Economics Lecture Nine

Economics Lectures - [1 - 2 - 3 - 4 - 5 - 6 - 7 - 8 - 9 - 10 - 11 - 12 - 13 - 14]

This Lecture is shorter because we first take the midterm exam. Now we are more than halfway through this course. We have already covered all of the basic concepts and are applying them to various new situations.

Today 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 in these entries, because it is so expensive to start a new railroad from scratch (nothing). 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 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. Microsoft still does.

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 when its marginal revenue is less than zero, or when it is less than its marginal cost.

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.

There are several other “barriers to entry” that prevent competition. They are listed and described below:

• The licensing of professionals creates a barrier to entry. To become a doctor, someone must go to an accredited medical school (which usually take 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 have licensing procedures that constitute a “legal barrier to entry” to reduce competition.

• 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. Your would become the wealthiest person in the world. 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 economic wealth in addition to the obvious spiritual 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 it.

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 the 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. At highest price extreme, 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 monopolists 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 for the public.

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, but competition does exist for those fans.

Three equations to memorize:

• In a natural monopoly, there is 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.

If the demand curve is P = 1000-100Q, then when P=0, Q=10. That 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?

At Q=5 on the demand curve, P=$500. The revenue at this point is PxQ=$2500. If Q moves to 4 units, then P moves to $600 and the revenue decreases to PxQ=$2400. If Q moves to 6 units, then P moves to $400 and PxQ=$2400 again. Moving quantity in either direction causes revenue to decline, so revenue is at its maximum. Marginal revenue, therefore, is no longer greater than zero. In fact, MR=0 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.

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. Microsoft would also hire innovate engineers who were developing something new that might be better than Microsoft products, and put these bright people into an office at Microsoft and stop their new work. It is difficult to measure the enormous harm caused that anti-competitive strategy.

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 to the greater output that would occur in a competitive environment. The deadweight loss the disutility imposed on society by a company.

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.

Note 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 lost consumer surplus and the lost producer surplus. Revising the graph in Lecture 7 to see a graphical display of these two surpluses.

Differences Between Monopoly and Competition

There are several important differences between a monopoly and competitive industry. 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 frequently “hangs” such that people have to reboot their computers. That annoyance is neither efficient nor competitive.

Another difference 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).

You would want perfect competition in the markets from which you buy your inputs, including your supply materials and your labor. That way you could keep your costs down. But you would want a monopoly for your 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. 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.

This lecture is devoted to all those situations in between perfect competition and true monopoly. The spectrum looks like this:

1. Monopoly (MC=MR is how the price is determined)
2. Cartel
3. Oligopoly
4. Monopolistic Competition
5. Perfectly Contestable Markets
6. Perfect Competition (P=ATC, average total cost, is how price is determined)

As a seller, you make more money the higher you are on the list. As a buyer, you save more money the lower you are the list. Let’s introduce each term:

Monopoly

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

Cartel

A group of producers that band together to raise prices, restrict output, or allocate market share. OPEC, a group of mostly Arab oil producers attempting to keep profits high, is the most famous cartel.

Oligopoly

A few producers that 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 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 her business.

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 it is so easy for another competitor to start selling newspapers that he always keeps 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!

There are other terms worth knowing in this area. “Monopsony” 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. Note 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?

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

Oligopoly

There are only a few firms in oligopoly. There are also high barriers to entry so that new companies cannot enter the industry and compete with existing firms. Each firm produces similar products.

Memorize the conditions: (1) few companies, (2) high barriers to entry, and (3) similar goods.

The car industry is a good example. General Motors, Ford, Toyota, Daimler-Chrysler, and so on. All the car companies in the world could be listed on one sheet of paper. There are only two American-owned car companies: GM and Ford. 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. I have not heard of new American car company being started in the last ten or fifteen years. 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. 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?

In some ways oligopolies are like monopolies, and in other ways they are not. Oligopolies are like monopolies in that the high barriers of entry keeps new competitors out. With less competition, it becomes possible to earn greater profits. Both oligopolies and monopolies can do this. But note that both are constrained by the downward-sloping demand curve.

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 GM. The pricing decisions of one company in oligopoly shift the demand curve for the other companies. When Ford raises its prices, for example, this causes the demand curve to shift upward for GM, to its benefit.

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 several 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. Its demand curve has a lower slope (e.g., more like a horizontal line) than the demand curve for the industry. 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.

Cartel

A cartel takes an oligopoly one step further. In a cartel, the companies have an actual agreement among each other to raise prices, reduce supply, or otherwise reduce competition. This is illegal. Agreements by companies to reduce competition are prohibited by federal law. The federal government can prosecute and convict anyone who agrees or conspires to reduce competition.

Even if the federal government does not get involved, private individuals or companies can sue to recover damages that result from agreements to limit competition. The penalties are harsh: they include treble (triple) damages plus an award of all the attorneys fees of any plaintiff who proves a restraint of competition or trade. These laws are called the antitrust laws, passed in the late 1800s and famously enforced by President Teddy Roosevelt in the early 1900s.

So if it is illegal, then why study it? First of all, important producers in foreign countries ignore our laws. The biggest and most dangerous cartel is the “Organization of Petroleum Exporting Countries,” or “OPEC”. Check them out on the internet at http://www.opec.org . It has eleven member countries: Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela. The website includes many facts about those countries and their oil production.

You may be wondering why we care what these foreign countries do with their oil production. The problem is that they control a substantial percentage of the production of oil in the world. When they agree to raise prices or reduce output, it directly affects the price of gasoline in America. Some have suggested that the federal government should use antitrust laws and sue this cartel due to its impact on American consumers.

In a cartel, there are (1) relatively few companies, (2) high barriers to entry, and (3) price and output determined by agreement so that all companies act alike. But isn’t that similar to a monopoly, with the only change being a few companies acting as though they are one?

There is one key difference: in a cartel, there is an incentive for each company to cheat. Iran can agree to the price and output of the OPEC cartel, but then secretly sell more oil at a slightly reduced price to maximize its profits. Other ways to maximize profits in a cartel include offering rebates or providing additional services or higher quality. This maximizes the profits of the cheating company, and reduces the profits of other members of the cartel.

Conservative economists, such as the late Milton Friedman, often predict that cartels cannot survive long-term. The profit incentives to violate the agreement cause the companies to go their different ways. Eventually, competition returns.

In a sense this has even happened to OPEC, the most powerful cartel of all. That cartel was able to cause a fourfold increase in oil prices after we helped Israel in the Yom Kippur War. There were enormous lines at gas stations in 1973 due to the oil crisis. Your parents would remember it. It was known as the 1973 Energy Crisis. In some areas of the United States, drivers of cars with odd-numbered license plates were only allowed to purchase gas on Monday, Wednesday and Friday, while even-numbered plates were assigned to Tuesday, Thursday and Saturday. People were prohibited from buying less than certain amounts at gas stations to prevent hoarding and try to reduce lines. But what would be the real cause of any shortage?

Think back on what you have learned earlier in the course. There is one major cause of shortages, and it is not the invisible hand. It is government price controls. In 1973, the government imposed certain price controls on gas, and that caused the shortages and inefficiently long lines at gas stations.

Milton Friedman would say that eventually the invisible hand does prevail. OPEC does not still have so much power over oil prices today, 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 asks like a mini-monopoly over its loyal customer base, and it also competes against the other mini-monopolies.

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

Nash Equilibrium

<use material from entry here> Here is the insight that won John Nash a Nobel prize in economics and led to a popular, Academy-Award winning movie called “A Beautiful Mind.” This is called the Nash equilibrium. It applies in particular to oligopolies.

When you have a small number of sellers, as in an oligopoly, the Nash equilibrium occurs when no seller can benefit by changing his price while the other sellers keep their prices unchanged.

The most famous example of the Nash equilibrium is the “Prisoner's dilemma,” where two accused persons are separated and interrogated. If neither confess, then no crime is proven and they must be released. If both confess, then they receive harsh sentences. If one confesses and the other does not, then the confessor is released but the other receives even harsher punishment.

The Nash equilibrium predicts both will confess, which is not their overall optimal result.

Assignment

Read and, if necessary, reread the above lecture.

1. An oligopoly that illegally agrees to raise its prices is called a __________.

2. List three industries that are oligopolies and explain why.

3. As an industry becomes more competitive, what happens to price (P) compared to marginal cost (MC)? Explain.

4. Suppose Daniel’s company sells goods in an industry having a demand curve with this set of Qs and Ps: (1,30), (2, 28), (3, 26), (4, 24), (5, 14), (6,8), (7,2). What type of industry is this, and what type of demand curve is this? If marginal cost equals $20 (MC=20), then what are the output and price in this industry?

5. Suppose you saw three different advertisements in three different industries: (1) “The lowest price in town is at Zack’s!”, (2) “Buy more channels from your cable service provider!”, and (3) Matt is the smartest surveyer in town ... call him to survey your property!” What type of industry would each ad likely represent?

6. What kind of industries are these: (1) one cleaners in town that sends the clothes out to be cleaned, (2) three car mechanics in town with hydraulic lifts and expensive electronic equipment, and (3) many apparel stores with distinctive fashions? Will consumers obtain the best prices?

7. Suppose two students separately own the only widget companies in the entire world. They sell at the same price and have no plans to change that. But they might advertise. If both advertise, then they lose profits due to the advertising expenses. If neither advertises, then they make the largest profit by reducing expenses. But if one advertises and the other does not, then the one that advertised makes phenomenal profits. What happens?

1. A monopoly can be extraordinarily profitable because there is no __________.

2. Provide three specific examples of monopolies and describe briefly what they do.

3. Given an example of how you lose time, money, or efficiency due to a specific monopoly.

4. “Monopolies may be bad, but government regulations of monopolies are even worse!” Do you agree? Explain.

5. List ways that monopolies can be established.

6. Suppose Katie likes to paint for money or even for free, but will not pay extra to paint. Suppose also that the monthly demand for her paintings is P = $500 - 50Q. How many paintings does she create each month?

7. List some differences between a monopoly and a competitive industry.

8. Suppose Anthony owns a company having marginal costs of $5 for all his units. If he sells only one, then he reaps $11; selling two fetches a price of $10 piece; selling 3 attains a price of $9; selling four reaps $8; Q=5 would have P=$7; Q=6 has P=$6, etc. A competitive firm would have the same cost and demand numbers. What does Anthony sell at, and what is the social cost of his monopoly?

9. Estimates are not very accurate about homeschooling, but some guess that 1 out of every 25 students is homeschooled. At what level or fraction would homeschooling end the public school monopoly? Discuss.

10. Suppose you live in a valley where water flows freely and abundantly from a spring. Suppose your entire family uses on average 80 gallons a day. But then a company bought the spring. If the demand curve is a straight line from P=$100, Q=0 to P=$0, Q=80, at what price and quantity would the company sell water?

11. Monopolies: should the government regulate them? If so, how?

New questions:

1. Identify something that a firm in monopolistic competition is unable to do.

2. How does a monopolist maximize his profits?

Honors

3. Nash Equilibrium question, with grid of choices and options.