2.5 Monopoly

 

[2.2 Economic Decision-Making]     [2.3 Dividing Value]    

[2.4 Determinants of Value]

 

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 buyersí relative added values and (2) the monopolist and buyersí 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 monopolistís ability and incentives to do this towards the end of this topic.


 

How Do Monopolies Arise?

 

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 buyerís choices are constrained and potentially limited to dealings with a single player.

 

Each of these instances of lock-in is the result of a buyerís 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 firmís 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 Microsoftís 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.

 

Ownership or control of key assets

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 firmís 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.

 

Natural monopoly

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.

 

Monopsony

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.


 

Negotiations with a monopolist

 

We now turn to consider the outcome of negotiations between several buyers and a single seller. Analysing this requires us to calculate each playerís added value and also to make assumptions regarding each playerís relative sophistication as a negotiator. However, in this context, it is also important that buyers are not able to trade with one another.

 

Added value in a monopoly

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 sellerís 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 Ė (200 x 4)).

 

Graphically, this situation is depicted in the figure below. Notice that the buyersí 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 playerís 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 agentís 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 sellerís 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 3ís 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 buyerís 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 buyerís 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 buyerís 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 sellerís opportunity cost of producing the good for that buyer. So the sale price could range from $200 to each buyerís 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) ł 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.

 

The no re-sale condition

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 4ís 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 sellerís 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.

 

Competition among buyers

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.

 

Added value under limited supply

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 Ė (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 playerís 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 sellerís 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 sellerís 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 sellerís expected profit is higher. This is because the sum of the buyerís 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 sellerís 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 buyerís willingness-to-pay, the seller knows that he will be able to elicit a higher bid from that buyer. This strengthens the sellerís bargaining position and hence, raises his expected surplus from any given trade.

 

Further limitations on supply

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 sellerís expected surplus reaches a maximum at three available units and then falls. This is because, while the sellerís 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

 

 

  


Exercising market power

 

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 monopolistís private incentives.

 

Choosing production capacity

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 plantís 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 monopolistís 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 buyerís 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.

 

Market power and commitment

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 monopolistís 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 monopolistís later deal with buyer 4. They will take this possibility into account during negotiations and will weaken the monopolistís bargaining position. The result is that if supply is really unlimited, the negotiated prices will be determined on that basis, despite the monopolistís 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 monopolistís 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.

 

Committing to exclude buyers

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 monopolistís 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 computerís 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 monopolistís ability to expand output. Hence, they can be employed to commit to supply restrictions and foster competition among buyers.

 

Market power in general

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 firmís 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 monopolistís 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