## AM03 Monopoly

This is Lecture 3 of Advanced Microeconomics I course at PIDE, Fall 2107,

Empirical realities of the world around us are starkly different from the textbook pictures of perfect competition. The world is characterized by large firms, which have the power to set prices. A key assumption of the model of perfect competition is “price-taking” behavior. If firms do not take prices as given, then a supply curve does not exist, and the supply and demand model is not a valid analytical tool. This lecture analyzes a very simple model of monopoly and shows how government regulation is beneficial. It also analyzes a duopoly model to show how results we get are extremely sensitive to the assumptions we make about the nature of competition. 94 minute video lecture:

OUTLINE made from lecture slides is given below. The SLIDES have some diagrams which are needed to fully understand the outline. The slides can be downloaded from the Google webpage for AM03 Monopoly.

AM03: Monopoly

Lec 3, Advanced Microeconomics, PIDE, 19 Sep 2017

AM03: How S&D analysis fails in monopoly

Dr. Asad Zaman, VC PIDE

# 1 What kind of Markets Does S&D analysis apply to?

Conventional Economics Textbooks create the impression that Supply and Demand Analysis applies to all types of markets. In fact, as the H&M Anti-Textbook demonstrates, S&D applies only to perfectly competitive markets.

Meta-Theoretical Questions that we will try to answer:

- What are the rhetorical strategies textbooks use to create this false and misleading impression about S&D?
- Why do textbooks want students to believe that S&D is universally applicable, when this is easily proven false?

# 2 S&D Theory does not apply to Monopoly

Supply curve only defined for PRICE TAKERS. Monopolies are price MAKERS. Furthermore, in a survey of 2000 firms by Blinder, nearly all firms surveyed SET the prices of their good, and FIX them for relatively long periods of time. NO RESPONSE to fluctuations of S&D. Empirically, Supply curves don’t exist in such markets. Therefore S&D Analysis is not valid

Varian knows all of this; mentions the failure of S&D in Oligopoly and Monopoly. How does he convince students to believe in Universal Validity of S&D? Rhetorical Strategy Used by Varian: S&D introduced in Chapter 1, USED in a wide range of examples, said to apply to all markets, when, In fact, it ONLY applies to perfectly competitive markets.

Textbook Examples are given of Cigarettes, Oil, Autos – these are all oligopolies. No good examples of perfectly competitive markets are available. Using these examples, without any discussion of market structure, convinces students that S&D can be used everywhere. Some textbooks actually say this.

Varian introduces Monopoly Chapter 25, after 450 pages. Discussed in very complex mathematical way. How it affects previous discussion of S&D model is not mentioned.

Toxic Textbooks: In 2011, Edward Fullbrook, writing on *Toxic Textbooks*, pointed out that “*No discipline has ever experienced systemic failure on the scale that economics has today*”. And added that the global financial crisis revealed that “..*we, the textbooks we use, and the courses that we teach harbour fundamental misconceptions about the way economies, most especially their markets, function*” (__http://ineteconomics.org/blog/inet/edward-fullbrook-toxic-textbooks__).

# 3 Economics as Rhetoric

Rhetoric is The Art of Persuasion, Dierdre/Donald McCloskey writes that:

Samuelson – Arrow created the cult of mathematics in economics. Arguing from axioms to proof, without ever checking against reality. Use of impenetrable mathematics created an aura of expertise and shielded them from criticism of critics, who could not understand/follow the complex mathematics they used.

Krugman: How did Economists get it so wrong?

**Before GFC 2007-8**: Celebration of Success: Lucas: Problem of prevention of depression has been solved (2004: AEA address)

Ben Bernanke: Great Moderation- Central Banks have tamed the business cycle.

**After GFC 2007-8**: It all came apart! Current Macro Models CANNOT be used to model crises. “*The profession as a whole went astray, because it mistook the beauty of math for truth*.”

## 3.1 Classical (Varian-style) Analysis: Simplified Form

First we replicate standard textbook arguments for efficiency of PC (perfect competition) relative to monopoly.

Under PC, market supply is the sum of the aggregate cost curve, so the industry cost curve is the same as the supply curve (*as noted before, this is actually the fallacy of composition – industry cost may not be same as sum of individual firm cost curves, for many reasons*). In PC, production will take place at intersection of S&D curves, which maximizes consumer surplus. In a monopoly, supply will be at point where MR=MC, where MR curve is below demand curve. So industry supply will be smaller and costs will be higher. Demand curve measures marginal benefit to society, while marginal cost measures costs to society. Expanding output in monopoly will increase benefit, while the cost of providing the benefit will still be less than the benefit. So expanding output is good for society – Monopoly is harmful, while Perfect Competition is beneficial to society

## 3.2 Effect of Government Regulation:

Suppose government sets a price ceiling equal to the competitive price – this will be below market price as set by monopoly. Then standard analysis shows that output expands, price drops. Price = Marginal Cost.

**Efficiency is achieved via Government Regulation !**.

OPPOSITE LESSONS from those of PERFECT COMPETITION.

Setting a PRICE CEILING leads to efficient production for monopolies. They cannot exploit market power to charge customers more than costs and make pure profits.

# 4 Alternative, less mathematical analysis

Firms DO NOT use calculus to maximize profits.

They have tables of values of production setups and approximate costs.

We show how maximization works, without any calculus. This is how it is done in real life. Easy, direct calculation is possible. Makes model intuitively understandable. This is ESSENTIAL aspect of models, which is not true for theoretical textbook economic models

Unique Seller – Monopolist –

Ice-Cream (Choc-bars) in F9 Park

Fixed Cost = PKr500; Var Cost = PKR 25/chocbar

Assumptions: Full Information, Zero Transaction Costs, Assumption: Certainty, no random variations

## 4.1 Role of Models

**Correct Role**: Helps to simplify complex reality, in order to understand significant aspects of it, while eliminating irrelevant or minor complications.

**WRONG role**: Makes simple reality hard to understand by covering it with irrelevant and complex mathematics, which subtracts from understand. Goal is to mislead and deceive students

The Rhetoric of Economics: Mislead students about realities of monopolies and perfect competition. Argue that free markets work best without interference and argue AGAINST government interventions.

By making a simple model, which can be understood intuitively, students can understand whether or not the model is reasonable. Covering the realities with mathematics makes it impossible for students to understand the meaning of the assumptions being made, and assess whether or not they are realistic. It is easy to see that Essential Aspects of Ice Cream Monopoly IGNORED in the textbook mode. Almost central to any model of this situation should be:

**UNCERTAINTY**: Stochastic Variation in Demand – It is impossible for the ice-cream seller to know how much he will be able to sell; there is too much random daily variation in numbers of people coming to the park and interested in buying ice-cream. This also depends on the weather, which cannot be predicted.

This uncertainty makes it IMPOSSIBLE to MAXIMIZE, in the same way as in CALCULUS models

So what is the ALTERNATIVE? Normal human beings use Rules-of-Thumb, also called HEURISTICS. This is how Agent-Based-Modelling works. We give agents rules for decision making and then ask computer to calculate what will happen. This cannot be done by calculus and math. In this course, we will not teach ABM, but we will teach the MINDSET behind ABM, so that you can CREATE ABM models.

There are two parts to any model: CONCEPTUALIZATION and CALCULATION. In ABM models, we focus on conceptualization – let computer do calculations

## 4.2 Effect of Price Regulation:

**REGULATION**: Maximum price of ice-cream can be only PKR – 50 Alternatively: Max Profit Margin can be 100%.

**Effect**: Monopolist Seller will charge PKR 50, His profits will go down to 19,500 from 27,000. Sales will go up from 500 to 800

The demand curve reflects the Willingness to Pay. When it is above the market price, then this difference reflects the benefits that the consumer derives from the purchase. Adding up all the surplus gives us the total consumer surplus, which is a measure of the total benefit to society which results from this market setup.

When a monopolist sells at a higher price than that of perfect competition, then some of this surplus is lost. The amount of lost surplus is the shaded triangle in the Fig 6.6 above, from the H&M textbook. That is called the deadweight-loss. However, there is one case in which this loss can be avoided. That is the case of the Discriminating Monopolist. If Monopolist can find out what the WTP is for each customer, and also sell to them at exactly that price – charging each customer differently, according to their willingness to pay – Then he extracts all surplus

The Result Is that: Market is FULLY and MAXIMALLY efficient:

That is EVERYBODY gets ice-cream, from PKR 300 to PKR 120. But everybody gets it at maximum price they are Willing To Pay. ALL benefits (surplus) goes to monopolist. ZERO benefits go to Consumers.

Illustration of very famous: **COASE THEOREM. **Give ownership to EITHER consumers, OR to PRODUCERS, and markets will be efficient, but DISTRIBUTION will be to one side or the other.

Consumer Surplus At Regulated Price: Much Higher, Price ceilings create welfare for consumers. Question are most markets perfectly competitive or monopolistic? If we don’t know the answer, how can we conclude that price ceilings are harmful?

## 4.4 Central Economic Problem: Income Distribution

Robert Lucas (Chicago School Ideology). *Of the tendencies that are harmful to sound economics, the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution*.

The concept of GNP per capita – evaluates the nation AS IF income was equally distributed among all the people.

This HIDES (deliberately) inequality. Then we add in the GINI coefficient (this FURTHER hides and CONFUSES). It is possible to easily display inequality. If these statistics were in use, then there would be more outcry about the amazing amount of inequality, which keeps rising.

Direct measurement of GNP in top quintile and bottom quintile is SIMPLEST solution. Not generally available.

## 4.5 First & Second Fundamental Welfare Theorems

The **First Theorem** states that a market will tend toward a competitive equilibrium that is weakly Pareto optimal when the market maintains the following three attributes:

**complete markets**– No transaction costs and because of this each actor also has perfect information, and**price-taking****behavior**– No monopolists and easy entry and exit from a market.

Furthermore, the First Theorem states that the equilibrium will be fully Pareto optimal with the additional condition of:

**local nonsatiation of preferences**– For any original bundle of goods, there is another bundle of goods arbitrarily close to the original bundle, but that is preferred.

The **Second Theorem** states that, out of all possible Pareto optimal outcomes, one can achieve any particular one by enacting a lump-sum wealth redistribution and then letting the market take over.

**Problem: Key Marxist Insight: POWER MATTERS**

The idea that we CAN redistribute income easily is a HUGE fallacy. This central problem cannot be solved BECAUSE: Income depends on POWER

Power concept does not exist in economics

Methodological individualism – there are no communities.

RHETORICAL STRATEGY used to dismiss Marx:

Marx taught the labor theory of value. This has been discovered false. Marx taught that Capitalism would collapse due to over-exploitation of laborers. this has proven false. By the same argument, we should not study Adam Smith, since he also taught labor theory of value!

SO NO NEED TO STUDY MARX!

- Marx’s theory: Money goes to the powerful
- Marx: Exploitation of Labor: Graph shows how the income share of laborers has declined as free market policies became widely adopted in the Reagan Thatcher era.

## 4.6 Evolution to Competitive Equilibrium

Monopoly will automatically disappear if

- there is FREE EXIT and ENTRY
- There are no increasing returns to scale (natural monopoly)

Ice-Cream Problem has this feature. New Vendor can come into the market. Let us examine effects of this.

As we will see, it is ESSENTIAL to examine the DYNAMICS of convergence to equilibrium. It is essential to KNOW what happens in dis-equilibrium, because that will determine whether or not convergence to EQUILIBRIUM occurs.

So CANNOT study ONLY Equilibrium outcomes !

# 5 Duopoly: Second Seller Enters Market

Under assumptions of FULL INFORMATION, ZERO transaction cost, What will happen?

One seller in park, selling icecream for 80 PKR

** **Second seller can either MATCH price and share sales, or CUT price and get ALL the customers (not realistic, but assumed by neoclassical economic theory

Calculate revenues to find that CUT gets more profits.

** ****Match** PKR 80 – both get 250 sales. (X has 250 unsold)

Revenue is 80*250=20,000 each. Cost is 6250+500=6750

Both have profit of 13,250 (X has loss of wasted ice-cream

**Cut Price**: PKR 70: All 600 customers goto Y. Y makes profits of 26,500. X makes a big loss of all his investment plus transaction cost = 12,500+500=13,000

So which one will he take? Short-Run Profit Max is CUT PRICE.

So in the round, first vendor loses all sales to the second. BUT what happens next day? He has the same two choices, and it turns out that CUT brings more profit. In third round second vendor again cuts price.

This is called Bertrand Price Competition. In this situation, equilibrium occurs at (30,30). Cutting prices always brings greater profits. No one can RAISE prices.

With duopoly, we are already at Perfect Competition Outcome. Price is nearly equal to marginal cost.

Is this a realistic outcome?

Why or why not?

Dynamic Games – Long run equilibria differ from short run maximization strategy.

Cooperation becomes possible

Stiglitz Critique: information and transaction costs MATTER. We will show in next lecture that if we make realistic assumptions, than other, different equilibria emerge. If vendor cuts price, he will get more customers, but not ALL the customers, in this case, we get different outcomes.

Next Lecture: AM04 Duopoly

Previous Lecture: AM02: Supply and Demand