Download Monopoly Monopoly Definition A firm is considered a monopoly if

Monopoly
Monopoly
Definition
Herbert Stocker
[email protected]
Institute of International Studies
University of Ramkhamhaeng
&
Department of Economics
University of Innsbruck
Repetition
Remember:
Firms maximize their profits subject to the
restrictions they face.
There are two kinds of restrictions:
Technological restrictions.
Market restrictions.
A firm is considered a monopoly if . . .
it is the sole seller of its product.
its product does not have close
substitutes.
Repetition
Remember:
Technological restrictions are the same for
monopolies and for firms on perfectly
competitive markets.
These are embedded in the cost function:
Remember that we did not need the price of
output for the derivation of the cost function!
Only market restrictions differ between
monopolies and firms on perfectly competitive
markets.
1
Monopoly & Perfect Competition
Monopoly & Perfect Competition
Perfect Competition: Every supplier
perceives demand for his own product as
perfectly elastic, he can sell every unit of
output for the same price.
Therefore, marginal revenue is simply the price,
and firms are price-takers!
Perfect Competition vs. Monopoly
Monopoly: A Monopolist is the only supplier
and there are no close substitutes for his
product. Therefore he perceives that the
demand for his product is falling when he
increases price.
Monopolistic firms are price-seekers; if they
want to sell more, they can do so only at a
lower price!
This has important implications for the
marginal revenue of a monopoly, e.g. marginal
revenue no longer equals price!
Total and Marginal Revenue
Perfect Competition:
P
‘perceived’
Market Demand
Monopoly:
P
‘perceived’
Market Demand
Q
Q
Each producer perceives the
demand for his product as
perfectly elastic.
Monopolist perceives demand
to be less than perfectly
elastic.
Example:
Q =6−P
Total
Marginal Average
Price Quantity
Revenue
Revenue Revenue
P
Q
R =P ×Q
MR
AR = P
6
0
0
–
–
5
1
5
5
5
4
2
8
3
4
3
3
9
1
3
2
4
8
−1
2
1
5
5
−3
1
0
6
0
−5
0
2
Marginal Revenue
Demand: Q = 6 − P
Marginal Revenue
⇒ Inverse Demand: P = 6 − Q
[Inverse Demand allows us to express revenue as a function of Q only]
P
MR
6
5
4
3
2
1
0
Revenue:
R = PQ = (6 − Q)Q
= 6Q − Q 2
Marginal Revenue:
dR
MR ≡
= 6 − 2Q
dQ
0 1 2 3 4 5 6 Q
Linear demand curves ⇒ MR
curve is double as steep as demand curve!
Marginal Revenue
In detail:
R1 = P1 Q1
R2 = P2 Q2
/−
∆R ≡ R1 − R2 = P1 Q1 − P2 Q2
= P1 (Q1 − Q2 ) + P1 Q2 − P2 Q2
= P1 (Q1 − Q2 ) + Q2 (P1 − P2 )
= P1 ∆Q + Q2 ∆P
≈ P∆Q + Q∆P
MR=
∆R
∆Q
∆P
= P + Q ∆Q
If a monopolist increases output there are two
effects:
he can sell the additional produced units of output
only at a lower price P: P × ∆Q
but he has to sell also all other units of output at
this lower price: Q × ∆P
The resulting change in total revenue is
therefore
∆R = Q × ∆P + P × ∆Q
Marginal Revenue is
∆R
∆P
≡ MR = Q ×
+P
∆Q
∆Q
Marginal Revenue
With Calculus:
Market Demand is a function of price:
Q = Q(P)
We rewrite this and express price as a function
of quantity: P = P(Q).
This is called inverse demand function.
Revenue R can then be expressed as a function
of Q only, i.e.
R = P(Q) × Q
For differentiating this use the product rule:
dR
dP
MR ≡
=
×Q +P
dQ
dQ
3
Marginal Revenue
Marginal Revenue
Therefore, marginal revenue depends in a very
specific way on the price elasticity of demand:
Rearranging terms gives
∆P
MR = P + Q ×
∆Q
∆P
Q
= P +P
P
∆Q
Q ∆P
= P 1+
P ∆Q
1
1
=P 1−
= P 1+
EQ,P
|EQ,P |
1
∆R
=P 1−
MR ≡
∆Q
|EQ,P |
When demand is elastic (|EQ,P | > 1) increasing
output will increase revenue (MR > 0).
When demand is inelastic (|EQ,P | < 1)
increasing output will decrease revenue
(MR < 0).
Output, Price Elasticity & Revenue
Monopoly
What happens with monopolist’s revenue, when he
reduces output?
P E = −∞
P E = −∞
el
tic
as
el
bc
tic
as
∆P
bc
E = −1
E = −1
in
tic
as
tic
as
el
el
in
bc
∆P
bc
E =0
∆Q
Elastic Demand:
Q↓⇒ P ↑⇒ R↓
Q
E =0
∆Q
Inelastic Demand:
Q↓⇒ P↑⇒ R↑
Q
Example
We can see from this simple analysis that a
monopolist will never produce a quantity in the
inelastic portion of the demand curve. Why?
If demand is inelastic a decrease of quantity
would increase revenue.
Producing less would lower cost.
This implies he could make higher profits by
reducing the quantity, therefore this cannot be
a maximum!
More generally . . .
4
Profit Maximization
Profit Maximization
Monopolists like all firms maximize profit, and
profit is the difference between revenue and
cost
π =R −C
For a maximum it must be true that
dπ
dR
dC !
=
−
=0
dQ |{z}
dQ |{z}
dQ
MR
MC
Therefore profit maximization implies
Perfect Competition
For a firm on a perfectly competitive market
demand is perfectly elastic, this implies MR = P.
Therefore, profit maximizing firms choose output
where
MR = P = MC
MR = MC
This result is true for monopolists and for firms on
perfectly competitive markets!
Profit Maximization
Monopoly
For a monopolist marginal revenue is
1
MR = P 1 −
|EQ,P |
therefore a monopolist chooses output and price
where
1
MR = P 1 −
= MC
|EQ,P |
MR = MC holds generally, but MR is different for firms under
perfect and imperfect competition!
Monopoly: Profit Maximization
Which
quantity
should a monopolist
produce?
P
Lost
Profit
MC
D(P)
AC
⇒ ⇐
MC MR
MR MC
MR
Q
When marginal revenue is higher than
marginal cost the firm
should produce more!
When marginal revenue is is smaller than
marginal cost the firm
should produce less!
5
Monopoly: Profit Maximization
Which
quantity
should a monopolist
produce?
P
MC
D(P)
bc
AC
MC
MR
MR
Q
∗
QM
Profits are maximized
when the cost of the
last unit are equal the
revenue of the last
unit,
Monopoly: Profit Maximization
Monopolies
are
‘price-seekers’:
P
MC
∗
PM
b
b
AC
MR = MC
Monopoly: Profit Maximization
D(P)
bc
MR
Q
b
∗
QM
Monopolist chooses
the output where
MR = MC, and
charges the maximum
price consumers are
willing to pay for this
output.
Monopoly: Profit Maximization
Profits:
Profits:
P
P
AC
b
Profits are defined as
MC
∗
PM
b
b
π
π = (P − AC)Q
AC
b
∗
QM
MC
Loss
b
b
D(P)
bc
b
∗
PM
MR
Q
D(P)
bc
i.e. profits depend
on average cost and
price!
If AC are high profits
become negative, the
monopoly runs a loss!
(Still, this output level
minimizes losses.)
b
∗
QM
MR
Q
6
Monopoly
In perfect competition, the market supply curve
is determined by marginal cost.
For a monopoly, output is determined by
marginal cost and the shape of the demand
curve (demand elasticity).
Since supply depends on the demand curve,
there is no supply curve for monopolistic
market.
Shifts in demand usually cause a change in
both price and quantity.
Monopoly
Monopoly
Profits of a monopolist:
P
Market demand: P = 4 − Q
4
Revenue: R = 4Q − Q 2
R
Marginal revenue: MR = 4 − 2Q
3
π∗
C
Cost: C = 0.2Q 2 + 0.5
∗
Marginal cost: MC = 0.4Q
P
2
MCCondition for profit maximum:
MR
MR = MC
1
4 − 2Q = 0.4Q
bc
bc
bc
bc
0
0
Example
∗
1 Q2
3
4Q
Q∗
π∗
= 1.667
= R ∗ − C ∗ = 2.833
Profits of a monopolist:
P
4
Q =4−P ↔
R
R = 4Q − Q 2 ,
3
π∗
C
C = 0.2Q 2 + 0.5,
P∗
Q
P
R
0.00
4.00
0.00
2
0.50
3.50
1.75
3.00
3.00
MC 1.00
1.50
2.50
3.75
1.67
2.33
3.89
MR
2.00
2.00
4.00
1
2.50
1.50
3.75
bc
P = 4−Q
MR = 4 − 2Q
MC = 0.4Q
bc
bc
bc
0
0
3.00
3.50
4.00
∗
1 Q2
3
1.00
0.50
0.00
3.00
1.75
0.00
MR
4.00
3.00
2.00
1.00
0.67
0.00
-1.00
-2.00
-3.00
-4.00
C
0.50
0.55
0.70
0.95
1.06
1.30
1.75
2.30
2.95
3.70
MC
0.00
0.20
0.40
0.60
0.67
0.80
1.00
1.20
1.40
1.60
π
-0.50
1.20
2.30
2.80
2.83
2.70
2.00
0.70
-1.20
-3.70
4Q
7
Monopoly: Alternative Presentation
Profit with Total Cost:
P
4
π∗
3
P∗
2
0
C
bc
MR
1
R
MC
bc
∗
1 Q2
3
4Q
π ∗ = R(Q) − C (Q)
Attention:
AC(Q ∗ ) = 0.63̇
MC(Q ∗ ) = 0.66̇
3
P∗
2
bc
MC
π∗
1
bc
0
Profit with Average Cost:
P
4
bc
Long-Run Profit Maximization
AC
bcbc
MR
0
0
∗
1 Q2
3
4Q
In the long run . . .
Monopolist maximizes profit by choosing to
produce output where MR = LMC, as long as
P > LAC
Will exit industry if P < LAC!
Monopolist will adjust plant size to the optimal
level.
π ∗ = (P − AC)Q
Long-Run Profit Maximization
A General Rule for Pricing
Optimal plant is where the short-run average cost curve is
tangent to the long-run average cost at the profit-maximizing
output level.
8
Markup Pricing
Markup Pricing
Remember
MR = P 1 −
1
|EQ,P |
= MC
This can be rearranged to express price directly
as a markup over marginal cost MC
P=h
MC
1−
1
|EQ,P |
i
If e.g. |EQ,P | = 2 then
P = MC/(1 − 0.5) = 2 × MC,
i.e. the monopolist charges double MC!
Markup Pricing: Supermarkets &
Convenience Stores
Example
Supermarkets:
Many firms, similar products.
The estimated demand elasticity for individual
stores is EQ,P ≈ −10
The profit maximizing markup is therefore
P = MC/(1 − 0.1) = MC/0.9 ≈ 1.11MC
Empirical evidence shows that prices are set
about 10 – 11% above MC.
Remember
MR = P 1 −
1
|EQ,P |
= MC
Another way to rewrite this is
P − MC
1
=
P
|EQ,P |
The left-hand side, (P − MC)/P, is the markup
over marginal cost as a percentage of price.
Therefore, the optimal markup as a percentage
of price is simply the inverse of the demand
elasticity!
Markup Pricing: Supermarkets &
Convenience Stores
Example
Convenience Stores:
Convenience differentiates shops
The estimated demand elasticity for individual
stores is EQ,P ≈ −5
The profit maximizing markup is therefore
P = MC/(1 − 0.2) = MC/0.8 ≈ 1.25MC
Prices are set about 25% above MC.
Convenience stores might still have lower profits because of
lower sales volume and high AFC! . . .
9
Markup Pricing: Rule of Thumb
P
Profits
MC
∗
PM
b
D(P)
bc
AC
b
∗
QM
P
π = (P − AC)Q
b
π
Markup Pricing: Rule of Thumb
MR
Q
are highest when
MR = MC,
but managers often
don’t know
their
marginal cost!
Market Power
If demand is very elastic, there is little benefit
to being a monopolist; the larger the elasticity,
the closer to a perfectly competitive market.
Pure monopoly is rare.
However, also a market with several firms, each
facing a downward sloping demand curve, will
produce so that price exceeds marginal cost!
∗
PM
b
b
bc
bc
b
∗
QM
Therefore, managers
sometimes use average
cost AC (or AVC) as
MC
a proxy and produce
where AC = MR.
D(P)
This results in smaller
AC
profits; but the loss
might be small when
MR demand is rather elasQ tic.
Market Power
Firms on markets with imperfect competition
often produce similar goods that have some
differences, thereby differentiating themselves
from other firms.
This gives them (limited) market power. The
analysis in this chapter is also applicable in
these cases.
10
Market Power
Monopoly power is determined by ability to set
price higher than marginal cost.
For a pure monopoly market power is
determined by the elasticity of demand the firm
is facing.
Since the monopoly is the only supplier the
demand it is facing is total market demand.
Degree of monopoly power is determined
completely by elasticity of market demand.
Market Power
Market Power
With more firms in the market offering close
substitutes elasticity of demand is usually much
higher, therefore the have much less market
power.
Demand for a firm’s product is usually (much)
more elastic than the market elasticity.
Even if market demand for eggs should be
inelastic, demand for eggs from a specific farmer
XXX is usually very elastic.
Attention: For Managers only the elasticity of
demand for their own product is relevant!
Measures of Market Power
Lerner Index:
Remember:
Monopoly power, however, does not guarantee
profits.
One firm may have more monopoly power but
lower profits due to high average costs.
Profit depends on average cost relative to price!
measure of market power that focuses on the
difference between a firm’s product price and
marginal cost of production.
L=
P − MC
1
=
P
|EQ,P |
Under perfect competition, i.e. when P = MC,
L = 0.
When L = 1 the market power is highest
possible.
11
Measures of Market Power
Cross Elasticity of Demand:
Percentage change in the quantity demanded of
good X relative to the percentage change in the
price of good Y:
EQX ,PY =
∂QX PY
∂PY QX
The higher the cross price elasticity, the greater the
potential substitution between goods and, therefore,
the lower is market power.
Sources of Monopoly Power
Why do some firms have considerable
monopoly power, and others have little or
none?
The less elastic the demand for a firm’s
product, the more monopoly power a firm has.
The monopoly power of a firm falls as the
number of firms increases; all else equal.
Managers would like to create barriers to
entry to keep new firms out of market.
Measures of Market Power
Concentration Ratios:
Measure market power by focusing on share of
the market held by the largest firms.
Assume that the larger the share of the market
held by few firms, the more market power those
firms have.
Problems:
Describe only one point on the size distribution.
Market definitions may be arbitrary.
Barriers to Entry
Economies of scale and mergers.
Barriers created by government.
Input barriers.
Brand loyalties.
Consumer lock-in and switching costs.
Network externalities.
12
Barriers to Entry
Economies of Scale and Mergers
Exist when a firm’s long run average cost curve
slopes downward or when lower production
costs are associated with larger scale of
operation.
Can act as a barrier to entry in different
industries (→ MES)
Mergers are particularly important in industries
with economies of scale, e.g. technology,
media, and telecommunications.
Barriers to Entry: Natural Monopolies
Natural Monopoly: when a firm can supply a
good or service to an entire market at a smaller
cost than could two or more firms.
A natural monopoly arises when there are
economies of scale over the relevant range of
output, i.e., average cost curve is falling over
the relevant range of output.
Natural monopolies cause market failure, and
are therefore often regulated or run by the
government.
Examples include tap water distribution
systems, bridges, . . .
Minimum Efficient Scale (MES)
MES & Market Entries:
Average cost at half of the MES (1/2 MES) is a
indicator for technological market entry barriers.
AC
AC
High
market
entry
barriers
bc
bc
bc
Low
market
entry
barriers
bc
MES
MES
1 MES
2
1 MES
2
MES
Q
MES
Q
→ important for intensity of competition, Mergers & Acquisitions, . . .
Barriers to Entry
Barriers Created by the Government
Licenses (e.g. for physicians and other
professionals).
Patents and copyrights: The need for patent
protection arises because innovations represent
new information that has the characteristics of
a public good.
Public goods: A good that has high costs of
exclusion and is nonrival in consumption.
Because of free riding behaviour public goods
would not be provided on free markets.
13
Barriers to Entry
Input Barriers
Control over raw materials (e.g. diamonds and
DeBeers).
Barriers in financial capital markets
Larger firms can get lower interest rates.
Smaller firms need more collateral for loans.
Smaller firms are perceived as riskier.
Barriers to Entry
Consumer Lock-In and Switching Costs
When consumers become locked into certain
types or brands and would incur substantial
switching costs if they changed.
Managers often use consumer lock-in and
switching costs strategies to gain market power.
Examples for consumer lock-in and switching
costs strategies:
Contractual commitments
Durable purchases
Brand-specific training
Specialized suppliers
Search costs
Loyalty programs, . . .
Barriers to Entry
Creation of Brand Loyalties
The creation of brand loyalties through
advertising and other marketing efforts is a
strategy that managers use to create and
maintain market power.
Managers hope that demand for their product
becomes less elastic by these measures.
Barriers to Entry
Network Externalities
Act as a barrier to entry because the value of a
product depends on number of customers using
the product.
Can be considered demand-side economies of
scale, in contrast to supply-side economies.
For example software systems.
14
Social Costs of Monopoly Power
P
Social Costs of Monopoly
Power
∗
PM
PC∗
b
b
b
MC = AC
bc
b
Q(P)
MR
b
∗
QM
b
QC∗
Q
(For simplicity we assume constant MC
and AC.)
Perfect Competition & Welfare
P
Perfect Competition & Welfare
Qs
Cost to
producers
Value to
Cost to
buyers
Qd
producers
Q
Value to buyers
Value to buyers
Value
to
buyers
is greater than
cost to sellers!
bc
Monopoly power
results in higher
prices and lower
quantities.
However, does
monopoly power
make consumers
and producers in
the aggregate
better or worse off?
We can compare
producer and
consumer surplus.
P
PC∗
Perfect competition is efficient, because
the allocation of resources
maximizes total
surplus!
Consumer surplus
Qs
bc
Producer
surplus
Qd
QC∗
Q
is less than
cost to sellers!
15
Monopoy & Welfare
Social Costs of Monopoly
P
Social cost of monopoly is likely to exceed the
deadweight loss.
The incentive to engage in monopoly practices
is determined by the profit to be gained.
Rent Seeking: Firms may spend to gain
monopoly power
MC
Deadweight
Loss
PM
PC∗
bc
MR
bc
bc
D
QM
QC∗
Q
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.
Turning some private monopolies into public
enterprises.
Doing nothing at all (if the market failure is
deemed small compared to the imperfections of
public policies).
Lobbying
Advertising
Building excess capacity
Antitrust Laws
Antitrust laws are a collection of statutes
aimed at curbing monopoly power.
Antitrust laws give government various ways to
promote competition.
They allow government to prevent mergers.
They allow government to break up companies.
They prevent companies from performing activities
that make markets less competitive.
16
Antitrust Issues
Antitrust Issues
Focus of the Horizontal Merger Guidelines:
Legislation limits market power of firms and
regulates how firms use their market power to
compete.
Antitrust legislation focuses for example on . . .
Price discrimination that lessens competition.
The use of tie-in sales and exclusive dealings.
Mergers between firms that reduce competition.
Regulation
Definition of the relevant market.
Level of seller competition in that market.
Possibility that a merging firm might affect
price and output.
Nature and extent of entry into the market.
Other factors influencing coordination among
sellers.
Extent to which any cost savings and
efficiencies could offset increase in market
power.
Public Policy Toward Monopolies
Government may regulate the prices that the
monopoly charges:
The allocation of resources will be efficient if
price is set to equal marginal cost.
However, in natural monopolies this will result
in a loss! (When average cost (AC) fall marginal cost (MC)
must be lower than AC. Optimal pricing P = MC would therefore
result in losses!)
In practice, regulators will allow monopolists to
keep some of the benefits from lower costs in
the form of higher profit, a practice that
requires some departure from marginal-cost
pricing.
Rather than regulating a natural monopoly
that is run by a private firm, the government
can run the monopoly itself (e.g., sometimes
the government runs the Postal Service).
Government can do nothing at all if the market
failure is deemed small compared to the
imperfections of public policies.
17
Any Questions?
18