Monopoly and other forms of imperfect competition

Sara

Imperfectly competitive markets:

A market in which firms have at least some ability to set their own price.

Monopolistic
Perfect competition
- A market in which Oligopoly Pure Monopoly
competition a large number of - a market in which
- Firms have - A market in which
firms produce only a few rival a single firm is the
perfectly elastic slightly lone seller of a
demand curve and firms produce
differentiated goods that are product for which
are price takers (no products that are there are no close
market power) close substitutes
reasonably close substitutes
substitutes for one
another.

Imperfect competition firm

1. faces a downward-sloping demand curve.

 An imperfect competitor charges a few cents more than its rivals for its product, some of
its customer may desert it. But others will remain, perhaps because they are willing to pay
extra to continue shopping at their most convenient location.

2. Is some degree a price setter, and commands market power (ability to raise the
price of a good without losing all its sales). The firm is able to pick a price-quantity
combination along its demand curve. This is derived from the fact that there is no
perfect substitute for their goods. In the case of monopoly, no close substitutes
exists.

3. For a monopolist, the market demand curve and the demand curve that the firm
faces are the same.
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Factors that underpin market power by presenting a barrier to entry

1. Exclusive control over important inputs
If a single firm controls an input essential to the production of a given product, that firm will
have market power.

2. Government created monopolies

Government can limit the extent to which other firms can enter a market through the issue
of patent and copyright protection and the grant of licences and franchises. These
protections enables the patent holder to set a price above the marginal cost of production
to recoup the cost of research on the product.

3. Economies of scale
Constant returns to scale
Proportion of change in inputs = proportion of change in outputs (in a production
process

Economies of scale
Proportion of change in inputs > proportion of change in outputs (in a production
process

When production is subject to economies of scale, the average cost of production declines
as the number of units produced increases.
While a firm must construct a transmission network costing many millions of dollars to transmit
electricity, having built it, additional electricity can be transmitted at a very low cost.

Natural monopoly
A monopoly that results from economies of scale.
The market for goods whose production exhibits economies of scale over output levels that are large
relative to the size of the market tend to be served by a single seller. In a case of natural monopoly, a
single firm can serve the entire market at a lower cost than can 2 or more firms.

4. Network economies
Product (e.g. faxes, email and credit cards) become more valuable to an individual user the
larger is the good’s network of users.
Essentially similar to economies of scale : When network economies are any value to the consumer, a
product’s quality increases as the number of users increases, so we can say that any given quality
level can be produced at lower cost as sales volume increases.

By far, the most important and enduring of these barriers to entry are economies of scale and
network economies. Lured by economic profit, firms almost always find substitutes for exclusive
inputs. Likewise patent protection is only temporary, firms often can evade patent laws by making
slight changes in the design of products.
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Economies of scale and the importance of fixed cost

Strictly speaking, there are no fixed costs in the long run, because by definition all cost can be varied.
As a practical matter however, start-up or first-copy costs often loom large for the duration of a
product’s useful life. Goods whose production entails large start-up costs and low reproduction
costs, will be subject to economies of scale.

Fixed cost are spread out over more

and more units of output – average
total cost declines. At extremely high
levels of output, the ATC becomes
very close to marginal cost, M. Fixed
cost per unit becomes almost
insignificant.

Example:
Supposing fixed costs for Playstation and Nintendo is $10 million, but Playstation sells 1700 000 units
while the other sells only 500 000.

If video games of the 2 firms are essentially similar, the fact that Playstation can charge significantly
lower prices and still cover its costs should enable it to attract customers away from Nintendo. As
more and more market goes to Playstation, its cost advantage will become self-reinforcing. The fact
that a firm could no longer survive at such severe disadvantage explains why the video market is
served now by only a small number of firms.

.........

If such cost advantages are combined with demand-side network economies, whereby individual
user’s reservation price increases a firm’s share of the market grows, fairly modest swings in sales
towards a single producer can ignite process of positive feedback whereby the strong gets stronger,
and the weak lose out. Being the first firm to increase its market share becomes of critical
importance in these industries.
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Profit maximisation for firms that are price-setters

The calculation of marginal cost for perfect and imperfect competition is the same.

For the perfectly competitive firm, the marginal revenue is exactly equal to the market price of the
product. However, for the price-setter, who (presumably) must sell all output at a single-price,
marginal revenue is strictly less than market price . The reason being that price-taking firms can sell
as many unit as it wishes at the market price, while the price-setter can only sell an additional unit if
it cuts the price, and it must sell all its outputs at a single price.

The monopolist receives $12 per week by selling 2 units

per week at price $6 each, but could earn $15 per week
by selling 3 units per week at $5 each. The marginal
benefit of selling the third unit is $3.

2.5
3.5
4.5

Because a single-price monopolist must cut price

to sell an extra unit, not only for the extra unit
sold but also for all existing units, marginal
revenue, MR from the sale of the extra unit <
selling price.

MR curve is 2 times the gradient of the demand

curve, intercepting the price-axis at the same
location

Profit maximising output level.

Profit is maximised at the level of output for which MR
=MC.
The monopolist maximises profit by selling 8 units a week –
the output level at which MR=MC.
The profit-maximising price is $4 per unit, the price that
corresponds to the profit maximising quantity of the demand
curve.
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But being a monopolist does not guarantee economic profit.

Like perfect competition

firms, the monopolist’s
shut down condition is
when price < minimum
AVC. It should leave the
market as well if it makes
economic losses in the
long run.

Lower fixed cost  lower ATC

Why the invisible hand breaks down under monopoly.

Is the monopolist’s profit maximising output level efficient from society’s view?
Social efficiency is achieved at the output level at which the market demand curve (marginal benefit
to society, and not the monopolist) = monopolist’s marginal curve (cost to society as well).

The socially optimal output level = 12 units per week

(MB to society = MC)

The profit maximising firm produces only 8 units, resulting

in a deadweight loss.
Marginal benefit to society at this quantity is $4. Since the
MC of producing an additional unit at that output level
=$2, society would gain a net benefit of $2 if the
monopolist expands production by one unit. Since
economic surplus is not realised, the profit maximising
monopolist is socially inefficient.

Since the monopolist’s marginal revenue is ALWAYS less than price, the monopolist’s profit
maximising output level is ALWAYS socially inefficient.
Why then is monopolist not against the law?
Answer: the alternatives of monopoly often entails problems of their own.
 Eliminating patents (protection that creates monopoly) would discourage innovation. Patents give
firms a chance to recover the R&D costs. Without it new products would seldom reach the market.
 Suppose the market in question is natural monopoly – one that because of economies of scale is most
cheaply served by one firm. If instead the market is served by many firms (each with significantly
higher average cost of production), it is a mere switch from one inefficiency to another.

Conclusion: Any intervention by the government should be subjected to the cost benefit test.
 Monopoly and other forms of imperfect competition
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Key difference between monopoly and perfect competition

When monopolists earn an economic profit, more firms will NOT enter the market and expand
supply. The source of monopolist’s market power acts as a barrier for invisible hand to operate.
Consequently, a monopolist may continue earning economic profit in the long run.

Monopolistic competition
what happens to price and output when market power is not coupled with barriers to entry?

Illustration:
A dozen of fitness
centres. Each centre’s
service offering is
differentiated. As a
result, each faces a
downward-sloping
demand curve

Setting MR=MC, the club’s owner will set
the price of membership at P dollars and
enjoy an economic profit.
Note that P > marginal cost (similar to a
monopolist)
But while no competitor can enter a
monopoly market, the economic profit
will entice new fitness clubs in a
monopolistically competitive market.
As a result, the demand and marginal
revenue curves of an individual firm shifts
left, causing the club’s owners to lower
price and reduce the number of members
(P↓,Q↓)
The invisible hand works until clubs are
earning normal profit in the long run
(similar to perfect competition.

Monopolistic firms differ from perfect competition in that they ...

1. Operate in excess capacity
2. Charge prices that > marginal cost
(meaning there are people who value belonging to a fitness club more than it would cost to provide for them,
but who at current prices are not members)
3. Provide differentiated products
(suggesting that to the extent that people value variety, putting up with some inefficiency might be
worthwhile)
4. Constantly look out for ways to further differentiate and promote their products
(in order to gain and keep an edge over competitors - advertisement)
 Monopoly and other forms of imperfect competition
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Oligopoly markets
A description of what it really is ...
1. Small number of firms
2. Each firm faces a downward-sloping demand curve reflecting its market power
3. But since the market is large relative to the size of the market, the actions of each firm will affect the
profit of all other firms.
4. There is some barriers to entry

Using discounts to expand the market

The invisible hand is not completely idle in the monopolist market. Individual self interest still leads people to respond to
unexploited opportunities. If the monopolist could sell another unit it would gladly do so, if only there is some way to
maintain the price of existing units. From the monopolist’s point of view, the price reduction the firm must grant existing
buyers to expand output is a loss. But from the point of view of the buyers, each dollar of price reduction is a gain.

Price discrimination:
The practice of charging different prices for essentially the same good/service, where differences do not
simply reflect differences in costs in supplying different buyers.
Exp. Senior citizen discounts on movie tickets.

Requirements:
1. Firm has some price setting ability, as does imperfectly competitive markets
2. Able to separate buyers into groups (either directly or indirectly) on the basis of their willingness to pay
3. Able to make sure that buyers with high willingness to pay do not purchase at discount price
4. Must avoid giving the impression of unfair discrimination

Perfect discrimination:
A firm that charges each buyer exactly his/her reservation price for each unit purchased.
In practice, this can never occur because
1. Sellers won’t know each and every buyer’s precise reservation price.
2. They need some means of excluding high reservation price buyers from buying at a low price

Group pricing (imperfect price discrimination):

A form of price discrimination where different discounts were offered in different sub-markets, while
members of a particular sub-market all receive the same discount.

Hurdle method/versioning:
The practice by which the seller offers a discount to all buyers who overcome some obstacle.
Successful hurdle pricing involves setting hurdles that cause people to self-select into groups according to their
reservation prices. This implies that high and low reservation price buyers must be differentially sensitive to the
hurdle and that the discount for jumping the hurdle must not be too generous.

Perfect hurdle:
A hurdle that complete segregates buyers precisely according to their reservation prices, and in the
process imposes no cost on those who jump the hurdle.
In practice, this does not exist. Some buyers will always jump the hurdle even though their reservation prices are
high.

CONCLUSION: Price discrimination enhances both consumer and producer surplus. Efficiency loss from
single price monopoly occurs because to the monopolist, the benefit of expanding output is smaller than
the benefit to the society as a whole. The hurdle method of price discrimination reduces this loss by
giving the monopolist practical means to cutting prices for price-sensitive buyers only. Hurdles are not
perfect however, some degree of inefficiency will inevitably be lost.
 Monopoly and other forms of imperfect competition
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How price discrimination affects output and profit.

Illustration:
Rosie edits term papers
for undergraduate. Each
with reservation price
listed in first 2 columns.
Her opportunity cost of
time to edit each paper
is $29.

Rosie chooses to edit 3 papers, as her marginal revenue of taking on the 3rd paper > opportunity cost.
Rosie’s economic profit is $108 – ($29)(3) = $21
Rosie’s profit-maximising choice of 3 papers is not a socially efficient outcome. Ideally, Rosie should edit all
papers for which the benefit exceeds her opportunity cost (student A  F, 6 papers a week). To attract that
number, she must charge ≤ $30 per week, total revenue = (6)($30) = $180 per week. Economic profit only
$180 – (6)($29) = $6 per week. When Rosie profit maximises by serving the ‘high end’ of market, the ‘low
end’ buyers represent cash left on the table.

Perfect If Rosie can perfectly discriminate. She will edit papers for student AF,
discrimination and earn a total revenue of $40+$38+$36+$34+$32+$30 = $210 per week (also her accounting profit).
Economic profit: $210 - $174 = $36 per week. ($30 more than constrained to charge customers at the
same price.
When Rosie discriminates this way, her profit maximising level is the socially efficient one. With a perfectly
discriminating monopoly, there is no loss of efficiency (all buyers who are willing to pay a high enough
reservation price to cover marginal cost is served). The monopolist’s MR curve = Demand curve.
Note: while total economic surplus is maximised, consumer surplus is ZERO, as economic surplus =
producer surplus.

ut ↓ from perfect price discrimination.

Group
pricing

Now, Rosie knows that

students whose
reservation price ≥ $34
are science students,
while those whose
reservation price < $34
are commerce students.

Rosie should serve 3 science students (A, B, C), as MR > $29. Her profit maximising price in the science sub-market is
$36.
For the commerce sub-market, Rosie edits only for 1 student (E), charging $32.
Total revenue: (3)($36) + (1)($32) = $140 per week. Economic profit: $140 – (4)($29) = $24 per week.
Note: Rosie serves more students (4 per week), and her economic profit ↑ from no price discrimination,
but ↓ from perfect price discrimination.
 Monopoly and other forms of imperfect competition
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Perfect
hurdle

This time, Rosie can offer a

rebate coupon that gives
discount to any student who
takes the trouble to mail it
back to her. Suppose further,
that students with reservation
prices ≥36 never mail in the
rebate, while others with
reservation prices < 36 always
do.

Rosie’s profit maximising price in the list price sub-market is $36, the highest price she can charge in that market and
still sell her services to students A, B, C. For the discount price sub-market, MR exceeds $29 only for the first 2
students (D and E). So the profit maximising price in this sub-market is $32. A discount price of $32 means that
students who mail in the coupon will receive a rebate of $4 on the $36 list price.

Note, Rosie now is able to serve 5 students a week, compared to 3 without the offer. Rosie’s combined
revenue is (3)($36)+(2)($32)=$172. Her economic profit is $172 –(5)($ 29) = $27 per week. More than
when she posted a single price with no rebate, but less than practicing perfect price discrimination.

Regulating natural monopolies

While the structural reform of many public monopolies, combined with increasing privatisation and
corporatisation, have encouraged competition, the continued existence of natural monopoly power in
industries such as telecommunications, transport, etc leaves a residual need for some sort of government
regulation of natural monopoly power. Generally aiming to permit economies of scale to be realised , while at
the same time protecting consumers and ensuring adequate output.

How much profit will a natural monopoly earn when they are subject to a ‘price = MC’ rule?

Economic surplus is maximised in this market when Q1 units of gas are

consumed each day, and by law the monopolist has to charge P1. At this level,
ATC>P1. A natural monopoly (gas company) will never be able to recover the
fixed cost of installation (of pipes).

How then does the government encourage natural monopolies to stay in business and produce where P = MC?
1. Get the monopolist to agree to produce at the socially efficient level and compensate them for their loss
2. Charging a 2 part tariff. Buyers pay a fixed charge for access to service, and then charged for each unit consumed.