Chapter 12 - Notes PDF

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10.1 Introduction to a Monopoly 

A monopoly: is a market in which there is ONE supplier that is protected from competition by a barrier preventing entry of new firms. A monopoly that produces a good or service for which no close substitute exists .

How a Monopoly Arises: 1. No Close Substitute  a monopoly sells a good that has no close substitutes. If a good has a close substitute, even if it is produced by one firm, that firm effectively faces competition from the producers of the substitute. 

Ex. monopolies include the market for electricity, gas, and water  government-owned or regulated utilities.

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Near-monopolies that are not government-owned or regulated. Ex. DeBeers diamond company, which has historically controlled upwards of eighty-five percent of the world’s supply of diamonds at one time.

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Monopolies may also have a geographic dimension to them. Ex. A local grocery store in a town that is geographically isolated may be the only grocery store within hundreds of miles that serves the local community.

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In a monopoly, the firm not only dominates the market, the firm is the market. There is no competition for a monopoly  market power.

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A monopoly is considered the polar opposite of perfect competition.

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In reality, finding an industry that meets the exact definition of a monopoly is difficult. So is finding an industry that meets the exact definition of perfect competition is rare.

2. Barriers to entry: a constraint that protects a firm from potential competitors. Three types of barriers are: 1. Natural 2. Ownership 3. Legal 1. Natural Barriers to Entry creates natural monopoly.  Natural Monopoly: is a market in which economies of scale enable one firm to supply the entire market at the lowest possible cost. Economies of scale are so powerful that they are still being achieved when the entire market demand is met. o LRAC curve is SLOPING DOWNWARD when it meets the demand curve. o One firm can supply the entire market at a lower price than 2+ firms.

o In some “real world” industries, economies of scales are pronounced and competition is simply impractical or unworkable; for example, water facilities, or railways. It is most efficient for the production of the good or service to be concentrated in one firm. These firms also tend to have a high ratio of fixed to variable costs. 2. Ownership Barriers to Entry 

An ownership barrier to entry occurs if one firm owns a significant portion of a key resource.

3. Legal barrier to Entry creates a legal monopoly Legal monopoly: is a market in which competition and entry are restricted by granting of a: 

Public franchise: an exclusive right that is granted to supply a good or service, such as Canada Post, which has the exclusive right to deliver mail in Canada.

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Government license: when the government controls entry into a particular occupation, profession, or industry. For example, the government in Canada controls the number of licensed medical physicians. Ex. taxicabs. In large cities, one must usually obtain a license to drive a taxicab. A license is meant to protect consumers from fraud and abuse.

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Patent: A patent is an exclusive right to the inventor of a product or service. Granting an inventor, a monopoly to their innovation increases the incentive to innovate (perform research and development projects). A patent is aimed at protecting the inventor of the good or service for a defined period of time from rival firms that did not share in the time, money, and effort needed to invent the good or service. Patents are often associated with modern industries. For example, General Motors has several patents on various engine designs in the cars they produce.

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A copyright is an exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work. A copyright works much like a patent; that is, an exclusive right is granted to an author or composer for a defined number of years.

Monopoly Price-Setting Strategies For a monopoly firm to determine the quantity it sells  choose appropriate price: 1. A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers. o marginal revenue is less than price at each level of output/quantity  MR< P. 2. Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.

Price and Marginal Revenue 

A monopoly is a price setter  demand for monopoly’s output = market demand.

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To sell a larger output, a monopoly must set a lower price.

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TR = P x Qsold

MR = the change in the TR that results from a one-unit increase in Qsold

Marginal Revenue and Elasticity   

A single-price monopoly’s marginal revenue is related to the elasticity of demand for the good. If demand is elastic, a fall in the price  increase in total revenue. MR is positive. The increase in revenue from the greater quantity sold outweighs the decrease in revenue from the lower price per unit.

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If demand is inelastic, a fall in the price  decrease in total revenue. MR is negative

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The rise in revenue from the increase in quantity sold is outweighed by the fall in revenue from the lower price per unit.

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If demand is unit elastic, a fall in the price does not change total revenue. MR=0 Total revenue is maximized.

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The rise in revenue from the greater quantity sold equals the fall in revenue from the lower price per unit. In Monopoly, Demand is Always Elastic 

A single-price monopoly never produces an output at which demand is inelastic.

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If it did produce when demand is inelastic  decrease output = increase total revenue, decrease total cost, and increase economic profit.

Price and Output Decision.

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The monopoly produces the profit-maximizing quantity, MR=MC. The monopoly sets its price at the highest level at which it can sell the profit-maximizing quantity. Economic profit = profit per unit x quantity produced

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The monopoly might make an economic profit, even in the long run, because barriers to entry protect the firm from market entry by competitor firms.

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In a competitive market, the economic profit would only exist in the short run, as firms would be attracted to the industry.

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Now, this does not mean that a monopolist is always guaranteed to make a profit. It is true that the likelihood of economic profit in a monopoly is high, but an economic profit is not a given.

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A monopoly that incurs an economic loss might shut down temporarily in the short run or exit the market in the long run.

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If low demand exists, even a monopoly will not be in a position to cover production costs and make an economic profit. Total profit depends on the position of the average total cost curve relative to the demand curve.

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Over the short run, a monopolist might incur an economic loss (P < ATC)

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Over the long run, a monopoly simply would not operate at a persistent loss. If you are the only supplier of a good or service and you are not able to make a profit, you will not be in that industry for very long. Overall, there are not many, if any, unprofitable monopolies.

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To achieve maximum economic profit, the monopolist must decide what quantity to produce. A profit-maximizing monopoly will never produce at a level of output in the inelastic range of the market demand curve.

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A single-price monopoly firm maximizes its profit by producing an amount of output (MR= MC) (higher price, smaller output).

10.2 Single Price Monopoly and Perfect Competition Compared. 

A market demand curve in perfect competition = a demand curve in a monopoly.

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A market supply curve in perfect competition = monopoly’s marginal cost curve. S = MC. A horizontal sum of the individual firms’ marginal cost curve.

In a perfect competition, equilibrium occurs quantity demanded = quantity supplied at quantity and price.  In a monopoly, equilibrium output, QM, occurs where MR=MC.  Equilibrium price, PM, occurs on the demand curve at the profit-maximizing quantity.  Monopoly produces a smaller output and charges a higher price.  The firm in the competitive market produces more than a monopoly firm. The firm in the competitive market does not have to worry about reducing its revenue per unit if it increases output. No matter what quantity a firm in a competitive market produces, the firm will always receive marginal revenue equal to the price of every unit sold. 

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In a monopoly, there is a downward-sloping demand curve  the more the monopolist produces, the less money per unit the monopolist will receive (can restrict output = price is higher than the price in the competitive market). The resulting reduction in output and higher price hurts the consumer, and the reduction in output results in inefficiency.

10.3 Single Price Monopoly and Perfect Competition Efficiency Comparison Perfect Competition

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The inefficiency of monopoly = P > MSC and MSB > MSC  dead weight loss arises, the monopoly under produced. A deadweight loss: measures allocative inefficiency = total loss of consumer and producer surplus. 

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Consumer surplus is less with a monopoly than with perfect competition. Consumer surplus shrinks because the consumer has to pay more for the good or service, and the consumer receives less of the good or service.

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At the same time, producer surplus expands. The producer surplus is larger with a monopoly than with perfect competition. The producer captures some of the consumer surplus to offset the loss of a bit of producer surplus because of the lower quantity and higher price. So, the monopolist is converting the gained consumer surplus into profit for themselves. Overall, the sum of surpluses falls … a deadweight loss.

Rent Seeking A single-price monopoly creates a deadweight loss that is inefficient. The social cost of a monopoly has the potential to be even greater than the deadweight loss. 

Economic rent: Any surplus (consumer surplus, producer surplus, or economic profit)

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Rent seeking is the pursuit of wealth by capturing economic rent.

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Rent seeking behaviour is an action that is directed towards trying to acquire monopoly status. Rent seeking can be very profitable to the potential firm if monopoly status is acquired, so rent seeking is considered a popular activity.

Rent seekers pursue their goals in two main ways: 1. Buy a monopoly — transfers rent to creator of monopoly. If someone uses resources to purchase monopoly rights for a price that is a bit less than the monopoly profit, rent seeking is occurring. 2. Create a monopoly — uses resources to obtain monopoly status. For example, if someone expends resources to lobby the government in search of monopoly status, or to erect barriers to entry, then rent seeking is occurring. The resources used in rent seeking actions are costs to society that adds to the monopoly’s deadweight loss  do not produce any output. 

As there are no barriers to entry in the activity of rent seeking, resources used for rent seeking = monopoly’s potential economic profit (in the limit).

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The cost of rent seeking is a fixed cost that must be added to a monopoly’s other costs if the monopoly status is achieved. Rent seeking and rent seeking costs in turn can increase costs to the point where no economic profit results.

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The monopoly’s rent seeking costs, which are fixed, add to the firm’s fixed cost and to the average total cost  shifts upwards the average total cost (ATC) curve to the point where producer surplus disappears, the firm breaks even, and potential economic profit is lost.

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Resources used in rent seeking can wipe out the monopoly’s producer surplus.

10.4 Price Discrimination 

Price discrimination: get buyers to pay a price for a good or service that is closest to the buyers’ willingness to pay for a good or service. Taking advantage of differences in the elasticity of demand of consumers.

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Price–discriminating monopolies will charge a higher price to customers that have a higher willingness to pay.

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A firm must be able to identify and separate among different types of buyers and sell a product that cannot be resold.  prevent the resale of the lower–priced good or service.

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A monopoly captures consumer surplus and converts it into producer surplus  more producer surplus = more economic profit (EP = TR – TC)

Two Ways of Price Discriminating  A monopoly can discriminate: 1. Among groups of buyers. A price–discriminating firm can charge a higher price to buyers with a higher willingness to pay, and charge a lower price to buyers with a lower willingness to pay.

For example, airlines often charge business travelers a different rate than non–business travelers. 2. Among units of a good (Ex. Quantity discounts, quantity discounts that reflect lower costs at higher volumes are not price discrimination). A price–discriminating firm can charge a higher price for the first unit of a good or service purchased and a lower price for latter units purchased. For example, when you have a pizza delivered, often the second pizza is not as much money as the first pizza. Not all price differences are the result of price discrimination. Price differences that arise from cost of production differences are not price discrimination (i.e. if it costs less to sell the good in large quantities rather than one by one — wholesaling). Increasing Profit and Producer Surplus Ex. A

Price Discriminating Airline.

Discriminating between 2 types of travelers.

Perfect Price Discrimination: occurs if a firm is able to sell each unit of output for the highest price someone is willing to pay. The perfect price discriminating monopoly increases its output until the price of the last trip = MC. 

The entire consumer surplus is captured by the producer. If perfect price discrimination is occurring, the price of each unit is the same as the unit’s marginal revenue, so the firm’s downward–sloping demand curve  the firm’s marginal revenue curve.

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The more perfect a monopoly can price discriminate, the greater the quantity the firm will generate and the firm becomes more efficient. If rent seeking is occurring,  reduce the economic profit.

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It is difficult to determine the exact willingness to pay for different groups of buyers without getting those buyers upset at the price they are paying.

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Different consumers are charged different prices, but achieving perfect price discrimination is rare in reality.

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The more perfectly a monopoly can price discriminate, the closer its output is to the competitive output (P=MC) and the more efficient is the outcome.

But this outcome differs from the outcome of perfect competition in two ways: 

The monopoly captures the entire consumer surplus  all of the surplus in the market.

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The increase in economic profit attracts even more rent-seeking activity  inefficiency.

10.5 Monopoly Regulation 

Regulation: rules administrated by a government agency to influence prices, quantities, entry, and other aspects of economic activity.

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Two theories about how regulation works:

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Social interest theory is that the political and regulatory process relentlessly seeks out inefficiency and regulates to eliminate deadweight loss.

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Capture theory is that regulation serves the self-interest of the producer, who captures the regulator and maximizes economic profit.

Efficient Regulation of a Natural Monopoly 

The quantity produced is LESS than the efficient quantity.

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Marginal cost pricing rule: is a regulation that sets the price equal to the monopoly’s marginal cost. The quantity demanded at a price = marginal cost is the efficient quantity.

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Regulating a natural monopoly in the social interest sets the quantity where MSB = MSC

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The demand curve is the MSB curve, the marginal cost curve is the MSC curve.

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Efficient regulation sets the price = MC

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With marginal cost pricing, the quantity produced is efficient, but the average cost exceeds price

AC > P = incurs an economic loss. 

A regulated natural monopoly might be permitted to price discriminate to cover the loss from marginal cost pricing.

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The natural monopoly might charge a one-time fee to cover its fixed costs and then charge a price equal to marginal cost.

Second Best Regulation of a Natural Monopoly 

Average cost pricing rule: Government regulators to permit the monopoly firm to produce the quantity at which price equals average cost and to set the price equal to average cost. (P = AC)

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Government can pay a subsidy = to the monopoly’s loss.

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Implement average cost pricing NOT possible for the regulator as they are not 100% sure what the firm’s costs are (cannot compel the firm to disclose proof of this information … an economic incentive exists for the firm to misreport a higher cost figure so that the price is set higher). 1. Rate of return regulation: a firm must justify its price by showing that its return on capital doesn’t exceed a specified target rate. It serves the self-interest of the firm rather than the social interest because the firm’s managers have an incentive to inflate costs and use more capital than the efficient amount.

2. Price cap regulation: is a price ceiling sets max. price. The highest price that the firm is permitted to charge. Gives the firm an incentive to operate efficiently and keep costs under control. Produce quantity on the demand curve at price cap.

What trend is the article conveying in relation to

monopolies over the past five years? Do you agree with the article and why? What the article is conveying in relation to monopolies over the past five years is that companies that are close to monopolies, or companies that have sales which make up over 50% or more in their respective markets, consistently outperform market indexes such as the Dow Jones composite index, the SNP 500, and the TSX composite index. These indexes are the benchmark of all markets as a whole where you can compare whether a stock had a good or bad week, month, year, or decade; stocks that outperform these indexes outperformed the market as a whole and thus, being better than average. Since each and every one of these companies outperforms the Dow Jones, this demonstrates how good these kinds of companies can be good for investors. These companies may not be good for consumers in general, as the article states because they behave more like price setters than price takers. Thus, lowering the consumer surplus or creating a deadweight loss . The opposite is true if you are inve...