1. A single price monopolist
a. Characteristics of monopoly
The following are characteristics of a monopoly market:
1. The firm is the only seller in the market.
2. The firm sells a unique product.
3. The firm has power to influence the price of the product.
4. There are barriers to other firms entering the market.
b. Cost and Revenue in the Short Run
The monopolist’s cost curves in the short run look the same as the cost curves of the perfectly competitive firm – diminishing returns means they are U-shaped.
Because the monopolist is the only firm producing in the market – the demand curve the monopolist faces, is the market demand curve.
Definition:
A single price monopolist charges the same price for all units
of the good it sells.
For a single price monopolist Average Revenue (AR) is equal to Price (P). Since P is read off the market demand curve, the market demand curve is also the firm’s AR curve.
Because the monopolist faces a negatively sloped demand curve – to sell each additional unit of the good, the monopolist has to lower the market price it charges on all units of the good. In that case, the addition to revenue from the sale of an extra unit (MR) is less than the price (P) the firm receives for that unit (MR < P).
Table 11-1.
Graph (insert here).
For the monopolist MR is always less than AR therefore MR is always less than P. This contrasts with the perfectly competitive firm which was a price taker and for whom MR = AR = P.
Marginal revenue and elasticity: The firm’s MR=0 at the output that is at the midpoint of the demand curve (unitary elasticity) – at that output TR is maximized.
Graph (insert here).
c. Short Run equilibrium for the monopolist
The monopolist produces an output Q* where MR=MC.
Graph (insert here).
Notice that MR = MC is less than P. The monopolist determines Q* where MR=MC then reads P off the demand curve.
Question: Why does the monopolist charge a price P read-off the demand curve rather than a price P where MR=MC?
There are three short run equilibrium outcomes for the monopolist:
1. Positive profits (insert graph here).
P > ATC
2. Normal profits (insert graph here).
P = ATC
3. Losses (insert graph here).
P < ATC
P > AVC
In describing the monopolist’s profit-maximizing behavior we are not able to derive a supply curve. There is no unique relationship between market price and the quantity supplied for a monopolist. It is possible for there to be many different MR curves that intersect MC at Q* and for each there is a different demand curve and a different price – since there can be many prices associated with one quantity, it is not possible to trace out a supply curve which tells how much the firm is willing to supply at each price.
d. Comparing the industry outcome under monopoly and under prefect competition.
Graph (insert here):
Under perfect competition: S=D at the industry level, which corresponds
to P=MC
Under monopoly: MR=MC, which corresponds to P > MC.
Monopoly produces less output and charges a higher price than in perfect
competition.
From society’s point of view, since P > MC, not enough output is being
produced – it would be better off if more output was produced up to the
point where P=MC.
e. Long Run equilibrium for the monopolist
In a monopoly as in a perfectly competitive industry, positive profits and losses are signals for resources to flow into, and out of, respectively, the industry.
A monopoly making losses in the LR will not continue producing.
If the monopoly is making positive profits in the SR however, new firms will want to enter the market. In monopoly markets there are impediments that prevent new firms from entering the market.
There are two long run equilibria for a monopolist:
1. Positive profits (called monopoly profits when they persist in the
LR):
P>AC
2. Normal profits
P = AC.
If monopoly profits are to persist in the long run, the entry of new firms must be prevented by effective entry barriers.
Entry Barriers can be natural or created:
1. Natural Barriers:
Economies of scale are the most common natural barrier to entry.
-- entrants have AC that are higher than those of existing firms and
therefore can’t compete.
A natural monopoly exists when the industry demand conditions allow
no more than one firm to cover its costs while producing at Minimum Efficient
Scale (MES).
Set-up costs are another natural barrier to entry.
-- in this case the costs to new firms of entering a market, developing
its product and establishing a brand name and distribution network are
all so high that they can’t compete with an existing firm.
2. Created Barriers: Many entry barriers are created by government action
Patents: sole legal right to produce a product for a specified period of time.
Charter or franchise: government granted prohibition of competition, eg. Post Office.
Other firm created barriers (discussed in Chapter on Imperfect Comp).
Significance of barriers to entry:
Profits can persist in a monopoly in the LR. The LR adjust process
that drives profits to zero in the LR does not operate in monopoly markets.
f. The very long run and creative destruction
In the VLR technology changes.
Innovation can break-down barriers to entry in monopoly markets.
Economist Joseph Schumpeter argued that barriers to entry were not a problem in the VLR – in fact he argues that they provided an incentive for entrepreneurs to take risks associated with invention and innovation.
Definition:
The process of creative destruction describes the replacement
of one monopolist by another through the invention of new products or production
processes.
Creative – referred to the rise of new products.
Destruction – referred to the demise of the existing monopoly.
Schumpeter argued that monopoly profits provide and important incentive for innovation which in turn promotes economic growth.
2. Cartels as Monopolies
A monopoly can arise in a market where there are many firms – if the firms agree to cooperate with one another and act as a single firm.
Definition:
A cartel is a group of firms that acts as a single seller to
maximize joint profits.
OPEC (Organization of Petroleum Exporting Countries) is an example of a cartel.
a. Effects of Cartelization
Suppose firms in a perfectly competitive industry form a cartel.
Note: This is unrealistic but it serves to illustrate the effects
of cartelization.
The firms cooperate to restrict output to the point where joint profits are maximized.
Graph (insert here):
Industry output is at Q* where MR=MC for the industry as a whole.
Each firm in the cartel gets an output quota so that total output = Q*.
b. Problems that cartels face
There are two problems that cartels have to deal with:
Cheating: Firms have an incentive to produce more than there
quota of output.
If only one firm sells more than their quota of output they don’t affect
the price of the output which is the monopoly price and they earn higher
profits (sell more output at about the same price).
The problem is if all firms cheat, the higher output drives the price
back down to the competitive level.
Cartels tend to be unstable because of incentives of individual firms
to cheat.
Note: The more transparent output is, the higher the chances of catching
a cheater, the less cheating there is likely to be.
Entrants: A cartel must also be able to prevent entry of new
firms if it wants to maintain its profits in the LR.
Successful cartels are often able to license firms.
Examples: AMA, Bar Associations, Professional sports leagues.
3. A multi-price monopolist: price discrimination
If a monopolist has the opportunity to sell different units of the same product at different prices, it can increase its profits above the level it could earn by selling at a single price.
Note: This practice occurs in monopoly markets and in oligopoly markets.
There are many examples of price discrimination in practice.
Eg. Airlines charging lower prices for staying over a Saturday night,
movies charging different price to students, children and seniors.
Definition:
Price discrimination occurs when a producer charges different
prices for different units of the same product, for reasons not associated
with differences in costs.
Note: Different prices for electricity at different times of the day are not an example of price discrimination – there are cost differences associated with providing electricity at peak and off-peak times.
The essence of price discrimination is that different groups of consumers have different demand curves for a product – a firm can increase its profits if it can charge higher prices to consumers with a higher marginal willingness to pay and lower prices to consumers with a lower willingness to pay.
The ability of a firm to charge multiple prices for a good gives it the opportunity to capture some consumer surplus.
Graph (insert here):
Perfect price discrimination: charging a different price on every unit
of the good sold.0
Question: How much consumer surplus remains when a firm can perfectly price discriminate.
When is price discrimination possible?
1.Among units of a good sold to the same person:
A firm sells each unit of a good bought by a consumer at a different
price.
To be able to do this the firm has to be able to keep track of all
units of a good purchased by that consumer.
Eg. The electric company can do this with meters.
2.Among different buyers:
A firm sells to some buyers at one price and to other buyers at another
price.
To be able to do this the firm must be able to prevent those who buy
at a low price from re-selling to those who would buy at a high price.
Eg. At the movies, tickets for different groups have different colors
or labeling.
Consequences of price discrimination:
1. Price discrimination if it is possible will lead average revenue
to be higher than what it would be by charging a single price.
2. Output under price discrimination will be higher than when the firm
charges a single price.
Normative aspects of price discrimination:
Price discrimination benefits buyers in terms of higher output but
it hurts them in terms of transferring income from buyers to sellers.
Question: How do we compare those two things?