Business Economics Monopoly Managerial Decisions for Firms with Market ower Monopoly Thomas & Maurice, Chapter 12 Herbert Stocker herbert.stocker@uibk.ac.at Institute of International Studies University of Ramkhamhaeng & Department of Economics University of Innsbruck Definition A firm is considered a monopoly if... it is the sole seller of its product. its product does not have close substitutes. Repetition Repetition Remember: Firms maximize their profits subject to the restrictions they face. There are two kinds of restrictions: Technological restrictions. Market restrictions. Remember: Technological restrictions are the same for monopolies and firms on competitive markets; they are embedded in the cost function! (rice was not needed to derive it!) Market restrictions differ between monopolies and firms on competitive markets.
Monopoly & erfect Competition Monopoly & erfect Competition erfect Competition: Every supplier perceives demand for his own product as perfectly elastic, he can sell every unit of output for the same price. marginal revenue is equal price: = firms are price-takers! Monopoly: A Monopolist is the only supplier and there are no close substitutes for his product. Monopolist does not loose ALL sales if he increases price; but he perceives that the demand for his product is falling when he increases price. Monopolistic firms are price-seekers; if they want to sell more they can do so at lower prices! This has important implications for the marginal revenue of a monopoly! erfect Competition vs. Monopoly erfect Competition: perceived Market Demand Each producer perceives the demand for his product as perfectly elastic. Monopoly: perceived Market Demand Monopolist perceives demand to be less than perfectly elastic. Total and Marginal Revenue Example: = 6 Total Marginal Average rice uantity Revenue Revenue Revenue R = AR = 6 0 0 5 1 5 5 5 4 2 8 3 4 3 3 9 1 3 2 4 8 1 2 1 5 5 3 1 0 6 0 5 0
Marginal Revenue Demand: = 6 Inverse Demand: = 6 [Inverse Demand allows us to express revenue as a function of only] Revenue: R = = (6 ) 6 = 6 2 5 Marginal Revenue: 4 3 dr 2 d = 6 2 1 Lineardemandcurves 0 curveisdoubleassteepasdemand 0 1 2 3 4 5 6 curve! Marginal Revenue If a monopolist increases output there are two effects: he can sell the additional produced units of output only at a lower price : but he has to sell also all other units of output at this lower price: The resulting change in total revenue is therefore Marginal Revenue is R = + R = + Marginal Revenue In detail: R1 = 11 R2 = 22 / R R1 R2 = 11 22 = 1(1 2)+12 22 = 1(1 2)+2(1 2) = 1 +2 + = R = + Marginal Revenue With Calculus: Market Demand is a function of price: = () We rewrite this and express price as a function of quantity: = (). This is called inverse demand function. Revenue R can then be expressed as a function of only, i.e. R = () For differentiating this use the product rule: dr d = d + d
Marginal Revenue Marginal Revenue Rearranging terms gives = + ( )( ) = + ( = 1+ ) ( = 1+ 1 ) ( = 1 1 ) E, E, Therefore, marginal revenue depends in a very specific way on the price elasticity of demand: R ( = 1 1 ) E, When demand is elastic ( E, > 1) increasing output will increase revenue ( > 0). When demand is inelastic ( E, < 1) increasing output will decrease revenue ( < 0). Output, rice Elasticity & Revenue What happens with monopolist s revenue, when he reduces output? E = elastic inelastic E = 1 Elastic Demand: R E = 0 E = elastic inelastic E = 1 Inelastic Demand: R E = 0 Monopoly Example Therefore a monopolist will never produce a quantity in the inelastic portion of the demand curve. Why? If demand is inelastic a decrease of quantity would increase revenue. roducing less would lower cost. This implies he could make higher profits by producing less, therefore this cannot be a maximum! More generally...
rofit Maximization Monopolists like all firms maximize profit, and profit is the difference between revenue and cost π = R C For a maximum it must be true that dπ d = dr }{{} d dc d }{{}! = 0 Therefore profit maximization implies = This result is true for monopolists and for firms on perfectly competitive markets! rofit Maximization erfect Competition For a firm on a perfectly competitive market demand is perfectly elastic, this implies =. Therefore, profit maximizing firms choose output where = = rofit Maximization Monopoly: rofit Maximization Monopoly A monopolist faces falling market demand, therefore marginal revenue is ( = 1 1 ) E, Monopolist chooses output and price where ( = 1 1 ) = E, = holds generally, but differs between firms under perfect and imperfect competition! Lost rofit AC D() What is the profit maximizing quantity? > firm should produce more! < firm should produce less!
Monopoly: rofit Maximization M AC D() What is the profit maximizing quantity? rofits are maximized when the cost of the last unit are equal the revenue of the last unit, = Monopoly: rofit Maximization M M AC D() Monopolies are price-seekers : Monopolist chooses the output where () = () charges the maximum price consumers are willing to pay for this output. Monopoly: rofit Maximization Monopoly: rofit Maximization rofits: M π M D() AC rofits are defined as π = ( AC) i.e. profits depend on average cost and price! rofits: M Loss M AC D() If AC are high profits become negative, the monopoly runs a loss! (Still, this output level minimizes losses.)
Monopoly In perfect competition, the market supply curve is determined by marginal cost. For a monopoly, output is determined by marginal cost and the shape of the demand curve (demand elasticity). Since supply depends on the demand curve, there is no supply curve for monopolistic market. Shifts in demand usually cause a change in both price and quantity. Example Monopoly Monopoly rofits of a monopolist: E = elastic inelastic π1 π2 E = 1 C R E = 0 If R is steeper than C increasing increases R and π If R is flatter than C increasing increases R and π Slope of R is, Slope of C is rofits of a monopolist: 4 R 3 π C 2 1 0 0 1 2 3 4 Market demand: = 4 Revenue: R = 4 2 Marginal revenue: = 4 2 Cost: C = 0.2 2 +0.5 Marginal cost: = 0.4 Condition for profit maximum: = 4 2 = 0.4 = 1.667 π = R C = 2.833
Monopoly Monopoly: Alternative resentation rofits of a monopolist: 4 R 3 π C 2 1 0 0 1 2 3 4 = 4 = 4 R = 4 2, = 4 2 C = 0.2 2 +0.5, = 0.4 R C π 0.00 4.00 0.00 4.00 0.50 0.00-0.50 0.50 3.50 1.75 3.00 0.55 0.20 1.20 1.00 3.00 3.00 2.00 0.70 0.40 2.30 1.50 2.50 3.75 1.00 0.95 0.60 2.80 1.67 2.33 3.89 0.67 1.06 0.67 2.83 2.00 2.00 4.00 0.00 1.30 0.80 2.70 2.50 1.50 3.75-1.00 1.75 1.00 2.00 3.00 1.00 3.00-2.00 2.30 1.20 0.70 3.50 0.50 1.75-3.00 2.95 1.40-1.20 4.00 0.00 0.00-4.00 3.70 1.60-3.70 rofit with Total Cost: 4 R 3 π C 2 1 0 0 1 2 3 4 π = R() C() rofit with Average Cost: 4 Attention: AC( ) = 0.6 3 3 ( ) = 0.6 6 2 π 1 AC 0 0 1 2 3 4 π = ( AC) Long-Run rofit Maximization Long-Run rofit Maximization In the long run... Monopolist maximizes profit by choosing to produce output where = L, as long as > LAC Will exit industry if < LAC! Monopolist will adjust plant size to the optimal level. Optimal plant is where the short-run average cost curve is tangent to the long-run average cost at the profit-maximizing output level.
Markup ricing Remember [ = 1 1 ] = E, A General Rule for ricing This can be rearranged to express price directly as a markup over marginal cost = [ ] 1 1 E, If e.g. E, = 2 then = /(1 0.5) = 2, i.e. the monopolist charges double! Markup ricing Remember [ = 1 1 ] = E, Another way to rewrite this is = 1 E, The left-hand side, ( )/, is the markup over marginal cost as a percentage of price. Therefore, the optimal markup as a percentage of price is simply the inverse of the demand elasticity! Markup ricing: Supermarkets & Convenience Stores Example Supermarkets: Many firms, similar products. The estimated demand elasticity for individual stores is E, 10 The profit maximizing markup is therefore = /(1 0.1) = /0.9 1.11 Empirical evidence shows that prices are set about 10 11% above.
Markup ricing: Supermarkets & Convenience Stores Example Convenience Stores: Convenience differentiates shops The estimated demand elasticity for individual stores is E, 5 The profit maximizing markup is therefore = /(1 0.2) = /0.8 1.25 rices are set about 25% above. Convenience stores might still have lower profits because of lower sales volume and high AFC!... Market ower If demand is very elastic, there is little benefit to being a monopolist; the larger the elasticity, the closer to a perfectly competitive market. ure monopoly is rare; firms with differentiated products have also some (limited) market power. Firms with differentiated products face a downward sloping demand curve, therefore they will also produce where price exceeds marginal cost! The analysis in this chapter is also applicable in these cases. Sources of Monopoly ower Barriers to Entry Why do some firms have considerable monopoly power, and others have little or none? Managers have little control over elasticity of demand; Sometimes technology or the government helps ; Monopoly power of a firm falls c.p. as the number of firms increases; Managers would like to create barriers to entry to keep new firms out of market. Natural Monopoly Barriers created by government. Input barriers. Economies of scale and mergers. Brand loyalties. Consumer lock-in and switching costs. Network externalities.
Barriers to Entry: Natural Monopolies Natural Monopoly: when a firm can supply a good or service to an entire market at a smaller cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of output, i.e., average cost curve is falling over the relevant range of output. Natural monopolies cause market failure, and are therefore often regulated or run by the government. Examples include tap water distribution systems, bridges,... Barriers to Entry Barriers Created by the Government Licenses (e.g. for physicians and other professionals). atents and copyrights: The need for patent protection arises because innovations represent new information that has the characteristics of a public good. ublic goods: A good that has high costs of exclusion and is nonrival in consumption. Because of free riding behaviour public goods would not be provided on free markets. Barriers to Entry Barriers to Entry Input Barriers Control over raw materials (e.g. diamonds and DeBeers). Barriers in financial capital markets Larger firms can get lower interest rates. Smaller firms need more collateral for loans. Smaller firms are perceived as riskier. Economies of Scale and Mergers Exist when a firm s long run average cost curve slopes downward or when lower production costs are associated with larger scale of operation. Can act as a barrier to entry in different industries ( MES) Mergers are particularly important in industries with economies of scale, e.g. technology, media, and telecommunications.
Minimum Efficient Scale (MES) Barriers to Entry MES & Market Entries: Average cost at half of the MES (1/2 MES) is a indicator for technological market entry barriers. AC 1 2 MES MES High market entry barriers MES AC 1 2 MES MES Low market entry barriers important for intensity of competition, Mergers & Acquisitions,... MES Creation of Brand Loyalties The creation of brand loyalties through advertising and other marketing efforts is a strategy that managers use to create and maintain market power. Managers hope that demand for their product becomes less elastic by these measures. Barriers to Entry Consumer Lock-In and Switching Costs When consumers become locked into certain types or brands and would incur substantial switching costs if they changed. Managers often use consumer lock-in and switching costs strategies to gain market power. Examples for consumer lock-in and switching costs strategies: Contractual commitments Durable purchases Brand-specific training Specialized suppliers Search costs Loyalty programs,... Barriers to Entry Network Externalities Act as a barrier to entry because the value of a product depends on number of customers using the product. Can be considered demand-side economies of scale, in contrast to supply-side economies. Example: software systems.
Social Costs of Monopoly ower Social Costs of Monopoly ower M C = AC () M C (For simplicity we assume constant and AC.) Monopoly power results in higher prices and lower quantities. However, does monopoly power make consumers and producers in the aggregate better or worse off? compare producer and consumer surplus. erfect Competition & Welfare erfect Competition & Welfare Value to buyers Cost to producers Value to buyers is greater than cost to sellers! s Cost to producers Value to buyers d Value to buyers is less than cost to sellers! C erfect competition is efficient, because the allocation of resources Consumer surplus roducer surplus maximizes total surplus! C s d
Monopoy & Welfare Social Costs of Monopoly M C Deadweight Loss M C D Social cost of monopoly may exceed the deadweight loss. The incentive to engage in monopoly practices is determined by the profit to be gained. Rent Seeking: Firms may spend to gain monopoly power Lobbying Advertising Building excess capacity ublic olicy Toward Monopolies Antitrust Laws Government responds to the problem of monopoly in one of four ways: Making monopolized industries more competitive. Regulating the behavior of monopolies. Turning some private monopolies into public enterprises. Doing nothing at all (if the market failure is deemed small compared to the imperfections of public policies). Antitrust laws are a collection of statutes aimed at curbing monopoly power. Antitrust laws give government various ways to promote competition. They allow government to prevent mergers. They allow government to break up companies. They prevent companies from performing activities that make markets less competitive.
Antitrust Issues Antitrust Issues Focus of the Horizontal Merger Guidelines: Legislation limits market power of firms and regulates how firms use their market power to compete. Antitrust legislation focuses for example on... rice discrimination that lessens competition. The use of tie-in sales and exclusive dealings. Mergers between firms that reduce competition. Definition of the relevant market. Level of seller competition in that market. ossibility that a merging firm might affect price and output. Nature and extent of entry into the market. Other factors influencing coordination among sellers. Extent to which any cost savings and efficiencies could offset increase in market power. Measures of Market ower Lerner Index: measure of market power that focuses on the difference between a firm s product price and marginal cost of production. L = = 1 E, Under perfect competition, i.e. when =, L = 0. When L = 1 the market power is highest possible. Measures of Market ower Cross Elasticity of Demand: ercentage change in the quantity demanded of good X relative to the percentage change in the price of good Y: = X Y EX,Y Y X The higher the cross price elasticity, the greater the potential substitution between goods and, therefore, the lower is market power.
Measures of Market ower Concentration Ratios: Measure market power by focusing on share of the market held by the largest firms. Assume that the larger the share of the market held by few firms, the more market power those firms have. roblems: Describe only one point on the size distribution. Market definitions may be arbitrary. Regulation Government may regulate the prices that the monopoly charges: The allocation of resources will be efficient if price is set to equal marginal cost. However, in natural monopolies this will result in a loss! (When average cost (AC) fall marginal cost () must be lower than AC. Optimal pricing = would therefore result in losses!) In practice, regulators will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing. ublic olicy Toward Monopolies Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself (e.g., sometimes the government runs the ostal Service). Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies. Any questions? Thanks!