MonopolyDr. Andrew McGeeSimon Fraser University
Monopoly Assumptions & Implications1. Single seller of a single good (many buyers)– Something prevents entry into this market,resulting in a single seller2. Monopolist chooses an output level– Monopolist is not a price taker; monopolist facesthe entire market demand curve– Maintained assumption: monopolist maximizesprofit
Monopoly profits• Unlike in perfect competition, the monopolistcan make positive profits in the long runbecause no other firms can enter to competeand lower the market price• What are these barriers to entry?
Barriers to entry1. Exclusive control of a natural resource2. Exclusive rights to use a product or technology– Patents (granted by governments)3. Exclusive franchise rights or licenses– Often granted by governments– Lead to localized monopolies4. Network effects – products become more valuablewhen more people use and consume them– More complementary goods and services (e.g., repairs)available5. Economies of scale – lead to natural monopolies– Electricity and other utilities
Natural monopoliesACMCPQSuppose Q’ represents a level of output larger thanthe entire potential market demand at any price P.Costs per unit of production are falling over the entirerange of potential equilibrium output levels. Thismarket will likely be served by a single firm. Why? Anyexisting firm can always lower its costs per unit belowthose of a new entrant with presumably smalleroutput and set a low price that the new entrant findsunprofitable but which is profitable for the larger firm.Q’In this way, the existing firm canalways deter entry. Thissituation, wherein average costsare falling over a wide range ofoutput levels, is known as anatural monopoly.Industries requiring large investments incapital infrastructure (which results in highMC for early units of output but lower anddeclining MC thereafter) tend to be naturalmonopolies. For instance, utility companies.
Persistence of monopolies in the LR• Which barriers to entry are likely to persist inthe LR?– Firms can find substitutes for important inputs ordevelop synthetics– Patents expire– Franchise rights & licenses can be revoked– New technologies can upend existing networks• Beta vs. VHS, CDs and iTunes, iTunes & “the cloud”
Persistence of monopolies in the LR• Natural monopolies may survive in the LR inthe absence of major technological change• Technological change is the enemy ofmonopoly• Even natural monopolies can be displaced bytechnological change– Land lines & cell phones, electricity & solarpanels?
Profit Maximization & MonopoliesPQMCDMRPMQM Q*Notice that the monopolist produces lessoutput than the industry would produce if itwere perfectly competitive (QM<Q*). Noticealso that as a result the monopoly price ishigher than the perfectly compeitiveNotice also that the gains from trade to society are not maximized. All of the units QMthrough Q* cost society less than society values them. The triangle above is (roughly) thedeadweight loss to society. This occurs because the monopolist is not maximizing socialwelfare but rather his own profits. This highlights one of the primary virtues of perfectlycompetitive markets: despite the absence of a central planner explicitly trying tomaximize social welfare, the market achieves the socially optimal result through the self-interested decisions of many parties.Deadweight loss
Efficiency & Monopoly• Monopolies do not achieve allocativeefficiency as the previous slide indicates• Monopolies are also not productively efficientinsofar as they do not produce at the outputlevel minimizing costs per unitPQMCACDQMMR
Monopoly Supply Curve• There is none.• For any given demand, there is a unique profit-maximizing price-quantity pair for themonopolist. The only thing that would cause themonopolist’s price and output to change wouldbe a change in consumer demand, which wouldchange the monopolist’s marginal revenue.Supply curves, however, plot the change inquantity supplied at different prices. Here,quantity supplied varies not with price but withconsumer demand, so there is no well-definedsupply curve.
Price discrimination• A monopoly engages in price discrimination ifit sells otherwise identical units of output atdifferent prices• Examples: student & senior ticket prices at themovies—the movie is the same for all viewers• Non-examples: differences in insurancepremiums for different drivers—differentdrivers present different risks and hence theinsurance product they receive differs
Law of one price• If buyers are able to costlessly exchange goodsamongst themselves, then a homogeneousgood must sell everywhere for the same price• Law of one price not satisfied with pricediscrimination– Buyers must not be able to practice arbitrage• Example: senior citizens hawking seniorstickets outside of a movie theater
First-degree (perfect) pricediscrimination• Selling to each buyer at the maximum price he or she iswilling to pay• Requires being able to identify each buyer and know theirwillingness to pay• The demand curve becomes the marginal revenue curve• Under perfect price discrimination, the social surplus ismaximized (gains from trade are exhausted). Themonopolist, however, extracts the whole surplus.• Consumers are indifferent between consuming themonopolist’s product and going without it• Perfect price discrimination is mainly a theoreticalconstruct. In practice, the other types of pricediscrimination are much more common. Not surprisinggiven the information a monopolist must have about allconsumer in order to engage in perfect price discrimination
First-degree (perfect) pricediscriminationPQD=MREach consumer (or group of consumer) paysa different price. Consumers enjoy noconsumer surplus.MCAs with any profit maximizing firm, themonopolist sets MC=MR
Third degree price discriminationthrough market separation• Far more likely than knowing each consumer’swillingness to pay is that a firm can separate itscustomers into different geographic markets. If(1) it knows that the willingness to pay (demandelasticity) differs in these markets and (2) canprevent customers in one market from re-sellingto customers in another market, it can and willsell its output for different prices in thesedifferent markets• Examples: foreign & domestic sales, differences inprovinces, urban & rural markets• Welfare effect of 3rd degree price discriminationis ambiguous
2nd degree Price Discrimination• Suppose a monopolist doesn’t know much aboutindividual preferences (willingness to pay)• Allow consumers to separate themselves byoffering different prices at different quantitiespurchased• Accomplished through quantitydiscounts, minimum purchase requirements, andtie-in sales• Again requires the absence of arbitrageopportunities
2nd degree Price DiscriminationPQDP1P2P3Q1 Q2 Q3If you purchase 0 through Q1 units, pay P1. If you purchase Q1through Q2 units, pay P2. If you purchase Q2 through Q3units, pay P3. And so on.
Regulating a monopolistDMRQPMCACPUQUPLRegulating a monopolist poses a dilemma: allow themonopolist to underprovide the good or service orsubsidize the monopoly indefinitelyQoptimalThe regulated price will be somewhere in thisrange. The monopolist must be able to earn apositive profit or it will shutdown. At Pr, thisfirm would earn zero profit (P=AC). This is theideal price from the economist’s point of view.PrUnfortunately calculating Pr is tricky because what we observe in reality are accountingand not economic profits. The regulator must determine what a fair rate of return to themonopolist would be. That is, what accounting profits (>0) would be required for themonopolist to earn zero economic profit?