PaM Singapore 2020 Lecture 9 PDF

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Lecture 9 Monopoly 9.1. Monopoly Power 9.2. Cost Advantages 9.3. Innovation 9.4. Entrepreneurship

Industry Prices and Markets: Block 3

173

9.1.1. Sources of Monopoly Power Monopolies are protected by prohibitive entry barriers. Different types of BTEs are the different sources of monopoly power and lead to different monopoly types.

BTE

Monopoly Type

Description Cecil Rhodes

ResourceAbsolute cost based advantages Monopoly

A single firm owns all of a necessary factor of production.

Economies of Natural Scale Monopoly

Due to high fixed costs, the minimum efficient scale is so high that the entire market demand can only provide sufficient returns for a single firm that supplies to the entire market at a lower cost than two or more firms.

Consumers become locked in to a firm's Product Vendor Lockproduct because their switching cost to a differentiation In competitor's product are too high. Legal

Governmentcreated (legal) monopolies

De Beers

Bill Gates

When the government gives one person or firm the exclusive right to sell a good or service. Examples: Patents, copyright for creative work, strategic industries. Ivan Kreuger

Zündwarenmonopol

9.1.2. Welfare Effects of Monopoly Power The theory of the firm and SCP-paradigm suggest that monopoly leads to poor conduct and poor efficiency (market power hypothesis). An alternative view suggests larger firms generally are necessary for economic efficiency (efficiency hypothesis). In this lecture we examine to what extent and when monopoly power can be good for economic welfare. determines

Structure

Market Significant BTEs, scale Power economies, product Hypothesis differentiation and cost advantages cause concentrated industries. Efficiency Higher concentration is a Hypothesis temporary result of efficient firms pushing out less efficient ones. BTEs can always be overcome.

determines

Conduct

Performance

Fewer, larger firms are better able Resulting lower output, high price to collude and engage in other and profits mean the market is anti-competitive conducts. inefficient.

Even only two firms could compete fiercely rather than collude. Firms in contestable markets will behave efficiently to stave off entry.

The profit motive provides an incentive for firms to invest in R&D to invent better products and processes to cut costs. Scale economies of larger firms makes them more efficient.

9.2.1. Economies of Scale Definition: (Dis)Economies of Scale arise when average cost falls (rises) as quantity of production increases. Marginal cost is below (above) average cost. Real economies of scale means changes in input quantities as a result of volume: 1. 2. 3. 4.

Indivisibilities of fixed assets Alternative production techniques Specialisation Inventories

Pecuniary economies: changes in prices paid by the firm for inputs 1. Purchasing power 2. Advertising 3. R&D

Diseconomies $ 1. 2. 3. 4.

Higher wages and unionisation Incentivisation and monitoring Communication and coordination difficulties (red tape) Specialised resources spread too thin

MC AC Constant returns to scale Economies of scale

Diseconomies of scale

0 Q MES Note that technically, economies of scale refer to the long run, when there are no fixed cost of production. of 15 We do not make this distinction between long run andPage short run here.

9.2.2. Perfectly Competitive Market Supply We take a quick detour to derive the supply curve of the perfectly competitive market to show why it is assumed to be upward-sloping (see 2.4.1). We did not do this previously because we would have needed the the theory of the firm to do so. The reason lies in diseconomies of scale and the upward-sloping MC-curve.

$ MC

D=AR=MR

How much would a perfectly competitive firm produce at a given price?It determines the quantity it wants to supply at different prices (i.e. its MR) using the MC curve because in profit maximisation, MR=MC. The quantity supplied at every price for all firms is therefore the sum of all firms’ individual MC-curves

D=AR=MR D=AR=MR

MC1

+

D=AR=MR

0

Q

MC2

+ + ...

MCn

=

S

9.2.3. L-Shaped Average Cost U-shaped average costs imply that large firms have a cost disadvantage compared with small ones operating at MES. Empirical studies have shown that many firms instead have L-shaped average cost curves where, after minimum efficient scale (MES) is reached, AC is constant. $

U and observed L-shaped average cost may be that the economic model ignores that as time progresses, (1) firms use better technology that shifts the average cost curve down, and (2) benefit from learning economies.

$

Definition: Learning economies: Cost per unit of output falls due to accumulating AC experience and know-how over time.

Hal Varian, chief economist at Google

Carl Shapiro

Definition: Information goods are goods that can be encoded and transmitted as information, the quality of which determines their value. Examples include ebooks, websites, software, digitised music and movies.

AC AC

High fixed cost Economies of scale

AC AC

0

MES

Q

0

low constant marginal cost

AC is tangential to MC - no MES

AC MC

Q

9.2.4. Monopoly with Scale Economies How does monopoly compare to perfect competition? Again imagine a perfectly competitive industry is taken over by a single monopolist. If the monopolist continues running the small plants of the previous perfectly competitive firms then costs will not change (see 8.4.2.). Price rises and quality falls under monopoly.

$

But if we assume that the monopolist closes down the individual plants and builds a single large plant that achieves greater economies of scale. If the economies of scale a large enough, price is lower and output greater than under perfect competition.

SPC = MCM (same plants) MCM' (new plant)

PM PPC

Some producer surplus from perfect competition is transferred to consumer surplus under monopoly but there is a total surplus gain.

PM'

DPC = ARM MRM

0

QM

QPC QM'

Q

Monopoly can be good for efficiency if achieves economies of scale that perfectly competitive firms cannot achieve because they operate separate plants of smaller size.

9.3.1. Research & Development Definitions: R&D is investment in developing information about new and superior product features (product R&D) or production processes (process R&D). Expenditure on R&D (% of GDP 2014-2018) 5 4 3

Delving

2 1 Turkey

Thailand

France

Russia

NZ

Brazil

Malaysia

Italy

Netherlands

UK

Singapore

Australia

China

Germany

USA

Japan

Taiwan

South Korea

Finland

Israel

0

GDP increases can only happen through (1) increases in the quantity of the FOPs or (2) generating more output from existing FOPs ("quality"). Technology is the application of scientific discoveries to make the FOPs more productive. Technology contributes about 85% to GDP growth in industrialised countries. Deeper For firms, R&D involves many types of risk: • risk of discovery (nothing is discovered) • risk of marketability (what is discovered cannot be sold) • risk of feasibility (what can be sold is too pricey) • risk of appropriability (what can be sold can be copied) • risk of regulation (what can be sold will be prohibited) • risk of redundancy (what can be sold will be superseded)

Technological Progress Invention Conception of new ideas

➔

Innovation Development into new marketable products, processes, markets, resources, organisational forms.

➔

Diffusion New products and processes spread across the economy as techlogocial change.

9.3.2. R&D and Market Structure Monopoly power may be necessary to afford R&D and innovation. According to SCP, technological change is caused by R&D which, in turn, is caused by market structure. To conduct R&D, the firm needs both the incentive and the ability to do R&D. Both of these differ between different market structures. Therefore there are different views of the relationship between monopoly and technological innovation. R&D Potential:

Ability: to absorb risk, to finance investment and to await the outcome of R&D.

Incentive: to raise BTEs through cost advantages (process R&D) and product differentiation (product R&D); to gain advantage over competitors.

Perfect and Low - zero profits. monopolistic competition

Ambiguous - Competitive firms have little impact on the market. But product differentiation steepens their demand curves and raises entry barriers to increase market power in the face of intense competition.

Oligopoly

Moderate - in between.

High - Oligopolistic firms stand to gain competitive advantage.

Monopoly

High - Large monopoly firms are more able to take and spread the R&D risk. They have the high profits necessary to finance the initial investment.

Ambiguous - Monopolies are protected by entry barriers and may have little to gain from risky R&D. But they are also are better able to reap the high economies of scale in R&D, to protect a technological advantage through patents and to apply it to more product types (diversification, see lecture 11). Monopolies may wish to fortify the BTEs on which they depend. Monopolies are more durable and can wait for R&D results.

In practice, the relationship between market structure and firm R&D is unclear. Other factors determine R&D such as technological opportunities, appropriability, and society's general rate progress.

9.4. Entrepreneurship In this view, monopoly power and high profits are a necessary but temporary incentive to stimulate entrepreneurial activity that will be eroded away when more efficient firms arise because markets are contestable. The the economy need entrepreneurship in order to be dynamically efficient, i.e. enjoy technological progress that raises GDP for all. Market structure is an ongoing competitive process and not a permanent state. Entrepreneurs drive technological change as a “perennial gale of creative destruction” that can wash away established monopolists. But innovation is a temporary advantage. Only large firms have the necessary investment funds and ability to take risk to invest to conduct R&D effectively and the organisational ability to protect their innovations. The efficiency hypothesis states that concentration is the result (and not the cause) of high profits earned by superior entrepreneurial ability (to lower cost and make better products) that cause a firm to grow. Regulation to curb concentration could punish Delving efficient firms and create inefficiency. Deeper Contestability is the degree to which new entrants can enter a market by avoiding sunk costs, accessing the same technology and overcoming barriers to entry such a product differentiation. In practice there are few if any industries with prohibitive entry barriers. Entrepreneurs do not accept existing market structures as fixed but find ways to lower entry barriers.

Joseph Schumpeter

Harold Demsetz

William Baumol...