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MONOPOLY

A firm is a monopoly if, within some defined (geographic and product characteristic) market, it is the only seller. Such a firm can affect market price by varying the quantity it is willing to sell. The pure monopoly is rare. However, many firms possess what is known as monopoly power. Monopoly power is the control over price that a pure monopoly holds - the demand curve facing the firm is downward sloping, so varying its output will effect the price it can charge. Many firms have some degree of market power, even when they have competitors in the market. Two particular types of markets where firms have market power are monopolistic competition and oligopoly. These market structures are covered in the next later. For the remainder of this chapter we will consider the case of the classic monopoly with only a single firm servicing the defined market. Thus, in this case, the market demand curve is also the demand curve facing the firm. When a firm has monopoly power, it is called a price setter rather than a price taker, which was the term applied to firms in perfect competition. Marginal Revenue, Profit Maximization and Price When a monopoly firm which faces the market demand curve as its own demand curve, its marginal revenue will be less than price. Recall that for any firm MR=P(11/ep), where ep is the price elasticity of the demand curve facing the firm, and we are taking it to be a positive value. In this case of a monopoly, this price elasticity is also the market price elasticity. Thus, unless the market demand curve is horizontal (an unlikely case that says consumers will buy an infinite amount of the good at the market price) ep is finite. As long as ep exceeds unity marginal revenue is less than price. Notice that ep>1 means 1/ep<1 (but still positive) so 0<(1-1/ep)<1. To find MR we multiply price by some positive fraction, meaning price must exceed marginal revenue.

Profit maximization requires that output be Q1, the output where MR=MC. Price is determined by the market demand curve. At an output of Q1, the highest price the firm can charge and still sell all its production, is P1. This is where the idea of demand as a constraining factor on a monopoly takes hold - the firm finds its best interest is served by producing an output of Q1, but once that decision is made the consumers, through the market demand curve, determine the price that the monopoly can charge. Monopoly in the Long Run There are two issues that affect a monopoly firm in the long run: the firm must deal with the preservation of its position as a monopoly; and the firm must find the correct level of output and technology to adopt to maximize its profit. As in every other market, the presence of economic profit is a signal to investors that entry into this market provides an opportunity to make better than normal returns. Thus, this is the point that barriers to entry, that is, the ability to preserve its monopoly, become critical to the firm. Barriers to entry can take various forms. Government licensing, patents, and regulations often serve the purpose of preserving a monopoly. Restrictions ensue for a variety of reasons usually founded for political expediency or concerns about efficiency. Local governments have granted cable television companies exclusive rights in cities on the supposition that a single firm can offer the service more efficiently than competing firms. Only one firm offers local telephone service for the same reason. And sometimes the monopoly persists because more than a single firm causes all firms to lose money, leaving no incentive for entry. Whatever the cause of

the long run continuance of a monopoly, it is possible that a monopoly will make a profit in the long run as well as the short run. Price Discrimination Firms commonly charge distinct groups different prices for the same good. Restaurants, movie theaters, and public transportation offer lower prices to senior citizens and children. Airlines offer different fares, determined primarily by the flexibility of the flyer with respect to time, day and advance notice. State supported universities have different tuition rates for in-state students and out-of-state students. Economists call differential pricing schemes price discrimination. As we shall see, price discrimination allows firms to turn consumer's surplus into profit. Thus, a monopolist who practices price discrimination will make a higher profit that one which follows normal profit maximizing behavior. Price differentials require two factors to qualify as price discrimination. 1. The same good (for example, goods of the same quality) must be sold to different consumers at different prices. When an airline charges first class passengers more than coach passengers, it is not considered price discrimination 2. The difference in prices cannot reflect cost differentials in servicing the different customers, even if the good consumed is the same. If the advance reservation requirements that reduced plane fares normally carry help airlines to plan more effectively, thereby lowering the cost of servicing pleasure travels as compared to business travelers, then it would not be price discrimination. Price discrimination shows up all over. Normal methods of car buying, where purchasers go in and bargain with sales people, often results with customers paying different prices. Regular sales at department stores, coupons on food, and student discounts for college football games all carry elements of price discrimination. Effective price discrimination requires two additional characteristics; 1. The firm must have some degree of monopoly power. 2. It must be difficult for the good to be resold, or the transactions costs of reselling must be high. Market Segmentation A common type of price discrimination is market segmentation price discrimination. Market segmentation requires the firm to distinguish two or more distinct classes of customers, sometimes termed submarkets, which can be identified and isolated. This allows the firm to treat each submarket separately. The firm maximizes profit by charging different prices within each submarket. Submarkets are classified by the relative elasticity of the different groups. It is commonly used where different groups are easily recognized and the resale of the

good between the groups is difficult or preventable. The firm increases its profit by charging the groups with relatively elastic demand for the good a lower price, while those groups with a relatively less elastic demand pay a higher price. We should expect this result. Recall that in any market marginal revenue is related to price through elasticity. That is, MR=P(1-1/ep). Suppose the marginal cost of providing a unit of a good to any market is the same. Then if we have two markets, 1 and 2, profit maximization requires that MC=MR1=MR2, so P1(1-1/ep1)=P2(1-1/ep2). As long as ep1<ep2 we must have P1>P2 to preserve this equality.

This conclusion is shown graphically in figure 11.17. Panels a and b show the demand in each of the market segments. Panel c aggregates the segments into a total market demand, giving a kink at the price where the quantity demanded from the more elastic group first becomes positive. Note that a mathematical artifact causes the marginal revenue curve to jump at the kink. Again for simplicity marginal cost is assumed constant. A non-price discriminating firm will produce where marginal cost crosses the total marginal revenue curve, MRT, and charge all customers F. Profit is the shaded area in panel c. Alternatively, this firm could segment the market. If the quantity supplied to each segment is where marginal cost equals the marginal revenue in the segment, then the firm will supply Q1 units in submarket a, charging P1 per unit. Similarly, market b gets Q2 units at a price of P2. Although marginal revenue is the same in each submarket (because they equal the common marginal cost) price is higher in submarket a and lower in submarket b than under a single price strategy. And the sum of the profits from the two segments, the dotted areas in panels a and b, exceed the profit obtained with a single price strategy.

The Efficiency Loss of Monopoly Efficiency was defined as achieving the maximum aggregate welfare possible from a market, without any concern for the distribution of the gains. By this definition, perfect competition is efficient. It forced firms, in the long run, to produce at minimum average cost. This is termed production efficiency. Additionally, the "right" amount of the good was produced, so total surplus value, the sum of producer and consumer surplus, is as large as possible - there is no dead weight loss because production takes place where price equals marginal cost.

In general a monopoly will produce less than the same market organized as a perfect competition. The easiest comparison assumes constant economies of scale, so long run marginal cost and average cost are constant. Look at figure 11.20. The long run equilibrium in perfect competition has price equal to marginal cost, giving an output of Qc and a price of Pc. The monopolist produces where marginal revenue equals marginal cost, output equals Qm, and charges Pm per unit. With constant costs, there can be no producers surplus. But we can see that the consumers surplus is smaller under a monopoly than under perfect competition by the triangle abd - the dead weight loss. This is the social cost of the monopoly. Notice that there is a distributional aspect as well. Under perfect competition total consumers surplus is the triangle edPc. Besides the portion that is lost as dead weight loss, the rectangle PmbaPc is transferred from consumers to the producer. This transfer of surplus value has no efficiency implications.