1 CHAPTER 15: MONOPOLY In writing these notes, help was taken from website: http://william-king.www.drexel.edu/top/prin/txt/Monch/mon3.html 15.1 Definition: Firm: A monopolist is the only seller of a product for which there is no close substitute. Market: A monopoly is an industry in which there is only one firm. Why is there only one firm? B/c of barriers to entry: entry is not free in contrast with the competitive case. 15.2 Why Do Monopolies Arise? 1. Government Created Monopolies: Exclusive Rights Granted to One Firm: Only Türk Telekom has the right to provide land phone service and cable TV service in Turkey. Patents, Copyrights, Trademarks, Trade Secrets: Patents give the inventor of new product exclusive rights to produce and sell the product for a specific amount of time. If the product in question does not have close substitutes, then the inventor firm becomes a monopolist until the patent expires. The idea behind patent law is to encourage research and development. İf there was no patent law, there would be a free rider problem: given that it is free to copy an invention once it is made, nobody would invest their time and money to research and development. 2 For example, Polaroid has owned the patent for instant cameras. When Kodak started to make instant cameras, a court found that this violates Polaroid’s patent rights. Then, Kodak had to stop production and pay a penalty to Polaroid. 2. Exclusive control of an input resource: More in history than now. The De Beers diamond monopoly. The firm owns most of the diamond mines in the world. 3. Natural Monopolies: • An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than can two or more firms. The LRATC curve is declining (there is economies of scale) to the point of entire market volume. The largest producer can undersell the rest, and still make profits. Draw the cost curves on notes. Examples: Cable service, wireless communication service, etc. An entry game: Suppose initially firm A operates in cable TV market in Istanbul and able to sell 100,000 subscriptions. To enter, a firm needs to commit YTL 1million fixed costs, but marginal cost is fixed at 10YTL per unit. Firms are identical. Also assume total number of cable subscribers is constant at 100,000. Assume firm B enters into this market and able to attract 20,000 customers. At this qty, ATC for firm B is 60 YTL (1,200,000 / 20,000) whereas for firm A ATC is down at 22.5 YTL (1,800,000 / 80,000). Any price war will kick firm B out of the market with huge losses. For example if firm A charges 30 YTL per subscription then it will still make a positive profit but firm B will have losses and cannot stay in the industry. In such an industry, potential entrant firms calculate and expect 3 such result and do not enter into the market at the first place. So we get a monopoly or oligopoly in industries with large initial fixed costs and small marginal costs such as GSM providers, computer software (Microsoft) and cable TV. (Unless they think they can kick the incumbent firm out of the market, but then we would still get a monopoly, right?) 4. Network Externalities How Does a Monopolist Make Production and Pricing Decisions? Demand curve faced by a monopolist is downward sloping unlike the competitive firm. Draw competitive case again. The market demand curve is the demand curve faced by the firm. A monopolist chooses the price it wants to charge given its demand curve. So a monopolist is a price maker, not a price taker like a competitive firm. Note that the monopolist cannot charge arbitrarily high price and hope to sell a lot. He is still constrained by the market demand. Show Table 1. Consider a small town with a single producer of water. The first two columns show the demand schedule: as more gallons sold, price on ALL gallons go down. Explain that marginal revenue is always less than price for a monopolist. For example, from 4 gallons to 5 gallons, the firm increases revenue from $28 to $30, MR=$2. This is lower than either $7 or $6, respective prices for selling 4 and 5 gallons. Show Figure 3. Profit Maximization: Draw Figure 4. The firm again picks the quantity at which MR=MC. The price that the monopolist can charge at this quantity is given by the demand curve. This price is called the monopoly price. 4 Since MR is always less than price for a monopolist, monopoly price Pm > MC as opposed to Pc=MC in competitive case. This is why Microsoft can charge $150 for a couple of software CDs that cost few dollars to make. Draw Figure 5: Monopoly profits. Welfare Cost of Monopoly: Desirability of monopoly outcome: Disadvantage: Price charged by monopolist will be above marginal cost of production. For example, consider a Microsoft Windows Operating System package. It is sold above $50, where the marginal cost to make it might be a few dollars. Draw Figure 7: Demand curve shows the value placed on each unit of the good by the consumer-buyer. Consumer Surplus is the extra value that consumer enjoys on top of the price she pays. CS is the area above price and below the demand curve. Supply curve shows the marginal cost of producing the good. The area above the supply curve and below price is the Producer Surplus. This is the extra benefit that the seller gets from selling the good. Total Surplus is the sum of CS and PS. Show how the competitive market outcome maximizes Total Surplus = Consumer Surplus + Producer Surplus. The point that maximizes TS is the free market equilibrium, where D intersects S. We also call such a point socially efficient. The competitive market satisfies this, so maximizes TS. But a monopoly does not maximize TS: Draw Figure 8: Deadweight Loss of Monopoly. This is a result of Pm > MC. Social efficiency requires price=marginal cost. There are some buyers in the society that value the good above the marginal cost of making it, but they are not 5 able to buy because of the monopoly. The monopolist produces too little and charges too high a price compared to competitive (and socially efficient) outcome. Is the monopoly’s profit a social cost? No, that part is just a redistribution of surplus from the buyers to the seller. The only social loss is the deadweight loss shown above. Public Policy Toward Monopolies: Antitrust law. Break companies up, prevent mergers& acquisitions, monitor firm “anti-competitive practices”. Control prices by setting prices closer to marginal costs. All of these policies have their drawbacks of their own. For example, in inddustries with high research & development investment but low marginsal cost, if the govt. tries to reduce prices to marginal cost, then firms go out of business because they need the monopoly profits to invest in new technologies, new drugs. Pharmaceutical companies is an example. There has to be a balance between those companies charging too much for drugs to especially poor countries and the fact that they need to invest for new cures. Price Discrimination: If the monopolist knows the demand schedule, then could charge different prices to each buyer according to their WTP. Then, there would be no consumer surplus, all surplus would be collected by the monopolist as profits. Also, there would not be any deadweight loss of monopoly. Show Figure 10. Note that a competitive firm cannot price discriminate since there must be one price only. 6 Examples: Firms’s Goal is to separate customers according to their WTP. Novels: First publish hardcover edition and sell it at 45 YTL, then a few months later publish paperback edition and sell at 10 YTL. Airline tickets: First class versus economy.