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Unformatted text preview: 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 245 11 Monopoly After studying this chapter,
y ou will be able to:
■ Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly ■ Explain how a single-price monopoly determines its output
and price ■ Compare the performance and efficiency of single-price
monopoly and competition ■ Explain how price discrimination increases profit ■ Explain how monopoly regulation influences output, price,
economic profit, and efficiency Microsoft, Google, and eBay are dominant players in perfectly competitive firms? Do they charge prices that are the markets they serve. Because most PCs use Windows, pro- too high and that damage the interests of consumers? What grammers write most applications for this operating system, benefits do they bring? which attracts more users. Because most Web searchers use In this chapter, we study markets in which the firm can Google, most advertisers use it too, which attracts more influence the price. We also compare the performance of the searchers. Because most online auction buyers use eBay, most firm in such a market with that in a competitive market and online sellers do too, which attracts more buyers. Each of examine whether monopoly is as efficient as competition. In these firms benefits from a phenomenon called a network Reading Between the Lines at the end of the chapter, we’ll externality, which makes it hard for other firms to break into take a look at what a European court thinks about some of their markets. Microsoft’s profit-seeking practices. Microsoft, Google, and eBay are obviously not like firms in
perfect competition. How does their behavior compare with 245 9160335_CH11_p245-268.qxd 9:03 AM Page 246 CHAPTER 11 Monopoly ◆ Monopoly and How It Arises FIGURE 11.1 A monopoly is a market with a single firm that produces a good or service for which no close substitute
exists and that is protected by a barrier that prevents
other firms from selling that good or service. How Monopoly Arises
Monopoly arises for two key reasons:
■ No close substitute
Barrier to entry No Close Substitute If a good has a close substitute, even though only one firm produces it, that firm
effectively faces competition from the producers of
the substitute. A monopoly sells a good or service
that has no good substitute. Tap water and bottled
water are close substitutes for drinking, but tap water
has no effective substitute for showering or washing a
car and a local public utility that supplies tap water is
Barrier to Entry A constraint that protects a firm from potential competitors is called a barrier to entry.
The three types of barrier to entry are
Legal Natural Barrier to Entry A natural barrier to entry
ates a natural monopoly: an industry in which Price and cost (cents per kilowatt-hour) 246 6/22/09 Natural Monopoly 20 15 10 5 LRAC
D 0 1 2
Quantity (millions of kilowatt-hours) The market demand curve for electric power is D, and the
long-run average cost curve is LRAC. Economies of scale exist
over the entire LRAC curve. One firm can distribute 4 million
kilowatt-hours at a cost of 5 cents a kilowatt-hour. This same
total output costs 10 cents a kilowatt-hour with two firms. One
firm can meet the market demand at a lower cost than two or
more firms can. The market is a natural monopoly.
animation cre- economies of scale enable one firm to supply the
entire market at the lowest possible cost. The firms
that deliver gas, water, and electricity to our homes
are examples of natural monopoly.
In Fig. 11.1 the market demand curve for electric
power is D, and the long-run average cost curve is
LRAC. Economies of scale prevail over the entire
length of the LRAC curve.
One firm can produce 4 million kilowatt-hours
at 5 cents a kilowatt-hour. At this price, the quantity demanded is 4 million kilowatt-hours. So if the
price was 5 cents, one firm could supply the entire
If two firms shared the market equally, it would
cost each of them 10 cents a kilowatt-hour to produce
a total of 4 million kilowatt-hours.
In conditions like those shown in Fig. 11.1, one
firm can supply the entire market at a lower cost than two or more firms can. The market is a natural
Ownership Barrier to Entry An ownership barrier to
entry occurs if one firm owns a significant portion of
a key resource. An example of this type of monopoly
occurred during the last century when De Beers controlled up to 90 percent of the world’s supply of diamonds. (Today, its share is only 65 percent.)
Legal Barrier to Entry A legal barrier to entry creates a
legal monopoly: a market in which competition and
entry are restricted by the granting of a public franchise, government license, patent, or copyright.
A public franchise is an exclusive right granted to a
firm to supply a good or service. An example is the
U.S. Postal Service, which has the exclusive right to
carry first-class mail. A government license controls
entry into particular occupations, professions, and
industries. Examples of this type of barrier to entry
occur in medicine, law, dentistry, schoolteaching, 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 247 Monopoly and How It Arises architecture, and many other professional services.
Licensing does not always create a monopoly, but it
does restrict competition.
A patent is an exclusive right granted to the inventor
of a product or service. A copyright is an exclusive right
granted to the author or composer of a literary, musical,
dramatic, or artistic work. Patents and copyrights are
valid for a limited time period that varies from country
to country. In the United States, a patent is valid for 20
years. Patents encourage the invention of new products
and production methods. They also stimulate innovation—the use of new inventions—by encouraging
inventors to publicize their discoveries and offer them
for use under license. Patents have stimulated innovations in areas as diverse as soybean seeds, pharmaceuticals, memory chips, and video games. Natural Monopoly Today
Information-age technologies have created four big
natural monopolies. These firms have large plant
costs but almost zero marginal cost, so they experience economies of scale.
Microsoft has captured 90 percent of the personal
computer operating system market with Windows and
73 percent of the Web browser market with Internet
Explorer. eBay has captured 85 percent of the consumer-to-consumer Internet auction market and
Google has 78 percent of the search engine market.
New technologies also destroy monopoly. FedEx,
UPS, the fax machine, and e-mail have weakened the
monopoly of the U.S. Postal Service; and the satellite
dish has weakened the monopoly of cable television
Operating systems Monopoly Price-Setting Strategies
A major difference between monopoly and competition is that a monopoly sets its own price. In doing
so, the monopoly faces a market constraint: To sell a
larger quantity, the monopoly must set a lower price.
There are two monopoly situations that create two
Price discrimination ■
■ Single Price A single-price monopoly is a firm that
must sell each unit of its output for the same price to
all its customers. De Beers sells diamonds (of a given
size and quality) for the same price to all its customers. If it tried to sell at a low price to some customers and at a higher price to others, only the
low-price customers would buy from De Beers.
Others would buy from De Beers’ low-price customers. De Beers is a single-price monopoly.
Price Discrimination When a firm practices price
discrimination, it sells different units of a good or service for different prices. Many firms price discriminate.
Microsoft sells its Windows and Office software at
different prices to different buyers. Computer manufacturers who install the software on new machines,
students and teachers, governments, and businesses all
pay different prices. Pizza producers offer a second
pizza for a lower price than the first one. These are
examples of price discrimination.
When a firm price discriminates, it looks as
though it is doing its customers a favor. In fact, it is
charging the highest possible price for each unit sold
and making the largest possible profit. Review Quiz ◆ Microsoft 1
Internet auctions eBay 2 Search engines Google 3 Web browsers Internet Explorer 0 20 40 How does monopoly arise?
How does a natural monopoly differ from a
Distinguish between a price-discriminating
monopoly and a single-price monopoly.
Work Study Plan 11.1
and get instant feedback. 60 Revenue (percentage of total)
Market Shares 247 80 100 We start with a single-price monopoly and see
how it makes its decisions about the quantity to produce and the price to charge to maximize its profit. 9160335_CH11_p245-268.qxd 248 6/22/09 9:03 AM Page 248 CHAPTER 11 Monopoly ◆ A Single-Price Monopoly’s Demand and Marginal
Revenue FIGURE 11.2 To understand how a single-price monopoly makes
its output and price decision, we must first study
the link between price and marginal revenue. Price and Marginal Revenue
Because in a monopoly there is only one firm, the
demand curve facing the firm is the market demand
curve. Let’s look at Bobbie’s Barbershop, the sole supplier
of haircuts in Cairo, Nebraska. The table in Fig. 11.2
shows the market demand schedule. At a price of $20,
Bobbie sells no haircuts. The lower the price, the more
haircuts per hour she can sell. For example, at $12,
consumers demand 4 haircuts per hour (row E ).
Total revenue (TR) is the price (P) multiplied by
the quantity sold (Q). For example, in row D, Bobbie
sells 3 haircuts at $14 each, so total revenue is $42.
Marginal revenue (MR) is the change in total revenue
( TR) resulting from a one-unit increase in the
quantity sold. For example, if the price falls from $16
(row C ) to $14 (row D), the quantity sold increases
from 2 to 3 haircuts. Total revenue increases from
$32 to $42, so the change in total revenue is $10.
Because the quantity sold increases by 1 haircut, marginal revenue equals the change in total revenue and
is $10. Marginal revenue is placed between the two
rows to emphasize that marginal revenue relates to
the change in the quantity sold.
Figure 11.2 shows the market demand curve and
marginal revenue curve (MR) and also illustrates the
calculation we’ve just made. Notice that at each
level of output, marginal revenue is less than
price—the marginal revenue curve lies below the
demand curve. Why is marginal revenue less than
price? It is because when the price is lowered to sell
one more unit, two opposing forces affect total revenue. The lower price results in a revenue loss, and
the increased quantity sold results in a revenue gain.
For example, at a price of $16, Bobbie sells 2 haircuts (point C ). If she lowers the price to $14, she
sells 3 haircuts and has a revenue gain of $14 on the
third haircut. But she now receives only $14 on the
first two—$2 less than before. As a result, she loses
$4 of revenue on the first 2 haircuts. To calculate
marginal revenue, she must deduct this amount
from the revenue gain of $14. So her marginal revenue is $10, which is less than the price. Price and marginal revenue
(dollars per haircut) Output and Price Decision
20 Total revenue loss $4
C 16 D 14 Total revenue gain $14
Marginal revenue $10 10 Demand MR 0 2 3 Quantity (haircuts per hour) Price
(P ) Quantity
(Q ) (dollars per
per hour) A 20 0 0 B 18 1 18 C 16 2 32 D 14 3 42 E 12 4 48 F 10 5 50 Total
( TR = P × Q )
( MR = Δ TR/ Δ Q )
haircut) . . . . . . . . . . .18
. . . . . . . . . . .14
. . . . . . . . . . . 10
........... 2 The table shows the demand schedule. Total revenue (TR) is
price multiplied by quantity sold. For example, in row C,
the price is $16 a haircut, Bobbie sells 2 haircuts, and total
revenue is $32. Marginal revenue (MR) is the change in
total revenue that results from a one-unit increase in the
quantity sold. For example, when the price falls from $16 to
$14 a haircut, the quantity sold increases by 1 haircut and
total revenue increases by $10. Marginal revenue is $10.
The demand curve and the marginal revenue curve, MR,
are based on the numbers in the table and illustrate the calculation of marginal revenue when the price falls from $16
to $14 a haircut.
animation 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 249 A Single-Price Monopoly’s Output and Price Decision In Monopoly, Demand Is Always Elastic The relationship between marginal revenue and elasticity of
demand that you’ve just discovered implies that a
profit-maximizing monopoly never produces an output in the inelastic range of the market demand
curve. If it did so, it could charge a higher price, produce a smaller quantity, and increase its profit. Let’s
now look at a monopoly’s price and output decision. Price and marginal revenue
(dollars per haircut) A single-price monopoly’s marginal revenue is related to
the elasticity of demand for its good. The demand for a
good can be elastic (the elasticity is greater than 1),
inelastic (the elasticity is less than 1), or unit elastic
(the elasticity is equal to 1). Demand is elastic if a 1
percent fall in price brings a greater than 1 percent
increase in the quantity demanded. Demand is
inelastic if a 1 percent fall in price brings a less than
1 percent increase in the quantity demanded.
Demand is unit elastic if a 1 percent fall in price
brings a 1 percent increase in the quantity demanded.
(See Chapter 4, pp. 82–83.)
If demand is elastic, a fall in price brings an
increase in total revenue—the revenue gain from the
increase in quantity sold outweighs the revenue loss
from the lower price—and marginal revenue is
positive. If demand is inelastic, a fall in price brings
a decrease in total revenue—the revenue gain from
the increase in quantity sold is outweighed by the
revenue loss from the lower price—and marginal
revenue is negative. If demand is unit elastic, total
revenue does not change—the revenue gain from
the increase in the quantity sold offsets the revenue
loss from the lower price—and marginal revenue is
zero. (See Chapter 4, p. 86.)
Figure 11.3 illustrates the relationship between
marginal revenue, total revenue, and elasticity. As the
price gradually falls from $20 to $10 a haircut, the
quantity demanded increases from 0 to 5 haircuts an
hour. Over this output range, marginal revenue is
positive in part (a), total revenue increases in part (b),
and the demand for haircuts is elastic. As the price
falls from $10 to $0 a haircut, the quantity of haircuts demanded increases from 5 to 10 an hour. Over
this output range, marginal revenue is negative in
part (a), total revenue decreases in part (b), and the
demand for haircuts is inelastic. When the price is
$10 a haircut, marginal revenue is zero in part (a),
total revenue is at a maximum in part (b), and the
demand for haircuts is unit elastic. FIGURE 11.3 20 Marginal Revenue
Unit elastic 10 Inelastic Quantity
10 per hour) D 0 5
total revenue –10 MR –20
(a) Demand and marginal revenue curves Total revenue (dollars per hour) Marginal Revenue and Elasticity 249 Zero
revenue 50 40 30 20 10 TR
0 5 10 Quantity
per hour) (b) Total revenue curve In part (a), the demand curve is D and the marginal revenue
curve is MR. In part (b), the total revenue curve is TR. Over
the range 0 to 5 haircuts an hour, a price cut increases total
revenue, so marginal revenue is positive—as shown by the
blue bars. Demand is elastic. Over the range 5 to 10 haircuts
an hour, a price cut decreases total revenue, so marginal revenue is negative—as shown by the red bars. Demand is
inelastic. At 5 haircuts an hour, total revenue is maximized
and marginal revenue is zero. Demand is unit elastic.
animation 9160335_CH11_p245-268.qxd 250 6/22/09 9:03 AM Page 250 CHAPTER 11 Monopoly Price and Output Decision Marginal Revenue Equals Marginal Cost You can see A monopoly sets its price and output at the levels
that maximize economic profit. To determine this
price and output level, we need to study the behavior
of both cost and revenue as output varies. A monopoly faces the same types of technology and cost constraints as a competitive firm, so its costs (total cost,
average cost, and marginal cost) behave just like those
of a firm in perfect competition. And a monopoly’s
revenues (total revenue, price, and marginal revenue)
behave in the way we’ve just described.
Table 11.1 provides information about Bobbie’s
costs, revenues, and economic profit, and Fig. 11.4
shows the same information graphically.
Maximizing Economic Profit You can see in Table 11.1 and Fig. 11.4(a) that total cost (TC ) and total revenue (TR) both rise as output increases, but TC rises
at an increasing rate and TR rises at a decreasing rate.
Economic profit, which equals TR minus TC,
increases at small output levels, reaches a maximum,
and then decreases. The maximum profit ($12)
occurs when Bobbie sells 3 haircuts for $14 each. If
she sells 2 haircuts for $16 each or 4 haircuts for $12
each, her economic profit will be only $8.
(P ) Bobbie’s marginal revenue (MR) and marginal cost
(MC ) in Table 11.1 and Fig. 11.4(b).
When Bobbie increases output from 2 to 3 haircuts,
MR is $10 and MC is $6. MR exceeds MC by $4 and
Bobbie’s profit increases by that amount. If Bobbie
increases output yet further, from 3 to 4 haircuts, MR
is $6 and MC is $10. In this case, MC exceeds MR by
$4, so profit decreases by that amount. When MR
exceeds MC, profit increases if output increases. When
MC exceeds MR, profit increases if output decreases.
When MC equals MR, profit is maximized.
Figure 11.4(b) shows the maximum profit as price
(on the demand curve D) minus average total cost
(on the ATC curve) multiplied by the quantity produced—the blue rectangle.
Maximum Price the Market Will Bear Unlike a firm in perfect competition, a monopoly influences the
price of what it sells. But a monopoly doesn’t set the
price at the maximum possible price. At the maximum possible price, the firm would be able to sell
only one unit of output, which in general is less than
the profit-maximizing quantity. Rather, a monopoly
produces the profit-maximizing quantity and sells
that quantity for the highest price it can get. A Monopoly’s Output and Price Decision (dollars
per haircut) Quantity
(Q ) Total
( TR = P × Q ) Marginal
( MR = Δ TR/ Q ) Total
( TC ) Marginal
( MC = Δ TC/ Q ) Profit
( TR – T C ) (haircuts per hour) (dollars) (dollars per haircut) (dollars) (dollars per haircut) (dollars) 20 0 0 20
. . . . . . . . . . . . 18 18 1 18 21
. . . . . . . . . . . . 14 16 2 32 3 24 42 4 30 48 5 +12
. . . . . . . . . . . 10 40
............ 2 10 +8
........... 6 ............ 6
........... 3 . . . . . . . . . . . . 10
........... 1 50 This table gives the information needed to find the profit-maximizing output and price. Total revenue (TR) equals price multiplied by the quantity sold. Profit equals total revenue minus total 8
. . . . . . . . . . . 15 55 5 cost (TC ). Profit is maximized when 3 haircuts are sold at a
price of $14 each. Total revenue is $42, total cost is $30, and
economic profit is $12 ($42 $30). 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 251 A Single-Price Monopoly’s Output and Price Decision Total revenue and total cost (dollars per hour) FIGURE 11.4 A Monopoly’s Output
TC 50 TR Economic
profit = $12 42 30 20 10 0 1 2 3 4
Quantity (haircuts per hour) Price and cost (dollars per haircut) (a) Total revenue and total cost curves 20 MC 14
profit $12 ATC 10 D 251 All firms maximize profit by producing the output
at which marginal revenue equals marginal cost. For a
competitive firm, price equals marginal revenue, so
price also equals marginal cost. For a monopoly, price
exceeds marginal revenue, so price also exceeds marginal cost.
A monopoly charges a price that exceeds marginal
cost, but does it always make an economic profit? In
Fig. 11.4(b), Bobbie produces 3 haircuts an hour. Her
average total cost is $10 (on the ATC curve) and her
price is $14 (on the D curve), so her profit per haircut
is $4 ($14 minus $10). Bobbie’s economic profit is
shown by the area of the blue rectangle, which equals
the profit per haircut ($4) multiplied by the number
of haircuts (3), for a total of $12.
If firms in a perfectly competitive industry make
a positive economic profit, new firms enter. That
does not happen in monopoly. Barriers to entry prevent new firms from entering the market, so a
monopoly can make a positive economic profit and
might continue to do so indefinitely. Sometimes
that economic profit is large, as in the international
Bobbie makes a positive economic profit. But suppose that Bobbie’s landlord increases the rent on her
salon. If Bobbie pays an additional $12 an hour for
rent, her fixed cost increases by $12 an hour. Her
marginal cost and marginal revenue don’t change, so
her profit-maximizing output remains at 3 haircuts an
hour. Her profit decreases by $12 an hour to zero. If
Bobbie’s salon rent increases by more than $12 an
hour, she incurs an economic loss. If this situation
were permanent, Bobbie would go out of business. MR
0 1 2 3 4
Quantity (haircuts per hour) (b) Demand and marginal revenue and cost curves In part (a), economic profit is the vertical distance equal to
total revenue (TR) minus total cost (TC ) and it is maximized
at 3 haircuts an hour. In part (b), economic profit is maximized when marginal cost (MC ) equals marginal revenue
(MR). The profit-maximizing output is 3 haircuts an hour.
The price is determined by the demand curve (D) and is
$14 a haircut. The average total cost of a haircut is $10, so
economic profit, the blue rectangle, is $12—the profit per
haircut ($4) multiplied by 3 haircuts.
animation Review Quiz ◆
3 4 What is the relationship between marginal cost
and marginal revenue when a single-price
monopoly maximizes profit?
How does a single-price monopoly determine
the price it will charge its customers?
What is the relationship between price, marginal revenue, and marginal cost when a singleprice monopoly is maximizing profit?
Why can a monopoly make a positive economic
profit even in the long run?
Work Study Plan 11.2
and get instant feedback. 9160335_CH11_p245-268.qxd 9:03 AM Page 252 CHAPTER 11 Monopoly ◆ Single-Price Monopoly
and Competition Compared
Imagine an industry that is made up of many small
firms operating in perfect competition. Then imagine that a single firm buys out all these small firms
and creates a monopoly.
What will happen in this industry? Will the price
rise or fall? Will the quantity produced increase or
decrease? Will economic profit increase or decrease?
Will either the original competitive situation or the
new monopoly situation be efficient?
These are the questions we’re now going to answer.
First, we look at the effects of monopoly on the price
and quantity produced. Then we turn to the questions about efficiency. Comparing Price and Output
Figure 11.5 shows the market we’ll study. The market demand curve is D. The demand curve is the
same regardless of how the industry is organized.
But the supply side and the equilibrium are different in monopoly and competition. First, let’s look at
the case of perfect competition.
Perfect Competition Initially, with many small perfectly competitive firms in the market, the market
supply curve is S. This supply curve is obtained by
summing the supply curves of all the individual firms
in the market.
In perfect competition, equilibrium occurs where
the supply curve and the demand curve intersect. The
price is PC, and the quantity produced by the industry
is QC. Each firm takes the price PC and maximizes its
profit by producing the output at which its own marginal cost equals the price. Because each firm is a small
part of the total industry, there is no incentive for any
firm to try to manipulate the price by varying its output. recall that in perfect competition, the industry supply
curve is the sum of the supply curves of the firms in
the industry. Also recall that each firm’s supply curve is
its marginal cost curve (see Chapter 10, p. 224). So
when the industry is taken over by a single firm, the
competitive industry’s supply curve becomes the
monopoly’s marginal cost curve. To remind you of
this fact, the supply curve is also labeled MC.
The output at which marginal revenue equals marginal cost is QM. This output is smaller than the competitive output QC. And the monopoly charges the
price PM, which is higher than PC.We have established that
Compared to a perfectly competitive industry, a
single-price monopoly produces a smaller output and
charges a higher price. We’ve seen how the output and price of a monopoly compare with those in a competitive industry.
Let’s now compare the efficiency of the two types of
Price and cost 252 6/22/09 Monopoly’s Smaller Output
and Higher Price Single-price
price and smaller
output PM Perfect
competition PC D MR Monopoly Now suppose that this industry is taken over by a single firm. Consumers do not change, so
the market demand curve remains the same as in the
case of perfect competition. But now the monopoly
recognizes this demand curve as a constraint on the
price at which it can sell its output. The monopoly’s
marginal revenue curve is MR.
The monopoly maximizes profit by producing the
quantity at which marginal revenue equals marginal
cost. To find the monopoly’s marginal cost curve, first S = MC 0 QM QC Quantity A competitive industry produces the quantity QC at price PC.
A single-price monopoly produces the quantity QM at which
marginal revenue equals marginal cost and sells that quantity for the price PM. Compared to perfect competition, a single-price monopoly produces a smaller output and charges
a higher price.
animation 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 253 Single-Price Monopoly and Competition Compared Price and cost Perfect competition (with no external costs and benefits) is efficient. Figure 11.6(a) illustrates the efficiency
of perfect competition and serves as a benchmark
against which to measure the inefficiency of monopoly. Along the demand curve and marginal social benefit curve (D = MSB), consumers are efficient. Along
the supply curve and marginal social cost curve (S =
MSC ), producers are efficient. In competitive equilibrium, the price is PC, the quantity is QC, and marginal
social benefit equals marginal social cost.
Consumer surplus is the green triangle under the
demand curve and above the equilibrium price (see
Chapter 5, p. 107). Producer surplus is the blue area
above the supply curve and below the equilibrium
price (see Chapter 5, p. 109). The sum of the consumer surplus and producer surplus is maximized.
Also, in long-run competitive equilibrium, entry
and exit ensure that each firm produces its output at
the minimum possible long-run average cost.
To summarize: At the competitive equilibrium,
marginal social benefit equals marginal social cost;
the sum of consumer surplus and producer surplus is
maximized; firms produce at the lowest possible longrun average cost; and resource use is efficient.
Figure 11.6(b) illustrates the inefficiency of
monopoly and the sources of that inefficiency. A
monopoly produces QM and sells its output for PM.
The smaller output and higher price drive a wedge
between marginal social benefit and marginal social
cost and create a deadweight loss. The gray triangle
shows the deadweight loss and its magnitude is a
measure of the inefficiency of monopoly.
Consumer surplus shrinks for two reasons. First,
consumers lose by having to pay more for the good.
This loss to consumers is a gain for monopoly and
increases the producer surplus. Second, consumers
lose by getting less of the good, and this loss is part of
the deadweight loss.
Although the monopoly gains from a higher price,
it loses some producer surplus because it produces a
smaller output. That loss is another part of the deadweight loss.
A monopoly produces a smaller output than perfect competition and faces no competition, so it does
not produce at the minimum possible long-run average cost. As a result, monopoly damages the consumer interest in three ways: A monopoly produces
less, increases the cost of production, and raises the
price by more than the increased cost of production. FIGURE 11.6 Inefficiency of Monopoly Consumer
surplus S = MSC PC Producer
quantity D = MSB
Quantity QC (a) Perfect competition Price and cost Efficiency Comparison 253 Consumer
surplus MSC PM
loss PC Producer
0 QM QC D = MSB
Quantity (b) Monopoly In perfect competition in part (a), output is QC and the price
is PC. Marginal social benefit (MSB) equals marginal social
cost (MSC ); consumer surplus (the green triangle) plus producer surplus (the blue area) is maximized; and in the long
run, firms produce at the lowest possible average cost.
Monopoly in part (b) produces QM and raises the price to
PM. Consumer surplus shrinks, the monopoly gains, and a
deadweight loss (the gray triangle) arises.
animation 9160335_CH11_p245-268.qxd 254 6/22/09 9:03 AM Page 254 CHAPTER 11 Monopoly Redistribution of Surpluses
You’ve seen that monopoly is inefficient because
marginal social benefit exceeds marginal social cost
and there is deadweight loss—a social loss. But
monopoly also brings a redistribution of surpluses.
Some of the lost consumer surplus goes to the
monopoly. In Fig. 11.6, the monopoly takes the difference between the higher price, PM, and the competitive price, PC , on the quantity sold, QM. So the
monopoly takes the part of the consumer surplus.
This portion of the loss of consumer surplus is not a
loss to society. It is redistribution from consumers to
the monopoly producer. Rent Seeking
You’ve seen that monopoly creates a deadweight loss
and is inefficient. But the social cost of monopoly
can exceed the deadweight loss because of an activity called rent seeking. Any surplus—consumer surplus, producer surplus, or economic profit—is
called economic rent. And rent seeking is the pursuit of
wealth by capturing economic rent.
You’ve seen that a monopoly makes its economic
profit by diverting part of consumer surplus to
itself—by converting consumer surplus into economic profit. So the pursuit of economic profit by a
monopoly is rent seeking. It is the attempt to capture
Rent seekers pursue their goals in two main ways.
■ Buy a monopoly
Create a monopoly Buy a Monopoly To rent seek by buying a monop- oly, a person searches for a monopoly that is for sale
at a lower price than the monopoly’s economic profit.
Trading of taxicab licenses is an example of this type
of rent seeking. In some cities, taxicabs are regulated.
The city restricts both the fares and the number of
taxis that can operate so that operating a taxi results
in economic profit. A person who wants to operate a
taxi must buy a license from someone who already
has one. People rationally devote time and effort to
seeking out profitable monopoly businesses to buy. In
the process, they use up scarce resources that could
otherwise have been used to produce goods and
services. The value of this lost production is part of
the social cost of monopoly. The amount paid for a monopoly is not a social cost because the payment is
just a transfer of an existing producer surplus from
the buyer to the seller.
Create a Monopoly Rent seeking by creating a
monopoly is mainly a political activity. It takes the
form of lobbying and trying to influence the political
process. Such influence might be sought by making
campaign contributions in exchange for legislative
support or by indirectly seeking to influence political
outcomes through publicity in the media or more
direct contacts with politicians and bureaucrats. An
example of a monopoly created in this way is the government-imposed restrictions on the quantities of textiles that may be imported into the United States.
Another is a regulation that limits the number of
oranges that may be sold in the United States. These
are regulations that restrict output and increase price.
This type of rent seeking is a costly activity that
uses up scarce resources. Taken together, firms spend
billions of dollars lobbying Congress, state legislators,
and local officials in the pursuit of licenses and laws
that create barriers to entry and establish a monopoly. Rent-Seeking Equilibrium
Barriers to entry create monopoly. But there is no
barrier to entry into rent seeking. Rent seeking is
like perfect competition. If an economic profit is
available, a new rent seeker will try to get some of
it. And competition among rent seekers pushes up
the price that must be paid for a monopoly, to the
point at which the rent seeker makes zero economic
profit by operating the monopoly. For example,
competition for the right to operate a taxi in New
York City leads to a price of more than $100,000
for a taxi license, which is sufficiently high to eliminate the economic profit made by a taxi operator.
Figure 11.7 shows a rent-seeking equilibrium. The
cost of rent seeking is a fixed cost that must be added
to a monopoly’s other costs. Rent seeking and rentseeking costs increase to the point at which no economic profit is made. The average total cost curve,
which includes the fixed cost of rent seeking, shifts
upward until it just touches the demand curve.
Economic profit is zero. It has been lost in rent seeking.
Consumer surplus is unaffected, but the deadweight loss from monopoly is larger. The deadweight
loss now includes the original deadweight loss triangle plus the lost producer surplus, shown by the
enlarged gray area in Fig. 11.7. 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 255 Price Discrimination Price and cost FIGURE 11.7 ATC MC PM
0 ◆ Price Discrimination Rent-Seeking Equilibrium Consumer
loss QM D
Quantity With competitive rent seeking, a monopoly uses all its economic profit to maintain its monopoly. The firm’s rent-seeking costs are fixed costs. They add to total fixed cost and to
average total cost. The ATC curve shifts upward until, at the
profit-maximizing price, the firm breaks even.
animation 255 You encounter price discrimination—selling a good
or service at a number of different prices—when
you travel, go to the movies, get your hair cut, buy
pizza, or visit an art museum or theme park. Many
of the firms that price discriminate are not monopolies, but monopolies price discriminate when they
can do so.
To be able to price discriminate, a firm must be able
to identify and separate different buyer types and sell
a product that cannot be resold.
Not all price differences are price discrimination.
Some goods that are similar have different prices
because they have different costs of production. For
example, the price per ounce of cereal is lower if you
buy your cereal in a big box than if you buy individual serving size boxes. This price difference reflects a
cost difference and is not price discrimination.
At first sight, price discrimination appears to be
inconsistent with profit maximization. Why would a
movie theater allow children to see movies at a discount? Why would a hairdresser charge students and
senior citizens less? Aren’t these firms losing profit by
being nice to their customers? Capturing Consumer Surplus Review Quiz ◆
4 Why does a single-price monopoly produce a
smaller output and charge more than the price
that would prevail if the industry were perfectly
How does a monopoly transfer consumer surplus to itself?
Why is a single-price monopoly inefficient?
What is rent seeking and how does it influence
the inefficiency of monopoly?
Work Study Plan 11.3
and get instant feedback. So far, we’ve considered only a single-price monopoly. But many monopolies do not operate with a single price. Instead, they price discriminate. Let’s now
see how a price-discriminating monopoly works. Price discrimination captures consumer surplus and
converts it into economic profit. It does so by getting buyers to pay a price as close as possible to the
maximum willingness to pay.
Firms price discriminate in two broad ways. They
■ Among groups of buyers
Among units of a good Discriminating Among Groups of Buyers People differ in the values they place on a good—their marginal benefit and willingness to pay. Some of these
differences are correlated with features such as age,
employment status, and other easily distinguished
characteristics. When such a correlation is present,
firms can profit by price discriminating among the
different groups of buyers.
For example, a face-to-face sales meeting with a
customer might bring a large and profitable order. So
for salespeople and other business travelers, the marginal benefit from a trip is large and the price that
such a traveler is willing to pay for a trip is high. In 9160335_CH11_p245-268.qxd 9:03 AM Page 256 CHAPTER 11 Monopoly contrast, for a vacation traveler, any of several different trips and even no vacation trip are options. So for
vacation travelers, the marginal benefit of a trip is
small and the price that such a traveler is willing to
pay for a trip is low. Because business travelers are
willing to pay more than vacation travelers are, it is
possible for an airline to profit by price discriminating between these two groups.
Discriminating Among Units of a Good Everyone
experiences diminishing marginal benefit and has a
downward-sloping demand curve. For this reason, if
all the units of the good are sold for a single price,
buyers end up with a consumer surplus equal to the
value they get from each unit of the good minus the
price paid for it.
A firm that price discriminates by charging a buyer
one price for a single item and a lower price for a second or third item can capture some of the consumer
surplus. Buy one pizza and get a second one free (or
for a low price) is an example of this type of price discrimination.
(Note that some discounts for bulk arise from
lower costs of production for greater bulk. In these
cases, such discounts are not price discrimination.)
Let’s see how price discriminating increases economic profit. Profiting by Price Discriminating
Global Airlines has a monopoly on an exotic route.
Figure 11.8 shows the market demand curve (D) for
travel on this route. It also shows Global Airline’s
marginal revenue curve (MR), marginal cost curve
(MC ), and average total cost curve (ATC ).
As a single-price monopoly, Global maximizes
profit by producing the quantity at which MR equals
MC, which is 8,000 trips a year, and charging $1,200
per trip. At this quantity, average total cost is $600
per trip, economic profit is $600 a trip, and Global’s
economic profit is $4.8 million a year, shown by the
blue rectangle. Global’s customers enjoy a consumer
surplus shown by the green triangle.
Global is struck by the fact that many of its customers are business travelers, and it suspects they are
willing to pay more than $1,200 a trip. Global does
some market research, which reveals that some business travelers are willing to pay as much as $1,800 a
trip. Also, these customers frequently change their
travel plans at the last minute. Another group of
business travelers is willing to pay $1,600. These A Single Price of Air Travel FIGURE 11.8
Price and cost (dollars per trip) 256 6/22/09 MC 2,100 ATC Consumer
surplus 1,800 Economic
0 5 8 10 D
Trips (thousands per year) Global Airlines has a monopoly on an air route. The market
demand curve is D. Global Airline’s marginal revenue curve
is MR, its marginal cost curve is MC, and its average total
cost curve is ATC. As a single-price monopoly, Global maximizes profit by selling 8,000 trips a year at $1,200 a trip. Its
profit is $4.8 million a year—the blue rectangle. Global’s
customers enjoy a consumer surplus—the green triangle.
animation customers know a week ahead when they will travel,
and they never want to stay over a weekend. Yet
another group would pay up to $1,400. These travelers know two weeks ahead when they will travel and
also don’t want to stay away over a weekend.
Global announces a new fare schedule: no restrictions, $1,800; 7-day advance purchase, nonrefundable, $1,600; 14-day advance purchase,
nonrefundable, $1,400; 14-day advance purchase,
must stay over a weekend, $1,200.
Figure 11.9 shows the outcome with this new fare
structure and also shows why Global is pleased with
its new fares. It sells 2,000 seats at each of its four
prices. Global’s economic profit increases by the dark
blue steps. Its economic profit is now its original $4.8
million a year plus an additional $2.4 million from
its new higher fares. Consumer surplus shrinks to the
sum of the smaller green areas. 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 257 Price Discrimination 2,100 Price Discrimination
MC Increased economic
profit from price
discrimination 1,800 ATC 1,600
0 2 4 6 8 10 15
Trips (thousands per year) Global revises its fare structure: no restrictions at $1,800, 7day advance purchase at $1,600, 14-day advance purchase
at $1,400, and must stay over a weekend at $1,200. Global
sells 2,000 trips at each of its four new fares. Its economic
profit increases by $2.4 million a year to $7.2 million a year,
which is shown by the original blue rectangle plus the dark
blue steps. Global’s customers’ consumer surplus shrinks.
animation Perfect Price Discrimination
occurs if a firm is able to
sell each unit of output for the highest price anyone
is willing to pay for it. In such a case, the entire
consumer surplus is eliminated and captured by the
producer. To practice perfect price discrimination, a
firm must be creative and come up with a host of
prices and special conditions, each one of which
appeals to a tiny segment of the market.
With perfect price discrimination, something special happens to marginal revenue—the market
demand curve becomes the marginal revenue curve.
The reason is that when the price is cut to sell a larger
quantity, the firm sells only the marginal unit at the
lower price. All the other units continue to be sold for
the highest price that each buyer is willing to pay. So
for the perfect price discriminator, marginal revenue
equals price and the demand curve becomes the marginal revenue curve. With marginal revenue equal to price, Global can
obtain even greater profit by increasing output up to
the point at which price (and marginal revenue) is
equal to marginal cost.
So Global seeks new travelers who will not pay as
much as $1,200 a trip but who will pay more than
marginal cost. Global offers a variety of vacation specials at different low fares that appeal only to new
travelers. Existing customers continue to pay the
higher fares. With all these fares and specials, Global
increases sales, extracts the entire consumer surplus,
and maximizes economic profit.
Figure 11.10 shows the outcome with perfect price
discrimination. The fares paid by the original travelers extract the entire consumer surplus from this
group. The new fares between $900 and $1,200
attract 3,000 additional travelers and take their entire
consumer surplus also. Global now makes an economic profit of more than $9 million.
Price and cost (dollars per trip) Price and cost (dollars per trip) FIGURE 11.9 257 Perfect Price Discrimination
1,800 Increase in economic
profit from perfect
price discrimination ATC 1,500
900 Perfect price discrimination 600
in output 300 0 5 8 11 D = MR 15
Trips (thousands per year) Dozens of fares discriminate among many different types of
business traveler, and many new low fares with restrictions
appeal to vacation travelers. With perfect price discrimination, the market demand curve becomes Global’s marginal
revenue curve. Economic profit is maximized when the lowest
price equals marginal cost. Global sells 11,000 trips and
makes an economic profit of $9.35 million a year.
animation 9160335_CH11_p245-268.qxd 9:03 AM Page 258 CHAPTER 11 Monopoly Efficiency and Rent Seeking with Price
With perfect price discrimination, output increases to
the point at which price equals marginal cost—where
the marginal cost curve intersects the demand curve
(see Fig. 11.10). This output is identical to that of perfect competition. Perfect price discrimination pushes
consumer surplus to zero but increases the monopoly’s
producer surplus to equal the sum of consumer surplus
and producer surplus in perfect competition. With perfect price discrimination, deadweight loss is zero. So
perfect price discrimination achieves efficiency.
The more perfectly the monopoly can price discriminate, the closer its output is to the competitive output
and the more efficient is the outcome. But there are two differences between perfect competition and perfect price discrimination. First, the
distribution of the total surplus is different. It is
shared by consumers and producers in perfect competition, while the producer gets it all with perfect
price discrimination. Second, because the producer
grabs all the surplus, rent seeking becomes profitable.
People use resources in pursuit of economic rent,
and the bigger the rents, the more resources get used
in pursuing them. With free entry into rent seeking,
the long-run equilibrium outcome is that rent seekers
use up the entire producer surplus.
Real-world airlines are as creative as Global
Airlines, as you can see in the cartoon!
You’ve seen that monopoly is profitable for the
monopoly but costly for consumers. It results in Attempting Perfect Price Discrimination
How Many Days at Disney World?
If you want to spend a day at Disney World in
Orlando, it will cost you $75.62. You can spend a
second (consecutive) day for an extra $72.42. A third
day will cost you $68.17. But for a fourth day, you’ll
pay only $9.59 and for a fifth day, $3.20. For more
days all the way up to 10, you’ll pay only $2.12 a day.
The Disney Corporation hopes that it has read your
willingness to pay correctly and not left you with too
much consumer surplus. Disney figures though that
after three days, your marginal benefit is crashing.
High price for up
to 3 days extracts
consumer surplus 60
Price of ticket (dollars per day) 258 6/22/09 40 20 0
1 2 3 4 5 6 7 8 9 10 Days spent at Disney World
Disney’s Ticket Prices Review Quiz ◆
3 4 Would it bother you to hear how Low price at
after 5 days What is price discrimination and how is it used
to increase a monopoly’s profit?
Explain how consumer surplus changes when a
monopoly price discriminates.
Explain how consumer surplus, economic
profit, and output change when a monopoly
perfectly price discriminates.
What are some of the ways that real-world
airlines price discriminate?
Work Study Plan 11.4
and get instant feedback. little I paid for this flight?
From William Hamilton, “Voodoo Economics,” © 1992 by
The Chronicle Publishing Company, p.3.
Reprinted with permission of Chronicle Books. inefficiency. Because of these features of monopoly, it
is subject to policy debate and regulation. We’ll now
study the key monopoly policy issues. 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 259 Monopoly Regulation ◆ Monopoly Regulation
Natural monopoly presents a dilemma. With
economies of scale, it produces at the lowest possible cost. But with market power, it has an incentive
to raise the price above the competitive price and
produce too little—to operate in the self-interest of
the monopolist and not in the social interest.
Regulation—rules administered by a government
agency to influence prices, quantities, entry, and
other aspects of economic activity in a firm or
industry—is a possible solution to this dilemma.
To implement regulation, the government establishes agencies to oversee and enforce the rules. For
example, the Surface Transportation Board regulates
prices on interstate railroads, some trucking and bus
lines, and water and oil pipelines. By the 1970s,
almost a quarter of the nation’s output was produced by regulated industries (far more than just
natural monopolies) and a process of deregulation
Deregulation is the process of removing regulation
of prices, quantities, entry, and other aspects of economic activity in a firm or industry. During the past
30 years, deregulation has occurred in domestic air
transportation, telephone service, interstate trucking,
and banking and financial services. Cable TV was
deregulated in 1984, re-regulated in 1992, and deregulated again in 1996.
Regulation is a possible solution to the dilemma
presented by natural monopoly but not a guaranteed
solution. There are two theories about how regulation actually works: the social interest theory and the
The social interest theory is that the political and
regulatory process relentlessly seeks out inefficiency
and introduces regulation that eliminates deadweight
loss and allocates resources efficiently.
The capture theory is that regulation serves the selfinterest of the producer, who captures the regulator
and maximizes economic profit. Regulation that benefits the producer but creates a deadweight loss gets
adopted because the producer’s gain is large and visible while each individual consumer’s is small and
invisible. No individual consumer has an incentive to
oppose the regulation but the producer has a big
incentive to lobby for it.
We’re going to examine efficient regulation that
serves the social interest and see why it is not a simple
matter to design and implement such regulation. 259 Efficient Regulation of a Natural Monopoly
A cable TV company is a natural monopoly—it can
supply the entire market at a lower price than two or
more competing firms can. Cox Communications,
based in Atlanta, provides cable TV to households in
20 states. The firm has invested heavily in satellite
receiving dishes, cables, and control equipment and
so has large fixed costs. These fixed costs are part of
the firm’s average total cost. Its average total cost
decreases as the number of households served
increases because the fixed cost is spread over a larger
number of households.
Unregulated, Cox produces the quantity that maximizes profit. Like all single-price monopolies, the
profit-maximizing quantity is less than the efficient
quantity, and underproduction results in a deadweight loss.
How can Cox be regulated to produce the efficient
quantity of cable TV service? The answer is by being
regulated to set its price equal to marginal cost,
known as the marginal cost pricing rule. The quantity
demanded at a price equal to marginal cost is the efficient quantity—the quantity at which marginal benefit equals marginal cost.
Figure 11.11 illustrates the marginal cost pricing
rule. The demand curve for cable TV is D. Cox’s
marginal cost curve is MC. That marginal cost curve
is (assumed to be) horizontal at $10 per household
per month—that is, the cost of providing each additional household with a month of cable programming is $10. The efficient outcome occurs if the price
is regulated at $10 per household per month with
10 million households served.
But there is a problem: At the efficient output,
average total cost exceeds marginal cost, so a firm
that uses marginal cost pricing incurs an economic
loss. A cable TV company that is required to use a
marginal cost pricing rule will not stay in business for
long. How can the firm cover its costs and, at the
same time, obey a marginal cost pricing rule?
There are two possible ways of enabling the firm
to cover its costs: price discrimination and a two-part
price (called a two-part tariff ).
For example, local telephone companies charge
consumers a monthly fee for being connected to the
telephone system and then charge a price equal to
marginal cost (zero) for each local call. A cable TV
operator can charge a one-time connection fee that
covers its fixed cost and then charge a monthly fee
equal to marginal cost. 9160335_CH11_p245-268.qxd 6/22/09 Page 260 CHAPTER 11 Monopoly 260 F IGURE 11.11
Price and cost (dollars per household) 9:03 AM Regulating a Natural
Monopoly 110 Profit
cost pricing 60 Government Subsidy A government subsidy is a Marginal
cost pricing 40
30 LRAC MC 10 MR
5 0 total cost curve cuts the demand curve. This rule
results in the firm making zero economic profit—
breaking even. But because for a natural monopoly
average total cost exceeds marginal cost, the quantity
produced is less than the efficient quantity and a
deadweight loss arises.
Figure 11.11 illustrates the average cost pricing
rule. The price is $30 a month and 8 million households get cable TV. D 8
Quantity (millions of households) A natural monopoly cable TV supplier faces the demand
curve D. The firm’s marginal cost is constant at $10 per
household per month, as shown by the curve labeled MC.
The long-run average cost curve is LRAC.
Unregulated, as a profit-maximizer, the firm serves 5
million households at a price of $60 a month. An efficient
marginal cost pricing rule sets the price at $10 a month.
The monopoly serves 10 million households and incurs an
economic loss. A second-best average cost pricing rule sets
the price at $30 a month. The monopoly serves 8 million
households and earns zero economic profit.
animation direct payment to the firm equal to its economic loss.
To pay a subsidy, the government must raise the revenue by taxing some other activity. You saw in
Chapter 6 that taxes themselves generate deadweight
And the Second-Best Is ... Which is the better option, average cost pricing or marginal cost pricing
with a government subsidy? The answer depends on
the relative magnitudes of the two deadweight losses.
Average cost pricing generates a deadweight loss in
the market served by the natural monopoly. A subsidy generates deadweight losses in the markets for
the items that are taxed to pay for the subsidy. The
smaller deadweight loss is the second-best solution to
regulating a natural monopoly. Making this calculation in practice is too difficult and average cost pricing is generally preferred to a subsidy.
Implementing average cost pricing presents the
regulator with a challenge because it is not possible to
be sure what a firm’s costs are. So regulators use one
of two practical rules:
■ Second-Best Regulation of a Natural
A natural monopoly cannot always be regulated to
achieve an efficient outcome. Two possible ways of
enabling a regulated monopoly to avoid an economic loss are
■ Average cost pricing
Government subsidy Average Cost Pricing The average cost pricing rule sets price equal to average total cost. With this rule
the firm produces the quantity at which the average Rate of return regulation
Price cap regulation Rate of Return Regulation Under rate of return regulation, a firm must justify its price by showing that
its return on capital doesn’t exceed a specified target
rate. This type of regulation can end up serving the
self-interest of the firm rather than the social interest. The firm’s managers have an incentive to inflate
costs by spending on items such as private jets, free
baseball tickets (disguised as public relations
expenses), and lavish entertainment. Managers also
have an incentive to use more capital than the efficient amount. The rate of return on capital is regulated but not the total return on capital, and the
greater the amount of capital, the greater is the total
return. 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 261 M onopoly Regulation Price Cap Regulation For the reason that we’ve just
examined, rate of return regulation is increasingly
being replaced by price cap regulation. A price cap
regulation is a price ceiling—a rule that specifies the
highest price the firm is permitted to set. This type of
regulation gives a firm an incentive to operate efficiently and keep costs under control. Price cap regulation has become common for the electricity and
telecommunications industries and is replacing rate
of return regulation.
To see how a price cap works, let’s suppose that the
cable TV operator is subject to this type of regulation. Figure 11.12 shows that without regulation, the
firm maximizes profit by serving 5 million households and charging a price of $60 a month. If a price
cap is set at $30 a month, the firm is permitted to sell Price and cost (dollars per household) FIGURE 11.12 Price Cap Regulation 110 any quantity it chooses at that price or at a lower
price. At 5 million households, the firm now incurs
an economic loss. It can decrease the loss by increasing output to 8 million households. To increase output above 8 million households, the firm would have
to lower the price and again it would incur a loss. So
the profit-maximizing quantity is 8 million households—the same as with average cost pricing.
Notice that a price cap lowers the price and
increases output. This outcome is in sharp contrast to
the effect of a price ceiling in a competitive market
that you studied in Chapter 6 (pp. 126–128). The
reason is that in a monopoly, the unregulated equilibrium output is less than the competitive equilibrium
output, and the price cap regulation replicates the
conditions of a competitive market.
In Fig. 11.12, the price cap delivers average cost
pricing. In practice, the regulator might set the cap
too high. For this reason, price cap regulation is often
combined with earnings sharing regulation—a regulation that requires firms to make refunds to customers
when profits rise above a target level. Review Quiz ◆ Profit-maximizing
outcome 1 Price cap
outcome 60 2
30 10 Price cap
lowers price ... ... and
0 5 LRAC MC
Quantity (millions of households) A natural monopoly cable TV supplier faces the demand
curve D. The firm’s marginal cost is constant at $10 per
household per month, as shown by the curve labeled MC.
The long-run average cost curve is LRAC.
Unregulated, the firm serves 5 million households at a
price of $60 a month. A price cap sets the maximum price
at $30 a month. The firm has an incentive to minimize cost
and serve the quantity of households that demand service at
the price cap. The price cap regulation lowers the price and
increases the quantity.
animation 261 4 What is the pricing rule that achieves an efficient outcome for a regulated monopoly? What
is the problem with this rule?
What is the average cost pricing rule? Why is it
not an efficient way of regulating monopoly?
What is a price cap? Why might it be a more
effective way of regulating monopoly than rate
of return regulation?
Compare the consumer surplus, producer surplus, and deadweight loss that arise from average cost pricing with those that arise from
profit-maximization pricing and marginal cost
Work Study Plan 11.5
and get instant feedback. ◆ You’ve now completed your study of monopoly. Reading Between the Lines on pp. 262–263 looks at
Microsoft’s near monopoly in PC operating systems
and a court challenge the firm faced in Europe. In the
next chapter, we study markets that lie between the
extremes of perfect competition and monopoly and
that blend elements of the two. 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 262 READING BETWEEN THE LINES European View of Microsoft
European Court Faults Microsoft On Competition
September 18, 2007 Europe’s second-highest court delivered a stinging rebuke to Microsoft Monday, … [for]
adding a digital media player to Windows, undercutting the early leader, Real Networks.
It also ordered Microsoft to … share confidential computer code with competitors. The
court also upheld the record fine levied against the company, 497.2 million euros
But the court decision comes as the center of gravity in computing is shifting away from the
software for personal computers, Microsoft’s stronghold. Increasingly, the e-mailing or
word-processing functions of a computer can be performed with software delivered on a Web
browser. Other devices like cell phones are now used as alternates to personal computers.
The real challenge to Microsoft, after more than a decade of dominating the technology
industry, is coming not from the government, but from the marketplace. …
[T]he Justice Department issued a statement expressing its concerns with the European
decision, saying that tough restraints on powerful companies can be harmful. Thomas O.
Barnett, assistant attorney general for the department’s antitrust division, said that the effect
“rather than helping consumers, may have the unfortunate consequence of harming consumers by chilling innovation and discouraging competition.”
Consumer welfare, not protecting competitors, should be the guiding standard in antitrust,
Mr. Barnett said. …
In the United States, the Justice Department chose to settle the Microsoft antitrust case in
2001 without challenging the company’s freedom to put whatever it wants in its operating
Copyright 2007 The New York Times Company. Reprinted with permission. Further reproduction prohibited. Essence of the Story
■ ■ 262 A European court fined Microsoft $689 million for
competing with Real Networks by adding a digital
media player to Windows, and the court ordered
Microsoft to share its code with competitors.
The market, not government, is Microsoft’s main challenge because the emphasis is shifting from PC software to software delivered on a Web browser, and to cell
■ The U.S. Justice Department did not challenge Microsoft’s right to put whatever it wants in Windows and
says that consumer welfare, not protecting competitors,
should be the guide. 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 263 Economic Analysis
■ Microsoft’s operating system, Windows, enables the
hardware of a PC to accept and execute instructions
from word processors, spreadsheets, Web browsers,
media players, and a host of other applications. ■ In addition to creating the operating system for a PC,
Microsoft develops and sells applications, the most famous of which are contained in its Office package
(Word, Excel, Outlook, and PowerPoint). ■ ■ ■ ■ Price (dollars per copy) ■ Other applications created by Microsoft are the Web
browser, Internet Explorer, and a digital media player,
Windows Media Player (the subject of the European
In the market for PC operating systems, Microsoft has a
In the markets for applications, Microsoft faces stiff
competition from other producers. The stiffest competition comes from the Internet.
In 1994, a firm called Mosaic Communications
launched the first easy-to-use Web browser, Netscape.
A year later, RealNetworks, Inc., launched its Real
video and audio players. PC users now needed Microsoft Windows, the
Netscape browser, and the RealPlayer to enjoy the full
scope of the Internet. ■ Microsoft could have stood still and marketed Windows in its 1995 stripped-down form. ■ If Microsoft had followed this strategy, it would have
faced the market described in Fig. 1. ■ As a profit-maximizing firm, Microsoft would have produced 20 million copies of Windows a year and sold
them for $115 a copy. ■ Instead, Microsoft improved Windows and added its
own Web browser and media player. ■ With a higher-value package, Microsoft faced the market shown in Fig. 2. ■ Microsoft maximized profit by producing 20 million
copies of Windows a year and selling them for $230
a copy. ■ Microsoft’s profit increased, but so did the consumer
surplus of Windows users. ■ As the U.S. Justice Department noted, limiting the actions of a monopoly doesn’t always help the consumer. These two developments led to a rapid growth of Internet activity and left Microsoft behind the curve. 500 Price (dollars per copy) ■ ■ A low-priced, stripped-down
Windows results in a … 400 300
… and small
consumer surplus 220 A high-priced Windows
with many features and
add-ons results in a … 450 … and large
profit, ... 10
0 500 MR
10 20 Figure 1 Windows stripped down ATC
Quantity (millions per year) … high
0 10 D MR
Quantity (millions per year) Figure 2 Windows with bells and whistles 263 9160335_CH11_p245-268.qxd 264 6/22/09 9:03 AM Page 264 CHAPTER 11 Monopoly SUMMARY ◆ Key Points ■ Monopoly and How It Arises (pp. 264–247) ■ ■ ■ ■ ■ A monopoly is an industry with a single supplier
of a good or service that has no close substitutes
and in which barriers to entry prevent competition.
Barriers to entry may be legal (public franchise,
license, patent, copyright, firm owns control of a
resource) or natural (created by economies of
A monopoly might be able to price discriminate
when there is no resale possibility.
Where resale is possible, a firm charges one price. Price Discrimination (pp. 255–258)
■ ■ ■ A Single-Price Monopoly’s Output and Price Decision
■ ■ A monopoly’s demand curve is the market demand
curve and a single-price monopoly’s marginal revenue is less than price.
A monopoly maximizes profit by producing the
output at which marginal revenue equals marginal
cost and by charging the maximum price that consumers are willing to pay for that output. Single-Price Monopoly and Competition Compared A single-price monopoly charges a higher price
and produces a smaller quantity than a perfectly
competitive industry. Price discrimination converts consumer surplus
into economic profit.
Perfect price discrimination extracts the entire
consumer surplus; each unit is sold for the maximum price that each consumer is willing to pay;
the quantity produced is the efficient quantity.
Rent seeking with perfect price discrimination
might eliminate the entire consumer surplus and
producer surplus. Monopoly Regulation (pp. 259–261)
■ ■ ■ ■ (pp. 252–255)
■ A single-price monopoly restricts output and creates a deadweight loss.
The total loss that arises from monopoly equals
the deadweight loss plus the cost of the resources
devoted to rent seeking. ■ Monopoly regulation might serve the social interest or the interest of the monopoly (the regulator
Price equal to marginal cost achieves efficiency but
results in economic loss.
Price equal to average cost enables the firm to
cover its cost but is inefficient.
Rate of return regulation creates incentives for
inefficient production and inflated cost.
Price cap regulation with earnings share regulation
can achieve a more efficient outcome than rate of
return regulation. Key Figures and Table
Figure 11.6 Demand and Marginal Revenue, 248
Marginal Revenue and Elasticity, 249
A Monopoly’s Output and Price, 251
Monopoly’s Smaller Output and
Higher Price, 252
Inefficiency of Monopoly, 253 Figure 11.9
Table 11.1 Price Discrimination, 257
Perfect Price Discrimination, 257
Regulating a Natural Monopoly, 260
Price Cap Regulation, 261
A Monopoly’s Output and Price
Decision, 250 Key Terms
Average cost pricing rule, 260
Barriers to entry, 246
Capture theory, 259
Economic rent, 254
Legal monopoly, 246 Marginal cost pricing rule, 259
Natural monopoly, 246
Perfect price discrimination, 257
Price cap regulation, 261
Price discrimination, 247 Rate of return regulation, 260
Rent seeking, 254
Single-price monopoly, 247
Social interest theory, 259 9160335_CH11_p245-268.qxd 7/1/09 3:47 PM Page 265 Problems and Applications PROBLEMS and APPLICATIONS 265 ◆ Work problems 1–9 in Chapter 11 Study Plan and get instant feedback.
Work problems 10–17 as Homework, a Quiz, or a Test if assigned by your instructor. 1. The United States Postal Service has a monopoly
on non-urgent First Class Mail and the exclusive
right to put mail in private mailboxes. Pfizer Inc.
makes LIPITOR, a prescription drug that lowers
cholesterol. Cox Communications is the sole
provider of cable television service in some parts
of San Diego.
a. What are the substitutes, if any, for the goods
and services described above?
b. What are the barriers to entry, if any, that protect these three firms from competition?
c. Which of these three firms, if any, is a natural
monopoly? Explain your answer and illustrate
it by drawing an appropriate figure.
d. Which of these three firms, if any, is a legal
monopoly? Explain your answer.
e. Which of these three firms are most likely to
be able to profit from price discrimination
and which are most likely to sell their good or
service for a single price?
2. Barbie’s Revenge: Brawl over Doll is Heading to
Four years ago, Mattel Inc. exhorted its executives to help save Barbie from a new doll clique
called the Bratz. … Market share was dropping
at a “chilling rate,” the presentation said. Barbie
needed to be more “aggressive, revolutionary, and
ruthless.” That call to arms has led to a federal
courthouse. … Mattel accuses … the maker of
Bratz, of … stealing the idea for the pouty-lipped
dolls with the big heads. Mattel is trying to seize
ownership of the Bratz line, …
The Wall Street Journal, May 23, 2008
a. Before Bratz entered the market, what type of
monopoly did Mattel Inc. possess in the market for “the pouty-lipped dolls with the big
b. What is the barrier to entry that Mattel might
argue should protect it from competition in
the market for Barbie dolls?
c. Explain how the entry of Bratz dolls might be
expected to change the demand for Barbie
dolls. 3. Antitrust Inquiry Launched into Intel
The Federal Trade Commission has opened a formal probe into whether Intel, the world’s largest
chipmaker, has used its dominance to illegally
stifle its few competitors. The move follows
years of complaints from smaller chip rival
Advanced Micro Devices. … Intel is many times
larger, holding 80 percent of the microprocessor
market. … In a sign that suggests the chip market remains competitive, Intel said, prices for
microprocessors declined by 42.4 percent
between 2000 and 2007… “evidence that this
industry is fiercely competitive. …” Intel said.
The Washington Post, June 7, 2008
a. Is Intel a monopoly in the chip market?
b. Evaluate the argument made by Intel that the
significant decline in prices is “evidence that
this industry is fiercely competitive.”
4. Minnie’s Mineral Springs, a single-price monopoly,
faces the market demand schedule:
Price Quantity demanded (dollars per bottle) (bottles per hour) 10
5 a. Calculate Minnie’s total revenue schedule.
b. Calculate its marginal revenue schedule.
c. Draw a graph of the market demand curve
and Minnie’s marginal revenue curve.
d. Why is Minnie’s marginal revenue less than
e. At what price is Minnie’s total revenue maximized?
f. Over what range of prices is the demand for
water from Minnie’s Mineral Springs elastic?
g. Why will Minnie not produce a quantity at
which the market demand for water is inelastic? 9160335_CH11_p245-268.qxd 9:03 AM Page 266 CHAPTER 11 Monopoly 5. Minnie’s Mineral Springs faces the demand
schedule in problem 4 and has the following
total cost schedule:
Quantity produced Total cost (bottles per hour) (dollars) 0
31 a. Calculate the marginal cost of producing each
output listed in the table.
b. Calculate Minnie’s profit-maximizing output
c. Calculate the economic profit.
6. La Bella Pizza can produce a pizza for a marginal
cost of $2. Its standard price is $15 a pizza. It
offers a second pizza for $5. It also distributes
coupons that give a $5 rebate on a standard-price
a. How can La Bella Pizza make a larger economic profit with this range of prices than it
could if it sold every pizza for $15?
b. Draw a graph to illustrate your answer to a.
c. Can you think of a way of increasing La Bella
Pizza’s economic profit even more?
d. Is La Bella Pizza more efficient than it would
be if it charged just one price?
7. The Saturday-Night Stay Requirement Is on Its
The Saturday-night stay—that pesky and expensive requirement that airlines instituted to ensure
that the business traveler pays outrageous airfares
if he or she wants to go home to the family for
the weekend—has gone the way of the dodo
Many low-fare carriers, such as Southwest,
JetBlue and AirTran, never had the Saturdaynight rule. Some of the so-called legacy airlines,
including America West and Alaska, have eliminated the restriction. United and American did
away with it in response to competition but
only on some routes. Still others, including
Continental, Delta, US Airways and Northwest,
mostly continue to enforce the rule, especially
in the markets they dominate. … Experts and industry spokesmen agree that lowfare carriers are the primary reason legacy airlines
are adopting more consumer-friendly fare structures, which include the elimination of the
Saturday-night stay, the introduction of one-way
and walk-up fares and the general restructuring
of its fares. …
Los Angeles Times, August 15, 2004
a. Explain why the opportunity for price discrimination exists for air travel.
b. How does an airline profit from price discrimination?
c. Describe the change in price discrimination in
the market for air travel when discount airlines entered the market.
d. Explain the effect of the change in price discrimination when discount airlines entered
the market on the price and the quantity of air
8. The figure shows a situation similar to that of
Calypso U.S. Pipeline, a firm that operates a natural gas distribution system in the United States.
Calypso is a natural monopoly that cannot price
Price and cost (cents per cubic foot) 266 6/22/09 10 8 6 4 LRAC
MC 2 D
0 1 2 3 4 5 Quantity (millions of cubic feet per day) What quantity will Calypso produce and what is
the price of natural gas if Calypso is
a. An unregulated profit-maximizing firm?
b. Regulated to make zero economic profit?
c. Regulated to be efficient?
9. In problem 8, what is the producer surplus, consumer surplus, and deadweight loss if Calypso is
a. An unregulated profit-maximizing firm?
b. Regulated to make zero economic profit?
c. Regulated to be efficient? 9160335_CH11_p245-268.qxd 6/22/09 9:03 AM Page 267 Problems and Applications Price
per ride) 220
120 Quantity demanded Total cost (rides)
per month) (dollars
per month) 0
680 a. Construct Hot Air’s total revenue and marginal revenue schedules.
b. Draw a graph of the demand curve and Hot
Air’s marginal revenue curve.
c. Find Hot Air’s profit-maximizing output and
price and calculate the firm’s economic profit.
d. If the government imposes a tax on Hot Air’s
profit, how does its output and price change?
e. If instead of taxing Hot Air’s profit, the government imposes a sales tax on balloon rides
of $30 a ride, what are the new profit-maximizing quantity, price, and economic profit?
12. The figure illustrates the situation facing the
publisher of the only newspaper containing local
Price and cost (cents per newspaper) 10. The following list gives some information about
■ Coca-Cola cuts its price below that of PepsiCola in an attempt to increase its market
■ A single firm, protected by a barrier to entry,
produces a personal service that has no close
■ A barrier to entry exists, but the good has
some close substitutes.
■ A firm offers discounts to students and
■ A firm can sell any quantity it chooses at the
■ The government issues Nike an exclusive
license to produce golf balls.
■ A firm experiences economies of scale even
when it produces the quantity that meets the
entire market demand.
a. In which of the seven cases might monopoly
b. Which of the seven cases are natural monopolies and which are legal monopolies?
c. Which can price discriminate, which cannot,
11. Hot Air Balloon Rides, a single-price monopoly,
has the demand schedule shown in columns 1
and 2 of the table and the total cost schedule
shown in columns 2 and 3 of the table: 267 100 80 MC
40 20 0 100 200 300 400 500 Quantity (newspapers per day) news in an isolated community.
a. On the graph, mark the profit-maximizing
quantity and price.
b. On the graph, show the publisher’s total revenue per day.
c. At the price charged, is the demand for this
newspaper elastic or inelastic? Why?
d. What are consumer surplus and deadweight
loss? Mark each on your graph.
e. Explain why this market might encourage rent
f. If this market were perfectly competitive, what
would be the quantity, price, consumer surplus, and producer surplus? Mark each on
13. Telecoms Look to Grow by Acquisition
A multibillion-dollar telecommunications merger
announced Thursday … shows how global cellular powerhouses are scouting for growth in
emerging economies while consolidating in their
own, crowded backyards.
France Télécom offered Thursday to buy
TeliaSonera, a Swedish-Finnish telecommunications operator. … Within hours, TeliaSonera
rejected the offer as too low, but analysts said
higher bids—either from France Télécom or others—could persuade [TeliaSonera] to accept a deal. 9160335_CH11_p245-268.qxd 268 6/22/09 9:03 AM Page 268 CHAPTER 11 Monopoly Meanwhile, in the United States, Verizon
Wireless, … agreed to buy Alltel for $28.1 billion, a deal that would make the company the
biggest mobile phone operator in the country.
A combination of France Télécom and
TeliaSonera would create the world’s fourthlargest mobile operator … smaller only than
China Mobile, Vodafone and Telefónica of Spain.
International Herald Tribune, June 5, 2008
a. Explain the rent seeking behavior of global
b. Explain how mergers may affect the efficiency
of the telecommunications market.
14. Zoloft Faces Patent Expiration
… Pfizer’s antidepressant Zoloft, with $3.3 billion in 2005 sales, loses patent protection on
June 30. …
When a brand name drug loses its patent, both
the price of the drug and the dollar value of its
sales each tend to drop about 80 percent over the
next year, as competition opens to a host of
generic drugmakers. … Some of those lost revenue will go to generic drugmakers. … But the
real winners are the patients and the insurers,
who pay much lower prices. The Food and Drug
Administration insists that generics work identically to brand-names.
CNN, June 15, 2006
a. Assume that Zoloft is the only antidepressant
on the market and that price discrimination is
not an option. Draw a graph to illustrate the
market price and quantity of Zoloft sold.
b. On your graph, identify consumer surplus,
producer surplus, and deadweight loss.
c. How might you justify protecting Pfizer from
competition with a legal barrier to entry?
d. Explain how the market for an antidepressant
drug changes when a patent expires.
e. Draw a graph to illustrate how the expiration
of the Zoloft patent will change the price and
quantity in the market for antidepressants.
f. Explain how consumer surplus, producer surplus, and deadweight loss change with the expiration of the Zoloft patent.
… Getting your hands on a new iPhone …
[means] signing … a two-year AT&T contract. …
Some markets, because of the sheer costs of being a player, tend toward either a single firm or a
small number of firms. … Everyone hoped and
thought the wireless market would be different.
… A telephone monopoly has been the norm for
most of American telecommunication history,
except for what may turn out to have been a brief
experimental period from 1984 through 2012 or
so. … [I]t may be that telephone monopolies in
America are a national tradition.
Slate, June 10, 2008
a. How does AT&T being the exclusive provider
of wireless service for the iPhone influence the
wireless telecommunication market?
b. Explain why the wireless market may “tend
toward either a single firm or a small number
of firms.” Why might this justify allowing a
regulated monopoly to exist in this market?
16. F.C.C. Planning Rules to Open Cable Market
The Federal Communications Commission is
preparing to impose significant new regulations to
open the cable television market to independent
programmers and rival video services. … The
agency is also preparing to adopt a rule this
month that would make it easier for independent
programmers, which are often small operations,
to lease access to cable channels … [and] set a cap
on the size of the nation’s largest cable companies
so that no company could control more than 30
percent of the market. …
The New York Times, November 10, 2007
a. What barriers to entry exist in the cable television market?
b. Are high cable prices evidence of monopoly
c. Draw a graph to illustrate the effects of the
F.C.C.’s new regulations on the price, quantity, consumer surplus, producer surplus, and
17. Study Reading Between the Lines on pp. 262 –
263 and then answer the following questions:
a. What does the news article mean when it says
that Microsoft’s main challenge comes from
the marketplace rather than government?
b. How does Microsoft try to raise barriers to the
entry of competitors?
c. Compare and contrast the anti-monopoly regulation in Europe with that in the United
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