MICROECONOMICS: Theory & Applications Chapter 15: Using Noncompetitive Market Models By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College

Learning Objectives Determine the relative magnitude of the deadweight loss of monopoly. Ascertain the extent to which, if any, monopolies suppress innovations. Explore whether government intervention can promote efficiency in the case of natural monopoly. Explore the concepts of iterated dominance and commitment in the context of game theory models. Copyright 2012 John Wiley & Sons, Inc.

Figure 15.1 - The Size of the Deadweight Loss of Monopoly Copyright 2012 John Wiley & Sons, Inc.

Why Are the Estimates of the Deadweight Loss Not Large? Estimates of the deadweight loss of monopoly in relation to GNP are not large. Reasons: Deadweight loss is compared to the size of the whole economy (GNP), not to the size of the monopoly There are few, if any, pure monopolies in the U.S. We cannot measure the restriction in output in any industry, only actual output. Copyright 2012 John Wiley & Sons, Inc.

Other Possible Deadweight Losses of Monopoly 2 undesirable consequences of monopoly: Restriction of output Redistribution of income in favor of the owner of the monopoly Other effects: In the absence of competition with other firms, the monopolist is under less pressure to minimize (production) cost. A monopoly may incur other costs (in addition to production costs) to ensure continuation of its monopoly power. Copyright 2012 John Wiley & Sons, Inc.

Do Monopolies Suppress Inventions? Worthwhile invention: one that allows a firm to produce a higher-quality product at an unchanged cost or to produce the same-quality product at a lower cost. Different industry structures: Competitive conditions: initial firm can gain until other firms copy it A worthwhile invention can be profitable for a monopolist. Conclusion: monopoly power does not necessarily suppress inventions Copyright 2012 John Wiley & Sons, Inc.

Figure 15.2 – Monopoly and Inventions Copyright 2012 John Wiley & Sons, Inc.

Natural Monopoly Natural monopoly – the case in which the average cost of a single enterprise declines over the entire range of market demand Economies of scale extend to very high output levels. Dilemma: Efficiency in production results from one supplier Lack of competition may lead to less output and higher prices Alternatives for public policy makers: Do nothing and let the monopoly produce unregulated Regulate the monopoly Governmental ownership and operation of the facility Allow the government to accept competitive bids from potential firms for the right to operate the facility Copyright 2012 John Wiley & Sons, Inc.

Figure 14.3 -Natural Monopoly Copyright 2012 John Wiley & Sons, Inc.

Regulation of Natural Monopoly: Theory Public utilities – public agencies charged with regulating natural monopolies Two pricing approaches: Average-cost pricing: AC=demand curve Marginal-cost pricing: MC=demand curve Average-cost pricing is more practical Output is greater and price is lower than if the monopoly were unregulated Monopoly’s owners receive no profit Copyright 2012 John Wiley & Sons, Inc.

Figure 15.4 - Regulation of Natural Monopoly Copyright 2012 John Wiley & Sons, Inc.

Regulation of Natural Monopoly: Practice Practice: reliance on the rate of return on invested capital (accounting profit) earned by a monopoly because complete knowledge of cost and demand conditions is unattainable Issues: The monopolist’s incentive to minimize cost is diminished. Regulated rates reduces the incentive to engage in research and development activities designed to develop new services or new products. Conclusion: Regulation is not ideal Alternatives are likewise unattractive Copyright 2012 John Wiley & Sons, Inc.

Regulating Natural Monopoly through Public Ownership Example: United States Postal Service (USPS) Objective: P=AC, not profit maximization Profit is constrained to equal zero Incentive to innovate and/or to encourage cost-minimization is attenuated Copyright 2012 John Wiley & Sons, Inc.

More on Game Theory: Iterated Dominance Iterated dominance – the concept of eliminating any strategy that is inferior to or dominated by another strategy Nash equilibrium (continued) Copyright 2012 John Wiley & Sons, Inc.

Table 15.1 - More on Game Theory: Iterated Dominance (continued) Copyright 2012 John Wiley & Sons, Inc.

More on Game Theory: Commitment Commitment – the strategy of adopting a particular course of action, constraining one’s choice of strategies, in order to increase your equilibrium payoff Appearance: competitive pricing Reality: allows two sellers to overcome the prisoner’s dilemma with the consumer being charges the highest possible price to the benefit of the two sellers. Copyright 2012 John Wiley & Sons, Inc.

Table 15.2 - More on Game Theory: Commitment (continued) Copyright 2012 John Wiley & Sons, Inc.

Table 15.3 - More on Game Theory: Commitment (continued) Copyright 2012 John Wiley & Sons, Inc.

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