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April 6, 2005

Patent Economics: Part 1 - Market Monopoly

This begins a series on the economics of patents. This first installment explains the economics of market monopoly, to be contrasted with patent economics in succeeding installments.

A patent is widely considered a monopoly, and though it smacks of truth, the reality is not so simple. Monopolies are generally ill-favored, as, at least in theory, they raise prices above what would naturally occur in a competitive market. Anti-patent ravers stake their rationale against patents as representing monopoly power that unduly costs society. A further contention, espoused most fervently nowadays by anti-software patent advocates, is that patents have the perverse effect of retarding innovation, rather than actually encouraging it. With some grounding in economics, specifically market monopoly, and an understanding of the economic nature of patents, one sees the "evil patent monopoly" viewpoint as gross overstatement.

The word monopoly dates to 1534, and its primary definition is "exclusive ownership through legal privilege, command of supply, or concerted action." Patents do share certain characteristics of a monopoly, specifically, exclusivity as a sole legal provider of a technology, which may translate to products sold in the market. But a patent as a monopoly differs considerably from a market monopoly.

Economists call products goods. While "good" in this usage is a noun, it shares its meaning with the adjective good; namely, goods are good for consumers, in benefit and usefulness.

The more money consumers have, the more goods they can consume. As the price of a good drops, the overall demand for that good goes up. People buy more when a product becomes cheaper. This states an inverse relationship between price and demand, resulting, if charted, as a downward-sloping demand curve.

A firm (company) selling in the market maximizes its profits by selling at the point where the firm's marginal revenue (MR) equals its marginal cost (MC). For a firm, churning out one more widget (unit) has an incremental (marginal) cost, which, when bought by a consumer, results in an incremental sale, and revenue. If marginal revenue is greater than marginal cost (MR > MC), then a company can make more money by making one more widget and selling it. The point at which a firm earns less that it costs to make and sell an additional unit is where it starts losing money; this is the point where marginal cost exceeds marginal revenue (MC > MR). So, a firm should produce and sell up to the point where marginal cost equals marginal revenue (MC = MR), and not go beyond that point.

In a competitive market, a seller can not charge more than the market price (Pc), as buyers would purchase from someone else. A firm in a competitive market cannot set the price, so is a price-taker. So, in a competitive market, each firm faces the same price. The theory behind dynamic competitive pricing is somewhat complex, but put simply, sellers compete to provide a good at the lowest price they can afford. The result is that, in a competitive market, a firm's marginal revenue (MRc) is stuck at the competitive market price (Pc).

A firm will sell at the quantity (Qc) where its marginal revenue, which is the same as the price of the good (MRc = Pc), equals its marginal cost (MR = MC).

In a monopoly, where there is a single seller of the market good, the demand curve is the same, but the monopolist can affect the price, so its marginal revenue (MRm) is not given by the competitive market price. A monopolist is a price maker. It is a fairly simple but somewhat long-winded explanation to demonstrate that, under monopoly conditions, the monopolist's marginal revenue (MRm) falls twice as fast as the total market demand. Mathematically, the slope of a monopolist's marginal revenue curve (MRm) is twice the slope of the market demand curve, starting from the same point.

Any firm in any market, monopolist included, maximizes its profits by selling at the point where the firm's marginal revenue equals its marginal cost (MR = MC). In the case of market monopoly, though, with a different marginal revenue curve (MRm), the result is a lower quantity (Qm) of goods sold at a higher price (Pm), compared to the competitive market situation (quantity Qc at price Pc). Thus, a monopolistic firm reaps profits that a competitive firm could not.

Under monopoly, consumers pay more for the same good, and there are less available, than under a competitive market situation. The classic economic term for this was monopoly "rent"; a slightly different meaning than house or apartment rent, though the concept may be thought of as society paying rent to the monopoly for its existence. A more recent term is "dead weight loss", referring to the loss in a society's wealth owing to a market monopoly.

Part 1 - Monopoly
Part 2 - Substitution
Part 3 - The Inventor's Dilemma
Part 4 - Incentives
Part 5 - Theories
Part 6 - Perspectives

Posted by Patent Hawk at April 6, 2005 10:38 AM | The Patent System