8. MONOPOLY: ONE PRODUCER AND MANY
CUSTOMERS.
Rama V. Ramachandran
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Summary.
Historically governments have used monopolies to raise revenues and they pushed
the prices so high that monopolies are identified with high prices and excess profits.
A monopolist, supplying the whole market, is facing the market demand curve.
Higher price leads to lower sales. Profits are maximized at the output at which
marginal cost equals marginal revenue.
Marginal revenue is less than marginal cost, price is greater than the constant
marginal cost which is also average variable cost. The difference will depend on the
price elasticity of demand. The firm may still suffer a loss if it has a high level of
fixed cost.
The cost of monopolies is the deadweight loss, the reduction in consumer’s surplus
in excess of increase in the profits of the firm.
Governments have confirmed monopolies on innovators on the ground that provide
needed incentive. It also instituted competition policies to increase competition in
commodities and financial markets.
8. 1.MONOPOLY: PAST MONOPOLIES AND
OPPOSITION TO MONOPOLIES -1.
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In the market with one producer and many consumers, the concern is that the
producer is able to earn excessive profit by charging consumers a high price.
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The ability to charge higher price was used by states to raise revenue and to
promote political goals like geographical exploration and occupation.
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English East India Company, established in 1600 not only sought to monopolize
trade from India but gradually occupied much of the territory before the Mutiny
of 1857 when the territory reverted to the British Crown. The Dutch East India
had a dominant position in trade from what is now Indonesia but its political
control was less secure than that of East India Company. British Hudson Bay
Company had a monopoly of trade with Canadian Indians and was till Canada
became a Dominion in 19th century, It was the largest landowner in Canada. Its
monopoly was abolished in 1870 relinquished the land it had under Royal
Charter.
8.2. SALT MONOPOLIES.
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As daily consumption of salt is a biological necessity and salting was the only
way to preserve fish and meat before the advent of refrigeration, governments
from France to China realized that they can monopolize the production and
distribution of salt and use it to raise revenue for the state by increasing its price
well above the cost of production.
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The price of salt in France in 1630 was 14 times the cost of production while in
1710 it was 140 times the cost. As states developed new sources of revenue they
stopped depending on salt though the monopolies lasted in France and Japan
well into the twentieth century.
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The actions of certain monopolies, particularly those with state mandate, led to
the view, expressed even by Adam Smith, that monopolies charge the highest
price possible. This set of slide examine price and profits of a firm.
8.3. MONOPOLIST CAN CHOOSE PRICE OR
SALES BUT NOT BOTH.
We are the customers. Price
We will decide how
High
much to buy.
price
Demand
curve
I am the monopolist.
I will decide the price
of my product.
Low
price
Quantity
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Since monopolist supplies the whole market, the demand for his product is
determined by the market demand curve.
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The quantity consumes purchase will decline with price. What the
monopolist can choose is a point on it that determines the price-quantity
combination. He cannot choose price and quantity independently.
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Since his profits depend on both price and quantity, he has to choose the
point on demand curve that maximizes it.
8.4. PRICE, SALES AND MARGINAL
REVENUE OF A MONOPOLIST.
$
Sales revenue = $8
$4.00
$4
$ 3.50
Sales revenue = $10.50
Marginal revenue = $2.50
Sales revenue = $12
Marginal revenue = $1.50
$3.50
$3.00
$2.50
Demand curve
$1.50
$3
Panel A
Marginal revenue
23 4
Panel B
Quantity
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To increase sales, the monopolist has to reduce price. If the price is $4, he
sells two bottles. To increases sales, he has to reduce the price to $3.50.
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The sales revenue increased by $3.50 from the third bottle but the reduction
in price reduced the sales revenue from the other two bottles by $1. Marginal
revenue, increase in sales revenue for unit increase in price, is $2.50.
Whenever a producer faces a downward sloping demand curve, his marginal
revenue will be less than the price and, at each output, is given by a point
below the demand curve.
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8.5 PROFIT MAXIMIZING OUTPUT AND
PRICE -1.
$
$
Marginal revenue
$
Demand
curve
Marginal$C
cost
$R
Monopoly
price
$R
$$
$C
$R
Marginal
cost
$ R
$C
$E $E
$ $C
$C
$
$
Output
Profit
maximizing
output
Panel A
Marginal revenue
Profit
Output
maximizing
output
Panel B
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In Panel A, the marginal revenue, the height of green boxes decreases as
output increases.
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As long as marginal revenue is greater than marginal cost, a unit increase in
output provides the monopolist an incremental revenue that exceeds his
incremental cost. He has incentive to increase output.
When the output at which the two are equal is reached, the monopolist will
not increase output any further. It is his profit maximizing output. The
condition for profit maximization is that marginal revenue equals marginal
cost.
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8.6. PROFIT MAXIMIZING OUTPUT AND
PRICE -2.
$
$
Marginal revenue
$
Demand
curve
Marginal$C
cost
$R
Monopoly
price
$R
$$
$C
$R
$ $C
$C
$C
$
$E $E
Output
Profit
maximizing
output
Panel A
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Marginal
cost
$ R
$
Marginal revenue
Profit
Output
maximizing
output
Panel B
The monopolist chooses the output at which marginal cost equals marginal
revenue. Since marginal revenue is less than the price, the price at which
monopolist sells his output will be greater than marginal cost (Panel B).
How high will be the price over marginal cost? Consider the firm producing an
output at which price equals marginal cost (the blue dot). Output is greater than
profit maximizing output. He has to move up the demand curve, increasing
price to reduce output to profit maximizing level.
How much he has to increase the price depends on how sensitive the quantities
consumers purchase are to price increases.
8.7. PRICE ELASTICITY – A MEASURE OF PRICE
SENSITIVENESS -1.
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Price elasticity of demand, as defined
in the diagram, is the measure of
consumers’ price sensitivity.
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Since price and quantity changes in
opposite directions, the ratio of the
two terms in bracket is negative (in
diagram, quantity is increasing while
price is decreasing).
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The ratio is multiplied by a negative
sign to make it positive number.
8.8. PRICE ELASTICITY, MARGINAL
REVENUE AND PROFIT MAXIMIZATION.
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At the output at which price equals
marginal cost, marginal revenue is less
than marginal cost. By reducing output,
firm increases its gross profit (since
administrative and finance cost is not
changing, it increases all measures of
profit).
The increase in price needed to reduce
output to profit maximization depends
on the price elasticity.
Relation between price, marginal cost
and price elasticity is given by the
equation on the right, known as Lerner’s
index. Higher is elasticity, the less is the
excess of price over marginal cost.
$
Demand
curve
Monopoly
price
Marginal
cost
Marginal revenue
Profit
Output
maximizing
output
Price - marginal cost
price
=
1
Elasticity
8.9 DOES PRICE EXCEEDING MARGINAL
COST IMPLY EXCESS PROFIT?
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Under the assumptions (marginal cost a constant for all levels of output), the
difference between price and marginal cost is the gross profit per unit of output. The
difference times output equals the total gross profit.
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The firm has to pay administrative and finance cost from the gross profits. It is
possible that the gross profit is not enough to meet these costs.
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Eurotunnel has a monopoly on rail link between France and England. Yet it was
near bankruptcy more than once since it started operations in 1994. It had, like all
megaprojects, cost overrun but it was hurt most by shortfall in projected revenue.
Rail traffic on opening was half of what was projected.
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Ferries that linked Continent with Europe cut fares. Businesses who had invested in
moving goods through ferries and passengers who liked privileges like duty free
liquor on board were not willing to shift to rail. Substitution limits monopoly power.
8.10. BENEFITTING FROM TRADE:
CONSUMER SURPLUS -1.
Price
Price
Consumer
surplus
6
5
4
Price
Cost to
consumer
0 1
2
Panel A
Quantity
Quantity
pruchased
Demand
curve
Quantity
Panel B
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Trading, the exchange between a producer and a consumer, in a free market
must benefit both. Otherwise one or the other party will withdraw. The benefit
to the producer is profit. What is the benefit to consumer?
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A consumer values the first unit she purchases slightly less than $6. If the price
is $6, she will not buy any unit (Panel A). If the price falls to $5, she will buy
one unit but, since she values it close to $6, her gains from being able to buy it
at $5 can be measured by the difference between her valuation and the price she
pays, $1.
8.11.CONSUMER SURPLUS -2
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She values the second unit less at just below $5. If the price falls to $4, she will
buy the second unit and her consumer surplus from that unit is $1. But the unit
she was valuing slightly less than $6, is also purchased at $4 and her surplus
from it is now $2. The total surplus is $3. Consumer surplus increases with
price reduction both from increase from units purchased before and from new
units. In case of continuous variation, the blue triangle-like are under the
demand curve and price line, is the measure of consumer surplus.
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The higher price (relative to marginal cost) that the monopolist charges has two
effects. It increases his profit and it reduces, reversing the earlier arguments, the
consumer surplus. Will the sum of the two increase or decrease?
8.12. DEADWEIGHT LOSS -1.
Consumer surplus
Gross profit
Deadweight loss
Price
Price
Consumer
surplus
Monopoly
price
Price
Cost to
consumer
Quantity
pruchased
Demand
curve
Quantity
Panel A.
Marginal
cost
Cost
of
production
Sales at
monopoly
price
Demand
curve
Sales if
Quantity
price equals
marginal cost
Panel B
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When price was equal to marginal cost, consumer surplus was equal to the blue
triangle in Panel A. When the price increased to monopoly price, consumer
surplus decreased to the blue triangle in Panel B. The difference is the area of
the grey triangle and the yellow rectangle.
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When the price was equal to marginal cost, the firm had no gross profit as its
cost of production was equal to his sales revenue. At monopoly price, his price
is higher than marginal cost and he has a profit equal to the yellow rectangle.
8.13. DEADWEIGHT LOSS -2
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Pareto criterion classifies only changes that improves one without hurting another or
vice versa.
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Here the monopolist increased profits while consumers have lower surplus. Pareto
criterion cannot judge such a change.
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But the increase in profit (yellow rectangle) is less than the reduction of consumer
surplus (yellow rectangle and grey triangle) The net loss, loss to consumer not made
by gain by producer, is the grey triangle. It is the deadweight loss of monopoly and is
a measure of welfare loss from monopoly.
8.14. JUSTIFICATION OF PATENTS AND
COPYRIGHT -1.
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An innovator has to incur an upfront cost to develop the product or process ( a
writer incurs cost as she prepares the manuscript).
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If the product once developed can be produced by many firms, the competition
will drive the price down to earn a competitive return on investment on
production. The innovator having no excess over what has to paid to investors
in manufacturing, has no way to recover the cost of developing the product.
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The four innovations in British textile industry that were at the forefront of
industrial revolution are: flying shuttle, spinning jenny, water frame, and the
mule. Yet two of the innovators, John Kay (flying shuttle) and Samuel
Crompton (mule) could not earn from their inventions and had to survive on
French government pension or help from friends.
8.15. JUSTIFICATION OF PATENTS AND
COPYRIGHT -2.
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The Model Corporation spends $5,000 million on research and development
each year (Slide 7.8). It has to recover these expenses from future net income of
the firm (Slide 7.9). If competition leaves only just enough net income from
manufacturing operations to allow investors a competitive return on their
investment, the company will never recover the expense on research and will
have no incentive to undertake it.
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Governments from ancient times recognized the need to provide incentives for
innovations. Agricultural and construction technologies developed under state
patronage. After sixteenth century European Renaissance, European courts
became active in patronage of innovators. Prizes were awarded and patents
granted as rewards. They were criticized as based on favoritism than merit and a
formal process of patenting began with the Venetian Statute of 1474 and
English Statute of Monopolies of 1623.
8.16. JUSTIFICATION OF PATENTS AND
COPYRIGHT -3.
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After sixteenth century European Renaissance, European courts became active
in patronage of innovators. Prizes were awarded and patents granted as rewards.
They were criticized as based on favoritism than merit and a formal process of
patenting began with the Venetian Statute of 1474 and English Statute of
Monopolies of 1623
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The benefits of the patent must be balanced against the cost it imposes on the
society by providing monopoly power.
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In addition to deadweight loss, a broad patent can restrict future innovations as
the entrants can be threatened with lawsuits. Society has to continuously
rebalance the benefits and costs.
8.17. POLICIES TO PROMOTE COMPETITION
– 1.
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Public resentment against monopolies also have a long history. Recently public
policies are directed at promoting competition.
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The expansion of markets with the transportation revolution opened the regional
market of the United States and forced firms to compete nationally. Firms
responded by forming cartels and Congress passed the Sherman Act of 1890.
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Firms found that get around the law by merging to form one firm (instead of
retaining separate identities under a cartel) and Clayton Antitrust Act of 1914
was enacted to extent the laws to restrict anti-competitive practices. New laws
were passed later to extent the scope of these laws.
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The Federal Trade Commission established in 1914 and Antitrust Division of
the Department of Justice empowered to enforce these laws.
8.18. POLICIES TO PROMOTE COMPETITION – 2.
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Economic analysis has contributed to the development of competition policies.
It focused on the need to be clear of the distributional questions. Should gains to
consumers and producers given equal weight? If a merger reduces fixed cost
and add to profits of firms but does not affect marginal cost or price, is it
acceptable? If merger increases efficiency in production, reduces marginal cost
but not price (merger leads to an increase in the gap between marginal cost and
price increases) is it acceptable. Should there be different policies regarding
merger of firms producing the same output and merger between a firm and its
supplier ( firm buying the source of raw material)? These questions are still
debated.
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Germany, in contrast, has a policy of favoring cartels till the end of Second
World War. The Treaty of Paris
8.19. POLICIES TO PROMOTE COMPETITION – 3.
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Germany, in contrast encouraged cartels as a way of stabilizing and controlling
the economy. This policy existed till the end of Second World War.
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After war The Treaty of Paris that created the European Coal and Steel
Community in 1951 included a number of pro-competitive measures to
diminish German power by making available essential iron and coal to other
European nations. The other motivation was recognition that competition is the
way to attain efficiency in market allocation of resources.
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The competition policy of the European Union is built on the same principles.
It calls for a system that does not distort internal markets and prohibits
discrimination on national grounds. But it exempts cartels formed to eliminate
excess capacity in a permanent way. The competition policy gives a favorable
treatment to small and medium firms. The subsidies they receive from the state
are not considered to affect trade and competition in the Common Market.