Monopolists are smarter than perfect competitors. They are not myopic. They realize that increasing production drives down prices, and they take this into account in planning their level of output. They produce where MC = MR or the change in revenue with increases in output, the price minus the change in price for earlier (inframarginal) units.
A perfect competitor will produce up until the point where the price equals MC. In equilibrium, production will be at A, with price PPC and quantity QPC. Perfect competitors won’t produce beyond this point because the price would fall below the rising MC; and they won’t stop until this point because all units up to QPC are produced at a MC below the price.
Perfect competition maximizes the sum of consumer and producer surplus which is the difference between the value of units, the MU or demand curve, and what they cost to produce, the MC curve. Production at point B beyond A would produce units of less value than the cost, the MU < MC. Producing at C, less than point A, would mean that some units would not be produced even though their value (MU) was greater than the cost.
While social welfare (total surplus) is maximized by perfect competition, perfectly competitive firms will loss money because they ignore the effect they have on price and neglect their fixed costs. Looking only at their marginal costs, a perfectly competitive firm may think that it is doing fine because it is producing at MC less than or equal to the price. But at the end of the year the perfect competitor will find that it has not made enough to cover its fixed costs for rent, replacing machinery, paying for marketing and office staff, and the like.
Monopolists are aware that they can produce and sell more only by lowering prices. They look at their Marginal Revenue (MR) curve which shows how much extra revenue they get from producing and selling one more unit after taking account of the lower prices they can charge to sell more . Instead of producing where P=MC, they produce where MR=MC because at any point (such as QPC) where MR<MC, they lose money even if P>MC. Because the MR includes this adjustment for lowering prices, the MR curve lies below the demand curve and will intersect the MC at a lower output (QMONO) than the output of the perfect competitor (QPC). At lower output, the price will be higher (PMONO > PPC).
Setting output where MR=MC, monopolists produce less. They lower total surplus by not producing some units where MU>MC. Raising prices on the remaining output, they transfer some surplus from consumers to themselves.
Monopolists produce less than perfect competitors because they produce at a lower MC. Because output is less, they can charge a higher price, the price on the MU (or demand) curve for the lower (monopoly) level of output. With lower output, there is a loss of surplus for both consumers and producers. At lower output and higher prices, monopolists also redistribute consumer surplus to the monopolist.
By producing where MR<MC, perfect competitors are losing on their last sales. They can sell their marginal output only by lowering prices. Indeed, they have to lower prices on all their inframarginal sales so much that what they lose is so great that the MR (the sum of the price on the last sale and the loss from lower prices) is less than MC.
Every company that sells something different from what other companies sell is a monopolist. In some cases, such as a brand-name gas station adjacent to a non-brand name station, or a station selling a different brand name, there may be little monopoly “power;” the elasticity of demand for that monopolist may be very high because consumers can easily switch to a different company. In other cases, such as the local cable company, there may be more monopoly power and, for products with a very distinct image, reputation, and high value, such as brand-name life-saving drugs still under patent protection, the monopolist may have great power because the elasticity of demand is very low.
Because they realize that higher output will drive down prices, monopolists realize they operate along a MR curve where they gain less from increasing output than the price. Setting output where MR=MC, instead of P=MC, means a lower MC. Because MC is upward sloping, a lower MC means less output. Less output means a higher price, a price above MC.
Producing where MR=MC instead of producing P=MC, monopolists produce less than perfect competitors. Less output means that some units are not produced even though MU>MC; this is a loss of consumer surplus and of producer surplus. Less output means higher prices, moving up along the demand curve. At higher prices, surplus is transferred from consumers to producers.
Many production processes are more efficient on a larger scale that allows the use of specialized production equipment. A monopolist can be more efficient than any potential entrant if it produces on a larger scale.
A monopolist may retain markets even at higher prices if its products are desired because they allow consumers to benefit from network economies that come from consuming the same products that others consume.
The greatest monopolies come from control over specialized talent because human talent cannot be reproduced.
Class 14 monopoly 100330
Monopoly Capitalism’s norm. And its necessity
The BIG Ideas <ul><li>Monopolists raise prices above MC by reducing output. This makes them rich at our expense. </li></ul><ul><li>But capitalist firms can only survive with some monopoly power. Perfectly competitive firms cannot survive. </li></ul><ul><li>Monopolies survive by controlling location, talent, technologies, reputation, or because there are economies to scale. </li></ul>
Just to get it out of the way One version of this game was invented by a follower of Henry George who believed that the fundamental problem in America was monopoly over land.
Monopolies act knowing that they can sell more only at a lower price They think about the effect increasing production has on inframarginal sales. They produce only if marginal revenue is at least equal to marginal cost, MR=MC. They are smart. You can be too!
Starting with Perfect Competition Equilibrium at A
Perfect competitors lose on their last (marginal) sales Perfect competitors produce at P=MC. There, MR<MC and perfect competitor loses profits. They lose their fixed costs. Monopolists produce where MR=MC and price to sell this (lesser) quantity. Monopolists raise prices to where they can stay in business by making profits to cover fixed costs. But, they reduce social welfare by producing too little
A monopolist is the only seller of its products This includes companies that are the only sellers of products in their industry – such as a local cable operator. Every company that puts a name on a product is a monopolist. These include Intel, Microsoft, Boeing, Antonio’s Pizza, and Bill’s Grass. All of these have a monopoly in their particular products.
How monopoly is different from perfect competition <ul><li>Monopolists produce less. </li></ul><ul><li>Monopolists charge more. </li></ul><ul><li>Monopolists don’t produce where MU>MC; i.e. where we wish there would be production. </li></ul><ul><li>Monopoly allows capitalist firms to survive. </li></ul>
If capitalism needs monopoly, why do orthodox economists emphasize perfect competition? Perfect competition is nicer because it aligns firm behavior with social benefits. Under PC, firms produce until MU=MC, maximizing consumer and producer welfare. Under Monopoly, firms produce less, lowering total welfare
Here is how Monopoly changes things They reduce output At lower output they raise prices Higher prices redistributes consumer surplus to monopolist Lower output means some lost surplus
Sources of monopoly and market power Economies to scale and high minimum efficient scale A typical factory to build semi-conductor chips costs $2.5-3.0 billion. Few companies can invest that much to compete with Intel.
Network economies and “lock in” Competition is limited where consumers need to consume the same products, or where you are locked-in to buying a company’s products because of past investment. Microsoft benefits from “network economies” because consumers want to talk to each other within Windows-world. Printer and razor companies are good at lock-in.
Location Control a good location and your competition is DOA. Would you want to own a parking lot next to Fenway Park? They charge $45 to park during a game.
Information and Brand Name How much extra will you pay for this? Do you feel safer in one of their planes?
The strongest monopolies control talent We’d be doomed without him:
Take-away Question Since monopoly is the norm, and even necessary for a capitalist market economy: why do orthodox economists largely ignore it to focus on the imaginary, and illusory, world of perfect competition? Could it be that they just want to make capitalism look good? She didn’t think so. Economist Rosa Luxemburg
Take-away points <ul><li>Monopolists raise prices above MC by reducing output. They redistribute income towards themselves and reduce social welfare. </li></ul><ul><li>Without monopoly pricing power, almost all firms would go out of business. </li></ul><ul><li>Monopolies are established by controlling location, talent, technologies, reputation, or by economies to scale. </li></ul>