Monopoly and Rent Seeking

Doc. Dr. Sezgin Polat

Public Economics CoursePolitical Science Department

Galatasaray University

Fall, 2017

Outline

Market PowerNatural Monopoly

Market Power

Market Power 1

I As the Two Theorems of Welfare Economics showed, they do this so wellthat Pareto-efficiency is attained. Imperfect competition arises wheneveran economic agent has the ability to influence prices.

I This requires that the agent must be large relative to the size of themarket in which they operate.

I Imperfect competition can take many forms. It can arise due to monopolyin product markets and through monopsony in labor markets.

I Firms with monopoly power will push price above marginal cost in orderto raise their profits. This will reduce the equilibrium level of consumptionbelow what it would have been had the market been competitive and willtransfer surplus from consumers to the owners of the firm.

Market Power 2

I The assumption of price-taking behavior used to prove the Two Theoremsis violated, and an economy with imperfect competition will not achievean efficient equilibrium

I If the influence on price can be exercised by the sellers of a product, thenthere is monopoly power. If it is exercised by the buyers, then there ismonosony power, and if by both buyers and sellers, there is bilateralmonopoly. A single seller is a monopolist and a single buyer amonopsonist. Oligopoly arises with two or more sellers who have marketpower, with duopoly being the special case of two sellers.

MarketI Market consists of the buyers and sellers whose interaction determines the

price and quantity traded. Two sellers will be considered to be in thesame market if their products are close substitutes.

I Markets are also defined by geographic areas, since otherwise identicalproducts will not be close substitutes if they are sold in different areasand the cost of transporting is large.

Pricing of MonopolyI Let us use p(y) to denote the market inverse demand curve and c(y) to denote

the cost function. Let r(y) = p(y)y denote the revenue function of themonopolist. The monopolist’s profit-maximization problem then takes the form

Maxy π = r(y) − c(y)π = p(y)y − c(y)

p+ y∂p

∂y=∂c

∂y

∂p

∂y< 0 (price falls as output increases), implies that

p > c

Monopoly Pricing > Marginal Cost of Production

Mark-up Pricing

p

p(p + y

∂p

∂y) = p(1 +

y

p

∂p

∂y) = p(1 +

1ε(y)

) = MC

p = MC(ε(y)

ε(y) − 1)

Example Monopoly 1

Example Monopoly 2

Example Monopoly 3

Competition

I Three distinct dimensions of competition.I The first dimension is contestability, which represents the freedom of

rivals to enter an industry.Legal monopoly rights (patent protection,operating licenses, etc.) or other barriers to entry (economies of scale andscope, the marketing advantage of incumbents, entry-deterring strategies,etc.).

I A second dimension is the degree of concentration that represents thenumber and distribution of rivals currently operating in the same market.The performance of a market depends on whether it is concentrated orunconcentrated.

I The third dimension of the market structure is collusiveness. This isrelated to the degree of independence of firms’ strategies within themarket or the possibility for sellers to agree to raise prices in unison.Collusion can either be explicit (e.g., a cartel agreement) or tacit (when itis in each firm’s interest to refrain from aggressive price cutting).

Herfindahl Index in Manufacturing Industry - Turkey (TurkStat)

Rank Code Highest Sub-sectors 2009 2010 2011 2012 2013 2014 20151 3211 Madeni para basımı 0.999 0.999 1.000 1.000 1.000 0.999 1.0002 2640 Tuketici elektronigi urunlerinin imalatı 0.784 0.656 0.658 0.589 0.920 0.938 0.8593 1920 Rafine edilmis petrol urunleri imalatı 0.836 0.617 0.744 0.760 0.840 0.703 0.8084 1910 Kok fırını urunlerinin imalatı 0.658 0.875 0.874 0.429 0.297 0.496 0.7525 2824 Motorlu veya pnomatik (hava basınclı) el aletlerinin imalatı 0.994 0.992 1.000 0.520 0.586 0.319 0.7516 1101 Alkollu iceceklerin damıtılması, arıtılması ve harmanlanması 0.536 0.619 0.789 0.481 0.644 0.610 0.6297 3040 Askeri savas araclarının imalatı 0.329 0.446 0.666 0.741 0.604 0.503 0.5988 2311 Duz cam imalatı 0.971 0.974 0.800 0.791 0.529 0.511 0.5829 1105 Bira imalatı 0.793 0.769 0.816 0.731 0.696 0.628 0.57710 2343 Seramik yalıtkanların (izolatorlerin) imalatı 0.801 0.730 0.410 0.532 0.542 0.408 0.571

Rank Code Lowest Sub-sectors 2009 2010 2011 2012 2013 2014 201510 3102 Mutfak mobilyalarının imalatı 0.007 0.008 0.003 0.005 0.006 0.006 0.0079 1623 Diger bina dogramacılıgı ve marangozluk urunlerinin imalatı 0.004 0.007 0.005 0.005 0.004 0.005 0.0068 2363 Hazır beton imalatı 0.013 0.011 0.011 0.009 0.009 0.006 0.0067 2223 Plastik insaat malzemesi imalatı 0.009 0.005 0.008 0.007 0.008 0.007 0.0066 2829 Baska yerde sınıflandırılmamıs diger genel amaclı makinelerin imalatı 0.006 0.007 0.006 0.008 0.006 0.007 0.0065 1812 Diger matbaacılık 0.004 0.006 0.004 0.004 0.003 0.005 0.0054 2370 Tas ve mermerin kesilmesi, sekil verilmesi ve bitirilmesi 0.003 0.003 0.003 0.003 0.003 0.003 0.0043 1413 Diger dıs giyim esyaları imalatı 0.004 0.004 0.003 0.004 0.004 0.004 0.0032 2512 Metalden kapı ve pencere imalatı 0.005 0.002 0.003 0.003 0.002 0.003 0.0031 1071 Ekmek, taze pastane urunleri ve taze kek imalatı 0.003 0.003 0.002 0.002 0.002 0.002 0.002

I Capital / Labor Intensive FirmsI Innovative FirmsI Scale- Economy (Decreasing Average Costs)I Small and Medium Enterprises

Natural Monopoly

[Leach, 2004], chapter 14A production process displays increasing returns to scale if output more thandoubles when the use of every input is doubled. The cost curves of a firm thatproduces under increasing returns to scale have two important properties :

I Average cost falls as output rises.I Marginal cost is everywhere below average cost.I A market in which production is characterized by increasing returns to

scale is said to be a natural monopoly because only one firm can survivein such a market. Initially, a number of competing firms will “race to getbig.” The larger firms will have lower average costs than their smallercompetitors and will be able to charge lower prices. The smaller firms willbe unable to earn profits and will be driven from the market. Ultimately,only one firm will remain in the market.

I Not a contestable market (rivals can not enter into the market). Largesunk costs and investments.

Natural Monopoly

I Regulation : A regulator would require the monopolist to raise its outputfrom qo so that the welfare cost of the monopoly is reduced. Raisingoutput from qo to q will reduce the welfare cost of the monopoly by anamount equal to the area ABDE. A welfare cost equal to the area BCDwould remain.

I Government ownership : A government-owned firm does not need to earnprofits. The government-owned firm should therefore operate at thesocially optimal output q∗ and charge the price p∗.

Rent SeekingConsider two situations :

I A firm is engaged in research intended to develop a new product. If theresearch is successful, the product will be unique, and the firm will have amonopoly position, and extract some rent from this, until rival productsare introduced.

I A firm has introduced a new product to the home market. A similarproduct is manufactured overseas. The firm hires lawyers to lobby thegovernment to prevent imports of the overseas product. If it is successful,it will enjoy a monopoly position from which it will earn rents.

Definitions :I Profit-seeking is the expenditure of resources to create a profitable

position that is ultimately beneficial to society. Profit-seeking, asexemplified by the example of research, is what drives progress in theeconomy and is the motivating force behind competition.

I Rent-seeking is the expenditure of resources to create a profitableopportunity that is ultimately damaging to society. Rent-seeking, asexemplified by the use of lawyers, hinders the economy and limitscompetition.

Rent seeking was first discussed systematically by Tullock (1967c). The term”rent seeking” was first used to describe the activity in question by Krueger(1974).

Governments and Rent Seeking

There are two channels through which the government is connected withrentseeking.

I Lobbying : In United States, there are 100,000 professional lobbyists.These lobbyists attempt to change government policy in favor of theinterests that employ them. If the lobbyists are successful, rents arecreated.

I Bureaucrats and politicians Bureaucrats and politicians in government areable to create rents through their policy choices. These rents can be“sold” to the parties that benefit. Selling rents generates income for theseller and gives an incentive for careers to be made in politics andbureaucracy.

Examples :I Public Procurement MarketsI Public Investment Projects (Real Estate Prices)I Protective Trade Policies (e.g. Infant Industry policies)

References I

Leach, J. (2004). A course in public economics. Cambridge University Press.