Download The Monopoly

The Monopoly
Market power
Monopoly equilibrium
Welfare aspects
The Monopoly

As we concluded last week, perfect
competition is not really a realistic outcome


So “real-life” competition suffers from
imperfection


It is an ideal situation which serves as a
benchmark for evaluating competition
But how can be characterise “imperfectness”?
1st step is to define the opposite benchmark

The most imperfect form of competition
imaginable: the Monopoly
The Monopoly
Market power
The market equilibrium under a
monopoly
Welfare aspects of the monopoly
The monopsony
The 5 conditions of perfect competition

Reminder: Perfect competition is defined by the
following 5 conditions:
5.
Large number of agents (Atomicity)
Homogeneous products
Free entry and exit from the market
Perfect information
Perfect mobility of inputs

All 5 are required for perfect competition to occur
1.
2.
3.
4.
Market power


Reminder: When one of these 5 assumptions
fails to hold, the market is in an imperfectly
competitive situation.
Two main consequences for firms:
 1: Their production decisions influence
the market price of their products

2: Their profits can depend on how
competitors react to these decisions
Market power

1st consequence: Their production decisions
influence the market price of their products




Firms are big enough to start influencing the
price of the market when they change their level
of production
This is market power
This does not occur under perfect competition
because of the atomicity assumption
It is of course maximal for in the monopoly
Market power

2nd consequence: Their profits can depend
on how competitors react to these decisions




Because a change in the production decision of a
firm will change the price, competitors will
probably react. The firm will have to take this
into account.
This is known as strategic behaviour, and is a
central focus of game theory.
Not really relevant for monopolies. There are no
competitors !!
This 2nd aspect will be covered in the next 2
weeks
Market power
The “competition continuum”
Market power of firms
Perfect
competition
Many firms with a
homogeneous
product
Monopolistic
competition
Many firms with
differentiated
products
Oligopoly
A few
producers
with high
market power
Monopoly
A single
producer
Market power


Market power refers to the ability of a firm
(a monopoly here) to influence the price
How can one measure this power ?




In perfect competition we have p =mC
One could expect a firm with market power to try
and push the price above the marginal cost so
that p >mC
This divergence is known as a mark-up and can
be measured,
This gives us our measure of market power.
Market power

Profit of the firm:
  TR  TC

The profit maximisation condition finds
output q such that :
mR  mC


This is valid for any firm, with or without
market power
But what it mR equal to when a firm has
market power?
Market power

Total revenue is simply equal to the quantity sold
times the price at which the output is sold:
TR  p  q

The derivative of total revenue is the sum of:
 The extra quantity produced ∂q times the price
 The effect of the increase on the market price
TR  p  q  p  q

This 2nd effect is equal to zero in perfect
competition, but not when a firm has market
power...
Market power

Dividing through by ∂q gives marginal revenue
TR  p  q  p  q
TR
p
 mR  p   q
q
q


The income generated by an extra unit of output is
equal to the price minus the negative impact of the
extra output on prices
Factorising price:
 p q 
mR  p 1   
 q p 
Market power
One can see that the “complicated” term inside
the brackets is the inverse of the price elasticity of
demand:


 p q 
mR  p 1    
 q p 
1
p 1  D 
  
p 

The term in brackets is our mark-up. This is also
sometimes called the Lerner index, and is the
measure of market power
The profit maximising condition mR = mC can be
written as:
mR  mC


1
p 1  D
 
p


  mC

Market power
Price
Graphical construction of mR
 pD  

1
mR  p  1  D
 
p

 pD  1



The slope of the mR
curve is twice that of
the demand curve
Demand
mR
 pD  0
Quantity
The Monopoly
Market power
The market equilibrium under a
monopoly
Welfare aspects of the monopoly
The monopsony
The market equilibrium under a monopoly

1.
2.
3.
4.
5.
The monopoly is an extreme case. It corresponds
to the following market structure :
A single producer
Homogeneous products
No entry of competing producers on the market
Perfect information
Perfect mobility of inputs
The market equilibrium under a monopoly
Reminder: Perfect competition equilibrium
Firm level
Market level
Price
Price
Positive
profits in SR
  p  q  TC
mC
S
AC
d2=mR2
p2
d=mR
p
Total Cost
q q2
quantity
D
Q
Q2
D2
Quantity
The market equilibrium under a monopoly
Monopoly equilibrium
Price
mC
1st : mC=mR
gives q
2nd
p
AC
2nd : given q,
the demand
curve gives p
Demand
1st
mR
q
Quantity
The market equilibrium under a monopoly
Price
mC
AC
  RT  CT
p
ACq =
TC
pq =
TR
Demand
mR
q
Quantity
The Monopoly
Market power
The market equilibrium under a
monopoly
Welfare aspects of the monopoly
The monopsony
Welfare aspects of the monopoly

Unsurprisingly, the monopoly is inefficient
compared to perfect competition:
Positive economic profit in the LR
 P ≠ mC: there is a mark-up on marginal
cost
 Not producing at minimal AC

Welfare aspects of the monopoly
Monopoly equilibrium

1st element

Price
mC

AC
mR
q
Demand
Quantity
This is due to the
existence of market
power

p
mC
p ≠ mC

The monopoly can
push prices above
the perfect
competition outcome
Prices are a mark-up
over marginal cost
Welfare aspects of the monopoly
Monopoly equilibrium

2nd element

Price
mC
  p  q  TC
AC

The monopoly makes
positive economic
products in the LR
This is due to the
existence of barriers
to entry
p

mR
q
Demand
Quantity
Competitors cannot
enter to compete
away the profit
Welfare aspects of the monopoly
Monopoly equilibrium

3rd element

Price
mC
min AC
AC
AC

p
mR
q
Demand
Quantity

The monopoly does
not produce at the
minimum point of
the AC curve
Some IRS
opportunities are not
used up
This market does not
produce at the most
cost-efficient point
Welfare aspects of the monopoly

There are therefore different sources of
inefficiency in the monopoly
The existence of market power
 The existence of barriers to entry


How can we measure the overall
inefficiency of the monopoly compared to
perfect competition ??

We use the surplus as a measure of
welfare
Welfare aspects of the monopoly
Price
Consumer surplus
mC
AC
Deadweight
loss
p
Producer
surplus
Demand
mR
q
Quantity
Welfare aspects of the monopoly


This is why competition policy often
regulates existing monopolies and attempts
to prevent the emergence of new ones
Examples :




US Antitrust legislation Sherman Act (1890) Clayton
Act (1914)
1911: John Rockefeller's Standard Oil is split
US 1934 Airmail Act splits United Aircraft and
Transport Corporation into Boeing, United Aircraft
(Pratt Whitney, Sikorsky) and United Airlines.
EU vs. Microsoft on Internet Explorer (aka “the
browser wars”)
Welfare aspects of the monopoly


There are different ways of regulating a
monopoly, based on the different
inefficiencies
The typical instrument is the price ceiling

Regulate at p = AC
 Pro: Zero-profits. The average cost is known
 Con: not the most efficient regulation (deadweight loss)

Regulate at p = mC
 Pro: Most efficient regulation (no deadweight loss)
 Con: Some positive profits remain. Difficult to calculate
the marginal cost !!
Welfare aspects of the monopoly
Price
Consumer surplus
mC
Deadweight
loss
p
Producer
surplus
AC
Regulate
at p= mC
p2
Demand
mR
q
q2
Quantity
Welfare aspects of the monopoly
Price
Consumer surplus
mC
Deadweight
loss
AC
Regulate
at p= AC
p
Producer
surplus
p2
Demand
mR
q
q2
Quantity
Welfare aspects of the monopoly

“Schumpeterian” argument:




Monopoly profits are a reward for a risky
investment decision by an entrepreneur
If these potential rewards are denied (through a
tough competition policy), no entrepreneur will
be willing to take risks.
Therefore, monopoly regulation has a negative
effect on innovation
See the Patent argument (Varian, chap 24)
The Monopoly
Market power
The market equilibrium under a
monopoly
Welfare aspects of the monopoly
The monopsony
The monopsony

Opposite situation to the monopoly


A single buyer instead of a single
producer
Similar aspects in terms of market power
and welfare
The buyer’s market power pushes the
price below the marginal cost
 There is a deadweight loss ⇒ inefficient
structure

The monopsony

1.
2.
3.
4.
5.
The monopsony corresponds to the following
market structure, similar to the monopoly case :
A single buyer
Homogeneous products
No entry of competing buyers on the market
Perfect information
Perfect mobility of inputs
The monopsony
Monopsony equilibrium
Price
mC
1st
mC
p
Supply
1st : mC=mP
gives q
2nd : given q,
the supply
curve gives p
2nd
Marginal Product
q
Quantity
The monopsony

How likely is this market structure ?

Actually important for some agricultural products
 Coffee, cocoa, bananas, etc...

Another situation can be the labour market
 There are many more suppliers of labour
(individual workers) than buyers (firms)
 Firms will have monopsony power on the labour
market. This will distort the market outcome !
 We shall examine this again when we talk about
the labour market (week 14)