Part Ii. Business Economics

PART II. BUSINESS ECONOMICS

Chapter 9. Market Power: Monopoly

Questions for consideration:

What do we mean by “market power”?

What is a monopoly? What kinds of monopolies are there?

Do pure monopolies actually exist in the “real world?

Why do we feel that monopolies are bad?

Many of you have played the board game, Monopoly. Monopoly is a game that involves buying and selling houses and properties, and charging rent to players who land on your holdings. Dice are used to introduce a substantial amount of uncertainty into the game. The goal of the game is to own as many properties on the board as you can, build more and more houses, charge higher and higher rents, accumulate as much money as possible, and in the end take all the money from all the other players. Whether you win or lost at the board game of Monopoly, you get the sense that the other players are trying to do you harm, to wipe you out. This game has given many of us a certain sense that monopoly is bad, that too much economic power in the hands of any one individual is bad for the rest of us. In this chapter we will probably confirm those suspicions for many of you. Many countries have taken the position that monopoly power is bad, and have instituted regulations strictly controlling possible monopoly situations. The contrast between this chapter and the last could not be greater. We move from many buyers and sellers in a perfectly competitive market to only one seller, a monopolist (and later, to one buyer). We referred to a firm in a perfectly competitive market structure as a “price taker”. By contrast, a monopolist is a “price maker” – the monopolist sets the price based on existing market conditions. However, in spite of the many differences between the two market structures, much of what we have already covered will see further application in this chapter.

What is a Monopoly?

A monopoly is a market structure in which there is only one producer (actually, one seller) of a product for which there are many buyers. A similar market structure on the “other side” of the market, in which there is only one buyer of a good or service, but many suppliers is a monopsony. Although we define monopoly as only one seller, we often refer to monopoly power as a situation in which one firm controls a substantial portion of the production or sale of a particular good or service, such that there is no formidable competition for the product. Thus the U.S. court system found that Microsoft Corporation exerted monopoly power with its Windows operating system and its Internet Explorer web browser, even though there were other operating systems and other web browsers available. The fear is that a firm with monopoly power may exert market power in its sale of the good, charging exceptionally high prices and earning excessive profits. Thus where monopoly power is found, governments often establish regulations to enforce limitations on prices and profits.

Although pure monopolies seldom exist (except those created as legal monopolies, as discussed below), monopoly power can often be found in smaller, more remote geographic regions. Thus a small retail store in a remote village may be the only outlet selling food, clothing or household goods in a wide area. Likewise, the fuel cost at gasoline stations in isolated areas is often much higher than the extra cost associated with delivering the gasoline to this remote location.

There are three types of monopolies. The first is a legal monopoly. A legal monopoly is an entity created by a government for which no competition is allowed. Utility companies in many countries and regions are legal monopolies. For example, the fixed cost of installing the plant, equipment, cables, and other structures for a cable television company is often quite large. The cable company expects to be able to cover those costs over time by having enough subscribers to the service to justify the initial expenditure. But if it must share the potential subscribers with a second cable company, it may never be able to generate enough revenue. So a cable company typically goes to the government in a particular community or region and asks for an exclusive right to provide cable television service to the area. Unfortunately for cable companies, however, satellite television has become quite the competitor for television services, and many cable companies are now battling for their economic lives. Other legal monopolies include copyright and patent protections, transit services, and the postal service (no other company is allowed to deliver first class mail, although many companies compete for overnight and package delivery.

A second type of monopoly is a resource monopoly, so named because one individual or firm is the sole owner or manager of a scarce resource. Although we often connect resource monopolies with minerals and other raw materials, in fact the more common occurrence of a resource monopoly is people with special skills, especially sports figures and entertainers. There is only one Tiger Woods, only one David Beckham, only one Jaroslav Jágr or Miro Šatan. Famous movie stars, such as Julia Roberts and Mel Gibson can “name their price” when negotiating with movie producers. Leading sports figures are able to “sell” their names as product endorsements in advertising campaigns. Although this type of “celebrity resource monopoly” does not directly affect many individuals or firms (except perhaps in slightly higher product prices to cover their endorsement costs), it is a form of resource monopoly and bears mention. The third type of monopoly is a natural monopoly, a situation where high fixed costs and relatively low operating expenses result in an average total cost curve that continues to decline over a large range of output. This cost combination makes it very difficult for competing firms to enter the market, unless they are willing to sustain huge losses in their start-up period. Natural monopoly will be examined and explained in greater detail later in the chapter.

The Theory of Monopoly

Our starting point in studying Monopoly is Figure 8.3 from the previous chapter. This figure had two panels. The market (or industry) supply and demand on the left side established the market price. Since the perfectly competitive firm accepted this price as “given”, the market price in the left panel passed to the right as a perfectly elastic (horizontal) demand curve. The interaction of this demand curve with the firm’s cost curves in the right panel then determined the optimal output and profit level for the firm. The marginal cost curve above the minimum point of average variable cost became the supply curve for the competitive firm, and the horizontal summation of all the firms’ demand curves became the industry supply curve.

In a monopoly market structure there is only one firm, so the market demand in the left panel is the monopolist’s demand. However, there is no market supply curve, since there are no firms to sum to get the industry supply. Also, there is no market price that is “given”, so there is no perfectly elastic demand curve in the right panel. If we eliminate the supply curve in the left panel and the demand curve in the right panel, we are left with the market demand in the left panel and the cost curves in the right panel. We bring those two panels together in Figure 9.1, where we see the downward-sloping market demand curve superimposed on the monopolist’s cost curves. That is, from a diagrammatic perspective, a monopoly differs from a perfectly competitive firm only in the demand curve, with the perfectly competitive firm facing a perfectly elastic demand curve and the monopolist facing a downward-sloping demand curve. This sloped demand curve, however, has serious consequences for the monopolist’s production decision.

Monopoly Profit Maximization

For the perfectly competitive firm, the horizontal demand curve resulted in the average revenue and the marginal revenue both being equal to the market price. For the monopolist, the average revenue and the marginal revenue are not the same. A downward-sloping demand curve has a divergent marginal revenue curve. In Table 9.1 we have generated a set of data for the demand curve, Qd = 10 - P . The first two columns, the price and quantity demanded constitute the demand curve. The third column is the total revenue (the price multiplied by the quantity demanded). The fourth column is the marginal revenue, calculated as the change in total revenue for one additional unit demanded. Note that as the price decreases by €1, from 9 to 8 to 7 and so on, the marginal revenue decreases by €2, from 9 to 7 to 5. That is, as the price is decreasing by €1, the marginal revenue is decreasing at twice the rate, by €2.

Table 9.1

This relationship is shown graphically in Figure 9.2, where the price and the marginal revenue are both plotted against the quantity demanded. The marginal revenue curve is plotted one-half unit to the left to reflect the fact that marginal revenue is calculated as the change in total revenue between any two units of output. There are three things worth noting in this figure. First, both the demand curve and the marginal revenue curve have the same vertical intercept, €10. Second, the marginal revenue curve is twice as steep as the demand curve. In fact, if we rewrite the demand curve as P = 10 - Q , the marginal revenue curve can be written as MR = 10 - 2Q. Thus for any positive price, the marginal revenue curve is located at one-half the quantity value of the demand curve. Third, the marginal revenue curve crosses the horizontal axis and moves into negative territory at five units, exactly one-half the horizontal intercept of the demand curve. That is, the marginal revenue curve intersects the horizontal axis at a point directly below the midpoint of demand curve, at the point where the demand curve goes from being elastic to being inelastic.

The reason for this particular demand - marginal revenue relationship is that we are assuming a “one-price” monopoly. The monopoly firm can set any price it wishes, but it must sell to all customers at that one price. So if the monopolist considers lowering the price by €1, it must lower the price on all buyers by €1, including all those who had been willing to pay the original price. In the table above, if the monopolist were to consider lowering the price from €8 to €7, s/he would lose €1 each on the two people who had been willing to pay €8, but would gain €7 on the one new customer, for a net gain (a positive marginal revenue) of €5. In considering the price movement from €5 to €4, the monopolist would lose €5 on those five customers who were already in the market, but would gain only €4 with the one new customer, a net loss (a negative marginal revenue) of €-1. The diagram in Figure 4.2 shows this outcome graphically. In lowering the price from €2 to €1, there is a loss of area [ab], but a smaller gain of area [c], again a negative marginal revenue outcome.

The demand, marginal revenue, and cost curves are brought together in Figure 9.3. The optimal production decision for a monopolist is the same as for a perfectly competitive firm, to produce the output where the marginal cost of producing one more unit of output is equal to the marginal revenue associated with the sale of that unit. In Figure 9.3 this intersection occurs at output Q*. If the monopoly firm produces Q*, it could price the product at P* and sell its entire production. At Q* the monopolist’s average cost is C*, so its profit per unit is the vertical distance between P* and C*. Thus its profit calculation is the rectangle formed by Q* multiplied by (P* - C*).

Natural Monopoly

A natural monopoly is formally defined as a situation in which the average total cost curve is still declining in the range of output where it strikes the market demand curve. As noted above, huge start-up costs and low variable expenses combine to generate this outcome. This situation is not uncommon. Once a cable television company or a fixed-line telephone company has installed the necessary mainline communication cables in a neighborhood, the cost of adding one more customer to the system is quite low. Likewise, a water company or electric utility has relatively high fixed costs and relatively low marginal costs. Music recordings on CD, movies on DVD, and books in print are other examples of products with high fixed costs and low marginal costs of production. In the range of output where its average total cost of production is declining, a firm is experiencing economies of scale. Thus a natural monopoly exhibits economies of scale over its entire range of output. When the average cost begins to rise, the firm begins to experience diseconomies of scale. Finally, a horizontal average cost curve reflects constant returns to scale.

A natural monopoly is depicted in Figure 9.4, where a relatively low horizontal marginal cost curve serves to bring down average total cost throughout the entire range of output. The optimal production decision is to produce there the marginal cost intersects the marginal revenue, at Q*. The product is priced at P*, the average total cost at Q* is C*, and the profit is calculated as Q* multiplied by (P* - C*). Note the difficulty of entry for a firm interested in competing in this market. A firm attempting to move in and capture one-third of this market would face average costs 2.5 times greater that the existing firm’s costs at Q*. And to capture one-third of a monopolist’s market is a daunting task. Most competing firms would be satisfied to garner ten percent of the market. The average cost at a ten-percent market share is more than four times greater than the existing firm’s cost at Q*. Hence a natural monopoly is a formidable competitor.

Evaluation of Monopoly

So how do we compare monopoly with a perfectly competitive market structure? Are our fears of price gouging and excessive profits justified? Suppose we paint a scenario of a medium-sized town with a large university population. Some students live at home, some live in the dormitory, and some rent apartments near the classroom buildings. We are interested only in the rental market. Suppose the market is initially competitive. Hundreds of flats are available for rent, and these flats are owned by many different individuals and firms, with no one individual or firm owning enough flats to exert substantial control over the rental price. The rental price in this situation would be the price at which the supply and demand curves intersect, at QC units in Figure 9.5 (approximately 350) with a rental price of PC.

Now an enterprising monopolist comes in and buys up all the available rental units. If we assume that the operating costs would not change substantially in this venture, the monopolist’s profit-maximizing behavior would be to shut down almost one-third of the rental units, reducing the number to Q* (around 250 units, where the marginal revenue equals the marginal cost) and raising the rental price to P*. So yes, monopolizing the competitive market would in fact reduce the competitive output and raise the price. This outcome also results in a large welfare loss. At output Q* students are willing and able to pay P*, while the marginal cost of production is much lower, at the marginal cost - marginal revenue intersection. There is a similar situation for all the remaining rental units between Q* and QC. Hence the total welfare loss is the “rounded triangle” formed by the demand and supply curves and the output Q*.

The welfare loss, the high prices, and the reduced output are all problems faced by society when a monopolist engages in profit-maximizing behavior. For these reasons, many countries have laws against monopoly behavior, regulations controlling price and profit levels, and antitrust laws restricting the consolidation of groups of firms into single units intent on market control. Where governments have created legal monopolies in the public interest, especially in the area of infrastructure and the provision of utilities, public utility commissions are set up to oversee the firm’s practices and to place restrictions on their prices and profits. Two of the more common methods of price regulation are marginal cost pricing and average cost pricing.

Price regulation by marginal cost pricing is a price ceiling set at the intersection of the market demand curve and the firm’s marginal cost curve, at price PC in Figure 9.5. The intent is to eliminate the welfare loss inherent in monopoly profit-maximizing behavior. As drawn in Figure 9.5, marginal cost pricing leaves the monopolist with positive profit and completely eliminates the welfare loss associated with the monopolist’s profit-maximizing behavior. There are two major problems associated with this approach, however. The first is the difficulty in finding agreement on the market demand curve and the firm’s marginal cost curve. Both the government and the firm have their analysts who work to estimate these functions. One could reasonably argue that the government’s analysts would be honest in their efforts. However, we can easily imagine that the monopolist’s analysts would do all they could to place the highest possible estimates on the market demand curve and on their costs, shifting their marginal cost curve to the left and the demand curve to the right, in both cases raising the price ceiling to their benefit. So there would need to be a good bit of discussion and negotiation between the parties before agreement could be reached on a fair price ceiling.