Monopoly
Why monopolies arise
A firm is a monopoly if it is the sole seller of its product an if its product does not have close substitutes. The fundamental cause of monopoly is barriers to entry: other firms cannot enter the market and compete with it. Barriers to entry have three main sources:
- A key resource is owned by one single firm
- The government gives a single firm the exclusive right to produce some good or service
- The cost of production makes a single produce more efficient than a large number of producers.
Monopoly resources
The simplest way for a monopoly to arise is for a single firm to own a key resource. In practice monopolies rarely arise for this reason.
Government-created Monopolies
In many cases, monopolies arise because the government has given one person or firm the exclusive right to sell some good or service. The patent and copyright laws are two important examples of how government creates a monopoly to serve public interest.
Natural Monopolies
An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. When a firm is a natural monopoly, it is less concerned about new entrants eroding its monopoly power. Normally, a firm has trouble maintaining a monopoly position, but in the case of a natural monopoly the entering of the market for another firm is unattractive. Thus as a market expands, a natural monopoly can evolve into a competitive market.
How monopolies make production and pricing decisions
Monopoly versus competition
The key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output.
Because a monopoly is the sole producer in its market, its demand curve is the market demand curve. The monopolist’s demand curve slopes downward for all the usual reasons.
A monopoly’s revenue
For a monopoly, marginal revenue is lower than the price because a monopoly faces a downward sloping demand curve.
Marginal revenue for monopolies is very different from marginal revenue for competitive firms. When a monopoly increases the amount it sells, it has two effects on the total revenue (P x Q):
- The output effect. More output is sold, so Q is higher
- The price effect. The price falls, so P is lower.
The marginal revenue for monopolies is negative, when the price effect on revenue is greater than the output effect.
Profit maximization
The profit maximum for a monopoly is at the quantity where the marginal revenue equals the marginal cost.
Remember:
- For a competitive firm: P= MR = MC
- For a monopoly firm: P > MR = MC
For both the profit-maximizing quantity is the equality of marginal revenue and marginal cost.
A monopoly’s profit
Recall that profit equals total revenue (TR) minus total cost (TC): Profit = TR – TC
Profit = (TR/Q – TC/Q) x Q Profit = (P – ATC) x Q
The welfare cost of monopoly
From the standpoint of consumers, this high price makes monopoly undesirable. At the same time, the monopoly is earning profit from charging this high price. From the standpoint of the owners of the firm, the high price makes monopoly very desirable.
We use total surplus as our measure of economic well-being. Consumer suplus is consumers’ willingness to pay for a good minus the amount they actually pay for it. Producer surplus is the amount producers receive for a good minus their costs of producing it. In this case, there is a single producer – the monopolist. Because a monopoly leads to an allocation of resources different from that in a competitive market, the outcome must fail to maximize total economic well-being.
The deadweight loss
A social planner tries to maximize total surplus, which equals producer surplus (profit) plus consumer surplus.
The socially efficient quantity is found where the demand curve and the marginal cost curve intersect. This is the quantity the social planner would choose. The monopolist chooses to produce and sell the quantity of output at which the marginal revenue and marginal cost curves intersect.
The area of the deadweight loss triangle between the demand curve and the marginal cost curve equals the total surplus lost because of the monopoly pricing
The monopoly’s profit: a social cost?
A monopoly firm does earn a higher profit by virtue of its market power. Welfare in a monopolized market includes welfare of both consumers and producers. Whenever a consumer pay an extra euro to a producer because of a monopoly price, the consumer is worse off by a euro, and the producer is better off by the same amount. This transfer from the consumers of the good to the owners of the monopoly does not affect the market’s total surplus. Meaning the monopoly profit is not a social problem.
The problem in a monopolized market arises because the firm produces and sells a quantity of output below the level that maximizes total surplus. The deadweight loss measures how much the economic pie shrinks as a result.
Public policy towards monopolies
Policy makers in the government can respond to the problem of monopoly in one of four ways:
- By trying to make monopolized industries more competitive
- By regulating the behavior of monopolies
- By turning some private monopolies into public enterprises By doing nothing at all
Increasing competition
The anti-trust laws (USA) give the government various ways to promote competition. The anti-trust laws also allow the US-government to break up companies. Also other countries try to increase competition.
Regulation
Another way in which the government deals with the problem of monopoly is by regulating the behavior of monopolists. This solution is common in the case of natural monopolies.
Public ownership
The third policy used by the government to deal with monopoly is public ownership. That is, rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly. An industry owned by the government is called a nationalized industry.
Doing nothing
Each of the foregoing policies aimed at reducing the problem of monopoly has drawbacks. As a result, some economies argue that it is often best for the government not to try to remedy the inefficiencies of monopoly pricing.
Price discrimination
In many cases monopoly firms try to sell the same good to different customers for different prices, even though the cost of producing for the two customers are the same. This practice is called price discrimination. (Price discrimination is not possible in competitive market)
A parable about pricing
Beispiel: Der Herausgeber eines Buches gibt es zuerst als normales Buch heraus und später gibt er ein Buch mit demselben Inhalt als billigeres Taschenbuch heraus. Seine Fans werden das teurere Buch kaufen, weil sie es möglichst schnell haben wollen (Bsp. Harry Potter). Sie werden diskriminiert im Bezug auf den Preis, weil die Druckkosten für das Taschenbuch kaum geringer sind.
The moral of the story
Three lessons about price discrimination:
- Price discrimination is a rational strategyforaprofit-maximizingmonopolist.
- Price discrimination requires the ability to separatecustomersaccordingtotheir willingness to pay.
- Price discrimination can raise economic welfare
The analytics of price discrimination
Perfect price discrimination describes a situation in which the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price. In reality of course there is no perfect price discrimination. Instead the firms divides the customers in groups differed by their willingness to pay. Nothing about price discrimination can be said is for sure except that price discrimination raises firms profit.
Examples of price discrimination
- Cinema tickets (children/adults)
- Airline Prices
- Discount coupons
- Quantity discount