Chapter 13
The Monopoly Game
In This Chapter
Understanding the monopolist mindset
Seeing why consumers and society lose out under monopoly
Combating monopolies
You can relax — despite its title, this chapter has nothing to do with the board game Monopoly and so you don’t have to pick whether to be the dog or the car or whatever. You don’t even have to explain why you didn’t choose the iron (no one ever does). You may, however, come away with some better ideas for how to win the game, if you ever find yourself playing it.
The kind of monopoly we’re interested in is the opposite of a competitive market (which contains many firms, none of whom has a significant market share): In a monopoly, one firm supplies the entire market. As you can imagine, when the production of a good is under monopoly control, there are plenty of consequences, most of which make economists quake in their boots.
In this chapter, we show you that a monopolist behaves differently from a firm in a competitive market and consumers lose out as a result. We also have a word or two about some of the other consequences of monopolies and how to deal with them in the real world. Plus, we describe the case of when a natural monopoly arises.
This chapter discusses a monopoly that is 100 percent a monopoly, the type of monopoly that economists use to compare to perfect competition. When you hear about the Department of Justice or the Federal Trade Commission investigating a monopoly, they’re almost certainly not dealing with a monopoly as we describe here, but with what economists call market dominance. For example, a dominant firm may have only 40 percent of a given market, while each competitor has at most 5 percent. Although the media often refer to this situation as a monopoly, the monopoly of this chapter has 100 percent of the market all to itself.
But forgive us for, ahem, monopolizing your attention. We now get right into monopolies.
Entering the World of the Monopoly
For a producer, a monopoly is a good thing to have. The absence of competition means you can make long-run profits — which would get competed away in a markets that had competition. If you supply the entire market, you can raise price higher than a competitive firm would without fear of being undercut. You may also get lazy and stop innovating when you’re not under any threat of an innovative competitor making a better product.
But consumers keenly feel the downsides of monopoly: They have to pay a higher price for goods, and society as a whole loses welfare because a monopoly doesn’t have to be productively efficient. That’s a problem and it’s one reason why economists are keen to recommend that markets be made competitive.
When you understand why profits are zero, and consumers get all the surplus in perfect competition (see Chapter 10), you will also see how monopolies do the opposite. Monopolies are better for the producer at the expense of the consumer and society as a whole.
Monopoly and competitive markets: The case of the missing supply curve
In a competitive market, you use the structure of the supply and demand model in Chapter 9 to investigate the way prices, quantities, and equilibrium change in a given market. When you have perfect competition, you focus on the marginal company — as in Chapter 10 — because it helps to see how prices affect each firm’s decision and then you aggregate up to the industry level. In contrast, a monopoly firm supplies the whole market, and that means you want to look at its decisions in a slightly different way.
One thing that’s different is that you aren’t looking at the aggregate of many firms’ decisions: You’re looking at just one firm. Therefore, you have to analyze how the monopoly supplies the market in a slightly different way. This section takes you through that process.
Here’s a conundrum for you: Equilibrium is usually identified as the point where demand and supply curves cross (as discussed in Chapter 9). But if you look at Figure 13-1, which describes the same equilibrium features in a monopoly, you can see that the supply curve has disappeared. We deal with this situation now.
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Pc = Marginal cost price in a perfectly competitive industry, Pm = Monopoly price, D (=AR) = Demand (= Average revenue), MC = Marginal cost, MR = Marginal revenue. MR= MC determines monopoly output.
Figure 13-1: Comparing monopoly to perfect competition.
The supply curve for a “normal” (that is, not monopolized) market comes from adding up the marginal costs of producing outputs for each of the individual firms in the market at each quantity of output.
But for a monopoly, only one firm is supplying the market, so the supply curve for that market is the same as the marginal cost curve of the monopoly. Therefore, instead of looking at the equilibrium supply and demand for the market, you can just look at the cost of supplying the market for the one firm. In a monopoly market, there is no need to construct a supply curve.
Thinking like a monopolist: “It’s mine … all mine! Bwa-ha-ha!”
We now think about what the monopolist is doing and how this mindset compares to a company in a competitive market. Again, economists are focusing on decisions of the firm — what it will want to produce at what price and how much it will make for doing it. Let’s go through an example now.
Looking at a monopoly model
To start, we assume that the monopolist, just like all the firms in this book, wants to maximize profits. With that in mind, let’s identify the profit-maximizing equilibrium for the monopoly. Figure 13-1 shows average and marginal cost curves looking more or less the way they do for a competitive firm (we define these curves in Chapter 7).
But what’s that? The demand (or average revenue, AR) curve and the marginal revenue (MR) curve are no longer identical — something that has some important implications.
The monopolist is the only firm supplying this good, so the market demand curve (derived by adding up all the consumer demand curves) is the same as the firm’s demand curve. So, the demand or average revenue curve for the monopolist is downward sloping. How much this firm sells on the market affects market price. That’s of course not true for a perfectly competitive firm whose output choice does not affect market. This demand (or AR) curve can be expressed by the following formula:
where Q is quantity.
This means that as Q goes up, AR goes down, and so the curve slopes downwards as we would expect normal market demand curves do.
Now multiply both sides of the equation by Q to turn it into total revenues (TR):
Now the marginal revenue curve, the contribution made by selling each additional unit, is going to be the change in TR as quantity, Q, changes. In other words, marginal revenue (MR) is the slope of the total revenue (TR) curve.
You can find the slope in a lot of ways. Probably the easiest is to work it out on a diagram, but we’re going to use a little bit of calculus here and find the slope of TR by differentiating it with respect to Q:
Look at the resulting equation. The 10 (the intercept — the place where it crosses the axis) is the same on both the AR and MR equations, telling you that it crosses the vertical axis at the same place.
But the important difference is when you look at the change in MR and AR when Q changes: This is captured by the bit after the minus sign. The minus sign indicates that both curves slope downwards, but the coefficient in this case says that the marginal revenue curve slopes down twice as fast as the average revenue or demand curve. At this point, you may ask what does all this have to do with the price of beans? Well, provided the beans are supplied by a monopoly, quite a bit.
Remember the profit-maximizing condition: MC = MR. Here, the evil bean monopolies (and the evil bean counters who presumably work out how many beans they should produce) set their output to maximize profits and then read off the demand curve the price (which, remember, equals average revenue) that the beans command in the marketplace. Looking at Figure 13-1, you can see the big difference between the marginal cost price (Pc) that you’d get in a perfectly competitive industry and the monopoly price (Pm) that you see here. So, a profit-maximizing monopoly supplies less output at a higher price.
Using quantity over price
You may want to call shenanigans on the way we look at this issue; after all, we do everything in terms of quantity and only mention price right at the very end. Well, we do so for a very sensible reason.
Even the most evil monopolists in the world can’t choose the quantity they make and the price the market is willing to pay for it. They have to choose one or the other, as follows:
- Set the price and allow the market (that is, consumers) to decide what quantity will be bought.
- Set the quantity and allow the market to determine the price consumers will pay for it — the price that clears the market.
Unless a monopolist can force price and quantity at the point of a gun, which in a marketplace they generally can’t, it must choose to work with either price or quantity, not both. In this case, we prefer to model monopolists as quantity setters to make comparisons across different types of market, so that we can use the same type of calculations to compare them.
Considering profits
So, the evil bean monopoly (picture a baked bean with a dismissive smirk on its face) is making the same type of decision but getting a higher price for its beans. Now, we look at its profits.
Again, remember that a firm in perfect competition makes in the long run economic profits of zero, and so the marginal firm is indifferent between being in the market and being out of it.
A monopoly, though, is alone in the market and stays a monopolist as long as there are barriers to entry. This means that if you’re making profits in that industry, you no longer face the threat of a new competitor coming in and competing away those profits. Figure 13-2 illustrates the profits a monopoly makes when it behaves rationally.
© John Wiley & Sons, Inc.
Pm = Monopoly price, O = Average cost at monopoly output, D (= AR) = Demand (= Average revenue), MC = Marginal cost, MR = Marginal revenue, Q = Quantity, AC = average cost.
Figure 13-2: Profits in a monopoly.
Remember profit are equal to total revenue less total cost.
And total revenue equals price multiplied by quantity. That means that we can rejig our equation a little by taking the quantity out of it. Total revenue divided by quantity is just price, and total costs divided by quantity are therefore average costs. So, to go through the stages:
Factor the terms on the right by quantity so that you can write Q out of the brackets:
If you take the markup on the right-hand side (price – average cost) and multiply it by quantity, you get the total level of profit, above zero, made by the monopoly.
Look at Figure 13-2 again. The area between AC*, Pm, Q*, and the demand curve gives the profits made by the monopoly.
Stretching a point: Elastic demand
We want to deal with one final implication of the model of a monopolist’s profit-maximizing choices here.
Monopolists produce only where the demand curve is elastic (see Chapter 9 for more on the elasticity of demand). The demand curve is inelastic when the elasticity of demand is between 0 and 1. On the inelastic part of its demand curve, the monopolist has an incentive to raise price.
To see why, consider quickly the relationship between marginal revenue and demand (discussed in the earlier section “Thinking like a monopolist: It’s mine … all mine! Bwa-ha-ha!”). The marginal revenue curve crosses the quantity axis at exactly halfway down the demand curve.
At the point where demand is exactly unit elastic, that is, where the marginal revenue is zero, any change in price leads to an exactly counterbalancing effect on quantity demanded. Below this point, demand is inelastic, and marginal revenue is less than zero, and so at no point where demand is inelastic can marginal revenue equal marginal cost. The fact to remember is that the monopoly only ever produces where demand is elastic.
In the messy world of reality, monopoly is constrained by antitrust laws enforced by the Department of Justice and/or the Federal Trade Commission. The law doesn’t deal with the consequences of pure monopoly as described in the textbooks, but with market dominance. The courts are treating almost no cases of a monopoly as we describe it in this chapter.
We say a little more about how this works in the later section “Tackling Monopoly in the Real World,” but for the moment, just bear in mind that legal monopoly (that is, the way in which the legal system defines a monopoly) and economic monopoly (what we talk about in this chapter) are related but distinct concepts.
Counting the Costs of Monopolies
In any particular market, welfare can be measured by the sum of producer and consumer surplus — see Chapter 9 for the definitions and an example of how this works. A monopoly is no exception.
What is important about a monopoly is that it causes a welfare loss to society as a whole, because it produces a lower quantity at a higher price. The monopolist does this to gain relatively more of the potential surplus that in a perfectly competitive market would have gone to consumers. If a monopoly could charge different prices to each consumer, it would do so and try and gain even more surplus at the expense of consumers. This is called price discrimination, and being able to price discriminate across consumers will reduce what we call the deadweight loss of surplus.
The next section shows you what the deadweight loss is and three ways monopolies can get some of it back.
Carrying a deadweight
One of the costs of monopoly is the deadweight loss that results from monopolists producing less output compared to competitive firms.
In Figure 13-3, we make a little comparison between the two cases.
© John Wiley & Sons, Inc.
Pc = Marginal cost price in a perfectly competitive industry, Pm = Monopoly price, D (= AR) = Demand (= Average revenue), MC = Marginal cost, MR = Marginal revenue, Q = Quantity.
Figure 13-3: Deadweight loss.
Worrying about the deadweight loss
In a competitive market, equilibrium is achieved where demand and supply cross. Because the supply curve is the sum of marginal cost curves, you know that the market price is equal to the marginal cost of output at each firm. Fine!
But look at the evil bean monopoly mentioned earlier and see the difference. The bean monopoly produces an output level where MC = MR, which is less than in a competitive marketplace, which would produce up to the point where the marginal cost curve crosses the demand curve, where P = MC.
In Figure 13-3, the area bounded by Pm and MR=MC (on the vertical axis) and the place where the marginal cost curve crosses the demand curve represents losses in welfare (that is, the sum of consumer and producer surpluses — as in Chapter 9) that are not realized in the economy due to the monopolist producing less output. Economists call this the deadweight loss caused by monopoly. Note that it consists of lost consumer surplus and lost producer surplus.
For economists, this deadweight loss is a troubling issue. They aim to see more produced for less resources overall, which happens in competitive markets. Economists can accept competition not being perfect, but when the monopoly makes higher profits and everyone loses out as a result, they start to get a little nervous. As a result, pretty much every economist since the days of Adam Smith has tried to find ways of preventing the monopoly situation from arising.
Using three degrees of price discrimination
In competitive markets, firms sell at the same price — any attempt to raise price or charge consumers different prices is undermined by arbitrage. This restriction doesn’t hold for a monopolist, though. A monopolist can use three cunning ruses to grab some of the potential surplus in the market.
These methods, collectively known as price discrimination, all have the end result of allowing a monopolist (or, in the real world, a firm with a significantly dominant position) to appropriate more surplus from consumers. The methods differ as to how many different prices a monopolist is able to charge for the same good, and so economists distinguish them by degrees, just like a prosecutor distinguishes crimes by seriousness in an episode of Law and Order.
We start at the top with the case when a monopolist is able to charge every consumer a unique price for its product.
First degree (or perfect) price discrimination
In this case, the evil bean (monopoly) company sells the same product (standard beans) at a different price to each consumer, such that each bean is sold to that consumer who values that bean most.
Figure 13-4 illustrates this scenario using a greatly simplified version of the earlier diagram (Figure 13-3). Here, the monopolist charges any consumer at the maximum price that they’re willing to pay for that good. As a result, the monopolist wants to sell to consumers as long as the price a consumer is willing to pay for that unit is greater than the marginal cost of that unit. The monopolist will produce up to where P = MC and extract every penny of consumer surplus. This means the consumer surplus that was lost when it charges a single price is now regained and goes to the monopolist. This eliminates the deadweight loss; but the real kicker is that all the welfare goes to the monopolist as producer surplus.
© John Wiley & Sons, Inc.
D (= AR) = Demand (= Average revenue), MC = Marginal cost, PC = Marginal cost, Pm = Monopoly price, MR = Marginal revenue.
Figure 13-4: First degree price separation.
First degree price discrimination was considered to be exceptional or very rare indeed, to the extent that it only existed in textbooks, largely because when you think about the practicalities of charging everybody different prices you realize how difficult it would be. You would have to identify “who is who” on the demand curve and prevent arbitrage among consumers who could buy at a low price and resell at a higher price.
These challenges are less daunting with the advent of online transactions, big data, and auction-style markets. Now first degree price discrimination is much simpler. Firms can now track customers and learn a lot about their willingness to pay — and in the case of services like airlines, you can easily prevent resale of the ticket.
Just because charging everybody different prices may be technically possible, please don’t get the idea that it’s always feasible in practice. Amazon, among other companies, has fallen afoul of customer complaints when customers noticed different prices being quoted to different customers and judged this to be an unfair practice.
Second degree price discrimination: Non-linear pricing
In second degree price discrimination, the price per unit paid by a consumer depends upon how much of the good (how many beans) the consumer buys.
Bulk discounts are an example. Here, the general principle is that the largest purchaser pays a lower per unit price because he buys a large quantity, whereas a consumer who buys a small quantity is charged a higher per unit price. The packaging of the goods makes it difficult for arbitrage — that is, difficult for the large purchaser to unbundle the package and resell it in smaller packages at a profit. Under second degree price discrimination, if two different consumers buy the same amount of the good, they pay the same amount. Differential pricing is based on quantity purchased by the consumer.
In contrast to first degree price discrimination, second degree price discrimination is relatively commonplace. Think for a moment about the market for soft drinks, typically sold by the wholesaler in cases of 24 cans. Suppose you operate a corner shop and sell, say, 5 cases a week, and charge a retail price of $1 per can. The wholesaler charges you $12 a case, making the cost to you equal to 50 cents per can. But now suppose the new supermarket around the corner is one branch of a large chain ordering 5,000 cases a week, and as a result the wholesaler is willing to charge only $5 a case. The cost to the supermarket of a can of soda is less than half yours. The supermarket can now undercut you while still making more money per can.
Second degree price discrimination in the form of bulk discounts like this is often why, in order to survive competition from the big box stores, small specialty stores must sell either different kinds of goods or the same goods at different times and places.
Third degree price discrimination: The student discount
In third degree price discrimination the monopolist segments consumers into different groups, and while consumers in one group pay the same price as each other, the individual groups pay different prices from each other.
To dig a bit deeper, the monopolist charges a higher price to the group with the less elastic demand (who reveal themselves as willing to pay a little bit more). Our example here comes from our experience with students, who often tell us that they don’t have much money. Not having resources makes them a little more willing to shop around for better prices, which leads us to suspect that their demand is more elastic.
A monopolist supplier can therefore offer a lower price to students, who need to show their student ID when making the purchase, and a higher price to its other customers. Movie theaters and entertainment venues routinely do this. Similar cases exist with senior bus passes, or with mobile network services where the business market has a less elastic demand and correspondingly is charged more for services.
Tweaking the product
The real world has many examples of firms with some degree of market power doing something that isn’t exactly covered by the three cases in the preceding section but is related to them. These firms offer fundamentally the same product in different versions with different features enabled in the higher price version — in one case, a printer manufacturer offered exactly the same product but with a cable cut in the cheaper version, causing the higher value features to be disabled!
This practice is common in the software industry, called versioning, where you often find the more expensive product labeled “Pro” even when it’s not particularly sold to professional markets.
Playing with time and space
Another form of third degree price discrimination is to segment consumers in different geographic markets and sell the same product at different prices in different areas, capturing more of the value from the inelastic market.
A variant of this practice is common in the film and video entertainment industry, where a film is released in different windows. In the first window — or exhibition — the film is delivered to cinemas where those people who are most willing to pay go and see it earlier. Those who don’t want to take the distributor up on the offer have the option of waiting for the DVD window, where they can view the same film at a lower cost per view. At the ultimate end of the chain is exhibition via TV where people can eventually view the same film for nothing. In this case, the distributor passes through each window, selling the product for a slightly lower price each time until the market is fully served.
This strategy, often known as cream skimming, also exists in the video game consoles market, where a high launch price is set and slowly allowed to fall over the lifetime of the console.
Tackling Monopolies in the Real World
In a pure monopoly, and compared to a competitive firm, the quantity a monopoly supplies is lower and the price higher (see the preceding section for details). If the monopoly charges only one price, the monopoly results in a deadweight loss, because producer and consumer surplus are lost. But if by charging different prices to each consumer or group of consumers, the monopolist supplies more output, this mitigates against the efficiency loss. However, the surplus typically goes to the monopolist in terms of higher profits. In addition, if barriers to enter the industry are high, monopolies are also likely to be less innovative because they aren’t subject to pressure from competitors.
Economists consider all these features of monopoly to be undesirable. The question is what to do about them.
Appreciating a complex problem
Tackling monopolies is a little tricky, because the solution depends crucially on how a monopoly comes about.
Nowhere in U.S. antitrust law is having a monopoly considered to be against the law. Although this seems counterintuitive, you can see why when you consider that in certain situations it may be the forces of competition that allow one firm to emerge much bigger than all its competitors.
For instance, Google search gets better the more people use it, because using it gives Google more data about what people search for and how, and this helps Google refine their algorithm. More users beget more users, leading to a situation where Google is the dominant search engine in the market.
Another type of legal monopoly is when intellectual property, such as patents or copyrights, have been granted. In this case, a person or firm is permitted to have a temporary monopoly in order to give people an incentive to do expensive research and development.
Understanding the legal response
The U.S. courts have interpreted antitrust law to mean that monopoly is not unlawful per se, but is unlawful if acquired through prohibited conduct that is seen as anticompetitive. So, a firm simply operating more efficiently than everyone else and therefore getting bigger than all its rivals is fine. But when in a dominant position, the firm can’t engage in behavior that disadvantages other smaller rivals from competing. These behaviors include the following:
- Full line forcing: The firm, typically a manufacturer, is not permitted to require a dealer of one of its products to stock its whole line of products with a minimum inventory requirement that effectively blocks or forecloses other competitors from selling through the dealer.
- Pricing below cost: If a firm has a dominant position, then it may be able to cut its prices below cost in the short run in order to drive a rival out of the market (with, naturally, the intention of raising prices after it has removed the rival). This action is called predatory pricing and is illegal, although it is often difficult to prove in practice.
- Making restrictive or exclusive agreements: For example, favoring some purchasers over others. For example, if you own a port, you aren’t allowed to charge your own boats less to use it than those of rivals. This example is highly relevant to Internet providers such as Comcast and content providers such as NBC — which is owned by Comcast.
The intention isn’t to prevent monopoly, but to prevent monopolizing markets. In other words, the monopoly can exist but it can’t go around throwing its monopoly weight around.
“You Make Me Feel Like a Natural Monopoly”
Okay, we admit that this heading’s phrasing scans much better with Carole King and Gerry Goffin’s original words, but in this section we describe how a monopoly can come about simply because it is efficient to have only one company serve a market. Water and wastewater networks and sewage treatment plants are natural monopolies and as a result run as public utilities typically owned by local government. Few persuasive arguments can be made that a community would be better off if government broke it up.
The key to understanding this point is to consider the long run average costs (LRAC) of the monopoly and, in particular, the minimum point of LRAC, referred to as the minimum efficient scale (or MES). Two cases apply here, depending on whether the MES is small relative to the total size of the market or close to it. Figure 13-5 shows both scenarios.
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LRAC = Long run average cost. (a) MES small fraction of total demand, market competitively supplied, (b) MES close to market demand, natural monopoly.
Figure 13-5: Comparing MES and natural monopoly.
When the MES of the firm serving that market is small, firms can operate at their most efficient scale when holding only a small fraction of the market. Therefore you’re likely to see the market as being competitively supplied. If, however, MES is very close to or even greater than the total demand in that market, that market is only ever likely to be supplied by one firm.
The question for economists is what to do about this situation, given that they don’t like monopolies very much. One option for dealing with natural monopoly, where you don’t expect much benefit to result from breaking the firm up, is to set up a system of regulation instead.
In practice, regulation tends to work in one of two ways:
- Rate of return regulation: The regulator oversees the pricing of goods and services so that the company makes a “fair” rate of return on its investments. In practice, however, this approach has drawbacks because it requires the regulator to have a lot of knowledge about the cost and the revenue side of the company. Despite its success in regulating public utilities for much of the 20th century, it has become replaced by price-cap regulation.
- Price-cap regulation: The regulator oversees a firm’s prices according to an index that reflects the overall inflation rate, the inflation of the firm’s inputs relative to the average firm in the economy, and the specific efficiencies this firm is able to realize relative to the average firm in the economy. It is often called CPI-X, where CPI is the Consumer Price Index or rate of inflation, and X is the expected efficiency savings. Price cap is intended to provide incentives for efficiency savings, as any savings above the predicted rate X can be passed on to shareholders of the firm.
Economists seldom expect the world to be perfect, even though the ideal is perfect competition. They do, however, prefer that monopoly be treated pro-actively. Where this is impossible, they may look for ways to regulate markets to make them work better.