MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 10 th Edition, Copyright 2009 PowerPoint prepared by Della L. Sue, Marist College Chapter 15: Using Noncompetitive Market Models

Copyright 2009John Wiley & Sons, Inc. 2 Learning Objectives Determine the relative magnitude of the deadweight loss of monopoly. Ascertain the extent to which, if any, monopolies suppress innovations. Explore whether government intervention can promote efficiency in the case of natural monopoly. Explore the concepts of iterated dominance and commitment in the context of game theory models.

Copyright 2009John Wiley & Sons, Inc. 3 The Size of the Deadweight Loss of Monopoly [Figure 15.1]

Copyright 2009John Wiley & Sons, Inc. 4 Why Are the Estimates of the Deadweight Loss Not Large ? Estimates of the deadweight loss of monopoly in relation to GNP are not large. Reasons: Deadweight loss is compared to the size of the whole economy (GNP), not to the size of the monopoly There are few, if any, pure monopolies in the U.S. We cannot measure the restriction in output in any industry, only actual output.

Copyright 2009John Wiley & Sons, Inc. 5 Other Possible Deadweight Losses of Monopoly 2 undesirable consequences of monopoly: Restriction of output Redistribution of income in favor of the owner of the monopoly Other effects: In the absence of competition with other firms, the monopolist is under less pressure to minimize (production) cost. A monopoly may incur other costs (in addition to production costs) to ensure continuation of its monopoly power.

Copyright 2009John Wiley & Sons, Inc. 6 Do Monopolies Suppress Inventions? Worthwhile invention: one that allows a firm to produce a higher- quality product at an unchanged cost or to produce the same- quality product at a lower cost. A worthwhile invention can be profitable for a monopolist. Figure 15.2

Copyright 2009John Wiley & Sons, Inc. 7 Natural Monopoly Natural monopoly – the case in which the average cost of a single enterprise declines over the entire range of market demand Economies of scale extend to very high output levels. Figure 15.3

Copyright 2009John Wiley & Sons, Inc. 8 How can policymakers do when natural monopoly conditions exist? 4 options: Leave the market alone Permit a monopoly to operate but to regulate its activities Allow the government to own and operate the facility Allow the government to accept competitive bids from potential firms for the right to operate the facility

Copyright 2009John Wiley & Sons, Inc. 9 Regulation of Natural Monopoly: Theory Public utilities – public agencies charged with regulating natural monopolies 2 pricing approaches: Average-cost pricing: AC=demand curve Marginal-cost pricing: MC=demand curve Average-cost pricing is more practical Output is greater and price is lower than if the monopoly were unregulated Monopoly’s owners receive no profit

Copyright 2009John Wiley & Sons, Inc. 10 Regulation of Natural Monopoly [Figure 15.4]

Copyright 2009John Wiley & Sons, Inc. 11 Regulation of Natural Monopoly: Practice Rely on the rate of return on invested capital (accounting profit) earned by a monopoly because complete knowledge of cost and demand conditions is unattainable Problems: The monopolist’s incentive to minimize cost is diminished. Regulated rates reduces the incentive to engage in research and development activities designed to develop new services or new products.

Copyright 2009John Wiley & Sons, Inc. 12 Regulating Natural Monopoly through Public Ownership Example: United States Postal Service (USPS) Objective: P=AC, not profit maximization Profit is constrained to equal zero Incentive to innovate and/or to encourage cost-minimization is attenuated

Copyright 2009John Wiley & Sons, Inc. 13 More on Game Theory: Iterated Dominance Iterated dominance – the concept of eliminating any strategy that is inferior to or dominated by another strategy Table 15.1 (continued)

Copyright 2009John Wiley & Sons, Inc. 14 More on Game Theory: Iterated Dominance (continued ) Eliminating dominated strategies Table 15.2

Copyright 2009John Wiley & Sons, Inc. 15 Iterating Toward an Airline Market Equilibrium (Starting Position ) [Table 15.3]

Copyright 2009John Wiley & Sons, Inc. 16 Iterating Toward an Airline Market Equilibrium (Step 1) [Table 15.4]

Copyright 2009John Wiley & Sons, Inc. 17 Iterating Toward an Airline Market Equilibrium (Step 2) [Table 15.5]

Copyright 2009John Wiley & Sons, Inc. 18 More on Game Theory: Commitment Commitment – the strategy of adopting a particular course of action, constraining one’s choice of strategies, in order to increase your equilibrium payoff Table 15.6

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