Study Session 5


Be able to identify the key features of a monopoly and how natural monopolies arise. Know the relationship between price, marginal revenue, average cost, and marginal cost for a monopoly and why monopolies restrict output to an

Focus economically inefficient quantity compared to pure competition. Understand the social benefit of regulation imposing average cost pricing and why marginal cost pricing for a natural monopoly requires a subsidy.

I.OS 19.a: Describe the characteristics of a monopoly, including factors thai allow a monopoly to arise, and monopoly price-setting strategies.

A monopoly is characterized bv one seller of a specific, well-defined product that has no good substitutes. For a firm to maintain its monopolv position it must be the case that barriers to entry to the market arc high.

Barriers to cntrv arc factors that make it difficult for competing firms to enter a market. There are two types of barriers to entry that can result in a monopoly: legal barriers and natural barriers.

Legal Barriers

Most legal barriers to entry do not result in actual monopolies. Restrictions on broadcast licenses for radio and television stations granted by the Federal Communications Commission in the U.S. present significant barriers to entry. Within each market, however, several such licenses are granted, so no one station has a monopoly on radio or television broadcasts. Such restrictions also offer an example of how market power of firms protected from competition by legal restrictions can erode over time as substitute products are developed. The introduction of cable television, satellite television, and, most recently, satellite radio have all significantly eroded the protection offered by possessing a local broadcast license.

Patents, copyrights, and government granted franchises are legal barriers to entry that can result in a single, monopoly, producer of a good in a market. U.S. laws give the U.S. Postal System the exclusive right to deliver mail (although substitute products have been introduced) and local laws grant exclusive rights to water, electric, and other utilities. Patents give their owners the exclusive right to produce a good for a period of years just as copyright protection is offered to the creators of original material. Pharmaceutical firms, semiconductor firms, and software creators are a few of the types of firms that enjoy such protection from competition.

Natural Barriers

In some industries, the economics of production lead to a single firm supplying the entire market demand for the product. When there are large economies of scale, it means that the average cost of production decreases as a single firm produces greater and greater output. An example is an electric utility. The fixed costs of producing electricity and building the power lines and related equipment to deliver it to homes are quite high. The marginal cost of providing electricity to an additional home or of providing more electricity to a home is, however, quite low. The more electricity provided, the lower the average cost per kilowatt hour. When the average cost of production for a single firm is falling throughout the relevant range of consumer demand, we say that the industry is a natural monopoly. The entry of another firm into the industry would divide the production between two firms and result in a higher average cost of production than for a single producer. Thus, large economies of scale in an industry present significant barriers to entry.

A monopoly faces a downward sloping demand curve for its product, so profit maximization involves a trade-off between price and quantity sold if the firm sells at the same price to all buyers. Assuming a single selling price, a monopoly firm must lower its price in order to sell a greater quantity. Unlike a firm in perfect competition, a firm facing a downward sloping demand curve must determine what price to charge, hoping to find the price and output combination that will bring the maximum profit to the firm.

Monopoly Price-Setting Strategies

Two pricing strategies that are possible for a monopoly are single-price and price discrimination. If the monopoly's customers cannot resell the product to each other, the monopoly can maximize profits by charging different prices to different groups of customers. When price discrimination isn't possible, the monopoly will charge a single price. Price discrimination is described in more detail later in this topic.

LOS J9.b: Explain the relation between price, marginal revenue, and elasticity for a monopoly, and determine a monopoly's profit-maximizing price and quantity.

To maximize profit, monopolists will expand output until marginal revenue (MR) equals marginal cost (MC). Due to high entry barriers, monopolist profits do not attract new market entrants. Therefore, long-run positive economic profits can exist. Do monopolists charge the highest possible price? The answer is no, because monopolists want to maximize profits, not price.

Figure 1 shows the revenue-cost structure facing the monopolist. Note that production will expand until MR = MC at optimal output Q*. To find the price at which it will sell Q* units you must go to the demand curve. The demand curve itself does not determine the optimal behavior of the monopolist. Just like the perfect competition model, the profit maximizing output for a monopolist is where MR = MC. To ensure a profit, the demand curve must lie above the firm's average total cost (ATC) curve at the optimal quantity so that price > ATC. The optimal quantity will be in the elastic range of the demand curve.

Figure 1: Monopolistic Short-Run Costs and Revenues

Reduce Costs Atc Curve

Once again, the profit maximizing output for a monopolistic firm is the one for which MR = MC. As shown in Figure 1, the profit maximizing output is Q*, with a price of P*. and an economic profit equal to (P* - ATC ) x Q'.

Monopolists are price searchers and have imperfect information regarding market demand. Thev must experiment with different prices to find the one that maximizes profit.

LOS 19.c: Explain price discrimination, and why perfect price discrimination i.s efficient.

Price discrimination is the practice of charging different consumers different prices for the same product or service. Examples are different prices for airline tickets based on whether a Saturday-night stay is involved (separates business travelers and leisure travelers) and different prices for movie tickets based on age.

The motivation for a monopolist is to capture more consumer surplus as economic profit than is possible by charging a single price.

For price discrimination to work, the seller must:

• Face a downward-sloping demand curve.

• Have at least two identifiable groups of customers with different price elasticities of demand for the product.

• Be able to prevent the customers paying the lower price from reselling the product to the customers paying the higher price.

As long as these conditions are met, firm profits can be increased through price discrimination.

Figure 2 illustrates how price discrimination can increase the total quantity supplied and increase economic profits compared to a single-price pricing strategy. For simplicity, we have assumed no fixed costs and constant variable costs so that MC = ATC. In panel (a), the single profit-maximizing price is $100 at a quantity of 80 (where MC = MR), which generates a profit of $2,400. In panel (b), the firm is able to separate consumers, charges one group Si 10 and sells them 50 units, and sells an additional 60 units to another group (with more elastic demand) at a price of $90. Total profit is increased to $3,200, and total output is increased from 80 units to 110 units.

Compared to the quantity produced under perfect competition, the quantity produced by a monopolist reduces the sum of consumer and producer surplus by an amount represented by the triangle labeled deadweight loss in Figure 3. Consumer surplus is reduced not only by the decrease in quantity but also by the increase in price relative to perfect competition. Monopoly is considered inefficient because the reduction in output compared to perfect competition reduces the sum of consumer and producer surplus. Since marginal benefit is greater than marginal cost, less than the efficient quantity of resources are allocated to the production of the good. Price discrimination reduces this inefficiency by increasing output toward the quantity where marginal benefit equals marginal cost. Note that the deadweight loss (DWL) is smaller in panel (b). The firm gains from those customers with inelastic demand while still providing goods to customers with more elastic demand. Phis mnv even cause production to take place-when it would not otherwise.

An extreme (and largclv theoretical) case o! price discrimination is perfect price discrimination. If it were possible ior the monopolist to charge each consumer the maximum they are willing to pay for each unit, there would be no deadweight loss, since a monopolist would produce rhe same quantity as under perfect competition. With perfect price discrimination, there would be no consumer surplus. Ir would all be captured bv the monopolist.

Figure 2: Effect of Price Discrimination on Output and Operating Profit

(a) Without price discrimination (b) With price discrimination

Price Price

Price Price

Figure 2: Effect of Price Discrimination on Output and Operating Profit

LOS 19.d: Explain how consumer and producer surplus are redistributed in l monopoly, including the occurrence of deadweight loss and rent seeking.

Figure 3 illustrates the difference in allocative efficiency between monopoly and perfect competition. Under perfect competition, the industry supply curve, S, is the sum of the supply curves of the many competing firms in the industry. The perfect competition equilibrium price and quantity are at the intersection of the industry supply curve and the market demand curve, D. The quantity produced is Qpc at an equilibrium price PpC. Since each firm is small relative to the industry, there is nothing to be gained by attempting to decrease output in an effort to increase price.

A monopolist facing the same demand curve, and with the same marginal cost curve, MC, will maximize profit by producing Q^q^ (where MC = MR) and charging a price ofPMON-

The important thing to note here is that when compared to a perfectly competitive industry, the monopoly firm will produce less total output and charge a higher price.

Recall from our review of perfect competition that the efficient quantity is the one for which the sum of consumer surplus and producer surplus is maximized. In Figure 3, this quantity is where S = D, or equivalently, where marginal cost (MC) = marginal benefit (MB). Monopoly creates a deadweight loss relative to perfect competition because monopolies produce a quantity that does not maximize the sum of consumer surplus and producer surplus. A further loss of efficiency results from rent seeking when producers spend time and resources to try to acquire or establish a monopoly.

Figure 3: Perfect Competition vs. Monopoly

LOS I9.e: Explain the potential gains from monopoly and the regulation of a natural monopoly.

Recall that a natural monopoly is an industry in which economies of scale are so pronounced that the ATC of total industry production is minimized when there is only one firm. Here, average total cost is declining over the entire range of relevant outputs. Fixed costs are high and marginal costs are quite low. We illustrate the case of a natural monopoly in Figure 4. Left unregulated, a single-price monopolist will maximize profits bv producing where MR = MC, producing quantity Qy and charging P^.. Given the economies of scale, having another firm in the market would increase the ATC significantly. Note in Figure 4 that if two firms each produced approximately one-half of output Qaq, average cost for each firm would be much higher than for a single producer producing Qy^. Thus, there is a potential gain from monopoly because of lower average cost production when LRAC is decreasing so that economies of scale lead to a single supplier.

Figure 4: Natural Monopoly—Average Cost and Marginal Cost Pricing


Figure 4: Natural Monopoly—Average Cost and Marginal Cost Pricing


Economies of scope can also lead ro a narural monopoly, especially in an industry where economies of scale also exist. Economies of scope occur when a firm expands the range of goods it produces such that its average total cost is reduced. A firm such as Boeing uses very specialized equipment and computer programs to engineer the many parts that go into an airplane. This means that it can produce these components at ?. lower average cost than individual suppliers could.

Regulators often attempt to increase competition and efficiency through eiibrts to reduce artificial barriers to trade, such as licensing requirements, quotas, and tariffs.

Since monopolists produce less than the optimal quantity (do not achieve efficient resource allocation), government regulation may be aimed at improving resource allocation by regulating the prices monopolies may charge. This may be done through average cost pricing or marginal cost pricing.

Average cost pricing is the most common form of regulation. This would result in a price of PAC and an output of Q^ as illustrated in Figure 4. It forces monopolists to reduce price to where the firm's ATC intersects the market demand curve. This will:

• Increase output and decrease price.

• Increase social welfare (allocative efficiency).

• Ensure the monopolist a normal profit since price = ATC.

Marginal cost pricing, which is also referred to as efficient regulation, forces the monopolist to reduce price to the point where the firm's MC curve intersects the market demand curve, which increases output and reduces price but causes the monopolist to incur a loss since price is below ATC, as illustrated in Figure 4. Such a solution requires a government subsidy in order to provide the firm with a normal profit and prevent it from leaving the market entirely.

Regulators sometimes go astray when dealing with the problems associated with markets with high barriers to entry. The reasons for this include:

• Lack of information. Regulators may not know the firm's ATC, MC, or demand schedule.

• Cost shifting. The firm has no incentive to reduce costs, since this will cause the regulators to reduce price. If the firm allows costs to rise, the regulator will allow prices to increase.

• Quality regulations. It is easier to regulate price than it is to regulate quality. If the firm faces falling profits due to a cost squeeze, it may reduce the quality of the good or service.

• Special interest effect. The firm may try to influence regulation by political manipulation designed to influence the composition and decisions of the regulatory board.

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