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University of Toronto Mississauga
Yasin Janjua

Eco205 Chapter 11 – Monopoly 13th January 2013 Causes of Monopoly Barriers to entry are the source of all monopoly power. There are two general types of barriers to entry: technical barriers and legal barriers. Technical Barriers to Entry Barriers to entry - Factors that prevent new firms from entering a market Large-scale firms are more efficient than small ones. Once a monopoly has been established, entry by other firms is difficult because any new firm must produce at low levels of output and therefore at high average costs. Because this barrier to entry arises naturally as a result of the technology of production, the monopoly created is sometimes called a natural monopoly Natural monopoly - A firm that exhibits diminishing average cost over a broad range of output levels. Another technical basis of monopoly is special knowledge of a low-cost method of production. In this case, the problem for the monopoly firm fearing entry by other firms is to keep this technique uniquely to itself. When matters of technology are involved, this may be extremely difficult, unless the technology can be protected by a patent. Ownership of unique resources (mineral deposits or land locations) or the possession of unique managerial talents may also be a lasting basis for maintaining a monopoly. Legal Barriers to Entry An example of a legally created monopoly is the awarding of an exclusive franchise or license to serve a market. These are awarded in cases of public utility (gas and electric) services, communication services, the post office, some airline routes, some television and radio station markets, and a variety of other businesses The restrictions on entry into certain industries are needed to ensure adequate quality standards (licensing of physicians, for example) or to prevent environmental harm In other cases, the restrictions act mainly to limit the competition faced by existing firms and seem to make little economic sense Profit Maximization A profit-maximizing monopoly will choose to produce that output level for which MR = MC. Because the monopoly faces a downward-sloping demand curve for its product, the MR < P (market price). To sell an additional unit, the monopoly must lower its price on all units to be sold in order to generate the extra demand necessary to find a taker for this marginal unit. In equating marginal revenue to marginal cost, the monopoly produces an output level for which price exceeds marginal cost. This feature of monopoly pricing is the primary reason for the negative effect of monopoly on resource allocation. Monopoly Supply Curve The monopolist bases its supply decision on marginal revenue rather than demand directly, and marginal revenue depends on the shape of the demand curve (both the slope of the demand curve as well as its level). Therefore, in the monopoly case, we refer to the firm’s supply ‘‘decision’’ rather than supply ‘‘curve” Monopoly Profits Profits are positive when market price exceeds average total cost. Since no entry is possible into a monopoly market, these profits can exist even in the long run. For this reason, some authors call the profits that a monopolist earns in the long run monopoly rents. These profits can be regarded as a return to the factor that forms the basis of the monopoly (such as a patent). Some other owner might be willing to pay that amount in rent for the right to operate the monopoly and obtain its profits. The huge prices paid for television stations or baseball franchises reflect the capitalized values of such rents What’s wrong with Monopoly? First, monopolies produce too little output; and second, the high prices they charge end up redistributing wealth from consumers to the ‘‘fat cat’’ firm owners. > A perfectly competitive industry would produce output level Q* at a price of P*. A monopolist would opt for Q** at a price of P**. Consumer expenditures and productive inputs worth AEQ*Q** are reallocated into the production of other goods. Consumer surplus equal to P**BAP* is transferred into monopoly profits. There is a deadweight loss given by BEA. It has been assumed that the monopoly produces under conditions of constant marginal cost and that the competitive industry also exhibits constant costs with the same minimum long-run average cost as the monopolist. The market at Q* is produced at a price of P*. The total value of this output to consumers is given by the area under the demand curve (by area FEQ*0), for which they pay P*EQ*0. Consumer surplus is given by the difference between these two areas (the triangle FEP*). A monopoly would choose output level Q**, for which marginal revenue equals marginal cost. Consumer surplus is FBP**, and consumer spending on the monopoly good is P**BQ**0. DWL The loss of consumer surplus given by the area BEA is an unambiguous reduction in welfare as a result of the monopoly. Redistribution from Consumers to the Firm If the market is a monopoly, that portion of consumer surplus is transferred into monopoly profits. The area P**BAP* does not necessarily represent a loss of social welfare. It does measure the redistribution effects of a monopoly from consumers to the firm, and these may or may not be undesirable However, profits from a monopoly may not always to go the wealthy Because perfectly competitive firms earn no economic profits in the long run, a firm with a monopoly position in a market can earn higher profits than if the market is competitive. It is the ability of monopolies to raise price above marginal cost that reflects their monopoly power. Because profitability reflects the difference between price and average cost, profits are not necessarily a definite consequence of monopoly power Buying a Monopoly Position Monopoly profits, after all, provide a tantalizing target for firms, and they may spend real resources to achieve those profits. They may adopt extensive advertising campaigns or invest in ways to erect barriers to entry against other firms and hence obtain monopoly profits. Price Discrimination A monopoly sells all its output at one price. The firm was assumed to be unwilling or unable to adopt different prices for different buyers of its product. There are two consequences of such a policy. First, the monopoly must forsake some transactions that would in fact be mutually beneficial if they could be conducted at a lower price. Second, although the monopoly does succeed in transferring a portion of consumer surplus into monopoly profits, it still leaves some consumer surplus to those individuals who value the output more highly than the price that the monopolist charges. The existence of both of these areas of untapped opportunities suggests that a monopoly has the possibility of increasing its profits even more by practicing price discrimination—by selling its output at different prices to different buyers. Price discrimination - Selling identical units of output at different prices Perfect Price Discrimination Perfect price Discrimination – is selling each unit of output for the highest price obtainable. Extracts all of the consumer surplus available in a given market One way for a monopoly to practice price discrimination is to sell each unit of its output for the maximum amount that buyers are willing to pay for that particular unit. Under this scheme, a monopoly would sell the first unit of its output at a price slightly below F, the second unit at a slightly lower price, and so forth. When the firm has the ability to sell one unit at a time in this way, there is no reason now to stop at output level Q**. Because it can sell the next unit at a price only slightly below P** (which still exceeds marginal and average cost by a considerable margin), it might as well do so. Indeed, the firm will continue to sell its output one unit at a time until it reaches output level Q*. For output levels greater than Q*, the price that buyers are willing to pay falls below marginal cost; hence, these sales would not be profitable. The result of this perfect price discrimination scheme is the firm’s receiving total revenues of 0FEQ*, incurring total costs of 0P*EQ*, and, therefore, obtaining total monopoly profits given by area P*FE. In this case, the entire consumer surplus available in the market has been transferred into monopoly profits. Consumers have had all the ex
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