2.3
Sources of monopoly power
• Basic question: What are the factors that lead to the number of firms in
market to be small (or one)?
• Reason 1: Economies of scale in production
– For reasons shown in Part VII, number of firms in long-run equilibrium
will be approximately given by
size
market/e f f icient
production
scale
where the level of efficient scale is given by the min of the ATC curve.
– As illustrated in Fig. 6, some industries have a small optimal-scale-ofproducion, others have a very large one
– Think. Can you relate this to the size of the FCs relative to other costs?
– Think. Can you use this example to make sense of the changes taking
place on the bookstore market?
– An extreme case of this, illustrated in Fig. 7, are increasing returns to
scale (often called a natural monopoly).
– Examples of natural monopolies include most utilities.
• Reason 2: Network economies
– Cases in which value of using a product increases with number of
otehrs suing it
– Ex: Facebook, HBO, software
• Reason 3: Ownership of essential/critical resources
– Ex: Suez Canal
– Ex: Unique deposits to a critical mineral required for computing
• Reason 4: Government allocation of monopoly rights
– Often given for patronage purposes
– But also frequently given to give incentives for private sector to carry
out expensive investments (e.g., infrastructure)
• Reason 5: Patents and copy-rights
– Innovators dilemma:
> many technologies and goods very expensive to produce but can be
copied at close to zero MC
> Ex: Star Wars, software
> Without copy-right protection no incentive to innovate
– If we have time, will discuss patents in more detail at end of this Part
of the course.
2.4 Government policy
• In order to address the problems associated with the monopolist DWL
and distributional issues, the government has three main policy tools at
its disposal:
1) Promote competition
2) Regulation
3) Tax policy
• Let’s look at each of them
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2.4.1
Promote competition
• The easiest solution is to introduce competition in the market, which
removes the source of the inefficiency in the first place
• Problem: Some of the reasons for the existence of market concentration,
such as increasing returns to scale and network economies, are not easily
eliminated
• So this policy tool is of limited value
• Exception:
– Some public investments public investments in R&D can help by promoting the development of new technologies that open markets to competition
– Ex: Cost-efficient small reactors would eliminate the natural monopoly
structure of power utilities
2.4.2
Regulation
• The basic idea of regulation is to get the monopolist to behave as a
perfectly competitive firm
• To analyze the effect of this policy, assume that the government has full
information about the market’s aggregate demand (after all, it can collect
it using the same market research methods used by the monopolist)
• There are two cases two consider: 1) full information about the firm’s
cost, and 2) imperfect information
• Case I: Full information
– In this case the government has full knowledge of the firm’s cost function
– Then the solution is trivial:
> Compute qoptimal and the associated price poptimal (= MSBopt = MSC opt )
> Allow the firm to either seel as much as it wants up to qoptimal (quantityregulation) or whatever it wants but at the price poptimal (price-regulation)
– In this idealized case the policy restores first-best
• Case II: Imperfect information
IMPORTANT:
> This case is meant to ’challenge’ your understanding.
> You will not be asked to solve this problem in PSs or Exams.
– The basic idea is that the government needs to choose either policy but
it has uncertainty about the firm’s true cost function
– A full treatment of this case is beyond the scope of the course, but an
example will provide insight into the about the economics of the problem, and on the difficulty of identifying optimal government policies in
this setting.
– Suppose, as before, that quadratic costs (so that c(q) = Aq2 ) and linear
demand (P(q) = 300 q).
– Problem: The government does not know if Ahigh = 1 or Alow =0.5 (and
it attributes an equal 50% likelihood to both events).
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– Look at price regulation, so that a policy is a price preg at which the
monopolist can sell as much as it wants.
– Intuition for the problem:
> The government cannot optimize the policy to the cost-parameters because it does not know them.
> Instead, the best it can do is to pick a single policy preg , that minimizes
the expected value (or averge).
– The monopolist reacts to the policy by setting
preg = MC
so for the parameters of the problem it sets
q=
if its costs are high and
preg
2
q = preg
if its costs are low.
– In contrast, the efficient level of produciton is given by solution to
P(q) = MC
which equals
300
= 100
2Ahigh + 1
if the costs are high and
300
= 150
+1
2Alow
if the costs are low.
> For use in the calculations below, let MSBopt ( A) denote the level of
the MSB at the optimum as a function of the cost parameter A, which is
given by 200 when costs are high and 150 when costs are low. (Think.
How do you know this?)
> The next step is to compute the DWL generated by everyp possible
combination of the policy and realization of the firm’s costs.
> This requiring looking at several cases
> Look first at the case in which costs are high (with Ahigh = 1).
> As illustrated in Fig. 8, there are several possibilities to consider.
> Sub-case 1: preg > 200.
– In this case, the quantity traded is given by D ( preg ) = 300 preg , and
by assumption is less than the optimal amount of 100.
– The DWL in this case is given by the triangle in Fig. 8 (top), which has
an area given by
0.5 ⇤ ( preg
2(300
preg )) ⇤ (100
(300
preg )) = 1.5( preg )2
600preg + 60, 000
– Note/intution-check:
1) The DWL is zero when preg = 200 (as it should be, since that prices
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induces optimal production)
2) The DWL increases with the square of deviations from the optimum.
3) DWL only deined for preg  300, since demand is zero beyond that
range.
> Sub-case 2: preg = 200
– This case is depicted in Fig. 8 (middle).
– The DWL is zero in this case since the policy induced optimal production by the monopolist (for the case of high-costs)
> Sub-case 3: preg < 200.
– This case is depicted in Fig. 8 (bottom).
– In this case the quantity traded is determined by the MC curve (i.e,
there is excess demand), and by the arguments above it is given by
preg /2.
– Assuming that the limited supply is obtained by the individuals with
the higher MB for it, the DWL is given by the area of the triangle depicted in the figure, and is equal to
0.5 ⇤ ((300
p reg
)
2
preg
1
) = (3( preg )2
2
8
preg ) ⇤ (100
1200preg + 120, 000).
> Now look at the case where costs are low (with Alow = 0.5).
> A similar series of arguments (not described in detail here) allow us
to establish that the DWL is as given in the following three sub-cases):
– subcase 1: preg > 150. Here the DWL is given by
0.5 ⇤ ( preg
(300
preg )) ⇤ (150
(300
preg )) =
1
⇤ (2( preg )2
2
600preg + 45, 000
– subcase 2: preg = 150. Here the DWL is zero.
– subcase 3: preg < 150.
0.5 ⇤ ((300
preg )
preg ) ⇤ (150
preg ) =
1
⇤ (2( preg )2
2
600preg + 45, 000.
• Fig. 9 (top and middle) provides a plot of how the DWL changes with
preg in both cases
• Given the government’s uncertainty about the firm’s costs, the best it
can do is to maximize the expected DWL, which is given by
1
1
DW L( Ahigh ) + DW L( Alow ).
2
2
• The government’s problem can then be written as
max preg
0
EDW L( preg )
• Fig 9 (bottom) describes the shape of the optimal DWL, as well as the
solution.
• The following two properties of the solution are generic and intuitive.
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• Property 1: optimal solution is to set the preg between the optimal MSB
of the of the two cost-cases (i.e., preg is between 150 and 200).
• Property 2: it is optimal to always have a positive DWL ex-post in orde
to minimize DWL on average.
• Why/intuition?
– As shown in Fig. 9, the slope of the DWL is approximately zero at the
opimum of each case.
– Thus, it makes sense to introduce a little bit of DWL in both cases, as
opposed to only distort the market ex-post in one of the cases.
2.4.3
Tax policy
• Another possibility is to give a subsidy to the monopolist in order to
restore its incentives
• Fig. 10 shows that, under full information, the optimal subsidy is given
by t = P(qopt ) MR(qopt ).
• Under these subsidy the FOCs of the monopolist become (at interior
solution)
MC = MR + t = P(qopt ) = MSBopt
which are sufficient to restore optimality
• If the subsidy is financed with lump-sum taxes (that do not introduce
inefficiencies of their own) the policy restores efficiency
• In the case of uncertainty the analysis is similar to the one of regulation
and leads to similar conclusions: Can’t fully restore efficiency for every
state of the world, only minimize DWL on average.
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