Monopoly

Are Apple and Google monopolies?

Image source: Apple.com

Google and Apple, as well as other US tech giants such as Facebook and Amazon where summoned to congress in order to testify about whether their firms engaged in monopolistic behavior that damaged the US economy.

In other words, the question was whether these giant tech companies managed to dominate their markets to a degree that they were able to unfairly damage their competitors and harm consumers.

In the US, there is a long history of regulating and even breaking up companies that had gotten to large and powerful. In the 1800's, the Standard Oil Company, owned by John D. Rockefeller, which had a near monopoly on petroleum production and distribution in the US, was broken up. In the 1980's, the tefephone monopoly AT&T, which owned nearly all telephone service in the US, was broken up. Famously, this lead to much lower prices and more innovation in telecommunications.

Apple, Google, Amazon and Facebook (now called "Meta") are without a doubt large and powerful companies. Occassionally they use their power to eliminate a potential competitor--sometimes by simply just buying them, like Meta did with Instagram.

But a key question is whether this dominance hurts consumers. After all, broadly speaking, consumers appear to be quite happy with the services and products these giants provide. Several of them provide useful services--like search and social networking--for free (though with substantial advertising).

It may be that we need to think differently about what the definition of monopoly is and the potential harm that it can bring. The absence of choice for consumers may be harmful in other ways than higher prices--like large amounts of advertising, or manipulative algorithms.

Monopoly and market power are central concepts in microeconomics. And as we can see from the discussion above, they are active and changing topics. But we will start with a simple model of monopoly that demonstrates economists primary concern with lack of competition.

In our model of monopoly we will see how a firm with market power can increase market prices by reducing production. While this is good for the profits of the firm, it leads to a loss for society at whole by making consumers worse off.

Market power and the demand curve

Increase market power Increase competition Increase price Reduce price

We will think about market power primarily from the perspective of the firm. In the figure we show the demand curve for the firm's product.

We start with a flat demand curve for a company's product. We are initially at a point where the company sells everything it produces at a market price.

Press the Increase price button. What we see is that if the company tries to raise the price above the market price, then they lose all of their customers and are unable to sell their product. This is the free market situation, where the company has no ability to affect the price of the product on the market.

But let us say that the company decides to buy up some competitors. Perhaps they are not a monopoly yet, but they have eliminated some of their fiercest competitors.

Press the Increase market power button a few times. Now we see that the firms demand curve gets a downward slope. Now if we press the Increase price button, we see that the firm can increase its price without losing all its customers. Still, there ability to raise prices is limited. If they raise prices too much they will lose many of their customers. This is the concept that microeconomists call demand elasticity. This is how much (in percent) demand changes when the price changes (measured in percent).

Mathematically we can write this as:

Now let us say that the company grows even more and becomes even more dominant in that market. They buy up additional competitors and increase their market power.

Press the Increase market power button a few more times. Now we have a steeper demand curve. What is the effect of increasing prices now?

Now we see that demand is still reduced, but not by as much as before. People have fewer choices in terms alternate producers and may be forced to accept higher prices.

When the demand curve becomes steeper, the demand elasticity has become lower and demand is less responsive to prices.

This is one way we can measure market power - the steepness of the demand curve. More market power means consumers have fewer choices, and a company may increase prices, potentially improving their profits, but with the consumers literally paying the price.

Market power and producer surplus

Increase price Reduce price

Here we again see a demand curve for our firm's product. We see that the slope is relatively steep, which is to say that the demand elasticity is small, and that the company has some market power.

The dark blue line represents the marginal costs of the firm (the firms supply curve).

The light blue rectangle represents the producer surpluss. We remember that this is the difference between the market price and the firm's marginal cost.

The producer surplus is also represented in the figure underneath on the y-axis.

Let us say that the firm thinks that it can earn more money by increasing price. Press the Increase price button. What happens to producer surplus?

Here we see that producer surplus increases. We can split up the consequences of higher prices into two effects:

1. With higher prices, we see less demand.
2. For those units that we still manage to sell, we get the higher price.

The combination of these two effects is what we call the marginal revenue (mr). Marginal revenue tells us how much extra income the company earns by increasing prices a little bit.

It turns out, that when we have a linear demand curve (like here), then we can draw in the marginal revenue curve as a line with a slope that is twice that of the demand curve.

So if we write the demand curve as:

Then we can write the marginal revenue curve as:

Why do we get this result?

Let us start at a point in the figure with a quite high price. Press the Increase price until quantity demanded is close to zero.

Now let us say that the firm wants to sell one more good. They know that to sell one more good, they need to reduce the price by b.

If we press the Reduce pricebutton we see two effects:

They sell one more good and they make extra revenue on that new unit sold corresponding to the price, p.

De får solgt en til vare. Og de tjener en ekstra income på den varen tilsvarende den nye prisen: p.

But marginal revenue (mr) doesn't just take into account the revenue from that extra unit sold. We also have to include the effect of a reduced price on all the other goods we would have sold anyways but initially at a higher price. This is why the marginal revenue curve lies underneath the demand curve.

From the firm's perspecitve, how many goods should they aim to sell?

If we assume that the firm is interested in maximizing its profits, then they would continue to produce as long as the extra revenue that comes from selling one more unit (marginal revenue, mr) is higher that the extra cost from producing and selling one more unit (marginal cost, mc). In other words we produce until mr=mr!

Press the Increase price button until we reach the point where mr=mc. You can confirm that this is the point that maximizes profits by looking at the figure underneath.

Notice that the quantity that the firm decides to produce when they have market power (when mr=mc) is quite a bit lower than under perfect competition (p=mc).

Efficiency and dead-weight loss under monopoly

Increase price Reduce price

Here we see a figure that looks like the previous figure we saw. We again take the perspective of a firm where we have a demand curve for the firm's good that shows that the firm has market power since the curve has a downward slope. Under the demand curve, we then also have a marginal revenue curve. We also show a marginal cost curve (the supply curve).

As before, we start with the optimal point from the firm's perspective. The firm sets a price so that marginal revenue is equal to marginal cost. This is where we maximize our profit.

The light blue rectangle represents the total producer surplus. This is the sum of the differences between marginal cost and the price of all the goods that are sold.

Consumer surplus is the purple triangle: The sum of the differences between the consumers' marginal willingness to pay (demand curve) and the price of the good.

If we sum up consumer surplus and producer surplus, we get the total social welfare.

The firm is happy with this situation, because it is maximizing its profits.

But this comes at a cost to society, which we measure with total social welfare. This loss is what we call dead weight loss, and is represented by the red triangle.

To see this, press the Reduce price button a few times.

With a lower price, more people are willing to buy and in turn benefit from buying the product. Everyone that would have bought the product at the higher price now benefits with a lower price.

The producer surplus (light blue area) becomes a little bit smaller, but consumer surplus (purple) becomes larger. The total surplus (light blue + purple) also becomes larger.

We can continue to lower the price until the dead-weight loss is completely gone. This is where we have maximized our total social welfare.

When a monopolist increases its price above that of the free market price, it increases its profits, but at the cost of lower total welfare in society.

Quiz

Answer True or False about the following statements

1.) Let us say that the demand function for a monopoly can be written:

The cost function can be written:

a.) What is the marginal cost? What is the equation for marginal revenue?

b.) Write an equation for the company's profit as a function of production, x.

c.) Find the production level, x, that maximizes profit. Is it correct that marginal revenue is equal to marginal cost with this production?

2.) Let us say that we have a free market for a certain good. In this market, we have an aggregated supply and demand functions that can be written:

a.) With a free market, how much is produced and what is the market price? If one of the producers tries to increase prices above the market price, what happens to that companies sales? If we take the perspective of a single firm, how does the demand curve look like?

b.) Now assume that one of the firms buys up all the other firms and obtains a monopoly in the market. If the firm maximizes profit, what is the price and how much is produced? (We assume that the company has the same aggregated demand function and the same aggregated supply function as the original free market situation.)