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__**Chapter 15 - Monopoly**

Key Terms__ monopoly natural monopoly price discrimination

//Introduction//



Monopoly comes from "mono" meaning one, alone, single, and "poly," meaning right to sell. Like in the game Monopoly above, a monopoly sells its good alone, without any competition.

There are many monopolies in life today. For example, if you're viewing this with a Microsoft, then you have a computer that has an operating system called Windows, that was patented, which gives only Microsoft the rights to sell Windows. If you look back to a competitive market, there are thousands of sellers, which makes it impossible for one seller to control the price. As a result, sellers are price takers because they take the price of what's in the market. However, because in monopolies, because there's only 1 seller for a particular good, monopoly sellers are called price makers because they can make their own price because they are the only sellers.

However, there are problems that can arise due to monopolies. From Chapter 1, if you still remember the 10 principles, one of them was that governments can sometimes improve market outcomes. Due to certain problems, the government can resolve it by making policies.

In this chapter, we will examine monopolies, and also the inherent problems that arise due to them.

__**WHY/HOW Monopolies Arise**__


 * monopoly** - a firm is a monopoly if it is the only seller of a product, and there are no close substitutes.

The reason why monopolies exist is because there are //barriers to entry//. This means that a monopoly remains the only seller of a product because there are barriers that impede other firms from joining the market. Here are some barriers of entry:

- a single firm owns a key resource. - the government gives a single firm the right to produce a good/service - costs of production make a single producer more efficient than a large number of producers


 * Monopoly Resources**

The easiest way for a firm to be a monopoly is to own a key resource. For example, if I own the only well 100 miles around, I would have a monopoly.



And because water is an inelastic and necessary for life, I could charge a high price for water, and still get a good profit. My marginal cost would be 0, because it doesn't cost me money to pump water.

However, because today's economy is so large, there are few resource monopolies. For example, even though I might have the only well around and charge a high price, firms could import water in water bottles in people around me. Then, I wouldn't really have a monopoly.


 * Government-Created Monopolies**

Many times, a government will give a firm the right to produce a product, and let it be the only firm to produce that product.

Sometimes, it's because of political clout, which means that the government gives business rights to friends and allies of powerful people in the government.

Other times, it's because of public interest. For example, the US government gives a firm called Network Solutions, Inc. the right to organize the database of all Internet addresses (.com, .org, .net), so that they are standardized.

Another way is through patents and copyright laws. For example, when an inventor makes something, the inventor brings it to the government for a patent. If the government deems the invention something truly original, then it will give it a patent, which would give the person the only person who can sell the invention for a certain amount of time. Also, a writer can copyright a book after writing it.

By doing this, the person who invents or writes is the only person who sells it, which leads that person to have profits. At the same time, the government encourages this type of behavior because it encourages people to invent good things and write books about better stuff, which is beneficial to society.



But when the patent runs out, the monopoly becomes like a perfectly competitive market because the barriers of entry have been removed. Anyone can join the market, and there are many sellers.


 * Natural Monopoly

natural monopoly** - a monopoly that arises because a single firm can supply a good at a smaller cost than many producers

This is basically saying that one firm can do something cheaper than a group of firms. A good example to exemplify this is water distribution and plumbing. For a town, a water network needs pipes. However, if a new market were to join the market, then whoever wanted water from the new market would have to get their pipes under his/her house ripped out and the new pipes installed. This would be a huge hassle, and so it would be easier if a single firm just controlled the whole market.

As a result, would-be entrants are discouraged from joining, because they know that even if they join, they wouldn't be able to make much money. Another factor in monopolies is the population size. If the city were really, really big, and there were many houses that didn't have any pipes, a new firm could possibly join the market.

__**How a Monopoly Makes Production/Pricing Decisions**__

Remember, a monopoly's goal is to maximize profits. The biggest difference between a monopoly and a perfectly competitive market is that a monopoly can decide the price of its good by adjusting its quantity supplied. A monopoly's demand curve is not perfectly elastic, but downward sloping, as usual.



Now, let's look at a table:

Due to the slope of the demand, price per individual unit goes down as quantity goes up. The average revenue is the price of the individual good for that quantity. So if the quality supplied was 4 gallons, the revenue of the water would be 7 dollars per gallon. So thus, it is the demand curve. The marginal revenue is the revenue a firm makes to produce one more unit. So going from 3 to 4 gallons of water would increase total revenue from 24 dollars to 28 dollars, thus making marginal revenue 4 dollars.

Note: because demand is going down, the marginal revenue curve is always lower than the demand curve. You'll see it in a few seconds. It's lower because the price goes down as quantity goes up. If the price stayed the same, the MR would be the same. Their values at Quantity supplied = 0 are the same because the marginal revenue of going from 0 to 1 units is the same as the total average revenue. Here's a graph that simplifies this:

This graph is for the table shown before.

Now in order to maximize profit, which is the goal of a monopoly, let's put in the marginal cost and average total cost in the next graph:



As you know from the last chapter, marginal cost is the price that a company must pay to make one more unit. So we should come to the conclusion that a monopoly produces where the marginal cost meets the marginal revenue curve, because if the quality supplied increases, then the company wouldn't make a profit. For example, if you go to quantity supplied = 0, you get a really large marginal revenue at a really small marginal cost, which means that there is a lot of profit. Keep on going to the right, and a firm can keep on profiting because the money it receives is greater than the cost it takes to make them until where the MC = MR.

At that quantity, go back to the demand table, and you can put the price on the demand curve, because a monopoly CAN sell at this price and still get the same amount of quality. Because remember, a monopoly wants to maximize profit, and it can by putting the price as high as possible without losing quantity.


 * Monopoly's Profit**

Profit = Total Revenue - Total Cost

Total Revenue = (TR/Q - TC/Q) * Q

The Q's should cancel each other out.

And TR/Q = average revenue, which is price. TC/Q is average total cost, ATC.

In conclusion,

Profit = ( P - ATC ) * Q



So that's the end of the production and pricing of a monopoly.


 * Monopoly Welfare**

Are monopolies good? Well, they're bad to the consumers, due to high prices. But they're good for owners, because of high profits.

__Deadweight Loss__ Because markets don't produce in the equilibrium quantity, where the demand = supply, there is a deadweight loss. In this case, it's the demand (average revenue) and supply (marginal cost) that don't meet at the center. Why? Because monopolists want to maximize profit. But this "effective" quantity doesn't maximize profits. Take a look:

The people who were willing to pay the price between the price of the good in a monopoly and the efficient quantity price decided not to buy the product due to its distorted price. So there is a deadweight loss like a tax. The wedge is the triangle.

__**Public Policy For Monopolies**__ We've seen that monopolies produce at quantities lower than the socially desirable quantity, and at a higher price. So how does the government respond to this? Here are four ways:

- make monopolies more competitive - regulate behavior of monopolies - turning private monopolies to public businesses - doing nothing

Let's observe each:

__Increasing Competition__ Well, you're probably asking yourself, "How can the government do this? There's only a few companies." Well, let's say for example, that Windows and Apple Inc. decided to merge to sell operating systems together. Well, this would make them a monopoly because almost all computers use Windows or Apple operating systems. As a result, lawmakers and the US Department of Justice could prevent them from merging.

These rules are called anti-trust laws and try to prevent too many monopolies. They prevent almost-monopolies (oligopolies, which will be discussed next chapter) from conspiring to raise prices. Also, it gives the government power to split up monopolies into smaller companies. For example, the government split up AT&T into 8 smaller companies in 1984.

However, there are some drawbacks. Throughout time, many companies, such as banks, have wanted to merge in order to cut production costs. But it could seem like a monopoly merger. In that respect, the anti-trust laws are bad. The government must determine which companies want to merge for good and bad.

__Regulating Monopolies__

These are common for necessities such as water and electricity. The companies themselves don't determine the price. The government does it instead.

What price should the government charge? Some people say that the government should charge where price = marginal cost, so that monopolies don't profit as much, and there won't be any deadweight loss. However, monopolies have a declining average total cost, because they don't have marginal product return. As a result, marginal cost is less than average total cost, which leads to a loss of money in monopolies. In this case, the firm would just leave the market. Take a look:



There is no perfect solution to this problem. Sometimes, the government subsidizes the monopolist, which also creates a deadweight loss, because the government taxes people to subsidize the monopolist.

Another problem with having marginal cost = demand is that it doesn't give the monopolist an incentive to lower prices, because they know that even if they do, the govenrment will alter the price so that marginal cost = price. To resolve this, the govenrment lets the monopolist keep a reduced profit.

__Public Ownership__ In public ownership, the government just takes over all the monopolist firms, such as telephone firms, water companies, and electric companies. This is common in many European countries but less common in the US, where only the Postal Service is government-owned. Economists prefer private ownership to public ownership becuase it gives the private owner an incentive to lower costs. If a worker does bad, the private owner can fire him/her, becuase the private firm is suffering. However, if a public owned monopolies, the losers are taxpayers. In conclusion, firms are more efficiently run in private ownership.

__Doing Nothing__ All of the solutions above have some drawbacks. So some economists argue that the government should just mind its own business.

__**Price Discrimination**__ We've been assuming that all monopolies sell its products at the same price to everyone. However, many firms try to sell its products to consumers at different prices in order to imcrease profits, even though the cost of producing for both are almost the same. This practice is called **price discrimination** (business of selling the same good at different prices to different customers).

THis isn't possible at a competitive market, because if a firm was to charge a price lower than the current price, which is also the marginal cost, it would lose money. A firm must have market power. This is what a monopolist wants to do:



The second picture to the right is called //perfect price discrimination// because the firm knows the willingness to pay for each customer and sells it to the customer at that price. However, it is pretty much impossible in real life. I'll tell you a story that exemplifies one form of price discrimination.

Let's say that you're the president of Scholastic Publishing Company, which produces books. Let's say that JK Rowling decides to write an eighth Harry Potter book, and so you give her 10 million dollars to have producing rights. To make things simple, let's keep the cost of production at 0. Your goal is to maximize profit. And because my only cost is the 10 million you paid to Rowling, your profits should be your total revenue - the 10 million.

So. What price should you sell these books for in order to maximize profits?

First, find out the demand for the book. Your marketing department tells you that there are 1,000,000 die-hard fans that are willing to pay $20 for the hardcover book the week the book comes out. They also say that there are 4,000,000 other potential readers who are willing to pay $5 for a paperback book a few months after the hardcover is released.

So what price shoiuld you put? If the price of the book is set at $20, then the 1,000,000 fans will buy the book. Revenue will be $20,000,000, and profit will be $10,000,000. If you set the price at $5, then you'll have 5,000,000 readers, with a revenue of $25,000,000 and a profit of $15,000,000. But could you get more?

This is where price discrimination kicks in. Up till now, we've been using one price to solve all of our problems. But for this dilemma, we can set 2 prices - $20 for the enthusiastic die-hard fans, and $5 for the normal readers. If you find out, for example, that all the die-hard fans are in England, where JK Rowling is from, and that the normal fans who would pay 5 bucks are from the US, then you could sell the books at different prices for each country. In this case, revenue would be $40,000,000, and profits would be $30,000,000. Your goal would be accomplished - profits were maximized, and you're now a rich man (or woman).

Although this rarely happens, if ever, it is a fairly accurate description of many publishing companies.

__Other Examples of Price Discrimination__

movie tickets - many theaters charge a lower price for children and seniors because their willingness to pay is not as high as adults and teenagers.

airline prices - most airlines charge different prices whether or not you stay over on a Saturday night. This is done to separate business travelers and person travelers. A businessman has a high willingness to pay because they are on business, and they usually don't want to stay over on Saturday nights. However, other person travelers usually do want to stay over on Saturday nights so to maximize their vacations.

discount coupons - if you look in newspapers, magazines, or in the mail, there are many coupons. A consumer can just rip out the coupon and use it. This allows people to price discriminate because people who are poorer are more likely to take that coupon, whereas someone rich and with a high willingness to pay wouldn't use that coupon.

financial aid - richer people have a higher willingness to pay for college. Poorer people who have a lower willingness to pay can apply for financial aid, so they can get into the same colleges as rich people.

quantity discounts - sometimes, monopolists charge lower prices for people who buy large quantities. As a willingness to pay declines as quality increases, this allows price discrimination.

__**Summary**__ A monopoly is a firm that has market power, due to control of a key resource, a government right, or because one firm can produce cheaper than two firms.

Because demand is a downward-sloping curve, a monopoly is different from a perfectly competitive market.

We have seen that monopolies behave very differently than perfectly competitive markets. They produce less than the sociably desirable quantity, and charge a higher price. Thus, deadweight losses occur.

Firms can price discriminate due to different willingness to pay for different types of consumers.

In a sense, all firms are kind of monopolies. They all have market power, but not much. They can decide the price of their products.

Look at the this table that compares Perfectly Competitive Markets with Monopolies.



QUESTIONS: 1. What is a natural monopoly? 2. Why are patents and copyright laws good? 3. Why is the quantity supplied where MC = MR? 4. What is the profit for a Monopoly? (Formula-wise) 5. Why is there deadweight loss in a monopoly? 6. What are anti-trust laws good? Bad? 7. What's a problem if a government puts down the price of a monopoly to the marginal cost? 8. What is perfect price discrimination? Does it happen in today's society often?

Answers: 1. A natural monopoly is a monopoly that arises because a single firm can supply a good or service to an entire market cheaper than two or more firms. 2. They are good because they give incentives for people to do research, make new inventions, and write books. 3. It's where profits are maximized. Any less, profit wouldn't be maximized. More than that, profits are lessened. 4. (P-ATC) * Q 5. There's deadweight loss because quality supplied is less than socially desirable. 6. They're good because they discourage monopolies and firms from controlling the price too much. They're bad because some firms try to merge in order to reduce costs. 7. There are two problems. Because ATC is less than MC, there would be a loss in the monopoly, forcing it to leave. Also, it doesn't encourage monopolies to lower its costs. 8. Perfect price discrimination is where monopoly knows exactly the willingness to pay for every customer, and charge each customer the exact amount.

Citations http://www.productwiki.com/upload/images/monopoly_electronic_banking_edition.jpg http://www.surrey.ca/NR/rdonlyres/C4AADB57-BB95-490C-BF32-539C16A511CF/26305/StoneWishingWell.jpg http://www.knoxpatents.com/Images/LettersPatent-55-b.jpg