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fra02885_ch09_231-268 17/06/2008 7:23 pm Page 231 pinnacle MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com PA RT 3 MARKET IMPERFECTIONS ■ We now abandon Adam Smith’s frictionless world to investigate what happens when people and firms interact in markets plagued by a variety of imperfections. Not surprisingly, the invisible hand that served society so well in the perfectly competitive world often goes astray in this new environment. Our focus in Chapter 9 will be on how markets served by only one or a small number of firms differ from those served by perfectly competitive firms. We will see that although monopolies often escape the pressures that constrain the profits of their perfectly competitive counterparts, the two types of firms have many important similarities. In Chapters 1 to 9 economic decision makers confronted an environment that was essentially fixed. In Chapter 10, however, we will discuss cases in which people expect their actions to alter the behavior of others, as when a firm’s decision to advertise or launch a new product induces a rival to follow suit. Interdependencies of this sort are the rule rather than the exception, and we will explore how to take them into account using simple theories of games. In Chapter 11 we will investigate how the allocation of resources is affected when activities generate costs or benefits that accrue to people not directly involved in those activities. We will see that if parties cannot easily negotiate with one another, the self-serving actions of individuals will not lead to efficient outcomes. Although the invisible hand theory assumes that buyers and sellers are perfectly informed about all relevant options, this assumption is almost never satisfied in practice. In Chapter 12 we will explore how basic economic principles can help imperfectly informed individuals and firms make the best use of the limited information they possess. fra02885_ch09_231-268 17/06/2008 7:23 pm Page 232 pinnacle MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com fra02885_ch09_231-268 17/06/2008 7:23 pm Page 233 pinnacle MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com CHAPTER 9 Monopoly, Oligopoly, and Monopolistic Competition LEARNING OBJECTIVES After reading this chapter, you should be able to: 1. Define imperfect competition and describe how it differs from perfect competition. 2. Define market power and show how this affects the demand curve facing the firm. 3. Explain how start-up costs affect economics of scale and market power. 4. Understand and use the concepts of marginal cost and marginal revenue to find the output level and price that maximize a monopolist’s profit. 5. Show how monopoly alters consumer surplus, producer surplus, and total economic surplus relative to perfect competition. 6. Describe price discrimination and its effects. 7. Discuss public policies that are often applied to natural monopolies. ome years ago, schoolchildren around the country became obsessed with the game of Magic. To play, you need a deck of Magic Cards, available only from the creators of the game. But unlike ordinary playing cards, which can be bought in most stores for only a dollar or two, a deck of Magic Cards sells for upward of $10. And since Magic Cards cost no more to manufacture than ordinary playing cards, their producer earns an enormous economic profit. In a perfectly competitive market, entrepreneurs would see this economic profit as cash on the table. It would entice them to offer Magic Cards at slightly lower prices so that eventually the cards would sell for roughly their cost of production, just as ordinary playing cards do. But Magic Cards have been on the market for years now, and that hasn’t happened. The reason is that the cards are S fra02885_ch09_231-268 17/06/2008 7:23 pm Page 234 pinnacle MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com 234 CHAPTER 9 MONOPOLY, OLIGOPOLY, AND MONOPOLISTIC COMPETITION copyrighted, which means the government has granted the creators of the game an exclusive license to sell them. The holder of a copyright is an example of an imperfectly competitive firm, or price setter, that is, a firm with at least some latitude to set its own price. The competitive firm, by contrast, is a price taker, a firm with no influence over the price of its product. Our focus in this chapter will be on the ways in which markets served by imperfectly competitive firms differ from those served by perfectly competitive firms. One salient difference is the imperfectly competitive firm’s ability, under certain circumstances, to charge more than its cost of production. But if the producer of Magic Cards could charge any price it wished, why does it charge only $10? Why not $100, or even $1,000? We’ll see that even though such a company may be the only seller of its product, its pricing freedom is far from absolute. We’ll also see how some imperfectly competitive firms manage to earn an economic profit, even in the long run, and even without government protections like copyright. And we’ll explore why Adam Smith’s invisible hand is less in evidence in a world served by imperfectly competitive firms. IMPERFECT COMPETITION Why do Magic Cards sell for 10 times as much as ordinary playing cards, even though they cost no more to produce? imperfectly competitive firm or price setter a firm with at least some latitude to set its own price pure monopoly the only supplier of a unique product with no close substitutes The perfectly competitive market is an ideal; the actual markets we encounter in everyday life differ from the ideal in varying degrees. Economics texts usually distinguish among three types of imperfectly competitive market structures. The classifications are somewhat arbitrary, but they are quite useful in analyzing real-world markets. DIFFERENT FORMS OF IMPERFECT COMPETITION Farthest from the perfectly competitive ideal is the pure monopoly, a market in which a single firm is the lone seller of a unique product. The producer of Magic Cards is a pure monopolist, as are many providers of electric power. If the residents of Miami don’t buy their electricity from the Florida Power and Light Company, they simply do without. In between these two extremes are many different types of imperfect competition. We focus on two of them here: monopolistic competition and oligopoly. Monopolistic Competition monopolistic competition an industry structure in which a large number of firms produce slightly differentiated products that are reasonably close substitutes for one another Recall from the chapter on perfectly competitive supply that in a perfectly competitive industry, a large number of firms typically sell products that are essentially perfect substitutes for one another. In contrast, monopolistic competition is an industry structure in which a large number of rival firms sell products that are close, but not quite perfect, substitutes. Rival products may be highly similar in many respects, but there are always at least some features that differentiate one product from another in the eyes of some consumers. Monopolistic competition has in common with perfect competition the feature that there are no significant barriers preventing firms from entering or leaving the market. Local gasoline retailing is an example of a monopolistically competitive industry. The gas sold by different stations may be nearly identical in chemical terms, but a station’s particular location is a feature that matters for many consumers. Convenience stores are another example. Although most of the products found on any given store’s shelves are also carried by most other stores, the product lists of different stores are not identical. Some offer small stocks of rental DVDs, for example, while others do not. And even more so than in the case of gasoline retailing, location is an important differentiating feature of convenience stores. fra02885_ch09_231-268 17/06/2008 7:23 pm Page 235 pinnacle MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com IMPERFECT COMPETITION 235 Recall that if a perfectly competitive firm were to charge even just slightly more than the prevailing market price for its product, it would not sell any output at all. Things are different for the monopolistically competitive firm. The fact that its offering is not a perfect substitute for those of its rivals means that it can charge a slightly higher price than they do and not lose all its customers. But that does not mean that monopolistically competitive firms can expect to earn positive economic profits in the long run. On the contrary, because new firms are able to enter freely, a monopolistically competitive industry is essentially the same as a perfectly competitive industry in this respect. If existing monopolistically competitive firms were earning positive economic profits at prevailing prices, new firms would have an incentive to enter the industry. Downward pressure on prices would then result as the larger number of firms competed for a limited pool of potential customers.1 As long as positive economic profits remained, entry would continue and prices would be driven ever lower. Conversely, if firms in a monopolistically competitive industry were initially suffering economic losses, some firms would begin leaving the industry. As long as economic losses remained, exit and the resulting upward pressure on prices would continue. So in long-run equilibrium, monopolistically competitive firms are in this respect essentially like perfectly competitive firms: All expect to earn zero economic profit. Although monopolistically competitive firms have some latitude to vary the prices of their product in the short run, pricing is not the most important strategic decision they confront. A far more important issue is how to differentiate their products from those of existing rivals. Should a product be made to resemble a rival’s product as closely as possible? Or should the aim be to make it as different as possible? Or should the firm strive for something in between? We will consider these questions in the next chapter, where we will focus on this type of strategic decision making. Oligopoly Further along the continuum between perfect competition and pure monopoly lies oligopoly, a structure in which the entire market is supplied by a small number of large firms. Cost advantages associated with large size are one of the primary reasons for pure monopoly, as we will discuss presently. Oligopoly is also typically a consequence of cost advantages that prevent small firms from being able to compete effectively. In some cases, oligopolists sell undifferentiated products. In the market for wireless phone service, for example, the offerings of AT&T, Verizon, and Sprint are essentially identical. The cement industry is another example of an oligopoly selling an essentially undifferentiated product. The most important strategic decisions facing firms in such cases are more likely to involve pricing and advertising than specific features of their product. Here, too, we postpone more detailed discussion of such decisions until the next chapter. In other cases, such as the automobile and tobacco industries, oligopolists are more like monopolistic competitors than pure monopolists, in the sense that differences in their product features have significant effects on consumer demand. Many long-time Ford buyers, for example, would not even consider buying a Chevrolet, and very few smokers ever switch from Camels to Marlboros. As with oligopolists who produce undifferentiated products, pricing and advertising are important strategic decisions for firms in these industries, but so, too, are those related to specific product features. Because cost advantages associated with large size are usually so important in oligopolies, there is no presumption that entry and exit will push economic profit 1 See Edward Chamberlin, The Theory of Monopolistic Competition (Cambridge, MA: Harvard University Press, first edition 1933, 8th edition 1962), and Joan Robinson, The Economics of Imperfect Competition (London: Macmillan, first edition 1933, second edition 1969). oligopoly an industry structure in which a small number of large firms produce products that are either close or perfect substitutes fra02885_ch09_231-268 17/06/2008 7:23 pm Page 236 pinnacle MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com 236 CHAPTER 9 MONOPOLY, OLIGOPOLY, AND MONOPOLISTIC COMPETITION to zero. Consider, for example, an oligopoly served by two firms, each of which currently earns an economic profit. Should a new firm enter this market? Possibly, but it also might be that a third firm large enough to achieve the cost advantages of the two incumbents would effectively flood the market, driving price so low that all three firms would suffer economic losses. There is no guarantee, however, that an oligopolist will earn a positive economic profit. As we’ll see in the next section, the essential characteristic that differentiates imperfectly competitive firms from perfectly competitive firms is the same in each of the three cases. So for the duration of this chapter, we’ll use the term monopolist to refer to any of the three types of imperfectly competitive firms. In the next chapter, we will consider the strategic decisions confronting oligopolists and monopolistically competitive firms in greater detail. RECAP MONOPOLISTIC COMPETITION AND OLIGOPOLY Monopolistic competition is the industry structure in which a large number of small firms offer products that are similar in many respects, yet not perfect substitutes in the eyes of at least some consumers. Monopolistically competitive industries resemble perfectly competitive industries in that entry and exit cause economic profits to tend toward zero in the long run. Oligopoly is the industry structure in which a small number of large firms supply the entire market. Cost advantages associated with large-scale operations tend to be important. Oligopolists may produce either standardized products or differentiated products. THE ESSENTIAL DIFFERENCE BETWEEN PERFECTLY AND IMPERFECTLY COMPETITIVE FIRMS If the Sunoco station at State and Meadow Streets raised its gasoline prices by 3 cents per gallon, would all its customers shop elsewhere? In advanced economics courses, professors generally devote much attention to the analysis of subtle differences in the behavior of different types of imperfectly competitive firms. Far more important for our purposes, however, will be to focus on the single, common feature that differentiates all imperfectly competitive firms from their perfectly competitive counterparts—namely, that whereas the perfectly competitive firm faces a perfectly elastic demand curve for its product, the imperfectly competitive firm faces a downward-sloping demand curve. In the perfectly competitive industry, the supply and demand curves intersect to determine an equilibrium market price. At that price, the perfectly competitive firm can sell as many units as it wishes. It has no incentive to charge more than the market price because it won’t sell anything if it does so. Nor does it have any incentive to charge less than the market price because it can sell as many units as it wants to at the market price. The perfectly competitive firm’s demand curve is thus a horizontal line at the market price, as we saw in Chapters 6 and 8. By contrast, if a local gasoline retailer—an imperfect competitor—charges a few pennies more than its rivals for a gallon of gas, some of its customers may desert it. But others will remain, perhaps because they are willing to pay a little extra to continue stopping at their most convenient location. An imperfectly competitive firm thus faces a negatively sloped demand curve. Figure 9.1 summarizes this contrast between the demand curves facing perfectly competitive and imperfectly competitive firms. fra02885_ch09_231-268 17/06/2008 7:23 pm Page 237 pinnacle MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com FIVE SOURCES OF MARKET POWER Market price Imperfectly competitive firm D Price $/unit of output Perfectly competitive firm D 0 Quantity (a) 0 Quantity (b) 237 FIGURE 9.1 The Demand Curves Facing Perfectly and Imperfectly Competitive Firms. (a) The demand curve confronting a perfectly competitive firm is perfectly elastic at the market price. (b) The demand curve confronting an imperfectly competitive firm is downward-sloping. FIVE SOURCES OF MARKET POWER Firms that confront downward-sloping demand curves are said to enjoy market power, a term that refers to their ability to set the prices of their products. A common misconception is that a firm with market power can sell any quantity at any price it wishes. It cannot. All it can do is pick a price–quantity combination on its demand curve. If the firm chooses to raise its price, it must settle for reduced sales. Why do some firms have market power while others do not? Since market power often carries with it the ability to charge a price above the cost of production, such power tends to arise from factors that limit competition. In practice, the following five factors often confer such power: exclusive control over inputs, patents and copyrights, government licenses or franchises, economies of scale, and network economies. EXCLUSIVE CONTROL OVER IMPORTANT INPUTS If a single firm controls an input essential to the production of a given product, that firm will have market power. For example, to the extent that some tenants are willing to pay a premium for office space in the country’s tallest building, the Sears Tower, the owner of that building has market power. PATENTS AND COPYRIGHTS Patents give the inventors or developers of new products the exclusive right to sell those products for a specified period of time. By insulating sellers from competition for an interval, patents enable innovators to charge higher prices to recoup their product’s development costs. Pharmaceutical companies, for example, spend millions of dollars on research in the hope of discovering new drug therapies for serious illnesses. The drugs they discover are insulated from competition for an interval—currently 20 years in the United States—by government patents. For the life of the patent, only the patent holder may legally sell the drug. This protection enables the patent holder to set a price above the marginal cost of production to recoup the cost of the research on the drug. In the same way, copyrights protect the authors of movies, software, music, books, and other published works. GOVERNMENT LICENSES OR FRANCHISES The Yosemite Concession Services Corporation has an exclusive license from the U.S. government to run the lodging and concession operations at Yosemite National Park. One of the government’s goals in granting this monopoly was to preserve the wilderness character of the area to the greatest degree possible. And indeed, the inns market power a firm’s ability to raise the price of a good without losing all its sales fra02885_ch09_231-268 17/06/2008 7:23 pm Page 238 pinnacle MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com 238 CHAPTER 9 MONOPOLY, OLIGOPOLY, AND MONOPOLISTIC COMPETITION constant returns to scale a production process is said to have constant returns to scale if, when all inputs are changed by a given proportion, output changes by the same proportion increasing returns to scale a production process is said to have increasing returns to scale if, when all inputs are changed by a given proportion, output changes by more than that proportion; also called economies of scale natural monopoly a monopoly that results from economies of scale and cabins offered by the Yosemite Concession Services Company blend nicely with the valley’s scenery. No garish neon signs mar the national park as they do in places where rivals compete for the tourist’s dollars. ECONOMIES OF SCALE AND NATURAL MONOPOLIES When a firm doubles all its factors of production, what happens to its output? If output exactly doubles, the firm’s production process is said to exhibit constant returns to scale. If output more than doubles, the production process is said to exhibit increasing returns to scale, or economies of scale. When production is subject to economies of scale, the average cost of production declines as the number of units produced increases. For example, in the generation of electricity, the use of larger generators lowers the unit cost of production. The markets for such products tend to be served by a single seller, or perhaps only a few sellers, because having a large number of sellers would result in significantly higher costs. A monopoly that results from economies of scale is called a natural monopoly. NETWORK ECONOMIES Although most of us don’t care what brand of dental floss others use, many products do become much more valuable to us as more people use them. In the case of home videotape recorders, for instance, the VHS format’s defeat of the competing Beta format was explained not by its superior picture quality—indeed, on most important technical dimensions, Beta was regarded by experts as superior to VHS. Rather, VHS won simply because it managed to gain a slight sales edge on the initial version of Beta, which could not record programs longer than one hour. Although Beta later corrected this deficiency, the VHS lead proved insuperable. Once the fraction of consumers owning VHS passed a critical threshold, the reasons for choosing it became compelling—variety and availability of tape rental, access to repair facilities, the capability to exchange tapes with friends, and so on. A similar network economy helps to account for the dominant position of Microsoft’s Windows operating system, which, as noted earlier, is currently installed in more than 90 percent of all personal computers. Because Microsoft’s initial sales advantage gave software developers a strong incentive to write for the Windows format, the inventory of available software in the Windows format is now vastly larger than that for any competing operating system. And although general-purpose software such as word processors and spreadsheets continues to be available for multiple operating systems, specialized professional software and games usually appear first—and often only—in the Windows format. This software gap and the desire to achieve compatibility for file sharing gave people a good reason for choosing Windows, even if, as in the case of many Apple Macintosh users, they believed a competing system was otherwise superior. By far the most important and enduring of these sources of market power are economies of scale and network economies. Lured by economic profit, firms almost always find substitutes for exclusive inputs. Thus, real estate developer Donald Trump has proposed a building taller than the Sears Tower, to be built in Chicago. Likewise, firms can often evade patent laws by making slight changes in design of products. Patent protection is only temporary, in any case. Finally, governments grant very few franchises each year. But economies of scale are both widespread and enduring. Firmly entrenched network economies can be as persistent a source of natural monopoly as economies of scale. Indeed, network economies are essentially similar to economies of scale. When network economies are of value to the consumer, a product’s quality increases as the number of users increases, so we can say that any given quality level can be produced at lower cost as sales volume increases. Thus network economies may be viewed as just another form of economies of scale in production, and that’s how we’ll treat them here. fra02885_ch09_231-268 7/15/08 5:28PM Page 239 ntt MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com ECONOMIES OF SCALE AND THE IMPORTANCE OF START-UP COSTS RECAP 239 FIVE SOURCES OF MARKET POWER A firm’s power to raise its price without losing its entire market stems from exclusive control of important inputs, patents and copyrights, government licenses, economies of scale, or network economies. By far the most important and enduring of these are economies of scale and network economies. ECONOMIES OF SCALE AND THE IMPORTANCE OF START-UP COSTS Total cost ($/year) TC  F  M *Q F  M *Q0 F 0 Q0 Q (a) Average cost ($/unit) As we saw in the previous chapter, variable costs are those that vary with the level of output produced, while fixed costs are independent of output. Strictly speaking, there are no fixed costs in the long run because all inputs can be varied. But as a practical matter, start-up costs often loom large for the duration of a product’s useful life. Most of the costs involved in the production of computer software, for example, are start-up costs of this sort, one-time costs incurred in writing and testing the software. Once those tasks are done, additional copies of the software can be produced at a very low marginal cost. A good such as software, whose production entails large fixed start-up costs and low variable costs, will be subject to significant economies of scale. Because by definition fixed costs don’t increase as output increases, the average total cost of production for such goods will decline sharply as output increases. To illustrate, consider a production process for which total cost is given by the equation TC  F  M*Q, where F is fixed cost, M is marginal cost (assumed constant in this illustration), and Q is the level of output produced. For the production process with this simple total cost function, variable cost is simply M*Q, the product of marginal cost and quantity. Average total cost, TCQ, is equal to FQ  M. As Q increases, average cost declines steadily because the fixed costs are spread out over more and more units of output. Figure 9.2 shows the total production cost [part (a)] and average total cost [part (b)] for a firm with the total cost curve TC  F  M*Q and the corresponding average total cost curve ATC  FQ  M. The average total cost curve [part (b)] shows the decline in per-unit cost as output grows. Though average total cost is always higher than marginal cost for this firm, the difference between the two diminishes as ATC  F/Q  M M 0 Q (b) FIGURE 9.2 Total and Average Total Costs for a Production Process with Economies of Scale. For a firm whose total cost curve of producing Q units of output per year is TC  F  M*Q, total cost (a) rises at a constant rate as output grows, while average total cost (b) declines. Average total cost is always higher than marginal cost for this firm, but the difference becomes less significant at high output levels. fra02885_ch09_231-268 17/06/2008 7:23 pm Page 240 pinnacle MHBR:MH-BURR:MHBR034:MHBR034-09: www.downloadslide.com 240 CHAPTER 9 MONOPOLY, OLIGOPOLY, AND MONOPOLISTIC COMPETITION output grows. At extremely high levels of output, average total cost becomes very close to marginal cost (M). Because the firm is spreading out its fixed cost over an extremely large volume of output, fixed cost per unit becomes almost insignificant. As the following examples illustrate, the importance of economies of scale depends on how large fixed cost is in relation to marginal cost. Two video game producers, Nintendo and Playstation, each have fixed costs of $200,000 and marginal costs of $0.80 per game. If Nintendo produces 1 million units per year and Playstation produces 1.2 million, how much lower will Playstation’s average total production cost be? Table 9.1 summarizes the relevant cost categories for the two firms. Note in the bottom row that Playstation enjoys only a 3-cent average cost advantage over Nintendo. Even though Nintendo produces 20 percent fewer copies of its video game than Playstation, it does not suffer a significant cost disadvantage because fixed cost is a relatively small part of total production cost. TABLE 9.1 Costs for Two Computer Game Producers (1) Nintendo Playstation Annual production 1,000,000 1,200,000 Fixed cost $200,000 $200,000 Variable cost Total cost Average total cost per game $800,000 $960,000 $1,000,000 $1,160,000 $1.00 $0.97 ◆ In the next example, note how the picture changes when fixed cost looms large relative to marginal cost. Two video game producers, Nintendo and Playstation, each have fixed costs of $10,000,000 and marginal costs of $0.20 per video game. If Nintendo produces 1 million units per year and Playstation produces 1.2 million, how much lower will Playstation’s average total cost be? The relevant cost categories for the two firms are now summarized in Table 9.2. The bottom row shows that Playstation enjoys a $1.67 average total cost advantage over Nintendo, substantially larger than in the previous example. TABLE 9.2 Costs for Two Computer Game Producers (2) Nintendo Annual production Fixed cost Variable cost Total cost Average total cost per game Playstation 1,000,000 1,200,000 $10,000,000 $10,000,000 $200,000 $240,000 $10,200,000 $10,240,000 $10.20 $8.53