Monopolies

WHAT IS A MONOPOLY AND WHY ARISES

A monopoly it a situation in which in the market there is only one firm selling products and the products which are sold do not have close substitutes. This happens because of high barriers to entry and sell in the industry making impossible for other firms to participate in the market and compete with the monopolist. Barriers to entry may be:

• Resources necessary for production which may be available only to the monopolist

• Government regulations that give specific rights and permissions only to a single firm

• A more efficient production process that is more cost efficient than the one of all other firms

A natural monopoly is a special kind of monopoly arising when a single firm can supply goods or services in a better and more efficient way than two or more firms. This is possible thanks to economies of scale (we talked about economies of scale in our lecture on production with two inputs). An example of natural monopoly could be firms supplying electricity: in order to provide electricity, if there are multiple firms, each firm in the market should hold its own network across the territory, therefore multiple networks are needed. If instead, there is only one firm is in the market, a single network is needed making the process of distributing energy much more cost efficient. Natural monopolies are often protected by the key resources they possess and thanks to the government.

HOW MONOPOLOIES AND PERFECT COMPETITION DIFFER

Monopoly and perfect competition differ mainly because a competitive firm can not influence prices (and because of that takes them as given) while a monopolist can. Because a competitive firm can sell how much it wants at the same price the market demand can be represented by an horizontal line. Saying that demand is horizontal makes its elasticity ∞ (we have an entire lecture dedicated to elasticity). Having infinite elasticity means that, if the competitive firm charges a higher price than the market one, customers will decide to buy the good somewhere else because of the huge amount of substitutes. Because, as said, the monopolist is the only producer and therefore there are no substitutes the demand curve it faces is not horizontal but downward sloping like a general demand curve.

Because the demand curve slopes downward, the more the monopolist charges for its products, the less quantity will be demanded on the market. A monopolist can choose any point on the demand curve selling x units of the good at a price y so which point on the demand curve will be chosen in the end?

REVENUES OF A MONOPOLIST

The average revenue, the amount of revenue the firm receives from one unit sold, is computed as:

AR = TR/Q

(total revenue divided by the quantity sold)

But, because the total revenue is simply the quantity sold multiplied by the market price, when dividing by the quantity, the only term remaining is the price (because both Q cancel out at the nominator and denominator). This means that AR = P so the average revenue the firm is getting is exactly the market price just as it is in the case of perfect competition. Because of the downward sloping demand curve a monopolist faces, its marginal revenue is instead very different from the one of a perfect competitive firm. This is because when increasing the amounts a monopoly sells when considering how total revenue changes (TR = Q∙P) we have to consider two effects:

• More units are sold (so Q grows) which makes revenues higher

• The price decreases (so P decreases) which makes revenues lower

So a monopolist marginal revenue is less than the price of the good.

Because a competitive firm is a price taker, the marginal revenue it gets when increasing production is exactly the price of the extra unit it sold. The monopolist, when increasing production, is, at the same time reducing the price of all the units it wants to sell and not just the price of the last one. By observing both the marginal revenue and the demand curve, you would notice that, even thought the marginal revenue curve is always lower than the demand curve, they start from the same point on the y-axis. This is because, when the firm is selling only one unit, the total revenue changes by exactly the price of the first units: it changes from 0 when selling nothing to the price of the unit (remember that the marginal revenue describes how the total revenue changes when increasing the quantity sold by 1 unit). The marginal revenue becomes negative when the firm produces an extra unit of output but total revenue declines instead of rising.

HOW A MONOPOLIST MAXIMIZES PROFITS

When marginal revenue is higher than marginal cost, if the firm increases production by 1 unit, the revenue it would get is more than the cost it has to bear making profits rise. This means that for the firm is more convenient to increase production. If instead, marginal cost is higher than marginal revenue, if the firm increases production by 1 unit, the revenue it would het is less than the cost it has to bear making profits. This means that for the firm it is more convenient to decrease production. The quantity the firm produces changes until it does not reach the quantity where marginal cost is exactly equal to marginal revenue. This is the exact same condition for the perfectly competitive firm but, while for the perfect competitive the marginal cost is equal to the marginal revenue and therefore the price of the good on the market, for a monopolistic firm the marginal cost and marginal revenue are both less than the price. After having determined the profit maximizing quantity by imposing marginal cost equal to marginal revenue, to find the price on the market it is sufficient to plug into the demand curve the profit maximizing quantity.

CALCULATING THE PROFIT

Remember that profit is defined as:

π = TR -TC

which can be written as:

π = (TR/Q -TC/Q)∙Q

TR/Q is the average revenue and remember that, as we said at the beginning of that lecture, average revenue is equal to the price P. TC/Q is instead the average total cost ATC. So we can rewrite the equation as:

graphically it can be represented by a box with the height P-ATC, which represents the profit the monopolist is making on each unit, and with base the quantity sold Q.

HOW A MONOPOLY INFLUENCES THE TOTAL SURPLUS

Because the monopolist charges prices higher than the marginal costs it bears, it makes a profit but, at the same time, because of those high prices, consumers will be worse off with respect to a situation of perfect competition. Remember that the total surplus in the market is the sum of consumers’ and producers’ surpluses (that we have analysed in a specific lecture). In the analysis for total surplus, we concluded that total surplus in the market is maximized in a perfectly competitive market and so when the demand and marginal cost curves intersect. If you consider a quantity which is less than the one when these curves intersect, the value of the product for buyers (so the price they are willing to pay) is higher than the cost to the monopolist and therefore total surplus increases when increasing the quantity while, if you consider a quantity higher than the efficient one the cost to the monopolist exceeds the value of the product for buyers and therefore total surplus increases by reducing the quantity. Because the monopolist produces less than a perfectly competitive firm, the value to the buyers is higher than it would in a perfectly competitive market. This means that the consumers that value the good more than the firm’s marginal cost but less than the price imposed by the monopolist will not buy the good. Those people would have bought the good if the price was a perfectly competitive one but now they are not. The price of the monopolist induces consumers not to trade and therefore the size of the market diminishes creating a deadwheight loss similar to the one happening when a tax is imposed in a perfectly competitive market (that we have analysed in another lecture).

HOW TO SOLVE THE DEADWHEIGHT LOSS WITH PRICE DISCRIMINATION

When discussing about the deadweight loss we assumed that every consumer in the market pays the same price to acquire the same good. But, if we remove that assumption, the situation changes radically. If the monopolist can sell the good at different prices depending on the consumer we have a situation of price discrimination. By doing that the monopolist can increase its profits because each buyer in the market will pay its reserve price (the maximum price he is willing to pay) meaning that people who buy the good more than the price the monopolists sets will pay more, while people who value the good more than the marginal cost to produce the good but less than the price imposed initially by the monopolist will pay less and buy the good. Graphically the reserve prices are represented by the height of the demand curve. In this way the deadweight loss is eliminated and the total surplus in the market is again reached but now it is equal only to the producers’ one meaning that there is no consumer surplus anymore. A price discrimination is not fair for buyers and it is a situation which is very hard to achieve because the monopolist should separate each buyer in order to sell the same exact product at different prices without letting who pays more for it to know.