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Title: Three Questions


1
Three Questions
  • What is wrong with monopoly
  • Does monopoly result in an inefficient outcome
  • And why
  • Why does monopoly exist
  • State monopoly
  • Natural monopoly
  • Artificial monopoly
  • cartel
  • What to do about it?
  • May depend on why it exists and what the
    alternatives are
  • And on the explanation for behavior such as
  • Tie-in sales
  • Vertical integration
  • Resale price maintainance

2
Whats Wrong with Monopoly?
  • Why do property and trade lead to efficient
    outcomes?
  • You use something if and only if its value to you
    is greater than its cost to you
  • The price you pay is the cost of producing it
  • So you use things if their value to you is
    greater than the cost to the producer, and
    similarly
  • Greater than the value to anyone else, since you
    were willing to pay a higher price than anyone
    who didnt get it
  • Similarly for inputs least cost production in
    money is also least cost in human values
  • Why does price correspond to cost?
  • If it costs me 10 to produce one more widget
  • And they sell for 11
  • It is in my interest to produce more
  • And the process continues until price driven
    down, or cost up, so they are equal

3
Suppose there is only one producer
  • I can produce as many widgets as I want at
    10/widget
  • Currently, I sell 1000 widgets/year _at_12/w
  • Revenue 12,000, cost 10,000
  • Profit 2,000
  • I could sell 1100 _at_11/widget
  • Revenue 12,100. Cost 11,000
  • Profit 1,100
  • Or 1200 _at_10/widget. Profit?
  • The argument for pricecost
  • Assumed I can sell more without driving down the
    price
  • A reasonable assumption if there are many firms
  • But not if there is only one
  • So a monopoly will sell at pricegtmarginal cost

4
What is Wrong with Monopoly
  • PricegtMC means that
  • A consumer who values the good at gtMC
  • But ltP doesnt get it
  • Although producing it for him produces a net gain
    in efficiency
  • Since value to him is more than cost to produce
  • Also a rent seeking problem
  • If there is only room for one firm
  • And the first firm gets the monopoly
  • There is an incentive to enter inefficiently
    early
  • So as to make sure your firm gets the monopoly
  • Just like the homesteading problem discussed
    earlier

5
The second efficiency conditon
  • One requirement for efficiency is
  • That everyone who values the good at at least its
    cost gets it
  • And PMC produces that result
  • The other is that the product only be produced if
    the total valuegttotal cost
  • Consider a computer program
  • MC1.00 (to copy a CD, package it)
  • Fixed cost of writing the program10,000,000
  • If you sell it at MC, 10,000 are sold
  • And you somehow know that at 10 none would be
    sold
  • Benefit to consumer is from 0-9
  • Total benefit from 0-90,000
  • It wasnt worth writing the program
  • How do we arrange to satisfy both conditions?

6
Why is Monopoly?
  • State Monopoly
  • Natural Monopoly
  • Cartel
  • Artificial Monopoly

7
State Monopoly
  • The original meaning of the word
  • Illegal for others to compete
  • Salt monopoly, say, used to raise revenue
  • Modern versions include
  • Government monopoly Post Office
  • Regulated industries Several firms but
  • New firms not free to join
  • Existing firms not free to compete on price and
    service
  • More nearly a cartel (see shortly) than a
    monopoly
  • Examples
  • Airlines before deregulation
  • Trucking
  • Barbers where the city licenses them

8
Natural Monopoly
  • Due to economies of scale and the size of the
    market
  • The more you produce the more cheaply you can
    produce?
  • Sometimes, for some range of output
  • Your design costs get spread over more units, but
  • More layers of control between the president and
    the factory floor
  • So cost falls and then eventually rises again
  • Natural monopoly if a firm big enough to produce
    for the entire market has lower costs than any
    smaller firm
  • That might be a big firm in an industry with a
    lot of economies of scale
  • Or a small firm in a very small market
  • Geographically small General store in small town
  • Niche market Me as a public speaker
  • In either case, the economic analysis of monopoly
    applies.

9
Cartel
  • Suppose economies of scale are not quite big
    enough
  • Big firms beat small firms
  • But there is room for multiple big firms
  • And still ones even bigger dont beat them
  • The firms make a deal
  • Ill keep price up, quantity down, if you do
  • Multiple firms functioning like a monopoly
  • What problems arise for the cartel?

10
Problems for a cartel
  • Problem 1
  • It is in each firms interest to cheat on the
    deal
  • Sell a little more at the high price
  • Solutions
  • An enforceable contract--not legal in the U.S.
  • Government regulators controlling output and
    price
  • Watch each other very carefully
  • A legal substitute for an enforceable
    contract--such as
  • Problem 2 Preventing entry of new firms
  • Problem 3 The smallest members have the most
    power
  • If the Saudis increase output, the cartel breaks
  • If Venezuela does, will anyone believe Saudi
    threats to do the same?
  • So the biggest members have to bear most of the
    cost of holding down output

11
Artificial Monopoly
  • Suppose I have a very big firm
  • I am not a natural monopoly--my costs are not
    lower. But
  • Since I have more money than the small firms
  • I can sell below cost to drive them out
  • And become a monopoly

What is wrong with this story?
  • Suppose I am ten times as big and as rich
  • Selling below cost I lose money ten times as fast
  • Probably faster--I have to sell as much as people
    want to buy at the low price
  • My competitors dont.
  • Who goes broke first?
  • And if I somehow outlast the competitor
  • What keeps him from selling out his plant to a
    new competitor
  • At a point when I am almost out of money?

12
What can be done about monopoly?
  • By the government
  • Regulate? How
  • Government ownership (Post Office)
  • General legal rules
  • Such as not enforcing cartel agreements
  • Or permitting merger to monopoly
  • By the monopoly
  • Consumers with Pgtvaluegtcost
  • Are not only a problem for efficiency
  • They are lost revenue for the monopoly
  • Price discrimination might solve that
  • Find a way of selling at a high price to those
    willing to pay it
  • But at a lower price to those who arent
  • Discriminate both among customers and among units
    bought by a single customer

13
Regulation
  • Order the monopoly to sell at marginal cost?
  • How does the government know what MC is?
  • There are fixed costs as well if the firm cannot
    cover them it goes broke
  • If the government offers to subsidize them, how
    does it make the monopoly minimize its costs?
  • Or know if the firm and product should exist?
  • If government is willing to subsidize the fixed
    cost
  • The firm covers its cost even if the good not
    worth producging
  • So how do we take care of the second efficiency
    condition?
  • Order it to sell at average cost?
  • Standard utility rate regulation
  • Price is still inefficiently high, and
  • Either regulator has to know what AC should be
  • Or observes costs, lets firm set price to cover
    them
  • So why should the firm hold costs down?
  • At least, firm will not exist if total
    valuelttotal cost (why?)
  • But might not exist even though total valuegttotal
    cost (why?)
  • And if the regulator could produce efficiency,
    why would he?
  • We can predict that the firm will try to maximize
    its profit
  • What makes it in the interest of the regulator to
    maximize efficiency?

14
Government Ownership
  • With the best of intentions
  • How does the firm get the information to know
  • If its existence satisfies the second condition?
  • It sets PMC, makes up fixed cost from taxes
  • It observes how many consumers valuegtMC
  • But not by how much more
  • So doesnt know if the taxes are buying a benefit
    worth the cost
  • Why should it have the best of intentions?
  • Post office jobs can reward political supporters
  • Contracts can be sold for campaign donations
  • How do we make it in the interest of a government
    run firm to try to maximize economic efficiency?
  • Or shut it down if it isnt worth running?

15
Problem with Both
  • Consider a private natural monopoly
  • As things change, it may cease to be a natural
    monopoly
  • And lose market share to new competitors
  • Suppose it is a regulated monopoly?
  • It may be able to get the regulators
  • To keep out the competitors
  • Airlines, Railroads, Trucks
  • Suppose it is a government run monopoly?
  • Likely to be a monopoly in the old sense too
  • The people running it believe in what they are
    doing
  • Post Office

16
Preventing Cartels
  • Not enforcing cartel agreements
  • Indeed, trying to punish them
  • If detected
  • Firms might merge--perhaps lose some efficiency
    but solve the cartel problem
  • So restrictions on merger to monopoly
  • But what about mergers for effciency?
  • One elegant but impractical solution is
  • Ask other firms if they approve of the merger
  • If they do, forbid it
  • If they dont, approve it
  • Because?

17
Price Discrimination
  • Ideally, a monopoly wants to
  • Sell every unit for which valuegtMC
  • At the highest price the customer will pay
  • One approach is to separate markets
  • Sell book for high price in U.S., low in U.K.
  • Offer cheap standby tickets only to youths
  • Sell hardcovers for more than paperbacks
  • By substantially more than the cost difference
  • The real fans will want the higher quality
  • And the earlier publication
  • Another is different prices for one customer
  • Customer values tenth cookie less than the first
  • So 1/cookie up to five, .50/cookie beyond that
  • Suppose cost is all fixed (Disneyland rides at
    below capacity)
  • Charge an entry fee, make rides free
  • PMC0, entry fee up to total value to customer
  • If done perfectly, this meets both efficiency
    conditions

18
Problems
  • For the seller
  • Seller must know enough to charge the right
    prices, and
  • Be able to prevent resale
  • I buy 100 cookies, sell five each to 20 people
    for .80/cookie
  • Harder to do the equivalent for the Disney ride!
  • So price discrimination easier for services
    consumed on the spot
  • For the economist
  • How do we distinguish price discrimination from
  • Different prices due to different costs
  • Coming from non-obvious causes
  • For example
  • Cheaper airline fares for standby, or
    non-refundable early purchases, or
  • Gasoline price differences for unleaded
  • Based not on wholesale cost for the gasoline, but
  • On larger tanks in older vehicles using leaded
    gasoline
  • Meaning lower transaction cost/gallon for the
    seller
  • Any joint cost problem
  • Consider the economics of mining ore, producing
    silver and gold, or
  • Flying a plane to Miami at the beginning of
    spring break, vs flying it back

19
Why is Price Discrimination Interesting?
  • It provides a possible solution to the problem of
    efficient outcomes
  • Can be used to get closer to everyone buys it
    who values it at its cost
  • But whether PD increases efficiency turns out to
    be ambiguous
  • How does it increase efficiency?
  • How might it decrease efficiency?
  • Perfect PD solves that problem, imperfect could
    make it worse
  • And PD increases the rent seeking problem (why?)
  • It provides a possible explanation for why firms
    do things
  • Consider tie-in sales
  • If you buy our printer, you must use our paper
  • (IBM card sorter and IBM cards in a later case)
  • Such terms have been found illegal under
    antitrust
  • Before deciding if they should be illegal, first
    question is
  • Why does the firm want to do it?

20
Why Tie-in Sales?
  • Old theory Leverage your monopoly
  • IBM makes the only (?) card sorters
  • Use that monopoly to get a monopoly on cards
  • Problem
  • Purchaser needs sorter and cards what matters to
    him is the total cost
  • So the more IBM charges for cards
  • The less they will be able to get for the sorter
  • IBM should let card producers compete down price
    to MC
  • And collect the whole profit off a single monopoly
  • Solution Price Discrimination
  • Firms that use the sorter a lot use lots of cards
  • And probably get lots of value from the sorter
  • So high priced cards are an indirect way of
  • Charging more to the high value users
  • A point made explicitly in the much older printer
    case

21
Vertical Integration
  • You have a monopoly of steel production
  • So use it to get a monopoly of autos
  • In order to extend your monopoly
  • Get two monopoly profits
  • But you could push up the price of autos
  • By what you charged auto producers for steel
  • Let them compete down their margin
  • While you collect the monopoly profit
  • If autos not a natural monopoly, that makes you
    more money
  • So why does vertical integration exist?
  • Because it is sometimes less costly to produce in
    house
  • Because it can reduce the inefficiency from
    monopoly pricing
  • Suppose steel costs you 10/ton to produce, you
    sell it to auto firms for 20/ton monopoly price
  • In deciding how much to use, they compare costs
    at 20
  • Which means inefficient substitution of aluminum
    etc.
  • If you make the autos, do internal calculations
    at 10
  • Produce at minimum cost--then sell cars at a
    monopoly price

22
Retail Price Maintainance
  • Producer sets a minimum price
  • Retailers may not sell for less
  • If they do, they dont get the product any more
  • Legally restricted but forms still exist
  • Again, conventional argument is
  • Producer is getting a second monopoly
  • On retailing
  • By preventing competition between outlets
  • Again, it doesnt work, because
  • Producer can force up retail price via his price
  • Let retailers compete down their margins
  • And so he gets all the monopoly profit
  • Why does it happen?

23
Why?
  • Perhaps to encourage rent seeking?
  • Pgtcost, pays to spend money on advertising,
    support
  • Even though some of it benefits other stores
  • And all of it would if they were free to cut
    their price instead
  • This leaves open another question
  • Why not sell support separately?
  • 20/hour to visit our stereo showroom, talk to
    experts
  • 50/hour for the auto equivalent
  • And we'll throw in free advice on the cheapest
    way to buy the stereo or car you choose.
  • Suppose you wanted to defend Homesteading
  • Is there an analogous argument
  • For why you want the land settled
  • "inefficiently early?"

24
The Real Problem Is
  • Not the existence of a (natural) monopoly
  • Breaking it up would just raise costs
  • Regulation has problems similar to those of
    monopoly
  • But the existence of conditions inconsistent with
    a competitive market
  • I.e. economies of scale
  • That run up to the full size of the market
  • Without competition, only bad answers
  • Private single price monopoly
  • Private monopoly with price discrimination
  • Regulated monopoly
  • Government owned monopoly
  • But better answers to
  • Government created monopoly or
  • Cartel
  • Since there competition may be an option

25
Network Externalities
  • The idea
  • The value of a good to me might depend
  • On how many other people are using it
  • Querty keyboard, MS Word, English language
  • So once one version somehow becomes dominant
  • Everyone wants to use that
  • Even if an alternative would be better for
    everyone
  • Consider driving on the left in England
  • So outcomes could be path dependent
  • Some random factor early in a technology
  • Puts us on the wrong path
  • Perhaps we could avoid that, or
  • Switch paths--as Sweden switched to the right

26
Is it a real issue?
  • Example used to be the Qwerty keyboard
  • Until Liebowitz and Margolis looked into the
    history
  • And found that all the asserted facts were false
  • It wasnt
  • Designed to slow typist down
  • Successful due to one typing contest
  • Hard to switch keyboards
  • Much inferior to the later Dvorak layout
  • Similar criticisms have been made of other
    supposed examples
  • Of inefficiency due to path dependence
  • By Liebowitz and Margolis in their book

27
How can One Tell?
  • If network externalities are large
  • The dominant product should still be dominant at
    a higher price
  • Giving its seller more profit
  • So MSWord, Excel, should sell at a higher price
    than competing software with similar features but
    lower sales
  • That doesnt seem to be how sellers act
  • LM argue that the actual economics of software
  • Is a natural monopoly of the currently best
  • With sequential competition
  • As better competitors appear, become dominant
  • Visicalc, Lotus, Excel
  • WordStar, WordPerfect, Word
  • They graphed the pattern of review in the
    magazines against the pattern of sales
  • When a new product started getting consistently
    favorable reviews
  • In comparison to the dominant one
  • Dominance shifted quickly
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