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CHAPTER 9 Monopoly © David Muir/Digital Vision/Getty Images. P laying the popular board game of Monopoly monopoly is derived from two Greek words meaning teaches some of the characteristics of monopoly “single seller.” A monopoly has the market power to set theory presented in this chapter. In the game version, its price and not worry about competitors. Perhaps your players win by gaining as much economic power as possi- college or university has only one bookstore where you ble. They strive to own railroads, utilities, Boardwalk, Park can buy textbooks. If so, students are likely to pay higher Place, and other valuable real estate. Then each player prices for textbooks than they would if many sellers tries to bankrupt opponents by having hotels that charge competed in the campus textbook market. high prices. A player who rolls the dice and lands on This chapter explains why firms do not or cannot another player’s property has no choice—either pay the enter a particular market and compete with a monopolist. price or lose the game. Then we explore some of the interesting actual mono- In the last chapter, we studied perfect competition, polies around the world. We study how a monopolist which may be viewed as the paragon of economic virtue. determines what price to charge and how much to pro- Why? Under perfect competition, there are many sellers, duce. The chapter ends with a discussion of the pros and each lacking any power to influence price. Perfect com- cons of monopoly. Most of the analytical tools required petition and monopoly are polar extremes. The word here have been introduced in previous chapters. 226 In this chapter, you will learn to solve these economic puzzles: • Why doesn’t the monopolist gouge consumers by charging the highest possible price? • How can price discrimination be fair? • Are medallion cabs in New York City monopolists? The Monopoly Market Structure The model at the opposite extreme from perfect competition is monopoly. Under monopoly, the consumer has a simple choice—either buy the monopolist’s product or do without it. Monopoly is a market structure characterized by (1) a single seller, (2) a unique product, and (3) impossible entry into the market. Unlike perfect competition, there are no close substitutes for the monopolist’s product. Monopoly, like perfect competition, corresponds only approximately to real-world industries, but it serves as a useful benchmark model. Following are brief descriptions of each monopoly characteristic. Monopoly A market structure characterized by (1) a single seller, (2) a unique product, and (3) impossible entry into the market. Single Seller In perfect competition, many firms make up the industry. In contrast, a monopoly means that a single firm is the industry. One firm provides the total supply of a product in a given market. Local monopolies are more common real-world approximations of the model than national or world market monopolies. For example, the campus bookstore, local telephone service, cable television company, and electric power company may be local monopolies. The only gas station, drug store, and grocery store in Nowhere County, Utah, and a hotdog stand at a football game are also examples of monopolies. Nationally, the U.S. Postal Service monopolizes first-class mail. Unique Product A unique product means there are no close substitutes for the monopolist’s product. Thus, the monopolist faces little or no competition. In reality, however, there are few, if any, products that have no close substitutes. For example, students can buy used textbooks from sources other than the campus bookstore, and textbooks can be purchased over the Internet. Natural gas and oil furnaces are good substitutes for electric heat. Similarly, the fax machine and email are substitutes for mail service, and a satellite dish can replace your local cable television service. Impossible Entry In perfect competition, there are no constraints to prevent new firms from entering an industry. In the case of monopoly, extremely high barriers make it very difficult 227 228 PA RT 3 MARKET STRUCTURES or impossible for new firms to enter an industry. Following are the three major barriers that prevent new firms from entering a market and competing with a monopolist. Ownership of a Vital Resource Sole control of the entire supply of a strategic input is one way a monopolist can prevent a newcomer from entering an industry. A famous historical example is Alcoa’s monopoly of the U.S. aluminum market from the late nineteenth century until the end of World War II. The source of Alcoa’s monopoly was its control of bauxite ore, which is necessary to produce aluminum. Today, it is very difficult for a new professional sports league to compete with the National Football League (NFL) and the National Basketball Association (NBA). Why? NFL and NBA teams have contracts with the best players and leases for the best stadiums and arenas. Legal Barriers The oldest and most effective barriers protecting a firm from potential competitors are the result of government franchises and licenses. The government permits a single firm to provide a certain product and excludes competing firms by law. For example, water and sewer service, natural gas, and cable television operate under monopoly franchises established by state and local governments. In many states, the state government runs monopoly liquor stores and lotteries. The U.S. Postal Service has a government franchise to deliver first-class mail. Government-granted licenses restrict entry into some industries and occupations. For example, the Federal Communications Commission (FCC) must license radio and television stations. In most states, physicians, lawyers, dentists, nurses, teachers, real estate agents, hairstylists, taxicabs, liquor stores, funeral homes, and other professions and businesses are required to have a license. Patents and copyrights are another form of government barrier to entry. The government grants patents to inventors, thereby legally prohibiting other firms from selling the patented product for 20 years. Copyrights give creators of literature, art, music, and movies exclusive rights to sell or license their works. The purpose behind granting patents and copyrights is to encourage innovation and new products by guaranteeing exclusive rights to profit from new ideas for a limited period. Economies of Scale Natural monopoly An industry in which the long-run average cost of production declines throughout the entire market. As a result, a single firm can supply the entire market demand at a lower cost than two or more smaller firms. Why might competition among firms be unsustainable so that one firm becomes a monopolist? Recall the concept of economies of scale from the chapter on production costs. As a result of large-scale production, the long-run average cost (LRAC) of production falls. This means a monopoly can emerge in time naturally because of the relationship between average cost and the scale of an operation. As a firm becomes larger, its cost per unit of output is lower compared to a smaller competitor. In the long run, this “survival of the fittest” cost advantage forces smaller firms to leave the industry. Because new firms cannot hope to produce and sell output equal or close to that of the monopolist, thereby achieving the monopolist’s low costs, they will not enter the industry. Thus, a monopoly can arise over time and remain dominant in an industry even though the monopolist does not own an essential resource or obtain legal barriers. Economists call the situation in which one seller emerges in an industry because of economies of scale a natural monopoly. A natural monopoly is an industry in which the long-run average cost of production declines throughout the entire C H AP T E R 9 MONOPOLY market. As a result, a single firm can supply the entire market demand at a lower cost than two or more smaller firms. Public utilities, such as the natural gas, water, and local telephone companies, are examples of natural monopolies. The government grants these industries an exclusive franchise in a geographic area so consumers can benefit from the cost savings that occur when one firm in an industry with significant economies of scale sells a large output. The government then regulates these monopolies through a board of commissioners to prevent exploitation. Exhibit 1 depicts the LRAC curve for a natural monopoly. A single firm can produce 100 units at an average cost of $15 and a total cost of $1,500. If two firms each produce 50 units, the total cost rises to $2,500. With five firms producing 20 units each, the total cost rises to $3,500. In the chapter on antitrust and regulation, regulation of a natural monopoly will be explored in greater detail. Conclusion Because of economies of scale, a single firm in an industry will produce output at a lower per-unit cost than two or more firms. Price and Output Decisions for a Monopolist A major difference between perfect competition and monopoly is the shape of the demand curve, not the shapes of the cost curves. As explained in the previous EXHIBIT 1 Minimizing Costs in a Natural Monopoly In a natural monopoly, a single firm in an industry can produce at a lower cost than two or more firms. This condition occurs because the LRAC curve for any firm decreases over the relevant range. For example, one firm can produce 100 units at an average cost of $15 and a total cost of $1,500. Two firms in the industry can produce 100 units of output (50 units each) for a total cost of $2,500, and five firms can produce the same output for a total cost of $3,500. 45 40 Five firms 35 Cost 30 per 25 unit (dollars) 20 Two firms One firm 15 10 LRAC 5 0 20 40 60 80 Quantity of output 100 120 229 GLOBAL ECONOMICS Monopolies around the World © North Wind Picture Archives. Applicable Concepts: monopoly Interesting examples of monopolies can be found in other countries. Let’s begin with a historical example. In the sixteenth through eighteenth centuries, monarchs granted monopoly rights for a variety of businesses. For example, in 1600 Queen Elizabeth I chartered the British East India Company and gave it a monopoly over England’s trade with India. This company was even given the right to coin money and to make peace or war with non-Christian powers. As a result of its monopoly, the company made substantial profits from the trade in Indian cotton goods, silks, and spices. In the late 1700s, the growing power of the company and huge personal fortunes of its officers provoked more and more government control. Finally, in 1858, the company was abolished, ending its trade monopoly, great power, and patronage. “Diamonds are forever,” and perhaps so is the diamond monopoly. DeBeers, a South African corporation, was close to a world monopoly. Through its Central Selling Organization (CSO) headquartered in London, DeBeers controlled 80 percent of all the diamonds sold in the world. DeBeers controlled the price of jewelry-quality diamonds by requiring suppliers in Russia, Australia, Congo, Botswana, Namibia, and other countries to sell their rough diamonds through DeBeers’s CSO. Why did suppliers of rough diamonds allow DeBeers to set the price 230 and quantity of diamonds sold throughout the world? The answer was that the CSO could put any uncooperative seller out of business. All the CSO had to do was to reach into its huge stockpile of diamonds and flood the market with the type of diamonds being sold by an independent seller. As a result, the price of diamonds would plummet in the competitor’s market, and it ceased to sell diamonds. In recent years, DeBeers lost some of its control of the market. Mines in Australia became more independent, diamonds were found in Canada, and Russian mines began selling to independents. To deal with the new conditions, DeBeers changed its policy in 2001 by closing the CSO and promoting DeBeers’ own brand of diamonds rather than trying to control the world diamond supply. DeBeers proclaimed its strategy to be “the diamond supplier of choice.” Will this monopoly continue? It is an interesting question. Genuine caviar, the salty black delicacy, is naturally scarce because it comes from the eggs of sturgeon harvested by fisheries from the Caspian Sea near the mouth of the Volga River. After the Bolshevik revolution in Russia in 1917, a caviar monopoly was established under the control of the Soviet Ministry of Fisheries and the Paris-based Petrosian Company. The Petrosian brothers limited exports of caviar and pushed prices up as high as $1,000 a pound for some varieties. As a result of this worldwide monopoly, both the Soviet government and the Petrosian Company earned handsome profits. It is interesting to note that the vast majority of the tons of caviar harvested each year was consumed at government banquets or sold at bargain prices to top Communist Party officials. With the fall of the Soviet Union, it was impossible for the Ministry of Fisheries to control all exports of caviar. Various former Soviet republics claimed jurisdiction and negotiated independent export contracts. As a result, caviar export prices dropped sharply. C H AP T E R 9 231 MONOPOLY chapter, a perfectly competitive firm is a price taker. In contrast, the next sections explain that a monopolist is a price maker. A price maker is a firm that faces a downward-sloping demand curve. This means a monopolist has the ability to select the product’s price. In short, a monopolist can set the price with its corresponding level of output, rather than being a helpless pawn at the mercy of the going industry price. To understand the monopolist, we again apply the marginal approach to our hypothetical electronics company—Computech. Marginal Revenue, Total Revenue, and Price Elasticity of Demand Suppose engineers at Computech discover an inexpensive miracle electronic device called SAV-U-GAS that anyone can easily attach to a car’s engine. Once installed, the device raises gasoline mileage to over 100 miles per gallon. The government grants Computech a patent, and the company becomes a monopolist selling this gas-saver gizmo. Because of this barrier to entry, Computech is the only seller in the industry. Although other firms try to compete with this invention, they create poor substitutes. This means the downward-sloping demand curve for the industry and for the monopolist are identical. Exhibit 2(a) illustrates the demand and the marginal revenue (MR) curves for a monopolist such as Computech. As the monopolist lowers its price to increase the quantity demanded, changes in both price and quantity affect the firm’s total revenue (price times quantity), as shown graphically in Exhibit 2(b). If Computech charges $150, consumers purchase zero units, and, therefore, total revenue is zero. To sell 1 unit, Computech must lower the price to $138, and total revenue rises from zero to $138. Because the marginal revenue is the increase in total revenue that results from a 1-unit change in output, the MR curve at the first unit of output is $138 ($138  0). Thus, the price and the marginal revenue from selling 1 unit are equal at $138. To sell 2 units, the monopolist must lower the price to $125, and total revenue rises to $250. The marginal revenue from selling the second unit is $112 ($250  $138), which is $13 less than the price received. As shown in Exhibit 2(a), as the monopolist lowers its price, price is greater than marginal revenue after the first unit of output. Like all marginal measurements, marginal revenue is plotted midway between the quantities. Conclusion The demand and marginal revenue curves of the monopolist are downward sloping, in contrast to the horizontal demand and corresponding marginal revenue curves facing the perfectly competitive firm [compare Exhibit 2(a) with Exhibit 1(b) of the previous chapter]. Starting from zero output, as the price falls, total revenue rises until it reaches a maximum at 6 units, and then it falls, tracing the “revenue hill” drawn in Part (b). The explanation was presented earlier in the discussion of price elasticity of demand in Chapter 5. Recall that a straight-line demand curve has an elastic (Ed > 1) segment along the upper half, a unit elastic (Ed ¼ 1) at the midpoint, and an inelastic (Ed < 1) segment along the lower half (see Exhibit 4 in Chapter 5). Recall from Chapter 5 that when Ed > 1, total revenue rises as the price drops, and total revenue reaches a maximum where Ed ¼ 1. When Ed < 1, total revenue falls as the price falls. As shown in Exhibit 2(b), total revenue for a monopolist is related to marginal revenue. When the MR curve is above the quantity axis (elastic demand), total revenue Price maker A firm that faces a downward-sloping demand curve and therefore it can choose among price and output combinations along the demand curve. 232 PA RT 3 EXHIBIT 2 MARKET STRUCTURES Demand, Marginal Revenue, and Total Revenue for a Monopolist Part (a) shows the relationship between the demand and the marginal revenue curves. The MR curve is below the demand curve. Between zero and 6 units of output, MR > 0; at 6 units of output, MR ¼ 0; beyond 6 units of output, MR < 0. The relationship between demand and total revenue is shown in Part (b). When the price is $150, total revenue is zero. When the price is set at zero, total revenue is also zero. In between these two extreme prices, the price of $75 maximizes total revenue. This price corresponds to 6 units of output, which is where the MR curve intersects the quantity axis, halfway between the origin and the intercept of the demand curve. (a) Demand and marginal revenue curves 150 125 100 75 50 Output per Hour 0 Total Price Revenue $150 $ Marginal Revenue $138 138 138 2 125 250 3 113 339 4 100 400 5 88 440 25 0 –25 –75 112 –100 89 –125 61 –150 75 450 7 63 441 8 50 400 9 38 342 10 25 250 (b) Total revenue curve 10 0 −9 −41 −58 −92 −107 11 13 143 12 0 0 Marginal revenue Quantity of output (units per hour) 40 6 Demand 1 2 3 4 5 6 7 8 9 10 11 12 –50 0 1 Price and marginal revenue (dollars) −143 500 400 Total revenue 300 (dollars) 200 100 0 Total revenue 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of output (units per hour) C H AP T E R 9 MONOPOLY is increasing. At the intersection of the MR curve and the quantity axis (unit elastic demand), total revenue is at its maximum. When the MR curve is below the quantity axis, total revenue is decreasing (inelastic demand). The monopolist will never operate on the inelastic range of its demand curve that corresponds to a negative marginal revenue. The reason is that, in this inelastic range, the monopolist can increase total revenue by cutting output and raising price. In our example, Computech would not charge a price lower than $75 or produce an output greater than 6 units per hour. Now we turn to the question of what price the monopolist will charge to maximize profit. In Exhibit 2(a), observe that the MR curve cuts the quantity axis at 6 units, which is half of 12 units. Following an easy rule helps locate the point along the quantity axis where marginal revenue equals zero: The marginal revenue curve for a straight-line demand curve intersects the quantity axis halfway between the origin and the quantity axis intercept of the demand curve. Short-Run Profit Maximization for a Monopolist Using the Total Revenue-Total Cost Method Exhibit 3 reproduces the demand, total revenue, and marginal revenue data from Exhibit 2 and adds cost data from the previous two chapters. These data illustrate a situation in which Computech can earn monopoly economic profit in the short run. Subtracting total cost in column 6 from total revenue in column 3 gives the total profit or loss in column 8 that the firm earns at each level of output. From zero to 1 unit, the monopolist incurs losses, and then a break-even point occurs before 2 units per hour. If the monopolist produces 5 units per hour, it earns the maximum profit of $190 per hour. As output expands between 5 and 8 units of output, the monopolist’s profit diminishes. After 8 units of output, there is a second break-even point, and losses increase as output expands. Exhibit 4 illustrates graphically that where the vertical distance between the total revenue and total cost curves is maximum corresponds to the profit-maximizing output. Note that the total revenue-maximizing output level of 6 units is greater than the profit-maximizing output at 5 units. Short-Run Profit Maximization for a Monopolist Using the Marginal Revenue Equals Marginal Cost Method Exhibit 5 reproduces the demand and cost curves from the table in Exhibit 3. Like the perfectly competitive firm, a monopolist maximizes profit by producing the quantity of output where MR ¼ MC and charging the corresponding price on its demand curve. In this case, 5 units is the quantity at which MR ¼ MC. As represented by point A on the demand curve, the price at 5 units is $88. Point B represents an average total cost (ATC) of $50 at 5 units. Because the price of $88 is above the ATC curve at the MR ¼ MC output, the monopolist earns a profit of $38 per unit. At the hourly output of 5 units, total profit is $190 per hour, as shown by the shaded area ($38 per unit  5 units). Observe that a monopolist charges neither the highest possible price nor the total revenue-maximizing price. In Exhibit 5(a), $88 is not the highest possible price. Because Computech is a price maker, it could have set a price above $88 and sold less output than 5 units. However, the monopolist does not maximize profit by charging the highest possible price. Any price above $88 does not correspond to the intersection of the MR and MC curves. Now note that 5 units is below the output level where MR intersects the quantity axis and total revenue reaches its peak. Since MR ¼ 0 and 233 234 PA RT 3 EXHIBIT 3 MARKET STRUCTURES Short-Run Profit-Maximization Schedule for Computech as a Monopolist (1) Output per Hour (Q) (2) Price per Unit (P) (3) Total Revenue (TR) 0 $150 $ 0 1 2 3 4 138 125 113 100 75 450 9 10 11 12 38 25 13 0 112 34 89 24 61 19 40 23 25 10 25 30 9 38 41 48 58 59 92 75 107 95 143 117 400 6 50 $50 339 440 8 $138 250 88 63 (5) Marginal Cost (MC) 138 5 7 (4) Marginal Revenue (MR) 441 400 342 250 143 0 (6) Total Cost (TC) (7) Average Total Cost (ATC) (8) Profit (+) or Loss (−) $100 — 150 $150 12 184 92 66 208 69 131 227 57 173 250 50 190 280 47 170 318 45 123 366 46 34 425 47 83 500 50 250 595 54 452 712 59 712 $100 Ed ¼ 1 when total revenue is maximum at 6 units of output, MC ¼ 0 must also hold to maximize revenue and profit at the same time. A monopolist producing with zero marginal cost is an unlikely case. Hence, the price charged to maximize profit is higher on the demand curve than the price that maximizes total revenue. Conclusion The monopolist always maximizes profit by producing at a price on the elastic segment of its demand curve. A Monopolist Facing a Short-Run Loss Having a monopoly does not guarantee profits. A monopolist has no protection against changes in demand or cost conditions. Exhibit 6 shows a situation in which the demand curve is lower at any point than the ATC curve, and total cost C H AP T E R 9 EXHIBIT 4 235 MONOPOLY Short-Run Profit Maximization for a Monopolist Using the Total Revenue-Total Cost Method The profit-maximizing level of output for Computech as a monopolist is shown in this exhibit. Part (a) shows that maximum profit is earned by producing 5 units per hour and charging a price of $88 per unit where the vertical distance between the total revenue and total cost curves is the greatest. In Part (b), the maximum profit of $190 per hour corresponds to the profit-maximizing output of 5 units per hour illustrated in Part (a). At output levels below 2 or above 8, the monopolist incurs losses. (a) Total revenue and total cost 800 700 Total cost 600 Maximum profit = $190 Total 500 revenue and 400 total cost (dollars) 300 Loss 200 Total revenue 100 Loss 0 Maximum profit output 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of output (units per hour) (b) Profit or loss 200 150 Profit (dollars) 100 Profit = $190 50 0 Loss –50 (dollars) 1 2 3 4 5 6 7 8 9 10 11 12 Loss Maximum profit output –100 –150 –200 –800 Quantity of output (units per hour) Loss