monopoly timothy s. sullivan, ph.d. economics 301: intermediate microeconomics department of...

Monopoly

Timothy S. Sullivan, Ph.D.Economics 301: Intermediate MicroeconomicsDepartment of Economics & FinanceSouthern Illinois University Edwardsville

Last update: July 9, 2004

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MonopolyMonopoly

A firm that is the sole seller of a product without close substitutes.

Monopolies are Caused by Barriers to Entry

Monopolies are Caused by Barriers to Entry

Anything that prevents firms from entering an industry is called a barrier to entry.

Common Barriers to Entry:Patents, copyrights, licenses and other government

actionsOwnership of key resources Natural Monopoly

Government BarriersGovernment Barriers

Governments provide patents to firms that develop new technology. Why?

Governments enforce copyright laws for creators of creative works, such as music. Why?

Governments require licenses to enter some industries, such as taxi driving. Why?

Governments sometimes are the monopolist, such as the postal service. Why?

Ownership of Key Resources

Ownership of Key Resources

When a key input is controlled by a particular firm, they will be a monopolist.

Examples:De Beers’ ownership of about 80% of all diamond

mines in the world makes them near-monopolists in the diamond market.

Polygram’s exclusive contract for U2 makes them a monopolist in the market for U2 CDs.

Natural MonopolyNatural Monopoly

Natural MonopolyNatural Monopoly

An industry where ATC continues to decline, such that minimum efficient scale is larger than the size of the market.

Typically occurs when FC are large and MC is small.In this case, the largest firm will always have the lowest

average costs, and will drive competitors out of business.Potential examples:

Cable televisionElectricityTrash collection

Monopoly & Market PowerMonopoly & Market Power

Monopolists are not price-takers.Their ability to set its price, rather than taking the

price set by the market, is called market power.There are no competitors to undercut the

monopolist’s price. Only the downward sloping demand curve restrains the monopolist from raising price.

We say that a monopolist is a price-maker.

Demand for a Monopolist’s Product

Demand for a Monopolist’s Product

A Monopolist’s PriceA Monopolist’s Price

What is the optimal price for a monopolist to choose?:

Raise price?: lose some customers (not necessarily all customers, because there are no close substitutes).

Cut price?: gain customers, but some customers would be willing to pay more.

For the time being, assume that the monopolist must charge one price to all customers.

Marginal Revenue & Demand

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 RevenueA Monopolist’s Revenue

A monopolist must lower price to sell more output (unlike competitive market, where firm could sell all it wanted to at market price).

Average revenue (price) falls with output. If average revenue is falling, marginal revenue

must be below average revenue.

Total Revenue, Marginal Revenue and Price

Total Revenue, Marginal Revenue and Price

Total Revenue, Marginal Revenue and Price

Total Revenue, Marginal Revenue and Price

Marginal Revenue < PriceMarginal Revenue < Price

Marginal Revenue =Extra Revenue from selling additional unit (price) - minus -Lost revenue from lowering price to those who were

already buying the product.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 double the slope.

Marginal Revenue < PriceMarginal Revenue < Price

It can be shown that MR = p +(p/Q)QIt can be shown that MR = p(1+1/)

Marginal Revenue can be < 0

Marginal Revenue can be < 0

It’s likely that, eventually, few new customers will be gained by lowering price.

In this case, a large price cut must be made (greatly lowering the revenue from existing customers) in order to sell the output.

In this case MR < 0.This will be the point where TR is at a maximum.

QuestionQuestion

If this firm has no costs, how much should they produce? What price should they charge?

Profit Maximization for Monopolists

Profit Maximization for Monopolists

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.

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).

Maximizing ProfitsMaximizing Profits

Maximizing ProfitsMaximizing Profits

Monopolist’s ProfitMonopolist’s Profit

Once again, TR = PQ

TC = ATCQ (since ATC = TC/Q)

Unlike competitive market, profits will not cause entry.

Profit = TR - TCProfit = TR - TC

Profit = TR - TCProfit = TR - TC

Monopolists can have Negative Profits

Monopolists can have Negative Profits

Social Costs of MonopolySocial Costs of Monopoly

Recall that in a competitive market, the equilibrium will be Pareto Efficient.

Social Cost of MonopolySocial Cost of Monopoly

Social Cost of MonopolySocial Cost of Monopoly

Monopolists stop producing at the profit maximizing quantity, which is less than the socially efficient point.

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.

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

Monopolies: The Good & the Bad

True or False: Monopolies always charge the highest price possible.

Price-Cost MarginPrice-Cost Margin

Recall that, in a competitive market, P=MR=MC.In a monopoly market P>MR=MC.It can be shown that P/MC = 1/(1+(1/))

Price-Cost MarginPrice-Cost Margin

The relative difference between P and MC is called the price-cost margin.

PC margin = (P-MC)/P = - 1/ or Lerner Index.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

Monopolies: The Good & the Bad

True or False: Society would be better off if all monopolies were broken up.

Monopolies: The Good & the Bad

Monopolies: The Good & the Bad

True or False: The existence of a monopoly must reduce consumer surplus and make consumers worse off.

Monopolies: The Good & the Bad

Monopolies: The Good & the Bad

True or False: Monopolies are less efficient (in production) than competitive firms.

Monopolies: The Good & the Bad

Monopolies: The Good & the Bad

True or False: Every monopolist will act as a monopolist.

Antitrust PolicyAntitrust Policy

Antitrust policies are government actions designed to promote competition among firms in the economy.

They are also known as competition policy or antimonopoly policy.

Sherman Antitrust Act of 1890

Sherman Antitrust Act of 1890

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, 5th ed., Addison Wesley, 1998, pg. 362.

Sherman Act: Section 1Sherman Act: Section 1

Section 1 makes price fixing illegal“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 2Sherman Act: Section 2

Section 2 addresses monopolies:“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

Standard Oil Company of NJ vs. United States

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

Other Important Antitrust Cases based upon

Sherman 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. 1970s & 1980s: AT&T is forced to split their long distance and local

companies. 1990s: Action brought against Microsoft.

Clayton Antitrust ActClayton Antitrust Act

1914: US law aimed at preventing mergers that would create monopolies.

Amended and clarified the Sherman Act.

Drafted by Henry De Lamar Clayton.

Federal Agencies Enforcing Antitrust Laws

Federal Agencies Enforcing Antitrust Laws

The Federal Trade Commission (FTC) was established in 1914 to help enforce antitrust laws in the US.

The Antitrust Division of the Justice Department also enforces antitrust law.

What is Considered When Approving a Merger?

What is Considered When Approving a Merger?

Concentration of industryMarket DefinitionHorizontal versus Vertical Mergers

Market definitionMarket definition

The geographic definition of the market is a key decision for policy makers.

The definition of the category of goods or services is another key decision for policy makers.

Answering these two questions is called defining the market, or stating the market definition.

Market DefinitionMarket Definition

What would be the appropriate definition for a Coke-Pepsi merger?

Why does it matter?

A Pepsi-Coke MergerA Pepsi-Coke Merger

Real-World ApplicationReal-World Application

In 2002, EchoStar Communications (supplier of Dish Network) attempted to purchase Hughes Electronics (parent company of DirectTV). The FTC eventually rejected the purchase.1

Explain how the definition of the market might have affected the FTC’s decision.

“EchoStar Ends Its Bid to Buy Hughes,” The Wall Street Journal, December 11, 2002, pg. A3.

Regulating MonopoliesRegulating Monopolies

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)?: Regulation (such as by a utility commission)

Marginal Cost Pricing Average Total Cost Pricing Incentive Regulation

Government Ownership

Social Cost of MonopolySocial Cost of Monopoly

Marginal Cost PricingMarginal Cost Pricing

If a monopolist is forced to charge the price where the marginal cost curve crosses demand, the outcome will be efficient.

Sometimes called optimal price regulation.Does not work with natural monopolies (they will

not earn a profit, and would exit the industry).

Marginal Cost Pricing & Natural Monopolies

Marginal Cost Pricing & Natural Monopolies

Average Total Cost PricingAverage Total Cost Pricing

For natural monopolies, the regulator can force monopolies to charge the price where ATC crosses Demand.

At this price economic profit will be zero, although there will be normal accounting profits.

Sometimes called nonoptimal price regulation.Smaller deadweight loss than unregulated

monopoly.

Average Total Cost Pricing & Natural Monopolies

Average Total Cost Pricing & Natural Monopolies

Lying to the regulatorsLying to the regulators

Average total cost pricing gives firms an incentive to either overstate their true costs, or to pad their costs.

They can get away with this due to asymmetric information.

Lying to the regulatorsLying to the regulators

Government ownershipGovernment ownership

If all else fails, the government can take over the monopoly.

This is relatively uncommon in the US.

Monopsony powerMonopsony power

There is increasing concern regarding market power among buyers (monopsony or oligopsony).

Philip Morris and some other US cigarette makers recently agreed to a $212M settlement when they were accused by tobacco growers of rigging bids.

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 Edition, January 27, 2004.

End of LectureEnd of Lecture

Read Chapter 11Do problems in Study GuideDo Problems at end of Chapter.