These notes provided by Laura Lamb are intended to complement class lectures. The notes are based on chapter 12 of Microeconomics and Behaviour 2 nd Canadian Edition by Frank and Parker (2004). Chapter 12 Monopoly A monopoly market structure is one characterized by a single seller of a unique product with no close substitutes. Unlike a competitive firm, a monopoly firm has significant control over the price it charges. A monopoly faces a demand curve. How does a firm become a monopoly? Why don t other firms enter the industry? In monopoly markets, barriers to entry exist. The sources of these barriers can be summarized as follows: 1. DeBeers once owned most of the world s diamond mines. They remain the dominant firm. Inco owned most of the world s nickel deposits. 2. The situation where the least costly way to serve a market is to have one firm produce all the product. The LAC curve slopes downward over a large quantity of output, large enough to provide for the entire market. A natural monopoly is an example i.e. BC hydro Returns to scale are important 3. A patent grants the right to exclusive benefit from all exchanges involving the invention to which it applies. 1
Although patents usually lead to higher prices for consumers, they make possible research and inventions that would not otherwise occur. In fact the firms usually need to sell their products at higher prices to cover the research and development of the product. In Canada, a patent has a life of 20 years. Pharmaceutical firms gain monopoly power through patents. 4. Network economies exist when a product increases in value as the number of consumers using it rises. (fax machines, cell phones) Microsoft s Windows operating system has resulted in near monopoly status for Microsoft (90% of world s pcs). Software developers have an incentive to write for he Window s format. It has become difficult to find software that is not written for Windows. 5. Governments grant limited licences for radio broadcasting Some university campuses have granted exclusive rights for vending machines sales We can safely assume, as we did for a competitive firm, that a monopolist s goal is to. The profit-maximizing behaviour of a monopolist: 2 methods: 1. Compare total revenue and total cost The total revenue curve for a monopolist is not upward sloping as it is for a competitive firm. Why? 2
The answer lies in the shape of the demand curves faced a firm in each market model. A competitive firm has a horizontal demand curve and a monopoly firm has a downward sloping demand curve. Remember the relationship between the changing elasticity on a downward sloping demand curve and total revenue. In order for a monopolist to sell a greater quantity of its product it must lower its price. Question: Sketch the total revenue curve for a monopolist whose demand curve is given by 100 2Q A monopolist will produce the quantity of output that corresponds with total revenue exceeding total cost by the greatest amount. 2. Compare marginal revenue and marginal cost In the short run, a profit maximizing monopolist will choose the level of output for which MC = MR, provided. Note that marginal revenue is derived from the slope of the total revenue curve. 3
Since the total revenue curve for a monopolist has a different shape than that for a competitive firm, we expect the marginal revenue curve for a monopolist to differ from that of a competitive firm s. For a monopolist, marginal revenue will be less than price, except in the special case of a perfectly discriminating monopolist discussed later in this chapter. Marginal revenue = (the gain in revenue from new sales) + (the loss in revenue from selling the previous output level at the new lower price) Marginal revenue and elasticity Remember from chapter 4 that there is a relationship between total revenue and price elasticity of demand. If a firm reduces price in the elastic section of the demand curve, total revenue will. In this case, the gain in revenue from the lower price is greater than the loss of revenue from selling previous output at a lower price, thus marginal revenue is. And conversely, if a firm reduces price in the inelastic section of the demand curve, total revenue will. In this case, the gain in revenue from the lower price is less than the loss of revenue from selling previous output at a lower price, thus marginal revenue is. 4
Graphing marginal revenue If demand is linear, marginal revenue is also linear. The marginal revenue curve has the same vertical intercept and twice the slope of the demand curve. Its horizontal intercept is half that of the demand curve. Question: Find the equation for the marginal revenue curve that corresponds to the demand curve P = 12-3Q Graphing the short-run profit maximization condition Illustrate how to calculate profit 5
Question: A monopolist faces a demand curve of P = 100 3Q and a short-run total cost curve of TC = 500 + 20Q. The associated marginal cost curve is MC = $20 per unit (note that this is the slope of TC). How much will the monopolist sell? What is the profit-maximizing price? How much economic profit will it earn at that price? Graph this question Will a monopolist ever produce on the inelastic portion of the demand curve?, because the marginal revenue will be and cannot be equated to. Note: inelastic demand implies that reducing output will increase total revenue and reduce total costs, and necessarily profits will rise. Thus any point where demand is inelastic cannot be a profit maximum.the firm can do better by reducing output. How is profit-maximizing mark-up determined? P MC MC 1 = η 1 For example, if price elasticity of demand facing a monopolist is equal to -2.5, then the profit-maximizing mark-up would be 1/(2.5-1)=.67 or 67%. This means than the profit-maximizing price is 67% higher than marginal cost. There is a negative relationship between price elasticity of demand and mark-up. 6
If price elasticity of demand is infinite (perfectly elastic), what is the mark-up? Will a monopolist ever shutdown? Whenever demand is lower than average variable cost for every possible level of output, the monopolist will produce nothing in the short-run. The economic loss will equal fixed costs, which is better than the economic loss that would be incurred if the firm produced any level of output. For a monopolist, the optimal level of production might occur either on the rising or on the falling portion of the MC curve, as long as it is a point where the MR curve intersects the MC curve from above. Find the optimal price and quantity for the monopolist described by the information in the following table: Q P MR SMC 0 10 20 30 40 50 500 450 400 350 300 250 500 425 375 325 275 225 600 425 340 320 275 300 The monopolist maximizes profit by expanding output until MC equal MR. Where is the monopolist s supply curve? Since a monopolist is not a price taker, there is no correspondence between price and marginal revenue when market demand shifts. A given marginal revenue for one demand curve can correspond to a particular price, while the same value of marginal revenue for a different demand curve corresponds to a different price. 7
Thus, a monopolist may produce Q* 1 and sell at P* in one period, and then sell Q* 2 at P* in another period (price remains constant). A monopolist does not have a, it has a which is to equate MR and MC. Long-run adjustments for monopolists A monopolist maximizes profits where MC = MR. Illustrate long-run profit situation: Sometimes economic profits will disappear for a monopolist in the long-run. 8
What might cause this to occur? In many cases, positive economic profits may persist in the long-run. Natural monopolies tend to enjoy positive profits over time. Price discrimination So far, we have considered the case of a single price monopolist where it is assumed that the firm sells its output at the same price to all their customers. In reality, monopolists often charge different prices to different buyers a practice called price discrimination. Examples: movie theatre tickets, airline tickets A monopolist can increase its profits by practicing price discrimination. And further, not all the increase in profit is at the expense of the buyer. Efficiency actually increases under price discrimination. Consider the situation where a monopolist sells to two distinct markets. For instance, a publisher sells a unique economics textbook in Canada and in China. In other words, the firm is the only supplier in the domestic market and in the foreign market. The demand curve and marginal revenue curves for the two markets are given: (Fig 12-13, p 372) 9
In order to maximize profit, the marginal revenue should be the same in each market, and will be equal to marginal cost at the profit-maximizing quantity of output. Graphically, the marginal revenue curves are added horizontally across the two markets. Question: Suppose a monopolist sells in two separate markets, with demand curves given by P 1 = 15 Q 1 and P 2 = 25 Q 2, respectively. If the total cost curve is given by TC = 7 + 3Q (MC = 2), what quantities should the firm sell and what prices should it charge in the two markets? How is price elasticity of demand related to the prices charged in each market? The monopolist charges the less elastic market. This scenario described above is an example of third degree price discrimination, the case there buyers in separate markets are charged different prices. Other examples of third degree price discrimination: movie theatre tickets to seniors and students. Seniors and students have more elastic demand for movie theatre tickets. 10
Price discrimination typically occurs where arbitrage is difficult or impossible. Arbitrage:. Arbitrage is not possible for movie theatre tickets. It is possible, but difficult, for the university textbook market. The case of perfect price discrimination (a.k.a. first degree price discrimination) Perfect price discrimination involves the greatest degree of market segregation. In this case, the monopolist charges each buyer a different price based on their price elasticity of demand. If the intervals into which the monopolist can partition the product are arbitrarily small, the firm s total revenue will increase by the total area of the triangle..the area that used to be consumer surplus. In this case the consumer pays the maximum he/she is willing to pay for each unit of output and subsequently receives no consumer surplus. 11
How much output will a profit-maximizing, perfectly discriminating monopolist produce? What is the MR curve for a perfectly discriminating monopolist? Rationale for MR curve = demand curve: The firm can lower price to sell additional output without having to reduce the price on the output originally sold. This results in a higher level of output. Comparison of a single price monopolist and a perfectly discriminating monopolist: 1. Perfectly discriminating monopolist produces a higher level of output. 2. A positive level of consumer surplus typically exists with a single price monopolist, but not with a perfectly discriminating one. ** Perfect price discrimination is a never-attained theoretical limit. (p 375). Why? Second-degree price discrimination The practice, on the part of the seller, of posting a schedule of prices reflecting price declines with quantity purchases. 12
Many electric utility companies use a declining tail-block rate structure, which is an example of second-degree price discrimination. Example: First 500 kilowatt-hours Next 700 kilowatt-hours Additional kilowatt-hours @ $0.10 per kilowatt-hour @ $0.07 per kilowatt-hour @ $0.04 per kilowatt-hour It is similar to first-degree price discrimination in that the strategy is an attempt to take consumer surplus from the buyer. There are two major differences that set it apart from first-degree price discrimination: 1. Same rate schedule applies to all buyers, thus the strategy does not attempt to set prices according to elasticity differences among buyers. 2. Limited rate categories tend to limit the amount of consumer surplus captured by the firm. Hurdle model of price discrimination This model consists of a technique whereby the firm induces the most elastic buyers to identify themselves. The seller sets up a hurdle and sets a discount price available to those buyers who elect to jump over it. The logic is that those buyers who are most sensitive to price will be much more likely than others to jump the hurdle (p 377). Examples 13
1. a rebate form included in the product package The hurdle is the time and effort it takes to fill out the form, find a stamp and an envelope, and get it to the post office. The firm hopes that people who do not care much about the price will not bother to go through the process. People with less elastic demand will end up paying the regular price and those with more elastic demand will pay the lower discount price 2. airlines: hurdles- book 2 weeks in advance and stay over a Saturday night. The hurdle works somewhat like a tax. The imposition of a hurdle places a perunit transaction cost T on those who choose to jump it. A buyer will not jump the hurdle if T> (P H P L ) A buyer will jump the hurdle if T< (P H P L ) With a perfect hurdle, none of the people who pay the discount price has a reservation price greater than or equal to the regular price. In other words, the buyers who jump the hurdle would not have purchased the product without the discount. The model is similar to first-degree price discrimination in that it tries to modify prices to the elasticities of the individual buyers. The model differs from first-degree price discrimination in that it cannot hope to capture the entire consumer surplus. 14
How efficient is a monopoly? The long-run equilibrium in a perfectly competitive industry maximum efficiency is achieved in that there are no possibilities for additional gains from exchange. The value to the buyers of the last unit of output = market value of the resources required to produce the last unit of output This does not hold true for a. A single price monopolist s equilibrium outcome results in a loss of consumer surplus. The cost to society is called the deadweight loss from monopoly. In the case of a perfectly discriminating monopolist, the results are the same as for a perfectly competitive industry, except that the benefit is producer surplus in place of consumer surplus. Public Policy toward natural monopoly To compare a monopoly to a perfectly competitive ideal is not so practical, but to compare it to real world market models is both practical and relevant. Consider a natural monopoly, a firm with an ATC curve that declines over a large quantity of output, which corresponds to the entire market demand. 15
Two objections to a single-price monopolist s output and price decision: 1. fairness: 2. efficiency: The efficient level of production: P = MC. Is there a problem with the efficient level of production? Alternative solutions: 1. State ownership and management Government would charge the efficient price, P = MC and absorb economic losses out of general tax revenues. Government enterprises are currently operated by all three levels of government: federal, provincial and local. Some are run as departments of the government, some as government-owned Crown corporations, and some as public-private collaborative enterprises. For instance, Canada Post is a crown corporation and a legislated monopoly with first-class mail delivery that may in part be justified by natural monopoly considerations. As well, it competes directly with private courier companies in providing express delivery services. 2. State regulation and private monopolies This option involves leaves firm ownership in private hands while providing regulations and guidelines that limit the power to price and restrict output. Rate-of-return regulation in Canada is a common form of government price regulation. Under this regulation, prices are set allowing the firm to earn a predetermined rate of return on invested capital. The rate of return is typically set according to the opportunity cost of its capital, i.e. a competitive rate of return on investment. Deciding on this rate can be difficult. Two disadvantages of rate-of-return regulation: 16
1. The : (purchasing more capital equipment than is necessary; there is an incentive to purchase the gold-plated rather than the regular water cooler. 2 : in the case where the monopoly serves more than one market, it charges below-cost prices in the more elastic market and cross-subsidizes the loss with above-cost prices in the less elastic market. The rationale behind cross-subsidization is that the below-cost price in the elastic market increases sales by more than the above-cost price in the less elastic market. The resulting increase in output increases the firm s capital requirements and increases the profits allowed by regulation. Despite some of the difficulties, governments all over the world regulate the price and output decisions of natural monopolies. 3. The government would specify in detail the service it wanted to provide and then call for private firms to submit bids to supply the service. The low bidder would then get the contract. The contract must specify the details of the service (i.e. postal delivery, garbage collection, etc.) to be provided in extraordinary detail. 4. Vigorous enforcement of This method involves controlling monopoly power through competition policy. The Competition Act deals with a broad range of issues which include anticompetitive activities. Provisions cover misleading advertising and predatory pricing (selling products below cost in an attempt to drive out a rival firm). The Act prohibits collusion between firms in price-setting, bidding for tenders, or partitioning the market. The Act requires government approval of any mergers which would significantly increase the degree of concentration in an industry. 5. Let the monopolist choose its own price and level of output. 17
What about fairness and efficiency? In some cases, the seriousness of these problems is reduced. Efficiency: For instance, the more finely the monopolist partitions the market under the hurdle model, the smaller the efficiency loss will be. When natural monopolies use hurdle pricing to expand their markets, the efficiency problem is reduced. Fairness: Hurdle pricing also can result in a reduced fairness problem. However, not all monopolies use hurdle pricing. Sum: None of the five options offers a perfect solution. All of the solutions are used in some form. 18