Econ 201
Spring 2009
Lecture 6.1b
Market Failure:
Monopoly – cont’d
1
What’s Different?
• The profit maximizing rule for both a
monopolist and a competitive firm is the
same
– Choose output level such that MRev = MCost
• Difference is:
– For a competitive firm: price = MRev
• As it takes price as given
– For a monopolist:
• Each successive unit supplied/sold lowers the
price (avg rev) and marginal revenue (MRev)
2
What’s the Impact on
Market Efficiency?
• DWLoss as higher P; lower Q
• Transfer from CS to PS
3
Monopolies and Market Efficiency
• A monopolist will sell:
– a lower quantity of goods
– at a higher price than firms would in a purely
competitive market.
• Monopoly will secure monopoly profits by
appropriating some or all of the consumer
surplus
4
3 Questions to Ponder?
• Does a monopolist earn “excess” profits,
or economic rent?
• At what demand elasticity will a monopolist
operate at, i.e., what is the demand
elasticity at the monopolists profit
maximizing output?
• Can a monopoly persist over time?
5
Monopoly Rents
• Is the monopolist earning an economic, or
excess, profit?
6
Persistence of the Monopoly
• Unique Costs
– High fixed costs
• Generally industrial: e.g., automotive (“big 3” before
globalization), airlines, telecomm and energy
– Economies-of-scale are so large
• “natural monopolies” – public utilities (telecomm, electricity,
energy)
• Scale economies are so large, that it is efficient for only 1
firm to exist
– High costs of switching to a substitute
• E.g., Windows XP to LINUX
7
More Complex Monopoly
Pricing Schemes
• Classic categorization of monopolies
– 3 levels of price discrimination
• First degree (Perfect Price Discrimination)
– Extract almost all of the Consumer Surplus
» Able to get a different price for each unit sold
» Moves consumer along the Demand Curve
• Second degree
– Provide quantity discounts; but have to buy in blocks, with each
larger block having a lower price than the last
• Third degree
– Different prices for same good in different markets
• In all cases, it is necessary to prevent resale!
8
Price Discrimination or
Differences in Cost?
• A Simple Example:
– Shell’s pricing of gasoline
• Madison Park and Montlake - $3.25 per gal
• Genesee and Ballard - $3.15
– Charging different prices for the same good in
different markets
– Alternative hypotheses/explanations?
9
Alternative Hypotheses
• Hypo A:
– Shell is performing 3rd degree price discrimination
• Based on different incomes in the two areas; Shell knows
that higher income areas will have higher demand for a
normal good (higher opportunity costs of time, fewer
substitutes)
• Hypo B:
– Higher costs in Madison Park
• Transport, labor and materials are similar, but
• Maybe (space) rental is higher?
• Could try and get rental data and compare!
10
Pricing Models for Retail Gas
• Price Optimization Models (Price Net)
If a retailer has 100 stations that each sell three grades of gasoline,
Stein pointed out, and that each have four competitors who also sell
three gasoline grades — then each day the chain must gather 1,500
prices. “Try to put all of that data into an Excel spreadsheet,” he
continued, “and it becomes very unwieldy. Our system handles all
that — and it keeps working on weekends and holidays.”
PriceNet is designed to automate that process, discern competitors’
pricing patterns, develop models of how consumers react, and then
automate the retailer’s competitive response—according to the
pricing rules, volume targets, and margin goals that the retailer
establishes. The need to automate these functions, Stein believes,
is seen in the fact that “marketers’ behavior isn’t the same seven
days a week, and many of your competitors are already changing
their prices more than once a day.”
11
And Then Add Game Theory
• Also in looking ahead to the future, Stein
foresaw the day when it may be possible
“not only to develop models of your
competitors’ pricing patterns, but to take
those models and predict what your
competitors will do in response to a
given condition.”
12
Empirical Evidence
• NBER Working Paper No. 12530
Issued in September 2006
NBER Program(s): IO EEE
• In this paper, we compare the price and income
elasticities of gasoline demand in two periods of similarly
high prices from 1975 to 1980 and 2001 to 2006.
• The short-run price elasticities differ considerably: and
range from -0.034 to -0.077 during 2001 to 2006, versus
-0.21 to -0.34 for 1975 to 1980.
• The estimated short-run income elasticities range from
0.21 to 0.75 and when estimated with the same models
are not significantly different between the two periods.
13
Some Additional Research
•
•
•
•
•
•
•
•
Retail Gasoline Pricing: What Do We Know?
Daniel S. Hosken1
Federal Trade Commission
Robert S. McMillan
Federal Trade Commission
Christopher T. Taylor
Federal Trade Commission
October 30, 2006
14
Their Findings
• find that stations do not appear to use simple static pricing rules:
– Stations do not charge a fixed mark-up over their wholesale costs,
– nor do they simply maintain their relative position in the pricing
distribution over time.
• Instead, a particular gasoline station frequently changes its relative
position in the pricing distribution, often dramatically.
• Also find differences in the pricing strategies of gasoline stations.
– Stations that charge very high or very low prices in one period are much
more likely to charge high or low prices in subsequent periods.
– Interestingly, there appears to be an asymmetry in this behavior.
• Stations charging low prices appear to remain low priced stations for much
longer periods than high priced stations.
• My observation: Madison Park station appears to maintain its rank
(as one of the highest priced) and relatively large price differential
over time
15
Journal of Marketing Research
588 Vol. XLIII (November 2006), 588–604
• Two important trends in this context are micromarketing
and “demand-based management,”which emphasize
tailoring supermarket retail chain prices to each store’s
clientele, environment, and performance conditions
• Micromarketing represents a manager’s interest to
combine the advantages of large operations with the
flexibility of independent, yet “customized,” neighborhood
stores.
• Iyer and Seetharaman (2003) provide empirical evidence
for such micromarketing strategies governing prices and
service decisions in gasoline retailing.
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Other Monopolist Pricing Strategies
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•
•
•
•
•
Predatory Pricing
Dumping
Zone Pricing
Block Pricing
Tie-in Sales
All aimed at extracting Consumer Surplus
17
Predatory Pricing
• Predatory pricing (also known as destroyer pricing) is the
practice of a firm selling a product at very low price with the intent of
driving competitors out of the market, or create a barrier to entry into
the market for potential new competitors. If the other firms cannot
sustain equal or lower prices without losing money, they go out of
business. The predatory pricer then has fewer competitors or even a
monopoly, allowing it to raise prices above what the market would
otherwise bear.
• In many countries, including the United States, predatory pricing is
considered anti-competitive and is illegal under antitrust laws.
However, it is usually difficult to prove that a drop in prices is due to
predatory pricing rather than normal competition, and predatory
pricing claims are difficult to prove due to high legal hurdles
designed to protect legitimate price competition.
18
The Standard Oil Case
• Rockefeller’s Standard Oil Monopoly
• Predatory pricing through sharp discounting is not beneficial to a
business in the short run, as it may result in a price war and will
cause loss of revenue and/or profits. Yet businesses may engage in
predatory pricing because it may pay dividends in the long run.
• This is because competitors who are not as financially strong as the
predator will suffer even more, either due to loss of business or
reduced profit margin caused by the aggressive price competition.
The predation continues until the competitor is driven to failure and
forced to leave the market. After the weaker competition has been
driven out, the surviving business can raise prices above
competitive levels (to "supra competitive pricing"). The business
hopes to thereby reap revenues and profits that will more than offset
the losses during the predatory pricing period.
19
Another Explanation
• McGee, John, "Predatory Price Cutting:
The Standard Oil (N.J.) Case," Journal of
Law and Economics Vol 1 (April 1958)
• Buy out other gas stations at a price
higher than the competitive value, based
on possible future monopolistic value
20
Game Theory and Predatory
Pricing Models
•
•
Since the early 1980s, economic models based on game theory and the theory of
imperfect information have suggested that predatory pricing can be rational and
profitable under certain circumstances. For instance, by increasing production and
lowering price below costs, a firm may convince its competitors that it has achieved a
lower cost of production than them—the competitors will see the firm's high volume
and low price and may believe that the firm's price is not below its costs but rather the
firm's costs are low because of its high volume—causing them to leave the market
based on the conclusion that it would not be profitable for them to compete; this is
known as low-cost signalling. Also, by pricing aggressively the incumbent firm will
acquire a reputation for being "tough", this may deter potential entrants in the future.
Another explanation for predatory pricing may be where long term success will
require a large market share from early on (e.g. market for computer operating
systems), usually markets with significant switching costs. By pricing aggressively to
start with, even pricing below cost, firms can ensure a base of customers in the future
from whom to make a profit. Moreover, the criticism of predatory pricing theory
suggests that competition will come flooding back in to profit from the irrational
market pricing. This view is based on conventional market economics, but it
overlooks that there may barriers to entry or other significant transaction costs that
cannot be borne by smaller competitors in the short run or in some cases even in the
long run.
21
More Game Theory
•
Moreover, most criticism of predatory pricing is based on oversimplified
models and demonstrably fallacious assumptions, which disregard the the
fact that businesses which engage in predatory pricing (1) are typically able
to buy in sufficient volume to negotiate lower costs and/or bypass one or
more levels of the distribution chain through which their competitors must
operate, (2) are typically diversified retailers, able to subsidize losses in
some departments with profits in others, and (3) are typically chain retailers,
able to subsidize a temporary overall loss at one location with profits from
other locations. Once all competitors for a given product line are driven out
of an area, prices on that product line can be raised to a point that is
profitable (particularly with reduced costs), yet low enough to serve as a
barrier to entry, at least for independent specialty merchants. Also
frequently overlooked by critics is the fact that predatory retailers typically
locate their stores far enough away from established local merchants to
discourage their customers from patronizing the local merchants in the
same trip. As local independent merchants are driven out of business,
customer traffic in established retail areas (both traditional downtowns and
shopping centers of various sizes and types) decreases, leaving the
remaining merchants more vulnerable to being driven out.
22
Upside to Monopolies?
• Dumping
– Some argue that it can be good to allow a firm to attempt to
monopolize a market, since practices such as dumping can
benefit consumers in the short term; and once the firm grows too
big, it can be dealt with via regulation
• Natural Monopolies (monopolies of scale)
– When monopolies are not broken through the open market, often
a government will step in,
• regulate the monopoly, turn it into a publicly owned monopoly,
• forcibly break it up (see Antitrust law). Public utilities,
• Natural monopolies are less susceptible to efficient breakup,
– strongly regulated or publicly owned.
– AT&T and Standard Oil are debatable examples of the breakup of a
private monopoly. When AT&T was broken up into the "Baby Bell"
components, MCI, Sprint, and other companies were able to compete
effectively in the long distance phone market and began to take phone
traffic from the less efficient AT&T.
23
Factors Working
Against Persistence
• Monopoly rents attract entry of other firms
– First mover advantage
• monopolies tend to become less efficient and innovative over time,
– complacent giants", do not have to be efficient or innovative to compete
in the marketplace
• One of the arguments advanced by AT&T for deregulating the Telecomm
industry in 1996
• Availability in the longer term of substitutes in other markets. For example, a
canal monopoly, while worth a great deal in the late eighteenth century
United Kingdom, was worth much less in the late nineteenth century
because of the introduction of railways as a substitute.
• However, loss of efficiency can raise a potential competitor's value
enough to overcome market entry barriers, or provide incentive for
research and investment into new alternatives.
24
Does a Single Supplier Always
Mean There is a Monopoly?
• The theory of contestable markets argues that in
some circumstances (private) monopolies are
forced to behave as if there were competition
because of the risk of losing their monopoly to
new entrants.
• This is likely to happen where a market's barriers to entry are
low.
• Single supplier does not necessarily mean there
is a monopoly
– Firm may behave as though its in a competitive
market
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