MONOPOLY:
Firms do not want to be perfect competitors.
Why? No Rents (economic profit, excess profit)
Remember: In a perfectly competitive market, the
existence of rents triggers entry, entry shifts the supply
curve to the right, price goes down, rents disappear.
S1
Rent
S2
P1
P2
200 (max)
Individual Supplier
700,000
Market (i.e., 5,000
Suppliers)
CHARACTERISTICS OF MONOPOLY
• SINGLE SELLER
• NO CLOSE SUBSTITUTES
• PRICE MAKER NOT PRICE TAKER
• BLOCKED ENTRY
o Patents & Licences
o Ownership or Control of Essential Resources
o Pricing & Strategic Barriers
BARRIERS TO MARKET ENTRY
CONDITIONS
• THE ENTRANT MUST INCUR A SIGNIFICANT
“SUNK” COST (AND INVESTMENT THAT HAS NO
VALUE IF THE ENTRANT FAILS, E.G.,
ADVERTISING)
• THE ENTRANT MUST BELIEVE THAT THE ODDS
ARE HIGH THAT IT WILL FAIL IF THE
INCUMBENT SELLER(S) ATTEMPT TO DRIVE IT
FROM THE MARKET
TYPES OF ENTRY BARRIERS
• SCALE (ONLY “ROOM” FOR ONE, OR A FEW
NUMBER OF SELLERS)
• ABSOLUTE COST
• PRODUCT DIFFERENTIATION
SCALE BARRIER
Unit Costs ($)
Figure 9.1 (modified).
Demand
Avg. Costs
Quantity
This is a "natural monopoly". The market will only support
one low cost firm, and even that firm does not achieve
MES.
Unit Costs ($)
ABSOLUTE COST ADVANTAGE
AC Firm 2
Pe
AC Firm 1
Quantity
Firm 1 is the incumbent (i.e., the firm already in the
market)
Firm 2 is the potential entrant.
Because Firm 1 has lower costs it can raise price just
below Pe (Firm 2's minimum AC), earn economic profits,
and forestall entry by Firm 2.
THE INEFFICIENCY OF MONOPOLY
• Allocative efficiency
• Productive efficiency
• Equity
• ALLOCATIVE EFFICIENCY
$
MC
Price
ATC
Demand
MR
Qm
Quantity
Marginal Revenue < Price
Marginal Revenue = Marginal Cost (profit maximization)
Therefore: Marginal Cost < Price; or: Price > Marginal
Cost
ALLOCATIVE EFFICIENCY IS NOT ACHIEVED!
Graphic representation of the allocative inefficiency of
Monopoly
Assume MC is constant (i.e., doesn't change) over the
relevant range of output.
Unit Costs ($)
A
C
Pm
Pc
D
ATC=MC
B
MR
Qm
Qc
Demand
Quantity
Under perfect competition consumer surplus is PcAB.
What happens to this surplus under monopoly? The
consumers still get a consumer surplus of PmAC. The
monopolist gets profits of PcPmCD. Who gets DCB?
NOBODY!
This is the “deadweight loss” of monopoly.
• PRODUCTIVE (TECHNICAL) EFFICIENCY
o SCALE
$
MC
MR1
ATC
MR3
MR2
Q1
Q2
Q3
Quantity
The monopolist's level of output depends on the MC and
MR curve.
With MR1, the monopolist produces Q1 which is
technically inefficient (all economies of scale are not
exploited).
With MR2, the monopolist produces Q2 and enjoys
minimum per unit costs.
With MR3, the monopolist produces too much for technical
efficiency.
Unit Costs ($)
X-INEFFICIENCY
Fig 8-7
ATC
•X
ATCX’
•X
‘
ATC2
Q2
Quantity
Monopolist is not operating on the ATC curve (at X'
production is at the per unit cost minimizing level, but
costs are not minimized)
Monopolist might have higher (than perfect competition)
costs because of:
• lack of incentive to minimize costs (waste, laziness,
etc.)
• rent seeking (spending resources to protect the
monopoly position).
• DYNAMIC EFFICIENCY
o This is a BIG issue. Do firms with monopoly
power and profits do more, and more effective
R&D (the Microsoft defence).
o Research provides no clear answer
• EQUITY
o Monopolists earn monopoly rents (economic
profits)
o These rents (profits) come from consumers.
o Many economists would argue that this is an
"unfair" redistribution of wealth.
PERFECT PRICE DISCRIMINATION
• Necessary conditions
o Have the power to set price
o Identify high and low "price" consumers
o Stop arbitrage (resale)
• Mechanics
The price discriminator can charge P1 for the first unit, so
the MR of the 1st unit is P1. The second unit is sold for P2
which is its marginal revenue. The firm will continue to
produce and sell until the MR of the last unit is equal to
marginal cost (in this case it produces 4,000 units and the
last one is sold for P4,000 which is its MC).
$
A
P1
P2
P3
P4
P4,000
B
ATC=MC
Demand =
MR
Qm = Qc
Quantity
• Price discrimination can be very profitable
o So why don't all firms do it?
Unit Costs ($)
A
C
Pm
Pc
D
ATC=MC
B
Demand
MR
0
Qm
Qc
Quantity
The price discriminating monopolist has:
• Total Revenues of 0ABQc
• Total Costs of 0PcBQc
• Economic profits of PcAB, which is much more than
PcPmCD
Efficiency impacts:
Under perfect price discrimination, the monopolist charges
a price for each unit, exactly equal to the value of that unit.
For the last unit, P = MC.
• Allocative efficiency is achieved.
• But, usually resources are expended in the practice
(identifying high price customers, stopping arbitrage).
These higher costs are not shown on the diagram.
REGULATED MONOPOLY (fig 8-9)
Monopoly price, P > MC,
and P > ATC, Monopolist
receives economic profits
(rents)
“Fair return price, P = ATC so
no rents, BUT, P > MC, so
allocative efficiency not
achieved.
•
Optimal social price, P =
MC, BUT, P < ATC,
monopolist will incur
losses
•
•
•
ATC
MC
Demand
Qm
MR
Qf
Qr
Figure 8-10
Consumer surplus
$
Producer surplus
MC
$
S=ΣMC
D
X
Pm
Pc
Pc
Y
D=MB
Qc
Purely Competitive
A
E
B
C
MR
D=MB
Qm Qc
Pure Monopoly
In the short run
Under perfect competition, Total surplus is X + Y
Under pure monopoly, Total surplus = D + A + E
X=D+A+B
Y = E +C
Loss in surplus is B + C
Note, from the diagram we cannot tell how much of
A + E is monopoly profit because we cannot tell the
monopolist's total costs at Qm (this is why I like to
assume a horizontal MC curve for this analysis).