Monopoly and Competitive Markets: An Analysis of Profit, Entry, and Externalities, Study notes of Microeconomics

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ECON 2005 Chapter 12: To analyze monopoly behavior we assume that:  Entry to the market is blocked  Firms act to maximize profit  The pure monopolist buys inputs in competitive input markets  The monopolistic firm cannot price discriminate  The monopoly faces a known demand curve  In a monopoly market, there is no distinction between the firm and the industry because the firm is the industry  The market demand curve is the demand curve facing the firm and total quantity supplied in the market is what the firm decides to produce  Marginal Revenue (MR) is the additional revenue that a firm takes in when it increased output by 1 additional unit o MR (q) = R(q) – R(q-1) o Example: MR(1) = R(1) – R(0)  The profit maximizing level of output for all firms is the output level where MR = MC  In perfect competition P = MR  But at every level of out[ut except one unit, a monopolist’s marginal revenue is below price  In perfect competition MR=P, therefore the firm will produce up to the point where MC = P  In monopoly MR < P  The firm will produce up to the point where MC = MR Profit and Revenue  The profit-maximizing level of output (Qm) occurs where MR = MC  The revenue-maximizing level of output occurs where MR = 0 or where elasticity = 1  That is the midpoint of the demand curve  The monopoly sets the price at a point in the elastic range of the demand curve. Why?  Calculating Profit, Revenue, and Cost:  It is possible for a profit-maximizing monopolist to suffer short-run losses and go out of business in the long-run  A monopoly firm has no supply curve that is independent of the demand curve for its product  Relative to a competitive industry, a monopolist restricts output, charges higher prices, and earns positive profits  Collusion is the act of working with other producers in an effort to limit competition and increase joint profits  When firms collude, the outcome would be exactly the same as the outcome of a monopoly in the industry  Collusion is difficult, 1. The firms may disagree about what the cartel should do 2. Each member of the cartel has an incentive to cheat 3. When everyone cheats, everyone suffers 4. Members might discourage cheaters through punishment 5. Cheating eventually destroys most cartels  If an economic system is Pareto efficient, then no individual can be made better off without another being made worse off.  A monopoly sets a price that is higher than marginal cost. Page 1 of 8 ECON 2005  This monopoly could produce one more output with a cost equal to MC, and there is a consumer that is ready to pay a price that is higher than this marginal cost. This means that if the monopoly produces one more output, the monopoly is better off and the consumer is better off.  An economic system is Pareto efficient, if p=MC  P > MC leads to inefficiency  Monopoly leads to an inefficient mix of output  Price is above marginal cost, which means that the firm is under producing from society’s point of view  Rent-seeking behavior refers to actions taken to preserve positive profits  A rational owner would be willing to pay any amount less than the entire profit that monopoly makes to prevent those positive profits from being eliminated as a result of entry.  The idea of rent-seeking behavior introduces the notion of government failure, in which the government becomes the tool of the rent-seeker, and the allocation of resources is made even less efficient than before  The idea of government failure is at the center of public choice theory, which holds that public officials who set economic policies and regulate the players act in their own self-interest, just as firms do.  James McGill Buchanan Jr. is a Hokie economist most renowned for his work on Public Choice Theory, and who won the 1986 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. o His book The Calculus of Consent is considered to be one of the classic works that founded the discipline of public choice in economics and political science Price Discrimination  Charging different prices to different buyers is called price discrimination  A firm that charges the maximum amount that buyers are willing to pay for each unit is practicing perfect price discrimination.  There is profit but no consumer surplus  A trust is an arrangement in which shareholders of independent firms agree to give up their stock in exchange for trust certificates that entitle them to a share of the trust’s common profits. A group of trustees then operates the trust as a monopoly, controlling output and setting price. Antitrust Law  Particular businesses are illegal when they are anticompetitive.  Attempting to obtain a dominant market position through unreasonable business practices is illegal  Tying occurs when a firm X, having a dominant position in the market for product A, forces people or firms buying A to also buy product B  Foreclosure occurs when firm X, having a strong position in the market for product A, forces the firms who trade with firm X not to buy (or sell) A from other firms.  Tying and foreclosure contracts were made illegal by Clayton Act of 1914.  Predatory pricing is selling below cost (marginal cost)  Price discrimination is illegal if it is significantly anticompetitive. (Robinson- Patman Act of 1936)  Most agreements between business competitors regarding the price of a product are considered price fixing and are illegal in many countries.  Congress began to formulate antitrust legislation in 1887, when it created the Interstate Commerce Commission (ICC) to oversee and correct abuses in the railroad industry. Page 2 of 8 ECON 2005 In the Long Run  If profits are positive, o New firms enter a monopolistically competitive industry o The demand curves of existing firms shift to the left o In the long run, profits are eliminated o This occurs for a firm when its demand curve is just tangent to its average cost curve  If profits are negative, o Some firms exit the monopolistically competitive industry o The demand curves of existing firms shirt to the right o In the long run, profits are eliminated  In the long-run, economic profits are eliminated; thus, we might conclude that monopolistic competition is efficient, however: o Price is above marginal cost. More output could be produced at a resource cost below the value that consumers place on the product. o Average total cost is not minimized. The typical firm will not realize all the economics of scale available. Smaller and smaller market share results in excess capacity. Chapter 13: Oligopoly  An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated.  All kinds of oligopoly have one thing in common: o The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry  A group of firms that gets together and makes price and output decisions to maximize joint profits is called a cartel.  Collusion occurs when price- and quantity-fixing agreements are explicit.  Tacit collusion occurs when firms end up fixing price without a specific agreement, or when such agreements are implicit.  The Cournot model is a model of a two-firm industry (duopoly) in which firms make a series of output-adjustment decisions  This leads to a final level of output between the output that would prevail if the market were organized competitively and the output that would be set by a monopoly.  The kinked demand curve model is a model of oligopoly in which the demand curve facing each individual firm has a “kink” in it. o The kink follows from the assumption that competitive firms will follow if a single firm cuts price but will not follow if a single firm raises price.  An increase in price, which is not followed by competitors, results in a large decrease in the firm’s quantity demanded (demand is elastic)  A price decreases are followed by competitors so the firm does not gain as much quantity demanded (demand is inelastic)  Price leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy.  The price leadership model outcome: o The quantity demanded in the industry is split between the dominant firm and the group of smaller firms o This division of output is determined by the amount of market power of the dominant firm. o The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly. Page 5 of 8 ECON 2005  The practice of a large, powerful firm driving smaller firms out of the market by temporarily selling at an artificially low price is called predatory pricing o Such behavior is illegal in the United States Contestable Markets  A market is perfectly contestable if entry to it and exit from it are costless  In contestable markets, even large oligopolistic firms end up behaving like perfectly competitive firms.  Prices are pushed to long-run average cost by competition, and positive profits do not persist. Game Theory  John von Neumann  Game theory is a branch of mathematics that studies strategic situations where players (firms) choose different actions in an attempt to maximize their returns  Game theory has been used to help understand many phenomena – from the provision of local  Game theory helps us to analyze oligopolistic behavior as a complex series of strategic moves and reactive countermoves among rival firms  A game has: o Players o Payoffs o Strategies  Assumptions: o 2 players o Full information o 2 strategies for each player  Regardless of what B does, it pays for A to advertise. o This is the dominant strategy, or the strategy that is best no matter what the opposition does.  In game theory, when all players are playing their best strategy given what their competitors are doing, the result is called Nash Equilibrium  Nash – A Beautiful Mind – story about him The Role of Government  The department of justice uses Herfindahl-Hirschman Index (HHI) to determine whether or not a proposed merger will be challenged by the government HHI Antitrust Division Act (Department of Justice Merger Guidelines) 1,800 Concentration Challenge if index is raised by more than 50pts by merger 1,000 Moderate Concentration Challenge if index is raised by more than 100pts by the merger 0 Unconcentrated No challenge Page 6 of 8 ECON 2005 Chapter 14: Externalities and Environmental Economics  Negative Externalities occurs when a production or consumption harms someone other than the consumer or producer o Examples: pollution, noisy parties, reckless driving, smoking  Negative Externalities occurs when a production or consumption helps someone other than the consumer or producer o Examples: Inventions, Education, improving your house  Marginal social cost (MSC) is equal to the sum of the marginal costs of producing the product and the correctly measured marginal damage costs involved in the process of production  Marginal damage cost (MDC) is the additional harm done by increasing the level of output by one unit, or: o MSC = MC + MDC  A market is efficient if: o MSC = price  With an externality, marginal social cost (MSC) exceeds the price paid by consumers. (because p = MC) Internalizing Externalities 1. Government imposes taxes and subsidies o Tax (per unit of output) = MDC o Subsidy (per unit of output) = Marginal positive externality  Tax is a “win-win”  Subsidy is not 2. Private bargaining and negotiation  Coase theorem: o The government can assign basic rights at issue o There are no impediments to bargaining o Only a few people are involved o Bargaining will bring the contending parties to the right solution regardless of where rights are initially assigned. 3. Legal rules  An injunction is a court order forbidding the continuation of behavior that leads up to damages.  Liability rules are laws that require A to compensate B for damages imposed. 4. Direct regulation includes legislation that regulates activities that, for example, are likely to harm the environment. Public Goods  A good is nonexcludable if, once produced, no one can be excluded from enjoying its benefits. o Examples: a road, clean air  The private sector will not provide them  Examples of excludable goods: o Apple, car, house, insurance  Free-rider problem: Because people can enjoy the benefits of nonexcludable goods whether they pay for them or not, they are usually unwilling to pay for them. Page 7 of 8