CHAPTER 23
Monopoly
Chapter 22 introduced you to the theory of perfect competition and the workings of the perfectly competitive market. Chapters 23 and 24 deal with markets that are not perfectly competitive. They are, in fact, often referred to as “structural market failures.” This chapter focuses upon the theory of monopoly and optimal behavior for a monopolist. In so doing, we see the polar opposite to perfect competition. Here we have one firm with considerable market power that sets its own prices, can make a sustained economic profit, and has little concern over new competition—all factors that are different from perfect competition. Chapter 23 begins with the theory of monopoly, paying particular attention to the issue of barriers to entry, then moves to optimal short-run and long-run pricing and output behavior for the monopolist, price discrimination, and, finally, the welfare costs of monopoly (as compared to perfect competition).
 
n CHAPTER OBJECTIVES
Upon completing this chapter, you should be able to:
1.   Discuss the theory of monopoly.
2.   Explain the differences between perfect competition and monopoly.
3.   Distinguish between government monopoly and market monopoly.
4.   Discuss the case against monopoly.
5.   Explain why rent seeking is socially wasteful.
6.   Identify the conditions under which a firm may price discriminate.
7.   Describe the effects of price discrimination.
KEY TERMS
•  monopoly                                                     •  deadweight loss of monopoly

•  public franchise                                            •  X-inefficiency

•  natural monopoly                                          •  price discrimination

•  price searcher                                               •  perfect price discrimination

•  arbitrage                                                       •  second-degree price discrimination

•  rent seeking                                                  •  third-degree price discrimination
 


CHAPTER OUTLINE

     I.  THE THEORY OF MONOPOLY

         A.  Basic Assumptions—The definition of   MONOPOLY rests on three basic assumptions.

                1.  There Is One Seller—In a pure monopoly there is only one seller, meaning that the firm is the industry and will, therefore, have significant influence over price.

                2.  The Monopolist sells a Product for Which There Are No Close Substitutes—

thus, the monopolist faces little, if any, competition.
                3.  There Are Extremely High Barriers to Entry—
It is very hard for new firms to get started.
Government restrictions, high costs, or exclusive ownership of vital resources make it very hard  for new firms to enter the monopolized industry, further limiting the competition faced by monopolists.
 
B.  Barriers to Entry: A Key to Understanding Monopoly—Where do entry barriers come from?
                1.  Legal Barriers—One major source of monopoly power is government. The government grants monopoly status to firms in three ways:
                     a.   PUBLIC FRANCHISE—a right granted to a firm by government that permits the firm to be the exclusive provider of a particular good or service. What the government gives, the government can take away.
 
For exampleThe electric utilities, airlines were legal monopolies. The government believed that it was so expensive to start firms in those industries -in the case of electric utilities all of the electric utility lines that are required to start
or they were concerned that they be run safely: they didn't wan't airlines competing by offering low cost, low quality service.
 
                     b.   PATENTS—The U.S. government grants patents to inventors of products or processes for a period of 20 years. During the patent period, only the patent holder has the right to make and use the patented product. So the company can charge a very high price and make a monoply profit.
 
This right to make monopoly profits from a product for a while gives pharmaceutical companies the incentive to invest in research.
    Example: HIV drugs
    This becomes an issue though if sick people desperately need the patented medicine and can't afford the high price.
 
                     c.   Licenses—Entry into some industries and occupations requires a government-granted license, the quantity of which may be controlled to restrict entry.
 
                2.  Economies of Scale—In some industries, start up and/or distribution costs are so high that production doesn’t become cost effective until fairly high levels of output. This means that new entrants must enter on a large scale, if they hope to be competitive, and must be able to afford such an entry.
                            If economies of scale are so pronounced in an industry that only one firm can be cost effective, this firm is called a NATURAL MONOPOLY.
This was the argument for making the electric utilities legal monopolies. Another example would be the New York Subway System. The New York Subway System has very large fixed but very low marginal costs.
 
                3.  Exclusive Ownership of a Necessary Resource—Existing firms may be protected from new entry by the ownership of all of the  resources needed to enter and produce in the industry.
Example; Alcoa,.
C.  What Is the Difference between a Government Monopoly and a Market Monopoly?—Monopolies avoid competition by one of two forces: legal mandate and economic situation.
1. Monopolies that are legally protected from competition are referred to as government monopolies.
2. Monopolies that are protected from competition due to economies of scale or the exclusive ownership of some vital resource are called market monopolies.
D.  Monopoly and the Boston Tea Party—The Boston Tea Party is one of the most famous events in Revolutionary War history. The colonists threw the tea overboard to protest their having to buy tea from a monopoly seller.
   II.  MONOPOLY PRICING AND OUTPUT DECISIONS—Because of its unique status in its market, the monopolist has some ability to control the price of the product it sells; as such, it is referred to as a price searcher.
 
PRICE SEARCHER A seller that has the ability to control to some degree the price of the product that it sells.
In contrast to a price taker, a price searcher can raise its price and still sell its product, although the number of units sold will fall as price rises.

 
 

         A.  The Monopolist’s Demand and Marginal Revenue—Since the monopolist is the sole supplier in its market, the monopoly firm faces the (downward-sloping) market demand curve. If the monopolist wants to sell additional output, it must lower price in order to do so. If the monopolist wants to charge a higher price, it will do so at the expense of a reduction in quantity sold.


 
 
 
 
 
 
 

          B. The Monopolist’s Demand and Marginal Revenue Curves Are Not the Same:

Why Not?—
Lowering the price of additional units of the good will lower the price of all units sold ,
marginal revenue will fall more rapidly than price.
 
As a result, after the first unit of output is sold, the monopolist’s marginal revenue (MR) curve will always lie below its demand curve.


 
 
 
 
 
 
 
 
 
 

         D.  Monopoly Price and Output for a Profit-Maximizing Monopolist—Assuming the monopolist is a profit-maximizer,

its optimal short-run level of output will be that quantity where Marginal revenue equals Marginal Cost (the same as with the perfectly competitive firm), and
it will charge the highest price per unit at which that quantity can be sold. In the Graph below the monopolist produces Q1 where MR = MC, and sells Q1 at the price on the demand curve that corresponds to that level of output. Notice that the monopolist charges a price greater than marginal cost.


 
 
 
 
 
 
 
 

          E.  Crucial Technical Differences between Perfect Competition and Monopoly—Two important differences between perfect competition and monopoly deserve emphasis:

(1) For the perfectly competitive firm, P = MR; for the monopolist, P > MR.
(2) For the perfectly competitive firm, P = MC; for the monopolist, P > MC.

          F.  In Perspective—

        Perfectly competitive and monopolistic firms also have many things in common.

1. Both try to maximize profits;
2. both are constrained by their demand curves; and
3. both equate marginal revenue with marginal cost.
 
There is a major difference between perfectly competitive and monopolistic firms, however.
If the perfectly competitive firm tries to sell its product for a price other than the market price, it will sell nothing.
This fact is not true for monopolies.
Monopolies can extort profits from buyers.
 
G. Monopoly and Perfect Competition, and Consumers’ Surplus—Monopoly firms charge higher prices than similarly situated competitive firms.  The greater price decreases the amount of consumers’ surplus, since consumers’ surplus is defined as the highest price a consumer would pay minus the price they actually have to pay.
 
  III.  THE CASE AGAINST MONOPOLY—Monopoly is inefficient compared to perfect competition. Here we examine some of those arguments.

 

         A.  THE DEADWEIGHT LOSS OF MONOPOLY— NOTICE THAT THE MONOPOLIST PRODUCES A LOWER QUANTITY OF OUTPUT (Q1)AND SELLS IT AT A HIGHER PRICE (P1) THAN IF THE  FIRM WEREOPERATING IN A PERFECTLY COMPETITIVE MARKET (P2,Q2). In the perfectly competitive market, Marginal Cost equals Price.
 


 
 
 

          B.  Rent Seeking—If a monopoly earns positive economic profits, these monopoly profits are sometimes referred to as economic rent, which is any payment in excess of opportunity cost.
 

Market participants who expend resources trying to influende public policy and capture economic rents in the hope of redistributing income to themselvesare engaging in RENT SEEKING and rent seeking will tend to decrease the actual (net) value of any economic rents earned, because the cost of rent seeking must be deducted from the rent earned.

Not only do monopoly profits represent a welfare cost to society, they also create an (inefficient) incentive to expend resources trying to compete for them. Rent seeking expends otherwise?productive resources in an effort to redistribute exiting value, rather than trying to create additional value.

         C.  X-Inefficiency—Since the monopolist lacks substantial competition, it is not under any pressure to minimize costs. As a result, it is possible for the monopolist to produce at a level above the lowest possible unit coast and still prosper. Economist Harvey Leibenstein referred to monopolists operating at higher-than-minimum cost, and to the organizational slack that is directly tied to this, asX-inefficiency.

         D.  Monopolists may engage in price discrimination: What Is Price Discrimination?—So far we have assumed that the monopolist charges the same price for all units of the good sold. However, since the monopolist is the market, and the monopolist-as-market has some control over price,

the monopolist may, under certain circumstances, charge different customers different prices for the same product.

Doing so is called PRICE DISCRIMINATION.
Price discrimination comes in three varieties
1.  First-Degree (PERFECT) PRICE DISCRIMINATION—charging each customer the highest price she is willing and able to pay for an additional unit of the good—that is, charging precisely the price for each unit of output that is indicated on the market demand curve.
Imagine that there was only one restaurant in a town and the owner could tell how much money you had and just how much you would pay for a meal. There wouldn't be any consumer surplus. He would chrge you the highest price that you would pay.
Imagine if he did that for water!
2.  SECOND DEGREE PRICE DISCRIMINATION—charging different prices based upon quantity purchased, such that the first unit or group of units is sold at the highest price, the next unit or group at a lower price, and so on.
3.  THIRD DEGREE PRICE DISCRIMINATION—charging different prices to different segments of the market or the buying population.
               Airlines distinquishing between business and recreation travelers
          E.  Why Would the Monopolist Want to Price Discriminate?—
        Price discrimination allows the monopolist to recapture some of the consumers’ surplus it loses by charging all customers the same price, even though some are willing and able to pay more. In fact, a monopolist who who compleely understood the consumers’ inclinations could price discriminate and completely eliminate consumer surplus.
               (if the monopolist can successfully perfectly price discriminate, then P = MR for all units sold, significantly increasing marginal and total revenue, and completely eliminating consumers’ surplus.)

 
 

          F.  Conditions of Price Discrimination—Given the revenue?enhancing benefits of price discrimination, why doesn’t everybody do it? In order to price discriminate, the following conditions must hold:

         1.  The Seller Must Exercise Some Control over Price; It Must Be a Price Searcher.

         2.  The Seller Must Be Able to Distinguish between Customers and Determine Their Willingness to Pay.

                3.  It Must Be Impossible for One Buyer to Resell the Good to Others—The possibility of arbitrage, “buying low and selling high,” must not exist.

ARBITRAGE Buying a good in a market where the price is low and thne taking it to another market where the price for the same good is higher.
 
 

OTHER VIEWS OF MONOPOLIES

Joseph Schumpeter saw capitalism as characterized by gales of monopolistic competition. In his view big companies introduce new ideas and new economies. They sieze control of industries for awhile by the force of their business success, but then they are swept aside by new monopolies with new technologies. So monopolies are necessary for the process of invention and innovation and monopolies drive our economy forward.


 
 

John Kenneth Galbraith argued that monopolistic corporations were a threat to democracies because their huge wealth becomes a huge lever to force government to do things the way that the way the monopolist want them done. Monopolies threaten democracy itself.