Macroeconomics

Harvard Business School 9-794-027 Rev. December 20, 1993

Professor Willis Emmons prepared this note as the basis for class discussion.

Copyright © 1993 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

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Note on Pricing and Public Policy

Prices play a critical role in the functioning of market economies, providing a key link between the supply and demand for goods. Under perfect competition, firms have no control over the prices charged for their output: they are merely price takers subject to the “invisible hand” of the market. In such an idealized world, where numerous firms compete with identical technology and in which economies of scale and scope are minor relative to demand, providers of any particular good or service charge identical prices and earn profits just sufficient to cover their cost of capital.

The underlying characteristics of many “real world” markets, however, deviate substantially from the model of perfect competition. In some cases, the presence of significant economies of scale and/or economies of scope in production will limit the number of firms that can participate in the relevant market(s) because of the relatively high levels of fixed costs. Alternatively, the number of competitors may be limited artificially through manipulation on the part of one or more firms or through barriers to entry imposed by policy makers. In other instances, various combinations of scale/scope economies, producer actions, and government intervention may generate a complex web of influence on market structure and outcomes, including price, output, profitability, and social welfare.

This note surveys a number of important issues relating to pricing and public policy in market economies. It begins with a brief review of the price determination process in competitive markets, then examines a range of topics involving pricing and public policy in monopoly and oligopoly markets.1

Pricing in Competitive Markets

In a perfectly competitive market, firms continue to expand output in the short run as long as the price received for each incremental unit sold exceeds the marginal cost of production at the corresponding level of output. At the same time, consumers expand their purchases of the good until the price paid for an additional unit exceeds the marginal utility (incremental value) derived from the

1A reader who is unfamiliar with the basic principles of social welfare economics may wish to draw on background material such as that presented in “The Welfare Economics of Competition and Monopoly,” pp. 15- 55 of Industrial Market Structure and Economic Performance, by F.M. Scherer and David Ross (Boston: Houghton Mifflin, 1990); and “Introduction: The Economic Rationale and Task of Regulation,” pp. 1-17 of Optimal Regulation by Kenneth E. Train (Cambridge: MIT Press, 1991).

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purchase. When the marginal cost of producing one more unit is identical to the marginal utility of consuming one more unit, the equilibrium price and output level for the good will have been reached. (See Figure A.) Thus marginal cost pricing is said to provide maximum “allocative efficiency” since no consumer is willing to pay for the additional allocation of resources that would be required to produce an incremental unit of output.2

Since all units of output are sold at the equilibrium competitive price, buyers receive a “consumer surplus” equal to the difference between the value of each unit they consume and the price paid, while sellers receive a “producer surplus” equal to the difference between the marginal cost incurred in generating each unit and the actual sales price. Under perfect competition, the producer surplus realized by the firm will compensate it exactly for the fixed costs incurred in the production process, thus enabling it to earn a normal (risk-adjusted) profit.3 This result is ensured by the fact that the price charged by the firm is equal to both the marginal cost and the average cost of production at its equilibrium output level. (See Figure B.)4

If we relax the assumption, however, that all firms utilize identical technology, we find that an innovative producer may be able to earn above normal profits, at least in the short term. For example, if a firm develops a proprietary process that allows it to reduce its production costs, it can accrue excess profits in the form of “rents” on its innovation. Specifically the firm will increase its output up to the point at which its marginal cost equals the market price and earn rents on each unit equal to the difference between price and average cost.5 (See Figure C.) In effect, the higher cost structure of the firm’s competitors provides a price umbrella under which it can earn superior profits. The future dynamics of the market would depend on a number of factors, including the ability of competitors to copy the innovation and the degree to which the innovator chooses to increase its own production capacity.

Pricing in Monopoly Markets

If a firm is able to secure a monopoly in a particular market it may be able to transform itself from a price taker to a price setter by virtue of its “market power.” In some cases, the firm may become a sole producer in an otherwise competitive industry by obtaining government-enforced barriers to entry (for example, a patent or a monopoly franchise) or by driving out actual and

2In explaining the concept of marginal cost pricing, the economist Alfred Kahn notes that “First, the essential criterion of what belongs in marginal cost and what not, and of which marginal costs should be reflected in price, is causal responsibility. All the purchasers of any commodity or service should be made to bear such additional costs—only such costs, but also all such costsCas are imposed on the economy by the provision of one additional unit. And second, it is short-run marginal cost to which price should at any given time— hence always—be equated, because it is short-run marginal cost that reflects the social opportunity cost of providing the additional unit that buyers are at any time trying to decide whether to buy.” Kahn also notes that “to the extent wear and tear of equipment varies with use . . . depreciation is a variable cost” and thus should be incorporated into a calculation of short-run marginal cost. However, “to the extent that maintenance, depreciation, cost of capital, and various overhead expenses other than overhead expenses are not a function of use, they do not belong in short-run marginal cost or, as such, in the ideal price.” See Alfred Kahn, The Economics of Regulation (Cambridge: MIT Press, 1988), vol I, pp. 71-72. 3Some economists refer to competitive returns as “zero profits,” signifying zero excess returns over the cost of capital. 4Rising marginal costs at higher levels of output can be attributed to factors such as increased overtime, maintenance expenses, transportation costs, and/or other manifestations of capacity constraints and the “law of diminishing returns.” 5This analysis assumes that at least in the short run, the additional output sold by the innovator will have only a negligible impact on the overall market supply and hence on market price.

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potential rivals through intimidation or predatory practices. In this note, these types of markets will be referred to as “artificial monopolies.” Alternatively, the firm may emerge as the sole producer due to cost and demand characteristics that create a “natural monopoly.” In these cases, the extent of economies of scale and/or scope are such that no combination of two or more firms can provide the relevant goods or services at a lower cost than can a single firm. Pricing and public policy issues with respect to artificial monopolies and natural monopolies are discussed separately below.

Artificial Monopolies

If a firm is able to obtain an artificial monopoly with no constraints on its pricing and production strategy, it will be able to earn profits in excess of normal returns. To maximize its profits, the firm will increase its output only as long as the marginal revenue gained from expanding production by one more unit exceeds the marginal cost incurred in providing the incremental unit.6

(See Figure D.) This monopoly pricing strategy, although profitable for the firm, is detrimental from the perspective of allocative efficiency since consumers are willing to pay more than the marginal cost of production for (Qcomp - Qmonop) units of additional output. Therefore, fewer resources will be devoted to this market than optimal from the standpoint of overall social welfare. The lower the price elasticity of demand for the product, the higher will be the monopoly price and the greater will be the deadweight loss to society resulting from allocative inefficiency.7

In principle, the monopolist would be willing to sell more than Qmonop units of production if it could do so without lowering the price at which it sold the units produced up to that point. However, this would be possible only if the monopoly could replace its uniform pricing approach with a price discrimination strategy. In the case of perfect (“first degree”) price discrimination, the monopolist would charge consumers according to their willingness to pay for each unit purchased. In so doing, the monopolist would capture the entire consumer surplus as monopoly profits. However, because production would expand from Qmonop to Qcomp, the outcome in terms of allocative efficiency would be identical to that achieved under perfect competition.

Perfect price discrimination is difficult to carry out in practice since it requires the monopolist (i) to know each consumer’s willingness to pay for each unit consumed, (ii) to implement a scheme for selling output at a wide range of prices; and (iii) to prevent buyers with lower willingness to pay from reselling goods purchased at low prices to buyers with a higher willingness to pay.8 As an alternative, the monopolist may be able to utilize a less complex form of price discrimination to increase its profits beyond the level obtained through uniform monopoly pricing. For example, if the product is purchased by two distinct groups of consumers with differing elasticities of demand, the monopolist might be able to charge one (higher) price to the more inelastic buyers and a second (lower) price to the more elastic buyers.9

In some cases, the monopolist might employ another form of nonuniform pricing known as two part tariffs. Under this approach, the seller charges an initial fixed (lump sum) fee to each buyer, plus a variable fee for each unit of output purchased. Particularly in cases where all potential buyers are relatively price inelastic with respect to their initial unit of demand for the good, the monopolist

6Since price falls with every additional unit of output, marginal revenue incorporates both the gain in revenue resulting from the sale of an incremental unit and the losses in revenue corresponding to the sale of all previous units of output at a slightly lower price. 7The price elasticity of demand for a product measures the sensitivity of demand for the product to changes in its price. The lower the elasticity of demand, the smaller the change in demand will be relative to a given proportional increase in price. 8Price discrimination may also be illegal in certain contexts. (See below under “Policy Issues”.) 9Take, for instance, the case of a pharmaceutical company with a patent on the production of a unique drug. The firm might be able to sell the drug at a higher price to insured buyers than to uninsured buyers.

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can use two part tariffs to increase profits beyond levels attained under uniform monopoly pricing, while also expanding production beyond Qmonop.

10 As in the case of price discrimination, however, two part tariffs would not be feasible if buyers were able to resell the product or service.

Policy issues What is the relationship between artificial monopolies and public policy? In some cases, government may actually sanction the creation of monopolies and allow them to price in an unconstrained manner. For example, patents may be granted to encourage innovation by enabling firms to internalize the positive externalities associated with research and development. In a more cynical context, a policy maker might grant a monopoly franchise to reward a firm that was a source of political and/or financial support. In other instances, the government might create a monopoly, yet impose restrictions on the firm’s pricing behavior. For example, it could set up a monopoly state- owned enterprise in an important industry sector but require it to sell its output at administratively determined “fair” prices. Also, when policy makers have sanctioned exclusive markets through patent policy they may bar practices such as price discrimination on equity grounds, even if allocative efficiency might increase as a result of such pricing schemes.

Artificial monopolies secured through private means are often opposed by policy makers. In the United States, for example, the Sherman Antitrust Act (1890) provides that “every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several states, or with foreign nations, shall be deemed guilty of a felony. . .” (Sec. 2). Under the Sherman Act, predatory pricing— the attempt of a firm to drive competitors out of business by pricing below costCis illegal.11 Furthermore, under the provisions of the Clayton Act (1914), price discrimination is illegal where “the effect of such discrimination may be substantially to lessen competition or tend to create a monopoly in any line of commerce. . . “ (Sec. 2).12

Natural Monopoly

In the case of natural monopoly, the absence of competition faced by the producer results neither from artificial barriers to entry nor from anticompetitive behavior on the part of the firm. Instead it is a function of the production technology employed and the demand characteristics associated with the market. Policy makers typically confront a dilemma when faced with a natural monopoly. Although they may believe that competition in the industry will lead to inefficient duplication of fixed costs, they may fear that if left unregulated, the natural monopoly firm will adopt monopoly pricing strategies such as those discussed above under “Artificial Monopolies”—strategies that usually lead to a reduction in allocative efficiency and a shift in income from consumers to producers.

The regulation of natural monopoly can take various forms, depending on the objective(s) of the policy maker and the nature of the relationship between the firm’s cost structure and the market demand. If the policy maker’s primary objective is to maximize social welfare, she will try to ensure

10For example, monopoly providers of water, electricity, or telephone service, if allowed to price in an unconstrained manner, would find a pricing strategy involving two part tariffs to be highly attractive. 11However, establishing that predatory pricing has actually occurred is quite complicated given the ambiguous nature of the costs involved (average or marginal costs? short run or long run costs?) and given the difficulty of determining the intent underlying pricing behavior (aggressive competition or desire to drive all rivals into bankruptcy?). 12However, the Clayton Act does permit price differentials “which make only due allowance for differences in the cost of manufacture, sale, or delivery resulting from the differing methods or quantities in which such commodities are to such purchasers sold or delivered.” (Sec. 2). The Robinson-Patman Act (1936) expanded the provisions of the Clayton Act so as to bar price discrimination where its effects “tend to injure, destroy, or prevent competition with any person who either grants or knowingly receives the benefits of such discrimination, or with customers of either of them.”

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that the natural monopoly adopts marginal cost pricing, thus in effect replicating the combination of price and output achieved under perfect competition. Therefore, in the case of the natural monopoly depicted in Figure E, the regulator would ideally induce the firm to set price equal to Pcomp and output equal to Qcomp.

In the case of the natural monopoly shown in Figure F, policy makers face certain trade-offs. If the firm is required to charge the efficient price Pcomp it will be unable to recover its total costs of production.13 Thus without some form of price subsidy, the firm would not be able to maintain the marginal cost pricing strategy consistent with maximization of allocative efficiency. Alternatively the policy maker could allow the natural monopoly to charge Pbreakeven, which although reducing total output below the optimal level, would enable the firm to operate without a loss. As a third possibility, the regulator could allow the firm to engage in a form of price discrimination to recover a greater amount of fixed costs without substantially reducing output. For example, the firm could employ Ramsey pricing, under which (i) prices would be increased differentially for different buyer groups, with the highest increases falling on the most inelastic consumers; and (ii) total revenues would not exceed total costs incurred by the firm.14 Yet another approach would be to allow the firm to employ two part tariffs to increase revenues without substantially reducing total output.

Figure G presents a third variation on the natural monopoly market. In this case, marginal cost pricing would actually enable the firm to earn above normal profits totalling Qcomp * (Pcomp - P’). If the firm were forced to reduce its price to Pbreakeven, its excess profits would fall to zero, yet its output, Qcomp, would be excessive from the standpoint of allocative efficiency.

15 Under these conditions, the regulator might allow the natural monopoly to charge Pcomp, yet impose a tax on the firm to capture its excess profits. Alternatively, it could require the firm to limit its revenues to the level of total costs by implementing Ramsey pricing in reverse—i.e., providing price discounts to buyers, with the largest percentage reductions applicable to the most price inelastic customers. Similarly, an inverse form of two part tariffs could be employed, in which the firm would provide a lump sum rebate to all customers as a way of reducing its profits.

Throughout the preceding discussion of natural monopoly, we have assumed that the primary objective of the policy maker is to maximize social welfare, defined as the sum of consumer and producer surplus. However, in reality, policy makers may have objectives of equal if not greater importance. For example, a regulator may be more concerned with distributional equity than with economic efficiency. Ramsey pricing by a natural monopoly to recover fixed costs may be opposed by policy makers, particularly if the most inelastic buyers are also those with the lowest incomes.16 Such equity concerns might block the adoption of two part tariffs as well if policy makers regard the lump sum fee as particularly onerous on certain buyers.17 Ramsey pricing and two part tariffs could be

13This shortfall results from the fact that the firm’s marginal cost (P comp

) is below its average cost (P’) at the efficient output level Q

comp . Thus marginal cost pricing would lead to total losses of Q

comp * (P’-P

comp ). This

situation is comparable to that faced by a major public utility whose fixed costs are so high that its marginal cost will always be below average cost for any feasible level of demand in its market. 14More specifically, the “Ramsey rule” requires that prices be adjusted so that the resulting percentage decrease in quantity demanded be identical across all buyers. 15The marginal cost of every additional unit produced after Q

comp is greater than the marginal utility provided to

buyers. 16As noted above, price discrimination that cannot be justified on the basis of differential cost of service is prohibited in the United States by the Clayton Act and the Robinson-Patman Act. (See page 4.) 17In some cases policy makers may allow for the imposition of a fixed fee, yet exempt certain classes of buyers from paying it. For example, state regulatory commissions permit telephone companies to charge a fixed monthly fee for local telephone service (including “access charges” for long distance service), even if the customer’s actual telephone usage is minimal or zero. However, certain states require that local telephone companies waive the monthly fixed fees for low income households, thereby providing “lifeline service” to such buyers.

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blocked as well by policy makers who were “captured” by particular interest groups which, regardless of income level, opposed pricing schemes that would require them to pay relatively higher rates.

In some cases, policy makers mayCin the name of “fairness”—impose uniform or average cost pricing requirements on a natural monopoly even if the cost of service varies substantially by customer. While such an approach to pricing may be politically popular, it in effect requires lower cost users to cross subsidize higher cost buyers. Therefore, this requirement reduces allocative efficiency by presenting individual buyers with prices that do not reflect the marginal cost to society of providing an additional unit of the relevant good or service. Furthermore, if substitute products are available to buyers who forced to provide the cross subsidy, these buyers may switch to purchasing the substitute, even if its marginal cost is higher than that of the original product. If such opportunities for “bypass” are widespread, the natural monopoly may be unable to maintain the pricing structure imposed on it by regulators and still earn normal profits.

Regulatory mechanisms for controlling natural monopoly In theory, the policy maker can achieve her objectives with respect to the control of natural monopolies by imposing cost-plus pricing or by adopting rate of return regulation in conjunction with certain constraints on the level and structure of prices. Yet in practice, the effectiveness of such regulatory mechanisms is reduced by the difficulties faced by policy makers in obtaining, interpreting, and applying the extensive amount of cost and demand information required to regulate prices and/or profits of the firm. If the natural monopoly is able to effectively evade regulatory constraints, it may choose to raise price and lower output relative to competitive levels, which would lead in turn to allocative inefficiency. Furthermore, if the firm faces neither effective regulation, nor effective discipline in the financial and product markets, it may not minimize its costs, thereby generating “X-inefficiency,” a form of technical (or production) inefficiency.

Yet ironically, “effective” regulation might lead to technical inefficiency as well. On the one hand, a firm constrained to earn a specific rate of return might overinvest in capital relative to labor in order to maximize its profits.18 On the other hand, a fully effective constraint on profits might lead to dynamic inefficiency by removing the incentives the firm would otherwise have to lower its production costs—and thus, increase its returnsCthrough innovation.

As an alternative to rate of return regulation, some policy makers have adopted price cap regulation of natural monopolies.19 Under this mechanism, a ceiling price is set for the firm’s good or service and is adjusted periodically to reflect the impact of inflation and a required minimum level of productivity improvement.20 Price caps are typically reevaluated after a number of years to determine whether or not changes in cost and demand conditions warrant an adjustment of the productivity factor. In theory, price caps are a simpler mechanism to implement than cost-plus or rate of return regulation since they do not involve extensive use of cost data. Furthermore, they also provide incentives for the firm to innovate by allowing it to retain the benefits of cost improvements beyond the required productivity gains. However, if regulators reevaluate the productivity factor too frequently, the firm’s incentive to reduce its costs could be diminished.

Potential competition and natural monopolies Some economists have argued that under certain conditions, regulation of natural monopoly pricing and/or profitability is unnecessary for achieving

18This phenomenon is referred to as the “Averch-Johnson effect,” named after the economists, Harvey Averch and Leland Johnson, who first identified the behavior. 19For example, British policy makers adopted this mechanism for the regulation of British Telecom after the utility was privatized in the mid-1980s. 20In the case of British Telecom, rates are adjusted annually by a percentage given as (RPI-X), where RPI is percentage change in the retail price index and X is a productivity factor set by the regulatory body, Oftel.

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efficient economic outcomes.21 In particular, if there are negligible barriers to entry and exit in the industry such as sunk costs (as opposed to merely fixed costs), the threat of potential competition may provide sufficient pressure on the natural monopoly to charge prices that lead to no more than normal profits. For these “contestable markets” to function properly, however, policy makers would have to remove all artificial barriers to entry—including the exclusive franchises typically granted in conjunction with rate of return regulation to prevent “wasteful duplication” of fixed costs.

Potential competition has been challenged on several grounds as an alternative to more traditional approaches to the control of natural monopoly. Since the industries most typically regarded as natural monopolies are utilities with substantial levels of sunk costs, the corresponding barriers to entry and exit would appear to reduce the threat of competition in practice. Even if sunk costs were minimal, the incumbent might be able to deter competitive threats by immediately lowering price in the face of entry to levels allowing for no more than normal profits. In these cases, opposition to the contestable markets approach is based on the belief that it would be ineffective as a means for preventing excess profits and allocative inefficiency in actual natural monopoly markets.

In other instances, a reliance on potential competition to control natural monopoly behavior has been opposed by those who believe that it may lead to price skimming or “cherry picking” on the part of an entrant choosing to serve only a subset of the market. Even if the incumbent is able to adjust prices immediately in response to the entrant, the former may have to abandon some of its higher cost buyers in order to maintain normal profits.22 In this case, the natural monopoly is unable to charge sustainable prices to serve the entire market in the face of competition. Under these cost and demand conditions, an exclusive franchise would appear to be a necessary (though not a sufficient) condition for the maximization of allocative efficiency. Similarly, under certain circumstances a natural monopoly based on economies of scope achieved in the production of two or more distinct goods or services may not be able to prevent an entrant from producing one of the goods on a stand-alone basis without abandoning portions of the markets it serves.

In spite of these myriad objections to the use of potential competition in natural monopoly markets, supporters offer additional justifications for the approach. First, they argue that even though the threat of competition could theoretically induce inefficiencies in certain natural monopoly markets, it is by no means clear that the combination of exclusive franchises and price or profit regulation leads to comparatively lower levels of inefficiency in the markets where such regulation is in effect. Second, competition advocates maintain that given the rapid changes in technology and demand that may occur over time in the market for a particular good or service, a monopoly may be “natural” only for limited duration. However, if policy makers prohibit competitive entry in a market indefinitely, they may ultimately be supporting an artificial monopoly. Finally, if policy makers allowed for the possibility of competition (and even “wasteful duplication”) in an unambiguous natural monopoly market, innovation in the industry might proceed at a much quicker pace than under traditional regulatory approaches. In particular, the incumbent would in theory always face the possibility of losing the market, while potential entrants would foresee the prospect of sharing, if not overtaking the monopolist’s market completely by achieving a superior cost and/or quality position.

21Proponents of this “contestability theory” include William Baumol, John Panzar, and Robert Willig. 22The cost curves in Figure 7 provide an example of a natural monopoly subject to threat from a potential entrant, even if the former is earning only normal profits. Specifically, the “breakeven” incumbent would be unable to prevent an entrant from operating at the lowest point on the average cost curve (at a much lower level of output than the incumbent’s) without abandoning all sales corresponding to the rising portion of the average cost curve.

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Pricing in Oligopoly Markets

Oligopoly markets fall between the extremes of monopoly and perfectly competitive markets. Pricing in a oligopoly market relative to marginal cost may vary considerably, depending on the cost and demand characteristics of the market and on the ability of firms in the market to collude, either tacitly or explicitly.

The presence of economies of scale and/or scope relative to demand is significant in oligopoly markets, although not so great as to create a natural monopoly. Under these conditions oligopoly firms will be tempted to cooperate so as to restrict aggregate industry output, thereby allowing price to rise above marginal cost and profits to rise above normal levels. However, pricing- fixing is prohibited in the United States by the terms of Sec. 1 of the Sherman Act, which states that “every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign governments, is hereby deemed to be illegal.” Nevertheless, oligopoly firms may be able to act in such a way as to raise prices above competitive levels without violating the Sherman Act by independently recognizing their mutual interests to do so.

Even if oligopoly firms are able at times to maintain price levels above marginal costs (and profits above normal levels), such cartels are inherently unstable. On the one hand, each firm has an incentive to “cheat” by lowering price slightly and increasing output in order to increase total profits. If some exogenous shock leads to a significant decline in industry demand, the pressure to lower price will become even greater. To the extent that the industry’s fixed costs are largely sunk costs, adverse demand shocks—such as those experienced during business cycles—could lead to price wars as firms continued to reduce price to the lower levels of marginal cost in effect under conditions of excess capacity. Although some or all firms in the industry might be unable to recover total costs of production, the minimal salvage value of fixed assets might make exit from the industry an even less attractive alternative. In such cases, firms might call on policy makers to grant various forms of assistance, including the sanctioning of barriers to entry or market-splitting arrangements; the provision of subsidies for the retirement of excess capacity; and/or the setting of minimum prices or target prices, supported if necessary by government subsidies. Yet although such measures might help to raise industry prices and profitability, they would represent market distortions that would be likely in turn to reduce allocative efficiency.

To the extent that an oligopoly firm possesses market power with respect to certain geographic markets, customer groups, or product lines, it may face opportunities and constraints similar to those experienced by monopolists. On the one hand, it may be able to earn excess profits in these market segments by employing the types of monopoly pricing practices discussed above. On the other hand, policy makers may restrict the use of certain pricing practices, even when such practices—for example, Ramsey pricing—might simply allow the firm to cover its fixed costs across all the markets it serves. Therefore, the oligopoly firm may in some instances confront the same problems of bypass and price sustainability encountered by certain natural monopolies.

Concluding Remarks

In the context of perfectly competitive markets, price equals marginal cost across the economy as a result of interaction between firms seeking to maximize profits and consumers seeking to maximize utility. Yet in actual markets, the price-setting mechanism may be considerably more complex. In particular, firms may be able to exert influence over pricing through market power derived from scale and scope economies, collusion, and/or the assistance of policy makers. Policy makers themselves may attempt to control pricing in certain markets in pursuit of objectives related to economic efficiency, distributional equity, and/or self-interest. Ultimately, the combination of market imperfections, strategic actions on the part of firms and interest groups, and intervention by policy makers will shape the level(s), structure, and dynamics of prices in any given market.

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Figure A Equilibrium Price, Output, and Surplus in a Competitive Market

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Figure B Costs, Pricing, and Output of a Representative Firm in a Competitive Market

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Figure C Rents Earned by an Innovative Firm in a Competitive Market

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Figure D Monopoly Pricing, Output and Deadweight Loss

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Figure E Natural Monopoly for which MC = AC at Efficient Price Level

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Figure F Natural Monopoly for which MC < AC at Efficient Price Level

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Figure G Natural Monopoly for which MC > AC at Efficient Price Level

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