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14
Understanding
Monopoly
Contrasting Competition
and Monopoly
Competitive Markets
Monopoly
Many firms
One firm
Produces efficient level of
output
(since P = MC)
Produces less than the
efficient level of output
(since P > MC)
Cannot earn long run
economic profits
May earn long run economic
profits
Has no market power
(is a price taker)
Has significant market power
(is a price maker)
Monopoly MR and Demand
The Monopolist’s Profit
The Problems with Monopoly
• Monopolies can make societies worse off
– Restricting output and charging higher prices
compared to competitive markets
– Operate inefficiently (deadweight loss). This
is referred to as market failure.
– Less choices for consumers
– Unhealthy competition called “rent seeking”
Deadweight Loss of Monopoly
Monopoly versus Competition
• Output (quantity)
– QMonopoly < QCompetition
• Price
– PCompetition < PMonopoly
• Deadweight loss
– Monopoly DWL > 0
– Competition DWL = 0
Monopoly Problems
• Few choices
– Restricts consumer ability to put downward pressure
on prices. No substitutes.
– Cable companies and bundling. Monopolies can
force you to buy more.
– And not necessarily the channels you want
What’s So Bad About
Monopolies?
• Compared to Perfect Competition
– Higher Price for Fewer Goods
• Economic Considerations
– P > MC
• Consumer’s value (MV) of Q* > Cost (MC) of resources
used
– Thus -> Deadweight Loss (Economic Inefficiency)
• Allocatively Inefficient
– Q* not produced at lowest cost (ATC >
min(ATC))
• Productively Inefficient
– Little Incentive to Adopt New Technology
• No competition -> no incentive to adopt new tech & reduce
cost
How Did It Happen?
• Monopoly
– Firm that is the sole seller of a product without
close substitutes
• Barriers to entry – prevent firms from
entering this market when there are +
economic profits
• Legal and Cost Barriers
– NBA, Medical, Patents (pharmaceutical)
• Monopoly resources
– Oil, Diamonds, Professional Sports
• Government regulation
– Comcast
• High Cost Barriers to Enter the Market – Aerospace
Barriers to Entry
• Monopolist needs a “barrier” (or
obstacle) to entry so that potential
competitors can’t get into the
Monopolist’s market
– Monopolies earn + long-run and shortrun profits that would “normally” attract
new entrants (i.e. potential competitors)
• Long-run profits = 0 in competitive firms where any
one can enter the market (no barriers)
Types Barriers That Exist and
Can Explain Why a Monopoly
Continues to Persist
• Limiting entry by legally granting
“entry” authorization to people already
in the industry
– AMA, Professional Sports
– New entrants would increase
competition -> driving prices (and
salaries) down
• Incentive to restrict entry
– Revenue sharing – more revenue
Types Barriers That Exist and
Can Explain Why a Monopoly
Continues to Persist
• Legal
– Patent – exclusive (property) right to the particular
ingredients (e.g., Big Pharma)
– Trademark – exclusive right to product name (brand
loyalty)
– Granted/protected by the government
– Meant to encourage investment in research and
development of new products/drugs
• Shkreli claims that the Turing Pharm. is increasing the
price for its prescription drug to conduct R&D for new
drugs
• Shkreli was able to get a new patent for this drug by
showing it could be used to treat a new disease – no
new development; just a new application
Big Pharma
• Big Pharma Is America’s New Mafia
– Pharmaceutical companies have more
power than ever, and the American
people are paying the price—too often
with our lives.
• http://time.com/3700497/john-oliverlast-week-tonight-big-pharma/
What’s So Bad About
Monopolies
• Martin Shkreli In September 2015,
Shkreli received widespread criticism
when Turing obtained the
manufacturing license for the
antiparasitic drug Daraprim and
raised its price by 5,556 percent (from
US$13.50 to US$750 per tablet)
leading him to be referred to by media
as the "most hated man in America".[4]
Types Barriers That Exist and
Can Explain Why a Monopoly
Continues to Persist
• Cost Barrier (High Fixed Costs)
– Large Initial Costs for Plant, Equipment
(i.e., Capital Structures) can prevent entry
• Aerospace
– Has both economies of scale and
– High Fixed (Plant) Cost to enter market
• Market currently dominated by 2 large
manufacturers (Airbus and Boeing)
– Nearly 100% market share (Europe, US
and Asia)
Aerospace
• Boeing and Airbus – Market Share
Types Barriers That Exist and
Can Explain Why a Monopoly
Continues to Persist
– Limited/Scarce Natural Resource
• Entry is limited by “limited” access to the resource
– Oil, Diamonds, Lithium Ion batteries
• Very few places to access the resource
• Once property rights are established – only owner
has access to the resource
– Oil – appox 14 major oil producers
(really only 3 or 4 are major producers)
• Prior to off-shore drilling and fracking
• Requires cooperation among members to “fix”
prices above competitive market price
Economies of Scale
• “Natural” Monopoly
– Having 1 firm produce the good, rather
than several smaller firms, reduces the
average cost of production
• “economies of scale” are present
• However, having the government
“license” the market to 1 provider can
result in “monopoly” like pricing unless
they also regulate its price
– Most require firm to set price at ATC + 10%
(assumes a normal ROR is ~ 10%)
• “cost plus” pricing
How A Firm Could
Limit/Reduce Competition
• Mergers
– Merging with a competitor can
• Reduce competition
• Possible to increase price without worrying about
competitor’s offering a lowering price
• Rational for DOJ, FCC, FTC being
involved and having to approve
mergers
Solutions to Monopoly
• “Divestiture” (Sherman Act (1890)
– Breaking one big company into a
smaller number of “competing”
companies
• AT&T (1982), Standard Oil (1911)
• Telecomm Act (1996)
– Allows competitors to access/rent current Telecomm companies
network at “forward-looking” costs (best, most efficient technology)
• Ignored that: (1) local phone company’s costs based on historical
costs to be recovered over 20 years
• (2) Residential rates subsidized (below costs)for universal service –
higher costs business rates
Professional Sports
• At the federal level, antitrust legislation
serves as one culprit in the city-switching
games played by teams.
• Pro sports leagues have been classified by
government officials as monopolies, and are
therefore subject to antitrust regulation.
• The exception to this has been Major
League Baseball, which operates under an
antitrust exemption, and indeed, baseball
teams remain far less mobile than, for
example, NFL teams.
Solutions to Monopoly
• Preventing anti-competitive mergers
– Sherman Act (1890) – FCC, FTC and
SEC
– AT&T and T-Mobile
• Reduce competition
AT&T – A Short History
• Alexander Graham Bell patented the telephone
in 1876,
– formed Bell Telephone which licensed local
telephone exchanges in major US cities. AT&T was
formed in 1885
• In 1913 AT&T became a regulated monopoly.
– had to connect competing local companies
– And let the Federal Communication Commission
(FCC) approve their prices and policies.
• All customers rented phones from AT&T, and no
other equipment could be attached to the
network for fear of "breaking" it.
AT&T – A Short History
• On January 1, 1984, a court forced AT&T
to give up its 22 local Bell companies
(Divestiture)
• This established seven Regional Bell
Operating Companies (RBOC).
– Since that time, mergers have reduced the
number of RBOCs to four: Verizon
(originally Bell Atlantic and Nynex), Qwest
(Qwest Communications International took
over US West), BellSouth and SBC
(originally Southwestern Bell and Pacific
Telesys).
How Do We “Fix” Monopolies
• Lower Barriers to Entry
– Goal is to increase competition by allowing
more firms to enter the market and compete
against each other
• AT&T Divestiture (1980)
– DOJ and FCC sought to introduce competition
into the local phone markets (dominated by 7
RBOCs, “bab y bells”)
– Required AT&T/RBOCs to lease local wirelines,
switching networks, transmission satellites and
local household connections at “forward”
looking economic costs (which were below
historical costs)
How Do We “Fix” Monopolies
•
AT&T Before and
After the Break-up
•
After the Break Up
Colbert on the AT&T Break-Up
http://www.ebaumsworld.com/video/watch/9
55486/
Natural Monopoly – Avg Cost Decrease with Increasing
Size/Scale of the Firm – Divestiture Raises Avg Cost
Average
Total
Cost
ATC in short
run with
small factory
ATC in short
run with
medium factory
ATC in short
run with
large factory
ATC in long run
6
$12,000
10,000
Economies
of scale
0
Constant returns to scale
1,000
1,200
Diseconomies
of scale
Quantity of Cars per Day
Because fixed costs are variable in the long run, the average-total-cost curve in the short run
differs from the average-total-cost curve in the long run.
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Why Monopolies Arise
• The production process
– A single firm can produce output at a
lower cost than can a larger number of
producers
• Natural monopoly
– Arises because a single firm can supply
a good or service to an entire market
• At a smaller cost than could two or more firms
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– Economies of scale over the relevant
Solutions to Monopoly
• For Natural Monopolies
– Price regulation
• Often, we don’t want to break up firms due to large
economies of scale
• Don’t need to have redundant water pipes, power
lines
– In this case, a monopoly may be
desirable, but we may still need to
regulate the firm to prevent market
power abuse
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Economies of scale as a cause of monopoly
Costs
Average total cost
0
Quantity of output
When a firm’s average-total-cost curve continually declines, the firm has what is called a natural
monopoly. In this case, when production is divided among more firms, each firm produces less,
and average total cost rises. As a result, a single firm can produce any given amount at the
smallest cost
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Regulatory Solution for Natural Monopoly
Marginal Cost Pricing
• At P = MC
– The monopolist experiences a loss
– MC < ATC, so P < ATC (results in losses)
• Solutions?
– Government subsidies given to the firm
– Set P = ATC at the P = MC output level
– Government ownership of the firm
– French approach
• Set P=MC => subsidize ∆ (ATC-MC) from taxes
Government Failure
• Government intervention
– Can eliminate the profit motive and the necessity to
innovate and improve efficiency
• Free market
– Firms under MC pricing have no incentive to lower
costs.
• Price Caps:
– Set maximum price to recover costs (P+ATC)
– Adjust price over time for efficiency
» P(next year) = P(today) – Average Industry Productivity
– Often better than government intervention and
changing incentives for a firm
Conclusion
• While competitive markets generally bring about
welfare-enhancing outcomes for society,
monopolies often do the opposite
– Government seeks to limit monopoly outcomes and
promote competitive markets
• Perfectly competitive markets and monopoly are
market structures at opposite extremes
– Most economic activity takes place between these
two alternatives
Natural Barriers to Entry
• Economies of scale
– “Bigger is better” (more cost-efficient)
– This is due to the ATC being downwardsloping over a large range of output
– Lower costs  lower prices
– Car production, electricity production,
mail delivery
• Natural monopoly
– A monopoly exists because a single large firm
has lower costs than any potential competitor
– In addition, breaking up the firm into multiple
competitors may increase costs as well
Summary
• Monopolies
– Market structure characterized by a single
seller who produces a well-defined product
with few good substitutes
– Operate in a market with high barriers to
entry, the chief source of market power.
– May earn long run profits
• Perfectly competitive firms are price
takers. Monopolists are price makers.
Summary
• Like perfectly competitive firms, a monopoly tries
to maximize its profits.
– Same profit maximizing rule of MR = MC is used.
• From an efficiency standpoint, the monopolist
charges too much and produces too little.
• Since the output of the monopolist is smaller
than would exist in a competitive market, the
outcome also results in deadweight loss.
Summary
• Government grants of monopoly power
encourage rent seeking
• There are four potential solutions to the problem
of monopoly
– First, the government may break up firms to restore a
competitive market
– Second, government can promote open markets by
reducing trade barriers
– Third, the government can regulate a monopolist’s
ability to charge excessive prices
– Finally, there are circumstances in which it is better to
leave the monopolist alone
Practice What You Know
Which of the following firms will most likely be
a natural monopoly?
A.
B.
C.
D.
A grocery store
A cable TV company
A gas station
A barbershop
Practice What You Know
Which of the following most accurately
describes a patent?
A.
B.
C.
D.
An incentive to innovate
A profit-sharing mechanism
A redistribution of wealth
An original invention
Practice What You Know
What is true for a profit-maximizing monopoly?
A.
B.
C.
D.
P = MR = MC
P = MR > MC
P > MR = MC
P > MR > MC
Practice What You Know
What is the reason for monopoly deadweight
loss (relative to perfect competition)?
A. The monopolist faces a downward sloping
demand curve
B. People boycott monopolies more often
C. The monopolist sells less output at a higher
price
D. The monopolist has no competitors
Practice What You Know
A monopolist will have negative profits and exit
the industry in the long run if:
A.
B.
C.
D.
A new competitor enters the industry
Demand becomes more elastic
Price < ATC
A monopolist never has negative profits