Topic 3: Monopoly firm

1. Topic 3: Monopoly firm • Price/quantity decision. • Constrained by a demand function (Figure 4.1 on page 90 of CP) • MR=MC ( calculus in class; graph in Figure 4.2 on page 91 of CP) • Monopoly power depends on the demand elasticity; the mark-up concept (derivation in class; content on page 92) • Can still earn negative profit • If fixed cost is high • Still strive for efficiency • In CE, can observe what others do. A firm can infer from the market price the cost of competing firms. Thus, they can improve their production efficiency. • For monopoly, no other firms to look at. Have no other standard by which to judge how efficiently it is operating.

2. Monopoly behavior over time • If demand is inelastic, the firm could increase is profits by raising its prices until it was operating in the elastic portion of its demand curve. • In actual markets, demand curves shift over time. • In the short run consumers may have a more inelastic demand curve. • It takes time for people to change their habits: some but few changed to bicycling when oil price hiked. • But in the long run, consumers can substitute away from its product in subsequent periods.

3. The costs and benefits of monopoly • The deadweight loss of monopoly: a monopoly restricts output and raises its price above marginal cost (Figure 4.2: consumer surplus, firm surplus, total surplus). • The magnitude of DWL is limited • Rent-seeking behavior • In monopoly: transfer from consumer to the firm; in tax: transfer from consumer to the government. • The use of a firm’s resources to hire lobbyists, lawyers, and economists to argue its case before legislators is a cost to society – not productive for the society. • The higher the monopoly profit, the more resources the firm is willing to spend. • Total loss: the DWL plus part of the monopoly profits.

4. The DWL depends on the demand elasticity of price; benefit of monopoly • Figure 4.3 • More elastic one: p=60-.5Q. • Q=50, p=35, profit=1250, DWL=625 • Less elastic one: p=90-.8Q. • Q=50, p=50, profit=2000, DWL=1000. • Intuition: • As the demand curve becomes less elastic at the monopoly equilibrium, people are less willing to do without this good: An increase in price causes the quantity they purchase to fall by less than if demand were more elastic. The monopoly, realizing this, increases its price and earns a larger profit. • Benefit of monopoly: were it not for the quest to obtain monopoly profits, firms might innovate less.

5. How a monopoly is created • Merge or act in concert (later) • take strategic actions that prevent entry by other firms. • Knowledge advantage • Only it knows how to produce a certain product (or it can produce the product at lower cost than others). Figure 4.4 • Cost advantage • Management advantage • First-move • Government protection • Patent laws • taxi: restrict number • Obtain a certificate of need; demonstrate that a new facility is needed. • High fixed costs; natural monopoly • A natural monopoly has falling average costs and constant or falling marginal costs in the region in which it operates. • “a firm product 100 units at an average cost of 10. • Now two firms. Each produce 50 units. The average cost is 15 per unit. Therefor total costs is 1500 • Often argued that electrical, gas, telephone, and cable television are natural monopolies. There is relatively high fixed cot for running an a phone line, but constant of falling mc of supplying the service.

6. Dominant firm with a competitive fringe • What happens to a monopoly when other, higher cost firms enter its market? • Or what happened if a lower cost firm enters a market with many price-taking higher-cost firms? • If a firm is a price setter and faces smaller price-taking firms, it is called a dominant firm. • Reasons some firms are dominant • It has lower costs than fringe firms. • More efficient • An early entrant; have learned by experience how to produce more efficiently. • An early entrant may have had time to grow large so as to benefit from economies of scale. By spreading fixed costs over more units, it may have lower average costs than a new entrant can instantaneously achieve. • The government may favor the original firm. • A dominant firm may have a superior product. This may be due to a reputation achieved through advertising or through goodwill generated by its having been in the market longer • A group of firms may collectively act as a dominant firm. • Whether a dominant firm can exercise market power in the long run depends on • Number of firms that can enter the market • How their production costs compare to those of the dominant firm • How fast they can enter.

7. When entry is not possible • Assumptions • One is much larger than the others -- all are price takers except the dominant firm • The number of firms is fixed • The dominant firm knows the market’s demand curve • The dominant firm can predict how much output other firms will produce. • The equilibrium • The dominant firm takes fringe firms’ decision into consideration and maximize profit • See Figure 4.6 (number of firms is fixed) • The dominant firm’s cost advantage is low • The both dominant firm and fringe firm has positive economic profit • The dominant firm's cost advantage is high • The dominant firm becomes monopoly.

8. When entry is possible • If the dominant firm’s marginal cost is high: the equilibrium is that it produces certain quantity, price is the minimum long run average cost • If the dominant firm's marginal cost is not that high, it can still enjoy positive economic profit.

9. Research ideas related to competition vs. monopoly • Does competition affect firms’ discrimination? • Hypothesis: firms in competitive environment can’t afford discrimination as it will lose out and be competed away quickly whereas firms with monopoly power can afford to do so since it won’t be competed away. • Becker’s paper. • Does competition lower the quality of credit rating? • Bo and Milbourn (JFE, 2012) • Hypothesis: credit rating agencies (CRAs) are paid by firms that they rate; CRAs thus face pressure to please firms to maintain market share. • They find with the introduction of a third rating firm, Fitch, the rating quality decreased • The level of ratings by S&P and Moody’s increased – more are ratings AAA. • The ability of rating to predict default decreased. • The correlation between rating and yield spread decreased. • They exploit the variation in market share of Fitch across different industries. • They explored alternative explanations of their results. • They used instrument variables to address the potential endogeneity issue. • They explored different theories for their findings that more competition is associated with lower rating quality.

10. Research ideas related to competition vs. monopoly • Does competition induce riskier behavior by banks given that they have depository insurance? • Keeley (1990; AER); Hellman et al. (2000; AER). • Moral hazard: deposit insurance, which reduces depositors’ incentives to monitor • Greater competition erodes the franchise value • Deposit rate control can be used together with capital reserve requirement. • Does competition exacerbate firms’ incentives to sell shoddy products? • Depends on whether the reputation mechanism works • Whether consumers have the information on the quality of the product/service. • How long it takes to know the quality • How easy the information can be transmitted • Does competition enhances firms’ incentives to evade taxes? • Cai and Liu (EJ) • They measure competition using four different methods, including HFDI, which we will talk about later. • They measure competition at the industry level.

11. Cooperative oligopoly • Why cartels form? • In a CE, firms do not internalize the impact of their decisions (q) on the other firms’ profit (via p). • When a firm sells one more unit, it does not think its impacts price. • But it does. • A monopoly internalize the impact of quantity on price sold • It is good for itsprofit

12. Factors that facilitate the formation of Cartels • Tacit collusion • necessary to establish a cartel: • A cartel be able to raise price above the non-cartel level without inducing substantial increased competition from nonmember firms. • Depends on price elasticity. • Entry by nonmember firms prevents a cartel from raising price • Entry of close substitutes produced in other industries prevents it. • The expected punishment is low • Depends on enforcement • Cost of establishing and enforcing an agreement is low. • Setting up a secret meeting without the government’s knowledge is relatively easy when there are few firm involved. • Empirical evidence: more concentrated industry: more likely • Similarly, the smaller the geographical area of a market, the more likely since a few firms have a larger share of the business • Easier when the product has similar qualities or properties. A firm can increase its quality and hold its price constant. • Empirical evidence: price-fixing cases : the product was relatively homogeneous across firms. • Trade association, by lowering the costs of meeting and coordinating activities among firms, facilitate the cartels.

13. Enforcing a cartel agreement • Detecting cheating • There are fewer firms in the market • Firms' share of the market (an indication of price cutting) is easier to detect. Moral suasion is easier when only f few conspirators. • Conspiracies are uncovered through info provided by private parties rather than by DOJ. • Prices do not fluctuate independently • Shifts in demand, input costs, or others, prices have to adjust often. • Manufacturers rotate the winning of sealed bids. • Prices are widely known • All cartel members sell identical products at the same point in the distribution chain. • For firms with same vertical integration arrangement, cheating is easier to detect.

14. Cartels with little incentives to cheat • No incentives to cheat if their mc curves are relatively inelastic, fixed costs low relative to overall costs, • MC curve is nearly vertical. When they near their full capacity. Indeed. Cartels force their mc curves to be more vertical by using union contracts that require double wages for overtime work or using similar techniques. • customers place small, frequent orders, • Without advertising, customers may not know. Then the benefit is small • or they have a single sales agent. • Use central sales office.

15. Method of preventing cheating • Divide the market • Assign each firm certain buyers or geographic areas • Use most-favored nation clauses • If either company cut its price, it would have to cut prices to all previous buyers as well. • Use meeting-competition clauses • Buyers will bring news of lower prices to the cartel. • Trigger prices • If the market price drops below a certain level, each firm will expand its output to the pre-cartel level. • Cartels and price wars • Customers gain as cartels fail • Price-fixing laws

16. Lower Effort in Relative Performance Evaluation (Bandiera et al. (2005) QJE) RPE:

17. Piece rate contract

18. Setting • An orchard in U.K. • Compensation=*y • Where y is the total kilograms of fruit picked by worker i on the field-day. • They measure y as the number of kilo of fruit picked per hour. • Under relative scheme, where the nominator is the minimum wage and the denominator is the average hourly productivity of all workers on the field-day. • At the start of each field-day, the field manager announces an ex ante unit wage based on her expectation of worker productivity. This unit wage is revised at the end of each field-day to ensure that a worker with the average productivity earns the pre-established hourly wage.

19. Setting, cont’d • Under piece rate, the unit wage is set ex-ante based on the manager’s assessment of productivity that field-day, and is not revised. • Between mid-May and the end of August. • Data are recorded electronically. • Sample is restricted to those who worked at least 10 field-days under each incentive scheme. • Sample contains 10,215 worker-field-day level observations, covering 142 workers, 22 fields , and 108 days • The pay scheme changed for all workers midway through the season. • The relative pay is adopted b/c it allow them to difference out common productivity shocks, such as those from weather and field conditions.

20. Descriptive stats • Under RPE: 5.01 kg/hr. Under piece rate.: 7.89, an unconditional increase of 59 percent. • Figure 1 shows the mean of worker productivity over time in the two fields that were operated for the most days under each incentive scheme. • Figure 2 shows kernel density estimates of individual productivity by each incentive scheme. The productivity of the 142 workers in the sample is average within each pay in this figure. The mean and variance of productivity both rise . • Note the average number of people each worker worked with on a given field-day is 40.

21. Figure I

23. Other changes? • Very few left before or just after the change in pay method. • Was it b/c the rate is higher? No; see below.

24. Estimation result: reduced-form evidence

25. Column 4, controls for -- a linear time trend to capture farm level changes over time. -- a measure of each field's life cycle to capture field level changes over time. --- the number of days/the total number of days the field is picked over the entire season. -- A measure of each worker’s picking experience.

26. Is it b/c factors that varies over time and not captured by the farm level trend or the filed-specific life cycle? • In first column of Table III, they augment the sample by adding worker-field-day obs from the same farm in 2004 when workers were paid piece rate throughout. • In 2nd column, they note that the two main fields operated most frequently under both pay scheme, experienced the change in pay method at one-quarter of their life cycle. They construct a placebo piece rate dummy for each field, set equal to one after a field has passed 25 percent of its life cycle and zero otherwise. • Column 3 exploits the same idea at the worker level. In the baseline sample, workers had been picking for an average of 19 days before the change in incentives. They create a placebo piece rate dummy for each such worker set equal to one after that worker has been picking for 19 days. • Column 4 they restrict the time window to 10 days before and after the intro of piece rate. to eliminate the effect of natural long-term changes in productivity. • Last, quality did not decrease.

28. Is this b/c income targeting, reaction to uncertainty, and ratchet concerns? • Income targeting: piece rate. is lower, so had to work harder to make the daily earnings: Three pieces of evidence cast doubt on the empirical relevance of income targeting in this setting. • Workers who face higher piece rates work harder. They exploit the real-level GDP and find that people from poorer countries work harder. • They find that workers earn in response to weather, inconsistent with the absolute daily income target. • They will show that the effect varies with the percentage of acquaintance. Those findings cast doubt on the hypothesis that income targeting is fully responsible for the difference in productivity • Uncertainty? Authors argue that is it unlikely to be driving the difference in productivity since workers from expectations on the unit wage based on repeated obs. Each field-day they pick. • Ratchet effect. That would make the estimate underestimated.

29. Is it b/c workers’ productivity is higher when they work with friends? -- Look at columns 2a and 2b.

30. Is it altruism or collusion? Both can explain the results. But altruism is unconditional while collusion requires the fact that players observe others’ deviation. Fruit 2: workers can’t observe each other.