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10 Monopoly

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Learning Outcomes

After reading this chapter, you should be able to

• Define monopoly and calculate marginal revenue, given data on price and output.

• 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.

210

Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

Introduction In 1956 the drug methotrexate was used to cure metastatic cancer (American Cancer Society, 2018). Since then, biopharmaceutical companies have been in a race to develop newer and better treatments for a wide range of cancers. In October 2017 the U.S. Food and Drug Admin- istration approved a new drug, abemaciclib (Verzenio), to treat advanced breast cancer. The manufacturer of the drug, pharmaceutical giant Eli Lilly, was projected to earn $1.8 billion in revenue by 2022. How could a company generate such high rates of return in such a short period of time? One reason is that demand for the drug would be incredibly high; an esti- mated 252,710 cases of invasive breast cancer were diagnosed in the United States in 2017. The drug would also be a necessity, demand would be very inelastic, and individuals would be willing to pay high prices.

With billions of dollars in profits to be made, why wouldn’t another firm step in and start selling the same product? In pharmaceuticals, like in technology and other industries that produce new products for the market, the creator of a new good can obtain a patent. Patent rights give sole authority to use the process or machine to the holder of the patent. In this case the owner of the patent has a legal monopoly. However, patents provide only a finite period of protection. In the United States plant and utility 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. In pharmaceuticals, this means that other companies can develop generic ver- sions of the drug. Until 2029 Eli Lilly will have the sole right to produce and sell Verzenio.

Monopolies can arise in several different ways, such as the granting of patents in the above example, or by natural or illegal means as discussed later in this chapter. Monopoly is at the other end of the market continuum from perfect competition, in the sense that perfect com- petition involves many firms and monopoly involves just one. Monopoly is the market struc- ture in which there is a single seller of a product that has no close substitutes.

Although pure monopolies are relatively rare, since even the sole producer of a new can- cer drug may face competition from new radiation treatments, there are many firms that have some degree of monopoly power. Monopoly power is the ability to exercise power over market price and output. Without the fear of competition, monopolies can choose the price– quantity combination that maximizes profit.

10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

A perfectly competitive firm faces a perfectly elastic demand curve. What this means is that a firm operating under perfectly competitive conditions can sell any amount it wants at the price that is currently prevailing. 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. This distinction is very important because market demand curves have nega- tive slopes. Thus, the monopolist can’t simply 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 reduction applies to all units of output that the monopolist sells, not

211

Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

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.

Imagine that a new start-up company, EatGluten, has patented a miracle drug that allows peo- ple with celiac disease to consume foods containing gluten without becoming ill. The drug, labeled Glutenme, must be consumed in pill form immediately before a meal and only works for 1 hour. The economists at EatGluten have generated an estimate of the market demand for the pills. Data illustrating the relationship among average, total, and marginal revenue for Glutenme are presented in Table 10.1. When 3 million pills are sold, the total revenue is $168 (3 × $56). In order to sell 4 million pills, EatGluten must reduce the price from $56 to $55. Total revenue will then increase by $55 because an additional unit is being sold for $55. At the same time, it will decrease by $3 because the other 3 million pills now sell for $1 less each ($55 each, rather than $56). The net result is that EatGluten has added $52 ($55 – $3) to total revenue by reducing the price from $56 to $55. Note that marginal revenue is $52, and price (average revenue) is $55 for 4 million pills.

Table 10.1: Average, total, and marginal revenue for the monopolist EatGluten

Pills sold (in millions)

Price (average revenue)

Total revenue (in millions)

Marginal revenue (in millions)

0 $65 $0 —

1 58 58 58

2 57 114 56

3 56 168 54

4 55 220 52

5 54 270 50

6 53 318 48

7 52 364 46

8 51 408 44

9 50 450 42

10 49 490 40

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 nega- tive. In Figure 10.1 a reduction in price below $34 will decrease total revenue because for the amount of pills demanded at $34, marginal revenue is negative. This region corresponds to the inelastic portion of the demand curve. However, a reduction in price from $40 to $34 would increase total revenue because the demand curve is elastic in this range.

212

Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

Price and Output Decisions Under Monopoly Where costs are positive, the monopolist finds the profit-maximizing level of output by equat- ing marginal cost and marginal revenue. A monopoly firm does not have a supply curve in the sense that a market typically does. 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 = 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.

Table 10.2 shows the revenue and cost data for the fictional monopolist EatGluten. With this information, EatGluten would maximize profits at an output level of 7 million pills, where MC = MR = $46. Price should be set at $52 because the demand curve indicates that 7 million pills will sell for $52 each. At a price of $52, total revenue is $364 million (7 × $52) and total cost is $322 ($46 × 7), which means that the monopolist is making a profit of $42 million ($364 – $322).

Figure 10.3 adds the cost information to Figure 10.2. A monopolist, like EatGluten, will maxi- mize profit by producing 7 million pills because at that level of output, MR = MC. If MR is greater than MC (that is, if output is less than 7 million), 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 7 million), the monopolist will reduce output because additions to output add more to total cost than to total revenue. The firm is earning more than is necessary to keep its resources employed in this industry—it is making an economic profit.

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 $34 and inelastic below $34.

0 -10

Price

Millions of pills/year

> 1Ed

= 1Ed

Ed < 1

D = AR

17.5

213

Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

Table 10.2: Cost and revenue data for producing Glutenme (in millions)

Output and sales (millions)

Total cost (TC)

Average cost (AC)

Marginal cost (MC)

Average revenue

(AR)

Total revenue

(TR)

Marginal revenue

(MR)

Economic profit

(millions)

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

6 277 46 42 53 318 48 41

7 322 46 46 52 364 46 42

8 372 46.5 50 51 408 44 36

9 429 47.67 57 50 450 42 21

10 490 49 61 49 490 40 0

Figure 10.2: The profit-maximizing position of a monopolist

The profit-maximizing monopolist will produce x1 units of output, where MC = MR. Since average cost (C1) is less than average revenue (P1) for output level x1, this monopolist is making an economic profit.

Price, cost

Millions of pills/ year

Economic profit

214

Section 10.2 Profits and Barriers to Entry

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, a monopoly cannot keep competitors out of the market.

Economics in Action: Viewing the Market Through Revenue and Cost Graphs

The Khan Academy reviews marginal revenue, total revenue, marginal cost, and average total cost in a monopoly through analyzing revenue and cost graphs. Follow the link to The Khan Academy (http://www.khanacademy.org) and search for the video “Review of Revenue and Cost Graphs for a Monopoly.”

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 search for the video “Monopoly Basics” to discover how it differs from perfect competition.

Natural Barriers Economies of scale can 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. 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 electric and water companies fit this category. Consider the case of two competing water companies. The fixed cost to install a second set of pipelines to each home and business would not be worth the decrease in price that comes with competition. The government recognizes that a single water-producing utility is more efficient for this reason and thus allows the company to exist as a natural monopoly, but the government regulates its prices and output.

Local monopolies are another form of natural 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.

http://www.khanacademy.org

215

Section 10.2 Profits and Barriers to Entry

Artificial Barriers An artificial barrier to entry is one that is contrived by the firm (or someone else) to keep oth- ers out. It doesn’t take much imagination to come up with a list of such barriers. A firm could choose to underprice its competitors to force them out of the market, as in the case of retail giant Walmart. Or a company could simply purchase its competition, as in the case of Face- book buying Instagram or Anheuser-Busch and InBev (AB InBev) buying SABMiller. In the case of AB InBev, the purchase led to market dominance of about 46% of global beer profits in 2017 (Feroldi, 2017).

Another method would be to obtain exclusive ownership of all the raw materials in a given industry. Once the scarce resources are under a company’s ownership, entry could be con- trolled by refusing to sell to potential new entrants.

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 enor- mous influence over price. In this case there was still competition because all diamonds that had been produced in the past were potential competitors. If De Beers manipulated production to drive price “too high,” individuals might enter the market as suppli- ers, selling diamonds they currently owned.

Legal 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. One of the primary legal barriers to entry are patents, discussed earlier. Other legal barriers can come in the form of tariffs (taxes on foreign imports) or quotas (quantity limits).

Suppose firms in the U.S. steel industry are earning economic profits. Firms that are produc- ing 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 legal industry. To practice as an attorney, one must be admitted to the bar in the United States (commonly referred to as passing the bar exam). Each U.S. state has its own court system that sets the rules for admission to the bar. However, a lawyer who is admit- ted to the bar in one state is not automatically allowed to practice law in any state. Thus, each state has its own legal barrier to entry to practice law.

Marcio Jose Sanchez/ASSOCIATED PRESS Facebook paid $1 billion to acquire Instagram, formerly a competitor, in 2012.

216

Section 10.2 Profits and Barriers to Entry

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 the top 25 countries by GDP and companies by gross sales. As you can see, Walmart is almost as large as Sweden and India combined. Corporations hold 9 spots in the top 25. These multinationals have a large amount of monopoly power.

Table 10.3: The world’s top 25 economies Rank Type Name Revenue (in millions)

1 Government United States 3,251

2 Government China 2,426

3 Government Germany 1,515

4 Government Japan 1,439

5 Government France 1,253

6 Government United Kingdom 1,101

7 Government Italy 876

8 Government Brazil 631

9 Government Canada 585

10 Corporation Walmart 482

11 Government Spain 474

12 Government Australia 426

13 Government Netherlands 337

14 Corporation State Grid 330

15 Corporation China National Petroleum 299

16 Corporation Sinopec Group 294

17 Government South Korea 291

18 Corporation Royal Dutch Shell 272

19 Government Mexico 260

20 Government Sweden 251

21 Corporation ExxonMobil 246

22 Corporation Volkswagen 237

23 Corporation Toyota Motor 237

24 Government India 236

25 Corporation Apple 234

From “Corporations vs governments revenues: 2015 data,” by Global Justice Now, n.d., Retrieved from http://www .globaljustice.org.uk/sites/default/files/files/resources/corporations_vs_governments_final.pdf

(continued)

http://www.globaljustice.org.uk/sites/default/files/files/resources/corporations_vs_governments_final.pdf

217

Section 10.3 Monopoly Power and Price Discrimination

10.3 Monopoly Power and Price Discrimination Up to this point we have assumed that the monopolist charges the same price to all con- sumers 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 con- sumer different prices depending on the quantity purchased, the monopolist is practicing price discrimination. Price discrimination is a way to expand monopoly profits by extract- ing consumer surplus from consumers. In this sense, discrimination 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.

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 government 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 different 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 countries force foreign firms to purchase a certain percentage 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 uncommon 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.

218

Section 10.3 Monopoly Power and Price Discrimination

To see how price discrimination works, you need to recall the discussion of consumer surplus in Chapter 5. 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 pur- chased 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 10.3 illustrates this concept. At price Pl in Figure 10.3, the consumer was receiving a “bonus” in terms of utility. This extra utility is called consumer surplus, repre- sented by the shaded area in Figure 10.3.

Figure 10.3: 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 P1.

Price

D = AR

Consumer surplus

Quantity/ time period

A monopoly producer might be able to deal separately with consumers, depending on the number of units purchased. In terms of Figure 10.4, the monopolist could say, “You may buy up to Q1 units for P1, from Q1 to Q2 units for P2, from Q2 to Q3 units for P3, and from Q3 to Q4 units for P4.” 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 10.4 to the shaded area in Figure 10.3. Both represent consumer surplus. In Figure 10.4, 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.

219

Section 10.3 Monopoly Power and Price Discrimination

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 separate 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 discrimination 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 $2.50 a cup; refills $1” are examples of this type of price discrimination.

The second type of price discrimination requires that the seller be able to separate markets according to different elasticities of demand. Movies offer cheaper tickets for children and those in the military. University athletic departments offer lower priced tickets to sports events to students and faculty. Senior citizens get discounts on all kinds of items, from hotels to restaurants and more. In each of these cases, the market with the greater elasticity gets lower prices. Let’s see why.

Figure 10.4: A price-discriminating monopolist

A price-discriminating monopolist can capture most of the consumer surplus by charging different prices for different amounts of consumption.

Price

Quantity/ time period

Q1 Q2 Q3 Q4

220

Section 10.3 Monopoly Power and Price Discrimination

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 inelastic demand? Busi- ness 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 developed sophisticated techniques to set and change fares instantaneously. Their objective is to juggle fares to match the bargain offerings of low-cost rivals while protecting their full-fare business.

Two conditions are necessary in order to practice price discrimination. First, it must be pos- sible to separate consumers into groups that have different demand elasticities. These groups need to be economically identifiable. If it costs too much to identify the groups, discrimi- nation 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 different 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. Businesspeople 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 mov- ies, 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 subscriptions. Sometimes subscription prices are only a fraction of the newsstand prices. Newsstand demand is more inelastic because it is typically a spur-of-the-moment, unplanned purchase. Book publishers charge much higher prices for hardcover novels than for softcover 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 situation. 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 happens? 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. Consider charg- ing 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 ID 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. For example, it would be challenging for an adult to claim to be a child in order to get the discounted price.

221

Section 10.4 Is Monopoly Bad?

The seller often justifies price discrimination as helping a group. Student or senior discounts are often thought of as being offered as a way to “help them out.” In reality, price discrimina- tion 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 monop- oly 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 that price equals marginal cost. This is common sense because the monopolist only restricts output in order to keep price from falling 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.

10.4 Is Monopoly Bad? Any entrepreneur would prefer to sell in a monopoly rather than a perfectly competitive industry, because economic profit tends to zero in the perfectly competitive market. A firm that can create a successful monopoly will be rewarded with continuing profits. Monopoly is obviously good for the monopolist, but monopoly markets can be bad for society.

How Monopoly Compares to Perfect Competition To see what’s so bad about monopoly, look at Figure 10.5. First, assume that Figure 10.5 rep- resents a perfectly competitive industry. The market demand curve (D) 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 Pc and Qc. 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 purchased firms’ marginal cost curves. The monopoly firm also faces the market demand curve and its corresponding marginal reve- nue curve. The monopoly firm will produce at Qm and Pm. In this case it is a very simple matter to contrast monopoly with perfect competition. The monopolist produces a smaller output (Qm < Qc) and charges a higher price (Pm > Pc) than the perfectly competitive firms did. This is possible because entry into the industry is blocked. Since new firms cannot enter, consum- ers are not getting the optimal amount of the good produced by the monopolist. Monopolies restrict output. This is the principal economic argument against monopoly.

222

Section 10.4 Is Monopoly Bad?

The monopolistic output and price, then, represent misallocation of resources if the monop- oly 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 individual firms, the monopoly introduced some inefficiencies of large-scale management. Such inefficiencies would cause an upward shift of the cost curves in Figure 10.5.

The misallocation of resources in a monopoly is illustrated in Figure 10.6. The monopoly is in equilibrium producing x1 units at a price of P1. The monopolist’s profit, which is total rev- enue minus total cost, is represented by rectangle CP1AB. Let’s examine closely what is going on at this equilibrium. First, price P1 is greater than average cost (which is x1B per unit). That is, P1 > AC, and economic profits are being earned. Second, price is greater than marginal cost (P1 > MC), which means the value consumers place on the last unit (P1) exceeds the opportu- nity cost of producing it (MC). From the society’s (and the consumer’s) point of view, more should be produced. The monopolist prevents output from increasing by restricting entry. Third, average cost at output x1 is greater than marginal cost at x1. That is, AC > MC. This means that the technologically most efficient level of output 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 10.5: Price and output determination under monopoly and perfect competition

The monopolist, equaling marginal cost and marginal revenue, produces output Qm and sells it at price Pm. If this same firm were perfectly competitive, the price would be Pc and output would be Qc.

Price, cost

Quantity/ time period

Qm Qc

S = MC

223

Section 10.4 Is Monopoly Bad?

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 insuf- ficient demand may cause a monopolist to lose money. For example, the U.S. Postal Service is a government-sanctioned monopoly with the exclusive right to deliver first class mail. How- ever, the U.S. Postal Service (2018) ended the 2016 fiscal year by posting a loss of $6.5 billion. Clearly, a monopoly is not necessarily granted the right to make profits.

Figure 10.7 shows a monopoly suffering a loss. The monopoly is producing x1 units and charg- ing the loss-minimizing price, P1. As a result, the monopolist is incurring losses equal to rect- angle P1CAB. 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 aver- age revenue) is above average variable costs, as is the case in Figure 10.7, 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 10.6: Misallocation of resources in a monopoly

A monopoly misallocates resources because price is greater than marginal cost. This means the value consumers place on the item exceeds the opportunity cost of producing it.

Price, cost

Quantity/ time period

x1 MR

Profit

224

Section 10.4 Is Monopoly Bad?

A monopolist can also earn only normal profits. Figure 10.8 illustrates this case. The monop- oly is producing x1 units and charges price P1. Total revenue is equal to rectangle 0P1Ax1. 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 profits. However, price is still greater than marginal cost, indicating that more units should be produced.

You can see, as in the case of the U.S. Postal Service, monopolies don’t always make profits. 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.

Figure 10.7: 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.

Price, cost

Quantity/ time period

x1 MR

MC AC

AVC

B Loss

225

Section 10.4 Is Monopoly Bad?

Figure 10.8: 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.

Price, cost

Quantity/ time period

x1 MR

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 = AC, only normal profit earned • MC = AC, producing at least cost combination

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 prof- its 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.

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Section 10.5 The Costs of Monopoly to Society

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 10.9 depicts a monopoly firm with constant marginal costs and thus constant average costs. Constant marginal costs and average costs are assumed for simplicity.

Figure 10.9: 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.

Price, cost

Quantity/ time period

Qm Qc

Monopoly profit

Deadweight loss

MC = AC

The monopolist will produce output level Qm and set price at Pm. A perfectly competitive struc- ture would have produced an output of Qc at price Pc. As a result of restricting output, the monopolist earns a monopoly profit equal to the shaded area in Figure 10.9. This shaded area represents a transfer from consumers (in terms of lost consumer surplus) to the monopo- list (in terms of monopoly profit). This transfer, however, is not the only cost the monopoly creates.

Deadweight Loss The crosshatched triangle in Figure 10.9 represents lost consumer surplus that was not con- verted into monopoly profits. This lost consumer surplus is received by no one. Consumers 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.

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Section 10.5 The Costs of Monopoly to Society

Policy Focus: Monopoly and Antitrust

Toward the end of the 19th century, there was a substantial 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 purpose of owning and thus controlling other firms. Trusts and holding 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 industrial revolution in the United States.

Eventually, the public began to view some of these arrangements with suspicion. In response, several states enacted antitrust statutes that regulated businesses chartered in those states. These state laws failed because corporations were able to obtain charters 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 prohibited 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 interpreted the law using the rule of reason, which said that monopolies that behaved well were not illegal. In 1945, after 13 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 $1.45 billion (that’s right, billion) for allegedly providing financial incentives to computer manufacturers not to buy computer chips from its rival, Advanced Micro Devices. Intel was still in the midst of appeals as of 2018.

Alfred Eisenstaedt/Time & Life Pictures/Getty Images 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

10.6 Fallacies and Facts About Monopoly This chapter has 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 misconceptions 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” con- sumers. 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 profits, and oth- ers 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 monopoly 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 2018 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 prof- its. This restriction of output means that the price charged is greater than marginal cost. Com- pared to perfect competition, monopolies are less efficient in allocating resources to match consumer preferences.

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Conclusion

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: Monopolists Ultimately Face 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 potential 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 impercep- tible degrees: that there is an element of monopoly in nearly all competitive business: and that nearly all the monopolies, that are of any practical impor- tance 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 competi- tion, direct and indirect. (Marshall, 1923, p. 397)

Conclusion Although Eli Lilly will surely enjoy the advantage that comes with having a patent and thus a legal barrier to entry for other firms to produce the drug Verzenio, the company will still need to worry about competition in the form of near substitutes and future medical treat- ments that perform better. In the end, a monopoly is only as strong as its barriers to entry. Although some monopolists may take this as an opportunity to sit back and enjoy the profits, a smart monopolist will recognize that, in the long run, a competitor will eventually emerge.

Key Ideas

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 monopolist maxi- mizes profits by producing the output level at which marginal revenue equals mar- ginal 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.

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Conclusion

7. Assume the marginal cost for the firm in Question 6 is MC = 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?

2. A monopolist is sometimes able to erect barriers to entry that allow profits to persist in the long run. Such barriers are very difficult to maintain. As a result, monopolists 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 industries. 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 ultimately face competition.

Critical-Thinking 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 mar-

ginal revenue column.

Price Quantity demanded Marginal revenue

10 0

9 1

8 3

7 4

6 5

5 6

4 7

3 8

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Conclusion

Key Terms barriers to entry Natural or artificial obstacles that keep new firms from entering an industry.

deadweight loss The lost consumer sur- plus due to monopolistic restriction of output.

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 different quantities purchased.

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 antitrust violation?

15. Why should the government pursue an active antitrust policy? Compare the costs and benefits.