Week 3: Monopoly, monopolistic competition, oligopoly and government Intervention Flashcards
Six characteristics of monopoly
- high barriers to enter market, no close substitutes
- only one firm
- sold quantity can only increase if price is lowered
- price is higher than marginal revenue
- demand curve is average revenue curve
- is able to manipulate the price
Four consequences of monopoly
- results in high prices
- results in low quantities sold
- results in high monopoly profits
- results in a total welfare loss (deadweight loss) as profits increase less than consumer surplus falls
Definintion price discrimination
Charging different prices for different groups of customers
Three conditions of price discrimination
- It must be possible to distinguish the different groups clearly
- both groups cannot trade the product with each other
- elasticity of demand strongly differs for the different groups
Seven assumptions/characteristics of monopolistic competition
- many suppliers, many buyers and a heterogeneous differentiated product
- Market behaviour of 1 firm does not have any influence on the market
- the goal of firms is maximizing profit
- firms have more or less identical cost structures (identical cost curves)
- firms are able to manipulate their price
- in the long run there are no barriers to entry or exit of firms
- firms compete on product quality, price and marketing
Differences between monopoly and monopolistic competition
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Four characteristics of oligopoly
- only a limited number of firms are active
- If there are only two firms: duopoly
- usually some barriers to entry, or some economies of scale
- profits not only depend on the decisions (price) of the firm but also on the decisions of its competitors
Game theory & its strategy for profit maximalisation
Oligopolistic model. Whatever strategy the competitor chooses, it will be most attractive to spend a lot on advertising
Cartel and its profit maximalisation
Oligopolistic model, however cartel works as a monopoly as it uses monopolistic pricing.
Monopolistic pricing
Pricing strategy followed by a seller whereby the seller prices a product to maximize his or her profits under the assumption that he or she does not need to worry about competition.
Remember: price above marginal revenue; demand curve is average total revenue curve and a higher quantity can only be sold when price decreases
The five problems of cartels
- with too many firms it is difficult to make arrangements
- free-rider problem, participants have an incentive to cheat and to produce too much
- high prices and high profits attracts competitors
- for an individual firm it is attractive to remain outside cartel (freedom to decide how much to produce and sell it at a self-designed price)
- cartels and collusion to manipulate prices are prohibited
Five main micro-economic government measures
- price floors/ price guarantees
- subsidies on production
- taxation
- price ceilings/ price support
- quota
Price floors/ price guarantees & consequences
minimum prices. Often combined with the government buying the overproduction at a set price.
- Leads to overproduction, extra costs on the government (that will sell it for a low price on the world market)
- Leads to deadweight loss as it blocks certain transactions
Quota and consequences
maximum production to create higher prices and protect producers.
When set lower than q equilibrium, will lead to deadweight loss
Price ceiling/ maximum price: aim and consequence
protecting consumers for high prices
welfare loss, less quantity offered
Subsidy consequences
- Higher quantity; lower prices and higher MC
- Welfare loss
- Increase in consumer and producer surplus due to the cost of subsidy being higher than the welfare gain
Societal welfare and Pareto
Societal welfare is at its maximum if no potential Pareto improvement is possible
Potential Pareto improvement is seen as a rise in welfare
Potential Pareto improvement
An improvement to a system when a change in the allocation of goods harms no one and benefits at least one person.
Seven reasons for government intervention justifies by economic theory
- protection of property rights
- public goods
- semi-public goods (cost of collection high)
- merit and demerit goods
- redistribution of income
- fighting unemployment
- monopoly pricing and cartels (as it generates welfare loss)
- taxation
- positive and negative external effects
Three types of monopolies
- legal monopoly: patents to stimulate innovation
- cartel: oligopolistic firms working together
- natural monopoly (high fixed costs or only one place where a natural resource can be found)
Four characteristics of natural monopoly
- TFC are huge
- ATC will diminish at high production
- MC of extra production is low
- to have one firm is economically the most efficient (having the lowest average costs)
Taxation and elasticities
The more inelastic the demand, the higher the share in the tax that consumers have to pay (huge price increase)
The more inelastic the supply, the higher the share in the tax the producers have to pay (limited price increase)
The more inelastic demand or supply, the higher the
tax revenue as the quantity sold hardly diminish
negative externalities
A cost that is suffered by a third party as a consequence of an economic transaction.
Without intervention lower price and higher quantity than with governmental intervention.
-> MSC is higher than MC, leading to a welfare loss
Four solutions to negative external effects
- government intervention creates a welfare optimum, which eliminates the deadweight loss. Government regulation and quotas (to mandate clean technology)
- Coase theorem: allocate property rights to one of the parties involved. problem: high transaction costs of negotiations
- taxation of polluting production or taxation of pollution directly
- Marketable/ tradable permits; cap-and-trade. Advantage: you can control the total pollution in an efficient way. Problem: government needs to know firms’ production costs
Coase theorem
allocate property rights to one of the parties involved. Problem: high transaction costs of negotiations
merit goods
The government thinks that the consumption of certain products have very positive effects, where people themselves are not aware of.
Also people do not take the long term beneficial effects enough into account
demerit goods
The government thinks that people are not aware of the disadvantages of consuming certain products.
Also, people do not take the long term negative effects enough into account.
Four characteristics of perfect competition
- large number of firms
- produce at lowest cost possible
- make zero profit in long run
- firms are efficient
Large number of firms implies
- small market share
- ignore other firms
- Collusion is impossible
Maximum profit according to cost and revenue functions
maximum profit is where MC equals MR
Two differences between monopolistic competition and perfect competition
- excess capacity in monopolistic competition, whereas it doesn’t exist in perfect competition (due to ATC being at its lowest)
- markup exist in monopolistic competition but not in perfect competition.
Markup is the price that exceeds marginal cost
in perfect competition, the price equals marginal cost
Efficient degree of product variety
Marginal Social Benefit = Marginal Social Cost
Consequences of small number of firms in the market
interdependence: each firm’s actions influence profits of all other firms
temptation to cooperate: cartel would limit output, whereas price and economic profit would increase
Two theories on regulation
Social interest theory: political and regulatory process relentlessly seek out inefficiencies and introduce regulation eliminating deadweight loss and allocate resources efficiently
Capture theory: regulation serves self-interest of producer who captures the regulator and maximises economic profit
Marginal cost pricing rule
regulation for monopoly
rule setting price equal to marginal cost (no mark up)
Reaction company to cover ATC: two-part tariff: one-time connection fee, plans at fixed prices with afterwards free access
average cost pricing
regulation for monopoly
price equals ATC: creates deadweight loss
government subsidy in regulation
Monopoly regulation
direct payment to firm equal to its economic loss: taxes create deadweight loss
Three regulations for monopoly
- marginal cost pricing rule
- average cost pricing rule
- government subsidy
antitrust law
regulates oligopolies preventing them from becoming monopolies or behaving like them.
Synonym: competition and monopoly law
three main methods of intervention in market for farmers products
- quota: upper limit to the q of a good that may be produced, decrease in s, rise in p, decrease in MC, inefficient underproduction, incentive to cheat and overproduce
- production subsidy: increase in t, fall in p and rise in q, increase MC, inefficient overproduction
- price support: rise in p, increase in MC, inefficient overproduction
Fourfold classification of goods
private goods: excludable and rival
public goods: non-excludable and non-rival
common ressources: non-excludable and rival
natural monopoly good: non-rival and excludable
Tragedy of commons
problem for common ressources where overconsumption and underinvestment lead to depletion of a common ressource
Rational ignorance
it’s rational for a voter to be ignorant about an issue unless that issue has a perceptible effect on voter’s economic welfare
Positive externalities
biggest two mixed goods: education and healthcare
social benefits exceed private benefit
Marginal Social Benefit
MSB= MB + marginal external benefit
marginal benefit enjoyed by society
Demand is MSB
marginal external benefit
benefit from an additional unit of a good or a service that people other than its consumer enjoy
Tax incidence & factors it is dependent on
division of burden of a tax between buyers and sellers
elasticity of supply and demand elastic supply: sellers pay tax elastic demand: buyers pay tax inelastic supply: buyers pay inelastic demand: sellers pay
When is tax efficient?
when there is no deadweight loss, meaning that in perfectly inelastic demand and supply situations, q bought and sold doesn’t change.
-> no deadweight loss
Two principles of fairness for a tax system
benefits principle: people should pay taxes equal to benefits they receive from services provided by government
ability-to-pay principle: people should pay taxes according to how easily they can bear burden of tax
Pigovian tax
incentivize producers to cut back on pollution
setting tax rate equal to marginal external cost
