MONOPOLY:
Firms do not want to be perfect competitors.
Why? No Rents (economic profit, excess profit)
Remember: In a perfectly competitive market, the existence of rents triggers entry, entry shifts the supply curve to the right, price goes down, rents disappear.
Rent S1 S2 P1
P2
200 (max) 700,000
Individual Supplier Market (i.e., 5,000 Suppliers)
CHARACTERISTICS OF MONOPOLY
• SINGLE SELLER
• NO CLOSE SUBSTITUTES
• PRICE MAKER NOT PRICE TAKER
• BLOCKED ENTRY
o Patents & Licences
o Ownership or Control of Essential Resources
o Pricing & Strategic Barriers
BARRIERS TO MARKET ENTRY
CONDITIONS
• THE ENTRANT MUST INCUR A SIGNIFICANT “SUNK” COST (AND INVESTMENT THAT HAS NO VALUE IF THE ENTRANT FAILS, E.G., ADVERTISING)
• THE ENTRANT MUST BELIEVE THAT THE ODDS ARE HIGH THAT IT WILL FAIL IF THE INCUMBENT SELLER(S) ATTEMPT TO DRIVE IT FROM THE MARKET
TYPES OF ENTRY BARRIERS
• SCALE (ONLY “ROOM” FOR ONE, OR A FEW NUMBER OF SELLERS)
• ABSOLUTE COST
SCALE BARRIER
Figure 9.1 (modified).
Demand Unit Costs ($) Costs Unit Avg. Costs
Quantity
This is a "natural monopoly". The market will only support one low cost firm, and even that firm does not achieve MES.
ABSOLUTE COST ADVANTAGE
Unit Costs ($)
AC Firm 2 Pe
AC Firm 1
Quantity
Firm 1 is the incumbent (i.e., the firm already in the market) Firm 2 is the potential entrant.
Because Firm 1 has lower costs it can raise price just below Pe (Firm 2's minimum AC), earn economic profits, and forestall entry by Firm 2.
THE INEFFICIENCY OF MONOPOLY • Allocative efficiency • Productive efficiency • Equity
• ALLOCATIVE EFFICIENCY
$
MC
Price ATC
Demand MR
Qm Quantity
Marginal Revenue < Price Marginal Revenue = Marginal Cost (profit maximization)
Therefore: Marginal Cost < Price; or: Price > Marginal Cost
ALLOCATIVE EFFICIENCY IS NOT ACHIEVED! Graphic representation of the allocative inefficiency of Monopoly
Assume MC is constant (i.e., doesn't change) over the relevant range of output.
Unit Costs ($) A
Pm C
Pc B ATC=MC D
MR Demand
Qm Qc Quantity
Under perfect competition consumer surplus is PcAB.
What happens to this surplus under monopoly? The consumers still get a consumer surplus of PmAC. The monopolist gets profits of PcPmCD. Who gets DCB? NOBODY!
This is the “deadweight loss” of monopoly.
• PRODUCTIVE (TECHNICAL) EFFICIENCY o SCALE $
MC
MR1 ATC
MR3 MR2
Q2 Q1 Q2 Q3 Quantity
The monopolist's level of output depends on the MC and MR curve.
With MR1, the monopolist produces Q1 which is technically inefficient (all economies of scale are not exploited).
With MR2, the monopolist produces Q2 and enjoys minimum per unit costs.
With MR3, the monopolist produces too much for technical efficiency. X-INEFFICIENCY Fig 8-7
Unit Costs ($) Costs Unit ATC • X
ATCX’ • X ‘
ATC2
Q2 Quantity
Monopolist is not operating on the ATC curve (at X' production is at the per unit cost minimizing level, but costs are not minimized)
Monopolist might have higher (than perfect competition) costs because of:
• lack of incentive to minimize costs (waste, laziness, etc.) • rent seeking (spending resources to protect the monopoly position).
• DYNAMIC EFFICIENCY o This is a BIG issue. Do firms with monopoly power and profits do more, and more effective R&D (the Microsoft defence). o Research provides no clear answer
• EQUITY o Monopolists earn monopoly rents (economic profits) o These rents (profits) come from consumers. o Many economists would argue that this is an "unfair" redistribution of wealth.
PERFECT PRICE DISCRIMINATION • Necessary conditions o Have the power to set price o Identify high and low "price" consumers o Stop arbitrage (resale)
• Mechanics
The price discriminator can charge P1 for the first unit, so the MR of the 1st unit is P1. The second unit is sold for P2 which is its marginal revenue. The firm will continue to produce and sell until the MR of the last unit is equal to marginal cost (in this case it produces 4,000 units and the last one is sold for P4,000 which is its MC).
$ P1 A P2 P3 P4
P4,000 B ATC=MC
Demand = MR
Qm = Qc Quantity
• Price discrimination can be very profitable o So why don't all firms do it? Unit Costs ($) A
Pm C
Pc B ATC=MC D
MR Demand
0 Qm Qc Quantity
The price discriminating monopolist has: • Total Revenues of 0ABQc • Total Costs of 0PcBQc • Economic profits of PcAB, which is much more than PcPmCD
Efficiency impacts:
Under perfect price discrimination, the monopolist charges a price for each unit, exactly equal to the value of that unit. For the last unit, P = MC. • Allocative efficiency is achieved. • But, usually resources are expended in the practice (identifying high price customers, stopping arbitrage). These higher costs are not shown on the diagram. REGULATED MONOPOLY (fig 8-9)
Monopoly price, P > MC, and P > ATC, Monopolist receives economic profits “Fair return price, P = ATC so no rents, BUT, P > MC, so (rents) allocative efficiency not achieved.
• Optimal social price, P = MC, BUT, P < ATC, monopolist will incur losses
• ATC • • MC
Demand
Qm MR Qf Qr
Figure 8-10
Consumer surplus
$ Producer surplus $ MC
S=ΣMC
D X Pm A B Pc Pc C Y E D=MB MR D=MB
Qc Qm Qc
Purely Competitive Pure Monopoly
In the short run Under perfect competition, Total surplus is X + Y Under pure monopoly, Total surplus = D + A + E X = D + A + B Y = E +C Loss in surplus is B + C Note, from the diagram we cannot tell how much of A + E is monopoly profit because we cannot tell the monopolist's total costs at Qm (this is why I like to assume a horizontal MC curve for this analysis).