Question

Use the following list, which gives some information about seven firms, to answer Problems 10 and 11 An airline company cuts ticket price to increase its market share. A single firm, has a significant portion of a key resource needed to manufacture a medicine that has no close substitutes. A barrier to entry exists, but the good has some close substitutes. A firm offers discounts on every Saturday. A firm will lose most of its customers if it increases the price of its product. The government issues a state-owned firm an exclusive license to produce oil. A power station experiences economies of scale even when it supplies electricity to all the residents in a city. Which of the seven cases are natural monopolies and which are legal monopolies? Which can price discriminate, which cannot, and why?

Short answer

Natural Monopoly: Power station. Legal Monopoly: State-owned firm with exclusive oil license. Can price discriminate: Airline company and firm offering discounts on Saturdays.

Step-by-step solution

- Understand Definitions

A natural monopoly arises when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms, often due to economies of scale. A legal monopoly occurs when a government gives exclusive rights to a single firm to produce a product or service.

- Identify Natural Monopolies

Review the given information about the firms to determine which ones meet the criteria for a natural monopoly. A firm that experiences economies of scale when supplying a product for the entire market would be considered a natural monopoly.

- Identify Legal Monopolies

Review the given information to find instances where the government has provided exclusive rights to a firm to operate in a specific market or produce a certain good or service. These firms are legal monopolies.

- Determine Price Discrimination Capabilities

Price discrimination occurs when a firm sells the same product to different buyers at different prices. Firms can price discriminate if they have some control over their prices and can segment the market. Evaluate which firms have such abilities based on the given information.

- Categorize Each Firm

Let's categorize each firm based on the information provided:1. Airline company cutting ticket price to increase market share: Can price discriminate2. Firm with significant portion of a key resource for a medicine: May be considered a type of monopoly but in itself doesn't fit neatly into natural or legal monopoly without government grant3. Barrier to entry with some close substitutes: Not a monopoly4. Firm offering discounts on Saturdays: Can price discriminate5. Firm losing most customers if price increased: Not a monopoly6. State-owned firm with an exclusive oil license: Legal monopoly7. Power station experiencing economies of scale: Natural monopoly

- Summarize Findings

Based on the categorization:Natural Monopolies: Power stationLegal Monopolies: State-owned firm with exclusive oil licenseFirms that can price discriminate: Airline company, Firm offering discounts on Saturdays

Key concepts

Natural Monopoly

A natural monopoly occurs when a single firm can supply an entire market more efficiently than multiple firms.
This often happens due to economies of scale, where the cost per unit decreases as more units are produced.
For example, in the exercise, the power station that supplies electricity to all the residents in a city is a natural monopoly.
The costs associated with infrastructure and distribution are so high that it makes sense for just one firm to handle the entire supply.
Because of this, natural monopolies typically experience lower operational and production costs relative to the size of their market, reinforcing their market dominance.

Legal Monopoly

A legal monopoly is created when the government grants a single firm exclusive rights to provide a particular good or service.
In the exercise, the government has issued a state-owned firm an exclusive license to produce oil.
This is a clear example of a legal monopoly.
Governments often establish legal monopolies to control industries that are vital to the economy or public interest.
This can include utilities, telecommunications, or natural resources.
The goal is to regulate production, ensure consistent services, and prevent over-exploitation of resources.

Price Discrimination

Price discrimination happens when a firm sells the same product to different buyers at different prices.
In the exercise, the airline company that cuts ticket prices to increase market share and the firm offering discounts on Saturdays are using price discrimination.
For a firm to price discriminate effectively, it must have some market power, the ability to segment markets, and prevent resale between different buyers.
Common forms include student discounts, senior citizen discounts, and peak vs. off-peak pricing.
This strategy helps firms maximize their profits by capturing consumer surplus and appealing to different customer groups.

Economies of Scale

Economies of scale refer to the cost advantages that firms enjoy when production becomes efficient.
As production scales up, the average cost per unit decreases.
This is due to factors like bulk purchasing of materials, more efficient use of production lines, and spreading of fixed costs over a larger number of units.
In the exercise, the power station supplying electricity to an entire city enjoys economies of scale.
The larger the company’s scale of operation, the more cost-effective it becomes to produce goods or services.
This concept is crucial for understanding why certain industries have natural monopolies.

Barriers to Entry

Barriers to entry are obstacles that prevent new competitors from easily entering an industry or area of business.
They can come in various forms such as high startup costs, strict regulations, or control over essential resources.
In the exercise, the firm holding a significant portion of a key resource needed for manufacturing a medicine acts as a barrier to entry.
Other common barriers include technology patents, brand loyalty, and exclusive contracts.
These barriers serve to maintain high market entry costs and limit the number of firms, protecting incumbent companies from new competition.
This, in turn, can lead to monopolistic or oligopolistic market conditions.