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Monopoly
Sources: Main source textbook, Ch. 12; Preston McAfee’s online text Ch. 6 is worth a look too.
Monopoly: a market with a single seller.
(Greek: ‘mono’ = one, ‘poly’=seller)
- Monopolist’s demand curve:
- It is the market demand curve (demand summed across all buyers).
- Not perfectly elastic (flat) as in perfect competition: there the firm is a price taker.
- Demand is downward sloping in price.
- Text definition of monopoly:
- no close substitutes for the firm’s product.
(vs. monopolistic competition: see Appendix to Ch. 13)
- The downward sloping demand curve drives differences from perfectly competitive firm model.
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- Why so much focus on the monopoly model?
Broader applications
- Markets with a single-seller don’t seem to be that common.
- The model of monopoly has wider application than “single-seller” markets.
e.g. cartels ; market where firms have ‘market power’
Cartel: a group of businesses acting collectively can give a monopoly outcome.
- Firms may have “monopoly power” or “market power” yet not be the only seller.
- P. McAfee Introduction to Economic Analysis Ch. 6 (website)
A firm has ‘monopoly power’ or ‘market power’ if it:
- faces a downward sloping demand curve;
- can charge more than marginal cost and sustain sales.
- Some models of ‘oligopoly’ and models of ‘monopolistic competition’ are built from the monopoly model.
- Are we in an age of monopoly? Internet, social media giants, high profits.
(http://www.economist.com/news/briefing/21695385-profits-are-too-high-america-needs-giant-dose-competition-too-much-good-thing )
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Some empirical indicators of monopoly power:
- Market share of sales and/or output (monopolist: near 100%)
- Size of cross-price elasticity of demand with other products.
(monopolist: low cross-elasticities, i.e. no close substitutes).
- Size of price mark-up over marginal cost (see below).
- The Economist "Scam Busters": unusual patterns in price data. (can imply prices are being fixed)
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Sources of monopoly:
- For monopoly to persist there must be barriers keeping other firms from entering the monopolist’s market.
- Sources of barriers and monopoly power:
(1) Exclusive control over a key input
(2) Economies of scale
(3) Network economies
(4) Government created monopolies
(5) Patent and copyright law
(6) Transport costs and other trade frictions
(7) Unique or differentiated good
- Lets look at each in turn.
(1) Exclusive control over a key input
e.g., - Debeers and diamonds, aluminium (past), chromium.
- Entertainment or sporting events: controlled admission.
- MS Word and interface with Windows (McAfee’s example)
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(2) Economies of scale:
- Economies of scale: exist over the range of output where long-run average cost (LAC) falls with output.
(qmes = minimum efficient scale level of output, i.e. output where average cost is at its minimum)
- If output levels with economies of scale are large compared to output demand may monopoly result.
e.g.
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- Why?
- A large firm has a cost advantage over smaller firms.
(AC higher for firm producing .5 qmes than qmes)
- A large firm can undercut prices of smaller competitors and drive them out of business.
- Natural monopoly: a monopoly resulting from economies of scale.(see Text Fig. 12.1)
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- Examples of industries with major scale economies:
- software, pharmaceuticals, microprocessors:
- costs are mainly product development costs: these costs are essentially fixed.
- more output, lower are set up costs per unit output.
- utilities, breweries (not a monopoly though), heavy industry
- large fixed capital costs.
- unit costs of a large scale producer smaller than a large scale producer.
e.g. an intuitive special case: Total Cost = F + m QF = fixed cost, m = marginal cost (a constant), Q =output
Then: Average Cost = (F+mQ)/Q = (F/Q)+ m
Firms with this cost structure have economies of scale at all output levels (AC always downward sloping).
- iPod cost data from Perfloff ($10/GB vs. $11-$25 for competitors)
- In small markets monopoly can arise in a broader range of industries due to economies of scale.
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(3) Network economies
- If a good becomes more valuable to individual users the greater the number of other users then it has network economies.
- Network economies give the most widely-used good an advantage over competitors.
- monopoly may result.
- Examples of network economies:
- VCRs, PC operating systems, FAX machines, modems.
- Adobe, browsers like Netscape, Google: giving away product to establish network economies.
- Social networking sites: more valuable if many users.
(4) Government created monopolies and license monopolies
- Law creates the monopoly, government controls entry.
- Ontario and LCBO, European history and salt monopolies, broadcast licenses.
- University food services: a similar idea. University controls right to sell food on campus – sells right to a specific company.
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(5) Patent and copyright law
- Patents give an inventor/innovator the exclusive right to sell a new product for some limited time period.
(Canada: 20 years)
- Copyright laws perform a similar function for books, music, artworks, etc.
(Canada: lifetime of creator plus 50 years)
- Could say it is a type of government created monopoly.
- Purpose of patents?
- provide an incentive for firms to innovate.
- allow monopoly profits to be made during the term of the patent.
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(6) Transport costs and other frictions that limit trade
- A source of monopoly power: can give a firm market power over a group of customers.
- Examples:
- Say economies of scale are large vs. the size of the local market but small vs. the size of the national market.
- without transport costs large national firms would dominate- but if transports costs are high enough local monopoly is
possible.
- Frictions and search costs as a source of market power (P. Diamond):
- Consumer at a Store ‘A’ is quoted a price.
- Say it is costly to go to another store or find information on prices at competing stores (this is the "friction")
- Store A can charge a bit more than its competitors, i.e. more than competitive price.
- All stores have the same incentive: all have some market power!
(7) Unique or differentiated good:
- unique characteristics appeal to some or all consumers.
- may be hard to sustain:
- can be copied by competitors (patents could prevent this)
- market power may be limited by close substitutes.
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A Model of a Single-Price Monopolist
- The most basic model of monopoly.
- Monopolist charges all buyers the same price: no price discrimination.
- next set of notes: models of price discrimination in monopoly.
- Decision-maker? a business firm (the monopolist); assumed rational.
- Behavior: Firm’s assumed goal is profit maximization.
- Possible issue: is profit maximization as good an assumption in monopoly as in perfect competition?
e.g. less competitive pressure: will costs be kept down? Will managers pursue own objectives? (see text’s “X-inefficiency discussion)
- Endogenous variables? Price and quantity bought and sold.
- Exogenous variables? - demand curve (consumer behaviour and its determinants: tastes, income, other goods prices)
- Determinants of costs (cost function): - technology - input prices.
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- Maximizing profit: a simple rule
- Firm undertakes simple benefit-cost comparison.
- Benefit of producing extra output: extra revenue(marginal revenue = MR)
- Cost of producing extra output: marginal cost (MC).
- Produce more output if MR>MC.
- Produce less output if MR<MC.
- Don’t change output if MR = MC.
(This reasoning relies on comparisons at the ‘margin’, i.e. focuses on small, marginal changes. These comparisons typically give the desired result and many microeconomic models rely on such comparisons.)
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Single-Price Monopoly’s Marginal Revenue:
Total revenue (TR) = Price x (Quantity of output) = P x Q
Marginal revenue = extra revenue from producing an extra unit of outputTR / Q (=∂TR/∂Q with calculus)
denotes change in the following variable (calculus: use a derivative instead; notation: use ∂ in place of ∆)
For a monopolist:
MR = P + Q P/Q (P + Q ∂P/∂Q calculus)
- Why? - sell an additional unit of output for the price P. (first term of MR, area B in graph)
- to sell another unit of output the firm cuts itsprice by P/Q. (P1-P0 in diagram)
- this loses revenue on the Q units the firm would sell if it had not boosted output (area A in graph).
- Note: P/Q < 0 (moving along demand curve)
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- Whether MR is >, < or =0 depends on whether the first or second term of MR is larger:
MR = P + Q P/Q
= P + Q P P (multiply and divide by P) Q P
= P + P 1 Q/Q P/P
= P ( 1 + 1/ )
where: = price elasticity of demand = Q/Q P/P
- So (where | | means absolute value):
MR > 0 if demand is elastic || > 1 ( < -1)
MR = 0 if demand is unit elastic || = 1 ( = -1)
MR < 0 if demand is inelastic || < 1 ( > -1)
(a familiar result: see Ch. 4 )
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- The MR curve: plot MR ($ per unit of extra output) vs. output.
- lies beneath the demand curve (height of the demand curve is P, height of MR is P + Q P/Q ).
- distance between the curves tends to grow with Q (second term of MR gets absolutely larger).
- Linear demand curve and MR:
P = a – b Q a and b intercept and slope of demand curve: constants.
MR = P + Q P/Q = (a – b Q) + Q (-b) = a – 2bQ
note: linear MR curve is twice as steep as its demand curve.
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- MR and elasticity typically differs at different points on the demand curve.
- Note: a monopolist will never choose a point on the inelastic part of the demand curve.
Why? MR is negative here – producing in this range reduces revenues!
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Profit Maximizing output:
- Say for now that the monopolist has typical marginal cost (MC – upward sloping), average cost (AC – u-shaped) and average variable cost (AVC) curves (u-shaped) – see figure next page.
(Typical from point of view of perfectly competitive model)
- Produce positive output only if output levels exist at which the firm can at least cover its variable costs.
i.e., output levels where Price > AVC
(demand curve higher than AVC in short-run)(long-run: Price > AC too)
- Raise output if: MR > MC (makes extra profit of MR-MC)
- Lower output if:MR < MC (avoid loss of MR–MC)
- Best positive level of output (Qmon):
MR = MC
- charge price at which demand just equals Qmon.
(Calculus version:
Profit = Total Revenue – Total Cost = TR - TC
At maximum profit: ∂Profit = 0∂Q
So:∂TR - ∂TC = 0 → ∂TR = ∂TC
∂Q ∂Q ∂Q ∂Q )
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- Profit level:
Profit (or loss) = TR – TC (TC = total cost)
= { (TR/Q) - (TC/Q) } Q
= ( P – AC ) Q
= (Profit per unit output) x Output
( graph: (Pmon-ACmon)∙Qmon )
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Markup Condition (Inverse Elasticity Pricing Rule):
- When maximizing profit:
MR = MC
P ( 1 + 1/ ) = MC
P/MC = 1/ ( 1 + 1/ )
(P – MC) = 1 – ( 1 + 1/ ) [ subtract “1” from each MC ( 1 + 1/ ) side i.e. MC/MC
(1+1/)/(1+1/) ]
P- MC = -1 . MC ( 1 + )
- Monopolist’s price is a “markup” over marginal cost.
i.e. RHS of last equation shows the “markup” P-MC as a share of MC.
- Size of the markup is larger the more inelastic is demande.g., = -1.5 markup = 2.00
= -2 markup = 1.00 = -3 markup = 0.50 = - markup = 0 (this and perfect competition)
(note: evaluating markup at -.9, -.5 etc. makes no sensesince the monopolist will not produce on the inelasticpart of the demand curve).
- Use of the markup? indicator of monopoly power.
- Perfect competition: P=MC (markup = 0)- Larger mark-up more monopoly power.
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- An alternative? Express the markup as a share of price (Lerner index)
P- MC = -1 . P
(Chidmi and Lopez (2007) results for breakfast cereals in US). ( see Botox and Apple examples from Perloff)
- See examples 12-1, 12-2 to work out the solution for the monopolist in a simple case (linear demand curve and constant marginal cost).
Aside: Cost curve shapes in imperfect competition
- In models of monopoly and oligopoly the MC curve need not slope upward at high output levels.
- Text examples often assumes constant MC (flat MC curve).
- In perfect competition rising MC is important: places a size limit on the firm, i.e.,
- MC must slope upward at higher output if firms are to be small.
- Upward sloping MC is also possible with monopoly or oligopoly but is not essential.
- declining MR at the market level will place a limit on the size of a firm.
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Monopoly and the firm supply curve: there is none!
- Supply curve: given a price it tells how much is produced.
- Monopoly: price and quantity are chosen jointly (both are endogenous!)
- Perfect competition: shift firm D-curve and and can trace out a unique supply curve (unique P,Q outcome)
- Monopoly: shift D-curve – possible that several P could go with a given Q.
Long-run (LR) in monopoly:
- Long-run: firm can change fixed inputs.
- If costs can be reduced in the long-run then the monopolists best outcome will change in the long-run.
- A new profit maximizing level of output will be found where long-run MC = MR (given that profits are positive).
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Comparative Statics in the Single-Price Monopoly Model:
- Comparative statics: how does the equilibrium outcome of the model change when exogenous variables change.
- Endogenous variables: variables determined within the model.
In the Monopoly model?
- Price and quantity (and resulting profits).
- Exogenous variables: variables determined outside the model that affect the outcome.
In the Monopoly model?
- Position of the demand curve
(deeper still: determinants of the position of the demand curve: tastes, incomes of buyers, prices of other goods)
- Position of the cost curves (especially MC)
(deeper still: determinants of MC e.g. input prices, technology)
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- So two types of comparative statics questions in the monopoly model:
(1) How do equilibrium price and quantity change if demand shifts?
- generally: rise in Demand, rise in P and Q.
(2) How do equilibrium price and quantity change if MC shifts?
- generally: rise in MC, rise in P, fall in Q.
(fall in Demand or fall in MC work in opposite direction)
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Welfare Effects of Single-Price Monopoly (Section 12.7)
- Consumer surplus: net benefit to consumers
- sum of the difference between maximum consumers would pay (height of D-curve) and Price over all units purchased.
i.e. area between Price and Demand curve (area A+B)
- Producer surplus: net benefit to firms
- sum of the difference between Price and MC for each unit sold.
i.e. area between Price and MC curve. (area C+D+F)
(review: Ch. 11, Sec. 11.7)
- a measure of profits made on units produced.
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- There is an efficiency loss from monopoly (area G):
- At the monopoly outcome consumers are willing to pay more for an extra unit of output than it costs to produce it (MC).
- some surplus is not realized.
- if more is produced the surplus could be split between buyers and sellers and both would be better off.
- this type of loss exists on any extra units for which the D-curve is higher than MC curve
- Size of the loss (area G in diagram above):
- area between D-curve and MC curve between the monopoly level of output and where D=MC.
- this area is the deadweight loss or excess burden of monopoly.
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Perfect competition vs. Monopoly (see diagram below)
- Efficiency? perfect competition gives output where P=MC (Pmon)
- this is efficient: combined producer and consumer surplus is at a maximum (A+B+K+L+J+M+N+H)
(vs. Monopoly: A+B+K+L+M+N i.e. smaller by N+H)
- Monopoly also affects the distribution of net gains.
- Suppliers are better off than in perfect competition: higher price, more profit on units sold, more producer surplus.
- Consumers are worse off than in perfect competition: higher price, less bought, less surplus on the units bought.
Perfect competition MonopolyConsumer surplus A+B+K+L+J A+BProducer surplus M+N+H M+N+K+L
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- Distributional effects of monopoly seem to often motivate policies to limit or regulate monopoly.
- Lobbying and monopoly:
- Businesses have an incentive to lobby governments to maintain or to create monopoly power. (“rent-seeking”)
- Businesses gain from having monopoly power:- there are ‘rents’: price paid to monopolist exceeds MC
on units produced.
- political clout could give monopolized markets: history, some countries today
- Canada: some agricultural products -- government created supplier cartels e.g. maple syrup in Quebec.
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