Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 1 Lesson 5: Market Structure (II) 5.1 The Monopoly A monopoly is a firm that has influence on the price it charges for its product. A competitive firm is a price taker. A monopolist is a price maker. In this lesson we will deal with the extreme case of monopoly power by assuming that there is only one firm in the relevant market. Why monoplies arise? a) Some firms have exclusive ownership of a key resource. Very rare. Example: Debeers diamond monopoly (80% of diamond mines in the world). b) The government gives a single firm the exclusive right to produce some good. Not prevalent now, but very frequent in the past (kings offered licences to friends and supporters). Nearest example: patents and copyrights. c) A firm may be more efficient than any other. We call this a natural monopoly. It emerges when there are economies of scale over the relevant range of output. Utilities like electricity, gas, water companies are examples of this type of monopoly.
Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 2 How do monopolies make productionj and pricng decisions? The key difference between a competitive firm and a monopoly is the ability of the monopoly to influence price. The competitive firm faces a price which is constant, whatever its amount of production. We say that the demand curve that a competitive firm faces is horizontal. The monopolist faces the whole demand curve of the market (remember that it is the only firm in this market). Therefore he knows that the price he will get depends on how much he produces: if it produces a lot the price will be low; if tit produces a little the price will be high. Given this, what will be the amount produced by a monopolist? We will assume that the objective of the monopolist is the same as that of the competitive firm: to maximize profit. Profit = Total revenue - Total cost The rule of behaviour is also the same as before (this is a very general rule that applies to practically any economic decision): Produce output up to the point that Marginal revenue = Marginal cost
Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 3 Costs are the same for a monopolist as for a competitive firm. So, we will not discuss costs any further. Revenues for a monopolist are different from revenues for a competitive firm. So, we need to have another look at revenues. 5.2 Average and marginal revenue Recall the last lesson. There, for a competitive firm Average revenue = Marginal revenue = price For a monopoly, the price is given by the demand curve, which is the average revenue. So, for a monopoly, Average revenue = price But since average revenue is given by the demand curve and the demand curve decreases with output, we find that marginal revenue is normally less than average revenue. Marginal revenue < Average revenue The best way to understand this is by means of a numerical example (taken from Mankiw).
Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 4 Average and marginal revenue for a monopolist Q P TR=PQ AR=TR/Q MR=DTR/DQ 0 11 0 - - 1 10 10 10 10 2 9 18 9 8 3 8 24 8 6 4 7 28 7 4 5 6 30 6 2 6 5 30 5 0 7 4 28 4-2 8 3 24 3-4 Average and marginal revenue for a monopolist 12 10 8 6 a) AR=Demand curve Price 4 2 b) AR MR 0-2 1 2 3 4 5 6 7 8-4 -6 Output
Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 5 Why is the MR curve below the AR curve? Marginal revenue is the change in revenue from selling one more unit of output. How can we measure this change? If I sell one more unit of output the price goes down; so I will get less revenue from all the previous units (this is called the price effect). On the other hand, this extra unit will bring me also more revenue because I will get for this extra unit the new price (this is called the output effect). Example: Using the data from the table and graph. If Q=3, P=8 and TR=3x8=24 If Q=4, P=7 and TR=4x7=28 By increasing Q by 1 unit, TR has increased by 4. MR therefore is 4. So the fourth unit of output fetches a price of 7 (the average revenue is 7 ) and brings in a marginal revenue of 4. Therefore, MR<AR. Two effects on revenue: a) TR due to P: -1x3=-3 Price effect. b) TR due to Q: 1x7=7 Output effect.
Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 6 The same in mathematics TR= TR TR 1 0 = PQ PQ 1 1 0 0 = PQ PQ + PQ PQ 1 1 1 0 1 0 0 0 ( ) ( ) = P Q Q + Q P P 1 1 0 0 1 0 = P1 Q+ Q0 P = Output effect + Price effect Using the numbers of the previous example: TR = 71 x + 3(7 8) = 7 3= 4 A proof that MR is below price (and average revenue) TR= P Q+ Q P 1 0 Dividing both sides of the equation by Q we have TR Q But 1 0 1 is negative, because when quantity increases the price falls (demand curve). So, But = P + Q P Q TR < Q P P Q TR = MR. So, MR < P 1 Q (4<7)
Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 7 5.3 The profit maximizing output of the monopolist The monopolist follows two steps: P a) First it determines output. The output that maximizes profit is that one for which MR=MC. The difference with the competitive firm is that now MR is different from the market price. This leads to Q*. b) Second it determines price. How much will the monopolist have to charge so that he can sell all its output? The answer to this question is given by the demand curve. This leads to P*. MC P* Demand=AR MR Q* Q
Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 8 Measurement of monopoly profit Profit = TR-TC=(P-ATC)*Q In a competitive firm P=MC ; in a monopoly, P>MC MC P* ATC MC* ATC* D=AR MR Q* 5.4 Efficiency evaluation of monopoly versus perfect competition Observe that, as in the case of taxation, monopoly prevents some production and consumption to be realized (Q* is a quantity of output lower than in the competitive market). We say that monopoly distorts the competitive equilibrium. This distortion. As in the case of taxation, has a cost: an efficiency cost; a loss of welfare as compared to perfect competition.
Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 9 The measurement of this efficiency cost proceeds as in the case of taxation. MC P(M) P(C) 1 2 4 3 5 D=AR MR Q(M) Q(C) Efficiency cost of monopoly Surplus Competitive Monopoly Difference Consumers 1+2+3 1-2-3 Producers 4+5 2+4 +2-5 Total 1+2+3+4+5 1+2+4-3-5
Introduction to Economic Analysis. Antonio Zabalza. University of Valencia 10 Check that you understand that the benefit of the monopolist can also be measured by the difference between total revenue and the area limited by the marginal cost. In the graph, this gives area 2+4 as the benefit of the monopolist. Conclusion: a) There is a loss for society equal to 3+5. This is the efficiency cost of monopoly. The deadweight loss of monopoly. b) As compared with the competitive situation, there is a redistribution of the market surplus. Consumers loose area 2 and producers gain area 2. c) Producers clearly gain. Otherwise we would not observe in the real world a tendency towards monopoly. Regulatory policy a) Increase the degree of competitiveness of the market: antitrust laws; institutions; etc. b) Impose marginal cost pricing. The problem is that a natural monopoly will generate loses. c) Public ownership. Other problems. Concluding mention Existence of less pure forms: duopoly, oligopoly, monopolistic competition, etc.