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Keith Cowling & Dennis C. Mueller (1978)-The social costs of monopoly power
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Keith Cowling & Dennis C. Mueller (1978)-The social costs of monopoly power

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  • 1. Keith Cowling & Dennis C. Mueller (1978)COURSE OF INDUSTRIAL ORGANIZATIONINTERNATIONAL BUSINESS ADMINISTRATION PROGRAMPRESENTED BY: JC PHAM, ID: A1008300
  • 2.  Introduction & Research Background Study Objectives The Four substantive Criticisms ofHarberger-type approaches Methodology & Empirical estimatesof the social cost of monopoly power Conclusions
  • 3.  The monopolist charges a higher price than aperfectly competitive firm would charge The monopolist also produces less than aperfectly competitive market It is suspected that monopoly is not good forconsumers
  • 4.  A monopoly (from Greek monos (alone or single) + polein (tosell)) exists when a specific person or enterprise is the onlysupplier of a particular commodity Characteristics Profit Maximizer: Maximizes profits. Price Maker: Decides the price of the good or product to be sold. High Barriers to Entry: Other sellers are unable to enter the market Single seller: the whole market is being served by a singlecompany, and for practical purposes, the company is the same as theindustry. Price Discrimination: A monopolist can change the price and qualityof the product. He sells more quantities charging less price for theproduct in a very elastic market and sells less quantities charging highprice in a less elastic market. Sources of monopoly power: three major types of barriers toentry; economic, legal and deliberate. In addition barriers toexit may be a source of market power.
  • 5.  Attention to the social welfare loss under monopolyconditions was led by the pioneering work ofHarberger in 1954▪ 0.1 of 1% of GNP of USA▪ Schwartzman (1960), Scherer (1970),Worcester (1973) Subsequent writers have considerably expanded ourunderstanding of the extent of the losses involved Kamerschen (1966): the estimate as high as 6% Posner (1975): the real problem “the social cost”, as muchas 30% of industry sales in some industries Abram Bergson (1973): a “general equilibrium model” with2 key parameters as an alternative & a series ofhypothetical estimates of welfare losses from monopoly
  • 6.  The monopolist will sell a lesser quantityof goods at a higher price than wouldcompanies by perfect competition Monopoly pricing creates a “deadweightloss” (DWL) referring to potential gainsthat went neither to the monopolist norto consumers It is often argued that monopolies tend tobecome less efficient and less innovativeover time, becoming "complacent“ This very loss of psychological efficiencycan increase a potential competition The theory of “contestable markets”
  • 7.  Traditionally the social loss has measured in terms ofthe deadweight loss (DWL) of monopoly, that iscostlessly created and maintained The opportunity to earn monopoly rents results inresources being invested in unproductive activities intheir pursuit that “rent seeking” behaviors occurs(Tullock;1967). Furthermore, resources may be expended wastefullyby opponents to the creation of a monopoly; in otherwords, a reaction such as "rent protection" may beprovoked. Monopolists will incur both strategic and administrativeexpenses
  • 8.  Level several objections against theHarberger-type approach Calculate estimates of the welfare lossfrom monopoly, empirical in US and UKindustries Employ a partial equilibrium frameworkwith all the necessary assumptions itrequired (Bergson, 1973)The welfare losses from monopoly arereally Significant!
  • 9.  The interdependence of dpi and dqi The measurement of monopolyprofits The aggregation biases from usingindustry data Welfare loss in the acquisition ofmonopoly power
  • 10.  In the partial equilibrium formulafor welfare loss is1/2dpdq, where low value of dpwere observed & low value of dqwere assumed: If ti is small, thenWL isinsignificant In Harberger’s case, the priceelasticity of demand in allindustries were unitary Small estimates of welfare loss
  • 11.  Assuming profit maximizing behavior: Price elasticity E = Pi/(Pi-MCi) (1) Using (1), we obtain welfare loss (WL) estimate byindividual firms from their price/costmargins, giving the change in its output implied byEi To the extent other firms also charge high prices, thetotalWL associated with firm i’s market power exceedsthe welfare loss we estimate Since Harberger observed low values of dpi and yetchose to assume that Ei = 1  dqi was also very small
  • 12.  Assuming interdependence: the WL is calculated by: dWi = ½ dpi/pi x dqi/qi x piqi (2)Where: dpi/pi = 1/Ei and dqi/qi = Ei x dpi/pi = 1Therefore: dpi piqidWi = x (3)pi 2Then assuming constant cost, we can rewrite (3) in termof profits:∏i piqi ∏idWi = x = (4)piqi 2 2
  • 13.  The obvious measure of monopoly profit is the excess of actualprofits over long-run (LR) competitive returns. Economic in equilibrium: the competitive rate is the minimum profit ratecompatible with LR survival Monopoly profit is thus the difference btw actual profits andprofits consistent with this minimum rate with: All would earn profit equal or greater than the minimum Actual estimateWL under monopoly using perfect competition as thestandard of comparison While Harberger & all subsequent studies: based the monopoly profitestimate on the size of the deviation btw actual profit rates and themean rate, i.e. an industry whose profit rate was 5% below the meanprofit rate was considered to have created as large a WL as anindustry whose profits are 5% above the mean; and assumed thedegree of monopoly equalized across all firms therefore the estimate ofWL is biased downwards.
  • 14.  Previous studies used industry data at a fairly highlevel of aggregation, including earning negativeeconomic profit firms Implicitly assumed that the monopoly profits earned bythe most profitable firms in the industry are somehowoffset those experiencing transitory losses The estimates of all previous studies through theassumption of a constant Ei across all industries The profit margin’s appearance as a squared term in thewelfare loss formula & further biases the WL estimatedownwards!
  • 15.  The previous studies underestimate the socialcosts of monopoly by failing to recognize the costsinvolved in attempts to gain & retain monopolypower Form of investment in excess productioncapability, excessive ads or R&D activities… Estimate ofWL therefore underestimate social costs ofmonopoly in 2 ways:▪ Understating monopoly rents  understate the distortions inoutputs monopoly produces▪ Failing to include these additional expenditures as part of thecosts of monopoly
  • 16.  Three adjustments to measureWL : Advertising is added to monopoly profit All of advertising is added to the welfare losses, thistakes the extreme view that ads as merely aninstrument for secure market power All of measured, after-tax profits above thecompetitive cost of capital are used as the estimate ofthe expenditure incurred by others to obtain control ofthe monopoly rents
  • 17.  Let C0 be observedcosts, including investment-type outlays & P0 observedprice that consistent withmonopoly firm’s demandschedule D0 Under more inelastic demandschedule assumption, bothprofits (∏) and welfare loss (L)are much larger An alternative procedure forcalculating WL: estimatePrice/cost margins from dataon demand elasticity?
  • 18.  Provide two sets of estimate, one based on ourassumptions (∆WkCM) , the other based on Harberger-type assumptions (∆WkH), both measured at the firm-level, in US & UK respectively Range of four estimate define as following: K=1, the one (∆WkCM) based on interdependence of dpi anddqi, the other (∆WkH) based on the Harberger methodology K=2, the same calculations are performed but in calculatingdpi, ads expenditure (Ai) is deducted from cost K=3, we add in Ads as a social cost K=4, we also add in monopoly profits after-tax as a furtherelement of social cost.At this point, the appropriated profitmeasure is before tax profit
  • 19.  Sample: companies operating in both intermediate & finalgoods markets Assumption of demand schedule for an intermediate representsa derived demand schedule (Marshallian model) To estimate monopoly profits: using the return rates instock markets: Regarded to be fairly close to satisfying the free-entry and – exitrequirement of a competitive industry All existing monopoly rents are fully capitalized at the beginningof the period Changes in monopoly rents over the period are accuratelyanticipated The estimate of the competitive return on capital:▪ in US :The Fisher- Lorie index of returns (1963-1966): 12%▪ In UK:The pretax real cost of capital from 1968-69 (Flemming et al.; 1976):8.15%
  • 20.  The sample of 734 firms on the COMPUSTAT tape in1963-6 period The firms are ranked according to the size ofWL asmeasured by ∆WkCM GM lead the list: annual WL over $1.78billion (>1/4 of 1%of average GNP during the period) Most of the other of the top20 are names expected 6 of 40 largestWL are accounted for by regulated firms ( 3telephone companies & 3 airlines) in which ads made up allor most of the losses The obtained estimates ranging btw 4 and 13% of GCPVS.the range from 0.4 and 7% for the Harberger approach
  • 21.  The same basis as the US estimates, contenting withan analysis of the top 103 firms in the UK from theperiods 1968/9 and 1970/4, these firms wereresponsible for roughly one-third of the GNP Ads expenditure was estimated by aggregating upfrom the brand level (TV & press) BP& Shell dominate the table, whichWL associated with BPalone is roughly a quarter of 1% of GNP The results of periods 1970/4 look much like the 1968/9despite the rapid inflation in UK in this time The aggregate estimates ofWL for ∆WkCM range btw 3.9and 7.2% of GCP for the 1968/9 periodVS. Harbergerapproach estimates ofWL btw 0.2 and 3% of GCP
  • 22.  The evidence suggest that significant welfare lossdue to monopoly power Any attempts to take large amount ofinvestment-type expenditures beyond the adsand adjust demand elasticity accordingly, whilemaintaining the assumption that companies doposses and exercise market power will lead tolarger estimates ofWL. The implications of potential importantpolicies, ex: antitrust towards to most significantcontributors to these losses
  • 23.  Tirole, J., (1988) : TheTheory of IndustrialOrganisation, MIT Press, Cambridge (MA). Krueger,A. (1972) : "The Political Economy of RentSeeking" in American Economic Review. Posner, R., (1975) : "The Social Costs of Monopolyand Regulation" Journal of Political Economy. Alan Dunne, Rent Seeking and the Social Costs ofMonopoly, visithttp://www.maths.tcd.ie/local/JUNK/econrev/ser/html/rent.html on 26Nov, 2012 Monopoly, visithttp://en.wikipedia.org/wiki/Monopoly#Sources_of_monopoly_power on 26Nov, 2012
  • 24. THANK YOU VERY MUCHFOR YOUR ATTENTION!ANY COMMENTS &QUESTIONS PLEASE?