Transcript Markets and market failures: theory and public policies

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

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.



Examples: cinema, train tickets…
The key factor that differentiates the monopoly
from the competitive firm is the elasticity of
demand facing the firm.



Although this definition looks very simple, it is not that
simple to apply in practice.
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 control over 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.



Network economies: on many markets, a
product becomes more valuable as the number
of customers that use it increases.



Costs: higher prices for consumers
Benefits: they make possible many inventions that
would not be so otherwise
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
Total revenue, total cost and economic
Profit
Marginal revenue

The marginal revenue is the change in total
revenue generated by a very small change in the
amount of output produced.
MR 

dT R
dQ
The monopolist will choose its production level in
order to maximise its profit
P = TR – TC

Profit is maximum when:
dP
 0  MR  MC
dQ
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:
DQ P

.
DP Q
 

DQ P
. 0
DP Q
The marginal value is given by:
MR  P 
MR  P 
DP
.Q  DP
DQ
DP
.Q
DQ
P
1
 MR  P 
.Q  P(1  )
Q. 

Marginal revenue and demand

Notice that :





When
When
When
When
=
>
=
<
∞
1,
1,
1,
(for Q = 0), MR = P
MR > 0
MR = 0
MR < 0
When the demand curve is a straight line

P = a – bQ where a,b > 0

Then:
TR = P.Q = aQ – bQ2
MR 
dT R
 a  2bQ
dQ
Marginal revenue and demand (ctd)
The short-run profit maximisation
condition

MR = MC :
The short-run profit maximisation
condition (ctd)

The profit-maximising mark-up:

Given that:
MR  P(1 


and
1
)

MR = MC
It follows that:
P
P  MC 1
MC  P  


P

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
Monopoly versus perfect competition
(ctd)
Adjustments in the long run
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.
P  MC 1

P


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 priceelastic 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 lost surplus
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 fairness objection: the producer earns a profit which
is higher than it would under perfect competition (P).

The efficiency objection: 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 return on 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)
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.