Chapter 10

Monopoly and other forms of imperfect competition

10.1 Imperfect competition and price-setters

- Imperfectly competitive market – a market in which firms have at least some ability to
set their own price.

Different forms of imperfect competition

- Pure monopoly – a market in which a single firm is the only supplier of a product for
which there are no close substitutes.
Ø Furthest away from perfectly competitive ideal.
Ø E.g. Auspost.
- Oligopoly – a market in which only a few rival firms produce goods that are close
substitutes.
Ø Closer to perfectly competitive ideal.
Ø E.g. Telstra and Optus.
- Monopolistic competition – a market in which a large number of firms produce slightly
differentiated products that are reasonably close substitutes for one another.
Ø Closer still to perfectly competitive ideal.
Ø E.g. local petrol market.

Market power and the firm’s demand curve

- Whereas the perfectly competitive firm faces a perfectly elastic demand curve for its
product, the imperfectly competitive firm faces a downward sloping demand curve.
- Demand for a perfectly competitive firm is perfectly elastic at the good’s market price
and the firm’s demand curve is thus a horizontal line at the market price. Each firm is a
price-taker.
- An imperfectly competitive firm faces a negatively sloped demand curve and is to some
degree a price setter.
- Hence the difference between the two is their ability to influence the price of the good
or service that they sell.
- Difference in marginal revenue curve between the two.
Ø Marginal revenue is the change in total revenue that occurs as a result of selling an
extra unit of output. Given that it faces a downward-sloping demand curve, the
single price monopolist must cut price on all units in order to expand sales by a unit.
Consequently, the resulting increase in total revenue will be less that the price.
Since the perfectly competitive firm faces a perfectly elastic demand curve, they
can sell any number of additional units at the market price. Hence, marginal
revenue equals price for this firm.
- Market power – a firm’s ability to raise the price of a good without losing all its sales.
- The market demand curve slopes downward in both cases, reflecting the law of demand.
However, from the individual, perfectly competitive firm’s point of view, the demand
 curve is horizontal. Because the individual firm is too small to affect the market price, it
can sell as many units as it wishes at that price. Since the monopoly firm is the only
seller of a particular good, the demand curve it faces is the downward sloping market
demand curve

10.2 Barriers to entry

- Exclusive control of important inputs
- Patent, copyrights and government licenses
- Economies of scale
- Network economies
Ø The most important and enduring of the four sources of market power are
economies of scale and network economies.

Exclusive control over important inputs

Government-created monopolies
- Patent and copyright protection
- Grant of licenses
- Franchises
Ø New drugs are insulated from competition for 20 years in Australia.

Economies of scale
- Constant returns to scale – a production process is said to have constant returns to scale
if, when all inputs are changed by a given proportion, output changes by the same
proportion.
- Increasing returns to scale (economies of scale) – a production process is said to have
increasing returns to scale if, when all inputs are changed by a given proportion, output
changes by more than that proportion.
- Natural monopoly – a monopoly that results from economies of scale.
- The market for goods whose economies of scale over output levels that are large relative
to the size of the market tend to be served by a single seller, or perhaps only a few sellers,
because having a large number of sellers would result in significantly higher costs.

Network economies
- Essentially similar to economies of scale.
- When network economies are of value to customer, a product’s quality increases as the
number of uses increases.
10.3 Economies of scale and the importance of fixed costs
- Goods, such as software and drugs, whose production entails large start-up costs and
low reproduction costs, will be subject to significant economies of scale in production.
Ø Hence low marginal cost and average total cost declines sharply as output grows.
- Research, design, engineering and other fixed costs account for an increasingly large
share of all costs required to bring products successfully to market.
- TC=FC + M x Q
Ø ATC=TC/Q=F/Q + M
Ø As Q increases, average cost declines since fixed costs are spread out over more
and more units of output.
- At extremely high levels of output, average total cost becomes very close to marginal
cost.

-
- Being the first firm to increase its market share becomes of critical importance in these
industries.
Ø Explains why many industries are dominated by either a single firm or a small
number of firms.
Ø E.g. Playstation VS Nintendo.
- Economies of scale occur only for monopolies.
- The socially desirable price to charge for natural monopolists is the one at which the
marginal benefit to consumers equals the marginal cost of production

10.4 Profit maximization for firms that are price-setters

- Basic goal of firm is to maximize its profit.
- For both price setters and price takers, the marginal benefit of expanding output is the
additional revenue the firm will receive if it sells one additional unit of output.
- Marginal revenue – the change in a firm’s total revenue that results from a one-unit
change in output.
Marginal revenue for the single-price, price-setting firm
- To a firm that has the ability to influence the price at which it sells its output, and who
must sell all output at a single price, the marginal benefit of selling an additional unit is
strictly less than the market price.

The monopolist’s profit-maximising decision rule

- Whenever marginal revenue exceeds marginal cost, the firm should expand its output
- Whenever marginal revenue falls short of marginal cost, the firm should reduce its
output.
- Profit is maximized at the level of output for which marginal revenue precisely equals
marginal cost.
- MR curve intercepts the horizontal axis halfway between the origin and the point at
which it is met by the demand curve.
- If demand curve is, P=12-2Q, then MR=12-4Q.

-
- A firm can be maximizing its profit, but still be making an economic loss. I.e. when ATC
curve is above demand curve.
- A monopolist will earn an economic profit only if price exceeds average total cost at the
profit-maximising level of output.
Ø I.e. area between demand curve and ATC curve.

-
- Monopolist will do best by shutting down and produce nothing in the short run if price is
less than the minimum value of AVC at the level of output where marginal revenue =
marginal cost.
- Economic losses will force a monopolist to leave a market in the long run.
- Total MC is the area under MC curve upto Q.

10.5 Why the invisible hand breaks down under monopoly

- The profit-maximising monopolist will produce an amount smaller than socially optimal
output.
Ø This results in a deadweight loss, or a loss of economic surplus.

Ø
- Profit-maximising output level is socially inefficient.
- Since the monopolist’s marginal revenue is always less than price, the monopolist’s
profit-maximising output level is always below the socially efficient level.
- Saying that monopoly is inefficient means that steps could be taken to make some
people better off without harming others.
Ø Governments worldwide do try to limit the extent of monopoly through
competition and anti-monopoly laws and regulations.
o But alternatives to monopoly often entail problems of their own.
o Eliminating patents would discourage innovation.
l Patents give firms a chance to recover the research and development
costs without which new products would seldom reach the market.
o If a natural monopoly is eliminated, then the market will be served by many
small firms, each with significantly higher average costs of production.
- Hence monopoly is socially inefficient and undesirable but the alternatives to monopoly
aren’t perfect.
- A key different between monopoly and perfect competition is that when a monopolist
earns an economic profit, more firms will not enter the market and expand supply;
hence allowing monopolists to continue to earn an economic profit in the long run.
 Ø The source of the monopolist’s market power acts as a barrier to the invisible hand
operating in this way.
- With monopolistic competition, market power is not coupled with some barrier that
prevents the free entry and exit of competitors to the market.
- New firms can enter a monopolistically competitive market.
Ø The demand and marginal revenue curves of the firm shifts to left and the invisible
hand will make sure that new firms keep opening until all are earning a normal
profit.
Ø A similarity with perfect competition.
- However, it is different from perfect competition in that
Ø Each firm will operate with excess capacity. E.g. empty treadmills at the gym.
Ø The price charged by a monopolistically competitive firm exceeds marginal cost.
Ø Variety is the hallmark of monopolistic competition.
Ø Firms will be constantly on the lookout for ways to differentiate and promote their
product in order to gain and keep the edge over their competitors.
- When each firm is large relative to the size of the market, the actions of each club will
affect the profit of all other clubs in town.
Ø Oligopoly markets
o Barriers to free entry.
o Interdependence.
o Strategy matters and decision making becomes part of an economic game.
- Even though the invisible hand does not work to prevent a monopolist from earning an
economic profit in the long run, individual self-interest still leads people to respond to
the incentive of unexploited opportunities.
Ø Incentive to develop substitute goods
Ø Ways of doing things that do not rely on owning a unique resource.
- Monopolist itself has an incentive to expand output, thereby increasing the economic
pie.
Ø A monopolist will sell another unit is they can maintain the price of existing units
and cut the price of only the extra units.
Ø Constantly struggle to find ways of serving buyers with low reservation prices
without spoiling the price at which they sell to higher reservation price buyers.

10.6 Using discounts to expand the market

Price discrimination defined
- Price discrimination – the practice of charging different buyers different prices for
essentially the same good or service, where differences do not simply reflect differences
in costs of supplying different buyers.
Ø E.g. senior citizens’ discounts on movie tickets, rebate coupons on retail
merchandise and volume-based discounts.
- Only possible where a firm has some price-setting ability.
Ø I.e. in imperfectly competitive markets.
- Firms must be able to separate buyers into groups, either directly or indirectly, on the
basis of their willingness to pay for the good, and to make sure that buyers with high
willingness to pay do not purchase at the discount price.

How price discrimination affects output and profit

- Without price discrimination, production should continue as long as marginal revenue
(total difference in total revenue) exceeds the opportunity cost of her time.
Ø Profit maximizing level when MR>OC
- Socially efficient outcome is when production continues for which benefit exceeds
opportunity cost.
- With price discrimination, production will continue until MR falls short of OC.
Ø Perfect discriminating produces max profit.
- Perfectly discriminating firm – a firm that charges each buyer exactly his or her
reservation price for each unit purchased.
- With a perfectly discriminating monopoly, there is no loss of efficiency.
Ø The firm’s profit-maximising level output is exactly the same as the socially efficient
level of output.
Ø This is because with perfect price discrimination, the benefit to the monopolist of
selling another unit is the same as the benefit to society.
o I.e. the monopolist’s marginal revenue curve is the same as the demand curve.
- However, all consumer surplus is exactly zero.
Ø All economic surplus is producer surplus.
- In practice, perfect price discrimination can never occur because no sellers knows each
and every buyer’s precise reservation price.
Ø Even if they did know, practical difficulties would stand in the way of their charging
a separate price to each buyer.
Ø Hence there is imperfect price discrimination, that is, price discrimination in which
at least some buyers are charged less than their reservation prices.

Group pricing
- The profit-maximising seller’s goal is to charge each buyer the highest price that buyer is
willing to pay.
- However, two obstacles are,
Ø Sellers don’t know exactly how much each buyer is willing to pay.
Ø They need some means of excluding those who are willing to pay a high price from
buying at a low price.
o In some markets, buyers may buy items at low prices and reselling to other
buyers at higher prices. Known as arbitrage.
- Seller are able to better price discriminate if they knows that buyers’ reservation prices
are correlated with some easily observable characteristic of the buyer, such as age or
employment status.
- Group pricing – a form of price discrimination where different discounts are offered in
 different sub-markets, while members of a particular sub-market all receive the same
discount.
- Group pricing yields a higher return than no price discrimination, but a lower profit than
when the firm uses perfect price discrimination.

The hurdle method of price discrimination

- Hurdle method of price discrimination (versioning) – the practice by which a seller
offers a discount to all buyers who overcome some obstacles.
Ø Solves the seller’s problems provided that buyers with low reservation prices are
more willing than others to jump the hurdle.
- Successful hurdle pricing involves setting hurdles that cause people to self-select into
groups according to their reservation price.
Ø High and low reservation buyers must be “differentially sensitive to the hurdle.
Ø The discount for jumping the hurdle must not be too generous.
- Perfect hurdle – a hurdle that completely segregates buyers whose reservation price lies
above it from others whose reservation prices lie below it, imposing no cost on those
who jump the hurdle.
- E.g. mail in coupon.
- A discount price means that those who jump the hurdle will receive a rebate off the list
price.
- Profit is still less than perfect price discrimination.

Is price discrimination a desirable thing?

- Both consumer and producer surplus may be enhanced by the monopolist’s use of the
hurdle method of price discrimination.
- Discount price sub-market generates additional consumer surplus as opposed to no price
discrimination.
Ø However, final outcome is not socially efficient
- Efficiency loss from single-price monopoly occurs because to the monopolist, the benefit
of expanding output is smaller than the benefit to society as a whole.
Ø The hurdle method of price discrimination cuts the price for price-sensitive buyers
only.
Ø The more finely the monopolist can partition a market using the hurdle method,
the smaller the efficiency loss.
- A price discriminating firm must be careful to avoid alienating customers who may see
the practice of charging different prices for essentially the same good as unfair or
inequitable.
- Firms are prevented under legislation from basing price on the attributes of a particular
group of consumers if it has the effect of disadvantaging that group of consumers.
Ø Race, gender or religion.
- Price discrimination is attractive to the firm because its profit will be larger than when it
is compelled to charge all buyers the same price.
- It is socially desirable because price discrimination enables the price-setting firm to
expand output and thereby reduce the deadweight loss.
10.7 Public policy towards competition
- Monopoly is problematic not only because of the potential loss in efficiency associated
with restricted output, but also because monopolist is able to earn an economic profit at
the buyer’s expense.

National competition policy

- The Australia Government’s approach to competition, as enshrined in national
Competition Policy (NPC) is based on an explicit assumption that
Ø Competitive markets will generally serve the interests of consumers and the wider
community by providing strong incentives for suppliers to operate efficiently and be
price competitive and innovative.
- TPA extended, reforms to government businesses to make them more commercially
focused and expose them to competitive pressure.
- To guard against overcharging by monopoly service providers.

The Trade Practices Act and the ACCC

- The Trade Practices Act 1974.
- Purpose was to enhance the welfare of Australians through the promotion of
competition and fair trading, and the provision of consumer protection.
- The act covers unfair market practices, industry code, mergers and acquisitions of
companies, product safety, product labeling, price monitoring, and the regulation of
industries such as telecommunications, gas and electricity.
- Administrated by the Australian Competition and Consumer Commission (ACCC).
- Section 50 of the TPA allows the government to prevent mergers that will substantially
increase market power.
- ACCC must be satisfied that the potentially actionable conduct would result in a benefit
to the public that outweighs the detriment resulting from the lessening of competition.
Benefits include,
Ø Anything of value to the community generally
Ø Any contribution to the aims pursued by the society including as one of its principal
elements the achievement of economic goals of efficiency and progress.
o Efficiency gains:
l Increased efficiency arising from economies of scale
l The lowering of transaction costs
l The correction of externalities
o Non-economic public benefits
l Safety
l Growth of exports
l Wide range of non-economic public benefits

Regulating natural monopolies

- Historically, high levels of protection of some public monopolies in Australia allowed
structures to develop that were inefficient and unresponsive to market conditions.
- The Competition Principles Agreement required the separation of the regulatory
functions from the commercial functions of monopolies and the separation of potentially
competitive elements of monopolies from the natural monopoly elements.
- The general aim of such regulation has been to permit economies of scale to be realized,
while at the same time protection consumers and ensuring adequate output.
- Price regulation method 1: “price=marginal cost regulatory rule” for a natural monopolist.
Socially efficient level of output.
Ø When the price is set equal to marginal cost, (firms earn more by setting mr=mc),
they will be suffering an economic loss.
Ø Monopolists may be compensated for this loss.
Ø Or they can cover the loss by charging a two-part tariff. The buyer pays a fixed
charge for access to the service and then are charged for each unit they consume.
- Method 2: P=ATC. Not efficient, but a normal profit.
Ø Pitfalls of average cost pricing.
Ø Generates costly administrative proceedings in which regulators and firms quarrel
over which of the firm’s expenditures can properly be included in the costs it is
allowed to recover.
Ø Cost of service regulation limits the firm’s incentive to adopt cost-saving
innovations.
- Limitation has resulted in incentive regulation, which refers to the use of regulatory
regimes that rely on rewarding firms for improvements in efficiency. E.g. price or revenue
capping which are now the most commonly adopted approaches in Australia, regulation
of electricity etc.
- Method 3: Price capping, which is a moving ceiling over some price or group of prices
that is automatically adjusted for inflation according to some agreed formula, but in
which the ceiling is adjusted upwards at a rate lower than the rate of inflation by some
amount X.
Ø Force regulated firms to strive for increased productivity since a firm that falls
behind in the productivity race will experience smaller profits or even losses.
Ø A firm that beats the productivity race will enjoy above-normal returns.