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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 a monopoly. 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 ■ ■ ■ Natural Ownership 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 3 4 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 market. 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 monopoly. 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 Monopolies 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 companies. 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 pricing strategies; Single price 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 legal monopoly? 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 demanded (Q ) (dollars per haircut) (haircuts 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 revenue ( TR = P × Q ) (dollars) Marginal revenue ( MR = Δ TR/ Δ Q ) (dollars per haircut) . . . . . . . . . . .18 . . . . . . . . . . .14 . . . . . . . . . . . 10 ........... 6 ........... 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 and Elasticity Elastic Unit elastic 10 Inelastic Quantity (haircuts 10 per hour) D 0 5 Maximum total revenue –10 MR –20 (a) Demand and marginal revenue curves Total revenue (dollars per hour) Marginal Revenue and Elasticity 249 Zero marginal revenue 50 40 30 20 10 TR 0 5 10 Quantity (haircuts 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. TABLE 11.1 Price (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 demanded (Q ) Total revenue ( TR = P × Q ) Marginal revenue ( MR = Δ TR/ Q ) Total cost ( TC ) Marginal cost ( 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 12 3 ........... 3 . . . . . . . . . . . . 10 14 –20 ........... 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 and Price TC 50 TR Economic profit = $12 42 30 20 10 0 1 2 3 4 5 Quantity (haircuts per hour) Price and cost (dollars per haircut) (a) Total revenue and total cost curves 20 MC 14 Economic 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 diamond business. 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 5 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 ◆ 1 2 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 market. FIGURE 11.5 Price and cost 252 6/22/09 Monopoly’s Smaller Output and Higher Price Single-price monopoly: Higher 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 surplus 0 Efficient quantity D = MSB Quantity QC (a) Perfect competition Price and cost Efficiency Comparison 253 Consumer surplus MSC PM Deadweight loss PC Producer surplus MR 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 consumer surplus. Rent seekers pursue their goals in two main ways. They might ■ ■ 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 Rent-seeking costs exhaust producer surplus MR 0 ◆ Price Discrimination Rent-Seeking Equilibrium Consumer surplus Deadweight 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 ◆ 1 2 3 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 competitive? 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 discriminate: ■ ■ 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 profit 1,500 1,200 900 $4.8 million 600 300 MR 0 5 8 10 D 15 20 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 1,400 1,200 900 600 300 D 0 2 4 6 8 10 15 20 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. FIGURE 11.10 Price and cost (dollars per trip) Price and cost (dollars per trip) FIGURE 11.9 257 Perfect Price Discrimination MC 2,100 1,800 Increase in economic profit from perfect price discrimination ATC 1,500 1,200 900 Perfect price discrimination 600 Increase in output 300 0 5 8 11 D = MR 15 20 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 Discrimination 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. 80 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 ◆ 1 2 3 4 Would it bother you to hear how Low price at marginal cost 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 began. 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 capture theory. 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 maximizing Average 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 10 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 loss. 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 Monopoly 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 Price cap 3 30 10 Price cap regulation lowers price ... ... and increases output MR 0 5 LRAC MC 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, 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 pricing. 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 http://www.nytimes.com 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 ($689.4 million). 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 system. … 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 phone software. ■ 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 court’s decision). In the market for PC operating systems, Microsoft has a near monopoly. 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 consumer surplus 300 230 115 100 100 ... low profit, ... 10 0 500 MR D 10 20 Figure 1 Windows stripped down ATC MC 30 40 Quantity (millions per year) … high profit, ... 10 0 10 D MR 20 ATC MC 30 40 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 scale). 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 (pp. 248–251) ■ ■ 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 being captured). 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 11.2 Figure 11.3 Figure 11.4 Figure 11.5 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 Figure 11.10 Figure 11.11 Figure 11.12 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 Deregulation, 259 Economic rent, 254 Legal monopoly, 246 Marginal cost pricing rule, 259 Monopoly, 246 Natural monopoly, 246 Perfect price discrimination, 257 Price cap regulation, 261 Price discrimination, 247 Rate of return regulation, 260 Regulation, 259 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 Trial 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 heads”? 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 8 6 4 2 0 0 1 2 3 4 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 the price? 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 1 2 3 4 5 1 3 7 13 21 31 a. Calculate the marginal cost of producing each output listed in the table. b. Calculate Minnie’s profit-maximizing output and price. 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 pizza. 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 Final Approach 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 bird. … 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 travel. 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 discriminate. 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 (dollars per ride) 220 200 180 160 140 120 Quantity demanded Total cost (rides) per month) (dollars per month) 0 1 2 3 4 5 80 160 260 380 520 680 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 seven firms. ■ Coca-Cola cuts its price below that of PepsiCola in an attempt to increase its market share. ■ A single firm, protected by a barrier to entry, produces a personal service that has no close substitutes. ■ A barrier to entry exists, but the good has some close substitutes. ■ A firm offers discounts to students and seniors. ■ A firm can sell any quantity it chooses at the going price. ■ 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 arise? b. Which of the seven cases are natural monopolies and which are legal monopolies? c. Which can price discriminate, which cannot, and why? 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 60 D 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 seeking. f. If this market were perfectly competitive, what would be the quantity, price, consumer surplus, and producer surplus? Mark each on your graph. 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 telecommunications companies. 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. 15. iSurrender … 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 power? 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 deadweight loss. 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 States. ...
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