Monopoly and
Regulation
Chapter 12
Slides by Pamela L. Hall
Western Washington University
©2005, Southwestern
Introduction

Polar extreme of perfect competition is a market with only one firm supplying
output
 Called a monopoly
• Firm with no substitutes (competition) for its output



This chapter discusses barriers to entry as cause of monopolies
We then develop short-run price and output determination for a profit-maximizing
monopoly
We derive relationship of a monopoly’s price with market elasticity of demand
 Based on this relationship, develop Lerner Index for measuring degree of monopoly
power

We investigate long-run equilibrium for monopolies
 As well as opportunity cost of capital as a consequence of monopolies earning only
long-run normal profits
• Based on this long-run equilibrium, we investigate welfare loss from monopoly power

In terms of price not equaling marginal cost, firms operating at less than full capacity, and rent-seeking
behavior
2
Introduction


We discuss and evaluate government regulation to correct potential welfare loss in
terms of a market’s contestability
Aim in this chapter is to show how a firm with monopoly power will misallocate
resources and is inefficient
 Taxing, regulating, or dismantling monopolies are possible solutions to improving
efficiency


We hope to provide an understanding of why agents with monopoly power are
detrimental to an economy
Growth of industrial state in 19th and 20th centuries spawned a wealth of
investigations by economists into causes, problems, and potential cures for an
economy with monopolies
 Question applied economists are now attempting to answer is
• Whether curing disease (monopoly power) will kill patient (advancing social welfare)


If costs of intervening into a market with monopolies (e.g., Microsoft) are more than any benefits received
(e.g., advances in computer operating systems)
 Such intervention is questionable
Applied economists actively attempt to measure benefits and costs of various
policies designed to promote efficient resource allocation by constraining
monopoly-power activities
3
Barriers to Entry




Cause of a monopoly is barriers (obstacles) to entry
If other firms could enter market, there would likely be no monopoly
Barriers to entry are anything that allow existing firms to earn pure profits
 Without threat of entry by other firms
 Either legal or technical obstacles
One type of a legal monopoly is established by a state or federal government awarding
only one firm an exclusive franchise to provide a commodity
 Government may do so because there are increasing returns to scale over a wide range of output
• One firm can supply market more efficiently than two or more firms

If society deems that unrestricted competition among firms in an industry is undesirable
 Government may establish a legal monopoly by granting a firm exclusive rights to operate
• For example, patents

Technological barriers to entry may result when a firm’s technology results in decreasing
LAC over a wide range of output, knowledge of a low-cost productive technique, or control
of a strategic resource
 Termed natural monopolies

• Because market forces establish monopoly
Sometimes progress can directly impact these natural monopolies
4
Price and Output Determination

Objective of monopolies
 Maximize profits
• First determine profit-maximizing output
• Then determine price required to sell output
 Alternatively, they can first determine profit-maximizing price
• Then from market demand curve determine level of output that can be
sold at this price
 Resulting profit-maximizing price/output combination will be the
same
• Regardless of which method is employed


Both are based on a monopoly’s determining its equilibrium price and output
given market demand curve
Market demand curve is downward sloping
 If a monopoly reduces output, price it receives for this output will
increase
5
Price and Output Determination


Monopoly has control over market price
 A price maker
Consider following linear market demand curve
 AR = p = a – bQ
 TR = (AR)Q = pQ = aQ – bQ2
 MR = ∂TR/∂Q = a – 2bQ = a – bQ – bQ = AR - bQ

• Where a, b > 0
For a linear demand curve, MR is twice as steep as AR
• Will bisect any horizontal line drawn from vertical axis to AR
curve

Illustrated in Figure 12.1
6
Figure 12.1 Linear market
demand curve
7
Price and Output Determination

In Figure 12.1, AR is falling as firm increases output
 Because consumers are willing and able to purchase more of
commodity at lower level of AR (price)

Falling AR implies that MR is below it
 MR is equal to AR plus adjustment factor, -bQ
• Given -b < 0 (falling AR), then MR < AR

For a given level of output, MR < AR
 For a firm to sell an additional unit of output it must lower its price on
all units to be sold, not just on additional units
• Adjustment factor, -bQ, accounts for this condition


For each additional output sold, price falls by -b
Multiplying this fall in price by number of units sold
 Results in adjustment to AR for determining MR
8
Profit Maximization

Mathematically, short-run profit is maximized by
 F.O.C. is
• ∂/∂Q = ∂TR/∂Q = ∂STC/ ∂Q = 0 = MR(Q) – SMC(Q) = 0


Profit-maximizing monopoly will equate MR to SMC to
determine its optimal level of output
Profit-maximizing output Q* corresponds to where MR =
SMC
 Illustrated in Figure 12.2
• Firm will produce Q* units of output and, given market demand curve
QD, it can sell all of this output at p*

p* corresponds to level of output Q* that consumers are willing and able to
purchase
9
Figure 12.2 Price and output
determination for a monopoly
10
Profit Maximization

SMC curve for a monopoly determines profit-maximizing price and
output
 However, in contrast to perfect competition, SMC curve above SAVC is not
monopoly’s short-run supply curve

In Figure 12.2, if SMC curve for a monopoly is a supply curve, at a price
of p*
 Firm would be willing and able to supply Q' units of output
• Although firm is able to supply Q' at p*, it is unwilling to supply it
 Profit-maximizing output is Q*

• Firm can sell all output at p*
Cannot determine a monopoly’s short-run supply curve without
restrictive assumptions
 Note that same factors that shift a monopoly’s short-run supply curve also
shift SMC curve in same direction
• Can view SMC curve as a proxy for supply curve
11
Profit Maximization

In Figure 12.2, price p* is above SATC* for output
level Q*
 Indicates monopoly is earning a pure profit



• Represented by shaded area SATC*p*AB
TR is represented by area 0p*AQ*
STC is represented by area 0(SATC*)BQ*
• Difference is pure profit
As illustrated in Figure 12.3, in short run a
monopoly can also earn only a normal profit
 When p* = SATC*
• Due to increased input prices or a decrease in demand for its
output
 In this case, TR* = STC*, area 0p*AQ*
12
Figure 12.3 Short-run profit maximization
for a monopoly earning a normal profit
13
Profit Maximization

In short run, a monopoly can also operate at a loss if demand falls or
costs increase
 Illustrated in Figure 12.4


• Losses represented by shaded area p*(SATC*)BA
As long as price is above SAVC a monopoly will continue to operate in
short run
Monopoly will cover all of its STVC and have some revenue left over for
paying a portion of its TFC
 Monopoly minimizes its losses by operating

If price falls below SAVC, monopoly is unable to cover its STVC
 Will minimize losses by shutting down

In summary, a monopoly can earn a pure profit, a normal profit, or can
operate at a loss in short run
 Firm’s level of profit is not an indicator of its degree of monopoly power
• Percentage markup in price over marginal cost, (p - SMC )/p, is indicator of
monopoly power
14
Figure 12.4 Price and output determination for
a monopoly operating at a loss
15
Lerner Index



Regardless of its level of monopoly power
 Firm only operates in elastic portion of demand curve
Given SMC > 0, a profit-maximizing firm will equate
MR = SMC > 0
Using product rule of differentiation and recalling
TR = pQ
 Relationships of MR to price and to elasticity of market
demand are
• MR = dTR/dQ = p + (∂p/∂Q)Q

MR is equal to price plus adjustment factor
16
Lerner Index

For each additional output sold price falls by ∂p/∂Q
 Multiplying this by number of units sold results in adjustment to AR for determining MR
 Factoring out price from right-hand side of MR = p + (∂p/∂Q)(Q) yields relationship
between MR and elasticity of demand
• MR = p[1 + (∂p/∂Q)(Q/p)] = p(1 + 1/D)

Where /D = (∂Q/∂p)(p/Q)], own-price elasticity of demand
 For MR > 0, (1 + 1/D) > 0
• Which implies D < -1 (elastic)
 If D > 1 (inelastic)
• MR = dTR/dQ < 0



Decrease in Q will increase TR
Given dSTC/dQ > 0, STC decreases with this decrease in Q
 Yielding an increase in pure profit
Profit-maximizing firm can continue to reduce Q and increase profit within
inelastic portion of demand curve
 Firm will reduce output until it is in elastic portion of demand curve
• Where MR = SMC

Table 12.1 summarizes relationships between demand elasticity and marginal
revenue
17
Table 12.1 Demand Elasticity and
Marginal Revenue
18
Lerner Index

At MR = SMC
 MR = p(1 + 1/D) = SMC
• Solving for p gives

p = SMC/(1 + 1/D)
 Under perfect competition, a firm is facing a perfectly elastic demand curve
• So 1/D = 0, indicating condition of p = SMC for profit maximization


Instead, a monopoly charges a higher price
 Since it only operates on elastic portion of demand curve
 Then 0 < (1 + 1/D) < 1, so p > SMC
A measure of degree of monopoly power is percentage markup in price
over marginal cost (p - SMC )/p
 Specifically, given p(1 + 1/D) = SMC and solving for (p - SMC )/p yields
Lerner Index (LI)
• LI = (p – SMC)/p = -1/D
• Lerner Index varies between 0 and 1 and measures percentage markup in price
due to monopoly power

Relative difference in price and marginal cost is dependent on elasticity of demand
19
Lerner Index

Under perfect competition, p = SMC, D = -, so LI = 0
 Firm is exercising zero monopoly power


If D = -1, then LI = 1, indicating existence of monopoly power
At -1 ≥ D > -, corresponding to 0 < LI ≤ 1, a relative wedge between price and
SMC exists
 Magnitude of this wedge is determined by elasticity of demand
• When demand curve becomes less elastic, wedge increases and LI approaches 1
• Wedge for a profit-maximizing firm without close substitutes will be large relative to a firm in a
market with many competitors

Monopoly is concerned with effect high price has on consumption
 When consumers react to a price increase by greatly reducing their demand
 Monopoly will not charge highest price it can for its output
• It will determine elasticity of demand for its output and calculate LI

Table 12.2 lists measurements of Lerner Index for steel and semiconductor
industries
20
Table 12.2 Measurements of the Lerner Index
for the Steel and Semiconductor Industries
21
Long-Run Equilibrium





Long-run equilibrium for a monopoly is illustrated in Figure
12.5
SATC and LAC curves are tangent at firm’s profitmaximizing output level Q*
 Where SMC = LMC = MR
At this equilibrium output and price (Q*, p*), firm is earning a
normal profit
In long run, firm can earn only a normal profit
If it had been earning a pure profit in short run, when firm is
sold in the long run
 New owners will pay a higher price for firm than if it had been
earning only a normal profit
• Increases cost of operation

Results in upward shift of cost curves
22
Figure 12.5 Long-run equilibrium
for a monopoly firm
23
Long-Run Equilibrium


Competition for purchasing firm will result in cost curves for new owners shifting
up to point of zero pure profit (normal profit)
Market price for firm will increase until, in long run, all short-run pure profits are
squeezed out
 p = SATC = LAC

Even if firm is not sold, cost of production (in terms of implicit cost) will increase
over time
 In long run, a firm that earned a short-run pure profit will be worth more, say $100,000
 Thus, owners of firm have a higher implicit cost of production
• Their opportunity cost for operating firm has increased because they could sell firm and
receive this increase in price ($100,000) and invest it in another activity

Called opportunity cost of capital
• If alternative activity had an annual rate of return of 10%, then firm’s implicit cost of production
would be $10,000 higher


Short-run pure profit is converted into implicit cost
Alternatively, if firm had been operating at a loss in short run, firm will not be
worth as much
 Cost curves will shift downward, resulting in a long-run normal profit
24
Long-Run Equilibrium

The worth of a monopoly based on its long-run pure-profit potential is
called monopoly rents
 Rent a possible entrant would be willing to pay for monopoly

Given positive monopoly rents, associated opportunity cost exists that
result in only long-run normal profits
 Without considering that cost adjusts to rents, it is possible to assume a
monopoly will earn a long-run pure profit

This fact is particularly important in basic business decision-making
 Since firms, even those with monopoly power, can only make a pure profit in
short run
• Owners of firms cannot continue their present activities and expect continued pure
profits


If they want to continue to reap pure profit, must anticipate market trends
 So as to sell their firms when conditions are right and be early entrants into markets
where firms are earning short-run pure profits
However, many individuals or firms either lack this knowledge or are unwilling to act
 Because they can maximize their utility by staying in a particular activity even if it
means earning only a normal profit
25
Welfare Loss from Monopoly
Power


Major objective of economics is to improve social welfare
Thus, market structures that result in economic inefficiency
are considered inferior
 Specifically, a monopoly market structure is inferior to a perfectly
competitive market structure based on monopolies’ inefficiency
• Monopoly is efficient in terms of both technical and allocative efficiency
• Monopoly will produce on production frontier (technical efficiency) and
•
employ least-cost production (allocative efficiency)
However, monopoly is not scale efficient

Does not equate price to marginal cost
• Thus, monopoly’s long-run equilibrium position is inefficient
26
Welfare Loss from Monopoly
Power

Inefficiency is characterized by two conditions
 p* > SMC* = LMC*
• Price a household pays for a commodity is marginal utility of
consumption

Monetary measure of how much an additional unit of a commodity is worth
to household
• Marginal cost is cost of producing an additional amount of commodity



If price is greater than marginal cost society would prefer firm increase
output
In perfect competition, price is equal to marginal cost
What society is willing to pay for an additional unit of output is equal to what
it costs society to produce this additional unit
 But monopoly restricts output and increases price
 So what society is willing to pay for an additional unit of output is
greater than what it costs society to produce this additional unit
27
Welfare Loss from Monopoly
Power

Second inefficiency of a monopoly
 Does not operate at full production capacity


• At full capacity average cost of production is at a minimum
Monopoly does not operate at minimum point of SATC or
LAC
For an efficient operation, output should increase to full
capacity
• Fixed costs are spread over too few units of output


Results in excess capacity and inefficiency
Can represent this inefficiency and associated
welfare loss with a monopoly by deadweight loss in
consumer and producer surplus
28
Welfare Loss from Monopoly
Power

As illustrated in Figure 12.6, perfectly competitive equilibrium is QC, pC
 Economic efficiency is area CAB, where pCAB is consumer surplus and
CpCB is producer surplus
• A firm with monopoly power restricts output from QC to QM

Results in price increasing
• Consumer surplus is reduced to pMAE, with firm capturing some of the lost
consumer surplus (area pCpMEF)

Captured consumer surplus is a measure of firm’s exploitation of consumers
• Producer surplus, with monopoly power, is area CpMED


Efficiency loss in social welfare is area DEB
Deadweight loss resulting from monopoly power provides a signal that
some government intervention may be desirable
 However, it does not suggest a particular course of action
• Causes of inefficiency should first be determined
• Then a possible set of actions formulated
29
Rent-seeking Behavior

There is a further efficiency loss associated with a monopoly
 Expense incurred to obtain and maintain monopoly power (called
rent-seeking behavior)


Rent is defined as monopoly’s producer surplus
 Represented in Figure 12.6 by area CpMED
Potential for obtaining this rent may lead firms to engage in
rent-seeking behavior
 Firms may incur both strategic expenses in form of
• Erecting barriers to entry or
• Administrative expenses such as lobbying government representatives
or
• Legal defense against antitrust actions
30
Rent-seeking Behavior



Extreme case of rent-seeking behavior
 All monopoly rents will be allocated to this behavior
Assuming that all rent-seeking behavior is socially wasteful
(has no social value)
 Actual deadweight loss is area CpMEBD in Figure 12.6
 Represents producer surplus (rents) plus deadweight loss DEB
All rent-seeking behavior is probably not socially wasteful
 So including producer surplus as a component of deadweight loss
may be used to represent upper boundary of efficiency loss
31
Figure 12.6 Deadweight loss
resulting from monopoly power
32
Taxing Rents



One proposed solution for inefficiency in monopoly power is
to tax monopolies’ profits
Either a lump-sum tax or a profit tax would reduce a
monopoly’s producer surplus
For lump-sum tax system, can represent profit as
  = pQ - STC – TRT
• Where TRT is lump-sum tax corresponding to total tax revenue collected
 F.O.C. for profit maximization is
• ∂ ÷ ∂Q = MR – SMC = 0


No change in optimal level of output or price, or for determining whether a
firm should operate
Level of profit falls by amount of increase in tax
 Illustrated in Figure 12.7 by upward shift in TFC and STC curves
33
Figure 12.7 Lump-sum or profit
tax
34
Taxing Rents

However, inefficiency of monopoly still exists
 Society still would prefer monopoly to increase output
and decrease price

Problem of resource misallocation is not solved by
a lump-sum tax
 Because lump-sum tax does not affect allocation of
resources
 Only affects distribution of total economic surplus
• By taking some producer surplus away from monopoly and
reallocating it to others
• Thus, lump-sum tax is only beneficial if reallocation of total
surplus improves social welfare

By redistributing surplus away from socially wasteful rent-seeking
behavior
35
Taxing Rents


With a profit tax there is no change in a monopoly’s optimal level of output or
price, or for determining whether it should operate
Can represent a monopoly’s profit with a profit tax as
  = pQ – STC – t(pQ – STC) = (1 – t)(pQ – STC)
• t is percentage of profit that is taxed
 F.O.C. is
• ∂ ÷ ∂Q = (1 – t)(MR – SMC) = 0


Implies that MR = SMC still remains as condition for profit maximization
Level of profit declines by amount of increase in tax
 Results in an upward shift in TFC and STC curves

Since firms are taxed on a percentage of their profits
 TFC shifts upward for alternative profit levels

Neither lump-sum nor profit taxes cure ills of monopoly power
 But both reduce ability of a monopoly to engage in socially wasteful rent-seeking
behavior
36
Franchise


City and County of Denver, Colorado, requires three cable channels for public
access programming in its franchise agreement with AT&T Broadband
This government issuance of a franchise is an alternative pricing policy
 Generally employed in cable television and radio airwaves markets

Right to be a monopoly within a local market or to control some public domain is
sold (franchised)
 Proceeds are rebated to consumers within this market
• Rebate either is in form of tax relief or a public good

If a competitive auction is used to determine price of franchise
 Competition will drive up franchise price to where only a normal profit will be earned
by the owners

However, once a franchise is established, it tends to perpetuate with the same
franchise owners in control
 Any renegotiation tends to occur without competitive bidding
 Thus, an issuance of a franchise does not cure problems associated with monopoly
power
• May not even reduce ability of monopoly to engage in rent-seeking behavior

Unless franchise is renegotiated with competitive bidding
37
Regulation of Monopoly

If a monopoly results in a misallocation of resources, it is inefficient
 Regulation may be required

However, prior to regulation degree of inefficiency should be determined
 Because cost of regulation may exceed any benefits gained

A firm with monopoly power may choose to not exercise its power
(called limit price analysis)
 Either because they are concerned that restricting output and increasing


price will result in other firms entering market or
That they will be regulated
Even threat of entry by another firm or threat of regulation may cause a
firm to expand output by equating price to marginal cost and operate
efficiently
 For instance, threat of antitrust actions and entry of new firms in industry has
resulted in cereal industry becoming more competitive
• Without government regulation
38
Government Regulation


In 1911, U.S. government succeeded in splitting oil monopoly created by
Standard Oil into 34 companies
In June 7, 2000, a U. S. District Court ruled to split Microsoft Corporation
into two smaller companies
 One to deal with operating systems and another with Internet browsers and
software applications

Main government policies for addressing inefficiencies of monopoly
power
 Break up firm
 Regulate it
• If LAC is declining over a wide range of output (a natural monopoly), it may not be
•
feasible to break up monopoly, so regulation is used
Alternatively, if LAC is relatively flat over a wide range of output

May be more efficient to break up monopoly
39
Government Regulation

Regulation policies vary according to type of government
 Socialist governments tend to regulate through direct government
ownership
• Example: Indian Airlines, owned by India

Capitalist governments will tend to establish public utility
commissions to oversee private (non-government) firms
 Example: power companies within U.S.
• Privately owned but publicly regulated

Whether a firm is government-owned or private, a
mechanism design is required for determining governmentregulated firm’s price and output
40
Government Regulation


Three major pricing policies exist for price and output
determination
Monopoly pricing
 In Figure 12.8, this is unregulated price and output equilibrium (pM,
QM)
• Assuming positive monopoly rents, monopoly is earning a long-run pure
profit
• Monopoly is Pareto inefficient with this pricing policy, because p > LMC

Pareto-efficient pricing policy is one that sets p = LMC
 Called marginal-cost pricing (pe,Qe)
 A problem with marginal-cost pricing is that firm will operate at a loss
• pe is below LACe
41
Figure 12.8 Public utility
regulation for a natural monopoly
42
Government Regulation

Many public utility agencies avoid this problem by allowing
regulated firm to price discriminate
 Can potentially increase revenue and not operate at a loss
 A public utility agency using marginal-cost pricing is faced with
difficulty of measuring marginal cost versus average cost
 Calculating average cost requires information on level of total cost
and output
• Such information is generally available in accounting records
 Calculating marginal cost not only requires information on level of
total cost, but also information on how total cost is changing for a
change in output
• Information is not generally available in accounting records

Relatively difficult to obtain
43
Government Regulation




An alternative, second-best pricing policy, is full-cost pricing
(or rate-of-return pricing)
 Most public utilities employ this method
 Illustrated in Figure 12.8
Under full-cost pricing, public utility agency equates LAC to
price (pf, Qf)
 p = LAC
Firm earns a normal profit
 Output and price are close to Pareto efficient solution
Allowing firm to price discriminate may increase output
 Shifting it closer to Pareto-efficient marginal-cost pricing solution
44
Government Regulation

Public utility agency may allow firm to provide price
discounts to its larger purchasers
 Results in larger purchasers increasing their purchases

• With an associated increase in total consumer surplus
Since discount is only for larger purchasers, it does not
affect firm’s other customers
• Largest purchasers will face a price equal to firm’s marginal cost
for last unit they purchase

Because if largest purchaser faced a price greater than marginal
cost and the price were lowered
 Purchaser would purchase an extra unit and seller would sell
this extra unit, so both would be better off
45
Government Regulation

Full-cost pricing policy includes a competitive (fair)
return on investment in capital as a constraint on
monopoly’s input choice decision
 Monopoly’s profit-maximizing decision does not yield the
same least-cost combination of capital and labor as does
unconstrained decision for the same level of output
• Effect is to encourage monopoly to hire more capital and less
labor

Thus, regulation encourages a monopoly to employ an inefficient
capital/labor ratio
 In an effort to extract more profits under full-cost pricing
constraint
46
Contestable Markets

A firm with zero sunk cost of operations can enter and exit industry at almost
zero cost
 Potential entrant firms could employ hit-and-run tactics
• Hit when pure profits exist and run once they are exhausted


Such industries are called contestable markets
Depending on contestability of an industry, all natural monopolies may not
require regulation
 If a monopoly that is earning a pure profit does not have large sunk costs, then
barriers to entry would be minor
• Even threat of entry by other firms may drive monopoly’s price down toward a price that
equals average cost

This theory indicates that, for industries with limited entry and exit costs, market
forces will produce same outcome as full-cost pricing regulation
 Need to regulate such firms is questionable

Theory is employed as a justification for deregulation in telecommunications and
airlines
 And for not pursuing regulation with currently unregulated firms such as computer
software firms
• One justification for not breaking up Microsoft
47