Monopoly Flashcards
What is the key defining feature of firms in a competitive market that does not apply to a monopoly?
Firms in a competitive market are assumed to be price takers: they can sell as much or as little as they want at the equilibrium market price. This is defined by the purely horizontal demand curve for an individual price taker’s output.
Price-taking firms in a competitive market can expand output without fear of influencing the equilibrium. Why is this not the case with monopoly?
Monopolies face the entire industry demand curve which slopes downwards. As the monopoly increases its own output it must decrease price in order maintain equilibrium (sell all its goods at market price).
Unlike standard price-taking firms, there are two components to a monopolist’s marginal revenue. Describe them both.
First, as in competitive markets, selling an extra unit means the monopolist’s revenues go up by the market price.
However, putting this extra unit on sale reduces the equilibrium price for this extra unit and all units it was previously selling. Therefore the monopolist’s revenue also goes down because it ends up selling its existing output - known as infra-marginal units - for less.
For a competitive firm, price is equal to marginal revenue and supply equals marginal cost. This means a competitive firm’s P = MR curve is horizontal at the competitive price and profit is maximised at the point MC (supply) = MR (Price and Demand).
With monopolies, however, price does not equal MR. Why is this and what is the impact on the market?
Reason: The intra-marginal unit effect.
Impact: A monopolist’s MR curve slopes downwards, reflecting the intra-marginal effect’s impact on marginal revenue as output is increased. Importantly, the MR curve has twice the slope of the demand (marginal benefit) curve and is below it. This results in deadweight loss (see P.126 of book for image).
There are three key forms of price discrimination under monopoly - name them.
First, Third, and Second-degree price discrimination.
First-degree price discrimination: Describe the concept and why it is difficult to implement in practice.
Monopolies charge each individual consumer a price equal to their marginal benefit curves. This would result in supernormal profit being made on each sale, as recall the consumer’s marginal benefit curves lie above the monopolist’s marginal revenue curve. This also causes the intra-marginal unit issue to disappear, so there is efficiency in the market.
This is hard to implement in practice as it would involve all consumers revealing their preferences to the monopoly, something they would want to keep private in order to be taken advantage of (though the internet makes this more feasible).
Third-degree price discrimination: Describe the concept and who “loses out” from the practice.
Third-degree price discrimination is widely practiced - student or senior discounts are examples. The idea is that by splitting the demand into sub-groups, the monopolist can trade more with one group without lowering the price for everyone.
This moderates the intra-marginal effect, allowing the monopoly to make more Pareto-improving deals and come closer to efficiency.
The losers are those outside the chosen group, as it allows the monopolist to raise “normal” prices without losing as many sales.
Second-degree price discrimination: How does it relate to third-degree price discrimination, what is the idea behind it, and how is it implemented?
It is similar to third-degree price discrimination in that it involves splitting demand into subgroups and dampening the intra-marginal effect.
The idea behind it to get people to self-select into these groups, not base it on observable characteristics. Examples are first and second-class travel.
The key implementation method is to offer slightly different goods. First and second-class travel will still get you from A to B, but only those with money to spare and a desire for quiet will pay for first-c;lass when they don’t have to.
What is a side-effect of second-degree price discrimination that can harm consumer experience?
Product crimping. This is when producers have the incentive to produce a purposefully-worse version of their “premium” product in order to scare those on the fence to spend more money.
An example of this is old IBM printers had a cheap/expensive version with slow/fast printing speed. The only difference was the cheap version had additional microchips in it to deliberately slow down the print speed.
Monopoly and policy: Normally, monopolies are unwanted due to the risks of holding too much market power and X-inefficiencies. What are the main “prevention” and “cures” to monopoly?
Prevention: Competition or antitrust authorities can block the merger of large companies if the merged entity will hold too much market power.
Cure: Monopolies can be legally broken up once formed into several firms in an attempt to make a market more efficient.
Monopolies owe their existence in cases to barriers to entry. Patents are a common barrier to entry, as they provide a firm intellectual monopoly over their innovation for a number of years. Why would doing away with patents, and this monopolistic barrier to entry, not be good for long-term innovation?
While patents create static inefficiency by allowing products to be supplied by a monopolist instead of a competitive industry, they provide dynamic efficiency in the long term by providing incentives to research new products. Patents prevent any new product being reverse-engineered on release, which would reduce the incentive by producers to innovate.
However, contrary to this simple thinking, some economists think the patent system as it stands does not deliver on its goal as well as it should. It provides incentive for “patent trolls” to mark many patents and make a living out of suing those who generate similar ideas - a counterproductive idea.
Natural monopoly: What is it, provide an example, why does it occur, and should they be broken up?
What is it: A natural monopoly is where competition in a market would be inefficient from the point of a consumer.
Example: Water or electricity companies, where there are steep upfront costs in constructing a distribution network but low marginal costs of transmission, are often natural monopolies.
Why they occur: The firms very large fixed costs and minimal marginal costs means the average cost curve slopes downwards - the monopoly experiences economies of scale - even when serving the whole market. The monopolists economies of scale are so large the AC curve intersects the demand curve above the MC curve, so any competitor would be pricing the good below AC to compete, and fail.
Should they be broken up: No. There are only two policy alternatives - nationalisation, or price regulation.
What is nationalisation of a firm, what does this enable to government to do, and what is the key difference in a nationalised firms’ aim?
Nationalisation: The government owns a controlling stake in a firm, owning more than 50% of the shares with voting rights.
What this does: Enables the government to hire and fire management and set the management’s objectives.
The aim: Ignore profit maximisation, aim to maximise social welfare by setting price equal to marginal cost, exploiting all Pareto-improving trades, and running the firm at a loss.
If, for whatever reason, it is politically unacceptable for the firm to run a loss, price will be set equal to average cost and as much trade will be done while remaining in the black.
What is a common issue with the running of nationalised firm?
X-inefficiency. As revenues tend to flow into government coffers, not managerial pay packets, there is little incentive to cut costs and behave efficiently.
As a result, a common way to deliver efficiency in natural monopoly scenarios was price regulation.
Price regulation: What is it and what are the incentive structures that underpin the idea?
What is it: To ensure the firm produces at minimum cost, and does not exploit monopoly power, the government sets a price cap.
If the firm cannot raise price above a certain level, the only way to increase profit is to decrease costs. The profit incentive remains, and the firm will have incentive to behave efficiently.
