In this session we will look at monopolies, where there is only one firm in the market with no close substitutes. For example, Microsoft first designed the operating system Windows. As a result of this innovation it received a copyright from the US government which gave it exclusive rights to manufacture and sell Microsoft office. As a result of this copyright Microsoft is the most dominant player in operating systems around the world. The National Broadband Network (NBN) is a government initiative that intends to vastly improve broadband internet speeds and access in Australian metropolitan and regional areas. The government aims to cover all Australian households with faster internet services. This entails laying down an expensive network of fibre and satellite technologies throughout Australia. Since there is only one provider of the NBN services at the wholesale level NBN will act as a monopoly. Other examples of monopoly include Australia Post. 1
Having only one firm in the market with no close substitutes alters the analysis significantly and the conclusion drawn from perfect competition do not apply to this particular market structure. Monopolies tend to be price setters rather than price takers as was the case with perfect competition. Since monopoly has market power it charges a price that exceeds marginal cost. A high price reduces quantity demanded. As a result of monopoly the consumers end with lower quantity purchased and pay a higher price. The result of a monopoly are often not desirable for the society. 2
One of the simplest way for a monopoly to arise is through ownership of key resources. For example, De Beers became the dominant player in the diamond industry because it owned most of the diamond mines. De Beers decided on keeping the price of diamonds high by limiting supply and thus adding value to the diamond trade. 3
Monopolies can also arise if government gives exclusive rights to companies for selling a product/service. The government can even grant these exclusive rights to itself. For example, in Sweden the government has exclusive rights to sell all alcoholic beverages under a state-owned monopoly known as Systembolaget. Research shows that this system has been successful in reducing the rate of alcohol related illnesses. Patents and Other Legal Barriers are another way of granting companies the exclusive rights to be sole producer of certain products. A licence, patent or a copyright are examples of legal barriers to entry. Usually patents and copyrights are only valid for a limited period of time. For example, government can grant sole rights to a pharmaceutical company to sell a certain drug. This is usually done through issuing a patent if the government believes that the firm has made an original discovery, which essentially gives the firm exclusive rights to sell the drug in the market for a certain period of time. A copyright provide exclusive rights to the original creator of a certain work such as a book so that the work cannot be reproduced without the creator s permission. Such laws have benefits and costs, governments generally issue patents and copyrights to encourage innovation, research, creation of art work etc. However, these regulations have a downside that they push market prices higher. 4
A natural monopoly arises when a single firm can supply a good or service at a lower price than two or more firms in the market. Natural monopolies arises for good that can be excludable and non-rival at the same time. For example, fire services in a town. Once a town has paid for the fire service, all the houses can be simultaneously protected by the same fire services. However, despite this people can be excluded from using the fire services for whatever reasons. Thus, fire services are excludable and non-rival. Moreover, the cost of including an additional house in the town for the fire services is almost negligible and therefore it would be pointless for two companies to be providing fire services to a small town. A natural monopoly thus arises when there exists economies of scale over a relevant range of output. Economies of Scale- When economies of scale exist, long run average cost decreases as output increases. This essentially implies that it is cheaper for one firm to produce large quantities than for a few firms to produce smaller quantities separately. For example, a large coal fired plant is likely to have lower average cost per unit than a smaller facility or one fire company will be far more efficient in providing fire services to the whole town rather than several companies. 5
The above slide shows the graph of a monopoly experiencing economies of scale. When a firm s average-total-cost curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among many firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the least cost possible. 6
Companies can also establish a dominant position through mergers, acquisition or takeovers. In a highly concentrated market, a few firms will be able to gain domination on other smaller firms- ultimately driving the smaller players out of the market. Due to this governments around the world have established restrictions regarding mergers. The Australian big four banks- Commonwealth Bank, Westpac, Australia and New Zealand Banking group, National Australia Bank- are increasingly under scrutiny due to their relatively high share of the market. 7
The key difference between monopoly and perfectly competitive markets is that monopoly faces a downward sloping demand curve whereas perfect competition faces a horizontal demand curve. Monopoly serves an entire market for a good that has no close substitutes and barriers to entry protect the market from competitors. For example, water supply is an example of monopoly. Since there is only one producer, the market demand curve is the demand curve for the monopolists product. This forms the basis of monopolists power, such that the monopolist is able to set a price along the market demand curve. 8
The slide above shows the demand curve faced by monopolist as well as perfectly competitive firms. Because competitive firms are price takers, they in effect face horizontal demand curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it faces the downward-sloping market demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it wants to sell more output. Even though monopolist has market power that does not mean it can charge whatever price it likes. Monopolist is constrained by the demand curve and has to find a profit maximising price along the demand curve. 9
To understand monopoly s profit maximising point we need to recall some key concepts of revenue and costs learnt earlier. A monopoly s total revenue = price times quantity A monopoly s average revenue is revenue per unit sold and is calculated by dividing total revenue by quantity. We will see shortly that average revenue is always equal to price. 10
A monopoly s marginal revenue is revenue per each additional unit of output. It is the change in total revenue when output increases by 1 unit. The marginal revenue curve of the monopolist is always less than the price. This is because unlike perfect competition a monopoly firm faces a downward sloping demand curve. In order to increase output, monopolist must lower the price it charges to all customers. Hence, marginal revenue is lower than price. 11
Lets take an example to make this clearer. The first column in the above table shows the quantity demanded of water. Lets say there is only one supplier of water in this market, therefore we have a monopoly situation. If the price of water is $10 then 1 gallon of water is demanded. When price reduces to $9 then 2 gallons of water are demanded and so on. What we have here is a downward sloping demand curve. As price goes down, the quantity demanded increases. Given this information we can calculate the total revenue. Now lets move on to the last column of the table. Marginal revenue is the extra revenue the firm receives for each additional unit sold. For example, when the firm is producing 1 gallon of water, the firm receives TR of 10. If it reduces the price to $9 and sells a total of 2 gallons of water, the total revenue increases to 18. The MR in this case is 8 (18-10). Note marginal revenue is less than price. To sell additional amount of water, the monopolist must lower the price to all customers. Also note that MR is going down and eventually becomes negative. 12
The demand curve shows how the quantity affects the price of the good. The marginal-revenue curve shows how the firm s revenue changes when the quantity increases by 1 unit. Because the price on all units sold must fall if the monopoly increases production, marginal revenue is always less than the price. 13
To summarize, since the monopolist faces a downward sloping demand curve, the MR differs as the price changes. Also MR lies below the demand curve and is less than the price. Why? TR=PxQ and MR= TR/ Q. As we sell more output the price is reduced. Thus, when we cut price, we sell more output but also receive a lower price for each unit sold. Causing the MR to go down as the monopoly sells greater quantities. MR and TR are also related to the concept of elasticity. The demand for a good can be elastic, unit elastic and inelastic. Elastic demand means that a reduction in price by 1% causes the quantity to go up by more than a 1%. In this case again we have two opposing things happen at the same time. When price goes down and output goes up. The percent fall in price is less than percent increase in quantity, causing the total revenue to increase. Hence, we are in the region where total revenue is going up. As the price falls further we reach the inelastic region of the demand curve and total revenue falls. At the unit elastic point the TR is maximized and MR=0. Remember here that MR is the slope of TR. So when TR is rising MR is positive. However, when TR falls, MR is negative. At the maximum point of TR the TR is neither rising or falling. TR/ Q=MR=0. 14
Like perfect competition, monopolist compares MR and MC to decide on the output produced. If MR > MC: increase production; If MC > MR: produce less. Monopolist maximises profit when MR=MC. 15
If MR>MC then profit increases as output increases. If MC>MR then profit increases as output reduces. At MC=MR, profit is maximized. So in the above graph monopolist will produce at the point Q MAX and charges the monopoly price. In other words what the monopolist has done is restricted quantity to charge a higher price. Once monopolist finds the point where MC=MR, it charges the most consumers will pay for Q MAX. This is informed by the demand curve. Point B shows the price that is consistent with Q MAX. So a monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (point A). It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B). 16
Even though there are some similarities between perfect competition and monopoly, there exists some important differences. Under perfect competition, P=MR=MC. However, in the case of monopoly there is a mark-up. P>MR=MC. 17
Monopoly is going to produce output at MC=MR and then charge the highest price it can get for the produced quantity. In the example above, Q MAX is where MC=MR and the profit is going to equal- (monopoly price minus average total cost at Q MAX ) x Q MAX. The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the number of units sold. 18
Lets take the example of pharmaceutical drug company that enjoys a patent. Once the company gets its new drug patented, it enjoys monopoly rights in its sale. However, when the patent expires the price should drop to the competitive level. The real world data shows that indeed this occurs. When the patent expires a number of firms start selling generic brands, which is often what the pharmacists offer when we go to buy a familiar brand of drug. These generic drugs are often cheaper and they ultimately induce the firm to reduce the price. 19
In the above market for drugs we have assumed that marginal cost is constant. This is not an unrealistic assumption in the case of drugs for example. The additional cost producing more tablets are unlikely to change very much as we increase production. In the graph above, when a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, which is well above the marginal cost of making the drug. When the patent on a drug runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost. 20
We have seen so far that monopoly outcome is very different from perfect competition. The price charged by monopolists is greater than MC and consumers end up paying more. But, the monopolist also receives a higher price and therefore more profit. So does the benefit received to the producer compensate for the loss by consumers. To analyse this we need to re-visit the concept of total surplus which is the sum of consumer surplus and producer surplus. Consumer surplus is directly derived from the market demand curve. As discussed in earlier session, market demand curve represents buyer s willingness and ability to pay. To derive consumer surplus we measure the difference between buyer s willingness to pay as well the amount the buyer actually ends up paying. Once we know the market price consumer surplus is easy to derive from the demand curve. 21
Producer surplus is amount a seller is paid for a good minus the seller s marginal cost of providing it. The lowest price at which a producer is willing to sell a particular unit is typically the marginal cost. Or it is the opportunity cost of producing one extra unit. If the monopoly was run by a benevolent social planner then the planner will try to maximise total surplus. 22
To find the optimal output the benevolent planner will compare the demandvalue to buyer with the costs of producing the goods. A benevolent social planner maximizes total surplus in the market by choosing the level of output where the demand curve and marginal-cost curve intersect. Below this level, the value of the good to the marginal buyer (as reflected in the demand curve) exceeds the marginal cost of making the good. Above this level, the value to the marginal buyer is less than marginal cost. At the optimal quantity, which is the equilibrium point, the value of an extra unit to consumers exactly equals the marginal cost of production. 23
Thus, the social planner produces at a point where the P=MC, which was also the equilibrium point in the diagram in the previous slide. However, the monopolist does not produce at the socially efficient level. By setting P>MC, monopolists produces a quantity that is inefficiently low. We can also see this by investigating the surplus lost. 24
The graph on the slide shows consumer surplus, which is measured as the difference between buyer s willingness to pay as well the amount the buyer actually ends up paying. The yellow area is the producer surplus. Producer surplus is amount a seller is paid for a good minus the seller s marginal cost of providing it. Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. The deadweight loss is represented by the area of the triangle between the demand curve (which reflects the value of the good to consumers) and the marginal-cost curve (which reflects the costs of the monopoly producer). The inefficiency of monopoly can be measured by the loss of total surplus, which is what we mean by deadweight loss. 25
From the perspective of the society, monopoly produces a bigger producer surplus and smaller consumer surplus. This is not necessarily a social problem because the surplus simply gets re-distributed between consumers and producers. Who gets the surplus is not the issue here. However, the social cost arises from deadweight loss as no one gets this potential surplus. If we produced at the socially efficient point then we will eradicate the deadweight loss. 26
As discussed previously monopoly produces at MC=MR and charges a high price by restricting output. Could the monopoly do any better than this? The answer is yes. If the monopolist could read our minds; monopolist could practice charging each consumer the maximum amount he or she will pay for each incremental unit. This will extract all surplus from consumers and distribute to the producer. 27
In the above case the monopolist charges each consumer there maximum willingness to pay then each unit monopolist charges a different price and thereby increases its sale and profit. Suppose you are the CEO of Readalot Publishing Company. The author of the book charges Readalot Publishing company $2 million and the cost of printing the book is $0. So the revenue received from selling the book minus $2 million is the profit. Let s assume that the book is read by two groups. One group of 100 000 avid readers will pay $30 for the book. The other group of 400 000 readers will pay $5 for the book. Now the Readalot has to set a price to maximise its profit. If it sets the price at $30 then the revenue will be $3 million as it will only have 100 000 buyers. If the publishing company sets the price at $5 for the book then it will get 500 000 buyers. The total revenue at $5, will therefore only be $2.5 million. Thus, to maximise profit Readalot should charge a price of $30 and sell only 100 000 books. The decision to restrict output and charge a higher price causes a deadweight loss as MC of producing another book is zero but 400 000 buyers are willing to pay $5 for the book. This situation, however, can be resolved if Readalot can separate the buyers into two groups. For example, if the buyers willing to pay $30 live in Switzerland and the buyers willing to pay $5 live in Turkey then Readalot can charge the two groups different prices. In this case, revenue is $3 million in Switzerland 28
and $2 million in Turkey. This strategy provides the company with a higher profit and also eliminates deadweight loss! It seems unintuitive that price discrimination eliminates deadweight loss. Lets look at this situation graphically to understand this better. 28
Panel (a) shows a monopoly that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopoly that can perfectly price discriminate, i.e is charge each consumer exactly what they are willing to pay. Because consumer surplus equals zero, total surplus now equals the firm s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus. 29
Some of the examples of perfect price discrimination include movie tickets. Movie theatres continually charge pensioners, children and students lower price as this group has a lower willingness to pay compared to the rest of the population. This is a broad generalisation and may not work as perfectly as shown in the previous diagram. However, it still helps movie companies to maximise their profit. Another example includes airlines offering cheaper tickets to customers 30
Because of the negative effects of monopoly, the governments all over the world have tried to prevent companies from acquiring too much power. These laws are commonly referred to as anti-trust law, anti-trust policy, and competition law/policy. These laws prevent mergers between companies that have substantial market power and where a merger would make the industry substantially less competitive. Anti-trust laws also provide legislators with authority to ban price fixing, prevent companies from coordinating activities that will make the markets less competitive such as information sharing, take up actions against cartels and monitor any other anti-competitive practices. 31
Government can also directly intervene in the market by regulating prices. This is commonly done for natural monopolies with declining ATC. 32
Even through monopoly has market power, it does not mean the profit is always positive. The economic profit will depend on the price, average cost per unit and the quantity produced. In the above diagram the monopoly's profit is zero if price=atc or monopolists makes a loss if price is equal to MC. For a regulator setting prices this poses a dilemma as marginal cost pricing leads to losses and average cost pricing causes deadweight loss. Thus, if regulator chooses MC pricing then the monopolist will exit the industry. The regulators can respond to this by subsiding the monopolist. This would require funds that can be raised through taxation, causing inefficiencies in another market. Also price regulation reduce incentives for firms to reduce costs to maximize profits. In reality most regulators resolve this dilemma by allowing firms to charge a higher price than MC. 33
The other recourse for governments managing natural monopolies is public ownership. However, key issue is cost of production. Private owners have an incentive to minimise costs to increase profits. The same does not apply to government bureaucrats. If the government bureaucrats fail to keep costs down then the losers are customers and taxpayers. Thus, there is no perfect solution to regulating monopolies and governments around the world use a range of market and non-market policies. 34