Chapter 4: Monopoly, Monopsony, & Dominant Firms

1. 2.

Maximizes profits:

MR = MC Price maker

Faces downward sloping demand:

3. Makes price by setting quantity 4. Creates P > MC by selling less output than competitive firm 5. Selling less output creates deadweight loss (DWL) Figure 4.2

Demand CS

Monopoly Profit (Producer Surplus)



Consumer Surplus = Willingness-to-Pay minus Price Producer Surplus = Price minus Willingness-to-Supply

Degree of market power – Lerner Index Monopoly or market power results in an “overcharge.” The overcharge is related to the elasticity of demand. From MR = MC and from MR = P [ 1 + ( 1 / ε )] We obtain the Lerner Index (LI) or monopoly markup LI = [ P – MC ] / P = 1 / - ε If MC = AC , then Gross Margin = [ P – AC ] / P = 1 / - ε In perfect competition, ε = - ∞ and LI = 0

Incentive for Efficient Operation While the inefficient competitive firm will not survive, an inefficient monopoly may survive. The value maximizing owners have an incentive to become efficient. However, with the separation of ownership and control there is great potential for X-inefficiency.

Welfare Comparison with Pure Competition 1. DWL is a welfare loss – hence inefficient

In a cartel situation, DWL represents an incentive to cheat (see Chapter 5

Other Costs of Monopoly:

Rent-seeking costs (expenditures on lobbying to obtain preferential government treatment). Monopolist would be willing to spend up to the amount of the monopoly profits

2. Advertising expenditures 3. X-inefficiency (no market discipline) Benefits of Monopoly: Society may benefit from a monopoly when the monopolist has secured its position through innovation (differentiation or cost leadership). The government may even be justified in providing preferential treatment in this case with a patent.



Early antitrust law was clear in making collusion (price fixing, cartels) illegal, but not clear to when merging was illegal (merger to monopoly wave in 1890 – 1905)


Strategic Entry Deterrence (Chap. 11) • Strategic investment to make entry by rival firms unprofitable (send signal to potential entrants) • Limit pricing • Predatory pricing • Capacity expansion

3. Knowledge Advantage • Asymmetric knowledge/technology 4. Government-Created Monopolies • Crony capitalism • Rents that rent-seeking behavior seeks • Intellectual property • U.S. Post Office

5. Natural Monopoly • Declining Average Cost • Cheaper for one firm to produce output than numerous smaller firms • Traditional public utilities (phone, electric, cable, gas) are considered natural monopolies, but with new technologies this may be changing

PROFITS & MONOPOLY 1. What appears to be positive economic profit may in fact be a “rent” to scarce resources and not monopoly profit 2. A monopoly does not guarantee positive economic profit Mergers to eliminate short-run losses may not be desirable in the short-run. Merger will lead to higher prices and a DWL. However, short-run losses cannot be sustained indefinitely. To survive in the long-run may require a merger.


MONOPSONY • A monopsony is a single buyer in a market. • The monopsony is a price taker in the input market. • The economics are symmetric with the monopoly case – with a marginal outlay schedule (marginal resource cost) lying above the supply curve. • The strategy of the monopsony is to maximize profit where marginal benefit of hiring (the demand curve) equals the marginal outlay, resulting in the monopsony restricting hiring and paying an input price below the competitive price. Note that a minimum wage set at wc in Figure 4.5 on page 107 will have the effect of increasing the wage and employment. This is because the marginal outlay curve is flat at wc until it intersects the demand curve (MRP curve)

DOMINANT FIRM MODEL Dominant Firm: A large price-setting firm with large market share, facing smaller price-taking firms. Fringe Firms: A group of small price-taking firms in a market with a dominant. With the fringe firms, the dominant firm will typically not set the conventional monopoly price, nor will the profit-maximizing dominant firm want to predatory price to drive out the fringe. Some examples might include: Dominant Firm Kodak Hewlett-Packard IBM Microsoft U.S. Steel General Motors Industry photographic film laser printers personal computers operating system software steel automobiles

In most cases the dominant firm’s dominance wanes over time.

Why Some Firms are Dominant 1. Lower cost with first mover advantage 2. Superior (differentiated) product with first mover advantage Cartel without full market share (e.g. OPEC)


Dominant Firm Model There are a number of variants of the dominant firm model, most of which assume that the dominant firm has a cost advantage. Consider 3 models: Umbrella Price Model


This situation is a price leadership model with the largest or dominant firm as the leader. As “benefactor” the dominant firm uses an umbrella price strategy.

The dominant firm’s umbrella price is higher than the price charged by the smaller fringe firms. The umbrella price policy will: 1. Ward off antitrust authorities (no predatory pricing) 2. Avoid a price war 3. If the dominant firm has a superior product, there will be little concern about losing significant market share. To show this mathematically, let β = % price cut by competitor or fringe entrant α = fraction of demand captured by the price cutting competitor from the dominant firm. The price umbrella is optimal for the dominant firm if α < β / PCM P = price C = average cost The strategy is desirable when: • β is large compared to α (price cut large compared to lost share) • PCM is small to begin with (margins are small) where (gross margin) PCM = (P – C) / P

To see the algebra, let Πno cut = Profit from maintaining the higher umbrella price Πcut = Profit from following the competitor’s price cut The dominant firm will maintain the umbrella price if Πno cut Where, Πno cut = [ P – C ] Q ( 1 – α ) Πcut Πno cut > = [ P ( 1 – β ) – C] Q Πcut when α < β / PCM > Πcut

Problems with Dominant firm and umbrella price: 1. With firm asymmetries, rivals are not interested in playing 2. Dominant firm may lose significant market share and profit, since the dominant firm is passive (no tit-for-tat, no grim trigger)


No-Entry Model • • • Fringe firms are identical price-takers Number of fringe firms is fixed and no new entry occurs Dominant firm knows market demand and fringe firms

supply – hence dominant firm knows residual demand and behaves as a monopoly with respect to the residual demand

Outcomes (see Figure 4.6, page 114) (i) Dominant firm charges high price and makes a profit – as do the fringe firms. The profit for the dominant firm is lower than would be the case if it was a monopoly. This market is not contestable since entry is restricted (ii) Dominant firm costs are so low that the monopoly price is below the fringe firm’s shut-down price


Free, Instantaneous Entry Model • Same situation as 2. above, except entry is not restricted • Dominant firm still has cost advantage

Outcomes (see Figure 4.7, page 118) (i)Dominant firm charges a price equal to the min(AC) of the fringe firms and makes a profit. Fringe firms earn zero economic profit. The profit for the dominant firm is lower than would be the case if it was a monopoly. This market has limited contestability since entry is limited by the cost differential (ii) Dominant firm costs are so low that the monopoly price is below the fringe firm’s shut-down price [min(AC)]

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