Topic 2.4 looked at price formation when there were only two parties to a transaction. There we noted that, since each party was essential to the creation of value from that transaction, each party had the same added value equal to the total value created. This meant that the key issue in any analysis was to determine what the precise source of the value created was.
In this topic, we introduce the effects of competition. Specifically, we look at the conditions under which competition among buyers serves to alter their added value and the added value of a single seller: a monopolist. If a monopolist can engender competition among buyers, he or she is able to exercise monopoly or market power. We will demonstrate that, in general, the effect of the exercise of market power is to reduce the total value created from exchange and increase the added value of the monopolist. Therefore a monopolist, who can exercise market power, will do so because it is likely to increase his or her own payoff.
We begin firstly by defining what a monopoly market is and how it may arise. Then we examine negotiations between a monopolist and several buyers. We note that, in order to negotiate different prices for each, re-sale must not be possible. The outcome of these negotiations depends on two factors: (1) the monopolist and buyers’ relative added values and (2) the monopolist and buyers’ relative sophistication as negotiators. However, prior to negotiations taking place, the monopolist may be able to take actions that alter these factors, specifically, to restrict available capacity. We will examine the monopolist’s ability and incentives to do this towards the end of this topic.
A monopoly is a
market with a single seller. In that market, the same player controls all of
the substitutable products. However, what are substitutes for one type of buyer
may not be substitutes for another. Hence, it is rare that a particular market
can be unambiguously classified as a monopoly.
To see this,
consider Sony Playstation 2 games. These games are disks developed to work
with the Playstation game console and no other. As such, if you own this
console and you wish to purchase a game, you have little choice but to consider
a Playstation game. When you consider substitutes, therefore, you will trade
off buying the game with engaging in another mode of entertainment. However, to
you, Sony is a monopolist in the gaming market.
On the other
hand, if you have not bought a Playstation game console but are considering
buying a computer game, your options are wider. You could purchase a Nintendo
Game Cube, Microsoft X-Box or even a PC. If you are a buyer in this position,
Sony hardly has a monopoly on your gaming options. Your willingness-to-pay for
any given game machine will depend more on the pricing and quality of a similar
machine rather than your alternative entertainment options.
This type of
analysis often applies in situations where you, as a buyer, make choices that
lock you into a particular set of choices later on. Consider software choices,
such as PC operating systems and applications, word processing packages, email
address books, or company accounting software, car purchase decisions and the availability
of spare parts, textbook adoption choices, or when you train an employee in
your organisation. In each of these situations, while there is competition at
the time of an initial decision, later on, a buyer’s choices are constrained
and potentially limited to dealings with a single player.
Each of these
instances of lock-in is the result of
a buyer’s purchase of an asset that is complementary with other components that
are controlled by a single seller. There are instances of lock-in that can arise
from other decisions. For example, there are many goods that exhibit network effects. These effects mean that
your willingness-to-pay for a particular firm’s product is higher when there
are more consumers of that product. A good example of this is the Windows
Operating System for PCs. One reason why Microsoft’s software is on 85 percent
of all PCs in the world is because of the importance of interchangeability.
Buyers of operating systems are concerned that, if they purchase another
system, such as Mac OS or Linux, they will have difficulties swapping data with
other users. In this case, buyers are locked into choosing Microsoft - not
because of their own past decisions necessarily - but because their co-workers
or colleagues have chosen Windows.
Lock-in is one
example of how a monopoly can arise. Essentially, the seller comes to own or
control a key resource through the choices of buyers. There are, however, other
examples of monopoly that arise when a firm owns a key resource.
·
Government
licensing
Sometimes governments create monopolies. Patent laws vest monopoly
rights with an innovator for a period of time. Copyright laws ensure that
others do not expropriate a firm’s brand. Government-run services are often
under the control of a single firm, eg, the Post Office or public transport. In
each of these cases, the government vests the ownership of a key asset with a
single player.
·
Cartels
Monopolies are sometimes formed when previous competitors get together
and form a cartel. Two prominent examples are the OPEC cartel of oil-producing
nations and the DeBeers Diamond cartel. In many nations, such cartels are made
illegal precisely because they give rise to monopolies. Unions are also an
example of a cartel. While they face restrictions, unions are legal
associations of groups of workers. They act like a monopolist because unions
engage in collective negotiations with individual employers and employer
groups.
·
Ownership
of raw materials
When a single firm owns a key raw material, this can allow them to
monopolise an industry. An example of this is the ESSO-BHP joint venture on gas
that comes from fields in Bass Strait between Tasmania and mainland Australia.
Up until recently, this joint venture was the only supplier of gas into the
Australian State of Victoria. Hence, users of gas had no alternative but to
purchase gas that came from ESSO and BHP.
By owning a key
asset, an agent can prevent others from entering the market for goods that rely
on that asset for production.
Another reason
why a monopoly may arise is technological in nature. It is sometimes the case
that a good or service can be produced at a lower per unit or average cost if
there is a single supplier. If there are economies of scale, ie, falling long-run average
costs, over the entire range of possible demand, then to have two suppliers
would generate inefficient duplication. In this case, we say that production
takes place using a natural monopoly technology.
There are many
examples of natural monopoly production technologies. For example:
·
Networks
Distribution networks are common in transportation, communications and
energy transmission. They have the quality that, for any desired capacity,
costs are lower on average if a given set of customers use a single network.
For example, in telecommunications, it is inefficient to have two systems side
by side that allow any caller on one network to call another. This simply
duplicates switching effort and the costs involved in keeping track of call
connections.
·
Mass
production
Some manufacturing and service industries require large sunk
investments in order to generate low marginal production costs. As demand
grows, such investments become more and more desirable allowing all potential
users in a region to be supplied at the lowest possible marginal cost.
Therefore if there are two firms, these sunk investment costs are duplicated.
·
Information
Once produced, information can be distributed relatively cheaply. As
such, fixed production costs form a large component of the average costs of
information provision. If two different suppliers produce the same information,
this simply duplicates those fixed costs.
Natural
monopolies are natural because to have a single supplier is best if your
objective is to minimise costs. As such, in the past, governments have vested
monopoly rights with a single supplier so as to ensure those scale economies
are reached.
However,
natural monopolies can also be natural because it is difficult for market
forces to sustain more than a single supplier. As we will see in segment 5, a
potential entrant to an industry with an incumbent using a natural monopoly
technology may fear a price war. Hence, that entrant may think twice about
incurring any sunk-investment costs that it may not recover in more competitive
circumstances. The resulting outcome is that the incumbent maintains its
monopoly position and profits despite the possibility of entry.
Finally while
we focus here on the case of a single seller in a market, there are situations
in which there is a single buyer and many sellers. This situation is called monopsony.
There are many examples of monopsonies. Consider a large employer in a small town, a national supermarket or department store chain dealing with wholesalers, electricity or gas supply onto their respective networks, or digital switch suppliers to a telecommunications network. In each of these cases, there are many potential suppliers but only one customer. Nonetheless, the type of price negotiations examined here easily carry over to these types of cases.
We now turn to
consider the outcome of negotiations between several buyers and a single
seller. Analysing this requires us to calculate each player’s added value and
also to make assumptions regarding each player’s relative sophistication as a
negotiator. However, in this context, it is also important that buyers are not
able to trade with one another.
For example,
suppose there are four potential buyers of a good but only one producer of that
good or any good that would be considered a substitute by the buyers. That
producer is therefore a monopolist.
To start with,
we assume that the monopolist can produce an unlimited number of units of the
good at a cost of $200 per unit. This is its opportunity or marginal cost of
production. Our four buyers only wish to purchase a single unit of the good
each and have willingnesses-to-pay of $1,000, $800, $600 and $400,
respectively. Notice that since each buyer has a willingness-to-pay greater
than the seller’s opportunity cost for that unit, the total value created will
be maximised by having the seller provide each buyer with the good. In this
case, the total value created will be $2,000 (= 1,000 + 800 + 600 + 400 – (200
x 4)).
Graphically,
this situation is depicted in the figure below. Notice that the buyers’
willingnesses-to-pay lie above the marginal cost of production. The shaded area
represents the total value created where all four buyers receive one unit of
the good each.
Total Value Created with Unlimited Supply
We can use this information to calculate each player’s respective added values. These are summarised in the table below.
Player
|
Added Value |
Likely Price |
Expected Surplus |
|
Buyer 1
(WTP = $1,000) |
$800 |
$600 |
$400 |
|
Buyer 2
(WTP = $800) |
$600 |
$500 |
$300 |
|
Buyer 3
(WTP = $600) |
$400 |
$400 |
$200 |
|
Buyer 4
(WTP = $400) |
$200 |
$300 |
$100 |
|
Seller |
$2,000 |
$450 on
average |
$1,000 |
|
Recall that an
agent’s added value is the difference in the total surplus when that agent
participates in a trade compared with the total surplus when they do not
participate. The seller is essential to the production of the good. Hence, when
they do not trade, there is no surplus. As such, the seller’s added value is
equal to the total value created. This is a characteristic of their monopoly
and we can state it as a general principle
A monopolist is essential to the creation
of value in a monopoly situation and, as such, its added value is always equal
to the total value created.
In a monopoly,
however, individual buyers are not necessarily essential to the creation of
value. For the buyers here, however, because supply is unrestricted, ie, the
monopolist is able to produce four units, each is essential to their own
particular transaction. Take, for example, buyer 3 who has a willingness-to-pay
of $600. If that buyer leaves the game, ie, refuses to purchase the good, then
the monopolist will only be able to sell goods to the remaining three buyers;
creating a value of $1,600. Hence, buyer 3’s added value is $400 (= 2,000 -
1,600). Notice that this is not an artefact of the fact that each buyer has a
different willingness-to-pay. If all four buyers had a willingness-to-pay of
$600, each individual buyer would have an added value of $400.
The reason for
this outcome is that buyers are not really competing with each other. While
there is only a single seller, that player is forced to deal with each buyer in
order to realise value from that trade. Hence, each buyer’s added value is
equal to the total value created from that trade. For buyer 3, the value
created from trade with the seller is $400. That buyer is essential to the
creation of that value so its added value is also $400. In the next section, we
will see what happens when supply is restricted. In that case, an individual
buyer’s added value will be reduced because it must compete with other buyers.
The above table
also lists the likely price and expected surplus that each player may receive.
These outcomes assume, as we did in topic 2.4, that the seller and individual
buyers are equally sophisticated negotiators. To see this, consider the extreme
outcomes that occur if the seller or a buyer had all of the bargaining power,
ie, could make take-it-or-leave-it offers in negotiations. If the seller could
make a take-it-or-leave-it offer to each buyer, it will offer a price equal to
each buyer’s willingness-to-pay. As such, it would receive prices of $1,000,
$800, $600 and $400, respectively, and appropriate all of its added value. On
the other hand, if an individual buyer can make a take-it-or-leave-it offer,
they will offer a price of $200. This is equal to the seller’s opportunity cost
of producing the good for that buyer. So the sale price could range from $200
to each buyer’s willingness-to-pay. In each individual negotiation, with equal
bargaining power, the price will lie halfway between these bounds. Hence, in
negotiations between the seller and buyer 3, the likely price will be $400 (=
(600 + 200) ¸ 2).
The expected
surplus is calculated using the likely price. For the seller, this is his or
her producer surplus or profit. It is equal to half of the total value created.
For each buyer, surplus is their willingness-to-pay less the price they
negotiate. This outcome is depicted in the graph below. While a buyer with
higher willingness-to-pay will pay a higher price for the good, they will
nonetheless earn a greater surplus than a buyer with a lower
willingness-to-pay. In this example, the consumer surplus, ie, the total value
realised by all buyers, is $1,000.
Price and Value Division with Unlimited Supply
Click here to see what happens if a competing seller is available.
An implicit
condition underlying this analysis is that buyers are not able to re-sell the
good to each other. Consider what might happen if this was possible. Because a
buyer, such as buyer 1, is only able to negotiate a relatively high price of
$600, while buyer 4 can negotiate a lower price of $300, this creates an
incentive for buyer 4 to sell its good to buyer 1. Buyer 4’s profits from that
transaction would be potentially as high as $300, in contrast to his own
surplus of $100. Even if this was not the case, buyer 4 could simply purchase
two units of the good and sell one unit to buyer 1.
Anticipating
this possibility, buyer 1 would not accept such a high price from the seller.
Ultimately, this would undermine the seller’s ability to negotiate different
prices for each buyer. Hence, in order for our analysis here to be valid, we
must assume that re-sale is not possible.
We will
consider what happens when re-sale is possible in segment 4. There, we will
look at mass markets where it is harder to imagine that a seller can control
re-sale by buyers. For the moment, however, we will continue to make the
assumption that re-sale is not possible.
A key
assumption for the above analysis was that supply was effectively unlimited.
The monopolist could produce any number of units for the same marginal cost of
$200. This meant that our four buyers were not really competing with each other
and, as such, were essential for their particular trade with the seller.
In contrast,
when supply is limited, buyers do compete with one another. Suppose that the
previous example is as before but that the seller now only has three units of
the good to sell. This might be because the seller only can produce three units
of the good or, alternatively, because producing a fourth good involves a very
high marginal cost. In contrast to the previous analysis, this simple change
alters the relative added values of the buyers and the seller.
To examine the negotiated outcomes under limited supply, we first need to consider what the maximal total value created is when there are only three units available. Whenever there is a scarce commodity, it is best allocated to those buyers who value it the most. In our example, buyers 1, 2 and 3 would receive the good while buyer 4 would be left out. This would create a total value of $1,800 (= 1,000 + 800 + 600 – (200 x 3)). Not surprisingly, this value is less than the situation with unlimited supply.
In terms of
added value, the changes are more dramatic with each player’s added value lower
than before. These are summarised in the following table:
Player
|
Added Value |
Likely Price |
Expected Surplus |
|
Buyer 1
(WTP = $1,000) |
$600 |
$700 |
$300 |
|
Buyer 2
(WTP = $800) |
$400 |
$600 |
$200 |
|
Buyer 3
(WTP = $600) |
$200 |
$500 |
$100 |
|
Buyer 4
(WTP = $400) |
$0 |
No trade |
$0 |
|
Seller |
$1,800 |
$600 on
average |
$1,200 |
|
The seller is
essential to all trades and hence, his added value is equal to the total value
created. Each buyer, however, is no longer essential. If any buyer left the
game, the seller would sell that unit to buyer 4. For instance, for buyer 3,
the total value created when she is not in the game would be $1,600. Hence, her
added value is only $200. Buyer 4 is effectively competing with every other
buyer. This gives the seller a stronger bargaining position. So even if buyer 3
was able to make a take-it-or-leave-it offer to the seller, she could not ask
for a price lower than $400 as the seller would be able to convince buyer 4 to
pay up to that amount.
To look at this
another way, with a limited number of units available, the seller’s opportunity
cost of supplying a given buyer is now different from his marginal cost of
production. As buyer 4 would be willing to pay up to $400 for a unit, the
seller’s cost of supplying another buyer is $400. So this, rather than their
production cost of $200, is the lower bound on the price the supplier would
accept in negotiations.
The result is
likely to be higher prices on average for the monopolist. The figure below
depicts the new division between buyers and the seller. Notice that even though
the total value created is smaller than before, as is the added value of all
players, the seller’s expected profit is higher. This is because the sum of the
buyer’s added values is not equal to the total value created but rather $1,200.
This leaves $600 that the seller can claim of the total value created without competing with any buyer. Hence, the
seller can expect to claim that and half of the remaining $1,200.
Price and Value Division with Limited Supply
Competition among buyers means that a seller’s outside option in negotiations becomes the willingness-to-pay of the just excluded buyer. If any other buyer tries to negotiate a price less than the just-excluded buyer’s willingness-to-pay, the seller knows that he will be able to elicit a higher bid from that buyer. This strengthens the seller’s bargaining position and hence, raises his expected surplus from any given trade.
What happens
when there are only one or two units available? Basically, the total value
created, and hence the added values of each player, continues to fall but the
average price negotiated rises.
The negotiated
outcomes with one and two available units are calculated in the two tables
below respectively.
Player
|
Added Value |
Likely Price |
Expected
Surplus |
Buyer 1
(WTP = $1,000) |
$200 |
$900 |
$100 |
Buyer 2
(WTP = $800) |
$0 |
No trade |
$0 |
Buyer 3
(WTP = $600) |
$0 |
No trade |
$0 |
Buyer 4
(WTP = $400) |
$0 |
No trade |
$0 |
Seller |
$800 |
$900 on
average |
$700 |
Player
|
Added Value |
Likely Price |
Expected
Surplus |
Buyer 1
(WTP = $1,000) |
$400 |
$800 |
$200 |
Buyer 2
(WTP = $800) |
$200 |
$700 |
$100 |
Buyer 3
(WTP = $600) |
$0 |
No trade |
$0 |
Buyer 4
(WTP = $400) |
$0 |
No trade |
$0 |
Seller |
$1,400 |
$750 on
average |
$1,100 |
The following
figure summarises the average price and surplus the seller can expect to
receive under the various scenarios regarding available supply. Notice that
while the price rises as supply becomes more limited, the seller’s expected
surplus reaches a maximum at three available units and then falls. This is
because, while the seller’s added value relative to the buyers rises as supply
becomes more limited, in absolute terms, it falls as the value created is
reduced.
Expected Price and Seller Profit
In the above example, the total value created is higher when there are more units available. However, if it was up to the seller, he would prefer a situation where supply is limited to three (or even two) units to the case of unlimited supply. This highlights the tension between social incentives to create value and a monopolist’s private incentives.
It is sometimes possible for the monopolist to choose the number of units available. For instance, prior to any negotiations, the monopolist may be considering investing in a plant to produce this good. In so doing, the monopolist will make a choice regarding the plant’s capacity. Let us consider the simple, but admittedly unrealistic, case where a plant of any capacity costs $500, but having chosen its capacity, it is prohibitively costly to expand the plant at a later date. At this investment cost, regardless of capacity chosen, the monopolist will earn a positive return on that investment. As these sunk investment costs do not depend on the size of the plant, the monopolist will have an incentive to choose a capacity of three. In so doing, the monopolist creates conditions of limited supply and is therefore able to force buyers to compete with one another. This results in a maximal level of profit for the monopolist.
The monopolist’s choice of plant capacity is made on a very different basis from the usual trade-offs in these decisions. The usual concern is with plant utilisation. Hence, if it is costly to produce plants with greater capacities, the concern will be the chance of unused capacity with the possibility that some sales may be lost if the firm underbuilds. On the other hand, a monopolist with his eye on subsequent negotiations and his added value there is concerned that overbuilding will give buyers power in those negotiations. Hence, a monopolist favours underbuilding so as to limit each buyer’s added value.
By restricting plant capacity to raise its subsequent added value and price, the monopolist is exercising monopoly or market power. It is this type of action that gives monopolists a bad name. Socially, a plant of unlimited capacity would be desirable, however, the monopolist, considering only his private interest, restricts available supply. The total value created from the investment is, therefore, not at its maximum.
By choosing plant capacity, the monopolist can exercise his market power and ensure that supply is limited. The reason why this works for the monopolist is that the limited capacity commits him to not being able to expand supply after he has sold his intended three units of the good.
To see why this is important, suppose that such capacity expansion was not costly. Initially, the monopolist chooses a capacity of three units with the intention of playing buyers against one other. Suppose, therefore, that he bargains successfully with buyers 1, 2 and 3 for the prices of $700, $600 and $500, respectively. Having done this, given the low cost of expanding capacity, the monopolist would find it worthwhile to produce another unit for buyer 4 and negotiate with him. Had buyers 1, 2 and 3 anticipated this, they could have bargained harder. The monopolist’s actual opportunity cost was not $400 but $200 as in the case of unlimited supply.
In economics, we suppose that buyers, such as 1, 2 and 3, are sophisticated enough to anticipate the monopolist’s later deal with buyer 4. They will take this possibility into account during negotiations and will weaken the monopolist’s bargaining position. The result is that if supply is really unlimited, the negotiated prices will be determined on that basis, despite the monopolist’s intention to convince them otherwise.
The difference between simply intending to restrict supply and actually doing it by making it costly to expand supply is an important one. The former intention is not credible. Buyers will anticipate the monopolist’s later incentive to sell to buyer 4 and alter his bargaining positions accordingly. If it is actually costly to sell to buyer 4, the monopolist is able to commit to limiting supply. This commitment gives the monopolist credibility in negotiations and allows him to negotiate higher prices with the first three buyers.
Thus, we see that while the monopolist has an incentive to exercise monopoly power, he may not have the ability to do so. This is because limitations on supply must be credible. The monopolist must be able to commit to not expanding supply later on to take advantage of value-creating trades. He must be able to convince buyers that one or more will be excluded in order to create competition among them. Unless this is a real commitment, then an intention to exclude will not be credible and the monopolist will not be able to exercise market power.
Limitations on
productive capacity are one way of committing to exclude buyers. There are,
however, other mechanisms. Note that the primary way a monopolist can commit to
exclude is by raising the opportunity cost he faces in expanding production at
a later date. A capacity commitment does this directly by raising physical
production costs.
But it is also
possible to raise the monopolist’s opportunity cost of subsequent expansions in
other ways. Here are three broad mechanisms that are used by sellers:
1.
Reputation
When a seller has repeated good offerings, it may be possible for him
to develop a reputation not to flood the market. This strategy is adopted by
collecting houses, such as the Franklin Mint. Disney has also tried to develop
a reputation for not discounting its video releases at a later date by
announcing short production runs. A firm with such a reputation faces higher
opportunity costs of subsequent output expansions. While these might yield
returns on their current product choices, they will lose their reputation for
future product offerings.
2.
Leasing
Rather than sell a product, some firms favour leasing. IBM followed
this approach in the 1970s with its mainframe computers. It claimed that
leasing would insure buyers against technological risk. However, it was also
concerned that potential buyers might wait for its prices to fall rather than
purchase a computer immediately. By leasing rather than selling these
computers, IBM made a commitment to offer the same pricing terms to early and
later purchasers. In so doing, it raised its opportunity cost of offering
discounts towards the end of a given computer’s product life cycle.
3.
Most favoured customer clauses
Some firms offer buyers a contract that guarantees them the best price
they offer any buyer. This means that a firm contemplating discounting to some
of its customers must discount to all of them.
Click
here to see how this type of clause can assist a monopolist in
increasing its profits.
Each of these
mechanisms is a credible means of reducing the monopolist’s ability to expand
output. Hence, they can be employed to commit to supply restrictions and foster
competition among buyers.
It is worth remarking that the ability of a firm to exercise market power does not necessarily rely on them being a monopolist. While it is true that when there are many sellers this ability will be limited, when a seller has a product that is not a perfect substitute for products sold by others, he or she will be able to raise the price by restricting their output somewhat. Nonetheless, in order to do this, that output restriction must be credible. So even in more competitive markets, some of the above practices will be employed as a means of raising a firm’s relative added value and creating competition among buyers.
Click here to examine if all monopolies are bad.
Click here for a discussion point.
Topic Summary
In this topic,
you have learnt how to
·
identify
some causes of monopoly in an industry
·
derive
the added value of a monopolist and likely price outcomes
·
analyse
a monopolist’s incentive to restrict his or her productive capacity
·
identify
some of the conditions that allow a monopolist to exercise monopoly power and
some of the challenges he or she might face in doing so