Microeconomics Notes Monopoly

Monopoly: Assumptions of the model: 1. There is a single firm or a dominant firm in the market. The single firm represents the entire market or industry. 2. The firm produces a good with no close substitutes (if there were close substitutes, it would not be a monopoly). 3. There are high barriers to entry: factors that prevent or make it difficult for other firms to enter the industry and begin production. Understanding Barriers to Entry: Barriers to entry are important features of both monopoly and oligopoly. Examples include: 1. Large economies of scale cause average costs to fall as output increases in the long run. Entry into new firms is difficult as entering on a smaller scale would mean higher average costs and high prices and, therefore, the inability to compete with the existing firm. 2. A natural monopoly occurs when a single firm can cover the needs of an entire market at a lower average cost than two or more firms. Due to the very low average costs of the natural monopolist, new firms are discouraged from entering. 3. Branding involves advertising to create a unique product image and name, attracting consumer loyalty. Firms may be unable to break inro markers with strong brands due to consumer loyalty towards already-existing products. 4. The legislation creates legal barriers, including patents (rights given to firms to be sole producers of a new product for some time), copyrights (rights to authors to be sole producers of written work), and tariffs and quotas (trade barriers restricting imports). 5. Aggressive tactics are methods used by existing firms to prevent outside firms from entering, such as lowering prices to make it difficult for a new firm to compete or threatening the new firm with a takeover. 6. Control of necessary resources involves the ownership or control of essential resources involved in production, such as oil reserves or diamond mines. The monopolist’s demand and revenues about price elasticity of demand (PED): Since P=AR, the AR curve is also the demand (D) curve facing the monopolist. The AR = D and MR curves about PED are shown here. The monopolist does not produce in the inelastic part of the demand curve. In the upper left portion of the demand curve, PED>1; at the midpoint, PED =1; and at the bottom right portion, PED<1. When PED>1, MR is positive (TR increases). When PED=1, MR is Zero (TR is at a maximum). When PED<1, MR is negative (TR decreases). This means that the monopolist will not produce in the inelastic portion of the demand curve. This can be seen from the profit-maximizing condition MR=MC. Since MC is always positive, it cannot equal MR at any negative MR value. Another way to see this is to note that as Q increases, TC increases, but if TR decreases (as it does when MR<1), profit must be falling, which the firm will not accept. Monopolist revenue maximization: Revenue maximization is an alternative goal to profit maximization. Revenue is maximized at the output level where MR=0, corresponding to maximum TR. 1. Find revenue maximizing Q where MR=0. 2. Find the corresponding price (AR=D). 3. The diagram below also shows profit-maximizing Q found by the MC=MR rule. 4. The revenue maximizer has a higher quantity and a lower price than the profit maximizer. Short-run and long-run equilibrium: Because of high barriers to entry, new firms cannot enter the market even if the monopolist is earning abnormal profits (positive economic profits). Therefore, it continues to earn abnormal profits in the long run. The short-run and long-run equilibrium of the profit-making monopolist is the same. Suppose the monopolist is making a loss (negative economic profit) in the short run. In that case, it may either shut down in the long run or continue to operate if it is subsidized by the government (if it is a natural monopoly). Natural monopoly: A natural monopoly is a monopoly with economies of scale so large that when it produces output that satisfies the demand of an entire market, it is still experiencing economies of scale (falling average costs); it is, therefore, not in society’s best interest to break it up, because two or more firms producing the same level of output would do so at a higher average cost. The demand curve of the natural monopolists intersects its ATC at a point where the average costs are falling (still experiencing economies of scale). The reasoning is that if the firm is earning at least normal profit (P=AC), it cannot produce any Q greater than Q* because if it did, P* (given by the demand curve) would be lower than AC, and the firm would be making a loss. Therefore, it must produce a Q less than Q*, but then it is experiencing economies of scale. If this firm were to split up into two or more firms, each would have substantially higher average costs. Therefore, it is not in society’s interest to split it up. Natural monopolies usually have high capital costs, including many public utilities such as water, electricity, and natural gas companies. Price and output compared with perfect competition: The firm in perfect competition has output Qpc and price Ppc, determined by the intersection of demand and the MC (supply) curve. The monopolist has output determined by MR=MC, which is Qm, sold at Pm. Therefore, the monopolist has a higher price and lower quantity produced than the perfectly competitive firm. This result is undesirable from the consumer’s point of view. Efficiency in monopoly: The higher price and lower quantity produced by the monopolist have effects on consumer and producer surplus: 1. Lower Q at Qm: Resource misallocation results from lower production than socially optimum (Qpc), leading to welfare loss and allocative inefficiency. 2. Higher P at Pm: Consumer surplus decreases by (Pm-Pc)*Qm, taken by producer surplus; the monopolist gains at the expense of consumers. The profit-maximizing monopolist cannot achieve productive and allocative efficiency: 1. Productive inefficiency: At Qm, AC is not at a minimum. 2. Allocative inefficiency: At Pm, P>MC. The value consumers attach to the last unit of the good is greater than the cost to produce it. X- inefficiency: The monopolist faces an additional type of inefficiency arising from its lack of competition, making it less careful to keep costs as low as possible. X-inefficiency means that the monopolist’s ATC may be higher than necessary; it may produce at a point such as X rather than at point a, which is on its AC curve. X–inefficiency may arise from poor management, inefficient workers, and a lack of concern about keeping costs low, all due to the lack of competition. Positive characteristics of monopoly: Research and development: Due to abnormal profits in the long run, the monopolist has funds to carry out R and D, leading to new products and technologies that benefit consumers and society. Possible lower prices due to technological innovations: The development and use of new technologies may lead to lower costs and, hence, lower consumer enjoyment. Economies of scale: Due to their large size, monopolistic firms are in a position to achieve large economies of scale, which in the long run result in lower average costs, leading to lower prices for consumers. Natural monopolies: When a firm is a natural monopoly, it can achieve economies of scale so large and AC so low that it is in society's best interest to maintain it as a monopoly. Evaluation of Monopoly: Pros: 1. Research and development. 2. Economies of scale. 3. Natural monopolies. 4. Possible lower prices due to technical innovation. Cons: 1. Allocative and productive inefficiency. 2. Higher prices and lower output for consumers. 3. Loss in CS as an expense of gain in PS. 4. Negative impacts on income redistribution: Some monopolies charge higher prices than perfectly competitive firms. There is a redistribution of income away from consumers who must pay these higher prices towards the owners of the monopoly in the form of higher profits. 5. X inefficiency due to lack of competition. 6. Potentially less innovation: No pressure to innovate because they are shielded from competition from high barriers to entry. Evaluating policies to regulate monopoly power: Monopoly power: The ability to influence price due to a downward-sloping demand curve, leading to resource misallocation and welfare loss. Both monopolies and oligopolies exercise a considerable amount of monopoly power. The inefficiencies of monopolies and oligopolies lead to government efforts to control and limit the degree of monopoly power, aiming to bring prices and quantities of ore in line with competitive markets and limit resource misallocation and welfare loss. Free, unregulated monopolies are generally illegal. Monopolies are allowed to exist mainly if they are natural monopolies, in which case the government regulates them. This applies to both publicly and privately owned monopolies. Abuse of market power: Anticompetitive practices refer to firms engaging in activities that result in reduced competition. Legislation to limit monopoly power: Legislation promoting competition: most countries have laws that: a) Do not permit the formation of monopolies (except natural ones) b) Do not permit collusion (agreements to fix prices and share output) among oligopolistic firms. c) Regulate mergers (agreements between firms to join together), imposing limits on the size of the merged firm to avoid excessive monopoly power. Pros: 1. Legislation is essential since greater competition is in the interests of consumers and society. It leads to greater quantities produced and lower prices, while monopoly power leads to allocative inefficiency and welfare loss. Cons: 1. Vague laws allow for different interpretations of ant-competitive behavior. 2. Depending on political views, there are differences between countries and changes over time in terms of how much monopoly power is too much and how large mergers should be. 3. There are different degrees of law enforcement. 4. There are major difficulties in finding evidence of collusion in oligopoly. Fines: Fines are imposed when a government agency responsible for investigating anti-competitive behavior discovers some wrongdoings. Pros: 1. If implemented properly, it could reduce allocative and productive inefficiency. Cons: 1. Often, these monopolies have higher lawyers who do a full cost analysis, and the profits from the illegal monopolistic activities are greater even with the fines than not being a monopoly at all. 2. Big firms often neglect the ethics of wrongful behavior. Regulation of Natural Monopoly: Government ownership of monopolies – nationalization. Nationalization: The transfer of firm ownership from the private to the public or government sector. Pros: 1. Government ownership allows the government to regulate natural monopolies, forcing them to lower prices and increase quantities produced in the interests of consumers, reducing allocative inefficiency and welfare loss. Cons: 1. Government ownership often leads to inefficiencies and higher-than-necessary production costs, as governments are not driven by the goal of maximizing profits. Government regulation of natural monopolies – marginal cost pricing and average cost pricing. Marginal cost pricing is a method used by governments to force natural monopolies to produce where P = MC. Decreasing p and increasing qty is socially desirable, and P=MC promotes allocative efficiency. Pros: 1. Achievement of Popt Qopt and allocative efficiency. Cons: 1. Losses for natural monopolists: Forcing P=MC results in a price too low for the firm to cover average costs. As a result, the firm either goes out of business or the government needs to subsidize to cover losses. Average cost pricing: Governments force natural monopolies to produce at P=AC, given by the intersection of demand with AC, resulting in Qacp and Pacp. The firm earns normal profit as P=AC. Price decreases, and quantity increases from the MR=MC unregulated monopoly’s output level. Pros: 1. P=AC, so normal profit is earned, and there is no need to shut down. 2. More efficient than the market solution as there is no abnormal profit, less P, and higher Q for consumers. 3. Increase in consumer surplus. Cons: 1. Productive efficiency is NOT archived (production is not at minimum AC). 2. Allocative efficiency is not achieved (P>MC), so welfare is lost. 3. Since the firm is guaranteed a price at P=AC, it has no incentive to keep its costs as low as possible.