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Slides by John F. Hall

Animations by Anthony Zambelli

INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 8 / MONOPOLY AND IMPERFECT COMPETITION

2005, South-Western/Thomson Learning

Chapter 8

Monopoly and

Imperfect Competition

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Lieberman & Hall; Introduction to Economics, 2005 2

Monopoly

A monopoly firm is the only seller of a good or service withno close substitutes Market in which the monopoly firm operates is called a monopoly

market

Key concept is notion of substitutability

Definition of monopoly firm or market may seem precise But in real world, definition is not always so clear-cut

Because we all have different tastes and characteristics, wecan have different opinions about what is, and what is not, a

close substitute As a result, we can have different ideas about how broadly or how

narrowly we should define a market when trying to decide if it is amonopoly

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Why Monopolies Exist

Existence of a monopoly means thatsomething is causing other firms to stay outof the market

Rather than enter and compete with firm alreadythere

What barrier prevents additional firms fromentering the market?

Several possible answers Economies of scale Legal barriers Network externalities

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Economies of Scale

If economies of scale persist to the point where asingle firm is producing for entire market, themarket is a natural monopoly Market in which, due to economies of scale, one firm can

operate at lower average cost than can two or more firms Unless government intervenes, only one seller

would survivemarket would naturally become amonopoly

Small local monopolies are often natural

monopolies Because they continue to enjoy economies of scale up to

point at which they are serving entire market

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Figure 1: A Natural Monopoly

B

A

300

C5

12

15

Pieces of Clothingper Week

Dollars

350

LRATC

DMarket

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Legal Barriers

Sometimes public interest is bestserved by having a single seller in amarket

Many monopolies arise because of legalbarriers including

Protection of intellectual property

Government franchise

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Protection of Intellectual Property

The words you are reading right now are an example of intellectualproperty, which includes literary, artistic and musical works, andscientific inventions

In dealing with intellectual property government strikes a compromise Allows creators of intellectual property to enjoy a monopoly and earn

economic profit, but only for a limited period of time

Once time is up, other sellers are allowed to enter the market, and it ishoped that competition among them will bring down prices

Most important kinds of legal protection for intellectual property are Patents

Temporary grant of monopoly rights over a new product or scientific discovery Copyrights

Grant of exclusive rights to sell a literary, musical, or artistic work

Copyrights and patents are often sold to another person or firm, but thisdoes not change monopoly status of the market, since there is still justone seller

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Government Franchise

Large firms we usually think of as monopolies havetheir monopoly status guaranteed throughgovernment franchise

Grant of exclusive rights over a product

Barrier to entry is

Any other firm that enters the market will be prosecuted

Governments usually grant franchises when they

think market is a natural monopoly

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Network Externalities

Exist when an increase in networks membershipincreases its value to current and potentialmembers

When network externalities are present, joining a

large network is more beneficial than joining asmall network Even if product in larger network is somewhat inferior to

product in smaller one

In addition to advantages of joining a larger

network Advantage in not leaving it once youve joined

Avoiding switching costs

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Network Externalities

All of this clearly applies to the market for computeroperating systems When you buy a computer already loaded with Microsoft Windows,

you benefit By having a large number of people with whom you can easily share

documents Huge number of computers everywhere you can easily operate

You gain access to many more software programs, like MicrosoftWord, Excel, or Outlook, since many more programs are designedforWindows than for the few alternatives

You can save time by just calling knowledgeable friends orcoworkers

Rather than attempting to contact technical support

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Monopoly Goals And Constraints

Goal of a monopolylike that of any firmis toearn highest profit possible

However, a monopolist faces constraints Constraint on monopolys cost

For any level of output it might produce, total cost is determinedby Technology of production Price it must pay for its inputs

Demand constraint Monopolists demand curve tells us maximum price monopolist

can charge to sell any given quantity of output And for any level of output it might produce, maximum price it can

charge is determined by market demand curve for its product

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Monopoly Price or Output Decision

Noncompetitive firmssuch as monopoliesdo not maketwo separate decisions about price and quantity, but ratherone decision Once firm determines its output level, it has also determined its price

When any firmincluding a monopolyfaces a downwardsloping demand curve, marginal revenue is less than priceof output Therefore, marginal revenue curve will lie below demand curve

Monopoly will produce at an output level where marginal

revenue is positive

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Figure 2: Demand and MarginalRevenue

5,000

BA

18

MR6,00020,000

21,00030,000

20

3038

4850

$60

Demand

FG

C

Number of Subscribers

MonthlyPrice per

Subscriber

15,000

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The Profit-Maximizing Output Level

To maximize profit, the firm should producelevel of output where MC = MR and

MC curve crosses MR curve from below

For a monopoly, price and output are notindependent decisions

But different ways of expressing the same

decision

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Profit And Loss

A monopoly earns a profit whenever P > ATC

Its total profit at best output level equals area of arectangle Height equal to distance between P and ATC

Width equal to level of output

A monopoly suffers a loss whenever P < ATC

Its total loss at best output level equals area of arectangle

Height equal to distance between ATC and P Width equal to level of output

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Figure 4: Monopoly Profit and Loss

E

MR10,000

$40

MC

32

Total

Profit

ATC

D

E

Total Loss

AVC

ATC

MR10,000

40

MC

D

$50

Dollars

(a)

Number ofSubscribers

Dollars

(b)

Number ofSubscribers

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The Shut-Down Decision

What if a monopoly suffers a loss in short-run?Any firm should shut down if P < AVC at output

level where MR = MC If monopoly suddenly finds that P < AVC,

government will usually not allow it to shutdown, Instead use tax revenue to make up for firms

losses

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Monopoly in the Long-Run

In the short run, a monopoly may earn an economicprofit or suffer an economic loss But what about the long run?

Important insights of previous chapterperfectly

competitive firms cannot earn a profit in long-runequilibrium However, monopolies may earn economic profit in

long-run A privately owned monopoly suffering an economic

loss in long-run will exit the industry Should not find privately owned monopolies suffering

economic losses in long-run

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Comparing Monopoly to PerfectCompetition

In perfect competition, economic profit is relentlesslyreduced to zero by entry of other firms In monopoly, economic profit can continue indefinitely

But monopoly differs from perfect competition in another

way Can expect a monopoly market to have a higher price and loweroutput than an otherwise similar perfectly competitive market

By raising price and restricting output, new monopoly earnseconomic profit

Consumers lose in two ways Pay more for output they buy

Due to higher prices they buy less output

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Figure 5(a/b): Comparing Monopolyand Perfect Competition

100,000

E

$10

D

S

1,000

ATCMC

d$10

Quantity ofOutput

Priceper

Unit

(a) Competitive Market (b) Competitive FirmDollars

perUnit

Quantity ofOutput

2. and each firm produces1,000 units, where P= MC.

1. In this competitivemarket of 100 firms,equilibrium price is $10

3.When monopolytakes over, the oldmarket supplycurve . . .

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Figure 5(c): Comparing Monopoly andPerfect Competition

100,000Quantity of

Output

Priceper

Unit

E

10

D

(c) Monopoly

S= MC

60,000

MR

$15F

6. with a higher price and lower marketoutput than under perfect competition.

4. becomes the monopoly's MCcurve.

5.The monopoly produces where MR= MC,

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Comparing Monopoly to PerfectCompetition

Changeover from perfect competition to monopoly benefitsowners of monopoly and harms consumers of the product Important proviso concerning this result

In comparing monopoly and perfect competition, price is higher andoutput is lower under monopoly if all else is equal

General conclusion Monopolization of a competitive industry leads to two opposing

effects

For any given technology of production, monopolization leads to higherprices and lower output

Changes in technology of production made possible under monopolymay lead to lower prices and higher output

Ultimate effect on price and quantity depends on relative strengths oftwo effects

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Monopolistic Competition

Imperfect competition refers to market structures between perfectcompetition and monopoly In imperfectly competitive markets, there is more than one seller, but still too

few to create a perfectly competitive market In addition, imperfectly competitive markets often violate other conditions of

perfect competition, such as the requirement of a standardized product orfree entry and exit

Monopolistic competition is a market sturcture with three fundamentalcharacteristics 1. Many buyers and sellers 2. Sellers offer a differentiated product 3. Sellers can easily enter into or exit from the market

Because it produces a differentiated product, a monopolistic competitorfaces a downward-sloping demand curve When it raises its price a modest amount, quantity demanded will decline

(but not all the way to zero)

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Monopolistic Competition in the Short-Run

Individual monopolistic competitor behavesvery much like a monopoly

Key difference is this

While a monopoly is the only seller in its market,a monopolistic competitor is one of many sellers

When a monopolistic competitor raises its price,its customers have one additional option

Can buy similar good from some other firm

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Figure 6: A MonopolisticallyCompetitive Firm in the Short Run

MR1

$70

30

250

d1

A MC

ATC

Dollars

Homes Serviced per Month

2. and charges$70 per home.

4. Kafka's monthlyprofit$10,000isthe area of theshaded rectangle.

1. Kafka services 250 homesper month, where MCandMRintersect . . .

3.ATCat 250 units is lessthan price, so profit perunit is positive.

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Monopolistic Competition in the Long-Run

Under monopolistic competitionin which there are nobarriers to entry and exitthe firm will not enjoy its profit forlong Entry will continue to occur, and demand curve will continue to shift

leftward

Under monopolistic competition, firms can earn positive ornegative economic profit in short-run But in long-run, free entry and exit will ensure that each firm earns

zero economic profit just as under perfect competition

In real world, monopolistic competitors often earn economicprofit or loss in the short-run

Butgiven enough timeprofits attract new entrants, and lossesresult in an industry shakeout

Until firms are earning zero economic profit

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Figure 7: A MonopolisticallyCompetitive Firm in the Long Run

d2MR2

E

MC

$40

100 250

Dollars

Homes Servicedper Month

ATC

MR1

In the long run, profit attractsentry, which shifts the firm'sdemand curve leftward.

The typical firm

produces whereits newMRcrosses MC.

d1

Entry continues until P= ATCat the best output level, andeconomic profit is zero.

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Nonprice Competition

If monopolistic competitor wants to increase its output it cancut its price Move along its demand curve

Any action a firm takes to increase demand for its outputother than cutting its priceis called nonprice competition

Examples include better service, product guarantees, free homedelivery, more attractive packaging

Nonprice competition is another reason why monopolisticcompetitors earn zero economic profit in long-run

All this nonprice competition is costly

Must pay for advertising, for product guarantees, for better stafftraining Costs must be included in each firms ATC curve, shifting it upward

None of this changes conclusion that monopolisticcompetitors will earn zero economic profit in long-run

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Oligopoly

When just a few large firms dominate a market So that actions of each one have an important impact on

the others

Would be foolish for any one firm to ignore its

competitors reactions In such a market, each firm recognizes its strategic

interdependence with others

An oligopoly is a market dominated by a small

number of strategically interdependent firms

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Economies of Scale: NaturalOligopolies

When minimum efficient scale (MES) for a typicalfirm is a relatively large percentage of market

A large firmsupplying a large share of the marketwillhave lower cost per unit than a small firm

Since small firms cant compete, only a few large firms survive Market becomes an oligopoly

Tends to happen on its own unless there is governmentintervention

Such a market is often called a natural oligopolyanalogous to

natural monopoly

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Reputation as a Barrier

A new entrant may suffer just from being new

Established oligopolists are likely to have favorablereputations

In some cases, where potential profits are great,investors may decide it is worth the risk and acceptinitial losses in order to enter industry

In other industries, the initial losses may be too

great and probability of success too low forinvestors to risk their money starting a new firm

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Strategic Barriers

Oligopoly firms often pursue strategies designed tokeep out potential competitors Maintain excess production capacity as a signal to a

potential entrant that they could easily saturate market

and leave new entrant with little or no revenue Make special deals with distributors to receive best shelf

space in retail stores

Make long-term arrangements with customers to ensurethat their products are not displaced quickly by those of a

new entrant Spend large amounts on advertising to make it difficult

for a new entrant to differentiate its product

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Legal Barriers

Patents and copyrightswhich can beresponsible for monopolycan also createoligopolies

Like monopolies, oligopolies are not shyabout lobbying government to preserve theirmarket domination

Government barriers can operate againstdomestic entrants, too

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Oligopoly Behavior

Oligopoly presents the greatest challenge toeconomists

Essence of oligopoly is strategic interdependence Wherein each firm anticipates actions of its rivals when

making decisions In order to understand and predict behavior in

oligopoly markets Economists have had to modify the tools used to analyze

other market structures and to develop entirely new tools

as well One approachgame theoryhas yielded rich

insights into oligopoly behavior

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The Game Theory Approach

Game theory An approach to modeling strategic interaction of

oligopolists in terms of moves and countermoves

In all gamesexcept those of pure chance, such

as roulettea players strategy must take accountof the strategies followed by other players

Game theory analyzes oligopoly decisions as ifthey were games by

Looking at the rules players must follow Payoffs they are trying to achieve

Strategies they can use to achieve them

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Simple Oligopoly Games

Duopoly

Oligopoly market with only two sellers

Assume that Gus and Filip must make their

decisions independently Without knowing in advance what the other will do

No matter what Filip does, Guss best move is tocharge a low pricehis dominant strategy

A similar analysis from Filips point of view, would tell usthat his dominant strategy is the same: a low price

Equilibrium price in market is the low price

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Fig. 4: A Duopoly Game

Confess

Confess

Dont Confess

Filips Actions

Guss profit= $25,000

FilipsProfit =$25,000

Guss profit= $10,000

Guss profit

= $75,000

Guss profit

= $50,000




Guss Actions

Dont Confess

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Cooperative Behavior in Oligopoly

In real world, oligopolists will usually getmore than one chance to choose their prices

The equilibrium in a game with repeated

plays may be very different from equilibriumin a game played only once

Often, firms will evolve some form of cooperation

in the long run

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Explicit Collusion

Simplest form of cooperation is explicit collusion Managers meet face-to-face to decide how to set prices

Most extreme form of explicit collusion is creation of a cartel Group of firms that tries to maximize total profits of the group as a

whole

If explicit collusion to raise prices is such a good thing foroligopolists, why dont they all do it? Usually illegal

Penalties, if the oligopolists are caught, can be severe

But oligopolists can collude in other, implicit ways

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Tacit Collusion

Any time firms cooperate without an explicitagreement, they are engaging in tacit collusion

Tit for tat

A game-theoretic strategy of doing to another player thisperiod what he has done to you in previous period

However, gentle reminder of tit-for-tat is not alwayseffective in maintaining tacit collusion

Oligopolist will sometimes go further Attempting to punish a firm that threatens to destroy tacit

cooperation

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Lieberman & Hall; Introduction to Economics, 200542

Tacit Collusion

Another form of tacit collusion is price leadership One firmthe price leadersets its price and other

sellers copy that price

With price leadership, there is no formal agreement

Rather the decisions come about because firms realizewithout formal discussionthat system benefits all ofthem

Decisions include Choice of leader Criteria it uses to set its price Willingness of other firms to follow

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The Limits to Collusion

Oligopoly powereven with collusionhasits limits

Even colluding firms are constrained by market

demand curve Collusioneven when it is tacitmay be illegal

Collusion is limited by powerful incentives tocheat on any agreement

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Antitrust Legislation and Enforcement

Antitrust enforcement has focused on three types of actions Preventing collusive agreements among firms

Such as price-fixing agreements

Breaking up or limiting activities of large firmsoligopolists andmonopolistswhose market dominance harms consumers

Preventing mergers that would lead to harmful market domination

Managers of other firms considering anticompetitive moveshave to think long and hard about consequences of acts thatmight violate antitrust laws

While thrust of these policies is to preserve competition Type of competition preservedand zeal with which policies are

appliedcan shift

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The Globalization of Markets

By enlarging markets from national ones to global ones,international trade can increase the number of firms in amarket Decreasing market dominance by a few, and increasing competition

Although oligopolists often try to prevent it, they faceincreasingly stiff competition from foreign producers

Entry of U.S. producers has helped to increase competitionin foreign markets for movies, television shows, clothing,

household cleaning products, and prepared foods While consumers in each nation may have access to more

firms, these may be larger and more powerful firms Creating greater likelihood of strategic interaction and danger of

collusion

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Technological Change

Technological change works to increase competition bycreating new substitute goods

Can reduce barriers to entry in much the same way thatglobalization does By increasing size of market

Technologythe internethas enabled residents in manysmaller towns to choose among a dozen or more onlinesellers of the same merchandize Trend can also be seen as encouraging oligopoly Result could be strategic interaction, or collusion, among large

national players

Finally, some technologies actually increase MES of typicalfirm Thereby encouraging formation of oligopolies

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The Four Market Structures: APostscript

Different market structures

Perfect competition

Monopoly

Monopolistic competition Oligopoly

Market structure models help us organize

and understand apparent chaos of real-worldmarkets

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