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Monopoly & Market Power

Dr. Gong Jie


Agenda

Market structure of monopoly


Monopolist’s profit-maximization
♦ The Inverse Elasticity Pricing Rule
♦ Market power: the ability to charge above MC
♦ Monopoly with multiple plants
Monopoly deadweight loss
Source of monopoly power
Market Structure: A Road Map

PERFECT COMPETITION MARKET POWER MONOPOLY

-Many small firms producing -A few firms with similar -A single firm producing a
identical goods products, but not perfect good without close substitutes
-Price is the market price; substitutes -Firm can price wherever it
firms are price takers. -Firm can price above wishes along the demand
perfectly competitive, but curve.
below monopoly.

EXAMPLES EXAMPLES EXAMPLES


•Agricultural commodities •Automobiles •Patented pharmaceuticals
•Electronic components •Search-linked advertising: •Microsoft Windows
Google, Yahoo, etc.
Perfectly Competitive Industry Monopoly Industry

 Industry is highly fragmented:  Industry is highly concentrated:


♦ No single firm has market ♦ A single firm accounts for a
power. dominant share.

 No barriers to entry  Significant barriers to entry

 No product differentiation  Brand loyalty or switching costs

 Each firm acts as a price-taker:  Monopolist acts as a price-maker:


♦ A single firm’s production ♦ Dominant firm’s decisions
and capacity decisions has determine the market price.
little influence on the
market price.
Monopoly Environment

Single firm serves the entire market.


♦ It is important to specify the relevant market.
 Most monopolies are “local” monopolies.
 Examples: utilities, postal service

The demand curve for the firm’s product is the


market demand curve.
Firm has control over price.
♦ The price charged affects the quantity demanded of the
monopolist’s product.
Managing a Monopoly

Market power permits you to price above MC.


Is the sky the limit? the optimal?
♦ No. How much you sell depends on the price you set!
The “volume-margin” trade-off
♦ Higher price means greater margin per unit sold.
♦ But increased price drives down the quantity sold.
How Does A Monopolist Maximize Profit?

The monopolist's profit-maximization problem:


Max π(Q) =TR(Q) - TC(Q)
Q

where TR(Q) = Q*P(Q), and P(Q) is market demand curve.


Principle for profit maximization:
MR(Q) = MC(Q)
Recall: For firms in a perfectly competitive market,
MR=P, thus set P = MC(Q)
What is MR(Q) for a monopolist?
Marginal Revenue for A Monopolist:
A Simple Example
Consider the monopolist faces a linear demand P=10-Q

Quantity Price Total Revenue Marginal Revenue


1 $9 $9 $9

2 $8 $16 $7

3 $7 $21 $5

4 $6 $24 $3

Why is the marginal revenue less than the price?


Marginal revenue is less than price

When the monopolist increases production by ΔQ ,


two forces affect the total revenue:
♦ On one hand, the firm can get another piece of revenue
from the additional sale, which is given by PΔQ.
♦ On the other hand, the firm drives down the price charged
to the existing sale, revenue is changed by QΔP.

ΔTR PΔQ +QΔP ΔP


MR = = = P +Q <P
ΔQ ΔQ ΔQ
ΔP
(note that <0 by law of demand)
ΔQ
For any linear demand P=a-bQ,
its total revenue is given by TR=aQ-bQ2;
its marginal revenue is given by:
MR= ΔTR(Q)/ ΔQ =a-2bQ

Demand
Marginal Revenue
Monopoly Profit Maximization
Produce where MR = MC.
Charge the price on the demand curve that corresponds to that quantity.
MC
$
Profit AC

PM
AC

QM Q
MR
A Simple Linear Example:

P(Q) = 100 - Q
TC(Q) = 100 + 20Q + Q2

a. What is the equation of the marginal revenue curve?


TR(Q) = Q*P(Q) = 100Q-Q2
MR(Q) = ΔTR(Q)/ΔQ= 100 - 2Q

b.What is the profit-maximizing output?


TC(Q) = 100 + 20Q + Q2
MC(Q) = 20 + 2Q

MR = MC => 100 - 2Q = 20 + 2Q => Q* = 20; P* = 80


Finding the “Sweet Spot” Algebraically:
 Invert the demand curve: solve for P in terms of Q

 Multiply the inverse demand curve to get TR


♦TR= P*Q

 Differentiate total revenue to get MR:


♦MR = ΔTR/ΔQ

 Solve for Q by setting MR = MC

 Solve for P, by substituting profit-maximizing Q back into the


inverse demand curve
Monopolistic Equilibrium

A monopolist earns positive profit in the long run


because of no competition.

A monopolist does not have a supply curve (i.e., an


optimal output for any exogenously-given price)
because price is endogenously-determined by
demand: the monopolist picks a preferred point on the
demand curve.
Inverse Elasticity Pricing Rule

The relationship between optimal price and price


elasticity of demand can be quantified:
P  MC 1

P E
P  MC
 P is the mark-up: by what percentage more
than the MC does a monopolist sell the product.
At the optimal quantity, the mark-up equals the
inverse of the elasticity.
The monopolist's ability to price above marginal cost
depends on the elasticity of demand.
Inverse Elasticity Pricing Rule: Proof
(optional)
Express MR as a function of the price elasticity of
demand:
ΔTR(Q) Δ( P * Q) ΔP ΔP Q 1
MR(Q) = = =P + Q = P(1 + ) = P(1 + )
ΔQ ΔQ ΔQ ΔQ P E
Δ( P * Q) ΔP
(note =P + Q by product rule in calculus)
ΔQ ΔQ

MR (Q) = MC (Q):


1 1 MC P - MC 1
P(1  )  MC ⇒ 1   ⇒ 
E E P P E
Monopolist never produces on the inelastic
region of the demand curve
P  MC 1
Notice that P
1 ,
so at the optimum 
E
1 ,
or E<-1
Intuitively, if produce on the inelastic region, the
monopolist can increase revenue and decrease cost by
cutting production.
P E = -∞

E = -1

D
E=0
Quantity
MR
If produce on inelastic region, the monopolist
can increase revenue by cutting production

P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
Market Power

An economic agent has Market Power if s/he can


affect, through his/her own actions, the price that
prevails in the market.
♦ the degree to which one can raise price above MC
Lerner Index
♦ (P-MC)/P, the measure of market power
♦ A monopolist has a positive Lerner Index.
♦ What is a competitive firm’s Lerner Index?
 Zero, because P=MC!
Monopoly Multi-Plant Decisions

Consider a monopoly that produces identical goods at


two production facilities.
♦ Example: a firm that generates and distributes electricity
from two facilities.
♦ Let C1(Q1) be the production cost at facility 1.
♦ Let C2(Q2) be the production cost at facility 2.
Decision Rule: Produce output where
MR(Q) = MC(Q) and MC1(Q1) = MC2(Q2)
where Q = Q1 + Q2.
Question 1: How should the monopolist
allocate production across the two plants?
Whenever the marginal costs of the two plants differ,
the firm can increase profits by reallocating
production towards the lower marginal cost plant and
away from the higher marginal cost plant.
 Example:
♦ Suppose the monopolist plans to produce 6 units
♦ If 3 units per plant => MC1 = $6, and MC2 = $3
♦ Simple way to reduce cost: reduce plant 1's units and
increase plant 2's units.
Optimal allocation rule: MC1(Q1) = MC2(Q2)
Question 2: How much should the
monopolist produce in total?
Principle: MR=MC.
What is the MCT for the multi-plant firm as a whole?
Multi-Plant Marginal Cost Curve is the horizontal
sum of the marginal cost curves of individual plants.
It shows the total output that can be produced at every
level of marginal cost.
MCT is the change in cost after all optimal adjustment
has occurred in the distribution of production across
plants.
Example:
For MC1 = $6, Q1 = 3; MC2 = $6, Q2 = 6.
Price Hence, for MCT = $6, QT = Q1 + Q2 = 9

MC1
MC2

MCT

6 • • •

3 6 9 Quantity
Example: Multi-Plant Monopolist Maximization
Price

MC1
MC2 MCT

P*

Demand

Quantity
Q*1 Q*2 Q*T MR
Example

P = 120 - 3Q market demand

MC1 = 10 + 20Q1 plant 1


MC2 = 60 + 5Q2 plant 2

Q1. What are the monopolist's optimal total quantity and price?

Step 1: Derive MCT as the horizontal sum of MC1 and MC2.

Q1 = -1/2 + (1/20)MCT
Q2 = -12 + (1/5)MCT MCT = MC1 + MC2 ? Wrong!
This is vertical sum!
QT = Q1 + Q2 = -12.5 + .25MCT The monopolist should allocate
Q = Q1+Q2 so that
Thus,
MC1(Q1) = MC2(Q2) = MCT
MCT = 50 + 4QT
Step2: Using the monopolist's profit maximization condition:

MR = MCT => 120 - 6QT = 50 + 4QT

Q T* = 7
P* = 120 - 3(7) = 99

Q2. What is the optimal division of output across the monopolist's plants?

MCT* = 50 + 4(7) = 78

Therefore, MC1= MC2 = 78

Q1* = -1/2 + (1/20)(78) = 3.4


Q2* = -12 + (1/5)(78) = 3.6
Application: Cartel’s Profit Maximization

 A cartel is a group of firms that collusively determine the


price and output in a market.
♦ A cartel acts as a single monopoly firm that maximizes total
industry profit.
 The problem of optimally allocating output across cartel
members is identical to the monopolist's problem of allocating
output across individual plants.
♦ A cartel does not necessarily divide up market shares equally
among members: higher marginal cost firms produce less.
♦ This gives us a benchmark against which we can compare actual
industry and firm output to see how far the industry is from the
collusive equilibrium.
Welfare Analysis of Monopoly

Why do governments dislike monopoly?


P > MC under monopoly
♦ Ideally, social welfare is maximized when the value of
another unit of output is the same as the cost of resources
needed to produce the additional unit, i.e., P=MC.
♦ P > MC means too little output, at too high a price.
Welfare effect of monopoly
♦ Total surplus shrinks: deadweight loss
♦ Allocation of surplus changes too: consumer surplus
decreases while producer surplus increases.
Deadweight Loss of Monopoly

Deadweight Loss
$
of Monopoly

MC

PM

MC
D

QM MR Q
Antitrust and Competition Laws

Government may intervene to move the market


toward a more competitive outcome and reduce
deadweight loss.
Antitrust and competition laws promote competition
by restricting firms from certain behavior that might
limit competition.
♦ bans on collusion among competitors with regard to pricing
♦ prevent firms from merging with or acquiring other firms if
doing so will increase market power
Competition Policy in Singapore

Competition Commission of Singapore (CCS)


oversees anti-competitive activities.
Competition Act (effective since 2004) is the law in
Singapore that protects consumers and business from
anti-competitive activities
♦ Abuse of dominance
♦ Anti-competitive agreements
♦ Merger
Abuse of Dominance

Being a dominant player is fine.


Anti-competitive activities that protects or enhances
its dominant position are illegal.
♦ Deter other competitors from entering the market
♦ Intend to drive competitors out of the market
Examples
♦ Exclusive dealing
♦ Aggressive pricing
Why do monopoly markets exist?

Source 1: Natural monopoly


Economies of scale may lead to a situation where a
single firm services the entire market for a good.
♦ Economies of scale: long-run average costs decline as
output increases.
♦ Example: electricity distribution requires an extensive
network of cables (large fixed cost). One provider can
achieve lower costs than multiple providers.
The beneficial effects of economies of scale may
outweigh the negative effects of market power.
Natural Monopoly
Consider a monopolistic firm that
bears substantial fixed cost.
The firm can make positive profit by
producing a quantity Q.
If there are two firms in the
industry, and each of them
produces Q/2, then both firms
incurs loss.
P

AC

MC

Q/2 Q
Source 2: “Created” Barriers to Entry
Government Regulation
♦ When economies of scale are strong, limiting competition
may avoid duplication and reduce the cost of service.
♦ Examples: local telephone service, electricity and gas,
postal services.
Patents, licenses, and copyrights
♦ Intellectual property protection helps the producers
monopolize and legally enforce their market power.
♦ Examples: Eli Lilly’s patent to Xigris; Microsoft’s
copyright over Office 2013.
Intellectual Property

IP protection grants the producers market power.


♦ Higher prices, lower consumer surplus, deadweight loss
Encourage innovation
♦ R&D involves massive amounts of fixed cost.
♦ If have to act like a competitive firm (price=marginal cost),
the firms have no incentive to invest in innovation.
IP protection is welfare-improving if the consumer
surplus created by innovation outweighs the
deadweight loss from their producers having market
power for a period of time.
Takeaways

A monopolist's profit maximization condition is to set


the marginal revenue of additional output equal to the
marginal cost of additional output.
Marginal revenue and marginal cost for a monopolist
is generally less than price. How much less depends
on the elasticity of demand.
A monopolist never produces on the inelastic portion
of demand since: in the inelastic region, raising price
and reducing quantity make total revenues rise and
total costs fall!