The basic model
Whilst a perfectly competitive industry consists of a large number of small firms, a monopoly is by definition both firm and industry. As a consequence it is faced by a demand curve that slopes downwards from left to right in the customary manner. The monopolist is therefore a price maker. Hence, in Figure 12.5, if D is the monopolist demand curve, MR its associated marginal revenue curve and SMC is short-run marginal cost curve, the short-run profit-maximizing output is Q, where the marginal cost curve cuts the marginal revenue curve from below, and P is the price at which is sold. The monopolist may also seek to increase his profits by advertising and varying his product. There are, however, certain issues arising from the basic price-output decision illustrated in Figure 12.5 that are worth considering further.
First of all, a popular misconception is that monopoly power gives the firm an ability to earn large profits. However, that depends on the relative positions of cost and revenue functions. In the case illustrated, price is considerably in excess of average costs (SAC) at the profit-maximizing output, but with less demand and higher costs the firm’s profitability could be considerably reduced. Indeed, monopolists have been known to make losses. In fact, a distinguishing feature of monopoly is not so much its absolute level of profits, but its ability to retain them in the long run because of the protection to its position afforded by barriers to entry. This means that the distinction between the short and the long run is of less significance in the case of monopoly than in perfect competition as, in the absence of movements in its cost function of the market demand function, the only long-run adjustment the monopolists needs to make is to ensure that short-run marginal cost is equal to long-run marginal cost.
An alternative approach to monopoly power, which was proposed by Lerner in the 1930s, is to consider the extent to which the monopolist can raise his price above marginal cost. Accordingly, Lerner suggested that monopoly power could be measured by: (P-MC)/P which, since marginal cost (MC) is usually positive, yields an index between 0 and 1.
Lying behind this index is the idea that the more competition a firm has the more elastic its demand, since it will be recalled from expression (11.5) above that, when the firms is maximizing its profits,
P-MC 1
P eP
Firms facing a lot of competition from rivals producing close substitutes to their own products thus face a highly elastic demand curve, which restricts their ability to raise price above marginal cost. The value of the Lerner index in their case is, therefore, close to zero. Indeed, in the limiting case of perfect competition where demand is infinitely elastic, the index has a zero value. In contrast, more monopolistic situations are marked by the absence of close substitutes and a less elastic demand, allowing a greater divergence between price and marginal cost and producing a value of the Lerner index closer to unity.
Another important feature of monopoly is the absence of a supply curve. In the case of perfect competition we were able to derive a determinate relationship between the amount the firm was willing to supply and price, which was independent of the form of the demand function. In the case of monopoly, the amount the firm is willing to sell at any price, or the price at which it is willing to sell any output, depends as much on demand conditions as on the form of its cost function.
The lack of a supply curve, it will be realized, applies not just to a single firm monopoly but to any situation in which a firm is a price maker. Likewise, all price makers enjoy the same degree of monopoly power as measured by the Lerner index. Further, barriers to entry may also, in many cases, provide some partial degree of protection to their profits in the long-run. All this merely serves to emphasize the point that, although single firm monopolies may be comparatively rare, some degree of monopoly power is more widespread.
Dead-weight losses
In certain respects, the long-run outcome of monopoly compares unfavourably with that of a perfectly competitive industry. This can be illustrated by considering the case of a competitive industry, operating under constant cost conditions, that is subsequently monopolized without, initially at least, disturbing the cost structure of the industry and where the demand curve for the industry’s product also remains unchanged. The long-run supply curve of the competitive industry can then be taken to be the long-run average and marginal cost curve of the monopolist, as indicated in Figure 13.1
In the competitive situation, we can see from the diagram that, with the supply curve, SC, an output of Q1 is produced and sold at a price of P1. The monopolist, however, facing the same situation (that is, with a long-run average cost of LAC1) maximizes his profits by reducing output to Q2 and raising price to P2 , thereby creating profits represented by the area P1BAP2. This represents the appropriation by the monopolist of part of the surplus previously enjoyed by the consumers. On the assumption that £1 gained by the producer can be treated as identical to £1 lost by the by a consumer, the aggregate surplus to society as whole is unaffected by this transfer of consumers’ surplus. There is, however, an additional loss to consumers of the triangle ABC, which arises because they are being denied access to the consumption of the Q1Q2 additional units of output that they would have bought in the competitive situation. Because consumers are willing to pay a price in excess of the marginal costs of producing these units of output, they can be produced with positive net benefits to society, represented by ABC, which are lost in the monopoly situation. These lost benefits constitute a dead-weight loss, since there are no compensating gains elsewhere.
It may also be noted, however, that when a monopolist takes over a competitive industry he may be able to rationalize its operations in such a way as to achieve significant cost savings. Under such circumstances the firm’s long-run average cost curse might fall, for example to LAC2 in Figure 13.1. Profit maximization then requires the monopolist to increase his output to Q3 and to reduce his price to P3. Compared with the competitive situation, the dead-weight loss from the restricted output (now reduced to CFG) is offset, to a greater or lesser extent, by the gain from the cost savings on the output produced (=C2P1FE), with the net effect being determined by the relative size of these two areas. But although this position might represent an improvement over the initial competitive equilibrium in terms of the overall net benefits to society, there would still be a dead-weight loss, measured this time by the triangle ECH, arising from the monopolist restriction of his output to Q3, because additional positive benefits could, in this situation, be obtained by increasing output to Q4 where price, which indicates the amount consumers are willing to pay for marginal units, is equal to marginal cost.
In general, dead-weight losses are an inescapable feature of a monopolist’s profit-maximizing behaviour. Hence, even where a monopolistic structure has advantages over a competitive structure-where, for example, it allows technical economies of scale, to be exploited-with a profit-maximizing monopolist the outcome, at best, will be a second best situation that can potentially be improved upon by devoting more resources to the monopolized product.
X-inefficiency
An additional source of welfare loss in a monopolistic situation can arise because the lack of competition pressure allows the monopolist to pursue, to some extent at least, other than profit-maximizing objectives. The precise effect of this depends on the nature of these other objectives, which might involve simply a preference for a “quiet” life, or a preference for the use of a particular type of input, but in either case it could lead to costs per unit being higher than in the firm’s sole objective was maximum profits. It would therefore, lead to some inefficiency in the use of resources. As a form of shortland, this type of inefficiency has been termed X-inefficiency by Leibenstein (Leibenstein, 1966, Comanor and Leibenstein, 1969), who was one of the first to examine its implications.
Parish and Ng (1972) have pointed out, the fact that the firm’s managers have chosen not to operate with maximum efficiency suggests that hey benefit in some way from the X-inefficiency. At this point, the distinction between owner-managed and other firms is relevant because, if the X-inefficiency firm is managed by its owners, they are choosing to sacrifice profits to allow them a more relaxed working life, more leisure or whatever. Presumably, therefore, the utility gain from the latter must be at least as great as the loss of utility from reduced profits, and so there can be no net loss additional to that suffered by consumers. However, where ownership is divorced from control, the loss of profit is borne by shareholders, whilst the benefits of X-inefficiency are enjoyed by the managers.
Price discrimination
So far, we have assumed that the monopolist sells all his output for a uniform price. In practice, this may not be the case because the monopolist is able, and finds it profitable, to practice price discrimination.
In general terms, price discrimination occurs when a producer sells a specific product to at least two distinct buyers at different prices that do not reflect differences in the cost of supply. Essentially it can arise whenever buyers’ willingness to pay different amounts for an identical good or service can be turned to the seller’s advantage. Where the seller is a profit-maximizing firm, the potential advantage is, of course, increased profits.
Successful discrimination, as will become clear when we discuss the formal models, requires three things to be true. In the first place, the monopolist must be able to deal with his buyers separately. Secondly, there must be differences in the prices buyers are willing to pay, and thirdly, the seller must have the market power to exploit these differences. Alternatively, it may be said that successful discrimination rests both upon the ability of the seller to select his clientele and upon the prevention of resale by the customer who buys cheaply to the customers who pay higher prices. Since it is extremely difficult to resell most services, it is much easier to practice price discrimination for services as compared to goods. It is also considerably easier to discriminate where markets are physically separated, such as home and abroad. In the latter circumstances, the monopolist is discriminating only between a few large markets, as is also true where, for example, a firm sells part of its production to another manufacturer for incorporation in his own products, and part direct to the general public at a much higher prices. It may be possible, however, for a monopolist to discriminate on an individual basis; for example, an eminent surgeon may be able to charge an enormous range of prices to patients of varying means, secure in the knowledge that the operations cannot be resold.
On a more formal note we can distinguish three degrees of price discrimination.
First degree price discrimination is what can be referred to as perfect price discrimination, since the monopolist is able to extract from each customer the highest price that the customer is prepared to pay for each successive unit. In other words, he acquires the entire consumers’ surplus. It also means that the demand curve becomes the firm’s marginal revenue curve rather than its average curve. With first degree price discrimination, in the absence of X-inefficiency, the dead-weight loss normally associated with monopoly disappears. However, this is at the expense of a transfer of the entire consumers’ surplus to monopolist. Nevertheless, in practical terms, first degree discrimination is unlikely because of the knowledge about is customers required by the monopolist, but the example of the surgeon above illustrates the possibility of its successful implementation in the service sector.
Second degree price discrimination occurs when a customer is offered a variety of prices according to the quantity he is willing to consume.
Third degree price discrimination occurs where different prices are charged in different markets.In Figure 13.4, the model incorporates a monopolist operating in two markets, in both of which the firm is faced with a downward-sloping demand curve. It is, however, an extremely simple matter to convert one of the markets into a perfectly competitive market where the firm is price taker, or to add on as many different markets as we wish, since the economic principles remain unaffected.
Regulation of monopolies
The fact that monopolistic behaviour can impose welfare losses on society raises the issue of how monopolies can be regulated to restrain their exercise of market power to the detriment of the community. Two approaches to this task are available in normal circumstances, the first of which is to regulate the monopolist’s price and the second of which is to impose taxes of varying kinds upon the monopoly.
Price regulation
Here the government may fix a price below that which the monopolist would have chosen in the absence of regulation. The problem for the government in this approach is, therefore, to fix the price ceiling at an appropriate level, usually in the absence of detailed information about the relevant cost and demand function. An obvious aim would be to try to fix it at a level that allows the monopolist to earn reasonable rather than excessive profits. If, however, in these circumstances the monopolist is led to believe that any increased profitability would lead to a reduction in the maximum permitted price, the firm might be tempted, in the absence of any controls on cost, to appropriate the benefits from new profitable opportunities by allowing X-inefficiency to develop, thus raising costs. In an attempt to discourage such tendencies, a retail price index minus X formula has been adopted to regulate the prices of recently privatized natural monopolies in the UK, which at least provides them with an incentive to reduce their costs in real terms. One problem with this approach, however, is that the ceiling applies to an index of prices rather than to any individual price, so it also provides an incentive for firms to increase their revenue through more effective price discrimination by raising prices in the more inelastic markets by more than the permitted average and those in more elastic markets by less.
Public ownership
Another possible approach to the regulation of monopolies is through public ownership, and until the 1980s that was the approach adopted in the UK as well as other countries for the more basic natural monopolies like electricity, water, telephone, and gas. This approach has the potential advantage that the government can prescribe pricing procedures more directly. Because of the scale on which they operate, the industries concerned are normally operating along the falling part of their average cost curve, as depicted in Figure 13.6.
In the situation depicted in Figure 13.6, there is a conflict between efficiency and profit targets. In the simple case of a single-product monopolist, the most straightforward response is to raise price to P3 (=average cost) if the requirement is simply to break even, or higher if there is some specific profit targets to meet. However, nationalized industries are typically multi-product enterprises, and as such the average cost of individual products is not precisely measurable because of the existence of joint costs. In these circumstances it has been shown that an approach that minimizes the dead-weight losses from higher prices is for the enterprise to behave like a price-discriminating profit maximizer by raising prices differentially, with the largest increases on the products with the more elastic demand, until the profit target is met.
An alternative approach, which is used in some cases, is to use second degree rather than third degree price discrimination in the form of two-part (or multi-part) tariffs. These involve either a standing charge, which is levied irrespective of the level of consumption, combined with a single preference for all units consumed, or a relatively high price for the first few units consumed combined with a lower price for subsequent units. Like all price discrimination, this has the effect of transferring some consumers’ surplus to producers, but in this context, if the lower price (or the price per unit) is related to the marginal cost of production, it provides a potential means of financing the losses that would arise with uniform prices set at the marginal cost level and hence largely avoids the dead-weight losses that arise with other approaches.
Regulation via taxation
Alternatively, attempts may be made to regulate monopolies through the imposition either of a lump-sum tax or a per-unit tax. A lump-sum tax is imposed irrespective of output, and hence can be straightforwardly treated as an increase in the firm’s fixed costs. By implication, such a tax cannot affect the firm’s marginal cost curve, and hence cannot affect the profit-maximizing price and output. All that happens, therefore, is that the monopolist’s profit is reduced by the amount of the tax itself, but the customer consumes as much as before at the same price as before. The dead-weight losses to the community are therefore, no less than before, and all that happens is that some of the monopolist’s profits are transferred to the government. The imposition of a per-unit tax would, however, cause the tax bill to rise progressively with increases in output, and the average cost curve would rise parallel to itself by the amount of the tax. Since a per-unit tax affects variable costs, the marginal cost curve would also increase and would therefore intersect the unchanged MR curve at a lower output than before. The price would accordingly be higher than before, and profit would be lower. In this case, therefore, not only is the firm affected adversely through a reduction in its profit, but consumers must also pay more for a smaller supply of the product. Given that the object of regulating the monopoly is to allow the consumer to buy more at a lower price than in the absence of regulation, a per-unit tax that has the opposite effect would be a most appropriate instrument of regulation.
Indeed, to induce the firm to move in the required direction, a per-unit subsidy is necessary. By itself, however, that would also have the effect of increasing the monopolist’s profit.
Monopolistic competition
The theory of monopolistic competition arose from attempts in the 1920s and 1930s to develop models to deal with situations lying between the extreme of perfect competition and monopoly. Chamberlin, in his original use of the term in his pioneering book on the subject (Chamberlin, 1933), used it to embrace both industries in which the number of firms is large and industries in which the number of firms is small. However, in the current usage, the term tends to be confined to the large group case, which in fact is the one to which Chamberlin made the most distinctive contribution, whilst the term oligopoly is used for situations where the number of firms is small.
On this definition, monopolistic competition is actually much closer to perfect competition than monopoly. In fact it differs from it in one major respect. Whereas the industry is assumed to consist of a large number of small firms, each of which is run by an entrepreneur who pursues the goal of profits maximization under conditions of perfect knowledge, and whereas there is considerable freedom of entry into, and exit from, the industry, each firm nevertheless cannot be regarded as a price-taker.
In essence every producer in the industry sets out to satisfy a specific consumer requirement, but does so in a way that is similar to, but never identical with, the way chosen by any other producer. Differences between products may either be real, or largely imaginary, but this distinction is unimportant provided that consumers treat the products of different firms as being less than perfect substitutes for one another.
In order to simplify the analysis it is helpful to make certain additional assumptions at this point. These are that:
(1) each firm has already decided upon the optimal degree of product differentiation and extent of sales promotion, thus allowing us to concentrate solely upon the effects of price changes upon profits;
(2) each firm operates along identical cost and revenue curves (whilst recognizing that this is unlikely to be true in practice since every product is different and is hence likely to cost a different amount to produce).
Although Chamberlin analysed in detail the process by which an equilibrium in monopolistic competition might come about, it is sufficient for our purposes to concentrate our attention on the long run equilibrium position, which is illustrated in Figure 13.7. This contains elements of the pure monopoly case, in that profits are maximized where the marginal cost curve cuts the downward-sloping marginal revenue curve, but it also reflects the effects of free entry, which, as in perfect competition, reduces the firm’s profit to zero. Hence, as in the diagram, the representative firm’s long-run equilibrium output is Q, where LMC=MR and where in addition the firm’s average revenue curve just touches its long-run average cost curve so that price equals long-run average cost.
Excess capacity
One particular feature of this long-run equilibrium that attracted considerable attention in the early days is that the downward-sloping demand curve must touch the average cost curve at an output less than that at which average costs are at a minimum. This appears to suggest that, in contrast to perfect competition, monopolistic competition in an industry leads to an inefficient use of resources in the sense that the same total output can be produced at a lower cost by a smaller number of firms. In other words, long-run equilibrium seems to involve excess capacity. However, the situation is not so simple as it appears at first sight.
In the first place, it is only unambiguously true in the rather special case where there are no selling expenditures. With positive selling expenditures, which are, of course, part of the firm’s costs, the average (total) cost curve can be disaggregated into average production costs and average selling costs. With a given level of selling expenditures, the average selling cost curve (ASC) is a rectangular hyperbola, as in Figure 13.8, like any other fixed-cost curve.
Secondly, the long-run equilibrium depicted in Figure 13.7, theoretically relates to a situation where the industry has a particular range of products. If concentrating output in fewer firms led to a smaller range of products being available, the losses to consumers from the restriction to the choice of available products could offset the benefits of reduced production costs.
Other problems
A more fundamental criticism of the model arises from its assumption that firms in the industry are virtually unaffected by the individual actions of other firms. This can only really be the case where one firm is an equally close competitor to a large number of other firms. However, since product differentiation means that individual firms’ products are likely to differ from each other in the proportions in which they combine various characteristics, our earlier analysis of product characteristics suggests that any individual firm’s product is likely to be a closer substitute to some than to others. This means that the effect of its actions is likely to be greater on some competitors than others. Moreover, in these circumstances the effect is likely to be significant. For example, if a fish and chip shop lowers its prices it could have a significant effect on the trade of a similar shop in the next street, event though the effect on shops farther away is negligible. This is also means that, before our fish and chip shop proprietor makes a decision to change his prices, he would need to consider precisely how his rival might react, because that would be an important factor in determining the final outcome. These problems are tackled explicitly in oligopoly models, but the fact that they can arise in situations where there are a large number of firms that are small in relation to the size of industry suggests that the assumptions of the monopolistic competition model relate to rather an extreme case in exactly the same way as those for perfect competition.
The perfectly competitive model is based on extreme assumptions, but it does yield a supply curve, which is useful, in conjunction with the demand curve, in the analysis of competitive markets and how they react to changes in external factors. With monopolistic competition, firms are price makers, as in monopoly, so they have no determinate supply curve. Hence there can be no aggregate industry supply curve. Further, even at the individual firm level, it is difficult to predict how it will respond to a simply change like an increase in demand because of the conflicting ways the relevant factors operate in determining the overall effect. Indeed, considerations of this kind have led one commentator to conclude that from this point of view the theory of monopolistic competition is almost theoretically empty (Archibald, 1961). However, an important contribution of the theory as developed initially by Chamberlin was to emphasize the importance of advertising and product variation in the analysis of the firm, and in recent years these aspects of his work have been the subject of renewed interest, particularly in the light of the development of the analysis of the characteristics of products.
Bibliography:
Curven, Peter and Else, Peter-Principles of Microeconomics, Unwin Hyman Ltd, 1990
Jenkinson, Tim-Readings in Microeconomics, Oxford University Press, 1996
Kroszner, Randall S. and Putterman, Louis-The economic nature of the firm, Cambridge University Press, 1996
