Monopolies and Public Policy

Econ 10

Holmes

Chapters 18, 19

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Another PP

• What do the following relationships tell you?– MR and MC– P and ATC– P and AVC

• Evaluate: “Monopolies are bad because they charge the highest price they can get.”

Some (Harder) PP

• Does a monopolist have a supply curve? That is, suppose I give you a price-can you tell me how much the firms will supply? [Hint: Can you draw a monopolist with two different D and MR curves that have the same price but different outputs?]

• Suppose a monopolist experiences a dramatic increase in TFC. Will the firm increase or decrease output?

Things you should know

• How to compute costs, MR..

• How to graph TC, TR, profit, loss…

• When firm should shut down

• How to find profit-max output

Are Monopolies “bad”?

• Up until now we have examined monopolies and their profit-maximizing output.

• Are there any public policy considerations?

Dead weight lossReturn to our competitive market. Suppose we have Supply and Demand Curves.

S

D

10

The 10th unit costs someone$4 to make and someone values it at $10. Society gains $6 by making the 10th unit.

$4

$10

What is the cost of making the 10th unit?

Answer: Think opportunity cost. If we make one more tape recorder, then the guy who makes that recorder cannot make a TV (say). If the TV were the best alternative use of the worker’s time (and the use of machinery) then the cost of the recorder is the portion of the TV those resources could have made (or the value of that portion).

Society’s benefit

S

D

So by making the 10th recorder, society gives up $4 of something else but someone is $10 happier, so society gains $6.

Society’s benefit from the 10th unit

10

Society’s total benefit

S

D

Suppose we produced 10 units instead of 30. What do we give up?

10 30

Dead Weight Loss Triangle

MC

D

MR

DWL

The red area is the benefit society foregoes because it cannot achieve the competitive outcome.

Note that the competitive outcome (P=MC) is where society’s benefit is maximized.

An exampleYou are Paul Simon (I am so sorry). You are thinking about giving a concert in Central Park. MC=$0

Consumer SocialQ P TR MR benefit Profit Welfare

50,000 $20 $1,000,000 $20 $0 $1,000,000 $1,000,000100,000 $10 $1,000,000 $0 $500,000 $1,000,000 $1,500,000150,000 $5 $750,000 -$5 $1,000,000 $750,000 $1,750,000200,000 $0 $0 -$10 $1,750,000 $0 $1,750,000

How do we get consumer benefit? Suppose P=$10. 50K people value it at $20 but pay $10; society is (20-10)*50K happier. Suppose P=$5. 50K are (20-5), another 50K are (10-5)==>1 million.

So what happens?Consumer Social

Q P TR MR benefit Profit Welfare50,000 $20 $1,000,000 $20 $0 $1,000,000 $1,000,000100,000 $10 $1,000,000 $0 $500,000 $1,000,000 $1,500,000150,000 $5 $750,000 -$5 $1,000,000 $750,000 $1,750,000200,000 $0 $0 -$10 $1,750,000 $0 $1,750,000

Paul wants to operate at P=$10 where profit is maximized. At that point, social welfare is 1.5 M (1M of which is Paul’s profit). If, however, we could force(or convince) Paul to sell at $0, then social welfare is 1.75 M (all of which is consumer benefit). So because Paul acts as a monopoly, society loses out on .75 M. This is the DWL.

A Graph

MCD

MR

100

$10

P

Q200

DWL (SOCIETY’s loss due to under production)

So what do monopolies do that is bad?

They under-produce. That is, when optimizing their output, they choose levels below the competitive equilibrium.

Perfectly Competitive Outcome (Social Optimum SO)

Versus

Profit Maximization(Market Equilibrium ME)

N Q P TVC AVC TC ATC TR MR MP MC3 50 50 1500 30 2500 50 2500 50 16.67 305 100 40 2500 25 3500 35 4000 30 25 206 150 30 3000 20 4000 26.67 4500 10 50 108 200 20 4000 20 5000 25 4000 -10 25 2012 250 10 6000 24 7000 28 2500 -30 12.5 4018 300 5 9000 30 10000 33.33 1500 -20 8.333 60

wage 500TFC 1000

N Q P TVC AVC TC ATC TR MR MP MC3 50 50 1500 30 2500 50 2500 50 16.67 305 100 40 2500 25 3500 35 4000 30 25 206 150 30 3000 20 4000 26.67 4500 10 50 108 200 20 4000 20 5000 25 4000 -10 25 2012 250 10 6000 24 7000 28 2500 -30 12.5 4018 300 5 9000 30 10000 33.33 1500 -20 8.333 60

wage 500TFC 1000

A Graph

Q

$

ME

SO

DMR

MC

ATC

AVC

DWL

DWL is area bounded byq*, MC, and D

q*

What have we learned about DWL?

• A triangle (like) shape bounded by q* (firm’s best profit Q>0), MC, and D

• Represents how much better society could have been if the firm behaved like a perfect competitor

• Represents the cost to society of noncompetitive behaviour

Common Questions

• Why does it represent the cost to society?

• If the SO is society’s best spot, why isn’t it the firm’s profit maximization point?

Application: Natural Monopolies

Suppose we have an industry that is so efficient that the point at which DMR begin to exist is so large that it is not within the scope of the firm’s choice.

Example: Duke Power

Duke Power

MC

ATC

Q

P Output that would provide power to all of NC

Why is Duke so efficient?

The plant and all the lines are already built. (Q: Why?) How much more does it cost to crank up the plant just a little?

A: Not much. “Hey Frank! Turn up Number Two a notch!”

Most of the cost is sunk into their capital.

Duke Power

MC

ATC

Q

P Output that would provide power to all of NC

MC

ATC

Let’s just examine the piece that is relevant

Duke Power

DMR

ATCMC

q

PWhere does DP profit-max?Why is D so inelastic?

$10 How can we regulate?Plan I: P=MCHow is firm doing? Society?

Plan 2: P=ATCHow is firm doing? Society?

PROFIT

Which is better?

• Most people would agree that the unregulated case (with expensive electricity and huge DP profits) is bad.

• Of the two regulations, which is better? Who knows????? How long can DP afford to suffer a loss? How long can we handle the DWL?

An additional considerationSuppose we regulate DP retrospectively--we ask them what their costs were and we allow them to recoup those (including normal profit). (Assume they can’t lie on their costs.)

What incentive does DP have to keep costs down?What is a valid cost? Employee Cafeteria? Swimming Pool? Suppose you are trying to choose between purchasing an Escort and a Ferrari to purchase for your meter-reading fleet--any incentive to buy the cheap one? Who pays for the extra costs?

How can we fix?How are you assessed in this class?

“Well, you only got a 17 percent on this test, but I’ll assume that you worked hard and this is the best you can do.”

How are you measured?

“You got a 17, but everyone else got a 10. Well done.”“You got a 17, but everyone else got a 99. Not good.”

Can we apply this same principle to Duke Power?Yardstick competition: reimbursement based on other firms’ costs.

“We’ll allow you to recover what CP&L, Piedmont Co-op, and ConEd paid in costs last year.”