Topic 10 - Monopoly and other forms of Imperfect Competition

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Monopoly And Other Forms Of Imperfect Competition

Imperfectly Competitive Markets

These are markets in which firms have some ability to set their own prices (they have market power), in essence they are not pure price takers. Different forms of imperfect competition exist and they include:

  • Monopoly - 1 firm, no substitutes
  • Oligopoly - few firms, close substitutes
  • Monopolistic Competition - many firms, slightly differentiated goods

Market Power And the Firms Demand Curve

In perfectly competitive markets, firms face a perfectly elastic demand curve (they can supply as much as they want at the market price but cannot charge any higher). In imperfectly competitive markets, the firm faces a downward sloping demand curve. [1]

10IC1.jpg

Market Power can arise from the following barriers to entry / competitive advantages:

  1. Exclusive Control Over Important Inputs - e.g. China and rare earth metals
  2. Government Created - limit entry, patents, trademarks, licenses
  3. Economies of Scale - declining average cost of production (natural monopoly) as production increases (makes it hard to enter and be competitive)
  4. Network Economies - become more valuable as people use it e.g. EBAY


Economies of Scale And the Importance of Fixed Costs

Economies of scale is a huge factor in markets with high start up costs and low reproduction costs. As quantity increases, fixed costs are spread (since ATC = Fixed Costs / Quantity + Marginal Cost) this means average total costs approach the marginal costs. Low cost producers draw more customers, allowing the firm to further utilise economies of scale. In these cases first mover advantage is important. [2]


10IC2.jpg


[3]

Profit Maximisation for Price Setters

[4]

Profit maximisation occurs when marginal revenue (marginal benefits) = marginal costs. However in the case of firms with market power, marginal revenue does NOT equal price. Marginal revenue will always be less than price as the demand curve is downward sloping as the firm must cut its price to sell an additional unit. Additionally, monopolists will not always make a profit.

10IC3.jpg

The Invisible Hand Breaks Down Under Monopoly

In imperfectly competitive markets, social efficiency or total economic surplus is not maximised. This is because the marginal benefits (to society - demand curve) do not equal the marginal costs (to society - the firms marginal cost curve) where profit is maximised for the monopoly.

  • From perfectly competitive markets we know that the optimum level is where marginal benefits (price) = marginal costs, but with imperfect competition marginal revenues are less than price (and lower than the demand curve) and hence the optimum quantity is not reached and too little is produced.
  • Barriers to market entry stop the invisible hand from attracting new companies even if the monopoly is earning economic profit.

[5]

10IC4.jpg

Monopolistic Competition

In monopolistic competition, economic profit does attract new competitors resulting in a leftward in shift in demand for the firms goods or services and hence a leftward shift in its marginal revenue curve.

Hence, in the long run, economic profit will be = 0, where the monopolistic producer produces at a quantity for which the average total cost intersects the demand curve (the demand curve represents the average revenue curve) as shown in this picture [6]

10IC5.jpg

Price Discrimination

Price Discrimination involves charging different buyers different prices for the same goods or services, where differences don’t reflect differences in costs of supplying. *Price discrimination was illegal until the 1995 Hilmer Review

  • Examples Include:
    • Senior citizen discounts, rebate coupons, volume based discounts
  • It is an important tool for firms so that they can separate buyers into groups on the basis of how much they’re ‘willing to pay’
  • Group Pricing: Offering discounts to certain sub markets
    • Don’t know each consumers reservation prices, excluding those who are willing to pay a high price
    • Hurdle Method of Price Discrimination / Versioning is utillised by offering discounts to those who overcome an obstacle, while imposing no cost on those who jump the hurdle - e.g. mail in Rebate coupon


Price discrimination allows the socially optimum amount (maximisation of total economic surplus) to be realised as a firms marginal revenue is equivalent to the demand curve (because the firm does not have to drop prices to all buyers to sell an additional unit - only to the next buyer) and thus the point of profit maximisation will occur when the demand curve (benefits to society) intersects the supply curve (costs to society).

Price Discrimination Examples From The Textbook

[7]

This example involves a person who is paid to edit other peoples essays. The exact reservation prices of each individual in the market is given. In real life things are not as clear cut as this.

  1. No Discrimination
  2. Perfect Discrimination
  3. Group Pricing
  4. Perfect Hurdle Pricing

10IC6.jpg

Regulating Natural Monopolies

A government may permit the realisation of economies of scale, while protecting consumers and ensuring adequate output so that lower costs per unit of output can be achieved to benefit society.

Various regulation controls may include:

  • Set Price = Marginal Costs - however this means the monopoly will lose money (will not recoup costs of initial investment (initial fixed cost or outlay)
  • Set Price = Average Total Costs - no economic profit will be realised but it discourages efficiency as the monopoly will not worry about controlling costs
  • 2 Part Tariff - charge buyers a fixed prices for access and then charged on a per unit basis (possibly to recoup initial outlay and cover marginal costs)
  • Other Price Caps

References

  1. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  2. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  3. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  4. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  5. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
  6. Scott French, School of Economics, UNSW Lecture Slides
  7. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
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