Principles of Economics. January 2018

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1 Principles of Economics January 2018

2 Monopoly Contents Market structures 14 Monopoly 15 Monopolistic competition 16 Oligopoly Principles of Economics January / 39

3 Monopoly Market power In a competitive market firm is a price taker. Each market participant is small relative to market. Goods are homogenous. Firm with market power has some control over the price. Most firms have at least some market power. There are many market structures with imperfectly competitive producers: Monopoly Monopolistic competition Oligopoly Principles of Economics January / 39

4 Monopoly Monopoly A firm is a monopoly if it is the sole seller of a product without close substitutes. For a monopoly to arise there must be some barrier to entry. What are the barriers? Monopoly resources (e.g. single working water well on island is owned by a firm) Government-created monopolies (e.g. retailing of alcohol) Natural monopolies (economies of scale, e.g. distribution of electricity) External growth (mergers and acquisitions) Threat of entry may force monopolies to behave more competitively. Principles of Economics January / 39

5 Monopoly Natural monopoly Allocative efficiency is reached with one producer. Figure: Economies of scale as a cause of monopoly Principles of Economics January / 39

6 Monopoly Decision making of a monopoly Competitive firm can sell any amount at the market price. Competitive firm makes a decision on quantity only. Monopoly faces the (downward sloping) market demand curve. Monopoly makes a joint decision on quantity and price. Principles of Economics January / 39

7 Monopoly Revenue of a monopoly Marginal revenue of a monopoly is not simply price. When monopoly increases the quantity Q the total revenue TR = P Q varies through two channels: 1 Q increases TR increases. 2 P decreases TR decreases. Principles of Economics January / 39

8 Monopoly Marginal revenue of a monopoly Marginal revenue is less than price. Principles of Economics January / 39

9 Monopoly Profit maximization of a monopoly Profit is maximized when marginal cost is set equal to marginal revenue. Note that P > MR = MC. Principles of Economics January / 39

10 Monopoly A monopoly s profit Profit = (P ATC) Q Principles of Economics January / 39

11 Monopoly A monopoly s pricing Example Newly developed pharmaceutical drugs enjoy patent protection which expires after a period of time. Evidence on pricing before and after patent expiration is consistent with below figure. Even after expiration the original developer may have some market power due to brand loyalty. Principles of Economics January / 39

12 Monopoly Welfare cost of monopoly Benevolent social planner would again choose the quantity where marginal value to buyers is equal to marginal cost to sellers. Principles of Economics January / 39

13 Monopoly Welfare cost of monopoly Welfare effect of a monopoly is equivalent to a private tax collector. Principles of Economics January / 39

14 Monopoly Welfare cost of monopoly Monopoly profit itself is a transfer from consumers to producers. Does not affect total surplus. Inefficiency stems from lower quantity. Inefficiency increases if part of the monopoly profit is used to merely protect the monopoly position. E.g. lobbying Principles of Economics January / 39

15 Monopoly Price discrimination So far we have assumed that firms sell the good at same price to all customers. Price discrimination means that firm sells the same good at different prices to different customers. Ability to discriminate buyers varies. Examples of price discrimination: Discounts for children and seniors Airline tickets (time, round-trips etc.) Discount coupons Quantity discounts Different prices for different countries Principles of Economics January / 39

16 Monopoly No price discrimination Principles of Economics January / 39

17 Monopoly Perfect price discrimination Total surplus increases (inefficiency related to monopolies disappears). Transfer from consumers to monopoly increases. Principles of Economics January / 39

18 Monopoly Public policy toward monopolies Possible government responses to inefficiencies of monopolies: Promote competition in monopolized industries Regulate behavior of the monopolies Turn private monopolies to public enterprises Do nothing All industrialized countries have some competition legislation. Principles of Economics January / 39

19 Monopoly Regulating natural monopoly With economies of scale monopoly may be a desirable market structure. Government may regulate pricing of natural monopoly Marginal cost pricing leads to losses (subsidies?) Regulation of pricing may lead to loss of incentives. Some argue that errors that regulators make cause more damage than the original problem Principles of Economics January / 39

20 Monopolistic competition Monopolistic competition In many (most?) markets there are many firms which sell products which are similar but not identical. Monopolistic competition has features from both competitive markets and monopolistic market: Many sellers (as with perfect competition) Product differentiation (each firm faces downward sloping demand as with monopolies) Free entry (economic profits tend to zero as with perfect competition) Principles of Economics January / 39

21 Monopolistic competition Monopolistically competitive firm in the short-run With differentiated goods firms face impercectly elastic demand curve (some market power) Decision-making is identical to a monopoly Principles of Economics January / 39

22 Monopolistic competition Monopolistically competitive firm in the short-run In the short-run there may be firms with negative profit (only variable costs must be covered). Principles of Economics January / 39

23 Monopolistic competition Monopolistic competition in the long-run Increase in number of firms shifts the demand curve of each incumbent firm left. With free entry number of firms adjusts until profits are equal to zero. Principles of Economics January / 39

24 Monopolistic competition Monopolistic competition vs perfect competition Excess capacity: monopolistic competition does not feature efficient scale. Mark-up: price exceeds marginal cost with monopolistic competition. Principles of Economics January / 39

25 Monopolistic competition Monopolistic competition and welfare There are deadweight losses as with monopolies. How to regulate? Regulation would involve huge amount of industries and firms. Firms are already making zero economic profit. Is the number of firms optimal? Externalities from entry: Negative externality on existing firms (business stealing) Positive externality on consumers (product-variety) Principles of Economics January / 39

26 Monopolistic competition Advertising Is advertising about manipulating tastes or about providing information? Does advertising impede or promote competition? Advertising may provide information indirectly (signaling): It may be that only high quality producers have incentive to advertise. It may be rational to buy the advertised product. The content of the advertising is irrelevant for the argument. Signaling is a powerful motive for e.g. education as well. Principles of Economics January / 39

27 Oligopoly Oligopoly Many imperfectly competitive markets fall between the polar cases of monopoly and monopolistic competition. Oligopoly is a market structure with only a few sellers dominating the market. Principles of Economics January / 39

28 Oligopoly Oligopoly Oligopolies differ in details. Special case of two firms is called a duopoly Concentration of markets can be measure e.g. by concentration ratio: market share of top x firms. Strategic behavior important. Behavior of a firm depends on what it thinks the others will do. Conflict between self-interest and cooperation between the firms. Firms would do the best by acting like a monopolist and sharing the profit. There may be incentives for individual firms to deviate from that. Principles of Economics January / 39

29 Oligopoly Duopoly example Assume there are two wells in a town, owned by Jack and Jill. Costs of pumping water are assumed to be zero. Principles of Economics January / 39

30 Oligopoly Competition, monopolies and cartels With perfect competition price equals marginal cost. Price would be zero and 120 liters of water would be supplied. Monopoly would maximize profit subject to market demand curve. Price would be 60 and 60 liters of water would be supplied. Price exceeds marginal cost and the outcome is inefficient. If Jack and Jill are able to collude they may agree on a cartel. Agree on charging the monopoly price. Share the demand e.g. 30 liters for Jack and 30 liters for Jill. Principles of Economics January / 39

31 Oligopoly Equilibrium for an oligopoly Why collusion might not happen? Competition legislation. Incentives to deviate from the agreement. Strategic behavior: Explicit consideration of actions of the others in decision-making. Not just a price-taker. Game theory and Nash equilibrium can be used to make predictions in case of strategic behavior: Each agent chooses her best strategy given the strategy others choose. No one has an incentive to unilaterally deviate from Nash equilibrium. Principles of Economics January / 39

32 Oligopoly Jack and Jill oligopoly game Each has incentive to deviate from agreement. With repeated games cooperation may be easier... Principles of Economics January / 39

33 Oligopoly Oligopoly What happens when the number of firms in an oligopoly grows? Collusion becomes more difficult. Each firm s share of demand gets smaller. Each firm s price effect gets smaller. With identical goods we get perfect competition at the limit. Principles of Economics January / 39

34 Oligopoly Competition legislation and strategic behavior Price-fixing (cartels) is not the only possible manifestation of strategic behavior. Competition legislation has to consider also more controversial practices, e.g. Resale price maintenance Predatory pricing Tying Principles of Economics January / 39

35 Further examples of games Prisoner s dilemma Principles of Economics January / 39

36 Further examples of games An oligopoly game Principles of Economics January / 39

37 Further examples of games An arms race game Principles of Economics January / 39

38 Further examples of games An advertising game Principles of Economics January / 39

39 Further examples of games A common resources game Principles of Economics January / 39