Monopoly

Sources: Main source textbook, Ch. 11; 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 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 ; markets 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 power? Tech & 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

De Loecker and Eeckhout (2017) The Rise of Market Power (http://www.janeeckhout.com/wp-content/uploads/RMP.pdf )

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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 so more market power).

- 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)

( https://www.economist.com/news/finance-and-economics/21568364-how-antitrust-economists-are-getting-better-spotting-cartels-scam-busters )

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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 monopoly may result.

e.g.

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- Why?

- A large firm has a cost advantage over smaller firms.

(LAC 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. 11.1)

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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. See text Ch. 1)

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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 down 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 perfect competition)

- 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 )

- See examples: 11-1, 11-2 to work out the solution for the monopolist in a simple case (linear demand curve and constant marginal cost).

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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 and

(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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DeLoecker and Eeckhout (2017) ‘The Rise of Market Power’

- Report P/MC for the US 1960-2014 (weighted average across products):

In 1980 P/MC=1.18 so markup (P-MC)/MC = .18 (18%)

In 2014 P/MC=1.67 so markup was .67 (67%)

- Some specific firm markups for 2014:Google 171% (P/MC=2.71)Mylan 87% (pharmaceuticals)Apple 49%Walmart 15%

- An alternative? Express the markup as a share of price (Lerner index)

P- MC = -1 . P

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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.

- When MC does not rise, 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 (see discussion of Fig. 11.19)

- 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. 10, pp. 330-334)

- 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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