Microeconomic Analysis

ECON 520 - SS 18
KFUPM - Fall-22
Dr. Muhammad Imran Chaudhry, CFA
 Monopoly- Definition and Sources
• What is a monopoly market structure?
– A market with only one producer of goods/services (without any close
substitutes) serves the entire market.
– Examples: Debeers for diamonds in 1970s; STC for phone lines in Khobar
and Murree Brewery for local alcoholic beverages in Pakistan.
– Definition of monopoly is rather simple, but difficult to apply in practice.
For example, does Amazon have monopoly in e-commerce?
• The answer depends on how we define ecommerce market i.e., B2C or B2B.
Similar questions raised for STC in Khobar and Murree Brewery in Pakistan.
• What are the sources of monopoly power:
– Exclusive control over key factors of production: Usually an input that is
difficult to duplicate e.g. Debeers controlled over 80% of world diamond
supply, and Perrier owns water springs with unique properties.
 Monopoly- Definition and Sources
– Patents: Subsequent to an invention, the right to exclusive production of
a good for a given period of time. Aspartame (artificial sugar) and GMOs
patented by Monsanto. Moderna and Pfizer Covid-19 vaccines.
– Government Licenses: Laws and regulations serve as a barrier for other
firms trying to enter a market e.g., eatery licenses at Highways/Airports
or import licenses for a specific product.
– Economies of Scale: High fixed costs and associated scale economies i.e.
large minimum efficient scale, act as a barrier for small firms attempting
to enter a market. In some cases, natural monopoly i.e. more production
leads to lower and lower costs: and Saudi Electric Company and STC.
• Network Economies: A service becomes more valuable, as more people use
it i.e., a kind of demand-side scale economies. For instance, Facebook and
Instagram, Microsoft Windows etc.
– Miscellaneous: Trade secrets (e.g., coke recipe) and branding (e.g., Rolex
and Bugatti). Usually difficult to sustain, and not a textbook monopoly.
 Monopoly- Optimal Decisions
• Understanding optimal production decisions?
– How is a monopoly different from perfect competition? Key difference is
that monopolist is price-setter, versus price-taker in perfect competition.
• A firm in perfect competition can sell as much output as it wants at market
price. For a monopolist being able to sell more output means cutting price
not only for the marginal unit but all preceding units sold as well!
– This has clear implications on the marginal revenue of a monopolist:
• Output effect: Sell more output and receive an additional revenue.
• Price effect: In order to sell more output, monopolist needs to reduce price
(remain on the demand-curve), and hence receives lower price for all units.
• Since, price-effect and output-effect work in opposite directions, as a result
marginal revenue is less than the revenue from the additional unit sold!
– Optimality condition is the same as before MC=MR, i.e., continue to sell
until MR<MC, but MR curve is no longer equal to the market price in the
case of a monopolist.
 Monopoly- Optimal Decisions
• Derivation of optimal production choice of monopolist:
– Draw the upward sloping marginal cost curve of a monopolist:
• Contrary to the case of firms in perfect competition, marginal cost curve of
the monopolist, is not called the monopolist’s supply curve. Why?
– Draw the downward sloping market demand curve for a monopolist:
• Contrary to case of firms in perfect competition, marginal revenue curve of
a monopolist is not a horizontal line (i.e. market price in the case of perfect
competition), but instead a steeper downward sloping curve below market
demand curve due to the opposing nature of the price and output effects.
– Optimal production choice is at the intersection of the marginal revenue
and marginal cost curves i.e. continue to produce until marginal revenue
is greater than marginal cost.
– At the optimal production level, we employ the market demand curve to
determine the market-clearing price for the optimal production level!
• Monopolist looks for a quantity-price combination on the “demand-curve”
that maximizes the monopolist’s profits!
 Monopoly- Welfare Analysis
• How does the monopoly market outcome compare to allocation
under perfectly completive markets?
– Comparison of the equilibrium allocations, reveals that under monopoly
market structure less goods are sold and at a higher price relative to the
case of perfectly competitive firms.
– Though lucrative for a monopolist, but this is detrimental to the society.
• From a societal perspective, feasible transactions remain un-transacted i.e.,
we interpret monopolist's marginal cost curve as the marginal societal cost
of production and market demand curve as society’s willingness to pay for a
good (or marginal societal benefit of consumption). In case of a monopolist
these transactions don’t occur (when they should), resulting in dead-weight
loss.
• The invisible hand theorem fails in the case of monopoly market structures.
• Public policy or government interventions are often employed if
market mechanisms fail to yield an efficient outcome:
 Monopoly - Policy Interventions
– Antitrust laws: Governments do not allow mergers/acquisitions that can
lead to monopolies and sometimes even break-up existing monopolies.
• At times bigger firms are better for society e.g., scale or scope economies,
natural monopolies.
– Regulation: Governments fix prices in monopoly market structures so as
to yield zero (economic) profit for a monopolist i.e. factors of production
earn the market rate or return.
• Deadweight loss reduced, but still not zero. Monopolies have little incentive
to reduce costs or remove cost inefficiencies as profit rate guaranteed. Plus,
management may exaggerate costs or spend resources to influence policies
to “capture” regulators. This “rent-seeking” behavior leads to inefficiencies.
– Public ownership: A monopoly is disbanded and government takes over.
Bureaucrats operate the monopoly at marginal cost pricing.
• Incentives of bureaucrats are seldom aligned with performance metrics like
cost per unit and firm profits, with a significant scope for corruption.
 Monopoly - Business Strategies
• What should you do if you are the manager of a monopoly:
– Maintain barriers, because monopoly power will be eroded as new firms
enter market.
– Develop strategies to effectively price discriminate. This can increase
profits by reducing the impact of price-effect stemming from selling
more units.
• Price discrimination essentially means to sell the same or similar
goods to different types of customers at different prices e.g., aid
at universities, discounts on movies/airplane tickets for students
or senior citizens, coupons for restaurant discounts etc.
– Two conditions need to be met for effective price discrimination:
• Monopolist is able to separate customers into distinct categories according
to their willingness to pay for the good.
• Monopolist is able to prevent low-willingness to pay customers from
directly selling to high-willingness to pay customers.
– In case of perfect price discrimination by a monopolist, there is no dead-
weight loss, but all the consumer surplus is usurped by the monopolist.