1. “A firm would prefer to be a monopoly, rather than be involved in a perfectly competitive market.” Discuss.
Every student attending economics class knows that perfect competition is ideal for any market, while monopoly is the worst possible situation due to a number of reasons. But at the same time, it is a well-known fact that since ancient times firms have strived to gain the status of monopoly. Why is it so? The matter lies in people’s nature – monopoly offers to a firm great power and control over market and requires practically no effort to get considerable income. At the same time, for people it brings many drawbacks, such as no choice in production, necessity to pay the stated prices and others. Perfect competition, on the contrary, requires a great amount of effort from a firm to stay up in the market and get the desired income, while for a customer and economics as a whole, it means vast selection of products, reasonable prices and other favorable conditions. But is it really so good for a firm to be a monopoly and for people to make use of a competitive market? In order to answer the question, it is necessary to analyze both concepts in details.
According to W. Nicholson (2006, p.495), "monopoly is a single supplier to a market [and it] may choose to produce at any point on the market demand curve". So, it is the only firm that creates a certain output for a product. Typically, monopolies produce fewer goods, selling them at higher rates if compared to the perfect competition, in such a way trying to maximize their profit at expense of consumer satisfaction. Perfectly competitive market is a completely opposite situation that is defined by Adam Smith (2003, p.126) as "one in which there is no impediment to free contracting and free entry and exit of productive resources". Analysis of the major differences between monopolies and competitive markets is presented in the table below, which will help me illustrate the firms’ desire to become monopolies.
Firms do not have any market power in setting prices. They are price takers. Price is defined by interaction between demand and supply. Firms can only take the stated price and produce product in a quantity that will maximize their profit.
It is clear that it is much more interesting for firms to adjust market to their needs, than otherwise. It is one of the main factors when it comes to the firms’ intention of becoming monopolies.
Product differentiation
High to absolute differentiation, which means that the monopolized good has no substitute. Customer can either buy the product on the firm’s terms, or live without it (Hirschey 2008, p.426).
Zero product differentiation. Every product has a perfect substitute.
For a firm such situation is also very appealing, as in such a way it has power over people’s choice and can put their own interests above customers’. It usually means higher profit and optimized production cost.
- Number of competitors
- Single seller and infinite number of customers.
- Infinite number of sellers and customers.
It is much easier to do business without competitors, which is why a monopoly is ideal for a firm in this aspect.
- Barriers to entry – factors that prevent competitors from entering the market.
- High barriers to entry, which are rather strong to prevent new sellers from offering their services on the market.
- Free entrance and exit for sellers.
For a firm it is beneficial to work in the market with high barriers to enter, as while being a monopoly, it not only has no competitors, but also there are low chances of acquiring such.
- Elasticity of demand
- Relatively inelastic demand curve.
- Perfectly elastic demand curve.
For a firm it is more interesting and effective to control the market situation, and inelastic demand curve contributes greatly to firm’s being independent from market’s demand.
Excess profit – profit above the expected return on investment.
It is possible to preserve excess profits in the long run, as high barriers to enter prevent seller from entering the market and creating a competition.
It is possible to make profit only in the short run, as in the long run there will appear competitors that will eventually decrease excess profits to zero.
Now it becomes rather clear, why firms tend to becoming monopolies, as there is a perfect blend of power over people’s choice, market prices, ability to receive considerable income and independence of competitors and necessity to base prices on the interaction of demand and supply.
Still, in order to completely understand the situation, we have to analyze the drawbacks of firm’s being a monopoly. In order to see it, I will present a well-known example of Microsoft Corporation. During the 1990s it was the monopoly in the software market, producing the Windows operation system. Within this period of time it issued new versions and updates of the system, but what is peculiar about it, there weren’t any major improvements in it – Microsoft just didn’t have any considerable incentive to develop and improve its product, as people still had to buy it, having no other alternative. And here we see one of the most important drawbacks of monopoly – no urge for improvement. While a company remains a monopoly, it doesn’t have any serious negative impact on firm’s profit, but in case of any powerful competitor entering the market, it can lead even to company’s downfall. In case of Microsoft, the situation didn’t turn to the worst, and there is practically no chance that it will, but still with Apple entering the market situation drastically changed for the former monopolist. Today Apple in many aspects outmatches Microsoft, as the latter firm has lost a considerable amount of time when being a monopoly that in ideal should have been spent on improvement and development of its products.
Moreover, perfectly competitive outcome is always more effective than that of a monopoly, which is illustrated in Fig. 1.
Figure 1. Comparison of efficiency between perfect competition and monopoly (Rittenberg and Tregarthen 2009, p.150).
In Fig. 1 equilibrium in perfectly competitive market is achieved at point C, quantity Qc and price Pc. In similar circumstances with the same demand and marginal cost curves monopoly maximizes its profit at Qm and applies prices Pm. So, in comparison with the competitive market, the output is lower and the price higher. So reorganization of a perfectly competitive market in industry will result in deadweight loss to society, depicted in Fig. 1 by the area GRC.
So, we can see that for a firm being a monopoly is not always a winning situation, and sometimes it can even bring destructive results. Although the motivation behind firms’ desire of becoming a monopoly is clear, it is also evident that it is nevertheless better to maintain perfectly competitive market. And as for consumers, monopoly for them results in many negative consequences, bringing practically no benefits.
2. In May 2009 Intel was fined a record amount by the EU for predatory pricing. Assess how easy is it to conclude that Intel undertook predatory pricing?
In May 2009 Intel was accused of predatory pricing by AMD, as it considerably lowered the prices for its products. The European Commission’s decision (2009) was based on specific incidents:
1. During December 2002 - December 2005, Intel's rebate was granted in return for Dell's exclusivity to it.
2. Apart from several conditions ranging from delaying launch of AMD processor equipped products to limiting sales channels of these products, Intel gave rebates to HP on the condition that they buy at least 95% of its corporate desktop x86 CPUs between November 2002 and May 2005.
3. Intel gave refunds to NEC Corporation on the condition that they supply at least 80% of their CPU needs for desktop and notebook computers from Intel.
4. In 2007, Lenovo received incremental funding from Intel on the condition that Lenovo grants Intel exclusivity for its notebook segment, which eventually caused cancellation of previously made deals with AMD in 2006.
5. During the period of October 1997 - February 2008, Intel and MSH made mostly unwritten agreements to exclusively sell Intel-based products in return for some rebates. Moreover, at Intel's request exclusivity agreement was kept secret.
After the decision on May13, 2009, according to the International Data Corporation (IDC), AMD’s CPU sales increased by 31.3% in the fourth quarter of 2009. Compared to the previous year, levels of the market share of AMD have increased from 17.7% to 19.4%. It was not before the first quarter of 2010 that Lenovo launched their first AMD-based computers (Shah, 2010).
The history of predatory pricing began a long time ago. This concept was popularized in the late 19th century and since that time its idea and system hasn’t changed much. First, the predatory organization lowers the price for its production to a level below the average prices of competitors. In such a situation, competitors have nothing to do except to lower their prices, in this way losing a considerable amount of money. If they decide not to decrease prices, they will lose customers, which will also mean great losses for them. So, for the predatory firm’s competitors this strategy is a no-win situation. Usually, the firm waits until the competition is forced out from the market, and then increases its prices and compensates the money it lost in its predatory campaign. As it was stated by Steizer (1987, p.5), “In short, predation may not maximize profits. But it may nevertheless be a rational, far from unthinkable policy for business managers seeking to maximize their own career opportunities. ”
Scientists have worked out different theories describing predatory pricing, as well as its irrationality, such as Easterbrook/McGee, Kreps-Wilson, Milgrom-Roberts. But in many aspects they are generalized and don’t give clear ideas behind the firms’ motivation to get engaged in predatory pricing. For instance, Easterbrook based his model on the assumption that firms know all the peculiarities of each other’s strategies and costs (1981, p.286). The variety and controversy of the existing models already presuppose that defining the act of predatory pricing is complicated. The situation in fact is even more complicated, as it is difficult to study this question completely in theory, while practical evidence varies greatly, and in different countries there are absolutely different instances, motives and situations.
There are different theories for assessment and testing of predatory pricing:
No rule (by Bork, McGee and Easterbrook). It is assumed that predatory pricing is too rare to try to identify it, and if the government will try, it may result in many false accusations.
Short-run cost-based rules (by Areeda and Turner). It is based on assessment of prices in relation to costs, not the intention of the price-maker.
Long-term cost-based rules (by Posner). This test is focused on long-term marginal costs and involves analysis of intent and defence.
Output expansion rules (by Williamson). These rules govern permissible output of dominant firms in response to new entry and the same pricing for all firms.
Rules governing price rises (by Baumol).These rules are aimed at price increases after predation.
Industry-specific rules (by Craswell and Fratrik). This set of rules is based on the statement that different industries require different approaches.
Rule-of-reason tests (by Scherer). These tests are aimed at long-run allocative efficiency and include predator’s intent and consequences of predation.
“Two-tier” rules (by Joskow and Klevorick). These rules are aimed at narrowing the anti-predation law to those areas where it causes maximum damage. According to them, first of all, it is necessary to assess whether predation is a working strategy in each particular case.
Moreover, apart from the complex tests that have to be run in order to define a firm’s guilt, in any case there won’t be 100% guarantee that the firm really got engaged in this practice. It is conditioned by the complex nature of predatory pricing. For instance, market conditions play a key role in the assessment, as well as the very nature of the capitalist system.
Analysis of the above described situation and history and system of predatory pricing showed that it is not easy to conclude that a firm makes use of this technique. Even with modern tests that help discover predatory pricing, it doesn’t give 100% guarantee of the firm’s fault. For instance, motivation behind price lowering may be issue of a new version of company’s product and, consequently, the necessity to sell the previous version. In this situation, the loss of profit for the previous model will be compensated in future profits. Besides, it is also difficult to uncover predation if a firm sells some goods together, implementing bundle discounts. To sum up, it is possible to say that predatory pricing revealing procedures should be further developed in order to provide reliable guarantees and evidence of companies’ predatory strategies.
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Shah, A., 2010. AMD Takes Processor Market Share From Intel, IDC Says. PCWorld, [online] 26 January. Available at: <http://www.pcworld.com/article/187671/amd_takes_processor_market_share_from_intel_idc_says.html> [Accessed 7 November 2010].
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