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Chapter 15 Monopoly Ratna K. Shrestha Microsoft’s Windows System When Microsoft designed “Windows” it received a copyright, an exclusive right to sell, from the government. Unlike in a Competitive market where many firms sell identical products, in “windows’ market, Microsoft is a sole seller. The MC of producing a copy of “Windows” CD is just a few $$ and yet its price is well over the MC, Why?? Airline Price Discrimination The airlines sort their customers according to their willingness to pay by offering a maze of advancepurchase and stopover restrictions that attract pricesensitive leisure but not by business travelers. Would it bother you to know what I paid for this seat? Overview Why Monopolies Arise? Production and Pricing Decisions Welfare Cost of Monopoly Public Policy and Monopoly Price Discrimination Monopoly A firm is considered a monopoly if: – it is the sole seller of its product – its product does not have close substitutes – it has some ability to influence the market price of its product or is a price maker A Pure Monopoly exists when a single firm is the only producer or seller of a product that has no close substitutes. Why Learn About Monopolies? It is estimated that about 5% of domestic output is supplied under monopoly conditions. It helps to understand more common market structures such as monopolistic competition and oligopoly. Why Monopolies Arise? The fundamental cause of a monopoly is Barriers to Entry. Ownership of Key Resource Legal Barriers By Government Large Economies of Scale Ownership of Key Resources A single owner of an important resource that cannot be readily duplicated, as with some natural resources. Example: De Beers, a South African Diamond Company, which controls about 80% of world’s diamond production. Government-Created Monopolies Governments also restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets. – E.g., Local cable television – ICBC in basic auto insurance market. ICBC was created by NDP government to give a monopoly to the government owned company (so that US insurance firms cannot enter the market. Patent and copyright laws give a firm or an individual exclusive rights to sell a product. – Certain new pharmaceutical drugs – a book. 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 cost than could two or more firms. A natural monopoly arises when there are economies of scale in production. ATC is smaller when produced by a single large firm than smaller many firms. e.g. BC Hydro, Coast Mountain Transportation, Telus, Terasen. Economies of Scale: Cause of Monopoly Cost ATC MC 0 Quantity of Output Monopoly Behavior Monopoly vs. Competitive Firm Monopoly Sole Producer Downward Sloping Demand Curve. The monopolist faces the whole market demand. Price Setter Reduces Price to Increase Sales Marginal Revenue curve below demand Monopoly Behavior Competitive Firm vs. Monopoly Competitive Firm One of many producers Horizontal Demand Curve: the firm sells all of its products at that same market price determined by the market. So the demand facing the competitive firm is a horizontal line at that market price. Price Taker Sells a lot or a little at the same price Marginal Revenue curve is horizontal and coincides with D curve. Demand Curves for Competitive and Monopoly Firms.. Price (a) A Competitive Firm’s Demand Curve Price (b) A Monopolist’s Demand Curve Demand Demand 0 Quantity of Output 0 Quantity of Output Monopoly’s Revenue Total Revenue: TR = Q x P Average Revenue: AR =TR/Q Marginal Revenue: MR = DTR/DQ A monopolist’s MR < P. The Marginal Revenue curve lies below its demand curve. A Monopoly’s Total, Average, and Marginal Revenue Quantity (Q) 0 1 2 3 4 5 6 7 8 Price (P) $11.00 $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 Total Revenue (TR=PxQ) $0.00 $10.00 $18.00 $24.00 $28.00 $30.00 $30.00 $28.00 $24.00 Average Revenue (AR=TR/Q) Marginal Revenue (MR= DTR / DQ ) $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 -$2.00 -$4.00 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 previously sold units also decreases. As a result MR < P. When a monopoly increases the amount it sells, it has two effects on total revenue. The output effect—more output is sold, so Q is higher. The price effect—price falls, so P is lower. So what happens to R (=PQ) is ambiguous; it depends on the elasticity of demand. Demand and Marginal Revenue Curves for a Monopoly... Price $11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 Demand (average revenue) Marginal revenue 1 2 3 4 5 6 7 8 Quantity of Water Profit Maximization of a Monopoly A monopoly maximizes profit by producing the quantity at which MR = MC. If MR > MC, profits can be increased by producing more. When MR = MC, there is no more opportunities to further increase profits. It then uses the demand curve to find the price that will induce consumers to buy that quantity. At this reduced quantity, consumers are willing to pay more and as a result P > MC. Profit-Maximization for a Monopoly.. 2. ...and then the demand curve shows the price consistent with this quantity. Costs and Revenue B Monopoly price 1. The intersection of MR curve and the MC curve determines the profit-maximizing quantity... Average total cost A Demand Marginal cost 0 Marginal revenue QMAX Quantity 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 Profit = TR – TC = (P - ATC) x Q As long as PM > ATC, economic profits will be earned. Monopolist’s Profit... Costs and Revenue Marginal cost Monopoly E price B Average total cost Average total cost D C Demand Marginal revenue 0 QMAX Quantity Case Study: Monopoly Drug Vs. Generic Drugs When a firm discovers a drug, patent laws give it a monopoly over the sales of that drug. But eventually, the firm’s patent runs out and the market switches to competitive one. Case Study: Monopoly Drug Vs. Generic Drugs Costs and Revenue Price during patent life Price after patent expires MC MR 0 QM Demand QC Quantity The Welfare Cost of Monopoly At monopoly prices, some potential consumers value the good at more than its MC but less than the monopolist’s price. These consumers do not end up buying the good. Monopoly pricing prevents some mutually beneficial trades from taking place deadweight loss. Because a monopoly sets price above MC it places a wedge, similar to a tax. As in the case of tax, the wedge causes the quantity sold (QM) to fall short of the social optimum (QC). The Efficient Level of Output... Marginal cost Price PM Goods in between QC and QM are not traded even if Value to Buyers > Costs to Sellers Demand (value to buyers) 0 QM QC Value to buyers is greater than cost to seller. Quantity Monopoly’s Deadweight Loss Price MC = Supply Monopoly DWL PM Efficient Quantity Q*! D QM MR Quantity Monopoly Deadweight Loss The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax. The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit. Monopoly charges a higher price and consumers pay that higher price. The extra profits/producer surplus the monopolist make (over the competitive market situation) is less than the loss in consumer surplus—the source of deadweight loss. Public Policy Toward Monopoly Government may intervene by. . . Creating a competitive market Implement/Enforce competition laws Regulating the behavior of monopolies Price control and regulation Public Ownership Government runs the monopoly itself Doing Nothing 1. Competition with Antitrust Laws In the United States, the competition laws are called antitrust laws; in Canada we call them competition laws. Antitrust (or competition) 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 (e.g., in 1975 US govt. broke AT&T into 15 “baby bells.”) They prevent companies from performing activities which make markets less competitive. Antitrust Laws in Canada First Antitrust Law in Canada (1889) Reduced the market power of the large and powerful “trusts” of that time. Recent Acts (1986): Competition Act Competition Tribunal Act. These acts are enforced by Competition Bureau, which is under Industry Canada. Antitrust Laws in Practice In 1990, the merger of Imperial Oil and Texaco was blocked. Similarly, in 1998 the merger of RB and BMO; and that of CIBC and TD was blocked. Benefits from merger: Reduced Cost of operation such as overhead/administrative costs. Social Cost of merger: Monopoly power and resulting deadweight loss. 2. Regulation Government may regulate the prices that the monopoly charges. The allocation of resources will be efficient if P = MC. In the case of Natural Monopoly, If price is regulated to be equal to MC, P < ATC and the monopolist will incur loss. In this case, the govt. can allow a natural monopolist to charge P = ATC. Or the govt. can enforce P = MC and cover the loss by providing a subsidy. MC Pricing for a Natural Monopoly... Price Average total cost Regulated price Average total cost Loss Marginal cost Demand 0 Quantity 3. Public Ownership Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself. e.g. (1) (2) Federal Corporations: Canada Post, CBC. BC crown corporations: BC Hydro, ICBC, BC Tel, etc. In this case what is possible is the government can have P = MC to avoid DWL and cover the loss from general taxation. 4. Doing Nothing Government can do nothing at all if the market failure due to Monopoly (measured in terms of DWL) is deemed small compared to the imperfections of public policies (regulation). Regulation itself can sometimes cause more welfare loss than no regulation especially when the government has no (or imperfect) knowledge on the market demand and supply curve and hence the efficient point. Price Discrimination The practice of charging different prices for different units of the same product, to different customers. Conditions required for price discrimination: – Is not possible in a competitive market. – In order to price discriminate, the firm must have some market power. – There should be no opportunities for arbitrage— a practice of buying at a cheaper price at one location and resell it at a higher price at another location. Examples: Price Discrimination Quantity Discounts: Long distance telephone rates: different rate for first minute and subsequent minutes. Airline Tickets: first class vs. economy class, one-way vs. round-trip. Discount Coupons: target group is price sensitive consumers who are more likely to use coupons. Financial Aid: Needy vs. wealthy students. Two-part tariff: Cell-phone plans: subscription fee/month and then extra price for each minute of call. Block Pricing: one price for the fist 100 L of water then after higher price. Peak-load Pricing: higher energy price during winter. Movie Tickets: Adult, Children, Senior rates. Examples 1. Perfect Price Discrimination Perfect or first-degree price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price, according to his/her willingness to pay. Perfect price discrimination is difficult in practice. Some of the close examples are: Car dealerships: they charge different price depending on your bargaining power (or willingness to pay) Ticket Scalping: the scalper charges different prices depending on customers willingness to pay. Welfare Without Price Discrimination (a) Monopolist with Single Price Price Consumer surplus Monopoly price Deadweight loss Profit Marginal cost Marginal revenue 0 Quantity sold Demand Quantity Welfare With Price Discrimination... Price (b) With perfect price discrimination DWL = 0. Monopolist extracts all the Consumer Surplus. PS Marginal cost Demand 0 Quantity sold Quantity 2. Second-Degree Price Discrimination Examples: Quantity discounts – Buying in bulk like at Sam’s Club Block pricing – the practice of charging different prices for different quantities of “blocks” of a good – Electric power companies charge different prices for a consumer purchasing a set block of electricity 3. Third-Degree Price Discrimination Practice of dividing consumers into two or more groups depending upon their demand (curves) and charging different prices to each group. Most common examples: – Airlines’ economy and business class fares, premium vs. non-premium liquor, discounts to students and senior citizens, frozen vs. canned vegetables. – Coupons. Example: Economics of Coupons and Rebates Those consumers who are more price elastic will tend to use the coupon/rebate more often when they purchase the product than those consumers with a less elastic demand. Thus, coupons and rebate programs allow firms to price discriminate based on their demand elasticities. Price sensitive consumers end up paying lower prices whereas other non-price sensitive consumers pay regular prices. How to Price a Best Selling Novel? Publisher must divide consumers into two groups: – Those willing to buy more expensive hard back – Those willing to wait for cheaper paperback Have to be strategic about when to release paperback after hardback – Publishers typically wait 12 to 18 months So this kind of publisher’s practice is an example of third-degree price discrimination. 4. The Two-Part Tariff Form of pricing in which consumers are charged an entry fee and usage fee as well. – EX: amusement park, golf course, telephone service, cell phone service. A fee is charged upfront for right to use/buy the product. An additional fee is charged for each unit the consumer wishes to consume – Pay a fee to play golf and then pay another fee for each game you play. Two-Part Tariff with a Single Consumer $/Q T* P* Usage price = P* is set equal to MC. Entry price = T*, the entire consumer surplus. Firm captures all consumer surplus as profit. MC D Quantity 5. Bundling Gone with the Wind Getting Gertie’s Garter Theater A $12,000 $3,000 Theater B $10,000 $4,000 Renting the movies separately would result in each theater paying the lowest reservation price for each movie: – Maximum price for Wind = $10,000 – Maximum price for Gertie = $3,000 Total Revenue = $26,000 Bundling If the movies are bundled: – Theater A will pay $15,000 for both – Theater B will pay $14,000 for both If each were charged the lower of the two prices, total revenue will be $28,000. The movie company will gain $2000 more revenue by bundling the movie (than selling separately). More profitable to bundle because relative valuation of two films are reversed. That is, demands are negatively correlated. – A pays more for Wind ($12,000) than B ($10,000). – B pays more for Gertie ($4,000) than A ($3,000). Bundling: Relative Valuations If the demands were positively correlated (Theater A would pay more for both films as shown) bundling would not result in an increase in revenue. Gone with the Wind Getting Gertie’s Garter Theater A $12,000 $4,000 Theater B $10,000 $3,000 Bundling If the movies are bundled: – The most Theater A would pay = $16,000 – The most Theater B would pay = $13,000 The maximum price that could be charged if bundled = $13,000. Thus, total revenue will be $26,000, the same as by selling the films separately. Price Discrimination Two Important Effects of Price Discrimination: – Can increase the monopolist’s profits. – Can reduce deadweight loss by increasing the producer surplus, and not the consumer surplus. Monopoly power is common. Most firms have some control over prices because of differentiated products. Baskin - Robins Ice Cream vs. Breyer’s Designer’s clothes vs. No-Name brands – However, firms with substantial monopoly power are rare because few goods are truly unique.
