Concentrated Markets The theory of monopoly

Section B, 25 mark question Jan 2010 qn4(b) Jun 2010 qn10 Evaluate the argument that managers controlling large companies might follow policies which do not necessarily maximise the profits of the owners 25 marks Discuss whether utilities such as gas, electricity and water, are better left in the private sector and open to competition or whether all, or some, should be taken back into the public sector. 25 marks

Monopoly defined Where the total market is made up of one firm and no other firm is able to enter the market. 100% 40% 25%

Learning aims Understand the conditions for monopoly. How the structure of monopoly determines price and output. To recognise a monopoly has a range of outputs (quantity) it can pursue; each having consequences for price and efficiency and welfare. (MC=MR, MR=0, MC=AR, ATC=AR) To appreciate a monopoly is unlikely to be statically efficient but can be dynamically efficient; i.e, monopolies under certain conditions can operate in the consumers’ interest. How monopolies can adopt price discrimination and extract consumer surplus.

1. The conditions for monopoly. The total output of the industry is in the hands of a single firm. Barriers to entry restrict other firms from entering the market. Patents Copyright Nationalised industries Economies of scale Limit pricing Legal monopolies (government sanctioned) Natural monopolies

The determination of price and output in a monopoly The monopolist’s revenue Despite being the only supplier in the market, the monopolist will face a downward sloping demand curve. This can be explained by the condition for perfect competition which is not satisfied in concentrated markets. That is that:- Buyers and seller cannot trade as much as they wish at the ruling market price. P P/AR=50 MR=30 D=AR Quantity AR/P TR MR 1 70 2 60 120 50 3 150 30 MR Q=3 Q

The determination of price and output in a monopoly The monopolist’s profit maximisation output MR=MC, that is the point at which the marginal cost of producing a good or service is equal to the revenue received from its sale. In this case the extra unit cost the monopolist £30. The amount received however, was £45 P MC P/AR=45 MR/MC=30 D=AR MR Q=3 Q

The determination of price and output in a monopoly The monopolist and supernormal profits The extra unit cost the monopolist £30. The amount received however, was £50. The monopolist will ensure the AR/P> ATC. In this case the unit cost of production at the profit maximising point is £40. The monopolist is making £20 on the MC of production (£50-£30). In terms of ATC, £10 profit is made on each unit (£50-£40). P MC ATC P/AR=50 ATC=40 MC=30 D=AR MR Q=3 Q

3. The range of monopoly outputs MR =MC (profit maximisation) MR=0 (revenue maximisation) AR=MC (welfare maximisation/ allocative efficiency, the point at which the cost of producing the extra unit is equal to the revenue the firm receives from that extra unit. Alternatively the cost of the resources used to produce that extra unit is equal to the price charged for that unit). AR=ATC (normal profit, the minimum price a monopolist will accept in order to stay in the market. P MC ATC D=AR MR A B C D Q

Natural monopoly and achieving allocative efficiency (AR=MC) A monopolist would produce at MR=MC, but as it faces a downward sloping demand curve (AR/P), this gives a price that returns super normal profits to the monopolist. While the monopolist can benefit from the economies of scale it does not pass on these benefits to the consumer. This does NOT maximise welfare. A government can intervene by instructing the monopolist to produce more (to a point where AR=MC otherwise known as welfare maximisation or allocative efficiency).

Natural monopoly and achieving welfare maximisation (AR = MC) The effect of government intervention on a monopoly when pursuing welfare maximisation /allocative efficiency QM is the monopolists chosen output . It is the point of profit maximisation and super normal profits are attained at priced PM. A government would not be happy with this outcome for the monopoly is not passing on the benefits of potential economies of scale to the consumer. The monopoly is forced to increase output to a point at which welfare is maximised (AR=MC), that is point QG. As the LRMC will always be below the ATC, the price charged at QG will be below the ATC, that is selling at a loss! The shortfall is made up in the form of a subsidy to the value AB. P PM ATC A LRATC MC=MR B LRMC D=AR MR QM QG Q

Natural monopoly and achieving allocative efficiency (AR = MC) Government attempts to bring about welfare maximisation and make the monopolist allocatively efficient results in the need for a subsidy having to be paid to the monopolist. Is there an alternative?

4. A monopolist is unlikely to be statically efficient Monopoly and efficiency ‘Dead weight loss’ A monopolists is not regarded as allocatively efficient for it does not operate at AR=MC (welfare maximisation). Also at PM it is able to extract much of the consumer surplus through higher prices (area above PM). There is considerable producer surplus (area below PM) A perfectly competitive market achieves allocative efficiency for it operates at AR=MC Lower prices provides for a greater area of consumer surplus (area above PC, more money in consumer’s pockets) Some of the producer surplus is gained (area below PC, less money in business’ pockets. The area ABC is the consumer and producer surplus lost in monopoly. It is referred to as the dead weight loss. P MC A PM B PC C D=AR MR QM QC Q

Monopoly and efficiency 4. A monopolist is unlikely to be statically efficient, but can achieve dynamic efficiency Monopoly and efficiency Reinvesting profits The MC curve becomes more shallow to give MC1. The monopolist still adopts a profit maximisation output at QM1 where MR=MC1. In this case however, a lower price is attained than that achieved than in a perfectly competitive market. How is this possible? Monopolies can make profits in the long run that can than be reinvested in making the business more efficient. P MC PM PC PM1 MC1 D=AR MR QM1 QM QC Q

Monopoly Disadvantages Advantages