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Monopoly Timothy S. Sullivan, Ph. D. Economics 301: Intermediate Microeconomics Department of Economics & Finance Southern Illinois University Edwardsville Last update: July 9, 2004
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Monopoly t. A firm that is the sole seller of a product without close substitutes.
Monopolies are Caused by Barriers to Entry t. Anything that prevents firms from entering an industry is called a barrier to entry. t. Common Barriers to Entry: t. Patents, copyrights, licenses and other government actions t. Ownership of key resources t Natural Monopoly
Government Barriers t. Governments provide patents to firms that develop new technology. Why? t. Governments enforce copyright laws for creators of creative works, such as music. Why? t. Governments require licenses to enter some industries, such as taxi driving. Why? t. Governments sometimes are the monopolist, such as the postal service.
Ownership of Key Resources t. When a key input is controlled by a particular firm, they will be a monopolist. t. Examples: t. De Beers’ ownership of about 80% of all diamond mines in the world makes them near-monopolists in the diamond market. t. Polygram’s exclusive contract for U 2 makes them a monopolist in the market for U 2 CDs.
Natural Monopoly t An industry where ATC continues to decline, such that minimum efficient scale is larger than the size of the market. t Typically occurs when FC are large and MC is small. t In this case, the largest firm will always have the lowest average costs, and will drive competitors out of business. t Potential examples: t Cable television t Electricity
Monopoly & Market Power t. Monopolists are not price-takers. t. Their ability to set its price, rather than taking the price set by the market, is called market power. t. There are no competitors to undercut the monopolist’s price. Only the downward sloping demand curve restrains the monopolist from raising price. t. We say that a monopolist is a price-
Demand for a Monopolist’s Product
A Monopolist’s Price t. What is the optimal price for a monopolist to choose? : t. Raise price? : lose some customers (not necessarily all customers, because there are no close substitutes). t. Cut price? : gain customers, but some customers would be willing to pay more. t. For the time being, assume that the monopolist must charge one price to all customers.
Marginal Revenue & Demand • Increasing output will, on one hand, increase revenue (as the additional output is sold). • Increasing output, on the other hand, will decrease revenue, as the price must be cut to sell the extra output.
A Monopolist’s Revenue t. A monopolist must lower price to sell more output (unlike competitive market, where firm could sell all it wanted to at market price). t. Average revenue (price) falls with output. t. If average revenue is falling, marginal revenue must be below average revenue.
Total Revenue, Marginal Revenue and Price
Total Revenue, Marginal Revenue and Price
Marginal Revenue < Price t. Marginal Revenue = Extra Revenue from selling additional unit (price) - minus Lost revenue from lowering price to those who were already buying the product. t. It can be shown that, if the demand curve is a straight line, the MR curve will be a line with the same intercept, and
Marginal Revenue < Price t. It can be shown that MR = p +( p/ Q)Q t. It can be shown that MR = p(1+1/ )
Marginal Revenue can be < 0 t. It’s likely that, eventually, few new customers will be gained by lowering price. t. In this case, a large price cut must be made (greatly lowering the revenue from existing customers) in order to sell the output. t. In this case MR < 0. t. This will be the point where TR is at a
Question t. If this firm has no costs, how much should they produce? What price should they charge?
Profit Maximization for Monopolists t. As in a competitive market, the monopolist will continue producing as long as the extra revenue exceeds the extra cost of producing the next unit (MR>MC), and will stop when MR=MC. t. Unlike a competitive firm, the price the monopolist can charge, for that amount of output will be higher than marginal revenue & marginal cost (P>MR).
Monopolist’s Profit t. Once t. TC again, TR = P Q = ATC Q (since ATC = TC/Q) t. Unlike competitive market, profits will not cause entry.
Profit = TR - TC
Profit = TR - TC
Monopolists can have Negative Profits
Social Costs of Monopoly t. Recall that in a competitive market, the equilibrium will be Pareto Efficient.
Social Cost of Monopoly
Social Cost of Monopoly t Monopolists stop producing at the profit maximizing quantity, which is less than the socially efficient point. t If a monopolist would produce more the cost of production would be less than what people would be willing to pay. But, it would require cutting price for current customers. t The total deadweight loss in the US, due to those monopolies that exist, is between 0. 5% and 2% of GDP.
Monopolies: The Good & the Bad t. True or False: Monopolies always charge the highest price possible.
Price-Cost Margin t. Recall that, in a competitive market, P=MR=MC. t. In a monopoly market P>MR=MC. t. It can be shown that P/MC = 1/(1+(1/ ))
Price-Cost Margin t. The relative difference between P and MC is called the price-cost margin. t. PC margin = (P-MC)/P = - 1/ or Lerner Index. t. The more market power the monopolist has, the larger the PC margin will be (it will be zero in a competitive market).
Monopolies: The Good & the Bad t. True or False: Society would be better off if all monopolies were broken up.
Monopolies: The Good & the Bad t. True or False: The existence of a monopoly must reduce consumer surplus and make consumers worse off.
Monopolies: The Good & the Bad t. True or False: Monopolies are less efficient (in production) than competitive firms.
Monopolies: The Good & the Bad t. True or False: Every monopolist will act as a monopolist.
Antitrust Policy t. Antitrust policies are government actions designed to promote competition among firms in the economy. t. They are also known as competition policy or antimonopoly policy.
Sherman Antitrust Act of 1890 t. Named after Senator John Sherman (R-Ohio), who had introduced similar bills in 1888 and 1889. Source: Hughes, Jonathon and Louis P. Cain, American Economic History, 5 th ed. , Addison Wesley, 1998, pg. 362.
Sherman Act: Section 1 t. Section 1 makes price fixing illegal t“Any contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several states or with foreign nations is hereby declared to be illegal. ”
Sherman Act: Section 2 t. Section 2 addresses monopolies: t“Every person who shall monopolize, or attempt to monopolize … any part of the trade or commerce among the several states, or with foreign nations, shall be deemed guilty of a felony. ”
Standard Oil Company of NJ vs. United States t t t May 15, 1911: Ten years after the case was first introduced, the US Supreme Court ruled that Standard Oil must be broken into seven smaller companies (Standard, Mobil, Chevron, Amoco, Exxon, etc. ). 1987: British Petroleum (BP) buys Standard 1998: BP merges with Amoco 1999: Exxon and Mobil merged 2001: Chevron merged with Texaco
Other Important Antitrust Cases based upon Sherman t t t 1911: American Tobacco Company forced to split with the British Imperial Tobacco Company. 1920: US Steel survived a breakup attempt, when the Supreme Court ruled that, based on the rule of reason, US Steel did not restrain competition. 1945 Alcoa Aluminum was found guilty when rule changed to allow efforts to maintain a monopoly as standard. 1969: Action brought against IBM. Subsequently dropped because of changes in the computer industry. 1970 s & 1980 s: AT&T is forced to split their long distance and local companies. 1990 s: Action brought against Microsoft.
Clayton Antitrust Act t 1914: US law aimed at preventing mergers that would create monopolies. t. Amended and clarified the Sherman Act. t. Drafted by Henry De Lamar Clayton.
Federal Agencies Enforcing Antitrust Laws t. The Federal Trade Commission (FTC) was established in 1914 to help enforce antitrust laws in the US. t. The Antitrust Division of the Justice Department also enforces antitrust law.
What is Considered When Approving a Merger? t. Concentration of industry t. Market Definition t. Horizontal versus Vertical Mergers
Market definition The geographic definition of the market is a key decision for policy makers. t The definition of the category of goods or services is another key decision for policy makers. t Answering these two questions is called defining the market, or stating the market definition. t
Market Definition t. What would be the appropriate definition for a Coke-Pepsi merger? t. Why does it matter?
A Pepsi-Coke Merger
Real-World Application t. In 2002, Echo. Star Communications (supplier of Dish Network) attempted to purchase Hughes Electronics (parent company of Direct. TV). The FTC eventually rejected the purchase. 1 t. Explain how the definition of the market might have affected the FTC’s decision. “Echo. Star Ends Its Bid to Buy Hughes, ” The Wall Street Journal, December 11, 2002, pg. A 3.
Regulating Monopolies t t Perhaps the best way to regulate monopolies is to break them up, or prevent them in the first place. What if a breakup is impractical or inefficient (e. g. , a natural monopoly)? : t Regulation (such as by a utility commission) t t Marginal Cost Pricing Average Total Cost Pricing Incentive Regulation Government Ownership
Social Cost of Monopoly
Marginal Cost Pricing t. If a monopolist is forced to charge the price where the marginal cost curve crosses demand, the outcome will be efficient. t. Sometimes called optimal price regulation. t. Does not work with natural monopolies (they will not earn a profit, and would exit the industry).
Marginal Cost Pricing & Natural Monopolies
Average Total Cost Pricing t. For natural monopolies, the regulator can force monopolies to charge the price where ATC crosses Demand. t. At this price economic profit will be zero, although there will be normal accounting profits. t. Sometimes called nonoptimal price regulation. t. Smaller deadweight loss than
Average Total Cost Pricing & Natural Monopolies
Lying to the regulators t. Average total cost pricing gives firms an incentive to either overstate their true costs, or to pad their costs. t. They can get away with this due to asymmetric information.
Lying to the regulators
Government ownership t. If all else fails, the government can take over the monopoly. t. This is relatively uncommon in the US.
Monopsony power There is increasing concern regarding market power among buyers (monopsony or oligopsony). t Philip Morris and some other US cigarette makers recently agreed to a $212 M settlement when they were accused by tobacco growers of rigging bids. t Generally less of a concern because it tends to lower costs for consumers (although it does cause social inefficiency). Wilke, John R. , “How Driving Prices Lower can Violate Antitrust Statutes, ” The Wall Street Journal Online t Edition, January 27, 2004.
End of Lecture t. Read Chapter 11 t. Do problems in Study Guide t. Do Problems at end of Chapter.