Monopoly and Other Forms of Imperfect Competition

An imperfectly competitive market is a market in which firms have at least some ability to set their own price, i.e. price setters. They enjoy a degree of market power, able to raise the price of a good without losing all its sales.

• Perfectly competitive market faces perfectly elastic demand curve for their products and it is equivalent to the market price for that product. There is NO incentive to change the price

• Imperfectly competitive market faces downward sloping demand curve for their products

Types of Imperfect Competition

• Pure Monopoly: a market in which a single firm is the only supplier of a product for which there are no close substitutes and high barriers of entry.
• Monopolistic Competition: a market in which a large number of firms produce slightly different products that are reasonably close substitutes to one
  • Product differentiation over product quality, price, marketing and branding
  • Firms can charge slightly higher prices, unlike perfect competition
  • No barriers to entry, therefore still forced to normal profit in long run

Barriers to Entry

Market power arises from barriers to entry that limits competition and the invisible hand from driving economic profit to zero. Barriers to free entry that give rise to market power are:

• Exclusive control over important inputs: control over raw materials such as rare-earth metal
• Government created monopolies: patents, licenses and copyright protection
• Network economies: products that become valuable to an individual user as the network of users grow, g. Facebook, mobile phones. Essentially a form of economies of scale

Economies of scale:

• Constant returns to scale: if a given proportion of change in inputs yields the same proportion of change in outputs
• Increasing returns to scale: if a given proportion of change in inputs yields a greater - proportion of change in outputs
• Natural monopoly: a monopoly that results from increasing returns to scale, where a single firm can serve the entire market at a lower cost than two or more firms.

For firms with economies of scale over production, the initial start-up fixed costs can be substantially large, e.g. for a pharmaceutical developing a new drug. However, once established, the marginal cost of production is very low. Thus, average total cost of production for such goods will decrease as output increases, since the large fixed cost is being spread among output

Monopolist’s Marginal Revenue

In an imperfectly competitive market, e.g. monopoly, a monopolist must cut price in order to sell additional units due to downward sloping demand curve, but it must cut price not only for the extra unit but for all existing units. Therefore marginal revenue is less than its selling price.

Graphically:

• Marginal revenue curve meets the demand curve at the y-intercept
• Marginal revenue curve cuts the x-axis at half of the demand curve

Monopolist’s Profit Maximising Rule

By the cost-benefit principle, monopolist should continue to expand output as long as the marginal revenue exceeds marginal cost. Profit maximisation rule is the same as perfectly competitive markets, i.e. marginal benefit to marginal cost, just that now marginal benefit doesn’t equal to price!

Monopolist and Economic Profit

For a monopolist to earn an economic profit, the profit maximising price, i.e. price on demand curve, must be GREATER than the average total cost.

Monopoly and Social Efficiency

For monopolists, since profit maximisation occurs when marginal cost equals marginal revenue which is ALWAYS less than price, the profit-maximising output is always below the socially efficient level

• Demand curve represent marginal benefit to society
• To achieve social efficiency, the monopolist should expand production until marginal benefit equals to marginal cost, e.g. 12
• Socially efficient output level: where market demand intersects monopolist’s marginal cost
• Monopolist will only produce at 8, the profit maximising output
• Since expanding production will benefit society, this unrealised economic surplus contributes to deadweight loss, thus inefficiency

Monopolist and the Invisible Hand

The invisible hand does not work to prevent a monopolist from earning an economic profit in the long run. However, individual self-interest still leads to people to respond to the incentive of unexploited opportunities. Potential competitors will still have incentive to develop substitute goods and lobby politicians to remove barriers to entry.

Price Discrimination to Expand Markets

Price discrimination is the practice of charging different buyers different prices for essentially the same good or service, where the differences do not simply reflect differences in costs of supplying different buyers.

Perfectly discriminating firms are price makers that charge each buyer exactly his or her reservation price for each unit purchased.

• Increase or maintain economic profit by reaching out to a larger market
• Serve the socially optimum output and thus efficient
• Benefit to monopolist of selling additional unit is the same as benefit to buyers in society
• Thus marginal revenue curve equals to demand curve

Whereas a firm that does NOT engage in price discrimination will only serve the high end of the market, i.e. those with high reservation prices, and only serve the profit maximising output. They will not serve those with lower reservation prices because that requires them to reduce the price to sell all units at the same price. From the monopolist’s point of view, this is a loss.

Price discrimination is fair because:

• It allows sellers to charge what each buyer is willing to pay
• Many buyers benefit from the discrimination by not being excluded from purchasing a product they could otherwise not afford

Price discrimination is socially efficient because:

• It can increase economic surplus and the number of buyers served
• Allows price setters to expand output without losing profit, thus reducing deadweight loss

Group Pricing

Group pricing is a form of price discrimination where different discounts are offered in different sub-markets, where members of a particular sub-market all receive the same discount, e.g. discounted tickets to seniors. Group pricing also prevents arbitrage, the act of buying a product at a low price and then reselling it to others at a higher price.

Hurdle Method of Price Discrimination

The hurdle method of price discrimination, or versioning, is when a seller offers a discount to all buyers who overcome a particular obstacle. E.g. sellers who offer a rebate to any buyer who makes the effort to mail in a rebate coupon.

A perfect hurdle is one that completely separates buyers whose reservation prices lie above it from others whose reservation price lie below it, imposing no cost on those who jump the hurdle. With a perfect hurdle, the highest reservation price among those buyers who jumped the hurdle will still be lower than the lowest reservation price among buyers who don’t.

Regulating Price Discrimination

Governments often regulate monopolies such as energy companies because of:

• Potential loss in efficiency
• Restricted output levels
• Economic profit at the buyer’s expense

Government can regulate monopolies by:

• Marginal cost pricing: forcing natural monopolies to produce output level such that price equals to marginal cost. This results in economic loss for the monopoly as they can never recover the initial fixed start-up cost
• Average cost pricing: forcing output levels such that price equal to average total cost, allowing the firm to make a normal profit.