In the first six weeks we described models of individual and firm choice, and given many individuals and many firms we were able to describe a competitive market.
In doing so we found that the outcomes in a competitive market allowed gains from trade – buyers who valued the products more than the sellers were trading with each other. But there were issues:
- It assumed there were lots of potential sellers of a homogenous product whose choices have no influence on the choice of other sellers.
- It assumed there were no systematic biases in consumer choices and ignored agency problems in production.
- It took for granted full, or at least symmetric, information about the product and the market.
- It didn’t incorporate the way the choice to produce or consume could impact upon a third party (externalities).
- It assumed that the institutional structure ensured the product was excludable.
These assumptions do hold in some circumstances – and even when they don’t there could be a good reason we start with it (eg assuming a systematic bias without evidence is just assuming people are stupid – which isn’t a good starting point for trying to objectively understand their choices).
But we would like to think about other types of market structures we observe.
Since then we have built some more tools to think about choice – comparative advantage, finance, game theory, and emergent macro-phenomenon.
Armed with these tools we can return to our original market model and ask “what happens when there is only one firm – with the same motives and desires as the many firms before”. This is the case of monopoly.
One firm – one price
Our monopoly has the same motivation as the perfectly competitive firm. It minimises its costs and maximises its profit. So the monopoly we are thinking about is not subject to the agency problems we have discussed could occur – and any X-inefficiency due to this is put to the side.
Given we are comparing like-with-like we want to think about why the aggregated choice of perfectly competitive firms, and the choice of a monopolist over the same industry would differ.
For this we can use the following pieces of understanding:
- A profit maximising firm will set MR = MC (marginal revenue equal to marginal cost).
- For a competitive firm, their choice of price does not influence the price they face OR the price faced by other firms. As a result, MR = P. In a competitive industry this implies that the overall supply curve is simply the MC curve (above average variable costs).
- To put another way – if a competitive firm set a higher price it loses all its customers, if it sets a lower price it simply loses revenue (as it can sell as much as it wants at a given price), so they only ever have an incentive to set that one price.
- For a monopoly, when they produce more they lower the price they face – as a result, making one more unit and selling it involves selling at a lower price to all the customers who would have purchased at a higher price (non-discrimination).
- As a result, selling an extra unit will provide an increase of revenue equal to the price the unit is sold for minus the lost revenue from their existing customers – so MR < P.
- Given this, MR = MC < P and the monopolist will only sell output up until the point where they make a margin on cost (where cost includes the opportunity cost of production).
- The monopolist WANTS to sell to another customer at a price below the current price. A customer WANTS to buy at this price. But they do not transact because the monopolist would have to cut the price for all other customers. Therefore, some transactions that have gains from trade do not occur.
That is our process for thinking about the monopoly – no graphs and no real math. This also tells us we can ensure all gainful trade occurs by allowing first degree (perfect) price discrimination – but then all of the surplus will be received by the monopolist, and none by the consumer. So we may view this as inequitable.
So to make sure we understand, lets do this with our graphs.
In this first graph we can see that the monopolist charges a mark-up on cost, and will produce less at a higher price that the competitive firm did (where demand equals marginal cost). The “lost surplus” for these missing transactions is coloured in yellow – we call this deadweight loss, and often term it the inefficiency in the market.
Our second graph here adds another perspective. If we have normal profits at the competitive equilibrium, then a monopolist will make supernormal profits. We know that these profits would incentivise entry – and so for entry to not occur there must be some specific nature of the industry (eg economies of scale and natural monopolies) or barrier to entry (either government or firm induced) that prevent a second firm from showing up.
Our model of monopoly leads to an outcome we would – in many ways – view as “worse” than the competitive situation. Transactions do not occur when there are gains from trade associated with them.
But this isn’t due to some specific motivation – the monopolist is no more evil than a competitive firm in our example, there are no differences in motivates and desires. Instead the trade-off they face is different – and they respond to that.
We did noticed that entry and the potential for competition are important – and this takes us to our final topic for the course, Oligopolies!