So far we have assumed that price-taker and price-searcher
markets are competitive, due to low barriers to entry (and exit).
We now look at industries where the barriers to entry/exit are high.
WHY ARE BARRIERS TO ENTRY SOMETIMES HIGH?
1. Economies of scale. See opening quote. If ATC is decling over the entire range of output that consumers are willing to buy, a single firm may dominate the industry. The cost advantage may protect the firm from competition, including potential rivals. The barrier to entry is the cost advantage that a single, very large firm may have. Example: ALCOA, dominated the aluminum industry for years.
2. Government Licensing. Legal barriers are the oldest and most effective way to get protection from competition, coercive monopoly. Using the power of the government to eliminate, reduce competition. Examples:post office, utilities, cable TV, radio/TV stations, Dept of Motor Vehicles, etc.
Occupational licensing - limits entry/competition. Examples: Physicians, lawyers, hair stylists, taxicabs, accountants, etc. Advantage: ensures minimum standards. Disadvantage: raises costs, reduces competition, puts in place barriers to enter the profession.
3. Patents, other intellectual property rights. Examples?? Most countries have copyright laws to grant legal protection to inventors, authors, songwriters, etc. Patents give owners an exclusive legal right to be protected from competition for 17 years in U.S. Advantages: stimulates research, development of new products, fosters innovation, creative discovery process. Without legal protection for intellectual property, there would less innovation, fewer new products, etc. Disadvantage: prices are higher during the patent period, owner has a temporary monopoly.
4. Control over an Essential Resource. Firm
has exclusive control over a natural resource, usually only temporarily,
due to substitutes, discoveries, etc. Example: diamonds are
found in a few places on the planet, mostly South Africa. One company
dominates the diamond market, Debeers.
THE CASE OF MONOPOLY
Monopoly literally means "single seller." In economic
terms, a monopoly is a market where there:
1) is a single seller of a good for which there are no good substitutes and
2) are high barriers to entry.
However, "no good substitutes" and "high barriers" are somewhat vague.
For example, barriers to enter the auto industry might be considered high, because you would need to operate at a huge scale to be competitive, and the large amount of financial capital necessary might be a barrier to entry. However, capital markets are efficient, there are thousands of global investors, so if there was a profitable opportunity, capital could be raised to compete against GM. Also, there are substitutes for everything, so there are very few situations where no good substitutes exist.
Monopoly is always a matter of degree. For example,
US Post Office is the single provider of first class mail, and it is a
protected, coercive monopoly with a legal protection from competition.
However, there are good substitutes for first class mail, such as????/
PRICE AND OUTPUT UNDER MONOPOLY
Suppose you have a patent on a new invention, so you are legally protected from competition for 17 years. You face the cost curves on page 261. You are only seller, so the market demand curve is also the demand curve the firm (patent holder) faces.
The general rule is exactly the same as before for price-searchers and price-takers:
1. Expand output as long as MR > MC. Stop producing when MR = MC, at Q* (profit max output level).
2. That level of output (Q*) will determine the market price (P*), from the demand curve.
3. Comparing P* vs ATC will determine the profit per unit,
and total profits.
See page 262 for a numerical example of a monopoly.
Firm would expand as long as MR > MC. At Q=8, MR > MC, $8.50 > $5.75.
At Q = 9, MC > MR, $6.25 > $6. Firm's profit would be slightly higher
at Q = 8 than Q = 9, $29.50>$29.25.
Q* = 8, P* = $17.25.
Important Points for Monopoly:
1. Firm can sustain LR econ profits since P > ATC will not attract direct competition, at least for the 17 year period of a monopoly.
2. Even monopolists cannot get away with charging whatever price it wants, it still faces a downward sloping demand curve. Remember, firms want to maximize profits, NOT price. If the monopoly on page 262 tried to raise Price from $17.25 to $18.50, demand would fall from 8 to 7 units per day, and profits would fall from $29.50/day to $26.75.
3. Even though the patent holder has a monopoly, it doesnt mean that a profit is guaranteed. There are thousands of patented products that are never produced because the demand-cost conditions are not favorable, see page 263. P < ATC, firms suffers losses. If permanent, firm should shut down. If temporary, it should continue production in SR if P > AVC. If P < AVC, firm should shut down in SR.
As before with the price-taker and price-searcher, the
monopolist never actually observes demand curve and cost curves.
Like other price searchers, the monopolist has a strong incentive to find
the profit maximizing price and output, and the firm will act as if MR
and MC had been used. The actual business owner of a patent will
act more on intuition, trial-and-error, discovery process, "seat-of- the-pants"
approach, but his/her decision making process will be consistent with economic
Monopoly = single seller. Oligopoly = several large, dominant firms/sellers compose the entire industry. Examples: automobiles, steel, cigarettes, aircraft, pianos, TV (before cable - ABC, CBS, NBC).
Oligopolistic markets are characterized by:
1. Small number of very large, dominant firms.
2. Interdependence among firms. "Strategic interdependence." Since there are only 3 or 4 firms in the entire industry, the reactions of rivals play an important role in strategic decisions. For example, if GM is thinking of a price increase (reduction), it has to think of how Ford will react. Oligopolistic firms are more inter-related than firms in other industries.
3. Economies of scale, large scale production result in only a few, very large firms. Example: auto industry, page 265. The entire market demand is 6m cars per year at P*. To be competitive, a single car company has to produce at least 1m cars per years. In this case, the entire industry can maybe only support 3 cost-efficient firms, no more than 5-6 firms.
4. High entry barriers. Economies of scale
are usually the entry barrier that limits competition in ologopolistic
markets. In the auto industry, it is difficult to start out small,
and gradually grow to the optimal size, you would have to start at the
optimal size immediately. It would be very difficult to compete with
GM producing 1000 cars per year, you would have to produce 1m cars/year
to be competitive. Domino's Pizza was able to start small, and eventually
grow large and compete with McDonald's, but no U.S. startup firm has been
able to challenge the position of GM, Ford and Chrysler for over 50 years.
Fast food would be more contestable, automobile industry has very high
barriers to entry.
PRICE AND OUTPUT FOR OLIGOPOLY
Firm considers not only how customers will react to a change in price or quality, but how rivals will react to price increase/decrease. If firms act competitively, Price will get driven down to LRATC, economic profits = 0, as on page 267. Output is Qc and Price is Pc. If the market price is temporarily above Pc, then P > LRATC, firms are making econ profits. Firms will have an incentive to cut price to Pc, attract customers from rivals, leading to additional price-cutting, reducing price back down to Pc. Therefore, when competition prevails, Price = LRATC in a competitive oligopolisitc market. Oligopoly doesn't necessarily mean anti- competitive behavior, market can be competitive.
Suppose oligopolistic firms exploited their interdependence by engaging in collusion, price-fixing, cartel behvior. Such a strategy is illegal in U.S. by antitrust law, considered "restraint of trade." The OPEC cartel formed because it was outside the control of the Dept of Justice, they agreed to restrict output, raise price and make economic profits for the members, as on page 267. Pm and Qm, result in pos econ profits, purple shaded rectangle, for the firms to share. A cartel is an example of Perfect Cooperation, with the same outcome as a monopolist. The colluding firms, by joining together as a unified group, are just like a single monopoly firm, with the result of potentially sustainable profits.
In the real world, the actual outcome would probably lie
between the extremes of perfect cooperation (Pm, Qm) and perfect competition
(Pc, Qc). Oligopolistic firms can never act totally like a monopolist,
because 1) it is illegal and 2) competitive pressure exists. However,
because of interdependence, firms know that they can all benefit by not
avoiding vigorous price competition, resulting in P > ATC, possible sustainable
OBSTACLES TO COLLUSION
A cartel is an example of collusion, an anti-competitive agreement to restrict output, raise price and avoid competitive practices, especially price reduction/competition. Collusion can either be a formal agreement, like OPEC, or informal, tacit, implicit collusion. Obvious collusion is illegal (conspiracy to restrain trade), tacit collusion may be hard to detect.
Conflicting pressures for arrangements to collude:
1. Cooperate with rivals/partners to maximize joint profit, avoid competition.
2. Secretly cheat on collusive agreement to increase share of profits, by lowering price. By secretly lowering price, the cheater can sell to a) customers who won't buy at the high collusive price and b) customers of the rivals. Steal customers from partners. Cartels/collusive agreements are very unstable.
See page 269. Industry demand and supply conditions
suggest a market price for the cartel of Pi, which will max profits for
the cartel as a group. However, the demand curve facing an individual
firm is much more elastic, panel b, so the ideal price for the firm would
be Pf, a lower price than the agreed upon cartel price of Pi. The
firm could increase its profits by cheating, taking a greater share of
the group profits, i.e. stealing from its partners.
SPECIFIC OBSTACLES to COLLUSION
1. As the number of firms increases, the harder it is to effectively collude, because it will be more difficult to achieve unity on pricing/output decisions, and more difficult to negotiate and enforce the agreements. The more firms, the more potential conflicts.
2. The more difficult it is to police, detect and prevent cheating, the less collusion will take place. Cheating can be subtle and may not just involve price cutting. How could an OPEC producer attract customers besides cutting prices?? How could they effectively lower the price without actually cutting the price?? And what enforcement mechanism is there to discipline cheaters?
3. Low barriers to entry are an obstacle to collusion. The smell of profits from the colluders will attract competition. If barriers to entry are low, collusion will be unsustainable. Example: if all the accountants/lawyers/physicians/plumbers in Flint agreed to raise prices, low barriers to entry would result in increased competition in the future. During OPEC, the high oil prices encouraged a) oil exploration by US, non-OPEC countries and b) alternative fuel research. In many cases, the cartels/colluders can't prevent new entry, making the arrangement unstable.
4. Unstable (stable) demand makes collusion less (more) likely. If demand is unstable, it will be harder to agree on the level of reduced output required to raise the price to an optimal amount. Collusion requires consensus and agreement, which is harder when demand is uncertain.
5. Collusion is illegal. Vigorous enforcement of
antitrust laws will minimize collusion. Fines/penalties are severe
- triple damages, and participants can be held personally liable.
Secret agreements might be hard to detect.
DEFECTS OF MARKETS WITH HIGH ENTRY BARRIERS
What are the problems when competition is restricted by high entry barriers?
1. High entry barriers reduce competitiveness of the market, and limit options available to consumers. Insulated from competition, protected firms or individuals can charge high prices and offer poor service, behavior that competitive firms cannot get away with. Who is more responsive to customers? Target or the Department of Motor Vehicles?
2. Reduced competition results in inefficiency. With protection from competition, monopolists or cartels, can charge P > ATC, make economic profits and not attract sufficient entry to drive P down to ATC. By restricting output and raising price, the optimal amount of trade does not take place. Society is worse off from the "restraint of trade", mutually beneficial trade does NOT take place is a loss of wealth, reduction of std of living.
3. Reduction of "consumer sovereignty." With high entry barriers, the discipline of the market is reduced, the responsiveness of producers to consumers is weakened. Firms are protected/insulated from competition because of the high entry barriers.
4. Barriers to entry encourage rent seeking. Grants of special favor (protection from competition) will lead to resources being devoted to rent seeking - lobbying, campaign contributions, etc. Some or all of rent seeking will be inefficient, resources are being diverted from productive activities to potential wasteful activities. Could be an overall reduction in welfare for society from the inefficient allocation of resources, contributing to the allocative inefficiency discussed in #2.
Example: Suppose a city or state (or federal) government considers granting a limited number of licenses providing a seller with some exclusive right to sell liquor, operate a taxicab, operate a car wash, offer legal/medical services, operate a cable TV company, inspect homes, cut hair, tow cars for the city, etc. Suppose this is new legislation being considered and assume that the legal protection from competition is worth $100,000 over the life of the license. How much would individual sellers be willing to spend to get the license? Other potential suppliers would also be willing to spend that amount trying to convince public officials that they will best "serve the public interest", resulting in more resources being spent collectively than $100,000, resulting in economic waste.
Example: Halloween costume party with a prize for
best costume of $1000.
POLICY ALTERNATIVES WHEN ENTRY BARRIERS ARE HIGH
Economists suggest four policy options when barriers are high.
1. Restructure the industry to increase the number of firms - maybe. In some cases, it is possible that a single dominant large firm has a "natural monopoly", since it has significant cost advantages over smaller firms. ATC is declining over the entire range of market demand. In this case, breaking up the monopoly would actually be inefficient, since the result would be more, smaller firms with higher costs. As long as there is a theat of potential competition, low entry barriers, the market is contestable and therefore efficient and competitive. Examples: a) single drug store, hardware store, restaurant in a small town, b) ALCOA, c) Microsoft?.
2. Reduce artificial barriers to trade - tariffs, quotas, licensing requirements, regulations. Deregulate the industry, open it up to competition, e.g. trucking and airlines in the early 80s. In many (most?) cases, the source of barriers to entry is the government itself, since it is government that is passing laws to restrict competition - tariffs, occupational licensing, regulations, etc.
Example: tariffs are a barrier to entry, since they impose a tax on foreign goods, giving the domestic firm a cost advantage by protecting them from competition. Protectionism protects the domestic firms from competition. Domestic firms can be disciplined by foreign competition, serving the interests of consumers.
Special interest issue. Domestic suppliers are concentrated and well-organized, and consumers are poorly organized and widely dispersed. Special interest groups will take advantage of consumers, resulting in too much regulation/protectionism from an overall efficiency standpoint.
Reducing artificial barriers to trade is economically desirable, but may not be politically realistic/feasible.
3. Regulate the protected producer, such as a regulated utility (phone, gas, electric companies, cable TV), being regulated by a state regulatory agency. See page 277. Unregulated monopolist would produce Q0 units and charge price P0, (MR = MC) resulting in P > MC and P > ATC. Solutions:
a. Average cost pricing. The regulatory agency could force the monopolist (electric company) to charge P = ATC, which would be P1, resulting in Q1. Society is better off, lower price and higher output increases welfare.
Problems with Regulating utilities, monopolies:
a. Lack of accurate information. It might be hard to accurately determine P = ATC, demand and cost curves are not easily observable. Usual solution: Regulated monopolist is supposed to earn a "normal accounting rate of return", which would be the same as "zero econ profits." If the utility's returns are too high (low), its regulated prices/rates are too high (low), need to be lowered (raised). However, the protected monopolist would try to do what?
b. Cost shifting/inefficiency. Regulated utilities have a fixed rate of return by the regulatory agency. Therefore, they will not have strong incentives to operate efficiently. If it find ways to reduce costs, its profits will rise, resulting in a price (rate) reduction by the regulators to reduce the "excessive" profits. On the other hand, if its cost of production rise, it knows it can apply to the reg agency for a rate increase. Managers of the utility, undisciplined by the market, will be more likely to fly first class, attend conferences in exotic places, spend lots of money entertaining (maybe on regulators), give high wage increases, give jobs to family/friends, etc. "Shirking" behavior by managers - increase personal benefits and increase costs, resulting in inefficiency, higher prices, rates.
c. Special interest influence. Regulated firms will try to influence the political process of regulation, try to have regulators appointed who will be favorable to the monopoly. "Capture theory" - utility benefits from regulation if they can "capture" (persuade, bribe, or threaten) the regulators, so that the regulators are favorable to what the utility/monopoly wants. Inefficiency results because the monopolist controls (influences) the regulatory process in their favor. Also, incestuous, inbreeding behavior is common - ex-regulators may be hired as a manager or "consultant" of the utility, managers of the utility may eventually become regulators, etc.
Public choice theory of special interests again.
Widely dispersed, poorly organized consumers are taken advantage of by
well-organized, concentrated special interest groups - the regulated monopolist.
4. Have government-operated firms supply the market, e.g. US Post Office, Tennessee Valley Authority (electric utility), local public utilities, public schools, roads, fire and police departments, etc. However, the same perverse managerial incentives apply as in the case of a regulated monopoly - ignore efficiency, promote personal objectives, etc - because the govt-operated firm is insulated from competition - no direct competitors. No reward for efficiency, cost effective operation. In fact, there is a perverse incentive to fail - why?
Rationally ignorant voters-taxpayers don't have the incentive to monitor the govt monopoly. Result of govt operated business - less efficient, higher cost operation compared to a private firm. US Post Office vs UPS. Target vs Dept of Motor Vehicles.
Conclusion: Government intervention is a two-edged
sword. If used judiciously and wisely, it can increase competition
by enforcing contracts and property rights, prosecuting fraud, deceptive
or misleading business practices, providing a minimal regulatory framework,
impose standards, etc. However, it can reduce overall economic efficiency
by erecting barriers to entry, granting special favors to protected indsutries/firms,
etc. Organized special interest groups engaged in rent seeking, appealing
to short-sighted politicians, taking advantage of rationally ignorant consumers/voters.
Therefore, most govt solutions are not terribly attractive and are not
necessarily superior to the market outcome.
The real danger is the "coercive monopoly", the firm that has some type of legal protection against competition that erects legal barriers to entry. A "coercive" monopoly by definition requires government intervention, since a private firm cannot coercively restrict competition. HIGH BARRIERS TO ENTRY usually require GOVERNMENT INTERVENTION of THE MARKET. True monopolies are a creation of the govt, not of the market. Policy conclusion, minimize government intervention.
Dynamic, competitive nature of the market is demonstrated by the composition of firms in the economy - of the 500 firms in the 1980 Fortune 500 list only half made it to the 1990 list. Constant change disciplines firms, successful firms attract resources to expand. The more the dynamic the economy, the less likely it is that regulations will be effective.