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Chapter 4: Monopoly, Monopsony, & Dominant Firms

PURE MONOPOLY (STATIC CASE)

Monopoly Behavior:

1. Maximizes profits: MR = MC2. Faces downward sloping demand: Price maker

3. Makes price by setting quantity

4. Creates P > MC by selling less output than competitive firm

5. Selling less output creates deadweight loss (DWL)

Figure 4.2

Consumer Surplus = Willingness-to-Pay minus Price

Producer Surplus = Price minus Willingness-to-Supply

Degree of market power Lerner Index

Monopoly or market power results in an overcharge.

The overcharge is related to the elasticity of demand.

From MR = MC and from MR = P [ 1 + ( 1 / )]

We obtain the Lerner Index (LI) or monopoly markup

LI = [ P MC ] / P = 1 / -

If MC = AC , then

Gross Margin = [ P AC ] / P = 1 / -

In perfect competition, = - and LI = 0

DWLMonopoly Profit

(Producer Surplus)

CS

MR

Demand

MC

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Incentive for Efficient Operation

While the inefficient competitive firm will not survive, an inefficient monopoly may survive. The value

maximizing owners have an incentive to become efficient. However, with the separation of ownership

and control there is great potential for X-inefficiency.

Welfare Comparison with Pure Competition

1. DWL is a welfare loss hence inefficient

2. In a cartel situation, DWL represents an incentive to cheat (see Chapter 5

Other Costs of Monopoly:

1. Rent-seeking costs (expenditures on lobbying to obtain preferential government treatment).Monopolist would be willing to spend up to the amount of the monopoly profits

2. Advertising expenditures

3. X-inefficiency (no market discipline)

Benefits of Monopoly:

Society may benefit from a monopoly when the monopolist has secured its position through innovation

(differentiation or cost leadership). The government may even be justified in providing preferentialtreatment in this case with a patent.

CREATING & MAINTAINING A MONOPOLY

1. Merge or Collude (Chap. 5)

Early antitrust law was clear in making collusion (price fixing, cartels) illegal, but not clear

to when merging was illegal (merger to monopoly wave in 1890 1905)

2. Strategic Entry Deterrence (Chap. 11)

Strategic investment to make entry by rival firms unprofitable (send signal to potential

entrants) Limit pricing

Predatory pricing

Capacity expansion

3. Knowledge Advantage

Asymmetric knowledge/technology

4. Government-Created Monopolies

Crony capitalism

Rents that rent-seeking behavior seeks

Intellectual property

U.S. Post Office

5. Natural Monopoly

Declining Average Cost

Cheaper for one firm to produce output than numerous smaller firms

Traditional public utilities (phone, electric, cable, gas) are considered natural monopolies,

but with new technologies this may be changing

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PROFITS & MONOPOLY

1. What appears to be positive economic profit may in fact be a rent to scarce resources and not

monopoly profit

2. A monopoly does not guarantee positive economic profit

3. Mergers to eliminate short-run losses may not be desirable in the short-run. Merger will lead to

higher prices and a DWL. However, short-run losses cannot be sustained indefinitely. To survivein the long-run may require a merger.

MONOPSONY

A monopsony is a single buyer in a market.

The monopsony is a price taker in the input market.

The economics are symmetric with the monopoly case with a marginal outlay schedule

(marginal resource cost) lying above the supply curve.

The strategy of the monopsony is to maximize profit where marginal benefit of hiring (the

demand curve) equals the marginal outlay, resulting in the monopsony restricting hiring

and paying an input price below the competitive price.

Note that a minimum wage set at wc in Figure 4.5 on page 107 will have the effect of

increasing the wage and employment. This is because the marginal outlay curve is flat at

wc until it intersects the demand curve (MRP curve)

DOMINANT FIRM MODEL

Dominant Firm: A large price-setting firm with large market share, facing smaller price-taking firms.

Fringe Firms: A group of small price-taking firms in a market with a dominant.

With the fringe firms, the dominant firm will typically not set the conventional monopoly price, nor will

the profit-maximizing dominant firm want to predatory price to drive out the fringe.

Some examples might include:

Dominant Firm IndustryKodak photographic film

Hewlett-Packard laser printers

IBM personal computers

Microsoft operating system software

U.S. Steel steel

General Motors automobiles

In most cases the dominant firms dominance wanes over time.

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Why Some Firms are Dominant

1. Lower cost with first mover advantage

2. Superior (differentiated) product with first mover advantage

3. Cartel without full market share (e.g. OPEC)

Dominant Firm Model

There are a number of variants of the dominant firm model, most of which assume that the dominant

firm has a cost advantage. Consider 3 models:1. Umbrella Price ModelThis situation is a price leadership model with the largest or dominant firm as the leader. As

benefactor the dominant firm uses an umbrella price strategy.

The dominant firms umbrella price is higher than the price charged by the smaller fringe firms. The

umbrella price policy will:

1. Ward off antitrust authorities (no predatory pricing)

2. Avoid a price war

3. If the dominant firm has a superior product, there will be little concern about losing significant

market share.

To show this mathematically, let = % price cut by competitor or fringe entrant

= fraction of demand captured by the price cutting competitor from the dominant firm.

The price umbrella is optimal for the dominant firm if

< / PCM where

PCM = (P C) / P (gross margin)

P = price

C = average cost

The strategy is desirable when:

is large compared to (price cut large compared to lost share) PCM is small to begin with (margins are small)

To see the algebra, let

no cut = Profit from maintaining the higher umbrella price

cut = Profit from following the competitors price cut

The dominant firm will maintain the umbrella price if

no cut > cut

Where,no cut = [ P C ] Q ( 1 )

cut = [ P ( 1 ) C] Q

no cut > cut when < / PCM

Problems with Dominant firm and umbrella price:

1. With firm asymmetries, rivals are not interested in playing

2. Dominant firm may lose significant market share and profit, since the dominant firm is

passive (no tit-for-tat, no grim trigger)

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2. No-Entry Model

Fringe firms are identical price-takers

Number of fringe firms is fixed and no new entry occurs

Dominant firm knows market demand and fringe firms supply hence dominant

firm knows residual demand and behaves as a monopoly with respect to the residual demand

Outcomes (see Figure 4.6, page 114)

(i) Dominant firm charges high price and makes a profit as do the fringe firms. The profit

for the dominant firm is lower than would be the case if it was a monopoly. This market is

not contestable since entry is restricted

(ii) Dominant firm costs are so low that the monopoly price is below the fringe firms shut-

down price

3. Free, Instantaneous Entry Model

Same situation as 2. above, except entry is not restricted

Dominant firm still has cost advantage

Outcomes (see Figure 4.7, page 118)

(i) Dominant firm charges a price equal to the min(AC) of the fringe firms and makes a profit.

Fringe firms earn zero economic profit. The profit for the dominant firm is lower than would

be the case if it was a monopoly. This market has limited contestability since entry is limited

by the cost differential

(ii) Dominant firm costs are so low that the monopoly price is below the fringe firms shut-down

price [min(AC)]