AM03 Monopoly

Lecture on the model for MONOPOLY, and how it differs from Perfect Competition

RECAP Of Lecture 2,

We discussed the theory of supply and demand. Conventional textbooks use rhetorical strategies to MISLEAD students into believing that this theory is UNIVERSALLY APPLICABLE

• If you read them CAREFULLY, you will find that the S&D theory applies ONLY to perfectly competitive markets.

• If you read them carefully, you will see admissions that conditions for perfect competition are almost impossible to fulfill in the real world -- two important assumptions are FULL INFORMATION and ZERO TRANSACTION COSTS. This means that if one firm cuts prices, ALL customers would show up at its door to demand the good. STIGLITZ has shown that even very small transaction costs will PREVENT results of Supply and Demand Analysis from being valid.

• In real world markets, MONOPOLIES and MONOPOLISTIC COMPETITION are far more common that perfect competition. In these market structures, firms have the power to set prices -- when firms set prices then SUPPLY CURVES DO NOT EXIST. Therefore, automatically, S&D Analysis is invalid.

In Lecture 3, we will study the theory of MONOPOLY -- the OPPOSITE extreme of perfect competition. Here, honest textbooks admit that there is NO Supply Curve, the monopolists set prices and quantities. However, while perfect competition S&D model is used throughout Varian's textbook, the MONOPOLY model is introduced near the end of the book, in chapter 25, page 458 of a thick book -- obviously, not a very important model!! In fact, the monopoly model is the MORE IMPORTANT model as it more accurately describes what we see in the real world around us.

1. Our first goal in Lecture 3 will be to review the monopoly model, to explain clearly why S&D fails in this model, and why policy conclusions for monopolies are the OPPOSITE of the policy conclusions from perfect competition. We CAN improve market outcomes using GOVERNMENT REGULATION. This is stated in textbooks. Nonetheless, students come away thinking that government regulation is always harmful, because this is the MAIN lesson being state for 450 pages, and so when a chapter says it MIGHT NOT hold in monopoly, you ignore it.

2. EVEN MORE interesting is the analysis by Steven Keen in Debunking Economics Chapter 4, which shows that even in the PERFECT COMPETITION models used in neoclassical textbooks, there is a simple mathematical error in the analysis. The textbooks assume that each firm faces a FLAT demand curve, even though the aggregate demand curve is sloping. That is, firms act as if the prices will not change when they expand output, even though prices will in fact change (but only by a very small amount). Even though you may ignore this small error for one firm, this CANNOT be ignored at the INDUSTRY level. A small change by one firm, when added up by thousands of firm across the industry, creates a big change. If, instead of making invalid approximations, we make exact calculations, we come up with a surprising result. The outcome for a competitive industry is the SAME as that for a monopoly. This argument is established in Keen's book on Debunking Economics in Chapter 4, . This is the material we will be covering in the next few lectures.

ILLUSTRATION of the mistake in Varian:

The graph below shows (and the text states) that even though the demand curve facing the industry is sloped, the individual firm faces a FLAT demand curve. Now the AGGREGATE DEMAND is the SUM of the demand curves faced by the firm. No matter how many thousands of flat demand lines we add, we cannot get to a curved line. An amount which is very small, when added up by a very large number of firms, becomes large and significant. ZERO is not the SAME as a VERY SMALL NUMBER. Once we correct this mistake in traditional textbooks, the theory of PERFECT COMPETITION looks very different. Now there is no longer any difference between MONOPOLY and PERFECT COMPETITION. Every firm produces a LITTLE bit less than the amount at which P=MC, because their Marginal Revenue is a LITTLE bit less than the price (because price drops a little bit due to their extra production). The industry as whole produces a LOT LESS than what it would if every firm followed P=MC rule, because a small drop by every firm, adds up to a big drop in production over the entire industry.

QUESTIONS FOR ASSIGNMENT (to be submitted in next class):

1: Textbooks assert that competitive markets are efficient while monopoly is not. Illustrate the key underlying wrong assumption behind this result.

2: Give ONE policy advice based on assumption of S&D and perfect competition which is recommended by textbooks.

3: Keeping in mind the theory of second best, explain why this policy advice does not necessarily guarantee an increase in efficiency.