Pricing & Costing

Module 1: Market Structure- Monopoly

 Why It Matters: Monopoly
• If perfect competition is at one end of the competitive
spectrum, at the other end is monopoly
• A monopolist is a single supplier, the only firm in an
industry
• Monopolies have monopoly power, which is the ability
to set the market price
• Consider the following questions:
• What prevents a monopoly from charging an infinite price?
• What is similar about the model of monopoly compared to
perfect competition?
• What is different about the model of monopoly compared to
perfect competition?
Monopolies

• A monopoly is a firm that supplies all of the

output in a market
• A monopoly faces no significant competition, it can
charge any price it wishes
• Examples of monopolies:
• U.S. Postal Service
• Your local electric and garbage collection companies
• A pharmaceutical firm that sells a particular drug
• For a time Microsoft was considered a monopoly
How Monopolies Form: Barriers to Entry
• With little to no competition, monopolies tend to earn significant
economic profits
• Profits would attract vigorous competition, but because of barriers to
entry they do not
• Barriers to entry: the legal, technological, or market forces that
discourage or prevent potential competitors from entering a market
• Two types of monopoly:
• Legal monopoly – laws prohibit (or severely limit) competition
• Natural monopoly – the barriers to entry are something other than legal
prohibition
Legal Monopoly
• For some products, the government erects barriers to entry by prohibiting
or limiting competition
• A patent gives the inventor the exclusive legal right to make, use, or sell an
invention for a limited time
• A trademark is an identifying symbol or name for a particular good, example: Nike
“swoosh”
• A copyright is form of legal protection to prevent copying, for commercial
purposes, original works of authorship, including books and music
• Trade secrets are methods of production kept secret by the producing firm,
example: Coca-Cola formula
• Intellectual property is the combination of patents, trademarks, copyrights, and
trade secret law
Natural Monopoly
• Natural monopoly occurs where the
economics of an industry naturally lead to
a single firm dominating the industry
• Economies of scale and sole ownership (or
control) of a natural resource are two
common examples of natural monopoly
• Economies of scale is when a firm faces
decreasing long run average costs as its level
of output increases
• Economies of scale can combine with the size
of the market to limit competition
Barriers to Entry
Table 1. Barriers to Entry

Barrier to Entry Government Role? Example

Government often
Water and electric
Natural monopoly responds with regulation
companies
(or ownership)
Control of a physical
No DeBeers for diamonds
resource
Post office, past
Legal monopoly Yes regulation of airlines and
trucking
Patent, trademark, and Yes, through protection
New drugs or software
copyright of intellectual property
Intimidating potential Predatory pricing; well-
Somewhat
competitors known brand names
Demand Curves Perceived by a Perfectly
Competitive Firm and by a Monopoly

• The pattern of costs for the monopoly can be analyzed within the same
framework as the costs of a perfectly competitive firm
• Because there is no competition for a monopoly, the decision process will
differ from a perfectly competitive firm
• The horizontal demand curve means that it could sell either a relatively
low or high quantity
 Total Cost and Total Revenue for a Monopolist
Table 1. Total Costs and Total Revenues of HealthPill

• Total costs for a monopolist follow the

same rules as for perfectly competitive Total
Quantit Total
firms Price Revenu
y Cost
• Total costs increase with output at an
Q
P e
TC
increasing rate TR
• Total revenue is different from perfect
competition 1 1,200 1,200 500
• Monopolists face a downward sloping 2 1,100 2,200 750
demand curve
• In order to keep selling output is to reduce 3 1,000 3,000 1,000
the price
• Selling more output raises revenue, but 4 900 3,600 1,250
lowering price reduces it
5 800 4,000 1,650
6 700 4,200 2,500
7 600 4,200 4,000
8 500 4,000 6,400
The Price and Revenue Schedule for Pure
Monopoly
Revenue and Cost Schedule for Pure Monopoly
Marginal Revenue and Marginal Cost for a
Monopolist
• In the real world, a monopolist often does not have enough information to
analyze its entire total revenues or total costs curves
• A firm doesn’t know what would happen if it were to alter production
dramatically
• However, a monopolist can use information on marginal revenue and
marginal cost
Choosing the Price
• A firm’s demand curve shows the
maximum price a firm can charge to
sell any quantity of output
• Graphically, start from the profit
maximizing quantity
• The place on the demand curve, up from
where marginal cost crosses marginal
revenue
• Then read the price off the demand curve
Computing Monopoly Profits

• Step 1: The Monopolist

Determines Its Profit-
Maximizing Level of Output
• Step 2: The Monopolist
Decides What Price to
Charge
• Step 3: Calculate Total
Revenue, Total Cost, and
Profit
 The Inefficiency of Monopoly
• Most people criticize
monopolies because they
charge too high a price
• Economists object to is that
monopolies do not supply
enough output to be
allocatively efficient
• Allocative efficiency is an
economic concept regarding
efficiency at the social or
societal level
• Refers to producing the optimal
quantity of some output
Price Discrimination and Efficiency

• Price discrimination means charging different prices to different

customers for the same product
• An example of price discrimination are sales at retail stores

• Three things are necessary for effective price discrimination

• Needs to have market power
• Needs to be able to sort the customers into who is willing to pay a higher price and
who is not
• Customers can’t resell the product
 Corporate Mergers

• A corporate merger occurs when two formerly separate firms combine to become a
single firm
• When one firm purchases another, it is called an acquisition
• In an acquisition, the newly purchased firm may operate under their former name
• Mergers can also be lateral, where two firms of similar sizes combine to become
one
• Mergers and acquisitions both lead to separate firms being under common
ownership
Regulations for Approving Mergers
• The laws that give government the power to block certain mergers, and even
in some cases to break up large firms into smaller ones, are called antitrust
laws
• The U.S. government approves most proposed mergers.
• In a market-oriented economy, firms have the freedom to make their own
choices. Private firms generally have the freedom to:
• Expand or reduce production
• Set the price they choose
• Open new factories or sales facilities or close them
• Hire workers or lay them off
• Start selling new products or stop selling existing ones
Regulating Anticompetitive Behavior

• U.S. antitrust laws regulate a wide array of anticompetitive practices

• It is illegal for competitors to form a cartel to collude to make pricing and
output decisions, as if they were a monopoly firm
• The Federal Trade Commission and the U.S. Department of Justice prohibit
firms from
• agreeing to fix prices or output
• rigging bids
• sharing or dividing markets by allocating customers, suppliers, territories, or lines
of commerce
• Under U.S. antitrust laws, monopoly itself is not illegal
Restrictive Practices
• Antitrust law includes rules against restrictive practices
• Restrictive practices are practices that do not involve outright agreements to
raise price or to reduce the quantity produced, but might have the effect of
reducing competition
• Types of restrictive practices are:
• A minimum resale price maintenance agreement
• Requires the dealers to sell for at least a certain minimum price
• An exclusive dealing
• An agreement that a dealer will sell only products from one manufacturer
• Tying sales
• Happen when a customer is required to buy one product if the customer also buys a second product
More Restrictive Practices

• Bundling
• A firm sells two or products as one
• Predatory pricing
• Occurs when the existing firm (or firms) reacts to a new firm by dropping prices very low, until
the new firm is driven out of the market, at which point the existing firm raises prices again
• The concept of restrictive practices is continually evolving, as firms seek
new ways to earn profits and government regulators define what is
permissible and what is not
Regulating Natural Monopolies

• Most true monopolies today in the U.S. are regulated, natural

monopolies
• A natural monopoly poses a difficult challenge for competition policy
• The structure of costs and demand makes competition unlikely or costly
• A natural monopoly arises when average costs are declining over the range of
production that satisfies market demand
• Typically, this happens when fixed costs are large relative to
variable costs
• As a result, one firm is able to supply the total quantity
demanded in the market at lower cost than two or more firms
The Choices in Regulating a Natural Monopoly

• What is the appropriate

competition policy for a natural
monopoly?
• The graph to the right
illustrates the case of natural
monopoly, with a market
demand curve that cuts
through the downward-sloping
portion of the average cost
curve
• Points A, B, C, and F illustrate
four of the main choices for
regulation
Choices in Regulating a Natural Monopoly

• Four main choices for regulation:

1. Leave the natural monopoly alone
• The monopoly will follow its normal approach to maximizing profits
2. Antitrust authorities decide to divide the company, so that new firms can
compete
3. Regulators may decide to set prices and quantities produced for this industry
• The regulators will try to choose a point along the market demand curve that benefits both
consumers and the broader social interest
4. Let the natural monopoly charge enough to cover its average costs and earn a
normal rate of profit
• The firm will continue to operate but won’t raise prices and earn abnormally high monopoly
profits
Cost-Plus Regulation

• Regulators of public utilities calculated the average cost of production for

water and electricity, added in an amount for normal rate of profit and set
the price accordingly for consumers
• This method was known as cost-plus regulation or when regulators
permit a regulated firm to cover its costs and to make a normal level of
profit
• Cost-plus regulation raises difficulties of its own
• If producers are reimbursed for their costs, plus a bit more, then at a minimum,
producers have less reason to be concerned with high costs
• Firms under cost-plus regulation even have an incentive to generate high costs by
building huge factories or employing lots of staff
Price Cap Regulation

• In the 1980s and 1990s, some regulators of public utilities began to

use price cap regulation, where the regulator sets a price that the firm
can charge over the next few years
• A common pattern was to require a price that declined slightly over time
• If the firm can find a way to reduce costs fast than the price caps, it can make a
large profit
• If a firm cannot keep up with the price caps or has bad luck in the market, it will
suffer losses
• Price cap requires delicacy, it won’t work if the price is too low or too high
Doubts about Regulation of Prices and Quantities

• Beginning in the 1970s, it became clear to policymakers of all political

leanings that the existing price regulation was not working well
• So the U.S. government removed controls over prices and quantities in
transportation, natural gas, and bank interest rates
• One difficulty with government price regulation is what economists
call regulatory capture, in which the firms supposedly being regulated
end up playing a large role in setting the regulations that they will follow
• The result of regulatory capture is that government price regulation can often
become a way for existing competitors to work together to reduce output, keep
prices high, and limit competition
The Effects of Deregulation

• The greater pressure of competition led to entry and exit

• When firms went bankrupt or contracted substantially in size, they laid off
workers who had to find other jobs
• Market competition is a full-contact sport
• A number of scandals led to the Sarbanes-Oxley Act in 2002
• Was designed to increase confidence in financial information provided by public
corporations to protect investors from accounting fraud
• One response to the Great Recession in 2007 was the Dodd-Frank Act
• Attempted major reforms of the financial system
Quick Review
• What are the characteristics of a monopoly?
• What are legal monopolies and what are some examples?
• How do economies of scale and the control of natural resources lead to
natural monopolies?
• What is the difference between barriers to entry?
• How does a demand curve for a monopoly differ from a demand curve for
a perfectly competitive firm?
• Analyze total cost and total revenue curves for a monopolist
• What is marginal revenue and marginal cost in a monopoly and how do
you calculate it?
• What is the level of output the monopolist should supply and the price it
should charge in order to maximize profit?
More Quick Review

• How do you illustrate a monopoly’s profits on a graph?

• What is allocative efficiency and its implications for a monopoly?
• What is price discrimination and why is it an allocatively efficient
outcome?
• What are antitrust laws and regulations?
• How do you calculate concentration ratios and the Herfindahl-Hershman
Index (HHI)?
• What is restrictive practices, including tying sales, bundling, and
predatory pricing?
• What is the appropriate competition policy for a natural monopoly?
• What is the difference between cost-plus and price cap regulation?
• What is the effectiveness of price regulation and antitrust policy?