Archive for the 'Monopoly' Category

Mar 04 2013

Monopoly prices – to regulate or not to regulate, that is the question!

Competitively Priced Electricity Costs More, Studies Show – New York Times

The problem with monopolies, as our AP students have learned, is that a monopolistic firm, left to its own accord, will most likely choose to produce at an output level that is much lower and provide their product at a price that is much higher than would result from a purely competitive industry.Regulated Monopoly A monopolist will produce where its price is greater than its marginal cost, indicating an under-allocation of resources towards the product. By restricting output and raising its price, the monopolist is assured maximum profits, but at the cost to society of less overall consumer surplus or welfare.

Unfortunately, in some industries, because of the wide range of output over which economies of scale are experienced, it sometimes makes the most sense for only one firm to participate. Such markets are called “natural monopolies” and some examples are cable television, utilities, natural gas, and other industries that have large economies of scale. (click graph to see full-sized)

Government regulators face a dilemma in dealing with natural monopolistic industries such as the electricity industry. A electricity company with a monopoly in a particular market will base its price and output decision on the profit maximization rule that all unregulated firms will; they’ll produce at the level where their marginal revenue is equal to their marginal cost. The problem is, for a monopolist its marginal revenue is less than the price it has to charge, which means that at the profit maximizing level of output (where MR=MC), marginal cost will be less than price: evidence of allocative inefficiency (i.e. not enough electricity will be produced and the price will be too high for some consumers to afford).

Here arises the need for government regulation. A government concerned with getting the right amount of electricity to the right number of people (allocative efficiency) may choose to set a price ceiling for electricity at the level where the price equals the firm’s marginal cost. This, however, will likely be below the firm’s average total cost (remember, ATC declines over a WIDE RANGE of output), a scenario which would result in losses for the firm, and may lead it to shut down altogether. So what most governments have done in the past is set a price ceiling where the price is equal to the firm’s average total cost, meaning the firm will “break even”, earning only a “normal profit”; essentially just enough to keep the firm in business; this is known as the “fair-return price”.

Below AP Economics teacher Jacob Clifford illustrates and explains this regulatory dilemma. Watch the video and see how he shows the effect of the two price control options on the firm’s output and the price in the market.

[youtube]http://www.youtube.com/watch?v=A2ePDt6-k8Q[/youtube]

The article above examines the differences in the price of electricity in states which regulate their electricity prices and states that have adopted “market” or unregulated pricing, in which firms are free to produce at the MR=MC level:

“The difference in prices charged to industrial companies in market states compared with those in regulated ones nearly tripled from 1999 to last July, according to the analysis of Energy Department data by Marilyn Showalter, who runs Power in the Public Interest, a group that favors traditional rate regulation.

The price spread grew from 1.09 cents per kilowatt-hour to 3.09 cents, her analysis showed. It also showed that in 2006 alone industrial customers paid $7.2 billion more for electricity in market states than if they had paid the average prices in regulated states.”

The idea of deregulation of electricity markets was that removing price ceilings would lead to greater economic profits for the firms, which would subsequently attract new firms into the market. More competitive markets should then drive prices down towards the socially-optimal price, benefiting consumers and producers by forcing them to be more productively efficient in order to compete (remember “Economic Darwinism”?). It appears, however, that higher prices have not, as hoped, led to lower prices:

“Since 1999, prices for industrial customers in deregulated states have risen from 18 percent above the national average to 37 percent above,” said Mrs. Showalter, an energy lawyer and former Washington State utility regulator.

In regulated states, prices fell from 7 percent below the national average to 12 percent below, she calculated…

In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates…”

That $48 billion represents higher costs of production for other firms that require large inputs of energy in their own production, higher electricity bills for cash-strapped households, and greater profits and shareholder dividends for the powerful firms that provide the power. On the bright side, higher prices for electricity should lead to more careful and conservative use of power, reducing Americans’ impact on global warming (since the vast majority of the country’s power is generated using fossil fuels).

Here arises another question? Should we be opposed to higher profits for powerful electricity firms if their profits result in much needed energy conservation and a reduction in greenhouse gas emissions? An environmental economist might argue that if customers are to pay higher prices for their energy, it might as well be in the form of a carbon tax, which rather than increasing profits for a monopolistic firm would generate revenue for the government. In theory tax revenue could be used to subsidize or otherwise promote the development and use of “green energies”.

Whether customers paying higher prices for traditionally under-priced electricity is a good or bad thing depends on your views of conservation. But whether higher profits for a powerful electricity company are more desirable than increased tax revenue for the government are beneficial for society or not seems clear. If we’re paying higher prices, the resulting revenue is more likely to be put towards socially desirable uses if it’s in the government’s hands rather than in the pockets of shareholders of fossil fuel burning electricity monopolies.

Discussion Questions:

  1. Why do governments regulate the prices in industries such as natural gas and electricity?
  2. Why would a state government think that de-regulation of the electricity industry might eventually result in lower prices in the long-run?
  3. Why, in reality, did the price of electricity in unregulated electricity markets ultimately increase so much that consumers in the market states paid billions of dollars more than in regulated states?
  4. What industries besides that for electricity share characteristics that might qualify them as “natural monopolies”? Which of the industries you identified should be regulated by government, and WHY?

230 responses so far

Mar 04 2013

“Drinking games” – Why a Budweiser / Corona merger would seriously bum out, like, a ton of frat boys

Facts: 65% of all the beer bought in the United States is produced by one of two companies: Anheuser Busch / InBev or Miller. 7% is produced by a company called Grupo Modelo. 72% of all the beer bought comes from these three companies. Much of the remaining market is shared by thousands of “micro-breweries” of varying sizes.

While there are literally thousands of beer makers in the US, technically speaking, the market is oligopolistic, since such a large share of the market (72%) is dominated by just three firms. To be classified as an oligopoly, a market must be dominated by a few large firm selling a differentiated (and sometimes a homogeneous) product. Firms are interdependent on one another and they tend to compete for consumers using “non-price competition”, which may include improving the quality of their product and offering customers a wider variety to choose from, and especially through advertising. A final characteristic of oligopoly is that high barriers to entry exist.

In the case of the beer market,  there are minimal economies of scale, since anyone with a $200 home brewing kit can technically “enter the market”. But other barriers to entering the national market for beer are significant, which explains why the market is dominated by three huge firms. Notably, brand recognition poses a barrier to entry to the thousands of small brewers in America. The brands owned by the big three firms are well-established and liked among consumers, making it difficult for smaller brewers to gain share in the market.

In the Planet Money podcast below, we hear the story two of these “big three” beer makers. Anheuser Busch / InBev is attempting to merge with Grupo Modelo, a transaction that would reduce the “big three” to the “big two”, which would give the new single firm a truly dominant position in the market, and increase the two-firm concentration ratio from 65% to 72%. The podcast explains how competition in the market for beer benefits consumers, and how a decrease in competition will harm consumers. Below, I will provide a graphical analysis of the situation.

As the podcast explains, the competition between the big three beer producers has several benefits for consumers, not least of which is the huge variety of beers available across the three firms, each trying to capture a larger share of the market by offering consumers beers that appeal to their diverse tastes. In addition, however, the nature of competition in oligopolistic markets tends to result in stable prices over time. Here’s why:

Imagine Anheuser Busch / InBev, which wishes to raise its price from P1 to P2 in the graph below. If AB/InBev raises its prices, while Modelo and Miller keep theirs unchanged, the demand for AB/InBev’s beer is likely to be highly elastic, meaning that even a small price increase will cause the quantity demanded to fall dramatically (from Q1 to Q2). Due to the high elasticity of demand above P1, such a price hike will lead to lower revenues for AB/InBev. Conclusion? A price hike is a bad idea.

graph 1

So what if AB/InBev decides to lower its prices? The graph below shows that at any price below P1, demand will most likely be highly inelastic, because a price cut will most likely be matched by Modelo and Miller, who would have to cut their prices to avoid losing a significant number of consumers to AB/InBev. If all three firms lower their prices, then each firm will see hardly any increase at all in their total sales. A price decrease by AB/InBev will set off a “price war” and the firm will see its revenues fall.

graph 2

What we end up with is what is known as a “kinked” demand curve for AB/InBev’s beers.

graph 3

The firm has almost no incentive to raise or lower its prices, since a change in either direction will cause revenues to decline. Therefore, beer consumers enjoy stable prices, and the firms choose to compete through product differentiation, innovation and, of course, advertising!

So how would a merger between two of the big three beer makers change the situation in the market? What if just TWO firms controlled 72% of the market instead of three? The fear is that AB/InBev, once it owns Modelo, will be less interdependent on the actions of Miller. In other words, it will care less whether Miller ignores its price increases or matches its price decreases. Since there will be fewer substitutes for the gigantic firm’s dozens (or hundreds?!) of beer brands, demand for them overall will be more inelastic. This would give AB/InBev more price making power, and essentially make the market look more like a monopoly.

graph 4

When a firm has monopoly power, as we can see, a large increase in price (from P1 to P2) leads to a relatively smaller decrease in sales (from Qt to Q2). If AB/InBev and Modelo were to merge the firm would be able to get away with raising the price of all of its beer brands, as consumers are less likely to switch to the competition, since a big chunk of the competition would be owned by the firm itself!

The amount of competition that exists in a market has major bearings on the consumers, as this podcast demonstrates and our graphs illustrate. With just three big firms making 72% of the beer in the US, it may not seem like that big a deal if two of them merge. But even the loss of one firm in a highly concentrated market like beer could lead to higher prices for dozens of the top selling beers in the country; hence the US government’s hesitance to give AB/InBev a green light in its plan to acquire Grupo Modelo!

Discussion Questions:

  1. How can a market with thousands of individual sellers be considered oligopolistic?
  2. Why is “brand recognition” considered a barrier to entry into the beer market?
  3. Explain why prices in oligopolistic markets tend not to increase or decrease very often.
  4. Why is “non-price competition” so important for beer makers in the US? What are some forms of non-price competition that they practice?
  5. What is meant by the statement that “monopoly price is higher and output is lower than what is socially optimal.” Would this apply to the beer market if the AB/InBev and Modelo merger were to proceed?

No responses yet

Jan 26 2011

Creative Destruction: Google, Apple, Facebook and the future of competition in the market for our minds…

I have recently been showing my AP and IB Econ classes the following New Yorker interview with Columbia Professor Tim Wu, the man who coined the phrase “net neutrality”. Wu shares his views on the “cycles” of competition in the communications industry, from radio, telephone and television in the 20th century to the internet and the “mobile web” today.

I find it a useful video for starting discussions about the pros and cons of perfectly competitive markets (represented by the “chaotic” period of any new communications technology) and imperfectly, more monopolistic industries (represented by the period later in the cycle of any communications technology when market power becomes concentrated among a few large firms).

Watch the video and pause it along the way to discuss some of the questions below.

Currents: Tim Wu on Communication, Chaos, and Control : The New Yorker

Discussion Questions:

  1. Why are new communications industries often characterized by “chaos” in their early years? How did the internet industry reflect the perfectly competitive characteristics in its early days, or even 10 years ago?
  2. How are consumers affected as communications industries go from “chaos” to control under big companies like Apple and Google?
  3. How does the behavior of firms like Google and Apple demonstrate the concept of non-price competition?
  4. Would the technology industry be more efficient if it were more competitive?
  5. Can you envision a world in which all of our online activities are done through one company, i.e. the “Googlenet” or the “Facebooknet” instead of the “Internet”? Would that world be better or worse than what we have now? Why?
  6. How is the communications industry today similar to the telephone industry 30 years ago? How is it different?
  7. Tim Wu suggest that in the future there will be no internet. Discuss as a class what you envision as a possible successor to the internet.
  8. If you had a time machine and could travel back to 1970, how would you try to explain to someone on the stree how we communicate with one another in 2011. How would you have tried to explain the internet and smart phones? Do you think someone from 1970 would believe your descriptions of products like Skype, like Google, like a phone you could watch movies on, like video chat, like “Google goggles”, etc…?
  9. If someone from 40 years in the future arrived in 2011 and tried to explain to you how humans are communicating in 2050, do you think you would believe them?
  10. Economist Joseph Schumpeter referred to capitalism as a system driven by a system of “creative destruction”. How does the history of the communications industry demonstrate the concept of “creative destruction”?

Imperfect competition in the News: After watching the video and discussion the questions with your class, go to Welker’s Wikinomics Universe and follow the link to the “Econ News” tab.  Browse the headlines from the various news feeds and look for articles that you think may be about non-price competition between firms in a monopolistically competitive or an oligopolistic market.

When you’ve found one good article, open your Diigo toolbar and add highlights to the lines in the article that you think demonstrate non-price competition between the firms described. Add one or two sticky notes using the Diigo toolbar, and when you’ve added your own thoughts, bookmark the article. Be sure to share it to your class’s group before bookmarking it so your classmates can view your highlights and sticky notes online.

If there is time left in class, log into your Diigo account and visit our class group. Read some of the highlights from your classmates’ articles and discuss with the people around you the various types of non-price competition described.

128 responses so far

Feb 07 2009

McAfee on Price Discrimination: a must-read for teachers of Microeconomics

Professor Preston McAfee on Price Discrimination

(you must have RealPlayer to view this video. Mac users can download it here)

CalTech Economics professor Preston McAfee is an expert on prices. His research spans three decades and examines the pricing behavior of firms in various market structures. In the lecture linked above the professor shares several examples of firms practicing price discrimination. I was surprised to see that many of the examples he discusses are ones that I have been using in my own lectures on price discrimination for the last few years.

McAfee presents a mathematical formula for monopoly pricing, which no AP or IB text that I’ve seen has included:

Monopoly Price = [PED/(1-PED)] x MC where PED is the price elasticity of demand of the customer and MC is the firm’s marginal cost of production.

The basic idea is that the more inelastic the customer’s demand, the higher price the monopolist should charge over its marginal cost. The implication, therefore, is that a monopolist prefers to charge higher prices to customer’s whose demand is inelastic and lower prices to customers who are “price sensitive” or whose demand is elastic. The charging of different prices to different consumers for the exact same product is what economists call price discrimination.

McAfee begins talking about price discrimination at minute 8:44 in the video. His examples include:

  • Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
  • Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
  • Grocery stores: Offer coupons to price sensitive consumers (people whose demand is inelastic won’t bother to cut coupons, thus will pay more for the same products as price sensitive consumers who take the time to collect coupons).
  • Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
  • Dell Computers: Dell price discriminates based on customer answers to questions during the online shopping process. Dell charges higher prices to large business and government agencies than to households and small businesses for the exact same product!
  • Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don’t even bother to ask.
  • Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don’t bother to ask.
  • Damaged goods discounts: When a company creates  and sells two products that are essentially identical except one has fewer features and costs significantly less to capture more price-sensitive consumers.
  • Book publishers: Some paperbacks cost more to manufacture but sell to consumers for significantly less than hard covers. Price sensitive consumers will buy the paperback while those with inelastic demand will pay more for the hard cover.
  • Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a roundtrip ticket that departs and returns during the week.

McAfee also goes into a fascinating discussion of price dispersion which is essentially a theory of oligopoly pricing. All Econ teachers should watch this video and find examples of price discrimination and oligopoly pricing that they can incorporate into their own class.

If you’re up for a challenge, try deciphering some of the mathematics in McAfee’s free, downloadable intro to economics text, available here.

5 responses so far

Feb 06 2009

Price Discrimination 101

YOUmoz | Price Discrimination in Pay Per Click AdvertisingSingle price vs. price discriminating monopolist

The article above gives a great introduction to and several examples of price discrimination among firms with market power. Read the excerpt below then discuss the questions that follow in your comments:

For any product or service, different people have different prices they are willing to pay. If you ever took an Economics course you surely remember the downward sloping demand curve, which is a graphical way of saying that you’ll get more buyers at a low price and fewer buyers at a high price. For a business that cannot price discriminate, this poses a problem. What price to offer?

There might be some consumers willing to pay 80, but twice as many consumers willing to pay 50. If you set the price at 50, you get more revenue, but the people who are willing to pay 80 are happy that your offering was 30 less than they were willing to pay. (Economists call this consumer surplus.) The ideal situation for the business would be to sell to some consumers at 80 and others (the price sensitive ones) at 50. Price discrimination – charging each consumer close to what he or she is willing to pay – increases revenue for the business.

Business strategists are forever trying to figure out ways to price discriminate. For commodities it can be difficult, but some markets are conducive to price discrimination. The classic example is the airline industry. Travelers have different itineraries and routes, and the airlines purposely impose complex pricing rules (e.g. cheaper if you stay over a Saturday) in order to price discriminate. Business travelers typically end up paying more than leisure travelers, and if you fly into or out of a small city you pay more than between large cities. On a flight with 100 passengers, it is possible that everyone paid a different price for the seat – 100 different prices for the same product. Consumers often resent these schemes, but economists love them.

Movie theaters price discriminate by charging lower admission for kids and seniors. Everyone gets the same product – a seat in the theater – but consumers that are more price sensitive pay less. Car dealers discriminate based on how much the customer haggles. Sellers of new products, especially consumer electronics, often price discriminate over time. When the iPhone was first released, consumers willing to pay $600 got to buy it. A couple months later, Apple lowered the price and a larger segment of the public was willing to buy. Apple could have charged $400 from the beginning, but then they would have lost all that revenue from the people willing to pay $600.

Buyers often feel like they are being played for chumps when they learn about price discrimination, but many economists absolutely are crazy about it and wish we had more price discrimination. Businesses are encouraged to make prices secret – create a fog of uncertainty – to get customers to accept prices offered to them. Preston McAfee, an economics professor at the California Institute of Technology, gave a talk about prices. He raves about Dell selling the same computer at different prices based on how the consumer identifies themselves at the website (small business, large business, home users).

Discussion Questions:

  1. Who suffers as a result of price discrimination?
  2. Who benefits from price discrimination and how do they gain?
  3. Is society as a whole better or worse off when a monopolist is able to price discriminate? Explain…

53 responses so far

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