Chapter 15

Monopoly

Ratna K. Shrestha

When Microsoft designed “Windows” it received a copyright, an exclusive right to sell, from the government.

Unlike in a Competitive market where many firms sell identical products, in “windows’ market, Microsoft is a sole seller.

The MC of producing a copy of “Windows” CD is just a few $$ and yet its price is well over the MC, Why??

Microsoft’s Windows System

The airlines sort their customers according to their willingness to pay by offering a maze of advance-purchase and stopover restrictions that attract price-sensitive leisure but not by business travelers.

Airline Price Discrimination

Would it bother you to know what I paid for this seat?

Overview

Why Monopolies Arise? Production and Pricing Decisions Welfare Cost of Monopoly Public Policy and Monopoly Price Discrimination

Monopoly

A firm is considered a monopoly if:– it is the sole seller of its product– its product does not have close substitutes– it has some ability to influence the market price of

its product or is a price maker

A Pure Monopoly exists when a single firm is the only producer or seller of a product that has no close substitutes.

Why Learn About Monopolies?

It is estimated that about 5% of domestic output is supplied under monopoly conditions.

It helps to understand more common market structures such as monopolistic competition and oligopoly.

Why Monopolies Arise?

Ownership of Key ResourceLegal Barriers By GovernmentLarge Economies of Scale

The fundamental cause of a monopoly is Barriers to Entry.

Ownership of Key Resources

A single owner of an important resource that

cannot be readily duplicated, as with some

natural resources.

Example: De Beers, a South African Diamond Company, which controls about 80% of world’s diamond production.

Government-Created Monopolies

Governments also restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets. – E.g., Local cable television– ICBC in basic auto insurance market. ICBC was

created by NDP government to give a monopoly to the government owned company (so that US insurance firms cannot enter the market.

Patent and copyright laws give a firm or an individual exclusive rights to sell a product. – Certain new pharmaceutical drugs– a book.

Natural Monopolies

An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.

A natural monopoly arises when there are economies of scale in production.

ATC is smaller when produced by a single large firm than smaller many firms.e.g. BC Hydro, Coast Mountain Transportation,

Telus, Terasen.

Economies of Scale: Cause of Monopoly

MC

Quantity of Output

Cost

0

ATC

Monopoly BehaviorMonopoly vs. Competitive Firm

Monopoly Sole Producer Downward Sloping

Demand Curve. The monopolist faces the whole market demand.

Price Setter Reduces Price to

Increase Sales Marginal Revenue curve

below demand

Monopoly BehaviorCompetitive Firm vs. Monopoly

Competitive Firm One of many producers Horizontal Demand Curve: the firm sells all of its

products at that same market price determined by the market. So the demand facing the competitive firm is a horizontal line at that market price.

Price Taker Sells a lot or a little at the same price Marginal Revenue curve is horizontal and

coincides with D curve.

Quantity of Output

Demand

(a) A Competitive Firm’s Demand Curve

(b) A Monopolist’s Demand Curve

0

Price

0 Quantity of Output

Price

Demand

Demand Curves for Competitive and Monopoly Firms..

Monopoly’s Revenue

Total Revenue: TR = Q x P Average Revenue: AR =TR/Q Marginal Revenue: MR = TR/Q A monopolist’s MR < P. The Marginal Revenue curve lies below its demand

curve.

A Monopoly’s Total, Average, and Marginal Revenue

Quantity(Q)

Price(P)

Total Revenue(TR=PxQ)

Average Revenue

(AR=TR/Q)Marginal Revenue(MR= )

0 $11.00 $0.001 $10.00 $10.00 $10.00 $10.002 $9.00 $18.00 $9.00 $8.003 $8.00 $24.00 $8.00 $6.004 $7.00 $28.00 $7.00 $4.005 $6.00 $30.00 $6.00 $2.006 $5.00 $30.00 $5.00 $0.007 $4.00 $28.00 $4.00 -$2.008 $3.00 $24.00 $3.00 -$4.00

QTR /

A Monopoly’s Marginal Revenue

A monopolist’s marginal revenue is always less than the price of its good.

The demand curve is downward sloping.When a monopoly drops the price to sell one more

unit, the revenue received from previously sold units also decreases. As a result MR < P.

When a monopoly increases the amount it sells, it has two effects on total revenue.

The output effect—more output is sold, so Q is higher.The price effect—price falls, so P is lower.So what happens to R (=PQ) is ambiguous; it depends

on the elasticity of demand.

Demand and Marginal Revenue Curves for a Monopoly...

Quantity of Water

Price

$11109876543210

-1-2-3

1 2 3 4 5 6 7 8

Marginalrevenue

Demand(average revenue)

Profit Maximization of a Monopoly

A monopoly maximizes profit by producing the quantity at which MR = MC.

If MR > MC, profits can be increased by producing more. When MR = MC, there is no more opportunities to further increase profits.

It then uses the demand curve to find the price that will induce consumers to buy that quantity. At this reduced quantity, consumers are willing to pay more and as a result P > MC.

Profit-Maximization for a Monopoly..

Monopolyprice

QuantityQMAX0

Costs andRevenue

Demand

Average total cost

Marginal revenueMarginal

cost

A

1. The intersection of MR curve and the MC curve determines the profit-maximizing quantity...

B

2. ...and then the demand curve shows the price consistent with this quantity.

Monopoly and Competition

For a competitive firm, price equals marginal cost.

P = MR = MC For a monopoly firm, price exceeds marginal

cost.P > MR = MC

Profit = TR – TC = (P - ATC) x Q As long as PM > ATC, economic profits will

be earned.

Monopol

yprofit

Monopolist’s Profit...

Quantity0

Costs andRevenue

Demand

Marginal cost

Marginal revenue

QMAX

BMonopolyprice

E

Averagetotal cost D

Average total cost

C

When a firm discovers a drug, patent laws give it a monopoly over the sales of that drug.

But eventually, the firm’s patent runs out and the market switches to competitive one.

Case Study: Monopoly Drug Vs. Generic Drugs

Case Study: Monopoly Drug Vs. Generic Drugs

Costs and Revenue

Price during patent

lifePrice after

patent expires

QM QC 0 Quantity

Demand

MC

MR

The Welfare Cost of Monopoly

At monopoly prices, some potential consumers value the good at more than its MC but less than the monopolist’s price.

These consumers do not end up buying the good. Monopoly pricing prevents some mutually beneficial

trades from taking place deadweight loss.

Because a monopoly sets price above MC it places a wedge, similar to a tax. As in the case of tax, the wedge causes the quantity sold (QM) to fall short of the social optimum (QC).

Price

0 Quantity

Marginal cost

Demand(value to buyers)

Value to buyers is greater than cost to seller.

The Efficient Level of Output...

PM

QM QC

Goods in between QC and QM are not traded even if

Value to Buyers > Costs to Sellers

Monopoly’s Deadweight Loss

Price

Quantity

PM

QM

MC = Supply

D

MR

Efficient Quantity Q*!

Monopoly DWL

Monopoly Deadweight Loss

The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax.

The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit.

Monopoly charges a higher price and consumers pay that higher price.

The extra profits/producer surplus the monopolist make (over the competitive market situation) is less than the loss in consumer surplus—the source of deadweight loss.

Public Policy Toward Monopoly

Government may intervene by. . . Creating a competitive market

Implement/Enforce competition laws Regulating the behavior of monopolies

Price control and regulation Public Ownership

Government runs the monopoly itself Doing Nothing

1. Competition with Antitrust Laws

In the United States, the competition laws are called antitrust laws; in Canada we call them competition laws.

Antitrust (or competition) laws are a collection of statutes aimed at curbing monopoly power.

Antitrust laws give government various ways to promote competition.They allow government to prevent mergers.They allow government to break up companies (e.g.,

in 1975 US govt. broke AT&T into 15 “baby bells.”)They prevent companies from performing activities

which make markets less competitive.

Antitrust Laws in Canada

First Antitrust Law in Canada (1889)Reduced the market power of the large and

powerful “trusts” of that time. Recent Acts (1986):

Competition ActCompetition Tribunal Act.These acts are enforced by Competition Bureau,

which is under Industry Canada.

Antitrust Laws in Practice

In 1990, the merger of Imperial Oil and Texaco was blocked.

Similarly, in 1998 the merger of RB and BMO; and that of CIBC and TD was blocked.

Benefits from merger: Reduced Cost of operation such as overhead/administrative costs.

Social Cost of merger: Monopoly power and resulting deadweight loss.

2. Regulation

Government may regulate the prices that the monopoly charges.

The allocation of resources will be efficient if P = MC.

In the case of Natural Monopoly, If price is regulated to be equal to MC, P < ATC and the monopolist will incur loss. In this case, the govt. can allow a natural monopolist to charge P = ATC. Or the govt. can enforce P = MC and cover the loss by providing a subsidy.

MC Pricing for a Natural Monopoly...

Regulatedprice

Quantity0

Loss

Price

Demand

Marginal cost

Average total costAverage total cost

3. Public Ownership

Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself.

e.g.

(1) Federal Corporations: Canada Post, CBC.

(2) BC crown corporations: BC Hydro, ICBC, BC Tel, etc.

In this case what is possible is the government can have P = MC to avoid DWL and cover the loss from general taxation.

4. Doing Nothing

Government can do nothing at all if the market failure due to Monopoly (measured in terms of DWL) is deemed small compared to the imperfections of public policies (regulation).

Regulation itself can sometimes cause more welfare loss than no regulation especially when the government has no (or imperfect) knowledge on the market demand and supply curve and hence the efficient point.

Price Discrimination

The practice of charging different prices for different units of the same product, to different customers.

Conditions required for price discrimination: – Is not possible in a competitive market.– In order to price discriminate, the firm must have

some market power.– There should be no opportunities for arbitrage—

a practice of buying at a cheaper price at one location and resell it at a higher price at another location.

Examples: Price Discrimination

Quantity Discounts: Long distance telephone rates: different rate for first minute and subsequent minutes.

Airline Tickets: first class vs. economy class, one-way vs. round-trip.

Discount Coupons: target group is price sensitive consumers who are more likely to use coupons.

Financial Aid: Needy vs. wealthy students. Two-part tariff: Cell-phone plans: subscription fee/month

and then extra price for each minute of call. Block Pricing: one price for the fist 100 L of water then

after higher price. Peak-load Pricing: higher energy price during winter. Movie Tickets: Adult, Children, Senior rates.

Examples

1. Perfect Price Discrimination

Perfect or first-degree price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price, according to his/her willingness to pay. Perfect price discrimination is difficult in practice. Some of the close examples are:

Car dealerships: they charge different price depending on your bargaining power (or willingness to pay)Ticket Scalping: the scalper charges different prices depending on customers willingness to pay.

Deadweightloss

Consumersurplus

Welfare Without Price Discrimination

Price

0 Quantity

Profit

Demand

Marginal cost

Marginalrevenue

Quantity sold

Monopolyprice

(a) Monopolist with Single Price

Welfare With Price Discrimination...

Price

0Quantity

Demand

Marginal cost

Quantity sold

(b) With perfect price discrimination DWL = 0. Monopolist extracts all the Consumer Surplus.

PS

2. Second-Degree Price Discrimination

Examples: Quantity discounts

– Buying in bulk like at Sam’s Club Block pricing – the practice of charging different

prices for different quantities of “blocks” of a good– Electric power companies charge different prices

for a consumer purchasing a set block of electricity

3. Third-Degree Price Discrimination

Practice of dividing consumers into two or more groups depending upon their demand (curves) and charging different prices to each group.

Most common examples:– Airlines’ economy and business class fares,

premium vs. non-premium liquor, discounts to students and senior citizens, frozen vs. canned vegetables.

– Coupons.

Example: Economics of Coupons and Rebates

Those consumers who are more price elastic will tend to use the coupon/rebate more often when they purchase the product than those consumers with a less elastic demand.

Thus, coupons and rebate programs allow firms to price discriminate based on their demand elasticities.

Price sensitive consumers end up paying lower prices whereas other non-price sensitive consumers pay regular prices.

How to Price a Best Selling Novel?

Publisher must divide consumers into two groups:– Those willing to buy more expensive hard back– Those willing to wait for cheaper paperback

Have to be strategic about when to release paperback after hardback– Publishers typically wait 12 to 18 months

So this kind of publisher’s practice is an example of third-degree price discrimination.

4. The Two-Part Tariff

Form of pricing in which consumers are charged an entry fee and usage fee as well.– EX: amusement park, golf course, telephone

service, cell phone service. A fee is charged upfront for right to use/buy the

product. An additional fee is charged for each unit the

consumer wishes to consume– Pay a fee to play golf and then pay another fee for

each game you play.

Usage price = P* is set equal to MC. Entry price = T*, the entire consumer surplus.Firm captures all consumer surplus as profit.

T*

Two-Part Tariff with a Single Consumer

Quantity

$/Q

MCP*

D

5. Bundling

Renting the movies separately would result in each theater paying the lowest reservation price for each movie:– Maximum price for Wind = $10,000– Maximum price for Gertie = $3,000

Total Revenue = $26,000

Gone with the Wind Getting Gertie’s Garter

Theater A $12,000 $3,000

Theater B $10,000 $4,000

Bundling

If the movies are bundled:– Theater A will pay $15,000 for both– Theater B will pay $14,000 for both

If each were charged the lower of the two prices, total revenue will be $28,000.

The movie company will gain $2000 more revenue by bundling the movie (than selling separately).

More profitable to bundle because relative valuation of two films are reversed. That is, demands are negatively correlated.– A pays more for Wind ($12,000) than B ($10,000).– B pays more for Gertie ($4,000) than A ($3,000).

Bundling: Relative Valuations

If the demands were positively correlated (Theater A would pay more for both films as shown) bundling would not result in an increase in revenue.

Gone with the Wind Getting Gertie’s Garter

Theater A $12,000 $4,000

Theater B $10,000 $3,000

Bundling

If the movies are bundled:– The most Theater A would pay = $16,000– The most Theater B would pay = $13,000

The maximum price that could be charged if bundled = $13,000.

Thus, total revenue will be $26,000, the same as by selling the films separately.

Price Discrimination

Two Important Effects of Price Discrimination:

– Can increase the monopolist’s profits.

– Can reduce deadweight loss by increasing the producer surplus, and not the consumer surplus.

Monopoly power is common. Most firms have some control over prices because of differentiated products.

Baskin - Robins Ice Cream vs. Breyer’s Designer’s clothes vs. No-Name brands

– However, firms with substantial monopoly power are rare because few goods are truly unique.