The Monopoly
Market powerMonopoly equilibrium
Welfare aspects
The Monopoly
As we concluded last week, perfect competition is not really a realistic outcome It is an ideal situation which serves as a
benchmark for evaluating competition So “real-life” competition suffers from
imperfection But how can be characterise “imperfectness”?
1st step is to define the opposite benchmark The most imperfect form of competition
imaginable: the Monopoly
The Monopoly
Market power
The market equilibrium under a monopoly
Welfare aspects of the monopoly
The monopsony
The 5 conditions of perfect competition
Reminder: Perfect competition is defined by the following 5 conditions:
1. Large number of agents (Atomicity) 2. Homogeneous products3. Free entry and exit from the market4. Perfect information5. Perfect mobility of inputs
All 5 are required for perfect competition to occur
Market power
Reminder: When one of these 5 assumptions fails to hold, the market is in an imperfectly competitive situation.
Two main consequences for firms:1: Their production decisions influence
the market price of their products
2: Their profits can depend on how competitors react to these decisions
Market power
1st consequence: Their production decisions influence the market price of their products Firms are big enough to start influencing the
price of the market when they change their level of production
This is market power This does not occur under perfect competition
because of the atomicity assumption It is of course maximal for in the monopoly
Market power
2nd consequence: Their profits can depend on how competitors react to these decisions Because a change in the production decision of
a firm will change the price, competitors will probably react. The firm will have to take this into account.
This is known as strategic behaviour, and is a central focus of game theory.
Not really relevant for monopolies. There are no competitors !!
This 2nd aspect will be covered in the next 2 weeks
Market power
Market power of firms
Perfect competition
Many firms with a homogeneous product
Oligopoly
A few producers with high market power
Monopoly
A single producer
Monopolistic competition
Many firms with differentiated products
The “competition continuum”
Market power
Market power refers to the ability of a firm (a monopoly here) to influence the price
How can one measure this power ? In perfect competition we have p =mC One could expect a firm with market power to
try and push the price above the marginal cost so that p >mC
This divergence is known as a mark-up and can be measured,
This gives us our measure of market power.
Market power
Profit of the firm:
The profit maximisation condition finds output q such that :
This is valid for any firm, with or without market power
But what it mR equal to when a firm has market power?
TR TC
mR mC
Market power
Total revenue is simply equal to the quantity sold times the price at which the output is sold:
The derivative of total revenue is the sum of: The extra quantity produced ∂q times the price The effect of the increase on the market price
This 2nd effect is equal to zero in perfect competition, but not when a firm has market power...
TR p q p q
TR p q
Market power
Dividing through by ∂q gives marginal revenue
The income generated by an extra unit of output is equal to the price minus the negative impact of the extra output on prices
Factorising price:
TR p q p q
TR pmR p q
q q
1p q
mR pq p
Market power
11 1
Dp
p qmR p p
q p
One can see that the “complicated” term inside the brackets is the inverse of the price elasticity of demand:
The term in brackets is our mark-up. This is also sometimes called the Lerner index, and is the measure of market power
The profit maximising condition mR = mC can be written as:
1 1
Dp
mR mC p mC
Market power
Price
Quantity
Demand
mR
Graphical construction of mRDp
1Dp
0Dp
The slope of the mR curve is twice that of the demand curve
11
Dp
mR p
The Monopoly
Market power
The market equilibrium under a monopoly
Welfare aspects of the monopoly
The monopsony
The market equilibrium under a monopoly
The monopoly is an extreme case. It corresponds to the following market structure :
1. A single producer2. Homogeneous products3. No entry of competing producers on the
market4. Perfect information5. Perfect mobility of inputs
The market equilibrium under a monopoly
mC
AC
Price Price
S
D
Reminder: Perfect competition equilibrium
Firm level Market level
Quantityquantity
d=mRp
q Q
D2
Q2
p2
q2
d2=mR2
Total Cost
p q TC
Positive profits in SR
The market equilibrium under a monopoly
Price
Quantity
mC AC
Demand
mR
q
p
Monopoly equilibrium
1st
2nd 1st : mC=mR gives q
2nd : given q, the demand curve gives p
The market equilibrium under a monopoly
pq = TR
ACq = TC
Price
Quantity
mC AC
Demand
mR
q
p
RT CT
The Monopoly
Market power
The market equilibrium under a monopoly
Welfare aspects of the monopoly
The monopsony
Welfare aspects of the monopoly
Unsurprisingly, the monopoly is inefficient compared to perfect competition:
Positive economic profit in the LRP ≠ mC: there is a mark-up on marginal
costNot producing at minimal AC
Welfare aspects of the monopoly
mC
AC
Price
Monopoly equilibrium
Quantity
mR
p
q
Demand
1st element p ≠ mC This is due to the
existence of market power
The monopoly can push prices above the perfect competition outcome
Prices are a mark-up over marginal cost
mC
Welfare aspects of the monopoly
mC
AC
Price
Quantity
mR
p
q
Demand
p q TC
2nd element The monopoly
makes positive economic products in the LR
This is due to the existence of barriers to entry
Competitors cannot enter to compete away the profit
Monopoly equilibrium
Welfare aspects of the monopoly
mC
AC
Price
Quantity
mR
p
q
Demand
3rd element The monopoly does
not produce at the minimum point of the AC curve
Some IRS opportunities are not used up
This market does not produce at the most cost-efficient point
Monopoly equilibrium
min AC
AC
Welfare aspects of the monopoly
There are therefore different sources of inefficiency in the monopolyThe existence of market powerThe existence of barriers to entry
How can we measure the overall inefficiency of the monopoly compared to perfect competition ??We use the surplus as a measure of
welfare
Welfare aspects of the monopoly
Consumer surplus
Producersurplus
Deadweight loss
Price
Quantity
mC AC
Demand
mR
q
p
Welfare aspects of the monopoly
This is why competition policy often regulates existing monopolies and attempts to prevent the emergence of new ones
Examples : US Antitrust legislation Sherman Act (1890) Clayton
Act (1914) 1911: John Rockefeller's Standard Oil is split US 1934 Airmail Act splits United Aircraft and
Transport Corporation into Boeing, United Aircraft (Pratt Whitney, Sikorsky) and United Airlines.
EU vs. Microsoft on Internet Explorer (aka “the browser wars”)
Welfare aspects of the monopoly
There are different ways of regulating a monopoly, based on the different inefficiencies
The typical instrument is the price ceiling Regulate at p = AC
Pro: Zero-profits. The average cost is known Con: not the most efficient regulation (deadweight
loss) Regulate at p = mC
Pro: Most efficient regulation (no deadweight loss) Con: Some positive profits remain. Difficult to
calculate the marginal cost !!
Welfare aspects of the monopoly
Consumer surplus
Producersurplus
Deadweight loss
Price
Quantity
mC AC
Demand
mR
q2
p2
q
p Regulate at p= mC
Welfare aspects of the monopoly
Consumer surplus
Producersurplus
Deadweight loss
Price
Quantity
mC AC
Demand
mR
q2
p2
q
p Regulate at p= AC
Welfare aspects of the monopoly
“Schumpeterian” argument: Monopoly profits are a reward for a risky
investment decision by an entrepreneur If these potential rewards are denied (through
a tough competition policy), no entrepreneur will be willing to take risks.
Therefore, monopoly regulation has a negative effect on innovation
See the Patent argument (Varian, chap 24)
The Monopoly
Market power
The market equilibrium under a monopoly
Welfare aspects of the monopoly
The monopsony
The monopsony
Opposite situation to the monopolyA single buyer instead of a single
producer
Similar aspects in terms of market power and welfareThe buyer’s market power pushes the
price below the marginal costThere is a deadweight loss ⇒ inefficient
structure
The monopsony
The monopsony corresponds to the following market structure, similar to the monopoly case :
1. A single buyer2. Homogeneous products3. No entry of competing buyers on the
market4. Perfect information5. Perfect mobility of inputs
The monopsony
Price
Quantity
mC Supply
Marginal Product
q
p
Monopsony equilibrium
1st
2nd
1st : mC=mP gives q
2nd : given q, the supply curve gives p
mC
The monopsony
How likely is this market structure ? Actually important for some agricultural
products Coffee, cocoa, bananas, etc...
Another situation can be the labour market There are many more suppliers of labour
(individual workers) than buyers (firms) Firms will have monopsony power on the labour
market. This will distort the market outcome ! We shall examine this again when we talk about
the labour market (week 14)