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CHAPTER 7
Monopoly
By the end of this chapter you will be able to:
1.
Specify the conditions that may permit the development of a “single-seller” monopoly and, using the two broad types of
barriers to entry, identify two types of monopoly.
2.
Explain why the monopolist’s marginal revenue decreases as output increases.
3.
Draw and interpret a diagram representing the price and output choices of a profit-maximizing monopolist.
4.
Draw a diagram to compare a monopolist’s performance relative to that of a perfectly competitive firm in terms of price,
output, and the effect on income distribution.
5.
Identify the long-run welfare loss caused by the presence of an “-artificial” monopoly and show it graphically.
6.
Explain what is meant by price discrimination and discuss its effects.
7.
Distinguish a natural monopoly from other forms of monopoly.
8.
Identify the two broad policy stances taken by the government with regard to an industry that exhibits monopoly
characteristics and the two government organizations charged with combating anticompetitive practices.
Lipitor, the cholesterol-reducing drug, has been the world’s best-selling branded medication in pharmaceutical history,
topping the sales performance lists since the late 1990s. Pfizer, its developer, has enjoyed a lucrative monopoly, protected by
patent law. In May 2012, generic drug makers became able to market their competing versions but it’s a safe bet that Lipitor
will continue to earn profits for Pfizer, supported by name-brand recognition and advertising. This situation—one seller of a
-patent-protected product with name-brand recognition—is far from perfect competitive model we have explored in the two
previous chapters but it is one that has been created and sustained by our legal system. In this chapter, we consider why.
Chapter Preview: In Chapters 5 and 6 we examined the consequences of having production organized through perfectly
competitive industries and discovered that perfect competition gave society generally beneficial results, through the operation
of what Adam Smith termed the “invisible hand” of self-interest. However, perfect competition is a rare beast in the real world
and, in this chapter, we turn our attention to the other end of the competitive spectrum—monopoly, the market structure in
which one firm dominates the industry.
Brain Teaser: Monopoly has frequently received a bad press and, certainly, our conclusions in Chapter 6 would seem to
argue that perfect competition bestows beneficial results in terms of productive efficiency and allocative efficiency. Can you
think of any examples or circumstances where we would prefer to have a single producer instead of perfect -competition?
The Making and Maintenance of a Monopoly: Is One the Loneliest Number?
Characteristics of a Monopoly
A pure monopoly arises when there is a single firm in an industry producing a good or service with no close substitutes and
where there are significant barriers to the entry of competitors. Clearly, the trick is to define what comprises the relevant
market. There is a market for Budweiser beer, but Budweiser is not a monopoly because there are other brands of beer
available that, for most buyers, are sufficiently similar. However, Microsoft’s bundling its own browser and other products
with its Windows operating system was found by the courts to be the practice of an “ abusive” monopoly. Note that a
monopoly need not be a large nationwide firm—your local water and sewage provider is likely to be a mono-polist, as is your
local cable TV provider.
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Whereas the perfectly competitive firm is a “price taker” (having no independent control over the price of his product), the
monopolist is said to be a “price maker.” The monopolist is the industry and can choose to set any price he desires, although
we continue to assume his actions are guided by the goal of profit-maximization. It is because of this power to dictate price
that many monopolies are subject to government regulation.
Initially, we assume that the firm sets the same price for all -customers, but, in many instances, monopolists practiceprice
discrimination—setting different prices for different classes of customer. We look at the implications of price discrimination
later in this chapter.
Circumstances may create a situation where there is only one seller of a good—a tornado rips through town, destroying all
the stores but one—but usually we think of a monopoly as having more staying power than this. For a monopoly to develop
and endure, there must exist some sort of restriction that prevents competitors from entering and competing with the
monopolist. These restrictions are known as barriers to entry.
Barriers to Entry
Artificial Barriers to Entry
Barriers to entry may be “artificial” or “natural.” An artificial barrier to entry, which often is legal in nature, imposes an
artificial restriction on competition—“artificial” in the sense that the barrier exists simply because society has chosen to
impose it. For example, patent laws bestow monopoly power on firms—Pfizer’s right to be the sole producer of Lipitor is due
to patent laws; if these laws were modified, then the legal basis for such monopolists would vanish.
Other artificial barriers to entry include government licenses, franchise agreements, ownership or control of key resources,
and overpowering advertising budgets or name identification with a class of product.
THINK IT THROUGH. Can you think of real-world examples of monopolies (or near-monopolies) sustained by each of
these barriers? Cable TV companies have monopoly power due to government licenses; marketing of foreign products can be
encouraged through franchise agreements; Alcoa once had a stranglehold on aluminum -production because of itsownership of
bauxite mines; and Coke, Kleenex, and Xerox all have had advantages over would-be rivals because of name recognition.
There may be good economic reasons for the establishment of an “artificial” monopoly. Having only one firm operating in
an area may prevent wasteful duplication of service or underemployment of resources—it makes little sense to have two or
more sets of water lines in a neighborhood, for example. The profit-earning attraction of a new process or product may
stimulate creativity if the innovation can be protected by patent while exclusive marketing rights may encourage the provision
of a new good or service that might otherwise not be offered to customers. After all, why go to the expense of researching and
developing a new product, then educating consumers about its advantages, if a low-cost competitor is then allowed to come
into the market and undercut the original developer’s price?
Natural Barriers to Entry
A natural barrier to entry is one that occurs through the nature of the market itself and results in the development of a
natural monopoly. The most obvious example of this type of barrier is the presence of substantial economies of scale. As we
saw in Chapter 6, as a firm expands its scale of operations, economies of scale drive down the per-unit cost of -production.
Suppose we have 20 companies in competition, with each firm producing 100 units of output at an average cost of $10.
Total industry production is 2000 units. The long-run average cost (LRAC) curve for each firm is identical and shown in
Figure 7-1.
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Figure 7-1. Economies of scale creating a monopoly.
The continually downward-sloping appearance of the LRAC curve tells us that ongoing economies of scale are present.
This is a potentially unstable situation because if one firm (Firm A) attracts a few customers from each of its rivals, then the
market will evolve into a monopoly. As Firm A’s output expands, its average costs decrease and it will be able to reduce its
price, whereas Firm A’s rivals will service fewer customers and, with lower output and rising average costs, will increase
price. Firm A’s relatively cheaper price will attract more customers to switch from its rivals—its output will expand further
and its price will decrease more, while the output of its rivals will contract further, forcing them to raise prices again.
Assuming that Firm A’s economies of scale are sufficiently sustained to service the entire market, the culmination of the
process will be a monopoly—a natural monopoly.
Note that there is no mechanism present to encourage renewed competition. Any new firm entering the market, with a small
scale of production and the associated high costs, would be forced out by low-cost, low-price Firm A.
We would expect to see a natural monopoly in an industry with substantial economies of scale, or in one that has high
set-up costs (electricity generation, for example).
Other situations where it is “natural” to have a single firm will be dealt with more fully in the section on natural
monopolies.
Monopoly in the Short Run: Stellio’s Pizzeria
In this section we consider the behavior of the “artificial” monopolist in the short run and, in the following section, the
long-run implications. After that, we turn to the special aspects of natural monopoly.
Monopolies need not be large national firms—many monopolies thrive in local markets. The benign country store in the
small rural town may, in many respects, be a monopolist and, in our example, so is Stellio’s Pizzeria and Fish Restaurant.
Stellio runs his pizzeria in a small, fairly isolated town and his is the only restaurant for many miles. If you crave a restaurant
meal, then it has to be served at Stellio’s. Stellio’s monopoly is sustained not by a legal barrier to entry but, in fact, by an
illegal one. He has Mafia connections and restaurateurs who have set up in opposition to Stellio in the past have had a nasty
history of unfortunate “accidents.”
The Monopolist’s Revenue Picture
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We can set up a demand schedule for Stellio’s pizzas. The law of demand would have us expect that higher prices would lead
to fewer pizzas being demanded each hour and this pattern is shown in Table 7-1.
Table 7-1. Revenue Information for Stellio’s Pizzeria
Price of a Pizza
Quantity of -Pizzas Demanded Total -Revenue Marginal -Revenue
$13
0
0
$12
1
$12
$12
$11
2
$22
$10
$10
3
$30
$8
$9
4
$36
$6
$8
5
$40
$4
$7
6
$42
$2
If Stellio increases the price of his pizzas, then quantity demanded will decrease—the law of demand holds true just as
firmly in the monopoly market as it does in perfect competition.
Total revenue (TR) or total spending was introduced in Chapter 4, and defined as price times quantity demanded (P × q).
This definition also holds for the monopolist and we use it to complete the “total -revenue” column in the table.
THINK IT THROUGH: Table 7-1 has no column for average revenue, but do we need a separate column for average
revenue? Average revenue (AR) was defined in Chapter 5 as total revenue divided by quantity and, we saw at that time, it is
simply another name for price. When price is $9, total revenue is $36, quantity is 4, and average revenue is $9 (the same as
price).
Marginal revenue (MR) was defined in Chapter 5 as how much total revenue changes as an extra unit is sold.
MR = DTR/ Dq
Again, we can apply that definition to determine the extra revenue brought in from each additional pizza sold. If Stellio
charges $11 per pizza, then his total revenue is $22. If he cuts his price to $10, then he sells another pizza and his total revenue
increases to $30.
MR = DTR/Dq = +$8/+1 = $8
We can complete the “marginal revenue” column in Table 7-1.
THINK IT THROUGH: Note that marginal revenue is positive decreasing as additional pizzas are sold. Can marginal
revenue fall so low that it becomes zero, or even negative? Yes, marginal revenue can become zero or negative. This is related
to the Total Revenue Test of elasticity in Chapter 4. When price decreases, we know that quantity demanded increases—in
terms of the marginal revenue formula, Dq is positive. However, the effect on the numerator of the formula (DTR) depends on
elasticity. If demand is elastic, then a price decrease will cause total revenue to increase (DTR is positive), and marginal
revenue will be a positive value. If, however, demand is inelastic, then a price decrease will cause total revenue to decrease (D
TR is negative), and marginal revenue will be a negative value. Finally, if demand is unit-elastic, then a price decrease will
have no effect on total revenue (DTR is zero), and marginal revenue will be zero.
When we looked at the perfectly competitive firm, we derived its “revenue picture” and found that it was a single
horizontal line. The monopolist’s revenue picture is a bit more complicated. Stellio’s revenue picture is shown in Figure 7-2.
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Figure 7-2. The monopolist’s revenue picture.
The revenue picture for a monopolist features a downward-sloping industry demand curve—which also represents price
(P), average revenue (AR), and marginal benefit (MB)—and a downward-sloping marginal revenue (MR) curve.
THINK IT THROUGH: The relationship between these two curves harks back to the “average-marginal rule” that we
developed in Chapter 5. First, we know that marginal revenue must lie below average revenue. Why? Because average
revenue is decreasing. We also know that the two curves must start at the same point—for the first observation, the average
and marginal values are equal. We saw this same phenomenon when we looked at the relationship between average product
and marginal product and, again, when we looked at the relationship between average variable cost and marginal cost. If
you’re unsure about the previous statements, go back now and revisit the average-marginal rule.
Comment for the mathematically minded reader: The MR curve is twice as steep as the AR curve.
The Monopolist’s Short-Run Cost Picture
Just as we have developed a revenue picture for the firm, so we can derive its short-run cost picture. In fact, there is no new
work to be done here because the cost picture for the monopolist is identical to that of the perfectly competitive firm. Why?
Because the monopolist is just as closely governed by the law of diminishing marginal productivity and the interplay of the
specialization effect and the congestion effect as the perfectly competitive firm. To be sure, the number of units the
monopolist produces may be much larger than that for the perfectly competitive firm, but the principles and the relationship
developed in Chapter 5 are the same—nothing new to learn.
Table 7-2 shows Stellio’s short-run costs.
Table 7-2. Short-Run Cost Information for Stellio’s Pizzeria
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Quantity of Pizzas Produced
Total Cost
Marginal Cost
0
$9
1
$11
$2
2
$14
$3
3
$18
$4
4
$24
$6
5
$32
$8
6
$43
$11
In the short run, the firm has some fixed resource and, therefore, some fixed costs that it incurs even when output is
zero—Stellio’s total fixed cost (TFC) is $9. Total variable cost (TVC) is zero when no pizzas are produced, but will increase,
as will total cost (TC), as pizza production is stepped up, as shown in the table—for instance, when 4 pizzas are produced,
total cost is $24, total fixed cost is (still) $9, and total variable cost is $15.
THINK IT THROUGH: What might these fixed resources be? What are Stellio’s variable resources?
We are familiar with marginal cost (MC) from Chapter 5. Marginal cost is defined as
MC = DTC/Dq
For instance, as output expands from 4 pizzas to 5 pizzas, total cost increases from $24 to $32, and the marginal cost of the
fifth pizza is $8.
The firm’s short-run cost picture shown in Figure 7-3, and the production and cost relationships it represents, is
indistinguishable from the one derived for perfect competition, that is, Figure 5-11.
Figure 7-3. The monopolist’s short-run cost picture.
Profit Maximization
The monopolist follows the same principles as the perfectly competitive firm when seeking to maximize his profit. As we saw
in Figure 5-15 of Chapter 5, there are three possible relationships between price (average revenue) and average total cost
(ATC)—the demand curve can intersect, be tangent to, or entirely miss the ATC curve. These relationships are shown in
Figure 7-4.
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Figure 7-4. Relationships between price and average total cost.
In Case 1, the firm can earn a positive economic profit because, at least at some output levels, its average revenue exceeds
its average cost. In Case 2 (the break-even case), the best the firm can manage is zero economic profit—a normal profit is
earned. In Cases 3 and 4, the firm will earn a negative economic profit and must decide whether to produce (Case 3) or shut
down (Case 4).
We look at each of these cases in turn but the important point to keep in mind is that, although the diagrams may appear
more complex, the principles involved for the monopolist are exactly the same as those we developed in Chapter 5 for the
perfectly competitive firm.
Comment: Before proceeding, you may wish to review the sections in Chapter 5 on the “Four Short-run Cases” and the
“General Procedure for Short-Run Profit Maximization,” both of which are highly pertinent here.
Case 1: Positive Economic Profit
When the product’s price exceeds average total cost, the firm can earn a positive economic profit. To maximize profit, the
firm should produce at the output level (q*) where MR = MC. At this output level, the difference between price and average
total cost (P – ATC) represents the economic profit per unit. Multiplying by the number of units gives us the total economic
profit.
Table 7-3 provides information for Stellio’s Pizzeria.
Table 7-3. Stellio’s Pizzeria and Profit Maximization
Quantity of Pizzas
Price
Total Revenue
Total Cost
0
$13
$0
$9
1
$12
$12
$11
2
$11
$22
3
$10
4
Marginal Revenue
Marginal Cost
Economic Profit
0
–$9
$12
$2
$1
$14
$10
$3
$8
$30
$18
$8
$4
$12
$9
$36
$24
$6
$6
$12
5
$8
$40
$32
$4
$8
$8
6
$7
$42
$43
$2
$11
–$1
Comparing the marginal revenue and marginal cost columns, marginal revenue equals marginal cost when 4 pizzas are
produced each hour. Accordingly, Stellio should set his price to $9 per pizza to attract the profit-maximizing number of
orders. Comparing total revenue ($36) and total cost ($24), we see that his total economic profit is $12 per hour.
We could arrive at the same result using the following alternative method:
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Total economic profit = (P ATC)q*
= ($9.00 $6.00) 4
= $12.00
We can depict the same conclusion with Figure 7-5.
Figure 7-5. Case 1: positive economic profit.
If, as is the case in this example, the demand curve intersects the average total cost curve, then a positive economic profit
can be earned. To interpret the diagram, recall that the firm’s first interest is to determine this profit-maximizing output level
(q*). This occurs where marginal revenue and marginal cost are equal (at 4 pizzas). The price associated with this output level
is determined by the demand curve. Total economic profit is represented by the shaded area in Figure 7-5.
Comment: Many students find it tempting to go to the vertical axis directly from the intersection between marginal revenue
and marginal cost. This is wrong, but understandable. In perfect competition, marginal revenue and price were the same value
but, in monopoly, a bit more caution is called for.
The remaining three short-run cases are presented briefly—the principles involved are no different from those developed in
Chapter 5 for the perfectly competitive firm.
Case 2: Zero Economic Profit—The Break-Even Case
If the demand curve touches the ATC curve at only one point, then this output level must be the profit-maximizing output
level (q*)—at every other level of output, an economic loss must be incurred because price (average revenue) is less than
average total cost. Accordingly, q* must be the output level at which marginal revenue and marginal cost are equal. The
profit-maximizing price is P*. See Figure 7-6.
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Figure 7-6. Case 2: zero economic profit.
Comment: In all other cases, the downward-sloping marginal revenue curve can be drawn in the short-run monopoly
diagram without much caution—as long as the MR curve is drawn below the demand curve then a reasonable diagram should
ensue. However, in this case, care must be taken to ensure that the diagram is consistent. The intersection of the MR curve and
the MC curve determines the profit-maximizing output level (q*) and this output level must be the one at which the demand
curve is tangent to the ATC curve. If the diagram is drawn otherwise, then it is inconsistent—you can’t have two “best” output
levels!
As we saw in perfect competition, the firm earning zero -economic profit will continue to produce—the entrepreneur is
earning a -normal profit (a reasonable rate of return equivalent to his opportunity costs).
Case 3: Negative Economic Profit but Continuing to Produce
When the demand curve lies below the ATC curve at every output level, then the firm must earn a negative economic profit.
As with the perfect competitor, the monopolist must decide whether or not to produce. Fortunately, the rule we created when
looking at perfect competition is equally applicable for a monopolist—if, at the profit-maximizing (that is, loss-minimizing)
output level, the firm’s price equals or exceeds its average variable cost, then it should produce, but, if its price is less than its
average variable cost, then it should shut down. Figure 7-7 depicts the former case while Figure 7-8 depicts the latter.
Figure 7-7. Case 3: negative economic profit but continuing to produce.
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Figure 7-8. Case 4: negative economic profit—the shut-down case.
If this firm should produce at all, then it should produce at q*, where MR = MC. This requires q* to be 100 units of output.
At this output, the demand curve dictates a price of $10, but average total cost is greater—say, $12. The firm will suffer a total
economic loss of $200.
Total economic profit = (P ATC)q*
= ($10.00 $12.00) 100
= $200.00
Total economic profit (a loss in this case) is represented by the shaded area in Figure 7-7.
Can this firm do better by shutting down? If it does shut down, then its total revenue will be zero and its total cost will be
limited to its total fixed cost as the firm can divest itself of its variable resources. Its total economic loss, therefore, will equal
its total fixed cost. We can determine the firm’s total fixed cost—it is $500.
At q*, ATC is $12. We can see that AVC is $7, meaning that AFC must be $5. Total fixed costs (AFC × q) must therefore
be $500.
By producing, the firm loses $200; by not producing, it loses more—it’s better for the firm to suffer the smaller loss and
continue to operate.
THINK IT THROUGH: As long as AVC is less than price, then it must be true that the total fixed cost will exceed total
economic loss and, therefore, the better option is to stay in business instead of shutting down.
Case 4: Negative Economic Profit—The Shut-Down Case
When the firm’s price is so low that it can find no level of production at which it can cover its variable costs, then the firm’s
best interests are served by shutting down. We can see this in the following example, as shown in Figure 7-8.
In this case, the profit-maximizing output level (if the firm opts to produce) is 80 units. This is where MR = MC. On the
basis of the demand curve, the price is $6 but the average total cost is $13. If it goes ahead, then the firm will lose $7 on each
unit produced, or $560.
If however, the firm shuts down, then its total revenue will be zero and its total cost will be limited to its total fixed cost.
Total fixed cost is average fixed cost times the number of units and is constant at all output levels. At 80 units of output,
because ATC is $13 and AVC is $8, then AFC must be $5. Total fixed cost must be $400. If the firm shuts down then its loss
will be lower than if it produces.
As we saw with perfect competition, the distinction between Case 3 and Case 4 lies in the relationship between price and
average variable cost. At any price equal to or above the minimum value for average variable cost, production should proceed
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because the producer can fully pay the variable resources and may have additional revenues that can defray some of the fixed
expenses. If, however, the product’s price is less than average variable cost, the firm should cease operations. There is no
point hiring resources that can’t pay their way.
Profit-Maximizing for the Monopolist
What this sequence of examples has shown is that the short-run profit-maximizing technique for the monopolist is
indistinguishable from that of the perfectly competitive firm. Propelled by their own self-interest, they think, and act, alike.
The Monopolist’s (Missing) Short-Run Supply Curve
You may recall from Chapter 5 that, after considering the “four short-run cases,” we derived the perfectly competitive firm’s
short-run supply curve and may have an expectation that we will now do the same for the monopolist. However, it is not
possible for us to derive a unique “price–quantity supplied” relationship for the monopolist. Figure 7-9 shows the problem.
Figure 7-9. The non-unique “price–quantity” relationship.
A supply curve depicts a unique, one-to-one relationship between price and quantity supplied and, in perfect competition,
we found that that relationship was governed by marginal cost. No such unique -relationship can be derived for the monopolist
because demand-side conditions are unpredictable. Let us suppose that the monopolist’s demand curve is D 1. Its
profit-maximizing output level is q* (where MR1 = MC). -However, if the monopolist’s demand curve is D2 then its
profit-maximizing output level is still q* (where MR2 = MC). Two prices (P1 and P2) but one output level—there is no unique
monopoly supply curve.
Monopoly in the Long Run: Long-Run Equilibrium Outcomes in Artificial Monopoly
We are now ready to turn our attention to the behavior of the “artificial” monopoly in the long run and, more particularly, in
long-run equilibrium. In a natural monopoly, long-run average cost (LRAC) continues to decline because of substantial
economies of scale. This is not true for the artificial monopoly—the LRAC curve is U-shaped.
In Chapter 6, we saw that, in long-run equilibrium, the typical perfectly competitive firm will be driven, by the entry and
exit of rivals, to a situation where only a normal profit will be earned. However, in monopoly, there are no rivals and
economic profits can be preserved, even in long-run equilibrium.
There are two possible cases. The first, unlikely, but possible, case is that the firm will earn only a normal profit. This
outcome could occur, but it is important to realize that there is no mechanism in monopoly that would compel it to occur—it
just would be the accidental alignment of the demand-side and supply-side conditions. The second, and more likely, case is
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that the firm will earn economic profits.
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Case 1: Long-Run Equilibrium with Zero Economic Profits
We consider the less likely case first, as shown in Figure 7-10.
Figure 7-10. Long-run equilibrium with zero economic profits.
At first glance, this diagram looks similar to Figure 7-6 and, in one respect, they tell the same story, that the firm is earning
only normal -profits. Profit maximization occurs at the output level (q*) where the demand curve is tangent to the LRAC curve
(and where MR = MC). The firm will charge a price of P*. The important difference is that the current context is long run
whereas in Figure 7-6 the context was short run. There is nothing inherent in this market that will cause change—firms cannot
enter (and, given that only normal profits are being earned, none will wish to enter) and the firm will remain in business as it
is earning a reasonable rate of return.
Performance Criteria—A Review
In Chapter 6, we developed three performance criteria for a firm in long-run equilibrium—that the firm earn only a normal
profit; that the firm be productively efficient (producing at the output level where long-run average costs are minimized); and
that the firm be allocatively efficient (producing at the output level where price (marginal benefit) equals long-run marginal
cost). Perfect competition fulfilled these criteria well—but what about monopoly?
The Monopolist’s Performance
We can relate what we learned about economic performance in Chapter 6 to the situation as depicted in Figure 7-10. The
monopolist is earning only a normal profit (Criterion 1). However, the monopolist fails the other two tests—the firm is neither
productively efficient nor allocatively efficient. The firm is not productively efficient because, at its chosen output level (q*),
long-run average costs are still decreasing—it should expand its output. The firm is not allocatively efficient because, at q*,
the price that consumers are willing to pay exceeds the long-run marginal cost of production. Again, the firm should expand
output, in this instance, to qe.
Left to its own devices, however, the firm will not expand output—it has achieved its preferred output level at q* and
preferred price at P*. If the monopolist were to expand output to the allocatively efficient level, q e, then, to attract the
additional customers, the price of the product would have to decrease to Pe. We can conclude, then, that the profit-maximizing
monopolist’s self-interest leads him to restrict output to a level that is less than the socially optimal level ( qe), and sets a price
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to be higher than the socially optimal price (Pe). The monopolist imposes a deadweight welfare loss on society equal to the
“gap” between marginal benefit (MB) and marginal cost in the range of output denied society from q* to q e, as shown by the
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shaded area in Figure 7-10.
Case 2: Long-Run Equilibrium with Positive Economic Profits
The more likely situation is that the monopolist will earn positive -economic profits, and this case is shown inFigure 7-11.
Figure 7-11. Long-run equilibrium with positive economic profits.
The Monopolist’s Performance
The story is similar to the previous case. The monopolist will produce q*, where MR = MC, setting a price of P*. Because the
price exceeds long-run average cost, the monopolist is earning an economic profit—he fails Criterion 1. The monopolist also
fails the other criteria. The firm is not productively efficient (Criterion 2) because, at its chosen output level (q*), long-run
average costs are not minimized. The firm is not allocatively efficient (Criterion 3) because, at q*, marginal benefit exceeds
marginal cost—the firm should expand output to qe. Society incurs a deadweight welfare loss equal to the “gap” between
marginal benefit (MB) and marginal cost, as shown by the shaded area in Figure 7-11.
THINK IT THROUGH: In fact, the firm could be productively efficient, but it would be a fluke. If demand conditions were
such that the marginal revenue curve passed through the minimum point on the LRAC curve then the monopolist would
choose to produce at the productively efficient output level. Draw it and confirm this!
THINK IT THROUGH MORE: It is impossible for the monopolist to maximize profits and also achieve allocative
efficiency. Profit maximization requires that MR = MC. Allocative efficiency requires that MB = MC. To accomplish both
goals would require that MR = MB and, with a downward-sloping demand curve, we know that marginal revenue will be less
than marginal benefit.
The profit-maximizing monopolist generally fails on each of the three performance criteria. In contrast, perfectly
competitive industries perform well. The monopolist overprices and underproduces, denies consumers the socially optimal
output level, squanders resources, and, in the case of the firm earning economic profits, forces a redistribution of spending
power away from the customers and to the owners of the monopoly. This unflattering scorecard has been the theoretical
justification for over a century of antitrust legislation and regulation of monopoly.
The Case of an Industry where there are no Economies of Scale
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In Chapter 6 we determined that the U-shape of the LRAC curve was due to the presence of economies and diseconomies of
scale. Are our conclusions regarding the relative merits of perfect competition and monopoly affected by the presence or
absence of such factors?
Consider Figure 7-12, in which the LRAC curve is horizontal, implying that there are no economies or diseconomies of
scale.
Figure 7-12. Graphical comparison of perfect competition and monopoly.
Initially, let us suppose that we have an industry composed of many perfectly competitive firms. Given that the LRAC
curve is horizontal, the average-marginal rule should convince us that the single line also represents long-run marginal cost
(LRMC). We have established that, under perfect competition, the industry will expand production until price (or marginal
benefit) equals marginal cost. Long-run output is at Qc* and the market price is Pc*. The consumer surplus is Pc*AB—the area
between the marginal benefit curve and the marginal cost curve.
THINK IT THROUGH: Verify that, at Qc*, the perfectly competitive industry is meeting each of the three performance
criteria.
What will be the effects if the firms are consolidated into one monopoly organization? First, because the firm is now a price
maker, we must consider the marginal revenue curve. The profit-maximizing monopolist will set price at P m* and output at Qm
*.
A comment on notation: Throughout this chapter, we have viewed the monopoly as a firm and used lower-case letters in
diagrams (e.g., q*) to be consistent with previous chapters. In this example, because we’re making an industry comparison,
upper-case letters are being used.
The presence of the monopoly has increased price and decreased output. Productive and allocative efficiency have suffered.
The consumer surplus that was being received under perfect competition has shrunk to Pm*AC—consumers have lost ground.
Part of the original consumer surplus has been appropriated by the monopolist as economic profits. Recalling that P c*
represents the firm’s average cost and Pm represents its price, the monopoly is earning an economic profit shown by the area Pc
* Pm*CE—income distribution has shifted in favor of the owners of the monopoly. The remaining portion of P c*AB—the
triangle CEB—represents the deadweight welfare loss caused to society by the presence of the monopolist.
Because of the deleterious effects of monopolies (and other forms of imperfect competition), the government may choose to
intervene to improve the allocation of society’s resources. There are two apparently conflicting government positions—first,
promotion of competition and restriction of market power through trust-busting legislation and, second, restriction of
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competition by regulation of industries. Antitrust actions are meant to promote competition; regulation intends to restrict
competition. Both policies are intended to promote allocative efficiency.
Antitrust actions prevent monopolies from forming or, if they have formed, break them up or inject additional competitive
elements into the market. In banking, for instance, economies of scale favor larger banks and, therefore, regulations have been
established to enhance the viability of smaller banks. A similar statement could be made about family farms. The Antitrust
Division of the Department of Justice enforces antitrust laws and must approve mergers between firms and it may refuse if the
merger is felt not to be in the public interest. The Federal Trade Commission was also created to investigate unfair
competition. The courts can impose civil and criminal penalties and can specifically forbid illegal actions in the future.
The Sherman Act of 1890 made monopoly and trade restraints illegal. Subsequent legislation has made it clear that the key
issue is not whether a firm is a monopoly but whether its actions to establish and secure its position represent “unreasonable
conduct.”
Think about an opposite case: Currently, there are 18 alcoholic beverage control (ABC) states. Although the particular
controls vary from state to state, the common feature is that the sale of liquor is regulated by a monopoly organization run by
the state government. We can predict the effect of such a monopoly presence in the market—the price of alcohol will be
higher and sales will be lower. Indeed, ABC regulations were frequently promoted by temperance organizations that wished
for precisely such an outcome!
Price Discrimination
So far, we have assumed that the firm charges all customers the same price but the monopolist may be able to practice price
discrimination, where the same product is sold at different prices to different consumers. For price discrimination to be
effective, the firm must be able to identify who will be willing to pay the higher price and must be able to prevent resale.
THINK IT THROUGH: Price discrimination surrounds us, although usually it’s expressed as special discounted prices for
select customers, not -special high prices for some customers. Senior citizen or student discounts, frequent flier bonuses, and
differential rates for children in movies or restaurants are all examples, as are quantity discounts such as “buy one, get one
free.” The friendly car saleswoman is intently trying to assess her customer’s willingness to pay for the new car he’s interested
in buying. In recent years, soft drinks machines have adjusted prices according to the temperature—higher temperature, higher
price. Airlines offering the same seat to different customers, or hotels offering the same room to different guests, but charging
different prices are practicing price discrimination. A student receiving financial aid, or one who pays “in-state” tuition, is
deriving benefits from price discrimination whereas nonrecipients and out-of-state students are penalized.
Perfect price discrimination occurs when the firm is able to charge each customer the maximum amount that that
customer is willing to pay. The price charged equals the customer’s marginal benefit and the entire consumer surplus is
appropriated by the producer. In such a situation, the extra revenue derived from the sale of an additional unit of output is
equal to the price charged to the customer. In other words, marginal revenue and price are equal. Graphically, the firm’s
demand curve is also its marginal revenue curve.
Armed with this new information, let’s revisit Figure 7-12. If the firm is able to price discriminate perfectly, then the
original marginal revenue disappears and the demand curve represents marginal revenue. The profit-maximizing monopolist
will produce at the output level where marginal revenue equals marginal cost, namely Q c*, the allocatively efficient output
level. Price discrimination can correct a misallocation of resources.
THINK IT THROUGH: The entire area Pc*AB will be taken over as profits by the monopolist! Can you see why?
Natural Monopoly: Regulation of Monopoly
As we have seen, some monopolies are the natural product of market forces. Such “natural” monopolies are often due to the
existence of substantial economies of scale or extremely high set-up costs. The presence of network externalities is another
reason why a single firm might be the most desirable market structure. Network externalities arise when the value of a good or
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service to a customer increases as the number of users increase—having one firm such as eBay is more beneficial for
customers than spreading auctions over many small firms.
THINK IT THROUGH: It makes sense to have one social media provider—Facebook has thrived while MySpace has
withered. One service location adds value for the customer. Similarly, software and Internet services, including interactive
video games, are more valuable for all users the more subscribers are added into the system. My purchase of a cell phone
bestows benefits not only for me but also for those who wish to phone me.
THINK IT THROUGH: Before the events of 9/11, airport security was provided by privately contracted firms. Following
9/11, many of these firms were felt to be inadequate and the Transportation Security Administration (TSA) was set up. The
belief was that an integrated government monopoly would perform more effectively than a patchwork of private firms. One
option, then, is that the government can wholly take over and manage an industry, such as airport security or the post office,
but this course of action is infrequently pursued in the United States.
When a natural monopoly is present, we would wish to preserve the benefits bestowed by the monopoly, but to regulate it.
We can see the theory underlying regulation in Figure 7-13. Let us assume that the firm is an electric company—Sparx.
Figure 7-13. Natural monopoly and regulation.
The diagram signals that Sparx is a natural monopoly because the LRAC curve is continually downward-sloping. Left to
itself, the profit-maximizing firm will set price (P*) and output (q*) based on the intersection of marginal revenue and
marginal cost. The firm is earning an economic profit and failing to produce electricity at the allocatively -efficient output level
(qe) where marginal benefit equals marginal cost. The deadweight welfare loss created by the monopolist is the area CEB.
Society, through government action, has a range of options. It can let things be and accept the situation; it can break up the
monopoly (losing all of the cost-saving advantages of economies of scale) and allow the entry of several small competitors
(“baby” Sparxs); or it can regulate the existing monopoly. If it chooses regulation, society still must make choices. Ought it
require the firm to generate electricity at the allocatively efficient output level or, if not at that level, where?
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Socially Optimal Output Level (P = LRMC)
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One option is that the monopolist is regulated in order to achieve the socially optimal output level (q e). To do this, the firm
would be required to produce level qe units of output, where marginal benefit equals marginal cost. However, in order to drum
up sufficient demand to absorb this amount of production, the firm’s price would have to be reduced to Pe.
This strategy poses a problem—at Pe, the price is lower than average cost and the firm will earn a negative economic profit.
The owners of this firm will not tolerate this—remember that this is a long-run situation—and will quit the industry in search
of a fair return on their investment elsewhere. Society, then, will have no electricity!
Sparx’s loss per unit of electricity generated is equal to the vertical gap between Pe and LRAC at qe. Society could “fill the
gap” by offering the company a subsidy that fully compensates for the loss. Economically, this might be feasible, but,
politically, may be imprudent.
THINK IT THROUGH: Sparx, a long-term monopoly that has been extracting economic profits from its customers for years
by withholding output and charging high prices is now seen by tax-paying voters to be receiving subsidies, financed by tax
hikes. The higher taxes may be borne by those same long-suffering customers or, if not, there is an income redistribution away
from taxpayers and to the monopoly’s customers. Either way, despite lower prices and improved service, there is a political
risk that voters will rebel. Some students may feel they see connections between this scenario and President Obama’s
managed health care system.
Fair Return Output Level (P = LRAC)
A compromise option that is frequently employed in regulation is to control the firm’s output and price in such a way that the
original deadweight welfare loss (CEB) is reduced, but not eradicated. “Fair return” (or average cost) pricing sets the firm’s
price so that the firm breaks even. If the price is set at Pf, where it equals average cost, then, on average, the firm will earn
zero economic profit. By earning a reasonable rate of return (a normal profit) for its owners, Sparx will continue to operate
without requiring a subsidy from taxpayers. Output will be higher than q* and price will be lower than P*.
Problems With Regulation
Controlling a natural monopoly presents particular problems. If a fair return is guaranteed, then there is little incentive to be
diligent in cutting costs, boosting productivity, or innovating. Cost-saving initiatives translate into lower future rates.
Reversing this point, regulated industries display the Averch–Johnson effect, which is the tendency for regulated firms to
accumulate an overabundance of capital. If the firm’s rate of return is based on the quantity of its capital, then there is an
incentive to increase investment. Although this may be rationalized as a desire to provide a high-quality service—in the case
of an electric firm, for example, fewer outages because of the additional generating capacity—the consequence is that the firm
is driven away from the socially optimal level. Efficiency is sacrificed to profit.
Regulatory capture suggests that, because of close association over time, the role of a regulatory agency may shift from
being a watchdog for the interests of customers to being a lapdog for the interests of the industry, with inefficient or
undesirable practices being supported or, at least, ignored.
THINK IT THROUGH: There are frequent claims of regulators being “in bed” with the executives of large firms—perhaps
the most notable recent example is the series of “lapses” in scrutiny that led to the meltdown on Wall Street in 2007–2008 and
the subsequent Great Recession. The Food and Drug Administration has been accused of promoting the interests of
agribusiness over that of consumer health, for example, in the continued use by milk producers of the growth hormone rBGH,
which has been linked to cancer and has been banned in the European Union, Canada, and Australia.
The Interstate Commerce Commission was accused by its critics of sympathetically setting railroad freight rates and
trucking rates at high levels and of acting to exclude competition through restrictive practices. The ICC was scrapped in
1995—subsequently, railroad freight rates and trucking rates have fallen by about 50 percent.
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Applications: Cable TV, NFL Logos, and Electricity Generation
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This section considers three examples of industries or firms whose practices have attracted the scrutiny of regulators.
Cable TV
It is frequently claimed that the cable TV industry is an example of a natural monopoly. With expensive cable to be laid, there
are high initial costs to set up the system but relatively low variable costs once the system is in operation. This implies that the
average cost decreases as the number of subscribers increases—a hallmark of a natural monopoly. Given that cable TV in a
local region is a natural monopoly, and during most of its history it has been treated as such, then why is it beneficial to
prevent competition in this case?
The argument goes that having more than one cable provider competing in a market would lead to wasteful duplication of
service, economies of scale would be reduced and average costs of production would increase.
Cable TV rates were deregulated in 1984 when price caps were removed. This policy change had several effects—prices
for cable TV subscribers increased but, because more channels and better quality programming was made available, the
number of subscribers increased. Cable was re-regulated in 1992, but only partially. Pricing on basic packages was controlled,
to ensure that viewers could afford television access, but premium channels were not subject to regulation. The result was
-predictable—cable companies provided mediocre “basic” packages and tried to tempt subscribers to the far more attractive
premium packages. Currently, only “basic tier” cable TV is regulated.
Cable TV has so far been successful in bundling channels together—to get a particular channel such as HBO the customer
must also subscribe to channels that they do not wish to have. The à la carte alternative, in which subscribers can pick and
pay for only those channels they wish to have, has been resisted as requiring very expensive technology.
Is Bundling Desirable? Bundling, the practice where the firm offers a take-it-or-leave-it choice of channels, is economically
sensible from the viewpoint of the provider—given that providing additional channels involves a low marginal cost.
Suppose Cabal Cable has two subscribers, Lionel and Nancy. Lionel values ESPN at $4.00 per month and MTV at $3.00
per month whereas Nancy values ESPN at $3.00 per month and MTV at $4.00 per month. With à la carte pricing, Cabal’s
revenues would be maximized if each channel cost $3.00 per month because each individual would buy ESPN and MTV,
spending $6.00 each. Cabal’s total revenue would be $12.00.
THINK IT THROUGH: If Cabal raised the price per channel to more than $3.00 per month, then Lionel would not wish to
subscribe to MTV and Nancy would not wish to subscribe to ESPN.
The two-channel bundle is worth $7.00 per month to Lionel and is worth $7.00 per month to Nancy. If Cabal offers the
bundle at $7.00 per month, then both viewers will subscribe, increasing Cabal’s revenue to $14.00. If the cost of adding a
subscriber to an established channel is zero (or negligible) then offering the bundle increases Cabal’s profitability.
Bundling may also benefit the subscriber. Instead of paying two charges to receive two desired but separate à la carte
channels, one lower fee may secure both desired channels. If Cabal offers its bundle at a rate of $6.50 per month, Lionel and
Nancy will each receive a consumer surplus of 50 cents per month.
NFL and Apparel Logos
In 2010, there was an antitrust case concerning the NFL’s practice of having an exclusive licensing agreement and negotiating
as a single unit with apparel companies that wished to market NFL team logos. The NFL’s position was that significant
competition existed between NFL teams and also that there was significant competition between the NFL and other forms of
entertainment. The court rejected this argument, however, finding that team logos were not good substitutes for one another
(would a Giants fan really wish to buy a Carolina Panthers t-shirt?) and that the NFL’s exclusive licensing agreement, in
which teams operated collectively, violated antitrust rules because the collective action had the consequence of driving up
licensing revenues.
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Electricity Generation and Deregulation
Enthusiasm for regulation swings like a pendulum. Following the financial missteps revealed by the meltdown on Wall Street
in 2008 and the bursting of the housing bubble, calls for more stringent regulation have increased in volume. In earlier
decades, deregulation was more favored. Deregulation in the airline industry reduced fares by about one-third, and telephone
service became cheaper.
Deregulation can go seriously wrong, however, as the following case demonstrates and, when it does, it can swing the
pendulum in the opposite direction. In 1998, California deregulated its wholesale electricity prices and prices began to rise.
This was due to an extraordinary and unforeseeable alignment of supply and demand factors—aging generating capacity, and
declines in water to power hydroelectric plants on the supply side, and an economic boom, rising population, and hot summer
weather boosting demand.
Electricity generating firms were quick to realize that, if supply were curtailed, then the price of electricity would rise
sharply, given an inelastic demand. Demand for electricity is inelastic because there are few substitutes and it is highly costly
to store for later use.
THINK IT THROUGH: In Chapter 4, we discussed the Total Revenue Test as a method of determining whether the demand
for a product was inelastic or not. We concluded that, if demand were inelastic, then an increase in price would cause total
revenue to increase. Clearly, the electricity producers had some economics majors on their payroll because they realized that,
by cutting supply, the price of their product would increase and their total revenue would also increase.
In order to reduce supply and drive up prices and revenue, many plants were closed down for “maintenance” during periods
of peak demand, widespread blackouts occurred and wholesale electricity prices increased, sometimes by tenfold. California’s
governor initiated a state of emergency that lasted for more than two years.
Unfortunately, the transmission and distribution of electricity for retail customers had not been deregulated so companies
such as Pacific Gas and Electric were being forced to buy electricity at high unregulated prices and sell to customers at low
regulated prices. Pacific Gas and Electric filed for bankruptcy in 2001. It was only with the bankruptcy of Enron, an
energy-trader and major player in the manipulation of the wholesale electricity market, that the situation began to stabilize.
Because of California’s experience, several states have reversed their moves toward electricity deregulation, while
California now requires electricity distributors to acquire their own generating capacity, in order to prevent reliance on
independent electricity-generating firms.
Review: In general, monopoly misallocates society’s scarce resources but this need not always be true—perfect price
discrimination may result in an allocatively efficient result, and natural monopoly’s cost-saving -economies may trump perfect
competition. Further, in the case of a regulated monopoly, the cure may be almost as injurious to efficiency as the cause.
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Rubric Name: MBA/MSHRM/MSL Discussion Grading Rubric - Timeliness v1
Criteria
Level 4 - Excellent
Level 2 Developing
Level 1 Emerging
3 points
2 points
1 point
Initial posting
demonstrates
some reflection
and answers
some aspects of
the threaded
discussion
question;
Limited
development of
concepts is
evident.
4 points
Initial posting
was not on topic;
the response was
unrelated to
threaded
discussion
question; and
post
demonstrated
only superficial
thought and poor
preparation.
6 points
Initial posting
demonstrates
legitimate
reflection and
answers most
aspects of the
threaded
discussion
question; full
development of
concepts is not
evidenced.
5 points
Responded to the
required number of
students and to the
professor, if
appropriate, for
every discussion.
Demonstrated
analysis of others’
posts; extends
Responded to
almost all of the
required students
and to the
professor, if
appropriate, for
every
discussion.
Provided
Responded to
some students
and to the
professor, if
appropriate, for
every discussion.
Little depth in
response; agreed
or acknowledged
3 points
4 points
Initial posting
reveals a clear
understanding of all
Quality of Initial Posting (first aspects of the
discussion only)
threaded discussion
question; uses factual
and relevant
information;
and demonstrates full
development of
concepts.
Quality of Responses to
Classmates
Level 3 Proficient
Did not respond
to any student or
the professor.
meaningful
discussions by
building on previous
peer posts and
offering alternative
perspectives.
3 points
4 points
3 points
Makes some
reference to
assigned
readings with
some citations or
cites
questionable
sources.
2 points
Demonstrates
mastery
conceptualizing the
problem; viewpoints
and assumptions of
experts are analyzed,
synthesized, and
evaluated; and
conclusions are
logically presented
Demonstrates
considerable
proficiency
conceptualizing
the problem;
viewpoints and
assumptions of
experts are
analyzed,
synthesized, and
Demonstrates
partial
proficiency
conceptualizing
the problem;
viewpoints and
assumptions of
experts are
analyzed,
synthesized, and
Refers to and
Reference to Supporting
properly cites either
Readings/Information Literacy
course and/or outside
readings in both
initial posting and
responses to peers.
Critical Thinking
comments and one other
new information classmate’s
to other posts;
initial posting.
not all responses
promote further
discussion of the
topic.
1 point
2 points
Refers to and
properly cites
course and/or
outside reading
in initial posting
only.
0 points
Makes no
reference to
assigned
readings without
citations or cites
questionable
sources.
1 point
Demonstrates
limited or poor
proficiency
conceptualizing
the problem;
viewpoints and
assumptions of
experts are
analyzed,
synthesized, and
with appropriate
rationale.
evaluated; and
conclusions are
presented with
necessary
rationale.
evaluated; and
conclusions are
somewhat
consistent with
the analysis and
findings.
1 point
evaluated; and
conclusions are
either absent or
poorly
conceived and
supported.
2 points
3 points
Timeliness
Overall Score
Initial post occurs in
a timely manner (1 –
3 days into module)
allowing ample time
for classmates to
respond and engage.
Level 4
18 or more
Initial post
Initial post
occurs
occurs later (4 – substantially late
5 days into
(6-7 days into
module)
module)
allowing limited allowing
time for
minimal to no
classmates to
time for
respond and
classmates to
engage.
respond and
engage.
Level 3
16 or more
Level 2
14 or more
0 points
Initial post
occurs after the
first week of the
module.
Level 1
0 or more
Purchase answer to see full
attachment