A few firms Imperfect Competition Oligopoly. Figure 8.1: Market structures

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1 8.1 Setup Monopoly is a single firm producing a particular commodity. It can affect the market by changing the quantity; via the (inverse) demand function p (q). The tradeoff: either sell a lot cheaply, or sell little for a high. This is the only thing that is different from the previous analysis of a perfectly competitive firm in particular, cost curves are not affected. That is, the firm is still perfectly competitive on the input markets and derives its cost function in the same way as previously. Market structures - monopoly and perfect competition as polar cases: One firm Monopoly A few firms Imperfect Competition Oligopoly Figure 8.1: Market structures Many firms Perfect Competition 8.2 Profit maximization The monopolist follows the same general rules as perfectly competitive firm. First (i) output decision by the comparison of Marginal Revenue (MR) and MC. MC < MR then q increases the profit MC > MR then q increases the profit MC = MR then a small change of q will not affect the profit: a candidate for optimal production level. Then (ii) shutdown decision shutdown if operating profit is not positive. The twist is in Marginal Revenue. In the case of a perfectly competitive firm, MR is equal to. Not for the monopoly. 8.3 Marginal Revenue of the monopoly As always, Marginal Revenue is a change of the revenue caused by an increase of production and sales by one unit, MR = R/ q. But now R = p (q) q. That is, the 53

2 p p(q 1 ) B Initial Revenue A q 1 q Figure 8.2: Marginal Revenue of the monopoly that the monopoly can select, depends on the quantity that the monopolist desires to sell. Figure 8.2 presents the trade-off of the monopolist. If quantity increases from q 1 by q, then initial revenue goes up by area A because the monopolist sells more, but also goes down by area B because the must be lowered from initial p (q 1 ) by p < 0. Rectangles A = q (p (q 1 ) + p) and B = p q 1. Since R = A B, we have MR = p (q 1 ) + p + ( p/ q) q 1. If the change of production is small then p is essentially zero and we ultimately have p (q 1 ) + ( p/ q) q 1. Comparison with perfect competition: Change of the induced by the firm s increase of production Monopoly Competitive Firm Negative, p/ q < 0 None, p = 0 Area B There is one There is none Marginal Revenue MR < p (q 1 ) MR = p Table 8.1: Monopoly versus perfect competition Table 8.2 presents a numerical example: First two columns describe the demand, the third column describes total cost. The optimal production level is q m = 3 units (where (i) MR is (almost) equal to MC and (ii) operating profit is not negative, p (q m ) > AV C) 54

3 p q C R MR MC AV C Table 8.2: Numerical example 8.4 Graphical illustration 8.4 Graphical illustration Choice: (i) Output decision find a candidate q m from MC = MR, then use demand to see what p m is acceptable to consumers. (ii) Shutdown decision verify that operating profit is not negative, p m AV C. p m MC AVC q m MR Figure 8.3: Monopoly decision graphically 8.5 Welfare properties of the monopoly. 1. The optimal behavior of the monopoly involves MC = MR < p m. That is, q m is less than competitive outcome q e with the same cost structure. Hence, there is DWL. Moreover, Consumer Surplus is lower than if the product is delivered by perfect competition, because the is higher. 55

4 2. The above social loss can in fact be greater, if firms actively spend resources to become monopolies (for instance, lobbying). Such behavior is called rent seeking. p m DWL relative to perf. comp. Social Welfare of monopoly MC AVC q m q e MR Figure 8.4: Welfare properties of the monopoly 8.6 Price discrimination Implicit assumption above: monopolist has to charge a single for all delivered units. It may be justified sometimes maybe in real world there is arbitrage: consumes who buy cheaper may resell to those who would be charged more. But if such resale is impossible then the monopolist may be able to charge different s to different consumers or for different units. This is called discrimination. Perfect discrimination is when the monopolist knows exactly how much each consumer is willing to pay for each unit. Monopolist may then sell precisely q e units for the of the entire Social Welfare (first unit for a very high, second for slightly lower, etc. until the consumer s valuation equals M C). Two consequences of such perfect discrimination: Socially optimal production level is delivered q e, resulting in no DWL but Consumer Surplus is zero, captured entirely by the monopolist via perfectly tailored s. 8.7 Why monopolies exist? Not only monopolies, but all firms with market power. 1. Cost Advantage. Consider the following exercise: Imagine a perfectly competitive market with free exit and entry, with long run AC that has its minimum at roughly of the size of the market or more The quantity that achieves this 56

5 8.7 Why monopolies exist? minimum is called the Minimum Efficient Scale MES. Let s try to find the competitive equilibrium according to our notes perfect competition: we find that in the long-run the must be p e, because this is where AC has its minimum, and individual production is equal to MES. Then we proceed to find the equilibrium number of firms, but this is where we realize that total quantity demanded is actually equal to production of a single firm and we conclude that equilibrium number of firms is n e = 1. This however contradicts our assumption that the number of firms is so great that they all should take s as given. Conclusion: If MES is large relative to the size of the demand, i.e. if firm has economies of scale for all relevant production levels, then we have a natural monopoly. If the industry is characterized by economies of scale then the structure with many firms will not be permanent the bigger one firm becomes the more cost-efficient it gets, gaining advantage over competitors. Ultimately, only one firm would survive. Examples: power plants (say nuclear) networks such as electricity, gas, water, rail, intellectual property such as software, movies, music, books, new drugs etc. in which producing the first unit is extremely expensive, but producing the second copy is costless. MC AC p e MES Figure 8.5: Natural Monopoly 2. Government actions: Patents or copyrights introduced to encourage scientific development and artistic creativity. As a result of barriers to entry to assure quality or standards medical professionals, architects, academic titles, solicitors etc. 57

6 As a result of government procurement contracts, or to assure reliability of deliveries national security, defense industry, energy supplies, food or medicine stock, etc. (but here the demand side is not a taker) Selling licenses or rights to operate to obtain budget revenue. Licensing, cartels or other less explicit methods due to lobbying, to protect interests of some political/professional groups or outright corruption. 58