Monopoly and

Regulation
Chapter 12

Slides by Pamela L. Hall

Western Washington University
©2005, Southwestern
 Introduction
 Polar extreme of perfect competition is a market with only one firm supplying
output
 Called a monopoly
• Firm with no substitutes (competition) for its output
 This chapter discusses barriers to entry as cause of monopolies
 We then develop short-run price and output determination for a profit-maximizing
monopoly
 We derive relationship of a monopoly’s price with market elasticity of demand
 Based on this relationship, develop Lerner Index for measuring degree of monopoly
power
 We investigate long-run equilibrium for monopolies
 As well as opportunity cost of capital as a consequence of monopolies earning only
long-run normal profits
• Based on this long-run equilibrium, we investigate welfare loss from monopoly power
 In terms of price not equaling marginal cost, firms operating at less than full capacity, and rent-seeking
behavior

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 Introduction
 We discuss and evaluate government regulation to correct potential welfare loss in
terms of a market’s contestability
 Aim in this chapter is to show how a firm with monopoly power will misallocate
resources and is inefficient
 Taxing, regulating, or dismantling monopolies are possible solutions to improving
efficiency
 We hope to provide an understanding of why agents with monopoly power are
detrimental to an economy
 Growth of industrial state in 19th and 20th centuries spawned a wealth of
investigations by economists into causes, problems, and potential cures for an
economy with monopolies
 Question applied economists are now attempting to answer is
• Whether curing disease (monopoly power) will kill patient (advancing social welfare)
 If costs of intervening into a market with monopolies (e.g., Microsoft) are more than any benefits received
(e.g., advances in computer operating systems)
 Such intervention is questionable

 Applied economists actively attempt to measure benefits and costs of various

policies designed to promote efficient resource allocation by constraining
monopoly-power activities
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 Barriers to Entry
 Cause of a monopoly is barriers (obstacles) to entry
 If other firms could enter market, there would likely be no monopoly
 Barriers to entry are anything that allow existing firms to earn pure profits
 Without threat of entry by other firms
 Either legal or technical obstacles
 One type of a legal monopoly is established by a state or federal government awarding
only one firm an exclusive franchise to provide a commodity
 Government may do so because there are increasing returns to scale over a wide range of output
• One firm can supply market more efficiently than two or more firms
 If society deems that unrestricted competition among firms in an industry is undesirable
 Government may establish a legal monopoly by granting a firm exclusive rights to operate
• For example, patents
 Technological barriers to entry may result when a firm’s technology results in decreasing
LAC over a wide range of output, knowledge of a low-cost productive technique, or control
of a strategic resource
 Termed natural monopolies
• Because market forces establish monopoly
 Sometimes progress can directly impact these natural monopolies

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Price and Output Determination
 Objective of monopolies
 Maximize profits
• First determine profit-maximizing output
• Then determine price required to sell output
 Alternatively, they can first determine profit-maximizing price
• Then from market demand curve determine level of output that can be
sold at this price
 Resulting profit-maximizing price/output combination will be the
same
• Regardless of which method is employed
 Both are based on a monopoly’s determining its equilibrium price and output
given market demand curve

 Market demand curve is downward sloping

 If a monopoly reduces output, price it receives for this output will
increase
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Price and Output Determination
 Monopoly has control over market price
 A price maker
 Consider following linear market demand curve
 AR = p = a – bQ
 TR = (AR)Q = pQ = aQ – bQ2
 MR = ∂TR/∂Q = a – 2bQ = a – bQ – bQ = AR - bQ
• Where a, b > 0
 For a linear demand curve, MR is twice as steep as AR
• Will bisect any horizontal line drawn from vertical axis to AR
curve
 Illustrated in Figure 12.1

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Figure 12.1 Linear market
demand curve

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Price and Output Determination
 In Figure 12.1, AR is falling as firm increases output
 Because consumers are willing and able to purchase more of
commodity at lower level of AR (price)
 Falling AR implies that MR is below it
 MR is equal to AR plus adjustment factor, -bQ
• Given -b < 0 (falling AR), then MR < AR
 For a given level of output, MR < AR
 For a firm to sell an additional unit of output it must lower its price on
all units to be sold, not just on additional units
• Adjustment factor, -bQ, accounts for this condition
 For each additional output sold, price falls by -b
 Multiplying this fall in price by number of units sold
 Results in adjustment to AR for determining MR

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 Profit Maximization
 Mathematically, short-run profit is maximized by

 F.O.C. is
• ∂/∂Q = ∂TR/∂Q = ∂STC/ ∂Q = 0 = MR(Q) – SMC(Q) = 0
 Profit-maximizing monopoly will equate MR to SMC to
determine its optimal level of output
 Profit-maximizing output Q* corresponds to where MR =
SMC
 Illustrated in Figure 12.2
• Firm will produce Q* units of output and, given market demand curve
QD, it can sell all of this output at p*
 p* corresponds to level of output Q* that consumers are willing and able to
purchase

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 Figure 12.2 Price and output
determination for a monopoly

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 Profit Maximization
 SMC curve for a monopoly determines profit-maximizing price and
output
 However, in contrast to perfect competition, SMC curve above SAVC is not
monopoly’s short-run supply curve
 In Figure 12.2, if SMC curve for a monopoly is a supply curve, at a price
of p*
 Firm would be willing and able to supply Q' units of output
• Although firm is able to supply Q' at p*, it is unwilling to supply it
 Profit-maximizing output is Q*
• Firm can sell all output at p*
 Cannot determine a monopoly’s short-run supply curve without
restrictive assumptions
 Note that same factors that shift a monopoly’s short-run supply curve also
shift SMC curve in same direction
• Can view SMC curve as a proxy for supply curve

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 Profit Maximization
 In Figure 12.2, price p* is above SATC* for output
level Q*
 Indicates monopoly is earning a pure profit
• Represented by shaded area SATC*p*AB
 TR is represented by area 0p*AQ*
 STC is represented by area 0(SATC*)BQ*
• Difference is pure profit
 As illustrated in Figure 12.3, in short run a
monopoly can also earn only a normal profit
 When p* = SATC*
• Due to increased input prices or a decrease in demand for its
output
 In this case, TR* = STC*, area 0p*AQ* 12
Figure 12.3 Short-run profit maximization
for a monopoly earning a normal profit

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 Profit Maximization
 In short run, a monopoly can also operate at a loss if demand falls or
costs increase
 Illustrated in Figure 12.4
• Losses represented by shaded area p*(SATC*)BA
 As long as price is above SAVC a monopoly will continue to operate in
short run
 Monopoly will cover all of its STVC and have some revenue left over for
paying a portion of its TFC
 Monopoly minimizes its losses by operating
 If price falls below SAVC, monopoly is unable to cover its STVC
 Will minimize losses by shutting down
 In summary, a monopoly can earn a pure profit, a normal profit, or can
operate at a loss in short run
 Firm’s level of profit is not an indicator of its degree of monopoly power
• Percentage markup in price over marginal cost, (p - SMC )/p, is indicator of
monopoly power
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Figure 12.4 Price and output determination for
a monopoly operating at a loss

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 Lerner Index
 Regardless of its level of monopoly power
 Firm only operates in elastic portion of demand curve
 Given SMC > 0, a profit-maximizing firm will equate
MR = SMC > 0
 Using product rule of differentiation and recalling
TR = pQ
 Relationships of MR to price and to elasticity of market
demand are
• MR = dTR/dQ = p + (∂p/∂Q)Q
 MR is equal to price plus adjustment factor

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 Lerner Index
 For each additional output sold price falls by ∂p/∂Q
 Multiplying this by number of units sold results in adjustment to AR for determining MR
 Factoring out price from right-hand side of MR = p + (∂p/∂Q)(Q) yields relationship
between MR and elasticity of demand
• MR = p[1 + (∂p/∂Q)(Q/p)] = p(1 + 1/D)
 Where /D = (∂Q/∂p)(p/Q)], own-price elasticity of demand
 For MR > 0, (1 + 1/D) > 0
• Which implies D < -1 (elastic)
 If D > 1 (inelastic)
• MR = dTR/dQ < 0
 Decrease in Q will increase TR
 Given dSTC/dQ > 0, STC decreases with this decrease in Q
 Yielding an increase in pure profit

 Profit-maximizing firm can continue to reduce Q and increase profit within

inelastic portion of demand curve
 Firm will reduce output until it is in elastic portion of demand curve
• Where MR = SMC
 Table 12.1 summarizes relationships between demand elasticity and marginal
revenue
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Table 12.1 Demand Elasticity and
Marginal Revenue

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 Lerner Index
 At MR = SMC
 MR = p(1 + 1/D) = SMC
• Solving for p gives
 p = SMC/(1 + 1/D)
 Under perfect competition, a firm is facing a perfectly elastic demand curve
• So 1/D = 0, indicating condition of p = SMC for profit maximization
 Instead, a monopoly charges a higher price
 Since it only operates on elastic portion of demand curve
 Then 0 < (1 + 1/D) < 1, so p > SMC
 A measure of degree of monopoly power is percentage markup in price
over marginal cost (p - SMC )/p
 Specifically, given p(1 + 1/D) = SMC and solving for (p - SMC )/p yields
Lerner Index (LI)
• LI = (p – SMC)/p = -1/D
• Lerner Index varies between 0 and 1 and measures percentage markup in price
due to monopoly power
 Relative difference in price and marginal cost is dependent on elasticity of demand

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 Lerner Index
 Under perfect competition, p = SMC, D = -, so LI = 0
 Firm is exercising zero monopoly power
 If D = -1, then LI = 1, indicating existence of monopoly power
 At -1 ≥ D > -, corresponding to 0 < LI ≤ 1, a relative wedge between price and
SMC exists
 Magnitude of this wedge is determined by elasticity of demand
• When demand curve becomes less elastic, wedge increases and LI approaches 1
• Wedge for a profit-maximizing firm without close substitutes will be large relative to a firm in a
market with many competitors
 Monopoly is concerned with effect high price has on consumption
 When consumers react to a price increase by greatly reducing their demand
 Monopoly will not charge highest price it can for its output
• It will determine elasticity of demand for its output and calculate LI
 Table 12.2 lists measurements of Lerner Index for steel and semiconductor
industries

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Table 12.2 Measurements of the Lerner Index
for the Steel and Semiconductor Industries

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 Long-Run Equilibrium
 Long-run equilibrium for a monopoly is illustrated in Figure
12.5
 SATC and LAC curves are tangent at firm’s profit-
maximizing output level Q*
 Where SMC = LMC = MR
 At this equilibrium output and price (Q*, p*), firm is earning a
normal profit
 In long run, firm can earn only a normal profit
 If it had been earning a pure profit in short run, when firm is
sold in the long run
 New owners will pay a higher price for firm than if it had been
earning only a normal profit
• Increases cost of operation
 Results in upward shift of cost curves
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Figure 12.5 Long-run equilibrium
for a monopoly firm

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 Long-Run Equilibrium
 Competition for purchasing firm will result in cost curves for new owners shifting
up to point of zero pure profit (normal profit)
 Market price for firm will increase until, in long run, all short-run pure profits are
squeezed out
 p = SATC = LAC
 Even if firm is not sold, cost of production (in terms of implicit cost) will increase
over time
 In long run, a firm that earned a short-run pure profit will be worth more, say $100,000
 Thus, owners of firm have a higher implicit cost of production
• Their opportunity cost for operating firm has increased because they could sell firm and
receive this increase in price ($100,000) and invest it in another activity
 Called opportunity cost of capital
• If alternative activity had an annual rate of return of 10%, then firm’s implicit cost of production
would be $10,000 higher
 Short-run pure profit is converted into implicit cost

 Alternatively, if firm had been operating at a loss in short run, firm will not be
worth as much
 Cost curves will shift downward, resulting in a long-run normal profit
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 Long-Run Equilibrium
 The worth of a monopoly based on its long-run pure-profit potential is
called monopoly rents
 Rent a possible entrant would be willing to pay for monopoly
 Given positive monopoly rents, associated opportunity cost exists that
result in only long-run normal profits
 Without considering that cost adjusts to rents, it is possible to assume a
monopoly will earn a long-run pure profit
 This fact is particularly important in basic business decision-making
 Since firms, even those with monopoly power, can only make a pure profit in
short run
• Owners of firms cannot continue their present activities and expect continued pure
profits
 If they want to continue to reap pure profit, must anticipate market trends
 So as to sell their firms when conditions are right and be early entrants into markets
where firms are earning short-run pure profits
 However, many individuals or firms either lack this knowledge or are unwilling to act
 Because they can maximize their utility by staying in a particular activity even if it
means earning only a normal profit
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 Welfare Loss from Monopoly
Power
 Major objective of economics is to improve social welfare
 Thus, market structures that result in economic inefficiency
are considered inferior
 Specifically, a monopoly market structure is inferior to a perfectly
competitive market structure based on monopolies’ inefficiency
• Monopoly is efficient in terms of both technical and allocative efficiency
• Monopoly will produce on production frontier (technical efficiency) and
employ least-cost production (allocative efficiency)
• However, monopoly is not scale efficient
 Does not equate price to marginal cost
• Thus, monopoly’s long-run equilibrium position is inefficient

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 Welfare Loss from Monopoly
Power
 Inefficiency is characterized by two conditions
 p* > SMC* = LMC*
• Price a household pays for a commodity is marginal utility of
consumption
 Monetary measure of how much an additional unit of a commodity is worth
to household
• Marginal cost is cost of producing an additional amount of commodity
 If price is greater than marginal cost society would prefer firm increase
output
 In perfect competition, price is equal to marginal cost
 What society is willing to pay for an additional unit of output is equal to what
it costs society to produce this additional unit
 But monopoly restricts output and increases price
 So what society is willing to pay for an additional unit of output is
greater than what it costs society to produce this additional unit

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 Welfare Loss from Monopoly
Power
 Second inefficiency of a monopoly
 Does not operate at full production capacity
• At full capacity average cost of production is at a minimum
 Monopoly does not operate at minimum point of SATC or
LAC
 For an efficient operation, output should increase to full
capacity
• Fixed costs are spread over too few units of output
 Results in excess capacity and inefficiency

 Can represent this inefficiency and associated

welfare loss with a monopoly by deadweight loss in
consumer and producer surplus
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 Welfare Loss from Monopoly
Power
 As illustrated in Figure 12.6, perfectly competitive equilibrium is QC, pC
 Economic efficiency is area CAB, where pCAB is consumer surplus and
CpCB is producer surplus
• A firm with monopoly power restricts output from QC to QM
 Results in price increasing
• Consumer surplus is reduced to pMAE, with firm capturing some of the lost
consumer surplus (area pCpMEF)
 Captured consumer surplus is a measure of firm’s exploitation of consumers
• Producer surplus, with monopoly power, is area CpMED
 Efficiency loss in social welfare is area DEB
 Deadweight loss resulting from monopoly power provides a signal that
some government intervention may be desirable
 However, it does not suggest a particular course of action
• Causes of inefficiency should first be determined
• Then a possible set of actions formulated

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 Rent-seeking Behavior
 There is a further efficiency loss associated with a monopoly
 Expense incurred to obtain and maintain monopoly power (called
rent-seeking behavior)
 Rent is defined as monopoly’s producer surplus
 Represented in Figure 12.6 by area CpMED
 Potential for obtaining this rent may lead firms to engage in
rent-seeking behavior
 Firms may incur both strategic expenses in form of
• Erecting barriers to entry or
• Administrative expenses such as lobbying government representatives
or
• Legal defense against antitrust actions

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 Rent-seeking Behavior
 Extreme case of rent-seeking behavior
 All monopoly rents will be allocated to this behavior
 Assuming that all rent-seeking behavior is socially wasteful
(has no social value)
 Actual deadweight loss is area CpMEBD in Figure 12.6
 Represents producer surplus (rents) plus deadweight loss DEB
 All rent-seeking behavior is probably not socially wasteful
 So including producer surplus as a component of deadweight loss
may be used to represent upper boundary of efficiency loss

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 Figure 12.6 Deadweight loss
resulting from monopoly power

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 Taxing Rents
 One proposed solution for inefficiency in monopoly power is
to tax monopolies’ profits
 Either a lump-sum tax or a profit tax would reduce a
monopoly’s producer surplus
 For lump-sum tax system, can represent profit as
  = pQ - STC – TRT
• Where TRT is lump-sum tax corresponding to total tax revenue collected
 F.O.C. for profit maximization is
• ∂ ÷ ∂Q = MR – SMC = 0
 No change in optimal level of output or price, or for determining whether a
firm should operate
 Level of profit falls by amount of increase in tax
 Illustrated in Figure 12.7 by upward shift in TFC and STC curves

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Figure 12.7 Lump-sum or profit
tax

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 Taxing Rents
 However, inefficiency of monopoly still exists
 Society still would prefer monopoly to increase output
and decrease price
 Problem of resource misallocation is not solved by
a lump-sum tax
 Because lump-sum tax does not affect allocation of
resources
 Only affects distribution of total economic surplus
• By taking some producer surplus away from monopoly and
reallocating it to others
• Thus, lump-sum tax is only beneficial if reallocation of total
surplus improves social welfare
 By redistributing surplus away from socially wasteful rent-seeking
behavior

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 Taxing Rents
 With a profit tax there is no change in a monopoly’s optimal level of output or
price, or for determining whether it should operate
 Can represent a monopoly’s profit with a profit tax as
  = pQ – STC – t(pQ – STC) = (1 – t)(pQ – STC)
• t is percentage of profit that is taxed
 F.O.C. is
• ∂ ÷ ∂Q = (1 – t)(MR – SMC) = 0
 Implies that MR = SMC still remains as condition for profit maximization

 Level of profit declines by amount of increase in tax

 Results in an upward shift in TFC and STC curves
 Since firms are taxed on a percentage of their profits
 TFC shifts upward for alternative profit levels
 Neither lump-sum nor profit taxes cure ills of monopoly power
 But both reduce ability of a monopoly to engage in socially wasteful rent-seeking
behavior

36
 Franchise
 City and County of Denver, Colorado, requires three cable channels for public
access programming in its franchise agreement with AT&T Broadband
 This government issuance of a franchise is an alternative pricing policy
 Generally employed in cable television and radio airwaves markets
 Right to be a monopoly within a local market or to control some public domain is
sold (franchised)
 Proceeds are rebated to consumers within this market
• Rebate either is in form of tax relief or a public good
 If a competitive auction is used to determine price of franchise
 Competition will drive up franchise price to where only a normal profit will be earned
by the owners
 However, once a franchise is established, it tends to perpetuate with the same
franchise owners in control
 Any renegotiation tends to occur without competitive bidding
 Thus, an issuance of a franchise does not cure problems associated with monopoly
power
• May not even reduce ability of monopoly to engage in rent-seeking behavior
 Unless franchise is renegotiated with competitive bidding
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 Regulation of Monopoly
 If a monopoly results in a misallocation of resources, it is inefficient
 Regulation may be required
 However, prior to regulation degree of inefficiency should be determined
 Because cost of regulation may exceed any benefits gained
 A firm with monopoly power may choose to not exercise its power
(called limit price analysis)
 Either because they are concerned that restricting output and increasing
price will result in other firms entering market or
 That they will be regulated
 Even threat of entry by another firm or threat of regulation may cause a
firm to expand output by equating price to marginal cost and operate
efficiently
 For instance, threat of antitrust actions and entry of new firms in industry has
resulted in cereal industry becoming more competitive
• Without government regulation

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 Government Regulation
 In 1911, U.S. government succeeded in splitting oil monopoly created by
Standard Oil into 34 companies
 In June 7, 2000, a U. S. District Court ruled to split Microsoft Corporation
into two smaller companies
 One to deal with operating systems and another with Internet browsers and
software applications
 Main government policies for addressing inefficiencies of monopoly
power
 Break up firm
 Regulate it
• If LAC is declining over a wide range of output (a natural monopoly), it may not be
feasible to break up monopoly, so regulation is used
• Alternatively, if LAC is relatively flat over a wide range of output
 May be more efficient to break up monopoly

39
 Government Regulation
 Regulation policies vary according to type of government
 Socialist governments tend to regulate through direct government
ownership
• Example: Indian Airlines, owned by India
 Capitalist governments will tend to establish public utility
commissions to oversee private (non-government) firms
 Example: power companies within U.S.
• Privately owned but publicly regulated
 Whether a firm is government-owned or private, a
mechanism design is required for determining government-
regulated firm’s price and output

40
 Government Regulation
 Three major pricing policies exist for price and output
determination
 Monopoly pricing
 In Figure 12.8, this is unregulated price and output equilibrium (pM,
QM)
• Assuming positive monopoly rents, monopoly is earning a long-run pure
profit
• Monopoly is Pareto inefficient with this pricing policy, because p > LMC
 Pareto-efficient pricing policy is one that sets p = LMC
 Called marginal-cost pricing (pe,Qe)
 A problem with marginal-cost pricing is that firm will operate at a loss
• pe is below LACe

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 Figure 12.8 Public utility
regulation for a natural monopoly

42
 Government Regulation
 Many public utility agencies avoid this problem by allowing
regulated firm to price discriminate
 Can potentially increase revenue and not operate at a loss
 A public utility agency using marginal-cost pricing is faced with
difficulty of measuring marginal cost versus average cost
 Calculating average cost requires information on level of total cost
and output
• Such information is generally available in accounting records
 Calculating marginal cost not only requires information on level of
total cost, but also information on how total cost is changing for a
change in output
• Information is not generally available in accounting records
 Relatively difficult to obtain

43
 Government Regulation
 An alternative, second-best pricing policy, is full-cost pricing
(or rate-of-return pricing)
 Most public utilities employ this method
 Illustrated in Figure 12.8
 Under full-cost pricing, public utility agency equates LAC to
price (pf, Qf)
 p = LAC
 Firm earns a normal profit
 Output and price are close to Pareto efficient solution
 Allowing firm to price discriminate may increase output
 Shifting it closer to Pareto-efficient marginal-cost pricing solution

44
 Government Regulation
 Public utility agency may allow firm to provide price
discounts to its larger purchasers
 Results in larger purchasers increasing their purchases
• With an associated increase in total consumer surplus
 Since discount is only for larger purchasers, it does not
affect firm’s other customers
• Largest purchasers will face a price equal to firm’s marginal cost
for last unit they purchase
 Because if largest purchaser faced a price greater than marginal
cost and the price were lowered
 Purchaser would purchase an extra unit and seller would sell
this extra unit, so both would be better off

45
 Government Regulation
 Full-cost pricing policy includes a competitive (fair)
return on investment in capital as a constraint on
monopoly’s input choice decision
 Monopoly’s profit-maximizing decision does not yield the
same least-cost combination of capital and labor as does
unconstrained decision for the same level of output
• Effect is to encourage monopoly to hire more capital and less
labor
 Thus, regulation encourages a monopoly to employ an inefficient
capital/labor ratio
 In an effort to extract more profits under full-cost pricing
constraint

46
 Contestable Markets
 A firm with zero sunk cost of operations can enter and exit industry at almost
zero cost
 Potential entrant firms could employ hit-and-run tactics
• Hit when pure profits exist and run once they are exhausted
 Such industries are called contestable markets

 Depending on contestability of an industry, all natural monopolies may not

require regulation
 If a monopoly that is earning a pure profit does not have large sunk costs, then
barriers to entry would be minor
• Even threat of entry by other firms may drive monopoly’s price down toward a price that
equals average cost
 This theory indicates that, for industries with limited entry and exit costs, market
forces will produce same outcome as full-cost pricing regulation
 Need to regulate such firms is questionable
 Theory is employed as a justification for deregulation in telecommunications and
airlines
 And for not pursuing regulation with currently unregulated firms such as computer
software firms
• One justification for not breaking up Microsoft
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