Markets comprises of products or services, buyers and sellers. Where as in a perfectly competitive market there will be a reasonably good number of buyers and sellers of the products or services. So the possibility of influencing the market by a single seller or buyer is nil. Depending upon the supply and demand prices will be determined. Market price and demand is the deciding factor of the companies to estimate how much to produce and sell, in consumers view it is a deciding factor how much to buy.
In contrary to the case which was discussed above, if the market is not a perfectly competitive market then the situations of monopoly and monopsony arise. Monopoly market is the one which has only one seller but so many buyers. Monopsony market is the one which has only one buyer and so many sellers. Monopolist is the sole producer of a product, in market demand curve, price is determined by the quantity which is offered by the monopolist to sell, the quantity of produce sold by monopolist is low and the price is high, it happens because his products has full demand and he wants to take full advantage in this situation.
Normally if the price is high, only a few buyers which have the potential to buy those goods will turn towards the seller. Pure monopoly is a bit rare but in actual existing market, in many sectors only a few sellers available. This gives an advantage to them because their scarcity, if these sellers syndicate then it would lead to stronger monopoly and they gain the monopoly power and have a firm control over selling price this tends them to enjoy higher margins and better profitability.
In monopsony, a single buyer is available for a lot of sellers. In this price determination is in the hands of buyer depending upon the quantity that he/she purchases. Monopsonists main goal is to buy as much quantity as possible by paying less amount of money, pure monopsony is unusual, but in many markets this occurs, they pay less than what they could be paying in a competitive market, this gains the buyer in this situation buyer attains the monopsony power.
Market power has two forms namely monopoly and monopsony, it is the ability by a seller or buyer to affect the price of a good or service, even in a competitive market, market power exists to at least some extent because no one wants to lose the buyer. MONOPOLY: As monopolist is the only one in the market who produces a product, he has the free will to change his selling policy whether to increase or decrease the selling price of a product or service. As the aim of an individual is to maximize profit, this can be achieved only when he raises the price.
So, normally price will be higher in a monopoly market when compared to a competitive market. Monopolist determines the price of a product only by its demand and costs associated with those products. So possessing some knowledge over these two aspects is crucial in deciding the price of a product. CONCEPT OF MARGINAL AND AVERAGE REVENUE: Average revenue is the price which it receives per unit sold, marginal revenue is the change in revenue that results from a unit change in output, in order to make more profits marginal revenue should be high. These aspects can be understood clearly with the help of a demand curve.
The following table shows the behavior of total, average and marginal revenues for a demand curve, revenue is zero when price is 6 because at that price nothing is sold. However at a price of 5 one unit is sold, and then total (and marginal) revenue is 5. An increase in quantity sold from 1 to 2 increases revenue from5 to 8. So that the marginal revenue is 3. As the quantity sold increases from 2 to 3, marginal revenue falls to 1, and when it increases from 3 to 4, marginal revenue becomes negative, when marginal revenue is positive, revenue is increasing with quantity, but when marginal revenue is negative, revenue is decreasing.
When the demand curve is downward sloping, the price (average revenue) is greater than marginal revenue because all units are sold at same price. To increase sales by 1 unit. , the price must fall, so that all units sold, not just the additional unit, earn less revenue. In the following table output is increased from 1 to 2 units, and price is reduced to 4. Marginal revenue is 3: 4 (the revenue from the sale of the additional unit of output) less 1 (the loss of revenue from selling the first unit for 4 instead of 5). Thus, marginal revenue (3) is less than price (4).
TABLE: Price (P)| Quantity (Q)| Totalrevenue( R )| Marginal revenue (MR)| Average revenue (AR)| 6| 0| 0| -| -| 5| 1| 5| 5| 5| 4| 2| 8| 3| 4| 3| 3| 9| 1| 3| 2| 4| 8| -3| 2| 1| 5| 5| -1| 1| per unit of 6 output 5 4 Average revenue (demand) 3 2 Marginal revenue 1 0 1 2 3 4 5 6 output Demand curve is a straight line, in this case marginal revenue curve has twice the slope of the demand curve and the same intercept. HOW MUCH TO PRODUCE BY A MONOPOLIST? A firm must set the output to maximize the profit when marginal revenue is equal to marginal cost.
In market demand curve D is monopolists average revenue curve, it specifies price per unit that monopolist receives as a function of its output level; the corresponding marginal curve shows marginal cost(MC) and average cost(AC). Marginal revenue and marginal cost are equal at the quantity corresponding to quantity Q, price P is determined. If a monopolist produces a smaller quantity Q1, he gets corresponding higher price P1. If he produces a little higher than Q1, he receives extra profit (MR-MC). So by increasing the output to much more extent the profit gained by him is higher.
So smaller quantity Q1 doesnt give much profit even though it earns high price. The larger quantity Q2 doesnt make much profit because marginal cost here exceeds marginal revenue. So if monopolist decides to produce a bit less than Q2 then it yields good profit (MC-MR), he could gain much more profit by decreasing Q2 to Q, Q maximizes profit, profit ? is the difference between revenue and cost, both are dependent on Q. ?(Q) = R(Q) C(Q) If Q is increased from zero; profit increases and reaches to maximum extent and then it decreases, thus profit maximizing Q should be in an incremental form resulting small increase in Q is just zero.
?? / ? Q = ? R/ ? Q ? C/ ? Q = 0 ? R/? Q is marginal revenue; ? C/? Q is marginal cost. Profit maximizing condition is MR-MC=0 or MR=MC. EXAMPLE: Cost of production is C(Q) = 50+Q2. Fixed cost of 50 and variable cost is Q2, demand is given by P(Q)-40-Q By setting marginal revenue equal to marginal cost, it is verified that profit is maximized when Q=10, corresponds to price of 30. Cost, revenue and profit is plotted in figure 1. when a company produces little or nothing, profit is negative because of fixed cost. Profit increases as Q increases, until it reaches a maximum of 150 at Q=10 and then decreases as Q is increased further.
And at the point of maximum profit, the slopes of the revenue and cost curves are the same. The slope of the revenue curve is ? R/ ? Q, or marginal revenue, and the slope of the cost curve is ? C/ ? Q, or marginal cost. Profit is maximized when marginal revenue equals marginal costs, so the slopes are equal. Figure 2 shows the corresponding average and marginal revenue curves. Marginal revenue and marginal cost intersect at Q=10. At this quantity, average cost is 15 per unit and price is 30 per unit, so average profit is 30 15 = 15 per unit.
Since 10 units are sold, profit is (10) (15) = 150, the area of the shaded rectangle. 400 300 c r 200 150 100profit 50 0 5 10 15 20 quantity FIGURE 1 /Q MC 40 30 AC 20 profit 15 AR 10 MR 5 10 15 20 QUANTITY FIGURE 2 A rule of thumb for pricing: The marginal revenue must be equal to marginal cost, both of which are based on price and output of the firm. But managers have limited knowledge of average and marginal revenue curves their firms face. So, we should translate the condition that marginal revenue should be equal to marginal cost into a rule of thumb and that can be applied easily in practice.
To do so, equation on marginal revenue can be rewritten as, MR= ? R? Q =? PQ? Q Extra revenue from incremental production of new unit ? (PQ)/? Q includes two components. Producing an extra unit and selling it at price P. But downward sloping demand curve decreases price of an unit by ? P/? Q per unit. Thus, MR=P+ ? P? Q = P+P(? P? Q)(QP) We know that elasticity of demand Ed is defined as (P/Q) (? Q/? P), So we can rewrite above equation as MR= P+P(1Ed) As firms aim is to maximise profits, marginal revenue can be set as marginal cost. So, MC = P+P(1Ed) Which can be rearranged to give P-MCP = -1Ed.
The above equation is a rule of thumb for pricing. The lefthand side of equation is markup over marginal cost as a percentage of price. We can rearrange above equation to express price as markup over marginal cost, P= MC1+(1Ed) Shifts in Demand: In a competitive market Supply curve indicates the relation between price and quantity supplied at different prices. But monopolistic market has no supply curve, which means that there is no one to one relation between price and quantity produced. This is because monopolistic output decision depends not only on marginal cost but also on shape of demand curve.
So shift in demand curve can lead to change in price with no change in output, change in output with no change in price or change in both. It is illustrated in figures below, MCMC P1 P2D2 P1=P2D2 MR2 MR2 D1 D1 MR1MR1 Q1=Q2 Q1Q2 QuantityQuantity Figure 10. 4a Figure 10. 4 Fig. 10. 4a Shift in demand curve leads to change in price but same output: Demand curve shifts from D1 to D2. But new MR curve, MR2 intersects at the same point as old MR curve, MR1 did on MC curve. So, profit maximizing output remains same though the price falls from P1 to P2. Fig. 10.
4b Shift in demand curve leads to change in output but same price: New MR curve, MR2 intersects at the higher point than old MR curve, MR1 on MC curve. But demand is more elastic now, price remains same. The Effect of a Tax: Tax has a different effect on monopolistic market than on competitive market. Price, sometimes may rise above the amount of tax. Suppose Rs n were imposed as tax by government. So a firm has to give Rs n for every unit it sells. So firms MC is increased by Rs n. The production decision now is given by, MR-MC+n Graphically, we shift the MC curve upwards by n and find the new intersection point with MR.
In fig 10. 5 Q0 and P0 are quantity and price before tax and Q1 and P1 after tax. Shifting MC curve upwards results in smaller quantity and higher price. In the fig 10. 5 price increased by more than tax, because in monopoly, the relationship between price and MC depends on Ed. P1 MC+W MC P0D=AR MR Q1Q2Quantity Fig. 10. 5 :Effect of excise tax on Monopolist: With tax w per unit, the firms effective marginal cost is increased by w to MC+W. The Multiplant Firm: Many firms produce goods in more than one plant. Operational costs differ from plant to plant. Profit is maximized when MC equals MR.
But output levels are decided treating each plant as a single plant firm. The amount of output to be produced is decided in two intuitive steps. Firstly, the total output should be divided equally between all plants so that MC is equal for each plant. Secondly, the total output be such that MR equals MC. Otherwise firm could increase total output by increasing or lowering total output. For a two plant firm, let Q1, C1 be the quantity and cost of production of plant 1 and Q2,C2 are of plant 2. Then, QT= Q1 + Q2 (QT is total quantity) and Profit, W = P (QT)-(Q1* C1)-(Q2* C2).
Firm should increase output from each plant until incremental profit from last unit produced is zero. It can be written as, ? W? Q1=? (PQT)? Q1-? C1? Q1 = 0 Here, ? (PQT)? Q1 is revenue from producing and selling additional unit i. e. Marginal revenue for entire firm. ?C1? Q1 is Marginal Cost for plant 1. So, we have MR-MC1=0 or, MR= MC1 and similarly we can obtain, MR= MC2 Putting together, MR= MC1 = MC2 MC2 MC1MCT P* D=AR MR*MR Q1 Q2 QT Quantity Fig. 10. 6 Production with two plants: MC1 and MC2 are marginal costs of plants 1 and 2 respectively.
MCT is total marginal cost and is obtained by summing MC1 and MC2 horizontally. Total output QT determines firms marginal revenue but Q1 and Q2 determine marginal costs at each of the two plants. Monopoly Power Pure monopoly is rare. Markets in which several firms compete with one another are much more common. Suppose, for example, that four firms produce toothbrushes, which have the market demand curve shown in Figure 10. 7a. Lets assume that these four firms are producing an aggregate of 20,000 toothbrushes per day (5000 per day each), and selling them at 1. 50 each.
Note that market demand is relatively inelastic; you can verify that at this 1. 50 price, the elasticity of demand is -1. 5. Now suppose that Firm A is deciding whether to lower its price to increase sales. To make this decision, it needs to know how its sales would respond to 200? 200 ? Rs/Q Market Demand /Q 1. 60 MCA 1. 50 1. 50 1. 40 DA 1. 00 1. 00 MR4 10,000 20,000 30,000 Quantity 3,000 5,000 7,000 Q a (a) (b) FIGURE 10. 7a Market Demand for Toothbrushes. FIGURE 10. 7b Demand for Toothbrushes as Seen by Firm A. At a market price of 1. 50, elasticity of . market demand is -1.
5. Firm A, however, sees a much more elastic demand curve DA because of competition from other firms. At a price of 1. 50, Firm As demand elasticity is -6. Still, Firm A has some rnonopoly power. Its profit-maximizing price is 1. 50, which exceeds marginal cost. A change in its price. In other words, it needs some idea of the demand curve it faces, a5 opposed to the market demand curve. A reasonable possibility is shown in Figure 10. 7b, where the firms demand curve DA is much more elastic than the market demand curve. (At the 1. 50 price the elasticity is -6. 0.).
The firm might anticipate that by raising price from 1. 50 to 1. 60, its sales will drop, say, from 5000 units to 3000, as consumers buy more toothbrushes from the other firms. (If all firms raised their prices to 1. 60, sales for Firm A would fall only to 4500. ) But for several reasons, sales wont drop to zero, as they would in a perfectly competitive market. First, Firm As toothbrushes might be a little different from its competitors; o some consumers will pay a bit more for them. Second, the other firms might also raise their prices. Similarly, Firm A might anticipate that by lowering its price from 1.
50 to 1. 40, it can sell more, perhaps 7000 toothbrushes instead of 5000. But it will not capture the entire market. Some consumers might still prefer the competitors tooth blushes, arid the competitors might also lower their prices. So Firm As demand curve depends on how much its product differs from its competitors products and on how the four firms compete with one another. One important point should be clear: Firm A is likely to face a demand curve that is more elastic than the market demand curve, but not infinitely elastic like the demand curve facing a perfectly competitive firm.
Given knowledge of its demand curve, how much should Firm a produce? The sane principle applies: The profit-maximizing quantity equates marginal revenue and marginal cost. In Figure 10. 7b that quantity is 5000 units, and the corresponding price is 1. 50, which exceeds marginal cost. This raises two questions. First, how can we measure monopoly power, so that we can compare one firm with another? (So far we have been talking about monopoly power only in qualitative terms. ) Second, what are the sources of monopoly power, and why do some firms have more monopoly power than others?
Measuring Monopoly Power Remember the important distinction between a perfectly competitive firm and a firm with monopoly power: For the competitive firm, price equals marginal cost; for the firm with monopoly power, price exceeds marginal cost. Therefore, a natural way to measure monopoly power is to examine the extent to which the profit-maximizing price exceeds marginal cost. In particular, we can use the markup ratio of price minus marginal cost to price that we introduced earlier as part of a rule of thumb for pricing.
This measure of monopoly power was introduced by economist Abba Lerner in 1934 and is called Lerners Degree of Monopoly Power: L=(P-MC)/P This Lerner index always has a value between zero and one. For a perfectly competitive firm, P == MC so that L = 0. The larger L is, the greater the degree of monopoly power. This index of monopoly power can also be expressed in terms of the elasticity of demand facing the firm. Using equation (10. 1), we know that L=(P-MC)/P= -1/Ed Remember, however, that Ed is now the elasticity of the firms demand curve, and not the market demand curve.
In the toothbrush example discussed above, the elasticity of demand for Firm A is -6. 0, and the degree of monopoly power is 1/6 = 0. 167. 6 Note that considerable monopoly power does not necessarily imply high profits. Profit depends on average cost relative to price. Firm A might have more monopoly power than Firm B, but might earn a lower profit because it has much higher average costs. The Rule of Thumb for Pricing P= (MC)/ (1+ (1/Ed)) A rule of thumb for any firm with monopoly power, if we remember that Ed is the elasticity of demand for the firm, and not the elasticity of market demand.
It is harder to determine the elasticity of demand for the firm than for the market because the firm must consider how its competitors will react to price changes. Essentially, the manager must estimate the percentage change in the firms unit sales that is likely to result from a 1 percent change in the price the firm charges. This estimate might be based on a formal model or on the managers intuition and experience. Given an estimate of the firms elasticity of demand, the manager can calculate the proper markup. If the firms elasticity of demand is large, this markup Rs/Q Rs/Q P*-MC P* MC P*-MC P* MR AR.
Q*QuantityQ*Quantity (a) (b) FIGURE 10. 8 Elasticity of Demand and Price Markup. The markup (P MC)IP is equal to minus the inverse of the elasticity of demand. If demand is ela5tic as in (a), the markup is small, and the firm has little monopoly power. The opposite is true if demand is inelastic, as in (b), will be small (and we can say that the firm has very little monopoly power). If the firms elasticity of demand is small, this markup will be large (and the firm will have considerable monopoly power). Figures 10. 8a and 10. 8b illustrate these two extremes. EXAMPLE 10. 1 MARKUP PRICING: SUPERMARKETS TO DESIGNER JEANS.
Three examples should help clarify the use of markup pricing. Consider a retail supermarket chain. Although the elasticity of market demand for food is small (about -I), several supermarkets usually serve most areas, so no single supermarket can raise its prices very much without losing many customers to other stores. As a result, the elasticity of demand for any one supermarket is often as large as -10. Substituting this number for Ed in equation (10. 2), we find P = MC/(1 0. 1) = MC/(0. 9) = (1. ll)MC. I11 other words, the manager of a typical supermarket should set prices about 11 percent above marginal cost.
For a reasonably wide range of output levels (over which the size of the store and the number of its employees will remain fixed), marginal cost includes the cost of purchasing the food at wholesale, together with the costs of storing the food, arranging it on the shelves, etc. For most supermarkets the markup is indeed about 10 or 11 percent. Small convenience stores, which are often open on Sundays or even 24 hours a day, typically charge higher prices than supermarkets. Why? Because a convenience store faces a less elastic demand curve. Its customers are generally less price sensitive.
They might need a quart of milk or a loaf of bread late at night, or find it inconvenient to drive to the supermarket. The elasticity of demand for a convenience store is about-5, so the markup equation implies that its prices should be about 25 percent above marginal cost, as indeed they typically are. The Lerner index, (P MC)/P, tells us that the convenience store has more monopoly power, but does it make larger profits? No. Because its volume is far smaller and its average fixed costs are larger, it usually earns a much smaller profit than a large supermarket, despite its higher markup.
Finally, consider a producer of designer jeans. Many companies produce jeans, but some consumers will pay much more for jeans with a designer label. Just how much more they will pay-or more exactly, how much sales will drop in response to higher prices-is a question that the producer must carefully consider because it is critical in determining the price at which the clothing will be sold (at wholesale to retail stores, which then mark up the price further for sale to their customers). With designer jeans, demand elasticitys in the range of -3 to -4 are typical for the major labels.
This means that price should be 33 to 50 percent higher than marginal cost. Marginal cost is typically 12 to 18 per pair, and the wholesale price is in the 18 to 27 range. EXAMPLE 10. 2 THE PRICING OF PRERECORD VIDEOCASSETTES During the mid-1980s, the number of households owning videocassette recorders (VCRs) grew rapidly, as did the markets for rentals and sales of prerecorded cassettes. Although many more videocassettes are rented through small retail outlets than are sold outright, the market for sales is large and growing. Producers, however, found it difficult to decide what price to charge for their cassettes.
As a result, in 1985 popular movies were selling for vastly different prices as the data for that year show in Table 10. 2. These price differences reflected uncertainty and a wide divergence of views on pricing by producers. The issue was whether lower prices would induce consumers to buy the videocassettes rather than rent them. Because producers do not share in the retailers revenues from rentals, they should charge a low price for cassettes only if that will induce enough consumers to buy them. TABLE 10. 2 The Prices of Videos in 1985 and 1993 19851983.
TITLE| RETAIL PRICE| TITLE| RETAIL PRICE| Purple Rain| 29. 98| Batman Returns| 19. 95| Raiders of the Lost Ark | 24. 95| Lethal Weapons| 17. 95| Jane Fonda Workout| 59. 95| Terminator| 17. 95| The Empire Strikers| 79. 98| Beauty and the Beast| 19. 95| An Officer and A Gentleman| 24. 95| Teenage Mutant Ninja Turtle Movie| 14. 95| Star Trek: The Motion Picture | 24. 95| Home Alone| 17. 95| Star Wars| 39. 98| Aladdin| 17. 95| Because the market was young, producers had no good estimates of the elasticity of demand, so they based prices on hunches or trial and error.
As the market matured, however, sales data and market research studies put pricing decisions on firmer ground. They strongly indicated that demand was elastic and that the profit-maximizing price was in the range of 15 to 30. As one industry analyst said, People are becoming collectors. . . . As you lower the price you attract households that would not have considered buying at a higher price point8, And, indeed, as Table 10. 2 shows, by 1993 most producers had lowered prices across the board. As a result, sales and profits increased.
Sources of Monopoly Power monopoly power is the ability to set price above marginal cost, and the amount by which price exceeds marginal cost depends inversely on the firms elasticity of demand. If the demand curve is less elastic , the monopoly power a firm is more. The ultimate determinant of monopoly power is therefore the firms elasticity of demand. Some firms (e. g. , a supermarket chain) face a demand curve that is more elastic, while others (e. g. , a producer of designer clothing) face one that is less elastic. Three factors that determine a firms elasticity of demand are i)The elasticity of market demand.
The firms own demand will be at least as elastic as market demand, so the elasticity of market demand limits the potential for monopoly power. ii)The number of firms in the market. If there are many firms, it is unlikely that any one firm will be able to affect price significantly. iii)The interaction among firms. Even if only two or three firms are in the market, each firm will be unable to profitably raise price very much if the rivalry among them is aggressive, with each firm trying to capture as much of the market as it can. Examining each of these three determinants of monopoly power:
The Elasticity of Market Demand In case if there is only one firm which is a pure monopolist then its demand curve is same as the market demand curve. Then the firms degree of monopoly power depends completely on the elasticity of market demand. More often, however several firms compete with one another; then the elasticity of market demand sets a lower limit on the magnitude of the elasticity of demand for each firm. example : soap producers The market demand for soaps might not be very elastic, but each firms demand will be more elastic. How much more depends on how the firms compete with one another.
But no matter how the firms compete, the elasticity of demand for each firm could never become smaller in magnitude than -1. 5. The demand for oil is fairly inelastic (at least in the short run), which is why OPEC could raise oil prices far above marginal production cost during the 1970s and early 1980s. The demands for such commodities as coffee, cocoa, tin, and copper are much more elastic, which is why attempts by producers to cartelize those markets and raise prices have largely failed. In each case, the elasticity of market demand limits the potential monopoly power of individual producers. The Number of Firms
Monopoly power, is the number of firms in the market. The monopoly power of each firm will fall as the number of firms increases. As more and more firms compete, each firm will find it harder to raise prices and avoid losing sales to other firms. What matters is, not just the total number of firms, but the number of major players. For example, if only two large firms account for 90 percent of sales in a market, with another 20 firms accounting for the remaining 10 percent, the two large firms might have considerable monopoly power when only a few firms account for most of the sales in a market the market is highly concentrated.
An increase in the number of firms can only reduce the monopoly power of each firm. An important aspect of competitive strategy is to create barriers to entry of new competitors. For example, one firm may have a patent on the technology needed to produce a particular product. This makes it impossible for other firms to enter the market, at least until the patent expires. A copyright can limit the sale of a product to a single company, and the need for a government license can prevent new firms from entering the market. Finally, economies of scale may make it too costly for more than a few firms to supply the entire market.
In some cases the economies of scale may be so large that it is most efficient for a single firm to supply the entire market. The Interaction among Firms Interaction of competing firms is also an important determinant for monopoly power. Suppose there are four firms in a market. They might compete aggressively, undercutting one anothers prices to capture more market share. This would probably drive prices down to nearly competitive levels. Each firm will be afraid to raise its price for fear of being undercut and losing its market share, and thus it will have little or no monopoly power. On the other hand, the firms might not compete much.
They might even violate antitrust laws agreeing to limit output and raise prices. Rising prices together rather than individually is more likely to be profitable, so collusion can generate substantial monopoly power. Monopoly power is smaller when firms compete aggressively and is larger when they cooperate A firms monopoly power often changes over time, as its operating conditions, its behaviour, and the behaviour of its competitors change. Monopoly power must therefore be thought of in a dynamic context. The market demand curve might be very inelastic in the short run but in much more elastic in the long run.
Real or potential monopoly power in the short run can make an industry more competitive in the long run. Large short-run profits can induce new firms to enter an industry, thereby reducing monopoly power over the longer term. Example: This is the case with oil, which is why OPEC had considerable short-run but less long run monopoly power. 10. 4 The Social Costs of Monopoly Power In a competitive market, price equals marginal cost, while monopoly power implies that price exceeds marginal cost. Because monopoly power results in higher prices and lower quantities produced, we would expect it to make consumers worse off and the firm better off.
To maximize profit, the firm produces at the point where marginal revenue equals marginal cost, so that the price and quantity are Pm and Qm. In a competitive market, price must equal marginal cost, so the competitive price and quantity, Pc and Qc, are found at the intersection of the average revenue curve and the marginal cost curve. Because of the higher price, those consumers who buy the good lose surplus of an amount given by rectangle A. Those consumers who do not buy the good at price Pm but will buy at price Pc also lose surplus, of an amount given by triangle B. The total loss of consumer surplus is therefore A + B.
The producer however, gains rectangle A by selling at the higher price but loses triangle C, the additional profit it would have earned by selling Qc Qm at price Pc. The total gain in producer surplus is therefore A C. Subtracting the loss of consumer surplus from the gain in producer surplus, we see a net loss of surplus given by B + C. This is the deadweight loss from monopoly power. Even if the monopolists profits were taxed away and redistributed to the consumers of its products, there would be inefficiency because output would be lower than under competition. The deadweight loss is the social cost of this inefficiency.
There may be an additional social cost of monopoly power that goes beyond the deadweight loss in triangles B and C. The firm may spend large amounts of money in a socially unproductive way to acquire, maintain, or exercise its monopoly power The economic incentive to incur these costs should bear a direct relation to the gains to the firm from having monopoly power. Therefore, the larger the transfer from consumers to the firm , the larger the social cost of monopoly. Rs/Q Lost consumer surplus Dead weight loss PmMC A B PC C AR MR Qm Qc Quantity FIGURE 10. 9 Deadweight Loss from Monopoly Power.
Price Regulation Because of its social cost, antitrust laws prevent firms from accumulating excessive amounts of monopoly power. Examining another means by which society can limit monopoly power-price regulation. In a competitive market price regulation always results in a deadweight loss. However, when a firm has monopoly power, On the contrary price regulation can eliminate the deadweight loss that results from monopoly power. Figure 10. 10 illustrates price regulation. Pm and Qm are the price and quantity that result without regulation. Now suppose the price is regulated to be no higher than P1.
Since the firm can charge no more than P1 for output levels up to Q1, its new average revenue curve is a horizontal line at P1. For output levels greater than Q1, the new average revenue curve is identical to the old average revenue curve because at these output levels the firm will charge less than Pi, and so it would be unaffected by the regulation. $/QMR MC PmMarginal revenue curve P1 P2-P1 AC P3 AR P4 Qm Q1 Q3 Q2 Q3 FIGURE 10. 10 Price Regulation. The firms new marginal revenue curve corresponds to its new average revenue curve, and is shown by the gray-shaded line in the figure.
For output up to Q1, marginal revenue equals average revenue. For output greater than Q1, the new marginal revenue curve is identical to the original curve. The firm will produce quantity Q1 because that is where its marginal revenue curve intersects its marginal cost curve. You can verify that at priceP1 and quantity Q1 the deadweight loss from monopoly power is reduced. As the price is lowered further, the produced quantity continues to increase and the deadweight loss to decline.