Week 9 Flashcards
Market power relates to the ability of sellers to affect __________, and arises because of ____________.
prices; barriers to entry.
Legal market power is created by ___________, and arises due to ____________.
the government; copyrights.
Natural market power is created by ___________, and arises due to ____________.
market forces; economies of scale.
Janet knows a lot of people who do not like Marmite®, a yeast extract that is used as a spread on toast. She says that Marmite is so unpopular that Unilever, the company that manufactures Marmite®, cannot possibly have any monopoly power.
Do you agree with this analysis?
Even if Marmite® is not liked by all (or even many) consumers, Unilever can still be a monopoly and have pricing power among the consumers who do demand the good. As long as this good has no close substitutes, then Unilever may indeed have monopoly power.
Edgar says that a single firm in the wind power industry is unlikely to have a significant degree of monopoly power for an extended period of time. Since the cost of producing an additional unit of wind energy is so low, a large number of firms can enter the market and compete away economic profits.
Do you agree with this analysis?
No, Edgar’s argument ignores potentially large fixed costs that will act as a barrier to entry.
Edgar’s argument completely ignores the fixed costs associated with entering the wind energy market. The cost of producing the first unit is likely high enough to act as a barrier to entry to new firms, which gives the incumbent firm a significant degree of monopoly power
Network externalties
Network externalities occur when a product’s value increases as more consumers begin to use it. An example of this is Facebook, which gains value to users as more people join.
Marginal revenue for a monopolist’s demand curve
1). The marginal revenue curve for a monopolist has the same y-intercept as the demand curve but has twice the slope. Therefore, the marginal revenue curve has a y-intercept of $8 and an x-intercept of 4 units.
Which of the following best describes the relationship between price (P), marginal revenue (MR), and total revenue (TR) for a monopolist?
When MR is positive, TR is rising, and when MR is negative, TR is falling.
TR curve
The total revenue curve starts at 0 and rises as quantity rises as long as MR is above 0. The total revenue curve peaks MR = 0 and then it starts to fall, since MR starts to become negative.
Both competitive firms and monopolies produce at the level where marginal cost equals marginal revenue.
Then, other things remaining the same, why is price lower in a competitive market than in a monopoly?
Competitive markets face perfectly elastic demand and marginal revenue, while monopolies face downward-sloping demand and marginal revenue.
A firm in a competitive industry sets its price where marginal cost equals demand (which also equals marginal revenue in perfect competition), while a monopolist finds its optimal quantity where marginal cost equals marginal revenue and then sets its price based on the demand curve at that quantity.
At this profit-maximizing output level, you earn a profit of
Profit is equal to total revenue minus total cost at the profit-maximizing output level. Since marginal cost is fixed, we can find total cost by multiplying marginal cost by output
Imagine you are operating a monopolistically competitive toothpaste firm. How will you decide what price to charge for your toothpaste?
Imagine you are operating a perfectly competitive cafe. How will you decide what price to charge for your coffee?
Price given by demand curve where MC = MR
You will charge the current market price for coffee
Structure: monopoly
- There is only one firm in the market;
- It is large;
- Product differentiation n/a – it is the only supplier of the product.
- Complete barriers to entry (no market entry)
Should you open on Easter Sunday when you have to pay your staff more. What rule can help
Shutdown if P < AVC
Monopoly is a price maker
(it has full market power, which is a source of market failure)
Price maker
A seller who can alter the price of its good by adjusting the quantity it supplies to the market.
The fundamental cause of monopoly
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 to compete with it.
3 sources of monopoly power
Resource based monopolies
Government created (legal) monopolies
Natural monopolies
Resource based monopolies
When a single firm owns a key resource for a product.
For e.g. the market for water. If a single firm owns the dams that supply water to a town, then that firm has a monopoly on water.
Monopoly resources are rare. Economies are large and resources are owned by many people.
- Government-created (legal) monopolies
When the government gives one person or firm the exclusive right to sell a good or service.
For e.g. a patent grants an inventor the exclusive right to manufacture and sell their invention and copyright laws grant a writer monopoly control over the sale of their work.
The benefits of patent and copyright laws are the increased incentives for creative activity. However, because these laws give one producer a monopoly, they lead to higher prices than under competition.
Natural monopolies
When a single firm can supply a good or service to an entire market at a lower cost than could two or more firms.
For e.g. the distribution of water. To provide water to a town, a firm has to pay the fixed cost of building a new network of pipes throughout the town. However, after entry, each firm would have a smaller piece of the market.
Natural monopolies and economies of sale
An industry is a natural monopoly when there are economies of scale over the relevant range of output.
For e.g. club goods, such as uncongested toll roads. Because there is a large fixed cost of building the road and a negligible marginal cost of additional trips, the ATC of a trip falls as the number of trips rises.
- 1.1. Structure: sources of monopoly power
3. Natural monopolies
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Structure: monopoly versus perfect competition
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 its market and is a price taker.
A monopoly is the sole producer in its market and is a price maker.
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Structure: revenue curves
Like monopolistic competition, the MR and D curves always start at the same point on the vertical axis. The monopolist’s MR on all units after the first is less than the P of the good. Thus, a monopoly’s MR curve lies below its D curve
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Because a monopoly faces a downward-sloping D curve
Because a monopoly faces a downward-sloping D curve, to increase the amount sold, a monopoly firm must lower the P of its good. Thus the monopoly faces a tradeoff between the quantity it sells and the price it receives.
Monopoly and price changes
When a monopoly increases the amount it sells (Q) by lowering P, this action has two effects on total revenue (TR = P × Q):
When a monopoly increases the amount it sells (Q) by lowering P, this action has two effects on total revenue (TR = P × Q):
The output effect
The price effect
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.
Structure: revenues measures (TR, AR, MR)
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At a low level of output, such as Q1, MC < MR
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At a low level of output, such as Q1, MC < MR. If the firm increased production by one unit, the additional revenue would exceed the additional costs, and profit would rise.
At high level of output, such as Q2, MC > MR
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At high level of output, such as Q2, MC > MR. If the firm reduced production by one unit, the costs saved would exceed the revenue lost.
profit maximisation
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The monopolist’s profit-maximising quantity of output (Qmax) is determined by the intersection of the marginal revenue curve and the marginal cost curve (where MC = MR).
After the monopoly firm chooses the quantity of output, it uses the D curve to find the price consistent with that quantity (it is a price maker)
How can profit be written
Recall that profit (TR – TC) can be written as: Profit = (P – ATC) × Q
supernormal profit
When the monopolist produces the quantity Qmax, the height of the rectangle is P – ATC, the profit per unit sold.
The width of the rectangle is the number of units sold.
Therefore, the area of the rectangle is the monopolist’s profit.
No entry to erode this profit in the long run, hence termed supernormal profit.
Performance: perfect competition vs. monopoly in long run equilibrium
In competitive markets, free entry and exit results in firms earning zero economic profits; in monopolies, the firm can earn (and maintain) a positive economic profit (supernormal profit).
In monopolies, no free entry and exit to force P to equal ATC. Hence, the firm is not producing at efficient scale (there is excess capacity).
In competitive markets, price equals marginal cost; in monopolies, price exceeds marginal cost.
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efficiency of perfect competition
In a perfectly competitive market (PC), total welfare (total surplus) is maximised at equilibrium.
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Performance: deadweight loss of monopoly
When a perfectly competitive (PC) market is taken over by a monopoly (M):
The deadweight loss of monopoly is the triangle between the demand curve and the marginal cost curve.
The deadweight loss is the reduction in economic wellbeing that results from the monopoly’s use of its market power.
This is the welfare cost of a monopoly.
The d curve and the marginal cost curve
The D curve reflects the value of the good to buyers, as measured by their willingness to pay for it. The marginal cost curve reflects the costs of the monopolist.
Social efficient quantity
The socially efficient quantity is found where the D curve and the MC curve intersect.
At low quantities
At low quantities, the value to buyers exceeds the MC of providing the good, so increasing output would raise total surplus.
At high quantities
At high quantities, the MC exceeds the value to buyers, so decreasing output would raise total surplus.
Lost gains from trade
Monopolies produce at QM, which is to the left of the efficient quantity, therefore there is lost gains from trade.
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The debate about monopoly
The market power of monopolies (and large firms generally) may have certain economic benefits that weight against the deadweight loss, which may in practice not be as serious as in theory.
The market power of monopolies (and large firms generally) may have certain economic benefits that weight against the deadweight loss, which may in practice not be as serious as in theory.
small estimated welfare loss of monopoly
Innovation, research and development
contestability
efficiency hypothesis
Does the monopoly’s profit impose a social cost?
A monopolist’s profit is not in itself necessarily a problem for society. After all, producer surplus is a part of the total surplus.
However if a monopoly firm has to incur additional costs to maintain its monopoly position, then these costs are a part of the social loss from monopoly.
Price discrimination - Introduction
A price-discriminating monopolist charges each customer a price closer to his or her willingness to pay than is possible with a single price.
Price discrimination
The business practice of charging different prices to different customers that are not based on differences in the costs of production.
Three requirements for successful price discrimination:
Firms must possess some degree of market power;
Firms must be able to
separate customers into different groups according to their willingness to pay;
Firms must be able to prevent arbitrage (reselling) among the different group of customers.
Price discrimination example
For e.g. airlines. Fixed cost $200,000 for each flight and a marginal cost of zero.
Two groups of passengers: 100 business people willing to pay $5000 each and 200 students willing to pay $1000 each.
If ticket is priced at $5000, will sell 100 for a profit of $ 300,000 (DWL = $200,000)
If ticket is priced at $1000, will sell 300 for a profit of $ 100,000 (no DWL)
Now suppose that the two types of passengers are located in separate markets.
The airline could charge business people $5000 (selling 100) and charge students $1000 (selling an additional 200).
Now the airline makes a profit of $500,000 and there is no DWL.
Welfare effects of price discrimination
Price discrimination can raise economic welfare and even eliminate the inefficiency inherent in monopoly pricing. Any increase in welfare from price discrimination shows up as higher producer surplus rather than higher consumer surplus.
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Three degrees of price discrimination
First degree – perfect price discrimination
Second degree - non-linear pricing
Third degree - group pricing
First degree – perfect price discrimination
Charging each consumer their maximum willingness to pay – a different price for every customer in every sale, e.g. haggling, used cars
Producers attempt to extract consumer surplus from their customers as profit (producer surplus)
How successful they are depends on their ability to determine exactly how much each customer is willing to pay and price accordingly
Second degree - non-linear pricing
Each customer faces the same price schedule but pay different prices depending on characteristics of their purchase, e.g. quantity discounts
Producers induce customers to self-select - sort themselves out according to their willingness to pay
Third degree - group pricing
Producers are able to identify different consumer groups with different willingness to pay
Segment them into separate markets and charge them accordingly, e.g. students, senior citizens
9.3. Government policy toward monopoly
We have seen that monopolists have a significant amount of control over the price that they receive for their products.
The market power of firms in these imperfectly competitive markets allows them to distort market outcomes away from the outcome that maximises economic wellbeing.
When monopolists exert their market power the result is a deadweight loss. For this reason, market power is regarded as a source of market failure.
9.3. Government policy toward monopoly
Antitrust policy
Antitrust policy aims to prevent anticompetitive pricing, low quantities, and deadweight loss.
Microsoft
Microsoft was accused of anticompetitive behaviour in bundling its Windows operating system with its Internet Explorer browser, squeezing out browser competitors like Netscape Navigator.
Price regulation
In certain cases, e.g. natural monopolies, increasing competition will increase the ATC of production and hence, not desirable.
In these cases, government regulate their prices, to prevent them from charging high prices.
Two models of price regulation
Efficient price (P = MC)
Fair-returns price (P = ATC)
(a) Efficient pricing
If the regulators set a price equal to MC, the monopoly will lose money.
Natural monopolies usually have declining ATC, implying that MC is less than ATC.
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Natural monopolies usually have declining ATC, implying that MC is less than ATC.
One way regulators can respond to this problem by subsidising the monopolist.
Fair-returns pricing
Alternatively, the regulators can allow the monopolist to charge a price higher than MC, but equal to ATC, in which case the monopolist earns exactly zero economic profit.
Average cost pricing leads to a deadweight loss, because the monopolist’s price no longer reflects the marginal cost of producing the good.
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Both marginal cost pricing and average cost pricing
Both marginal cost pricing and average cost pricing give the monopolist no incentive to reduce costs.
If a regulated monopolist knows that regulators will reduce prices whenever costs fall, the monopolist will not benefit from any reduction in costs.
Price cap regulation
Price cap regulation allows the regulated firm to keep all the benefits from lower costs for a fixed period of time. This type of regulation is used to control market power in the electricity, gas and telecommunications industries in Australia.
Summary of firm types
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