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University of Essex Session 2011/12

Department of Economics Autumn Term

EC111: INTRODUCTION TO ECONOMICS

MONOPOLY AND REGULATION

Monopoly is the opposite extreme to perfect competition. In this case there is only

one (actual and potential) supplier of a good.

Monopoly relies on barriers to entry to the industry; these could be legal barriers,

they could be the result of special resources (factors or materials) owned by the

firm, or they could be the result of technology.

The key feature is that the monopolist faces the entire market demand curve.

The marginal revenue, MR, curve is downward sloping and below the demand

curve (which represents average revenue, AR).

In order to sell more the monopolist drives down the price of all units sold, not just

the marginal unit. Hence MR is the addition to total revenue of selling one more unit

minus the fall in revenue from dropping the price of all the intra-marginal units.

Thus MR < P at any level of output.

MR

P, MR

Elasticity = 1

Q

D

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Note that:

MR is zero at the point of unit elasticity on the demand curve. This is where

total revenue for the firm (total expenditure of the buyers) is maximised.

Beyond that, total revenue falls, so marginal revenue is negative.

The slope of MR is two times the slope of AR (the demand curve). In the

linear case the MR bisects the horizontal axis between zero and the intecept

of the demand curve.

The relationship between marginal revenue and price depends on the

elasticity of demand:E

11PMR . When demand is perfectly elastic, E =

, and MR = P.1

Profit maximising equilibrium for the monopolist is where MR = MC. For a

monopolist with U shaped costs we have:

1 To show this we require some calculus. Note that the change in Total Revenue along the demand

curve can be expressed as PdQQdPdTR and therefore Marginal Revenue is

PdQ

dPQ

dQ

dTRMR . The elasticity of demand is

Q

P

dP

dQE and thus P

dQ

dP

P

QPMR .

Remembering that elasticity is always expressed as a positive number we haveE

11PMR

P

P*

Q* Q

MR

Profit

D

MC

AC

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Note that:

The monopolist has market power. Unlike the competitive firm, it can

influence the price. The monopolist chooses the price (and therefore the

quantity) that maximises its profits.

The monopolist picks a point on the demand curve where demand is elastic.

Q: How can we be sure of this?

Here we are not distinguishing between the short run and the long run (the

diagrams would look somewhat similar). But it is useful to think of the long

run. Q: Why?

The monopolist makes profit (PAC)Q. Because P > AC the monopolist

makes super-normal profits, i.e. profits in excess of opportunity costs.

Because there is no threat of entry the monopolist can sustain super-normalprofits in the long run.

A numerical example with constant costs.

Demand: Q = 12 P

Total cost function: TC = 4Q

From the second equation we have MC = 4 (constant marginal and average cost).

Inverting the first equation gives average revenue, Q224Q2/11

2/112P

Total revenue is: TR = PQ =24Q2Q2

Marginal revenue is the change in TR for a unit change in Q. MR = 244Q

[You need calculus for this, but the MR function can easily be derived by noting

that it has the same intercept and twice the slope of the AR function]

The profit maximising condition is: MR = MC: 244Q = 4.

Solving for Q: 244Q = 4; 20 = 4Q; Q = 5

From the demand curve P = 2425 = 14

Profits are: (PAC)Q; (144)5 = 50.

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I ll ustrating the numerical calculation

Comparing Monopoly and Perfect Competition

Assuming constant average and marginal costs makes it easier to compare

monopoly with perfect competition. If there are lots of identical small firms then, in

the long run, we have constant average and marginal costs (which is the industry

supply curve).

Q: If the monopolist faces the same cost conditions (lots of small plants) then how

does it sustain its monopoly power?

Under perfect competition we have P = MC in the long run. How much would the

perfectly competitive industry produce?

We have costs: AC = MC = 4 (which is the perfectly elastic industry supply curve),

and demand: P = 242Q.

Setting P = MC: 242Q = 4 ; Q = 10.

And from the demand curve P = 242 10 = 4.

Total profits are (PAC) Q = (44) 10 = 0.

So, we have for monopoly: Q = 5; P = 14; Profit = 50

And for perfect competition: Q = 10; P = 4; Profit = 0

P

24

14

4

5 10 Q

MR

Profit

D

MC = AC

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Welf are impl ications

Under monopoly:

Consumer surplus (area ABC) = (2414)5 = 25

Producer surplus (area BCEF) = (144)5 = 50

Social surplus = consumer surplus + producer surplus = 25 + 50 = 75

Under perfect competition:

Consumer surplus (area AEG) = (244)10 = 100

Producer surplus = 0

Social surplus consumer surplus + producer surplus = 100 + 0 = 100

The difference is deadweight loss (area CFG) = (144)(105) = 25

The monopolist restricts output in order to keep the price up. The producer gains,

but consumers lose more than the producer gains. The difference is the deadweight

loss.

G

FE

CB

A

P

24

14

4

5 10 Q

MR

D

MC = AC

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Natural Monopoly

Technology may be such that there are economies of scale over a range of output up

to and beyond total demand.

.

Here marginal costs are below average costs over the whole range of output

In this situation average costs would be higher if production was spread over several

different firms.

If there were a number of firms then one firm might be able to reduce costs by

taking over the others and eliminating them from the market.

Potential entrants may not be willing to enter the market because they would have

too small a market share to make positive profits. Here there is freedom to enter,

but firms dont enter.

P

Q

MR

D

MC

AC

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Price discrimination

Price discrimination is a situation where different units of a good are sold at

different prices.

This can work only if the firm can keep the markets separate i.e. prevent a situationwhere some people buy the good at a lower price and resell it to others who would

otherwise have to pay a higher price.

Thir d degree pri ce discrimination

In this illustration, constant costs are assumed and the two markets are drawn

back to back. The situation is similar to two separate monopolists except that

marginal costs are the same across both markets.

If the monopolist can discriminate between the two markets then it maximises

profits by setting MRA= MRB= MC.

At any given price demand is more elastic in market B than in market A. The firm

will charge a higher price in the market with the lower elasticity:

B

B

A

AE

11P

E

11PMC Since EA < EBit follows that PA> PB

QB

DBMRA MRBDA

Market BMarket A

MC = AC

P

QA

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The welfare implications of third degree price discrimination are ambiguous.

Consumers in low-elasticity markets are hurt by price discrimination

because they face a higher price, buy a smaller quantity and enjoy less

consumer surplus than under uniform pricing. The opposite is true for

consumers in high elasticity markets. Producer surplus increases with pricediscrimination. So the overall effect on social surplus is ambiguous.

But this assumes that the monopolist serves both markets. If price

discrimination was prohibited then it is possible that the firm would not

serve the high elasticity market at all, which would definitely result in lower

welfare than under price discrimination.

Second degree pri ce discriminati on

Suppose that there are two different types of customer, low elasticity or high

elasticity.

The diagram is now drawn for two individual customers, one of each type. But the

firm cannot identify the type. Q: Examples? Airline pricing?

The firm has to offer the same price to both types but the firm can discriminate

indirectly by offering various packages so that different groups buy different

packages.

The firm uses this strategy to extract more of the consumer surplus than under the

normal uniform pricing.

q

P

MRA MRBDA

Type BType A

MC = AC

P

qA

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Examples

Offering a two-part tariff, T(q) = A + Pq.

Non-linear pricing of a more general form e.g. quantity discounts.

Offer different packages each directed to a different customer type.

The welfare implications of second-degree price discrimination are ambiguous.

F ir st degree pri ce discrimination

The firm can identify each consumers marginal valuation of the good. (It is helpful

here to think of each consumer buying one unitas we move down the demand

curve, more consumers decide to buy a unit).

What was previously the demand (AR) curve, now becomes the MR curve. This is

because the firm can sell another unit at a lower price without reducing the price of

all the intra-marginal units. Q: Where is the new average revenue curve?

The monopolist will maximise its profit where MC = MR which is now at Q*in the

diagram.

Note that:

The firm converts the whole of consumer surplus into profits: area ABC.

Its output is the equivalent to perfect competition. Social surplus is

maximised.

Q* Q

CB

AP

D = MR

MC = AC

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Regulation

We assume that the regulators objective is to maximise the sum of consumer and

producer surplus.

One form of regulation is price cap regulation. The regulator seta a maximum price

of PPC, the perfectly competitive price which is equal to marginal cost.

Now the firm can sell as much as it wishes at PPC

; it is equivalent to making the

firms demand curveperfectly elastic, as in the competitive case.

The firm chooses to produce at QPC, which maximises social welfare (and consumer

surplus).

Problems with regulati on

Asymmetric information: the regulator may not be able to identify the firms costs.

(In the formula used in the UK, RPI minus X, the regulator allows the firm to

raise its price each year in line with inflation plus or minus an amount X).

Firms may have little incentive to reduce cost since if they are successful, the

regulator will simple reduce the price to match. This incentive effect will depend on

how often the price is adjusted.

The firm may capture the regulator. Q: What does this mean?

P

PM

PPC

QM QPC Q

MR

D

MC = AC

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Natural monopoly

Social surplus is maximised where P = MC.

Note that:

If the regulator sets the price where P = MC then the firm will make a loss

because at that point AC > MC. An alternative would be to set P = AC so

that the firm breaks even, There will be some deadweight loss since P > MC.

Alternatively set a two part tariff with a fixed charge plus a per unit price at

P = MC, such that the firm breaks even. This eliminates deadweight loss

when consumers are identical.

P

Q

MR

D

MC

AC

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Liberalisation versus regulation

Liberalisation means removal of restrictions on competition, such as making it

easier for new firms to enter.

Starting with a protected monopolist in a potentially competitive market, should thegovernment:

Allow for free entry or restrict entry?

Break up the monopolist into smaller units or leave it intact?

Regulate price and/or quality? And if so, how?

Liberalisation and regulation can be complements rather than substitutes.

For instance the utility industries (electricity, gas, telecommunications, etc.)combine activities that are natural monopolies with activities that are potentially

competitive.

Transmission networks (e.g. electricity distribution) are natural monopolies,

so regulation of these activities is necessary.

The provision of services over the networks (e.g. electricity generation or the

supply of electricity to consumers) is not a natural monopoly, so competition

in these activities is possible.

A number of important issues remain:

If there is room for only a few firms to be given the right to use the network,

Should this firms compete for that right, by periodic allocation of franchises,

and if so how should that be organised?

Should the firm that runs the network also be allowed to compete in

providing services over the network?

How should the government regulate the terms on which this firm gives

network access to other firms?