Monopoly CHAPTER. Goals. Outcomes

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1 CHAPTER 15 Monopoly Goals in this chapter you will Learn why some markets have only one seller Analyze how a monopoly determines the quantity to produce and the price to charge See how the monopoly s decisions affect economic well-being See why monopolies try to charge different prices to different customers Consider the various public policies aimed at solving the problem of monopoly Outcomes after accomplishing these goals, you should be able to List three reasons why a monopoly can remain the sole seller of a product in a market Use a monopolist s cost curves and the demand curve it faces to show the profit earned by a monopolist Show the deadweight loss from a monopolist s production decision Demonstrate the surprising result that price discrimination by a monopolist can raise economic welfare above that generated by standard monopoly pricing Show why forcing a natural monopoly to charge its marginal cost of production creates losses for the monopolist 147

2 148 Chapter 15 Monopoly Strive for a Five The material covered in Chapter 15 has been tested quite heavily in recent years on the free response portion of the AP microeconomics exam. You should be prepared to create a cost curve model for a monopoly. Specific issues to understand include: Monopoly market power Monopoly profit maximization Inefficiency of monopolies discrimination Natural monopolies Key Terms Monopoly A firm that is the sole seller of a product without close substitutes Natural monopoly A monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms discrimination The business practice of selling the same good at different prices to different customers Arbitrage The process of buying a good in one market at a low price and selling it in another market at a higher price Perfect price discrimination A situation in which the monopolist is able to charge each customer precisely his or her willingness to pay Chapter Overview Context and Purpose Chapter 15 is the third chapter in a five-chapter sequence dealing with firm behavior and the organization of industry. Chapter 13 developed the cost curves on which firm behavior is based. These cost curves were employed in Chapter 14 to show how a competitive firm responds to changes in market conditions. In Chapter 15, these cost curves are again employed, this time to show how a monopolistic firm chooses the quantity to produce and the price to charge. Chapters 16 and 17 will address the decisions made by monopolistically competitive and oligopolistic firms. A monopolist is the sole seller of a product without close substitutes. As such, it has market power because it can influence the price of its output. That is, a monopolist is a price maker as opposed to a price taker. The purpose of Chapter 15 is to examine the production and pricing decisions of monopolists, the social implications of their market power, and the ways in which governments might respond to the problems caused by monopolists. Chapter Review Introduction Monopolists have market power because they can influence the price of their output. That is, monopolists are price makers as opposed to price takers. While competitive firms choose to produce a quantity of output such that the given market price equals the marginal cost of production, monopolists charge prices that exceed marginal costs. In this chapter, we examine the production and pricing decisions of monopolists, the social implications of their market power, and the ways in which governments might respond to the problems caused by monopolists. Why Monopolies Arise A monopoly is a firm that is the sole seller of a product without close substitutes. A monopoly is able to remain the only seller in a market only if there are barriers to entry. That

3 Chapter 15 Monopoly 149 is, other firms are unable to enter the market and compete with it. There are three sources of barriers to entry: Monopoly resources: A key resource required for production is owned by a single firm. For example, if a firm owns the only well in town, it has a monopoly for the sale of water. DeBeers essentially has a monopoly in the market for diamonds because it controls 80 percent of the world s production of diamonds. This source of monopoly is somewhat rare. Government regulation: The government gives a single firm the exclusive right to produce some good. When the government grants patents (which last for twenty years) to inventors and copyrights to authors, it is giving some one the right to be the sole producer of that good. The benefit is that it increases incentives for creative activity. The costs will be discussed later in this chapter. The production process: The costs of production make a single producer more efficient than a large number of producers. A natural monopoly arises when a single firm can supply a good to an entire market at a smaller cost than could two or more firms. This happens when there are economies of scale over the relevant range of output. That is, the average-total-cost curve for an individual firm continually declines at least to the quantity that could supply the entire market. This cost advantage is a natural barrier to entry because firms with higher costs find it undesirable to enter the market. Common examples are utilities such as water and electricity distribution. How Monopolies Make Production and Pricing Decisions A competitive firm is small relative to the market, so it takes the price of the good it produces as given. Because it can sell as much as it chooses at the given market price, the competitive firm faces a demand curve that is perfectly elastic at the market price. A monopoly is the sole producer in its mar ket, so it faces the entire downward-sloping market demand curve. The monopolist can choose any price/quantity combination on the demand curve by choosing the quantity and seeing what price buyers will pay. As with competitive firms, monopolies choose a quantity of output that maximizes profit (total revenue minus total cost). Because the monopolist faces a downward-sloping demand curve, it must lower the price of the good if it wishes to sell a greater quantity. Therefore, when it sells an additional unit, the sale of the additional unit has two effects on total revenue (P Q): The output effect: Q is higher. The price effect: P is lower (on the marginal unit and on the units it was already selling). Because the monopolist must reduce the price on every unit it sells when it expands output by one unit, marginal revenue ( TR/ Q) for the monopolist declines as Q increases and marginal revenue is always less than the price of the good. As with a competitive firm, the monopolist maximizes profit at the level of output where marginal revenue (MR) equals marginal cost (MC). As Q increases, MR decreases and MC increases. Therefore, at low levels of output, MR > MC and an increase in Q increases profit. At high levels of output, MC > MR and a decrease in output increases profit. The monopolist, therefore, should produce up to the point where MR = MC. That is, the profit-maximizing level of output is determined by the intersec tion of the marginalrevenue and marginal-cost curves. Because the MR curve lies below the demand curve, the price the monopolist charges is found by reading up to the demand curve from the MR = MC intersection. That is, it charges the highest price consistent with that quantity. Recall that for the competitive firm, because the demand curve facing the firm is perfectly elastic so that P = MR, the profit-maximizing equilibrium requires that P = MR = MC. However, for the mo nopoly firm, MR < P, so the profit-maximizing equilibrium requires that P > MR = MC. As a result, in competitive markets, price equals marginal cost while in monopolized markets, price exceeds marginal cost. Evidence from the pharmaceutical drug market is consistent with our theory. While the patent is enforced, the price of a drug is high. When the patent expires and generic drugs become available, the price falls substantially.

4 150 Chapter 15 Monopoly As with the competitive firm, profit = (P ATC) Q, or profit equals the average profit per unit times the number of units sold. The Welfare Cost of Monopolies Does a monopoly market maximize economic well-being as measured by total surplus? Recall that total surplus is the sum of consumer surplus and producer surplus. Equilibrium of supply and de mand in a competitive market naturally maximizes total surplus because all units are produced where the value to buyers is greater than or equal to the cost of production to the sellers. For a monopolist to produce the socially efficient quantity (maximize total surplus by produc ing all units where the value to buyers exceeds or equals the cost of production), it would have to produce the level of output where the marginal-cost curve intersects the demand curve. However, the monopolist chooses to produce the level of output where the marginal-revenue curve intersects the marginal-cost curve. Because for the monopolist the marginal-revenue curve is always below the demand curve, the monopolist produces less than the socially efficient quantity of output. The small quantity produced by the monopolist allows the monopolist to charge a price that ex ceeds the marginal cost of production. Therefore, the monopolist generates a deadweight loss because, at the high monopoly price, consumers fail to buy units of output where the value to them exceeds the cost to the monopolist. The deadweight loss from a monopoly is similar to the deadweight loss from a tax, and the mo nopolist s profit is similar to tax revenue except that the revenue is received by a private firm. Because the profit earned by a monopolist is simply a transfer of consumer surplus to producer surplus, a monopoly s profit is not a social cost. The social cost of a monopoly is the deadweight loss generated when the monopolist produces a quantity of output below that which is efficient. Discrimination discrimination is the business practice of selling the same good at different prices to different customers. discrimination can only be practiced by a firm with market power such as a mo nopolist. There are three lessons to note about price discrimination: discrimination is a rational strategy for a profit-maximizing monopolist because a monop olist s profits are increased when it charges each customer a price closer to his individual willingness to pay. discrimination is only possible if the monopolist is able to separate customers according to their willingness to pay by age, income, location, etc. If there is arbitrage the process of buy ing a good in one market at a low price and selling it in another market at a higher price price discrimination is not possible. discrimination can raise economic welfare because output increases beyond that which would result under monopoly pricing. However, the additional surplus (reduced deadweight loss) is received by the producer, not the consumer. Perfect price discrimination occurs when a monopolist charges each customer her exact will ingness to pay. In this case, the efficient quantity is produced and consumed and there is no dead weight loss. However, total surplus goes to the monopolist in the form of profit. In reality, perfect price discrimination cannot be accomplished. Imperfect price discrimination may raise, lower, or leave unchanged total surplus in a market. Examples of price discrimination include movie tickets, airline tickets, discount coupons, financial aid for college tuition, quantity discounts, and tickets for Broadway shows. Public Policy Toward Monopolies Monopolies fail to allocate resources efficiently because they produce less than the socially optimal quantity of output and charge prices that exceed marginal cost. Policymakers can respond to the problem of monopoly in one of four ways: By trying to make monopolized industries more competitive. The Justice Department can employ antitrust laws (statutes aimed at reducing monopoly power) to prevent mergers that reduce competition, break up extremely large companies to increase competition, and prevent companies from colluding. However, some mergers result in

5 Chapter 15 Monopoly 151 Helpful Hints synergies that reduce costs and raise efficien cy. Therefore, it is difficult for government to know which mergers to block and which ones to allow. By regulating the behavior of the monopolies. The prices charged by natural monopolies such as utilities are often regulated by government. If a natural monopoly is required to set its price equal to its marginal cost, the efficient quantity will be consumed but the monopoly will lose money because marginal cost must be below average variable cost if average variable cost is declin ing. Thus, the monopolist will exit the industry. In response, regulators can subsidize a natural monopoly with tax revenue (which creates its own deadweight loss) or allow average-total-cost pricing, which is an improvement over monopoly pricing but it is not as efficient as marginal-cost pricing. Another problem with regulating prices is that monopolists have no incentive to reduce costs because their prices are reduced when their costs are reduced. By turning some private monopolies into public enterprises. Instead of regulating the prices charged by a natural monopoly, the government can run the monopoly itself. The Postal Service is an example. Economists generally prefer private ownership to government ownership because pri vate owners have a greater incentive to minimize costs. By doing nothing at all. Because each of the previously listed solutions has its own shortcomings, some econo mists urge that monopolies be left alone. They believe that the political failure in the real world is more costly than the market failure caused by monopoly pricing. Conclusion: The Prevalence of Monopolies In one sense, monopolies are common because most firms have some control over the prices they charge. On the other hand, firms with substantial monopoly power are rare. Monopoly power is a matter of degree. 1. A monopolist can choose the quantity and see what price buyers will pay or can choose the price and see what quantity buyers will purchase. That is, a monopolist is still subject to the demand curve for its product. The monopolist cannot choose both a high price and a large quantity if that combination does not lie on the demand curve facing the monopolist. 2. A monopolist is not guaranteed to earn profits. Any one of us can be the monopolist in the production of gold-plated textbook covers (because there is currently no producer of such a product), but the demand for such a product is likely to be too low to cover the costs of production. In like manner, gaining a patent on a product does not guarantee the holder of the patent future profits. Self-Test Multiple-Choice Questions 1. Which of the following statements is correct? a. A competitive firm and a monopolist are price takers. b. A competitive firm and a monopolist are price makers. c. A competitive firm is a price taker, whereas a monopolist is a price maker. d. A competitive firm is a price maker, whereas a monopolist is a price taker. e. A competitive firm is a price maker, whereas a monopolist is a price setter.

6 152 Chapter 15 Monopoly 2. Which of the following statements is (are) true of a monopoly? (i) A monopoly has the ability to set the price of its product at whatever level it desires. (ii) A monopoly s total revenue will always increase when it increases the price of its product. (iii) A monopoly can earn unlimited profits. a. (i) only b. (ii) only c. (iii) only d. (i) and (ii) only e. (ii) and (iii) only 3. The supply curve for the monopolist a. is horizontal. b. is vertical. c. is upward sloping. d. is downward sloping. e. does not exist. 4. A monopolist s average revenue is always a. equal to marginal revenue. b. greater than the price of its product. c. equal to the price of its product. d. less than the price of its product. e. less than marginal revenue. Figure 15-1 P MC A B C F G H ATC J K L MR 5. Refer to Figure What price will the monopolist charge? a. A b. B c. C d. F e. H 6. Refer to Figure What area measures the monopolist s profit? a. (B-F)*K b. (A-H)*J c. (B-G)*K d. 0.5[(B-F)*(L-K)] e. B*K

7 Chapter 15 Monopoly 153 Figure 15-2 Curve C Curve D P 5 P 3 P 4 P 2 P 1 P 0 Curve B Curve A Q 1 Q 3 Q 2 Q 4 7. Refer to Figure A profit-maximizing monopoly s total revenue is equal to a. P4 x Q3. b. P5 x Q1. c. P3 x Q4. d. (P4-P2) x Q3. e. P2 x Q3. 8. Refer to Figure A profit-maximizing monopoly s total cost is equal to a. P4 x Q3. b. P2 x Q3. c. P1 x Q3. d. (P4-P1) x Q3. e. P3 x Q4. 9. Refer to Figure A profit-maximizing monopoly s profit is equal to a. P4 x Q3. b. (P4-P2) x Q3. c. (P4-P1) x Q3. d. (P5-P0) x Q1. e. P2 x Q Refer to Figure Profit on a typical unit sold for a profit-maximizing monopoly would equal a. P5-P0. b. P4-P2. c. P4-P1. d. P4-P3. e. P4-P Refer to Figure At the profit-maximizing level of output, a. marginal revenue is equal to P3. b. marginal cost is equal to P3. c. average revenue is equal to P4. d. average total cost is equal to P0. e. price is equal to P3.

8 154 Chapter 15 Monopoly 12. The socially efficient level of production occurs where the marginal cost curve intersects a. average variable cost. b. average total cost. c. demand. d. marginal revenue. e. minimum average total cost. 13. The economic inefficiency of a monopolist can be measured by the a. number of consumers who are unable to purchase the product because of its high price. b. excess profit generated by monopoly firms. c. poor quality of service offered by monopoly firms. d. deadweight loss. e. difference between marginal cost and marginal revenue at the profit maximizing level of output. Figure MC A B C D J I H F MR Demand Refer to Figure Which area represents the deadweight loss from monopoly? a. J b. H c. H + I d. J + H e. F 15. discrimination requires the firm to a. separate customers according to their willingness to pay. b. differentiate between various units of its product. c. engage in arbitrage. d. use coupons. e. charge a higher price than break even. 16. For a typical natural monopoly, average total cost is a. falling, and marginal cost is above average total cost. b. falling, and marginal cost is below average total cost. c. rising, and marginal cost is below average total cost. d. rising, and marginal cost is above average total cost. e. constant, and marginal cost is equal to average total cost.

9 Chapter 15 Monopoly If the government regulates the price that a natural monopolist can charge to be equal to the firm s average total cost, the firm will a. earn zero economic profits. b. earn positive economic profits, causing other firms to enter the industry. c. earn negative economic profits, causing the firm to exit the industry. d. minimize costs in order to lower the price that it charges. e. not be able to continue to operate in the long run. Figure 15-4 Panel A D Panel B Panel C D Panel D D D 18. Refer to Figure Which of the following statements is correct? a. Panel C represents the typical demand curve for a perfectly competitive firm, and Panel B represents the typical demand curve for a monopoly. b. Panel B represents the typical demand curve for a perfectly competitive firm, and Panel C represents the typical demand curve for a monopoly. c. Panel A represents the typical demand curve for a perfectly competitive firm, and Panel B represents the typical demand curve for a monopoly. d. Panel C represents the typical demand curve for a perfectly competitive firm, and Panel D represents the typical demand curve for a monopoly. e. Panel A represents the typical demand curve for a monopoly, and Panel B represents the typical demand curve for a perfectly competitive firm. 19. The profit-maximization problem for a monopolist differs from that of a competitive firm in which of the following ways? a. A competitive firm maximizes profit at the point where marginal revenue equals marginal cost; a monopolist maximizes profit at the point where marginal revenue exceeds marginal cost. b. A competitive firm maximizes profit at the point where average revenue equals marginal cost; a monopolist maximizes profit at the point where average revenue exceeds marginal cost. c. For a competitive firm, marginal revenue at the profit-maximizing level of output is equal to marginal revenue at all other levels of output; for a monopolist, marginal revenue at the profit-maximizing level of output is smaller than it is for larger levels of output. d. For a profit-maximizing competitive firm, thinking at the margin is much more important than it is for a profit-maximizing monopolist. e. For a competitive firm, marginal revenue at the profit-maximizing level of output is equal to marginal cost, however for a monopolist, marginal revenue at the profit-maximizing level of output is larger than marginal cost. 20. When a monopolist increases the amount of output that it produces and sells, average revenue a. increases, and marginal revenue increases. b. increases, and marginal revenue decreases. c. decreases, and marginal revenue increases. d. decreases, and marginal revenue decreases. e. decreases, and marginal revenue remains constant.

10 156 Chapter 15 Monopoly Free Response Questions 1. Graphically depict the deadweight loss caused by a monopoly. How is this similar to the deadweight loss from taxation? 2. Explain how a profit-maximizing monopolist chooses its level of output and the price of its goods.

11 Chapter 15 Monopoly 157 Solutions Multiple-Choice Questions 1. c TOC: Monopoly 2. a TOC: Monopoly 3. e TOC: Monopoly 4. c TOC: Average revenue 5. b TOC: Monopoly 6. c TOC: Profit maximization 7. a TOC: Total revenue 8. c TOC: Total cost 9. c TOC: Profit 10. c TOC: Profit 11. c TOC: Average Revenue 12. c TOC: Welfare 13. d TOC: Deadweight loss 14. d TOC: Deadweight loss 15. a TOC: discrimination 16. b TOC: Natural monopoly 17. a TOC: regulation/natural monopoly 18. a TOC: Monopoly/Perfect competition 19. b TOC: Monopoly/Perfect competition 20. d TOC: Average revenue Free Response Questions 1. A profit-maximizing monopolist will choose to produce Q 0 units of output and sell at price P 0. However, marginal cost is MC 0. This is identical to the deadweight loss of taxation when the tax forces a wedge between market price and marginal cost. MC P 0 MC 0 MR Demand Q 0 TOP: Deadweight loss 2. A profit-maximizing monopolist produces the output level where marginal revenue equals marginal cost and charges the corresponding price from the market demand curve. Note that a monopolist charges a price that exceeds marginal cost, unlike a competitive firm, for which price equals marginal cost. TOP: Profit maximization

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