The Monopoly Market power Monopoly equilibrium Welfare aspects

The Monopoly As we concluded last week, perfect competition is not really a realistic outcome It is an ideal situation which serves as a benchmark for evaluating competition So “real-life” competition suffers from imperfection But how can be characterise “imperfectness”? 1 st step is to define the opposite benchmark The most imperfect form of competition imaginable: the Monopoly

The Monopoly Market power The market equilibrium under a monopoly Welfare aspects of the monopoly The monopsony

The 5 conditions of perfect competition Reminder: Perfect competition is defined by the following 5 conditions: 1. Large number of agents (Atomicity) 2. Homogeneous products 3. Free entry and exit from the market 4. Perfect information 5. Perfect mobility of inputs All 5 are required for perfect competition to occur

Market power Reminder: When one of these 5 assumptions fails to hold, the market is in an imperfectly competitive situation. Two main consequences for firms: 1: Their production decisions influence the market price of their products 2: Their profits can depend on how competitors react to these decisions

Market power 1 st consequence: Their production decisions influence the market price of their products Firms are big enough to start influencing the price of the market when they change their level of production This is market power This does not occur under perfect competition because of the atomicity assumption It is of course maximal for in the monopoly

Market power 2 nd consequence: Their profits can depend on how competitors react to these decisions Because a change in the production decision of a firm will change the price, competitors will probably react. The firm will have to take this into account. This is known as strategic behaviour, and is a central focus of game theory. Not really relevant for monopolies. There are no competitors !! This 2 nd aspect will be covered in the next 2 weeks

Market power Market power of firms Perfect competition Many firms with a homogeneous product Oligopoly A few producers with high market power Monopoly A single producer Monopolistic competition Many firms with differentiated products The “competition continuum”

Market power Market power refers to the ability of a firm (a monopoly here) to influence the price How can one measure this power ? In perfect competition we have p =mC One could expect a firm with market power to try and push the price above the marginal cost so that p >mC This divergence is known as a mark-up and can be measured, This gives us our measure of market power.

Market power Profit of the firm: The profit maximisation condition finds output q such that : This is valid for any firm, with or without market power But what it mR equal to when a firm has market power?

Market power Total revenue is simply equal to the quantity sold times the price at which the output is sold: The derivative of total revenue is the sum of: The extra quantity produced ∂ q times the price The effect of the increase on the market price This 2 nd effect is equal to zero in perfect competition, but not when a firm has market power...

Market power Dividing through by ∂ q gives marginal revenue The income generated by an extra unit of output is equal to the price minus the negative impact of the extra output on prices Factorising price:

Market power One can see that the “complicated” term inside the brackets is the inverse of the price elasticity of demand: The term in brackets is our mark-up. This is also sometimes called the Lerner index, and is the measure of market power The profit maximising condition mR = mC can be written as:

Market power Price Quantity Demand mR Graphical construction of mR The slope of the mR curve is twice that of the demand curve

The Monopoly Market power The market equilibrium under a monopoly Welfare aspects of the monopoly The monopsony

The market equilibrium under a monopoly The monopoly is an extreme case. It corresponds to the following market structure : 1. A single producer 2. Homogeneous products 3. No entry of competing producers on the market 4. Perfect information 5. Perfect mobility of inputs

The market equilibrium under a monopoly mC AC Price S D Reminder: Perfect competition equilibrium Firm levelMarket level Quantityquantity d=mR p q Q D2D2 Q2Q2 p2p2 q2q2 d 2 =mR 2 Total Cost Positive profits in SR

The market equilibrium under a monopoly Price Quantity mC AC Demand mR q p Monopoly equilibrium 1 st 2 nd 1 st : mC=mR gives q 2 nd : given q, the demand curve gives p

The market equilibrium under a monopoly p  q = TR AC  q = TC Price Quantity mC AC Demand mR q p

The Monopoly Market power The market equilibrium under a monopoly Welfare aspects of the monopoly The monopsony

Welfare aspects of the monopoly Unsurprisingly, the monopoly is inefficient compared to perfect competition: Positive economic profit in the LR P ≠ mC: there is a mark-up on marginal cost Not producing at minimal AC

Welfare aspects of the monopoly mC AC Price Monopoly equilibrium Quantity mR p q Demand 1 st element p ≠ mC This is due to the existence of market power The monopoly can push prices above the perfect competition outcome Prices are a mark-up over marginal cost mC

Welfare aspects of the monopoly mC AC Price Quantity mR p q Demand 2 nd element The monopoly makes positive economic products in the LR This is due to the existence of barriers to entry Competitors cannot enter to compete away the profit Monopoly equilibrium

Welfare aspects of the monopoly mC AC Price Quantity mR p q Demand 3 rd element The monopoly does not produce at the minimum point of the AC curve Some IRS opportunities are not used up This market does not produce at the most cost-efficient point Monopoly equilibrium AC

Welfare aspects of the monopoly There are therefore different sources of inefficiency in the monopoly The existence of market power The existence of barriers to entry How can we measure the overall inefficiency of the monopoly compared to perfect competition ?? We use the surplus as a measure of welfare

Welfare aspects of the monopoly Consumer surplus Producer surplus Deadweight loss Price Quantity mC AC Demand mR q p

Welfare aspects of the monopoly This is why competition policy often regulates existing monopolies and attempts to prevent the emergence of new ones Examples : US Antitrust legislation Sherman Act (1890) Clayton Act (1914) 1911: John Rockefeller's Standard Oil is split US 1934 Airmail Act splits United Aircraft and Transport Corporation into Boeing, United Aircraft (Pratt Whitney, Sikorsky) and United Airlines. EU vs. Microsoft on Internet Explorer (aka “the browser wars”)

Welfare aspects of the monopoly There are different ways of regulating a monopoly, based on the different inefficiencies The typical instrument is the price ceiling Regulate at p = AC  Pro: Zero-profits. The average cost is known  Con: not the most efficient regulation (deadweight loss) Regulate at p = mC  Pro: Most efficient regulation (no deadweight loss)  Con: Some positive profits remain. Difficult to calculate the marginal cost !!

Welfare aspects of the monopoly Consumer surplus Producer surplus Deadweight loss Price Quantity mC AC Demand mR q2q2 p2p2 q p Regulate at p= mC

Welfare aspects of the monopoly Consumer surplus Producer surplus Deadweight loss Price Quantity mC AC Demand mR q2q2 p2p2 q p Regulate at p= AC

Welfare aspects of the monopoly “Schumpeterian” argument: Monopoly profits are a reward for a risky investment decision by an entrepreneur If these potential rewards are denied (through a tough competition policy), no entrepreneur will be willing to take risks. Therefore, monopoly regulation has a negative effect on innovation See the Patent argument (Varian, chap 24)

The Monopoly Market power The market equilibrium under a monopoly Welfare aspects of the monopoly The monopsony

Opposite situation to the monopoly A single buyer instead of a single producer Similar aspects in terms of market power and welfare The buyer’s market power pushes the price below the marginal cost There is a deadweight loss ⇒ inefficient structure

The monopsony The monopsony corresponds to the following market structure, similar to the monopoly case : 1. A single buyer 2. Homogeneous products 3. No entry of competing buyers on the market 4. Perfect information 5. Perfect mobility of inputs

The monopsony Price Quantity mC Supply Marginal Product q p Monopsony equilibrium 1 st 2 nd 1 st : mC=mP gives q 2 nd : given q, the supply curve gives p mC

The monopsony How likely is this market structure ? Actually important for some agricultural products  Coffee, cocoa, bananas, etc... Another situation can be the labour market  There are many more suppliers of labour (individual workers) than buyers (firms)  Firms will have monopsony power on the labour market. This will distort the market outcome !  We shall examine this again when we talk about the labour market (week 14)