Keith Cowling & Dennis C. Mueller (1978)-The social costs of monopoly power
Keith Cowling & Dennis C. Mueller (1978)COURSE OF INDUSTRIAL ORGANIZATIONINTERNATIONAL BUSINESS ADMINISTRATION PROGRAMPRESENTED BY: JC PHAM, ID: A1008300
Introduction & Research Background Study Objectives The Four substantive Criticisms ofHarberger-type approaches Methodology & Empirical estimatesof the social cost of monopoly power Conclusions
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
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.
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
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”
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
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!
The interdependence of dpi and dqi The measurement of monopolyprofits The aggregation biases from usingindustry data Welfare loss in the acquisition ofmonopoly power
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
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
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
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.
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!
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
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
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?
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
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%
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
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
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
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
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