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Chapter 17. Monopoly. 1. Market Power. In many situations, competition is not intense A firm has market power when it can profitably charge a price that is above its marginal cost Most firms have some market power, though it may be very slight
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Chapter 17 Monopoly 1
Market Power • In many situations, competition is not intense • A firm has market power when it can profitably charge a price that is above its marginal cost • Most firms have some market power, though it may be very slight • Depends on whether their competitors’ products are close substitutes • Two market structures in which firms have market power: • A monopoly market has a single seller • An oligopoly market has a few, but not many, producers • Determining what is and is not a monopoly market can be trickier than simple definitions might suggest 3
How Do Firms Become Monopolists? • Firms get to be monopolists in various ways: • Government grants a monopoly position to a firm (cable TV companies in local communities, drug patents) • Economies of scale (concrete supply in a small town) • Being first to produce a new product (iPod) • Owning all of an essential input (De Beers diamond producer) • Many of these ways of initially capturing market power tend to erode over time 4
Figure 17.1: 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
Monopoly Pricing • Monopolist will choose the price that maximizes its profit, given the demand for its product • Whenever the firm’s profit-maximizing sales quantity is positive, marginal revenue equals marginal cost at that sales quantity • Marginal cost curve applies as usual • Need to examine the shape of the marginal revenue curve • Recall that a firm’s marginal revenue curve captures the additional revenue it gets from the marginal units it sells, measured on a per-unit basis 6
Marginal Revenue for a Monopolist • An increase in sales quantity (ΔQ) changes revenue in two ways • Firm sells ΔQ additional units of output, each at a price of P(Q), the output expansion effect • Firm also has to lower price as dictated by the demand curve; reduces revenue earned from the original (Q-ΔQ) units of output, the price reduction effect • The overall effect on marginal revenue is: • So the price reduction effect makes the monopolist’s marginal revenue less than price 7
Monopoly Profit Maximization • When a monopolist maximizes its profit by selling a positive amount, its marginal revenue must equal its marginal cost at that quantity • If marginal revenue exceeded marginal cost the firm would be better off selling more • If marginal revenue were less than marginal cost the firm would be better off selling less • Two-step procedure for finding the profit-maximizing sales quantity • Step 1: Quantity Rule • Identify positive sales quantities at which MR=MC • If more than one, find one with highest profit • Step 2: Shut-Down Rule • Check whether the quantity from Step 1 yields higher profit than shutting down 9
Markup • A monopolist facing a downward sloping demand curve will set its price above marginal cost • Firm in a perfectly competitive market sets price equal to marginal cost, meaning that the firm has no market power • Extent to which price exceeds marginal cost is a measure of monopolist’s market power • A firm’s markup, price-cost margin, or Lerner index equals the difference between its price and its marginal cost, as a percentage of its price 11
Markup • A monopolist’s markup at its profit-maximizing price always equals the reciprocal of the elasticity of demand, times negative one • The less elastic the demand curve, the greater the firm’s markup over its marginal cost • When demand is less elastic, raising the price is more attractive because fewer sales are lost • This also implies that demand must be elastic at the profit-maximizing price 12
Welfare Effects ofMonopoly Pricing • By charging a price above marginal cost, the monopolist makes consumers worse off than under perfect competition • Consumers who buy the product pay more for it • Some who would have bought it under perfect competition will not buy it at the higher price • Welfare effects of monopoly pricing: • Firm gains • Consumers lose • Deadweight loss incurred • Deadweight loss from monopoly pricing is the amount by which aggregate surplus falls short of its maximum possible level, which is attained in a competitive market 13
Distinguishing Monopoly from Perfect Competition • Existence of more than one firm in a market does not guarantee perfect competition • How can we tell whether multiple firms in a market are behaving like price takers or colluding and acting like a monopoly? • Easy to answer if we could observe marginal costs and compare to price • Monopolists and perfectly competitive industries behave differently in responses to changes in demand and changes in costs 15
Response to Changes in Demand • Monopolist’s profit-maximizing price depends on elasticity of demand • Price in perfectly competitive market depends on level of demand • If elasticity of demand changes but level of demand does not, provides a way to distinguish between market structures • Can investigate this through data collection over time and statistical analysis 16
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-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 (cannot increase P by more than T) • The monopolist’s pass-through rate depends on the shape of the demand curve • Can be greater than one with a constant-elasticity demand curve: 18
P=(Ed / (Ed+1)) MC • or: PM is a multiple of its MC • if Ed=-2, then P=2MC 19
Effects of a Specific Tax – Shifting the Supply Curve ST S Increase in Consumer Cost per Gallon Po + T B Pb T Price Paid by Consumers ($/gallon) A Po Ps = Pb - T Decrease in Firms’ Receipts per Gallon D QT Qo Gallons of Gas per Month
Nonprice Effects of Monopoly: Product Quality • Product quality is a decision firms make • Raising a product’s quality increases the consumer’s willingness to pay • Producing a higher-quality product usually costs more • The firm must decide whether the extra benefit is worth the extra cost • How does the quality provided by a monopolist compare to the level that would maximize aggregate surplus? • If different consumers value quality differently, the monopolist may not choose to offer the quality that maximizes aggregate surplus • May over- or under-produce quality 21
Nonprice Effects of Monopoly: Advertising • Spending on advertising is another important decision for many firms • Because the monopolist’s marginal cost is less than the price, each additional sale increases its profit • Firms in perfectly competitive markets have no individual incentive to advertise • Each firm perceives itself as capable of selling as much as its desires at the market price • Marginal benefit of advertising equals the increase in sales times the firm’s profit on additional sales • At the profit-maximizing level of advertising, this marginal benefit must equal the extra dollar expended • For a monopolist, the ratio of the amount spend on advertising to the firm’s total sales revenue, the advertising-sales ratio, equals the advertising elasticity divided by the elasticity of demand, times negative one 22
Nonprice Effects of Monopoly: Investments • Firms can also 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 less avoidable fixed costs • If 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 • 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) 23
Monopsony • Read monopsony section: p:648-652 24
Regulation of Monopolies • Deadweight loss from monopoly pricing provides a justification for government intervention • Government actions that keep prices closer to marginal cost can protect consumers and increase economic efficiency • Intervention can take many forms • Antitrust legislation (see Chapter 19) • Direct regulation of prices • Price regulation (not common in U.S. today) • More prevalent in the past • Still used for electricity, natural gas, local telephone service • More common in some other countries 25
Why Are Some Monopolies Regulated? • Regulation arises out of political pressure and economic concern about market dominance • When governments create monopolies they may then regulate them to deal with the negative consequences • May create a monopoly to ensure that goods are produced at least cost • A market is a natural monopoly when a good is produced most economically through a single firm • Average cost falls as quantity increases • Second firm may enter but this would cause costs to rise • Government can designate one firm to be the provider • Institute price regulation to protect consumers 26
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 problems with achieving this lead to second-best regulation • Regulator may not know the firm’s 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 28
