1.6: Monopoly II: Consequences

# 1.6: Monopoly II: Consequences
## ECON 326 · Industrial Organization · Spring 2020
### Ryan Safner Assistant Professor of Economics <a href="mailto:safner@hood.edu"> safner@hood.edu</a> <a href="https://github.com/ryansafner/IOs20"> ryansafner/IOs20</a> <a href="https://IOs20.classes.ryansafner.com"> IOs20.classes.ryansafner.com</a>

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# Social Consequences of Monopoly

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# Perfectly Competitive Market: Takeways

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- In a .hi[competitive market] in .hi[long run equilibrium]:
  - .hi-purple[Economic profit] is driven to $0
  - .hi-purple[Allocatively efficient]: `$p=MC(q)$`, maximized .blue[CS] `$+$` .red[PS]
  - .hi-purple[Productively efficient]: `$p=AC(q)_{min}$` (otherwise firms would enter/exit)

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# The Bad of Monopoly: DWL I

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- Consider a market with some simplified cost assumptions:
  - No fixed costs
  - Constant variable costs `$2q$`
    - implies `$MC(q)=AC(q)=2$`

- If this was a *competitive* market, firms would set `$p=MC(q)$` and produce 8
  - .blue[Consumer surplus] maximized
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# The Bad of Monopoly: DWL II

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- A **monopolist** faces the *entire* market demand and sets `$(q^m,p^m)$`:
  - Sets .purple[`\$MR(q)\$`] `$=$` .red[`\$MC(q)\$`] at **4**
  - Raises price to .blue[maximum consumers are WTP (Demand)]: **$6**

- .hi-purple[Restricts output and raises price], compared to competitive market

- Earns .hi-green[monopoly profits (`\$p>AC\$`)]

- Loss of .hi-blue[consumer surplus]

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# The Bad of Monopoly II

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- **Deadweight loss** of surplus destroyed from lost gains from trade
  - Consumers willing to buy more than 4 units for lower prices!
  - Monopolist willing to accept lower prices to sell more, but would earn *less* total profits this way

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# The Bad of Monopoly: X-Inefficiency

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> "The best of all monopoly profits is a quiet life" - Sir John Hicks

- Monopoly may generate .hi["X-inefficiency"]

- Lack of competition causes monopoly to be **complacent** or **lazy**
  - May inefficiently .orange[raise costs] of production

- Creates further distortions (lost surpluses)

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# The *Ugly* of Monopoly: Rent-Seeking I

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- The .hi-green[monopoly profits] earned with market power are an .hi[economic rent]
  - This is the "prize" of market power

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# The *Ugly* of Monopoly: Rent-Seeking II

- Think of an .hi[economic rent] as a "prize," the payment a person receives for a good above its opportunity cost

- Creating rents creates competition for the rents, causing people to invest resources in .hi[rent-seeking]

- The cost of the rent is not just the rent itself, but the resources invested in rent-seeking!
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# Government Intervention Creates Rents I

- Political authorities intervene in markets in various ways that benefit some groups at the expense of everyone else
  - subsidies to groups (often producers)
  - regulation of industries
  - tariffs, quotas, and special exemptions from these
  - tax breaks and loopholes
  - conferring monopoly and other privileges
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# Government Intervention Creates Rents I

- These interventions create .hi[economic rents] for their beneficiaries by reducing competition

- This is a transfer of wealth from consumers/taxpayers to politically-favored groups

- The promise of earning a rent breeds **competition over the rents** (.hi[rent-seeking])

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# Rent-Seeking II

Gordon Tullock

1922-2014
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> "The rectangle to the left of the [Deadweight loss] triangle is the income transfer that a successful monopolist can extort from the customers. **Surely we should expect that with a prize of this size dangling before our eyes, potential monopolists would be willing to invest large resources in the activity of monopolizing.** ... **Entrepreneurs should be willing to invest resources in attempts to form a monopoly** until the marginal cost equals the properly discounted return," (p.231).

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.source[Tullock, Gordon, (1967), "The Welfare Cost of Tariffs, Monopolies, and Theft," *Western Economic Journal* 5(3): 224-232.]

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# Antitrust

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# Antitrust and Competition Law I

- Aren't monopolies illegal in the U.S.?

- **Yes**: engaging in anticompetitive practices in the U.S. is illegal under .hi[antitrust laws]
  - Laws intended to promote economic competition and reduce excessive market power
  - enforced by DOJ (criminal) and FTC (civil)

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![:scale 45%](https://www.dropbox.com/s/zwc6kgdwe1nksct/ftc.png?raw=1)

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# Antitrust and Competition Law II

- Aren't monopolies illegal in the U.S.?

- **No**: most monopolies exist *because* of explicit or implicit government-backing
  - Some markets actually work *better* as a monopoly (**"the good"**, .hi-purple[natural monopoly], patents, etc.)
  - Some markets and regulators are .hi-purple[captured] via **rent-seeking** firms to block competition (**"the ugly"**)

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# Antitrust and Competition Law III

**Sherman Antitrust Act (1890)**
.smallest[
 > `$\S$` 1: "Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal."

> `$\S$` 2: "Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony [...]"
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# Antitrust and Competition Law IV

Source: [WSJ (Jan 23, 2017)](http://www.wsj.com/articles/federal-judge-blocks-aetna-humana-merger-on-antitrust-grounds-1485190239)
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- Mergers, acquisitions, and major corporate activities are scrutinized by DOJ and FTC on antitrust grounds
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# Sources of Market Power

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# Control Over a Key Resource

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# Control Over a Key Resource I

![:scale 75%](https://www.dropbox.com/s/7ztods3nn9078wu/alcoa2.jpg?raw=1)
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- Being one of the largest providers of a resource where there are few substitutes

- Aluminum Company of America (Alcoa) once controlled 90% of the market for bauxite (used to create aluminum), and produced 63% of world aluminum supply

- United States v. Alcoa 148 F.2d 416 (2d Cir. 1945)

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# Control Over a Key Resource II

![:scale 75%](https://www.dropbox.com/s/9inyyd3o1np3vly/debeersdiamonds.jpg?raw=1)
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- De Beers once owned 85% of the world's diamond supply

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# Control Over a Key Resource: Inventors?

- What about inventors and new products?

- Every first producer enjoys monopoly power...for a time

- Eventually, new entrepreneurs find a way to compete and **enter** the market with *substitutes*

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# Control Over a Key Resource: Inventors?

- What about inventors and new products?

- Every first producer enjoys monopoly power...for a time

- Eventually, new entrepreneurs find a way to compete and **enter** the market with *substitutes*

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# Control Over a Key Resource: Inventors?

- What about inventors and new products?

- Every first producer enjoys monopoly power...for a time

- Eventually, new entrepreneurs find a way to compete and **enter** the market with *substitutes*

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# Control Over a Key Resource: Inventors?

- What about inventors and new products?

- Every first producer enjoys monopoly power...for a time

- Eventually, new entrepreneurs find a way to compete and **enter** the market with *substitutes*

- **UNLESS...**
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# Barriers to Entry

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# Barriers to Entry

- .hi[Barrier to entry]: something that makes it costly, difficult, or even illegal for competitors to enter a market & compete with incumbent firm(s)
  - technological advantage
  - name recognition
  - high fixed/sunk costs
  - intellectual property rights
  - occupational licensing
  - government granted privileges
  - regulatory compliance
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# Barriers to Entry: Legal Prohibitions

- The United States Postal Service is the only provider of first class mail allowed by order of the government

- Starting another business that delivers mail is **illegal**

- Note: FedEx and UPS deliver *express packages*, can *not* deliver mail or use USPS mailboxes
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# Barriers to Entry: Taxis I

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# Barriers to Entry: Taxis II

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# Barriers to Entry: Taxis III

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# Barriers to Entry: Milk

Source: [*New York Times* (Feb 13, 2017)](https://www.nytimes.com/2017/02/13/well/eat/got-almond-milk-dairy-farms-protest-milk-label-on-nondairy-drinks.html)
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# If You Look at the World Long Enough...

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# Regulation has a Dark Side

George Stigler

1911-1991

Economics Nobel 1982
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> "[A]s a rule, regulation is acquired by the industry and is designed and operated primarily for its benefits," (p.3).

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.source[Stigler, George J, (1971), "The Theory of Economic Regulation," *Bell Journal of Economics and Management Science* 3:3-21]

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# Barriers to Entry: Occupational Licensing I

In 1950, 1 in 20 jobs required a license. Today it's 1 in 4. Source: [Obama White House (2015): Occupational Licensing: A Framework for Policymakers](https://obamawhitehouse.archives.gov/sites/default/files/docs/licensing_report_final_nonembargo.pdf)
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# Barriers to Entry: Occupational Licensing II

Source: [Mercatus Research (March 25, 2014): Occupational Licensing: Bad for Competition, Bad for Low-Income Workers](https://www.mercatus.org/publication/occupational-licensing-bad-competition-bad-low-income-workers)
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# Barriers to Entry: Occupational Licensing III

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# Barriers to Entry: Occupational Licensing IV

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> "'It is illegal in the state of Utah to do any form of extensions without a valid cosmetology license," the e-mail read. "Please delete your ad, or you will be reported.'

>To get a license, Jestina would have to spend more than a year in cosmetology school. Tuition would cost $16,000 dollars or more."

Source: [NPR Planet Money](https://www.npr.org/sections/money/2012/06/22/155596305/episode-381-why-its-illegal-to-braid-hair-without-a-license)
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# Barriers to Entry: Intellectual Property I

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# Barriers to Entry: Intellectual Property II

Source: [Washington Post (Sept 8, 2017)](https://www.washingtonpost.com/news/morning-mix/wp/2017/09/08/game-of-thrones-was-pirated-more-than-a-billion-times-far-more-than-it-was-watched-legally/)
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# Barriers to Entry: Intellectual Property III

- For these economic reasons, .hi[patent] (for ideas and inventions) and .hi[copyright] (for expressions) laws exist

- Grant *temporary* monopoly to holder in order to recover their fixed costs and provide incentive to undertake (risky and expensive) research/creativity

- A utilitarian *tradeoff* between incentives and access

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![:scale 50%](https://www.dropbox.com/s/l4vep529mbzckfh/copyright.png?raw=1)

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# Barriers to Entry: Intellectual Property IV

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# Barriers to Entry: Intellectual Property V

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- [Apple, Inc. vs. Samsung Electronics Co., Ltd.](https://www.theverge.com/apple/2011/11/2/2533472/apple-vs-samsung)

- [Freakonomics: Apple vs. Samsung: Who Owns the Rectangle?](http://freakonomics.com/2012/08/03/apple-vs-samsung-who-owns-the-rectangle/)
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# Economies of Scale and Natural Monopoly

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# Economies of Scale and Natural Monopoly I

- Recall: .hi-purple[economies of scale]: as `$\uparrow q$`, `$\downarrow AC(q)$`

- .hi-purple[Minimum Efficient Scale (MES)]: `$q$` with the lowest `$AC(q)$`

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# Economies of Scale and Natural Monopoly I

- Recall: .hi-purple[economies of scale]: as `$\uparrow q$`, `$\downarrow AC(q)$`

- .hi-purple[Minimum Efficient Scale (MES)]: `$q$` with the lowest `$AC(q)$`

- If MES is small relative to market demand...
  - .orange[AC] hits .blue[Market demand] during **diseconomies of scale**...

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# Economies of Scale and Natural Monopoly I

- Recall: .hi-purple[economies of scale]: as `$\uparrow q$`, `$\downarrow AC(q)$`

- .hi-purple[Minimum Efficient Scale (MES)]: `$q$` with the lowest `$AC(q)$`

- If MES is small relative to market demand...
  - .orange[AC] hits .blue[Market demand] during **diseconomies of scale**...
  - .hi-purple[...can fit more identical firms into the industry!]

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# Economies of Scale and Natural Monopoly I

- If MES is *large* relative to market demand...
  - .red[AC] hits .blue[Market demand] during **_economies_ of scale**...
  - .hi-purple[likely to be a single firm in the industry!]

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# Economies of Scale and Natural Monopoly I

- If MES is *large* relative to market demand...
  - .red[AC] hits .blue[Market demand] during **_economies_ of scale**...
  - .hi-purple[likely to be a single firm in the industry!]

- A .hi[natural monopoly] that can produce higher `$q^*$` and lower `$p^*$` than a competitive industry!

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# Economies of Scale and Natural Monopoly II

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.green[**Example**]: Imagine a single isolated condo complex with 1,000 units far from any other buildings or telco infrastructure

- **Fixed costs**: laying cable to the complex is $100,000
- **Marginal costs**: connecting each unit: $0
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# Economies of Scale and Natural Monopoly II

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- Suppose 10 providers serve the complex, each laying down their own cables, and each serving 100 units:

$$\mathbf{\text{Average cost}}=\frac{\$100,000}{10}=\$1,000 \text{ per subscriber}$$

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# Economies of Scale and Natural Monopoly II

- Suppose 1 provider serves the complex serving all 1,000 units:

$$\mathbf{\text{Average cost}}=\frac{\$100,000}{1000}=\$100 \text{ per subscriber}$$

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# Regulating Natural Monopolies

- Governments avoid "wasteful duplication" of competition, grant **exclusive franchises**, a single monopolist allowed in geographic region

- Provider made a **common carrier**: monopolist must provide universal service to all

- **Rate of return regulation**: gov't and monopolist agree on a price to guarantee a "modest return on capital" (i.e. some `$\pi>0)$`
  - Attempting to `$\uparrow q$` and `$\downarrow p$`
  - Prohibition on price discrimination, enforced subsidies 
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# Regulating Natural Monopolies II

Locations with only 1 (wireline) broadband provider Source: [FCC: Broadband Provider Map](http://broadbandmap.gov/number-of-providers)

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