Monopoly: Chapter 13

• Monopoly is Chapter 13

Introduction

• AIDS has killed more than 40 million people since 1981
• Deaths from AIDS in the US dropped 50% between 1995 and 1997 because of Combivir and similar drugs
• Combivir pills cost $0.50 to produce, but are sold for $12.50, which is 25x higher

Definitions

• Market power is the power to raise price above marginal cost without fear that other firms will enter the market
• Monopoly as a concept is a firm with market power
• Marginal revenue (MR) is the change in total revenue from selling an additional unit
• Marginal cost (MC) is the change in total cost from selling an additional unit

Market Power

• GlaxoSmithKline (GSK) owns the patent on Combivir
• Patents give exclusive rights to make, use, or sell a product
• GSK's patent for Combivir prevents competition, giving GSK market power
• India does not recognize the Combivir patent
• In India, an equivalent drug sells for $0.50, or the marginal cost
• To maximize profit, firms produce at the level of output where MC = MR
• Firms with market power must lower prices to sell an additional unit
• Firms with market power face a downward-sloping demand curve
• Additional revenue per unit < current price, i.e. MR < P

Marginal Revenue

• When the price drops from $16 to $14, quantity increases from 2 to 3 units
• Total revenue increases from $32 to $42
• Marginal revenue, or the change in total revenue, is $10
• The MR begins at the same point on the vertical axis as demand
• MR has twice the slope

Monopoly Maximization

• Monopoly maximizes profit by achieving MR = MC at 80 million pills
• Profit-maximizing price is $12.50
• Profit per pill is $10.00
• Total profit is $10 x 80, totaling $800 million

Elasticity

• Two effects make demand for pharmaceuticals inelastic
• The "you can't take it with you" effect occurs because people with serious illnesses are relatively insensitive to the price of life-saving drugs
• The "other people's money" effect says if third parties are paying for the medicine, then people are less sensitive to price
• The more inelastic the demand curve, the more a monopolist will raise price above MC

Deadweight Loss

• Monopolies charge a higher price and produce less than competitive firms
• Monopolies reduce total surplus (consumer surplus + producer surplus)
• A deadweight loss occurs because sales do not occur because the monopoly price is above the competitive price

Corruption and Inefficiency

• Many monopolies result from government corruption
• Tommy Suharto, the Indonesian president’s son, was given the clove monopoly
• He bought the Lamborghini company with the monopoly profits
• Monopolies are especially harmful if they control a good that is used to produce other goods
• In Algeria, a dozen army generals each control a key good
• The generals are referred to as General Wheat, General Tire, etc, each trying to get a larger share of the economic pie
• Results is greater deadweight loss, and the "pie" shrinks

Incentives for Research and Development

• Drug prices are lower in India and Canada, due to India not offering strong patent protection and Canada controlling drug prices
• It costs over $1 billion to develop a new drug
• Patents are one way of rewarding research and development (R&D)
• Without patents, firms would not spend on R&D, and fewer new drugs would be developed
• Prizes can reward R&D without creating monopolies
• Patent buyouts are another alternative
• Buyouts reduce price without reducing R&D
• Government must raise taxes to pay for the patent, but it may be difficult to determine a price

Monopoly Power Sources

• Monopoly power arises from economies of scale, barriers to entry, network effects and innovation
• Economies of scale are the advantages of large-scale production that reduce average cost as quantity increases
• Natural monopoly occurs when a single firm can supply the entire market at a lower cost than 2+ firms can
• Monopolies arise naturally when economies of scale allow a single firm to produce at a lower cost than can many small firms
• Utilities like water, natural gas, and cable television are often natural monopolies
• If economies of scale are large enough, price can be lower under a natural monopoly than under competition
• Barriers to entry are factors that increase the costs to new firms entering an industry
• Potential barriers to entry include: ownership of an input hard to duplicate, brands and trademarks, and the development of a relationship with the market
• Network effects occur when products/services are more valuable as number of users increases
• Facebook has few competitors because everybody uses it
• There are only a few credit card companies because customers want cards widely accepted and firms want to accept cards widely used
• Innovation can lead to products that other firms cannot immediately duplicate
• Innovation involves a trade-off as iPhones are priced higher, but Apple would have less incentive to innovate if it didn’t expect monopoly profits

Regulation

• The government has many tools to regulate monopolies, including price controls, government ownership and antitrust law
• Price controls on a monopoly can increase output
• Reducing monopoly prices increases output/consumer surplus while decreasing the incentive to innovate
• Government ownership and regulation of electricity has provided the US with cheap power for decades
• Around 2/3 of the 3,000 electric utilities are government-owned
• Without competition or profit motive, there is a tendency to become inefficient
• Without regulation, providers can exploit market power
• Antitrust laws are antimonopoly laws
• The Sherman Act (1890) and the Clayton Act (1914) are 2 important U.S. antitrust laws
• These laws give the government legal authority to prosecute monopolies or firms’ attempts to monopolize, break up monopolies, prohibit mergers, and prevent acts that reduce competition
• Prices, technology, and market conditions are constantly changing, and firms grow, shrink, split, and merge
• Mergers lead to efficiencies of scale but also more market power
• Authorities must try to balance lower costs with higher prices