Chapter 12

"pure" monopoly
heterogenous/homogenous products
natural monopoly
oligopoly
cartel/collusion
intellectual property rights
price discrimination - 1st, 2nd and 3rd degree
demand elasticity
barriers to entry
diminishing ATC (returns to scale)
anti-trust legislation

We will look at four cases where the ‘free market’ doesn’t work very well. These include:

monopoly power
externalities
public goods
imperfect information

These are all examples when economists believe that government intervention may be preferable to the free market. In other words, the free market is not efficient.

Monopolies or firms with market power provide one xample where the free market does not provide the most efficient solution and government intervention may be warranted.

Always helpful to begin with the perfectly competitive case - what do we know in that case?
p given, firms determine q based on p (market), MR=MC, LR p=min ATC

Last time we talked about whether pure monopolies were common -
To help you think about that, it is helpful to ask what distinguishes a monopoly and how is it different from other markets/commodities?

unique product (are there any close substitutes)
single supplier of that product
ability to control the market (determine your own price)

In most cases, monopolies, like taxes and other price manipulations, create dead weight loss.

In other words, they move us away from an efficient market equilibrium. Monopolists also reduce consumer surplus, so there may be an equity issue as well.

Let’s say you are a firm which realizes that the demand for your good is inelastic. What will you want to do? Raise your price. (Remember if the demand is inelastic, total revenue rises with a higher price.) Also, you can capture some of consumers’ surplus.

Let’s look at the numbers:

The equilibrium price is $40 and the equilibrium quantity is 60.

What is consumer surplus in this case? Can we calculate producer surplus?

½ (p_e - p_o) q = PS and (almost identical to CS, except different origin prices will be used and reverse in order of prices.

½ (p_o - p_e) q = CS

In this case CS= ½ (100 - 40) (60) = 1800, PS = ½ (40 - 10) (60) = 900

What is total surplus? 2700 (area of both triangles.)

What is Total revenue in this case? p q = TR (40) (60) = 2400

How are monopolies different from other firms?

They are price setters, rather than price makers.

If they know the demand for their product is inelastic, what might they do?

They can raise their price and capture more surplus (and revenue), even though the quantity goes down.

If they raise the price by $10, what will be the result? Q will equal 50.

What will CS be? ½ (100 - 50) (50) = 1250 (a loss of 550)

What will PS be? This is a little trickier - need to estimate triangle and rectangle area (or trapezoid). How can we do that?

((p_d - p_s) + (½ (p_s - p_o)) q = PS

((50 - 35) + (½ (35 - 10)) (50) = 1375 (PS has increased by 450)

What was the total surplus now? 2625. What is the dead weight loss? 75.

To summarize:

Monopolies have market power, so they can set their own price.

As a result, they capture part of CS, but also create dead weight loss.

How do monopolies determine the appropriate price for their product?
They maximize profit just as perfectly competitive firms do, by setting MC=MR. In the case of the pc firm, MR=p (price is given), whereas in the case of the monopolist MR varies, depending on the price set. MR = change in TR/change in Q

p	Q	TR	MR
$4.00	400	1600	4.00
$3.50	800	2800	3.00
$3.00	1400	4200	2.33
$2.50	2800	7000	2.00
$2.00	4000	8000	0.83

Suppose that the MC is constant, at 2. Where will the monopolist produce? Q = 2800.

Where would the perfectly competitive firm produce? Q = 4000.

In the real world there are not many pure monopolies. But there are firms with market power - meaning they can set their own price and thus create inefficiency. Whether a firm is a monopoly or has too much market power is also debated by policy makers.

When is a firm likely to have market power?

1. 'natural monopoly.'

This is the case when  a company experiences what economists call ‘diminishing returns to scale.’ In other words, the more of a product is produced, the cheaper the product is. - examples include: cable, phone, electricity, water distribution

Electricity could be seen as a natural monopoly because of how it is transmitted - the electricity grid has diminishing ATC - it doesn't make sense for 2 companies build transmission networks side by side and compete.

2. when they have control over a natural resource (diamond/oil).

3. when the government gives them patent rights (it's rather ironic that the government both works to eliminate monopoly power and creates it at the same time.)

4.  when a firm is able to convince consumers that it has a ‘unique’ product and thus can charge more. Emphasis on the role that marketing plays. (oligopoly).

5. When firms get together and plan to control Q, thus raising P. (Cartel or collusion)

6. when a firm can identify consumers with differing demand elasticities (price discrimination)

# 4 does not create a pure monopoly, but market power is often created through advertising - firms that spend a lot of time convincing customers that they have a unique product are trying to create monopoly power. While these firms may not be "pure monopolies," they have what economists call "market power," which means they have a certain amount of power over the price they charge. How do they do this? By convincing consumers that their product is unique. This may not be the case - there may be many substitutes for the good the firm produces - but if the firm can convince the customers, then it has a certain amount of monopoly power.

When is government likely to intervene to prevent market power?

Whether a firm is a monopoly depends on what you define as substitutes to the product.

Key to the question of monopolies is the the term ELASTICITY which is also linked to marketing.

How do you know a company is a monopoly and what stands out about monopolies that makes them unique?

What is the solution?

Role of government (anti-trust legislation):

1. monitor firms to determine whether they are too powerful
2. price controls
3. break up monopolies
4. other restrictions

What do we know about the markets we have discussed so far?

Perfectly competitive firms see what the price is in the market is, and they produce accordingly. Or in the case of the monopoly, the firm determines is demand and sets q (which in turn determines p) such as that they max profit.

Another variation on market power is price discrimination -

What if a firm could figure out exactly what each consumer would be willing to pay for a good? How would you price and what would be the result?

Economists call this perfect price discrimination. What types of markets are perfectly price discriminating?

How might we graph the fact the difference between what the average "perfectly competitive firm" perceives as their price, and the monopoly perceives as their price and consumer demand?

A less extreme case might be the case where you have a general idea of your demand curve, but can’t charge a different price for each individual. - 2nd and 3rd degree price discrimination

If you were a firm and you knew what the demand curve of your consumers was, how would you behave?

You might try to figure out where you could make the most money (trying to extract the most consumer surplus) and then price accordingly.