Microeconomics - Monopoly

Chapter 12: Monopoly

Introduction to Monopoly

  • Monopoly is a market structure where a single firm supplies a unique product without close substitutes.
  • A monopoly can be a potential advantage for society, which will be explored further.
  • The mere mention of "monopoly" often evokes negative associations.
  • Schering-Plough Corporation, as an example, held a patent for Claritin, granting them exclusive rights to produce and sell it for twenty years.

Monopoly vs. Competitive Firms

  • A firm with market power behaves differently from a competitive firm.
  • Monopolists produce less and charge more, improving their economic position by securing economic profits in both the short and long term.
  • These gains occur at the expense of consumer welfare and a reduction in social surplus.
  • Governments actively control and regulate monopolies due to public concerns.

Price-Takers vs. Price-Makers

  • In competitive markets, firms are price-takers.
  • A more common situation is one in which a firm is a price-maker, meaning it sets the price of the good.
  • This ability comes from holding market power.
  • Monopoly represents an extreme case of market power.
  • In a monopoly, only one firm provides a good without close substitutes and doesn't worry about the behavior of others.

Perfect Competition vs. Monopoly

  • Number of Firms: Many in perfect competition, one in monopoly.
  • Product: Homogeneous in perfect competition, unique in monopoly.
  • Example: Corn in perfect competition, patented drugs or tap water in monopoly.
  • Barriers to Entry: None in perfect competition, high in monopoly.
  • Price Control: Price-taker in perfect competition, price-maker in monopoly.
  • Price Relationship: P = MR = MC in perfect competition, P > MR = MC in monopoly.
  • Demand Curve: Perfectly elastic (horizontal) in perfect competition, downward sloping in monopoly.
  • Social Surplus: Maximized in perfect competition, not maximized in monopoly.
  • Long-Run Profits: Zero in perfect competition, potentially greater than zero in monopoly.

Sources of Market Power

  • Market power arises from barriers to entry.
  • Barriers to entry prevent potential competitors from entering the market, protecting the firm from competition.
  • Examples include Facebook and Google.
  • Barriers range from complete exclusion of new entrants to preventing new firms from competing on equal terms with existing monopolists.
  • There are two types of market power: legal and natural.

Legal Market Power

  • Legal market power is obtained through barriers created by the state.
  • These barriers can be patents or copyrights.
  • Patents: Exclusive rights to produce, sell, or license a good or service.
  • Copyright: Exclusive rights to the creator of an original work.
  • Disadvantages include higher costs for consumers.
  • Advantages include incentives for research and development due to patent protection.

Natural Market Power

  • Natural market power arises organically.
  • It is obtained through barriers to entry created by the firm itself.
  • Examples include railway networks, roads, water distribution networks, and airports.
  • Two main sources:
    • Control of a key resource.
    • Economies of scale.
  • A natural monopoly occurs when economies of scale make it efficient for a single firm to supply a good or service.
  • This is typical in activities requiring large initial investments, like utilities and infrastructure.

Key Resources and Network Externalities

  • Key resources are essential for producing a good or service.
  • Controlling the entire supply of a key resource is a way to develop market power.
  • Another key resource is individual talent.
  • Network externalities occur when the value of a product increases as more consumers use it (e.g., Facebook or Twitter).

Natural Monopoly

  • With economies of scale, the average total cost decreases as production increases.
  • The marginal cost remains constant.
  • Only one firm operates in the market, and its average total costs are lower than those faced by multiple firms.

The Monopolist's Problem

  • The monopolist's problem shares two aspects with that of a competitive firm:
    • Understanding how to combine inputs to obtain products.
    • Knowing the costs of production.
  • However, the main difference is that the monopolist faces the market demand curve, which is downward sloping.
  • Unlike a perfectly competitive firm, the monopolist can raise the price without losing all its business.
  • To increase sales, it must lower the price.

Demand and Revenue

  • In perfect competition, D = MR = P and the demand is perfectly elastic.
  • The monopolist faces a downward-sloping demand curve, creating a trade-off between price and quantity.
  • The monopolist faces the entire market demand alone.
  • A monopoly is powerful but cannot push sales beyond the market demand curve.

Claritin Example

  • To illustrate changes in total revenue as the price varies, consider Schering-Plough selling Claritin.
  • Their goal is to maximize profits from the drug.
  • Claritin is used for allergies, and Schering-Plough has a patent on it.
  • The key is to understand the market demand curve for Claritin.
  • A higher price means more revenue per unit but fewer units sold.
  • TR = P \times Q is the total revenue.
  • Marginal revenue is the change in TR from selling one additional unit.
  • Changes in TR depend on the elasticity of demand.

Price vs. Quantity Effect

  • If the monopolist lowers the price from $5 to $4, the effect on total revenue depends on the price effect and the quantity effect.
  • The price effect is the change in revenue due to the price change.
  • The quantity effect is the change in revenue due to the quantity change.
  • The net effect depends on the elasticity of demand.
  • If demand is elastic, reducing the price leads to higher revenues.

Elasticity of Demand Example

  • Price decreases from $5 to $4 (20% decrease).
  • Quantity demanded increases from 200 to 400 (100% increase).
  • Elasticity = 100%/20% = 5.
  • Since demand is elastic, the quantity effect outweighs the price effect.

Optimal Quantity and Price

  • The marginal revenue curve lies below the demand curve because, to increase sales, the monopolist must lower the price on all units sold.
  • The change in total revenue from an additional unit is always smaller.
  • MR = a - 2bQ where RT = aQ - bQ^2
  • The marginal revenue curve is twice as steep as the demand curve and intersects the x-axis at half the quantity.
  • The demand curve is the average revenue curve.

Total, Marginal, and Average Revenue

  • Total Revenue: RT = aQ - bQ^2
  • Marginal Revenue: RM = a - 2bQ (derivative of RT with respect to Q).
  • Average Revenue: RT/Q = a - bQ
  • The slope of the demand curve is -1, while the slope of the marginal revenue curve is -2.
  • The marginal revenue curve lies below the demand curve and is twice as steep.

Maximizing Total Revenue

  • Total revenue first increases and then decreases.
  • When marginal revenue crosses the x-axis, further sales reduce total revenue.
  • Total revenue is maximized when MR = 0.
  • Producing at the point where MR = 0 maximizes total revenue, but not necessarily profit.

Choosing the Optimal Production Level

  • The monopolist chooses the production level by comparing marginal cost and marginal revenue.
  • In perfect competition, MR = P, while in monopoly, MR < P.
  • If MR > MC, the monopolist should expand production.
  • Production should increase until MR = MC.
  • Unlike perfect competition, where P = MR = MC, the monopolist is a price-maker.
  • After determining the optimal quantity, the monopolist sets the selling price.

Setting the Price

  • The decision regarding price is critically linked to the nature of the market's demand curve.
  • At the optimal quantity where MC = MR, the monopolist sets the price according to the demand curve.
  • P > MR = MC in monopoly.
  • P = MR = MC in perfect competition.
  • The monopolist sets the price according to the demand curve, while the market determines the price in perfect competition.

Calculating Profits

  • At the optimal production level where MC = MR, profit is calculated as:
  • Profit = TR - TC = (P \times Q) - (ATC \times Q) = (P - ATC) \times Q
  • In a monopoly, profits can persist due to barriers to entry.
  • Without the threat of new competitors, there's no increase in supply to drive down prices and eliminate economic profits.

No Supply Curve in Monopoly

  • Monopolies do not have a supply curve because, as price-makers, they don't vary production based on market price.
  • It doesn't make sense to ask how much a monopolist will produce at a given market price.

The Cost of Monopoly

  • Market power can disrupt the efficient allocation of resources.
  • A firm with market power reallocates resources towards itself, sacrificing social surplus.
  • Consider the Claritin market before and after patent expiration.
  • After patent expiration, the price is lower, and quantity demanded increases.

Change in Surplus

  • Producer: Loses in terms of selling price but gains in terms of quantity sold.
  • Consumer: Gains as they can buy at a lower price.
  • Change in Surplus: Surplus = Consumer Surplus + Producer Surplus = (B + C)
  • (B + C) = Net loss from monopoly.

Market Equilibrium

  • Perfectly competitive market equilibrium occurs after patent expiration.
  • Consumer surplus increases, while producer surplus decreases.
  • The deadweight loss represents the loss of social surplus due to the monopoly.

Restoring Efficiency

  • Besides waiting for patent expiration, other ways to restore market efficiency exist.
  • A social planner could choose the monopoly price and quantity.
  • This requires knowing the marginal cost and consumer willingness to pay.

Price Discrimination

  • This occurs when firms charge different prices to different consumers for the same good or service.
  • Buyers at lower prices cannot resell to those facing high prices to prevent arbitrage.
  • Firms could raise profits by practicing price discrimination.

Types of Price Discrimination

  • First-degree (Perfect): The firm charges each consumer the maximum price they're willing to pay.
  • Second-degree: The firm charges different prices based on the quantity purchased.
  • Third-degree: The firm charges different prices to different groups based on characteristics like age or location.

Impact of Price Discrimination

  • Perfect price discrimination can substantially increase the surplus of the firm.
  • Consumers, in aggregate, clearly lose out.

First-Degree Price Discrimination

  • Firm extracts every cent the consumer is willing to pay.
  • Consumer surplus is reduced to zero.