MODULE 62: MONOPOLY & PUBLIC POLICY

MODULE 62: MONOPOLY & PUBLIC POLICY Schmidty School of Economics 1

LEARNING TARGETS I CAN Ø Compare & Contrast the effect that perfect competition and monopoly has upon society's welfare. Ø Explain how policy-makers address the problem posed by monopoly. The purpose of this module is to show that, when compared to perfect competition, the existence of monopoly reduces output and raises prices to consumers, while earning economic profit for the firm. By producing at an output below that where P=MC, monopoly causes a loss of total welfare: deadweight loss. In order to mitigate the negative consequences for consumers, government can adopt policies to regulate a monopoly firm. 2

KEY ECONOMIC CONCEPTS A monopoly, if left unregulated, will decrease consumer surplus and increase producer surplus. However the losses to CS outweigh the gains to PS, thus creating deadweight loss. Deadweight loss occurs because output is reduced and at the monopoly output, P > MC. Thus mutually beneficial transactions go unmade. A natural monopoly exists when one large firm can produce the product at lower average costs than can several competing firms. The markets for utilities like electricity, natural gas and water are good examples. If the government regulates the natural monopoly so that deadweight loss is eliminated, the firm will suffer losses and exit the industry. To avoid bankrupting the natural monopoly firm, the government can regulate price such that normal economic profits are earned. 3

MODULE OUTLINE I. Welfare Effects of Monopoly II. Preventing Monopoly Power III. Dealing With a Natural Monopoly A. Public Ownership B. Regulation 4

Consumer Surplus in PC Comparing total welfare under perfect competition and monopoly. The perfectly competitive output is Qc and the price is Pc=MC=ATC. Total welfare is the sum of consumer & producer surplus. In this case, PS=0 so the entire surplus goes to the consumers. The area of this large triangle will be used as the benchmark so we can compare this triangle to the total surplus under monopoly. Note: consumer surplus is the area of a triangle below the demand curve and above the price. ½ bxh 5

NOW THE MARKET OF THE MONOPOLIST The monopoly output is Qm and the price Is Pm>MC=ATC. Total welfare is still the sum of consumer and producer surplus. CS has shrunk while PS (profit) has increased. This PS is a transfer from consumers to the firm. There is an area that used to belong to CS, but now belongs to nobody. This deadweight loss shows us that total surplus under monopoly is less than under perfect competition. 6

PC & MONOPOLY SIDE BY SIDE ü Total surplus under perfect competition is equal to: CSc ü Total surplus under monopoly is equal to: CSm + PSm ü Because of the deadweight loss, we can see that CSc > CSm + PSm Ø Economists see this loss of total welfare as a major drawback to monopoly and is an argument for regulation or prevention of monopolies. What exactly is the deadweight loss? It represents transactions (between Qc and Qm) that Could have been made, but are not made under monopoly. This will always occur when the level of output restricted such that Pm >MC. 7

I. WELFARE EFFECTS OF MONOPOLY The previous module showed that, when we compare monopoly to perfect competition: Qm < Qc, Pm > Pc, and Monopoly profit is greater than zero. 8

I. WELFARE EFFECTS OF MONOPOLY Monopoly: The monopoly output is Qm and the price is Pm>MC=ATC. Total welfare is still the sum of consumer and producer surplus. But we see that CS has shrunk while PS (profit) has increased. This PS is a transfer from consumers to the firm. However there is an area that used to belong to CS, but now belongs to nobody. This deadweight loss shows us that total surplus under monopoly is less than under perfect competition. 9

I. WELFARE EFFECTS OF MONOPOLY Total surplus under perfect competition is equal to: CSc Total surplus under monopoly is equal to: CSm + PSm Because of the deadweight loss, we can see that CSc > CSm + PSm Economists see this loss of total welfare as a major drawback to monopoly and is an argument for regulation or prevention of monopolies. 10

REVIEW PRICING (PC) 1. What Q of output will be produced? 2. What P will the market establish? 3. Calculate the CS and shade the area. 4. Calculate the PS and shade the area. 6 ½ (6) (6) =$18 ½ (6) (6) =$18 $6.00 34.1 Perfect Competition 12 6 0 CS PS MC 0 6 12 D

EQUILIBRIUM FOR THE MONOPOLIST 12 8 4 Part B: Figure 34.2 Monopoly CS PS1 PS2 MR MC 0 4 6 12 ATC D 5. What Q of output will be produced? Why? MR=MC at this quantity 6. What P will the monopolist establish? $8.00 This is the max P the Why? monopolist can charge & still sell 4 units. 7. Calculate & shade CS. ½ (4) (4) = $8.00 8. Calculate & shade PS. 4(4) + ½ (4) (4) 4 16 + 8 =$24

9. How does price and output of a monopolist differ from that of the perfectly competitive industry? Price is higher and output is lower. 10. What portion of the CS in the comp. situation was transferred to the firm in the monopoly situation? $8.00 was transferred to Producer. Total consumer surplus was $18, so 8/18 or 4/9 was transferred to producer. 11. How does a monopoly affect CS? Is this good or bad? CS is transferred from consumer to the producer. This is bad for the consumer and good for the producer.

II. PREVENTING MONOPOLY POWER Some monopolies arise due to mergers and acquisitions of rival companies or due to ownership of a critical production input. The government has Antitrust Laws to deal with the harmful effects of these types of monopolies. But other monopolies are created by massive economies of scale. These natural monopolies If this is the case, it s more efficient to allow the natural monopoly to exist, but with regulation to prevent abuse of pricing power and sizeable deadweight loss. 12/1/13 10:07 14

II. PREVENTING MONOPOLY POWER Monopolies produce less and charge a higher price. Anti-trust laws are in place and CAN be enforced to stop monopolistic practices. 15

III. DEALING WITH NATURAL MONOPOLY A. Public Ownership The government could purchase and operate the firm. The advantages seem clear. Because the government is not in the business of maximizing profit at Qm,Pm, prices should be lower to consumers. If the government could operate the electricity market where Pc=MC, there would be no deadweight loss. Downsides exist, however. The government, as a very large bureaucracy with many other issues to deal with, is not always the best entity at keeping costs low. Waste and political favors may cause electricity rates to rise and taxpayer money to be wasted. 12/1/13 10:07 16

III. DEALING WITH NATURAL MONOPOLY A. Public Ownership B. Regulation A commonly used option is to regulate the market for electricity. We are assuming that a large fixed cost exists (imagine huge power plants) and the variable cost of providing another unit of electricity is very small and constant. This creates a downward sloping ATC curve with huge economies of scale and a lower constant MC curve. 12/1/13 10:07 Duffka School of Economics 17

III. DEALING WITH NATURAL MONOPOLY A. Public Ownership B. Regulation 1. Unregulated: Produces Qm where MR=MC, charges Pm. The firm earns positive economic profit as Pm>ATCm; seen below as the shaded rectangle. Consumer surplus would shrink and deadweight loss would exist because Pm>MC. 12/1/13 10:07 Duffka School of Economics 18

III. DEALING WITH NATURAL MONOPOLY A. Public Ownership B. Regulation 2. Regulated to the perfectly competitive outcome. Output would be Qc and price Pc. Consumer surplus would be maximized. There would be no deadweight loss as Pc=MC. The firm would suffer losses as Pc<ATC. Because society does not want to bankrupt the only electricity provider in the area, this regulation, while efficient would not be chosen. 19

III. DEALING WITH NATURAL MONOPOLY A. Public Ownership B. Regulation 3. Regulated such that the firm earns a normal profit. Output would be Qr and price Pr. Economic profit is zero as Pr=ATC. Consumer surplus is larger than without regulation. Some deadweight loss exists as Pr>MC, but not as much as would exist if the firm were unregulated. 12/1/13 10:07 Duffka School of Economics 20

III. DEALING WITH NATURAL MONOPOLY A. Public Ownership B. Regulation 1. Regulated to the perfectly competitive outcome. 2. Regulated such that the firm earns a normal profit. Option 2 is a compromise between the unregulated monopoly outcome (worst for consumers and the most deadweight loss) and the perfectly competitive outcome (best for consumers, zero deadweight loss, but bankrupts the firm). 12/1/13 10:07 Duffka School of Economics 21

ANOTHER EXAMPLE Suppose a natural monopoly exists in the local electricity market. The producer, WE Energy, is so large that the ATC of producing electricity is lower than would be the case if the government broke WE Energy into several small competing firms. But we saw above that monopoly pricing power creates problems for consumers and a loss of total welfare. How can the government deal with this natural monopoly? 22

Unregulated WE Energy We Energy produces Qm where MR=MC, charges Pm. The firm earns positive economic profit as Pm>ATCm; the shaded rectangle. Consumer surplus would shrink and deadweight loss would exist because Pm>MC. DWL 23

GOVERNMENT OPTION #1 FOR REGULATION OF WE ENERGY REGULATED TO THE PERFECTLY COMPETITIVE OUTCOME. (IN THE RED) Output would be Qc and price Pc. Consumer surplus would be maximized. There would be no deadweight loss as Pc=MC. The firm would suffer losses as Pc<ATC. Because society does not want to bankrupt the only electricity provider in the area, this regulation, while efficient would not be chosen. 12/1/13 10:07 24

GOVERNMENT OPTION #2 FOR REGULATION OF WE ENERGY REGULATED SUCH THAT THE FIRM EARNS A NORMAL PROFIT. (NOT IN THE RED) Output would be Qr and price Pr. Economic profit is zero as Pr=ATC. Consumer surplus is larger than without regulation. Some deadweight loss exists as Pr>MC, but not as much as would exist if the firm were unregulated. Qr@Pr 25

2009 FREE RESPONSE #1 Directions: You have 50 minutes to answer all three of the following questions. It is suggested that you spend approximately half your time on the first question and divide the remaining time equally between the next two questions. In answering the questions, you should emphasize the line of reasoning that generated your results; it is not enough to list the results of your analysis. Include correctly labeled diagrams, if useful or required, in explaining your answers. A correctly labeled diagram must have all axes and curves clearly labeled and must show directional changes. Use a pen with black or dark blue ink. 1. CableNow is the only supplier of cable TV services offering a wide range of TV channels. CableNow is an unregulated firm and is currently earning an economic profit. Assume that CableNow does not practice price discrimination. (a) Draw a correctly labeled graph for CableNow and show each of the following. Make sure your graph is large enough to be legible. (i) The profit-maximizing quantity of cable services, labeled as Q* (ii) The profit-maximizing price, labeled as P* (iii) The area of economic profit, completely shaded (iv) The socially optimal level of cable services, assuming no externalities, labeled as QS (b) Assume that the government grants CableNow a lump-sum subsidy of $1 million. Will this policy change CableNow s profit-maximizing quantity of cable services? Explain. (c) Instead of granting a subsidy, assume now that the government chooses to require CableNow to produce the quantity at which CableNow earns zero economic profit. On the graph you drew in part (a), label this quantity QR. (d) At QR, is the firm s accounting profit positive, negative, or zero? Explain. (e) Assume that a new study reveals there are external benefits associated with watching TV. Will the socially optimal quantity of cable services now be larger than, smaller than, or equal to the QS you identified in part (a)(iv)?

FREE RESPONSE 2009 #1 (a) Draw a correctly labeled graph for CableNow and show each of the following. Make sure your graph is large enough to be legible. (i) The profit-maximizing quantity of cable services, labeled as Q* (ii) The profit-maximizing price, labeled as P* (iii) The area of economic profit, completely shaded (iv) The socially optimal level of cable services, correctly labeled assuming no externalities, labeled as QS a) ANSWER 5 points: P=MC One point is earned for a correctly labeled graph for CableNow, with a downwardsloping demand curve and with the marginal revenue curve below the demand curve. One point is earned for identifying the profit-maximizing quantity of cable services, Q*, at MC = MR. One point is earned for identifying the profit-maximizing price of cable services, P*, on the demand curve above Q*. One point is earned for showing the area of economic profit, completely shaded. One point is earned for identifying the socially optimal level of cable services, QS, where the MC curve intersects the demand curve.

FREE RESPONSE 2009 #1 (b) Assume that the government grants CableNow a lump-sum subsidy of $1 million. Will this policy change CableNow s profitmaximizing quantity of cable services? Explain. (b) 2 points: One point is earned for stating that the lumpsum subsidy will have no impact on the quantity of services CableNow produces. *Reminder: Lump-sum (tax or subsidy) affects total costs not variable or marginal costs. One point is earned for explaining that the lump-sum subsidy will not affect MC.

FREE RESPONSE 2009 #1 (c) Instead of granting a subsidy, assume now that the government chooses to require CableNow to produce the quantity at which CableNow earns zero economic profit. On the graph you drew in part (a), label this quantity QR. ANSWER: (c) 1 point: One point is earned for identifying the quantity of cable services, QR, where the ATC curve intersects the demand curve. Demand (P)=ATC

FREE RESPONSE 2009 #1 (d) At QR, is the firm s accounting profit positive, negative, or zero? Explain. (d) 2 points: One point is earned for stating that accounting profit is positive. One point is earned for explaining that accounting profit excludes implicit costs.

FREE RESPONSE 2009 #1 (e) Assume that a new study reveals there are external benefits associated with watching TV. Will the socially optimal quantity of cable services now be larger than, smaller than, or equal to the QS you identified in part (a)(iv)? (e) 1 point: One point is earned for stating that the socially optimal quantity will be larger than QS.

PRACTICE QUESTION 1 1. Which of the following statements is true of a monopoly as compared to a perfectly competitive market with the same costs? I. Consumer surplus is smaller. II. Profit is smaller. III. Deadweight loss is smaller. a. I only b. II only c. III only d. I and II only e. I, II, and III

PRACTICE QUESTION 2 2. Which of the following is true of a natural monopoly? a. It experiences diseconomies of scale. b. ATC is lower if there is a single firm in the market. c. It occurs in a market that relies on natural resources for its production. d. There are decreasing returns to scale in the industry. e. The government must provide the good or service to achieve efficiency.

PRACTICE QUESTION 3 3. Which of the following government actions is the most common for a natural monopoly in the United States? a. prevent its formation b. break it up using antitrust laws c. use price regulation d. public ownership e. elimination of the market

PRACTICE QUESTION 4 4. Which of the following markets is an example of a regulated natural monopoly? a. local cable TV b. gasoline c. cell phone service d. organic tomatoes e. diamonds

PRACTICE QUESTION 5 5. Which of the following is most likely to be higher for a regulated natural monopoly than for an unregulated natural monopoly? a. product variety b. quantity c. price d. profit e. deadweight loss