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Varian, natural monopoly

Varian, natural monopoly - estimated benefits and ions a...

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Unformatted text preview: estimated benefits and ions, a patent life of 17 t it achieved 90 percent e basis of these figures, ) make drastic changes nts provides incentives observers have argued to business processes, atent quality. nsions: length, width, ant protection applies. t are interpreted. The ermining whether the niy the iength is easily adth, and novelty, can cent years, many firms y every aspect of their a and compete with an find itself encumbered it important to invest paid $440 million to ‘.s related to computer osystems in which it )03—04, Microsoft was ;e companies like Mi- ; chips in cross—license crate like the nuclear Jar. Each had enough sured destruction” in :ould risk an attack. tries to sue HP for if its own patents and logy. Even companies lr business are forced rm NATURAL MONOPOLY 43 to do so in order to acquire the ammunition necessary for defe other suits. The “nuclear bomb” option in patent thickets is a iminary injunc— tion.” In certain circumstances, a judge might co el a company to stop selling an item that may be infringing on so me else’s patent. This can be exceedingly costly. In 1986, Kodak h 0 completely shut down its in- stant photography business due to a rt—ordered injunction. Eventually Kodak had to pay a billion~doll udgrnent for patent infringement. An injunction to stop pro tiou can be a huge threat, but it has no force against companies the out produce anything. InterTrust, for example, didn’t sell any p ucts—all of its income came from licensing patents. Hence, it c threaten to sue other companies for patent infringement witho uch worry about the threat of countersuits. E 24.6 Natural Monopoly We have seen earlier that the Pareto efficient amount of output in an indus— try occurs where price equals marginal cost. A monopolist produces where marginal revenue equals marginal cost and thus produces too little output. It would seem that regulating a monopoly to eliminate the inefiiciency is pretty easy—all the regulator has to do is to set price equal to marginal cost, and profit mam'mization will do the rest. Unfortunately, this anal— ysis leaves out one important aspect of the problem: it may be that the monopolist would make negative profits at such a price. An example of this is shown in Figure 24.6. Here the minimum point of the average cost curve is to the right of the demand curve, and the intersection of demand and marginal cost lies underneath the average cost curve. Even though the level of output ppm is efficient, it is not profitable. If a regulator set this level of output. the monopolist would prefer to go out of businesa This kind of situation often arises with public utilities. Think of a gas company, for example. Here the technology involves very large fixed costsefi creating and maintaining the gas delivery pipes——and a very small marginal cost to providing extra units of gas—once the pipe is laid, it costs very lit— tle to pump more gas down the pipe. Similarly, a local telephone company involves very large fixed costs for providing the wires and switching net: ,. work, while the marginal costs of an extra unit of telephone service is very low. When there are large fixed costs and small marginal costs, you can easily get the kind of situation described in Figure 24.6. Such a situation is referred to as a natural monopoly. If allowing a natural monopolist to set the monopoly price is undesir— able due to the Pareto inefficiency, and forcing the natural monopoly to produce at the competitive price is infeasible due to negative profits, what is left? For the most part natural monopolies are regulated or operated .INWeowe Mull.» Mos/mos) a meow Mam, ,ng —--7 b7/ \‘l . \lIV-XW COPHMW 2006 [7 1‘}. Wires/91d Figure 24.6 436 MONOPOLY (Ch. 24) use 3.1-”.-. '__ i- ' ' Losses to the 'firm ‘ ' from marginal cost pricinIgII: I Pmc " A natural monopoly. If 333111311 monopolrst 3113131333 131331"- . :price- equals marginal cost then it W111 produce an efiicient level of output yMc, but it Will- 'be Unable to cover its 3031.3. If it" '1‘; is reguned to. pr3duce an output W11313 price 3311313 3v3rage I '= . cost 9110.; then it will cover its costs, but Will produc3 13311313.. I .3.- output relative toI-the_efi1cient'arnount.-f- " by governments. Difierent countries have adopted different approaches. In some countries the telephone service is provided by the government and in others it is provided by private firms that are regulated by the government. Both of these approaches have their advantages and disadvantages. For example, let us consider the case of government regulation of a net“ ural monopoly. If the regulated firm is to require no subsidy1 it must make nonnegative profits, Which means it must operate on or above the average cost curve. If it is to provide service to all Who are willing to pa}r for it, it must also operate on the demand curve. Thus the natural operating position for a regulated firm is a point like {131101311101 in Figure 24.6. Here the firm is selling its product at the average cost of production, so it covers its costs, but it is producing too little output relative to the efficient level of output. This solution is often adopted as a reasonable pricing policy for a natural monopolist. Government regulators set the prices that the public utility is allowed to charge. Ideallyr these prices are. supposed to he prices that just allow the firm to break even-eproduce at a point Where price equals average costs. The problem facing the regulators is to determine just What the true ._.=....L—.‘.__ ___1,AA4__ _____M_—,_____._______ ._.._,___ ._ WHAT CAUSES MONOPOLiES? 437 costs of the firm are. Usually there is a public utility commission that investigates the costs of the monopoly in an attempt to determine the true average cost and then sets a price that will cover costs. (Of course, one of these costs is the payment that the firm has to make to its shareholders and other creditors in exchange for the money they have loaned to the firm.) ' “In the United States these regulatory boards operate at the state and local level. Typically electricity, natural gas, and telephone service operate in this way. Other natural monopolies like cable TV are usually regulated at the local level. The other solution to the problem of natural monopoly is to let the gov- ernment operate it. The ideal solution here in this case is to operate the service at price equals marginal cost and provide a lump—sum subsidy to keep the firm in operation. This is often the practice for local public trans- portation systems such as buses and subways. The lump—sum subsidies may not reflect inefficient operation per se but rather, simply reflect the large fixed costs associated with such public utilities. Then again, the subsidies may just represent inefficiency! The problem with government-run monopolies is that it is almost as difficult to mea- sure their costs as it is to measure the costs of regulated public utilities. Government regulatory commissions that oversee the operations of public utilities often subject them to probing hearings to require them to justify cost data whereas an internal government bureaucracy may escape such intense scrutiny. The government bureaucrats who run such government monopolies may turn out to be less accountable to the public than those who run the regulated monopolies. 24.7 What Causes Monopolies? Given information on costs and demand, when would we predict that an industry would be competitive and when would we predict that it would be monOpolized? In general the answer depends on the relationship between the average cost curve and the demand curve. The crucial factor is the size of the minimum efficient scale (MES), the level of output that minimizes average cost, relative to the size of demand. Consider Figure 24.7 where we have illustrated the average cost curves and the market demand curves for two goods. In the first case there is room in the market for many firms, each charging a price close to p“ and each Operating at a relatively small scale. In the second market, only one firm Cari make positive profits. We would expect that the first market might well Operate as a competitive market and that the second would operate . as a monopolist. Thus the shape of the average cost curve, which in turn is determined by the underlying technology, is one important aspect that determines whether Figure 24.7 438 MONOPOLY (Ch. 24) ': 15emand relative .to. minimum- efficient scale (A ). AIf'de- 5 ' _ .3 .rnand 15- large ' a we to the minimum. efficient. scale a compet- c‘l itive market is likely to result (B ) Blf it is small. a monopolistic .{ industry. structure, is possible. a market will operate competitively or monopolistically. If the minimum efficient scale of productionithe level of output that minimizes average costs—4s small relative to the size of the market, we might expect that competitive conditions will prevail. Note that this is a relative statement: what matters is the scale relative to the market size. We can’t do too much about the minimum efficient scale—- that is determined by the technology. But economic policy can influence the size of the market. If a country chooses nonrestrictive foreign-trade policies, so that domestic firms face foreign competition, then the domestic firms’ ability to influence prices will be much less. Conversely, if a country adopts restrictive trade policies, so that the size of the market is limited only to that country, then monopolistic practices are more likely to take hold. If monopolies arise because the minimum efficient scale is large relative to the size of the market, and it is infeasible to increase the size of the market, then the industry is a candidate for regulation or other sorts of government intervention. Of amuse such regulation and intervention are costly too. Regulatory boards cost money, and the efforts of the firm to satisfy the regulatory boards can be quite expensive. From society’s point of view, the question should be Whether the deadweight loss of the monopoly exceeds the costs of regulation. A second reason Why monopoly might occur is that several different firms in an industry might be able to coliude and restrict output in order to raise prices and thereby increase their profits. When firms collude in this way and attempt to reduce output and increase price, we say the industry is organized as a cartel. Cartels are illegal. The Antitrust Division of the Justice Department and the Bur with see If the gr output 1 questior On t1 by histc have em entering “tooling already potentie to enter eventual; prevent EXAMP The De South A world’s . yearly 1: monopo several 1 First, produce market1 the cart of total is reduc raising 1 Third diamonr in boxes cannot i of diamc the box: Finall by the $ can be E that are 2 A shot face ar . descrip WHAT CAUSES MONOPOLIES? 439 the Bureau of Competition of the Federal Trade Commission are charged with searching for evidence of noncompetitive behavior on the part of firms. If the government can establish that a group of firms attempted to restrict output or engaged in certain other anticompetitive practices, the firms in question can be forced to pay heavy fines. O_n_ the other hand, an industry may have one dominant firm purely by historical accident. If one firm is first to enter some market, it may have enough of a cost advantage to be able to discourage other firms from entering the industry. Suppose, for example, that there are very large “tooling—up” costs to entering an industry. Then the incumbent——the firm already in the industry——may under certain conditions be able to convince potential entrants that it will cut its prices drastically if they attempt to enter the industry. By preventing entry in this manner, a firm can eventually dominate a market. We will study an example of pricing to prevent entry in Chapter 28. EXAMPLE: Diamonds Are Forever The De Beers diamond cartel was formed by Sir Ernest O penheimer, a South African mine operator, in 1930. It has since gro into one of the world’s most successful cartels. De Beers handles ove 0% of the world’s yearly production of diamonds and has managed o maintain this near— monopoly for several decades. Over the years e Beers has developed several mechanism to maintain control of the iamond market. First, it maintains considerable stocks diamonds of all types. If a producer attempts to sell outside the ca 1, De Beers can quickly flood the market with the same type of diamon , thereby punishing the defector from the cartel. Second, large produc ’ quotas are based on the proportion of total sales. When the mar t is weak, everyone's production quota is reduced proportionally, t reby automatically increasing scarcity and raising prices. Third, De Beers is i olved at both the mining and wholesaling levels of diamond productio . n the wholesale market diamonds are sold to cutters in boxes of assor d diamonds: buyers take a whole box or nothingH—they cannot ohoos ndividual stones. If the market is weak for a certain size of diamon e Beers can reduce the number of those diamonds offered in the box , thereby making them more scarce. Fi 1y, De Beers can influence the direction of final demand for diamonds by e $110 million a year it spends on advertising. Again, this advertising an be adjusted to encourage demand for the types and sizes of diamonds that are in relatively scarce supply.2 2 A short description of the diamond market can he found in “The cartel lives to face another threa ,“ The Economist, January 10, 1987, 58—60. A more detailed description can he found in Edward J. Epstein, Cartel (New York: Putnam, 1978). ...
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