1. Mod 62: Monopoly & Public Policy
9/18/2018 7:29 AM
Duffka School of Economics

2. Duffka School of Economics
Key Economic Concepts
• A monopoly, if left unregulated, will decrease consumer surplus and increase producer surplus. However the losses to CS outweigh the gains to PS, thus creating deadweight loss. • Deadweight loss occurs because output is reduced and at the monopoly output, P > MC. Thus mutually beneficial transactions go unmade. • A natural monopoly exists when one large firm can produce the product at lower average costs than can several competing firms. The markets for utilities like electricity, natural gas and water are good examples. • If the government regulates the natural monopoly so that deadweight loss is eliminated, the firm will suffer losses and exit the industry. • To avoid bankrupting the natural monopoly firm, the government can regulate price such that normal economic profits are earned.
9/18/2018 7:29 AM
Duffka School of Economics

3. Duffka School of Economics
Module Outline
I. Welfare Effects of Monopoly II. Preventing Monopoly Power III. Dealing With a Natural Monopoly A. Public Ownership B. Regulation
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Duffka School of Economics

4. I. Welfare Effects of Monopoly
The previous module showed that, when we compare monopoly to perfect competition: • Qm < Qc, • Pm > Pc, and • Monopoly profit is greater than zero.
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Duffka School of Economics

5. I. Welfare Effects of Monopoly
Monopoly: The monopoly output is Qm and the price is Pm>MC=ATC. Total welfare is still the sum of consumer and producer surplus. But we see that CS has shrunk while PS (profit) has increased. This PS is a transfer from consumers to the firm. However there is an area that used to belong to CS, but now belongs to nobody. This deadweight loss shows us that total surplus under monopoly is less than under perfect competition.
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Duffka School of Economics

6. I. Welfare Effects of Monopoly
Total surplus under perfect competition is equal to: CSc Total surplus under monopoly is equal to: CSm + PSm Because of the deadweight loss, we can see that CSc > CSm + PSm Economists see this loss of total welfare as a major drawback to monopoly and is an argument for regulation or prevention of monopolies.
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Duffka School of Economics

7. APE U3 L4 A34 Monopoly Pricing
34.1 Perfect Competition
1. What Q of output will be produced?
What P will the market establish?
3. Calculate the CS and shade the area.
4. Calculate the PS and shade the area. 6 MC 12 6
$6.00 CS
½ (6) (6) =$18 PS
½ (6) (6) =$18 D

8. APE U3 L4 A34 Equilibrium for the Monopolist
5. What Q of output will be produced?
Why?
6. What P will the monopolist establish?
7. Calculate & shade CS.
8. Calculate & shade PS.
Part B: Figure Monopoly 4 MC 12 8 4
ATC
MR=MC at this quantity CS
$8.00
PS1
This is the max P the monopolist can charge & still sell 4 units.
PS2 MR D
½ (4) (4) = $8.00
4(4) + ½ (4) (4)
=$24

9. APE U3 L4 A34
9. How does price and output of a monopolist differ from that of the perfectly competitive industry?
Price is higher and output is lower.
10. What portion of the CS in the comp. situation was transferred to the firm in the monopoly situation?
$8.00 was transferred to Producer. Total consumer surplus was $18, so 8/18 or 4/9 was transferred to producer.
11. How does a monopoly affect CS? Is this good or bad?
CS is transferred from consumer to the producer.
This is bad for the consumer and good for the producer.

10. II. Preventing Monopoly Power
Some monopolies arise due to mergers and acquisitions of rival companies or due to ownership of a critical production input. The government has Antitrust Laws to deal with the harmful effects of these types of monopolies. But other monopolies are created by massive economies of scale. These natural monopolies If this is the case, it’s more efficient to allow the natural monopoly to exist, but with regulation to prevent abuse of pricing power and sizeable deadweight loss.
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Duffka School of Economics

11. II. Preventing Monopoly Power
Monopolies produce less and charge a higher price. Anti-trust laws are in place and CAN be enforced to stop monopolistic practices.
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Duffka School of Economics

12. III. Dealing With Natural Monopoly
A. Public Ownership The government could purchase and operate the firm. The advantages seem clear. Because the government is not in the business of maximizing profit at Qm,Pm, prices should be lower to consumers. If the government could operate the electricity market where Pc=MC, there would be no deadweight loss. Downsides exist, however. The government, as a very large bureaucracy with many other issues to deal with, is not always the best entity at keeping costs low. Waste and political favors may cause electricity rates to rise and taxpayer money to be wasted.
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Duffka School of Economics

13. III. Dealing With Natural Monopoly
A. Public Ownership B. Regulation A commonly used option is to regulate the market for electricity. We are assuming that a large fixed cost exists (imagine huge power plants) and the variable cost of providing another unit of electricity is very small and constant. This creates a downward sloping ATC curve with huge economies of scale and a lower constant MC curve.
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Duffka School of Economics

14. III. Dealing With Natural Monopoly
A. Public Ownership B. Regulation Unregulated: Produces Qm where MR=MC, charges Pm. The firm earns positive economic profit as Pm>ATCm; seen below as the shaded rectangle. Consumer surplus would shrink and deadweight loss would exist because Pm>MC.
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Duffka School of Economics

15. II. Preventing Monopoly Power
Regulated monopolies must advertise to subdue complaints to the legislature that regulates their price.
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Duffka School of Economics

16. III. Dealing With Natural Monopoly
A. Public Ownership B. Regulation 1. Regulated to the perfectly competitive outcome. • Output would be Qc and price Pc. • Consumer surplus would be maximized. • There would be no deadweight loss as Pc=MC. • The firm would suffer losses as Pc<ATC. Because society does not want to bankrupt the only electricity provider in the area, this regulation, while efficient would not be chosen.
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Duffka School of Economics

17. III. Dealing With Natural Monopoly
A. Public Ownership B. Regulation 1. Regulated to the perfectly competitive outcome. 2. Regulated such that the firm earns a normal profit. • Output would be Qr and price Pr. • Economic profit is zero as Pr=ATC. • Consumer surplus is larger than without regulation. • Some deadweight loss exists as Pr>MC, but not as much as would exist if the firm were unregulated.
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Duffka School of Economics

18. III. Dealing With Natural Monopoly
A. Public Ownership B. Regulation 1. Regulated to the perfectly competitive outcome. 2. Regulated such that the firm earns a normal profit. Option 2 is a compromise between the unregulated monopoly outcome (worst for consumers and the most deadweight loss) and the perfectly competitive outcome (best for consumers, zero deadweight loss, but bankrupts the firm).
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Duffka School of Economics

19. APE U3 L5 A37 Regulating Monopoly: 1. Not regulated
A. About 1,500 units
B. $4.00
C. TR= ($4 X 1,500)=$6,000
D. TC= ($3 X 1,500)=$4,500
E. Profit ($6,000-$4,500)=$1,500

20. APE U3 L5 A37 Regulating Monopoly: 2. MC Pricing (socially optimal)
A. About 3,000 units
B. $1.50
C. TR=($1.50X3,000)=$4,500
D. TC=(3,000X$2.50)=$7,500
E. Loss ($7500-$4500)=$3,000
F. Yes (lump sum subsidy)
G. $3,000

21. APE U3 L5 A37 3. Cost of service regulation A. 2,500 B. $2.50
C. TR=($2.50X2,500)=$6250
D. TC=($2.50x2,500=$6250
E. $0 Economic Profit
4. The firm operates at its most allocatively efficient point, but the government must subsidize.
5. Output is higher and price is lower compared with an unregulated firm. The firm, however, is not operating at its most efficient output. Nevertheless, no government subsidy is required.

22. 2009 Free Response #1
Directions: You have 50 minutes to answer all three of the following questions. It is suggested that you spend approximately half your time on the first question and divide the remaining time equally between the next two questions. In answering the questions, you should emphasize the line of reasoning that generated your results; it is not enough to list the results of your analysis. Include correctly labeled diagrams, if useful or required, in explaining your answers. A correctly labeled diagram must have all axes and curves clearly labeled and must show directional changes. Use a pen with black or dark blue ink.
1. CableNow is the only supplier of cable TV services offering a wide range of TV channels. CableNow is an unregulated firm and is currently earning an economic profit. Assume that CableNow does not practice price discrimination.
(a) Draw a correctly labeled graph for CableNow and show each of the following. Make sure your graph is large enough to be legible.
(i) The profit-maximizing quantity of cable services, labeled as Q*
(ii) The profit-maximizing price, labeled as P*
(iii) The area of economic profit, completely shaded
(iv) The socially optimal level of cable services, assuming no externalities, labeled as QS
(b) Assume that the government grants CableNow a lump-sum subsidy of $1 million. Will this policy change CableNow’s profit-maximizing quantity of cable services? Explain.
(c) Instead of granting a subsidy, assume now that the government chooses to require CableNow to produce the quantity at which CableNow earns zero economic profit. On the graph you drew in part (a), label this quantity QR.
(d) At QR, is the firm’s accounting profit positive, negative, or zero? Explain.
(e) Assume that a new study reveals there are external benefits associated with watching TV. Will the socially optimal quantity of cable services now be larger than, smaller than, or equal to the QS you identified in part (a)(iv) ?

23. Free Response 2009 #1 P=MC correctly labeled
(a) Draw a correctly labeled graph for CableNow and show each of the following. Make sure your graph is large enough to be legible.
(i) The profit-maximizing quantity of cable services, labeled as Q*
(ii) The profit-maximizing price, labeled as P*
(iii) The area of economic profit, completely shaded
(iv) The socially optimal level of cable services,
assuming no externalities, labeled as QS
correctly labeled
a) ANSWER 5 points:
• One point is earned for a correctly labeled graph for CableNow, with a downward-sloping demand curve and with the marginal revenue curve below the demand curve.
• One point is earned for identifying the profit-maximizing quantity of cable services, Q*, at MC = MR.
• One point is earned for identifying the profit-maximizing price of cable services, P*, on the demand curve above Q*.
• One point is earned for showing the area of economic profit, completely shaded.
• One point is earned for identifying the socially optimal level of cable services, QS, where the MC curve intersects the demand curve.
P=MC

24. Free Response 2009 #1
(b) Assume that the government grants CableNow a lump-sum subsidy of $1 million. Will this policy change CableNow’s profit-maximizing quantity of cable services? Explain.
(b) 2 points:
• One point is earned for stating that the lump-sum subsidy will have no impact on the quantity of services CableNow produces.
*Reminder: Lump-sum (tax or subsidy) affects total costs not variable or marginal costs.
• One point is earned for explaining that the lump-sum subsidy will not affect MC.

25. Free Response 2009 #1 Demand (P)=ATC
(c) Instead of granting a subsidy, assume now that the government chooses to require CableNow to produce the quantity at which CableNow earns zero economic profit. On the graph you drew in part (a), label this quantity QR.
ANSWER: (c) 1 point:
• One point is earned for identifying the quantity of cable services, QR, where the ATC curve intersects the demand curve.
Demand (P)=ATC

26. Free Response 2009 #1
(d) At QR, is the firm’s accounting profit positive, negative, or zero? Explain.
(d) 2 points:
• One point is earned for stating that accounting profit is positive.
• One point is earned for explaining that accounting profit excludes implicit costs.

27. Free Response 2009 #1
(e) Assume that a new study reveals there are external benefits associated with watching TV. Will the socially optimal quantity of cable services now be larger than, smaller than, or equal to the QS you identified in part (a)(iv) ?
(e) 1 point:
• One point is earned for stating that the socially optimal quantity will be larger than QS.

28. Practice Question 1
1. Which of the following statements is true of a monopoly as compared to a perfectly competitive market with the same costs?    I. Consumer surplus is smaller.    II. Profit is smaller.    III. Deadweight loss is smaller.
a. I only
b. II only
c. III only
d. I and II only
e. I, II, and III

29. Practice Question 2
2. Which of the following is true of a natural monopoly?
a. It experiences diseconomies of scale.
b. ATC is lower if there is a single firm in the market.
c. It occurs in a market that relies on natural resources for its production.
d. There are decreasing returns to scale in the industry.
e. The government must provide the good or service to achieve efficiency.

30. Practice Question 3
3. Which of the following government actions is the most common for a natural monopoly in the United States?
a. prevent its formation
b. break it up using antitrust laws
c. use price regulation
d. public ownership
e. elimination of the market

31. Practice Question 4
4. Which of the following markets is an example of a regulated natural monopoly?
a. local cable TV
b. gasoline
c. cell phone service
d. organic tomatoes
e. diamonds

32. Practice Question 5
5. Which of the following is most likely to be higher for a regulated natural monopoly than for an unregulated natural monopoly?
a. product variety
b. quantity
c. price
d. profit
e. deadweight loss