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Chapter 4 Monopoly. Outline. What is a monopoly? The profit maximising monopolist Price discrimination The efficiency loss from monopoly Public policy toward natural monopoly. Definition of a monopoly.
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Outline. • What is a monopoly? • The profit maximising monopolist • Price discrimination • The efficiency loss from monopoly • Public policy toward natural monopoly
Definition of a monopoly • A monopoly is a situation in which the market is served by only one seller, the product of which has no close substitute on the market. • Although this definition looks very simple, it is not that simple to apply in practice. • Examples: cinema, train tickets… • The key factor that differentiates the monopoly from the competitive firm is the elasticity of demand facing the firm. • Perfectly competitive firm: infinite • Monopoly: finite • One practical measure: examine the cross-price elasticity of demand for the closest substitute
Five sources of monopoly • Exclusive controlover important inputs • Examples: Perrier, DeBeers… • Economies of scale: when the long-run AC curve is downward sloping the least costly way to serve the market is to concentrate production in one single firm: this is a natural monopoly.
Five sources of monopoly (ctd) • Patents: they confer the right to exclusive benefit from the invention to which it applies. • Costs: higher prices for consumers • Benefits: they make possible many inventions that would not be so otherwise • Network economies: on many markets, a product becomes more valuable as the number of customers that use it increases. • Example: telephones • May give rise to a monopoly. Example: Microsoft • Government licenses or franchising: in many markets, only those firms that get a license from the government can set up a business.
Outline • The profit maximising monopolist • Price discrimination • The efficiency loss from monopoly • Public policy toward natural monopoly
Total revenue • Perfectly competitive firm: horizontal demand curve • So, firm’s total revenue is given by
The monopolist: • Faces a downward sloping demand • If he wants to sell more, he needs to cut his price
Marginal revenue • The marginal revenue is the change in total revenue generated by a very small change in the amount of output produced. • The monopolist will choose its production level in order to maximise its profit P = TR – TC • Profit is maximum when:
Marginal revenue (ctd) • In the case of the monopoly firm, marginal revenue is always going to be less than the price.
Marginal revenue (ctd) • The monopolist wants to increase production from Q0 to (Q0 + DQ). Needs to lower its price from P0 to (P0 - DP) where DP > 0. • The new total revenue is (Q0 + DQ).(P0 - DP) = P0Q0 + P0DQ - DPQ0 - DP DQ MR = (P0DQ - DPQ0 - DP DQ)/ DQ MR = P0 - (DP/ DQ).Q0 – DP MR = 60 – 10 – (10/50).100 = 30$
Marginal revenue and price elasticity • The price elasticity of demand at a point (Q,P) is given by: • The marginal value is given by:
Marginal revenue and demand • Notice that : • When = ∞ (for Q = 0), MR = P • When > 1, MR > 0 • When = 1, MR = 0 • When < 1, MR < 0 • When the demand curve is a straight line • P = a – bQ where a,b > 0 • Then: TR = P.Q = aQ – bQ2
The short-run profit maximisation condition • MR = MC:
The short-run profit maximisation condition (ctd) • The profit-maximising mark-up: • Given that: • and MR = MC • It follows that:
The monopolist shut-down condition • The monopolist should stop production when average revenue is less than average variable costs at any level of output
Monopoly versus perfect competition • Both choose an output level by weighing the benefits of expanding (resp. contracting) output against the corresponding costs • Both compare MC and MR • The main difference is that for the perfectly competitive firm, the marginal revenue is equal to the market price whereas for the monopolist, it is less than the price • The output level chosen by the monopolist is lower than the output level chosen by the perfect competitor
Outline • Price discrimination • The efficiency loss from monopoly • Public policy toward natural monopoly
Sales in different markets • Suppose the monopolist has two completely distinct markets: what quantity should it sell and what price should it charge in both markets?
Sales in different markets (ctd) • The monopolist will charge a higher price in the market where demand is less elastic to price. • This is called third-degree price discrimination. • This is feasible only when it is impossible for buyers to trade among themselves. • If trading is feasible: arbitrage Example: train tickets
Perfect discrimination • First-degree or perfect discrimination is a situation in which each unit of product is sold at each customer at the highest price the customer is willing to pay for it.
Perfect discrimination (ctd) • How much output will the monopolist produce?
Second-degree price discrimination • It is a practice according to which sellers do not post a single price but a schedule along which price declines with the quantity one buys.
The hurdle model of price discrimination • It consists in inducing the most price-elastic buyers to identify themselves. • The seller sets up a hurdle an offers a discount to those buyers who jump over it. • The underlying idea is that those buyers who are most sensitive to price will be more likely than others to jump the hurdle • Examples. • The rebate included in a product package. • Airlines offering restricted fares
Outline • The efficiency loss from monopoly • Public policy toward natural monopoly
The deadweight loss • If the firm would behave like a perfect competitor, the whole triangle above the LAC curve would be consumer surplus • If the firm perfectly discriminates, the whole triangle becomes producer surplus • If the firm is a non-discriminating monopolist, part of the consumer surplus is lost . This is the deadweight loss from monopoly
Outline • Public policy toward natural monopoly
Fairness and efficiency objections • How does monopoly compare with alternatives? • Let's consider a technology in which total costs are given by: TC = F + MQ • There are 2 main objections to the equilibrium reached by the monopoly • The fairnessobjection: the producer earns a profit which is higher than it would under perfect competition (P). • The efficiencyobjection: the price is above the marginal cost loss in consumer surplus (S).
State ownership and management • One solution in that case is to have the state take over the industry. • Advantage: the government is not as much constrained as a private firm. Can set the price equal to the marginal cost and absorb the corresponding economic losses out of general tax revenues. • Drawbacks: it often reduces the incentives for cost-conscious efficient management, thus generating X-inefficiency.
State regulation of private monopolies • The most frequent regulation consists in setting a price that allows the firm to earn a pre-defined rate of returnon its invested capital. • Ideally this rate of return should allow the firm to recover exactly the opportunity cost of its capital be equal to the competitive rate of return on investment. • However, in practice, regulatory commissions lack information on what the competitive rate of return should be.
Exclusive contracting for natural monopolies • Accept that the product be produced by only one firm but to create strong competition in order to determine who will be the supplier. • Specify in detail the service that is wanted and then call for private companies to make bids to supply this service. • This should be better than state management in terms of keeping cost down if X-inefficiency is lower in private than in public firms. • But the advantages of such systems are often more apparent than real.
Antitrust laws • The most famous antitrust laws: • The Sherman Act (1890). It makes it illegal to "monopolise or attempt to monopolise any part of the trade or commerce among the several States". • The Clayton Act (1914) prevents companies from buying shares in a competitor where the effect would be to "substantially lessen competition or create monopoly“ • The U.S. Justice Department prohibits mergers between competing companies whose combined market share would exceed some predetermined fraction of total industry output.
Laissez-faire policy • A last possibility for dealing with natural monopolies is laissez-faire, or doing nothing. The main objections to this policy are those with started with, namely the fairness and efficiency objections • Efficiency objection: the monopolist charges a price above the marginal cost which excludes many potential buyers from the market. • But in the case of a two-price monopolist, the deadweight loss is limited • The more finely the monopolist can partition her market under the hurdle model, the smaller the efficiency loss will be.
Laissez-faire policy (ctd) • The fairness problem: It consists in the fact that the monopolist transfers resources from consumers to firms. • Raises a distributional problem • One argument in favour of the hurdle model of price discrimination is that most of the profit earned by the monopolist comes from the high price elasticity consumers • Overall, each of the policy options for dealing with natural monopolies has problems. • None completely eliminates the problem of having only one producer serving a market.