Lesson 8 - Regulating Monopolies

This lesson examines regulating monopolies.  A monopoly forms when a market has entry barriers.  Market barriers protect a monopoly from competition.  Moreover, the economics of an unregulated monopoly is examined, included market price and output.  A brief discussion why monopolies are bad and the common policies government uses to reduce monopoly power.

Market Entry Barriers

1.  Economies of scale - Natural monopoly.

• Firm has to be large to obtain low per-unit cost.
• Firm has very large fixed costs.
• A new firm entering this market would need substantial amounts of capital to reach this low-cost production level.
• Usually supplies the whole market.
• Examples:  Local phone service, electricity, natural gas, and rail roads.
• Large amount of equipment & infrastructure required.
• More convenient - imagine 12 electric power stations competing in one city.  Each has its own power lines, power substations, etc.  This would be a mess.

Economies of Scale

2.  Legal Barriers

1. Licensing - oldest form of protection.
   • Protects businesses from competition.
     • Doctors.
     • Legal services.
     • Taxicabs.
     • Funeral homes, etc.
• Sometimes the license has little costs, while other cases, they are expensive.
• Ex:  Taxicabs in New York City.
• The # of taxi licenses are fixed.
• Licenses can sold/traded.
• Market price of license > $100,000.
2. Patents - most countries have them.
• U.S. - gives the exclusive right to produce product for 17 years
• Benefits - encourages costly scientific research.
• Costs - higher prices to consumers until patent expires.

3.  A firm controls an essential resource.

• Example:  Before World War II
• Aluminum Company of America controlled the supply of bauxite.
• Other firms could not produce aluminum cheaply without bauxite.
• Example:  DeBeer Corporation of South Africa.
• Controls 80 to 85% of the world's supply of diamonds.
• "Diamond is forever."

4.  Unfair competition:

• Example:  Standard Oil - John Rockefeller.
• Came into a small town and charge a price below cost.
• Drove competitors out of business.
• Standard Oil would buy these businesses for cents on the dollar and consolidate them into Standard Oil.
• With no competition, Standard Oil charged monopoly prices.
• Standard Oil moved to the next town
• Controlled 90% of U.S. oil market.

Given enough time, technology allows new firms to circumvent the high barriers and drive economic profits to zero. Example - Cell phone technology opened telecommunications market to competition.

• Characteristics.
1. Single seller of a product.
• The demand for the monopolist's product is the market demand curve.
• A one firm industry.
2. No close substitutes for the product.
• You either buy the product from him or you don't.
3. A monopolist can exert control over the price.
• He decreases production level and market price increases.
4. Other firms are prevented from entering the market, because of high barriers.
• No competition.

2.  Price and output under monopoly.

• Monopolists expands output when MR > MC.
• Profits are maximized at MR = MC.
• Unregulated monopolist:  Market price, P* and production level, Q*.
• P* > ATC*, therefore monopolist earns economic profits.
• High entry barriers prevent competition.
• Monopolist earns long-run profits.
• Price gouging
  • Monopolist charges the price, where MR = MC. 
  • He does not raise price further, because profits fall. 
• Monopolies may not earn long-run economic profits.
• Patents for products that consumers do not want.

A Monopolist

 

• Monopolies  may earn economic profits in the long run.
• Buying these company stocks may not be profitable, because the monopoly value is already captured in the stock price.
• Early bird - unless you are the first person to buy the stock when economic profits began.

These firms may not be good investments.

1. Little competition limits the options to consumers.
• You either buy the product from the monopolist or you go without.
2. Reduced competition results in allocative inefficiency.
• Consumers value the products more highly than what it costs to produce them.
• P* > ATC.
• Firms are earning economic profits.
3. Consumers are not able to direct monopolies to serve their interests.
• Bad service.
• No incentive to improve products, etc.
4. Gov. grants of monopoly encourage rent seeking.
• Rent seeking behavior - gov. officials takes cash & assets from private companies & people.
• Russia:
• Companies bribe public officials, then officials grant licenses to those businesses, restricting competition.
• U.S.
• Corporations funnel campaign money to Congressmen.
• Congress passes laws favorable to corporations.

1. Reduce regulations that create market barriers

• Tariffs - tax on imported goods.
• Quotas - limit # of imported units.
• Licensing requirements.
• These policies protect monopolies from international competition.

2. Government can "ideally" regulate natural monopolies.

• Two pricing methods
  • Average Cost Pricing
  • Marginal Cost Pricing

Example 1 - Unregulated monopolist produces  at MC = MR, so the market price is P* and output is Q*

• Average Cost Pricing - the gov. sets the price where the demand curve intersects the long-run ATC.
• The price is lower ( P~< P*).
• The quantity produced is higher (Q~ > Q*).
• The firm earns zero economic profit in long run.
• Social welfare improves.
• Allocative inefficient.
• Price does not equal MC.

A Monopolist - Average Cost Pricing

Example 2 - Unregulated monopolist produces at MC = MR, so the market price is P* and output is Q*.

• Marginal Cost Pricing - the gov. sets the price where the demand curve intersects the MC.
• The price is the lowest (P~ < P*).
• The quantity produced is the highest (Q~ > Q*).
• The same social welfare as a competitive market.
• Allocative efficient.
• P = MC.
• The firm earns a loss in long run
• Ramsey Pricing
  • Regulated monopoly charges two prices
    • Unit charge is where P = MC
    • Fixed charge - take the monopolist's loss and divide evenly among consumers
      • The loss is the red square

A Monopolist - Marginal Cost Pricing

3. Antitrust policies - government breaks up monopolies  

• Increase the number of firms in a market.
  • Ex:  Government broke Standard Oil into several companies
    • Amoco Corporation
    • Chevron Corporation
    • Exxon Corporation
    • Mobile Corporation
  • Prevent companies from merging that may reduce competition.
  • Prosecute firms engaging in collusive behavior.
  • Do not breakup natural monopolies!
  • Per-unit costs will be higher with more firms.
  • 1984, AT&T was broken down into five baby bells.
  • A large monopoly broken down into 5 smaller regional monopolies.

4. Gov. can take over monopoly.

• Maybe worse than a private firm monopoly.
• No profit motive.
• No incentives to minimize costs and satisfy consumers.
• Taxpayers could end up subsidizing it.
• Example 1 - U.S. Postal Service - facing intense competition (e-mail, faxes, other mail carriers), so this agency is good.