Lecture (9-12) Microeconomics: Monopoly, Price Discrimination, Oligopoly, Monopolistic Competition, Externalities & Public Goods

Roadmap

Sequence of topics emphasized in the lecture series
- Monopoly → Profit maximization for a single-price monopolist → Cartels → Regulation of Natural Monopoly
- Price discrimination (all forms)
- Measures of market concentration → Oligopoly → Public policy toward oligopoly & monopoly
- Monopolistic competition
- Externalities (negative & positive) → Public goods → Common-property & club goods

Monopoly

1. Characteristics

Single seller dominates the entire market
Product has no close substitutes
Firm is a price-maker (faces the downward-sloping market demand)
Barriers to entry protect monopoly status

2. Barriers to Entry (detailed)

Economies of scale
- If the Average Total Cost (ATC) curve falls over the whole range of market demand, least-cost production occurs with only one producer → Natural monopoly
Ownership or control of essential resources (e.g., diamonds, rail track)
Government regulations: patents, licences, legal franchises
Network effects (product’s value rises with number of users)

3. Demand & Revenue for a Single-Price Monopolist

Market demand curve = firm’s demand curve = Average Revenue (AR) curve
Formulas
- Total revenue TR = p \times Q
- Average revenue AR = \frac{TR}{Q} = p
- Marginal revenue MR = \frac{\Delta TR}{\Delta Q}
Because the firm must lower the price on all units to sell an extra unit, MR < p; therefore MR curve lies below the demand/AR curve

4. Profit Maximization

Choose output Q^* where MC = MR
Price p^ read off the demand curve at Q^
Economic profit rectangle: height (p^* - ATC(Q^)) × base Q^ (red rectangle in slide)
No supply curve: monopolist is not a price taker; chooses point on demand curve that maximizes profit

5. Monopoly vs. Perfect Competition

Competitive output higher, monopoly output lower
In perfect competition p = MC; in monopoly p > MC; difference p - MC is markup
Creates a deadweight loss (DWL): lost surplus to society

6. Inefficiency Diagram

Demand (D) & MR downward; MC upward; competitive price Pc where D = MC; monopoly price Pm where MR = MC
DWL is the triangle between MC and D from Q_m to competitive quantity

7. Schumpeter’s View (dynamic efficiency)

Joseph Schumpeter argued monopoly can be “the most powerful engine of progress” by enabling long-run innovation & expansion, despite static inefficiency

Cartels

Cartel: coalition of producers acting jointly as a monopoly to maximize total profits
Consequences: restricted output, higher price, higher joint profit
Practical Problems
- Enforcing output quotas (individual members have incentive to cheat)
- Preventing new entry (cartel profits attract competitors)

Regulation of Natural Monopoly

Social dilemma: one firm minimizes cost but yields monopoly power
Regulatory approaches
1. Marginal-cost pricing
- Set price p = MC → allocative efficiency
- Leads to losses because p < ATC ⇒ unsustainable without subsidy
1. Two-part tariff
- Lump-sum access fee + per-unit price = MC; recovers fixed cost efficiently
1. Average-cost pricing
- Set price p = ATC → zero economic profit, but p > MC ⇒ DWL
1. Rate-of-return regulation
- Allowed % return on capital; danger of cost padding (“Averch-Johnson effect”)
1. Price-cap regulation
- Regulator sets maximum price path (e.g., CPI – X); firm keeps cost-saving gains

Price Discrimination

1. Definition

Selling identical goods at different prices not justified by cost differences

2. Forms

Among units (first-degree / perfect)
- Charge each unit at consumer’s maximum willingness-to-pay — captures entire consumer surplus; efficient but transfers all surplus to firm
Among market segments (third-degree)
- Charge different groups different prices based on elasticity (student discounts, geographic pricing)
- Profit-maximizing rule: set output in each segment so that MC = MRi where MRi is marginal revenue in segment i; higher price where demand is less elastic
Hurdle pricing (second-degree)
- Firm erects an obstacle (coupon, rebate, time cost, versioning) so consumers self-select; those willing to ‘jump’ pay lower price

3. Prevention of Arbitrage

Physical separation, legal contracts, product differentiation, time separation, digital rights management

4. Consequences

Often raises firm profit above single-price monopoly level
Total output can rise; if so, total surplus ↑ and DWL ↓; consumer welfare ambiguous
Perfect price discrimination eliminates DWL but eliminates consumer surplus entirely

Measures of Market Concentration

1. Four-Firm Concentration Ratio (CR4)

CR4 = \frac{\text{Revenue of 4 largest firms}}{\text{Total industry revenue}} \times 100\%
Industry considered competitive if CR4 < 60\%

2. Herfindahl–Hirschman Index (HHI)

HHI = \sum{i=1}^{N} si^2 where s_i = market share (%) of firm i (up to 50 largest firms)
Interpretation
- HHI < 1500 → competitive
- 1500 \le HHI \le 2500 → moderately concentrated
- > 2500 → highly concentrated

3. Empirical snapshots (Statistics Canada)

Cigarettes: HHI = 4409 (high concentration)
Clothing: HHI = 2657
Computer & electronic products: HHI = 1915 (moderate)
Sporting goods: HHI = 370 (competitive)

Oligopoly

1. Definition & Features

Few sellers, product may be homogeneous or differentiated
Strategic interdependence: each firm’s P, Q choice affects rivals → reactions matter
Analyzed using Game Theory

2. Game-Theory Concepts

Payoff matrix, normal form representation
Nash Equilibrium (NE): each player best-responds to others; no unilateral incentive to deviate
Dominant strategy: best regardless of opponent’s move (not always exists)
Prisoner’s Dilemma: NE is mutually worse than cooperation outcome

3. Duopoly Example (Collude vs. Compete)

If both collude → split monopoly output → high profit
If one competes while other colludes → competitor gets higher profit, other lower
NE: both choose “compete”; joint profit not maximized ⇒ oligopolist’s dilemma

4. Airline Price War Game

Strategies: cut fares 50% or keep price
Profits matrix (in million ):
- Both cut: (400, 400)
- Neither cut: (600, 600)
- One cuts: (800, 200) and vice-versa
NE: both cut (dominant strategy) → lower joint profit

5. Public Policy

Antitrust / Competition laws aim to curb collusion and market power, moving outcome toward competitive benchmark; debates about optimal enforcement

Monopolistic Competition

1. Characteristics

Many firms, each with small market share & acting independently
Product differentiation ⇒ downward-sloping, highly elastic demand per firm
Free entry & exit

2. Short-Run vs. Long-Run

Short run: choose MC = MR; profits may be +, 0, or –
Long run: entry (if \pi > 0) or exit (if \pi < 0) shifts individual demand until economic profit = 0 and MC = MR at tangent where p = ATC

3. Comparison with Perfect Competition

Lower output per firm (excess capacity)
Higher price: positive markup p - MC
Some DWL, but benefits of variety

4. Welfare Nuances

Entry creates product-variety externality (positive) and business-stealing externality (negative)
Hard to measure net welfare; regulation difficult

5. Advertising

Perfect & monopoly: little need (perfect info or no rivals)
Oligopoly & monopolistic competition: heavy advertising to differentiate & gain market share
Pros: info dissemination, stimulates competition; Cons: manipulative, raises cost

Externalities

1. General Definition

Externality = cost/benefit borne by non-decision-maker
Negative (external cost) vs. Positive (external benefit)

2. Negative Externality Example: Paint Pollution

Private Cost = producer’s cost; External Cost = harm to others; Social Cost SC = PC + EC
If unregulated: equilibrium where MC = MSB ⇒ overproduction
Efficient outcome where MSC = MSB; gap generates DWL
Valuation via housing price differentials: rent gap \$500 × 10 homes = \$5{,}000/month external cost

3. Cost Curves

MC: marginal private cost
Marginal external cost: vertical distance between MC and MSC
MSC = MC + \text{external cost}

4. Remedies

Property rights (Coase): internalize externality if transaction costs low; allocation of rights irrelevant to efficiency per Coase Theorem
Command-and-control: mandate clean tech, emission standards
Pigovian Tax: set \text{tax} = \text{marginal external cost} ⇒ MC + tax = MSC; raises revenue and achieves efficiency
Cap-and-Trade: set aggregate emission cap; tradeable permits make marginal abatement cost equal across firms; equivalent to Pigovian tax in efficiency

5. Carbon Tax Case (BC)

Applied to motor fuels; revenue recycled to households/businesses
2007–2016: real GDP ↑ 19\%, net emissions ↓ 3.7\%

6. Global Externalities

Climate change = international prisoner’s dilemma; requires coordination

Positive Externalities: Knowledge & Education

Marginal private benefit MB vs. marginal external benefit → MSB = MB + \text{external benefit}
Unregulated market underproduces (quantity where MB = MSC)
Government tools
1. Public production (state universities)
2. Subsidies equal to external benefit
3. Vouchers (education vouchers allow consumer choice)
4. Patents & copyrights: grant temporary monopoly to encourage R&D

Public Goods

1. Definitions

Non-rivalrous: one person’s use doesn’t diminish others’ use
Non-excludable: impossible/costly to prevent non-payers
Examples: national defence, lighthouse

2. Related Categories

Private goods: rival & excludable (bread)
Common-property resources: rival & non-excludable (fisheries)
Club goods: non-rival & excludable (cable TV, e-book)

3. Efficient Provision

Society’s MSB for public good = vertical sum of individual MB curves
Optimal quantity Q^* where vertical MB = MC
Free-rider problem causes private underprovision
Solutions: taxation & public provision, fostering cooperation

4. Common-Property Resources

Tragedy of the Commons: over-exploitation due to non-excludability
Remedies: assign property rights, quotas, individual transferable quotas (ITQs), social norms

5. Club Goods

Tend toward inefficient exclusion; pricing can promote efficient scale when marginal cost ≈ 0 (e.g., digital goods)

Key Equations & Terms (Quick Reference)

Total Revenue: TR = pQ
Average Revenue / Price: AR = p
Marginal Revenue: MR = \frac{d(TR)}{dQ} (discrete: \Delta TR/\Delta Q)
Markup: \text{Markup} = p - MC
Monopoly profit: \pi = (p - ATC)Q
Marginal Social Cost: MSC = MC + \text{Marginal external cost}
Marginal Social Benefit (positive externality): MSB = MB + \text{Marginal external benefit}$$
CR4 & HHI formulas (see above)

Ethical, Philosophical & Practical Implications

Trade-off between static inefficiency of monopoly and dynamic incentives for innovation (Schumpeterian argument)
Regulation balances consumer protection with incentives for cost reduction & innovation
Equity concerns: who bears Pigovian taxes? Need revenue recycling
Cartels and collusion raise moral and legal questions about fair competition
Advertising: tension between informative role and manipulative potential
Intellectual property: balance innovation incentives with access and diffusion

Connections to Previous & Future Topics

Builds on concepts of cost curves and competitive equilibrium from earlier lectures
Sets foundation for welfare analysis, public policy, and advanced topics like asymmetric information and environmental economics in subsequent modules