Characteristics of a Monopoly
|Pure monopoly - a firm is sole producer / supplier of a product in the market
Market Entry Barriers - Prevent entry of
competitors into the market
- Single seller of a product
- The demand for the monopolist's product is the market demand curve
- A one firm industry
- No close substitutes for the product
- You either buy the product from him or you don't
- A monopolist can exert control over the price
- He decreases production level and market price increases
- Other firms are prevented from entering the market, because of high barriers
1. Economies of scale - also called
a natural monopoly - monopoly has to be large to obtain low per-unit cost.
- Firm has very large fixed costs
- A new firm entering this market would need substantial amounts of capital to reach this low-cost production level
- Monopoly usually supplies the whole market.
- Examples: Local phone service, electricity, and natural gas.
- Requires large amount of equipment & infrastructure
- More convenient - imagine 12 electric power stations competing in Arkadelphia. Each has its own power lines, power substations,
etc. This would be a mess.
- Economies of scale are shown below
- Output is the whole market before a monopoly hits the constant economies of scale
|Economies of Scale|
2. Legal Barriers - government's rules or regulations create an entry barrier
- Licenses - oldest form of protection - government grants permission to engage in an activity
- Protects businesses from competition
- Legal services
- Funeral homes, etc.
- Sometimes the license has little costs, while other cases, they are expensive.
- Example: Taxicabs in New York City.
- The number of taxi licenses are fixed.
- Licenses can be sold or traded.
- Market price of license exceeds $100,000.
- Patents - government protects a new invention, drug, device, etc.
- U.S. - gives the exclusive right to produce product for 17 years
- Benefits - encourages costly scientific research
- Costs - higher prices to consumers until patent expires
- Firms have come up with ways to renew patents
- Pharmaceutical companies invent similar medications, obtain a patent on them, and phase out production of old medications as
their patents expire
3. A firm controls an essential resource
- Example: Before World War II
- Aluminum Company of America (Alcoa) controlled the supply of bauxite
- Other firms could not produce aluminum cheaply without bauxite
- Example: DeBeers Corporation of South Africa.
- Controlled 80 to 85% of the world's supply of diamonds
- Currently controls approximately 55% of market
- "Diamond is forever."
4. Unfair competition:
- Example: Standard Oil - John Rockefeller.
- Came into a small town and charge a price below cost.
- Drove competitors out of business.
- Standard Oil would buy these businesses for cents on the dollar and consolidate them into Standard Oil.
- With no competition, Standard Oil charged monopoly prices.
- Controlled 90% of U.S. oil market.
||Given enough time, technology allows new firms to circumvent the high barriers and drive economic profits to zero.|
||Intel and AMD both compete for microprocessors. VIA is trying to break into the market with its 64-bit microprocessor Nano. The Nano
can beat the Intel's Atom processor.|
The Case of Monopoly
1. Price and output under monopoly
- Profits are maximized at MR = MC
- Monopolists expand output when MR > MC
- Monopolists contract output when MC > MR
- Unregulated monopolist: Market price, P* and production level, Q*
- P* > C*, therefore monopolist earns economic profits
- High entry barriers prevent competition
- Monopolist earns long-run profits
- Market barriers prevents competition
- Monopolist does not have a supply function
- Monopolist produces at MC =MR, which is one point
- Monopolist has lower social welfare than a competitive market
- Monopolistic market has higher price and lower quantity
- Consumers' surplus is transferred from consumers to monopolist as
|Price, Per-unit costs|
2. Other information about monopolies
- Price gouging
- Monopolist charges the price, where MR = MC
- He does not raise price further, because profits will fall
- A monopolist does not price gouge
- Investing in a monopolist's stock may not be profitable, because the monopoly value is already captured in the stock price.
- Early bird - unless you are the first person to buy the stock before economic profits began
- Investing in monopolists may not be a good investment.
- Monopolies may not earn long-run economic profits.
- Patents for products that consumers do not want.
- The monopolists do not know the MR and MC curves.
- They approximate the rule MR = MC by max. revenue, min. costs, and
changing production levels.
Why Monopolies are Bad?
|Not only does this list apply to monopolies in the private market, but also includes government that has monopolies over certain services.
- Little competition limits the options to consumers
- You either buy the product from the monopolist or you go without
- Reduced competition results in allocative inefficiency
- Consumers value the products more highly than what it costs to produce them
- P* > MC
- Firms are earning economic profits
- Consumers are not able to direct monopolies to serve their interests
- Bad service
- No incentive to improve products, etc.
- X-Inefficiency - firms or agencies may not produce at low cost
- lack of competition
- no incentive to minimize costs
- poorly motivated workers
- X-Inefficiency - may be worse with government organizations because they can be much larger
- Monopoly power may encourage rent seeking behavior
- Rent seeking behavior - government officials take cash &
assets from private companies & people
- Companies bribe public officials, then officials grant licenses to those businesses, restricting competition.
- Corporations funnel campaign money to Congressmen
- Congress passes laws favorable to corporations
|Price discrimination - a firm sells products/services at different prices to different buyers.
- Firms, who price discriminate, capture some of the consumers' surplus as additional revenue.
- Senior citizen discounts for dinners, etc.
- Student discounts on movies, software, etc.
- Coupons, rebates, family specials, etc.
- Three conditions:
- Identify different groups of customers
- Price elasticities of demand is different for each group
- Prevent customers who buy at the low price and sell to customers at higher prices
- Senior citizen selling her "discounted" medication to another customer
- Firm has some monopoly power.
- Example: College Financial Aid
- First case, college does not price discriminate.
- Total Revenue = P q* = $10,000 q*
- Second case, college divides students into 3 groups
- "Rich students" are charged $20,000
- Number of students: q1 - 0
- Revenue = $20,000 q1
- "Middle-class students" are charged $15,000
- Number of students: q2 - q1
- Revenue = $15,000 (q2 - q1)
- "Poor students" are charged $10,000
- Number of students: q* - q2
- Revenue = $10,000 (q* - q2)
- Total revenue increases.
|No Price Discrimination
- Firms maximize profits by expanding output until:
- MRrich = MC
- MRmiddle class = MC
- MRpoor = MC
- Rich students are less sensitive to price changes.
- Poor students are very sensitive to price changes.
Government Policy Alternatives
Policies are ranked from the economically best to the worse.
1. Government reduces market barrier:.
- Reduce licensing requirements.
- Reduce trade barriers that exposes monopoly to international competition
2. Government can "ideally" regulate natural monopolies. Unregulated monopolist produces at MC = MR, so the market price is P* and output is
1. Average Cost Pricing - the government sets the price where the demand curve
intersects the long-run ATC.
- The price is lower ( P~< P*)
- The quantity produced is higher (Q~ > Q*)
- The firm earns zero economic profit in long run
- Social welfare improves
- Allocative inefficient
|A Monopolist - Average Cost Pricing|
|Price, Per-Unit Costs|
Unregulated monopolist produces at MC = MR, so the market price
is P* and output is Q*.
2. Marginal Cost Pricing -
the government sets the price where the demand curve intersects the MC.
- The price is the lowest (P~ < P*)
- The quantity produced is the highest (Q~ > Q*)
- The same social welfare as a competitive market
- Allocative efficient
- The firm earns a loss in long run
- May need to be subsidized
- Red area shows the loss
3. Ramsey Pricing - regulated monopolist charges two prices
- Two prices
- Rate charge is the price, P~, where price equals marginal costs
- Fixed charge - monopolist take loss and charges the loss to consumers as fixed fees
- Allocative efficient and does not need to be subsidized by government
|A Monopolist - Marginal Cost Pricing|
|Price, Per-Unit Costs|
3. Antitrust policies - increase the number of firms in a market.
- Government can break up monopolies.
- Prevent companies from merging that may reduce competition.
- Prosecute firms engaging in collusive behavior.
- Do not breakup natural monopolies!
- Per-unit costs will be higher with more firms.
- In 1984, AT&T was broken down into five baby bells.
- A large monopoly broken down into 5 smaller regional monopolies.
4. Government can take over monopoly.
- Maybe worse than a private firm monopoly
- No profit motive
- No incentives to minimize costs and satisfy consumers
- Taxpayers could end up subsidizing it
- pure monopoly
- market entry barriers
- economies of scale
- natural monopoly
- price gouging
- early bird
- rent-seeking behavior
- price discrimination
- average cost pricing
- marginal cost pricing