ECMA04H – Week 9
Efficiency in competitive and monopolistic
markets. Regulating natural monopoly.
Objectives this week:
- Review Consumer Surplus and Producer
Surplus
- Define Gain to Society (GTS) as summary
measure of net economic benefits
- Discuss allocative efficiency in
competitive and monopolistic markets
- Discuss ways to regulate natural
monopolies, including marginal cost pricing
and average cost pricing
First, complete our discussion of monopoly
1
An excise tax on a monopoly. Solve it
graphically.
Price
per unit
quantity
MC
AC
Demand
MR
0
Quantity
produced
per unit of
time
2
Solve it algebraically. Place a $15 tax on the
monopoly problem we had before. What is
the effect on equilibrium price and
equilibrium quantity?
What is the effect on profit?
3
What is the excess burden of the tax?
4
Other thoughts about monopoly:
Think about elasticity and monopoly. Will a
monopolist have elastic or inelastic demand?
What makes most sense?
5
This week’s problem: compare Monopoly to
Perfectly Competitive market. Which is
better, which is worse, and why? What are
the remedies (if any)?
Difficult to make comparison, because
problem of apples and oranges. Situation is
often different.
Still, useful exercise…
Compare using:
1. Allocative efficiency – Gain to Society
2. Distribution of benefits between
producers and consumers
3. Dynamic efficiency
6
Does the monopolist’s output maximize the
Gain to Society?
“Efficiency” is achieved when resources are
allocated in a way that delivers the most gain
to society
How do we measure Gain to Society (GTS)?
Sum of Consumer Surplus plus Producer
Surplus (sometimes use profit instead of
producer surplus)
7
How much does society gain from the
activities of producing and consuming?
In the simple situation, the benefits to
society are the benefits to the individuals
that are participating in consuming and
producing.
i.e., consumer surplus and producer surplus
(or profit).
Simple situation means when there are no…
(a) taxes or tariffs
(b) external benefits
(c) external costs
(d) public goods
8
Consumer surplus (CS) is dollar value of
utility received by consumers above
cost of purchase
CS represents extra “willingness to pay”
above the current price. It is a
measure of the “satisfaction” that
consumers get above what they have to
pay for a good.
Increasing CS represents a social gain –
a gain to society
9
What is producer surplus?
Producer surplus (PS) is the dollar value of
revenue received by producers above the
minimum amount they require to be willing to
supply the good.
It is a form of “surplus” received by
producers, and therefore can also be
considered a gain to society
10
In the short run, the minimum amount
producers require is to cover their TVC – the
total variable costs of production.
Therefore, PS = TR – TVC
But, since Π = TR – TFC - TVC
Therefore, TR – TVC = Π + TFC
In other words, PS = Π + TFC
Producer surplus differs from profit only by
the amount of fixed costs. So, if we are
comparing two situations with same fixed
costs (e.g., competition and monopoly), then
we can use either PS or Π in our calculation of
Gain to Society.
Look at CS and PS on graph
11
Price
$60
Supply
$30
$25
$15
$11
0
Demand
100,000
300,000
350,000
Market for 4’ x 8’ sheets of ¾” plywood
12
475,000
450,000 Quantity
Per month
Price
$60
Supply
$30
$25
$15
$11
0
Demand
100,000
300,000
350,000
Market for 4’ x 8’ sheets of ¾” plywood
13
475,000
450,000 Quantity
Per month
Now, compare competition and monopoly
Imagine there are 100 firms in a perfectly
competitive market. In the long run, in this
constant cost industry, supply is given by P =
100 (horizontal long run supply at a price of
$100).
Consumer demand in the industry is given by P
= 1000 – Q
What is the equilibrium in this industry in the
LR, and what is the GTS?
14
Draw the diagram
15
GTS = CS + Π
16
Imagine that a monopoly firm is able to buy up
all 100 firms and establish some barrier to
new firms entering the industry (e.g., a
government licence as exclusive supplier).
The monopolist keeps all the 100 plants
separate and operates as many as he needs to
supply the good. In effect the SLR becomes
the MC curve (and the AC curve) of the
monopolist.
17
The Gain To Society in the monopoly situation
is given by
GTS = CS + Π
18
How do perfect competition and monopoly
compare?
Under PC, GTS = $405,000 (and all of it
goes to the consumers). Producers receive
just enough to keep them in the industry
and producing, but not more.
Under monopoly, GTS = $303,750 (lower by
$101,250), and there has been a transfer of
surplus so that the producer receives the
biggest part ($202,500) and consumers
receive $101,250.
19
Perfect competition maximizes the sum of
the surpluses to consumers and to
producers. Therefore, PC has the largest
Gain to Society and is efficient.
There is a loss of Gain To Society under
monopoly. In other words, there is a loss of
efficiency under monopoly. We call this a
“deadweight” loss or efficiency loss.
“Deadweight” because it is completely lost
to society (rather than transferred to
someone else). Note: not all losses are
deadweight losses.
20
What about the distribution of the benefits
of production? Different from allocative
efficiency.
Does the monopolist transfer potential CS
into profit for the producer?
21
What about dynamic efficiency?
Joseph Schumpeter – “waves of creative
destruction”
22
Now let’s summarize comparison:
Competition
Price
Profit
Consumer
Surplus
Total (GTS)
Deadweight
Loss
Dynamic
Efficiency
23
Monopoly
Classic view is that monopoly distorts
resource allocation and causes deadweight
efficiency loss. Monopolist produces too
little output (uses too few resource
24
How does monopoly persist?
Π > 0, so needs some barrier to entry
Could be:
(a) government licence or restriction
(patent)
(b) ownership of scarce but essential
resource
(c) some other barrier to entry (e.g., huge
advertising costs, manipulation of
access to market)
Or,
(d) cost advantage – economies of scale
which are large relative to the size of
the market (known as “natural
monopoly”) [q* < qMES]
25
What should government policy be towards
monopoly?
It depends:
(a) is allocative efficiency the only
measure? What about dynamic
efficiency? (Schumpeter – waves of
creative destruction)
(b) Why does the monopoly exist? What is
the nature of the “barrier to entry”?
Is it a government patent? Is it a
economies of scale (i.e., natural
monopoly)?
(c) What can government do? Can
government restore competition? Can it
regulate the monopolist? Will the
results be better?
26
In case of natural monopoly (electricity,
telephone, roads, bridges, etc.),
governments may regulate the monopolist.
(Another alternative is to take firm into
public sector).
Rate of return regulation
Control monopolist by forcing it to charge a
certain price that will affect the profits
and production of the monopolist.
2 choices:
(a) Regulate monopolist to charge P = MC
(b) Regulate monopolist to charge P = AC
27
Diagramatically, what are these
alternatives?
28
What are the effects of P = MC?
29
What are the effects of P = AC?
30
What will happen if the government does
nothing?
31
What are the strengths and weaknesses of
these different solutions?
32
An algebraic example:
Highway 407.
Privately owned and operated highway.
Demand: P = 300 - .5Q, where Q is
measured in trips per day
FC = $1,950 per day
VC = $100 per trip
TC = $1,950 + 100Q
33
What will unregulated monopolist do and
what is the GTS?
34
What if government regulates the
monopolist to charge P = MC? What
happens and what is the GTS?
35
What if government regulates the
monopolist to charge P = AC? What happens
and what is the GTS?
36
Conclusions?
Problem with Regulation:
loss of incentive
to keep costs low
to deliver high quality
to innovate
37
so summarize
Arguments for and against monopoly
Against:
reduce Q, raise P, reduce CS
hard to regulate
For:
natural monopoly
even if not natural monopoly,
dynamic argument Joseph Schumpeter
lure of monopoly profits lead to innovation
eg. Microsoft ??
Policy issue:
break up?
regulate?
leave alone?
38
1. Break up:
- issue of proof. anti-trust
law in Canada used to be
criminal. problem of proof, so
now civil
- assumes no economies of
scale (microsoft?)
- restores advantages of
market (airlines)
- loses reward for innovation
2. Regulate:
- losses of efficiency?
- how to retain incentives
- cost of regulation
- issue of “capture”
- how to deal with new
technologies and entry
39
3. Leave alone:
- static losses in efficiency
- higher prices
- gains of potential competition
in long run
40