How the Limit-Pricing Model Fit within the Harvard Approach to Industrial Economics - Assignment Example

What barriers to entry are there' How does the limit-pricing model fit within the Harvard approach to industrial economics' How might economists fromthe Chicago school differ in their assessment of the damage caused by these barriers' Normally monopoly refers to a market situation which is characterized by the presence of numerous buyers and a single producer. The definition clearly points out that there must exist some restrictions that the new entrepreneur faces while he is trying to have an access in the market to sell own product. Those are given below. 1. There are some technological causes behind the barriers for the new firms to enter in the market. Among these technological causes one is the diminishing cost structure of the monopolist firm. There are some internal and external economies and diseconomies of scale. If the economies of scale dominate over the diseconomies of scale the firm faces diminishing cost. That's why the cost declines with the expansion of the firm. Higher the amount of production, lower would be the average and marginal cost and hence higher would be the capability to charge lower price. That can be shown with the help of the following diagram. In the following diagram the horizontal axis measures output and the vertical axis measures cost. The AC is the average and MC is the marginal cost curve. The above case is called the phenomenon of natural monopoly; the new firm's entry gets restricted automatically because of the technological nature of the existing firm. New firm would not be able to compete with the existing firm. (Kutsoyiannis 1994) 2. There are many barriers that are responsible for the monopoly power that a firm may enjoy. A high level of fixed cost is also a cause behind the emergence of monopoly power. If in an industry, starting of a new venture is subject to high establishment cost or resource cost it would be difficult for the new entrants to start a new venture in the market. That also contributes to the monopoly power of the firm or firms as the scope of new entry becomes narrower due to high time and cost required for starting production in the market. (Hoag 2006) 3. Another major cause behind the emergence of the monopoly power is the legal barriers to entry. In this situation the monopolist is protected by the legal system of the country from competition from new firms. The state enforces some laws that would enable a single company to sell any particular good or service. The best example is the case of USPS for delivering the first class mail. No other company is entitled with the right to sale same commodity. That's why USPS enjoys the monopoly power in the market. The monopoly power is protected by the federal law. (Mofatt, n.d.) 4. One major cause of the emergence of monopoly is the right of patents or some copyright or intellectual property rights. By these things a person or a firm or an organization gets the sole right to produce and sale a particular commodity on which none else can enjoy any type of right of producing that in the market. Hence the owner of the patent or copyright or intellectual property right is entitled with the monopoly power. Hence the patent act is a major barrier for the entry of new firms in the market. (Langinier 2004) 5. Licensing policy by the government also acts as a barrier for the new firms to enter into the market. Only the license holders would enjoy the right to sale that particular commodity in the market. 6. The ownership right on some essential resources also acts as a barrier for the entry of the new firms in the market. The best example was the International Nickel Company of Canada had 90 percent control over the global sale of Nickel products due to its ownership on nickel. (Campbell, McConnell, and Campbell 2004) Limit Pricing: Limit pricing is a policy played by the firms under the situation of imperfect competition, especially by a monopolist. The main objective of the policy of limit pricing is to create a barrier before the new entrepreneurs who want to enter the market. Whenever a new entrant wants to sell the product in an imperfect market the existing firm or firms would apply this strategy to restrict the entry of the new firm. On the other hand the incumbent firm or firms would not decrease the quantity produced. The limit price is chosen in the way that it would be lower than the average cost of production. The effect of this policy is that the production no longer remains profitable to the entering firm due to the limit price or lower price. What is the logic behind such application' The economists of Chicago College would interpret this as the strategy to wipe out any chance of competition in future. If we consider a monopolist we know that he can make super normal profit in the market. When his monopoly situation is endangered by the entrance of new firm it would select the price low enough so that the new firm cannot compete in the market. On the other hand the higher quantity produced by the monopolist deters the entry of the new firm in the market and that quantity assures it higher profit also. What costs are associated with monopoly' What do Cowling and Muller's (1978) results suggest with the regard to the size of these costs' Evaluate the implications of their study' Perfect competition is known to be the most desirable form of market. According to the economists the supremacy of the perfect competition lies in the fact that in such a market neither any buyer nor any seller enjoys any kind of market power and the demand supply interaction determines the price level. On the other hand the monopoly situation is the extreme case of market imperfection. In this we find only one seller who controls the entire supply of the product in the market. This helps the monopolist to enjoy the market power and that's why the monopolist can charge market price higher than the marginal cost i.e. the marginal cost pricing rule is not followed. That can be shown mathematically Normally we know that the total revenue function can be given as: TR=P.q while TR= Total Revenue. P= Price level and q=quantity Then differentiating both sides with respect to q we get or, we can write ) or Or or we know that i.e Price elasticity of demand (Henderson and Quandt, 1980, pp.176-177) Hence we can say that MR= ) this is the relationship between price and marginal revenue. Under perfect competition '=1 i.e. every firm's product is characterized by the presence of numerous substitutes and hence the price elasticity of demand is equal to . Hence we can say that (1/ ') = 0, hence MR= P, this is the unique characteristic of the perfectly competitive market. Now under monopoly 0< ' < hence 1/ ' >0. That implies there is a positive difference between P and MR; P>MR. Now the equilibrium condition of the firm can be derived from the profit maximization problem of the firm While ' = Profit, Revenue function and = Cost function both dependent on output. and The first order condition of maximization requires: =0 => or MR - MC= 0 or MR = MC Under perfect competition MR= P and hence we can say that under perfect competition P=MC i.e. the rule of marginal cost pricing is followed. On the other hand under monopoly P>MR and the equilibrium condition is MR=MC so P>MR=MC or P>MC The expression of MR is given as MR= ) so P- MC= P- MR =) or P-MC= or Here the rule of marginal cost pricing is not followed and hence we can say that monopoly implies a distortion in the market functioning. This change in price would obviously be followed by a change in the quantity. The change in quantity along with change in price would cause a loss in the society which we can call the social cost of monopoly. (Kutsoyiannis, 1979) K. Cowling and D. Mueller have used a partial equilibrium analysis to examine the social cost under monopoly. Here the assumption is based on a profit maximizing monopolist. Here the case of pure monopoly or rather we can consider an oligopoly firm with a perfect form of collusion to form a multi product monopolist type market structure so that the market situation could be exploited at the best level of the monopoly situation. The price elasticity of demand can be given as The price elasticity of demand can be expressed as That equation would help to calculate for the loss in welfare that is associated with the decision of the firm regarding the policy to charge the price above the marginal cost by keeping the mark up. How much of the quantity would be changed the elasticity of demand would determine that amount. While we consider a collusive form of oligopoly then it is sure that a higher pricing policy followed by one firm would be followed by the other firms also. If we consider that the firm is converging towards the competitive equilibrium that would definitely raise the level of consumption. But that would be a general equilibrium approach to find the convergence of the entire market. That's why Cowling and Mueller argued "To the extent that a simultaneous reduction to zero of all price cost margins is contemplated, however, Ji overestimates the net effect of the reduction in P on the ith firm's output. What the latter effect on output and welfare would be is a matter for general equilibrium analysis and is not the focus here." (Cowling and Mueller, 1978, p.729) It would be better to calculate the proportional significance of the dispersion in the output level of any firm. Here we assume a collusive cartel and the fact is that each of the firm in the market of collusive cartel enjoys some market power. That's why everybody can choose the mark up. Here we consider firm 'i' whose price is and the quantity is. Moreover we have to remember that the change in the quantity is mainly dependent on the change in demand. Then Cowling and Mueller considered the welfare loss function as: On the other hand we have obtained that from the relationship between marginal revenue and price. So from the above expression we can write or we can say that Or, from the equation of elasticity we can obtain According to the definition of elasticity of demand we know that Or we can write that (again we have just obtained that , substituting value we get that So the equation expressing the welfare loss can be written as Now in this equation in both numerator and denominator price is present, finally the equation can be obtained as: now hence The term represents the mark up. Hence the term implies the entire profit of the ith firm in the market. That can be expressed as. So the change in welfare can be expressed as This is the social cost under monopoly. (Cowling and Mueller 1978) In the study of Cowen and Mueller (1978) there has been an effort to show the loss in social welfare with the help of a mathematical approach. The derivation of the loss in social welfare is based on the assumption that the change in quantity follows a change in price which was not found in the earlier form of calculation of the loss in social welfare. The change in welfare with the perspective of the elasticity of demand is a logical explanation. But one thing is to be remembered that the proportional change in demand is found to be unity. That tends the equation of the price elasticity of demand as unity. On the other hand the theory of monopoly states that the monopolist can produce at the level of output while price elasticity of demand equals unity only in a unique condition. That is possible while the cost of production equals zero. This is perhaps a drawback of this system. We know that the equilibrium condition is MC=MR On the other hand) if ' =1 that implies MR=0 So that can be equilibrium point while the cost of production equals zero. (The midpoint of the demand) That can be shown with the help of the following diagram, P D MR A 0 B Q In the diagram horizontal and vertical axes measure output and price respectively. D is the demand and MR is the corresponding marginal revenue curve. At point A of the demand curve price elasticity of demand equals zero. So at that level MR curve intersects horizontal axis. If the cost of production equals zero then MC will lie on the horizontal axis. The equilibrium would be achieved on point B. (Stonier and Hague, 1980, pp.194-195) References 1. Campbell, R. McConnell, S. L. and Brue C. R. R. 2004. Microeconomics: principles, problems, and policies, 16th Edition, NY: McGraw-Hill Professional 2. Cowling, Keith and Dennis C. Mueller (1978) The Social Costs of Monopoly Power, The Economic Journal, Vol. 88, No. 352, 727-748 3. Henderson, James.M and Quandt, Richard T (1980), Microeconomic Theory: A Mathematical Approach; McGrawhill International Editions pp-176-177 4. Hoag, A. J. 2006. Introductory Economics, Ohio: World Scientific. 5. Kutsoyiannis, A 1979, Modern Microeconomics, English Language Book Society 6. Kutsoyiannis, A. 1994. Modern Microeconomics, By: English Language Book Society, Ch- Theory of the Firm. 7. Langinier, C. 2004, "Are Patients Strategic Barriers to Entry", Journal of Economics and Business, Elsevier, vol. 56(5), pages 349-361. 8. Moffatt, M. n.d. "What You Need to Know about Monopoly and Monopoly Powers", Economics, retrieved on May 5, 2009 from: http://economics.about.com/cs/microeconomics/a/monopoly.htm 9. Stonier, Alfred W and Hague, Douglas, C, 1980, A Textbook of Economic Theory; English Language Book Society pp-194-195 Read More