Welfare Loss from Monopoly

Doug McKee, Cornell University-Endowed Colleges, George Orlov, Cornell University
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Summary

Students are presented with several potential markets and asked to consider the welfare consequences of monopoly power in each.

Context for Use

This activity could be appropriate for the latter half of an introductory or intermediate microeconomics course. It expects students to have prior exposure to monopolies, consumer surplus, and price elasticities of demand. The activity combines all three of these ideas and is good for reviewing or fleshing out understanding of each. We expect students to take about 10 minutes in their groups and that the follow-up discussion will take another 10 minutes.

Overview

Students will consider several potential markets and think hard about the welfare consequences of monopoly power in each. Students will ideally recognize that there are several factors that matter including the price elasticity of demand for the good, the size of the market, and the importance the product to subgroups. Since the focus is on focus on consumer surplus, students should recognize that marginal cost of production has no effect.

Expected Student Learning Outcomes

- Estimate the effects of monopoly power on consumer surplus

Information Given to Students

Suppose that in each of the below markets one firm supplies most (or all) of the consumers. The government is considering breaking up one or more of these firms to increase competition and help consumers. Where would you recommend they start? Be prepared to explain your answer.

A) Salt
B) Carrots
C) Diamonds
D) Music Streaming Services
E) EpiPens
F) Cable TV


Student Handout for Welfare Loss from Monopoly (Microsoft Word 2007 (.docx) 13kB Aug22 19)

Teaching Notes and Tips

The instructor should introduce the exercise and make sure in particular that the students know that EpiPens are devices that allow individuals to administer epinephrine in the case of a severe allergic reaction. They often save lives.

The instructor should emphasize that we are analyzing hypothetical monopolies here. There are actually multiple firms supplying most of these markets in the United States. In this exercise the goal is to discuss when and why it makes sense to break up a monopoly, not analyze real world markets.

Teams should initially identify that in each market one firm has monopoly power and that this question hinges on the effect that monopoly power has on the total consumer surplus in the market. If groups are stuck, the instructor might suggest these connections.

We expect each team to then consider each market individually. There are several factors that might affect the impact of the monopoly power:
1. Elasticity of demand for the product. The more inelastic the demand, the more the monopolist will be able to raise the price (in order to maximize their own profit). Salt and epi-pens have very inelastic demand, though for different reasons. Salt makes up a small fraction of a typical household's consumption and epi-pens can be the difference between life and death. Students will likely debate the elasticities of the other goods based on availability of close substitutes. Cable TV, Music Streaming Services, and even diamonds have experienced big technological changes recently making this an interesting discussion.
2. Size of market. Monopoly power may have a huge effect on the salt market, but because it is relatively small compared to the rest of consumer spending, it might not matter very much. Cable TV on the other hand accounts for a large fraction of many households' spending.
3. Vulnerability of subgroups. The epi-pen market is relatively small, but the effects of monopoly power are huge on the subset of consumers that are interested in purchasing epi-pens. It is hard to imagine any consumers being significantly hurt by not being able to afford carrots or music streaming services.

After providing their answers, teams should be prepared to defend their answers. During the debriefing conversation, try to elicit the factors that went into their decision-making process and write them down. Ideally at the end you have a list that looks similar to the one above.

Some students may argue that cable TV is a natural monopoly and breaking it up would result in production inefficiency whose cost is passed on to the consumer. This is a completely reasonable argument though it also implies a role for regulation. Some students may also recognize that monopolists are more likely to engage in price discrimination and argue that some markets are naturally more susceptible to price discrimination.

Assessment

- Do monopolists profit more in a market that has elastic or inelastic demand? Why? A: Inelastic, because customers are relatively more willing to purchase the good when price is increased.
- What are the primary determinants of monopolist profit? A: price elasticity of demand and size of market.

References and Resources

Instructors may want to ask students to read articles about some of the markets ahead of time. E.g.,

"FDA Approves Generic EpiPen That May Be Cheaper" NY Times August 16, 2018 https://www.nytimes.com/2018/08/16/health/epipen-generic-drug-prices.html

"`Diamonds Are Forever,' and Made by Machine" NY Times May 29, 2018 https://www.nytimes.com/2018/05/29/business/de-beers-synthetic-diamonds.html

"Spotify Reaches 100 Million Subscribers, but Not Without Some Dissonance" April 29, 2019 https://www.nytimes.com/2019/04/29/business/media/spotify-100-million-subscribers-apple-podcasts.html