Monopoly and Imperfect Competition

- Why Should I Care?

Markets are not always perfect, and consumers sometimes pay too much for what they get. Producers will always try to “Cherry Pick” the best prices from consumers’ demand schedule.

- This Lecture Has 3 Parts

• Monopoly
• Oligopoly
• Monopolistic Competition

- What is Imperfect Competition?

Some markets are more competitive than others. The level of competition is actually one of the most important factors that ensures a fair transaction. Of course there are rules, and regulations, that protect both buyers and sellers. But when you are the only game in town, either the only buyer (monopsony), or the only seller (monopoly), then you have more power over the outcome of the transaction.

Most of the time, there are way more buyers than sellers, so the monopoly is naturally the hot-ticket issue for consumer's interests. Health competition will ensure fair prices, but also fair treatment of clients, including quality of the product and post-transaction product service and support.

What makes an imperfect market? In simple terms, the number of producers determines the level of competition. One supplier is a monopoly, two producers is a duopoly, and three to eight producers is considered an oligopoly.

Why can this be a problem? When competition is low, suppliers can increase prices to increase their profits. We assume suppliers will always try to sell at the highest price possible, hoping to maximize revenues. Four reasons explain this: production and keeping inventory always entails some level of risk, suppliers can be greedy, they may have increasing costs, or they may have other, more profitable ventures they would prefer to pursue.

• Monopoly

In the case of a monopoly, there is only one producer. In Latin, monopolium stems from mono (one), and polein, which means to sell. One company is now the only seller.

This producer can “cherry pick” the price-quantity combination that best suits him. The supplier compares the demand schedule to his costs. A monopolist will move supply to match the level of demand for a given price. By reducing supply (Qs), the monopolist can increase the price. Of course, his overall sales will drop, so its up to the monopolist to figure out the optimal combination of quantities, and price, to maximize his revenues.

There are no shortages or surplus in the monopoly scenario. The producer matches his Qs with the Qd he prefers. He picks a price-quantity combination that maximizes his revenues, or his profits (you can look into this in a more advanced course of micro-economics). The monopolist can move the supply to match the demand. This being said, the firm has to live with the parameters set by consumers. You can’t force people to buy more product and increase the price.

There is no supply curve, because that curve represents other suppliers coming to the market when the price is high (among other things). In this case, there are no other suppliers.

Scenario: The 100 villagers of VillageTown like ice-cream. But there is no ice-cream to be found. One of the older villagers, Grandma Jones, has an ice-cream machine and would like to try herself at this market. She buys her cream from the grocery store. She knows it costs her 1.50 $ to produce one tub of ice-cream. She also likes to keep some time off to play bridge with her friends. She does not know what else to do with her time though…

Costs    = fixed costs                 + variable costs + opportunity cost

            = kitchen equipment    + ingredients     + not playing bridge

If she’s wise, she will ask around and estimate how much people are ready to pay for ice-cream. She will also research how much ice-cream sells for in other villages. She draws a demand curve. She then has to decide how much to produce.

Ice-Cream Monopoly in VillageTown

Situation	Price	Quantity demanded (tubs/week)	Potential Spending ($)
A	6	100	600
B	5	250	1250
C	4	300	1200
D	3	400	1200
E	2	500	1000

Grandma Jones looks at the demand schedule and she thinks: If I make 250 tubs, I can sell them for 5 $ each and receive 1,250 $ per week. Why make 300 or 400 tubs for a lower revenue?

Grandma Jones is so evil!

Let's look at it on the graph.

She cherry picks situation B, where the price (5 $) and quantity (250) from the demand schedule maximize her sales at 1,250 $.

Which situation would be better for the consumers? Situation E, of course! The villagers would love to have 500 tubs of ice cream for 2 dollars, each week.

There are several reasons why a monopoly would exist. Sometimes, a company will benefit from industrial consolidation. This is a process that takes years, but can be very effective. In mature industries, the larger companies will buy smaller ones, to reduce the number of players in the market. In its final stages, consolidators will shut down production capacity to reduce supply and increase prices. A famous consolidator is General Motors, Corp. whose strategy worked rather well until competition rose from Japan and South Korea.

Another reason for monopolies is being innovative. If you are first-to-market, it takes some time before the competition can even start to produce. Companies often use patents to protect their inventions, which allows them to be a monopoly for up to 20 years. Pricing a new product can be difficult, since there are notno baselinecomparable comparisons.products on the market. How do you decide what the price of the iPad will be, before anyone even knows what an iPad is?

First, you have to estimate a demand curve for a product people don’t even know. Second, you have to calculate the optimal price, which will maximize your sales revenues. Later, when competition arises on this new market, you will have to adjust your pricing to the open-market price.

• Oligopoly

In this scenario, there are usually half a dozen suppliers, who produce identical products (commodities) such as lumber, gas, or paper. They can be very competitive, or they could collaborate, which is called collusion, to the expense of consumers. Economists are not quite sure why some industries compete, and others collude. Ironically, if competition is too strong, and one of the players goes bankrupt, the industry consolidates and may then become less competitive.

A) Collusion.
In this situation, producers collude and act as one producer. We call this a cartel. Usually, they agree not to compete on each other's exclusive territory, or in specific niche markets. Acting as one, as a monopoly, they “cherry pick” the most lucrative price-quantity combination. There is no supply curve in this scenario.

Examples of cartels (who were caught) include flat-screen TV manufacturers in Korea and Japan, the Montreal construction industry, and gasoline distribution in Central Quebec.

http://www.taipeitimes.com/News/biz/archives/2006/12/13/2003340302

B) Competition.
In this situation, producers are competitive. You will see price differences, and each company will be present on each other's territory. If prices were to increase, the producers could not stop each other from increasing quantities supplied. They also could not stop new producers from entering the market. There is a supply curve because each player can't control the other players.

Examples of competitive oligopolies include mining companies, cable-TV service and cell phone service.

In VillageTown, a cartel could form if Grandma Jones’ bridge partners decide they want to join the industry and corner the market by setting prices when they meet for their weekly bridge game.

• Monopolistic Competition

There is a third form of imperfect competition that accurately depicts many of our industries. It applies to a completely different set of products, those that are differentiated in an important way. For example, the iPad is not a regular laptop. Apple had a monopoly on this product for its first year on the market (2010). However, the iPad is a close substitute to laptops and smartphones, so Apple cannot overcharge for this product.

In this scenario, only one supplier exists, because the product is sufficiently different that it has created its own market (niche market). But other products are possible substitutes, and so the niche market prices are limited to an implicit ceiling. The supplier can cherry-pick the optimal price-quantity combination, but with a very strict price ceiling imposed by substitution. The concept of monopolistic competition was originally proposed by the British economist Joan Robinson.

In VillageTown, an example of this would be if one of Grandma Jones’ bridge partners decided to invent a new product, such as frozen yogurt. They would enjoy a small monopoly position, but couldn’t corner the market so much because people could easily go back to ice-cream if the price of frozen yogurt was too high.

- Wrap-Up

Markets are often imperfect, as suppliers use the demand curve to “cherry pick” the price-quantity combination that maximizes their revenues (sales).

Even if markets are imperfect, most of them are still relatively competitive. This does not mean the government does not have to regulate against cartels and monopolies.

- Cheat Sheet

Monopoly:
A lone supplier that “cherry picks” the price-quantity combination that maximizes his revenues.

Oligopoly:
A small group of suppliers producing a commodity (non-differentiated product).

Cartel:
An oligopoly with collusion to fix prices and quantities at levels desired by the suppliers.

Monopolistic Competition:
A monopolist on a niche market. He cannot maximize his revenues because there is competition from substitute products (similar, but differentiated product).

- References and Further Reading

Marshall, A. (1890). Principles of Economics.

Robinson, J. (1933). The Economics of Imperfect Competition.