Chapter 23 Monopoly 23-1 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives The graph of the monopolist How monopolist’s profits are calculated The monopolist in the short run and long run Barriers to entry Limits to monopoly power Economies of scale and natural monopoly What makes bigness bad? 23-2 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Monopoly Defined A monopoly is the ONLY firm in an industry –No one else sells what the monopolist is producing –There are local monopolies Some examples are a hardware store, a dry cleaners, and a drugstore –There are national/regional monopolies Some examples are diamonds dealers, gas and electric companies, and local phone companies A monopoly produces ALL the output in an industry There are no close substitutes for the product or service 23-3 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Graph of the Monopolist Monopoly is the first of three types of imperfect competition –The other two are monopolistic competition and oligopoly The distinguishing characteristic of imperfect competition is that the firm’s demand curve slopes downward to the right –This means the imperfect competitor has to lower price to sell more 23-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Graph of the Monopolist The imperfect competitor has to lower price to sell more 23-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. D Q2Q2 Q1Q1 P2P2 P1P1

23-6 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Hypothetical Demand & Cost Schedule for a Monopoly Output Price TR MR TC ATC MC 1 $

23-7 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Hypothetical Demand & Cost Schedule for a Monopoly Output Price TR MR TC ATC MC 1 $16 $

23-8 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Hypothetical Demand & Cost Schedule for a Monopoly Output Price TR MR TC ATC MC 1 $16 $16 $

23-9 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Hypothetical Demand & Cost Schedule for a Monopoly Output Price TR MR TC ATC MC 1 $16 $16 $16 $20 $

23-10 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Hypothetical Demand & Cost Schedule for a Monopoly Output Price TR MR TC ATC MC 1 $16 $16 $16 $20 $ $

23-11 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (This is the graph of the previous schedule) The monopolist will make a profit if for some range of output her ATC lies below the demand curve

23-12 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (This is the graph of the previous schedule) In this instance, the monopolist maximizes her profit at five units of output charging a price of $12

23-13 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (Calculating the Monopolist’s Profit) In this instance, the monopolist maximizes her profit at five units of output charging a price of $12 This is where MC=MR

23-14 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (Calculating the Monopolist’s Profit) Price The ATC at five units of output is about $9.90 ATC

23-15 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (Calculating the Monopolist’s Profit) Price ATC Total Profit = (Price – ATC) X Output = ($12 - $9.90) X 5 ($2.10 X 5) = $10.50

23-16 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (Calculating the Monopolist’s Profit) Price ATC Every firm produces where MC=MR. The perfect competitor produced at the most profitable output, which in the long run always happened to be the most efficient output

23-17 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (Calculating the Monopolist’s Profit) Price ATC The monopolist has no competition and does not have to produce where output is at its most efficient level (the minimum point on the ATC).

23-18 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (Calculating the Monopolist’s Profit) Price ATC The perfect competitor will produce at the most efficient output level which is the minimum point on the ATC

23-19 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (Calculating the Monopolist’s Profit) Price ATC The perfect competitor’s P=MR=D=$9.80 and its ATC is equal to price.

23-20 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit (Calculating the Monopolist’s Profit) Price ATC Perfect competitor Monopoly Price $9.80 Price $12.00 Output $5.45 units Output 5 units ATC $9.80 ATC 9.90

Summary The monopolist makes a profit (economic), whereas in the long run the perfect competitor makes no profit (economic) The monopolist operates at less than peak efficiency, while the perfect competitor operates at peak efficiency (the lowest point on the ATC) The perfect competitor(s) charges a lower price and produces a larger output than the monopolist Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

23-22 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit Output is 5 Price is $17 ATC is $14 TP = (P – ATC) X Output TP = ($17 – $14) X 5 TP = ($3) X 5 TP = $15

23-23 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist Making a Profit Output is 5 Price is $17 ATC is $14 TP = (P – ATC) X Output TP = ($17 – $14) X 5 TP = ($3) X 5 TP = $15 The output at which the firm would produce most efficiently is 5.1 The perfect competitor would produce at an output of 5.1 The perfect competitor would charge

23-24 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Monopolist in the Short Run and the Long Run There is no distinction between the short run and the long run for the monopolists –If there is a demand for their product or service they make a profit (economic profits) –If there is not enough demand for their product for them to make a profit they go out of business –

23-25 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Demand and Supply under Monopoly Because the monopolist is the ONLY seller in the industry, her individual demand curve is also the Market Demand curve. Likewise her supply curve is the Market Supply curve. The monopolist’s supply curve is her MC curve. Her supply curve begins at the break-even point (that is, the minimum point of the ATC) Break even point

23-26 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Are All Monopolies Big Companies No... many monopolies are tiny firms operating in a very small market –What matters is size relative to the market - the proverbial big fish in a small pond –Chances are there is only one book store on your campus It is not nearly as big as Barnes and noble –The only video store in a very small community would be a monopoly There are tens of thousands of gas stations, convenience stores, restaurants, cleaners, and repair shops that have monopolies in their communities

23-27 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Barriers to Entry Control over an essential resource Economies of scale Legal barriers Required scale for innovation Economies of being established

23-28 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Control over an Essential Resource In economics the basic resources are land, labor and capital Some examples are –The Metropolitan Opera has most of the world’s opera stars under contract –The NFL had virtually all the top football stars under contract until the early 1960s –DeBeers Diamonds own four fifths of the world’s diamond mines –The International Nickel Company of Canada owns ninety percent of the world’s nickel reserves

23-29 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economies of Scale Typically, heavy industry - iron, steel, copper, aluminum, and automobiles - has high start up cost –Once the plant and equipment are in place, you can take advantage of economies of scale with high volumes of output

23-30 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Legal Barriers Legal barriers include licensing, franchises, and patents –Licensing prevents just anybody from driving a taxi, cutting hair, peddling on the street, practicing medicine, burying bodies, etc Often the licensing procedure is designed to hold down the number of people going into the field This tends to keep prices high in that field

23-31 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Legal Barriers Legal barriers include licensing, franchises, and patents –Government franchises are the most important legal barrier –When the number is large, for example radio stations, usually there is no big problem –However, government franchises can be, (illegally) obtained through bribes –The most important form of local franchise is the public utility gas and electric companies

23-32 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Legal Barriers Legal barriers include licensing, franchises, and patents –Patents are granted to investors so they can have a chance to get rich before some one else can use their ideas (Patents are granted for 17 years) Some times firms buy up patents to prevent competition Some times, just before the 17 years are up, a firm makes a slight improvement and gets a patent for another 17 years

Required Scale for Innovation Most inventors don’t have the wherewithal to produce and market their ideas Most inventors would probably be quite happy to hand their ideas and innovations over to one of the big guys for a share of the profits While individuals come up with all the great ideas, only large firms have the money and know-how to bring them to the marketplace Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

23-34 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economies of Being Established Companies that have been in business for a number of years have certain advantages –Recognizable brand names –The sales reps have established territories –The sellers and buyers have long-standing relationships Sometimes these companies can set the standard for the industry, i.e., –Microsoft in software, Matsushita-VCR format

23-35 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Limits to Monopoly Power The ultimate limit to monopoly power may come from the government or from the market itself –If a firm gets too big or too bad, or both, the government may decide to step in using antitrust laws –The market limits monopoly power basically through the development of substitutes

23-36 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Economies of Scale and Natural Monopoly There are only two justifications for monopoly –Economies of Scale justify bigness because sometime only a firm with the capability of a very large output can produce anywhere close to the minimum point of its ATC –Natural Monopoly is a situation where one firm is able to provide a service at a lower cost than could several competing firms

23-37 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. AB One electric Company Is Better than Four Panel A shows a single electric transmission feeder cable serving all the homes in one block. Panel B shows four cables serving that same block. It is a lot more efficient (and cheaper) to have one cable than four

The Rationale for Natural Monopoly Today the rationale for natural monopoly is disappearing –In more than half the states the electric power industry has been deregulated, so that local electric monopolies are getting a great deal of competition –Once the transmission cables had been laid, it became possible under deregulation for competition to develop, and the rationale for monopoly no longer was valid –The original local phone or electric company was a natural monopoly, but once we’re all connected, then let the competition begin Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

When Is Bigness Bad? Monopolies tend to be inefficient because they do not produce at the minimum point on their ATC –This prevents resources from being allocated in the most efficient manner Big business always has great political power –Economic power is easily converted into political power The monopolist may engage in price discrimination Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

When Is Bigness Good? Natural monopolies can take advantage of economies of scale and deliver services much more cheaply than a multitude of competing firms It is probably all right if a firm is big because it is very good If a firm is big because it is bad is another story Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

23-41 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Corporate Hierarchy

Because there is no competition, there is no great incentive to control cost or to use resources efficiently There is no need to spend much money on research and development, to improve processes, to develop new products, or to be responsive to customer needs A monopolist can charge higher prices and provide poorer quality and service Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The Economic Case Against Bigness

23-43 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Two Policy Alternatives Two ways to prevent public utilities from charging outrageous prices –government regulation –government ownership

23-44 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Conclusion Natural Monopolies are probably all right, but only if they do not abuse their power Monopolies based on other factors must be looked on with suspicion –They may be up to no good –They may even be illegal Any monopoly must pass the test of whether or not there are close substitutes