WEEK 6 - Chapter 15: Monopoly

Question 1

What is a monopoly?

Answer 1

A firm that is the sole seller of a product without close substitutes.

The fundamental cause of monopoly is barriers to entry – a monopoly remains the only seller in its market because other firms cannot enter the market and compete with it.

Question 2

What are the 3 main sources of barriers to entry?

Answer 2

. Monopoly resources: A key resource is owned by a single firm.
. Government regulation: The government gives a single firm the exclusive right to produce some good or service.
. The production process: A single firm can produce output at a lower cost than can a larger number of firms.

Question 3

Monopoly resources.

Answer 3

The simplest way for a monopoly to arise is for a single firm to own a key resource.

Eg. consider the market for water in a small town in the outback. If there is only one resident in town who can pump out underground water and it is impossible to get water from anywhere else, then that resident has a monopoly on water. Not surprisingly, the monopolist has much greater market power than any single firm in a competitive market.

In the case of a necessity like water, the monopolist can command quite a high price, even if the marginal cost of pumping an extra litre is low.

Although exclusive ownership of a key resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason. Economies are large and resources are owned by many people.

Question 4

Government created monopolies.

Answer 4

In many cases, monopolies arise because the government has given one person or firm the exclusive right to sell some good or service.

Sometimes the monopoly arises from the sheer political clout of the would-be monopolist.

Question 5

Example of government created monopolies.

Answer 5

Kings, for example, once granted exclusive business licences to their friends and allies.

At other times, the government grants a monopoly because doing so is in the public interest. For instance, until October 2001, the Australian government had given a monopoly to a company called Melbourne IT to issue .com.au Internet addresses. Since then, the monopoly licence has been given to another company, AusRegistry.
Having a single company maintain the address database avoids problems such as issuing the same name twice.

Patent and copyright laws are one example of how the government creates a monopoly to serve the public interest. When a pharmaceutical company discovers a new medicine, it can apply to the government for a patent. If the government deems the medicine to be truly original, it approves the patent, which gives the company the exclusive right to manufacture and sell the medicine for a certain number of years.

In Australia, patents for medicine last for 20 years. Similarly, when a novelist finishes a book, she can copyright it. The copyright is a government guarantee that no one can print and sell the work without the author’s permission. The copyright makes the novelist a monopolist in the sale of her novel.

Question 6

Natural monopoly.

Answer 6

A monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms.

Eg. an industry is a natural monopoly when there are economies of scale over the relevant range of output.

Figure 15.1 shows the average total costs of a firm with economies of scale. In this case, a single firm can produce any amount of output at the least cost. That is, for any given amount of output, a larger number of firms leads to less output per firm and higher average total cost.

An example of a natural monopoly is the distribution of water.

Question 7

Monopoly Vs Competition.

Answer 7

The key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output.

A competitive firm is small relative to the market in which it operates and, therefore, takes the price of its output as given by market conditions.

In contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market.

One way to view this difference between a competitive firm and a monopoly is to consider the demand curve that each firm faces. When we analysed profit maximisation by competitive firms in chapter 14, we drew the market price as a horizontal line.

Question 8

Monopoly Demand vs competitive Demand.

Answer 8

Because a competitive firm can sell as much or as little as it wants at this price, the competitive firm faces a horizontal demand curve. In effect, because the competitive firm sells a product with many perfect substitutes (the products of all the other firms in its market), the demand curve that any one firm faces is perfectly elastic.

In contrast, because a monopoly is the sole producer in its market, its demand curve is the market demand curve. Thus, the monopolist’s demand curve slopes downwards for all the usual reasons, as in panel. If the monopolist raises the price of its good, consumers buy less of it. In other words, if the monopolist reduces the quantity of output it sells, the price of its output increases.

Question 9

A monopoly’s revenue.

Answer 9

A monopolist’s marginal revenue is always less than the price of its good. As a result D line is above MR line (acute angle between them).

Marginal revenue for monopolies is very different from marginal revenue for competitive firms.

When a monopoly increases the amount it sells, this action has two effects on total revenue (PxQ):
. The output effect: more output is sold, so Q is higher, which tends to increase total revenue.
. The price effect: the price falls, so P is lower, which tends to decrease total revenue.

Question 10

Profit maximisation - monopolies.

Answer 10

Firms adjusts their level of production until the quantity reaches QMAX, at which marginal revenue equals marginal cost.

Thus, the monopolist’s profit-maximising quantity of output is determined by the intersection of the marginal-revenue curve and the marginal-cost curve.

MC and MR intersect = Q-max
P is determined by bringing the Q-max line up to the Demand line

Question 11

A monopolies price.

Answer 11

For a competitive firm: P = MR = MC
For a monopoly firm: P > MR = MC

When a patent gives a firm a monopoly over the sale of a product, the firm charges the monopoly price, which is well above the marginal cost. When the patent runs out, new firms enter the market, making it more competitive. As a result, the price falls from the monopoly price to marginal cost.

Question 12

Monopoly profit.

Answer 12

The space between Q-max and D intersection, lowest point of ATC and the vertical axis is profit.

Profit = (P - ATC) x Q

Question 13

The welfare cost of monopoly.

Answer 13

From a consumer’s position the fact that a monopoly charges a price above marginal cost makes monopolies undesirable - cost of resource to make one more unit is less than the value of that unit to society.

However, from the standpoint of owners of the firm, the high price makes monopoly very desirable.

Question 14

The inefficiency of monopoly.

Answer 14

The monopolist produces less than the socially efficient quantity of output.

Question 15

The deadweight loss of monopoly.

Answer 15

The area between monopoly quantity, efficient quantity and monopoly price point on D = deadweight loss.

. The monopoly deadweight loss is similar to a tax deadweight loss.
. The difference between the two cases is that:
- the government gets the revenue from a tax
- whereas a private firm gets the monopoly profit.

Question 16

How large is the social cost from monopolies?

Answer 16

Monopolies have a greater impact on lower income households.

Abuse of monopoly power has a social cost and tends to increase social inequality.

The problem in a monopolised market arises because the firm produces and sells a quantity of output below the level that maximises total surplus. The deadweight loss measures how much the economic pie shrinks as a result. This inefficiency is inextricably connected to the monopoly’s high price – consumers buy fewer units when the firm raises its price above marginal cost.

Question 17

What is price discrimination?

Answer 17

The business practice of selling the same good at different prices to different customers.

Price discrimination is when the same good is sold at different prices to different customers, even though the production costs for the two customers are the same.

• price discrimination is not possible in a competitive market since there are many firms all selling a good at the market price.
• in order to price discriminate, the firm must have some market power.

Question 18

What is perfect price discrimination?

Answer 18

Perfect price discrimination refers to the situation when the monopolist knows exactly the willingness to pay for each customer and can charge each customer a different price.

Two important effects of price discrimination:
. It can increase the monopolist’s profit.
. It can reduce the deadweight loss.

Question 19

Discuss welfare with and without price discrimination.

Answer 19

A a monopoly that charges the same price to all customers leaves deadweight loss (triangle right of profit) and consumer surplus (triangle above profit). Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus.

A monopoly that can perfectly price discriminate leaves zero consumer surplus, meaning total surplus now equals the firm’s profit. Monopolies can squeeze every last drop of consumer surplus and make it profit for themselves (the space between D and MC is profit).

Comparing these two, you can see that perfect price discrimination raises profit, raises total surplus and lowers consumer surplus.

Question 20

What are examples of price discrimination?

Answer 20

. Movie tickets (charge a lower price for children, students and senior citizens than for other patrons).
. Airline prices (seats on aeroplanes are sold at many different prices).
. Store brands (many large shops have a store brand. The store-brand products are shelved next to well-known brands and are often cheaper than these well-known products).
. Quantity discounts (Sometimes monopolists price discriminate by charging different prices to the same customer for different units that the customer buys. Eg. many firms offer lower prices to customers who buy large quantities)

Question 21

Comparison between competition and monopoly.

Answer 21

SIMILARITIES
Goals of firms: Maximise profits vs Maximise profits
Rule for maximising profit: MR = MC vs MR = MC
Can earn economic profits in the short run?: Yes vs Yes

DIFFERENCES
Number of firms: Many vs One
Marginal revenue: MR = P vs MR < P
Price: P = MC vs P > MC
Produce welfare-maximising level of output: Yes vs No
Entry in the long run?: Yes vs No
Can earn economic profits in the long run? No vs Yes
Price discrimination profitable: No vs Yes

Question 22

Different degrees of price discrimination.

Answer 22

First degree price discrimination - charge different price for each unit.

Second degree price discrimination - discounts for bulk purchases.

Third degree price discrimination - segmenting market by elasticity.

Question 23

Describe a monopoly with profits.

Answer 23

Price is above MC and ATC.

Profit area is between Q(monopoly) and P(monopoly) intersection on D=AR line, Q(monopoly) point on ATC and Vertical axis.

Q(monopoly) goes through the point where MR and MC intersect.

Consumer surplus is the triangle above this and deadweight loss is between the MR and MC intersection AND the D=AR and MC intersection.

Question 24

Describe a monopoly with zero profits.

Answer 24

P(monopoly) is at the point where D=AR intersects with ATC.

Q(monopoly) and P(monopoly) intersect at this same point.

Q(monopoly) goes though where MR and MC intersect.

Question 25

Describe a monopoly with loss.

Answer 25

ATC is above P(monopoly) because D=AR is lower than ATC.

Q(monopoly) goes through the point where MR and MC intersect.

Where ever the Q(monopoly) touches the ATC is the top right of the square of loss.

The bottom left of this square is where Q(monopoly) touches D=AR as this is where the P(monopoly) intersect.

Question 26

Monopoly: shut down.

Answer 26

ATC and AVC are much higher than p(monopoly).

Question 27

Static Vs Dynamic efficiency.

Answer 27

Static:
. Deadweight loss
. Inefficiency, little effort needed
. Rent seeking - resources devoted to maintaining monopoly rather than production

Dynamic:
. Innovation, R and D
- easier to fund
- incentive to maintain market position