Basics of Monopoly

MONOPOLY:
 
Chapter Summary:

Market power occurs from intellectual property, unique resources, scale and scope economies, product differentiation or regulation. A seller with market power restrains sales to increase the market price above the competitive level and take out big profits. It maximizes gain by producing the quantity at which the marginal revenue equivalents marginal cost.

The level to which a monopoly must adjust the price and sales in response to modifications in demand or costs based on the shapes of both the marginal revenue and marginal cost curves. The profit-maximizing price and quantity doesn’t base on fixed costs. The profit-maximizing level of promotion for a seller with market power is the incremental margin multiplied by the elasticity of demand multiplied by sales.

A buyer with market power restrains purchases to demoralize the price beneath the competitive level and increase its total benefit. Competing sellers and, similarly, competing buyers raise profit by restraining the competition. They can do so by making a cartel or via horizontal integration.
 
Key Concepts:

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General Chapter Objectives:

A) Enumerate and elucidate the various sources of market power.

B) Examine how a monopoly finds out its profit-maximizing output and price level.

C) Describe how a monopoly must adjust price in response to modifications in demand and cost.

D) Examine how much a monopoly must spend on advertising.

E) Describe how a monopoly must adjust advertising in response to modifications in cost and price.

F) Compare and contrast output and price beneath monopoly and perfect competition.

G) Examine how competing sellers can increase their combined gain by restraining competition via cartels and horizontal integration.

H) Examine how a monopsony finds out its total benefit maximizing purchase and price.

I) Examine how competing buyers can increase their combined total benefit by restraining the competition.
 
Notes:

1) Sources of market power:

a) A seller (or buyer) with market power can affect market demand (or supply), price and quantity demanded (or supplied).

b) Monopoly: it is a market where there is just one seller.

c) Monopsony: it is a market where there is just one buyer.

d) Sources of market power for monopolies and monopsonies: barriers which deter or avert entry by competing sellers (or buyers).

  • Unique resources, example: human resources: a superstar in sport and performing arts; natural or physical resources: exclusive right to utilize the Eurotunnel;
  • Intellectual property, example: ownership of copyrights or patents over expressions or inventions.
  • Scale and scope economies, example: electricity distribution; cable TV and local telephone service and so on.
  • Government regulation, example: govt. awarded exclusive franchises (that is, intended to evade duplication and lower costs) for distribution of natural gas and electricity, and local telephone service; govt. monopolyies over defense and issuance of the currency.
  • Product differentiation via promotion, advertising, product design and location.

(e) Extra source of market power for a monopsony: the presence of a monopoly. A seller which has a monopoly over some service or good is likely to encompass market power over the inputs into that item.

2) Monopoly Pricing:

a) A monopoly:

i) Faces a down-ward sloping market demand curve.

ii) It can either set price or let the market find out how much to buy, or set the quantity supplied and allow the market find out the price; however not both.

iii) The process for setting price and quantity is similar in the short and long runs.

b) A monopoly which sets the price and lets the market find out the quantity of sales.

i) Supposition: Profit maximization.

ii) Profit = revenue (price * sales) less cost.

iii) To sell additional units, the price should be decreased.

iv) Total cost usually rises with the scale of production.

v) Marginal revenue is the modification in total revenue occurring from selling an additional unit. This is the price of marginal unit minus the loss of revenue on inframarginal units. This could be negative.

vi) Inframarginal units are such, other than the marginal unit.

vii) Contribution margin is the net revenue less variable cost.

viii) Modification in contribution margin for an additional unit sold = marginal revenue – marginal cost.

ix) Price usually surpasses marginal revenue, and the difference based on the elasticity of demand.

  • When demand is much elastic, the seller require not decrease the price very much to raise sales, the marginal revenue will be close to price.
  • When demand is much inelastic, the seller should decrease the price substantially to raise sales, the marginal revenue will be much lower than the price.

x) Profit-maximizing scale of production is where:

  • Marginal revenue equivalents marginal cost, or
  • The sale of extra unit outcomes in no change to the contribution margin.

c) A monopoly restrains the production to raise profit.

d) Economically incompetent choice of the production. Where marginal benefit surpasses marginal cost, a gain can be made via resolving the ineffectiveness.

e) Response to modifications in cost or demand.

i) Monopoly’s response to modifications in demand based on both the new demand (that is, new marginal revenue) and the original marginal cost.

ii) Monopoly’s response to modifications in cost based on both the original demand and the latest marginal cost.

iii) New profit maximizing price and scale based on the shapes of both marginal revenue and the marginal cost curves. The monopoly must adjust its price till the marginal revenue equivalents marginal cost.

iv) Note: Modifications in fixed cost do not influence marginal cost, and will not influence the profit maximizing sales and price; unless, though, that fixed cost is too large that total cost surpasses total revenue, and then the monopoly will shut down.

3) Promotion/Advertising:

a) Promotion: It is the set of marketing activities which a business undertakes to communicate with its customers and sell its product, comprising advertising, public relations and sales promotion.

b) A monopoly consists of market power and can affect demand (that is, modifications in demand and/or elasticity of demand).

c) The total benefit of promotion or advertising to a seller is the increment in contribution margin (that is, as opposed to sales) less promotion or advertising expenses.

d) Profit maximizing ratio of promotion or advertising expenses to sales: the incremental margin multiplied by the elasticity of demand regarding raise in promotion or advertising.

i) The incremental margin is the price less marginal cost (that is the raise in the contribution margin from selling an extra unit, holding the price constant).

ii) The elasticity of demand concerning an increase in promotion or advertising is the percentage by which demand will modify when the seller’s promotion or advertising expenses increases by 1percent, other things equivalent.

e) A seller must increase the advertising-sales ratio if:

i) The incremental margin is very high as each dollar of advertising generates relatively more benefit (example: whenever a seller increases its price or its marginal cost drops).

ii) The advertising elasticity of demand is greater as the affect of advertising on buyer demand is comparatively greater.
 
4) Market Structure:

a) Perfect competition (that is, a market with many sellers, each too small to influence market conditions) in respect of monopoly.

i) Market price: The monopoly can set a comparatively higher price. Competition (and beneath particular conditions, even potential competition) pushes the market price down in the direction of long run average cost and outcomes in more production.

ii) Output or production: The monopoly limits production beneath the competitive level.

iii) Profit: the profit of a monopoly surpasses what would be the joint profit of all the sellers when similar market was competitive.

b) Potential competition:

i) It is the degree to which the market price can increase above long-run average cost based on the height of entry and exit barriers (example: exit and liquidation costs).

ii) Monopoly in a perfectly contestable market (that is, one where sellers can exit and enter at no cost) can’t raise its price substantially above its long run average cost. The other sellers can gain by entering the market. The resultant raise in supply will drive the market price back in the direction of long run average cost.

c) There is no such thing as supply curve for a monopoly, since monopoly can’t sell a limitless amount at specified price.

d) Lerner Index (or incremental margin percentage).

i) The incremental margin (or price-marginal cost) divided by the price; or the incremental margin percentage.

ii) It evaluates the degree of real and potential competition in a market.

iii) It allows comparison of monopoly power in markets with distinct price levels.

  • Perfectly competitive market: price equivalents marginal cost, that is, the incremental margin is 0.
  • With potential competition: when a monopoly sets a price close to its marginal cost, its Lerner Index will be comparatively low.
  • Monopoly: the more inelastic is the market demand, higher a monopoly can increase its price above marginal cost.

iv) It doesn’t detect the power which a monopoly doesn’t exercise. Example: when a monopoly faces inelastic demand however nonetheless sets a price near to marginal cost.
 
5) Monopsony:

a) Supposition: Maximization of total benefit.

b) Total benefit = benefit less expenses.

c) Marginal benefit (evaluated in terms of contribution = revenue less variable cost) from an input drops with the scale of purchases.

d) Price should be greater to induce a greater quantity of supply, therefore the average expenses curve slopes upward.

e) Marginal expenses are the modification in expenses resultant from the purchase of one more unit. For the average expenses curve to slope upward, the marginal expenditure curve should lie above the average expenditure curve and slope upward more abruptly.

f) The total benefit maximizing scale of purchases is where marginal benefit equivalents the marginal expenditure.

g) A monopsony limits purchases (or demand) to get a lower price and raise its benefit above the competitive level.
 
6) Restraining competition:

a) Competitors can restrain competition via cartel or horizontal integration.

b) Cartels:

i) Cartel: it is an agreement to restrain competition (that is, illegal in most countries)

  • A seller cartel restrains the competition in supply (that is, sets a maximum sales quota for each and every participant) to increase the market price and gain above the competitive level.
  • A buyer cartel is an agreement to restrain the competition in demand. It restrains each and every participant’s purchases to a maximum quota to decrease the market price.

ii) The success of a buyer or seller cartel mainly depends on private enforcement against existing members beyond their quotas and potential entrants.

iii) Factors which raise the efficiency of enforcement:

  • Few members; 
  • Relation of industry capacity to market demand: little surplus capacity; 
  • Degree of sunk costs: sellers with irrelevant sunk costs will be comparatively less willing to cut the price and surpass quotas; 
  • Degree of exit and entry barriers: not perfectly contestable; and 
  • When the product is homogeneous, it is simple to monitor cheating. Though, then incentive to cheat is bigger.

c) Labor unions:

i) Explicit seller cartels which limit competition among workers in the selling labor.

  • They hold down employment to increase wages.

ii) It is a union with closed shop (that is, where the employer commits to not hiring non-union workers) consists of a monopoly over labor supply.

iii) Utilization of automation or shifting production overseas symbolizes the replacement of equipment or foreign labor for the domestic labor.

d) Horizontal integration:

i) Horizontal integration: It is the combination of two entities, in similar or identical businesses, beneath a common ownership.

  • A combination which makes a monopoly will be capable to set price and sales at monopoly levels (decrease quantity supplied, increase the market price and raise gains), subject to the entry of the potential competitors.
  • Competing buyers can restrain the competition via horizontal integration.  It is a combination of 2 buyers which each contain 50 percent of the demanded purchases will make monopsony.

ii) Vertical integration: It is the combination of assets for two successive phases of production beneath a common ownership.

Question-Answer:

The Daily Sin is the only newspaper in Sin City. Its price has been 25 cents a copy. A recent drop in the cost of newsprint caused the Daily Sin's marginal cost to drop by 2 cents per copy.  In the meantime, the govt. introduced an annual license fee of $500,000 per newspaper.

a) Employing relevant diagrams, exemplify the Daily Sin's profit-maximizing price prior to the drop in cost of newsprint and new license fee.

b) How must the Daily Sin adjust its price to take account of the 2 cent fall in the cost of newsprint?

c) How must the Daily Sol adjust its price in reply to the new license fee?

d) How must the Daily Sin adjust its advertising-sales ratio in response to the 2 cent drop in the cost of newsprint and latest license fee?

Answer:

a) The figure is as shown below. The profit-maximizing price is around 25 cents. 

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b) The Daily Sin must decrease the price to p, and hence at the new sales quantity, the marginal revenue equivalents the new marginal cost (that is 2 cents lower).

c) License fee is an addition to the fixed cost. As it does not influence the marginal cost of production, the Daily Sin must not adjust its price in response to the latest license fee.

d) The decrease in price is less than the decrease in marginal cost (that is, 2 cents) therefore the new incremental margin is greater than the original incremental margin. Supposing no change in the advertising elasticity of demand, the profit-maximizing advertising-sales ratio is greater.

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