8 Monopoly

Definition of Monopoly Market: A monopoly is an industry in which there is only one firm (seller). Firm: A firm is considered a monopolist if...  it is the only seller of its product.  its product does not have close substitutes.

Why Do Monopolies Arise? Why is there only one firm in the market? Because there are barriers to entry in the market.

Why Do Monopolies Arise? Barriers to entry have three sources: 1.Government restricts entry by giving a single firm the exclusive right to sell a particular good, service, idea Land phone service is given to Türk Telekom, postal services given to PTT, natural gas given to İGDAŞ, tap water to İSKİ in İstanbul. Patents, copyrights, intellectual property rights.

Government-Created Monopolies Patents, copyrights and intellectual property rights laws creates a monopoly to increase social welfare. Purpose is to encourage research and development. If there were no such laws, then it would be free to copy inventions (ideas, films, books, formulas...), then nobody does research & development. Ex: Aspirin is patented to Bayer for 5 years and no other firm can use the same formula without purchasing patent rights during 5 years. After 5 years, “generic drugs” can sell the same formula.

Why Do Monopolies Arise? 2.Natural Monopoly: Cost structure of production make a single producer more efficient than multiple producers. Natural monopolies arise when there are very large fixed costs but low marginal costs. Ex: High technology products, research& development, inventions (Ex:light bulb, microwave oven), software, energy, telecom, etc. “İSKİ” and tap water production, Türk Telekom (Cable TV & Land Phones), Tüpraş, İGDAŞ (Natural Gas Distributor), etc.

Natural Monopolies An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller average cost than can two or more firms. (i.e. when there are economies of scale over the entire market size)

Figure 1 Economies of Scale as a Cause of Monopoly Copyright © 2004 South-Western Quantity of Output Average total cost 0 Cost

Why Do Monopolies Arise? 3.Ownership of a key resource: Diamonds (De Beers), Hazelnuts & Boraks (Turkey as a country), İGDAŞ (Natural Gas Distributor), etc.

How Does a Monopolist Choose its Quantity and its Price? Monopoly versus Competition  Monopoly Is the sole producer Faces a downward-sloping demand curve Has market power (power to choose the price).  Competitive Firm Is one of many producers Faces a horizontal demand curve Is a price taker Can sell much or little at the same price

Property of a Monopoly While a competitive firm is a price taker, a monopoly firm is a price maker. Monopolist can choose its own price. Does this mean that it chooses the maximum possible price? No.

Figure 2 Demand Curves for Competitive and Monopoly Firms Copyright © 2004 South-Western Quantity of Output Demand (a) A Competitive Firm’s Demand Curve(b) A Monopolist’s Demand Curve 0 Price Quantity of Output 0 Price Demand

A Monopoly’s Revenue Total Revenue P  Q = TR Average Revenue TR/Q = AR = P Marginal Revenue  TR/  Q = MR

Table 1 A Monopoly’s Total, Average, and Marginal Revenue Copyright©2004 South-Western

Figure 3 Demand and Marginal-Revenue Curves for a Monopoly Copyright © 2004 South-Western Quantity of Water Price $ –1 –2 –3 –4 Demand (average revenue) Marginal revenue

A Monopoly’s Revenue A Monopoly’s Marginal Revenue  A monopolist’s marginal revenue is always less than the price of its good. The demand curve is downward sloping. When a monopoly drops the price to sell one more unit, the revenue received from all previously sold units also decreases.

How Does a Monopolist Choose its Quantity and its Price? A monopolist maximizes profit by producing the quantity at which marginal revenue equals marginal cost. After choosing optimal qty, monopolist uses the demand curve to find the price of the good. At that price, consumers will buy the optimal quantity that maximizes firm’s profit.

Figure 4 Profit Maximization for a Monopoly Copyright © 2004 South-Western Quantity QQ0 Costs and Revenue Demand Average total cost Marginal revenue Marginal cost Monopoly price Q MAX B 1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity... A and then the demand curve shows the price consistent with this quantity.

How Does a Monopolist Choose its Quantity and its Price? Comparing Monopoly and Competition  For a competitive firm, price equals marginal cost. P = MR = MC  For a monopoly firm, price exceeds marginal cost. P > MR = MC

A Monopoly’s Profit Profit equals total revenue minus total costs.  Profit = TR - TC  Profit = (TR/Q - TC/Q)  Q  Profit = (P - ATC)  Q

Figure 5 The Monopolist’s Profit Copyright © 2004 South-Western Monopoly profit Average total cost Quantity Monopoly price Q MAX 0 Costs and Revenue Demand Marginal cost Marginal revenue Average total cost B C E D

A Monopolist’s Profit The monopolist will receive economic profits as long as price is greater than average total cost.

Figure 6 The Market for Drugs Copyright © 2004 South-Western Quantity 0 Costs and Revenue Demand Marginal revenue Price during patent life Monopoly quantity Price after patent expires Marginal cost Competitive quantity

THE WELFARE COST OF MONOPOLY In contrast to a competitive firm, the monopoly charges a price above the marginal cost. From the perspective of consumers, this high price makes monopoly undesirable. However, from the perspective of the firm, the high price makes monopoly very desirable.

Figure 7 The Efficient Level of Output Copyright © 2004 South-Western Quantity 0 Price Demand (value to buyers) Marginal cost Value to buyers is greater than cost to seller. Value to buyers is less than cost to seller. Cost to monopolist Cost to monopolist Value to buyers Value to buyers Efficient quantity

The Deadweight Loss Because a monopoly sets its price above marginal cost, it places a difference between the consumer’s marginal benefit and the producer’s marginal cost.  This difference causes the quantity sold to be less than the socially optimal qty where MB=MC.

Figure 8 The Inefficiency of Monopoly Copyright © 2004 South-Western Quantity 0 Price Deadweight loss Demand Marginal revenue Marginal cost Efficient quantity Monopoly price Monopoly quantity

The Deadweight Loss of Monopoly The Inefficiency of Monopoly  The monopolist produces less than the socially efficient quantity of output AND  Charges a price that is greater than socially efficient MC.

PUBLIC POLICY TOWARD MONOPOLIES Government responds to the problem of monopoly in one of four ways.  Making monopolized industries more competitive.  Regulating the behavior of monopolies: control price.  Turning some private monopolies into public enterprises.  Doing nothing at all.

Increasing Competition with Antitrust Laws Antitrust laws aim to decrease monopoly power. Antitrust laws give government various ways to increase competition. If necessary,  They allow government to prevent mergers.  They allow government to break up companies.  They prevent companies from performing activities that make markets less competitive: Predatory pricing. Large firm prevents other firms from entering the market by setting a very low price. Collusion: firms get together and arrange prices and share the market. Ex: OPEC, intercity travel companies.

Regulation Government may regulate the prices that the monopoly charges.  The allocation of resources will be efficient if price is set to equal marginal cost.

Figure 9 Marginal-Cost Pricing for a Natural Monopoly Copyright © 2004 South-Western Loss Quantity 0 Price Demand Average total cost Regulated price Marginal cost Average total cost

Govt. Policy Against Monopoly In practice, regulators allow monopolists to make some positive profits by allowing price>MC. This is because if price is forced to be equal to MC in a natural monopoly, profit is always negative and the firm cannot survive. Ex: research & development, new ideas. Price of Stata is $500 but MC is only $20, but initial research effort is $1million.

Public Ownership Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself (Ex: in the US and in Turkey, government runs the Postal Service. In Turkey, government runs the distribution of natural gas).

PRICE DISCRIMINATION Price discrimination is the business practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.

PRICE DISCRIMINATION Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power. Perfect Price Discrimination  Perfect price discrimination takes place when the monopolist knows exactly the marginal benefit (willingness to pay) of each customer and can charge each buyer a different price equal to that buyer’s willingness to pay.

PRICE DISCRIMINATION Three important effects of price discrimination: Show on graph:  It increases the monopolist’s producer surplus.  It decreases consumer surplus.  It decreases deadweight loss, therefore increases total surplus of the society.

PRICE DISCRIMINATION Examples of Price Discrimination  Movie tickets  Airline prices  Discount coupons  New publications: novels, films, etc.  Financial aid  Quantity discounts

CONCLUSION: THE PREVALENCE OF MONOPOLY How prevalent are the problems of monopolies?  Monopolies are common.  Most firms have some control over their prices because of differentiated products.  Firms with substantial monopoly power are rare.  Few goods are truly unique. There are usually substitutes, but they may be poor substitutes. Ex: natural gas. Substitute?