Monopolies and Market Power

• This is a study text on monopolies and market power.

Monopoly and Market Power

• This topic covers the characteristics of monopolies, the income curves of monopolists, production decisions in the short term, market power and its measurement, long-term equilibrium, social costs, and the regulation of monopolies including natural monopolies.

Perfect Competition

• Perfect competition involves many buyers and sellers, homogeneous products, free entry and exit, and perfect information.
• Perfect competition leads to an efficient market.

Market Failures

• Market failure occurs when the conditions for perfect competition aren't met.
• This includes market power/monopolies, externalities, public goods, and imperfect information.
• Free markets are not efficient in the presence of these failures.

Monopoly Characteristics

• A monopoly consists of one seller and many buyers, a product without close substitutes, blocked entry, and perfect information.

Monopolist Objectives

• Monopolists aim to maximize profit, defined as π(q) = I(q) - C(q) where I is income and C is cost.
• Costs are determined by technology and input prices, while income depends on the market structure.

Monopoly Revenue

• Competitive firms are price-takers, so their demand curve equals marginal revenue and price.
• Monopolists face the entire market demand, which affects marginal revenue differently such that marginal revenue and price are not equal

Marginal Revenue Formula

• The marginal revenue calculation accounts for how price changes with quantity sold.
• Marginal revenue is expressed as IM = P + (dP/dQ) * Q, which is less than the price (IM < P).

Monopoly Equilibrium

• Profits are maximized where marginal revenue (IM) equals marginal cost (CM).
• If IM > CM, increasing production raises profits.
• If IM < CM, decreasing production can increase profits.
• Therefore, production level is optimal when IM = CM.

Shutdown Conditions

• In the short-term, a company will close if its income is less than its variable costs, which implies the price should be greater than the average variable cost, expressed as p > CVMe.
• In the long-term, closure happens when income is less than total costs, so the price must be greater than the average total cost, expressed as p > CMeL.

Monopoly vs Competition

• Perfect competition sees the marginal cost determine the market supply curve.
• In a monopoly, output is determined by both marginal cost and demand curve position.
• Demand changes typically affect quantity and price, but monopolies lack a supply curve because there isn't a unique relationship between price and quantity.

Long-Term Equilibrium

• Monopolists can adjust all production factors in the long run.
• Barriers to entry allow monopolists to sustain extraordinary or zero profits in equilibrium.

Measuring Market Power

• In perfect competition, P = IM = CM.
• For monopolies, P > CM, and market power is present in most markets except those with perfect competition.

Lerner Index

• The Lerner Index measures market power using the formula:
• (P - CM) / P.
• The Lerner Index is inversely related to demand elasticity.
• It is zero in perfect competition and positive in monopolies.
• Higher elasticity lowers the Lerner Index, thus increased number of available substitutes reduces monopoly power.

Social Cost of Monopoly

• Compared to perfect competition, monopolies produce less at a higher cost.
• Consumers pay higher prices increasing producers surplus while lowering consumer surplus.

Efficiency Loss

• Monopoly market power reduces potential gains from trade. Efficiency losses stem from not maximizing gains from the IM intersects the demand curve, resulting in a loss of efficiency.

Monopoly Regulation

• Regulation in competitive markets previously caused inefficiencies; now, in monopolies, regulation intends to correct those losses
• Ideally, governments impose price caps equal to marginal costs, eliminating the inefficiencies.

Natural Monopoly

• Natural monopolies exist when a single firm can produce at a lower average cost than multiple firms.
• Efficient regulation of natural monopolies (p = CM) leads to company losses since average cost is greater than the marginal cost.

Multi-Plant Monopoly

• In multi-plant production, the total production level should be set where the marginal revenue equals the marginal cost.
• Production is allocated such that marginal cost of the last unit is the same in each plant.