Monopolies

Question 1

What are the major problems which Monopolies cause?

Answer 1

1. The Monopoly Firm produces less output than firms in a competitive industry.
2. The Monopoly Firm sells its output at a higher price than if the industry was competitive.
3. The Monopoly Firm’s output is produced less efficiently and at a higher cost than the output produced by firms in a competitive industry.

Question 2

What causes the difference in outcomes between a competitive industry (previous chapter) and a monopoly industry?

Answer 2

The difference in outcomes are not caused by bad intentions.

It results from the fact that monopolies are free from the pressures that lead competitive industries to produce the socially optimal output level.

Without these pressures, monopoly firms can increase prices and restrict output to increase their profits - things that competitive firms would also love to do but can’t.

Question 3

Where do bad outcomes generated by a monopoly derive from?

Answer 3

They all derive from the same source: unlike a competitive firm that faces a horizontal marginal revenue curve, the monopoly faces a downward-slpoing MR curve (MR: is the increase in total revenue that comes from selling each successive unit of a product).

This simple fact causes monopolies to charge more, produce less at higher costs than competitive firms.

Question 4

What does a downward-sloping MR cuve imply?

Answer 4

It implies that each additional unit that the monopoly sells brings less revenue than the previous unit.

i.e. where the 10th unit brought £8 in revenue, the 11th unit only brings in £3.

Obviously, such a situation reduces the incentive to produce a lot of output.

Question 5

In contrast, what type of MR curve do competitive firms face?

Answer 5

Competitive firms face horizontal MR curves, meaning that if they sell 11 units or 11,000, each unit brings in the same amount of money. Naturally, that’s much more of an inducement to produce a lot of output.

Question 6

Why is there such a difference between the MR curves facing monoploies and competitive firms?

Answer 6

A monopoly firm can choose its price because, being the only firm in its industry, it contols all the output in that industry. A competitive firm on the other hand, has to take the market price as given.

Question 7

What output level does a Monopoly firm want to produce?

Answer 7

It wants to produce at the profit-maximising output level: where the MR curve intersects the MC curve.

Question 8

How is a Monopoly’s MR curve related to the Demand curve for the Monopoly’s output?

Answer 8

They have a very close relationship. The MR of each successive unit is less than the MR of the previous unit because the D curve is downward sloping.

If the D curve is a straight line, the slope of the MR curve is twice as steep as the slope of the D curve, meaning that MR falls quite quickly as output increases.

Question 9

Graphically depict the MR curve for a Monopoly facing a straight line D curve.

Answer 9

Remember: the MR = the change in total revenue which happens as you increase output by one unit.

Question 10

Using TR, explain why the MR curve falls so quickly.

Answer 10

TR = p x q

The important thing to notice is how total revenue changes as you move from A to B to C and output increases from one to two to three units. TR goes from £9 to £16 to £21. Obviously, TR increases.

But look more deeply. Moving from A to B, TR increases by £7 (from £9 to £16). By moving from B to C, it increases only by £5. Each successive increase in TR is smaller than the previous increase.

Question 11

Explain how as Monopolies increase production, MR declines.

Answer 11

Look at points G and H.

G = Monopoly can sell 7 units for £3 each so TR = £21

But at H = 8 units are only sold for £2 each so TR = £16

Increasing output from 7 to 8 units means decreasing TR from £21 to £16. In other words, the MR is negative £5 as you move from 7 to 8 units of output.

Question 12

What is the impact on MR as a result of the downward sloping demand curve?

Answer 12

MR keeps decling and even becomes negative because the d curve slopes downward, meaning that the only way to get people to buy more stuff is to offer them a lower price. You have to offer them a lower price not just on additional units, but on all previous units as well.

In other words, if the monopoly firm wants to sell only one unit it can get £9 for that unit. But if the monopoly wants to sell 2 units, it has to lower the price down to £8 per uni for both the first and the second unit

Question 13

Using calculus, prove that the MR curve falls twice as fast as the demand curve.

Answer 13

1. Take the equation of the demand curve which is: p = 10 - q
2. Substitute this equation into the TR equation, TR = p x q
3. Take the first derivative with respect to output, q.
4. Because MR is dTR/dq, you find that MR = 10 - 2q, meaning that MR has the same vertical intercept as the demand curve but twice as steep a slope.

Question 14

What output level do Monopolists choose to maximise profit?

Answer 14

A Monopoly firm is no different to a competitive firm when it comes to costs of producing output i.e. it has fixed, variable and marginal costs - which all act the same way as a competitive firm’s.

The key difference is that a Monopoly firm faces a downward sloping MR curve which causes a profit-maximising monopoly to produce less output than a profit-maximising competitive firm.

Question 15

Graphically depict how a Monopolist goes about setting MR = MC to maximise profits and explain the concepts of ATC and MC.

Answer 15

The ATC curve gives the average total cost per unit of producing q units of output. This curve is U-shaped because ATC’s first fall due to increasing returns and then increase due to diminishing returns.

The MC curve gives the cost of producing one more unit of output; that is, it tells you how much TC’s rise if you increase output by one unit.

Question 16

Using ‘low output, q^L’ as an example, explain why q^M is an optimal output level for the Monopoly to produce.

Answer 16

At output level q^L, go up vertically and see that MR at that output exceeds MC, meaning if you produce and sell that unit, it brings in more revenue than it costs to produce.

Clearly this unit is a good one to produce. Because a similar relationaship holds true for all output levels less than q^M, the monopoly should keep increasing output until it reaches q^M.

Question 17

Using ‘high output, q^H’ as an example, explain why qM is an optimal output level for the Monopoly to produce.

Answer 17

On the other hand, the monopoly doesn’t want to increase output beyond q^M. To see why, examine output level q^H. At that output level, MC are much bigger than MR’s, meaning if you produce that unit of output, the cost of producing it exceeds the money you can get selling it.

In other words, if you produce that unit, you lose money.

Question 18

How might the monopolist figure out which price to charge?

Answer 18

To figure out what the price of each unit of output needs to be, use the demand curve. Move up vertically from the monopoly’s profit-maximising output level to the demand curve and then head sideways - you can see that at output level q^M the monopoly can charge price p^M.

Question 19

What does the monopoly’s profit look like on the graph?

Answer 19

The TR rectangle (O, p^m, C, q^m) is bigger than the TC rectangle (0, A, B, q^m), meaning that the monopoly is earning a profit = shaded rectangle A, p^m, C and B. Which represents the difference in areas between the TR and TC rectangles.

Question 20

Does a monopoly guarantee profitability?

Answer 20

No.

If demand is too weak, prices are too low to make any money. In other words, because demand is weaker, the monopoly operates at a loss represented by the shaded rectangle (once again, compare the TR rectangle with the TC rectangle).

Question 21

What is another way of understanding where a loss comes from when demand is too weak?

Answer 21

Compare the monopoly’s ATC per unit with the price per unit it gets when producing and sellng at output level q^m₁. At that output level, the price per unit, q^m₁, is found by starting on the horizontal axis at q^m₁, and then going up even farther to get to the ATC curve, meaning that the ATC per unit to make q^m₁ units exceeds the price per unit you get from selling these units.

This fact implies that the firm loses money producing at output level q^m₁

Question 22

Graphicaly depict the scenario where a monopoly and a competitive firm have the same cost structure.

Answer 22

The monopoly produces less, which causes a DWL.

MR^c = Competitive firm MR

MR^m = Monopoly firm MR

Remember: both firms maximise profits by producing at the point where their MR intersects MC.

Question 23

1)Why do competitive firms produce more than the monopoly?

Answer 23

Because the competitive firm doesn’t have to worry about reducing its revenue per unit if it increases output. No matter how much it produces the competitive firm always receives MR^c = p^c on every unit sold because its output is too small relative to total output to affect the market price.

Question 24

2)Why do competitive firms produce more than the monopoly?

Answer 24

The monopoly faces the market demand curve, meaning that every additional unit it sells lowers the price per unit it receives on all units sold.

Geometrically, this fact implies the downward sloping MR, which leads the monopoly to restrict output because it knows that the more it produces, the less money per unit it gets.

Question 25

How do monopolies cause harm/what does the monopolies DWL demonstrate?

Answer 25

Monopolies cause harm because they reduce output below the socially optimal level produced by competitors.

The DWL triangle demonstrates that when monopolies restrict output in order to maximise their profits, they fail to produce units for which benefits exceed the costs - and that harms society.

Question 26

Are monopolies efficient producers?

Answer 26

No. Remember: competitive firms produce at the lowest point on ATC curve which minimises production costs per unit of output.

Compare points E and F below. Point E is much higher on the ATC curve implying that a monopoy produces output at a more costly output level than a competitive firm.

Question 27

Briefly summarise a Monopolist firm.

Answer 27

A monopolist produces too little at too high a cost and then turns round and sells it for too much money.

Question 28

Give an example of how a monopoly may benefit the interests of a society.

Answer 28

Patents.

Patents give inventors the exclusive right to market their inventions for 20 years, after which time their inventions become public property. That is, patents give inventors the right to run a monopoly for 20 years.

Question 29

Why are monopolies important in the context of innovation?

Answer 29

Because without them inventors are unlikely to ever see any financial reward for their hard work: copycats are likely to steal their ideas and flood the market with rip offs, thereby collapsing the price.

Consequently, in a world without patents, far fewer people woud bother to put in the time, effort and money required to come up with new inventions.

Question 31

Give an example of how monopolies actually reduce the need for annoyingly redundant competitors.

Answer 31

1) Rubbish collectors - Bin lorries are loud and annoying. If one firm has a monopoly on collection then you only have to endure a loud, annoying collection once per week. But think of the annoyance say, 7 bin lorry companies would create i.e. one pick up per day.
2) Natural gas - Laying the pipes that deliver natural gas is expensive, and laying multiple grids of gas pipe in one area would be wasteful. Thats why most utilities and local services are supplied by a monopoly, whether stat or private. Each company is given a monopoly and is then regulated to make sure itdoesn’t exploit its customers i.e. the supply of water in london (Thames water) is a monopoly.

Question 32

What are natural monopoly industries or natural monopolies?

Answer 32

An industry is a natural monopoly if one lage producer can produce output at a lower at a lower cost than many small producers.

A good example is electricity distribution. The enormous fixed cost of setting up a national power grid means that there’s no way of setting up a grid to serve a fraction of the market. In this case it has to be all or nothing.

Question 33

Why is the market for electricity distribution known as a natural monopoly?

Answer 33

Because it naturally becomes dominated by a single low cost producer.

Question 34

What should policy makers do with a natural monopoly?

Answer 34

Governments usually allow the natural monopoly to stay in business as the only firm in the industry but at the same time they regulate it so that people don’t have to worry about high prices or low output levels.

By doing so, society gets the benefits that the most efficient production method generates without having to worry about the problems that may result if the monopoly was left unregulated.

Question 35

Why might a government choose to subsidise a monopoly?

Answer 35

Remember - a monopoly’s output level q^m, is less than the socially optimal output level that would be produced by a competitive firm, q^c.

By subsidising the monopoly’s production costs its marginal cost curve should shift down vertically = MC and MR curves meet at a higher output level.

Question 36

Give an example of a gov subsidising a monopoly.

Answer 36

Some gov’s use a subsidy to get gas, electricity and phone companies to serve more people, especially poor people.

If the monopoly firms’ costs of hooking up customers are subsidised, the firms are willing to hook up more customers than they would without the subsidy.

Some people object to subsidising a monopoly, so this sort of solution isn’t necessarily the most popular politically; but it is effective in increasing output.

Question 37

What is another way of getting monopolies to produce more output?

Answer 37

By imposing a minimum output requirement.

i.e. in some places telephone companies are required to provide basic telephone services to everyone - even to people who can’t afford it themselves (the idea is to make sure that everyone can call for help in case of an emergency).

Question 38

What must regulators be careful about when forcing a monopoly to increase output?

Answer 38

Regulators have to be careful, not to bankrupt a monopoly when regulating. Because regualors don’t want to bankrupt monoploies and thereby deny consumers access to the goods or services they produce, regulators are careful to take a monopoly’s cost structure into account when considering a minimum output requirement.

Question 40

What is the most common way of regulating a monopoly?

Answer 40

Setting the price at which the monopolist can sell each and every unit of output that it produces. This approach works because it changes the monopolist’s MR curve from sloping downward to being horizontal. Therefore, it eliminates the monopoly’s usual problem that the more it sells, the less it can charge per unit.

Question 41

How might a regulator want to modify the monopoly’s behaviour re. price?

Answer 41

A well intentioned regulator may want to get the monopoly to produce every single unit of output for which benefits exceed costs.

i.e. the regulator wants to get the monopoly to produce the output level q^mc, defined by where the demand curve intersects the MC curve. Why? Because producing each unit up to and including q^mc is socially beneficial.

Question 42

What price does the regulator set for the monopolist?

Answer 42

The regulator sets the price p^mc. At that price, the demand curve tells us that consumers want to purchase q^mc units of output.

Question 43

What is the big problem when monopolies produce the output level q^mc?

Answer 43

Given this particular monopoly’s cost structure: the monopoly goes bankrupt, because at output leve q^mc, the firm’s total costs exceed its total revenues.

Question 44

What is the difference between marginal cost pricing and average cost pricing?

Answer 44

MCP: when the regulated price, p^mc, is set where the MC curve crosses the demand curve.

But because this method can cause a monopoly to lose money, a more common alternative is average cost pricing: which sets the regulated price where the ATC curve intersects the demand curve.

Question 45

Graphically depict a regulator using average cost pricing.

Answer 45

A regulator using average cost pricing would set the price at p^ac. At that price, consumers demand q^ac units of output. The monopoly is happy to supply that output level because for each and every unit up to q^ac, MR (the regulated price per unit, p^ac) exceeds MC.

This means the monopoly gains financially by producing each and every one of these units.

Question 46

What is the main benefit of using the average cost pricing system?

Answer 46

You don’t have to worry about the monopoly going bankrupt (or where to get the money to subsidise a monopoly that would go bankrupt under marginal cost pricing). Average cost pricing guarantees that the monopoly is going to break even.

=> Because the ATC per unit are equal to the regulated price per unit - and so the firm must be breaking even.

Question 47

What is the downside of average cost pricing?

Answer 47

For this monopoly the downside of ACP is that all the socially beneficial units between q^ac and q^mc don’t get produced.

On the other hand, the only way to keep this monopoly in business to produce those units if you imposed marginal cost pricing is to subsidise it.

Question 48

Using average cost pricing eliminates…?

Answer 48

Any worries associated with providing subsidies. In particualr, you don’t have to worry about any potential harm that you may cause when raising the taxes that have to be imposed somewhere else in the economy in order to subsidise the monopoly.