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Prof. Carlo [email protected]
Monopoly, Market Power
and Market Failures
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Review of Perfect Competition
Large number of buyers and sellersHomogenous product
Perfect information
Firm is a price takerSolution
P = (L)MC = (LR)AC
Normal profits or zero economic profits in thelong run
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Review of Perfect Competition
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Microeconomics: a review
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Individual demand: consumerbehavior
Under the local nonsatiation assumption, the optimal
consumer demanded bundle of goods (i = 1, .., n) is given bythe following problem:
where pis the vector of market prices and mthe income levelof the consumer.
v(p, m) is the maximum utility achievable at given prices andincome and is called indirect utility function. The optimal x(p,m) is therefore the consumers demand function.
mpxts
xumpvx
=
=
..
)(max),(
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Individual demand: consumerbehavior
The Lagrangian for the Utility maximization problem
can be written as:
The FOC is given by:
And it can be re-elaborated as:
)()( mpxxuL =
nipx
xui
i
,...1for0)(
==
njip
p
x
xu
x
xu
j
i
j
i,...1,for
*)(
*)(
==
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Individual demand: consumerbehavior
The indirect utility, i.e. the maximum utility asa function of pand mhas the followingproperties:
It is non increasing in p, that is if p p, thenv(p, m) v(p, m). Similarly, v(.,.) is nondecreasing in m.
It is continuous and quasi-convex
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The quasi-linear utility function
Partial equilibrium analysis: analyse the market
functioning of a good that has a relatively low weighton the global economy.
Hence, we can introduce two simplifying assumptions: 1. the impact of a change in consumers income on the
expenditure of the good is limited (no income effect); 2. the substitution effect on the other goods is small too.
The prices of the rest of goods can then be consideredas fixed and we can be assume them as a numeraire,normalised to 1.
We can then simplify our utility function in the followingway (yi is the rest of goods, i.e. the numeraire):
yxuyxU += )(),(
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The quasi-linear utility function
u(xi) is a continuous, increasing, twice-differentiable,
and convex function. The optimization problem becomes:
FOCs:
This leads to the following optimal condition:
mypxts
yxuyxU
=+
+=
..
)(),(
01
0)(
==
=
=
y
L
px
xu
x
L
pxu
x
xu==
)(
)(
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Surplus: a review
Consumer surplus is the total benefitor value that consumers receive beyondwhat they pay for the good
Producer surplus is the total benefit orrevenue that producers receive beyond
what it costs to produce a good
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Marginal effects of a price/quantity
changes on Consumer Surplus
Consumer surplus, as a function of price, is given by:
Hence, it results:
Intutition: the demand has a negative slope, the minusis needed in order to have a positve quantity
==*
)()(p
dppqpVCS
)()(
pqdp
pdV=
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Marginal effects of a price/quantity
changes on Consumer Surplus
Consumer surplus, as a function of quantity,
is given by:
Hence, it results:
==
*
0)(where
)()(
q dqqpS(q)
qqpqSCS
)()(
qpdq
qdS=
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Perfect competition and Welfare
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Welfare economics
What are the welfare properties of the perfect
competitive equalibrium? The representative consumer approach: suppose
that the market demand, x(p), is generated bymaximizing the utility of a single representativeconsumer who has a quasi linear utility function u(x)+y,where xis the good under examination and yeverything else.
Under this utility function, we know that:
Hence, the direct demand function x(p) is simply the
inverse of the above condition Note that in case of a quasi-linear utility the demand
function is independent of income!!
pxu = )(
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Welfare economics
Consider now a representative firm having a costfunction c(x), with c > 0, c> 0 and c(0) = 0.
In a perfect competitive market, the profit maximizing(inverse) supply function of a representative firm isgiven by p= c(x).
In equilibrium demand = supply
Hence, the equilibrium level of output of the x-good issimply the solution to the equation:
This is the level of output at which the marginalwillingness to pay for the x-good just equals its marginalcost of production.
)()( xcxu =
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Welfare analysis
What is the optimal amount of output that maximizes therepresentative consumers utility?
Let w be the consumers initial endowment of the y-good. Theconsumers problem is:
Intuition: the welfare maximizing problem is simply to maximizetotal utility consuming x-good and y-goods. Since xunits of the x-good means giving up in a competitive market - c(x) units of they-good, our social objective function becomes:
The Foc is given by (as before):
The competitive market results in exactly the same level ofproduction and consumption as does maximizing utility directly.
)(..
)(max,
xcwyts
yxuyx
=
+
)()(max,
xcwxuyx
+
)()( xcxu =
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Welfare analysis
Another way to look at the same problem.
Let CS(x) = u(x) - pxbe the consumers surplus and PS(x)= pxc(x) be the producers surplus.
The total surplus, or welfare, is:
We can conclude saying that the competitive equilibriumlevel of output maximizes total surplus!
[ ]
)()(
)()()()(max
xcxu
xcpxpxxuxPSxCSW x
=
=+==+=
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Welfare analysis: a generalization
Suppose there are i= 1,, nconsumers andj = 1,,m
firms. Each consumer has a quasi-linear utility functionui(xi)+yiand each (perfectly competitive) firm has a costfunction cj(xj).
An allocation describes how much each consumer
consumers of x-good and the y-good, (xi, yi), i= 1,, n,and how much the firm produces of the x-good, zj,j =1,,m .
The initial endowment of each consumer is taken to be
some given amount of the y-good and 0 of the x-good. The sum of utilities is given by:
= =
+n
i
n
i
iii yxu
1 1
)(
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Welfare analysis: a generalization
The total amount of the y-good is the sum of
initial endowments, minus the amount used upin production:
Observing that the total amount of the x-goodproduced must equal the total amountconsumed, we have
===
=m
j
jj
n
i
i
n
i
i zcwy111
)(
==
===
=
+
m
j
j
n
i
i
m
j
jj
n
i
i
n
i
iizx
zxts
zcwxuji
11
111,
..
)()(max
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Welfare analysis: a generalization
Let the Lagrangian multiplier on the
constraint, we have
where p* = since the market is perfectlycompetitive!
Hence, market equilibrium necessarilymaximizes welfare for a givenpattern of initialendowments (wi).
=
=
)('
)('
jj
ii
zc
xu
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Consumer Equilibrium in a
Competitive Market
First Theorem of Welfare Economics
If everyone trades in a competitivemarketplace, all mutually beneficial tradeswill be completed and the resulting
equilibrium allocation of resources will beeconomically efficient
Welfare economics involves the normative
evaluation of markets and economic policy
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Consumer Equilibrium in a
Competitive Market
Pareto Optimality
An outcome is Pareto optimal if it is not possibleto make one person better off without makingone another worse off
If this is possibile, we face a potential Paretoimprovement(PPI)
The adoption of the PPI criterion means that wecan focus on what happens to total surplus.
Hence an outcome that maximizes total surplusis Pareto optimal.
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Consumer Equilibrium in a
Competitive Market
Difficult for efficient allocation with manyconsumers and producers unless allmarkets are perfectly competitive
Efficient outcomes can also be achievedby centralized system
Competitive outcome preferred since
consumers and producers can betterassess their preferences and supplies
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Equity and Efficiency
Although there are many efficient
allocations, some may be more fair thanothers
The difficult question is, what is the most
equitable allocation?We can show that there is no reason to
believe that efficient allocation from
competitive markets will give an equitableallocation
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Equity and Perfect Competition
Must a society that wants to be more
equitable necessarily operate in aninefficient world?
Second Theorem of Welfare EconomicsIf individual preferences are convex, then
every efficient allocation is a competitive
equilibrium for some initial allocation ofgoods
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Equity and Perfect Competition
Any equilibrium that is equitable can beachieved by redistributing resources andmay be efficient
Typical ways to redistribute goods,however, are costly
Taxes lead to bad incentives
Firms devote fewer resources to production inorder to avoid taxes
Encourage individuals to work less
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Market Failures
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Why Markets Fail
Market Power
Those with market power choose the priceand quantity
Less output is sold than in competitive
markets
Inefficiency
Can have market power as producers or as
inputs
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Why Markets Fail
Externalities
Market prices do not always reflect theactivities of either producers or consumers
Consumption or production has indirect
effect on other consumption or productionnot reflected in market prices
May be impossible to get insurance because
suppliers of insurance lack information
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Why Markets Fail
Public Goods
Nonexclusive, nonrival goods that can bemade available cheaply but which, onceavailable, are difficult to prevent others from
consumingCompany thinking about researching a new
technology if cant get patent
Once its made pubic, others can duplicate it
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Why Markets Fail
Incomplete Information
Consumers must have accurate informationabout market prices or production quality formarkets to operate efficiently
Lack of information can change supply Buy products with no value
Dont buy enough of products with value
Some markets may never develop
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Market Failures
Economic motivations
Existence of market power (monopoly, naturalmonopoly, collusive oligopoly)Externality (positive or negative)Market incompleteness (asymmetric information)
Social motivations:Redistributive concerns (urban to rural areas; rich to
poor citizens)Merit goods (essential services should be provided to
everybody at affordable prices)
need of State policy in the form of ex ante(regulation) or ex post (antitrust) interventions
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Monopoly
Monopoly
1. One seller - many buyers
2. One product (no good substitutes)
3. Barriers to entry
4. Price Maker
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Monopolists Output Decision
1. Profits maximized at the output level
where MR = MC
2. Cost functions are the same
MRMCor
MRMCQCQRQ
QCQRQ
=
===
=
0///
)()()(
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Lostprofit
P1
Q1
Lostprofit
MC
AC
Quantity
$ perunit ofoutput
D = AR
MR
P*
Q*
Monopolists Output Decision
P2
Q2
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Monopolists Output Decision
1. Profits maximized at the output level
where MR = MC
2. Cost functions are the same
+=
+=
+=
DEPPMR
QP
PQPP
QPQPMR
1
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Equilibrium Pricing
1
1
MCMRwheremaximizedis
D
D
EP
MCP
MCEPP
=
=
+
=
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Elasticity of Demand and Price
Markup
P*
MR
D
$/Q
Quantity
MC
Q*
P*-MC
The more elastic isdemand, the less the
markup.
D
MR
$/Q
Quantity
MC
Q*
P*
P*-MC
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Measuring Monopoly Power Could measure monopoly power by the extent
to which price is greater than MC for each firm
Lerners Index of Monopoly Power
L = (P - MC)/P
The larger the value of L (between 0 and 1)the greater the monopoly power
L is expressed in terms of EdL = (P - MC)/P = 1/EdEd is elasticity of demand for a firm, not the
market
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Monopoly Power
Pure monopoly is rare
However, a market with several firms,each facing a downward sloping demandcurve, will produce so that price exceeds
marginal costFirms often product similar goods that
have some differences, thereby
differentiating themselves from otherfirms
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Sources of Monopoly Power
Why do some firms have considerable
monopoly power, and others have little ornone?
Monopoly power is determined by abilityto set price higher than marginal cost
A firms monopoly power, therefore, is
determined by the firms elasticity ofdemand
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Sources of Monopoly Power
The less elastic the demand curve, the
more monopoly power a firm hasThe firms elasticity of demand is
determined by:
1) Elasticity of market demand2) Number of firms in market: entrybarriersand entry deterrence
3) Strategic behaviour by incumbent4) New Technology
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Elasticity of Market Demand
With one firm, their demand curve is market
demand curveDegree of monopoly power is determined completely
by elasticity of market demand (ex. OPEC)
The presence of alternative suppliers or substitute
products reduces market power (supply and demandside substitution)
With more firms, individual demand may differfrom market demand
Demand for a firms product is more elastic than themarket elasticity
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Demand elasticity in telecoms under
a Monopoly: evidence from Italy
Dependent Variable Price Income
SIP (1988) National calls 0,12 0,5-0,9Cappuccio(1990)
Revenues from calls (annualbase 1973)
0,11 0,52
Gambardella
(1991)
Revenues from calls (annual
base 1964)
0,35 0,25
Ravazzi (1991) Membership 0,1 0,3Mosconi (1994)e Colombino(1998)
Urban callsNational callsInternational calls
0,190,250,52
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Demand elasticity in telecoms under
Monopoly: evidence from US
Bodnar et al.(1988) Taylor e Kridel (1990)
Dimension
(000
Price
Elasticity Economic Position PriceElasticity
of inhabitants)> 500 0,007 Poor and rural 0,071100 500 0,006 Poor and urban 0,07730 100 0,010 Poor black rural 0,089
< 30 0,013 Rich white urban 0,026Rurale 0,014 State Price Income
Age Elasticity Elasticity< 26 0,024 Arkansas 0,059 26 44 0,009 Kansas 0,023 45 64 0,007 Missouri 0,031 > 64 0,008 Oklahoma 0,034
Income($ 000)
Texas 0,037
< 12 0,026 Average 0,037 0,04212 20 0,01220 28 0,00628 38 0,002
> 38 0,0005
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Number of Firms
The monopoly power of a firm falls as the
number of firms increases; all else equalMore important are the number of firms with
significant market share
Market is highly concentrated if only a fewfirms account for most of the sales
Firms would like to create barriers toentry to keep new firms out of marketPatent, copyrights, licenses, economies of
scale
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Number of Firms
Entry barriers are of interest from two perspectives: (i)corporate strategy and (ii) public policy.
Incumbents want to protect not only their market sharesbut also their profits
A key objective of corporate strategy is profitable entrydeterrence.
Profitable entry deterrence occurs when incumbent firmsare able to earn monopoly profits without attracting entry Profitable entry deterrence depends on the interaction
between structural entry barriers and incumbentsbehaviour
Public policy should aim at eliminating entry barriers anddetect entry deterrence
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Government Restrictions on Entry
Governments create entry barriers when
they grant exclusive rights to produce toincumbent preventing additional entry
Forms of exclusive franchises:
Natural Monopoly;Source of revenues (from State owned
companies);
Redistribute rents among citizens;
Intellectual Property Rights (IPRs)
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Structural Barriers to Entry
Structural characteristics that protect market
power without attracting entry, such as:Economies of scaleSunk expenditures of the entrantAbsolute cost advantage: incumbent may face lower
costs or a better access to existing facilities (i.e. the
use of the network in the telecoms industry)Sunk expenditures by consumers and product
differentiation: If a consumer faces a large cost for switching to a
new product, he could decide not to switchswitching costsand creation of brand loyalty.
Finally, consumer might not view the offerings ofother firms as substitute.
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Strategic behavior by Incumbents
Incumbents may behave in order to enhance
barriers to entry to rivals. Potential strategies:
Aggressive postentry behavior: commit to beaggressive; ex. Investment in sunk capacity
Raising rivals cost: raising cost of a potential entry orreducing the profitability of entry
Reducing rivals revenues: again reduce the
profitability of entry increasing the consumersswitching costs and so the market demand for theentrant
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New Technology
Technological change can generate new
products and services, and theintroduction of these products reducesthe market power of producers of
established products.Nintendo in 80 was a monopolist, but the
monopoly ended after the entry by Sega
and later on by Sony (Playstation) andMicrosoft (X Box)
The Social Costs of Monopoly
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The Social Costs of Monopoly
Power
Monopoly power results in higher prices
and lower quantitiesHowever, does monopoly power make
consumers and producers in the
aggregate better or worse off?From a social point of view, the effects of
the monopolistic inefficiency can be
appreciated if we look at the Marshallssurplus
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Monopoly Dead Weight Loss
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Monopoly Dead Weight Loss
The DWL area measures the surplus that could
have been created with a competitive market,but goes loss due to level of the price which isfixed by the monopolist
The deadweight loss decreases with EDwhenthe elasticity is large, but it vanishes when thedemand is perfectly rigid, because in this case
moving prices simply correspond to a surplustransfer between firms and consumers
The determinants of Deadweight
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The determinants of Deadweight
loss
Assume constant marginal cost. The
deadweight loss associated with a monopolypricing is approximately equal to:
DWL = 1/2dPdQ
It can rewritten as:
=
P
P
Q
Q
P
P
dP
dPdPdQDWL
2
1
The determinants of Deadweight
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The determinants of Deadweight
loss
Since marginal cost is constant, dP= Pm-c, it results
Harbergers loss: the inefficiency of a monopoly isgreater the larger the elasticity of demand, the largerthe Lerner Index and the larger the industry(measured by industry revenues) however L is
inversely related to Ed
2
2
1LQPEDWL mmd=
The determinants of Deadweight
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The determinants of Deadweight
loss
Since for a monopolisitc firm L = 1/Ed
Loss in the US long distance telecomsmarket: entrants of RBOC into the long
distance market (mid 1990s) decreases thewelfare loss by $2.78 billion
22
1
2
1 2 =
==
m
mmmmm
dP
cPQPLQPEDWL
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Durable Goods Monopoly
A durable good is a good which provides
a stream of sustained consumptionservices: it can be used more than once.
Two complicating factors:
Monopoly creates its own competition! Theexistence of a second-hand market limitsmonopoly market power
The price consumers are willing to pay todaydepends on the expectations about the priceof the good tomorrow
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Durable Goods Monopoly
Assume that the good last forever and so
that it does not depreciate over time.Example: land
Competitive supply: the supply curve isfixed; supply and demand determine theequilibrium price for a lifetime
consumption. Alternatively, the price canbe transformed in a yearly rental price.
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Durable good in perfect competition
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Durable good in monopoly
The monopolist sets the marginal revenues
equal to the marginal cost (= 0) and determinethe first year consumption and price (Q1 and P1)
In the second period, the monopolist faces aresidual demand given by QcQ1 where
consumers have a willingness to pay larger thanmarginal costs but lower than P1.
In order to sell additional units of the good anduse its stock, the monopolists cannot do betterthan reducing the price up to the competitiveprice!
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Durable good in monopoly
Durable goods: the Coase
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g
conjecture
The monopolist has therefore the
incentive to practice intertemporal pricediscrimination: it increases its profitdecreasing prices over time.
Initially, monopolist only supplies thoseconsumers having a high willingness topay.
Then, the monopolist increases its profitby moving down the demand curve
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Durable goods and strategic actions
Strategic consumers: Incentives to delay purchasing if they anticipate that the
monopolist will lower prices in the future
Cost of waiting depends on the discount rate, i.e. on theactual cost of consumption tomorrow: the larger it is, thegreater the preference of consumers for a dollar today as
opposed to a dollar tomorrow. Assume that the adjusting period is very small and the
discount rate equal to 0 (the discount factor is equal to 1):a durable goods monopolist has no monopoly power if
the time between price adjustment is vanishingly small
the Coase Conjecture
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Durable goods and strategic actions
Strategies to mitigate the Coase Conjecture:
Firms might convince consumers that prices donot decrese over time thoughLeasing, since the good is returned to the firm
Investment in reputationnot to increase supply (ex
Disney movies)Limit capacity
New customers, i.e. expected increase in the demand
Planned obsolescence, decreasing the durability of its
good, and so enhacing the demand tomorrow keepingthe price high!
Durable goods and Pacman
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g
economics
Is it true that the monopoly always loose its
market power? No, it is the contrary, monopolycomes perfectsince the firm can now extract allsurplus from consumers!
Monopolistic firm only needs to move down the
demand selling to consumers sequentially inorder of their reservation prices : this is thePacman Strategy
This results is more likely when the number ofbuyer is finite and the willigness to pay ofconsumers highly differs.
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Durable goods: Coase vs. Pacman
Study by Von der Fehr and Kuhn (1996):
When the number of buyers is very large andthere are small differences in willingness topay, then Coase outcome is more likely
when the number of buyer is finite and thewilligness to pay of consumers highly differs,Pacman discriminatory outcome emerges.
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Natural Monopoly and
Government Intervention
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The Social Costs of Monopoly Social cost of monopoly is likely to exceed the
deadweight loss
No allocative efficiency, no incentive to minimize costX-inefficiency
Hickss statement: The best of all monopoly profit is aquite life!!
Rent Seeking Firms may spend to gain monopoly power Lobbying Advertising Building excess capacity
Dynamic efficiency? Shumpeter vs. Arrow approach onthe effect of the market structure on investment
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The Social Costs of Monopoly
Government can regulate monopoly
power through price regulationRecall that in competitive markets, price
regulation creates a deadweight loss
Price regulation can eliminate deadweightloss with a monopoly
Regulation vs. Competition policy
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CP attempts to avoid situation where market powercan be exploited; regulation deals with thesituation.
Prices/profits/quality are not usually explicitlycontrolled with CP
Regulation specifies precise details of what firmcan and cannot do (ex ante intervention); CPissues guidelines and uses precedent (ex post
intervention) Typically have sector-specific regulators, and a
generalist competition policy authority
If left alone, a monopolistproduces Q
mand charges P
m.
For output levels above Q1
,the original average and
marginal revenue curves apply.
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AR
MR
MCPm
Qm
AC
P1
Q1
Marginal revenue curvewhen price is regulatedto be no higher that P
1.
If price is lowered to PC
output
increases to its maximumQ
Candthere is no deadweight loss.
Price Regulation$/Q
Quantity
P2 = PC
Qc
Any price below P4resultsin the firm incurring a loss.
P4
The Social Costs of Monopoly
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Power
Natural Monopoly
A firm that can produce the entire output ofan industry at a cost lower than what it wouldbe if there were several firms
Usually arises when there are largeeconomies of scale
We can show that splitting the market into
two firms results in higher AC for each firmthan when only one firm was producing
Regulating the Price of a Natural
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MC
AC
AR
MR
$/Q
Quantity
Setting the price at Pr
giving profits as large aspossible without going
out of business
Qr
Pr
PC
QC
If the price were regulate to be Pc,
the firm would lose moneyand go out of business. Cant
cover average costs
Pm
Qm
Unregulated, the monopolistwould produce Q
mand
charge Pm
.
Monopoly
Some definitions on Natural Monopoly
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Single product contest: presence ofeconomy of scale, i.e. ATC should bealways decreasing
Is this definition sufficient also in a
multiproduct setting? NOT AT ALL!! In a multiproduct setting, given a vector of
quantities i= 1,.., n, the cost function C(.)
should be sub additive, i.e.
Some definitions on Natural Monopoly
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Sufficient conditions to have a naturalmonopoly in a multiproduct setting are:
Presence of economies of scope:C(q
1
,0) + C(0,q2
) > C(q1
,q2
)
Average incremental costs should be decreasing(Baumol, Panzar and Willig, 1982)
where IC1(q1,q2)= C(q1,q2) - C(0,q2)
C(0,q2) is the so called stand alone cost of product 2AIC= IC1(q1,q2)/q1
Questions that need to be addressed:
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Whether (and how) to privatise?
Whether to break up monopoly (or allowmergers)? Structural regulation(vertical or
horizontal separation)
Which parts of the industry to regulate?
Example: Telecommunications
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Local telephony
Long distance
tele hon
International
telephony
Internet
Mobile telephony
Naturalmonopoly
Example: Electricity market
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Production and Import
National Transmission
(high voltage)
Local transmission (lowvoltage
Final market
Natural
Monopolies
Example: Gas industry
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Production and Import
National transmission
Local transmission
Retail market
Natural
monopolies
Reserve in stock
Structural Regulation: the US example
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But then mergers among Baby Bells
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The current situation
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Conduct regulation: price control
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First best pricing: price equal to marginalcost (as in a perfect competitive
environment)
Public transfer to cover firms loss
P
Q
PAC
PCm
QCm
D
AC
C
QAC
m
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Demo: consumers have a quasi-linear utility
function Uh
= Rh
+ Sh
(p), such thatUh/p = Sh(p)/ p(no revenueeffect)
In a monoproduct setting:Maxp W= S(p) T+
where = pq(p) + T- C(q) F
Thus, W= S(p) + pq(p) - C(q) FDeriving w.r.t. p, we get: p= C(q)
Conduct regulation: price control
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In absence of any kind of transfer from
regulator to the firm, what could happen?The regulator should set prices in order to
let the firm reach its break even
Second best solution: price = AC
The average cost pricing rule
Conduct regulation: price control
Fi fi b h i l
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Firms profit are zero, but there is always adeadweigh loss (squared area in figure)
q
D
MC
AC
$
qAC
pAC
Conduct regulation: price control
M lti d t tti ti l th d f ll
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Multiproduct setting: practical methods, fullydistributed costs (FDC)
Suppose to have a cost function:
Price equal marginal cost leads to losses.How to cover them?
A rule to share the fixed cost Fshould bedefined by the regulator.
Conduct regulation: price control
F ll di t ib t d t (FDC) i h ld
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Fully distributed costs (FDC): price shouldcover not only direct (marginal) cost, but alsoa share of the fixed costs, i.e.
where fi is the so called cost driver:
=
=
=
=
Method)Costable(Attribuitif)(
Method)Output(Relativeif)(
Method)Revenues(Grossif)(
1
1
1
n
iii
n
i
ii
n
iii
i
CDCDc
QQb
RRa
f
Conduct regulation: price control/6
It i t h th t ll th th th d
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It is easy to show that all the three methodsabove described leads to define a equalmark up rule.
In fact:
Is this efficient?
Conduct regulation: price control
The answer is NO!
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The answer is NO!
A+B = Extra-revenues to cover fixed costC+D = deadweight loss!!
q q
MCMC
DR
DE
pp
A BC DA B
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How to minimize deadweight loss?
Mark up on prices should be different according to
the different demand structure of the goods:
Even if A+B = A + B, C+D< C+D
q q
MCMC
DR
DE
pE
pR
BD
A C
B
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Immagine that no public transfer could be used andij= 0
Regulator should set prices such that: MaxpiS(pi) + s.t. 0
Denoting with the lagrangian multiplier of the
constraint we have: L = S(pi) + (1+ ) = S(pi) + (1+ )(piqi C(qi))
What is ? It can be interpreted as the shadow price ofpublic funds.
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Optimal second best solutions: Ramsey-Boiteaux Pricing rule
i.e. the price-cost margin (in percentage ofprice) should be inversely related to the
price elasticity of demand:
ii
iii
p
cpL
1
1+=
=
i
i
i
ii
q
p
p
q
=
Cross subsidization
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In many Utilities, the price in some servicesare set lower than their marginal cost mainly
for distributional concerns.
Example: in Telecoms, USO implies thatprice for urban calls and the fixee fee havebeen set for long time below marginal cost,while long distance calls (national andinternational) have been set above costs inorder to recoup the losses on other services.
Cross subsidization
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Problem: cross subsitization could bestrategically used by the incumbent
operator in order to prevent entry in themarket or to induce exit of new entrants.
Potential anticompetitive behaviour:
incumbent could set price above cost in themonopolistic segment of the market (i.e.Local telephony), in order to reduce its pricein the more competitive ones (Longdistance or Internet)
Cross subsidization
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How to avoid or detect cross subsidization?
Faulhabers Test (1975).Two services (p1and p2).
I^ test on incremental cost:
p1q1IC1(q1,q2)= C(q1,q2) - C(0,q2)
p2q2IC2(q1,q2)= C(q1,q2) - C(q1,0)
Cross subsidization
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II^ test on incremental cost:
p1q1 C(q1,0)p2q2 C(0,q2)
If the two tests have success, then retail tariffs aresubsidy free. Otherwise, Incumbent could have setits tariffs anticompetitively, and so more scrutiny isneeded (from Competition or Regulatory Authority)