Topic 8: Monopolies

Question 1

What are the assumptions in monopolies

Answer 1

1. There is only ONE firm – but many buyers
2. There are prohibitive barriers to entry for potential entrants
3. Resource mobility and market information may be influenced by the monopolist
4. The monopolist aims to maximise profits
5. There are no close substitutes for this product.

Question 2

How do monopolies arise?

Answer 2

• probably the single most important characteristic of monopoly is the barriers to entry condition. These barriers can take a number of forms:
  1. Government blocks the entry of more than one firm into a market
• patents and copyright incentives – a patent is a legal barrier to entry that conveys to its holder the exclusive right to supply a product for a certain period of time
• granting a public franchise (exclusive provider)

1. One firm has control of a key resource material necessary to produce a good
   * occurs when a firm controls some non-reproducible resource critical to production
2. There are important network externalities in supplying the good or service
   * getting a ‘critical scale’ of users makes entry difficult for other firms − e.g. Windows operating system, Facebook
3. Economies of scale are so large that one firm has a natural monopoly

• when a single firm experiences substantial economies of scale (a single firm can satisfy the market at a lower average cost per unit) e.g. gas and electricity, NBN Co
• reliant on infrastructure

Question 3

Describe revenue in monopolies

Answer 3

• because the monopolist supplies the entire market, the market demand curve is also the demand curve faced by the monopolist this has implications for revenue: in perfect competition firms were price takers (so MR curve horizontal). this is not so for the monopolist.
• if the monopolist wishes to ↑ production, it must lower its price not just for the additional units, but for all units.
  
  • a gain in revenue from selling more output
  • a loss of revenue from selling each unit at a lower price.
• marginal revenue is the extra revenue from selling one more unit of output, in perfect competition this was the same as price, but not here.

Economic profit

• cost curves for monopolist are the same as in perfect competition;
• profit-maximising rule is also the same: MR = MC
• but it is MR we look at, not price, do π-max level of output occurs at Q*
• although MR=MC is profit max, consumers pay P*
• once π-max Q has been found, read up to the demand curve to determine price charged to consumers
• the amount of economic profit is also calculated in same way as perfect competition: [P*-ATC*] x Q*
• in the long run:
  
  • because of barriers to entry, the distinction between the long and short run for a monopolist is not as relevant – monopolists can enjoy positive economic profits indefinitely
  • it is not true, however, to say that a monopolist can charge ‘whatever they like’. Monopolists are constrained by the demand for their product, as well as their costs

Question 4

Are monopolies economically efficient?

Answer 4

• equilibrium in perfect competition is where P=MC
• equilibrium in monopoly is where MR=MC
• Consumer surplus: Perfect comp = A + B + C Monopoly = A [consumers lose B + C]
  
  • Can see that consumers lose under a monopoly compared to perfect competition. Prices are higher (PM > PPC), and output lower (QM < QPC)
• Producer surplus: Perfect comp = E + D Monopoly = E + B [producers lose D < gain of B] – greater positive profits in short run and long run
  
  • Producers have a net gain, because Area B (captured from consumers) is greater than the loss from Area D.
  • there is a deadweight loss from a monopoly: DWL = C + D, by restricting output, the MB to consumers (at PM) is > the MC. Society would benefit from the monopolist producing additional units, but they won’t because they gain more by keeping output at QM

Question 5

Are monopolies productively/allocatively efficient?

Answer 5

• productive efficiency: the monopolist, because it is insulated from competition, has no need to produce at min ATC. Therefore produces to the left of min ATC at ATC1.
• allocative efficiency: P>MC/MB>MC consumers value last unit at Pm and want more resources devoted towards it

Question 6

Are monopolies dynamically efficient?

Answer 6

• generally not an economically efficient market structure but there are potentially dynamic elements where over time, the monopoly can adopt the most efficient productive techniques
• rationale: technological change over time promotes ‘creative gales of destruction’ – blowing out old inefficient industries and bringing in new dynamic industries
• argument for monopolies being dynamically efficient due to heavy investment in research and development
  
  1. Only extremely large firms have the ability to undertake very expensive R&D – in competitive markets, smaller firms w potentially not the capacity to undertake this
  2. Given the role of technological innovation in modern economies, this private expenditure on R&D allows for more innovation than would be possible from the public sector alone (universities for example).

Question 7

What are reasons for giving patents?

Answer 7

• the patent is a ‘reward’ for undertaking research and development:
  
  • allows the producer to recoup their investment (and then make further investments).
• physical production costs are usually very low:
  
  • so if no patent protection were given it would be impossible to recoup this investment.
• example: in 2001, the patent on the world’s most popular antidepressant, Prozac, expired. Before the patent expired, one pill sold for around $2.40, and earned its producer, Eli Lilly, around $2.7 billion per year. Within a few weeks, prices had fallen from $2.40 (for Prozac) down to $0.32 for its generic counterpart. Eli Lilly’s earnings fell 22%, and its market share went from 100% down to 30% within six months
  
  • in short run, no incentive to undertake research and development due to extremely high costs, high price allows for this

Question 8

What is price discrimination and what are the conditions for it to occur?

Answer 8

def.: increasing profit by selling the same good at different prices to different consumers for reasons unrelated to cost

Conditions for price discrimination

1. Firm must have some degree of market power (does not have to be a monopolist though)
2. Consumers must have different elasticities of demand
3. The firm must be able to identify these different elasticities and be able to charge accordingly
4. Re-sale by consumers is not possible.

Question 9

Describe first degree price discrimination

Answer 9

• market demand curve shows the maximum price consumers are willing to pay for each unit of output
• firms would love to be able to charge each consumer this maximum willingness to pay - they would be able to convert every dollar of consumer surplus into producer surplus, and hence increase revenue (and profit)
• assume ATC is constant and assume different prices are changed (to match different consumers’ MB)
• allocatively efficient, because the marginal cost of the last unit produced is equal to the price they charged for that unit. • i.e. there is no DWL.
• not a reason for giving monopolists more market power, because:

1. First degree price discrimination is very rare
2. Consumer surplus is still zero – equity issue
3. There is no reason why firms will be productively efficient.

Question 10

Describe second degree price discrimination

Answer 10

• much more common in economies
• consumers ‘self-select’ themselves as having a particular ED - the firm will offer a range of different pricing schemes and consumers will select which one they want
• examples:
  
  • airline tickets – MC is essentially 0, demand is more elastic when booking in advanced (leading to lower price offered)
  • phone contracts
  • supermarkets: home brand – trying to get as far down on the demand curve as they can (maximising profit), discount coupons and discounts to bulk buyers

Third degree

Question 11

Describe third degree price discrimination

Answer 11

• the difference to 2nd degree is here there is generally no choice.
• different types of consumers are ‘lumped together’ as having the same elasticity – over time have figured out general elasticity of group, can do more than one elasticities
• examples: movie tickets – you’re either a student / pensioner / adult or you’re not; bus and train tickets – same principle as above;

Question 12

Describe imperfect price discrimination

Answer 12

• assume constant (same) marginal costs for both segments, and the firm can divide the market into two broad segments
• Π max is calculated in the normal way for each segment (MR=MC)
• can see that the consumers in the inelastic market pay more (P1) than those in the elastic segment (PE).
• importance of ‘no re-sale’: – If re-sale possible, then people would buy in the elastic market and sell it for more in the inelastic market. This would raise the price in the elastic segment (↑ demand) and lower it in the inelastic segment (supply ↑)

Question 13

What are the implications from price discrimination?

Answer 13

1. Good for firms: firms can earn higher profits than if they didn’t price discriminate (that’s why they do it!)
2. Bad for buyers in total
   
   • using price discrimination, different prices are charged to different buyers, and prices span higher and lower than the one price which would be charged if price discrimination was not possible
   • this means that some are worse off because they now enjoy less consumer surplus, but some buyers (with the highest price elasticity or lowest ability/willingness to pay) are now able to procure the good/service whereas they would otherwise be priced out of the market

nonetheless, the total consumer surplus will always be lower with price discrimination than without.