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Learning Objectives
By the end of this chapter, you will be able to:
• Define monopoly and calculate average revenue and marginal revenue, given data on price and output. Diagram average revenue, marginal revenue, marginal cost, and average cost curves for a monopolistic firm making an economic profit, a loss, and finally, a normal profit.
• Describe the economic role of natural and artificial barriers to entry into an industry.
• Explain why firms practice price discrimination.
• Discuss how a monopolist misallocates resources in terms of price and costs.
• Describe the costs associated with monopoly.
• Explain facts and fallacies of monopoly organization.
Monopoly
10
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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10
Introduction
Consider this. . . Do you ever cut coupons out of the local Value Mailer? Maybe you have a membership tag on your key chain for your local grocery store. No doubt you’ve seen shoppers with their coupons organized into binders and fold- ers by product line so they can maximize the amount of money they save. Some retailers promote double and triple coupon days. There are countless websites devoted to cou- pons: manufacturers’ sites offer printable coupons for their products, social network sites enable shoppers to share current deals, and other sites teach shoppers how to save money on grocery shopping by being very organized in coupon gathering. The author of one such extreme couponing site, a self-described “stay at home mom of two gorgeous baby girls,” (“About Me,” para. 1) teaches couponing classes to local community groups. She estimates that she spends 90 minutes each week cutting, filing, and organizing her cou- pons to maximize her budget and estimates that she saves on average $300 a month. For her time and effort, that comes to an equivalent wage of about $50.00 per hour take-home pay. There aren’t many part-time jobs that pay that well!
The benefits to the coupon user are obvious. But why do stores issue coupons for a 50 cent discount rather than simply reduce the price of the product by 50 cents for all shoppers? And why doesn’t everybody use coupons? After you study the material in this chapter, you will be able to explain this behavior and analyze why stores and manufacturers use coupons as promotional tactics.
Monopoly is at the other end of the market continuum from perfect competition, in the sense that perfect competition involves many firms and monopoly involves just one. The word monopoly is derived from the Greek words mono for “one” and polein for “seller.” Monopoly is the market structure in which there is a single seller of a product that has no close substitutes.
Although there are no pure monopolies, there are many firms that have some degree of monopoly power. Monopoly power is the ability to exercise power over market price and output. As you learned in the last chapter, firms in perfect competition are price takers. In this chapter, you will see that, because it has some control over price, a monopoly is a price searcher. A price searcher is a firm that sets price in order to maximize profits. A price-searching firm has monopoly power. It searches for the price–quantity combination that will maximize its profit.
10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly
A perfectly competitive firm faces a perfectly elastic demand curve. As a result, price (or average revenue) and marginal revenue are equal. However, a monopolistic firm faces the market demand curve because the firm is the single seller and is, therefore, the market. This distinction is very important because market demand curves have negative slopes. Since the monopolist’s demand curve has a negative slope, its mar- ginal revenue curve will lie below that curve. The commonsense explanation for why the marginal revenue curve lies below the demand curve is that the monopolist can’t simply
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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10
choose any price at which to sell its products. A monopolist still has to follow the law of demand and must lower price in order to sell more units of output. The price reduc- tion applies to all units of output that the monopolist sells, not just the last, or marginal, unit. Each additional unit sold adds to total revenue by the amount it sells for (its price) but takes away from total revenue by the reduction in price on each unit sold. Thus, the change in revenue (the marginal revenue) must be less than the change in price.
Some data illustrating the relationship among average, total, and marginal revenue for a monopoly firm are presented in Table 10.1. When 3 units are sold, the total revenue is $186 (3 3 $62). In order to sell 4 units, the monopolist must reduce the price from $62 to $60. Total revenue will then increase by $60 because an additional unit is being sold for $60. At the same time, it will decrease by $6 because the other 3 units now sell for $2 less each (for $60 each rather than for $62). The net result is that the monopolist has added $54 ($60 2 $6) to total revenue by reducing the price from $62 to $60. Note that marginal revenue is $54 and price (average revenue) is $60 for 4 units. Marginal revenue has to be smaller than average revenue whenever units other than the marginal one suffer a price reduction.
Table 10.1: Average, total, and marginal revenue for a monopolist Units sold Price (Average revenue) Total revenue Marginal revenue
0 $65 0 0
1 64 $64 $64
2 63 126 62
3 62 186 60
4 60 240 54
5 58 290 50
6 56 336 46
7 54 378 42
8 52 416 38
9 50 450 34
10 48 480 30
The relationship between marginal revenue and demand is graphed in Figure 10.1. When demand is inelastic, decreases in price will cause total revenue to decline. If total revenue is declining, additions to total revenue must be negative. That is, marginal revenue is negative. In Figure 10.1, a reduction in price below P
1 will decrease total revenue because
marginal revenue will be negative. This region corresponds to the inelastic portion of the demand curve. However, a reduction in price from P
2 to P
1 would increase total revenue
because the demand curve is elastic in this range.
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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10
Figure 10.1: Demand and marginal revenue
The marginal revenue curve lies below the average revenue curve when there is a negatively sloped demand curve. For a linear demand curve, the marginal revenue curve will intersect the x-axis exactly halfway between the origin and the point where the average revenue curve interests the x-axis. Demand is elastic above P
1 and inelastic below P
1 .
Profit Maximization
Think back to the discussion of demand elasticity and Cournot’s analysis of the min- eral spring owner’s situation. In that problem, the monopoly owner of a mineral spring with no production costs maximized profits by setting price where the price elasticity of demand was unitary. We can now apply the profit maximization rule MR 5 MC to this case. If costs were zero, the MC curve would lie along the horizontal axis. In Figure 10.1, the monopolist would maximize profits by producing x
l units (where MR 5 MC 5 0) and
selling them at price P 1 . Since monopolists are profit maximizers, they produce the quan-
tity where MR 5 MC and sell the product for the maximum price that the market will pay. The demand curve shows the limits of what price buyers are willing to pay for all levels of output. The mineral spring monopolist will increase sales of water as long as marginal revenue is positive, since it costs nothing more to produce another unit. You should note that this does not mean the mineral spring monopolist sells as much as possible. Rather, the monopolist sells the quantity that maximizes profit. The quantity at which profit is maximized is where marginal revenue equals marginal cost.
0
Price
Quantity/ Time Period
P1
P0
P2
E > 1d
E = 1d
E < 1d
x 1 x 0x 2 MR
D = AR
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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10
Price and Output Decisions Under Monopoly
In the more general case, where costs are positive, the monopolist finds the profit- maximizing level of output by equating marginal cost and marginal revenue. The per- fectly competitive firm is a price taker. The monopoly firm is a price searcher. A monopo- list searches for the profit-maximizing price, not the highest price. This process can be seen by looking at the cost relationships graphically.
In Figure 10.2, a monopolist is producing a certain good for which the market demand curve is D. The marginal revenue curve (MR), derived from D, and the average cost (AC) and marginal cost (MC) curves are also given. The monopolist will maximize profit by producing x
1 units because at that level of output, MR 5 MC. If MR is greater than MC
(that is, if output is less than x 1 ), the monopolist can increase profits by expanding output.
Additions to output will cause total revenue to increase by more than the increase in total cost. On the other hand, if MR is less than MC (that is, if output is greater than x
1 ,), the
monopolist will reduce output because additions to output add more to total cost than to total revenue.
Figure 10.2: The profit-maximizing position of a monopolist
The profit-maximizing monopolist will produce x 1 units of output, where MC 5 MR. Since average cost
(C 1 ) is less than average revenue (P
1 ) for output level x
1 , this monopolist is making an economic profit.
0
Price, Cost
Quantity/ Time Period
P1
C1
x1 MR
D
MC
AC
B
A Economic
Profit
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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10
After choosing output level x 1 , the monopolist will search for the highest price it can
charge and still sell that amount of output. In Figure 10.2, this price is P 1 . The monopolist
can sell x 1 units of output at price P
1 because the demand curve in Figure 10.2 shows that
P 1 is the maximum that consumers will pay for that level of output.
At P 1 and x
1 , the monopolist is making an economic profit. The average revenue (price) is
P 1 , and average cost is C
1 . Since P
1 is larger than C
1 , the monopolist is making a profit of
P 1 2 C
1 on each unit for a total profit of (P
1 2 C
1 ) 3 x
1 . In Figure 10.2, total cost is
represented by rectangle 0C 1 Bx
1 , and total revenue is represented by rectangle 0P
1 Ax
1 .
Total revenue minus total cost equals economic profit, or rectangle C 1 P
1 AB. Since the cost
curves include both explicit and implicit costs, the monopoly firm is making more than its opportunity cost. That is, the firm is earning more than is necessary to keep its resources employed in this industry—it is making an economic profit.
Table 10.2 shows the revenue and cost data for a monopolist. The monopolist would maxi- mize profits at an output level of 7 units, where MC 5 MR 5 $46. Price should be set at $52 because the demand curve (AR) indicates that 7 units will sell for $52 each. At a price of $52, total revenue is $364 (7 3 $52) and total cost is $322 ($46 3 7), which means that the monopo- list is making a profit of $42 ($364 2 $322). If you don’t believe this is maximum profit, cal- culate the profit at each level of output from 1 to 10 units. You will see profit is maximized at 7 units because at that level, MR 5 MC. Actually, in this numerical example, the firm would maximize profit at either 6 or 7 units. A unique point exists only when dealing with continu- ous functions that allow you to find a point somewhere between 6 and 7 units.
Table 10.2: Cost and revenue data for a monopolist Output and sales
Total cost (TC)
Average cost (AC)
Marginal cost (MC)
Average revenue (AR)
Total revenue (TR)
Marginal revenue (MR)
Economic profit
0 $60 $— $— $0 $0 $0 $60
1 100 100 40 58 58 58 –42
2 136 68 36 57 114 56 –22
3 168 56 32 56 168 54 0
4 200 50 32 55 220 52 20
5 235 47 35 54 270 50 35
6 276 46 41 53 318 48 42
7 322 46 46 52 364 46 42
8 372 461/2 50 51 408 44 36
9 429 472/3 57 50 450 42 21
10 490 49 61 49 490 40 0
The Monopolist’s Supply Curve
A supply curve shows how much output will be offered for sale at various prices. In order to determine a supply curve, it is necessary to show that a firm will supply a unique quan- tity of output at any given price. This supply is, by definition, independent of demand.
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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10
A monopoly firm does not have a supply curve in this sense. A monopolist sets the price at the profit-maximizing level of output, so it doesn’t make sense to ask how much will be supplied at various prices. For a monopoly, the profit-maximizing output, where MC 5 MR, will depend on the location and shape of the demand curve. A monopoly firm therefore doesn’t have a supply curve that is independent of demand.
To convince yourself that the monopolist does not have a supply curve, examine Figure 10.3. In part (a), two different prices, P
1 and P
2 are consistent with output x
1 , depending on
where the market demand curve is located (D 1 or D
2 ). The marginal revenue curves that
are derived from the demand curves D 1 and D
2 both intersect the monopolist’s marginal
cost curve at the same level of output. In part (b), two different output levels, x 1 and x
2 , can
be produced at price P 1 , depending on whether market demand is represented by D
1 or D
2 .
Figure 10.3: One output with two prices or one price for two outputs
It is possible to trace out a supply curve only if a unique price is associated with a certain output. In graph (a), there are at least two prices, P
1 and P
2 , consistent with output x
1 . In graph (b), there are at
least two outputs, x 1 and x
2 , consistent with P
1 .
Figure 10.3 shows that, in the case of a monopolist, you cannot discuss supply indepen- dent of demand. There is no way to predict what the monopolist will do without knowing the demand curve. The predictive powers of economists are, therefore, more limited in an analysis of monopoly. In this case, economists cannot say that an increase in demand will cause price to rise, ceteris paribus.
0 Quantity/ Time Period
Quantity/ Time Period
Price, Cost
0
Price, Cost
(a) (b)
P1 P1
x 1 x 1 x 2
MC
MC
P2 D1
D2
D1
MR 1 MR 1
MR 2
MR 2
D2
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Section 10.2 Profits and Barriers to Entry CHAPTER 10
10.2 Profits and Barriers to Entry
If a monopolist is earning profits, other entrepreneurs will want some of those profits. As a result, there will be pressure from new firms entering the industry. But wait! A monopoly is a single seller producing a product that has no close substitutes. If there is new entry, there is no longer a monopoly. If a monopoly is to persist, there must be some forces at work to keep new firms from entering. Barriers to entry are natural or artificial obstacles that keep new firms from entering an industry. Without such barriers, monopoly cannot continue.
Economics in Action: And Then There Was One What if the government wanted only one major player to take care of one product? Welcome to the monopoly system. Follow the link to the Khan Academy (http://www.khanacademy.org), and then do a search for the video "Monopoly Basics" to learn more about how it differs from perfect competition.
Natural Barriers
Economies of scale provide a natural barrier to entry. If the long-run cost curves are such that the optimal-size firm is very large relative to the size of the market, there may be room for only one cost-efficient firm in the industry. If there are great economies of scale, one firm that is bigger than any of the others will be able to undersell the rest. In such a case, the bigger firm will cut its price below that of its rivals and capture their customers. Eventually the large firm will become the only firm in the industry. When just one firm emerges in this way, the firm is called a natural monopoly. Natural monopolies exist in very few industries.
Public utilities such as telephone companies, electric companies, and cable television companies fit this category. The government recognizes that these are natural monopo- lies and therefore charters them and then regulates their prices and output levels. Some economists argue that even public utilities are not really natural monopolies. Since the occurrence of a natural monopoly is rare, most of the monopoly power that exists in our economy is due to artificial barriers.
Artificial Barriers
An artificial barrier to entry is one that is contrived by the firm (or someone else) to keep others out. It doesn’t take much imagination to come up with a list of such barriers. The
Economics in Action: Viewing the Market Through Revenue and Cost Graphs The Khan Academy analyzes revenues and cost graphs to discuss topics such as marginal revenues, total revenue, marginal cost, and average total cost in a monopoly. Follow the link to the Khan Acad- emy (http://www.khanacademy.org), and then do a search for the video "Review of Revenue and Cost Graphs for a Monopoly."
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Section 10.2 Profits and Barriers to Entry CHAPTER 10
least sophisticated, but perhaps the most effective example, would be the use of violence. Suppose you want to have a monopoly on the illegal numbers racket in South Chicago. If new entrepreneurs move in to reap some of these profits, you simply “do away” with them and hence establish a monopoly—very effective! This sort of tactic may sound bar- baric, but business history contains many examples of the use of violence to keep out com- petitors. In the early history of oil exploration and drilling in the United States, private armies were often essential.
On a more civilized level, it may be possible to erect artificial barriers that are legal, or at least quasi-legal. If exclusive ownership of all the raw materials in an industry could be captured, entry could be controlled by refusing to sell to potential new entrants. The firm of Alcoa enjoyed a monopoly before World War II because it controlled almost all the known sources of bauxite, the essential ore for the production of aluminum.
A recent example of the use of artificial barriers could be found in the market for diamonds. Through most of the 20th century the de Beers Company of South Africa controlled most of the world’s diamond supply. This firm effectively controlled the mining and marketing of new diamonds and wielded enormous influence over price. In this case, there was still competition because all diamonds that had been produced in the past were potential com- petitors. If de Beers manipulated production to drive price “too high,” individuals might enter the market as suppliers, selling diamonds they presently owned.
Another way to create artificial barriers is to own the patent on a process or machine that is vital in production. Patent rights give sole authority to use the process or machine to the holder of the patent. The problems with a patent, however, are twofold: First, a patent provides only a finite period of protection. In the United States plant and util- ity patents expire after 20 years while design patents are good for only 14 years. After that the patent expires and everyone is entitled to use the idea. Second, to get a patent, detailed plans on how the item is produced must be provided, and these plans are available to potential competitors at the Library of Congress. So it appears a patent is not a very effective entry barrier to anyone who is willing to risk a lawsuit brought by the patent holder (and patent holders don’t always win their cases). A good alternative to pat- ents is secrecy. If a firm can keep its vital process or machine secret, it can keep new firms out of its industry. Now you know why there is barbed wire around some research and development offices, why you aren’t told the formula for Pepsi-Cola, and why corporate spying is big business.
BananaStock/Thinkstock
Alcoa used to have a monopoly over bauxite, which is essential in the production of aluminum.
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Section 10.2 Profits and Barriers to Entry CHAPTER 10
Governmental Barriers to Entry
It is very difficult to be a monopolist because it is very hard to keep new entrants out of an industry—unless you can get the government to help you. Let’s look briefly at two industries where firms have significant market power: the steel industry and the taxicab industry.
Suppose firms in the U.S. steel industry are earning economic profits. Firms that are pro- ducing steel in other countries see profits being earned and gear up to export steel to the United States to earn some of these profits. In effect, the foreign steel firms are entering the U.S. market. The domestic firms then appeal to Congress and/or the President to keep the foreign firms out (to block their entry). Tariffs or quotas may be put into effect. These tariffs or quotas serve as artificial barriers to entry for foreign firms by raising the price of foreign goods or prohibiting their sale in the United States.
Next, consider the taxicab industry. You probably consider this to be a competitive indus- try since in any large city there are cabs from many companies on the street every day. But, if you decide to start a cab business, you might be in for some trouble. Suppose you already own a car, so the entry costs are relatively small. All you need to do is to mark your car so that it can be recognized as a cab, and perhaps install a meter. However, you will need a permit, which in some cities will be very difficult and expensive to obtain. If you operate as an underground cab that avoids city regulations, you will make the exist- ing cab owners very unhappy. In many cities, cabs are a monopoly enterprise, and it is government that protects the monopoly.
In these examples, government supplied the artificial barriers to entry. Federal, state, and local governments all restrict entry and thereby ensure protected market positions. It should not be too surprising that many instances of corruption in government have centered on the granting of monopoly privileges. A government official or agency protects a monopoly by keeping competitors out. The monopolist is often willing to pay for this with campaign contributions, favors, or outright bribes, such as direct cash payments, free vacations, or jobs for relatives.
If monopoly power persists for a long period of time, there is very likely to be some explicit or implicit government role in creating barriers to entry. Monopoly profits are a very pow- erful and attractive force, and new entry is very difficult for the monopolist alone to block. As a result, monopolies usually try to enlist governmental support of one kind or another.
Global Outlook: Of Companies and Countries Many multinational corporations are very large relative to the countries in which they operate. Some companies may have worldwide net sales that are larger than the GDP of the country in which they are operating. Table 10.3 ranks cities and countries by GDP and companies by gross sales. As you can see, ExxonMobil is larger than Colombia. Wal-Mart is larger than Denmark and Israel combined. In the top 100, there are 53 countries, 34 cities, and 13 corporations. This ranking is based on 2009 data, and there may now be even fewer countries and more companies on the list. In 2011, Wal-Mart sur- passed Norway and would rank as the world’s 25th biggest country in the world (Trivett, 2011). These multinationals have a large amount of monopoly power in small host countries. (continued)
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Section 10.2 Profits and Barriers to Entry CHAPTER 10
Global Outlook: Of Companies and Countries (continued)
Table 10.3: The world’s top 100 economies Country/City/ Company
GDP/ Revenues
Country/City/ Company
GDP/ Revenues
Country/City/ Company
GDP/ Revenues
1 United States 14,204 35 ExxonMobil 426 69 Chevron 255 2 China 7,903 36 Osaka/Kobe, Japan 417 70 Toronto, Canada 253 3 Japan 4,354 37 Wal-Mart Stores 406 71 Detroit, USA 253 4 India 3,388 38 Colombia 395 72 Peru 245 5 Germany 2,925 39 Mexico City, Mexico 390 73 Portugal 245 6 Russian Federation 2,288 40 Philadelphia, USA 388 74 Chile 242 7 United Kingdom 2,176 41 Sao Paulo, Brazil 388 75 Vietnam 240 8 France 2,112 42 Malaysia 383 76 Seattle, USA 235 9 Brazil 1,976 43 Washington, DC,
USA 375 77 Shanghai, China 233
10 Italy 1,840 44 Belgium 369 78 Madrid, Spain 230 11 Mexico 1,541 45 Boston, USA 363 79 Total 223 12 Tokyo, Japan 1,479 46 Buenos Aires,
Argentina 362 80 Singapore,
Singapore 215
13 Spain 1,456 47 BP 361 81 Sydney, Australia 213 14 New York, USA 1,406 48 Venezuela 357 82 Bangladesh 213 15 Korea, Republic of 1,358 49 Sweden 344 83 Mumbai, India 209 16 Canada 1,213 50 Dallas/Forth Worth,
USA 338 84 Rio de Janeiro,
Brazil 201
17 Turkey 1,028 51 Ukraine 336 85 Denmark 201 18 Indonesia 907 52 Greece 329 86 Israel 201
19 Iran, Islamic Rep 839 53 Switzerland 324 87 Ireland 197 20 Los Angeles, USA 792 54 Moscow, Russian
Federation 321 88 Hungary 194
21 Australia 762 55 Hong Kong, China 320 89 Finland 188 22 Taiwan 710 56 Austria 318 90 General Electric 183 23 Netherlands 671 57 Philippines 317 91 Kazakhstan 177 24 Poland 671 58 Nigeria 315 92 Volkswagen Group 158 25 Saudi Arabia 589 59 Atlanta, USA 304 93 ENI 158 26 Chicago, USA 574 60 Romania 302 94 AXA Group 157 27 Argentina 571 61 San Francisco/
Oakland, USA 301 95 Phoenix, USA 156
28 London, UK 565 62 Houston, USA 297 96 Minneapolis, USA 155 29 Paris, France 564 63 Miami, USA 292 97 Sinopec-China
Petroleum 154
30 Thailand 519 64 Seoul, South Korea 291 98 San Diego, USA 153
31 South Africa 492 65 Norway 277 99 HSBC Holdings 142
32 Royal Dutch Shell 458 66 Algeria 276 100 Barcelona, Spain 140
33 Egypt, Arab Rep 441 67 Toyota Motor 263 Country City Company GDP/Revenues in $ billions PPP, 200834 Pakistan 439 68 Czech Republic 257
Data sources: Country data: GDP–PPP from the Development Data Platform time series, World Bank; City data: PricewaterhouseCoopers (PwC). 2009. Which are the largest city economies in the world and how might this change by 2025? Economic Outlook; Companies; Data
retrieved from http://www.forbes.com/lists/2008/18/biz_2000global08_The-Global-2000_Rank.html (accessed November, 2009) Hoomweg, D., Bhada, P., Freire, M., Trejos Gomez, C.L., Dave, R. 2010. Cities and climate change: An urgent agenda. World Bank.
(continued)
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Section 10.3 Monopoly Power and Price Discrimination CHAPTER 10
Global Outlook: Of Companies and Countries (continued)
The political and economic dilemmas faced by multinational corporations and host governments have even come to the United States. For decades, U.S. policy makers were confronted with only one side of the problem, that of U.S. corporations in foreign countries. Recently, however, the United States has become a host country for foreign investment.
Small, developing countries face a political dilemma in bargaining with large multinational companies. At the onset, such a country may have very little bargaining power with the multinational because the company can “shop around” for hospitable governments. If the country’s policy makers want to pursue economic growth, they may have to agree initially to the multinational’s terms.
As time passes and the company invests more fixed capital assets in the country, the host govern- ment can increase taxes and capture more of the monopoly profits. However, a delicate balance must be maintained. Taxes and government controls diminish the profitability of investment and future investment for the multinational. Other multinationals may be driven away by changes in a host country’s business climate.
Host country controls on multinationals can take several forms. Some countries impose foreign exchange regulations that require the foreign firm to convert earnings at exchange rates that are dif- ferent from market exchange rates. Another control is a rule requiring the foreign firms to use their earnings to buy local products and export them to countries with freely exchangeable currencies. Some countries (such as India) require foreign companies to divest their assets over time by selling them to native investors. This policy is a form of expropriation with compensation. Still other coun- tries force foreign firms to purchase a certain percent of the components in a manufacturing process from domestic sources. Finally, although it may be illegal (or if not illegal, at least hushed), politicians in some countries may require bribes as a condition for doing business. This practice is not uncom- mon in countries with dictators.
In a small country, multinational companies not only exert monopoly power but also must confront monopoly power exerted by the host government. In this situation, with one monopoly confronting another, it is not always clear who wins.
10.3 Monopoly Power and Price Discrimination
In analyzing monopoly behavior, we have assumed that the monopolist charges the same price to all consumers and the same price for all units sold to a specific consumer. If, on the other hand, the monopolist is able to charge different consumers different prices or charge a given consumer different prices depending on the quantity purchased, the monopolist is practicing price discrimination. Price discrimination is a way to expand monopoly profits by extracting consumer surplus from consumers. In this sense, discrimi- nation does not have a negative connotation; it simply means that the sellers are able to differentiate between different types of consumers in order to maximize profits. Have you ever used a student ID card to pay a lower price to enter a museum or see a movie? Many businesses choose to offer lower prices to students, senior citizens, and other groups of people who have been identified as a lower demand group, typically because of a lower ability to pay. If a business can differentiate across different types of consumers, it can offer different prices in order to maximize profits.
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Section 10.3 Monopoly Power and Price Discrimination CHAPTER 10
To see how price discrimination works, you need to recall the discussion of consumer sur- plus in the chapter on demand and consumer choice. Consumer surplus is the extra utility gained by consumers who end up paying less for an item than they would be willing to pay for it. Consumers purchase an item until the marginal utility of the last dollar spent on the item is equal to the marginal utility of spending the dollar on any other good or of holding the dollar. The marginal utility of previously purchased units was greater than the price paid for those units because they were all purchased at the price of the last unit. The consumer would have been willing to pay higher prices for those units. Figure 10.4 illustrates this concept. At price P
l in Figure 10.4, the consumer was receiving a “bonus”
in terms of utility. This extra utility is called consumer surplus, represented by the shaded area in Figure 10.4.
Figure 10.4: Consumer surplus
Consumer surplus is the difference between the total utility received from the purchase of a product and the total revenue generated by the product. It exists because the marginal utility of each previous unit purchased was greater than price P
1 .
A monopoly producer might be able to deal separately with consumers depending on the number of units purchased. In terms of Figure 10.5, the monopolist could say, “You may buy up to Q
1 units for P
1 , from Q
1 to Q
2 units for P
2 , from Q
2 to Q
3 units for P
3 , and from
Q 3 to Q
4 units for P
4 .” By doing this, the monopolist extracts most of the consumer surplus
and converts it into revenue for the firm. Compare the shaded areas in Figure 10.5 to the
0
Price
D = AR
Consumer Surplus
Quantity/ Time Period
P1
Q 1
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Section 10.3 Monopoly Power and Price Discrimination CHAPTER 10
shaded area in Figure 10.4. Both represent consumer surplus. In Figure 10.5, by charging different prices for different amounts of consumption, the monopolist has expropriated much of the consumer surplus. It is theoretically possible for the monopolist to capture all the consumer surplus by charging a different price for each unit.
Figure 10.5: A price-discriminating monopolist
A price-discriminating monopolist can capture most of the consumer surplus by changing different prices for different amounts of consumption.
The second type of price discrimination occurs when a monopolist can separate markets and charge different prices to different groups of consumers. If the monopolist can sepa- rate the markets and prevent resale, it can price discriminate by adjusting output for the different demand elasticities in the two markets.
Price Discrimination in Practice
In practice, the first type of price discrimination is common. It requires that the seller have the power to separate sales on a unit-by-unit basis. This form of price discrimina- tion is what is being practiced when multiples of a product can be purchased for a total that is less than the per-unit price times the number purchased. “Artichokes: $2.50 each or two for $4.00” and “Coffee $1.50 a cup; refills 50 cents” are examples of this type of price discrimination.
0
Price
D = AR
Quantity/ Time Period
P1
P2
P3
P4
Q 1 Q 2 Q 3 Q 4
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Section 10.3 Monopoly Power and Price Discrimination CHAPTER 10
The second type of price discrimination requires that the seller be able to separate markets according to different elasticities of demand. Bookstores offer lower prices to professors than to students. Airlines charge lower fares to students and vacationers than to business people. University athletic departments offer lower-priced tickets to sports events to stu- dents and faculty. Medical doctors charge different patients different fees for the same service. Senior citizens get discounts on all kinds of items, from prescriptions to theater tickets. In each of these cases, the market with the greater elasticity gets lower prices. Let’s see why.
Consider plane tickets. If you fly to Europe and stay for more than 14 days, the fare is cheaper than if you stay for less than 14 days. If you stay a month or longer, flights are even cheaper. Why? Which class of consumers of air transportation have the most inelas- tic demand? Business travelers, of course, who tend to travel on tight schedules and have bosses who don’t want them sightseeing in France for 14 days! Major carriers have devel-
oped sophisticated techniques to set and change fares rela- tively quickly. Their objective is to juggle fares to match the bar- gain offerings of low-cost rivals while protecting their full-fare business.
It should be clear that two con- ditions are necessary in order to practice price discrimina- tion. First, it must be possible to separate consumers into groups that have different demand elas- ticities. These groups need to be economically identifiable. If it costs too much to identify the groups, discrimination might not pay. When economists talk
about price discrimination, they’re not talking about discriminating on the basis of race, sex, or national origin, unless different races, sexes, or nationalities have different demand elasticities for certain products. Many times, age is used to identify groups with differ- ent demand elasticities. Senior citizens and students have more elastic demand curves because they typically have a tighter budget and more time to shop around than middle- aged people do. In the case of airfares, the classes of consumers are separated by length of stay. Business people seldom want to stay at a destination for more than a few days.
Time-of-day price discrimination includes matinee performances of cultural events and movies, bowling alley use, and lunch and dinner menus. In these cases, demand is more inelastic at night because some consumers are limited to night consumption. Magazine publishers charge higher prices for magazines purchased at newsstands than for subscrip- tions. Sometimes subscription prices are only a fraction of the newsstand prices. News- stand demand is more inelastic because it is typically a spur-of-the-moment, unplanned
Brand X Pictures/Thinkstock
Universities often offer lowered-ticket prices to students and faculty. This is an example of price discrimination.
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Section 10.3 Monopoly Power and Price Discrimination CHAPTER 10
purchase. Book publishers charge much higher prices for hardcover novels than for soft- cover versions of the same novel. They separate the markets by publishing the softcover version after the hardcover demand has been satiated. Some colleges charge in-state and out-of-state tuition because it is very easy to separate these two markets. Has your car ever broken down when you were out of town? Your demand is very inelastic in such a situa- tion. You have little information about services available, and you are easy to identify as a one-time customer (you may have an out-of-state license plate). What do you think hap- pens? You’re right! You pay much more than a local person with car trouble would pay.
The second major requirement for price discrimination is that the monopolist must be able to prevent the resale of goods or the movement of customers between markets. Con- sider charging different prices to different classes of customers for tickets for a college football game. It only works if the customers paying the lower price are prohibited from reselling their tickets. If not, the college is no longer a monopolist in the sale of the higher- priced tickets. Is it any wonder that the athletic department requires you to show your picture I.D. card and your ticket at the gate? The higher-priced ticket holders are only required to present their tickets. Price discrimination works well where resale is very difficult. Services are good candidates for price discrimination because it is very difficult to resell a service. Medical doctors are very successful in practicing price discrimination because they have easily recognizable submarkets with different elasticities (by income and insurance category) and because resale is almost always ruled out.
The seller often justifies price discrimination as helping a group. For example, doctors might claim they practice price discrimination (charging less to some groups) in order to “help” the poor. Students or senior citizens might be charged less “to help them out.” In reality, price discrimination is almost always practiced because it increases profit.
Gainers and Losers From Price Discrimination
Price discrimination does have a positive side effect. It will usually cause output under monopoly to increase. Earlier in this chapter, you learned that one of the disadvantages of monopoly is that it restricts output. If a monopoly can, however, sell output one unit at a time, output will be pushed to the point where price equals marginal cost. This is com- mon sense because the monopolist only restricts output in order to keep price from fall- ing on all units. If price falls only on the additions to output (not other units), then price equals marginal revenue, and output will be increased to the point where price equals marginal cost. This is the same conclusion as for perfect competition. The difference, of course, is that more of the benefit accrues to the monopolist. Price discrimination converts consumer surplus into monopoly profits, making monopolists wealthier and consumers worse off than if price discrimination did not exist.
Many people believe price discrimination is unfair because people pay different prices for the very same product. Why should an airplane ticket be cheaper because someone is a tourist rather than a business traveler? Why should professors get their books and pens for lower prices than students? Why should students pay less for a football ticket than nonstudents?
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Section 10.4 Is Monopoly Bad? CHAPTER 10
Interestingly, it is sometimes the group that benefits from price discrimination that com- plains. Price discrimination is common in international trade because the separation of national markets is often easy to maintain. Tariffs and transportation costs can help pre- vent resale. When firms in a country sell in a foreign market at a lower price than they do at home, they are engaging in price discrimination. Demand in the foreign country may be more elastic than domestic demand because there is more competition, and, therefore, more good substitutes are available. The foreign monopolist sells to foreigners at a lower price than at home. The U.S. Treasury calls this form of price discrimination dumping. Dumping occurs, for example, when the Japanese sell televisions in the United States at a lower price than they sell the same sets domestically.
The odd thing is that dumping has a bad reputation. When the Japanese dump televi- sions in the United States, the U.S. government takes action against Japan. This is curious because Japanese firms are giving U.S. consumers a better deal than Japanese consumers. Complaining about being offered a lower price doesn’t seem to make sense. Seen from the producer’s angle, however, dumping is worth complaining about. You can understand why domestic manufacturers don’t particularly approve of foreign competitors selling in this country more cheaply than in their own home market.
Price Discrimination and Monopoly
We developed the concept of price discrimination in connection with the study of monop- oly. Price discrimination is not limited to monopolies, however. It will never occur in per- fect competition, but it could occur in monopolistic competition and oligopoly, which we will study in the next chapter. However, since the opportunity to use price discrimination is greater if consumers have few good substitutes, it is easiest to price discriminate under monopolistic conditions.
10.4 Is Monopoly Bad?
Any entrepreneur would prefer to sell in a monopoly rather than a perfectly com-petitive industry, because economic profit tends to zero in the perfectly competi-tive market. A firm that can create a successful monopoly will be rewarded with continuing profits. Monopoly is obviously good for the monopolist, but monopoly mar- kets can be bad for society.
How Monopoly Compares to Perfect Competition
To see what’s so bad about monopoly, look at Figure 10.6. First, assume that Figure 10.6 represents a perfectly competitive industry. The market demand curve (D 5 AR) is that faced by the numerous sellers, and the marginal cost (MC) curve is the summation of all the individual firms’ marginal cost curves. The competitive price and output are P
c and
Q c . Now suppose the industry is monopolized by one firm that has bought up all the
competitive firms but still has the same cost curves. The monopoly firm, then, will face the same cost conditions that the aggregate of competitive firms faced. The market supply curve becomes the monopolist’s marginal cost curve because it is the summation of the
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Section 10.4 Is Monopoly Bad? CHAPTER 10
purchased firms’ marginal cost curves. The monopoly firm also faces the market demand curve and its corresponding marginal revenue curve. The monopoly firm will produce at Q
m and P
m . In this case, it is a very simple matter to contrast monopoly with perfect com-
petition. The monopolist produces a smaller output (Q m
, Q c ) and charges a higher price
(P m
. P c ) than the perfectly competitive firms did. This is possible because entry into the
industry is blocked. Since new firms cannot enter, consumers are not getting the optimal amount of the good produced by the monopolist. Monopolies restrict output. This is the principal economic argument against monopoly.
Figure 10.6: Price and output determination under monopoly and perfect competition
The monopolist, equaling marginal cost and marginal revenue, produces output Q m
and sells it at price P
m . If this same firm were perfectly competitive, the price would be P
c and output would be Q
c .
The monopolistic output and price, then, represent misallocation of resources if the monopoly has the same cost conditions as the aggregate of the competitive firms. Note that the misallocation under monopoly could be even worse if, in buying up the individ- ual firms, the monopoly introduced some inefficiencies of large-scale management. Such inefficiencies would cause an upward shift of the cost curves in Figure 10.6.
0
Price, Cost
Quantity/ Time Period
Pc
Pm
Q m Q c
S = MC
D = AR
MR
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Section 10.4 Is Monopoly Bad? CHAPTER 10
The misallocation of resources in a monopoly is illustrated in Figure 10.7. The monopoly is in equilibrium producing x
1 units at a price of P
1 . The monopolist’s profit, which is total
revenue minus total cost, is represented by rectangle CP 1 AB. Let’s examine closely what
is going on at this equilibrium. First, price P 1 is greater than average cost (which is x
1 B per
unit). That is, P 1 . AC, and economic profits are being earned. Second, price is greater
than marginal cost (P 1 . MC), which means the value consumers place on the last unit
(P 1 ) exceeds the opportunity cost of producing it (MC). From the society’s (and the con-
sumer’s) point of view, more should be produced. The monopolist prevents output from increasing by restricting entry. Third, average cost at output x
1 is greater than marginal
cost at x 1 . That is, AC . MC. This means that the technologically most efficient level of out-
put is not being produced, because the monopolist is restricting output. You can easily see, therefore, what economists mean when they say that monopoly misallocates resources.
Figure 10.7: Misallocation of resources in a monopoly
A monopoly misallocates resources because price is greater than marginal cost. This means the consumers’ price on the item exceeds the opportunity cost of producing it.
Monopoly Profits and Losses
There is a common misconception that a monopoly situation guarantees profits. A monopoly is not a license to make profits. If the U.S. government granted you an absolute monopoly in the manufacture and sale of toxic sludge, you would probably lose money. High costs or insufficient demand may cause a monopolist to lose money. For example,
0
Price, Cost
Quantity/ Time Period
C
P1
x1 MR
MC
AC
B
A
Profit
D = AR
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Section 10.4 Is Monopoly Bad? CHAPTER 10
the U.S. Postal Service is a government-sanctioned monopoly with the exclusive right to deliver first class mail. However, the U.S. Postal Service ended the 2012 fiscal year by post- ing a record net loss of $15.9 billion. (U.S. Postal Service, 2012) Clearly, a monopoly is not necessarily granted the right to make profits.
Figure 10.8 shows a monopoly suffering a loss. The monopoly is producing x 1 units and
charging the loss-minimizing price, P 1 . Average costs of producing are x
1 A per unit. As a
result, the monopolist is incurring losses equal to rectangle P 1 CAB. Since the demand (or
average revenue) curve is below the average cost curve, there is no way to avoid losses. Will the monopolist continue to produce? If price (or average revenue) is above average variable costs, as is the case in Figure 10.8, the monopolist will be better off in the short run if it continues producing. In the long run, if demand does not increase, the monopoly will go out of business. The presence of losses indicates that the productive resources are not earning their opportunity cost. Those inputs will move to more productive uses.
Figure 10.8: A monopoly suffering losses
The monopolist might suffer losses in the short run. If average cost is greater than average revenue, the monopolist is suffering a loss.
0
Price, Cost
Quantity/ Time Period
C
P1
x1 MR
MC AC
AVC
A
B Loss
D = AR
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Section 10.4 Is Monopoly Bad? CHAPTER 10
A monopolist can also earn only normal profits. Figure 10.9 illustrates this case. The monopoly is producing x
1 units and charges price P
1 . Total revenue is equal to rectangle
0 P 1 Ax
1 . In this instance, the monopoly is earning its opportunity cost. There will be no
incentive for other firms to try to enter this industry or for this firm to leave the industry. Price is equal to average cost, which means that producers are not earning economic prof- its. However, price is still greater than marginal cost, indicating that more units should be produced.
Figure 10.9: A monopoly earning a normal profit
It is possible that a monopoly might earn only a normal profit. In this case, there is no incentive for other firms to enter the industry and no need for barriers to entry.
You can see, as in the case of the U.S. Postal Service, monopolies don’t always make prof- its. In fact, they might often incur losses and go out of business. Also, monopolists do not charge the highest price possible. Remember the mineral spring example? Monopolists charge the profit-maximizing price, and this price will depend on the demand conditions and costs in the industry.
0
Price, Cost
Quantity/ Time Period
P1
x1 MR
MC
AC
A
D = AR
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Section 10.5 The Costs of Monopoly to Society CHAPTER 10
Monopoly in the Long Run
The monopolist, unlike the perfectly competitive firm, can continue to earn economic profits in the long run. As long as the barriers to entry remain, economic profits can be maintained. Sustaining these barriers in the long run is very difficult, however, because the economic profits will attract new firms, substitute products, and new processes. In principle, then, even with government help, the power of any single monopoly is likely to decline in the very long run.
Real-World Monopolies
We have pointed out that there are no examples of true monopoly in the real world. A complete monopoly cannot exist, because all products or services have some substitutes with which they compete. There are, however, firms with some monopoly power. The model of monopoly is useful in explaining the behavior of these firms. Public utilities are allowed to operate as monopolies because they are considered natural monopolies. They are then regulated to reduce the ill effects of the monopoly power. Monopolies that are set up by some nations to engage in international trade are also monopolistic.
Local monopolies are another form of real-world monopoly. A local monopoly is a firm that has monopoly power in a geographic region. Even though close substitutes for the firm’s product exist, the distance to other sources of supply creates a virtual monopoly. If you grew up in a small, remote town, there may have been only one movie theater or perhaps only one grocery store. A firm in such a situation is a local monopoly because the substitutes are costly in the sense that you must travel to reach them. Economists use the model of monopoly to examine the effects of monopoly power in such real- world situations.
10.5 The Costs of Monopoly to Society
We have made the point that a monopoly misallocates resources by contriving shortages—producing less than the competitive output to create monopoly profits. There are, however, other costs associated with monopoly. Figure 10.10 depicts a monopoly firm with constant marginal costs and, thus, constant average costs. Constant marginal costs and average costs are assumed for simplicity.
Check Point: Comparison of Monopoly and Perfect Competition
Monopoly
• One firm • Barriers to entry • P . AC, so economic profits exist • MC . AC, the technologically most
efficient level of production
Perfect Competition
• Many firms • Free entry • P 5 AC, only normal profit earned • MC 5 AC, producing at least-cost
combination
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Section 10.5 The Costs of Monopoly to Society CHAPTER 10
Figure 10.10: The deadweight loss of monopoly
A monopoly converts some consumer surplus to monopoly profit. The crosshatched area, however, represents consumer surplus that is lost. It is the deadweight loss associated with monopoly.
The monopolist will produce output level Q m
and set price at P m
. A perfectly competitive structure would have produced an output of Q
c at price P
c . As a result of restricting out-
put, the monopolist earns a monopoly profit equal to the shaded area in Figure 10.10. This shaded area represents a transfer from consumers (in terms of lost consumer surplus) to the monopolist (in terms of monopoly profit). This transfer, however, is not the only cost the monopoly creates.
Deadweight Loss
The crosshatched triangle in Figure 10.10 represents lost consumer surplus that was not converted into monopoly profits. This lost consumer surplus is received by no one. Con- sumers have lost it because the monopoly has restricted output, but it has not been received by anyone in the economy. The lost consumer surplus is referred to as the deadweight loss of monopoly. The deadweight loss is the lost consumer surplus due to monopolistic restriction of output. It is a deadweight loss because nothing is received in exchange for the loss. It is equivalent to throwing a valuable resource away.
0
Price, Cost
Quantity/ Time Period
Pc
Pm
Q m Q c
MR
Monopoly Profit
Deadweight Loss
AR
MC = AC
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Section 10.5 The Costs of Monopoly to Society CHAPTER 10
Policy Focus: Monopoly and Antitrust Toward the end of the 19th century, there was a substan- tial increase in the number of large business organizations in the United States. This period saw the establishment of legal arrangements such as trusts, which were organizations set up to control the stock of other companies through boards of trustees, and holding companies, which were firms set up for the sole pur- pose of owning and thus controlling other firms. Trusts and hold- ing companies enabled robber barons, as they have been called by economic historians, to control and coordinate the activities of many previously independent firms. At first, these new types of companies were viewed as a natural outgrowth of the Indus- trial Revolution in the United States.
Eventually the public began to view some of these arrangements with suspicion. In response, several states enacted antitrust stat- utes that regulated businesses chartered in those states. These state laws failed because corporations were able to obtain char- ters in less restrictive states. Two of the more lenient states were New Jersey and Delaware. By 1888, the antitrust sentiment had become so widespread and intense that both national political parties had an antitrust plank in their platforms.
In 1890, Congress passed the Sherman Antitrust Act, the first federal antitrust law. This act had two major provisions. Section 1 declared every contract, combination, or conspiracy in restraint of trade to be illegal. Section 2 made it illegal to monopolize or attempt to monopolize. The language of the act is strong, but it is also vague, and the courts took years to determine its scope. We will trace some of the important decisions, after identifying the other major antitrust laws. The Clayton Act, passed in 1914, made illegal certain business practices that could lead to monopoly. It pro- hibited a company from acquiring the stock of a competing company if such an acquisition would “substantially lessen competition.”
It took some time for the courts to determine the scope of the Sherman Act, in particular, and to form a legal definition of the phrase “in restraint of trade.” Under a strict economic definition, a firm with any monopoly power (that is, power to restrict output or to increase price) would be guilty of restraint of trade. In two famous cases against Standard Oil and American Tobacco in 1911, the Supreme Court inter- preted the law using the rule of reason, which said that monopolies that behaved well were not illegal. In 1945, after thirteen years of litigation, the rule of reason was dropped. Judge Learned Hand ruled in a case against Alcoa that size itself was enough to prove the exercise of monopoly power.
In recent years there has been a steady increase in antitrust cases worldwide. In 2009, the European Commission fined computer chip manufacturer Intel a record $1.33 billion (that’s right, billion) for allegedly providing financial incentives to computer manufacturers to not buy computer chips from its rival, Advanced Micro Devices. Although Intel is still in the midst of appeals as of 2012, once this case concludes, it will certainly set a precedent for all antitrust lawsuits to follow (Chee, 2012).
Alfred Eisenstaedt/Time & Life Pictures
Judge Learned Hand’s ruling against Alcoa overturned the previous rule of reason, which said that monopolies that behaved well were not illegal.
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Section 10.6 Fallacies and Facts About Monopoly CHAPTER 10
10.6 Fallacies and Facts About Monopoly
In this chapter, we have developed a model of monopoly. Although there is no such thing as a true monopoly in the real world, there are firms that have monopoly power. The model is useful in describing their behavior. Since there are so many miscon- ceptions about monopoly, it is worthwhile to summarize a few fallacies and facts about monopolies.
Fallacy: Monopolies Charge the Highest Possible Price
The public often believes that monopolies charge the highest possible price and “rip off” consumers. This view is often supported by the press and by consumer lobby groups. As you have seen in this chapter, however, monopolies produce the profit-maximizing output and then sell that output on the market at a price that is constrained by the market demand curve.
Fallacy: Monopolies Always Earn (High) Profits
A similar, but slightly different, fallacy is that monopolies always earn profits. You have seen in this chapter that some monopolies earn economic profits, some earn normal prof- its, and others suffer economic losses. To be sure, monopolists try to earn profits, but if demand changes, they might incur an economic loss. The key difference between monop- oly and competition is that profits of a monopoly can persist because they don’t lead to new entry. In cases where monopolies suffer losses, however, the resources will flow to other industries. In some cases, the government has tried to keep unprofitable monopolies from going out of business.
Fallacy: Monopolists Don’t Have to Worry About Demand
It is a commonly held belief that monopolists don’t have to worry about demand. Having a monopoly on buggy whip production in 2012 and 1896 are quite different. Monopolists are constrained by the market demand for the good or service they produce. Their search for the price that maximizes their revenue is strictly tied to that demand curve. It might even be possible for the monopolist to increase demand by advertising the product. The decision to do so would depend on the cost of that advertising versus the revenue it could be expected to generate.
Fact: Monopolies Charge a Price Higher Than Marginal Cost
You have seen in this chapter that a monopoly restricts output in order to earn economic profits. This restriction of output means that the price charged is greater than marginal cost. Compared to perfect competition, monopolies are less efficient in allocating resources to match consumer preferences.
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Summary CHAPTER 10
Fact: Monopolists Produce Where Demand Is Elastic
It is often mistakenly believed that a monopoly will produce where demand is inelastic. You have seen, though, that monopolies will always raise the price if demand is inelastic. Every monopoly will always be producing in an elastic portion of its demand curve.
Fact: Monopolies Do Not Have Supply Curves
As you have seen in this chapter, a monopoly is a price searcher. The monopoly estab- lishes the profit-maximizing output and price is equal to average revenue. As a result, the concept of a unique supply curve is meaningless.
Fact: The Monopolist Ultimately Faces Competition
The model of monopoly assumes that the firm faces no competition because it defines a market structure consisting of a single firm producing a good with no close substitutes. In reality, however, the monopolist that earns an economic profit will be pursued by poten- tial competitors, and the natural or artificial barriers to entry will be difficult to maintain. In a global economy, even if there are no domestic competitors, there is almost always a threat of competition from abroad.
As a closing note, it is appropriate to quote Alfred Marshall (1842–1924), the great neoclas- sical economist, on this subject:
It will in fact presently be seen that, though monopoly and free competition are really wide apart, yet in practice they shade into one another by imperceptible degrees: that there is an element of monopoly in nearly all competitive busi- ness: and that nearly all the monopolies, that are of any practical importance in the present age, hold much of their power by an uncertain tenure; so that they would lose it ere long, if they ignored the possibilities of competition, direct and indirect (Marshall, 1923, p. 397).
Summary
Consider again. . . The manufacturers’ coupons that we brought to your attention at the start of this chapter are a vehicle for price discrimination. The manufacturer that pays to create those coupons and or send them in the mail is price discriminat- ing because different groups of consumers have different elasticities of demand for these products. The producer reasons that the firm can separate these markets by the time cost across different shoppers. Retired people and stay-at-home moms have more time to take advantage of these discounts by searching for deals on the Internet, cutting coupons, and creating a shopping strategy. Other shoppers with full-time jobs may not have this kind of time to spend on couponing and instead must pay a higher price for the groceries.
As we saw in this chapter, there are necessary conditions for price discrimination to suc- ceed. The coupon issuer must have pricing power. Almost all coupons are for brand name products in concentrated markets—for example, soap and breakfast cereal. The second
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Key Terms CHAPTER 10
barriers to entry Natural or artificial obstacles that keep new firms from enter- ing an industry.
deadweight loss The lost consumer surplus due to monopolistic restriction of output.
dumping The practice of selling in foreign markets at lower prices than in domestic markets (a form of price discrimination).
local monopoly A firm that has monopoly power in a geographic region because of the large distance from other suppliers of its product (or substitutes).
monopoly The market structure in which there is a single seller of a product that has no close substitutes.
monopoly power The ability to exercise some of the economic effects predicted in the model of monopoly by restricting output.
price discrimination The practice of charging different prices to different con- sumers or to a single consumer for differ- ent quantities purchased.
price searcher A firm that sets price in order to maximize profits and thus has monopoly power.
necessary condition is that resale must be prevented. This is done in the coupon market by limiting the number of items per purchase and by the fact that there is no well-developed market for individuals to resell food.
Key Points
1. Monopoly is a market structure in which there is a single seller of a product with no close substitutes. The monopoly firm faces a negatively sloped demand curve and a marginal revenue curve that lies below that demand curve. The monopo- list maximizes profits by producing the output level at which marginal revenue equals marginal cost. The price is the one on the demand curve at which exactly that amount of output can be sold. Since price is often greater than average cost for a monopoly, economic profits may exist.
2. A monopolist is sometimes able to erect barriers to entry that allow profits to per- sist in the long run. Such barriers are very difficult to maintain. As a result, monop- olists often appeal to the government for help in maintaining entry barriers.
3. A monopoly can increase its revenues if it practices price discrimination. For price discrimination to be successful, customers must have different demand elasticities, they must be separated, and they must be prohibited from reselling the product or service.
4. Monopolies produce a lower output at a higher price than do competitive indus- tries. At equilibrium, the monopoly firm is producing at a level of output where price is not equal to marginal cost (and often not average cost).
5. Monopolies charge the profit-maximizing price, they don’t always earn profits, they worry about demand, they produce where demand is elastic, they charge a price higher than marginal cost, they do not have supply curves, and they ulti- mately face competition.
Key Terms
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Critical Thinking and Discussion Questions CHAPTER 10
Critical Thinking and Discussion Questions
1. Why would a monopolist never want to produce in the inelastic portion of the demand curve?
2. How does a monopolist maximize profit? Describe the process in steps. 3. What inefficiencies exist in a monopoly market? 4. What is required for a monopolist to make profits in the long run? What could a
monopolist do to ensure long run profits? 5. What is a “trust” and what steps has the government taken to combat markets
with monopoly power? 6. The following table describes the demand curve for a monopolist. Complete the
marginal revenue column.
Price Quantity demanded Marginal revenue 10 0
9 1
8 3
7 4
6 5
5 6
4 7
3 8
7. Assume the marginal cost for the firm in Question 6 is MC 5 2. What quantity would the monopolist choose to produce? What price would be set?
8. Using the data from Question 6 and Question 7, calculate the monopoly profit. 9. Using the information from Question 7 and Question 8, what would happen in
the long run if the monopolist could not maintain barriers to entry? 10. Movie theaters exhibit price discrimination in ticket sales and in sales of conces-
sions. Describe the different methods used and explain how movie theaters are able to use price discrimination.
11. Should the government subsidize monopolies that are losing money to keep them in business? How does this reasoning apply to an entity like the U.S. Postal Service?
12. It seems like every store has a rewards card or other customer loyalty program these days. How could the information obtained from these cards and programs be used to facilitate price discrimination?
13. Should firms be socially responsible? What are the benefits to corporate philan- thropy? Why might some firms be better off focusing efforts on maximizing profits?
14. If prices charged by all firms in a market are identical, is this evidence of an anti- trust violation?
15. Why should the government pursue an active antitrust policy? Compare the costs and benefits.
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