Question

Suppose a new product is developed and is supplied by a monopolist with a patent. Compared with the monopoly outcome, indicate whether consumer surplus, producer surplus, and total surplus increase, decrease, or remain the same under the following scenarios. [LO 15.8] a. Another producer creates a similar product and colludes with the original producer. b. Another producer creates a similar product and competes with the original producer. c. The patent expires.

Short answer

a) No change; b) Consumer surplus increases, total surplus increases; c) Consumer surplus increases, total surplus increases.

Step-by-step solution

Understand the Monopoly Outcome

In a monopoly, the monopolist is the only supplier of the product, which allows them to set both the price and the quantity. This generally leads to higher prices and lower quantities compared to a competitive market, resulting in a higher producer surplus and lower consumer surplus.

Analyzing Collusion Scenario (Part a)

When another producer creates a similar product and colludes with the original producer, they act like a monopoly. Both companies will set prices and quantities to maximize their combined profits rather than competing. This scenario typically does not change consumer surplus, producer surplus, or total surplus significantly from the original monopoly because prices remain high, and quantities remain low.

Analyzing Competition Scenario (Part b)

In this scenario, the new producer competes with the original monopolist. This competition generally leads to lower prices and higher output. Consumer surplus tends to increase because consumers benefit from lower prices and more choices. Producer surplus may decrease as the original monopolist has to reduce prices, but total surplus (the sum of consumer and producer surpluses) usually increases due to more efficient market outcomes.

Analyzing Patent Expiration (Part c)

When the patent expires, the monopolist loses its exclusive right to produce the product, opening the market to new entrants. This usually results in increased competition, leading to lower prices and greater quantity of the product. As in the previous step, consumer surplus increases, producer surplus may decrease due to price reductions, and total surplus typically increases as the market becomes more efficient.

Key concepts

Consumer Surplus

Consumer surplus is the benefit consumers receive when they purchase a product for less than the maximum price they’re willing to pay. In a monopolistic market, prices are set higher, which generally lowers consumer surplus because consumers must pay more per unit of the product than they would in a competitive market.

However, when new competitors enter the market or when patents expire allowing more producers to join, the dynamics shift. Consumers benefit greatly as prices tend to drop due to competitive pressure. This results in an increase in consumer surplus since they can purchase the product at lower prices and have more options.

• In a collusion scenario, consumer surplus often does not change significantly since the price control remains with the now united producers.
• In a competition scenario, consumer surplus increases, reflecting greater satisfaction of consumer preferences due to higher product availability and lower prices.
• Once the patent expires, consumer surplus increases further because even more producers can enter the market, enhancing choices and price decreases.

Producer Surplus

Producer surplus is the benefit sellers receive when they sell a product for more than the minimum price they are willing to accept. In a monopoly, the producer surplus is usually quite high because the monopolist sets prices above the competitive equilibrium, allowing for greater profits.

When a monopolist colludes with another producer, the producer surplus may remain similar to the monopoly situation, as the control over prices continues. However, in cases of open competition or expired patents:

• Producer surplus may decrease in a competitive market as businesses reduce prices to attract consumers, squeezing profit margins.
• If other firms enter the market as soon as a patent expires, increased competition may force a reduction in prices, potentially reducing individual producer surplus.

While the original producer’s surplus might decrease, the overall market becomes more efficient, and smaller or new producers may gain if they succeed in capturing part of the market share.

Total Surplus

Total surplus is the sum of consumer and producer surpluses and is a measure of overall economic well-being in a market. In monopoly situations, total surplus is often lower compared to competitive markets due to inefficient market quantities and high prices.

When markets evolve towards competition, as in cases of new market entrants or patent expiration:

• Total surplus tends to increase because competition drives the market closer to equilibrium, enhancing efficiency, and distributing surplus more equally between consumers and producers.
• In collusion scenarios, total surplus doesn't majorly improve since limited competition keeps the market closer to a monopolistic equilibrium.
• Market efficiency improves further when a patent expires, increasing total surplus, as more producers join the market and drive prices closer to costs.

An increase in total surplus signifies a healthier market where resources are optimally utilized, benefiting both consumers and the gamut of producers in the industry.