Monopoly Lecture 10 Shahid Iqbal
A firm is a monopoly if...
it is the only seller of its product.
its product does not have close substitutes.
A firm is considered a monopoly if it is the sole seller of its product and its product does not have close substitutes.
Why Monopolies Arise
The fundamental cause of monopoly is the existence of barriers to entry.
Barriers to entry have three sources!!!
Ownership of a key resource.
The government gives a firm the exclusive right to produce some good.
Costs of production make one producer more efficient than a large number of producers.
Government-Created Monopolies
Governments may restrict entry by giving one firm the exclusive right to sell a particular good in certain markets. Any Example?
Example: Patent and copyright laws are two important examples of how governments create monopoly to serve the public interest.
Public Policy Toward Monopolies Governments may respond to the problem of monopoly in one of four ways.
1. Making monopolized industries more competitive.
2. Regulating the behavior of monopolies.
3. Turning some private monopolies into public enterprises.
4. Doing nothing at all. Government may do nothing at all if the market failure is deemed small compared to the imperfection of public policies.
Natural Monopolies An industry is a natural monopoly when one firm can supply a good or service to an entire market at a smaller cost than could two or more firms. Example: delivery of electricity, phone service, tap water, etc.
Increasing Competition with Antitrust Laws Antitrust laws are laws aimed at curbing monopoly power. Antitrust laws give government various ways to promote competition such as:
1. They allow government to prevent mergers.
2. They allow government to break up companies.
3. They prevent companies from performing activities that make markets less competitive.
Public Ownership Rather than regulating a natural monopoly that is run by a private firm, the government may run the monopoly itself e.g. in the United States, the government runs the U.S. Postal Service.
Price Discrimination Price discrimination is the business practice of selling the same good at different prices to different customers, even though the cost of production is the same for all customers. What do you think of this practice?
Price discrimination is not possible in a competitive market as there are many firms all selling the same product at the market price. In order to price discriminate, the firm must have some market power. That is, it must have the ability to set its prices without being afraid that its customers will go to competing firms. Price discrimination won t work if resale is easy.
Examples of Price Discrimination Movie tickets Airline tickets Discount coupons Financial aid Quantity discounts
CONCLUSION: The Prevalence of Monopoly We have seen that monopoly is inefficient. But how widespread is monopoly? How worried should we be? Monopolies are common. Most firms have some control over their prices because of differentiated products. But Firms with substantial monopoly power are rare. Few goods are truly unique.
Pricing Power While a competitive firm is a price taker, a monopoly firm is a price maker.
Regulated monopoly As the unregulated monopolies seek to maximize profits, output is restricted so that price is set higher than what everyone can afford. However, some monopolies control services that are considered basic necessities for human survival. In order to get companies to produce enough of a product for everyone, governments regulate a firm's output.
Dilemma of regulation: When a regulated monopolies price is set to achieve the most efficient allocation of resources, the regulated monopoly is likely to suffer losses, or economic losses, while only making normal profits.
Internal Rate of Return A project s IRR is the return it generates on the investment of its cash outflows. Project s return on investment.
Internal Rate of Return Decision Criteria The decision rule is: Accept when internal rate of return is equal to or greater than the required rate of return. Reject when internal rate of return is less than required rate.
Internal Rate of Return (IRR) A project s IRR is the return it generates on the investment of its cash outflows For example, if a project has the following cash flows 0 1 2 3-5,000 1,000 2,000 3,000 The price of receiving the inflows The IRR is the interest rate at which the present value of the three inflows just equals the $5,000 outflow
Decision Rules of Internal Rate of Return (IRR) Stand-alone Projects If IRR > cost of capital (k) accept If IRR < cost of capital (k) reject Helps to determine the YIELD on an investment.
So now what? Once you ve calculated IRR If IRR is greater than the cost of capital, then you ve got a GOOD project on your hands (go for it!). If IRR is less than the cost of capital, then you ve got a BAD project on your hands (don t undertake the project ). If the IRR and cost of capital are equal, then you should use another method to evaluate the project. Basically, the higher the IRR, the better the project
Multiple IRRs When projects have non-normal cash flows, multiple IRRs may occur A non-normal cash flow occurs when a project calls for a large cash outflow sometime during or at the end of its life. There is no way to know which IRR is correct??
Sign changes in the Cash Flows IRR evaluates a project correctly when there is an initial negative cash flow, followed by a series of positive ones (-+++). If the signs are reversed (+---), that will change the accurateness of the IRR calculation. If there are multiple sign changes in the cash flows (+-+-+) or (-+-+-), your calculation would result in multiple IRRs, also making the project very difficult to evaluate.
NPV vs. IRR? The NPV calculation will usually always provide a more accurate indication of whether or not a project should be undertaken or not. However, since IRR is a percentage, and NPV is shown in $$, it is more appealing for a manager to show someone a particular rate of return, as opposed to $$ amounts.
Why do we use IRR? IRR is necessary from a capital budgeting standpoint. Just as NPV is a way to evaluate an investment, IRR provides more insight into whether or not a project/investment should be undertaken. More useful for long term investments, with multiple cash flows. Allow you to track performance over time, seeing when investment is doing well and when poorly. Allow you to quantify risk (volatility) and correlation (comovement) with other investments and other phenomena. Are fairer for judging investment performance when the investment manager does not have control over the timing of cash flow into or out of the investment fund
Modified Internal Rate of Return Another capital budgeting tool for investments Assumes that the project s cash flows are reinvested at the cost of capital, not at the IRR. This slight difference, makes the MIRR more accurate than the IRR.