Monopoly Chapter 9

Introduction This chapter examines how a market controlled by a single producer behaves. What price will a monopolist charge? How much will the monopolist produce? Are consumers better or worse off when only one firm controls an entire market?

Market Power Market power is the ability to alter the market price of a good or service.

The Downward-Sloping Demand Curve Firms with market power confront downward-sloping demand curves. Competitive firms face a horizontal demand curve.

Firm vs. Industry Demand The competitive firm Quantity (bushels per day) Price (per bushel) The industry Quantity (thousands of bushels per day) Demand facing competitive firm $13 $13 Market demand

Monopoly The demand curve facing the monopoly firm is identical to the market demand curve for the product. Monopoly is a firm that produces the entire market supply of a particular good or service.

Price and Marginal Revenue A monopoly faces a different profit maximizing situation than competitive firms. Profit-maximization rule – Produce at that rate of output where MR = MC.

Price and Marginal Revenue Unlike competitive firms, marginal revenue for a monopolist is not equal to price.

Price and Marginal Revenue Marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

Price and Marginal Revenue So long as the demand curve is downward-sloping, MR will always be less than price. The MR curve lies below the demand (price) curve at every point but the first.

Price and Marginal Revenue

Price and Marginal Revenue $14 A B 12 C b D 10 E c F 8 G Price (per basket) Demand (= price) d 6 e 4 f Marginal revenue 2 g 1 2 3 4 5 6 7 8 9 10 Quantity (baskets per hour)

Profit Maximization We need to find the intersection of marginal cost and marginal revenue. This will give us the profit-maximizing rate of output. Only one price is compatible with the profit-maximizing rate of output.

Profit Maximization $14 13 Demand Marginal revenue Marginal cost Average total cost 12 11 D 10 9 Profits 8 Price or Cost (per basket) 7 d 6 5 4 3 2 1 1 2 3 4 5 6 7 8 9 Quantity (baskets per hour)

Market Power at Work: Computer Market Revisited As an example, we’ll use a fictitious company called Universal Electronics that acquires an exclusive patent on the production of microprocessors.

Market Power at Work: Computer Market Revisited The patent functions as a barrier to entry. Barriers to entry – Obstacles that make it difficult or impossible for would-be producers to enter a particular market, such as patents.

Market Power at Work: Computer Market Revisited For comparison purposes, Universal is not taking advantage of economies of scale. Economies of scale – Reductions in minimum average costs that come about through increases in the size (scale) of plant and equipment.

The Production Decision Like any producer, Universal wants to produce at the rate that maximizes profits. Universal faces a production decision concerning its many plants. Production decision – The selection of the short-run rate of output (with existing plant and equipment).

The Production Decision Universal cannot have each of its factories competing with each others – expanding output and driving down prices. Instead, Universal will seek to coordinate the production decisions of its plants.

Marginal Revenue Each Universal plant faces a downward-sloping demand curve, thus, the marginal revenue no longer equals price. Only firms that confront a horizontal demand curve equate marginal cost and price.

Reduced Output The typical Universal plant will produce fewer computers that would be produced by a typical perfectly competitive firm.

The Monopoly Price The intersection of the marginal revenue and marginal cost curves establishes the profit-maximization rate of output.

The Monopoly Price The demand curve tells us how much consumers are willing to pay for that output.

Initial Conditions in the Monopolized Computer Market $1200 1000 800 600 400 200 1200 1600 Price (per computer) Quantity (computers per month) W C M B Average total cost Demand curve facing single plant Marginal revenue of single plant Marginal cost Monopoly outcome 1200 1000 800 600 400 200 24,000 Price (per computer) Quantity (computers per month) A X Market demand Competitive market supply Competitive outcome

Monopoly Profits Total profit equals average profit per unit times the number of units produced. Profit per unit = price – average total cost Profit per unit = p – ATC Total profits = profit per unit X quantity Total profits = (p – ATC) X q

Monopoly Profits A monopoly receives larger profits than a comparable competitive industry by reducing the quantity supplied and pushing prices up.

Monopoly Profits: The Typical Universal Plant $1200 1000 800 600 400 200 Price (per computer) Quantity (computers per month) 1200 1400 W K B Average total cost Marginal cost Demand curve facing single plant Marginal revenue of single plant C Profit

Monopoly Profits: The Entire Company Quantity (computers per month) Price (per computer) Monopolist's equilibrium MC Competitive short-run equilibrium A $1100 Monopoly profit R X ATC $1000 Competitive long-run equilibrium T U V Market demand MR qM qC

Barriers to Entry Unless there are barriers to entry, high monopoly profits tend to attract profit-hungry entrepreneurs into the market.

Barriers to Entry These profits will be maintained as long as barriers to entry prevent any competitors from entering the market.

A Comparative Perspective on Market Power Outcomes differ under competitive and monopoly conditions.

Competitive Industry High prices and profits signal consumers’ demand for more output. The high profits attract new suppliers. Production and supplies expand.

Competitive Industry Prices slide down the market demand curve. A new equilibrium is established. Price equals marginal cost at all times.

Competitive Industry Throughout the process, there is great pressure to reduce costs or improve product quality.

Monopoly Industry High prices and profits signal consumers’ demand for more output. Barriers to entry are erected to exclude potential competition. Production and supplies are constrained.

Monopoly Industry Prices don’t move down the market demand curve. No new equilibrium is established. Price exceeds marginal cost at all times.

Monopoly Industry There is no squeeze on profits and thus no pressure to reduce costs or improve product quality.

Monopoly Industry Because monopoly markets do not tend towards marginal cost pricing, consumers do not get the mix of output that delivers the most utility from available resources. Marginal cost pricing – the offer (supply) of goods at prices equal to their marginal cost.

Political Power A firm with considerable market power likely to have significant political power as well.

The Limits to Power Monopolists only have absolute control of the quantity of output supplied to the market. Monopolists must still contend with the market demand curve.

The Limits to Power How strong a constraint that is depends on the price elasticity of demand. Price elasticity of demand – The percentage change in quantity demanded divided by the percentage change in price.

The Limits to Power The greater the price elasticity of demand, the more a monopolist will be frustrated in its attempts to establish both high prices and high volume.

Price Discrimination A monopolist may be able to extract greater profits by practicing price discrimination. Price discrimination is the sale of an identical good at different prices to different consumers by a single seller.

Entry Barriers There are six barriers to entry.

Entry Barriers Patents – offers a producer 20 years of exclusive rights to produce a particular product.

Entry Barriers Monopoly franchises – governments also create and maintain monopolies by giving a single firm the exclusive right to supply a particular good or service.

Entry Barriers Control of key inputs – a company may lock out competition by securing exclusive access to key inputs.

Entry Barriers Lawsuits – may be used to prevent new companies from successfully entering an industry.

Entry Barriers Acquisition – when all else fails, purchase a potential competitor.

Entry Barriers Economies of scale – a monopoly may persist because of cost advantages over smaller firms

Pros and Cons of Market Power It is conceivable that monopolies could benefit society.

Research and Development Because of their greater profits, monopolists have a greater advantage in pursuing research and development. They do not have a clear incentive to do so.

Entrepreneurial Incentives Market power can be an incentive for entrepreneurial activity. An innovator can make substantial profits in a competitive market before the competition catches up.

Economies of Scale If economies of scale exist, the monopolist may attain much greater efficiency than a large number of competitive firms.

Economies of Scale There is no guarantee that such economies of scale will exist in a given industry.

Natural Monopolies A natural monopoly is an industry in which one firm can achieve economies of scale over the entire range of market supply.

Natural Monopolies Economies of scale act as a “natural” barrier to entry.

Natural Monopolies Examples of natural monopolies include local telephone services, local cable services, and other local utility services.

Natural Monopolies While economically desirable, natural monopolies may be abused.

Contestable Markets A contestable market is an imperfectly competitive market subject to potential entry if prices or profits increase.

Contestable Markets Contestable markets are characterized by moderate barriers to entry. When potential profits reach a certain level competitors are enticed to enter the market.

Structure vs. Behavior The structure of monopoly is, in itself, not a problem. If potential rivals force a monopolist to behave like a competitive firm, then a monopoly imposes no cost on consumers or on society at large.

Microsoft: Bully or Genius? Concerning Microsoft, critics argue that Microsoft: Charges too much for its systems software. Suppresses substitute technologies. Bullies potential competitors.

The AT&T Case The federal government dismantled AT&T in 1984. Prior to the break-up, AT&T supplied 96 percent of all long-distance service and over 80 percent of local telephone service.

The AT&T Case The authority for the federal government to break up monopolies lies in the three major antitrust laws existing in the U.S.

Antitrust Laws Sherman Act (1890) – prohibits “conspiracies in restraint of trade.

Antitrust Laws Clayton Act (1914) – principally aimed at preventing the development of monopolies by prohibiting price discrimination, exclusive dealing agreements, certain types of mergers, and interlocking boards of directors among competing firms.

Antitrust Laws The Federal Trade Commission Act (1914) – created the FTC to study industry structures and behavior so as to identify anti-competitive practices.

The Microsoft Case The antitrust accusations against Microsoft are: It thwarted competitors in operating systems by erecting entry barriers, including exclusive purchase agreements with computer manufacturers. It used its monopoly position in operating systems to gain an unfair advantage in the applications market. It bought out its competitors.

Microsoft’s Defense In its defense, Microsoft asserted that: It dominates the computer industry because it produces the best products at attractive prices. The computer industry is highly contestable if not perfectly competitive.

The Verdict A federal court concluded that Microsoft abused its monopoly position in operating systems.

The Verdict By limiting consumer choices and stifling competition, Microsoft had denied consumers better and cheaper information technology.

The Remedy The trial judge suggested a structural remedy, that Microsoft might have to be broken into two companies to ensure competition. The U.S. Department of Justice decided to seek a behavioral remedy instead.

Monopoly End of Chapter 9