Semester II, AY2013-2014

NUS Business School

BSP1005 Managerial Economics

Lecture Notes 7

MARKET POWER
AND
ECONOMICS OF MONOPOLY
By Jo Seung-Gyu

OUTLINE

Preliminary Discussion
Review of Perfect Competition
Market Power
Economics of Monopoly with Simple (Uniform) Pricing
Strategies
Monopolistic Equilibrium
Rule of Thumb Pricing
Economics of Multi-plant Monopoly
Social Costs of Monopoly
Mini Case Studies: Microsoft and US Electricity

Monopsony is to be skipped.
2

OUTLINE
Preliminary Discussion

Review of Perfect Competition

Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
Monopolistic Equilibrium
Rule of Thumb Pricing
Economics of Multi-plant Monopoly
Social Costs of Monopoly
Mini Case Studies: Microsoft and US Electricity

Perfect competition is the most ideal market

structure from the efficiency perspective.

Review of Perfect Competition

P = LRMC = LRAC ( = SRMC = SRAC)

Above-normal profits may prevail in the short run but only normal
profits (or zero economic profits) in the long run.
P

P
D

S
SRMC

LRMC LRAC
SRAC

P0

P0

Q0
Market

D = MR = P0

q0
Individual Firm

OUTLINE
Preliminary Discussion
Review of Perfect Competition

Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
Monopolistic Equilibrium
Rule of Thumb Pricing
Economics of Multi-plant Monopoly
Social Costs of Monopoly
Mini Cases: Microsoft and US Electricity

We now examine markets where firms are not price

takers any longer. That is, firms now have market
power.
5

Market Power

We now examine markets where firms are not price takers any longer.
That is, firms now have market power.
Market power: Ability of a seller or buyer to affect the price of a
good

 Sources of Market Power

Access to unique Resources (Eurostars exclusive right to use the

Eurotunnel)

Control over Intellectual Property and Copy Rights (Eli Lillys patent
to Zovant a drug for sepsis, Microsofts copyright over Windows 8)

Economies of Scale and Scope (electricity distribution, cable TV/local

telephone service/Internet Service)

Regulation (natural gas, public transportation)

Product differentiation, brand value (Evian vs generic mineral water

brand)

Sources of Market Power cont.

The less elastic its demand curve, the more monopoly power a firm has. The
ultimate determinant of monopoly power of a firm is therefore the price
elasticity of the firms demand.
Three factors determine the elasticity of a firms demand.
1. The elasticity of market demand. Because the firms own demand will be
at least as elastic as market demand, the elasticity of market demand limits
the potential for monopoly power.
2. The number of firms in the market. If there are many firms, it is unlikely
that any one firm will be able to affect price significantly.
3. The interaction among firms. Even if only two or three firms are in the
market, each firm will be unable to profitably raise price very much if the
rivalry among them is aggressive, with each firm trying to capture as much
of the market as it can.

 How to Measure Market Structures

We need a summary measure

Our preference is for a simple measure, but no single one is perfect.

a. Concentration Measures:
Concentration ratio(CRi) or
Herfindahl-Hirschman index (H or HHI)
b. Performance Measure:
Lerner Index (LI)

Note: Refer to the reading Measuring Market Power for more details.

Concentration Measures: CRi and HHI

i

Concentration Ratio(CRi) vs Herfindahl-Hirschman index (H or HHI)

(Case of top 4 firms)

Firm Rank

Market Share (%)

Squared Market Share

25 25

625

25 25

625

25 25

625

5 5

25

25

25

25

25

Concentration Index

CR4 = 80

H4 = 1,900
10

Concentration Measures: CRi and HHI cont.

i

Compare two different measures of concentration:

(Case of top 4 firms)
Firm Rank

Market Share (%)

A

Squared Market Share

A

2500

625

400

625

50

20

25 25
25 25

25 25

25

625

5 5

25

25

25

25

25

25

Concentration Index

CR4 = 80

CR4 = 80

H4 = 2,950

H4 = 1,900

11

 Concentration index is affected by, e.g. merger

Firm Rank

Market Share
(%)

1
Assume
that firms
24 and 5 decide
to merge
3
4
5
6
7

25 25

625
Market shares
25 25
625
change
25 25
625
5

5
5

The Concentration
Index changes

8
Concentration Index

Squared Market
Share

10

25
25

25

25

25

CR4 = 80

85

H = 2,000

100

1,925

12

b. Measure for Market Performance : Lerner Index

Market performance is often measured using the Lerner Index

LI =

P-MC
P

Perfect competition: LI = 0 since P = MC

Monopoly: LI = 1/ i.e. inverse of the price elasticity of demand

Lerner Index can be a useful measure for the market structure, but has
its own misspecification for a good performance measure:
A dominant firm may charge a low price to prey upon
competitors or to deter new entrants (predatory or preemptive
practices)
A severe price-competition even among few firms may lead
to near-competitive prices
13

OUTLINE

Preliminary Discussion

Review of Perfect Competition

Market Power

Economics of Monopoly with Simple (Uniform) Pricing Strategies

Monopolistic Equilibrium

Rule of Thumb Pricing

Economics of Multi-plant Monopoly
Social Costs of Monopoly
Mini Cases: Microsoft and US Electricity

True monopoly markets are rather rare, yet their underlying

economic principles help identify optimal behavior in
markets where managers have varying degrees of market
power. Such markets are quite prevalent in the business
world.
14

Introduction

Here we consider a simple case of monopoly: Supply-Side Monopoly

with uniform pricing.
One seller and many buyers.
No close substitutes
Barriers to entry

Our Plan
Simple (Uniform) pricing Strategies under Monopoly (This lecture)
Sophisticated Pricing Strategies under Monopoly (Next lecture)
Price Discriminations
Two Part Pricing and Bundling

15

 Demand and MR

P
a

In the case of linear demand curves,

the MR curve has the same price
intercept as the demand curve (or AR
curve) and twice the slope.

Q
D = a bQ
MR = a 2bQ

16

 Monopolistic Equilibrium

The demand curve also represents the average revenue (AR)

In the case of linear demand curves, the MR curve has the same price
intercept as the demand curve (or AR curve) and twice the slope.
The monopolist produces where MR = MC.
So output will equal Q*, market price is P*, and Profit = = P*ABC
$ per
unit of
output

MC
P1

AC

P*
P2

C
Lost Profit
if Q = Q1

D: P(Q)

E
Lost Profit
if Q = Q2

MR
O

Q1

Q*

Q2

Quantity

17

Monopolistic Equilibrium contd.

An Algebraic Illustration:
(Q) = TR(Q) TC(Q) is maximized when MR = MC
since
d (Q)/dQ = [dTR(Q)/dQ] [dTC(Q)/dQ]]
= MR MC = 0
= [P + Q [dP(Q)/dQ]] - MC

Note that P > MR = MC at Monopolistic Equilibrium.

18

A Numerical Example
Suppose
P = 10 Q and TC = 5 + Q + 0.5Q2.

Then
MR = 10 2Q = 1 + Q = MC yields
Q = 3 and P = 7.
= TR TC = 7x3 12.5 = 8.5

MC = 1 + Q
7

Or, more systematically,

1

= TR TC = (10 Q)Q (5 + Q + 0.5Q2)

and
d/dQ = 0 yields Q = 3.
Then P = 7 and = 8.5

3
MR

Demand:
P = 10 - Q
19

A numerical example cont.

TR

MR

eD

TC

10
9
8
7
6
5.5
5
4
3
2
1
0

0
1
2
3
4
4.5
5
6
7
8
9
10

0
9
16
21
24
24.75
25
24
21
16
9
0

10
8
6
4
2
1
0
-2
-4
-6
-8
-10

-
-9
-4
-2.33
-1.5
-1.22
-1
-0.67
-0.43
-0.25
-0.11
0

5
-5
6.5
2.5
9
7
12.5 8.5**
17
7
19.625 5.125
22.5 2.5
29
-5
36.5 -15.5
45
-29
54.5 -45.5
65
-65

VC

ATC MC

0
1.5
6.5
4
4.5
7.5
4.167
12
4.25
14.625 4.361
17.5 4.5
24
4.833
31.5 5.214
40
5.625
49.5 6.056
60
6.5

2
3
4
5
5.5
6
7
8
9
10
11

monopoly eqlm
competitive eqlm

Comparison between Monopoly (M) and Competitive (C) Market:

PM > PC, and QM < QC

M > c
PM> PC = MCC > MCM, thus resource allocation is not efficient.
- As we will see later, this inefficiency is represented through the
monopoly deadweight loss: (CS + PS)M < (CS + PS)C
20

Outline
Preliminary Discussion
Review of Perfect Competition
Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
Monopolistic Equilibrium

Rule of Thumb Pricing

Economics of Multi-plant Monopoly

Social Costs of Monopoly
Mini Cases: Microsoft and US Electricity

In the real world, managers may only have a

limited knowledge of D and C. Still, we can
derive a heuristic yet more practical rule of
thumb from MR = MC condition.
21

 Monopoly - A Rule of Thumb (Markup) Pricing

Rewriting MR formula,
MR = dTR/dQ = d(PxQ)/dQ = P + Q (dP/dQ)
= P + P (Q/P)(dP/dQ)
= P [1 + (Q/P)(dP/dQ)]
= P [1 + (1/e)]
where e = (P/Q)(dQ/dP) < 0 is the price elasticity of demand

Since MR = MC, we have

MR = P [1 + (1/e )] or P[1 (1/|e | )] = MC

Then,

P MC = (P/e ) or (P/|e | ). Thus,

22

Monopoly - A Rule of Thumb (Markup) Pricing

cont.

Meaning:
Price can be viewed as a simple markup over marginal cost.
Monopoly mark-up is always positive since e < 0 or |e | > 0, and thus
/ or
/| | are always smaller than one.
If e is large, markup is small and if e is small, markup is large, as depicted
below:
Example:
When the MC of a unit is $10 and the own price elasticity is 2.
Then the monopolist can determine the price as follows:
P = 10/(1 + [1/-2]) = 10/[1/2] = $20.
23

Examples of Mark-up Pricing

Astra-Merck prices Prilosec, a new generation antiulcer medication.
Prilosec was approved as a long-term ulcer treatment in 1995, while others were only for short- term
treatment, which created a very large market with no major competitor.

Price of Prilosec = $3.5/daily dose

MC of Prilosec = 30 - 40 cents/daily dose
Price elasticity estimated to be between ( 1.0) and ( 1.2).
Then,
P=

1=

0.35
1

1
1.1

0.35
0.09

= 3.89

Price of $3.5 is quite consistent with the rule of thumb pricing.

24

Example of Mark-up Pricing cont.

Supermarkets vs Convenience Stores
Supermarkets

Convenient Stores

1. Several firms

1. Higher prices than supermarkets

2. Similar product
3. E d 10 for individual stores

2. Convenience diffrentiates them

3. Ed 5

4 .P

MC
MC

1 .11( MC )
1 1 10 0 .9

5 . Prices set about 10 - 11% above MC.

4.P

MC
MC

1.25(MC)
1 1 5 0.8

5. Pricesset about 25 % aboveMC.

Comparison: Convenience stores have more monopoly power.

Question: Do convenience stores have higher profits than supermarkets?

25

Outline
Preliminary Discussion
Review of Perfect Competition
Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
Monopolistic Equilibrium
Rule of Thumb Pricing

Economics of Multi-plant Monopoly

Social Costs of Monopoly

Mini Cases: Microsoft and US Electricity

Many firms produce goods and services at multiple

locations (for the same market). One issue facing
managers is how to allocate production across the
various plants.
26

 Story of a Multi-plant Monopoly

You have two water-bottling plants in Indonesia and Malaysia. You import
from the two plants and sell in Singapore. Your decisions include:
How many to sell at Singapore at what price
How many to import from each plant
Singapore
MRT (Q1 + Q2)
Indonesia
MC1 (Q1)

Malaysia
MC2 (Q2)

Experiment:
What would you do if MRT = MC1 > MC2 ?

Questions were:
What should its total output be, and how much of that output should
each plant produce? We can find the answer intuitively in two steps.
Step 1. Whatever the total output, it should be divided between
the two plants so that marginal cost is the same in each plant.
Otherwise, the firm could reduce its costs and increase its profit
by reallocating production. (MC1 = MC2 = MC3 =..)
Step 2. We know that total output must be such that marginal
revenue equals marginal cost. Otherwise, the firm could increase
its profit by raising or lowering total output. (MCi = MR for i = 1,
2, 3, )
Therefore, the profit maximization condition for a two-plant monopoly
becomes:
MR = MC1 = MC2

Profit Maximization Condition for Multi-plant monopoly

= PxQT C1(Q1) C2(Q2), where QT = Q1 + Q2

/Q1 = (PxQT)/ Q1 dC1(Q1)/dQ1 dC2(Q2)/dQ1
= MR MC1 = 0
So MR = MC1 for plant 1.

We can do the same for plant 2 (i.e. /Q2 = 0) and derive

MR = MC2.

Combining the both conditions, it follows:

MR = MC1 = MC2

29

MC1

MC2

MCT

Remarks:

P*
MR*

D = AR
MR
Q
Q1

Q2

QT

Algorithm: You choose total quantity

QT first by equalizing MR and MCT and
distribute QT over the two plants so that
MC1 = MC2 = MR. (Note that MCT is
obtained by horizontally adding up MC1
and C2.)

When MCs are non-constant but

increasing, the monopolist will produce
more from the lower-cost plant than
from the higher-cost firm. If MCs of
the two firms are not increasing in the
same speed, the distribution of the
production across the two plants would
depend on how big the total sales is,
which again would depend on how
strong the market demand is.
If the demand is not too strong, then
the monopolist may decide to produce
the total sales from one plant only and
idle the other plant.
(Can you depict the cases graphically?)
30

Outline
Preliminary Discussion

Review of Perfect Competition

Market Power

Economics of Monopoly with Simple (Uniform) Pricing Strategies

Monopolistic Equilibrium
Rule of Thumb Pricing
Economics of Multi-plant Monopoly

Social Costs of Monopoly

Mini Cases: Microsoft and US Electricity

Monopoly power results in higher prices and

lower quantities, leading to a social welfare
loss (called deadweight loss). Therefore,
monopolies are inefficient from a social cost
perspective.
31

 Welfare Effect of Monopoly: Deadweight loss

Consumers lose A+B and producer gains A-C

Deadweight loss = (B+C)
$/Q
Lost Consumer Surplus

Pm

Deadweight
Loss

B
C

PC

Qm

MC

AR=D
MR
QC

Quantity

Debates on Economic Effects of monopoly:

Can there be additional costs other than (B+C)?

Can there be benefits of monopoly not captured in the above
diagram?
32

Additional costs of monopoly

Deadweight loss in practice can be bigger than (B+C).
If the monopolist spends resources to create and/or maintain the
monopoly position (so called Rent-Seeking Behavior such as
lobbying, advertising and legal efforts), there could be an
additional loss. (A monopoly would have an incentive to spend up
to (A-C) for the monopoly right.)

Potential Benefits of monopoly

Sometimes, offsetting efficiency may result from the creation or
maintaining of a monopoly
Prospect of monopoly profit is the main motivation for R&D,
which is why innovation is patent-protected.
However: Patent monopoly is only temporary, but network effect can
extend monopoly beyond patent expiration.

33

 Price Regulation of Usual Monopoly

The regulatory authority
would be concerned about
potential inefficiency of a
monopoly. Often, monopoly is
regulated through a price
ceiling.
Monopoly price: Pm
Price regulation (price ceiling)
could be set at
P1: still economic profit > 0
(MC-Pricing) P2 = PC:
competitive equilibrium
P3: shortage

34

 Price Regulation of Natural Monopoly

A natural monopoly exists
when there is great scope for
economies of scale to be
exploited over a very large
range of output: AC decreases.
(natural gas, cable TV,
electricity etc)
Monopoly price: Pm
Price regulation
(MC-pricing) If P2 = PC
(=MC) as in usual monopoly
regulation case, firm makes
a loss and would go out of
business.
(AC-pricing) Pr is the price
ceiling that would induce the
firm to yield the highest
possible output while not
losing money (zero econ.
profit)

35

 Regulation in Practice
The regulation of a monopoly is sometimes based on the rate of return
that it earns on its capital. The regulatory agency determines an allowed price,
so that this rate of return (ROR) is in some sense competitive or fair.
rate-of-return regulation Maximum price allowed by a regulatory agency
is based on the (expected) rate of return that a firm will earn.
It has its own drawbacks:
A firms capital stock is difficult to value.
A firms actual cost of capital depends in turn on the behavior of the
regulatory agency.
Regulatory lag is a natural nuisance.

Outline
Preliminary Discussion

Review of Perfect Competition

Market Power

Economics of Monopoly with Simple (Uniform) Pricing Strategies

Monopolistic Equilibrium
Rule of Thumb Pricing
Economics of Multi-plant Monopoly
Social Costs of Monopoly

Mini Cases: Microsoft and US Electricity

Now, let us bring some real aspects.

37

 CASES OF US AND EU ANTITRUST

AGAINST MICROSOFT

Over the past two decades Microsoft has grown to become the largest
computer software company in the world, and has dominated the office
productivity market.
Under the antitrust laws of the United States and the European Union,
efforts by firms to restrain trade or to engage in activities that
inappropriately maintain monopolies are illegal.
Did Microsoft engage in anticompetitive, illegal practices?

38

US AND EU ANTITRUST AGAINST MICROSOFT cont.

In 1998, the U.S. government said yes; Microsoft disagreed. The

Antitrust Division of the U.S. DOJ filed suit, claiming that Microsoft
had illegally bundled its Internet browser, Internet Explorer, with its
operating system for the purpose of maintaining its dominant operating
system monopoly. Following an eight-month trial that was hardfought on a range of economic issues, the District Court found that
Microsoft did have monopoly power in the market for PC operating
systems, which it had maintained illegally in violation of Section 2 of
the Sherman Act.

The U.S. case was ultimately settled in 2004, with (among other
things) Microsoft agreeing to give computer manufacturers (1) the
ability to offer an operating system without Internet Explorer and (2)
the option of loading competing browser Programs on the PCs that
they sell.

39

US AND EU ANTITRUST AGAINST MICROSOFT cont.

Microsofts problems did not end with the U.S. settlement, however. In
2004, the European Commission ordered Microsoft to pay $794 million in
fines for its anticompetitive practices, to produce a version of Windows
without the Windows Media Player to be sold alongside its standard
editions. In 2008, the European Commission levied an additional fine of
$1.44 billion, claiming that Microsoft had not complied with the earlier
decision. Even more recently, in response to a concern relating to the
bundling of browsers, Microsoft agreed to offer customers a choice of
browsers when first booting up their new operating system.

As of 2011, the European case against Microsoft remains on appeal.

There is strong evidence that the European-imposed remedies have had
little impact on the market for media players or browsers.

However, Microsoft is facing an even stronger threat than U.S. or E.U.

enforcement, such as competition from the powerful Google search engine
and social media sites such as Facebook
40

 CASE OF ELECTRICITY: REGULATE OR NOT?

Electricity in US

Regulation (Price ceiling) seems to be necessary

But some states in USA rather removed price ceilings.

Hoping deregulation will increase competition and lower the
prices.
But deregulation did not lead to lower prices (recall 2001
California Blackout)
Reasons are:
o Capacity constraint (environmental regulations banned new
power plants)
o Collusive behavior by whole sale suppliers, while retail market
became competitive
41

From the Reading:

NYT article Competitively Priced Electricity Cost More, Studies

Show (Nov 6, 2007)
Since 1999, prices for industrial customers in deregulated states have
risen from 18 percent above the national average to 37 percent above, said
Mrs. Showalter, an energy lawyer and former Washington State utility
regulator.
In regulated states, prices fell from 7 percent below the national average to
12 percent below, she calculated
In market states, electricity customers of all kinds, from homeowners to
electricity-hungry aluminum plants, pay $48 billion more each year for power
than they would have paid in states with the traditional system of government
boards setting electric rates

42

Environment Issue:

For deregulated market, high electricity price leads to high costs to

households and producers but high profits to power-generating firms.
High price may be good news to environmentalists (mostly power is
generated using fossil fuels)
- Some advocates carbon taxes: government utilize tax revenue
for social benefits, which power-generators hight profits
cannot do.

43

44

Here are some exercises for you to get

cooled down.

45

Exercise 1
You work for Nuxo Lighting Company. Nuxo produces specialized lighting fixture generally
acknowledged as the best in their class and there are no close substitutes. A market research firm
has estimated the market demand to be:
Q = 2,000 5P
You estimate Nuxos total cost for producing, storing, and marketing its lighting fixtures to be:
TC = 100 + 4Q + 0.4Q2
You are asked to estimate how many lighting fixtures should be manufactured and how should they
be priced to maximize profits?
Step 1: Rewrite the demand function
or
Step 2: Find TR

5P = 2,000 Q
P = 400 0.2Q
TR = P*Q = (400 0.2Q)Q = 400Q 0.2Q2

Step 3: Derive MR
MR = dTR/dQ = 400 0.4Q
Step 4: Derive MC
MC = dTC/dQ = 4 + 0.8Q
Step 5: Set MR = MC to maximize profits
MR = 400 0.4Q = 4 + 0.8Q = MC
or
or

1.2Q = 396
Q = 330

Step 6: Substitute Q = 330 into the demand curve to get P

P = 400 0.2(330) = 400 66 = 334

46

Exercise 2
Consider a monopolist with the following market demand and total cost:
P = 10 Q and TC = 5 + Q + 0.5Q2
Solve for the competitive outcome and monopoly outcome, respectively. Also, do
the welfare analysis.
Competitive outcome:

P = 10 Q = 1 + Q = MC gives
Q = 4.5 and P = 10 4.5 = 5.5

Monopoly outcome:

MR = 10 2Q = 1+ Q = MC gives
Q = 3 and P = 10 3 = 7

Note that society is better off with perfect competition, i.e., consumer gains less
producer losses = 5.625 3.375 = 2.25. This is shown in the figure in the next
slide:

47

10
MC
A

If monopoly, CS = A and PS = B + C + E
Thus, social welfare (SW) is:
CS + PS = A + B + C + E

7
B

CS: consumers surplus

PS: producers surplus
SW: social welfare

If perfect competition, CS = A + B + F
and PS = E + C + G
Thus, SW = A + B +C + E + F + G

5.5

So SW under perfect competition is greater

than SW under monopoly by F + G

4
E

(F + G = 0.5x3x1.5 = 2.25)

D = AR
MR
3

4.5

10

48

THANK YOU!

49