what is the problem with monopoly compare monopoly to the benchmark of perfect competition

14.one Market Power and Monopoly

Learning Objectives

1. What is a monopoly?
2. What is the outcome when there is a monopoly?
3. What are the policies taken to deal with monopolists?

When at that place are many buyers and sellers of a homogeneous product, we take a competitive marketA market that satisfies 2 conditions: (1) there are many buyers and sellers, and (2) the appurtenances the sellers produce are perfect substitutes. (Figure 14.ane "The Competitive Market place Outcome"). Equilibrium is at the intersection of supply and need. At the equilibrium level of output, households enjoy heir-apparent surplusA measure of how much the buyer gains from a transaction, equal to the heir-apparent's valuation minus the price. , given by the marked area below the need curve and above the equilibrium price. The surplus arises from the fact that some buyers are willing to pay more than the equilibrium price for the good.

Figure 14.1 The Competitive Marketplace Issue

At the equilibrium quantity in a competitive market, all gains from trade are exhausted.

Surplus as well flows to firms. Think that a competitive firm's private supply curveHow much output a business firm in a perfectly competitive market place volition supply at any given cost. It is the same every bit a firm's marginal cost curve. is equal to its marginal toll curve. In Effigy 14.1 "The Competitive Market place Event", the supply curve slopes upwardly considering marginal cost is increasing. Firms obtain surplus because they can produce output at a marginal toll that is less than the equilibrium price of the expert. This is shown as seller surplus in the figure.

At the equilibrium quantity, in that location are no further gains from trade. Producing more output would not increase the full surplus. In fact, producing more than output would reduce the surplus: the marginal price of producing more than output would exceed the marginal valuation of actress output. Producing less output would too lower total surplus because the buyers and the sellers would lose some of their surplus.

The competitive marketplace provides a benchmark because information technology leads to an efficient outcome. Just very few markets are truly competitive. In almost markets, firms possess some market power. This ways, in item, that they are able to set a price above marginal cost without losing all of their sales. In a competitive market, the demand curve facing a business firm is perfectly elastic at the market price, whereas when a firm has market ability, its demand curve slopes downward.

The Definition of a Market

At the other extreme to the competitive market is the case of monopolyA single supplier of a good or service in a market. . A monopoly arises when at that place is a single producer in a market. The demand bend facing a firm is, in this case, the same as the market demand curveThe number of units of a skillful or a service demanded at each price. .

The definition of a monopoly seems easy, nonetheless it is hard to decide exactly what we hateful past "a market." Think virtually diamonds. Information technology is often said that the De Beers Corporation is a monopolist in the market place for diamonds because this company controls well-nigh of the world's diamond supply. Yet, depending on how broadly or narrowly we define the market, De Beers has either a lot of competitors or only a few. We could define the market very narrowly as "De Beers-branded diamonds" (De Beers is able to brand its diamonds by using certificates of actuality). De Beers would and so be a monopolist past definition. Nosotros could define the market more than broadly every bit "all diamonds," in which instance De Beers has substantial marketplace ability just does not have a total monopoly. This is perchance the nigh natural definition to use, yet it misses the fact that other precious stones, such equally emeralds, rubies, or opals, are also possible substitutes for diamonds. An fifty-fifty broader market definition is "the market place for precious stones." We could become fifty-fifty further even so and consider De Beers as part of the market for luxury goods, competing with, say, Louis Vuitton bags and Ferrari sports cars. We illustrate this in Figure 14.2 "The Extent of Competition Depends on the Definition of the Market".

Figure 14.two The Extent of Competition Depends on the Definition of the Market

There is no difficult-and-fast definition of a market place, but goods that are highly substitutable for each other are generally taken to be in the same market.

Figure 14.2 "The Extent of Competition Depends on the Definition of the Market" also gives an illustration for the case of music. By definition, a given indie band has monopoly power over its ain music. And so again, with a very narrow definition of the marketplace, we would say that the band is a monopolist for its own songs. But that band also competes with other indie bands for consumers' dollars, so another definition of the market would be "CDs by all indie bands." Once more, we could define the market yet more than broadly equally "all music" or even "all forms of entertainment."

Ane of the difficult tasks of antitrust regime is deciding what definition to use for a market place. There is no unmarried right way to ascertain a market, and the extent of market power depends on where we cull to draw the line. For this reason, the term monopoly is somewhat misleading. Almost all firms are monopolists if we adopt a sufficiently narrow definition of the marketplace. The decision nigh how to fix prices in the presence of market power, which is sometimes chosen the monopoly pricing trouble, actually applies to nigh every firm in the economic system. What matters in practice is determined past the extent of a firm's market power.

The extent of a firm'south market power depends on 2 things: (1) the number of firms that potentially compete with it and (two) the extent to which those other companies produce close substitutes for a firm's product. A strip mall at the border of town might contain several dissimilar fast-nutrient restaurants. Each restaurant enjoys some market power because the food it has available is slightly different from that at the other establishments. Just many consumers are likely to be willing to substitute reasonably freely among the different restaurants, so the market place power of each restaurant is limited. Contrast that with a fancy French eating house with a famous chef. That restaurant enjoys much more market place power because there are about certainly fewer comparable restaurants nearby and the meals at other high-cease restaurants are non such close substitutes.

Market ability can stalk from many different sources. A firm has marketplace power if it is selling a unique product or service. A firm can besides derive market ability from its superior or exceptional service. If a firm creates customer loyalty, either through exceptional service or by loyalty programs (such every bit frequent flyer miles), this is also a source of market power. Retail firms tin can derive market power from their location: your local corner shop has some market power because you lot would prefer to walk at that place rather than drive to a more afar supermarket.

Firms devote a lot of resource to establishing, protecting, and increasing their market power through ad and other forms of marketing. Many firms spend a bang-up deal of coin on developing their brand image and brand awareness. Sporting goods companies such equally Nike and Adidas are classic examples. When customers are loyal to brands, firms have market power.

Pricing with Marketplace Power and the Monopoly Outcome

The managers of a monopoly firm must pick the point on the demand curve that will maximize the firm's profits—the total revenues of the firm minus its costs of producing its output. We can call up about the business firm choosing either its level of output or its toll. If a firm chooses how much to produce, then the price of its product is determined from its demand curve. (Remember that the demand curve facing the firm and the market demand curve are the same thing for a monopolist.) If a house chooses a price for its product, then the quantity produced is adamant past the demand bend. For now, we tell the monopoly story assuming information technology chooses the quantity of output.

When a firm is maximizing its profit, producing a little more or a lilliputian less output volition not increase the business firm's profit. This ways that the extra revenue from producing ane more unit of output is exactly equal to the cost of producing i more than unit of measurement of output: marginal revenue equals marginal cost. We call this level of output the profit-maximizing quantity and illustrate it in Figure xiv.3 "The Monopoly Consequence". The price the monopolist sets, termed the profit-maximizing price, can then be read from the need curve. In one case a monopolist determines how much to produce, the cost of its output is determined by the maximum corporeality that consumers are willing to pay for the good.

Figure xiv.3 The Monopoly Result

A monopolist produces a quantity such that marginal revenue equals marginal toll. The price is determined past the need bend.

Distortions Due to Market Power

We have competition policies in marketplace economies considering market power oft leads to an outcome that is not efficient. To understand this distortion, compare the monopoly issue with the competitive marketplace outcome we saw earlier. Figure 14.4 "Distortions Due to Market Power" is Figure 14.ane "The Competitive Market Consequence" with some areas of the figure labeled.

• We indicate the buyer surplus—the area between the price set by the monopolist and the demand curve. Even though there is a monopolist in this market, buyers can still relish some surplus if their marginal valuation of the good exceeds the toll they pay. Then while the price may be besides loftier in the monopoly case, at that place still remains some surplus flowing to buyers.
• There is an area labeled variable cost—the total area under the marginal cost bend.
• At that place is an surface area labeled seller surplus (monopoly profit)—the difference between revenues at the monopoly toll and variable costs. The full acquirement received by the monopolist is the price times the quantity sold. This is a rectangle. Monopoly profit, as shown in the figure, equals this rectangular area minus variable costs.
• The difference between the competitive and monopoly outcomes creates a social loss—the triangular area labeled deadweight loss in Figure 14.4 "Distortions Due to Marketplace Power". The need curve reflects consumers' marginal valuation of the good. Below the competitive quantity, this marginal valuation is greater than the marginal cost of producing the good. This means that there are potential gains from merchandise that are not being realized.

Figure fourteen.4 Distortions Due to Market Power

A monopolist produces a quantity that is less than socially optimal: there is a deadweight loss.

Comparing Figure xiv.1 "The Competitive Market Outcome" with Figure 14.iv "Distortions Due to Market place Power", nosotros see that—relative to the competitive effect—the monopolist charges a college price and produces a lower quantity. Since the competitive outcome was efficient, the monopoly result is inefficient. Households in the economy would be better off if the monopolist produced at the competitive level of output and sold at the competitive toll.

Competition Policy toward Monopolies

When a firm has market ability, there is a distortion in the marketplace: prices are besides high, and output is too low. Antitrust laws are designed to address precisely this situation.

Antitrust

By virtue of the Sherman Antitrust Human action of 1890, the US government can have legal action to break up a monopoly. In 1902, President Theodore Roosevelt used the Sherman Antitrust Deed as a footing for trying to break up the monopolization of railway service in the The states. The resulting legal case, known as Northern Securities Co. v. United states of america, involved two cardinal elements: restraint of trade and interstate commerce.

Multiple providers of runway service had joined together in the Northern Securities Company, resulting in a restraint of merchandise. The Supreme Court decisionCornell Academy Police Schoolhouse, Legal Information Institute, "Northern Securities Co. v. United States (No. 277)," accessed March 14, 2011, http://www.law.cornell.edu/supct/html/historics/USSC_CR_0193_0197_ZS.html. provides straight discussion of the anticompetitive nature of the creation of this visitor, noting that the company had been fix to eliminate competition amongst the different providers. Farther, this restraint of trade had interstate implications because the railway lines themselves were not contained inside any 1 land. This was a central indicate of jurisdiction: the Sherman Antitrust Act spoke directly about the furnishings of marketplace power on interstate trade. Nether the U.s. Constitution, interstate commerce is part of the responsibility of the federal government.

Another famous antitrust case decided past the Supreme Courtroom (http://supreme.justia.com/united states of america/221/1/case.html) centered effectually the breakup of the Standard Oil Trust in 1911.Justia.com, U.s.a. Supreme Court Center, "Standard Oil Co. of New Jersey 5. United States, 221 U. Southward. 1 (1911)," accessed March 14, 2011, http://supreme.justia.com/us/221/1/case.html. John D. Rockefeller founded Standard Oil in 1870 soon subsequently the discovery of oil in Ohio. By the late 1870s, the company controlled nearly 90 percentage of the refineries in the Us. Shortly thereafter, the Standard Oil Trust was formed with the idea that the individual shareholders in a group of companies would come together to create a unmarried visitor. This company would then jointly manage all the companies that joined the trust. In doing so, a monopoly was created. (This, by the manner, is where the term antitrust comes from.)

Once again, the upshot of jurisdiction played a part. Standard Oil was originally deemed a monopoly past the Ohio Supreme Court, which ordered it to be cleaved up. Instead, the visitor was simply reorganized every bit a New Jersey–based corporation. Because the company had moved to another state, the Ohio ruling became irrelevant, and the federal authorities had to step in to forbid unlawful interstate trade. The court ruled that the trust exist dismantled. In the mod era, like concerns arise across national borders: if two companies merge in Europe, for example, US antitrust authorities still accept an interest, and vice versa.

These cases may seem like ancient history. Nevertheless they remain very relevant today for at least 2 reasons. First, the legal system relies heavily on precedent, meaning that cases decided today depend on past rulings in similar cases. The actions of the Supreme Court in these two cases created a significant precedent for the present-day antitrust deportment of the federal government. Second, antitrust deportment continue to this twenty-four hours. A recent instance again alleging a violation of the Sherman Antitrust Human activity was brought against Microsoft Corporation by the US government in 1998. Microsoft was charged with monopolizing the software market through its Windows operating system. As stated in the case, "Almost all major PC manufacturers observe it necessary to offer Microsoft operating systems on most of their PCs. Microsoft's monopoly power allows it to induce these manufacturers to enter into anticompetitive, long-term licenses nether which they must pay royalties to Microsoft not only when they sell PCs containing Microsoft's operating systems, only besides when they sell PCs containing non-Microsoft operating systems."A full description of this aspect of the example is contained in John Kwoka and Lawrence White, eds., The Antitrust Revolution (New York: Oxford Academy Printing, 2004).

One noteworthy chemical element of the example concerned the definition of the market place. After all, there are competing operating systems to Microsoft, most notably Apple Computer'south operating organization. If the court viewed these products as substitutes for Microsoft'south operating arrangement, and so the claim that Microsoft was a monopolist would exist less clear. Interestingly, the court ruled that Apple was not in the same market as Microsoft.

Price Discrimination

Because in that location are people willing to pay more than the marginal toll, it seems equally if the monopolist in our earlier example is leaving some money on the table. Is in that location a manner for the monopolist to make higher profits? The answer to this question hinges on an assumption that was implicit in our assay: we suppose that the monopolist has to sell every unit of measurement of the proficient at the same price. In many cases, however, firms sell different units of their production at different prices. This is known equally price discriminationWhen a business firm sells different units of its product at different prices. , and information technology can arise either considering (ane) a firm sells to different customers at different prices or because (ii) a firm sells different units at different prices to the aforementioned customer. There are numerous examples of both kinds of price discrimination. An example of the first is discounts offered to senior citizens or students. An example of the second is quantity discounts such as "buy two, get ane free."

Firms have developed many creative forms of price discrimination, and we could hands fill a whole chapter with them. Our main focus here, however, is to empathize how price discrimination operates in a monopoly market. Let u.s. call up about a example where the monopolist faces a unit need curveThe special example of the private demand curve when a buyer might purchase either zero units or 1 unit of a expert but no more than than one unit. : each buyer either purchases a unit of measurement of the good or does not buy the skillful at all. The downward-sloping demand curve comes from the fact that different individuals have dissimilar valuations of the expert.

At present imagine what the monopolist would exercise if she knew everyone'due south individual valuations and was as well able to charge a different toll to different buyers. In this case, we obtain a remarkable result. If the monopolist could sell each unit of measurement at whatsoever price she wanted, then she would charge each individual his valuation of the skillful, with striking consequences.

• The monopolist captures the entire buyer surplus. Compared to the competitive case, in that location is a redistribution of surplus from buyers to the monopolist.
• The deadweight loss from the monopoly is eliminated. The monopolist produces the same level of output as in a competitive market place because it is worthwhile to sell to anyone whose valuation exceeds marginal toll.

Buyers obtain no surplus because each buyer surplus equals his valuation minus the toll he pays—which we have just said is equal to his valuation. Each buyer is actually indifferent almost buying or non buying the good. (If this seems odd, then yous can imagine that the monopolist charges a price slightly below individuals' valuations, so buyers obtain only a tiny amount of surplus. The conclusion is the same.) And so where does their surplus go? Information technology shows up as monopoly profits. By price discriminating, the monopolist captures all the gains from trade in this market. And where do these monopoly profits eventually become? They menstruum to the owners of the monopoly. The heir-apparent surplus that is taken away past the price-discriminating monopolist is eventually returned to the household sector every bit dividends from the firm. Even so, it is not the same households who gain and lose surplus. Not everyone is a shareholder in the monopoly. Monopoly ability causes a redistribution from the monopolists' customers to its shareholders.

A situation like the i nosotros have described, where a monopolist knows the valuations of all her customers, may seem a bit farfetched. Still, in situations where a monopolist negotiates individual prices with buyers, she volition do her best to gauge their valuations. For example, think of a used auto dealer. When a prospective customer arrives on the lot, the dealer will typically engage the customer in conversation in an attempt to learn where he lives, what kind of job he has, so on. Such information helps the dealer guess the heir-apparent's valuation.

Other Kinds of Price Discrimination

There are many kinds of price discrimination.

• Explicit partition. The monopolist may be able to split up the market into identifiable segments and charge different prices to different segments. For example, picture theaters often offer student and senior citizen discounts. As another example, businesses often charge dissimilar prices in different countries. The thought is that the monopolist can accuse higher prices to segments that are less price sensitive.
• Self-selection. If a firm cannot explicitly identify different segments, information technology can set a carte du jour of prices and permit customers to sort themselves into different groups. When Apple tree introduced the iPhone, it originally charged a loftier toll, knowing that impatient customers would buy immediately. It then dropped the cost to capture the more patient, more price-sensitive customers. Discount coupons are another example. Individuals with more time to spare will prune and redeem coupons—and these individuals will typically besides be more sensitive to toll.

From the perspective of a firm, the biggest danger of toll discrimination is the possibility of arbitrageThe act of buying and so selling an asset to brand a turn a profit. . If yous are selling your product more cheaply to some than to others, you don't want someone to buy at the cheap price and and then resell to your college-value customers. This is a particular issue for pharmaceutical companies that charge different prices in unlike countries. If you need proof of this, look at the spam in your e-postal service. The chances are very adept that you lot have recently received an electronic mail offering you pharmaceuticals at Canadian prices.

Competition Policy on Price Discrimination

The Robinson-Patman Act of 1936 directly forbids certain forms of price discrimination. The following is from the act, with our emphasis added: "It shall be unlawful for whatever person engaged in commerce…to discriminate in cost between different purchasers of commodities of like grade and quality, where either or any of the purchases involved in such discrimination are in commerce…and where the effect of such bigotry may exist substantially to lessen contest or tend to create a monopoly in any line of commerce."Cornell University Police Schoolhouse, Legal Information Institute, "§ thirteen. Bigotry in price, services, or facilities," accessed March 14, 2011, http://www.police force.cornell.edu/uscode/fifteen/13.html.

The blazon of price bigotry nosotros have discussed certainly involves discrimination amidst different purchasers. What is less clear is whether such actions would "lessen competition or tend to create a monopoly." In our earlier example, price discrimination actually makes the market more efficient, and in general, cost bigotry tin can increase or decrease efficiency. At that place are no simple guidelines, and each case must exist examined on an individual basis.

Price discrimination also occurs in business organization-to-businessA marketplace where firms sell goods and services to other firms. transactions between firms. In a recent toll-bigotry example involving Volvo, a car dealer charged that other dealers had obtained deeper discounts (price concessions) that permitted them to exist more competitive.Run across Cornell University Constabulary School, Legal Information Institute, "Volvo Trucks North America, Inc. v. Reeder-Simco GMC, Inc. (04-905) 546 U.S. 164 (2006) 374 F.3d 701, reversed and remanded," accessed March 14, 2011, http://www.law.cornell.edu/supct/html/04-905.ZS.html. This seems to fit the requirements of the Robinson-Patman Act because Volvo trucks are a homogeneous good (Volvo trucks in this instance), and the practice allows one dealer to undercut another.

A jury trial led to an award of $4.1 meg to the injured company. Not surprisingly, Volvo appealed the decision, partly because, so it claimed, the other dealers were non in direct competition with the dealer filing the conform. In one case over again, you tin see the critical significance of defining the marketplace. The Supreme Court eventually decided the case in January 2006 in favor of Volvo.

Cardinal Takeaways

• A monopoly occurs when in that location is a single seller, called the monopolist, in a marketplace.
• A monopolist produces the quantity such that marginal acquirement equals marginal toll. This is a lower level of output than the competitive market place outcome.
• The government has the legal authority to suspension up monopolies and forbids price discrimination.

Checking Your Understanding

1. Think of 2 goods or services yous have bought recently. Were close substitutes bachelor? Do yous call up the producer and the retailer of those products had a lot of market power?
2. Looking at Effigy 14.iv "Distortions Due to Market Power", why exercise buyers accept whatsoever surplus?

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