Chapter 15: Monopoly

15-1: Why Monopolies Arise

  • Monopoly: A firm that is the sole seller of its product which has no close substitutes
    • Caused by a barrier to entry; other firms cannot enter the market and compete
    • Three main barriers to entry: monopoly resources, government regulation, and production process

Monopoly Resources

  • A monopoly can arise if a firm has sole access to a key resource
    • For example, a small town might only have one well; the owner of said well has a monopoly
    • Famous example is DeBeers, a diamond company that controls 80% of diamonds produced
  • Monopolies rarely arise because of access to a key resource, as most resources are freely available

Government-Created Monopolies

  • Monopolies can arise when the government provides one person or firm the sole ability to sell a product
    • The two most important ways the government does so is through patent and copyright laws
  • Though the laws create a monopoly which is undesirable compared to a competitive market, they also encourage research and development

Natural Monopolies

  • A natural monopoly occurs when a single firm can supply a good or service at a lower cost than two (or more) other firms combined
    • Naturally monopolistic companies have constant economies of scale
  • Industries with natural monopolies are hard to enter; new firms cannot produce at as low of a price and compete
  • Smaller markets are more condusive to natural monopolies, as the profit from competing with existing firms has a lower potential

15-2: How Monopolies Make Production and Pricing Decisions

Monopoly versus Competition

  • The key difference between competitive firms and monopolies is that monopolies can control the price of the output while competitives firms (price takers) cannot
    • The demand curve for a competitive firm is elastic, as they can produce any quantity and have people buy at that price
    • The demand curve for a monopoly slopes downward, as higher quantities induce lower prices and vice versa
    • Figure: image

A Monopoly’s Revenue

  • Consider a water producer with the following statistics: image
    • Note that the marginal revenue is always less than the price of the good
      • This is because monopolists lose money on earlier sales while gaining revenue at the new price
      • When you go from a quantity of 3 to 4, your price drops by a dollar; you lose $3 on the original quantity while increasing revenue by the price * one unit
  • When a monopoly increases the amount it sells, there are two effects on total revenue (P x Q):
    • The output effect: More output is sold, so Q is higher and the total revenue increases
    • The price effect: The price is lower, so P is lower and the total revenue decreases
  • Marginal revenue is positive when the output effect outweighs the price effect but is negative when the price effect outweighs the output effect
  • Graph of Demand Marginal Revenue Curves: image

Profit Maximization

Graph of relevant curves for a monopoly: image

  • Similar to competitive firms, monopolies choose the level of production where marginal revenue equals marginal cost
    • Low quantity = lower marginal cost = increase quantity produced
    • High quantity = high marginal cost = decrease quantity produced
  • Unlike competitive firms, the marginal revenue is always lower than the price
    • Competitive firms: P = MR = MC
    • Monopolies: P > MR = MC
  • Therefore, to choose the price of the product, monopolies create the quantity at which MR = MC and determine the price using the demand curve
  • Because the price is greater than the marginal cost for monopolies, a social cost is created

A Monopoly’s Profit

  • Similar to competitive firms:
    • Profit (P) = Total Revenue (TR) - Total Cost (TC)
    • P = (TR/Q - TC/Q) * Q
    • P = (Price - ATC) * Q
  • Graph that shows a monopoly’s profit: image

Main Steps to Maximize a Monopoly’s Profit

  1. Derive the MR curve using the demand curve
  2. Find the quantity at which MR = MC
  3. On the demand curve, find the price that matches the quantity
  4. If the price is greater than the average total cost, the monopoly profits

15-3: The Welfare Cost of Monopolies

The Deadweight Loss

  • The quantity the maximizes total surplus is the found at the intersection of the supply curve (or marginal cost curve) and the demand curve
    • Figure: image
  • The quantity that the monopolist chooses is the one that maximizes profit which is at the intersection of marginal revenue and marginal cost
    • Recall that marginal revenue is always lower than price (or demand)
    • Thus, monopolies produce lower than the efficient quantity.
    • This causes a deadweight loss because some consumers might value the price above the monopoly’s cost but below its price
    • Graph: image
  • The deadweight loss caused by monopolies is similar to a tax; it drives a wedge between supply and demand
    • Instead of creating revenue for the government, it creates revenue for the monopoly

The Monopoly’s Profit: A Social Cost?

  • The fact that the firm profits does not mean that there is a social cost; it simply means that producers benefit more than consumers
    • However, because monopolies produce less than is efficient, there is a social cost
  • There is a caveat to this: if monopolies use their profits to maintain their monopoly, then all producer surplus is lost and the deadweight loss grows bigger

15-4: Price Discrimination

  • Price discrimination: Selling the same good at different prices to different customers

A Parable about Pricing

  • If one party values a good more than another party, then a monopoly would want to try to sell their product at a higher price to the party that values it more
    • This eliminates deadweight loss, as parties unwilling to buy a good at a higher price will buy the good at a lower one
    • Increasing the amount sold is equivalent to increasing the quantity; the inefficiency of monopolies is lessened because they produce more

The Moral of the Story

  • Price discrimination is a rational decision to maximize profit
  • To price discriminate, firms must be able to separate customers by their willingness to pay (either by geography, method of buying, etc.)
    • Adding on to this, there must be some measure in place to prevent arbitrage, or buying a good in one market at a low price and selling it in another at a higher price
  • Price discrimination can raise economic welfare, as more consumers purchase the product
    • Note that all increases in surplus are producer-side; they make more profit while consumers purchase goods at their willingness to buy (resulting in zero consumer surplus)

The Analytics of Price Discrimination

  • Perfect price discrimination is when a monopolist knows each customer’s willingness to pay and can charge them accordingly
    • Assuming the monopolist can perfectly price discriminate, the following graphs can be made: image
  • All marginal consumers get the product at their value, and the monopoly pockets all surplus
  • Imperfect price discrimination can raise, lower, or not affect the total surplus in a market
    • All that is certain is that price discrimination increases the monopoly’s profit, as firms would only price discriminate if there was a benefit

Examples of Price Discrimination

  • Movie Tickets - Though the marginal cost of selling a theater seat is constant, there are discounts for kids and seniors
  • Airline Prices - Depending on the timing of your flight, you might be charged more because you are a businessperson and value a flight more
  • Discount Coupons - Richer people won’t use coupons and stores can make a bigger profit off of them because of that
  • Financial Aid - Wealthy families have a higher willingness to pay and thus don’t receive aid so the college can make the most money
  • Quantity Discounts - The more of a good you purchase, the lower your marginal willingness to pay is, so stores sell in bulk

15-5: Public Policy Towards Monopolies

Increasing Competition with Antitrust Laws

  • If two big companies wish to merge, then the Department of Justice analyzes the deal before approving, as the union of two big companies could result in a monopoly
    • Horizontal merges are typically blocked, as they remove all competition
    • Vertical merges are allowed because it doesn’t remove competition; it just makes one firm more efficient
  • Laws such as the Sherman and Clayton Antitrust Acts allow the government to prevent mergers
  • Antitrust laws prevent monopolies, but mergers can also create more efficient methods of production
    • It’s up to the government to decide if a merger is beneficial or not, and critics question the government’s decisionmaking abilities

Regulation

  • Governments regulate the behaviors (typically through pricing) of monopolies, usually focusing on natural monopolies like water or electricity
  • The price the government sets is difficult to determine
    • A low price could cause the firm to incur a loss, forcing them to exit the industry
    • A high price (that results in zero economic profit) might not be the profit maximizing quantity for a firm, causing a deadweight loss
  • A regulated price also gives the monopolist no incentive to lower their costs, as they can’t make a higher profit

Public Ownership

  • Governments have the option to run a natural monopoly itself
    • Common in European countries where the government owns telephone, water, and electric companies
    • The US runs the Postal Service
  • Private monopolies are preferred to public monopolies, as private ones have an incentive to lower costs and become more efficient while public ones are slowed by the bureaucracy

Doing Nothing

  • Policies aimed at reducing monopolies have drawbacks, and some economists argue that it is most efficient to allow monopolies to flourish

Summarizing Graphic

image