ECON 356 - Outline Thirteen

Monopoly - The Mainstream Model

The Importance of Market Structure in Mainstream Theory

Market Structure:

    Perfect Competition: 

    Monopoly:

    Monopolistic Competition:

    Oligopoly (monopolistic competition):

So as we will see with monopoly -- it is the opposite of "perfect" -- structure basically determines everything in the model:

Structure - Conduct - Performance Theory:

 

 

 

 

So under this view -- how the "industry" is defined (or how close substitutes are defined) is very important.

So in this model - the important distinction between monopoly and competition is that the demand curve facing the individual competitive firm is horizontal (irrespective of the price elasticity of the corresponding market demand curve), while the monopolist's demand curve is simply the downward-sloping demand curve for the entire market.

So how is this "monopoly power" measured?

One popular measure is the cross-price elasticity of demand with close substitutes.  The higher the cross-price elasticity -- the more consumers see the goods as competitors.

Example:  Famous antitrust case - DuPont Corporation.  Had 80% of the market in cellophane traded.  But it showed that the cross-price elasticities between cellophane and waxed paper and aluminum foil were pretty high.  Broadening the market to include these products meant that DuPont only had about 20% of the market share.  It won the case.

But of course there can be so many substitutes for a good -- or for how a consumer spends their money -- defining a monopoly really is very subjective (more on this later).

Sources of Monopoly Under This Model

1. Exclusive control over important inputs:  Example:  Perrier (water is out of a certain mineral spring that it owns).  Now is this really a monopoly?

 

2. Economies of scale (increasing returns to scale):  Natural monopoly theory, but the idea is that because of the low LRATC, other firms can't compete.  So efficiency is seen as a reason for a monopoly.

 

3.  Network Economies:  On the demand side of the market, a product becomes more valuable as greater numbers of consumers use it.  So if one company has network economies -- other companies can't compete.  Example:  Microsoft Windows - the more people that used it, the more valuable it was for users -- and the more likely that newcomers would use it too. 

4.  Patents: 

    Costs and benefits:  owner of the patent can get a higher price -- but benefits - without the patent, the owner might never have created the invention.

 

5.  Government granted monopolies (licenses and franchises):  Example:  The Post Office

    Government licenses are sometimes accompanied by strict regulations that spell out what the licensee can and cannot do.  Where the government gives a chain restaurant an exclusive license, for example, the restaurant will often be required to charge prices no more than, say, 10 percent higher than it charges in its unregulated outlets.  Example:  At rest areas on the Massachusetts Turnpike, not just any fast-food place is free to set up operations.  The Turnpike Authority negotiates with several companies, chooses one, and then grants it an exclusive license to serve a particular area.   Their reasoning:  to keep down congestion.

In other cases, the government charges an extremely high fee for the license.  Thus -- the licensee must charge very high prices to pay the fee.  Example:  Ever wonder why food at airports is so expensive?  Because these places have been granted licenses by the Port Authority -- with high fees -- and they are passed on to consumers.

The Profit-Maximizing Monopolist

Assume again:  The business wants to maximize monetary profit.  In the model of perfect competition, price does not change as more or less units are sold.  Under monopoly, with a negatively sloped demand curve, additional units can be sold only by lowering price, and price must be reduced on previous units sold. 

So again, in the short run, this means the firm will choose an output level where the difference between TR and TC is maximized.

So where does the MR curve lie with respect to the demand curve?

Remember with a perfectly competitive firm the Demand Curve was horizontal where = P = MR = AR.  But this is not true with a downward sloping demand curve.

The demand curve is still the Average Revenue curve.  Why?  Whenever the monopolist sells a certain quantity of units, it sells all of them at that particular price on the demand curve.  Example:  Sell 100 units when the price is $5.  What is the average revenue?  Total revenue = 100 x 5 = 500.  Average revenue = 500/100 = $5.  So each price along the demand curve tells us average revenue at that price.

But the average is falling along the curve -- and if average is falling, where is marginal?  Below it!!

Due to the downward sloping demand curve, marginal revenue is less than price for any change in output.

Where will the firm operate?  At what level of Q?

Guess what -- just like the competitive firm, the monopolist will operate where MR = MC (for the same reasons). 

 

Remember that MR = change in total revenue due to a change in output.  So at the higher portion of the demand curve (elastic) - a drop in price will bring enough additional demand (change in Q) such that marginal revenue will be positive (total revenue is increasing).

If unitary elastic - a change in price brings no change in total revenue - so marginal revenue = 0.

If inelastic, a change in price brings a less than proportional change in demand (Q) such that marginal revenue is negative (total revenue is decreasing).

 

 

 

 

 

So the monopolist wants to operate where MR is positive - or in the elastic portion of the demand curve. An increase in price would no longer bring in more revenue --

If he was in the inelastic portion of the curve, he could increase his price and bring in more revenue.

GRAPH (see Figure 9.3)

 

 

 

 

 

So now we can graph the Short Run Profit Maximization Condition for the Monopolist:

    A monopolist making economic profit:

Step one:  Find output level where MR = MC.

Step two:  Find the price at that output level along the demand curve (this is the price that the firm is able to get)

Step three:  Where is ATC compared to AR?  Remember, the demand curve = AR (Price) at any given level of Q.  If ATC is below AR (price), economic profit, if they are equal, zero economic profit and if ATC is above AR (price) - economic loss.  Monopolies can make an economic loss!

What if the ATC  curve is below the price -- the monopolist is making an economic profit.

GRAPH: (see figure 9.5)

 

 

 

 

 

 

What if the ATC  curve is above the price -- the monopolist is making an economic loss.

GRAPH (see figure 9.5)

 

 

 

 

 

Again Note:  A Monopolist (profit-maximizing) will Never Produce on the Inelastic Portion of the Demand Curve.  Why?

If the monopolist  were to increase price at such an output level (where demand is inelastic), the effect would be to increase total revenue.  Since economic profit is the difference between total revenue and total cost, profit would necessarily increase in response to a price increase from an initial position on the inelastic portion of the demand curve. 

The profit maximizing level of output therefore must lie on the elastic portion of the demand curve – and where MR = MC for the same reasons we have discussed before. 

The Monopolist’s Short Run Shut Down Condition

        Again, in the short run, the monopolist will shut down if the AVC curve is above the demand curve (or AR) at the best output level.

GRAPH:

 

 

 

 

Monopolist’s Short Run Supply Curve?  So does this mean that the monopolist’s supply curve is the MC curve as in the model of perfect competition?  NO!. 

Remember – a supply curve shows us the combination of prices and output levels where a firm will produce.  In the model of perfect competition – MR = P, so as the price changed, the firm moved along their MC curve to determine output.  So we had the combination:  price and output known to us.

But this is not the case with a monopoly.  MR does not = P.  P is greater than MR.  For each quantity where MR = MC (which is how the quantity supplied is chosen) – there is not a single price.  The price will depend upon where the demand curve lies.  So the supply curve for the monopolist can not be determined in this model.

GRAPH (see Figure 9.7)

Text Box:  Price, MC, MR

 

 

  

 

 

Long Run Maximizing Monopolist      

If the monopolist is covering costs (making at least a zero economic profit), it will continue to operate in the long run.

In fact, it will also continue to make an economic profit if that is the case.  Why?

Because there is no long run entry in this model.  There is exit – the monopoly can close in the long run, but others can NOT enter.

Barriers to entry – unlike perfect competition, all of the sources of monopoly mentioned earlier are considered barriers to entry.

GRAPH (see Figure 9.8)    

 

 

 

Furthermore, there is no reason to believe that the monopolist will operate at the minimum point of the long run average total cost curve (as in the model of perfect competition) – where firms will enter and exit and change size until that is the case in the long run.  Therefore:

 

Efficiency?   Is the monopolist efficient?  When defined the same way (allocative and productive) – the answer is no. 

The monopolist does not operate at the minimum of its long run average total cost curve and can earn a positive economic profit in the long run.

 Comparison:  Monopoly vs. Perfect Competition 

Assume:  Constant LRMC.  Which means that LRATC is also constant.  Just makes the graph easier to read, doesn’t change the theory.

GRAPH (see Figure 9.10)

 

 

 

 

 

Remember, the perfectly competitive firm will operate where MR = MC = Price.

“Welfare Loss” of the monopoly: 

            Review consumer surplus:

            With monopoly, the consumer surplus shrinks – so there’s a benefit loss from having less trade. 

            Welfare triangle FHJ. 

But could also be another loss too:

Rent Seeking Loss:  When monopoly is viewed as existing because of a government granted favor –

            Rent Seeking:

So the loss = economic profit (or a little under but probably not due to resources spent by others seeking the monopoly right as well).  The producer spends these resources (and will be willing to spend up to the amount of the economic profit) to get the monopoly privilege (taking senators to lunch, hiring lobbyists, etc.).  All a waste of resources that could have gone to something productive.    

Of course we can talk about this waste of resources without using this model of mainstream monopoly.

(In Class Exercise Here)