12
MONOPOLY Chapter AND MONOPSONY
QUESTIONS AND ANSWERS
Q12.1
Describe the monopoly market structure and provide some examples.
Q12.1
ANSWER
Monopoly is a market structure characterized by a single seller of a highly
differentiated product. Because a monopolist is the sole provider of a desired
commodity, the monopolist is the industry. Although the producer of every product
faces at least some competition in the sense of competing for a share of the
consumer's overall market basket of goods, monopolists face no effective
competition from either established or potential rivals able to offer the same product.
This allows the monopolist to simultaneously determine price and output levels for
the firm (and the industry). Substantial barriers to entry or exit are often present,
thereby deterring potential entrants and offering both efficient and inefficient
monopolists the opportunity for excess profits, even in the long-run.
Examples of monopoly markets include: local telephone service (or basic
hook-up); municipal bus companies; and gas, water and electric utilities, among
others.
Q12.2
From a social standpoint, what is the problem with monopoly?
Q12.2
ANSWER
The problem with monopoly from a social standpoint is that it leads to an inefficient
allocation of productive resources and an inequitable allocation of income. From an
efficiency perspective, monopolies produce too little output at too high a price. As a
result, the demands of consumers are only partially met. Because P > MC, the
marginal value of output (P) exceeds marginal production costs, and social welfare
would rise with an increase in production. From an equity perspective, the excess
profits that can arise due to unregulated monopoly are often criticized as unwarranted
and thus unfair.
Q12.3
Why are both industry and firm demand curves downward sloping in monopoly
markets?
Q12.3
ANSWER
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In monopoly, the firm is the industry. Thus, firm and industry demand and supply
curves are identical. The monopoly demand curve will be downward sloping, like all
industry demand curves, because this output must, to a greater or lesser degree,
compete with all goods and services for a share in the consumer's market basket. The
diminishing marginal utility associated with the consumption of all goods and
services will ensure that the industry demand curve is downward sloping for all
products.
Q12.4
Give an example of monopoly in the labor market. Discuss such a monopoly's effect
on wage rates and on inflation.
Q12.4
ANSWER
With industrialization came a growing concentration on the purchase of labor
services, and in some instances, this growing concentration was sufficient to create
buyer (monopsony) power. Labor laws in the United States granted workers the right
to unionize in order to create countervailing seller (monopoly) power in the market
for labor services. The advantage of countervailing power is that markets
characterized by monopsony-monopoly confrontation can sometimes lead to more
efficient price-output combinations than markets characterized by uncontested buyer
or seller power.
Q12.5
Given the difficulties encountered with utility regulation, it has been suggested that
nationalization might lead to a more socially optimal allocation of resources. Do
you agree? Why or why not?
Q12.5
ANSWER
This question is, of course, very subjective. However, experience suggests that
economic efficiency is best served by vigorous competition in the marketplace. With
utilities such competition is certainly limited, but private utilities must still compete
for capital resources. This no doubt aids in the efficient allocation of scarce
economic resources. With nationalization, even this role of competition in
determining efficient resource use would be removed, and it seems unlikely that a
nationalized firm with no profit incentive would operate at either an optimal output
level, or facilitate an efficient allocation of resources.
Q12.6
Antitrust statutes in the United States have been used to attack monopolization by big
business. Does labor monopolization by giant unions have the same potential for the
misallocation of economic resources?
Q12.6
ANSWER
Monopoly and Monopsony
116
Economically speaking, the monopolization of labor can be as harmful as is the
monopolization of big business. Both lead to a misallocation of economic resources.
From an efficiency standpoint, monopolization of both labor and business should be
vigorously prosecuted.
Q12.7
When will an increase in the minimum wage increase employment income for
unskilled laborers? When will it cause this income to fall? Based on your
experience, which is more likely?
Q12.7
ANSWER
Demand analysis indicates that an increase in price will increase total revenue so
long as demand is inelastic (|P| < 1). Similarly, an increase in the minimum wage
will increase employment income for unskilled workers so long as the demand for
unskilled labor is inelastic. Unfortunately, the demand for unskilled labor may be
quite elastic, given the propensity of consumers to substitute self-service labor for
high-priced unskilled labor. Declining job opportunities for unskilled workers such
as bus boys, caddies, gas station attendants, movie theater ushers, waitresses, and so
on, suggest that increasing the minimum wage can hurt, rather than help, unskilled
workers.
Q12.8
Explain why state tax rates on personal income vary more on a state-by-state basis
than do corresponding tax rates on corporate income.
Q12.8
ANSWER
In considering state tax rates, it is interesting to note a greater variance from state to
state in personal as opposed to corporate tax rates. This phenomena can be explained
by the fact that corporations, more so than individuals, are willing to relocate to take
advantage of state tax rate differentials. Individuals become attached to geographic
locations and value geographic proximity to family and friends. As a result,
individuals are often reluctant to move; the coal miners stayed in West Virginia long
after the mines shut down. Corporations, on the other hand, exhibit few such ties to
geographic location. This implies a higher tax revenue elasticity for corporate tax
rate schedules than for personal tax rate schedules.
Q12.9
Do the U.S. antitrust statutes protect competition or competitors? What is the
difference?
Q12.9
ANSWER
U.S. antitrust statutes are meant to protect competition (the fight), rather than
currently active competitors (the fighters). Vigorous competition sometimes
results in bankruptcy and exit for previously viable competitors. Moreover, there is
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not necessarily a close link between fewness in the number of competitors and the
lack of competition. This point is sometimes overlooked in antitrust analysis. The
important point to consider is that competition requires viable competitors. With
substantial economies of scale in an industry, for example, viable firms are going to
be large. However, even a handful of firms can still be, and often are, vigorous
competitors.
Q12.10
Describe the economic effects of countervailing power, and cite examples of markets
in which countervailing power is observed.
Q12.10
ANSWER
Countervailing power exists in a market when buyer market power is used to offset
the effects of seller market power, and vice versa. The effect of countervailing power
is to reduce market prices and/or expand output in the case of new monopsony
(buyer) power created to challenge established monopoly (seller) power. Similarly,
new seller power created to challenge established buyer power has the effect of
raising market prices and/or expanding output.
In defense procurement, the monopsony (buyer) power of the federal
government is often used to offset the monopoly (seller) power of single-source
defense contractors. Similarly, local governments use their buyer power to offset the
seller power of local road and building contractors. The effects of countervailing
power are also sometimes observed when large retail chains buy major appliances,
car rental companies buy automobiles, and in several labor markets.
SELF-TEST PROBLEMS AND SOLUTIONS
ST12.1
Capture Problem. It remains a widely held belief that regulation is in the public
interest and influences firm behavior toward socially desirable ends. However, in
the early 1970s, Nobel laureate George Stigler and his colleague Sam Peltzman at
the University of Chicago introduced an alternative capture theory of economic
regulation. According to Stigler and Peltzman, the machinery and power of the state
are a potential resource to every industry. With its power to prohibit or compel, to
take or give money, the state can and does selectively help or hurt a vast number of
industries. Because of this, regulation may be actively sought by industry. They
contended that regulation is typically acquired by industry and is designed and
operated primarily for industry's benefit.
Types of state favors commonly sought by regulated industries include direct
money subsidies, control over entry by new rivals, control over substitutes and
complements, and price fixing. Domestic "air mail" subsidies, Federal Deposit
Insurance Corporation (FDIC) regulation that reduces the rate of entry into
commercial banking, suppression of margarine sales by butter producers, price
fixing in motor carrier (trucking) regulation, and American Medical Association
Monopoly and Monopsony
118
control of medical training and licensing can be interpreted as historical examples of
control by regulated industries.
In summarizing their views on regulation, Stigler and Peltzman suggest that
regulators should be criticized for pro-industry policies no more than politicians for
seeking popular support. Current methods of enacting and carrying out regulations
only make the pro-industry stance of regulatory bodies more likely. The only way to
get different results from regulation is to change the political process of regulator
selection and to provide economic rewards to regulators who serve the public
interest effectively.
Capture theory is in stark contrast to more traditional public interest theory,
which sees regulation as a government-imposed means of private-market control.
Rather than viewing regulation as a "good" to be obtained, controlled, and
manipulated, public interest theory views regulation as a method for improving
economic performance by limiting the harmful effects of market failure. Public
interest theory is silent on the need to provide regulators with economic incentives to
improve regulatory performance. Unlike capture theory, a traditional view has been
that the public can trust regulators to make a good-faith effort to establish
regulatory policy in the public interest.
A.
The aim of antitrust and regulatory policy is to protect competition, not to
protect competitors. Explain the difference.
B.
Starting in the 1970s, growing dissatisfaction with traditional approaches to
government regulation led to a global deregulation movement that spurred
competition, lowered prices, and resulted in more efficient production.
Explain how this experience is consistent with the capture theory of regulation.
C.
Discuss how regulatory efficiency could be improved by focusing on output
objectives like low prices for cable or telephone services rather than
production methods or rates of return.
ST12.1
SOLUTION
A.
Entry and exit are common facts of life in competitive markets. Firms that efficiently
produce goods and services that consumers crave are able to boost market share and
enjoy growing revenues and profits. Firms that fail to measure up in the eyes of
consumers will lose market share and suffer declining revenues and profits. The
disciplining role of competitive markets can be swift and harsh, even for the largest
and most formidable corporations. For example, in August, 2000, Enron Corp.
traded in the stock market at an all-time high and was ranked among the 10 most
valuable corporations in America. Nevertheless, Enron filed for bankruptcy just 16
months later as evidence emerged of a failed diversification strategy, misguided
energy trading, and financial corruption. Similarly, once powerful telecom giant
WorldCom quickly stumbled into bankruptcy as evidence came to light concerning
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the companys abuse of accounting rules and regulations. In both cases, once
powerful corporations were brought to their knees by competitive capital and product
markets that simply refused to tolerate inefficiency and corporate malfeasance.
In evaluating the effects of deregulation, and in gauging the competitive
implications of market exit by previously regulated firms, it is important to remember
that protecting competition is not the same as protecting competitors. Without
regulation, it is inevitable that some competitors will fall by the wayside and that
concentration will rise in some previously regulated markets. Although such trends
must be watched closely for anti-competitive effects, they are characteristics of a
vigorously competitive environment. Bankruptcy and exit are the regrettable costs of
remedying economic dislocation in competitive markets. Though such costs are
regrettable, experience shows that they are much less onerous than the costs of
indefinitely maintaining inefficient production methods in a tightly regulated
environment.
B.
Although it is difficult to pinpoint a single catalyst for the deregulation movement, it
is hard to overlook the role played by George Stigler, Sam Peltzman, Alfred E. Kahn,
and other economists who documented how government regulation can sometimes
harm consumer interests. A study by the Brookings Institution documented
important benefits of deregulation in five major industries--natural gas,
telecommunications, airlines, trucking, and railroads. It was found that prices fell 415% within the first two years after deregulation; within 10 years, prices were 2550% lower. Deregulation also leads to service quality improvements. Crucial social
goals like airline safety, reliability of gas service, and reliability of the
telecommunications network were maintained or improved by deregulation.
Regulatory reform also tends to confer benefits on most consumers. Although it is
possible to find narrowly defined groups of customers in special circumstances who
paid somewhat higher prices after deregulation, the gains to the vast majority of
consumers far outweighed negative effects on small groups. Finally, deregulation
offers benefits in the sense of permitting greater customer choice.
Although many industries have felt the effects of changing state and local
regulation, changing federal regulation has been most pronounced in the financial,
telecommunications, and transportation sectors. Since 1975, for example, it has been
illegal for securities dealers to fix commission rates. This broke a 182-year tradition
under which the New York Stock Exchange (NYSE) set minimum rates for each
100-share ("round lot") purchase. Until 1975, everyone charged the minimum rate
approved by the NYSE. Purchase of 1,000 shares cost a commission of ten times the
minimum, even though the overhead and work involved are roughly the same for
small and large stock transactions. Following deregulation, commission rates
tumbled, and, predictably, some of the least efficient brokerage firms merged or
otherwise went out of business. Today, commission rates have fallen by 90% or
more, and the industry is noteworthy for increasing productivity and innovative new
product introductions. It is also worth mentioning that since brokerage rates were
deregulated, the number of sales offices in the industry, trading volume, employment,
Monopoly and Monopsony
120
and profits have skyrocketed. This has lead some observers to conclude that
deregulation can benefit consumers without causing any lasting damage to industry.
In fact, a leaner, more efficient industry may be one of the greatest benefits of
deregulation.
In Canada, the deregulation movement led to privatization of governmentowned Air Canada. Trucking, historically a regulated industry, also was deregulated.
Specialized telecommunications services industries were deregulated and thrown
open to competition. In other areas where the government considered continued
regulation desirable and necessary, regulatory agencies were pressured to reform and
improve the regulatory decision-making process to reduce inefficiencies,
bureaucratic delays, and administrative red tape.
C.
A significant problem with regulation is that regulators seldom have the
information or expertise to specify, for example, the correct level of utility
investment, minimum transportation costs, or the optimum method of pollution
control. Because technology changes rapidly in most regulated industries, only
industry personnel working at the frontier of current technology have such specialized
knowledge. One method for dealing with this technical expertise problem is to have
regulators focus on the preferred outcomes of regulatory processes, rather than on the
technical means that industry adopts to achieve those ends. The FCC's decision to
adopt downward-adjusting price caps for long-distance telephone service is an
example of this developing trend toward incentive-based regulation. If providers of
long-distance telephone service are able to reduce costs faster than the FCC-mandated
decline in prices, they will enjoy an increase in profitability. By setting price caps
that fall over time, the FCC ensures that consumers share in expected cost savings
while companies enjoy a positive incentive to innovate. This approach to regulation
focuses on the objectives of regulation while allowing industry to meet those goals in
new and unique ways. Tying regulator rewards and regulated industry profits to
objective, output-oriented performance criteria has the potential to create a desirable
win/win situation for regulators, utilities, and the general public. For example, the
public has a real interest in safe, reliable, and low-cost electric power. State and
federal regulators who oversee the operations of utilities could develop objective
standards for measuring utility safety, reliability, and cost efficiency. Tying firm
profit rates to such performance-oriented criteria could stimulate real improvements
in utility and regulator performance.
Although some think that there is simply a question of regulation versus
deregulation, this is seldom the case. On grounds of economic and political
feasibility, it is often most fruitful to consider approaches to improving existing
methods of regulation. Competitive forces provide a persistent and socially desirable
constraining influence on firm behavior. When vigorous competition is absent,
government regulation can be justified through both efficiency and equity criteria.
When regulation is warranted, business, government, and the public must work
together to ensure that regulatory processes represent the public interest. The
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unnecessary costs of antiquated regulations dictate that regulatory reform is likely to
remain a significant social concern.
ST12.2
Deadweight Loss From Monopoly. The Las Vegas Valley Water District (LVVWD)
is a not-for-profit agency that began providing water to the Las Vegas Valley in
1954. The District helped build the city's water delivery system and now provides
water to more than one million people in Southern Nevada. District water rates are
regulated by law and can cover only the costs of water delivery, maintenance, and
facilities. District water rates are based on a four-tier system to encourage
conservation. The first tier represents indoor usage for most residential customers.
Rate for remaining tiers becomes increasingly higher with the amount of water
usage.
To document the deadweight loss from monopoly problem, allow the monthly
market supply and demand conditions for water in the Las Vegas Water District to
be:
QS
= 10P
(Market Supply)
QD
= 120 - 40P
(Market Demand)
where Q is water and P is the market price of water. Water is sold in units of one
thousand gallons, so a $2 price implies a user cost of 0.2 cents per gallon. Water
demand and supply relations are expressed in terms of millions of units.
A.
Graph and calculate the equilibrium price/output solution. How much
consumer surplus, producer surplus, and social welfare is produced at this
activity level?
B.
Use the graph to help you calculate the quantity demanded and quantity
supplied if the market is run by a profit-maximizing monopolist. (Note: If
monopoly market demand is P = $3 - $0.025Q, then the monopolists MR = $3
- $0.05Q)
C.
Use the graph to help you determine the deadweight loss for consumers and
the producer if LVVWD is run as an unregulated profit-maximizing monopoly.
D.
Use the graph to help you ascertain the amount of consumer surplus
transferred to producers following a change from a competitive market to a
monopoly market. How much is the net gain in producer surplus?
ST12.2
SOLUTION
A.
The market supply curve is given by the equation
Monopoly and Monopsony
122
QS = 10P
or, solving for price,
P = 0.1QS
The market demand curve is given by the equation
QD = 120 - 40P
or, solving for price,
40P = 120 - QD
P = $3 - $0.025QD
To find the competitive market equilibrium price, equate the market demand
and market supply curves where quantity is expressed as a function of price:
Supply = Demand
10P = 120 - 40P
50P = 120
P = $2.40
To find the competitive market equilibrium quantity, set equal the market
supply and market demand curves where price is expressed as a function of quantity,
and QS = QD:
Supply = Demand
$0.1Q = $3 - $0.025Q
0.125Q = 3
Q = 24 (million) units per month
Therefore, the competitive market equilibrium price-output combination is a
market price of $2.40 with an equilibrium output of 24 (million) units.
The value of consumer surplus is equal to the region under the market demand
curve that lies above the market equilibrium price of $2.40. Because the area of such
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a triangle is one-half the value of the base times the height, the value of consumer
surplus equals:
Consumer Surplus = [24 ($3 - $2.40)]
= $7.2 (million) per month
In words, this means that at a unit price of $2.40, the quantity demanded is 24
(million), resulting in total revenues of $57.6 (million). The fact that consumer
surplus equals $7.2 (million) means that customers as a group would have been
willing to pay an additional $7.2 (million) for this level of market output. This is an
amount above and beyond the $57.6 (million) paid. Customers received a real
bargain.
The value of producer surplus is equal to the region above the market supply
curve at the market equilibrium price of $2.40. Because the area of such a triangle is
one-half the value of the base times the height, the value of producer surplus equals:
Producer Surplus = [24 ($2.40 - $0)]
= $28.8 (million) per month
At a water price of $2.40 per thousand gallons, producer surplus equals $28.8
(million). Producers as a group received $28.8 (million) more than the absolute
minimum required for them to produce the market equilibrium output of 24 (million)
units of output. Producers received a real bargain.
In competitive market equilibrium, social welfare is measured by the sum of
net benefits derived by consumers and producers. Social welfare is the sum of
consumer surplus and producer surplus:
Social Welfare = Consumer Surplus + Producer Surplus
= $7.2 (million) + $28.8 (million)
= $36 (million) per month
Monopoly and Monopsony
124
Las Vegas Valley Water District
Monopoly
Deadweight
Loss
Consumer Surplus
Transferred to Producer
Surplus
$3.50
$3.00
MC = $0.1Q
A
Price
$2.50
B
$2.00
D
Demand
P = $3 - $0.025Q
C
$1.50
MR = $3 - $0.05Q
$1.00
$0.50
$0.00
0
0
4
8
12
16
20
24
28
32
36
40
Quantity (000)
B.
If the industry is run by a profit-maximizing monopolist, the optimal price-output
combination can be determined by setting marginal revenue equal to marginal cost
and solving for Q:
MR = MC = Market Supply
$3 - $0.05Q = $0.1Q
$0.15Q = $3
Q = 20 (million) units per month
At Q = 20,
P = $3 - $0.025Q
= $3 - $0.025(20)
= $2.50 per unit
125
C.
Chapter 12
Under monopoly, the amount supplied falls to 20 (million) units and the market price
jumps to $2.50 per thousand gallons of water. The amount of deadweight loss from
monopoly suffered by consumers is given by the triangle bounded by ABD in the
figure. Because the area of such a triangle is one-half the value of the base times the
height, the value of lost consumer surplus due to monopoly equals:
Consumer Deadweight Loss = [(24 - 20) ($2.50 - $2.40)]
= $0.2 (million) per month
The amount of deadweight loss from monopoly suffered by producers is given by the
triangle bounded by BCD. Because the area of such a triangle is one-half the value
of the base times the height, the value of lost producer surplus equals:
Producer Deadweight Loss = [(24 - 20) ($2.40 - $2)]
= $0.8 (million) per month
The total amount of deadweight loss from monopoly suffered by consumers and
producers is given by the triangle bounded by ACD. The area of such a triangle is
simply the amount of consumer deadweight loss plus producer deadweight loss:
Total Deadweight Loss = Consumer Loss + Producer Loss
= $0.2 (million) + $0.8 (million)
= $1 (million) per month
D.
In addition to the deadweight loss from monopoly problem, there is a wealth transfer
problem associated with monopoly. The creation of a monopoly results in a
significant transfer from consumer surplus to producer surplus. In the figure, this
amount is shown as the area in the rectangle bordered by $2.40$2.50AB:
Transfer to Producer Surplus = 20 ($2.50 - $2.40)
= $2 (million) per month
Therefore, from the viewpoint of the producer, the change to monopoly results in a
very favorable net increase in producer surplus:
Net Change in Producer Surplus = Producer Deadweight Loss + Transfer
= -$0.8 (million) + $2 (million)
Monopoly and Monopsony
126
= $1. 2 (million) per month
From the viewpoint of consumers, the problem with monopoly is twofold.
Monopoly results in both a significant deadweight loss in consumer surplus ($0.2
million per month), and monopoly causes a significant transfer of consumer surplus
to producer surplus ($2 million per month). In this example, the cost of monopoly to
consumers is measured by a total loss in consumer surplus of $2.2 million per month.
The wealth transfer problem associated with monopoly is seen as an issue of equity
or fairness because it involves the distribution of income or wealth in the economy.
Although economic profits serve the useful functions of providing incentives and
helping allocate resources, it is difficult to justify monopoly profits that result from
the raw exercise of market power rather than from exceptional performance.
PROBLEMS AND SOLUTIONS
P12.1
Monopoly Concepts. Indicate whether each of the following statements is true or
false, and explain why.
A.
The Justice Department generally concerns itself with significant or flagrant
offenses under the Sherman Act, as well as with mergers for monopoly covered
by Section 7 of the Clayton Act.
B.
When a single seller is confronted in a market by many small buyers,
monopsony power enables the buyers to obtain lower prices than those that
would prevail in a competitive market.
C.
A natural monopoly results when the profit-maximizing output level occurs at a
point where long-run average costs are declining.
D.
Downward-sloping industry demand curves characterize both perfectly
competitive and monopoly markets.
E.
A decrease in the price elasticity of demand would follow an increase in
monopoly power.
P12.1
SOLUTION
A.
True. Generally speaking, the Justice Department concerns itself with significant or
flagrant offenses under the Sherman Act, as well as with mergers for monopoly
covered by Section 7 of the Clayton Act.
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B.
False. When a single buyer is confronted in a market by many smaller sellers,
monopsony power enables the buyer to obtain lower prices than those that would
prevail in competitive markets.
C.
False. A natural monopoly occurs in a market when the market clearing price, or
price where Demand (Price) = Supply (Marginal Cost), occurs at an output level
where long-run average costs are declining.
D.
True. Downward sloping demand curves follow from the law of diminishing
marginal utility and characterize both perfectly competitive and monopoly market
structures.
E.
True. A decrease in the price elasticity of demand would result following an increase
in monopoly power.
P12.2
Natural Monopoly. On May 12, 2000, the two daily newspapers in Denver,
Colorado, filed an application with the U.S. Department of Justice for approval of a
joint operating agreement. The application was filed by The E.W. Scripps Company,
whose subsidiary, the Denver Publishing Company, published the Rocky Mountain
News, and the MediaNews Group, Inc., whose subsidiary, the Denver Post
Corporation, published the Denver Post. Under the proposed arrangement, printing
and commercial operations of both newspapers were to be handled by a new entity,
the Denver Newspaper Agency, owned by the parties in equal shares. This type of
joint operating agreement provides for the complete independence of the news and
editorial departments of the two newspapers.
The rationale for such an
arrangement, as provided for under the Newspaper Preservation Act, is to preserve
multiple independent editorial voices in towns and cities too small to support two or
more newspapers. The Act requires joint operating arrangements, such as that
proposed by the Denver newspapers, to obtain the prior written consent of the
Attorney General of the United States in order to qualify for the antitrust exemption
provided by the Act.
Scripps initiated discussions for a joint operating agreement after determining
that the News would probably fail without such an arrangement. In their petition to
the Justice department, the newspapers argued that the News had sustained $123
million in net operating losses while the financially stronger Post had reaped $200
million in profits during the 1990s. This was a crucial point in favor of the joint
operating agreement application because the Attorney General must find that one of
the publications is a failing newspaper and that approval of the arrangement is
necessary to maintain the independent editorial content of both newspapers. Like
any business, newspapers cannot survive without a respectable bottom line. In
commenting on the joint operating agreement application, Attorney General Janet
Reno noted that Denver was one of only five major American cities still served by
competing daily newspapers. The other four are Boston, Chicago, New York, and
Washington, D.C. Of course these other four cities are not comparable in size to
Monopoly and Monopsony
128
Denver; theyre much bigger. None of those four cities can lay claim to two
newspapers that are more or less equally matched and strive after the same
audience.
A.
Use the natural monopoly concept to explain why there is not a single city in
the U.S. that still supports two independently owned and evenly matched, highquality newspapers that vie for the same broad base of readership.
B.
On Friday January 5, 2001, Attorney General Reno gave the green light to a
50-year joint operating agreement between News and its longtime rival, the
Post. Starting January 22, 2001, the publishing operations of the News and the
Post were consolidated. At the time the joint operating agreement was formed,
neither news organization would speculate on job losses or advertising and
circulation rate increases from the deal. Based upon your knowledge of
natural monopoly, would you predict an increase or decrease in prices
following establishment of the joint operating agreement? Would you expect
newspaper production (and employment) to rise or fall? Why?
P12.2
SOLUTION
A.
Economies of scale in production explain why few cities can support more than one
local newspaper. Local newspapers are the classic example of natural monopoly.
Almost all production and distribution costs are fixed. Marginal production and
distribution costs are almost nil. Once the local news stories and local advertising
copy are written, there is practically no additional cost involved with expanding
production from, say, 200,000 to 300,000 newspapers per day. Once a daily edition
is produced, marginal costs may be as little as 5 per newspaper. When marginal
production costs are minimal, price competition turns vicious. Whichever competitor
is out in front in terms of total circulation simply keeps prices down until the
competition goes out of business or is forced into accepting a joint operating
agreement. This is exactly what happened in Denver. Until 2001, the cost of a daily
newspaper in Denver was only 25 each weekday and 50 on Sunday at the
newsstand, and even less when purchased on an annual subscription basis. The
smaller News had much higher unit costs and simply couldnt afford to compete with
the Post at such ruinously low prices.
B.
Starting January 22, 2001, the publishing operations of the News and the Post were
consolidated. The Denver Newspaper Agency, owned 50/50 by the owners of the
News and Post, is now responsible for the advertising, circulation, production and
other business departments of the newspapers. Newsrooms and editorial functions
remain independent. Therefore, the owners of the News and Post are now working
together to achieve financial success, but the newsroom operations remain
competitors. Under terms of the agreement, E.W. Scripps Co., parent of the
struggling News, agreed to pay owners of the Post $60 million. Both newspapers
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publish separately Monday through Friday. The News publishes the only Saturday
paper and the Post the only Sunday paper.
At the time the joint operating agreement was formed, neither news
organization would speculate on job losses or advertising and circulation rate
increases from the deal. Both proclaimed that neither job losses nor rate increases
would be substantial. In fact, the company announced significant job cuts and steep
advertising rate increases in the period following formation of the joint operating
agreement. For example, Jake Jabs, who owns the American Furniture Warehouse
chain in Denver, said his contract came up for renewal in February, 2001, and joint
operating agreement executives said theyd keep his rates the same until they could
negotiate a new agreement in March, 2001. However, in March, 2001, newspaper
officials proposed a new four-year contract for Jabs that required ads in both papers,
with a 100% rate increase the first year, and 25% per year for the following three
years. Jabs and other major local advertisers were so incensed that they sued in
federal court. They lost. In early 2001, U. S. District Judge John Kane Jr. rejected a
preliminary injunction sought by Jabs and a coalition of retailers called Coloradans
Against Newspaper Monopolies. They wanted to roll back new ad rates at the News
and the Post, and accused the papers of violating advertisers free speech rights by
raising ad rates too high. Kane found no authority in support of the alleged
constitutional violation, and the suit was dismissed. Kane said antitrust laws
prohibiting business monopolies dont apply to newspapers in joint operating
agreements.
The circulations of the Post and the News fell sharply after the two newspapers
dropped deep discounts on subscription rates. In the first two months after the two
papers combined business operations and began sharing profits, the News lost 17.9
percent of its Monday through Saturday circulation and the Post lost 11.9 percent.
The News Monday-through-Saturday circulation dropped from 446,465 to 366,499,
and Post circulation dropped from 413,730 to 364,451. Sunday circulation for the
News dropped from 552,085 to 448,032, and the Posts Sunday circulation dropped
from 558,560 to 522,903. Despite the losses, both papers remain among the top 20
largest weekday papers in the nation. Combined circulation places the Sunday Post
as the fifth-largest Sunday paper in the nation, with 970,935. The top four Sunday
papers are The New York Times, The Washington Post, the Los Angeles Times and
the Chicago Tribune.
P12.3
Price Fixing. An antitrust case launched more than a decade ago sent tremors
throughout the academic community. Over the 1989 -91 period, the Department of
Justice (DOJ) investigated a number of highly selective private colleges for price
fixing. The investigation focused on overlap group meetings comprised of about
half of the most selective private colleges and universities in the United States. The
group included 23 colleges, from small liberal arts schools Colby, like Vassar, and
Middlebury to larger research universities like Princeton and MIT. DOJ found that
when students applied to more than one of the 23 institutions, school officials met to
coordinate the exact calculation of such students financial need.
Monopoly and Monopsony
130
Although all of the overlap colleges attempted to use the same need formula,
difficult-to-interpret information from students and parents introduced some
variation into their actual need calculations. DOJ alleged that the meetings enabled
the colleges to collude on higher tuition and to increase their tuition revenue. The
colleges defended their meetings, saying that they needed coordination to fully cover
the needs of students from low-income families. Although colleges want capable
needy students to add diversity to their student body, no college can afford a
disproportionate share of needy students simply because it makes relatively generous
need calculations.
Although the colleges denied DOJs price-fixing allegation, they discontinued
their annual meetings in 1991.
A.
How would you determine if the overlap college meetings resulted in price
fixing?
B.
If price fixing did indeed occur at these meetings, which laws might be
violated?
P12.3
SOLUTION
A.
The effects of the DOJ overlap group inquiry has become the subject of an
interesting study by the National Bureau of Economic Research, Inc. The NBER
study found no evidence that the overlap colleges were colluding to raise tuition,
raise net tuition revenue, or to save expenditures on grants. Both the overlap colleges
and the control colleges raised tuition about 4 percent a year both before and after the
antitrust action. However, as a result of the suit, financial aid at the overlap colleges
became less progressive with respect to parents income and more sensitive to the
merit of individual students, as measured by standard aptitude tests. In other words,
financial aid became less sensitive to parents income and students with more
academic promise obtained more aid. As a consequence of the DOJ case, the
apparent trend in overlap colleges is to have a student body with proportionately
more well-off students and relatively fewer black and Hispanic students.
Apparently, DOJ found it difficult to apply standard economic analysis to
college education. Although students are consumers of education, they are also
producers in sense that peers affect the student experience. Many students would like
colleges to maintain need-based aid for others, but make exceptions for them if they
fail to qualify. (Note: Founded in 1920, NBER is a private, nonprofit, nonpartisan
research organization dedicated to promoting a greater understanding of how the
economy works. NBER research is conducted by more than 600 university professors
around the country.)
B.
If price-fixing is indeed the intent and logical result of the financial-aid overlap
meetings, a violation of Section 1 of the Sherman Act could be involved.
131
P12.4
Chapter 12
Tying Contracts. In a celebrated case tried during 1998, The Department of Justice
charged Microsoft Corporation with a wide range of anti-competitive behavior.
Among the charges leveled by the DOJ was the allegation that Microsoft illegally
bundled the sale of its Microsoft Explorer Internet browser software with its basic
Windows operating system. DOJ alleged that by offering a free browser program
Microsoft was able to extend its operating system monopoly and substantially
lessen competition and tend to create a monopoly in the browser market by
undercutting rival Netscape Communications, Inc. Microsoft retorted that it had the
right to innovate and broaden the capability of its operating system software over
time. Moreover, Microsoft noted that Netscape distributed its rival Internet browser
software Netscape Navigator free to customers, and that it was merely meeting the
competition by offering its own free browser program.
A.
Explain how Microsofts bundling of free Internet browser software with its
Windows operating system could violate U.S. antitrust laws, and be sure to
mention which laws in particular might be violated.
B.
Who was right in this case? In other words, did Microsofts bundling of
Microsoft Explorer with Window extend its operating system monopoly and
substantially lessen competition and tend to create a monopoly in the
browser market?
P12.4
SOLUTION
A.
Section 3 of the Clayton Act forbids tying contracts that reduce competition. A firm,
particularly one with a patent on a vital process or a monopoly on a natural resource,
could use licensing or other arrangements to restrict competition. One such method
was the tying contract, whereby a firm tied the acquisition of one item to the
purchase of another. For example, IBM once refused to sell its business machines. It
only rented machines to customers and then required them to buy IBM punch cards,
materials, and maintenance service. This had the effect of reducing competition in
these related industries. The IBM lease agreement was declared illegal under the
Clayton Act, and the company was forced to offer machines for sale and to separate
leasing arrangements from agreements to purchase other IBM products.
Clearly, in the 1998 case, The Department of Justice argued that Microsoft had
engaged in a similar pattern of anticompetitive behavior. If the market for Internet
browser software can indeed be seen as distinct from the market for desktop PC
software, then DOJ would appear to have a case that Microsoft illegally bundled
the sale of its Microsoft Explorer Internet browser software with its basic Windows
operating system. If the market for Internet browser software is not distinct from the
market for desktop PC software, then the DOJ case would appear to be meddling in
software design, as critics allege.
Monopoly and Monopsony
132
B.
As stated in part A, if the market for Internet browser software can indeed be seen as
distinct from the market for desktop PC software, then the DOJ would appear to have
a case that Microsoft illegally bundled the sale of its Microsoft Explorer Internet
browser software with its basic Windows operating system. On the other hand, if the
market for Internet browser software is not distinct from the market for desktop PC
software, then support would be gained for Microsofts contention that it has the
right to innovate and broaden the capability of its operating system software over
time. The governments case seems to have been weakened by Microsofts
observation that Netscape distributed its rival Internet browser software Netscape
Navigator free to customers. This suggests that Microsoft may indeed have merely
moved to meet the competition in the browser market. It is also worth noting that
Netscape Navigator continues to have an important share of the browser market, and
the profits of Netscapes parent-company AOL-Time Warner continue to flourish.
P12.5
Monopoly Price/Output Decision. Calvins Barber Shops, Inc. has a monopoly on
barbershop services provided on the south side of Chicago because of restrictive
licensing requirements, and not because of superior operating efficiency. As a
monopoly, Calvins provides all industry output. For simplicity, assume that
Calvins operates a chain of barbershops and that each shop has an average
cost- minimizing activity level of 750 haircuts per week, with Marginal Cost =
Average Total Cost = $20 per haircut.
Assume that demand and marginal revenue curves for haircuts in the south
side of Chicago market are
P = $80 - $0.0008Q
MR = $80 - $0.0016Q
Where P is price per unit, MR is marginal revenue, and Q is total firm output
(haircuts).
A.
Calculate the monopoly profit- maximizing price/output combination, and the
competitive market long-run equilibrium activity level.
B.
Calculate monopoly profits, and discusses the monopoly problem from a
social perspective in this instance.
P12.5
SOLUTION
A.
The monopoly profit-maximizing activity level is obtained by setting marginal
revenue equal to marginal cost, or marginal profit equal to zero (M = 0), and solving
for Q:
MR
= MC
133
Chapter 12
$80 - $0.0016Q
= $20
$0.0016Q
= $60
Q = 37,500 haircuts per week.
Under monopoly, the optimal market price is
P
= $80 - $0.0008(37,500)
= $50
The competitive market long-run equilibrium activity level is obtained by setting
marginal revenue equal to marginal cost at the average-cost minimizing output level.
In this case, the competitive market long-run equilibrium price is where P = MC =
ATC = $20. Setting P = MR = MC and solving for Q:
P
= MC
$80 - $0.0008Q
= $20
$0.0008Q
= $60
Q = 75,000 haircuts per week.
The competitive market long-run equilibrium price is equal to marginal cost at the
average-cost minimizing activity level
P
B.
= $20
At the Q = 37,500 monopoly activity level, Calvins will operate a chain of 50
barbershops (= 37,500/750). Although each outlet produces Q = 750 haircuts per
week, a point of optimum efficiency, the benefits of this efficiency accrue to the
company in the form of economic profits rather than to consumers in the form of
lower prices. Economic profits from each shop are
= TR - TC
= P Q - AC Q
= $50(750) - $20(750)
= $22,500 per week
Monopoly and Monopsony
134
With 50 shops, Calvins earns total economic profits of $1,125,000 (= 50 $22,500)
per week. As a monopoly, the industry provides only 37,500 units of output, down
from the 75,000 units provided in the case of a perfectly competitive industry. The
new price of $50 per haircut is up substantially from the perfectly competitive price
of $20. The effects of monopoly power are reflected in terms of higher consumer
prices, reduced levels of output, and substantial unwarranted economic profits for
Calvins.
P12.6
Deadweight Loss From Monopoly. The Onondaga County Resource Recovery
(OCRRA) system assumed responsibility for solid waste management on November
1, 1990, for thirty-three of the thirty-five municipalities in Onondaga County, New
York. OCRRA is a non-profit public benefit corporation similar to the New York
State Thruway Authority. It is not an arm of county government. Its Board of
Directors is comprised of volunteers who develop programs and policies for the
management of solid waste. The OCRRA Board is responsible for adopting a budget
that ensures there will be sufficient revenues to cover expenditures. It does not rely
on county taxes. OCRRA has implemented an aggressive series of programs
promoting waste reduction and recycling where markets exist to create new
products. While a number of communities struggle to surpass the 20% recycling
mark, Onondaga County's households and commercial outlets currently recycle
more than 67% of the waste that once was buried in landfills. Converting nonrecyclable waste into energy (electricity) is also a top priority.
To show the deadweight loss from monopoly problem, assume that monthly
OCRRAs market supply and demand conditions are:
QS
= -2,000,000 + 10,000P
(Market Supply)
QD
= 1,750,000 - 5,000P
(Market Demand)
where Q is the number of customers served, and P is the market price of annual
trash hauling and recycling service.
A.
Graph and calculate the equilibrium price/output solution. How much
consumer surplus, producer surplus, and social welfare are produced at this
activity level?
B.
Use the graph to help you determine the deadweight loss for consumers and
the producer if the market is run by unregulated profit-maximizing monopoly.
(Note: If monopoly market demand is P = $350 - $0.0002Q, then the
monopolists MR = $350 - $0.0004Q.)
135
Chapter 12
P12.6
SOLUTION
A.
The market supply curve is given by the equation
QS = -2,000,000 + 10,000P
or, solving for price,
10,000P = 2,000,000 + QS
P = $200 + $0.0001QS
The market demand curve is given by the equation
QD = 1,750,000 - 5,000P
or, solving for price,
5,000P = 1,750,000 - QD
P = $350 - $0.0002QD
To find the competitive market equilibrium price, equate the market demand
and market supply curves where quantity is expressed as a function of price:
Supply = Demand
-2,000,000 + 10,000P = 1,750,000 - 5,000P
15,000P = 3,750,000
P = $250
To find the competitive market equilibrium quantity, set equal the market
supply and market demand curves where price is expressed as a function of quantity,
and QS = QD:
Supply = Demand
Monopoly and Monopsony
136
$200 + $0.0001QS = $350 - $0.0002QD
$0.0003Q = $150
Q = 500,000
Therefore, the competitive market equilibrium price-output combination is a
market price of $250 with an equilibrium output of 500,000 customers served.
The value of consumer surplus is equal to the region under the market demand
curve that lies above the market equilibrium price of $250. Because the area of such
a triangle is one-half the value of the base times the height, the value of consumer
surplus equals:
Consumer Surplus = [500,000 ($350 - $250)]
= $25 million
In words, this means that at a competitive market price of $250 the quantity
demanded is 500,000, resulting in total revenues of $125 million per year. The fact
that consumer surplus equals $25 million means that customers as a group would
have been willing to pay an additional $25 million per year for this amount of
service. This is an amount above and beyond the $125 million paid per year.
Customers received a real bargain.
The value of producer surplus is equal to the region above the market supply
curve at the market equilibrium price of $250. Because the area of such a triangle is
one-half the value of the base times the height, the value of producer surplus equals:
Producer Surplus = [500,000 ($250 - $200)]
= $12.5 million
At a competitive market price for trash hauling and recycling service of $250,
producer surplus equals $12.5 million per year. Producers as a group received $12.5
million per year more than the absolute minimum required for them to produce the
market equilibrium output of 500,000 customers served. Producers received a real
bargain.
In competitive market equilibrium, social welfare is measured by the sum of
net benefits derived by consumers and producers. Social welfare is the sum of
consumer surplus and producer surplus:
137
Chapter 12
Social Welfare = Consumer Surplus + Producer Surplus
= $25 million + $12.5 million
= $37.5 million per year
Trash Hauling/Recycling
Consumer
SurplusCM
$400
Welfare-loss
triangle
$350
A
Price
$300
$250
B
$200
Supply
P = $200 +
Demand
D
C
Competitive
Market
Producer
$150
$100
$50
MR = $350 - $0.0004Q
$0
0
100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000
Quantity (customers)
B.
If the industry is run by a profit-maximizing monopolist, the optimal price-output
combination can be determined by setting marginal revenue equal to marginal cost
and solving for Q:
MR = MC = Market Supply
$350 - $0.0004Q = $200 + 0.0001Q
$0.0005Q = $150
Q = 300,000
Monopoly and Monopsony
138
At Q = 300,000,
P = $350 - $0.0002Q
= $350 - $0.0002(300,000)
= $290 per year
Under monopoly, the amount supplied falls to 300,000 and the market price jumps to
$290 per year for trash hauling and recycling service. The amount of deadweight
loss from monopoly suffered by consumers is given by the triangle bounded by ABD
in the figure. Because the area of such a triangle is one-half the value of the base
times the height, the value of lost consumer surplus due to monopoly equals:
Consumer Deadweight Loss = [(500,000 - 300,000) ($290 - $250)]
= $4 million per year
The amount of deadweight loss from monopoly suffered by producers is given by the
triangle bounded by BCD. Because the area of such a triangle is one-half the value
of the base times the height, the value of lost producer surplus equals:
Producer Deadweight Loss = [(500,000 - 300,000) ($250 - $230)]
= $2 million per year
The total amount of deadweight loss from monopoly suffered by consumers and
producers is given by the triangle bounded by ACD. The area of such a triangle is
simply the amount of consumer deadweight loss plus producer deadweight loss:
Total Deadweight Loss = Consumer Loss + Producer Loss
= $4 million + $2 million
= $6 million per year
P12.7
Wealth Transfer Problem. The Organization of the Petroleum Exporting Countries
(OPEC) was formed on September 14, 1960 in Baghdad, Iraq. The current
membership is comprised of five founding members plus six others: Algeria,
Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab
139
Chapter 12
Emirates and Venezuela. OPECs stated mission is to bring stability and harmony
to the oil market by adjusting their oil output to help ensure a balance between
supply and demand. At least twice a year, OPEC members meet to adjust OPECs
output level in light of anticipated oil market developments. OPEC's eleven
members collectively supply about 40 per cent of the world's oil output and possess
more than three-quarters of the world's total proven crude oil reserves.
To demonstrate the deadweight loss from monopoly problem, imagine that
market supply and demand conditions for crude oil are:
QS
= 2P
(Market Supply)
QD
= 180 - 4P
(Market Demand)
where Q is barrels of oil per day (in millions) and P is the market price of oil.
A.
Graph and calculate the equilibrium price/output solution. How much
consumer surplus, producer surplus, and social welfare is produced at this
activity level?
B.
Use the graph to calculate the amount of consumer surplus transferred to the
monopoly producer following a change from a competitive market to a
monopoly market. How much is the net gain in producer surplus?
P12.7
SOLUTION
A.
The market supply curve is given by the equation
QS = 2P
or, solving for price,
P = 0.5QS
The market demand curve is given by the equation
QD = 180 - 4P
or, solving for price,
4P = 180 - QD
Monopoly and Monopsony
140
P = $45 - $0.25QD
To find the competitive market equilibrium price, equate the market demand
and market supply curves where quantity is expressed as a function of price:
Supply = Demand
2P = 180 - 4P
6P = 180
P = $30
To find the competitive market equilibrium quantity, set equal the market
supply and market demand curves where price is expressed as a function of quantity,
and QS = QD:
Supply = Demand
$0.5Q = $45 - $0.25Q
$0.75Q = $45
Q = 60 (million) barrels per day
Therefore, the competitive market equilibrium price-output combination is a
market price of $30 with an equilibrium output of 60 (million) barrels per day.
The value of consumer surplus is equal to the region under the market demand
curve that lies above the market equilibrium price of $30. Because the area of such a
triangle is one-half the value of the base times the height, the value of consumer
surplus equals:
Consumer Surplus = [60 ($45 - $30)]
= $450 (million) per day
In words, this means that at a competitive market price of $30 per barrel, the quantity
demanded is 60 (million barrels per day), resulting in total revenues of $1,800
(million) per day. The fact that consumer surplus equals $450 (million) per day
141
Chapter 12
means that customers as a group would have been willing to pay an additional $450
(million) per day for this level of market output. This is an amount above and beyond
the $1,800 (million) paid per day. Customers received a real bargain.
The value of producer surplus is equal to the region above the market supply
curve at the market equilibrium price of $30. Because the area of such a triangle is
one-half the value of the base times the height, the value of producer surplus equals:
Producer Surplus = [60 ($30 - $0)]
= $900 (million) per day
At a competitive market price for oil of $30 per barrel, producer surplus equals $900
(million) per day. Producers as a group received $900 (million) per day more than
the absolute minimum required for them to produce the market equilibrium output of
60 (million) barrels of oil per day. Producers received a real bargain.
In competitive market equilibrium, social welfare is measured by the sum of
net benefits derived by consumers and producers. Social welfare is the sum of
consumer surplus and producer surplus:
Social Welfare = Consumer Surplus + Producer Surplus
= $450 (million) + $900 (million)
= $1,350 (million) per day
Monopoly and Monopsony
142
Crude Oil Market
Producer Surplus
T ransferred to
Consumers
Price
Deadweight
Loss in Producer
Surplus
$45.00
Supply
P = $0.5Q
A
PM = $33.75
D
PCM = $30.00
B
Competitive
M arket Producer
Surplus
$22.50
Demand
P = $45 - $0.25Q
C
MR = $45 - $0.5Q
0
15
30
45
60
75
90
Quantity (millions bbls/day)
B.
The amount of deadweight loss from monopoly suffered by the monopoly producer
is given by the triangle bounded by BCD. Because the area of such a triangle is onehalf the value of the base times the height, the value of lost producer surplus equals:
Producer Deadweight Loss = [(60 - 45) ($30 - $22.50)]
= $56.25 (million) per day
The creation of a monopoly also results in a significant transfer from consumer
surplus to producer surplus. In the figure, this amount is shown as the area in the
rectangle bordered by PCMPMAB:
Transfer to Producer Surplus = 45 ($33.75 - $30)
= $168.75 (million) per day
143
Chapter 12
Therefore, from the viewpoint of the producer, the change to monopoly results in a
very favorable net increase in producer surplus:
Net Change in Producer Surplus = Producer Deadweight Loss + Transfer
= -$56.25 (million) + $168.75 (million)
= $112.5 (million) per day
The wealth transfer problem associated with monopoly is seen as an issue of equity
or fairness because it involves the distribution of income or wealth in the economy.
Although economic profits serve the useful functions of providing incentives and
helping allocate resources, it is difficult to justify monopoly profits that result from
the raw exercise of market power rather than from exceptional performance.
P12.8
Monopoly Profits. Portland Fluid Control, Inc., (PFC) is a major supplier of
reverse osmosis and ultrafiltration equipment, which helps industrial and
commercial customers achieve improved production processes and a cleaner work
environment. The company has recently introduced a new line of ceramic filters that
enjoy patent protection. Relevant cost and revenue relations for this product are as
follows:
TR = $300Q - $0.001Q2
MR = TR/Q = $300 - $0.002Q
TC = $9,000,000 + $20Q + $0.0004Q2
MC = TC/Q = $20 + $0.0008Q
where TR is total revenue, Q is output, MR is marginal revenue, TC is total cost,
including a risk-adjusted normal rate of return on investment, and MC is marginal
cost.
A.
Compute PFCs optimal monopoly price/output combination.
B.
Compute monopoly profits and the optimal profit margin at this profitmaximizing activity level.
Monopoly and Monopsony
144
P12.8
SOLUTION
A.
Set MR = MC to find the optimal price/output combination:
MR = MC
$300 - $0.002Q = $20 + $0.0008Q
0.0028Q = 280
Q = 100,000
P = TR/Q
= ($300Q - $0.001Q2)/Q
= $300 - $0.001Q
= $300 - $0.001(100,000)
= $200
B.
Because the cost of capital is already included in the total cost function, any excess of
revenues over total cost represents economic profits.
= TR - TC
= $300Q - $0.001Q2 - $9,000,000 - $20Q -$0.0004Q2
= -$0.0014Q2 + $280Q -$9,000,000
= -$0.0014(100,0002) + $280(100,000) - $9,000,000
= $5,000,000
And finally, the optimal profit margin is:
Profit Margin = /TR
= $5,000,000/$200(100,000)
145
Chapter 12
= 0.25 or 25%
P12.9
Monopoly versus Competitive Market Equilibrium.
During recent years,
MicroChips Corp. has enjoyed substantial economic profits derived from patents
covering a wide range of inventions and innovations for microprocessors used in
high-performance desktop computers. A recent introduction, the Penultimate, has
proven especially profitable. Market demand and marginal revenue relations for the
product are as follows:
P = $5,500 - $0.005Q
MR = TR/Q = $5,500 - $0.01Q
Fixed costs are nil because research and development expenses have been fully
amortized during previous periods. Average variable costs are constant at $4,500
per unit.
A.
Calculate the profit-maximizing price/output combination and economic profits
if MicroChips enjoys an effective monopoly because of patent protection.
B.
Calculate the price/output combination and total economic profits that would
result if competitors offer clones that make the market perfectly competitive.
P12.9
SOLUTION
A.
The profit-maximizing price/output combination is found by setting MR = MC.
Because AVC is constant, MC = AVC = $4,500. Therefore:
MR = MC
$5,500 - $0.01Q = $4,500
0.01Q = 1,000
Q = 100,000
P = $5,500 - $0.005(100,000)
= $5,000
Monopoly and Monopsony
146
Economic Profits = P Q - AVC Q
= $5,000(100,000) - $4,500(100,000)
= $50,000,000
(Note: As a monopolist, the company is the industry).
B.
In a competitive market, P = MC. In this instance, AVC is constant and, therefore,
MC = AVC. Competitive market equilibrium occurs where:
P
$5,500 - $0.005Q
0.005Q
= MC = AVC
= $4,500
= 1,000
Q
= 200,000
P
= $5,500 - $0.005(200,000)
= $4,500
Economic Profits
= P Q - AVC Q
= $4,500(200,000) - $4,500(200,000)
= $0
In words, the transformation from monopoly to perfect competition has brought a
$1,000 reduction in price and a 100,000 unit expansion in output. At the same time,
economic profits have been eliminated.
P12.10
Monopoly/Monopsony Confrontation. Safecard Corporation offers a unique
service. The company notifies credit card issuers after being informed that a
subscriber's credit card has been lost or stolen. The Safecard service is sold to card
issuers on an annual subscription basis. Relevant revenue and cost relations for the
service are as follows:
147
Chapter 12
TR
= $5Q - $0.00001Q2
MR
= TR/Q = $5 - $0.00002Q
TC
= $50,000 + $0.5Q + $0.000005Q2
MC
= TC/Q = $0.5 + $0.00001Q
where TR is total revenue, Q is output measured in terms of the number of
subscriptions in force, MR is marginal revenue, TC is total cost, including a riskadjusted normal rate of return on investment, and MC is marginal cost.
A.
If Safecard has a monopoly in this market, calculate the profit-maximizing
price/output combination and optimal total profit.
B.
Calculate Safecard's optimal price, output, and profits if credit card issuers
effectively exert monopsony power and force a perfectly competitive
equilibrium in this market.
P12.10
SOLUTION
A.
The profit-maximizing monopoly price/output combination is found by setting MR =
MC and solving for Q:
MR
$5 - $0.00002Q
0.00003Q
= MC
= $0.5 + $0.00001Q,
= 4.5
Q
= 150,000
P
= TR/Q = $5 - $0.00001Q
= $5 - $0.00001(150,000)
= $3.50
= TR - TC = -$0.000015(150,0002) + $4.5(150,000) - $50,000
Monopoly and Monopsony
148
= $287,500
(Note: Profit is falling for Q > 150,000.)
B.
If credit card issuers effectively exert monopsony power and force a perfectly
competitive equilibrium, P = MR and, therefore, P = MC at the average cost
minimizing output level. To find the output level where average cost is minimized,
set MC = AC and solve for Q:
MC
= AC
$0.5 + $0.00001Q
= ($50,000 + $0.5Q + $0.000005Q2)/Q
$0.5 + $0.00001Q
= $50,000Q-1 + $0.5 + $0.000005Q
50,000Q-1
= 0.000005Q
50,000Q-2
= 0.000005
50,000
2
Q
= 0.000005
Q
=
50,000
0.000005
= 100,000
AC
= $50,000/100,000 + $0.5 + $0.000005(100,000)
= $1.50
At the average-cost minimizing output level, MC = AC = $1.50. Because P = MR in
a perfectly competitive industry, at the profit-maximizing output level:
P
= MR = MC = AC = $1.50
= P Q - TC
= $1.50(100,000) - $50,000 - $0.5(100,000) - $0.000005(100,0002)
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Chapter 12
= $0
(Note: Average cost is rising for Q > 100,000.)
Monopoly and Monopsony
150
CASE STUDY FOR CHAPTER 12
Effect of R&D on Tobins q
The idea of using the difference between the market value of the firm and accounting book
values as an indicator of market power and/or valuable intangible assets stems from the
pioneering work of Nobel laureate James Tobin. Tobin introduced the so-called q ratio, defined
as the ratio of the market value of the firm divided by the replacement cost of tangible assets.
For a competitive firm in a stable industry with no special capabilities, and no barriers to entry
or exit, one would expect q to be close to one (q 1). In a perfectly competitive industry, any
momentary propensity for q > 1 due to an unanticipated rise in demand or decrease in costs
would be quickly erased by entry or established firm growth. In a perfectly competitive industry,
any momentary propensity for q < 1 due to an unanticipated fall in demand or increase in costs
would be quickly erased by exit or contraction among established firms. In the absence of
barriers to entry and exit, the marginal value of q would trend towards unity (q 1) over time
in perfectly competitive industries. Similarly, a firm that is regulated so as to earn no monopoly
rents would also have a q close to one. Only in the case of firms with monopoly power protected
by significant barriers to entry or exit, or firms with superior profit-making capabilities, will
Tobins q ratio rise above one, and stay there. In the limit, the theoretical maximum Tobins q
ratio is observed in the case of a highly efficient monopoly. If q > 1 on a persistent basis, one
can argue that the firm is in possession of market power or some hard-to-duplicate asset that
typically escapes measurement using conventional accounting criteria.
Tobins q ratio surged during the 1990s, and some made the simple conclusion that
monopoly profits had soared during this period. In the early 1990s, however, the overall
economy suffered a sharp recession that dramatically reduced corporate profits and stock
prices. By the end of the 1990s, the economy had logged the longest peacetime expansion in
history, and both corporate profits and stock prices soared to record levels. Corporate profits,
stock and Tobins q ratios for major corporations took a sharp tumble over the 2000-03 period
as the country entered a mild recession. Therefore, much of the year-to-year variation in
Tobins q ratios for corporate giants can be explained by the business cycle. At any point in
time, more fundamental changes are also at work. Leading firms today are characterized by
growing reliance on what economists refer to as intangible assets, like advertising capital,
brand names, customer goodwill, patents, and so on. Empirically, q > 1 if valuable intangible
assets derived from R&D and other such expenditures with the potential for long-lived benefits
are systematically excluded from consideration by accounting methodology. The theoretical
argument that q 1 over time only holds when the economic values of both tangible and
intangible assets are precisely measured. If q > 1 on a persistent basis, and Tobi=s q is closely
tied to the level of R&D intensity, one might argue successfully for the presence of intangible
R&D capital.
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Chapter 12
In Table 12.3, q is approximated by the sum of the market value of common plus the book
values of preferred stock and total liabilities, all divided by the book value of tangible assets, for
a sample of corporate giants included in the Dow Jones Industrial Average (DJIA). To learn the
role played by R&D intensity as a determinant of Tobins q, the effects of other important
factors must be constrained, including: current profitability, growth, and risk. Current
profitability is measured by the firms net profit margin, or net income divided by sales. Positive
stock-price effects of net profit margins can be anticipated because historical profit margins are
often the best available indicator of a firms ability to generate superior rates of return during
future periods. Stock-price effects of profit margins include both the influences of superior
efficiency and/or market power. Because effective R&D can be expected to enhance both current
and future profitability, the marginal effect of R&D intensity on Tobins q becomes a very
conservative estimate of the total short-term plus long-term value of R&D when such impacts
are considered in conjunction with the stock-price effects of current net profit margins. Revenue
growth will have a positive effect on market values if future investments are expected to earn
above- normal rates of return and if growth is an important determinant of these returns. While
growth affects the magnitude of anticipated excess returns, a stock-price influence may also be
associated with the degree of return stability. Influences of risk are estimated here using stockprice beta. With an increase in risk, the market value of expected returns is anticipated to fall.
A.
Explain how any intangible capital effects of R&D intensity can reflect the effects of
market power and/or superior efficiency.
B.
A multiple regression analysis based upon the data contained in Table 12.3 revealed
the following (t statistics in parentheses):
q
= 1.740 + 0.041 Profit Margin + 0.018 Growth - 0.421 Beta + 0.057
R&D/S
(2.33) (1.74)
(0.31)
(-1.43)
(2.15)
R2 = 41.1%, F statistic = 4.36
Are these results consistent with the idea that R&D gives rise to a type of intangible
capital?
CASE STUDY SOLUTION
A.
Intangible R&D capital can be derived from the value obtained from patents and
other monopoly protections offered to firms making significant new discoveries and
innovations. Alternatively, significant R&D capital can result from the unpatented
advantages gained from effective basic research and applied development. In
Monopoly and Monopsony
152
economic terminology, superior rewards earned from exceptional productive
capability or superior efforts are called Ricardian rents after the early British
economist David Ricardo. Monopoly rents which are usually regarded as unjust
compensation for the antisocial exercise of market power through high prices.
Richardian rents are conventionally regarded as fair compensation for superior
productive capability that results in higher revenues or lower production costs. To
the extent that the firm possesses factors which increase revenues or lower costs
relative to the marginal firm, it will persistently display q > 1. To the extent that
productive R&D allows the firm to increase revenues and/or lower costs, and thereby
persistently display q > 1, the firm can be said to possess significant unmeasured
intangible R&D capital.
It is worth noting that this study compares a stock measure, the market
value of the firm, with the flow of R&D expenditures. On a theoretical basis, it
would seem more appropriate to compare market values with the stocks of intangible
capital tied to R&D. However, if economic amortization of the exponential decay
type can be assumed, along with constant percentage rates of growth in R&D
expenditures, then the magnitude of intangible capital equals annual expenditures on
R&D multiplied by a constant. Given these assumptions, the stock of intangible
R&D capital is strictly proportional to the flow of R&D expenditures, and the net
income and stock-price effects of R&D expenditures can be taken as indicative of
intangible capital influences.
B.
Yes, these results are consistent with the idea that R&D gives rise to a type of
intangible capital. On an overall basis, the simple model estimated here explains
more than one-third (41.1%) of the variation in Tobins q ratio seen for the giant
corporations included in the DJIA. This is a statistically significant explanation (F =
4.36) of a meaningful share of q variation.
Positive and statistically significant stock-price effects of net profit margins
reflect the effects of superior efficiency and/or market power. Because effective
R&D can be expected to enhance both current and future profitability, the marginal
effect of R&D intensity on Tobins q is a very conservative estimate of the total
short-term plus long-term value of R&D when such impacts are considered in
conjunction with the stock-price effects of current net profit margins. For this
sample of firms, revenue growth fails to exhibit the expected positive effect on
market values, but influences of risk are found using stock-price beta. With an
increase in risk, the market value of expected returns appears to fall, as anticipated.
Interestingly, R&D intensity appears to have a consistently positive effect on
the Tobins q, even after allowing for the market value-effects of current profit
margins. These results are consistent with the hypothesis that R&D makes an
important contribution to the long-term profitability of the firm, and gives rise to a
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Chapter 12
type of intangible capital with long-lived influences. In considering the economic
determinants of Tobins q it is important that the effects of superior efficiency or
capability be separated from the simple influences of market power. More detailed
consideration of the favorable long-term effects of R&D is a small step in this
direction.