ECMA04H Week 9 Efficiency in competitive and monopolistic markets. Regulating natural monopoly.

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1 ECMA04H Week 9 Efficiency in competitive and monopolistic markets. Regulating natural monopoly. Objectives this week: - Review Consumer Surplus and Producer Surplus - Define Gain to Society (GTS) as summary measure of net economic benefits - Discuss allocative efficiency in competitive and monopolistic markets - Discuss ways to regulate natural monopolies, including marginal cost pricing and average cost pricing First, complete our discussion of monopoly 1

2 An excise tax on a monopoly. Solve it graphically. Price per unit quantity MC AC Demand MR 0 Quantity produced per unit of time 2

3 Solve it algebraically. Place a $15 tax on the monopoly problem we had before. What is the effect on equilibrium price and equilibrium quantity? What is the effect on profit? 3

4 What is the excess burden of the tax? 4

5 Other thoughts about monopoly: Think about elasticity and monopoly. Will a monopolist have elastic or inelastic demand? What makes most sense? 5

6 This week s problem: compare Monopoly to Perfectly Competitive market. Which is better, which is worse, and why? What are the remedies (if any)? Difficult to make comparison, because problem of apples and oranges. Situation is often different. Still, useful exercise Compare using: 1. Allocative efficiency Gain to Society 2. Distribution of benefits between producers and consumers 3. Dynamic efficiency 6

7 Does the monopolist s output maximize the Gain to Society? Efficiency is achieved when resources are allocated in a way that delivers the most gain to society How do we measure Gain to Society (GTS)? Sum of Consumer Surplus plus Producer Surplus (sometimes use profit instead of producer surplus) 7

8 How much does society gain from the activities of producing and consuming? In the simple situation, the benefits to society are the benefits to the individuals that are participating in consuming and producing. i.e., consumer surplus and producer surplus (or profit). Simple situation means when there are no (a) taxes or tariffs (b) external benefits (c) external costs (d) public goods 8

9 Consumer surplus (CS) is dollar value of utility received by consumers above cost of purchase CS represents extra willingness to pay above the current price. It is a measure of the satisfaction that consumers get above what they have to pay for a good. Increasing CS represents a social gain a gain to society 9

10 What is producer surplus? Producer surplus (PS) is the dollar value of revenue received by producers above the minimum amount they require to be willing to supply the good. It is a form of surplus received by producers, and therefore can also be considered a gain to society 10

11 In the short run, the minimum amount producers require is to cover their TVC the total variable costs of production. Therefore, PS = TR TVC But, since Π = TR TFC - TVC Therefore, TR TVC = Π + TFC In other words, PS = Π + TFC Producer surplus differs from profit only by the amount of fixed costs. So, if we are comparing two situations with same fixed costs (e.g., competition and monopoly), then we can use either PS or Π in our calculation of Gain to Society. Look at CS and PS on graph 11

12 Price $60 Supply $30 $25 $15 $11 Demand 0 100, , , ,000 Market for 4 x 8 sheets of ¾ plywood ,000 Quantity Per month

13 Price $60 Supply $30 $25 $15 $11 Demand 0 100, , , ,000 Market for 4 x 8 sheets of ¾ plywood ,000 Quantity Per month

14 Now, compare competition and monopoly Imagine there are 100 firms in a perfectly competitive market. In the long run, in this constant cost industry, supply is given by P = 100 (horizontal long run supply at a price of $100). Consumer demand in the industry is given by P = 1000 Q What is the equilibrium in this industry in the LR, and what is the GTS? 14

15 Draw the diagram 15

16 GTS = CS + Π 16

17 Imagine that a monopoly firm is able to buy up all 100 firms and establish some barrier to new firms entering the industry (e.g., a government licence as exclusive supplier). The monopolist keeps all the 100 plants separate and operates as many as he needs to supply the good. In effect the S LR becomes the MC curve (and the AC curve) of the monopolist. 17

18 The Gain To Society in the monopoly situation is given by GTS = CS + Π 18

19 How do perfect competition and monopoly compare? Under PC, GTS = $405,000 (and all of it goes to the consumers). Producers receive just enough to keep them in the industry and producing, but not more. Under monopoly, GTS = $303,750 (lower by $101,250), and there has been a transfer of surplus so that the producer receives the biggest part ($202,500) and consumers receive $101,

20 Perfect competition maximizes the sum of the surpluses to consumers and to producers. Therefore, PC has the largest Gain to Society and is efficient. There is a loss of Gain To Society under monopoly. In other words, there is a loss of efficiency under monopoly. We call this a deadweight loss or efficiency loss. Deadweight because it is completely lost to society (rather than transferred to someone else). Note: not all losses are deadweight losses. 20

21 What about the distribution of the benefits of production? Different from allocative efficiency. Does the monopolist transfer potential CS into profit for the producer? 21

22 What about dynamic efficiency? Joseph Schumpeter waves of creative destruction 22

23 Now let s summarize comparison: Competition Monopoly Price Profit Consumer Surplus Total (GTS) Deadweight Loss Dynamic Efficiency 23

24 Classic view is that monopoly distorts resource allocation and causes deadweight efficiency loss. Monopolist produces too little output (uses too few resource 24

25 How does monopoly persist? Π > 0, so needs some barrier to entry Could be: (a) government licence or restriction (patent) (b) ownership of scarce but essential resource (c) some other barrier to entry (e.g., huge advertising costs, manipulation of access to market) Or, (d) cost advantage economies of scale which are large relative to the size of the market (known as natural monopoly ) [q* < q MES ] 25

26 What should government policy be towards monopoly? It depends: (a) is allocative efficiency the only measure? What about dynamic efficiency? (Schumpeter waves of creative destruction) (b) Why does the monopoly exist? What is the nature of the barrier to entry? Is it a government patent? Is it a economies of scale (i.e., natural monopoly)? (c) What can government do? Can government restore competition? Can it regulate the monopolist? Will the results be better? 26

27 In case of natural monopoly (electricity, telephone, roads, bridges, etc.), governments may regulate the monopolist. (Another alternative is to take firm into public sector). Rate of return regulation Control monopolist by forcing it to charge a certain price that will affect the profits and production of the monopolist. 2 choices: (a) Regulate monopolist to charge P = MC (b) Regulate monopolist to charge P = AC 27

28 Diagramatically, what are these alternatives? 28

29 What are the effects of P = MC? 29

30 What are the effects of P = AC? 30

31 What will happen if the government does nothing? 31

32 What are the strengths and weaknesses of these different solutions? 32

33 An algebraic example: Highway 407. Privately owned and operated highway. Demand: P = Q, where Q is measured in trips per day FC = $1,950 per day VC = $100 per trip TC = $1, Q 33

34 What will unregulated monopolist do and what is the GTS? 34

35 What if government regulates the monopolist to charge P = MC? What happens and what is the GTS? 35

36 What if government regulates the monopolist to charge P = AC? What happens and what is the GTS? 36

37 Conclusions? Problem with Regulation: loss of incentive to keep costs low to deliver high quality to innovate 37

38 so summarize Arguments for and against monopoly Against: reduce Q, raise P, reduce CS hard to regulate For: natural monopoly even if not natural monopoly, dynamic argument Joseph Schumpeter lure of monopoly profits lead to innovation eg. Microsoft?? Policy issue: break up? regulate? leave alone? 38

39 1. Break up: - issue of proof. anti-trust law in Canada used to be criminal. problem of proof, so now civil - assumes no economies of scale (microsoft?) - restores advantages of market (airlines) - loses reward for innovation 2. Regulate: - losses of efficiency? - how to retain incentives - cost of regulation - issue of capture - how to deal with new technologies and entry 39

40 3. Leave alone: - static losses in efficiency - higher prices - gains of potential competition in long run 40

MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

MBA 640 Survey of Microeconomics Fall 2006, Quiz 6 Name MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 1) A monopoly is best defined as a firm that