Chapter 12 | Monopoly 146
Chapter 12 | Monopoly 135
Chapter 12
Monopoly
Questions
1. What is meant by market power? What are the ways in which a
monopoly gains market power?
Answer: Market power relates to the ability of sellers to affect
prices. For the monopolist, market power arises because of barriers
to entry. Barriers to entry are obstacles that prevent potential
competitors from entering the market. There are two types of market
power that arise from barriers to entry: legal market power and
natural market power. Legal market power occurs when a firm obtains
market power through barriers to entry created not by the firm
itself, but by the government. For example, firms gain market power
through patents and copyrights. Natural market power arises when
the monopolist owns or controls a key resource necessary for
production or there are economies of scale in production over the
relevant range of output.
2. Use a graph to explain the difference between a competitive
firm’s average total cost curve and the average total cost curve of
a natural monopoly.
Answer: A natural monopoly enjoys economies of scale over the
relevant range of output. Economies of scale occur when the average
total cost per unit of output decreases as total output increases.
This means that the average total cost curve for a natural monopoly
is continuously declining and is negatively sloped. On the other
hand, a perfectly competitive firm faces a U-shaped average total
cost in the long run, which suggests that it faces increasing
returns to scale, constant returns to scale, and diminishing
returns to scale. Figure (a) shows the average total cost curve of
a competitive firm in the long run. Figure (b) shows the average
total cost curve of a natural monopoly in the long run.
3. What does it mean to say that a good generates network
externalities?
Answer: For a good with network externalities, the value of the
good to any particular consumer increases as more customers begin
to use it. For example, the value to you of being on Facebook is
higher the more people who use Facebook. Therefore by acquiring a
large customer base, a particular firm may acquire market
power.
4. Examine the following items and state whether each is a legal
or natural monopoly:
a. Railway infrastructure in the United States.
b. A seawater desalinization company in the United States.
c. A bicycle pedal manufacturing company in Denmark.
d. A mining company in South Africa.
e. An art restoration company in Serbia.
Answer:
a.A natural monopoly
b.A legal monopoly – patent
c.A legal monopoly – copyright
d.A legal monopoly – patent
e.A natural monopoly
5. There is no difference between a monopoly arising due to
legal market power and a monopoly resulting from natural market
power. Do you agree? Explain.
Answer: The statement is false. There are two types of market
power that arise from barriers to entry: legal market power and
natural market power. Legal market power occurs when a firm obtains
market power through barriers to entry created not by the firm
itself, but by the government. For example, firms gain market power
through patents and copyrights. Natural market power arises when
the monopolist owns or controls a key resource necessary for
production or there are economies of scale in production over the
relevant range of output.
6. Prior to the liberalization of the telecommunication market
in Singapore, there was only one company, Singapore Telecoms, which
provided phone services in Singapore. Did this mean that Singapore
Telecoms could charge any price it desired for its services?
Explain your answer.
Answer: The statement is false. The monopolist is powerful but
cannot sell at a point beyond the market demand curve; a monopoly
cannot set any price it wishes to because it faces a
downward-sloping market demand curve. With an increase in price,
the firm will sell a smaller number of units but will gain more
revenue per unit sold. With a decrease in price, the number of
units sold will increase but the revenue per unit will fall.
7. What is the difference between a perfectly competitive firm’s
demand curve and a monopolist’s demand curve?
Answer: A perfectly competitive firm's demand curve is
horizontal since the firm is a price taker and it is the same as
its marginal revenue curve. A monopolist's demand curve is downward
sloping since the firm's demand curve is the market demand curve
and it is above the marginal revenue curve. Refer to the diagram
below:
Monopolist's demand curve:
Competitive firm's demand curve:
8. What is the relationship between price, marginal revenue, and
total revenue for a monopolist?
Answer: As shown in the following figure, the total revenue
curve takes on a hump-back shape because it increases when marginal
revenue is positive and decreases when marginal revenue is
negative. For this reason, total revenue is at its maximum when the
marginal revenue curve crosses the x-axis — that is the point where
an additional unit of output causes marginal revenue to equal
zero.
9. Both competitive firms and monopolies produce at the level
where marginal cost equals marginal revenue. Then, other things
remaining the same, why is price lower in a competitive market than
in a monopoly?
Answer: In both market structures, firms produce the level of
output such that marginal cost equals marginal revenue. A firm in a
perfectly competitive market faces a perfectly elastic demand
curve. As a result, marginal revenue for a competitive firm is
equal to price. Therefore when a competitive firm equates marginal
revenue and marginal cost it also equates price and marginal cost.
For a monopolist, however, marginal revenue is less than marginal
cost. A monopolist faces a downward sloping market demand curve. As
a consequence a monopolist must reduce price in order to sell an
additional unit of its product. Therefore, for a monopolist,
marginal revenue is less than price; the difference between price
and marginal revenue is the effect of reducing price in order to
sell more output. As a result, when a monopolist equates marginal
revenue and marginal cost price will be greater than marginal cost
(since price is greater than marginal revenue).
10. Why does a monopoly firm not have a supply curve?
Answer: Firms that are price takers will decide how much to
produce based on the given market price. The quantity at which the
marginal cost of producing the last unit of a good is equal to any
given market price determines the firm’s supply decisions. However,
monopolists do not vary their production based on market price
because they set the price; it is not relevant to ask how much of a
good a monopolist will produce at a given price. Since a
monopolist’s production decision is based on demand, it cannot be
depicted as an independent supply curve (keep in mind that the
supply curve is willingness to sell at various prices, regardless
of demand). A monopolist chooses both price and quantity.
11. Explain why firms practice the following price
discrimination and classify the types of price discrimination.
a. A hotel charges walk-in customers a higher price than
customers who book rooms in advance.
b. A supermarket is promoting a particular brand of canned food
with a “buy two, get one free” offer.
c. Theaters charge a higher price during weekends and a lower
price during weekdays for the same movie.
Answer:
a. Depending on the cost in terms of time and effort required
this may or may not be price discrimination. If the cost is higher
to cut a woman’s hair than for a man’s, then there is no price
discrimination. However, if this is not so, then this is a case of
third-degree price discrimination.
b. This is an example of second-degree price discrimination
where consumers are charged different prices based on the
characteristics of their purchase.
c. This is an example of third-degree price discrimination where
price varies based on a customer’s attributes.
12. Why can a government choose to set a price ceiling for
natural monopolies?
Answer: Governments can set a price ceiling in a monopolized
market that is equal to marginal cost, which will likely be lower
than the average total cost. This means that the firm will
experience economic losses that may lead to an exit from the
industry. Alternatively, the government could require firms to set
the price at average total cost. This would allow the monopolist to
stay in business as the firm would not incur losses. The problem is
that the price is higher than the marginal revenue and marginal
cost. This means that the firm cannot produce enough goods or
provide enough services because the price will be too high for the
consumers. Setting a price ceiling means that a firm has no
incentive to minimize costs or to innovate.
13. Are there any cases where a monopoly is beneficial to the
economy? Explain.
Answer: Firms that are allowed monopoly profits search out every
possible avenue for innovative technologies that they can bring to
market. If there were perfect competition, firms would have less of
a reason to invest in research and development because they would
not enjoy the same levels of profit from innovation. Through entry,
economic profits would be driven to zero in the long run. If
innovators are not granted protection, profits may not be available
to spur invention. So, granting patents and copyrights involves a
tradeoff between the deadweight loss of a monopoly and the
incentive for research and development. It may also be the case
that the firm is a natural monopoly, which means it will enjoy
economies of scale that make it more efficient for a single firm to
operate in the market. Splitting supply between firms will leave
each seller with higher costs and lower profits.
Problems
1. This chapter explains that a monopoly is an industry
structure in which only one firm provides a good or a service that
has no close substitutes. Examine the following statements and
explain if you agree or not:
a. In case of natural monopolies, the companies should be
state-owned because their activity needs to be regulated by the
government.
b. In case of large industries, the companies need a competitive
attitude in the market even if there is vertical integration
because consumers need to maximize their benefits.
c. In all sectors of an economy, there should be no economic
concentration because the companies should have a wide distribution
of power.
Answer:
a. In the case of natural monopolies, based on the economies of
scale concept, it is efficient for a single firm to serve the
entire market, because it can do so at a lower cost than any larger
number of firms could. There are to be considered the high
infrastructural costs and other barriers to entry that are relative
to the size of market, which gives those industries important
advantages over potential competitors. Natural monopolies have high
fixed costs, for a product that does not depend on output, but its
marginal cost of producing one more unit of a good or service is
roughly constant, and small.
b. In the case of industrial activities, consumers want those
companies to be in competition, because this gives rise to
wide-ranging and diverse outcomes. Competition between sellers can
be fierce, with relatively low prices and high production,
innovation and marketing tools to attract more consumers. This
could lead to an efficient outcome for the consumers. Product
differentiation may be homogenous (chemicals) or heterogenous
(cars).
c. In all other sector of economy, there is no need for
price-makers, only for price-takers. The consumers want perfectly
competitive markets with low entry and exit barriers, homogeneity
of products and services, perfect knowledge about quality and
prices.
2. Critically analyze the following and explain whether you
agree or disagree:
a. Janet knows a lot of people who do not like Marmite, a yeast
extract that is used as a spread on toast. She says that Marmite is
so unpopular that Unilever, the company that manufactures Marmite®,
cannot possibly have any monopoly power.
b. Edgar says that a single firm in the wind power industry is
unlikely to have a significant degree of monopoly power for an
extended period of time. Since the cost of producing an additional
unit of wind energy is so low, a large number of firms can enter
the market and compete away economic profits.
Answer:
a. Janet is incorrect in assuming that a company cannot have
monopoly power in a market simply because she knows a lot of people
who do not like the product. A firm’s market power depends on its
ability to set prices in the market. If Unilever is the only firm
in the market for yeast spread and Marmite does not have any close
substitutes, it is likely that Unilever has monopoly power.
b. Edgar is incorrect as he ignores the fixed cost of operating
in the wind energy market. While the marginal cost of producing
wind energy may be low, a firm that wishes to enter the market will
face substantial fixed costs. This high fixed cost serves as a
barrier to entry in the market which means that an incumbent will
enjoy a significant degree of monopoly power.
3. Textbook publishers hope to maximize profits. Authors,
however, face very different incentives. Authors are typically paid
royalties, which are a specified percentage of total revenue from
the sale of a book. And so, for example, if an author’s contract
says that she will receive 20 percent of the revenues from the sale
of a text and the publisher’s total revenues are $100,000, the
author’s royalties will be $20,000. Who will prefer a higher price
for the text, the publisher or the author?
Answer: The publisher is likely to prefer a higher price for the
text. The diagram below helps explain this problem. The publisher
wants to maximize profits and therefore would prefer to sell Q1
books, the quantity that equates MR and MC. The publisher would
therefore like to choose the price P1. In contrast, an author who
wishes to maximize royalties will want to maximize total revenues;
the author in our example maximizes 20 percent of total revenues by
maximizing total revenues. In order to maximize total revenue, the
author would choose Q2, the quantity such that MR = 0. If MR = 0,
then total revenues will not rise if the publisher sells one more
book nor rise if the publisher sells one fewer book. The author
would therefore like to choose P2, which is less than the
publisher’s preferred price P1.
4. A profit maximizing translational firm produces upholstery
items. It has factories in other countries that specialize in
producing seats, padding, springs, and fabric cover. Each factory
receives 10 percent of the profit because the parent company wants
to encourage innovation and higher quality products. If the total
revenues of the parent company are $5,000,000, then each factory
receives $500,000 to develop itself. Who will benefit from higher
prices, the mother company or the factories? Explain.
Answer: We learned from the chapter that when price decreases,
total revenue increases if the quantity effect dominates the price
effect, or decreases if the price effect dominates the quantity
effect.
From the graph, we notice that if the company chooses a price of
$6,000, it will sell 10 pieces, but if it chooses a price of $8,000
or higher, it will sell nothing, despite having a monopoly.
Lowering the price to $4,000 will allow the company to sell 5 more
units (the quantity effect), thus an increase in revenues occurs.
However, the consumers who were buying at $5,000 will buy at
$4,000, so there is a loss in revenues (price effect). Calculating
the areas, the price effect is equal to $15,000 and the quantity
effect is $80,000. In this case, the price effect is lower than the
quantity effect, thus the total revenues increase and the demand is
elastic over this range of the demand curve.
5. A monopolist producing with a constant average cost and
marginal cost of $6 has the following demand for its product.
Price
Quantity
$10
1
$9
2
$8
3
$7
4
$6
5
a. Calculate total and marginal revenue for each output
level.
b. Find the optimal output and price.
c. Determine the profit or loss as this output.
Answers:
a. Total revenue is obtained by multiplying price by quantity.
Marginal revenue is obtained by change in total revenue over change
in output. Refer to the following table:
Price
Quantity
Total Revenue
Marginal Revenue
$10
1
$10
$10
$9
2
$18
$8
$8
3
$24
$6
$7
4
$28
$4
$6
5
$30
$2
b. The optimal output occurs at MR = MC. Since the marginal cost
is $6, the optimal output is 3 units where MR also equals $6. The
price is $8.
c. Since Price is $8 and the average cost is $6, the firm is
making a profit. The profit is ($8 − $6) × 3 = $6.
6. Suppose Cattcom is a monopolist in providing communication
services. The marker demand curve is P = 100 – Q, its total costs
are TC = Q/2 + 100, and its marginal cost is given by: MC = 10 +
Q.
a. What is the profit maximizing price and the quantity?
b. Suppose that the government imposes a tax, so the MC = 20 +
Q. What is the profit maximizing price and the quantity?
Answers:
a. To find the profit maximizing quantity, we need MR. For a
downward sloping demand curve, the MR has the same y-intercept and
twice the slope of this demand curve: MR = 100 – 2Q. Thus, MC = MR
→ 10 + Q = 100 – 2Q → Q = 30 units. Using this quantity, the profit
maximizing price is P = 100 – Q → P = $70 per unit.
b. If MC = 16 + Q, then 20 + Q = 100 – 2Q → Q = 26.6. The price
is P = 100 – Q → P = $73.4.
7. The following graph shows the demand, marginal revenue, and
marginal cost curves in a monopoly market.
a. Identify the profit-maximizing price and quantity for this
monopolist.
b. What is the value of the consumer surplus, producer surplus,
and deadweight loss in the market?
c. How would consumer surplus change if this market was
competitive?
Answer:
a. The monopolist will maximize profits by producing at the
quantity at which marginal cost equals marginal revenue. The
marginal revenue curve intersects the marginal cost curve at a
quantity of 4 units. Reading off the demand curve, the monopolist
should set a price equal to $22.50.
b. The value of consumer surplus (the area highlighted in medium
gray in the figure) = ½ × 4 × ($40.00 - $22.50) = $35
The value of producer surplus (the area highlighted in light
gray in the figure) = 4 × ($22.50 - $5.00) = $70
Deadweight loss (the area highlighted in dark gray in the
figure) = ½ × (8 – 4) × ($22.50 - $5.00) = $35
c. If this market was competitive, a firm would produce at the
point where the demand curve intersects the marginal cost curve.
The area above the marginal cost curve and below the demand curve
would be equal to consumer surplus. The value of consumer surplus
(the area highlighted in light gray in the figure) = ½ × 8 × ($40 -
$5) = $140.
8. Suppose that during the weekends, consumers choose to do
their shopping in large grocery chains, but during the week, they
choose their local corner store to satisfy their immediate
needs.
a. How can sellers maximize their profits using the consumers’
preferences?
b. Many retailers observe consumers’ online behavior. What price
strategy can large and local grocery retailers choose based on this
information?
Answer:
a. Sellers try to capture consumer surplus by setting a price
that is close or equal to the consumers’ willingness to pay. The
consumers state their willingness to pay more while going to large
grocery chains, because they buy in bulk, the products that they
normally use in high quantities. For daily use, however, they will
buy per unit goods.
b. The companies can monitor a consumer’s online behavior based
on their online purchasing, browsing history and social media
preferences and activity. If the prices seem to be too high for the
consumers, they will change their price strategy in the short term,
using digital advertising, promotions, coupons, discounts to meet
the consumer’s willingness to pay for those goods.
9. Yours is the only stall selling orange juice in a school
cafeteria. Your cost of producing one cup of orange juice is $0.50.
Currently, you are charging $1 for one cup of orange juice from
every student. You discover that students after PE class buy more
orange juice from you. On the other hand, students after a class on
calculus appear to be neutral to buying the orange juice.
a. If you were to charge the same price from every student, what
can you say about the consumer surplus and your profit?
b. If you were to practice price discrimination, what should you
do to the price of orange juice when you sell to the two groups of
students?
Answers:
a. Your marginal cost is $10. If you treat only John, your total
revenue is $30 and your total cost is $10, and your profit is $20.
If you treat both patients, you will charge a price of $25. In this
case, your total revenue is $50, your total cost is $20 and your
profit is $30. Hence, the price you charge is $25 and your profit
is $30.
b. You will charge each patient his or her reservation prices.
This will lead to first-degree price discrimination. Your total
revenue is $30 + $25 = $55 and your total cost is $20. Hence, your
profit is $35.
10. Consider a small city that is infested by cockroaches. You
have just opened the only pest control company in the city. There
are two distinct residential areas in the city, high-end area and
low-end area, but the cost to exterminate cockroaches is the same
in both areas. Consider two consumers with different demand curves.
Consumer A stays in the high-end residential area and has a
relatively inelastic demand for your pest control service. In
contrast, Consumer B stays in the low-end residential area and has
a relatively elastic demand for your pest control service.
a. If you were to engage in price discrimination, who will you
charge a higher price and who a lower price? Explain your
answer.
b. What is the type of price discrimination you engage in your
answer to part a? What are the conditions for price discrimination
to occur? Explain why you will earn a lower profit if you charge
the same price to both customers as compared to exercising price
discrimination.
Answers:
a. You will charge Consumer A a higher price since her demand is
relatively inelastic. This implies that Consumer A is not sensitive
to price. You will charge Consumer B a lower price since her demand
is relatively elastic, which means Consumer B is sensitive to
price.
b. This is the third-degree price discrimination where the firm
varies its price based on the consumers’ attributes. If you charge
a single price, it may be too low for Consumer A, when you can
actually earn more by charging a higher price. If you charge too
high a price, the price-sensitive Consumer B may not engage your
service. Thus, by charging a higher price to Consumer A and a lower
price to Consumer B, you can earn more profit than charging a
standard price to both consumers.
11. Imagine that you arrive at an economics experiment with six
other people and are told that you will simulate a market. You will
be the only seller. The other five people will be assigned a dollar
value that they will receive if they buy the good for any amount of
money (so if a person's value is $6, he will buy the good for any
price less than six dollars and will be happy). You are also given
the following demand curve, and told that it represents the values
that the "buyers" are assigned:
a. If you are told that you can produce as many units as you
like at a cost of $2 per unit, what would your marginal cost curve
look like? Add the marginal cost curve that you face as the
monopolist to the graph.
b. Draw the marginal revenue curve that you face as the
monopolist, based on the demand curve given above.
c. What price would you set and what quantity would you produce
if you have to post one price at which everyone can purchase the
good?
d. Based on the price and quantity you selected in part c, what
would consumer surplus be? What would producer surplus be? Is there
a deadweight loss?
e. Imagine that you are told that now you can have a discussion
with each buyer privately to negotiate a price. Would you still
charge everyone the same price? Explain your answer.
f. Calculate the surplus and the deadweight loss for a scenario
with perfect price discrimination.
Answers:
See diagram.
To get marginal revenue, first calculate total revenue (TR) for
each quantity. To sell one unit, price is $6 so TR = $6. To sell
two units, price is $5, so TR = $10. To sell three, price is $4, TR
= $12. Four, price is $3, TR = $12. Five, price is $2, TR = $10.
And to sell six units, price is $1, so TR = $6. The difference in
these numbers gives the marginal revenue, plotted in the diagram.
(MR = -$4 for Q = 6 is not shown.)
Profit will be maximized at the point where marginal revenue
equals marginal cost. This happens at either Q = 2 or Q = 3. For Q
= 2, price is $15, for Q = 3, price is $4. Either way profit is
maximized.
For price of $5, consumer surplus is ($6-$5) + ($5-$5) = $1. For
price of $4, consumer surplus is ($6-$4) + ($5-$4) + ($4-$4) = $3.
Either of these is a correct answer. The producer surplus is the
same either way (which is why there are two correct answers: $6.
For price of $5, you will sell two units at marginal cost of $2, so
surplus is $10 - $4 = $6. A similar calculation for price of $4
yields $12 - $6 = $6. The deadweight loss in the Q = 2 case is
($4-$2) + ($3 - $2) = $3. For Q = 3, deadweight loss is only ($3 -
$2) - $1. In both cases, it is the unrealized trades for which
benefit is greater than cost.
If you can negotiate a price individually with each buyer, you
will be able to charge each buyer a separate price based on his or
her willingness to pay. This is perfect price discrimination and
will allow you to maximize your surplus by capturing the entire
consumer surplus.
You would sell to the first five buyers but not the sixth (since
her willingness to pay is less than your marginal cost). You would
charge each consumer his or her willingness to pay and so in total
you would charge them $6 + $5 + $4 + $3 + $2 = $20. Your total cost
would be 5 x $2 = $10 and so your producer surplus would equal $20
- $10 = $10. Under perfect price discrimination consumer surplus is
zero and producer surplus is the maximized value of total surplus.
Thus, perfect price discrimination is socially efficient - it
provides the maximum level of social surplus – but the producer
captures the entire surplus.
12. A monopolist with constant marginal cost of $4 faces demand
QD = 20 - 2P. This implies that the inverse demand curve is P = 10
- (1/2)Q and that the marginal revenue is MR = 10 - Q.
a. Sketch demand, marginal revenue, and marginal cost.
b. What quantity and price will the monopolist set?
c. What is the producer surplus (profit, ignoring fixed costs)
for the firm?
Answers:
a. See diagram.
b. Set MR = MC, or 10 - Q = 4, thus Q = 6. At this quantity the
monopolist charges the highest price possible: P = $7.
c. Area below the price ($7) but above the cost curve. In this
case it is a rectangle: PS=($7-$4)(6-0)=$18.
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© 2017 Pearson Education, Inc.
©2018 Pearson Education Ltd.