Chapter 10 Monopoly 2004 Thomson LearningSouthWestern Monopoly l

Chapter 10 Monopoly © 2004 Thomson Learning/South-Western

Monopoly l A market is described as a monopoly if there is only one producer. – – l 2 This single firm faces the entire market demand curve. The monopoly must make the decision of how much to produce. The monopoly’s output decision will completely determine the good’s price.

Causes of Monopoly l l Barriers to entry which are factors that prevent new firms from entering a market are the source of all monopoly power. There are two general types of barriers to entry – – 3 Technical barriers Legal barriers

Technical Barriers to Entry l A primary technical barrier is when the firm is a natural monopoly because it exhibits diminishing average cost over a broad range of output levels. – l 4 Hence, a large-scale firm is more efficient than a small scale firm. A large firm could drive out competitors by price cutting.

Technical Barriers to Entry l Other technical barriers to entry. – – – 5 Special knowledge of a low-cost method of production. Ownership of a unique resource. Possession of unique managerial talents.

Legal Barriers to Entry l Pure monopolies can be created by law. – The basic technology for a product can be assigned to only one firm through a patent. l – The government can award an exclusive franchise or license to serve a market. l 6 The rational is that it makes innovation profitable and encourages technical advancement. This may make it possible to ensure quality standards

APPLICATION 10. 1: Should You Need a License to Shampoo a Dog? l l State governments license many occupations and impose penalties for those who run a business without a license. Specific examples include: – Dry Cleaning in California l l l 7 Perspective dry-cleaners must take a licensing exam which may require attending a school. Profits are higher than in other states. Existing firms are staunch defenders of the law.

APPLICATION 10. 1: Should You Need a License to Shampoo a Dog? – Liquor Stores l l Currently 16 states operate liquor-store monopolies. In 34 other states, liquor stores are licensed and subject to restrictions on pricing and advertising. States with licenses have higher prices. – Existing owners are most stringent supporters. – – Taxicabs l l l 8 Many cities limit number of taxicabs. In Toronto, prices are about 225 percent higher. New York city taxi medallions cost about $250, 000.

Profit Maximization l l To maximize profits, a monopoly will chose the output at which marginal revenue equals marginal costs. The demand curve is downward-sloping so marginal revenue is less than price. – 9 To sell more, the firm must lower its price on all units to be sold in order to generate the extra demand.

A Graphic Treatment l l A monopoly will produce an output level in which price exceeds marginal cost. Q* is the profit maximizing output level in Figure 10. 1. – 10 If a firm produced less than Q*, the loss in revenue (MR) will exceed the reduction in costs (MC) so profits would decline.

FIGURE 10. 1: Profit Maximization and Price Determination in a Monopoly Market MC Price AC E P* A C D MR 0 11 Q* Quantity per week

A Graphical Treatment – – l l 12 The increase in costs (MC)would exceed the gain in revenue (MR) if output exceeds Q*. Hence, profits are maximized when MR = MC. Given output level Q*, the firm chooses P* on the demand curve because that is what consumers are willing to pay for Q*. The market equilibrium is P*, Q*.

Monopoly Supply Curve l l l 13 With a fixed market demand curve, the supply “curve” for a monopoly is the one point where MR = MC (point E in Figure 10. 1. ) If the demand curve shifts, the marginal revenue curve will also shift and a new profit maximizing output will be chosen. Unlike perfect competition, these output, price points do not represent a supply curve.

Monopoly Profits l l Monopoly profits are shown as the area of the rectangle P*EAC in Figure 10. 1. Profits equal (P - AC)Q*, – – 14 If price exceeds average cost at Q* > 0, profits will be positive. Since entry is prohibited, these profits can exits in the long run.

Monopoly Rents l Monopoly rents are the profits a monopolist earns in the long run. – These profits are a return to the factor that forms the basis of the monopoly. l l 15 Patent, favorable location, license, etc. . Others might be willing to pay up to the amount of this rent to operate the monopoly to obtain its profits.

What’s Wrong with Monopoly? l Profitability – – l 16 Monopoly power is the ability to raise price above marginal cost. Profits are the difference between price and average cost. In Figure 10. 2, one firm earns positive economic profits (a) while the other (b) earns zero economic profits.

FIGURE 10. 2: Monopoly Profits Depend on the Relationship between the Demand Average Cost Curves Price MC AC P* P*=AC AC D D MR 0 Q* Quantity per week (a) Monopoly with Large Profits 17 MR 0 Q* Quantity per week (b) Zero-Profit Monopoly

What’s Wrong with Monopoly? – l People may also be concerned that economic profits go to the wealthy. – 18 If monopoly rents accrue to inputs, the monopoly may appear to not earn a profit. However, as with the Navajo blanket monopoly, the profits of the low-income Navajo are coming from the more wealthy tourists.

APPLICATION 10. 2: Who Makes Money at Casinos? l l l 19 U. S. casinos take in about $50 billion each year in gross revenues. In some markets, casinos operate quite competitively…there are so many casinos in Las Vegas that it is unlikely that any one of them has much power to set prices monopolistically. However, many other locales have adopted such restrictions on the numbers and sizes of casinos that owners of these casinos are able to capture substantial monopoly profits.

Riverboat Gambling l l 20 A number of states on the Mississippi River permit casino gambling only in riverboats. One clear impact of the way that riverboat gambling is regulated is to provide monopoly rents to a number of different parties. States are the primary beneficiaries – they usually tax net profits from riverboats at more than 30 percent. The owners of riverboats also make monopoly profits.

Indian Gaming l l 21 The Indian Gaming Regulatory Act of 1988 clarified the relationship between state and the Indian tribes living within their borders. The Act made it possible for these tribes to offer casino gambling under certain circumstances. Since the passage of the Act, more than 120 tribes have adopted some form of legalized gambling. The distributional consequences of Indian gaming are generally beneficial.

What’s Wrong with Monopoly l Distortion of Resource Allocation – Monopolists restrict their production to maximize profits. l – 22 Since price exceeds marginal cost, consumers are willing to pay more for extra output than it costs to produce it. From societies point of view, output is too low as some mutually beneficial transactions are missed.

Distortion of Resource Allocation l l 23 In Figure 10. 3 the monopolist is assumed to produce under conditions of constant marginal cost. Further, it is assumed that if the good where produced by a perfectly competitive industry, the long-run cost curve would be the same as the monopolist’s.

Distortion of Resource Allocation l l l 24 In this situation, a perfectly competitive industry would produce Q* where demand equals longrun supply. A monopolist produces at Q** where marginal revenue equals marginal cost. The restriction in output (Q* - Q**) is a measure of the harm done by a monopoly.

FIGURE 10. 3: Allocational and Distributional Effects of Monopoly Price D MR B P** MC ( =AC) A 25 0 Q** Quantity per week

Monopolistic Distortions and Transfers of Welfare l The competitive output level (Q* in Figure 10. 3) is produced at price P*. – – 26 The total value to consumers is the area DEQ*0 Consumers’ pay P*EQ*0. Consumer surplus is DEP*.

FIGURE 10. 3: Allocational and Distributional Effects of Monopoly Price D MR B P** P* 27 E A MC ( =AC) 0 Q** Q* Quantity per week

Allocational Effects l A monopolist would product Q** at price P**. – – – 28 Total value to the consumer is reduced by the area BEQ*Q**. However, the area AEQ*Q** is money freed for consumers to spend elsewhere. The loss of consumer surplus is BEA which is often called the deadweight loss from monopoly.

FIGURE 10. 3: Allocational and Distributional Effects of Monopoly Price D MR B P** P* 29 E A Value of transferred inputs MC ( =AC) 0 Q** Q* Quantity per week

Distributional Effects l In Figure 10. 3 monopoly profits equal the area P**BAP*. – – l 30 This would be consumer surplus under perfect competition. It does not necessarily represent a loss of social welfare. This is the redistributional effects of monopoly that may or may not be desirable.

FIGURE 10. 3: Allocational and Distributional Effects of Monopoly Price D P** P* 31 MR B Transfer from consumers to firm E A MC ( =AC) Value of transferred inputs 0 Q** Q* Quantity per week

FIGURE 10. 3: Allocational and Distributional Effects of Monopoly Price D P** P* 32 MR B Transfer from consumers to firm Deadweight loss A E Value of transferred inputs MC ( =AC) 0 Q** Q* Quantity per week

Monopolists’ Costs l Monopolists costs may be higher due to: – – 33 Resources spent to achieve monopoly profits such as ways to erect barriers to entry. Monopolists may expend resources for lobbying or legal fees to seek special favors from the government such as restrictions on entry through licensing or favorable treatment from regulatory agencies.

Monopolists’ Costs l l The possibility that costs may be higher for monopolists complicates the comparison of monopoly with perfect competition. Studies that have attempted to measure welfare losses from monopoly find estimates are sensitive to assumptions. – 34 Estimates range from as little as 0. 5 percent of GDP to as much as 5 percent of GDP.

APPLICATION 10. 3: Pricing Problems in Dallas l l 35 “People in the same trade seldom meet together even for merriment and diversion but the conversation ends … in some contrivance to raise prices” (Adam Smith) The CEO of American Airlines was taped in a conversation where he suggested that if Braniff Airway would raise prices, American Airlines would follow.

APPLICATION 10. 3: Pricing Problems in Dallas l Later, American Airlines was accused of predatory pricing. – l 36 It was accused of lowering prices to drive small carriers out of the market and then raise prices after the small firms leave. Unless prices are below average variable cost (a “shutdown standard”), this pricing behavior is not necessarily illegal.

A Numerical Illustration of Deadweight Loss l l Table 10. 1 repeats the information about the cassette tape market used as an illustration in previous chapters. If tapes have a $3 marginal cost, this would be the price under perfect competition. – 37 As shown in the Table, this would result in consumer surplus equal to $21.

TABLE 10. 1: Effects of Monopolization on the Market for Cassette Tapes 38 Competitive Equilibrium: (P = MC) Monopoly equilibrium: (MR = MC)

A Numerical Illustration of Deadweight Loss l l l 39 If the industry were a monopoly the firm would produce where marginal revenue equals marginal cost, an output of 4 units. As shown in the Table, this would result in $12 of monopoly profits and $6 of consumer surplus which totals $18. The deadweight loss is the difference between the $21 and the $18 or $3.

Price Discrimination l l Price discrimination occurs if identical units of output are sold at different prices. If the monopolist could sell its product at different prices to different customers, new opportunities exits as shown in Figure 10. 4. – – 40 Some consumer surplus still exists (area DBP**). The possibility of mutually beneficial trades exist as represented by the area BEA.

FIGURE 10. 4: Targets for Price Discrimination Price D MR B P** E P* 41 MC ( =AC) A 0 Q** Q* Quantity per week

Perfect Price Discrimination l Perfect price discrimination is selling each unit of output for the highest price obtainable. – – 42 The firm would sell the first unit at slightly below 0 D (Figure 10. 4), the next for slightly less, and so on until the firm reaches Q*, where a lower price would result in less profit. All consumer surplus (area P*DE) would be monopoly profit.

Perfect Price Discrimination l l l 43 Since the monopolist would produce and sell Q* units of output, which is the competitive equilibrium. This pricing scheme requires a way to determine what each consumer would be willing to pay, and The monopolist must be able to stop consumers from selling to each other.

APPLICATION 10. 4: Financial Aid at Private Colleges l Prior to the 1990 s the U. S. government proposed a formula to determine a student’s need, and schools would offer such aid. – l 44 Because the formula differed among colleges, the net price (family contribution) differed. The Overlap Group (23 prestigious colleges) negotiated the differences so that each college offered the same net price.

APPLICATION 10. 3: Financial Aid at Private Colleges l l 45 The U. S. Justice Department challenged this pricing scheme as price fixing. Although the schools signed a consent decree, they were exempted from the antitrust laws by the Higher Education Act of 1992.

APPLICATION 10. 3: Financial Aid at Private Colleges l Several innovative pricing schemes were put forth by schools in the 1990 s. – l 46 Several schools adopted sophisticated statistical models used to offer the lowest price necessary to get a particular student to accept an offer of admission. Schools using this approach come very close to perfect price discrimination.

Quantity Discounts l Quantity discounts allow some sales at the monopolist’s price (P** in Figure 10. 4), and sales beyond Q** at a lower price which increases profits. – l 47 Examples include a second pizza for a lower price and supermarket coupons. The monopolist must keep customers who buy at lower prices to sell to customers at a price less than P**.

Two-Part Tariffs l l In this pricing scheme, customers must pay an entry fee for the right to purchase a good. A classic example is the pricing of movie popcorn. – – 48 The entry fee, which should be set to obtain as much of the consumer surplus as possible, is the price of movie itself. Popcorn is then priced to maximize admission so long as the price exceeds cost.

APPLICATION 10. 4: Pricing at the Magic Kingdom l l 49 During the 1960 s Disneyland patrons had to purchase a “passport” containing a ticket for admission to the rides (see Table 1 for the structure of a typical passport). Because of higher labor costs, Disney switched to an entry fee with zero marginal prices for all rides.

TABLE 1: Structure of a Typical Disneyland Passport 50

APPLICATION 10. 4: Pricing at the Magic Kingdom l l 51 Disney could also use other price discrimination practices such as reduced prices for multiday tickets. With ever-growing attractions and newer ticket technology (especially optical scanners) has allowed Disney to again price discriminate in a manner similar to their practices in the 1960 s.

Market Separation l l If the market can be separated into two or more categories may be able to chare different prices. Figure 10. 5 shows the separation into two markets. – 52 The profit-maximizing decision is to sell Q 1* in the first market and Q 2* in the second market where, in both cases, MR = MC.

FIGURE 10. 5: Separated Markets Raise the Possibility of Price Discrimination Price P 1 P 2 D 2 MC D 1 MR 1 Quantity in market 1 Q* 1 53 MR 0 Q* 2 2 Quantity in market 2

Market Separation l The two market prices will be P 1 and P 2 respectively. – – 54 As shown in Figure 10. 5, the price-discriminating monopolist will charge a higher price in the market with the more inelastic demand. Examples include book publishers charging higher prices in the U. S. or charging different prices for a movie in the day than at night.

Pricing for Multiproduct Monopolies l If a firm has pricing power in markets for several related products, other strategies can be used. – l 55 Firms can require users of one product to also buy a related product such as coffee filters bought with coffee machines. Firms can also create pricing bundles such as option packages on cars or computers.

APPLICATION 10. 6: Bundling of Satellite TV Offerings l Theory of Program Bundling – Four consumer’s willingness to pay for either sports or movie programming is shown in Figure 1. l l 56 Two, A and D, are willing to pay $20 per month for sports (A) or movies (D). B want sports but some movies and C wants movies with some sports.

FIGURE 1: Willingness to Pay for Cable TV Options Movies 20 D C 15 B A 8 57 15 20 Sports

APPLICATION 10. 6: Bundling of Satellite TV Offerings – – – 58 Charging $15 per each package would yield $60 from these customers. A bundling scheme that charges $20 per package, if purchased individually, or $23 if both are bought, would yield $86. Thus, revenue can be increased by the proper choice of pricing bundles of services.

APPLICATION 10. 6: Bundling of Satellite TV Offerings l Bundling by Direct TV, Inc. – – – 59 Bundling prices are shown in Table 1, where the incremental costs help to demonstrate the bundling price scheme. Notice adding sports costs $10 extra, but the full movie package adds $43 ($15 for Showtime and $28 for HBO/STARZ). Both packages together ($51) offers a minor savings over buying the separate packages.

TABLE 1: Sample Direct TV Program Options 60

Marginal Cost Pricing Regulation and the Natural Monopoly Dilemma l l By marginal cost pricing the deadweight loss from monopolies is minimized. However, this would require a natural monopoly to operate at a loss. – 61 A unregulated monopoly would produce QA at price PA in Figure 10. 6, yielding a profit of PAABC.

FIGURE 10. 6: Price Regulation for a Natural Monopoly Price P A A B C AC MC MR 62 0 QA D QR Quantity per week

Marginal Cost Pricing Regulation and the Natural Monopoly Dilemma – l 63 Marginal cost pricing of PR which results in QR demanded would generate an a loss equal to the area GFEPR because PR < AC. Either marginal cost pricing must be abandoned or the government must subsidize the monopoly.

FIGURE 10. 6: Price Regulation for a Natural Monopoly Price P A A B C 64 F H G P R E J 0 QA MR AC MC D QR Quantity per week

Two-Tier Pricing Systems l l l 65 Under this system the monopoly is permitted to charge some users a high price and charge “marginal” users a low price. The regulatory commission might allow the monopoly to charge PA and sell QA to one class of buyers. Other users would pay PR and would demand QR - Q A.

Two-Tier Pricing Systems l l l 66 At total output of QR average costs are 0 G. Under this system, monopoly profits (area PAAHG) balance the losses (area HFEJ). Here the “marginal user” pays marginal cost and is subsidized by the “intramarginal” user.

APPLICATION 10. 7: Can Anyone Understand Telephone Pricing? l l 67 In January 1, 1984 AT& T formally divested itself of its seven local Bell Operating Companies as the result of a 1974 Department of Justice antitrust suit. The goal of the restructuring was to improve the performance and competitiveness of the U. S. telephone industry.

APPLICATION 10. 7: Can Anyone Understand Telephone Pricing? l Subsidization of Local Phone Service – – – 68 Prior to the breakup, regulators forced AT&T to subsidize local residential phone services. They covered these losses by charging aboveaverage costs on long distance calls. Residential services cost an average of $28 per month but the typical charge was $11.

APPLICATION 10. 7: Can Anyone Understand Telephone Pricing? l After the breakup regulators had to choose between implementing huge increases in residential telephone rates or continuing subsidies. – 69 The politically expedient choice was to force AT&T and other to continue to subsidize local residential rates.

APPLICATION 10. 7: Can Anyone Understand Telephone Pricing? l The Telecommunications Act of 1996 – – – 70 The government used this act to increase entry into the local phone market to try to reduce the monopoly power of local providers. This was attempted by specifying specific conditions under which these local companies could offer long distance service. To obtain this right, local companies had to sell services to potential entrants into their market.

Rate of Return Regulation l l 71 Regulators may permit a monopoly to charge a price above average cost that will earn a “fair” rate of return on investment. If the allowed rate exceeds that an owner might earn under competitive circumstances, the firm has an incentive to use relatively more capital input than needed to minimize costs.