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Monopoly, Market Power, and
Economies of Scale
Today: Introduction of situations
in which the Invisible Hand breaks
down
Up until now…

…we have typically analyzed markets
with no control over market price

Each firm was a price taker, since it only
produced a very small fraction of quantity
supplied in the market
Many sellers vs. one seller

Many sellers


No control over price
One seller, also known as a monopolist

Complete control over price (sort of)
Sort of?


Recall that demand curves are
downward-sloping
Each time price increases, fewer people
are willing to pay the price to purchase
the good

The monopolist can control price, but must
face the consequences that price
determines quantity sold
MB in a competitive vs.
monopolistic environment

Competitive environment


MB is price, since price does not depend on
quantity supplied by an individual firm
Monopolistic environment

We will see that MB decreases as quantity
supplied increases
What happens to the monopolist
when it sells another unit?


Each time another
unit is sold, price of
the good decreases
We will go through a
simple example,
shown to the right,
to determine MR for
the monopolist
P
4
Q
0
3
1
2
2
1
3
0
0
Marginal revenue

Marginal revenue



How much additional
is received by selling
one more unit of the
good?
We must first
calculate TR
Notice that for
Q > 1, MR < P
P
4
Q
0
TR
0
MR
3
3
1
3
1
2
2
4
-1
1
3
3
-3
0
4
0
Market inefficiencies of
monopoly

Decreasing marginal revenue creates
inefficiencies in the market

We will talk about this more in the next
lecture
And now, onto the big
question of the day?

How Do Firms Gain Market Power?





Exclusive control over important inputs
Patents and copyrights
Government licenses or franchises
Economies of scale  Natural monopoly
Networks
Exclusive control over
important inputs

If a company controls a significant
portion of the important inputs to a
product, it can have significant
influence on price
Exclusive control over
important inputs

Example: De Beers



Rough diamond explorer
Around 40% of world diamond production
by value
Sales and marketing through the Diamond
Trading Company

This company sells almost half of the world’s
rough diamonds by value
(Information from http://en.wikipedia.org/wiki/De_Beers, checked
Feb. 3, 2008)
De Beers

Such large control over the market
makes De Beers able to act similarly to
a monopolist

Marketing of diamond jewelry does not
have to be brand specific


"A Diamond is Forever" attempts to prevent old
jewelry from entering the market
De Beers does have some control over
world prices
Patents and copyrights

Patents and copyrights prohibit others
from copying private work and
discoveries

Example: Copying songs and movies that
are copyrighted are typically prohibited by
law
Government licenses or
franchises


Government owned property often
allows exclusive operation of the
property for various uses
This is to prevent competition that
could deteriorate a natural destination
Government licenses or
franchises

Example: Yosemite
National Park



Limited parking
Tasteful hotels
Most of the park is
undeveloped


Most of park development
is in only 7 square miles
Park is 1,200 square miles
Vernal Fall
Economies of scale

Some technologies are such that as the
quantity produced increases, ATC
decreases for all reasonable quantities
produced

This is due to increasing returns to scale


This happens when ALL inputs double and
production MORE THAN doubles
Often happens with large fixed costs and
nearly-linear variable costs
Example where a single firm
could gain market power


When a firm gains
market control with
economies of scale, it
is called a natural
monopoly
There are problems
with natural
monopolies if left
uncontrolled

Price ($)
D
ATC
Deal with this later
Quantity
Network economies

What do the following products have in
common?




Skype
Sony IVE
Microsoft's MSN Messenger
Ojo
Network economies


They are all trying
to become the
leader in video
calling programs
This technology has
improved since the
PicturePhone was
unveiled in 1964
Monopoly inefficiency


As we will see, monopolies typically
produce quantities that are less than
efficient
This leads to positive economic profits
Controlling monopolies


Laws have been passed to control
monopoly profits
Regulation typically tries to set
economic profit to be about zero

This sometimes makes regulated stocks a
relatively safe investment
Controlling monopolies


Why are monopolies typically regulated?
We will analyze this in the next lecture


In the absence of regulation, a monopoly will
usually produce a quantity that is below the
optimal amount in order to make positive
economic profits
Monopolies can increase efficiency by price
discrimination

However, the monopolist sometimes benefits more than
consumers do