Assumptions of Pure Monopoly
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Single Seller (Many Buyers)
Heterogeneous good
Perfect Information
Barriers to Entry
Implications of Pure Monopoly
• Recall the old conclusion if there is no price discrimination
MR=P(1+1/E)
• Since E<0, P > MR
• Thus, we conclude that (since MR = MC, P>MR)
Why We Hate Monopoloy
• Because the monopolist is guaranteed a profit?
– There is no guarantee
– What’s wrong with profits?
• Because the monopolist charges “too much”
– Yes, but too much in relation to what?
Monopoly, Profit and Entry Barriers
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Note that the monopoly may or may not make economic
profit
• If they are profitable, there must be something preventing
other firms from entering the market
What is a Barrier to Entry
• Useless Definition: Anything that impedes the entry of a new
firm into a market.
• Useful Definition: A cost faced by a potential entrant into the
market that was not faced by the incumbent
Sources of Entry Barriers
• Legal Barriers
– Patents, trademarks, copyrights
– License requirements, exclusive franchises
• “Natural Barriers”
– Economies of Scale (maybe)
– Capital Requirements
– “First Mover”
Measuring Industry Concentration (When is a
Monopoly a Monopoly)
• The first question is “what is an industry?” which is harder
than you might think.
• The Dept of Commerce used to use the Standard Industrial
Classfication (SIC) and now uses the North American Industry
Classification System (NAICS pronounced Nakes) Here is
what they say about it
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NAICS is a unique, all-new system for classifying business establishments. It is the first
economic classification system to be constructed based on a single economic concept.
Economic units that use like processes to produce goods or services are grouped together.
This "production-oriented" system means that statistical agencies in the United States will
produce data that can be used for measuring productivity, unit labor costs, and the capital
intensity of production; constructing input-output relationships; and estimating employmentoutput relationships and other such statistics that require that inputs and outputs be used
together.
Naics can assign any firm reporting in the Census a 6
digit number. Here is what they mean
NAICS
2-digit
Sector
3-digit
Subsector
4-digit
Industry Group
5-digit
NAICS Industry
6-digit
National
“Natural Monopoly” : Industry where it is always less
costly for a single firm to produce all the output
“Natural Monopoly” and Economies of Scale: An Example
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Costs
– Insurance Policy(FC)=$1000
– Cost of Single Dose of Vaccine (MC)=$10
Demand:
– 10 Rich People Willing to Pay $200
– 90 Poor People Willing to Pay $11
– Efficient Solution
– Give 100 Doses (efficient because the value, $11, is greater than the marginal
cost)
Problem: To sell 100 doses, the price can’t be greater than $11, but at a price of $11,
profits=$11x100-$1000-$10x1000=-$900
Conclusion:Natural Monopoly most commonly occurs when there are high fixed
costs relative to low marginal costs
Problem: It is not possible to charge the efficient price (that is, the price at which
everyone who places a higher value on the good than the marginal cost of
producing it) without losing money
Serious Examples
• Roads,
• Public Utilities
• Information
Solutions to The Problem of Natural Monopoly
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Price Discrimination
Subsidies and/or Public Ownership (e.g., DART)
Public Regulation (e.g., PUC)
Franchise Bidding (e.g., Cable TV)
Natural Monopoly and the Firm: Single Source
Suppliers
• Benefits of SSS:
– Lower transactions costs
– Pecuniary economies (volume discounts)--much more
likely when the supplier experiences real economies.
• Costs of SSS: Lack of competition ex post (I.e., after the
contract is formed).
Opportunistic Behavior and SSS:Midwest Mower v
Rexite Casting
• Facts
– Original Contract: MM will purchase 120,000 castings
from RC for $.64 per part
– RC delivers some20,000 and then sends MM a letter saying
they refuse to deliver any more unless the price is raised to
$.72.
– MM writes back, saying they agree but “under duress”
– When it comes time to pay, MM refuses to pay more than
$.64
• Economic Issue
• Legal Issue: How to interpret an incomplete contract
– RC’s argument: Conditions have changed and it is no
longer economical to produce at $.64
– MM’s argument: So what? The contract is silent on this
point, meaning the intent is for you to accept the risk. In
fact, this is necessary to keep you from behaving
opportunistically
Related examples
• Austin Instruments v Loral: a threat to breach a contract in
order to coerce signing a new contract
• GM v Fisher Body: Vertical integration to prevent
opportunistic breach