Market Structure: Monopoly

MONOPOLY
Single seller that produces a product with no close substitutes

Market and firm demand curve slopes downward.

Monopoly demand curve is always above the marginal revenue curve, P = AR > MR Is at the opposite extreme of perfect competition. Monopolist is a price maker as against perfect competitor who is price taker Entry prohibited or difficult Opportunity for economic profit in LR.

 The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power.
Under perfect competition, the price and quantity are determined by supply and demand. Here, the equilibrium is at C, where the price is PC and the quantity is QC. A monopolist reduces the quantity supplied to QM, and moves up the demand curve from C to M, raising the price to PM.

Why Do Monopolies Exist?

A monopolist has market power and as a result will charge higher prices and produce less output than a competitive industry. This generates profit for the monopolist in the short run and long run.
Profits will not persist in the long run unless there is a barrier to entry. This can take the form of control of natural resources or inputs, economies of scale, technological superiority, or legal restrictions imposed by governments, including patents and copyrights.

Economies of Scale and Natural Monopoly

A monopoly created and sustained by economies of scale is called a natural monopoly.

It arises when economies of scale provide a large cost advantage to having all of an industrys output produced by a single firm. Under such circumstances, average total cost is declining over the output range relevant for the industry. This creates a barrier to entry because an established monopolist has lower average total cost than any smaller firm.

Economies of Scale Create Natural Monopoly

A natural monopoly can arise when fixed costs required to operate are very high the firms ATC curve declines over the range of output at which price is greater than or equal to average total cost. This gives the firm economies of scale over the entire range of output at which the firm would at least break even in the long run. As a result, a given quantity of output is produced more6cheaply by one large firm than by two or more smaller firms.

Monopoly Short-Run Equilibrium

Demand curve for the firm is the market demand curve
Firm produces a quantity (Q*) where marginal revenue (MR) is equal to marginal cost (MC) When D is linear, slope of MR is twice the slope of D
[P=a-bQ, TR = PQ = (a-bQ)Q, MR = d(TR)/dQ=a 2bQ]

Profit maximising under monopoly

Rs

MC

Pm

D MR
O

Qm

Profit maximising under monopoly

Rs

MC AC

PM Profit AC

D MR
O

Qm

Lessens Learnt
As the only seller, a monopolist faces the market demand curve Profit maximizing output is determined by equating marginal revenue with marginal cost A monopolist could also incur losses in the SR, depending on the height of the AC curve at the best level of output. If AC > P, monopolist incurs a loss and may remain in business in SR as long as P>AVC (like PC) If entry by other firms is difficult, the monopolist can earn economic profit even in the long run Production is not likely to take place at the lowest point in LAC curve, unlike perfect competition in LR

Computing Profit Maximizing Price & Output

Cost equation of monopolist; TC = 500+20Q2 Demand equation is P=400 20Q Total revenue is TR = 400Q 20Q2 What are profit maximizing price & output?

Soln: MR = d(TR)/dQ = 400 - 40Q MC = d(TC)/dQ = 40Q MR = MC; Q = 5 & P = Rs. 300

Monopoly and Public Policy

By reducing output and raising price above marginal cost, a monopolist captures some of the consumer surplus as profit and causes deadweight loss To avoid deadweight loss, government policy attempts to prevent monopoly behavior.

When monopolies are created rather than natural, governments should act to prevent them from forming and break up existing ones.

Monopoly Causes Inefficiency

Panel (a) depicts a perfectly competitive industry: output is QC and market price, PC , is equal is to MC. Since price is exactly equal to each producers cost of production per unit, there is no producer surplus. Total surplus is therefore equal to consumer surplus, the entire shaded area. Panel (b) depicts the industry under monopoly: the monopolist decreases output to QM and charges PM. Consumer surplus (blue area) has shrunk because a portion of it is has been captured as profit (green area). Total surplus falls: the deadweight loss (orange area) represents the value of mutually beneficial transactions that do not occur because 13 of monopoly behavior.

Dealing with Natural Monopoly

Breaking up a monopoly that isnt natural can be a good idea, but its not so clear whether a natural monopoly, one in which large producers have lower average total costs than small producers, should be broken up, because this would raise average total cost Yet even in the case of a natural monopoly, a profit-maximizing monopolist acts in a way that causes inefficiencyit charges consumers a price that is higher than marginal cost, and therefore prevents some potentially beneficial transactions.

Dealing with Natural Monopoly

What can public policy do about this? A common response in the United States is price regulation
A price ceiling imposed on a monopolist does not create shortages as long as it is not set too low.

There always remains the option of doing nothing

Regulated and Unregulated Natural Monopoly

In panel (a), if the monopolist is allowed to charge PM, it makes a profit, shown by the green area; consumer surplus is shown by the blue area. If it is regulated and must charge the lower price PR, output increases from QM to QR, and consumer surplus increases. Panel (b) shows what happens when the monopolist must charge a price equal to average total cost, the price PR*. Output expands to QR*, and consumer surplus is now the entire blue area. The monopolist makes zero profit. This is the greatest consumer surplus possible when the monopolist is allowed to at least break even, making PR* the best regulated price.

 Income redistribution from consumer to monopolist in the form of profit does not necessarily represent a loss in society Monopolist could use this for R & D Some resources will be transferred to the production of other products, which are valued less by the society Two major negative consequences of monopoly are Technical Inefficiency & Rent Seeking

Technical Inefficiency & Rent Seeking

Price, cost Per unit

Pm Economic Profit
Rent Seeking

Pc

Tech Inefficiency

A D MR

Qm

Qc

Quantity per period

Technical Inefficiency
Objective of a firms manager is to maximize profit A necessary condition for profit maximization is cost minimization A monopoly, earning supernormal profit and insulated from competition, may not keen on cost minimization because
Manager, who is salaried and not a stockholder, may not give significant effort Faulty labour contract, which consider number of hours work, not efficiency Everybody wants leisure

Rent Seeking
Rent-seeking is an attempt to obtain economic rent by manipulating the social or political environment in which economic activities occur, rather than by creating new wealth
For example, spending money on political lobbying in order to be given a share of wealth that has already been created Monopoly producer often pays a pert of its profit to maintain its monopoly status

Rent seeking behavior does not increase the amount of goods and services produced and also results in deadweight loss

Case Study: Price of Caviar

In Soviet era, Bureau of Fisheries made decisions about sales of caviar In a typical year, out of 2000 tons of cavier, only 150 tons were allowed to export The caviar which was available in $5 in Russia could easily have been sold in $500 - $1000 in US Monopoly arrangement caused substantial redistribution of income from US to USSR After breaking up of USSR in 1991, increase competition in caviar mkt as fisheries are now under the control of Russia and Kazakhstan. Fisherman in Caspian sea bypass government and establish their own export business Price of caviar dropped by 20% in one year

 The Organization of the Petroleum Exporting Countries (OPEC) was formed on September 14, 1960 in Baghdad, Iraq. The current membership is comprised of five founding members plus six others: Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. OPECs stated mission is Ato bring stability and harmony to the oil market by adjusting their oil output to help ensure a balance between supply and demand.@ At least twice a year, OPEC members meet to adjust OPECs output level in light of anticipated oil market developments. OPEC's eleven members collectively supply about 40 per cent of the world's oil output and possess more than three-quarters of the world's total proven crude oil reserves. To demonstrate the deadweight loss from monopoly problem, imagine that market supply and demand conditions for crude oil are:
QS = 2P (Market Supply) QD = 180 - 4P (Market Demand) where Q is barrels of oil per day (in millions) and P is the market price of oil. Graph and calculate the equilibrium price/output solution. How much consumer surplus, producer surplus, and social welfare is produced at this activity level? Use the graph to help you ascertain the amount of consumer surplus transferred to the monopoly producer following a change from a competitive market to a monopoly market.

 The competitive market equilibrium price-output combination is a market price of $30 with an equilibrium output of 60 (million) barrels per day.
Consumer Surplus = 2 [60 *($45 - $30)] = $450 (million) per day Producer Surplus = 2 [60 *($30 - $0)] = $900 (million) per day Social Welfare = Consumer Surplus + Producer Surplus $450 (million) + $900 (million) = $1,350 (million) per day

 The amount of deadweight loss from monopoly suffered by the monopoly producer is given by the triangle bounded by BCD.
Producer Deadweight Loss = 2 [(60 - 45) * ($30 - $22.50)] = $56.25 (million) per day The creation of a monopoly also results in a significant transfer from consumer surplus to producer surplus. In the figure, this amount is shown as the area in the rectangle bordered by PCMPMAB: Transfer to Producer Surplus = 45 * ($33.75 - $30) = $168.75 (million) per day

Example: SEBs Monopoly

OPERATIONAL REASONS FOR PRODUCTIVITY GAP GENERATION
Index :US = 100
Poor quality Low capacity utilisation Inefficient deployment of
manpower Overengineering Construction overruns India India average average = 34% = 34% 3 7 13 coal Shortage of coal

Higher High ash

content coal capital work-in progress

Less
availability of gas 100 5

86 80 3 1 2

30 27

Lack of Lack of Best Supply Lack of Lack of India viable scale practice relaviable infrast- poteninvestIndia tions invest- ructure tial ments ments * Organisation of functions and tasks Source: Planning Commission; CEA; EIA; ASI; Interviews; McKinsey analysis

SEBs

Excess Poor manOFT* power

Supplier relations

High growth rates

Plant mix

US average

Example: SEBs Monopoly

OPERATIONAL REASONS FOR PRODUCTION GAP T&D
Index :US = 100
Underinvestment in substations, capacitors etc. 100

Outdated meter Theft Excessive

hierarchy reading technology 58

Thefts Inefficient
deployments of manpower

42 33 India India average average = 4% = 4% 4 SEBs 6 22 1 Excess manpower Poor OFT* Lack of viable investments Best practice India Excess manpower Poor OFT* Lack of viable investments India potential Low per capita consumption US average 2 5 2

* Organisation of functions and tasks Source: CEA; CMIE; ASI; Planning Commission; EIA; Interviews; McKinsey analysis

MONOPOLY

Disadvantages of monopoly
high prices / low output: short run high prices / low output: long run

lack of incentive to innovate

X-inefficiency

Advantages of monopoly
economies of scale profits can be used for investment

Economic & Normal Profit

In economics, the term profit has two related but distinct meanings.
Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an entrepreneur or investor. Normal profits are basically earning what is required to keep you in the business. Any less than that, and you would go do something else Economic profit (also abnormal, pure, supernormal or excess profit, as the case may be monopoly or oligopoly profit, or simply profit) is the difference between a firm's total revenue and all costs, including normal profit.