Section 1.5 Theory of the firm and market structures (HL only ...

Section 1.5 Theory of the firm and market structures (HL only ...

SECTION 1.5 THEORY OF THE FIRM AND MARKET STRUCTURES (HL ONLY) MONOPOLIES SECTION 1.5 THEORY OF THE FIRM AND MARKET STRUCTURES 1. Describe, using examples, the assumed characteristics of a monopoly: a single or dominant firm in the market; no close substitutes; significant barriers to entry. The four key characteristics of monopoly are: Single Supplier: First and foremost, a monopoly is a monopoly because it is the only seller in the market. The word monopoly actually translates as "one seller." As the only seller, a monopoly controls the supply-side of the market completely. If anyone wants to buy the good, they must buy from the monopoly. Unique Product: A monopoly achieves single-seller status because the

good supplied is unique. There are no close substitutes available for the good produced by a monopoly. Barriers to Entry: A monopoly often acquires and generally maintains single seller status due to restrictions on the entry of other firms into the market. Some of the key barriers to entry are: (1) government license or franchise, (2) resource ownership, (3) patents and copyrights, (4) high startup cost, and (5) decreasing average total cost. These restrictions might be imposed for efficiency reasons or simply for the benefit of the monopoly. Specialized Information: A monopoly often possesses information not available to others. This specialized information comes in the form of legallyestablished patents, copyrights, or trademarks. 2.Explain, using examples, barriers to entry, including economies of scale, branding and legal barriers. Monopolies achieve their single-seller status for four interrelated reasons: Economies of Scale: Many real world monopolies emerge due to economies of scale and decreasing average cost. If average cost

decreases over the entire range of demand, then a single seller can provide the good at lower per unit cost and more efficiently than multiple sellers. This often leads to what is termed a natural monopoly. The market might start with more than one seller, but it naturally ends up with a single seller that can best take advantage of decreasing average cost. Many public utilities (such as electricity distribution, natural gas distribution, garbage collection) have this natural monopoly inclination. Government Decree: The monopoly status of a firm can be established by the mandate of government. Government simply gives one and only one firm the legal authority to supply a particular good. Such single seller legal status is usually justified on economic grounds, such as an electric company that naturally tends 2.Explain, using examples, barriers to entry, including economies of scale, branding and legal barriers. Resource Ownership: A monopoly is likely to arise

if a firm has complete control over a key input or resource used in production. If the firm controls the input, then it controls the output. Monopolies have arisen over the years due to control over material resources (petroleum and bauxite ore), labor resources (talented entertainers and skilled athletes), or information resources (patents and copyrights). Branding: Certain firms may command monopoly power due to huge brand loyalty. The product is synonymous with the brand and it is very difficult for any other firm to exist. This is usually true for firms which innovate a new product line. 3. Explain that the average revenue curve for a monopolist is the market demand curve, which will be downward sloping. Single-seller status means that monopoly faces a negatively-sloped

demand curve. In fact, the demand curve facing the monopoly is the market demand curve for the product. The top curve in the exhibit is the demand curve (D) facing the monopoly. The lower curve is the marginal revenue curve (MR). 4. Explain, using a diagram, the relationship between demand, average revenue and marginal revenue in a monopoly. Because a monopoly is a price maker with extensive market, it faces a negativelysloped demand curve. To sell a larger quantity of output, it must lower the price. For

this reason, the marginal revenue generated from selling extra output is less than price. Because a monopoly has market control and faces a negatively-sloped factor demand curve it must charge a lower price to sell more. 5. Explain why a monopolist will never choose to operate on the inelastic portion of its average revenue curve. The relation between the price elasticity of demand and the marginal revenue curve indicates that a monopoly is only able to maximize profit by producing a quantity of output that falls in the elastic range of the demand curve. A monopoly cannot maximize profit in the inelastic range of demand because this involves negative marginal revenue,

and by virtue of the profit-maximizing equality between marginal revenue and marginal cost, it requires negative marginal cost, which is just not a realistic possibility. The connection between marginal revenue and elasticity works like this: If the demand is elastic, then marginal revenue is positive. If the demand is inelastic, then marginal revenue is negative. If demand is unit elastic, then marginal revenue is zero. 5. Explain why a monopolist will never choose to operate on the inelastic portion of its average revenue curve. 5. Explain why a monopolist will never choose to operate on the inelastic portion of its average revenue curve. The key question is how these elasticity alternatives relate to marginal revenue and total revenue.

When the average revenue (demand) curve is elastic, marginal revenue is positive and total revenue is increasing. When the average revenue (demand) curve is inelastic, marginal revenue is negative and total revenue is decreasing. When average revenue (demand) curve is unit elastic, marginal

revenue is zero and total revenue is not changing. The primary conclusion is that marginal 6. Explain, using a diagram, the short- and long-run equilibrium output and pricing decision of a profit maximizing (loss minimizing) monopolist, identifying the firms economic profit (abnormal profit) or losses. Even though monopoly is more likely to earn economic profit than a perfectly competitive firm, it is not guaranteed an economic profit. Should demand conditions change, monopoly might incur an economic loss or be forced to shut down in the short run. Comparable to any firm, a monopoly faces

three short-run production alternatives based on a comparison of price, average 6. Explain, using a diagram, the short- and long-run equilibrium output and pricing decision of a profit maximizing (loss minimizing) monopolist, identifying the firms economic profit (abnormal profit) or losses. P > ATC: Total revenue exceeds total cost and the monopolist receives a positive economic profit. In this case, the firm maximizes profit by producing the quantity of output that equates marginal revenue and marginal cost. More to the point, the price that the firm

charges at the profitmaximizing quantity is greater than average total cost. 6. Explain, using a diagram, the short- and long-run equilibrium output and pricing decision of a profit maximizing (loss minimizing) monopolist, identifying the firms economic profit (abnormal profit) or losses. ATC > P > AVC: Total revenue falls short of total cost, meaning the monopolist incurs an economic loss (or negative economic profit). In spite of the loss, because the price set at the profit-maximizing production level exceeds average variable cost, the firm can minimize loss by

producing the indicated quantity of output. The Monopolist receives enough revenue to cover ALL variable cost plus a portion of fixed 6. Explain, using a diagram, the short- and long-run equilibrium output and pricing decision of a profit maximizing (loss minimizing) monopolist, identifying the firms economic profit (abnormal profit) or losses. P < AVC: Total revenue also falls short of total cost, and the monopolist incurs an economic loss (or negative economic profit) that exceeds total fixed cost. In this case the firm minimizes losses by reducing the quantity of output to zero,

or producing no output in the short run. By producing a positive quantity, the monopolist does not receive enough revenue to cover variable cost, let alone any fixed cost. The economic loss 6. Explain, using a diagram, the short- and long-run equilibrium output and pricing decision of a profit maximizing (loss minimizing) monopolist, identifying the firms economic profit (abnormal profit) or losses. Market power means that monopoly does necessarily not have a supply relation between the quantity of output produced and the price. By way of comparison a perfectly competitive firm has a short-run supply curve based on the positively sloped marginal cost curve.

However, market power means that price is NOT equal to marginal revenue, and thus monopoly does NOT equate marginal cost and price. As such, a monopoly firm does not move along the marginal cost curve. A monopoly does not necessarily supply larger quantities at higher prices or smaller quantities at lower prices. 6. Explain, using a diagram, the short- and long-run equilibrium output and pricing decision of a profit maximizing (loss minimizing) monopolist, identifying the firms economic profit (abnormal profit) or losses. As a price maker that controls the market, a monopoly reacts to demand conditions, especially the price elasticity of demand, when setting the price and corresponding quantity produced. While it is not out of the question for a monopoly to supply a larger quantity at a higher price, it is also

conceivable that a monopoly produces a smaller quantity at a higher price or a larger quantity at a lower price. The bottom line is that monopoly does not necessarily have a short-run supply curve relation. Profit-Maximization Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC.

Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity. It finds this price from the D curve. Monopolist have the Market Power to set the price. Market Power market power In economics, market power is the ability of a firm to alter the market price of a good or service. A firm with market power can raise price without losing all customers to

competitors. When a firm has market power it faces a downward-sloping demand curve. The source of Market Power is the Downward slopping Demand curve that causes MR to be less than Profit-Maximization 1. The profitmaximizing Q is where MR = MC.

2. Find P from the demand curve at this Q. Costs and Revenue MC P D MR Q Quantity

Profit-maximizing output Profit Maximization for a Monopoly Costs and Revenue 2. . . . and then the demand curve shows the price consistent with this quantity. B Monopoly price 1. The intersection of the marginal-revenue curve and the marginal-cost

curve determines the profit-maximizing quantity . . . 3. Note that P > MR = MC in equilibrium. Average total cost A MC Demand Marginal cost Marginal revenue 0

Q QMAX Q Quantity 4. Recall that in perfect competition P = MR = MC in equilibrium. Can you pinpoint the perfect competition outcome in this 7. Examine the role of barriers to entry in permitting the firm to earn economic profit (abnormal profit). Barriers to entry are designed to block potential entrants from entering a market profitably. They seek to protect the monopoly power of existing (incumbent) firms in an industry and therefore maintain supernormal (monopoly) profits in the long run. Barriers to entry have

the effect of making a market less contestable. The economist Joseph Stigler defined an entry barrier as "A cost of producing (at some or every rate of output) which must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry" This emphasizes the asymmetry in costs between the incumbent firm (already inside the market) and the potential entrant. If the existing businesses have managed to exploit some of the economies of scale that are available to firms in a particular industry, they have developed a cost advantage over potential entrants. They might use this advantage to cut prices if and when new suppliers enter the market, moving away from short run profit maximization objectives - but designed to inflict losses on new firms and protect their market position in the long run. 8. Explain, using a diagram, the output and pricing decision of a revenue maximizing monopoly firm. If a monopoly decides to maximize revenue

rather than profit, then the price of each unit of quantity sold will decrease, but the number of units sold will increase. The firm will lose profit despite more sales because the price of every unit sold will decrease. 9. Compare and contrast, using a diagram, the equilibrium positions of a profit maximizing monopoly firm and a revenue maximizing monopoly firm. If we assume that a business faces a downward sloping

demand curve, the total revenue curve will rise at a decreasing rate until marginal revenue = zero. The shape of the total cost curve depends on what happens to marginal cost, if we assume that diminishing returns occurs in the short run, then the total cost will eventually start to rise at an increasing rate. The profit maximizing output occurs at the greatest vertical distance between the TR and TC 9. Compare and contrast, using a diagram, the equilibrium positions of a profit maximizing monopoly firm and a revenue maximizing monopoly firm.

An alternative way of showing the differences in price and output that come from varying the objectives of the firm is by using average and marginal revenue curves together with average and marginal cost curves. The profit maximizing output (where MC=MR) is Q1 which can be sold at a price P1, whereas a firm seeking to maximize revenue will produce at output Q2 9. Compare and contrast, using a diagram, the equilibrium positions of a

profit maximizing monopoly firm and a revenue maximizing monopoly firm. 10. Calculate from a set of data and/or diagrams the revenue maximizing level of output. HOW TO: Total revenue is maximized when MR=0. If you have a table you can calculate the change in TR at each level of output, and when this equals zero, the firm would be maximizing its total revenues. Anything beyond this level of output, MR will be negative and the firms revenues will begin to fall. 11. With reference to economies of scale, and using examples, explain the meaning of the term natural monopoly.

An industry is classified as natural monopoly when a single large firm can produce for the entire market at a lower average total cost than two or more smaller firms. This tends to be the case in industries where capital costs predominate, creating economies of scale that are large in relation to the size of the market, and hence high barriers to entry; examples include public utilities such as water services and electricity. It is very expensive to build transmission networks (water/ gas pipelines, electricity and telephone lines); therefore, it is unlikely that a potential competitor would be willing to make the capital investment needed to even enter the monopolist's market. 11. With reference to economies of scale, and using examples, explain the meaning of the term natural monopoly.

In the case of natural monopolies, trying to increase competition by encouraging new entrants into the market creates a potential loss of efficiency. The efficiency loss to society would exist if the new entrant had to duplicate all the fixed factors - that is, the infrastructure. It may be more efficient to allow only one firm to supply to the market because allowing competition would mean a wasteful duplication of resources. 11. With reference to economies of scale, and using examples, explain the meaning of the term natural monopoly. With natural monopolies, economies of scale are very significant so that minimum efficient scale is not reached until the firm has become very large in relation to the total size of the market.

Minimum efficient scale (MES) also known as Constant returns to scale, is the lowest level of output at which all scale economies are exploited. If MES is only achieved when output is relatively high, it is likely that few firms will be able to compete in the market. When MES can only be achieved when one firm has exploited the majority of economies of scale available, then no more firms can enter the market. Because there is the potential to exploit monopoly power, governments tend to nationalize or heavily regulate them. 11. With reference to economies of scale, and using examples, explain the meaning of the term natural monopoly. With a natural monopoly, average total costs (ATC) keep

falling because of continuous economies of scale. In this case, marginal cost (MC) is always below average total cost (ATC) over the whole 11. With reference to economies of scale, and using examples, explain the meaning of the term natural monopoly. An unregulated natural monopoly would attempt to maximize profits by producing the quantity of output where marginal revenue equals

marginal cost. MC = MR This is the option the profit maximizing firm would choose. Problem: Huge dead weight loss. $8 7PUN 6 - Deadweight Loss 5$ 4- MC

ATC 3POPT 2 10 0 10 20 30 40 50 60

QUN MR Quantity (thousands) Consumer Surplus DWL 70 80 90 QOPT

100 D =P 11. With reference to economies of scale, and using examples, explain the meaning of the term natural monopoly. A regulated pricing option in a Natural Monopoly model is to produce the quantity where price equals marginal cost (and thus where marginal social benefit equals marginal social cost). P = MC This is the best option for

the consumer because the price is low and there is no dead weight loss. $8 7PUN 6 MC 5$ 4- ATC 3P OPT 2 10 0 10 20 30 40

50 60 70 80 90 100 D =P QUN Q OPT MR Quantity (thousands) Consumer Surplus 11. With reference to economies of scale, and using examples, explain the meaning of the term natural monopoly. When price is set where P = MC, notice that the price Popt is below the

average cost at that quantity. If average cost is below the price, then the company would lose money. The only way for this company to survive is for the government to subsidize or allow price discrimination. $8 7PUN 6 MC 5$ Subsidy

4- ATC 3POPT 2 10 0 10 20 30 40

50 60 QUN MR Quantity (thousands) 70 80 90 100 D =P QOPT 11. With reference to economies of scale, and using examples, explain the meaning of the term natural monopoly. To avoid the need for a subsidy, natural monopolies are often regulated to earn zero economic profit (a normal

profit). This leads to problems: 1. The natural monopoly lacks incentives to control costs. 2. The regulators may not be able to obtain accurate information. However: - the price is lower than it would be if the government left the industry unregulated and the dead weight loss is smaller. - the government would not have to subsidize the company - the downfall is that there is no incentive for the company to keep cost low. AC will simply rise and costs will be pushed on to customers. 11. With reference to economies of scale, and using examples, explain the meaning of the term natural monopoly. Price = ATC

Consumer Surplus DWL Natural monopoly Un-Regulated Pricing: Monopoly price ~ P > (MC = MR) Regulated Pricing: Fair Return Price ~ P = ATC (Normal Profit) Socially Optimum Price ~ P = MC

(Allocative Efficiency) 12. Draw a diagram illustrating a natural monopoly. 12. Draw a diagram illustrating a natural monopoly. 12. Draw a diagram illustrating a natural monopoly. Un-regulated Monopoly Natural Monopoly If the government regulates a Natural monopoly and sets the price at the allocative efficient level of output (P =MC) the firm will incur a loss. In order for the firm to continue to produce at this level, the government would have to subsidize the firm for the difference

between ATC and (P=MC) at that output. The government could also allow the firm to price discriminate. Natural Monopoly Natural Monopoly Price Unregulate d Profit Maximizati on Highest Lowest Price

Output Regulated Normal Profit Lower than unregulat ed Regulated Lowest Allocative Price Efficiency Output Profit/ Deadwei

Loss ght Loss Consu mer Surplu s Econo mic Profit Highest Level Smalles t

Higher than Unregulat ed Norma l Profit Low Level Larger than Unregulat ed Highest Output

Loss None Largest 13. Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive inefficiency. Allocative efficiency occurs when consumers pay a market price that reflects the private marginal cost of production. The condition for allocative

efficiency for a firm is to produce an output where marginal (P = MC) 13. Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive inefficiency. 13. Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive inefficiency. Productive efficiency occurs when a firm is combining resources in such a way as to produce a given output at

the lowest possible average total cost. Costs will be minimized at the lowest point on a firm's short run average total cost curve. This also means that ATC = MC, because MC always cuts ATC at the lowest point on the ATC curve. MC = ATC 13. Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive inefficiency. 13. Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive

inefficiency. Ae = Allocative Efficiency Pe = Productivity Efficiency 13. Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and prod uctive inefficiency. Productive inefficiency Monopolies may be productively inefficient because there are no direct competitors a monopolist has no incentive to reduce average costs to a minimum, with the result that they are likely to be productively inefficient.

Allocative inefficiency Monopolies may also be allocative inefficient it is not necessary for the monopolist to set price equal to the marginal cost of supply. In competitive markets firms are forced to take their price from the industry itself, but a monopolist can set (make) their own price. Consumers cannot compare prices for a monopolist as there are no other close suppliers. This means that price can be set well above marginal cost. 13. Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productive inefficiency. Dynamic Efficiency Dynamic efficiency is concerned with the productive efficiency of a firm over a period of time. A firm which is dynamically efficient will be reducing its cost curves by implement new production processes. Dynamic Efficiency will enable a

reduction in both SRAC and LRAC. Therefore dynamic efficiency is concerned with the optimal rate of innovation and investment to improve production processes which help to reduce the long run average cost curves. For example, investment in new machines and technology may enable an increase in labor productivity. Dynamic efficiency may also involve implementing better working practices and better management of human capital. For example, better relationships with unions that help to introduce new working practices. Dynamic efficiency involves a trade off. To invest in better technology may involve higher costs in the short run. But, without this investment and innovation, the firm may be unable to improve over time. 13. Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productiv e inefficiency. Dynamic efficiency The concept of dynamic efficiency is commonly associated with the

Austrian Economist Joseph Schumpeter and means technological progressiveness and innovation. Neo-classical economic theory suggests that when existing firms in an industry, the incumbents, are highly protected by barriers to entry they will tend to be inefficient. Schumpeter argued that this is not necessarily the case; indeed, firms that are highly protected are more likely to undertake risky innovation, and generate dynamic efficiency. Firms can benefit from two types of innovation: Process innovation occurs when new production techniques are applied to an existing product. For example, this is common in the production of motor vehicles with firms constantly looking to develop new methods and production processes. Product innovation occurs when firms generate new or improved products. For example, this is common in many consumer product markets, including electronics and communications. 13. Explain, using diagrams, why the profit maximizing choices of a monopoly firm lead to allocative inefficiency (welfare loss) and productiv

e inefficiency. DEFINITION of 'RentSeeking' When a company, organization or individual uses their resources to obtain an economic gain from others without reciprocating any benefits back to society through wealth creation. An example of rent-seeking is when a company lobbies the government for loan subsidies, grants or tariff protection. These activities don't create any benefit for society, they Welfare Allocation of

Monopolies Because a monopoly sets its price above marginal cost, it places a wedge between the consumers willingness to pay and the producers cost. This wedge causes the quantity sold to fall short of the social optimum. The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax. The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit. The Inefficiency of Monopoly Price

P > MC; monopo ly Deadweight loss Marginal cost Monopoly price P = MC; perfect competition and optimum

Marginal revenue 0 Monopoly Efficient quantity quantity The monopolist Demand produces less than the socially efficient Quantity quantity Welfare Allocation of

Monopolies The following graph shows the areas of producer surplus and consumer surplus with a downward sloping demand curve. The equilibrium price and quantity is at the point were marginal cost (MC) is equal to the demand curve In a competitive market, Demand=AR=MR=P. The competitive output is the efficient output for the market. Welfare Allocation of Monopolies

The monopolist produces where marginal cost equals marginal revenue, but sets its price off the demand curve. The monopolist quantity is less than the competitive quantity and the monopolist price is greater than the competitive price. In a monopolistic market, consumer surplus is show by the yellow triangle, which is the area below the demand curve, above the monopolist price, and left of the monopolist quantity. The producer surplus is now the red area, which is the quantity above the marginal cost curve (also supply curve), below the monopolist price,

and left of the monopolist quantity. Welfare Allocation of Monopolies When a market does not produce at its efficient point there is a deadweight loss to society. The yellow triangle represents the lost consumer surplus and the red triangle represents the lost producer surplus when the market operates at the monopolistic output instead of the competitive output. The lost consumer surplus plus the lost producer surplus is the total deadweight loss to

society. Welfare Allocation of Monopolies The blue rectangle is the amount transferred to the monopolist from the consumers. By operating at the monopolist output, the monopolist captures some consumer surplus. Since the monopolist gains the blue rectangle, it is not part of the deadweight loss to society. Although the monopolist lost some producer surplus, the transfer to him (blue rectangle) is greater than

the loss, therefore, he ends up better off. 14. Evaluate reasons why, despite inefficiencies, a monopoly may be considered desirable for a variety of reasons, including the ability to finance research and development (R&D) from economic profits, the need to innovate to maintain economic profit (abnormal profit), and the possibility of economies of scale. Advantages of monopoly It may be able to achieve substantial economies of scale owing to larger plant size, centralized administration and the avoidance of unnecessary duplication; The monopolist can use part of its supernormal profits for Research & Development (R & D) and investment; The promise of abnormal profit, protected perhaps by patent may encourage the development of new monopoly industries producing new products;

There are those who maintain that a monopolist has gained his status by being the most efficient in the industry. Indeed Natural monopolies must also be mentioned here. 14. Evaluate reasons why, despite inefficiencies, a monopoly may be considered desirable for a variety of reasons, including the ability to finance research and development (R&D) from economic profits, the need to innovate to maintain economic profit (abnormal profit), and the possibility of economies of scale. Monopolies can provide certain benefits, including: Exploit economies of scale If the firm exploits its monopoly power and grow large it can also exploit economies of large scale. This means that it can produce at low cost and pass these savings on to the consumer. However, there would be little incentive to do this and the savings made might be used to increase profits or raise barriers to entry for future rivals.

Dynamic efficiency Monopolists can also be dynamically efficient - once protected from competition monopolies may undertake product or process innovation to derive higher profits, and in so doing become dynamically efficient. It can be argued that only firms with monopoly power will be in the position to be able to innovate effectively. Because of barriers to entry, a monopolist can protect its inventions and innovations from theft or copying. 14. Evaluate reasons why, despite inefficiencies, a monopoly may be considered desirable for a variety of reasons, including the ability to finance research and development (R&D) from economic profits, the need to innovate to maintain economic profit (abnormal profit), and the possibility of economies of scale. Avoidance of duplication of infrastructure The avoidance of wasteful duplication of scarce resources - if the monopolist is a natural monopoly it can be argued that competitive supply would be wasteful. Natural monopolies include gas, rail and electricity supply. A natural monopoly occurs when all or most of the available economies of scale have

been derived by one firm this prevents other firms from entering the market. But having more than one firm will mean a wasteful duplication of scarce resources. Revenue Monopolists can also generate export revenue for a national economy. A single firm may gain from economies of scale in its own domestic economy and develop a cost advantage which it can exploit and sell relatively cheaply abroad. 15. Evaluate the role of legislation and regulation in reducing monopoly power. The failure of markets to self regulate is at the heart of monopoly as a market failure. There are a number of ways in which the negative effects of monopoly power can be reduced: Regulation of firms who abuse their monopoly power. This could be a chieved in a number of ways, including: Price controls Setting price controls. For example, the current UK competition regulator, the

Office of Fair Trading (OFT), has developed a system of price capping for the previously state owned natural monopolies like gas and water. This price capping involves tying prices to just below the current general inflation rate. The formula, RPI X, is used, where the RPI (the Retail Price Index) is the chosen index of inflation and X is a level of price reduction agreed between the regulator and the firm, based on expected efficiency gains. Prohibiting mergers Prohibiting mergers in the UK the Competition Commission can prohibit mergers between firms that create a combined market share of 25% or more if it believes that the merger would be against the public interest. In making their judgment, the public interest takes into account the effect of the merger on jobs, prices and the level of competition. 15. Evaluate the role of legislation and regulation in reducing monopoly power. Breaking up the monopoly Breaking up the monopoly into several smaller firms. For example regulators in the EU are currently investigating potential abuse of market dominance by

Microsoft, which is under threat of being broken up into two companies one for its operating systems and the other for software. Nationalization Bringing the monopoly under public control which is referred to as nationalization. The ultimate remedy for an abusive monopoly is for the State to take a controlling interest in the firm by acquiring over 50% of its shares, or to take it over completely. The monopolist can still be run along commercial lines, but be made to operate as though the market were competitive. De-regulation In those cases where a monopolist is already State controlled, such as the Post Office, it may be necessary to engage in deregulation to enable it to become more efficient. Deregulation could be used to bring down barriers to entry and open up a previously state controlled industry to competition, as has happened with the British Telecom and British Rail monopolies. This may help encourage new entrants into a market. 16. Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency,

price and output, research and development (R&D) and economies of scale. Monopoly is a market structure with complete market control. As the only seller in the market, a monopoly controls the supply-side of the market. Perfect competition, in contrast, is a market structure in which each firm has absolutely no market control. No firm in perfect competition can influence the market price in anyway. The best way to compare monopoly and perfect competition is the four characteristics of perfect competition: (1) large number of relatively small firms, (2) identical product, (3) freedom of entry and exit, and (4) perfect knowledge. 16. Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency, price and output, research and development (R&D) and economies of scale.

Perfect Competition Monopoly large number of relatively small firms Single Supplier identical product Unique Product freedom of entry and exit Barriers to Entry perfect knowledge

Specialized Information 16. Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency, price and output, research and development (R&D) and economies of scale. Number of Firms: Perfect competition is an industry comprised of a large number of small firms, each of which is a price taker with no market control. Monopoly is an industry comprised of a single firm, which is a price maker with total market control. Available Substitutes: Every firm in a perfectly competitive industry produces exactly the same

product as every other firm. An infinite number of perfect substitutes are available. A monopoly firm produces a unique product that has no close substitutes and is unlike any other product. 16. Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency, price and output, research and development (R&D) and economies of scale. Barriers to entry: Perfectly competitive firms have complete freedom to enter the industry or exit the industry. There are no barriers. A monopoly firm often achieves monopoly status because the entry of potential

competitors is prevented. No other firm can enter the market. Resource Mobility: Perfectly competitive firm's have perfect resource mobility where as a monopoly firm has exclusive access to key resources. Example, rare earth in China or DeBeers diamonds. Information: Each firm in a perfectly competitive industry possesses the same information about prices and production techniques as every other firm. A monopoly firm, in contrast, often has information unknown to others. 16. Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency, price and output, research and development (R&D) and economies of scale. The consequence of these differences include: First, the demand curve for a perfectly competitive firm is perfectly elastic and the

demand curve for a monopoly firm is THE market demand, which is negatively-sloped according to the law of demand. A perfectly competitive firm is thus a price taker and a monopoly is a price maker. Second, the monopoly firm charges a higher price and produces less output than would be achieved with a perfectly competitive market. In particular, the monopoly price is not equal to marginal cost, which means a monopoly does not efficiently allocate resources. 16. Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency, price and output, research and development (R&D) and economies of scale.

Third, while an economic profit is NOT guaranteed for any firm, a monopoly is more likely to receive economic profit than a perfectly competitive firm. In fact, a perfectly competitive firm IS guaranteed to earn nothing but a normal profit in the long run. The same cannot be said for monopoly. Fourth, the positively-sloped marginal cost curve for each perfectly competitive firm is its supply curve. This ensures that the supply curve for a perfectly competitive market is also positively sloped. The marginal cost curve for a monopoly is NOT, repeat NOT, the firm's supply curve. There is NO positively-sloped supply curve for a market 16. Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency, price and output, research and development (R&D) and economies of scale.

16. Draw diagrams and use them to compare and contrast a monopoly market with a perfectly competitive market, with reference to factors including efficiency, price and output, research and development (R&D) and economies of scale. Monopoly vs. Competition: Demand Curves In a competitive market, the market demand curve slopes downward. but the demand curve for any individual firms product is horizontal at the market price. The firm can increase Q without lowering P, so MR = P for the

competitive firm. A competitive firms demand curve P D Q Monopoly vs. Competition: Demand Curves A monopolist is the only seller, so it faces the market demand curve. P

A monopolists demand curve To sell a larger Q, the firm must reduce P. Thus, MR P. D Q Perfect Competition vs Monopoly Welfare Monopoly Vs Perfect Competition

Monopoly Vs Perfect Competition Section 1.5D: Price discrimination 1.5D:23. Describe price discrimination as the practice of charging different prices to different consumer groups for the same product, where the price difference is not justified by differences in cost. Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider. Price discrimination can only be a feature of monopolistic and oligopolistic markets, where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the

consumer buying at the higher price but with a tiny discount. As long as a firm faces a downward-sloping demand curve and thus has some degree of monopoly power, it may be able to engage in price discrimination. 1.5D:24. Explain that price discrimination may only take place if all of the following conditions exist: the firm must possess some degree of market power; there must be groups of consumers with differing price elasticitys of demand for the product; the firm must be able to separate groups to ensure that no resale of the product occurs. Conditions necessary for Price Discrimination 1. The firm must have some degree of monopoly powerit must be a price setter. 2. The market must be capable of being fairly easily segmentedseparated so that customers with different elasticity's of demand can be identified and treated differently.

3. The various market segments must be isolated in some way from one another to prevent customers who are offered a lower price from selling to customers who are charged a higher price. 1.5D:24. Explain that price discrimination may only take place if all of the following conditions exist: the firm must possess some degree of market power; there must be groups of consumers with differing price elasticitys of demand for the product; the firm must be able to separate groups to ensure that no resale of the product occurs. To be a successful price discriminator a seller must satisfy three things: Market Control: First and foremost, a seller must be able to control the price. Monopoly is quite adept at price discrimination because it is a price maker, it can set the price of the good. Oligopoly and monopolistic competition can undertake price discrimination to the extent that they are able to control the price. Perfect competition, with no market control, does not do well in the price discrimination arena. Different Buyers: The second condition is that a seller must be able to identify different groups of buyers, and each group must have a different price elasticity of demand. The different price elasticity means that buyers are willing and able to pay

different prices for the same good. If buyers have the same elasticity and are willing to pay the same price, then price discrimination is pointless. The price charged to each group is the same in this case. Segmented Buyers: Lastly, price discrimination requires that each group of buyers be segmented and sealed into distinct markets. Segmentation means that the buyers in one market cannot resell the good to the buyers in another market. Price discriminate is not effective if trade among groups is possible. Those buyers charged a higher price cannot purchase the good from those paying the lower price instead of from the seller. 1.5D:25. Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand. First-degree discrimination, alternatively known as perfect price

discrimination, occurs when a firm charges a different price for every unit consumed. The firm is able to charge the maximum possible price for each unit which enables the firm to capture all available consumer surplus for itself. In practice, first-degree discrimination is rare. 1.5D:25. Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand. Monopoly Profits under perfect price discrimination

1.5D:25. Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand. Monopoly Profits under perfect price discrimination 1.5D:25. Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand. 1.5D:25. Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand. Second-degree price discrimination means charging a different price

for different quantities, such as quantity discounts for bulk purchases. Suppliers do not know who is going to fall into which buying group (purchasing a lot of a little of a product) force the buyers to self select into the pricing arrangement that is best for them. 1.5D:25. Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand. Third-degree price discrimination means charging a different price to different consumer groups.

For example, airline travelers can be subdivided into commuter and casual travelers, and cinema goers can be subdivide into adults and children. Splitting the market into peak and off peak use is very common and occurs with gas, electricity, and telephone supply, as well as gym membership and parking charges. Third-degree discrimination is the commonest type. Discrimination is only worth undertaking if the profit from separating the markets is greater than from keeping the markets combined, and this will depend upon the elasticity's of demand in the sub-markets. Consumers in the inelastic sub-market will be 1.5D:25. Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand. Diagram for price discrimination If we assume marginal cost (MC) is constant across all markets, whether

or not the market is divided, it will equal average total cost (ATC). Profit maximization will occur at the price and output where MC = MR. If the market can be separated, the price and output in the inelastic sub-market will be P and Q and P1 and Q1 in the elastic sub-market. 1.5D:25. Draw a diagram to illustrate how a firm maximizes profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand. Price Discrimination An Evaluation Advantages to the Firm Enables producers to gain a higher level of revenue Enables producers to produce more and gain from economies of scale. Profits gained in inelastic market segment can be used to drive away competition in more elastic market segment Advantages to the Consumers

Poorer consumers may be able to consume products. Allows people to purchase a product at a lower price than they would have had to pay if the producer had not been able to secure higher prices from others. Increased output provides opportunity for more consumers to use the product. Economies of scale: If total output increases significantly, this may result in lower average cost and thus lower prices for consumers. Price Discrimination An Evaluation Disadvantages of Price Discrimination Any consumer surplus that existed before the price discrimination will be lost. Some consumers will pay more than the price that would have been charged in a single, non discriminated market. If a firm succeeds in driving rival firms out

from the market, it can use its increased monopoly power to increase prices and exploit the consumers. With the aid of at least one diagram, explain one way a consumer might gain from the behavior of a monopolist and one way a consumer might lose from the behavior of a monopolist. M10/3/ECONO/HP2/ENG/TZ2/XX/M+

a definition of a monopolist graphical representation of a monopoly market structure. Gains to the consumer: economies of scale innovation use of a diagram to illustrate how the above can lead to gains for the consumer. Losses to the consumer: compared to a competitive industry, it will charge consumers a higher price compared to a competitive industry, it will have a lower level of output compared to a competitive industry, it will result in lower consumer surplus it will give rise to productive and allocative inefficiency

use of a diagram to illustrate consumer losses, or productive and allocative inefficiency. Using appropriate diagrams, discuss whether monopoly is more efficient or less efficient than perfect competition. M06/3/ECONO/HP2/ENG/TZ0/XX/M

definitions of efficiency: allocative and productive efficiency the firm in perfect competition: in long-run equilibrium the firm is allocative and productively efficient correctly drawn and labelled diagram explanation of perfect competition the firm in monopoly: in long-run equilibrium the firm is neither allocative nor productively efficient correctly drawn and labelled diagram explanation of monopoly dynamic efficiency: increased profits of monopoly used for investment leading to greater output and lower prices than in perfect competition (economies of scale) correctly drawn and labelled diagram Evaluate the view that greater economic efficiency will always

be achieved in perfect competition as compared to monopoly. M09/3/ECONO/HP1/ENG/TZ0/XX/M+ definitions of perfect competition and monopoly explanation of economic efficiency in terms of allocative and productive efficiency (and possibly dynamic efficiency) explanation of achievement of allocative efficiency (P = MC) in perfect competition diagram illustrating the above explanation of achievement of productive efficiency (AC = MC), operating at the minimum AC diagram illustrating the above explanation of allocative inefficiency (P greater than MC) in monopoly diagram illustrating the above explanation of productive inefficiency in monopoly (not operating with minimum AC) diagram illustrating the above possibility of economies of scale in monopoly and therefore lower costs and prices possibility of long-run dynamic efficiency in monopoly abnormal profits in monopoly provide funds for research and development

importance of externalities for efficiency reference to the case of natural monopoly. Evaluate the view that monopoly is an undesirable type of market structure. M07/3/ECONO/HP1/ENG/TZ0/XX/M+

definition of monopoly at least one appropriate diagram comparisons between monopoly and perfect competition, e.g. price usually higher and output lower allocative and productive inefficiency failure by monopolist to produce at the socially optimum level of output lack of choice for consumers lack of innovation and higher unit costs because of absence of competition possibility of lower unit costs and prices owing to economies of scale long run dynamic efficiency in monopoly benefits of natural monopoly benefits to some consumers of monopolistic price discrimination

potential competition and contestable markets

an explanation of natural monopoly in terms of economies of scale and/or a market sufficient to support only one firm an explanation of perfect competition in terms of a large number of small firms, freedom of entry, perfect knowledge, homogenous product natural monopoly analyzed in terms of economies of scale/falling long-run average costs over the relevant range of output perfect competition analyzed in terms of efficiency natural monopoly analyzed in terms of efficiency possibility of greater R&D expenditure under monopoly leading to lower costs and possible long-run benefit to consumers possibility of anti-competitive behavior by monopolists against the interests of consumers reference to cases where a natural monopoly can be broken by privatization with the introduction of competition in the market (e.g. privatization of public utilities such as telephones, electricity, gas supply etc.) local examples of natural monopolies, e.g. electricity distribution

Monopoly mind-map Lump Sum VS Per Unit Lump Sum Tax / Subsidy Treat as a Fixed Cost Cost curves that move: AFC & ATC Output and Price is NOT effected Per Unit Tax / Subsidy Treat as a Variable Cost Cost curves that move: AVC, ATC & MC Output and Price is effected

Lump Sum Tax / Subsidy Increase Lump sum tax ~ AFC, ATC shift up Decrease in Lump sum tax ~ AFC, ATC shift down Increase Lump sum subsidy ~ AFC, ATC shift down Decrease in Lump sum subsidy ~ AFC,

ATC shift up Lump sum tax / subsidy do NOT change AVC, MC Per Unit Tax / Subsidy Increase Per Unit tax ~ AVC, ATC, MC shift up Decrease in Per Unit tax ~ AVC, ATC, MC shift down Increase Per Unit subsidy ~ AVC, ATC,

MC shift down Decrease in Per Unit subsidy ~ AVC, ATC, MC shift up CONCLUSION: The Prevalence of Monopoly In the real world, pure monopoly is rare. Yet, many firms have market power, due to selling a unique variety of a product

having a large market share and few significant competitors In many such cases, most of the results from this chapter apply, including markup of price over marginal cost deadweight loss CONCLUSION Profit Maximizing Price and Output? CONCLUSION

Social Optimal Level of Price & Output? Allocative efficient level of Price & Output? CONCLUSION Zero Economic Profit, Fair Return, or Normal Profit, Zero opportunity cost; Price & Output? CONCLUSION Revenue Maximizing Price & Output? CONCLUSION The area of Consumer Surplus, Producer Surplus for a Monopoly or a

Competitive firm? CONCLUSION The area of Deadweight Loss?

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