MIC ECON Lec 05 – Monopoly

CHAPTER 5:

PURE MONOPOLY

LEARNING OBJECTIVE The goal of this topic is to show how a monopoly determines price and quantity for its maximum profit. The monopoly form of market is defined. Demand and marginal revenue are presented. The rule of equating marginal revenue to marginal cost is shown to secure the optimum quantity and price. The economic effects of monopoly and price discrimination are outlined. The chapter closes with an analysis of regulated monopolies.

PURE MONOPOLY Pure monopoly is a type of market characterized by – a single seller or producer, – a unique product, with no close substitute, – the ability of the seller to ask any price it wishes, – entry to the industry completely blocked by legal, technological or economic barriers, and – no need for nonprice actions, except public relations or goodwill advertising.

 Examples of pure monopolies are not common because monopolies are either usually regulated or prohibited altogether. Cases where a company has substantial amount of monopoly power, but cannot be considered a pure monopoly, can easily be found.

MONOPOLY UNIQUE PRODUCT A monopoly exists when a firm is the only producer of a given product. That product is therefore unique to that firm. Such situation is rarely observed because products providing a similar service can usually be found in other industries or regions of the world. The product is unique in the sense that no close substitutes are presently easily available to consumers.

 For close to half a century, ALCOA was a virtual monopoly because it had control over mining of the aluminum ore (bauxite).

MONOPOLY POWER OVER PRICE A monopoly has extensive power over the price it may want to charge its customers. The monopolist is sometimes referred to as a price maker. It must be noted, however, that a monopolist does not charge the highest possible price. Instead it charges the price for which its profits are the largest. Moreover, a monopolist does not set a price independently of the volume produced: quite the contrary, price setting is implemented by restricting output.

MONOPOLY ENTRY BARRIERS Monopoly exists when entry barriers are present; these may be – legal, from the ownership of a patent or a copyright, – legal, from its appointment as public utility for natural monopolies, – technological, from a secret method of production, – due to large size, age, or good reputation, – stemming from access to a key resource (such as ore), or – resulting from unfair tactics or unfair competition.

UNFAIR COMPETITION Various strategies used by firms to eliminate competitors by forcing them into bankruptcy or preventing new firms from entering the industry, are referred to as unfair competition. They may include – drastic underpricing of products, or – cornering of a resource market. Most of these tactics have been declared illegal in antitrust legislation.

 The history of railroad expansion in the United States during the latter half of the 19th century is full of examples of actions by railroad companies seeking to eliminate competitors

MONOPOLY NONPRICE ACTION Since a monopolist is the only firm in the industry, it appears that there is no need for non-price action, such as advertising. However, advertising and other nonprice action are used as a form of public relations and for the purpose of avoiding customer antagonism.

 Electric companies are natural monopolies and do not need to advertise because customers have no choice but to receive their electricity from them. But, they do advertise. The purpose is often to convince consumers that the company is on their side by giving them tips on energy conservation, for instance.

monopoly-demand-and-marginal-revenue

 

MONOPOLY DEMAND The demand of a monopoly is downsloping because the monopoly is the only firm in the market, and demand for most products is price sensitive.

 The demand of natural monopolies, such as an electric company, is downsloping. Indeed, if the electric company were successful in obtaining a large rate increase, many customers may switch to alternative sources of energy, such as gas for heating and cooking.

MONOPOLY MARGINAL REVENUE Marginal revenue is the additional revenue received for the last unit sold. Since the monopolist can sell one more unit only by lowering the price on all the units sold, the marginal or additional revenue is not constant but decreasing. The marginal revenue is less than price at any quantity. If the demand curve is a straight line, the slope of marginal revenue is twice the slope of the demand curve.

 Simple algebra can show that the slope of marginal revenue is twice that of the corresponding demand curve. If demand can be written as

P=-aQ+b, total revenue is PQ, or PQ=(-aQ+b)Q.

Then, marginal revenue is the first derivative of total revenue, and that is

P=-2aQ+b. Thus, the coefficient of the slope of marginal revenue is -2a,

twice that of demand -a.

MONOPOLY DEMAND ELASTICITY The upper portion of the demand curve of a monopoly is elastic, and marginal revenue is positive for this region of output. The lower portion of demand is inelastic, and marginal revenue is negative in that region. It follows that a monopolist would never want to be in the inelastic portion of its demand since it can increase revenues by raising price.

MONOPOLY PROFIT A monopoly finds its maximum profit by producing at a level of output where marginal revenue equals marginal cost (i.e. the intersection of marginal revenue and marginal cost curves). If it produces one less unit a profit is foregone (on the last unit it failed to sell), and if it produces one more unit a decrease in profit is incurred (as the marginal cost exceeds the marginal revenue for that last unit).

 Many of the largest fortunes in the United States are the result of monopoly profits accumulating over time. For instance, Standard Oil (before it was split up) produced the wealth of the Rockefeller family.

MONOPOLY OPTIMUM QUANTITY The profit of a monopoly is determined by first finding the optimum quantity with the marginal revenue equal to marginal cost rule. After that, the unit price on the demand curve and the unit cost on the average total cost curve are found based on the optimum quantity established first.

MONOPOLY PROFIT GRAPH The monopoly profit is the difference between total revenue and total cost. Total revenue is represented as a rectangle with price (on the demand curve) as its height, and quantity (determined by MR=MC) as it width. Total cost is a rectangle with average unit cost (on average total cost) as its height, and quantity as its width. The area by which total revenue exceeds total cost is the profit area.

monopoly-profit

MONOPOLY LOSS A monopoly seeks to maximize profits, and is capable of achieving such a goal by controlling price and quantity. However, should customer demand decrease significantly, the monopolist will be content with minimizing loss (in the short run) and may even be forced to close down.

monopoly-loss

MONOPOLY SUBOPTIMAL PROFIT The strategy of a monopoly should be to maximize total profit. Such outcome would not be obtained by maximizing either unit profit, unit price or total revenue. However, in some cases a monopoly may want to use a suboptimal pricing strategy, for instance, to create additional entry barriers or to avoid customer confrontation.

MONOPOLY ECONOMIC EFFECT A monopoly form of market is highly undesirable for our society because of the sizable loss of productive and allocative efficiency: the price paid is higher than in perfect competition and the quantity is smaller. The monopoly underutilizes the resources for the production of a good wanted by society. The price charged is much higher than the cost of additional resources used. However, economies of scale and technological progress are possible.

 OPEC is not a pure monopoly. But, in 1973 and 1979, it acted as a monopoly in successfully increasing prices of oil and fuel by limiting their supply. Many people throughout the world, including the United States, were harmed by these actions. Some could no longer afford the cost of heating their home and the cost of needed transportation. Others lost their jobs as businesses were forced to cut production as costs increased.

MONOPOLY ECONOMIES OF SCALE In spite of the undesirable economic effect of a monopoly in general, a monopoly may in certain circumstances generate substantial economies of scale, which can be passed on to society in a lower price. The small firms of perfect competition are not large enough to bring about the economies of scale. Such economies of scale are to be found primarily in natural monopolies. Some economists have questioned the existence of this beneficial economic effect.

MONOPOLY TECHNOLOGICAL PROGRESS Another potential benefit to society from monopoly type firms is that profits are often the motivation for technological progress and investment in new technology is made possible by the presence of these profits. However, monopolies well protected by entry barriers will not need to seek new technology, and if they do, their goal may be to lower costs for additional profits and new entry barriers.

PRICE DISCRIMINATION Price discrimination exists whenever different prices are charged for the same product and the difference in price cannot be explained by costs.

 

 

 The telephone company charging different rates for night and day calls is a good example of price discrimination. The reason why the telephone company is able to charge the higher day rates is because the demand is inelastic: certain calls have to be made during business hours. The regulatory commission tolerates the price discrimination because it provides a saving for those who can wait until the evening to make their calls.

PRICE DISCRIMINATION CONDITIONS In order for the price discrimination to be possible, a firm must – be a monopoly or have some power over price, – be able to segment its market, and – be able to prevent cross selling from one market segment to another. Generally, the market segments will have different elasticities.

PRICE DISCRIMINATION EFFECTS The purpose of price discrimination is to increase the profit of the monopolist. This is achieved by charging a higher price to those customers who are more inelastic. Price discrimination is generally considered harmful to society and an unfair practice. It is declared illegal in the Sherman Act. However, price discrimination is, nevertheless, tolerated in many instances, in part, because it may result in larger overall output, and is occasionally a form of income redistribution.

NATURAL MONOPOLY Natural monopolies are said to exist in industries where competition is unworkable and would result in costly duplication of fixed capital. Most natural monopolies are public utilities. These are regulated by commissions.

 A water supply company is a typical natural monopoly. It is usually the only supplier of water for a given section of a town because it would be wasteful (in fixed assets) to have more than one company offering water to the same house.

REGULATED MONOPOLY The major task of the commission regulating a natural monopoly is to set the price (or rate) that the utility is allowed to charge. One method is the fair-return pricing method. The price is set at the point where it is equal to average total cost. The average total cost is allowed to include a market rate of return to make sure that new funds can be attracted for expansion. This practice often results in cost padding by utilities.

 Gas, water, electric and telephone companies are all regulated companies. Many companies in the transportation sector are also regulated (such as urban bus transportation and trucking). Deregulation of some of the industries has shown that the regulatory process was (for instance in the case of airlines) to the detriment – not benefit – of consumers.

REGULATED MONOPOLY SUBSIDY In a few cases of natural monopolies, a price below average cost is imposed on a utility to require a large output from the firm. The loss incurred by the firm is then offset with a subsidy.

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