Chapter 12 Monopoly POWER AND FIRM PRICING DECISIONS

3 FIGURE 12.1 The Monopolist’s Demand and Marginal Revenue Curves The demand curve facing a monopolist slopes downward, for it is the same as market demand.. The answer can be found

Monopoly Power and Firm

Pricing Decisions

That competition is a virtue, at least as far as enterprises are concerned has been a basic article of faith in the American Tradition, and a vigorous antitrust policy has long been regarded as both beneficial and necessary, not only to extend competitive forces into new regions but also to preserve them where they may be flourishing at the moment

G Warren Nutter Henry Alder Einhorn

t the bottom of almost all arguments against the free market is a deep-seated

concern about the distorting (some would say corrupting) influence of

monopolies People who are suspicious of the free market fear that too many

producers are not controlled by the forces of competition, but instead hold considerable

monopoly power Unless government intervenes, these firms are likely to exploit their

power for their own selfish benefit This theme has been fundamental to the writings of

John Kenneth Galbraith

The initiative in deciding what is produced comes not from the sovereign consumer who, through the market, issues instructions that bend the productive mechanism to his

ultimate will Rather it comes from the great producing organization which reaches

forward to control the markets that it is presumed to serve and, beyond, to bend the

customers to its needs.1 Currently, the Department of Justice and nineteen state attorneys general are suing Microsoft because of the concern that one firm has too much “market

power.” Furthermore, the company, as a consequence, is harming consumers as well as its potential market rivals and may be doing other damage to the economy, for example,

impairing competition

This chapter is really a continuation of our earlier discussion of “market failures,”

for monopoly is often seen as one of the gravest of all forms of failure in markets

Accordingly, we will examine the dynamics of monopoly power and attempt to place

their consequences in proper perspective We will also consider the usefulness of

antitrust laws in controlling monopoly and promoting competition This chapter will

elucidate the government’s concerns with Microsoft’s market position It will also help

us understand Microsoft’s court defense In the next chapter, we will apply the model of monopoly developed here to two forms of partial monopoly, monopolistic competition

The Origins of Monopoly

We have defined the competitive market as the process by which market rivals, each pursuing its own private interests, strive to outdo one another This competitive market process has many benefits It enables producers to obtain information about what

consumers and other producers are willing to do It promotes higher production levels, lower prices, and a greater variety of goods and services than would be achieved

otherwise

Monopoly power is the conceptual opposite of competition Monopoly power is the ability of a firm to raise profitably the market price of its good or service by reducing production Whereas the demand curve of the competitive firm is horizontal (see the previous chapter), a firm with monopoly power faces a downward-sloping demand curve

By restricting production the monopoly can raise its market price To maximize its

profits (or minimize its losses), such a firm need only search through the various quantity combinations In very general terms, then, a firm with monopoly power is a price searcher It can control price because other firms are to some extent unable or unwilling to compete As a result, a monopolized market produces fewer benefits than perfect competition

price-Businesses vary considerably in the extent of their monopoly power The postal service and your local telephone company both have significant monopoly power They confront few competitors, and entry into their markets is barred by law IBM has far less monopoly power Although it can affect the price it charges for its computers by

expanding or contracting its sales, IBM is restrained by the possibility that other firms will enter its market On a smaller scale, grocery stores face the same threat They may have many competitors already, and they must be concerned about additional stores entering the market Nevertheless, grocery stores still retain some power to restrict sales and raise their prices

The exact opposite of perfect competition is pure monopoly Since, by definition, the pure monopolist is the only producer of a product that has no close substitutes, the demand it confronts is the market demand for the product Unlike the perfect competitor, who has no power over price, the pure monopolist can raise the price of its product without fear that customers will go elsewhere With no other producers offering the same product, or even a close substitute, the consumer has nowhere to turn As we will see, production levels are generally lower and prices higher under pure monopoly than under competition

How does monopoly arise? To answer that question clearly, we must reflect once again on the basis for competition Competition occurs because market rivals want to exploit profitable opportunities and can enter markets where such opportunities exist In the extreme case of perfect competition, there are no barriers to entry, and competitors are numerous Entrepreneurs are always on the lookout for any opportunity to enter such

a market in pursuit of profit Individual competitors cannot raise their price, for if they

do, their rivals may move in, cut prices, and take away all their customers If a wheat farmer asks more than the market price, for example, customers can move to others who will sell wheat at market price For this reason perfect competitors are called price

takers They have no real control over the price they charge

The essential condition for competition is freedom of market entry In perfect competition entry is assumed to be completely free Conversely, the essential condition for monopoly is the presence of barriers to entry Monopolists can manipulate price because such barriers protect them from being undercut by rivals

Barriers to entry can arise from several sources

• First, the monopolist may have sole ownership of a strategic resource, such as bauxite (from which aluminum is extracted)

• Second, the monopolist may have a patent or copyright on the product, which prevents other producers from duplicating it For years, Polaroid had a patent monopoly on the instant-photograph market (Eastman Kodak developed an alternative process, but was forced to withdraw its camera from the market when a Federal court ruled that it infringed on Polaroid’s patent.)

• Third, the monopolist may have an exclusive franchise to sell a given product

in a specific geographical area Consider the exclusive franchise enjoyed by your local telephone company, or was enjoyed, until very recently, your local electric utility

• Fourth, the monopolist may own the rights to a well-known brand name with a highly loyal group of customers In that case, the barrier to entry is the costly process of trying to get customers to try a new product

• Finally, in a monopolized industry, production may be conducted on a very large scale, requiring huge plants and large amounts of equipment The

enormous financial resources needed to produce on such a scale can act as a barrier to entry, because a new entrant operating on a small scale would have costs too high to compete effectively with the dominant firm

All in all, these external barriers to entry can be thought of as costs that must be borne by potential competitors before they can complete Such barriers may be “low,” which means that a sole producer’s monopoly power may be very limited, but such

barriers could, theoretically, be prohibitively high

The Limits of Monopoly Power

Unlike the competitive seller, the monopolist has the power to withhold supplies from the market and to charge more than the competitive market price Even the pure

monopolist’s market power is not completely unchecked, however It is restricted in two important ways First, without government assistance, the monopolist’s control over the market for a product is never complete Even if a producer has a true monopoly of a good, the consumer can still choose a substitute good whose production is not

monopolized For instance, in most parts of the nation, only one firm is permitted to provide local telephone service Yet people can communicate in other ways They can talk directly with one another; they can write letters or send telegrams; they can use their children as messengers In a more general sense, consumers can use their income to buy rugs or bicycles instead of private lines To the extent that the individual has alternatives,

his consumption of any good must be considered voluntary As the Nobel Laureate Friedrich Hayek has written,

If, for instance, I would very much like to be painted by a famous artist (one

who has monopoly power) and if he refuses to paint monopoly efficient for

less than a very high price, it would clearly be absurd for monopoly efficient

to say that I am coerced The same is true of any other commodity or service that I can do without So long as the services of a particular person are not

crucial to my existence or the preservation of what I most value, the

conditions he exacts for rendering these services cannot be called “coercion.”2This is not to say that the effects of monopoly are all positive If monopoly means that one firm is garnering the assets and markets of all other competitors, it can be viewed as a force that reduces consumer choice Although the monopolist’s coercive power may not

be complete, it nevertheless can restrict consumer freedom

Monopoly power can develop for other reasons A firm may gain monopoly power because it has built a better mousetrap or developed a good that was previously unavailable In other words, a firm may be the only producer because it is the first

producer, and no one has been able to figure out how to duplicate its product In this instance, although monopolized, a new product results in an expansion of consumer choice Furthermore, the monopoly may be only temporary, for other competitors are likely to break into the market eventually

The monopolist is also restricted by market conditions—that is, by the cost of production and the downward-sloping demand curve for the good If the monopolistic firm raises its price, it must be prepared to sell less How much less depends on what substitutes are available The monopolist must consider as well the costs of expanding production and of trying to prevent competitors from entering the market The important point here is that there is a range of possible costs and prices at which the monopolistic firm can sell various quantities of a good Its task is to search through the available price-quantity combinations for the one that maximizes profit

In a free and open market, monopoly power can be dissolved in the long run With time, competitors can discover weakly protected avenues through which to invade the monopolist’s domain The Reynolds International Pen Company had a patent

monopoly on the first ballpoint pen that it introduced in 1945 Two years later other pen companies had found ways of circumventing the patent and producing a similar but not identical product The price of ballpoint pens fell from an initial $12.50 to the low prices

of today Many other products that are freely produced today—calculators, video games, car telephones, and cellophane tape, to name a few—were first sold by companies that enjoyed short-run monopolies Thus the imperfection of monopoly power is crucial In the long run, excessively high prices, restricted supply, and high profits give potential competitors the incentive to find and exploit imperfections in the monopolist’s power Like the proverbial hole in the dike, those imperfections can undermine even the

One of the most effective ways for a monopoly to retain its market power is to enlist the coercive power of the state in protecting or extending it boundaries This

strategy has been used effectively for decades in the electric utilities industry and the cable television market The insurance industry and the medical profession, both of

which are protected from competition through licensing procedures, are also good

examples Even the power of the state may not be enough to shield an industry from competition forever Consumer tastes and the technology of production and delivery can change dramatically over the very long run The franchise-monopoly of electric power companies, for example, is slowly being weakened by the introduction of home solar power The railroad industry’s market, which was protected from price competition by the state for almost a century, has been gradually eroded by the emergence of new

competitors, principally airlines, buses, and trucks Even the first-class mail monopoly of the U.S Postal Service is being eroded by Federal Express and other overnight delivery firms In the long run, government protection may be extended to the very competitors who arise to break a state-protected monopoly (Such was the case, until recently, with the airline, bus, and tracking industries.)

Should government attempt to break up all monopolies? Since without state protection monopoly may eventually dissipate, the relevant public policy questions are how long the monopoly power is likely to persist if left alone, and how costly it will be while it lasts, in terms of lost efficiency and unequal distribution of income The

machinery of government needed to dissolve monopoly power is costly in itself Thus the decision whether to prosecute antitrust violations depends in part on the costs and benefits of such an action Often the rise of a monopoly does warrant government action, but in some cases the benefits of action cannot justify the costs As described in Chapter

3, the first seller of land calculators enjoyed a temporary monopoly of the U.S market in

1969 Subsequently the industry developed very rapidly, however, and in retrospect it is clear that a long, drawn-out antitrust action would have been inappropriate

To give another example, in 1969 the Justice Department found that IBM enjoyed

an unwarranted monopoly of the domestic computer market, which was dominated by large mainframe computers It concluded that an antitrust suit against IBM was justified Prosecution of the case, which the Justice Department dropped in January 1982, took more than a decade The accumulated documentation from the proceedings filled a warehouse, and the Justice Department and IBM devoted an untold number of lawyer-hours to the case In the meantime, IBM’s alleged monopoly was seriously eroded by new firms producing mini-and microcomputers, a trend that has continued (and

accelerated) since 1982 Thus the net benefits to society from the antitrust action against IBM are at best debatable, and probably negative That is, the costs most likely exceeded the benefits

Equating Marginal Cost with Marginal Revenue

In deciding how many times a week to play tennis, an athlete weights the estimated

benefits of each game against its costs Producers of goods follow a similar procedure, although the benefits of production are measured in terms of revenue acquired rather than personal utility A producer will produce another unit of a good if the additional (or

marginal) revenue it brings is greater than the additional cost of its production—in other words, if it increases the firm’s profits The firm will therefore expand production to the point where marginal cost equals marginal revenue (MC = MR) This is a fundamental rule that all profit-maximizing firms follow, and monopolies are no exception

Suppose you are in the yo-yo business You have a patent on edible yo-yos, which come in three flavors—vanilla, chocolate, and strawberry (We will assume there

is a demand for these products.) The cost of producing the first yo-yo is $0.50, but you can sell it for $0.75 Your profit on that unit is therefore $0.25 ($0.75 - $0.50) If the second unit costs you $0.60 to make (assuming increasing marginal cost) and you can sell

it for $0.75, your profit for two yo-yos is $0.40 ($0.25 profit on the first plus $0.15 profit

on the second) If you intend to maximize your profits, you—like the perfect

competitor—will continue to expand production until the gap between marginal revenue and marginal cost disappears As a monopolist, however, you will find that your

marginal revenue does not remain constant Instead, it falls over the range of production

The monopolist’s marginal revenue declines as output rises because the price must be reduced to entice consumers to buy more Consider the price schedule in Table 12.1 Price and quantity are inversely related, reflecting the assumption that a monopolist faces a downward-sloping demand curve (Because the monopolist is the only producer

of a product, its demand curve is the market demand curve.) As the price falls from $10

to $6 (column 2), the number sold rises from one to five (column 1) If the firm wishes

to sell only one yo-yo, it can charge as much as $10 Total revenue at that level of

production is then $10 To see more—say, two yo-yos—the monopolist must reduce the price for each to $9 Total revenue the rises to $18 (column 3)

By multiplying columns 1 and 2, we can fill in the rest of column 3 As the price

is lowered and the quantity sold rises, total revenue rises from $10 for one unit to $30 for five units With each unit increase in quantity sold, however, total revenue does not rise

by an equal amount Instead, it rises in declining amounts—first by $10, then $8, $6, $4, and $2 These amounts are the marginal revenue from the sale of each unit (column 4), which the monopolist must compare with the marginal cost of each unit

At an output level of one yo-yo, marginal revenue equals price, but at every other output level marginal revenue is less than price Because of the monopolist’s downward-sloping demand curve, the second yo-yo cannot be sold unless the price of both units 1 and 2 is reduced from $10 to $9 If we account for the $1 in revenue lost on the first yo-

yo in order to sell the second, the net revenue from the second yo-yo is $8 (the selling price of $9 minus the $1 lost on the first yo-yo) For the third yo-yo to be sold, the price

on the first two must be reduced by another dollar each The loss in revenue on them is therefore $2 And the marginal revenue for the third yo-yo is its $8 selling price less the

$2 loss on the first two units, or $6

Thus the monopolist’s marginal revenue curve (columns 1 and 4) is derived directly from the market demand curve (columns 1 and 2) Graphically, the marginal revenue curve lies below the demand curve, and its distance from the demand curve

increases as the price falls (see Figure 12.1, above).3 (More details on the derivation of the marginal revenue curve can be found in the appendix to this chapter.)

TABLE 12.1 The Monopolist’s Declining Marginal Revenue

Quantity Total Marginal

of Yo-yos Price Revenue Revenue

Sold of Yo-yos (col 1 x col 2) (change in col 3)

FIGURE 12.1 The Monopolist’s Demand

and Marginal Revenue Curves

The demand curve facing a monopolist

slopes downward, for it is the same as

market demand The monopolist’s marginal

revenue curve is constructed from the

information contained in the demand curve

(see Table 12.1)

Figure 12.2 adds the monopolist’s marginal cost curve to the demand and

marginal revenue curves from Figure 12.1 Because the profit-maximizing monopolist

will produce to the point where marginal cost equals marginal revenue, our yo-yo maker

will produce Q2 units At that quantity, the marginal cost and marginal revenue curves

intersect If the yo-yo maker produces fewer than Q2 yo-yos say Q1 profits are lost

3

Prove this to yourself by plotting the figures in columns 1 and 2 versus the figures in columns 1 and 4, on

a sheet of graph paper (Another simple way of drawing the marginal revenue curve is to extend the demand curve until it intersects both the vertical and horizontal axes Then draw the marginal revenue curve starting from the demand curve’s point of intersection with the vertical axis to a point midway between the original and the intersection of the demand curve with the horizontal axis This method can be used for any linear demand curve.)

unnecessarily The marginal revenue acquired from selling the last yo-yo up to Q1, MR1,

is greater than the marginal cost of producing it, MC1 Furthermore, for all units between

Q1 and Q2 , marginal revenue exceed marginal cost In other words, by expanding

production from Q1 to Q2 , the monopolist can add more to total revenue than to total

cost Up to an output level of Q2 , the firm’s profits will rise

Why does the monopolist produce no more than Q2 ? Because the marginal cost

of all additional units beyond Q2 is greater than the marginal revenue they bring Beyond

Q2 units, profits will fall If it produces Q3 yo-yos, for instance, the firm may still make a

profit, but not the greatest profit possible The marginal cost of the last yo-yo up to Q3

(MC2 ) is greater than the marginal revenue received from its sale (MR2) By producing

Q3 units, the monopolist adds more to cost than to revenues The result is lower profits

Once the monopolistic firm selects the output at which to produce, the market

price of the good is determined In this illustration, the price that can be charged for Q2

yo-yos is P1. (Remember, the demand curve indicates the price that can be charged for any quantity.) Of all the possible price-quantity combinations on the demand curve,

therefore, the monopolist will choose combination a

FIGURE 12.2 Equating Marginal Cost with

Marginal Revenue

The monopolist will move toward production

level Q2 , the level at which marginal cost equals

marginal revenue At production levels below

Q2, marginal revenue will exceed marginal cost;

the monopolist will miss the chance to increase

profits At production levels greater than Q2,

marginal cost will exceed marginal revenue; the

monopolist will lose money on the extra units

Short-Run Profits and Losses

How much profit will a monopolist make by producing where marginal cost equals

marginal revenue? The answer can be found by adding the average total cost curve developed in the last chapter to the monopolist’s demand and marginal revenue curves (see Figure 12.3) As we have seen, the monopolist will produce where the marginal cost

and revenue curves intersect, at Q1, and will charge what the market will bear for the

quantity, P1 We know also that profit equals total revenue minus total cost (Profit = TR – TC) Total revenue of P1 times Q1, or the rectangular area bounded by 0P1aQ1 Total

cost is the average total cost, ATC1, times quantity, Q1, or the rectangular area bounded by

0ATC1bQ1 Subtracting total cost from total revenue, we find that the monopolist’s profit

is equal to the shaded rectangular area ATC1P1ab (Mathematically, the expression profit

= P1Q1-ATC1Q1 can be converted to the simpler form, profit = Q1 (P1- ATC1 ).)

FIGURE 12.3 The Monopolist’s Profits

The profit-maximizing monopoly will produce at

the level defined by the intersection of the marginal

cost and marginal revenue curves: Q1 It will charge

a price of P1 as high as market demand will bear

for that quantity Since the average total cost of

producing Q1 units is ATC1 , the firm’s profit is the

shaded area ATC1P1ab

Like perfectly competitive firms, monopolies are not guaranteed a profit If market demand does not allow them to charge a price that covers the cost of production, they will lose money Figure 12.4 shows the situation of a monopoly that is losing

money Because losses are negative profits, the monopolist’s losses are obtained in the same way as profits, by subtracting total cost from total revenue The maximum price the monopolist can charge for its profit-maximizing (or in this case, loss-minimizing) output

level is P1, which yields total revenues of P1Q1 or 0P1bQ1 Total cost is higher: ATC1Q1,

or 0ATC1Q1 Thus the monopolist’s loss is equal to the shaded rectangular area bounded

by P1ATC1ab

_

FIGURE 12.4 The Monopolist’s Short-Run

Losses

Not all monopolists make a profit With a demand

curve that lies below its average total cost curve,

this monopoly will minimize its short-run losses by

continuing to produce where marginal cost equals

marginal revenue (Q1 units) It will charge P1 , a

price that covers its fixed costs, and will sustain

short -run losses equal to the shaded area

P1ATC1ab

Why does the monopolist not shut down? Because it follows the same rule as the perfect competitor Both will continue to produce as long as price exceeds average

variable cost that is, as long as production will help to defray fixed costs In Figure

12.4, average fixed cost is equal to the difference between average total cost, ATC1, and

average variable cost, AVC1–or the vertical distance ac Total fixed cost is therefore ac times Q1, or the area bounded by AVC1 ATC1ac Because the firm will suffer a greater

loss if it shuts down (AVC1 ATC1ac) than if it operates (P1.ATC1ab), it chooses to operate

and minimize its losses

Of course, in the long run, when the monopoly firm is able to extricate itself from its fixed costs, it will shut down

Production Over the Long Run

In the long run the monopolistic firm follows the same production rule as in the short run:

it equates marginal revenue with long-run marginal cost In Figure 12.5(a), for instance,

the firm produces quantity Q a , and sells it for price P a , (As always, profits are found by

comparing the price with the long-run average cost As an exercise, shade in the profit areas on the figure.) Unlike the perfect competitor, the monopoly firm does not attempt

to produce at the lowest point on the long-run average cost cure With no competition, the monopolistic firm has no need to minimize average total cost By restricting output,

it can charge a higher price and earn greater profits than it can by taking advantage of economies of scale

Monopolists sometimes do produce at the low point of the long-run average cost curve They do so only when the marginal revenue curve happens to intersect the long-run marginal and average cost curves at the exact same point [see Figure 12.5(b)] In

this case the monopolist produces quantity Q b , and sells it at a price of P b, earning

substantial monopoly profits in the process

If the demand is great enough, the monopolist will actually produce in the range

of diseconomies of scale [see Figure 12.5(c)] How can the monopolist continue to exist when its price and costs of production are so high? Because barriers to entry protect it from competition If barriers did not exist, other firms would certainly enter the market and force the monopolistic firm to lower its price The net effect of competition would

be to induce the monopolist to cut back on production, reducing average production costs

in the process

Monopolists cannot exist without barriers to market entry If other firms had access to the market, the monopolist’s profit would be its own undoing—for profit is what others want and will seek, if they can enter the market

The Comparative Inefficiency of Monopoly

The last chapter concluded that in a perfectly competitive market, firms tend to produce

at the intersection of the market supply and demand curves That point (b in Figure 12.6)

is the most efficient production level, in the sense that the marginal benefit to the

consumer of the last unit produced equals its marginal cost to the producer All units whose marginal benefits exceed their marginal costs are produced All possible net

benefits to the consumer have been extracted from production

FIGURE 12.5 Monopolistic Production Over the

Long Run

In the long run, the monopolist will produce at

the intersection of the marginal revenue and

long-run marginal cost curves (part (a)]

Unlike the perfect competitor, the monopolist

does not bother to minimize long-run average

cost by expanding its scale of operation It can

make more profit by restricting production to

Qb and charging price Pb In part (b), the

monopolist produces at the low p oint of the

long-run average cost curve only because that

happens to be the point where marginal cost and

marginal revenue curves intersect In part (c),

the monopolist produces on a scale beyond the

low point of its long-run average cost curve

because demand is high enough to justify the

cost In each case, the monopolist charges a

price higher than its long-run marginal cost

When the supply and demand model is applied to a monopolized market, the

industry supply curve becomes the monopolist’s marginal cost curve (for the monopolist must long-run the plants that in a competitive industry would belong to other producers).4Similarly, the industry’s demand curve becomes the monopolist’s demand Where as

individual competitors must produce at the intersection of supply and demand, the

monopolistic firm can choose the price-quantity combination it prefers By employing

fewer resources from production, it can sell a smaller quantity at a higher price That is just what happens In short, the monopolist produces less than the competitive level of

production Qm instead of Q c,

_

FIGURE 12.6 The Comparative Efficiency of

Monopoly and Competition

Firms in a competitive market will tend to

produce at point b, the intersection of marginal

cost and demand (marginal benefit)

Monopolists will tend to produce at point c, the

intersection of marginal cost and marginal

revenue, and to charge the highest price the

market will bear Pm In a competitive market,

therefore, the price will tend to be lower (P c) and

the quantity produced greater (Q c) than in a

monopolistic market The inefficiency of

monopoly is shown by the shaded triangular area

abc, the amount by which the benefits of

producing Qc – Qm units (shown by t he demand

curve) exceed their marginal cost of production

For each unit between Qm and Q c, the marginal benefits to the consumer, as

illustrated by the market demand curve, are greater than the marginal costs of production These are net benefits that consumers would like to have, but that are not delivered by the monopolistic firm interested in maximizing profits, not consumer welfare The resources that are not used for their manufacture must either remain idle or be used in a less

valuable line of production (Remember, the cost of doing anything is the value of the

next-best alternative forgone.) In this sense, economists say that resources are

misallocated by monopoly Too few resources are used in the monopolistic industry, and too many elsewhere

On balance, then, the inefficiency of monopoly is the benefits lost to consumers when production is restricted When compared to the outcome under perfect competition, monopoly price is too high and output too low In Figure 12.6, the gross benefit to

consumers of Qc – Q m units is equal to the area under the demand curve, or QmabQc The

cost of those additional units is equal under the marginal cost curve, or QmcbQc

Therefore the net benefit of the units not produced is equal to the shaded triangular area

abc This area represents the inefficiency of monopoly, sometimes called the

dead-weight welfare loss of monopoly To put it another way, area abc represents the gain in

4

The industry supply curve is not the monopolist’s supply curve, however, for a firm’s supply is its pric quantity relationship—and a monopolist’s price will always exceed its marginal cost

e-consumer welfare that could be achieved by dissolving the monopoly and expanding

production from Qm to Q C This area helps explain consumers prefer Q C and producers

prefer Qm Figure 12.7(a) shows the additional benefits consumers would receive from

Qc – Q m units, the area under the demand curve, Q m abQc The additional money

consumers must pay producers for Qc – Q m units, shown by the area under the marginal

revenue curve, is a much smaller amount: only Q m cdQc That is, the additional benefits

of Qc – Q m units, exceed the cost to consumers by the shaded area abcd Consumers

obviously gain from an increase in production

FIGURE 12.7 The Costs and Benefits of Expanded Production

If the monopolist expands production from Qm to Qc in part (a), consumers will receive additional benefits equal to the area bounded by QmabQc They will pay an amount equal to the area QmcdQc for those benefits,

leaving a net benefit equal to the vertically striped area abcd To expand production, the monopoly must incur additional production costs equal to the area QmcbQc in part (b) It gains additional revenues equal to the area

Q m cdQc, leaving a net loss equal to the shaded area cbd Thus expanded production helps the consumer but

hurts the monopolist

Yet for virtually the same reason, the monopolistic firm is not interested in

providing Qc – Q m units It must incur an additional cost equal to the area Q m cdQc (part

(b)] , while it can expect to receive only Q m cdQc in additional revenues The extra cost

incurred by expanding production from Qm to Q c exceeds the additional revenue acquired

by the horizontally stripped area cbd Thus an increase in production will reduce the

monopolistic firm’s profits (or increase its losses) Notice that consumers would gain

more from an increase in production than the monopolist would lose The shaded area in

part (a) is larger than the shaded area in part (b) The difference is the triangular area

abc

Price Discrimination

A grocery store may advertise that it will sell one can of beans for $0.30, but two cans for

$0.55 Is the store trying to give customers a break? Sometimes this kind of pricing may simply mean that the cost of producing additional cans decreases as more are sold At

other times it may indicate that customer’s demand curves for beans are downward

sloping and that the store can make more profits by offering customers a volume discount than by selling beans at a constant price In other words, the store may be exploiting its

limited monopoly power

Consider Figure 12.8 Suppose the demand curve represents your demand for

beans, and the supply curve represents the store’s marginal cost of producing and offering the beans for sale If the store charges the same price for each can of beans, it will have

to offer them at $0.25 each to induce you to buy two Its total revenues will be $0.50 As the graph shows, however, you are actually willing to pay more for the first can

$0.30—than for the second If the store offers one can for $0.30 and two cans for $0.55, you will still buy two cans, but its revenues from the sale will be $0.55 instead of $0.50.5 Similarly, to entice you to buy three cans, the store need only offer to sell one for $0.30, two for $0.55, and three for $0.75, and its profits will rise further.6 The deal does not

change the marginal cost of providing each can, which is below the selling price for the

first two units and equal to the selling price for the third The marginal cost of the first

can is $0.09; the second, $0.14; and the third, $0.20 The total cost of the three cans to the store is $0.43, regardless of how the cans are priced

_

FIGURE 12.8 Price Discrimination

By offering customers one can of beans for $0.30,

two cans for $0.55, and three cans for $0.75, a

grocery store collects more revenues than if it offers

three cans for $0.20 each In either case, the

consumer buys three cans But by making the

special offer, the store earns $0.15 more in revenues

A firm can discriminate in this way only as long as its customers do not

resell what they buy for a higher price—and as long as other firms are unable to

move into the market and challenge its monopoly power by lowering the price In

the case of canned beans, resale is not very practical The person who buys three

cans has little incentive to seek out someone who is willing to pay $0.25 instead

of $0.20 for one can The profit potential—five cents—is just not great enough to

bother with Suppose a car dealer has two identical automobiles carrying a book

price of $5,000 each, however If the dealer offers one car for $5,000 and two

cars for $9,000, many people would be willing to buy both cars and spend the

time needed to find a buyer for one of them at $4,500 The $500 gain they stand

to make would compensate them for their time and effort in searching out a

resale

Thus advertised price discrimination is much more frequently found in grocery

stores than in car dealerships Price discrimination is the practice of varying the price of

a given good or service according to how much is bought and who buys it, supposing that marginal costs do not differ across buyers Car dealers also discriminate with regard to price, however The salesperson who in casual conversation asks a customer’s age, income, place of work, and so forth is actually trying to figure out the customer’s demand curve, so as to get as high a price as possible Similarly, many doctors and lawyers

quietly adjust their fees to fit their clients’ incomes, using information they obtain from client questionnaires Whether price discrimination is unadvertised and based on income,

as in the case of doctors and car dealers, or advertised and based on volume sold, as in the case of utilities and long-distance phone companies, the important point is that the

products or services involved are typically difficult if not impossible to resell

Some monopolies’ products are not difficult to resell, and so they cannot engage

in price discrimination For example, copyright law gives the publishers of economics textbooks some monopoly power, but textbooks are easily resold, both through a network

of used-book dealers and among students Thus, although textbook publishers can alter their sales by changing the price, they rarely engage in price discrimination Nor do they encourage college bookstores to price-discriminate in their sales to students The

discounts publishers give bookstores on large sales reflect cost differences in handling large and small orders, not students’ or professors’ downward-sloping demand curves for books The same can be said about a host of other products protected by patents and copyrights

The monopolist whose production level was shown in Figure 12.6 could not discriminate among buyers or units bought by each buyer A monopolist who has such

power, however, can produce at a higher output level than Qm and earn greater profits Just how much greater depends on how free, or “perfect,” the monopolist’s power to discriminate is

Perfect Price Discrimination

The monopolist represented Figure 12.9 can charge a different price for each and every unit sold Theoretically, this firm has the power of perfect price discrimination

(“perfect” from the standpoint of the producer, not the consumer) Perfect price

discrimination is the practice of selling each unit of a given good or service for the

maximum possible price Under perfect price discrimination, the seller’s marginal

revenue curve is identical to the seller’s demand curve In Figure 12.10, for instance, the firm’s marginal revenue curve is not separate and distinct from its demand curve, as in Figure 12.7 Its demand curve is its marginal revenue curve If the first unit can be sold for a price of, say, $20, the marginal revenue from that unit is equal to the price, $20 If the next unit can be sold for $19.95, the marginal revenue from that unit is again the same

as the price; and so on In short, the seller extracts the entire consumer surplus

_

FIGURE 12.9 Perfect Price Discrimination

The perfect price-discriminating monopolist will

produce where marginal cost and marginal revenue

are equal (point a) Its output level, Qc is therefore

the same as that achieved under perfect competition

But because the monopolist charges as much as the

market will bear for each unit, its profits—the

shaded area ATC1P1ab—are higher than the

competitive firm’s

As in Figure 12.3, the perfectly price-discriminating monopolist equates marginal

revenue with marginal cost Equality occurs this time at point a, the intersection of the

demand curve (also the marginal revenue curve) with the marginal cost curve (see Figure 12.9) Thus the perfectly price-discriminating monopolist achieves the same output level

as does the perfectly competitive industry In this sense the perfect price discriminating firm is an efficient producer As before, profit is found by subtracting total cost from total revenue Total revenue here is the area under the demand curve up to the

monopolist’s output level, or the area bounded by 0P1aQc Total cost is the area bounded

by 0ATC1bQc (found, you may recall, by multiplying average total cost times quantity) Profit is therefore the shaded area above the average total cost line and below the demand

curve, bounded by ATC1P1ab

Through price discrimination the monopolist increases profits (compare Figure 12.3) Consumers also get more of what they want, although not necessarily at the price they want In the strict economic sense, perfect price discrimination increases the

efficiency of a monopolized industry Consumers would be still better off if they could

pay one constant price, Pc, for the quantity Qc, as they would under perfect competition This, however, is a choice the price-discriminating monopolist does not allow

Discrimination by Market Segment

Charging a different price for each and every unit sold to each and every buyer is of

course improbable, if not impossible The best most producers can do is to engage in

imperfect price discrimination—that is, to charge a few different prices, like the grocery

store that sells beans at different rates Imperfect price discrimination is the practice of

charging a few different prices for different consumption levels or different market

segments (based on location, age, income, or some other identifiable characteristic that is unrelated to cost differences) The practice is fairly common Electric power and

telephone companies engage in imperfect price discrimination when they charge different rates for different levels of use, measured in watts or minutes Universities try to do the same when they charge more for the first course taken than for any additional course

Both practices are examples of multipart price discrimination Drugstores

price-discriminate when they give discounts to senior citizens and students, and theaters price discriminate by charging children less than adults In those cases, discrimination is based

on market segment—namely, age group By treating different market segments as having distinctly different demand curves, the firm with monopoly power can charge different

prices in each market

Figure 12.10 shows how discrimination by market segment works Two

submarkets, each with its own demand curve, are represented in parts (a) and (b) Each also has its own marginal revenue curve To price its product, the firm must first decide

on its output level To do so it adds its two marginal revenue curves horizontally The

combined marginal revenue curve it obtains is shown in part (c) of the figure The firm

must then equate this aggregate marginal revenue curve with its marginal cost of

production, which is accomplished at the output level Qm in part (c)

FIGURE 12.10 Imperfect Price Discrimination

The monopolist that cannot perfectly price-discriminate may elect to charge a few different prices by segmenting its market To do so, it divides its market by income, location, or some other factor and finds the demand and marginal revenue curves in each (part (a) and (b)] Then it adds those marginal revenue

curves horizontally to obtain its combined marginal revenue curve for all market segments, MRm (part (c)]

By equating marginal revenue with marginal cost, it selects its output level, Qm Then it divides that

quantity between the two market segments by equating the marginal cost of the last unit produced (part (c)]

with marginal revenue in each market (Parts (a) and (b)] It sells Qa in market A and Qb in market B, and charges different prices in each segment Generally, the price will be higher in the market segment with the less elastic demand (part (b)]

Finally, the firm must divide the resulting output, Qm, between markets A and B The division that maximizes the firm’s profits is found by equating the marginal revenue

in each market (shown in parts (a) and (b)] with the marginal cost of the last unit

produced (part c) That is, the firm equates the marginal cost of producing the last unit of

Qm, (part (c)] with the marginal revenue from the last unit sold in each market segment

(MC = MR a = MR b ) For maximum profits, then, output Qm, must be divided into Qa for

market A and Qb for market B

Why does selling where MC = MR a = MR b result in maximum profit? Suppose

MR a were greater than MR b Then by selling one more unit in market A and one less unit

in market B, the firm could increase its revenues Thus the profit-maximizing firm can

be expected to shift sales to market A from market B until the marginal revenue of the

last unit sold in A exactly equals the marginal revenue of the last unit sold in B

Having established the output level for each market segment, the firm will charge

whatever price each segment will bear In market A, quantity Qa will bring a price of Pa

In market B, quantity Qb will bring Pb (Note that the price-discriminating monopolist

charges a higher price in a market with the less elastic demand—market B.) To find total profit, add the revenue collected in each market segment (parts (a) and (b)] and subtract the total variable cost of production (the area under the marginal cost curve in part (c)]

and the fixed cost

Applications of Monopoly Theory

Economics is a fascinating course of study because it often leads to counterintuitive

conclusions This is clearly the case with monopoly theory, as we can show with several

policy issues relating to monopoly

Price Controls under Monopoly

Market theory suggests that price controls can cause monopolistic firms to increase their

output Figure 12.11 shows the pricing and production of a monopolistic electric utility

Without price controls, a firm with monopoly power will produce Qm kilowatts and sell

them at Pm If the government declares that price too high, it can force the firm to sell at

a lower price—for example, P1 At that price the firm can sell as many as Q1 kilowatts

With the price controlled at P1, the firm’s marginal revenue curve for Q1 units becomes

horizontal at P1a Every time it sells an additional kilowatt, its total revenues will rise by

P1

As we stressed in the last chapter, the firm’s ideal production level is the point at which marginal cost equals marginal revenue If the firm cannot exactly equate marginal

cost and marginal revenue, it should strive to come as close as possible With the

maximum price controlled at P1, the firm can increase its revenues by selling up to Q1

units, which is all demand will permit At that point marginal revenue approaches but does not equal marginal cost (MC) (To equate marginal revenue with marginal cost, the

firm would have to expand production past Q1, the limit consumers will buy.) Notice that

Q1 is greater than Qm, the amount the firm would produce under a free but monopolized market In short, price controls can cause a firm with market power to expand

production (Some exceptions to this rule will be described later.)

_

FIGURE12.11 The Effect of Price Controls on the

Monopolistic Production Decision

In a free market, a monopolistic utility will produce

Qm kilowatts and will sell them for Pm If the firm’s

price is controlled at P1, however, its marginal

revenue curve will become horizontal at P1 The

firm will produce Q1 more than the amount it

would normally produce

Taxing Monopoly Profits

Some people claim that the economic profits of monopoly can be taxed with no loss in economic efficiency By definition, economic profit represents a reward to the resources

in a monopolized industry that is greater than necessary to keep those resources

employed where they are It also represents a transfer of income, from consumers to the owners of the monopoly Therefore a tax extracted solely from the economic profits of monopoly should not affect the distribution of resources and should fall exclusively on monopoly owners—so the argument goes

Figure 12.12 shows the reasoning behind this position This monopoly produces Qm1,

charges Pm1, and makes an economic profit equal to the shaded area ATC1Pm 1 ab Since

marginal cost and marginal revenue are equal at Q m 1, the firm is earning its maximum possible profit Expansion or contraction of production will not increase its profit Even

if the government were to take away 25, 50, or 90 percent of its economic profit, then the firm would not change its production plans or its price Nor would it raise prices to pass

the profits tax on to consumers The monopolist price-quantity combination, Pm1 and

Qm1, leaves the monopolist with the largest after-tax profit—regardless of the tax rate The economic profit shown on the graph is not the same as the firm’s book profit,

however Book profit tends to exceed economic profit by the sum of the owners’

opportunity cost and risk cost For practical reasons, government must impose its tax on

book profit, not economic profit As a result, the tax falls partly on the legitimate costs of

doing business, shifting the firm’s marginal cost curve upward, from MC1 to MC2 in

Figure 12.12 The monopolist, in turn, will reduce the quantity produced from Qm1 to

Q m 2 , and raise the price from P m 1 to Pm 2 Thus part of the government tax on profits is passed along to consumers as a price increase Consumers are doubly penalized—first through the monopoly price, which exceeds the competitive price, and second through the surcharge added by the profits tax

_

FIGURE 12.12 Taxing Monopoly Profits

Theoretically, a tax on the economic profit of

monopoly will not be passed on to the consumer—

but taxes are levied on book profit, not economic

profit As a result, a tax shifts the firm’s marginal

cost curve up, from MC1 toMC2, raising the price

to the consumer and lowering the production level

Monopolies in “Goods” and “Bads”

Because monopolies restrict output, raise prices, and misallocate resources, students and policy-makers tend to view them as market failures that should be corrected by antitrust action If a monopolized product or service represents an economic good—something that gives consumers positive utility—restricted sales will necessarily mean a loss in

welfare

Some products and services, however, may be viewed as “bads” by large portions of the citizenry Drugs, prostitution, contract murder, and pornography may be goods to their buyers, but they represent negative utility to others in the community Thus

monopolies in the production of such goods may be socially desirable If a drug

monopoly attempts to increase its profits by holding the supply of drugs below

competitive levels, most citizens would probably consider themselves better off

The question is not quite that simple, however A heroin monopoly may restrict the sale of heroin in a given market Yet because the demand for heroin is highly inelastic (because of drug addiction), higher prices may only increase buyers’ expenditures,

raising the number of crimes they must commit to support their habit Paradoxically

then, reducing heroin sales could lead to more burglaries, muggings, and bank hold-ups

Of course, drugs and other underground services are not normally subject to antitrust action; they are illegal The analogy may be applied to legal goods and services,

however, such as liquor Given the negative consequences of drinking, as well as

religious prohibitions, many people might consider alcoholic beverages an economic bad

In that case a state-long-run liquor monopoly could provide a social service By

restricting liquor sales through monopoly pricing, it would reduce drunk driving, thus limiting the external costs associated with drinking (The same objective—fewer liquor sales and less drunk driving—could also be accomplished through higher taxes.)

The Total Cost of Monopoly

High prices and restricted production are not the only costs of monopoly The total social cost of monopoly power is actually greater than is shown by the supply and demand model in Figure 12.6 Many firms attempt to achieve the benefits of monopoly power by erecting barriers to entry in their markets The resources invested in building barriers are diverted from the production of other goods, which could benefit consumers The total social cost of monopoly should also include the time and effort that the antitrust Division

of the Department of Justice, the Federal Trade Commission, state attorneys general, and various harmed private parties devote to thwarting such attempts to gain monopoly power and to breaking it up when it is acquired

Another, subtler social cost of monopoly is its redistributional effect Because of

monopoly power, consumers pay higher prices than under perfect competition (P m

instead of P c in Figure 12.6) The real purchasing power of consumer incomes is thus decreased, while the incomes of monopoly owners go up To the extent that monopoly increases the price of a good to consumers and the profits to the producer, then, it may redistribute income from lower-income consumers to higher-income entrepreneurs Many consider this redistributional effect a socially undesirable one

In addition, when we measure the inefficiency of monopoly by the triangular area

abc in Figure 12.6, we are assuming that demand for the monopolized product and all

other goods is unaffected by the redistribution of income from consumers to monopoly owners This may be a reasonable assumption when the monopolist is a maker of

vegetable-slicing machines It is less reasonable for other monopolies, such as the postal, local telephone, and electric power services Those firms, which are quite large in

relation to the entire economy, can shift the demand for a large number of products, causing further misallocation of resources

Finally, our analysis has assumed that a monopoly will seek to minimize its cost structure, just as perfect competitors do That may not be a realistic assumption because the monopolist does not, by definition, face competitive pressure If a monopoly relaxes its attentiveness to costs, the result can be the inefficient employment of resources

Why a Durable Goods Monopoly

Must Charge the Competitive Price

If prohibitive barriers to entry protect it, can a monopolist always charge the monopoly price indicated? University of Chicago Professor of Law and Economics and Noble Laureate Ronald Coase wrote a very famous article years ago in which he pointed out

that even a monopolistic producer of a durable good would charge a competitive price for its product.7

Why? Because no sane person would buy all or any portion of the durable good

at a price above the competitive level He used the example of a monopoly owner of a plot of land If the owner tried to sell the land all at once, he would have to lower the price on each parcel until all the land were bought – where the downward sloping

demand for land crossed the fixed vertical supply of land which means the owner

would have to charge the competitive price (where the demand for the land and the

supply of the land came together)

You might think that the sole/monopoly owner of land would be able to restrict sales and get more than the competitive price However, buyers would reason that the monopoly owner would eventually want to sell the remaining land, but that land could only be sold at less than the price of land already sold This means that the buyers would rationally wait to buy until the price came down This means that the owner would sell nothing at the monopoly price, and would only be able to sell the land at the competitive price

This analysis works out this way only because the land is durable Monopolies can charge monopoly prices for nondurable goods, and they can do that because they have control over production This means that one way a monopoly can elevate its price above the competitive level is by somehow making its product less durable This may explain why many software producers are constantly bringing out new, updated, and

upgraded versions of their programs – to, in the minds of consumers, make their

programs less than durable

Still, computer programs must remain, to some degree for some time, “durable,” which ultimately imposes a competitive check on dominant software producers, for

example, Microsoft The Justice Department seems to believe that Microsoft doesn’t have competitors Well, and one of Microsoft’s biggest competitors is none other than Microsoft itself Any new version of, say, windows, must compete head to head with the existing stock of old versions, which computer users can continue to use at zero price That very low price on old versions of Windows imposes a check on the prices that

Microsoft can charge on any new version

Monopolies in Network Goods

The conditions under which monopoly might be expected to emerge and prosper have expanded in recent years with the development of the theory of networks, which we have already introduced As noted in an earlier chapter, in 1998, the Justice Department filed

an antitrust suit against Microsoft for, among other things, engaging in “predatory”

pricing in the Internet browser market The Justice Department argued that by giving away Internet Explorer, Microsoft was attempting to snuff out a serious market rival in

7

Ronald H Coase, “Durability and Monopoly,” Journal of Law and Economics, vol 15 (April 1972), pp 143-149

the browser market and a potential competitive threat in the operating system market The Justice Department also argued that the market dominance Microsoft now enjoys in the operating system market could be equated with monopoly power because of the presumed existence of “high switching costs” and “lock-ins.”

Switching Costs and Lock-Ins

Once people have adopted the operating system, along with the accompanying computer hardware, and have learned how to use the accompanying applications, there are

presumed costs of switching to other operating systems To switch, people have to buy a different operating system, and maybe different computer equipment, as well as learn new applications that might require different instructions and have a different “look and feel.” They might also have to retool and retrain their computer service providers, or switch providers altogether

Assistant Attorney General Joel Klein introduced “switching costs” into his

argument by first repeating his position that Microsoft was convinced that it could not win the browser war based on the relative merits of Internet Explorer He then quoted Microsoft’s Megan Bliss and Rob Bennett, who wrote in an email that the way to

increase Internet Explorer’s share of the browser market was by “leveraging our strong share of the desktop”: “[I]f they get our technology by default on every desk, then they’ll

be less inclined to purchase a competitive solution .”8 The Justice Department’s chief economist Franklin Fisher gave more details in his testimony for the government, “Where network effects are present, a firm that gains a large share of the market, whether through

innovation, marketing skill, historical accident, or any other means, may thereby gain

monopoly power This is because it will prove increasingly difficult for other firms to persuade customers to buy their products in the presence of a product that is widely used

The firm with a large market share may then be able to charge high prices or slow down

innovation without having its business bid away” (emphasis added).9 Fisher added later,

“As a result of scale and network effects, Microsoft’s high market share leads to more applications being written for its operating system, which reinforces and increases

Microsoft’s market share, which in turn leads to still more applications being written for Windows than for other operating systems, and so on.”10

The government’s position on the role of switching costs has been widely adopted

in the media For example, the editors at The Economist have summed up the network effects/switching costs/lock-in line of argument very neatly in their retort to Microsoft’s supporters: