Difference between revisions of "Economics Lecture Nine"

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In this lecture we learn the important concept of a "monopoly". Readers of the New Testament in Greek will know what a “monopoly” is by its roots: “monos” means one, and “polein” means “to sell.” A monopoly is only one seller in an industry. Examples are the United States Postal Service for regular mail, many local power companies for your gas or electricity, your cable television provider and, to some extent, your local public school system. Monopolies arise for a variety of reasons.

There are "natural" monopolies, where an industry has increasing economies of scale, such that long-run average costs of production decrease, like power companies or railroads. There are "barriers to entry" that prevent new competition, because it is so expensive to start a new railroad. There are monopolies created by government regulation (the Post Office) or by laws (copyright law is one cause of the Microsoft monopoly) or perhaps even by illegal behavior (Microsoft was found to have violated laws against anti-competitive behavior).

Thousands of companies enjoy market power that are, in effect, monopolies. Microsoft is the most profitable example. It has over 90% of the market for computer operating systems, which is the software needed to make your computer work. Microsoft’s operating system is called “Windows”. There are other operating systems available (such as Linux), but they have small market share and Windows has nearly a complete monopoly.

For most of the last century, AT&T enjoyed a monopoly over telephones. It controlled local and long distance service and equipment, including the provision of actual telephones to residents and businesses.

IBM was the big monopoly in the computer industry for a long time, particularly for businesses. The popular saying was that “no one was ever fired for recommending to buy from IBM.”

Perhaps the most famous monopoly of all time was John D. Rockefeller’s “Standard Oil,” which controlled most of the oil industry in America around 1900.

What do all these monopolies have in common? In their heyday, they made extraordinary profits.

These monopolies were able to garner enormous profits for one simple reason: they had no competition. As a monopoly increases its price, there is no other company to take customers away from it with a lower price. If Microsoft increases (or fails to reduce) its price on Windows, there is almost nothing the consumer can do about it except pay. If you want a computer that is compatible with all the other computers out there, then you will likely buy Windows even if overpriced.

Is the monopoly able to increase its price without limitation? No. The Law of Demand still applies to monopolies: demand will decrease as the price increases simply because people will buy less as the price increases. People have limits on what they will spend. Even a monopoly has to live with the demand curve. The marginal revenue is not always positive as price increases, even for a monopoly. At some high price, a further increase in price causes a larger drop in quantity, and the marginal revenue goes down. A monopoly does not increase its price further if its marginal revenue declines to equal its marginal cost.

Monopoly

A monopoly is defined as a firm that is the only seller in a market, such as the company that supplies electricity to an area. That firm has complete control of its market. There is no supply curve in this market. But note that while the monopoly is the only seller, there are still many buyers: the public. So there is a demand curve.

A monopoly is more profitable without competitors than an ordinary firm is in a competitive market. A monopoly is like a football team playing a game without an opponent. The team still has to score touchdowns, but it is so easy to do so.

A monopoly increases its profit by increasing prices, which it can do because there is no competition and no substitutes. A monopoly reduces its output when it increases its price, as fewer people buy the good due to the Law of Demand (higher price, less demand). As a result, a monopoly produces less output than the efficient quantity (i.e., less than the equilibrium level of output in a competitive market).

If you have played the board game called "Monopoly", you might have noticed that the rents on property increase enormously when someone has all two or three properties in a "color group." The player monopolizes property and then obtains much higher rent because it. The player who monopolizes the most property is usually the one who wins. In summary, monopolies are the most profitable companies.

How Monopolies Arise

Monopolies arise in a variety of ways. Government sometimes creates monopolies by operation of law. For example, maker of a vaccine will enjoy a profitable monopoly if it can lobby state legislatures to require that its vaccine be given to all public school children. A cable television company can obtain a monopoly over a region by winning a franchise from the local town. Once a monopoly forms this way, there are then enormous “legal barriers to entry” by other firms who want to compete. The law prevents competition.

Here is a list of “barriers to entry” that prevent full competition:

• The licensing of professionals creates a barrier to entry. To become a doctor, someone must graduate from an accredited medical school (which usually takes four years), and then pass certain exams. Most doctors also spend several years doing internships and residencies in hospitals. Attorneys, electricians, barbers, and just about every other line of work also have licensing procedures that constitute a “legal barrier to entry” to reduce competition by others.

• Control of a valuable resource can also create a monopoly. If you owned all the oil wells in the world, then you would essentially have a monopoly and become extremely wealthy. A company called DeBeers once controlled the vast majority of diamond production, giving it a monopoly.

• Economies of scale can create a monopoly by rewarding the biggest company with the lowest average cost. Wal-Mart fits this description, though it does not have a complete monopoly yet. There still are competitors to Wal-Mart (such as Target). But Wal-Mart is able to negotiate lower and lower costs by virtue of its enormous size, and thereby obtain enormous economic advantage.

• Finally, there are government grants of monopoly such as patents and copyrights. Thomas Edison still holds the record for receiving the most number of patents for his inventions. He created more economic wealth than any American, or perhaps anyone in history. (Except for Jesus, that is, whose teachings created the potential for unlimited wealth.)

Copyrights are what gave Microsoft its profitable monopoly. It holds and defends copyrights on its software, including Windows and Microsoft Word and Excel and Internet Explorer. Hollywood also uses copyrights to profit from its movies and prevent sales by others.

Like all “barriers to entry,” they can be misused to suppress competition or even criticism. Consider this: should copyright law apply to versions of the Bible, thereby preventing them from being copied or distributed without the owner's permission? The copyright on the King James Version has expired in the United States, but in England the Crown (King or Queen) still uses copyright to prohibit people from freely copying and distributing the King James Version.

Query: Should government own a copyright on anything, since its operations are funded by taxpayers? In the United States, the federal government does not claim a copyright in any of its works, but state governments do.

Pricing by Monopoly

Even Bill Gates and his Microsoft monopoly is limited by the demand curve, and the Law of Demand. Even for a monopoly, the higher its price, the lower its quantity sold. Overall revenue is price times quantity, so a monopoly does not maximize revenue simply by maximizing its price. For example, a monopoly will not charge a price higher than what the wealthiest people will pay.

A monopoly maximizes profit by lowering price until marginal revenue (MR) equals marginal cost (MC). The universal rule of pricing applies to monopolies just like any other firm: they all sell where MR=MC.

Because a monopoly owns its industry, all of its focus is on the demand curve. There are no competitors. Accordingly, there is no supply curve for any competitors either. There is no market supply curve when there is a monopoly, but there is still a market demand curve by the public for the good.

If a firm can raise the price of its goods or services and still hold on to some of its customers, then it must possess at least some monopoly power. Professional athletes and actors enjoys a bit of a monopoly on their own fans.

Three equations to memorize:

• In a natural monopoly, marginal cost (MC) decreases as size increases, and thus ATC > MC. The falling MC causes ATC (average total cost) to fall also, but it is always bigger than MC

• A monopoly should shut down in the short run if AVC > P when MR = MC.

• A monopoly should shut down in the long run if ATC > P when MR = MC.

Honors Example: The Straight Line Demand Curve

When the demand curve is a straight downward-sloping line, the curve for the marginal revenue of a monopoly has exactly twice the negative slope, and intersects the x-axis at exactly half the quantity where the demand curve intersects the demand curve. Let’s illustrate this by an example.

Suppose the demand curve is P = 1000-100Q. When P=0, then Q=10. The demand curve intersects the x-axis at Q=10. According to the above rule, the curve for the marginal revenue of a monopoly should intersect the x-axis at Q=5. Its equation should be P=1000-200Q. Is it? Let's do the calculations next.

At Q=5 on the demand curve, P=$500. The revenue at this point is PxQ=$2500. If Q decreases to 4 units, then P increases to $600, but the overall revenue then decreases to PxQ=$2400. If Q increases to 6 units, then P decreases to $400 and PxQ=$2400 again. Thus, moving quantity in either direction causes revenue to decline, so revenue is at its maximum at P=$500. MR=0 for any change in quantity at this point. (If you changed Q by a tiny fraction less than one unit, then you would see that marginal revenue is actually zero at Q=5).

Revenue is maximized by setting Q to equal one-half the value of Q when P=0. This is very useful when MC=0. Because a monopoly sets its price at MR=MC, when MC=0 then MR=0 can be easily determined when the demand curve is a straight line.

Honors: Deadweight Loss

Adam Smith, the founder of the “invisible hand” in economics, was an opponent of monopolies created by the government. He viewed them as very hurtful, and wrote brilliant criticisms of them. Monopolies produce less, and they charge the public more. They maximize their profit by increasing the price and reducing the quantity sold. They are also less efficient and less innovative than a competitive company.

Sometimes monopolies cause even greater harm. Microsoft, to perpetuate its monopoly, makes its software incompatible with competitors in order to force consumers to buy Microsoft products. Users cannot copy text from a Microsoft Word document and paste into a competitive product like WordPerfect, for example. When there was a clever, innovative engineer developing something at another company, which might become better than Microsoft's product, Microsoft would hire the bright engineer at a higher salary in order to stop his new project at the competitor. The harm caused by that anti-competitive strategy is enormous.

We can measure the harm caused by how a monopoly reduces its output. The reduction in output is always hurtful, because there is a loss in consumer surplus corresponding to the missing output. The loss in consumer surplus is called the "deadweight loss." Economists measure the “deadweight loss” imposed by monopolies in terms of the reduced output Q sold by a monopoly compared with the greater output that would occur in a competitive environment. The deadweight loss is the disutility imposed on society.

For a monopoly, the deadweight loss is defined as Price minus marginal cost (P-MC) summed over all of the output not sold by the monopoly that would have been sold in a competitive industry. In a competitive industry, P and Q are determined by where supply meets demand, and the good would have sold at MC. In an industry that has been monopolized by one company, the higher price charged by a monopoly summed over the reduced quantity causes the deadweight loss in the amount of the higher price used (P), minus the price that would have been used in a competitive market (MC), summed over the amount of output lost.

Notice that the net loss to society is not the amount the consumers overpay to the monopoly. That is simply a transfer in wealth, without any overall loss in societal wealth. Instead, the "deadweight loss" is only the loss in value due to the reduction in output Q. It is similar to the burden on society of a price control, a rationing system, or a tax, which also reduces the output Q. On a graph it is the area enclosed by three points: the equilibrium P and Q in a competitive market (where supply meets demand), the higher P and lower Q charged by a monopoly because there is no competition, and the lower supply cost at that lower Q.

Let’s look at an example. Suppose a monopoly cuts its output by two units that would have sold for $80, in order to reduce supply and increase the sales price to $95 for all his units. Suppose further that the marginal cost of those eliminated units is $80, and in a competitive environment all the goods would sell for $80. The social cost of reducing the production is (P-MC) = $95-80 = $15. That is multiplied by the number of eliminated units, which is two here. Total social cost is therefore $15 x 2 = $30.

A sales (or excise) tax on a good also causes a "deadweight loss" even when there is no monopoly, because the tax has the effect of increasing the price and reducing the output. In the case of an excise tax, the "deadweight loss" is both the decrease in consumer surplus and the decrease in producer surplus due to the lower output and higher price. Revisit the graph in Lecture 7 to see a graphical display of these two surpluses.

Differences Between Monopoly and Competition

Now that we have learned about perfect competition, at one extreme, and the monopoly, at the other extreme, let's contrast the two. The biggest difference is that consumers obtain goods at cheaper prices when there is competition than when there is a monopoly. Competitive companies will produce goods at their minimum average total cost in the long run. Monopolies usually do not.

Quality may also be better in a competitive industry. Microsoft Windows is not only expensive, but many think it is not as good as a competitive operating system would be. For example, it takes a long time to "boot up" and it sometimes "hangs", requiring users to turn off their computers (and lose their work-in-progress) in order to reboot. These annoyances are not efficient, and reflect poor quality.

Another difference between a monopoly and perfect competition is that an increase in demand does not necessarily cause a monopoly to supply more. In contrast, in a competitive industry, an increase in demand always forces an increase in supply (greater Q).

As an owner of a small business, you want perfect competition in the markets from which you buy your inputs, including your supply materials and your labor. That way you can keep your costs down. But you would want a monopoly for your own company in the market in which you sell your good or service. That way you could charge more and make higher profits.

In reality, there is almost never perfect competition, and complete monopolies are also rare. The business world is typically somewhere between perfect competition and a monopoly, depending on the market. Some markets are more competitive than others. Some companies enjoy more of a monopoly than others.

What Is Between a Monopoly and Perfect Competition?

The spectrum of different types of markets looks like this:

1. Monopoly
2. Cartel
3. Oligopoly
4. Monopolistic Competition
5. Perfectly Contestable Markets
6. Perfect Competition

For all of the above, the selling price P is determined by when MC=MR, but the higher in the list, the higher that price P will be. The lowest P occurs for perfect competition, for which P=ATC.

Let’s review each type of market next:

Monopoly

A monopoly is a single seller of a product having no competition or close substitutes. The seller comprises the entire industry.

A related concept is the “monopsony”, which is a “buyer’s monopoly.” It consists of a single buyer of a good or service. In a one-company isolated town, where one company employs most of the people, the company is nearly a monopsony with respect to labor in that town. Notice that the more it hires, the greater its wage costs will become. But perfect monopsonies are difficult to imagine. Can you think of another one?

Cartel

A cartel is a group of producers who agree on fixing prices, restricting output, or allocating market share. OPEC, a group of mostly Arab oil producers attempting to keep profits high, is the most famous cartel. Cartels are illegal in the United States; they are prohibited here by American antitrust law.

Oligopoly

An oligopoly is a few producers who dominate a market without fixing prices or output. If the good is identical among the companies, then it is a perfect or pure oligopoly. Examples include the steel and cement industries. Cement is cement, period. If the good is not identical, then it is an imperfect oligopoly. Examples are the car or soap industries. Cars are not identical to each other, but the auto industry is an (imperfect) oligopoly.

Monopolistic Competition

This has more sellers than an oligopoly and more competition too. But companies are able to increase their prices without losing all their customers. Why? Because in monopolistic competition there are “differentiated products.” An example is the haircutting or hairdressing industry. Cutting hair is a service that is not a perfect substitute for other haircutting services. One with a loyal customer base can increase her prices without losing all her customers.

Perfectly Contestable Markets

This is where there is no barrier to entry into the market and no start-up costs. There are only a few sellers, or maybe only one seller, but competition is always threatened. A newspaper vendor in a shopping mall is an example. He may be the only one, but he does not have an monopoly because it is so easy for another competitor to start selling newspapers. This "perfect" threat of competition forces him always to keep his prices as low as he can.

Perfect Competition

A large number of sellers and buyers have full knowledge and perfect mobility of resources. The good or service is homogeneous. Competition is ruthless in keeping prices down. Price (P) equals Marginal Cost (MC) equals Average Total Cost (ATC). This is what happens when Wal-Mart moves in next door!

Understand all the above concepts? We’ll review the most important ones now in greater detail.

Oligopoly

Memorize these three conditions for an oligopoly market: (1) few companies, (2) high barriers to entry, and (3) similar goods.

The car industry is a good example: General Motors, Ford, Toyota, and a handful of others. All the car companies in the world could be listed on one sheet of paper. So this satisfies the first condition: few companies.

Is there a high barrier to entry? Yes. It is not easy or cheap to start a new car company. There has not been a new American car company in decades. John DeLorean was the last one to try, and his effort went bankrupt. So condition two is satisfied.

Are cars similar goods? Yes again. There are differences, of course, but they all have four wheels, an engine, and run on gas (or sometimes an electric rechargeable battery). They take you from point A to point B. When you need to drive somewhere, you usually do not care what type of car is available. Any one will typically do. So condition three is satisfied.

Thus the car industry is an oligopoly. Can you think of other oligopolies?

Oligopolies, like monopolies, can charge higher prices than when there is perfect competition. The high barrier of entry keeps new competitors out. With less competition, it becomes possible to increase prices and reduce output. Both oligopolies and monopolies can do this. But there are limits: the Law of Demand still applies to every type of firm.

The major difference between the oligopolies and the monopolies are that there is at least some competition in an oligopoly. Ford could cut prices on its cars to attract customers from Toyota.

You can see an oligopoly at some street corners. How? If there are two gas stations at a street corner and no other ones nearby, then that has some characteristics of an oligopoly. Not a monopoly, because there are two of them. But not perfect competition either, because there are only two and they may end up raising their prices in imitation of each other.

There are two models for what the demand curve looks like for an oligopoly. One famous model is the “kinked” demand curve. In this scenario, if one firm raises its price then the other firms do not have to imitate it. The firm that raises its price sees a sharp falloff in demand. The change in slope causes the “kink” in the curve. However, if a firm lowers its price, then the other firms must lower their price also to keep their customers.

The other model for an oligopoly is when there is a dominant firm that sets the price for the entire industry as the “price leader.” There can be many smaller firms or companies, but they follow the pricing of the dominant firm. If they don’t, then the powerful firm can “punish” them with price-cutting. If the demand is relatively inelastic, then the dominant firm sets a high and profitable price. The smaller companies must follow it in order to avoid being “punished” for underselling it.

Game Theory and the Nash Equilibrium

"Game theory" is the serious study of strategy used in game-like situations, such as multiple participants competing against each other in some way. One insight by the mathematician John Nash about game theory applies to oligopolies, and it won him the Nobel prize in Economics. Hollywood, in a rare moment of excellence, made a fine movie about him called “A Beautiful Mind,” which won an Academy Award.

His insight is called the Nash equilibrium, which predicts an "equilibrium" set of pricing decisions by firms, where the market "settles down" to a stable price.

The Nash equilibrium occurs when no firm can improve its position by changing its decision, assuming the other firms' decisions remain unchanged. If a firm can improve its position, then it does so, and then check again to see if another firm can improve its position. Keep doing this until no firm can improve its position on its own, and then you've found the equilibrium (the Nash equilibrium). Group decisions are prohibited, just as oligopolies are prohibited by law from making decisions together.

A famous application of the Nash equilibrium is the "prisoner's dilemma," whereby two partners in crime are interrogated in separate rooms. In this "game" the best individual result is obtained by one criminal if he confesses but his partner does not, and the second best result is if neither confesses. But if neither confess then one criminal can improve his outcome by confessing and testifying against his partner, and then the other criminal can improve his result by also confessing. The Nash equilibrium predicts that the outcome moves to an "equilibrium" of both confessing.

Microeconomics exams usually have at least one question about the Nash equilibrium. Trial-and-error using the above bolded rule helps to solve it, and then check your answer by switching the rivals in the game (or firms in the market). The outcome should be the same no matter how you interchange the rivals, and at the equilibrium no one acting alone should be able to improve his reward by changing his decision.

Example: two gas stations at the same intersection. The Nash equilibrium for the prices charged will not be higher than marginal cost, because if it were, then one of the two gas stations would lower its price slightly in order to attract customers from the other gas station. But then the other gas station would also lower its price to avoid losing its customers. Eventually the price for both stations would become equal to their marginal cost, and neither gas station would be able to improve its profits by changing its price.

Cartel

A cartel is an illegal oligopoly whereby the firms agree with each other to "fix" or increase prices. In a cartel, the companies have an actual agreement with each other to raise prices, reduce supply, and otherwise reduce competition. This is illegal in the United States. But foreign countries -- the oil producing nations of Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela -- formed a big cartel known as “Organization of Petroleum Exporting Countries,” or “OPEC”.

On the CLEP exam you need know only this: a cartel causes higher prices and less quantity than competition. A cartel is nearly as bad for the public as a monopoly, except in a cartel some of the companies may "cheat" and sell more output at a lower price than the fixed, agreed-upon price.

In a cartel, there are (1) relatively few companies, (2) high barriers to entry, and (3) a higher price and lower output determined by agreement so that all companies act alike (except for some cheating that may occur by some of the companies).

Conservative economists predict that eventually the invisible hand, and competition, will prevail. A famous American economist, the late Milton Friedman, predicted that even OPEC would eventually fail. Indeed, OPEC has lost much of its former power to control oil prices, and it faces competition from Russia, Mexico, the United States, Canada, and other non-OPEC nations.

Monopolistic Competition

Finally, we need to explore the concept of “monopolistic competition.” It has four conditions: (1) many buyers and sellers, (2) goods that have differences among each other, (3) sufficient knowledge about the market, and (4) free entry into the industry by new companies.

Earlier we mentioned barber or hairdresser shops as an example. They have relatively small start-up costs (low barrier to entry), and there are many buyers and sellers. The services are not identical. They are not perfect substitutes for each other, so differentiation is possible. Each company is able to develop a loyal clientele. Knowledge is fairly high about the market.

Each company acts like a mini-monopoly over its loyal customer base, and it also competes against the other mini-monopolies.

Can you think of other examples of monopolistic competition? Perhaps CDs by popular singers, or books by popular authors?

Assignment

Read and, if necessary, reread the above lecture. Homework is lighter this week to give you a break after the exam last week.

Answer 4 out of these 5 questions:

1. Identify an industry not mentioned in the lecture that is an oligopoly, and explain why.

2. Order the types of industries from those having the lowest price (due to the greatest competition) to those having the highest price (due to the least competition).

3. Explain which specific type of industry (e.g., oligopoly or something else) each of these quotes probably refers to: (1) "She's the finest hair stylist in town; no one has her special style!", (2) "Crazy Eddie ... his low prices are INSANE!", (3) "Don't like his prices? He's the only one in town selling what you need."

4. List how monopolies can be established.

5. What prevents a monopoly from increasing its prices without limitation? Explain.

Honors

Answer question 6, and then 2 out of the subsequent 3 questions:

6. Where is the Nash equilibrium for this set of options, where (x,y) represents the profits to (Firm A, Firm B)? Explain.

7. Monopolies: should the government regulate them? Or is regulation worse?

8. Does the "deadweight loss" equal the "consumer surplus"? Explain the relationship.

9. How does a monopolist maximize his profits?