Microeconomics: Chapter 13 Monopoly

PART FOUR: MARKET POWER
Chapter 13 Monopoly
A price maker is an economic decision maker that recognizes that its quantity choice has an influence on the price at which it buys or sells a good.

Market power is another name for the firm’s ability to influence price.

13.1 The Basic Monopoly Model
The Fundamental Assumptions
1. Sellers are price makers
2. Sellers do not behave strategically
3. Entry into industry is completely blocked. No new suppliers can join the industry.
4. Buyers are price takers.

The Appropriate Market Structure
1. The size and number of buyers: We require many buyers, no one large enough to influence price.
2. The size and number of sellers: There is only one firm in the industry, so the firm is a price maker, and there is no scope for strategic behavior.
3. The degree of substitutability of different sellers’ products. Assume buyers are prefectly informed – i.e. all buyers know about the monopolist’s price and the characteristics of its product.
4. Conditions of entry: This model applies to markets into which entry by new firms is completely blocked by either technological or legal barriers.

Equilibrium
A monopolist must meet the marginal output rule (produce at an output where marginal revenue is equal to marginal cost) and the shut-down rule( if at every choice of output level the firm’s average revenue is less than its average economic cost, then the firm should shut down).

Marginal Revenue for a Monopolist
When a monopoly increases its output by one unit there are two effects on revenue. Revenue rises by the extra amount of output times the price at which it’s sold. Revenue falls by the decrease in price times the number of units sold.

Inframarginal units are the units of output that the price could have sold at the old price, but now must sell at the new, lower price that prevails when it increases its output level.

If the firm is a price-maker, the marginal revenue curve lies below the demand curve everywhere except at an output of zero. At zero output, there are no inframarginal units on which to suffer losses, so the two curves coincide.

When demand is highly inelastic (close to vertical), the loss on the inframarginal units is large. When demand is relatively elastic, the loss on inframarginal units is relatively small.

Like any profit-maximizing firm, the monopolist chooses the output level at which marginal revenue is equal to marginal cost. The equilibrium price is found by looking at the price associated with this level of output on the demand curve.

Applying the Rules for Profit Maximization
A monopolist charges an equilibrium price that is greater than marginal cost.

Price Elasticity and Profit Maximization
The only way marginal revenue can be positive is for the price elasticity of demand to be greater than 1. Demand must be elastic at the monopolist’s equilibrium price and output levels.

The Long and the Short of Monopoly
The distinction between short run and long run is less important for monopoly than it is with perfect competition, because under perfect competition, firms can enter or leave the market in the long run. In a monopolized market, further entry is locked. Because it does not face the threat of entry, a monopolist may earn positive economic profit in the long run.

Monopoly Compared to Perfect Competition
A multi-plant monopolist produces less output than would perfect competitors facing the same industry demand.

Taxing a Monopolist
Even though the firm raises its price in response to a unit tax, a monopolist’s profit falls when a unit tax is imposed on it.

Incentives to Innovate
Process innovation refers to an idea that lowers the cost of producing existing products. Product innovation refers to an idea that gives rise to a new good or service.

Process Innovation
As long as the innovation leads to lower production costs, the monopolist derives benefits from innovation, even if it means rendering existing plants and machinery obsolete.

Product Innovation
If a firm can apply for a patent, then the incentive to undertake R&D is the entire amount of monopoly profit that the firm will be able to earn once it obtains the patent.

13.2 Normative Analysis of Monopoly
Equity
Monopolization raises the firm’s profit and the income of the firm’s owners, and it lower the incomes of consumers. Whether or not this is desirable depends on our ethical judgments regarding how deserving the suppliers and consumers are.

Efficiency
A Partial Equilibrium Analysis
The deadweight loss of monopoly is the loss in total surplus that arises because a monopolist produces less than the total-surplus-maximizing amount of output.

Firm’s private incentive = Change in producer surplus
Social incentive = Change in producer surplus + Change in consumer surplus

A General Equilibrium Analysis
Production efficiency: [Marginal technical rate of substitution (MRTS) between any two inputs (capital and labor) is equal to their price ratio] A profit-maximizing firm that is a price maker in the output market, but a price taker in the input markets, makes an efficient input choice.

Consumption efficiency: [Every consumer must have the same marginal rate of substitution (MRS) between the monopolist’s good and any other good.] If other firms in the economy do not engage in price discrimination, then the equilibrium for a nondiscrimination monopolist entails an efficient allocation of output among consumers taking as given the total amount produced.

Allocation Efficiency: If all of the other goods in the economy are sold in perfectly competitive markets at prices equal to their marginal costs, then the monopolist violates the condition for allocation efficiency because it sets the price of its product greater than its marginal costs.

13.3 Public Policy toward Monopoly
Patent Policy
A patent allows a firm to have a monopoly, and this monopoly produces a smaller amount of total surplus than a competitive market. The government chooses to provide patents to ensure that the firm has the incentive to innovate and create new products.

Antitrust Policy
Antitrust Policy is the set of laws designed to prevent firms from exercising market power by the firms’ restricting output and engaging in anticompetitive behavior.

A conduct remedy is a government-imposed change in firm behavior (conduct) designed to make the market more competitive. A structural remedy is a government imposed change in the industry structure designed to make the market more competitive.

Determinants of Market Structure
Economies of Scale: When average cost declines over the entire range of output levels, the lowest-cost way to produce any given level of output is to have one firm responsible for all of the output; the industry in a natural monopoly. (A natural monopoly is an industry in which, over the range of relevant output levels, a single firm can produce the total industry output at less cost than can any greater number of firms.)

Barriers to Entry: In addition to economies of scale, the number of firms in an industry may be limited by barriers to entry. There are two types of barrier: technological and legal.

Product Differentiation: When firms’ products are differentiated, producers are not price takers even when there are many firms in the market.

It may be prohibitively costly, or even impossible, to create a competitive market structure in some industries.

Regulation of Monopolies
Regulation is the process by which the government engages in pervasive intervention in the operation of a market. Governments that decide to regulate the firm must realize that the regulated firm is a self-interested decision maker. This has three implications:
1. A regulated firm must be allowed to earn nonnegative profit.
2. A regulated firm will use its private information to its own advantage.
3. Regulatory controls may have unintended consequences

13.4 Price Discrimination
Price discrimination is the practice of charging different consumers different prices for the same good.

Conditions Necessary for Profitable Price Discrimination
1. The firm must be a price maker.
2. The firm must be able to identify which consumer is which.
3. Consumers must not be able to engage in arbitrage. Arbitrage is the process whereby customers whom the firm charges low prices make purchases that they then resell to customers who would otherwise have to pay high prices.

First-Degree Price Discrimination
First-degree price discrimination is the practice of selling each unit of output at a price just equal to the buyer’s maximal willingness to pay for that unit. Another name for this is perfect price discrimination.

Welfare Effects of First-Degree Price Discrimination
A perfectly discriminating profit-maximizing monopolist produces the total-surplus-maximizing amount of output.

Second Degree Price Discrimination
Second-degree price discrimination is price discrimination in which the same price schedule is offered to all buyers but they sort themselves through self-selection. Two-part tariffs (that include a fixed fee and a per-unit charge) are an example of second-degree price discrimination.

Welfare Effects of Second-Degree Price Discrimination
In the typical case in which demands can be ordered, the monopolist restricts output below the socially optimal level.

Third Degree Price Discrimination
Third-degree Price Discrimination is the practice of identifying separate groups of buyers of a good and charging different prices to these groups. An example is “ladies-night,” which uses sex as an indicator of a consumer’s willingness to pay.

Welfare Effects of Third-Degree Price Discrimination
When total output falls under third-degree price discrimination, so does total surplus – the output that is produced is allocated to consumers inefficiently and there is less of it. But hen total output rises, the welfare analysis is ambiguous – the output that is produced is allocated inefficiently, but there is more output. Consequently, total surplus may rise or fall, depending on the specific details of the market.