Introduction to Economic Analysis Chapter 15 Monopoly

Chapter 15 Monopoly We have spent a great deal of time on the competitive model , and we now turn to the polar opposite case , that of monopoly . 15 SOU Of LEARNING OBJECTIVE . How do monopolies come about ?

A is a firm that faces a downward sloping demand and has a choice about what price to without fearing of chasing all of its customers away to rivals . There are very few pure monopolies . The post has a monopoly in mail but faces competition from FedEx and other companies , as well as from fax and providers . has a great deal of market power , but a small percentage of personal computer users choose Apple or operating systems . In contrast , there is only one US . manufacturer of aircraft carriers . However , many firms have market power or monopoly power , which means that they can increase their price above marginal cost and sustain sales for a long period of time . The theory of monopoly is applicable to such , although they may face an additional and important constraint A price increase may affect the behavior of rivals . This behavior of rivals is the subject of the next chapter . A large market share is not proof of a monopoly , nor is a small market share proof that a lacks monopoly power . For example , US . Air dominated air traffic to Philadelphia and Pittsburgh but still lost money . Porsche has a small share of the automobile even the automobile still has monopoly power in that market . There are three basic sources of monopoly . The most common source is to be granted a monopoly by the government , either through which case the monopoly is through a government franchise . was a government franchise that was granted a monopoly on satellite communications , a monopoly that ultimately proved quite lucrative . Many cities and towns license a single cable company or taxi company , although usually basic rates and fares are set by the terms of the license agreement . New drugs are granted patents that provide the monopoly power for a period of time . Patents generally last 20 years , but pharmaceutical drugs have their own patent laws . Copyright also confers a limited monopoly for a limited period of time . Thus , the Disney Corporation URL books 355

owns copyrights on Mickey that , by law , should have expired but were granted an extension by Congress each time they were due to expire . Copyrights create monopoly power over music as well as cartoon characters . Time Warner owns the rights to the song Happy Birthday to You and receives royalties every time that it is played on the radio or other commercial venue . Many of the Beatles songs that Paul were purchased by Michael Jackson . A second source of monopoly is a large economy of scale . The scale economy needs to be large relative to the size of demand . A monopoly can result when the average cost of a single serving the entire market is lower than that of two or more serving the market . For example , telephone lines were expensive to install , and the company to do so , AT , wound up being the only provider of service in the United States . Similarly , scale economies in electricity generation meant that most communities had a single electricity provider prior to the , when new technology made relatively smaller scale generation more efficient . The equivalent of an economy of scale is a network externality . A network externality arises when others use of a product makes it more Valuable to each consumer . Standards are a common source of network externality . Since AA batteries are standardized , it makes them more readily accessible , helps drive down their price through competition and economies of scale , and thus makes the AA battery more valuable . They are available everywhere , unlike proprietary batteries . Fax machines are valuable only if others have similar machines . In addition to standards , a source of network externality is products . Choosing Windows as a computer operating system means that there is more software available than for Macintosh or , as the widespread adoption of Windows has led to the writing of a large variety of software for it . The Video Home System of came to dominate the Sony Beta system , primarily because there were more movies to rent in the format than in the Beta format at the video rental store . In contrast , recordable have been hobbled by incompatible standards of and , a not resolved even as the next discs such as Sony to reach the market . themselves were slow to be adopted by consumers because few discs were available for rent at video rental stores , which is a consequence of few adoptions of players . As players became more prevalent and the number of discs for rent increased , the market tipped and came to dominate . The third source of monopoly is control of an essential , or a sufficiently Valuable , input to the production process . Such an input could be technology that confers a cost advantage . For example , software is run by a computer operating system and needs to be designed to work well with the operating system . There have been a series of URL books 355

allegations that kept secret some of the application program interfaces used by Word as a means of hobbling rivals . If so , access to the design of the operating system itself is an important input . KEY TAKEAWAYS A monopoly is a firm that faces a downward sloping demand and has a choice about what price to increase in price does send most , or all , of the customers away to rivals . There are very few pure monopolies . There are many firms that have market power or monopoly power , which means that they can increase their price above marginal cost and sustain sales for a long period of time . A large market share is not proof of a monopoly , nor is a small market share proof that a firm lacks monopoly power . There are three basic sources of monopoly one created by government , like patents a large economy of scale or a network externality and control of an essential , or a sufficiently valuable , input to the production process . Basic Analysis LEARNING OBJECTIVE . What are the basic effects of monopoly , compared to a competitive industry ?

Even a monopoly is constrained by demand . A monopoly would like to sell lots of units at a very high price , but a higher price necessarily leads to a loss in sales . So how does a monopoly choose its price and quantity ?

A monopoly can choose price , or a monopoly can choose quantity and let the demand dictate the price . It is slightly more convenient to formulate the theory in terms of quantity rather than price , because costs are a function of quantity . Thus , we ( be the demand price associated with quantity , and ( be the cost of producing . The monopoly are ( The monopoly earns the revenue and pays the cost This leads to the condition for the maximizing quantity a ( The term ( is known as marginal revenue . It is the derivative of respect to quantity . Thus , a monopoly chooses a quantity where marginal revenue equals marginal cost , and charges the URL books 357

maximum ( that the market will bear at that quantity . Marginal revenue is below ( because demand is downward sloping . That is , Figure ( URL books 358 Deadweight Loss Monopoly URL oo 359 The choice of monopoly quantity is illustrated in Figure Basic monopoly diagram . The key points of this diagram are . First , marginal revenue lies below the demand curve . This occurs because marginal revenue is the ( plus a negative number . Second , the monopoly quantity equates marginal revenue and marginal cost , but the monopoly price is higher than the marginal cost . Third , there is a deadweight loss , for the same reason that taxes create a deadweight loss The higher price of the monopoly prevents some units from being traded that are valued more highly than they cost . Fourth , the monopoly profits from the increase in price , and the monopoly is shaded . Fifth , competitive equals marginal cost , the intersection of marginal cost and demand corresponds to the competitive outcome . We see that the monopoly restricts output and charges a higher price than would prevail under competition . We can rearrange the monopoly pricing formula to produce an additional insight ( or ) Is . The side of this equation ( price minus marginal cost divided by price ) is known as the COST margin or Index . The side is one divided by the elasticity of demand . This formula relates the markup over marginal cost to the elasticity of demand . It is important because perfect competition forces price to equal marginal cost , so this formula provides a measure of the deviation from competition and , in particular , says that the deviation from competition is small when the elasticity of demand is large , and vice versa . Marginal cost will always be greater than or equal to zero . If marginal cost is less than zero , the least expensive way to produce a given quantity is to produce more and throw some away . Thus , the margin is no greater than one and , as a result , a monopolist produces in the elastic portion of demand . One implication of this observation is that if demand is everywhere inelastic ( for ) the optimal monopoly quantity is essentially zero , and in any event would be no more than one molecule of the product . In addition , the effects of monopoly are related to the elasticity of demand . If demand is very elastic , the effect of monopoly on prices is quite limited . In contrast , if the demand is relatively inelastic , monopolies will increase prices by a large margin . We can rewrite the formula to obtain ( Thus , a monopolist marks up marginal cost by the factor , at least when . This formula is sometimes used to justify a markup policy , which means that a company adds a constant percentage markup to its products . This is an policy , not by the formula , because the formula suggests a markup that depends upon the demand for the product in question , and thus not a markup for all products that a company produces . URL books 350

KEY TAKEAWAYS Even a monopoly is constrained by demand . A monopoly can either choose price , or choose quantity and let the demand dictate the price . A monopoly chooses a quantity where marginal revenue equals marginal cost , and charges the maximum price ( that the market will bear at that quantity . Marginal revenue is below demand ( because demand is downward sloping . The monopoly price is higher than the marginal cost . There is a deadweight loss of monopoly for the same reason that taxes create a deadweight loss The higher price of the monopoly prevents some units from being traded that are valued more highly than they cost . A monopoly restricts output and charges a higher price than would prevail under competition . The margin is the ratio of price minus marginal cost over price and measures the deviation from marginal cost pricing . A monopoly chooses a price or quantity that equates the margin to the inverse of the demand elasticity . A monopolist produces in the elastic portion of demand . A monopolist marks up marginal cost by the factor 524 , when the elasticity of demand exceeds one . If demand is linear , a , what is marginal revenue ?

Plot demand and marginal revenue , and total revenue ( as a function of . For the case of constant elasticity of demand , what is marginal revenue ?

If both demand and supply have constant elasticity , compute the monopoly quantity and price . a monopolist with cost . URL books 351 a . If demand is given by 50 , what is the monopoly price and quantity ?

What are the profits ?

Repeat part ( a ) for demand given by . The government wishes to impose a tax , of fraction , on the profits of a monopolist . How does this affect the optimal output quantity ?

If demand has constant elasticity , what is the marginal revenue of the monopolist ?

Effect of Taxes LEARNING OBJECTIVE . How does a monopoly respond to taxes ?

A tax imposed on a seller with monopoly power performs differently than a tax imposed on a competitive industry . Ultimately , a perfectly competitive industry must pass on all of a tax to consumers because , in the long run , the competitive industry earns zero . In contrast , a monopolist might absorb some portion of a tax even in the long run . To model the effect of taxes on a monopoly , consider a monopolist who faces a tax rate unit of sales . This monopolist earns ( The condition for maximization yields ( Viewing the monopoly quantity as a function of , we obtain ' the sign following from the condition for maximization . In addition , the change in price ' Thus , a tax causes a monopoly to increase its price . In addition , the monopoly price rises by less than the tax if ' or ' This condition need not be true but is a standard regularity condition imposed by assumption . It is true for linear demand and increasing marginal cost . It is false for constant elasticity of demand , which is the relevant case , for otherwise the conditions fail ) and constant marginal cost . In the latter case ( constant elasticity and marginal cost ) a tax on a monopoly increases price by more than the amount of the tax . URL books 352

KEY TAKEAWAYS A perfectly competitive industry must pass on all of a tax to consumers because , in the long run , the competitive industry earns zero profits . A monopolist might absorb some portion of a tax even in the long run . A tax causes a monopoly to increase its price and reduce its quantity . A tax may or may not increase the monopoly markup . Use a revealed preference argument to show that a tax imposed on a monopoly causes the quantity to fall . That is , hypothesize quantities before the tax and qa after the tax , and show that two monopoly preferred to qa , and the taxed monopoly made higher profits from imply that qa . When both demand and supply have constant elasticity , use the results of to compute the effect of a proportional tax ( a portion of the price paid to the government ) Price Discrimination LEARNING OBJECTIVES . Do monopolies charge different consumers different prices ?

Why and how much ?

Pharmaceutical drugs for sale in Mexico are generally priced substantially below their counterparts . Pharmaceutical drugs in Europe are also cheaper than in the United States , although not as inexpensive as in Mexico , with Canadian prices usually falling between the US . and European prices . The comparison is between identical drugs produced by the same manufacturer . Pharmaceutical drugs differ in price from country to country primarily because demand conditions vary . The formula ( shows that a monopoly seller would like to charge a higher markup over marginal cost to customers with less elastic demand than to customers with more elastic demand because is a decreasing function of , for . Charging different prices for the same product to different customers is known URL books 353

as price discrimination . In business settings , it is sometimes known as pricing , which is a more palatable term to relay to customers . Computer software vendors often sell a student version of their software , usually at substantially reduced prices , but require proof of student status to qualify for the lower price . Such student discounts are examples of price discrimination , and students have more elastic demand than business users . Similarly , the student and senior citizen discounts at movies and other venues sell the same ticket to the different prices , and thus qualify as price discrimination . In order for a seller to price discriminate , the seller must be able to identify ( approximately ) the demand of groups of customers , and prevent arbitrage . Arbitrage is also known as buying low and selling high , and represents the act of being an intermediary . Since price discrimination requires charging one group a higher price than another , there is potentially an opportunity for arbitrage , arising from members of the group buying at the low price and selling at the high price . If the seller can prevent arbitrage , arbitrage essentially converts a system to sales at the low price . Why offer student discounts at the movies ?

You already know the answer to this Students have lower incomes on average than others , and lower incomes translate into a lower willingness to pay for normal goods . Consequently , a discount to a student makes sense from a demand perspective . It is relatively simple to prevent arbitrage by requiring that a student card be presented . Senior citizen discounts are a bit Generally , senior citizens aren poorer than other groups of customers ( in the United States , at least ) However , seniors have more free time . and therefore are able to substitute to matinee showings or to drive to more distant locations should those offer discounts . Thus , seniors have relatively elastic demand , more because of their ability to substitute than because of their income . Airlines commonly price discriminate , using Saturday night and other devices . To see that such charges represent price discrimination , consider a passenger who lives in Dallas but needs to spend Monday through Thursday in Los Angeles for weeks in a row This passenger could buy two roundtrip tickets Trip First Monday Dallas Los Angeles First Friday Los Angeles Dallas Trip URL books 354

Second Monday Dallas Los Angeles Second Friday Los Angeles Dallas At the time of this writing , the approximate combined cost of these two was . In contrast , another way of arranging exactly the same travel is to have two , one of which originates in Dallas , while the other originates in Los Angeles Trip First Monday Dallas Los Angeles Second Friday Los Angeles Dallas Trip First Friday Los Angeles Dallas Second Monday Dallas Los Angeles This pair of involves exactly the same travel as the pair , but costs less than 500 for both ( at the time of this writing ) The difference is that the second pair involves staying over Saturday night for both legs , and that leads to a major discount for most airlines . American Airlines quoted the fares . How can airlines price discriminate ?

There are two major groups of customers business travelers and leisure travelers . Business travelers have the higher willingness to pay overall , and the nature of their trips tends to be that they come home for the weekend In contrast , leisure travelers usually want to be away for a weekend , so a weekend stay over is an indicator of a leisure traveler . It doesn work perfectly as an business travelers must be away for the it is sufficiently correlated with leisure travel that it is for the airlines to price discriminate . These examples illustrate an important distinction . Senior citizen and student discounts are based on the identity of the buyer , and qualifying for the discount requires that one show an identity card . In contrast , airline price discrimination is not based on the identity of the buyer but rather on the choices made by the buyer . Charging customers based on identity is known as direct price discrimination , while offering a menu or set of prices and permitting customers to choose distinct prices is known as indirect price discrimination . Two common examples of indirect price discrimination are coupons and quantity discounts . Coupons offer discounts for products and are especially common in grocery stores , where they are usually provided in a free newspaper section at the front of the store . Coupons discriminate on the basis of the cost of time It takes time to the coupons for the URL books 355

products that one is interested in buying . Thus , those with a high value of time won it worth their while to spend 20 minutes to save ( effectively a 15 per hour return ) while those with a low Value of time will that return worthwhile . Since those with a low Value of time tend to be more ( more elastic demand ) coupons offer a discount that is available to all but used primarily by customers with a more elastic demand , and thus increase the of the seller . Quantity discounts are discounts for buying more . Thus , the large size of milk , laundry detergent , and other items often cost less per unit than smaller sizes , and the difference is greater than the savings on packaging costs . In some cases , the larger sizes entail greater packaging costs some manufacturers band together individual units , incurring additional costs to create a larger size that is then discounted . Thus , the of paper towels sells for less per roll than the individual rolls such large Volumes appeal primarily to large families , who are more on . KEY TAKEAWAYS A monopoly seller would like to charge a higher markup over marginal cost to customers with less elastic demand than to customers with more elastic demand . In order for a seller to price discriminate , the seller must be able to identify ( approximately ) the demand of groups of customers , and prevent arbitrage . Since price discrimination requires charging one group a higher price than another , there is potentially an opportunity for arbitrage . Airlines commonly price discriminate , using Saturday night and other devices . Direct price discrimination is based upon the identity of the buyer , while indirect price discrimination involves several offers and achieves price discrimination through customer choices . Two common examples of indirect price discrimination are coupons and quantity discounts . URL books 355

EXERCISE whether the following items are direct price discrimination , indirect price discrimination , or not price why . a . Student discounts at local restaurants . Financial aid at colleges Matinee discounts at the movies Home and professional versions of operating system Lower airline fares for weekend flights specials Welfare Effects LEARNING OBJECTIVE . Is price discrimination good or bad for society as a whole ?

Is price discrimination a good thing or a bad thing ?

It turns out that there is no answer to this question . Instead , it depends on circumstances . We illustrate this conclusion with a pair of exercises . This exercise illustrates a much more general proposition If a price discriminating monopolist produces less than a monopolist , then price discrimination reduces welfare . This proposition has an elementary proof . Consider the price discriminating monopolist sales , and then allow arbitrage . The arbitrage increases the gains from trade , since every transaction has gains from trade . Arbitrage , however , leads to a common price like that charged by a monopolist . Thus , the only way that price discrimination can increase welfare is if it leads a seller to sell more output than he or she would otherwise . This is possible , as the next exercise shows . In Exercise , we see that price discrimination that brings in a new group of customers may increase the gains from trade . Indeed , this example involves a improvement The seller and Group are better off , and Group is no worse off , than without price discrimination . A improvement requires that no one is worse off and at least one person is better off . URL books 357

Whether price discrimination increases the gains from trade overall depends on circumstances . However , it is worth remembering that people with lower incomes tend to have more elastic demand , and thus get lower prices under price discrimination than absent price discrimination . Consequently , a ban on price discrimination tends to hurt the poor and the rich , no matter what the overall effect . A common form of price discrimination is known as . pricing usually involves a charge and a marginal charge , and thus offers the ability for a seller to capture a portion of the consumer surplus . For example , electricity often comes with a price per month and then a price per , which is pricing . Similarly , long distance and cellular telephone companies charge a fee per month , with a number of included minutes , and a price per minute for additional minutes . Such contracts really involve three parts rather than two parts , but are similar in spirit . Figure ( URL books 368

Consumer Surplus Fixed Fee Price URL oo From the seller perspective , the idea price is to charge marginal cost plus a charge equal to the customer consumer surplus , or perhaps a penny less . By setting price equal to marginal cost , the seller maximizes the gains from trade . By setting the fee equal to Consumer surplus , the seller captures the entire gains from trade . This is illustrated in Figure pricing . KEY TAKEAWAYS If a price discriminating monopolist produces less than a monopolist , then price discrimination reduces welfare . Price discrimination that opens a new , previously unserved market increases welfare . A ban on price discrimination tends to hurt the poor and benefit the rich , no matter what the overall effect . pricing involves a fixed charge and a marginal charge . The ideal price is to charge marginal cost plus a fixed charge equal to the customer consumer surplus , in which case the seller captures the entire gains from trade . Let marginal cost be zero for all quantities . Suppose that there are two groups of customers , Group with demand ( 12 , and Group with demand ( Show that a monopolist charges a price of , and the discriminating monopolist charges Group the price of and Group the price of . Then calculate the gains from trade , with discrimination and without , and show that price discrimination reduces the gains from trade . Let marginal cost be zero for all quantities . Suppose that there are two groups of customers , Group with demand ( 12 , and Group with demand ( Show that a monopolist charges a price of , and the discriminating monopolist charges Group the price of and Group the price of . Then calculate URL books 370

the gains from trade , with discrimination and without , and show that price discrimination increases the gains from trade . Natural Monopoly LEARNING OBJECTIVES . When there is a scale economy , what ma prices will a rise ?

ow is the monopoly price constrained by the threat of entry ?

A natural arises when a single can serve the entire market because average costs are lower with one than with two . An example is illustrated in Natural . In this case , the average total cost of a single is lower than if two were to split the output between them . The monopolist would like to price , which maximizes . Historically , the United States and other nations have regulated natural monopoly products and supplies such as electricity , telephony , and water service . An immediate problem with regulation is that the efficient is , the price that maximizes the gains from a subsidy from outside the industry . We see the need for a subsidy in Natural because the price that maximizes the gains from trade , which sets the demand ( marginal value ) equal to the marginal cost . At this price , however , the average total cost exceeds the price , so that a with such a regulated price would lose money . There are two alternatives . The product could be subsidized Subsidies are used with postal and passenger rail services in the United States and historically for many more products in Canada and Europe , including airlines and airplane manufacture . Alternatively , regulation could be imposed to limit the price topi , the lowest price . This is the more common strategy used in the United States . Figure URL books 371

There are two strategies for limiting the price regulation , which directly imposes a maximum price , and rate Of return regulation , which limits the of . Both of these approaches URL books 372 induce some of production . In both cases , an increase in average cost may translate into additional for the , causing regulated to engage in unnecessary activities . KEY TAKEAWAYS A natural monopoly arises when a single firm can efficiently serve the entire market . Historically , the United States and other nations have regulated natural monopolies including electricity , telephony , and water service . The efficient price is typically unsustainable because of decreasing average cost . Efficient prices can be achieved with subsidies that have been used , for example , in postal and passenger rail services in the United States and historically for several products in Canada and Europe , including airlines and airplane manufacture . Alternatively , regulation could be imposed to limit the price to average cost , the lowest price . This is the more common strategy in the United States . Two common strategies for limiting the price are regulation , which directly imposes a maximum price , and rate of return regulation , which limits the profitability of firms . Both of these approaches induce some inefficiency of production . Pricing LEARNING OBJECTIVE . How do monopolies respond to predictable cost fluctuation as it arises in electricity and hotel markets ?

Fluctuations in demand often require holding capacity , which is used only a fraction of the time . Hotels have seasons when most rooms are empty . Electric power plants are designed to handle peak demand , usually on hot summer days , with some of the capacity standing idle on other days . Demand for transatlantic airline is much higher in the summer than during the rest of the year . All of these examples have the similarity that an amount of space , airplane seats , electricity be used over and over , which means that it is used in URL books 373

both high demand and low demand states . How should prices be set when demand ?

This question can be as to how to allocate the cost of capacity across several time periods when demand systematically . Consider a that experiences two costs a capacity cost and a marginal cost . How should capacity be priced ?

This issue applies to a wide variety of industries , including pipelines , airlines , telephone networks , construction , electricity , highways , and the Internet . The basic problem , pioneered by Marcel ( considers two periods . The are given ' max , Setting price equal to marginal cost is not sustainable because a firm selling with price equal to marginal cost would not earn a return on the capacity , and thus would lose money and go out of business . Consequently , a capacity charge is necessary . The question of pricing is how the capacity charge should be allocated . This question is not trivial because some of the capacity is used in both periods . For the sake of simplicity , we will assume that demands are independent that is , is independent , and Vice Versa . This assumption is often unrealistic , and it actually doesn complicate the problem too much . The primary complication is in computing the social welfare when demands are functions of two prices . Independence is a convenient starting point . Social welfare is ( max , The Ramsey problem is to maximize to a minimum condition . A technique for accomplishing this maximization is to instead maximize ) By varying ) we vary the importance of profits to the maximization problem , which will increase the profit level in the solution as ) increases . Thus , the correct solution to the constrained maximization problem is the outcome of the maximization of , for some value of A useful notation is , which is known as the indicator function of the setA . This is a function that is whenA is true , and zero otherwise . Using this notation , the condition for the maximization ofL ( or ( is the characteristic function ofthe event . Similarly , as before that ) co yields the monopoly solution . URL books 374

There are two potential types of solutions . Let the demand for Good exceed the demand for Good . Either , or the two are equal . Case ( 121 and ( In Case , with all of the capacity charge allocated to Good , quantity for Good still exceeds quantity for Good . Thus , the peak period for Good is an extreme peak . In contrast , Case arises when assigning the capacity charge to Good would reverse the all of the capacity charge to Good would make Period the peak . Case ( The equation can be . This equation determines , and prices are determined from demand . The major conclusion from pricing is that either the entire cost of capacity is allocated to the peak period or there is no peak period , in the sense that the two periods have the same quantity demanded given the prices . That is , either the prices equalize the quantity demanded or the prices impose the entire cost of capacity only on one peak period . Moreover , the price ( or , more properly , the markup over marginal cost ) is proportional to the inverse of the elasticity , which is known as Ramsey pricing . KEY TAKEAWAYS Fluctuations in demand often require holding capacity , which is used only a fraction of the time . pricing the cost of capacity across several time periods when demand systematically fluctuates . Important industries with problems include pipelines , airlines , telephone networks , construction , electricity , highways , and the Internet . Under efficient pricing , either the prices equalize the quantity demanded , or the prices impose the entire cost of capacity only on one peak period . Moreover , the markup over marginal cost is proportional to the inverse of the elasticity . EXERCISE each of the following items , state whether you would expect pricing to equalize the quantity demanded across URL books 375

periods or impose the entire cost of capacity on the peak period . Explain why . a . Hotels in Miami . Electricity URL books 376