MONOPOLIES, MONOPSONIES

and DOMINANT FIRMS

 Monopoly behavior
Monopoly is the only supplier of product for which
there is no close substitute
Monopoly sets price above MC; Thus less is sold
than competitive regime where P=MR=MC
Under monopoly, MR not equal to price
Faces a downward sloping demand curve which
constrains monopoly behavior: Can set price or
quantity, but not both. If it sets Q, demand curve
will determine price; if it sets price, demand curve
will determine Q
 Monopoly Profit maximization

Demand, D

Pm
overcharge

Deadweight
Monopoly

Monopoly
profit loss, DWL

MC
Pe
MR
Qm Qc Output, Q
 Monopoly Profit maximization
Monopoly profit maximized where MR=MC
By substitution, we get
(p-MC)/p= -1/e where e= elasticity of demand
Price-cost margin= Lerner Index of market power=
(p-MC)/p
Elasticity is key determinant of market power.
The higher the elasticity of demand, the closer is
the monopoly price to competitive price NB
monopoly demand curve is getting flattish
 Monopoly Profit maximization
Ref diagram
Intersection of MR and MC determines Q whose
interaction with demand curve determines
monopoly price
The consumer surplus is reduced as it goes into
monopoly profit and deadweight loss
Thus monopoly is inefficient when compared to
competitive market
 Monopoly shutdown point
Monopoly shutdown condition is same as
competitive firm: In SR if p is lower than AVC,
stop producing
 Market and monopoly power
Distinguish between two terms
Monopoly power is making profit by optimally
setting its price above MC
Market power when a firm earns the
competitive profit when it sets its price
optimally above its MC
 Incentive for efficient operations
An inefficient competitive firm may not stay in
business because it is unprofitable
An inefficient monopoly can profitably remain in
business.
Thus some argue that monopoly has little
incentive to be efficient. But this is rejected by
many: Monopoly like other firms prefer more to
less; to maximize profit at its chosen level of
output all firms try to minimize cost.
 Incentive for efficient operations
A firm in competitive market can learn from
other firms e.g it can compare its costs with
market costs that reflect other firms’ efficiency.
Monopoly has no comparative standards to
learn from , and may be more vulnerable to
inefficient operations
 Monopoly behavior over time
If demand is very inelastic, it is not possible to
meet the profit maximization condition. Thus
monopoly never operates on the inelastic
portion of D. If on the inelastic portion,
monopoly will increase its profit by raising
prices until it starts operating in the elastic
portion.
An extensive inelastic portion e.g whole D curve
is not a realistic assumption especially in LR
 Monopoly behavior over time
Consumers more likely to have inelastic D in SR
rather than in LR
In SR limitations on how fast can consumers find
substitutes for product whose P has risen, but if
monopoly takes advantage of inelastic D in SR, in
subsequent periods consumers will try find
substitutes. E.g. when OPEC raised oil prices in
1970s, total consumption changed very little, But
over time, consumers adopted energy saving
strategies and oil D fell sharply
 Rent seeking behavior
When monopolies are created by Government
regulations, the deadweight loss is greater than
was shown; also includes expense made to
lobby for the regulations. Rent seeking is the
costs from anticipated monopoly profit that
goes into lobbying for Government induced
monopoly.
 Benefits of monopoly
The quest for monopoly profits may motivate
development of new products; improve
products; find lower cost methods of
manufacturing
Patent protection helps and encourages R&D
 Creating / maintaining monopoly
Several ways including:
1.Mergers
2.Strategic action to prevent entry
3. Special knowledge
4. Government protection
5. Natural monopoly
 Creating / maintaining monopoly
1. Mergers
A merger of competing firms can lead to
monopoly.
2. Strategic action to prevent entry
Any action that prevents entry of competitors.
During the Rockefeller oil monopoly in USA, any
competitor was persuaded to sell company to
Rockefeller
 Creating / maintaining monopoly
3. Knowledge advantage
A firm can be a monopoly because only it knows
how to produce the product; or has production
technique that enables it produce at lower cost
than others. This usually lead to patent
protection if it is an invention
 Creating / maintaining monopoly
4 Government created monopolies
Governments often give special protection to
maintain monopoly status for selected enterprises
,quasi Government or even private firms e.g ZESCO
until recently was the sole generator of power.
5. Natural monopoly
In some markets, it is efficient for only one firm to
operate because production costs would rise with
other producers. In case of decreasing costs as
output increases, new firms may not compete with
an existing firm.
 MONOPSONY
Monopsony is single buyer in the market: flip
side of monopoly
Monopsony buys more if value of extra
consumption ( as given by its demand curve)
exceeds MC. Given monopsony in labor market:
To hire extra worker, Monopsony needs to raise
the wage ,say, from K5 ph. to K6. The extra cost
for hiring this additional worker is not K6, but K6
plus K1 each for original work force.
 MONOPSONY
If original establishment was 100, the total wage
bill rises from K500 to K606; an increase of
K106.
The marginal cost of hiring additional labor is
given by the MARGINAL OUTLAY SCHEDULE that
is analogous to marginal revenue curve. It lies
above the upward sloping supply curve because
monopsony must raise wages for all workers to
raise the wage of the extra worker
 MONOPSONY
Profit maximizing monopsony hires where the
intersection of D and the marginal outlay
schedule ( analogous to MR curve). Any point to
the right means MC is above marginal benefit
or you are reducing profit for each extra
employee; hence you reduce on employment.
Any point on left means your marginal benefit is
higher than MC: it is profitable to expand
employment.
 MONOPSONY
• The intersection of marginal outlay curve and
D gives monopsony employment level ( Lm)
whose intersection with labor S determines
monopsony wage ( wm)which is lower than
Competitive wage (wc)
• Monopsony’s marginal benefit is given by its D
curve
 MONOPSONY

Wages Marginal outlay schedule, MO

Supply of labor

We
DWL
Wm D

Lm Le Workers, L
Dominant firm with competitive fringe
Dominant firm has a high market share ,
enough to set the market price, while facing
smaller price taking firms called fringe firms.
Entry limits market power of dominant firm;
2cases:
a) Entry by other firms impossible
b) Entry by competing fringe firms easy
Show the dom. firm’s price setting behavior
depends on entry by fringe firms
Dominant firm with competitive fringe
Two main conclusions:
1.Not in profit maximizing interest for dom. Firm
to set price so low that it drives out all fringe
firms from the market
2. The presence of fringe firms or threat of entry
may force dom. firm to set price lower than
monopoly
Dominant firm with competitive fringe
With sufficient numbers of fringe firms, the dom
cannot charge price higher than minimum AC of
these firms. If potential entrants’ costs are as
low as the dom., the dom. has no more market
power than any other firm.
 WHY some firms are dominant
3Reasons why some firms are dominant:
1.Dominant firm may have lower costs than fringe
firms. Four possible causes for this:
a) A firm may be more efficient than its rivals
b) Early entrant to market may have lower costs by
learning from experience
c) Early entrant may have time to grow and harvest
economies of scale
d) Governmentt may favor original firm
 WHY some firms are dominant
2. Dominant firm may have superior product in a
differentiated market
3. A group of firms may collectively act as a
dominant firm e.g The Philippine coconut oil
producing firms act collectively in 80% of global
market to face fringe firms from other countries
 NO-entry model
Consider mkt with dominant firm and fringe firms
where no other firm can enter;
Five assumptions:
1.There is dominant firm due to lower costs
2 Except for dominant , all firms are price takers
3. The number( n) of competitive fringe is fixed
4. Dominant firm knows the market demand curve.
Each firm produces a homogeneous product, so
there is a single price in the market
 NO-entry model
5. The dominant firm can predict how much
output can be produced by competitive fringe
The last two assumptions ensure that the
dominant firm knows enough to be able to set
its output level optimally
 Dominant firm’s reasoning
As DF lowers its output to raise p, the
competitive fringe (CF) output increases
because the fringe supply curve S(p) is
increasing in p, As a result mkt output falls less
than desired, and p does not rise as high as
under monopoly. Thus dominant firm (DF)’s
problem is more complex than that of monopoly
It must consider CF’s reaction to DF’s action
 Dominant firm’s reasoning
Since you cannot stop them, let CF sell as much
as they can at mkt p, set by DF. The DF is then in
monopoly position with the residual demand.
First determine the DF residual demand curve
Then act like a monopoly on the residual
demand curve
 CF graphic analysis
MCf
$ ACf

S (p)

P*
P
πf

qf Qf Fringe firm and total supply, q, Q

 Competitive fringe market share
With mkt demand curve D(p), the CF firm’s
supply curve is the MC curve above the
minimum of its AC curve which is the CF firm’s
shutdown price.
Above this price each fringe firm makes
economic profit. At this price each firm is
indifferent between operating and closing down.
Below this price, each CF firm shuts down, and
dominant firm is a monopoly
 Competitive fringe market share
The CF supply curve S(p) is horizontal
summation of individual CF firms’ supply curves
S(p)= nq(p) : n is number CF firms; q is output of
typical CF firm
 DF graphic analysis
$ MCd
D(p)
ACd
Dd(p)
P*
p
πd
MC*d
P*

MRd

Qd Q
Q* d Market quantity Q
Qf
 Residual Demand curve
DF residual demand curve is the horizontal
difference between mkt demand curve and the
CF supply curve
In diagram, the mkt demand curve is above
residual demand curve at prices above
shutdown price; but residual is equal to mkt D at
prices below the shutdown. Above shutdown,
the CF firms meet some or all of the mkt
demand
Dominant firm profit maximization
DF profit maximization point is where MC=MR
DF picks Q and p from the intersection of its MC
curve with MR curve
The MR is derived from its residual demand
curve. Discrete jump between 2 sections of MR
at a point where Mkt demand curve meets the
residual demand curve
Dominant firm profit maximization
Since MR has two sections there are two
possible types of equilibrium depending on the
DF ‘s cost structure:
1. DF charges price such that it makes economic
profit, and CF firms also make profit or break
even
2. DF sets price so low, the fringe firms
shutdown making DF a monopoly
 DF-CF Equilibrium
The 1st type of equilibrium ( top of diagram) is
when DF ‘s costs are not substantially less than
those of CF firms. DF’s MC curve crosses the first
segment of MR to determine output of DF, then
p is determined by residual demand curve.
The difference between DF ‘s output (at p) and
the mkt demand is the CF ‘s supply.
If the DF costs are this high, DF maximizes profit
at a price high enough for CF firms to stay alive
 DF-CF Equilibrium
The area above AC shows the economic profit
for DF. The profit of typical CF firm is also
positive because p is higher than the shutdown
price. This profit is shown in earlier diagram,
Since DF’s AC is lower than that of CF typical
firm, the DF makes more profit per unit, and
sells more than any CF firm. Hence makes more
total profit.
 DF-CF Equilibrium
DF maximizes its profit at a high price that
makes it lose some market share to CF, It does
not make sense for DF to set prices so low that
it kills the CF.
In this scenario, DF makes less profit than
monopoly. CF can hurt DF for consumer benefit
E.g. in 1993, NEC corp. which had 50% Japan
mkt for personal computers had to cut its prices
in half due to increased CF competition from U.S
 Dominant firm as monopoly
Second scenario: DF has very low costs; MR
crosses MC in lower part of its 2 downward
sloping sections. This intersection of MR and MC
determines output while the D determines p.
Since p is below the CF shutdown price, the CF
firms produce nothing; and DF is able to operate
as monopoly
 Model with free instantaneous entry
This section retains all assumptions, except that
now unlimited CF firms may enter the market.
As number of CF firms increase at p equal to
shutdown or break even point, the slope of CF
supply curve becomes flatter until it is
essentially horizontal at that price. There are no
economic profits, but CF firms can stay and
supply any quantity demanded,
 Model with free instantaneous entry
The residual demand curve facing DF is horizontal at
shutdown p. The corresponding MR is also
horizontal and is identical to the residual demand
curve (similar to competitive mkt). Below shutdown
price, the residual demand curve is the mkt D
curve.
There are two possible equilibria
1. If DF ‘s MC IS very high, it crosses the horizontal
portion of MR to determine DF output
 Model with free instantaneous entry
What is left to CF depends on DF cost structure.
At this price, the CF firms each make zero
economic profit, and are indifferent between
staying in business or exiting
If CF firms flood the market whenever economic
profits appear, the DF cannot charge price above
minimum AC of CF firm.
DF can make economic profit, but CF firms just
break even
 Model with free instantaneous entry
In absence of easy entry, the DF’s p would be
above the shutdown level, then consumers are
better off with easy entry
2. The second type of equilibrium is when the
DF ‘s MC is low enough to hit the MR curve in
the down ward sloping portion. Here p is lower
than the shutdown level, and there are no CF
firms in operation. Hence DF is a monopoly
Model with free instantaneous entry
MCd
$
D(p)

Dd(p)
MRd MC*d
P* Dd(p)

MRd
Qd Q Q*d Quantity Q
Qf