telecoms under
a Monopoly: evidence from Italy

Dependent Variable Price Income

SIP (1988) National calls –0,12 0,5-0,9
Cappuccio Revenues from calls (annual –0,11 0,52
(1990) base 1973)
Gambardella Revenues from calls (annual –0,35 0,25
(1991) base 1964)
Ravazzi (1991) Membership –0,1 0,3
Mosconi (1994) Urban calls –0,19
e Colombino National calls –0,25
(1998) International calls –0,52

45
Demand elasticity in telecoms under
Monopoly: evidence from US
Bodnar et al. (1988) Taylor e Kridel (1990)

Dimension Price
(000 Elasticity Economic Position Price
Elasticity
of inhabitants)
> 500 –0,007 Poor and rural –0,071
100 – 500 –0,006 Poor and urban –0,077
30 – 100 –0,010 Poor black rural –0,089
< 30 –0,013 Rich white urban –0,026
Rurale –0,014 State Price Income
Age Elasticity Elasticity
< 26 –0,024 Arkansas –0,059 –
26 – 44 –0,009 Kansas –0,023 –
45 – 64 –0,007 Missouri –0,031 –
> 64 –0,008 Oklahoma –0,034 –
Income Texas –0,037 –
($ 000)
< 12 –0,026 Average –0,037 0,042
12 – 20 –0,012
20 – 28 –0,006
28 – 38 –0,002
> 38 –0,0005
46
Number of Firms
z The monopoly power of a firm falls as the
number of firms increases; all else equal
More important are the number of firms with
significant market share
Market is highly concentrated if only a few
firms account for most of the sales
z Firms would like to create barriers to
entry to keep new firms out of market
Patent, copyrights, licenses, economies of
scale

47
Number of Firms
z Entry barriers are of interest from two perspectives: (i)
corporate strategy and (ii) public policy.
z Incumbents want to protect not only their market shares
but also their profits
z A key objective of corporate strategy is profitable entry
deterrence.
z Profitable entry deterrence occurs when incumbent firms
are able to earn monopoly profits without attracting entry
z Profitable entry deterrence depends on the interaction
between structural entry barriers and incumbent’s
behaviour
z Public policy should aim at eliminating entry barriers and
detect entry deterrence

48
Government Restrictions on Entry

z Governments create entry barriers when

they grant exclusive rights to produce to
incumbent preventing additional entry
z Forms of exclusive franchises:
Natural Monopoly;
Source of revenues (from State owned
companies);
Redistribute rents among citizens;
Intellectual Property Rights (IPRs)

49
Structural Barriers to Entry
z Structural characteristics that protect market
power without attracting entry, such as:
 Economies of scale
 Sunk expenditures of the entrant
 Absolute cost advantage: incumbent may face lower
costs or a better access to existing facilities (i.e. the
use of the network in the telecoms industry)
 Sunk expenditures by consumers and product
differentiation:
z If a consumer faces a large cost for switching to a
new product, he could decide not to switch ⇒
switching costs and creation of brand loyalty.
z Finally, consumer might not view the offerings of
other firms as substitute.

50
Strategic behavior by Incumbents

z Incumbents may behave in order to enhance

barriers to entry to rivals.
z Potential strategies:
 Aggressive postentry behavior: commit to be
aggressive; ex. Investment in sunk capacity
 Raising rivals’ cost: raising cost of a potential entry or
reducing the profitability of entry
 Reducing rivals’ revenues: again reduce the
profitability of entry increasing the consumers
switching costs and so the market demand for the
entrant

51
New Technology
z Technological change can generate new
products and services, and the
introduction of these products reduces
the market power of producers of
established products.
z Nintendo in ’80 was a monopolist, but the
monopoly ended after the entry by Sega
… and later on by Sony (Playstation) and
Microsoft (X Box)

52
The Social Costs of Monopoly
Power
z Monopoly power results in higher prices
and lower quantities
z However, does monopoly power make
consumers and producers in the
aggregate better or worse off?
z From a social point of view, the effects of
the monopolistic inefficiency can be
appreciated if we look at the Marshall’s
surplus

53
Monopoly Dead Weight Loss

54
Monopoly Dead Weight Loss
z The DWL area measures the surplus that could
have been created with a competitive market,
but goes loss due to level of the price which is
fixed by the monopolist

z The deadweight loss decreases with ED when

the elasticity is large, but it vanishes when the
demand is perfectly rigid, because in this case
moving prices simply correspond to a surplus
transfer between firms and consumers

55
The determinants of Deadweight
loss

z Assume constant marginal cost. The

deadweight loss associated with a monopoly
pricing is approximately equal to:

DWL = 1/2dPdQ

z It can rewritten as:

1 ⎛ dP ⎞⎛ P ⎞⎛ Q ⎞⎛ P ⎞
DWL = dPdQ⎜ ⎟⎜ ⎟⎜⎜ ⎟⎟⎜ ⎟
2 ⎝ dP ⎠⎝ P ⎠⎝ Q ⎠⎝ P ⎠
56
The determinants of Deadweight
loss

z Since marginal cost is constant, dP = Pm-c, it results

1
DWL = Ed P Q L
m m 2

2
z Harnerger’s loss: the inefficiency of a monopoly is
greater the larger the elasticity of demand, the larger
the Lerner Index and the larger the industry
(measured by industry revenues) … however L is
inversely related to Ed

57
The determinants of Deadweight
loss

z Since for a monopolisitc firm L = 1/Ed

1 1 ⎛ P m
−c⎞ π
DWL = Ed P Q L = P Q ⎜⎜
m m 2 m m
m
⎟⎟ =
2 2 ⎝ P ⎠ 2

z Loss in the US long distance telecoms

market: entrants of RBOC into the long
distance market (mid 1990s) decreases the
welfare loss by $2.78 billion

58
The Multi-plant Firm
z For some firms, production takes place
in more than one plant, each with
different costs
z Firm must determine how to distribute
production between both plants
1. Production should be split so that the MC in
the plants is the same
2. Output is chosen where MR=MC. Profit is
therefore maximized when MR=MC at each
plant.

59
The Multi-plant Firm

z We can show this algebraically:

Q1 and C1 is output and cost of production
for Plant 1
Q2 and C2 is output and cost of production
for Plant 2
QT = Q1 + Q2 is total output
Profit is then:
π = PQT – C1(Q1) – C2(Q2)

60
The Multi-plant Firm

z Firm should increase output from each

plant until the additional profit from last
unit produced at Plant 1 equals 0
Δπ Δ( PQT ) ΔC1
= − =0
ΔQ1 ΔQ1 ΔQ1
MR − MC1 = 0
MR = MC1
61
The Multi-plant Firm
z We can show the same for Plant 2
z Therefore, we can see that the firm
should choose to produce where
MR = MC1 = MC2
z We can show this graphically
MR = MCT gives total output
This point shows the MR for each firm
Where MR crosses MC1 and MC2 shows the
output for each firm

62
Production with Two Plants
$/Q MC1 MC2

MCT

P*

MR* D = AR

MR

Q1 Q2 QT Quantity

63
Durable Goods Monopoly
z A durable good is a good which provides
a stream of sustained consumption
services: it can be used more than once.
z Two complicating factors:
 Monopoly creates it own competition! The
existence of a second-hand market limits
monopoly market power
The price consumers are willing to pay today
depends on the expectations about the price
of the good tomorrow

64
Durable Goods Monopoly
z Assume that the good last forever and so
that it does not depreciate over time.
Example: land

z Competitive supply: the supply curve is

fixed; supply and demand determine the
equilibrium price for a lifetime
consumption. Alternatively, the price can
be transformed in ayearly rental price.

65
Durable good in perfect competition

66
Durable good in monopoly
z The monopolist sets the marginal revenues
equal to the marginal cost (= 0) and determine
the first year consumption and price (Q1 and P1)
z In the second period, the monopolist faces a
residual demand given by Qc – Q1 where
consumers have a willingness to pay larger than
marginal costs but lower than P1.
z In order to sell additional units of the good and
use its stock, the monopolists cannot do better
than reducing the price … up to the competitive
price!

67
Durable good in monopoly

68
Durable goods: the Coase
conjecture

z The monopolist has therefore the

incentive to practice intertemporal price
discrimination: it increases its profit
decreasing prices over time.
z Initially, monopolist only supplies those
consumers having a high willingness to
pay.
z Then, the monopolist increases its profit
by moving down the demand curve

69
Durable goods and strategic actions
z Strategic consumers:
 Incentives to delay purchasing if they anticipate that the
monopolist will lower prices in the future
z Cost of waiting depends on the discount rate, i.e. on the
actual cost of consumption tomorrow: the larger it is, the
greater the preference of consumers for a dollar today as
opposed to a dollar tomorrow.
z Assume that the adjusting period is very small and the
discount rate equal to 0 (the discount factor is equal to 1):
a durable goods monopolist has no monopoly power if
the time between price adjustment is vanishingly small ⇒
the Coase Conjecture

70
Durable goods and strategic actions

z Strategies to mitigate the Coase Conjecture:

z Firms might convince consumers that prices do
not decrese over time though
 Leasing, since the good is returned to the firm
 Investment in reputation not to increase supply (ex
Disney movies)
 Limit capacity
 New customers, i.e. expected increase in the demand
 Planned obsolescence, decreasing the durability of its
good, and so enhacing the demand tomorrow keeping
the price high!

71
Durable goods and Pacman
economics

z Is it true that the monopoly always loose its

market power? No, it is the contrary, monopoly
comes perfect since the firm can now extract all
surplus from consumers!
z Monopolistic firm only needs to move down the
demand selling to consumers sequentially in
order of their reservation prices : this is the
Pacman Strategy
z This results is more likely when the number of
buyer is finite and the willigness to pay of
consumers highly differs.

72
Durable goods: Coase vs. Pacman

z Study by Von der Fehr and Kuhn (1996):

When the number of buyers is very large and
there are small differences in willingness to
pay, then Coase outcome is more likely
when the number of buyer is finite and the
willigness to pay of consumers highly differs,
Pacman discriminatory outcome emerges.

73
 Natural Monopoly and
Government Intervention

74
The Social Costs of Monopoly
z Social cost of monopoly is likely to exceed the
deadweight loss
z No allocative efficiency, no incentive to minimize cost ⇒
X-inefficiency
z Hicks’s statement: “The best of all monopoly profit is a
quite life!!”
z Rent Seeking
 Firms may spend to gain monopoly power
z Lobbying
z Advertising
z Building excess capacity
z Dynamic efficiency? Shumpeter vs. Arrow approach on
the effect of the market structure on investment

75
The Social Costs of Monopoly

z Government can regulate monopoly

power through price regulation
Recall that in competitive markets, price
regulation creates a deadweight loss
Price regulation can eliminate deadweight
loss with a monopoly

76
Regulation vs. Competition policy

z CP attempts to avoid situation where market power

can be exploited; regulation deals with the
situation.
z Prices/profits/quality are not usually explicitly
controlled with CP
z Regulation specifies precise details of what firm
can and cannot do (ex ante intervention); CP
issues “guidelines” and uses precedent (ex post
intervention)
z Typically have sector-specific regulators, and a
generalist competition policy authority
77
 Price Regulation Marginal revenue curve
when price is regulated
$/Q to be no higher that P1.
MR

Pm MC
P1

P2 = PC
AC
P3

P4 AR
AnyIfprice
left alone,
below Pa4 monopolist
results
Ifthe
price
For
Ifinprice is
outputlowered
levels
is lowered
firm
produces incurring
Q to to
PCPoutput
above
a loss. 3 output
QP1 , .
m and charges m
decreases andmaximum
the original
increases to its aaverage
shortage
and
Q exists.
C and
marginal
there revenue
is no curves
deadweight apply.
loss. Qm Q1 Q3 Qc Q’3 Quantity
78
The Social Costs of Monopoly
Power

z Natural Monopoly
A firm that can produce the entire output of
an industry at a cost lower than what it would
be if there were several firms
Usually arises when there are large
economies of scale
We can show that splitting the market into
two firms results in higher AC for each firm
than when only one firm was producing

79
Regulating the Price of a Natural
Monopoly
$/Q
If the price
Unregulated, were regulate to be Pc,
the monopolist
the firmQwould
would produce m and
lose money
and go P
charge out
m.
of business. Can’t
cover average costs

Setting the price at Pr

giving profits as large as
Pm possible without going
out of business

AC
Pr

MC
PC
AR
MR

Qm Qr QC Quantity

80
Some definitions on Natural Monopoly

z Single product contest: presence of

economy of scale, i.e. ATC should be
always decreasing
z Is this definition sufficient also in a
multiproduct setting? NOT AT ALL!!
z In a multiproduct setting, given a vector of
quantities i = 1,.., n, the cost function C(.)
should be sub additive, i.e.

81
Some definitions on Natural Monopoly

z Sufficient conditions to have a natural

monopoly in a multiproduct setting are:
Presence of economies of scope:
 C(q1,0) + C(0,q2) > C(q1,q2)
Average incremental costs should be decreasing
(Baumol, Panzar and Willig, 1982)
 where IC1(q1,q2)= C(q1,q2) - C(0,q2)
 C(0,q2) is the so called stand alone cost of product 2
 AIC = IC1(q1,q2)/q1

82
Questions that need to be addressed:

z Whether (and how) to privatise?

z Whether to break up monopoly (or allow

mergers)? Structural regulation (vertical or
horizontal separation)

z Which parts of the industry to regulate?

83
Example: Telecommunications

Local telephony Internet

Mobile telephony
Long distance
Natural telephony
monopoly

International
telephony

84
Example: Electricity market

Production and Import

National Transmission
(high voltage)

Local transmission (low

voltage
Natural
Monopolies
Final market

85
Example: Gas industry

Production and Import

National transmission

Reserve in stock

Natural
monopolies
Local transmission

Retail market

86
Conduct regulation: price control

z First best pricing: price equal to marginal

cost (as in a perfect competitive
environment)
P

PAC
AC
PCm Cm
D

QAC Q Cm

z Public transfer to cover firm’s loss

Q

87
Conduct regulation: price control

z Demo: consumers have a quasi-linear utility

function Uh = Rh + Sh(p), such that
∂Uh/∂p = ∂Sh(p)/ ∂p (no revenue
effect)
z In a monoproduct setting:
Maxp W = S(p) – T + π
where π = pq(p) + T - C(q) – F
Thus, W = S(p) + pq(p) - C(q) – F
Deriving w.r.t. p, we get: p = C’(q)

88
Conduct regulation: price control

z In absence of any kind of transfer from

regulator to the firm, what could happen?
z The regulator should set prices in order to
let the firm reach its break even

z Second best solution: price = AC

z The average cost pricing rule

89
Conduct regulation: price control
z Firm’s profit are zero, but there is always a
deadweigh loss (squared area in figure)

pAC
AC

MC
D
q
qAC
90
Conduct regulation: price control
z Multiproduct setting: practical methods, fully
distributed costs (FDC)
z Suppose to have a cost function:

z Price equal marginal cost leads to losses.

How to cover them?
z A rule to share the fixed cost F should be
defined by the regulator.
91
Conduct regulation: price control
z Fully distributed costs (FDC): price should
cover not only direct (marginal) cost, but also
a share of the fixed costs, i.e.

z where fi is the so called cost driver:

⎧ n
⎪ ( a ) R i ∑ R i if (Gross Revenues Method)
i=1
⎪
⎪⎪ ( b ) Q n
fi=⎨ i ∑ Q i if (Relative Output Method)
i=1
⎪
⎪ n
⎪ ( c ) CD i ∑ CD i if (Attribuit able Cost Method)
⎪⎩ i=1

92
Conduct regulation: price control/6
z It is easy to show that all the three methods
above described leads to define a “equal
mark up rule”.
z In fact:

z Is this efficient?

93
Conduct regulation: price control
z The answer is NO!
DR

DE

p’
p’
A C B D

MC MC

q q

z A+B = Extra-revenues to cover fixed cost

z C+D = deadweight loss!!

94
Conduct regulation: price control

z How to minimize deadweight loss?

z Mark up on prices should be different according to
the different demand structure of the goods:
DR

DE

pR
B’
D’
pE B
A’ C’
MC MC

q q

z Even if A’+B’ = A + B, C’+D’< C+D

95
Conduct regulation: price control

z Immagine that no public transfer could be used and

εij = 0
z Regulator should set prices such that:
z Maxpi S(pi) + π s.t. π ≥ 0
z Denoting with λ the lagrangian multiplier of the
constraint we have:
z L = S(pi) + (1+ λ)π = S(pi) + (1+ λ)(Σpiqi – C(qi))

z What is λ? It can be interpreted as the shadow price of

public funds.

96
Conduct regulation: price control

z Optimal second best solutions: Ramsey-

Boiteaux Pricing rule
pi − ci λ 1
Li = =
pi 1+ λ ηi

z i.e. the price-cost margin (in percentage of

price) should be inversely related to the
price elasticity of demand:
∂qi pi
ηi = −
∂pi qi
97
Conduct regulation: price control

z In general, we have:

z If demands are interdependent (i.e. εij ≠ 0) ..

Superelasticities (Laffont and Tirole, 1993)

98
Cross subsidization

z In many Utilities, the price in some services

are set lower than their marginal cost mainly
for distributional concerns.
z Example: in Telecoms, USO implies that
price for urban calls and the fixee fee have
been set for long time below marginal cost,
while long distance calls (national and
international) have been set above costs in
order to recoup the losses on other services.

99
Cross subsidization

z Problem: cross subsitization could be

strategically used by the incumbent
operator in order to prevent entry in the
market or to induce exit of new entrants.
z Potential anticompetitive behaviour:
incumbent could set price above cost in the
monopolistic segment of the market (i.e.
Local telephony), in order to reduce its price
in the more competitive ones (Long
distance or Internet)

100
Cross subsidization

z How to avoid or detect cross subsidization?

z Faulhaber’s Test (1975).Two services (p1

and p2).

z I^ test on incremental cost:

p1q1≥IC1(q1,q2)= C(q1,q2) - C(0,q2)
p2q2≥IC2(q1,q2)= C(q1,q2) - C(q1,0)

101
Cross subsidization

z II^ test on incremental cost:

 p1q1 ≤ C(q1,0)
 p2q2 ≤ C(0,q2)

z If the two tests have success, then retail tariffs are

subsidy free. Otherwise, Incumbent could have set
its tariffs anticompetitively, and so more scrutiny is
needed (from Competition or Regulatory Authority)

102