Chapter 9 Monopoly (Introductory Microeconomics) PDF

Chapter 9 Inefficiency and Inequity of Monopoly and the Need to Regulate ©1 Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM One of the famous observations of A. Smith was that businesspersons scarcely meet without conspiring against...

Chapter 9 Inefficiency and Inequity of Monopoly and the Need to Regulate ©1 Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM One of the famous observations of A. Smith was that businesspersons scarcely meet without conspiring against the public interest by forming monopolies to restrict output and raise prices. In simple terms a monopoly is a single supplier or a group of suppliers that agree to act like a single supplier, facing a large number of buyers who have very limited information about the product sold by the single supplier. In practice, Adam Smith’s casual observation may have been difficult to verify in his time. At present, it is no less difficult to verify directly. However, we have abundant indirect evidence that shows the pervasive nature of monopoly in today’s economies, although some judges in courts of law, with little understanding of economics or for other reasons, confuse perfect competition with hidden monopoly on the basis that as long as there is more than one supplier in the market of a product, there is (perfect) competition and the product’s market will achieve an efficient allocation of resources, In reality, every market has elements of monopoly to a varying degree. Since a monopolist supplier restricts output to raise price in comparison with perfect competition, we shall show in this chapter that the monopolist supplier must not be operating at minimum average cost and the price must be higher than the marginal social cost. He/she must also restrict employment. If monopoly is pervasive in an economy, it must also lead to high unemployment rates and increased government spending on social security. That is, monopoly produces an inefficient allocation of resources. In this chapter, we demonstrate these propositions about monopolist suppliers and/or producers. Types of monopoly We distinguish four types of monopoly, they share the same characteristics as to their effects on efficiency and distribution of incomes. They are all abated by government politicians and supported by the financial system of a country. 1. Legal monopoly This is a situation where the government grants an exclusive privilege to one producer or seller to produce and/or sell a given product or line of products. The government of European colonial powers used to grant such monopolies quite often in colonial times. For example, the Hudson Bay Company had a monopoly on the fur trade in North America from the then British government. 2. Natural resources monopoly This is a situation where one producer owns exclusive access to a natural resource such as oil or land suitable for the production of a given product such as coffee. This exclusive ownership may be true for a country but most likely not for the whole world. 3. Natural monopoly This is a situation of a product market or industry where at a price equal to minimum long run average cost, the quantity demanded can be most efficiently supplied with only one producer or supplier. Figure 1 illustrates the case of a natural monopoly. In figure 1, the long run average cost for a single firm intersects the demand curve AD at the minimum of the former. This situation occurs when economies of scale in the production of a product obtain for a wide range of output compared to the quantity demanded at a price equal to the minimum long run average cost. This is the case for 1Cartago Research and Development, 8/20/24, 4:23 PM CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 2 9- example when a country’s market for a product is too small relative to the size of the output range of a single producer over which economies of scale (or increasing returns to scale) occur. If the managers of a single firm or produce a quantity QA = 80 units of the product as shown in figure 1 and behave like a producer operating under perfect competition, they will produce this quantity at the minimum long run average cost ACA = $2 and they will make a normal profit selling the product at a price equal to the minimum long run average cost which is equal to ACA= $2. At point A of the market demand curve AD, the market will be at equilibrium with quantity demanded equal to quantity supplied, marginal social benefit = marginal social cost = minimum long run average cost = $2. They will earn a normal profit and no economic profit. Now suppose instead that we bring in a second producer with access to the same technology and thus with the same long run average cost curve CBA. Let the first producer produce Q1 30 units and the second producer produce Q2 = 50 units with Q1 + Q2.= QA.= 80 units Figure 1 Natural Monopoly Price in $ 11 Market Demand Curve 10 D Long Run Average 9 Cost Curve 8 7 Long Run Margianl Cost Curve AC1 = 6 C 5 4 AC2 = B 3 A ACA = 2 1 0 0 10 20 30 40 50 60 70 80 90 100 Q1 =30 Q2=50 QA = 80 Output Each producer faces the same long run average cost curve as given in figure 1. The long run average cost of producer 1 is AC1 = $6 and that of producer 2 is AC2 = $3.5. Clearly, AC1 and AC2 are both greater than the minimum value ACA = $2 of the long run average cost at A. Despite the fact that the sum of the number of units of output of both firms is equal to QA = 80 units, this arrangement does not maximize total net social benefit. The total cost of producing QA is greater than that when only one firm produces all of it. Since AC1 > AC A and AC2 > AC A , it follows that: Total cost with two firms = AC1 x Q1 + AC2 x Q2 = $6x30 units + $3.5x50 units = $355 > ( AC A x Q1 ) + ( AC A x Q2 ) = AC A x QA = $2 x 80 units = $160 = One single producer total cost. CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 3 9- The same conclusion holds for any number of producers greater than one whose total output is equal to QA.. Thus, efficiency requires that a single producer should produce the number of units QA = 80 units of the product, which number of units maximizes total net social benefit with marginal social cost = marginal social benefit. However, a single producer is tempted to behave like a monopoly, especially if there are large startup sunk costs, which give rise to the large economies of scale responsible for the situation in the first place. Startup costs of a firm are sunk costs. In case of a recurrent economic loss, the owners of the firm cannot recover the startup costs by selling the firm and/or changing product lines. Huge investment in specialized equipment and legal costs of setting up the firm are examples of startup- sunk costs. Startup sunk costs make up for a huge impenetrable exit barrier and entry barrier, which gives a great advantage to a first comer producer who has access to huge financial resources supplied by managers of financial institutions. The barrier to exit makes potential competitors wary of entering the market because of the risk of losing their sunk cost in case the existing firm decides to fight back by reducing the price to a level equal to the minimum long run average cost. In this case, The barrier to entry is even more formidable because of the need to borrow a huge amount of financial resources, which existing financial institutions managers will not provide under pressure from the first comer who would threaten not to repay her loan if the new comer gets the required financing. It is natural to expect that a monopoly would take over such a market. We call it a natural monopoly. 4. Patent Monopoly This is a limited period monopoly granted by government officials and politicians to protect intellectual property rights. These politicians and special interest groups justify the granting of such a monopoly encourages research and development because it allows such a monopolist to earn much more than a normal profit for an arbitrarily long period of time. When individuals or managers of firms engage in research activity they cannot borrow to make investments in equipment and spend money to hire scientists and research workers without appropriate protection for their investments. Furthermore, some of this research activity is successful but some is not. When it is successful, the commercial application of the research activity must pay for the initial successful and non-successful investments and a fair rate of return. In the absence of any barrier to replicate the results of successful research investments, potential competitors would easily duplicate the results of successful research without having to make any investment in research and development. This is an example of a positive externality that government’s officials and politicians suppress by granting a patent for some arbitrary long number of years, thereby creating monopolies and causing inefficient allocation of resources. The average cost of the discoverer and producer of a new product or a cheaper way to produce an old product must include an allowance for research costs. However, the average cost of those producers who duplicate the discovery does not. Without protection, the competitors who duplicate will drive the discoverer out of business before recuperating her/his costs. Protecting the discoverer or finding a way to allow her/him to recover her/his costs of investment in research plus a fair rate of return on own capital used to make the discovery will benefit both the discoverer and society. If society does not help a discoverer recover her/his research costs plus a fair rate of return, few individuals would want to invest in research and development and society would suffer a deadweight loss. However, every government action to improve the efficiency of economic activity is subject to abuse and manipulation, CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 4 9- One way to protect the investor in research and development is to grant him/her the exclusive right to use its new discovery in the production of a new product for a limited period. We call this right a patent. The patent grants the discoverer a temporary monopoly on the new product or the new method of production. In the pharmaceutical industry, the patent may run for eleven years or longer. It gives rise to a lot of waste of resources to society in litigation caused by the discoverer to prevent any duplication of or further improvement over the discovery, even years after he/she has recovered her/his research costs plus a normal profit. Marginal Revenue and Price Elasticity of a Market Demand Curve When we discussed the problem of the maximization of total economic profit by the managers or owners of a firm operating in a perfect competition market, we found that an important characteristic of the level of output that they would choose is such that the marginal cost at that output level is equal to the market equilibrium price. This being true for every such firm, it follows that, at equilibrium, the marginal social benefit is equal to the market equilibrium price equal to the long run marginal social cost. This characteristic of decision-making by managers or owners of a firm operating in perfect competition markets is not a valid characteristic of the output level that maximizes the total economic profit of the owners or managers of a firm who have a monopoly in the market of the firm’s product. In this type of markets, the market equilibrium will result in an inefficient allocation of resources and an inequitable income distribution. Our task in this section and the next one is to prove these assertions. Perceived Demand curve by Owners of a Firm Operating In Perfect Competition Markets For a producer ora supplier operating in a perfect competition market, the market equilibrium price is the additional revenue from selling an additional unit of her/his product. To sell an additional unit the producer does not need to lower her/his price below the market equilibrium price. At equilibrium, the producer can sell as much as he/she can produce at an average cost lower than or equal to the market equilibrium price. If he/she charges less than the market equilibrium price, he/she will make less economic profit. He/she will attract quantity demanded higher than the quantity he/she can get by selling at the market equilibrium price. Because its average cost rises quickly above the market equilibrium price, most of that additional quantity demanded can be satisfied only at a loss. Thus, a producer operating in a prefect competition market would not want to lower the price below the market equilibrium price. Figure 2 Marginal Revenues of a firm under perfect competition CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 5 9- Price or Unit Cost A Long Run Average Cost Curve Perceived Demand Curve Market Equilibrium B C Price= $3 Qm Quantity QM On the other hand, he/she would not raise the price of her/his product above the market equilibrium price for fear of losing all her/his customers at once and incur a total economic loss equal to the total fixed cost. Thanks for free entry and perfect competition, there are potential producers who would enter the market and sell at a price below the price of the producer who is raising his price above the equilibrium price, replace her, and make an economic profit Thus, the two-segment curve ABC in figure 2 represents the perceived demand curve by a producer operating in a perfect competition market when the market price is equal to the equilibrium price. Segment AB at 0 unit of the product represents the demand curve for a producer if he charges a price higher than the market equilibrium price and it reflects the fact that if he/she charges more than the market equilibrium price, e.g. $3, he/she loses all her/his customers and can sell only zero units. At the market equilibrium price of $3, he/she can sell any number of units between Qm and QM, for which the market equilibrium price is greater than the long run average cost. For all outputs greater than QM, the game is not worth the candle even at the market equilibrium price. Because QM is small compared to the total quantity demanded by all demanders of the product at the market equilibrium price, the producer’s perceived demand curve BC is a horizontal line at the market equilibrium price. Furthermore, along the horizontal segment at the market equilibrium price, the producer’s marginal revenue, defined as the additional revenue from supplying one more unit of the product, is constant it is equal to the market equilibrium price The demand curve for a producer who has a monopoly on the production or supply of a product is much different and her/his marginal revenue is not constant. We shall call a producer or group of managers of a firm who has a monopoly on the production of its product a Monopolist Demand Curve of a Monopolist A monopolist faces the whole market demand curve for her/his product. At a given price, the demand curve gives the maximum number of units demanded for which the willingness to pay is greater than or equal to the given price. This is the maximum quantity that the monopolist can sell at the given price. If he/she wants to sell more, it cannot attract demanders away from other producers since it faces the whole demand curve. He/she must attract consumers whose willingness to pay is less than CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 6 9- her/his current price. To attract the most promising ones of these consumers, he/she must reduce her price. Figure 3 Decomposition of a change in the total revenue of a monopolist Price and Unit Costs Market Demand Curve P1 A B P2 C E D G F Q1 Q2 Quantity Demanded For example, figure 3 shows that if the monopolist charges P1, she can sell any number of units of her/his product less than or equal to quantity Q1. To sell a quantity Q2, greater than Q1, he/she must lower the price of her/his product to P2, both on each unit of Q1 that he was selling before and lower it also on the additional units (Q2 - Q1) he/she wishes to sell. Thus the additional revenue obtained from selling the additional (Q2 - Q1) units is not equal to P1 x (Q2 - Q1). This additional revenue is: Additional Revenue = Sales proceeds P2 x (Q2 - Q1) from selling (Q2 - Q1) at P2 - Loss of (P1 – P2) x Q1 incurred on the Q1 units due to the price reduction = Green Area CEFG - Red Area ABCD in figure 2 Thus, Additional Revenue = P2 x (Q2 - Q1) – (P1 – P2) x Q1 (1) When Q2 - Q1 = 1, the additional revenue as given by equation (1) is called the Marginal Revenue MR. Marginal Revenue MR = Additional revenue from an additional unit sold or demanded as given in equation (1) Replacing Q2 - Q1 by 1 in equation (1), we get: MR = P2 – (P1 – P2) x Q1 < P2 (2) If Q2 - Q1 is not equal to one then we calculate MR by dividing both sides of equation (1) by Q2 - Q1. It follows: P2 x (Q2 - Q1 ) - (P1 - P2 ) x Q1 P - P2 MR = = P2 - 1 x Q1 (3) Q2 - Q1 Q2 - Q1 Equations (2) and (3) imply that MR is always less than the price. Suppose that the demand schedule is given by columns (1) and (2) of Table 1. Let us suppose that the monopolist wants to know her MR when she sells Q1 = 20 units at a price of Q1 = $8. In order to CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 7 9- sell 10 additional units, she must lower the price to P2 = $7. In this case, the change in quantity demanded and sold is equal to (Q2 - Q1) = 10 units and the change in price = (P1 – P2) = $8 -$7 = $1. We apply equation (3) to get MR = 7 – [(1/10) x 20] = 5. We record this value of MR in column (6) of Table 1 between the rows corresponding to the quantities 20 units and 30 units. Since MR is the change in total revenue per additional unit sold, we have another way of calculating MR. We use the demand curve schedule to calculate total revenue at every quantity demanded then calculate the marginal revenue according to the formula Change in total revenue MR = (4) Change in quantity Clearly, Total Revenue TR is: TR = Price x Quantity Demanded and sold at that Price. Table 1 shows an example of the calculation of MR according to equation (4). This method of calculating MR yields the same results as those we obtain using equation (3). For example, suppose that the monopolist wants to know MR when she sells 20 units of her/his product at a price of $8. Then TR = $8 x 20 = $160 as indicated in column (3) of Table 1. Table 1 The Marginal Revenue Quantity Price Total Change Change in MR in $= In $ Revenue in Total Revenue (5)/(4) in $ Quantity in $ (1) (2) (3) (4) (5) (6) 0 10 0 10 90 90/10 =9 10 9 90 10 70 70/10 = 7 20 8 160 10 50 5 30 7 210 10 30 30/10 = 3 40 6 240 10 10 1 50 5 250 10 -10 -1 60 4 240 10 -30 -30/10 = -3 70 3 210 10 -50 -5 80 2 160 10 -70 -7 90 1 90 10 -90 -9 100 0 0 CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 8 9- To sell 10 additional units he/she must lower the price to $7. TR increases to $7 x 30 = $210. Thus, the change in TR = $210 - $160 = $50. Column (5) of Table 1 records the change in total revenue TR. The change in quantity is 10 units= (30 units - 20 units). Column (4) of Table 1 gives the change in quantity demanded. Using equation (5), we get MR = $50/10 = $5. This is the same result as we obtained using equation (2). In Table 1, we record the changes in between the corresponding rows. Figure 4.a plots the demand curve and the corresponding marginal revenue curve as given in Table 1. At any given quantity demanded, the demand curve gives the maximum price consumers are willing to pay for an additional unit of the product and the marginal revenue curve gives the marginal revenue. As figure 4.a shows, the MR curve is located below its demand curve. According to column (3) of Table 1, TR starts increasing from a value of zero when the quantity demanded is zero, it attains a maximum, and then falls back to zero again, when the product price is equal to zero. Figure 4.b illustrates this characteristic behavior of TR. By comparing figures 4.a and 4.b, we note that TR is rising when MR is positive, it attains its maximum when MR = zero. TR starts falling when MR becomes negative. Since price and quantity vary inversely along the demand curve it is not surprising that total revenue does not always rise as the price falls and the quantity demanded increases. If the effect of the increase in the quantity demanded is less than offset by the fall in the price, total revenue rises. Figure 4 Demand Curve, Marginal Revenue Curve, and Total Revenue Curve Figure 4.a Price Ep > 1 15 Ep < 1 Ep = 1 Demand Curve 10 5 0 0 10 20 30 40 50 60 70 80 90 100 -5 Marginal Revenue Quantity demanded Curve -10 -15 Figure 4.b CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 9 9- Total Revenue 300 250 Total Revenue 200 150 100 50 Quantity 0 0 10 20 30 40 50 60 70 80 90 100 Whether the fall in price will more than offset the rise in the quantity demanded depends on how responsive is the quantity demanded to the fall in price. If it takes relatively only a small decrease in the price to get a relatively large increase in quantity demanded, then Total Revenue TR would increase. Otherwise it would fall. In the first case, the quantity demanded is very responsive to the fall in the price. In the second case, it is not responsive. Therefore, to find out how TR changes we need only to compare the percentage change in quantity demanded to the percentage change in the price. In fact, because total revenue is the product of quantity demanded by the price and the two variables vary in an inverse relation to each other, we can write: % Change in Total Revenue = % Increase in quantity demanded - % Decrease in (6) Price Thus, % Change in Revenue > 0 if and only % Increase in Quantity demanded > % Decrease in Price That is: % Increase in Quantity Demanded % Change in Revenue > 0 if and only >1 % Decrease in Price However, the price elasticity of demand E p is: % Increase in Quantity Demanded (7) Ep = % Decrease in Price Accordingly, If E p > 1, Total Revenue increases (MR > 0) when the price falls and the quantity demanded rises If E p < 1, Total Revenue falls (MR < 0) when the price falls and the quantity demanded rises If E p =1, Total Revenue is constant or MR = 0 when the price falls and the quantity demanded rises CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 10 9- When the price elasticity is less than one, the demand curve is inelastic. When the price elasticity is greater than one the demand curve is elastic. Table 2 illustrates the relationship between MR and price elasticity. To calculate the price elasticity, we calculate first the percentage change in quantity demanded and the corresponding percentage change in price. Then we divide the former by the latter. Column (3) of Table 2 gives the percentage change in quantity demanded, column (4) of Table 2 gives the percentage change in price, and column (5) of Table 2 gives the corresponding price elasticity of the demand curve. Table 2 The Marginal Revenue and Price Elasticity of Demand Curve Quantity % Change % Price Demande Price in Quantity Change Elasticity MR d Demanded in Price (1) (2) (3) (4) (5) (6) 0 10 10 9 200 10.5 19.04 9 20 8 66 11.7 5.64 7 30 7 40 13.3 3 5 40 6 29 15.3 1.89 3 50 5 22 18 1.22 1 60 4 18 22 0.818 -1 70 3 15.3 29 0.517 -3 80 2 13.3 40 0.333 -5 90 1 11.7 66 0.177 -7 100 0 10.5 200 0.053 -9 To calculate the percentage change in quantity demanded between 10 and 20 units we divide the change in the quantity demanded equal to 10 units by the average 15 of the two quantities demanded 20 units and 10 units and multiply the result by 100. Column (3) of Table 2 shows that this percentage change is equal to (10/15)* 100 = 66 %. To calculate the percentage change in price between the two corresponding prices $9 and $8 dollars, we divide the change of $1 in the price by the average $8.5 of the two corresponding prices $8 and $9 and multiply the result by 100. Column (4) of Table 2 shows that this percentage change is equal to (1/8.5)* 100 = 11.7. Column (5) of Table 2 records the corresponding price elasticity of 66/11.7 = 5.64, between rows corresponding to the quantities demanded of 10 units and 20 units. As columns (5) and (6) of Table 2 show, the price elasticity of demand is greater than one when MR > 0 or when the quantity demanded is between 0 and 50. The price elasticity of demand is less than one when MR < 0 or the quantity demand is between 50 and 100. Note also that the elasticity is relatively low when the price is low and relatively high when the price is high. A monopolist does not want to sell at a low price. At a low price, she can sell much more. However, at low prices, the price elasticity is low. She can increase total revenue by reducing the quantity supplied and sold and raising the price. As Table 2, shows at a low price, for example price =1, the price elasticity of the demand curve is 0.177 and very low. Thus, when she raises the price by say 10% the CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 11 9- quantity demanded and hence the quantity sold falls by 1.7% = (10%) x 0.17, a smaller percentage. Thus, total revenue increases. In addition, the monopolist’s total cost falls because the quantity demanded is less and she needs to produce less. Her total economic profits would rise. That is why monopolists like to raise the price when the price is low but they would not raise the price indefinitely. They keep raising the price and reducing the quantity demanded and produced as long as the price elasticity of the demand curve is less than one. In terms of figure 4.a, as long as her/his price is lower than $5 and the quantity demanded and produced is more than 50 units, the monopolist would keep raising the price, producing less, increasing her total revenue while reducing her total costs, and thus, making more profits. Once the price is raised to $5 and the quantity demanded falls to 50 units, raising the price and reducing the quantity demanded and sold would not necessarily increase her/his total economic profit. While a further reduction in the quantity produced, sold and demanded would reduce total costs, it also reduces total revenue as Table 1 and Figure 4.b show. If the monopolist raises the price too much, profits would certainly fall. Therefore, there is a certain price and a corresponding quantity demanded at which the monopolist would stop raising the price and reducing the quantity demanded. At this price and the corresponding quantity demanded and produced, the monopolist would maximize her/his total economic profit. In the following section, we investigate what are the characteristics of the price and quantity demanded and produced that would maximize the monopolist’s total economic profit. Monopolist’s Maximization Problem of Total Economic Profit There are two methods to calculate the quantity that maximizes the total economic profit of the monopolist. We use interchangeably the following phrases: output, quantity supplied, quantity demanded. Also, we use interchangeably the pronouns: he/she, her, his, and he/she.. First method: a) Calculate total revenue, TR, total cost, TC, and total economic profit at each quantity demanded and produced. b) Find the quantity demanded that maximizes total economic profit. Second method: a) Start from the lowest level of output and quantity demanded at which the monopolist breaks even when she produces and sells that output, then increase output by one unit at a time. b) Compare marginal revenue MR to long run marginal cost MC. Since MR adds to total revenue and MC adds to total cost, as long as MR > MC, the additional economic profit (= MR – MC) is positive. The monopolist’s total economic profit would increase and she would continue increasing her output and her sales by raising output by unit and lowering her price correspondingly. c) When MR = MC the additional economic profit MR - MC = zero. She would stop increasing output and lowering the price. She has reached the output and sales level that maximize her total economic profit. d) If she raises output and sales by an additional unit then MR drops below MC and the additional economic profit MR - MC is negative. Producing and selling one more unit would lower her total economic profit. We conclude: CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 12 9- At the output and quantity demanded that maximize her total profit, MR = MC. The second method looks more complicated than the first one. However, like in the case of firms operating under perfect competition, information is not readily available for all levels of output. The firms managers must use the second method to find the quantity to produce and sell and the price to charge to maximize their total economic profit. Table 3 Economic profit Maximization Quantity Price ATC TR TC Total Economic MR MC Demanded profit (1) (2) (3) (4) (5) (6) (7) (8) 0 10 0 20 -10 9 8 10 9 10 90 100 -10 20 8 7.5 160 150 10 7 5 30 7 5.66 210 170 40 5 2 40 6 5 240 200 40 3 3 50 5 4.8 250 240 10 1 4 60 4 5 240 300 -60 -1 6 70 3 5.57 210 390 -180 -3 9 80 2 6.5 160 520 -360 -5 13 90 1 8 90 720 -630 -7 20 100 0 9.6 0 960 -960 -9 24 Table 3 illustrates both methods and it shows that they both yield the same solution. Columns (1) and (2) of Table 3 describe the market demand schedule. Columns (1) and (3) of Table 3 show the long run average total cost ATC schedule. Columns (1) and (4) of Table 3 show the total revenue TR schedule. Columns (1) and (5) of Table 3 show the long run total cost TC schedule. It is the product of columns (1) and (3). Columns (1) and (6) of Table 3 show the total economic profit schedule. Columns (1) and (7) of Table 3 show the marginal revenue MR schedule. Columns (1) and (8) show the long run marginal cost, MC schedule. First, we use the first method to find the output level that maximizes total economic profit. According to column (6) of Table 3, not all output levels produce an economic profit. Only output levels between 20 and 50 units yield a profit. According to Columns (1) and (6) of Table 3, output levels of 30 units and 40 units yield a maximum total economic profit of $40. Now we use the second method to show how to find the output level and corresponding price that maximize the total economic profit of the monopolist. To understand better this method we plot the market demand curve, the MR curve, the MC curve, and the ATC curve in figure 5. Figure 5 Economic Profit Maximization by a Monopsonist CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 13 9- Figure 5 shows that the ATC and the market demand curves intersect at two points A and B where the corresponding quantities demanded and produced are equal respectively to approximately 17 units and 50 units. Inside (outside) this range of output and prices the total economic profit is positive (negative). Since the height of the market demand curve is the maximum price consumers are willing to pay, it follows that at 17 units the maximum price the demanders are willing to pay is equal to ATC. When the monopolist produces 17 units, she breaks even. If she produces and sells one more unit, TR rises by MR = 6.2. and total cost rises by MC = 4.2. Figure 5 shows that at 17 units MR > MC. Her economic profit would rise by MR – MC = 2 > 0. Thus, the monopolist would produce an additional unit and must lower the price. Driven by self-interest she would increase output and lower the price further as long as MR > MC. Her economic profit keeps rising until MR = MC at point C. At point C, the output is approximately equal to 35 units. If she increases output further and lower the price further, then, as figure 5 shows, MR drops below MC and the additional economic profit MR - MC is negative. Her total economic profit starts falling. The 35 units of output and the corresponding price of $6.5 maximize her total economic profit. The quantity demanded at this price is of course equal to 35 units. This is the same solution that we obtained using the first method. The monopolist would charge the maximum the demanders are willing to pay at 35 units for an additional unit. This is given by the height $6.5 of the market demand curve at point D in figure 5. The second method is more practical and yields more useful information: At the output level that maximizes the total economic profit of the monopolist, we have: MR = MC (8) We know that the price is greater than MR. Thus, we expect the monopolist to change a price greater than MC. Indeed, at 35 units the long run marginal cost MC = $3 and the monopolist charges a price of $6.5, which is also the marginal social benefit. It follows: At the output that maximizes the total economic profit of the monopolist: CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 14 9- The marginal social benefit is greater than the marginal social cost The owners and/or managers of a monopoly cause an inefficient allocation of resources. Furthermore, they collect both a normal profit and an economic profit while other participants in economic activity earn only a normal profit. Monopoly is inefficient If the monopolist behaved like a producer operating perfect competition, she would charge a price equal to the minimum long run average cost equal to 4.8 and would produce 50 units of output where the demand curve intersects the long run MC curve and the long run average cost curve at the minimum of the latter as in figure 5. At that output, the marginal social cost is equal to the marginal social benefit. The monopolist would help the economy achieve an efficient allocation of resources. In fact, guided by self-interest, the monopolist produces 35 units of output. For all units between 35 and 50 units, the marginal social benefit given by the height of the market demand curve (= price) is greater than marginal social cost given by the long run marginal cost curve. Because the monopolist does not produce those units, society loses the excess of the additional benefit over their corresponding long run marginal cost curve for all those units. Triangle CDB in figure 5 represents the total loss. We call triangle CDB the dead weight loss caused by the monopolist acting according to self-interest. In this case promoting self-interest does not promote the public interest. Adam Smith is not wrong, because he warned us against monopoly. Furthermore, because monopoly restricts output, it restricts employment, distorts the allocation of resources and causes a higher level of unemployment and distortions to investment in education. In societies that offer a social security, to help those who lose their jobs because of monopoly the government must pay income support and unemployment insurance benefits and therefore it must raise taxes exactly on those who are earning a normal profit or impose an inflation tax on those who can afford it least to finance greater budget deficits. Monopoly is bad. Government must control it. It is not easy to do it. Regulated Monopoly When monopoly is not a government legislated monopoly, a natural resources monopoly or a patent monopoly; it is most likely a natural monopoly. Examples of natural monopoly abound in the real world: Electric power generation, telephone service, public transportation, and highways. They all involve large start up costs called sunk costs. The minimum efficiency size is so large compared to the market quantity demanded at the minimum long run average cost that economies of scale obtain over a very wide range of output. The sunk costs make up for a huge barrier to entry and a huge barrier to exit. The establishment of a monopoly needs the help of the financial system, which is always forthcoming. The first comer would be able, with the help of borrowing from the financial sector, to secure a monopoly and charge a price greater than the minimum long run average cost and greater than the corresponding value of the long run marginal cost. In terms of figure 5 which we reproduce here as figure 6 for convenience, the monopolist left unregulated would choose point D on demand curve AEB. She charges a $6.5 price higher than the minimum average total cost and the corresponding marginal cost equal to $5. Figure 6 Regulated Monopoly CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 15 9- One approach to eliminate the resulting efficiency loss, triangle BCD in figure 6, is for the government to force the monopolist to operate at B, which represents an efficient allocation of resources. The problem is that the government does not have all the information about the long run average cost curve, the efficient level of output, and the efficient price to charge. The monopolist will never provide willingly that information. To remedy the lack of information, governments appoint special commissions, the Utility Board in Nova Scotia Canada, to deal with natural monopolies such as railroad, telephone and electric power companies. Every time the monopolist wishes to change the price, the government commission would request that he must submit to the government information about her his costs and the corresponding output. Based on this information and some other ad-hoc information, the commission computes an average total cost including some notion of normal profit and uses it to set the new price the monopolist could charge for the following year. Government politicians hope that this procedure would lead the monopolist to choose point B in figure 6 and produce the corresponding efficient level of output equal to 50 units. If the monopolist produces less, for example 35 units, she must charge a price equal to the corresponding average cost which is equal to approximately $5.5. At this price, consumers would demand approximately 47 units, or more than 35 units. The monopolist must increase output. She would continue to increase output, which would cause a decrease in average total cost. The commission would force the monopolist to reduce the price accordingly. Hopefully, the process would continue until output reaches the socially efficient level of 50 units and the price becomes equal to the minimum long run average total cost of $5. If the market looks like that described in figure 6 and the information provided by the monopolist is accurate, the government commission may succeed in getting the monopolist to act like owners of a firm operating in a market under perfect competition at long run equilibrium. That is, she cannot charge a price greater than minimum long run average total cost. She would operate with a capital stock equal to the minimum efficiency size. She would choose a point on the demand curve where price = minimum long run average total cost = long run marginal cost of the minimum efficiency size. Since the normal profit is included in the total cost, the monopolist would earn a normal profit. CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 16 9- In figure 6, it happens that the curves representing the marginal social benefit, the marginal social cost and the minimum average cost all intersect at the same point B. In practice, the three curves may not intersect at the same point. This is the case in figure 7. The output that maximizes total net social benefit is equal to QE. At this output, the average total cost is greater than the price consumers are willing to pay. Obviously, the monopolist would not accept to produce this output unless the government accepts to give him a subsidy equal to the corresponding total loss or more. To avoid giving a subsidy, the next best solution is to allow the monopolist to charge a price equal to the average total cost at the corresponding quantity demanded. This solution corresponds to point H located at the intersection of the demand and the long run average cost curves. At H in figure 7, the regulating commission allows the monopolist to charge a price equal PH. The monopolist produces the corresponding quantity demanded and she breaks even but she earns a normal profit. This method of regulating the natural monopoly is called the average cost pricing method. Figure 7 Regulated Monopoly, another case Price or Long Run Average Cost Long Run Average Cost Unit Cost F Market Demand Curve PM C D A B PH H J PE K E Marginal Revenue Curve G 0 QM QH QE Quantity The average cost pricing method relies on information provided by the monopolist. Even if the monopolist provides the correct information about her costs, there is still an important question to answer correctly. What is the total normal profit that should be included in the total cost of the monopolist? The normal profit must be included in the average cost in order to induce the monopolist to stay in business. In the jargon of regulated monopolies, the normal profit is called a fair return on own capital. To calculate the fair return, the government commission requests the monopolist to provide it with information about the size of its capital stock. The information is used to calculate the cost of depreciation of the total value of the capital stock that should be included as part of the total cost and to estimate that portion of the value of the capital stock supplied by the monopolist out of its own CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 17 9- funds and not borrowed. Applying what is called a fair rate of return (10%) to this figure, the commission calculates the fair return or the total normal profit that is needed to be included in the long run total cost. The procedure of computing the fair return is open to abuse and may become a cause for another type of inefficiency. The monopolist knows that the price the commission will set must include a fair return and the depreciation costs on the capital stock. Furthermore, she knows that the commission sets the fair rate of return at a level higher than the interest rate on riskless investments. Naturally, she has the incentive to borrow at the risk-less rate of interest to purchase and use more capital than necessary to produce any given level of output without additional risk. This procedure results in an inefficient allocation of resources. The monopolist uses more units of capital and less labor than required to produce the efficient level of output resulting in a substantial increase of the ling run average cost. Along with this increase in average cost, we must add the government costs of operating the regulating commission and the fact that the commission itself is open to influence by the very monopolist it is supposed to regulate. Some economists think that given enough time and the stakes at hand the regulated monopoly ends up controlling the commission itself and he/she is then controlling her own output and her own price instead of the government commission. Discriminatory Monopoly In some cases, the startup costs are so large that the demand curve lies entirely below the long run average cost (LRAC) curve, as illustrated in figure 8. In this case, even a monopolist would not want to operate this business as a monopoly, At every quantity demanded and produced, the price that demanders are willing to pay is greater than the corresponding long run average cost. For example, at a quantity of 6 units as given in figure 8, the price that demanders are willing to pay for the sixth unit is $6. The long run average cost at 6 units is $7, greater than the price the demanders are willing to pay for the sixth unit. The monopolist would make a loss if she produces 6 units. The same argument shows that if the monopolist produced any other quantity she would make a loss if she charges the price demanders are willing to pay at that quantity. However, from the social point of view, it is worthwhile to produce 10 units of the product because at this quantity the marginal social benefit (= height of the demand curve) is equal to the marginal social cost (= height of the long rune marginal cost curve). Furthermore, at an output equal to 10 units of the product as shown in figure 8, the total social benefit is equal to area of trapezoid HFKO = $70 (= (($11 + $3) x 10)/2). This is significantly greater than the long run total cost, which is equal to $30 (= $3x10). One way to produce the efficient output of 10 units, and yet rely only on self-interest to produce it, is the following. Let the government allow the monopolist to discriminate among demanders. The first demanders (from 1 to 6 units) are willing to pay more for an additional unit of the product than demanders for the 7 to 10 units are willing to pay. Can the monopolist produce the socially optimal amount of the product (10 units) by charging a higher price for the first 6 units and a lower price for units 7 to 10? Figure 8 Discriminatory Monopoly CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 18 9- The answer is yes. When she produces the socially optimal output of 10 units, the long run average cost is equal to $4, which is greater than the price of $3 that the demanders are willing to pay for an additional unit of the product. If the monopolist charged this price, she would make a $10 loss. However, let the monopolist produce 10 units of the product. For each one of the first 6 units, demanders are willing to pay more than $6. Let the monopolist charges them $6 for each one of the first 6 units, she can make an economic profit equal to $12 = (6 - 4) x 6 units= (price charged for the first 6 units - LRAC) x 6. Area ABCD of figure 8 represents the total economic profit realized on the production and sale of the first six units. Next let the monopolist charge $3 for each one of the 7 to 10 units. She will make a total loss, equal to $4 Loss = - $4 = ($3 – $4) x 4 units Area CEFG, in figure 8, represents this loss. The total economic profit of the monopolist is ABCD - CEFG = $12 - $4 = $8. By discriminating based on the willingness to pay the monopolist can produce the socially optimal amount of the product. One application of this result is to the case of doctors in rural areas. By extending doctors services to a larger number of people the doctor can lower his or her ATC by discriminating between rich and poor, the doctor can break even or even make an economic profit. By charging a single price, she would make a loss and would not produce the socially optimal level of services. Another application is the air travel market. Airline companies discriminate among passengers based on willingness to pay and they make huge economic profit. Other examples in the real world abound, where a simple monopoly, which yields already a large total economic profit, is transformed into a discriminatory monopoly under the nose of the government’s regulators. Conclusions CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 19 9- Monopoly is not efficient. It restricts employment and charges a price greater than marginal cost. It causes a dead weight loss or a social loss. In addition, it increases income inequality as it earns an economic profit while owners of firms in perfect competition earn only a normal profit. Because it produces less than the socially optimal amount, it causes a temporary increase in unemployment and a permanent efficiency loss. Accordingly, government expenditures on social security must increase to deal with the increase in poverty resulting from the increase in unemployment. Therefore, government has to increase taxes on the middle class to pay for the financial assistance it must provide unemployed workers who lose their jobs or could not find jobs because of the monopoly. The unemployed people cannot find easily a suitable job and become long term unemployed. They lose their skills and their education. Their children will either be poor and/or would not care about acquiring education and skills. They know jobs are scarce and they will receive income assistance from government. For all these reasons, monopoly is bad and government must step in to create an environment inimical to it or regulate it. The role of Regulation consists in forcing the monopoly to charge a price equal to long run average cost. This is regulation according to average cost pricing. Average cost pricing does not insure that the monopoly would produce the efficient output. However, it is the second best policy. It is open to abuse and governments should strive to supplement and if possible replace it by reducing barriers to entry through the adoption of a free trade. End CHAPTER 9 MONOPOLY, Chapter 9 Monopoly, Introductory Microeconomics, July 2023, 8/20/2024 4:23 PM 20 9- Fortunately, recent improvements in technology, a substantial reduction in transportation costs and the elimination of trade barriers have reduced considerably the extent to which many industries are susceptible to become a natural monopoly. Economies of scale over ranges of output that loom large relative to a local market demand schedule are not large when compared to a world demand schedule. Thus, telephone companies are now facing global demand schedules and global competition from other international telephone and cable companies. Consequently, some countries have deregulated their telephone companies or forced large companies like AT&T to break into smaller companies.