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University of Essex Session 2011/12

Department of Economics Autumn Term

EC111: INTRODUCTION TO ECONOMICS

MONOPOLY AND REGULATION

Monopoly is the opposite extreme to perfect competition. In this case there is only
one (actual and potential) supplier of a good.

Monopoly relies on barriers to entry to the industry; these could be legal barriers,
they could be the result of special resources (factors or materials) owned by the
firm, or they could be the result of technology.

The key feature is that the monopolist faces the entire market demand curve.






















The marginal revenue, MR, curve is downward sloping and below the demand
curve (which represents average revenue, AR).

In order to sell more the monopolist drives down the price of all units sold, not just
the marginal unit. Hence MR is the addition to total revenue of selling one more unit
minus the fall in revenue from dropping the price of all the intra-marginal units.
Thus MR < P at any level of output.


MR
P, MR
Elasticity = 1
Q
D
2

Note that:

MR is zero at the point of unit elasticity on the demand curve. This is where
total revenue for the firm (total expenditure of the buyers) is maximised.
Beyond that, total revenue falls, so marginal revenue is negative.

The slope of MR is two times the slope of AR (the demand curve). In the
linear case the MR bisects the horizontal axis between zero and the intecept
of the demand curve.

The relationship between marginal revenue and price depends on the
elasticity of demand:
E
1
1 P MR . When demand is perfectly elastic, E =
, and MR = P.
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Profit maximising equilibrium for the monopolist is where MR = MC. For a
monopolist with U shaped costs we have:






















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To show this we require some calculus. Note that the change in Total Revenue along the demand
curve can be expressed as PdQ QdP dTR and therefore Marginal Revenue is
P
dQ
dP
Q
dQ
dTR
MR . The elasticity of demand is
Q
P
dP
dQ
E and thus P
dQ
dP
P
Q
P MR .
Remembering that elasticity is always expressed as a positive number we have
E
1
1 P MR

P



P
*

Q
*
Q
MR
Profit
D
MC
AC
3

Note that:

The monopolist has market power. Unlike the competitive firm, it can
influence the price. The monopolist chooses the price (and therefore the
quantity) that maximises its profits.

The monopolist picks a point on the demand curve where demand is elastic.
Q: How can we be sure of this?

Here we are not distinguishing between the short run and the long run (the
diagrams would look somewhat similar). But it is useful to think of the long
run. Q: Why?

The monopolist makes profit (P AC)Q. Because P > AC the monopolist
makes super-normal profits, i.e. profits in excess of opportunity costs.

Because there is no threat of entry the monopolist can sustain super-normal
profits in the long run.

A numerical example with constant costs.

Demand: Q = 12 P

Total cost function: TC = 4Q

From the second equation we have MC = 4 (constant marginal and average cost).

Inverting the first equation gives average revenue, Q 2 24 Q
2 / 1
1
2 / 1
12
P
Total revenue is: TR = PQ =24Q 2Q
2


Marginal revenue is the change in TR for a unit change in Q. MR = 24 4Q

[You need calculus for this, but the MR function can easily be derived by noting
that it has the same intercept and twice the slope of the AR function]

The profit maximising condition is: MR = MC: 24 4Q = 4.
Solving for Q: 24 4Q = 4; 20 = 4Q; Q = 5

From the demand curve P = 24 25 = 14

Profits are: (P AC)Q; (14 4)5 = 50.


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I llustrating the numerical calculation






















Comparing Monopoly and Perfect Competition

Assuming constant average and marginal costs makes it easier to compare
monopoly with perfect competition. If there are lots of identical small firms then, in
the long run, we have constant average and marginal costs (which is the industry
supply curve).
Q: If the monopolist faces the same cost conditions (lots of small plants) then how
does it sustain its monopoly power?

Under perfect competition we have P = MC in the long run. How much would the
perfectly competitive industry produce?

We have costs: AC = MC = 4 (which is the perfectly elastic industry supply curve),
and demand: P = 24 2Q.

Setting P = MC: 24 2Q = 4 ; Q = 10.

And from the demand curve P = 24 2 10 = 4.

Total profits are (P AC) Q = (4 4) 10 = 0.

So, we have for monopoly: Q = 5; P = 14; Profit = 50
And for perfect competition: Q = 10; P = 4; Profit = 0
P

24



14






4

5 10 Q
MR
Profit
D
MC = AC
5



Welfare implications




















Under monopoly:
Consumer surplus (area ABC) = (24 14)5 = 25
Producer surplus (area BCEF) = (14 4)5 = 50
Social surplus = consumer surplus + producer surplus = 25 + 50 = 75

Under perfect competition:
Consumer surplus (area AEG) = (24 4)10 = 100
Producer surplus = 0
Social surplus consumer surplus + producer surplus = 100 + 0 = 100

The difference is deadweight loss (area CFG) = (14 4)(10 5) = 25

The monopolist restricts output in order to keep the price up. The producer gains,
but consumers lose more than the producer gains. The difference is the deadweight
loss.


G
F
E
C B
A
P

24



14






4

5 10 Q
MR
D
MC = AC
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Natural Monopoly

Technology may be such that there are economies of scale over a range of output up
to and beyond total demand.
.




















Here marginal costs are below average costs over the whole range of output

In this situation average costs would be higher if production was spread over several
different firms.

If there were a number of firms then one firm might be able to reduce costs by
taking over the others and eliminating them from the market.

Potential entrants may not be willing to enter the market because they would have
too small a market share to make positive profits. Here there is freedom to enter,
but firms dont enter.










P





Q
MR
D
MC
AC
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Price discrimination

Price discrimination is a situation where different units of a good are sold at
different prices.

This can work only if the firm can keep the markets separate i.e. prevent a situation
where some people buy the good at a lower price and resell it to others who would
otherwise have to pay a higher price.

Third degree price discrimination



















In this illustration, constant costs are assumed and the two markets are drawn
back to back. The situation is similar to two separate monopolists except that
marginal costs are the same across both markets.

If the monopolist can discriminate between the two markets then it maximises
profits by setting MR
A
= MR
B
= MC.

At any given price demand is more elastic in market B than in market A. The firm
will charge a higher price in the market with the lower elasticity:

B
B
A
A
E
1
1 P
E
1
1 P MC Since E
A
< E
B
it follows that P
A
> P
B






Q
B

D
B
MR
A
MR
B
D
A
Market B Market A
MC = AC
P

Q
A
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The welfare implications of third degree price discrimination are ambiguous.

Consumers in low-elasticity markets are hurt by price discrimination
because they face a higher price, buy a smaller quantity and enjoy less
consumer surplus than under uniform pricing. The opposite is true for
consumers in high elasticity markets. Producer surplus increases with price
discrimination. So the overall effect on social surplus is ambiguous.

But this assumes that the monopolist serves both markets. If price
discrimination was prohibited then it is possible that the firm would not
serve the high elasticity market at all, which would definitely result in lower
welfare than under price discrimination.



Second degree price discrimination

















Suppose that there are two different types of customer, low elasticity or high
elasticity.

The diagram is now drawn for two individual customers, one of each type. But the
firm cannot identify the type. Q: Examples? Airline pricing?

The firm has to offer the same price to both types but the firm can discriminate
indirectly by offering various packages so that different groups buy different
packages.

The firm uses this strategy to extract more of the consumer surplus than under the
normal uniform pricing.

q
P

MR
A
MR
B
D
A
Type B Type A
MC = AC
P

q
A
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Examples

Offering a two-part tariff, T(q) = A + Pq.

Non-linear pricing of a more general form e.g. quantity discounts.

Offer different packages each directed to a different customer type.

The welfare implications of second-degree price discrimination are ambiguous.

First degree price discrimination

The firm can identify each consumers marginal valuation of the good. (It is helpful
here to think of each consumer buying one unitas we move down the demand
curve, more consumers decide to buy a unit).


















What was previously the demand (AR) curve, now becomes the MR curve. This is
because the firm can sell another unit at a lower price without reducing the price of
all the intra-marginal units. Q: Where is the new average revenue curve?

The monopolist will maximise its profit where MC = MR which is now at Q
*
in the
diagram.

Note that:

The firm converts the whole of consumer surplus into profits: area ABC.

Its output is the equivalent to perfect competition. Social surplus is
maximised.
Q
*
Q
C B
A
P





D = MR
MC = AC
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Regulation

We assume that the regulators objective is to maximise the sum of consumer and
producer surplus.




















One form of regulation is price cap regulation. The regulator seta a maximum price
of P
PC
, the perfectly competitive price which is equal to marginal cost.

Now the firm can sell as much as it wishes at P
PC
; it is equivalent to making the
firms demand curve perfectly elastic, as in the competitive case.

The firm chooses to produce at Q
PC
, which maximises social welfare (and consumer
surplus).

Problems with regulation

Asymmetric information: the regulator may not be able to identify the firms costs.
(In the formula used in the UK, RPI minus X, the regulator allows the firm to
raise its price each year in line with inflation plus or minus an amount X).

Firms may have little incentive to reduce cost since if they are successful, the
regulator will simple reduce the price to match. This incentive effect will depend on
how often the price is adjusted.

The firm may capture the regulator. Q: What does this mean?

P





P
M





P
PC

Q
M
Q
PC
Q
MR
D
MC = AC
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Natural monopoly



















Social surplus is maximised where P = MC.

Note that:

If the regulator sets the price where P = MC then the firm will make a loss
because at that point AC > MC. An alternative would be to set P = AC so
that the firm breaks even, There will be some deadweight loss since P > MC.

Alternatively set a two part tariff with a fixed charge plus a per unit price at
P = MC, such that the firm breaks even. This eliminates deadweight loss
when consumers are identical.

P





Q
MR
D
MC
AC
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Liberalisation versus regulation

Liberalisation means removal of restrictions on competition, such as making it
easier for new firms to enter.

Starting with a protected monopolist in a potentially competitive market, should the
government:

Allow for free entry or restrict entry?

Break up the monopolist into smaller units or leave it intact?

Regulate price and/or quality? And if so, how?

Liberalisation and regulation can be complements rather than substitutes.

For instance the utility industries (electricity, gas, telecommunications, etc.)
combine activities that are natural monopolies with activities that are potentially
competitive.

Transmission networks (e.g. electricity distribution) are natural monopolies,
so regulation of these activities is necessary.

The provision of services over the networks (e.g. electricity generation or the
supply of electricity to consumers) is not a natural monopoly, so competition
in these activities is possible.

A number of important issues remain:

If there is room for only a few firms to be given the right to use the network,
Should this firms compete for that right, by periodic allocation of franchises,
and if so how should that be organised?

Should the firm that runs the network also be allowed to compete in
providing services over the network?

How should the government regulate the terms on which this firm gives
network access to other firms?