Chapter
12
monopoly
Chapter Key Ideas
The Only Game in Town
A.Most buyers use e-Bay for auctions because most sellers use
e-Bay for auctions. Most companies and organizations list their
websites on Google because most internet browsing customers use
Google to search the web.
1.These firms clearly have little competition and enjoy
significant market power (ability to influence market price), so
these firms can’t be operating in a perfectly competitive
market.
2.Is there anything different about how firms with market power
operate? Do industries with a singularly dominant firm behave
differently than competitive ones?
B.Students get lots of price breaks—at the movies. Seniors get
price breaks at restaurants. Business travelers tend to pay higher
prices for tickets on the airlines.
1.How do firms get different people to pay different prices?
2.How can it be profit maximizing to offer lower prices to some
customers but higher prices to others?
Outline
I.Market Power
A.Market power and competition are the two forces that influence
the market structure of most markets.
1.Market power is the ability to influence the market, and in
particular the market price, by influencing the total quantity
offered for sale.
2.A monopoly is a firm that produces a good or service for which
no close substitute exists and which is protected by a barrier that
prevents other firms from selling that good or service.
B.How a Monopoly Arises
1.A monopoly market has two key features:
a)No close substitutes. The absence of any firms making close
substitute goods or services allows the monopolist to avoid
competition in the market.
b)Barriers to entry. Legal or natural constraints that protect a
firm from potential competitors are called barriers to entry.
2.There are two types of barriers to entry:
a)Legal barriers to entry create a legal monopoly—a market in
which competition and entry are restricted by the granting of a
public franchise, a government license, a patent, or a
copyright.
i)A public franchise exists when an exclusive right is granted
to a firm to supply a good or service. For example, the U.S. Postal
Service has a public franchise to deliver first-class mail.
ii)A government license exists when the government controls
entry into particular occupations, professions and industries. For
example, a license is required to practice law. Licensing doesn’t
always create a monopoly, but it does restrict competition.
iii)A patent is an exclusive right granted to the inventor of a
product or service, and a copyright is an exclusive right granted
to the author or composer of a literary, musical, dramatic, or
artistic work. Patents and copyrights don’t always create a
monopoly, but because these rights can be sold, they do restrict
competition.
b)Natural barriers to entry create a natural monopoly, which is
an industry in which one firm can supply the entire market at a
lower price than two or more firms can. Figure 12.1 shows the LRAC
curve for an electrical power company that is a natural
monopoly.
C.Monopoly Price-Setting Strategies
1.Monopolies face a tradeoff between the price it charges and
the quantity it can sell. For a monopoly firm to determine the
quantity it sells, it uses its market power to choose the
appropriate price.
2.There are two types of monopoly price-setting strategies:
a)Price discrimination is the practice of selling different
units of a good or service for different prices. Many firms price
discriminate, but not all of them are monopoly firms.
b)A single-price monopoly is a firm that must sell each unit of
its output for the same price to all its customers.
3.Although the practice of price discrimination appears to be
for the benefit some consumers, it is really an attempt by the firm
to receive the maximize price for each unit sold to maximize its
economic profit.
II.A Single-Price Monopoly’s Output and Price Decision
A.Price and Marginal Revenue
1.The demand curve facing a monopoly firm is the entire market
demand curve.
2.This demand curve relates the market price at which the
monopoly firm can sell the corresponding quantity of output.
a)Total revenue, TR, is the price, P, multiplied by the quantity
sold, Q.
b)Marginal revenue, MR, is the change in total revenue resulting
from a one-unit increase in the quantity sold. The key feature of a
single-price monopoly is that at each level of output, marginal
revenue is less than the price, that is, MR < P.
c)MR < P at every level of output because the single–price
monopoly firm must lower its price on all units sold to sell an
additional unit of output. This fact means that the extra revenue
received equals the price of the additional unit sold minus the
decrease in price for each of the previous units it would have sold
at the higher price. As a result, the net increase to firm’s
revenue, that is, its MR, is less than the price of the last unit
sold.
d)Figure 12.2 uses a demand curve to show how these offsetting
influences on total revenues.
B.Marginal Revenue and Elasticity
1.A single-price monopoly’s MR is related to the elasticity of
demand for its good.
a)If demand is elastic, a fall in price brings an increase in
total revenue. The rise in revenue from the increase in quantity
sold outweighs the fall in revenue from the lower price per unit,
and so the MR is positive.
b)If demand is inelastic, a fall in price brings a decrease in
total revenue. The rise in revenue from the increase in quantity
sold is outweighed by the fall in revenue from the lower price per
unit, and so the MR is negative.
c)If demand is unit elastic, a fall in price does not change the
firm’s total revenues. The rise in revenue from the increase in
quantity sold equals the fall in revenue from the lower price per
unit, and so the MR is zero.
2.Figure 12.3 shows the relationship between elasticity of
demand and total revenues for all three cases.
3.A single-price monopoly will never produce at an output for
which demand is inelastic. If it did so, the firm could decrease
output, increase total revenue while decreasing total cost, and
thereby enjoy higher economic profits. So a single price monopoly
will always maximize its economic profit by producing in the
elastic range of its demand.
C.Price and Output Decisions
1.The monopoly faces the same types of technology and cost
constraints as does a competitive firm, so its costs behave the
same as the costs of a perfectly competitive firm. But the monopoly
faces a different type of market constraint.
a)The monopoly selects the profit-maximizing level of output in
the same manner as a competitive firm, choosing the level of output
where: MR = MC.
b)The monopoly sets its price at the highest level at which it
can sell the profit-maximizing quantity. Table 12.1 uses a
numerical example to illustrate the monopoly firm’s output and
price decision.
2.The monopoly might earn an economic profit—even in the long
run—because the barriers to entry protect the firm from market
entry by competitor firms.
a)Figure 12.4 illustrates the profit-maximizing choices of a
single-price monopolist.
b)A monopoly is not guaranteed an economic profit. An economic
profit is received only when P > ATC.
III.Single-Price Monopoly and Competition Compared
A.Comparing the same industry under perfect competition and
monopoly reveals the significant differences in these two types of
markets.
B.Comparing Output and Price
1.Figure 12.5 shows the market outcomes under perfect
competition and under monopoly.
2.The market demand curve, D, in perfect competition is the same
demand curve that the firm faces in monopoly.
3.The market supply curve, S, in perfect competition is the
horizontal sum of the individual firm’s marginal cost curves (S =
sum of MC for each firm). This supply curve is also the monopoly’s
marginal cost curve.
4.Equilibrium in perfect competition occurs where the quantity
demanded equals the quantity supplied at quantity QC and market
price PC.
5.The profit-maximizing equilibrium output for a monopoly QM
occurs where MR = MC. Equilibrium price for the monopoly, PM, is
obtained from the demand curve, at the profit-maximizing
quantity.
6.The monopoly firm produces less output and charges a higher
price than a perfectly competitive market.
B.Efficiency and Comparison
1.The monopoly output decision is inefficient. Figure 12.6 shows
why this result is so.
a)The demand curve, D, is the marginal benefit curve for
society, MB, and the competitive market supply curve, S, is the
marginal cost curve for society, MC. So competitive equilibrium is
efficient because output is produced where MB = MC.
b)Monopoly is inefficient because output occurs where MB >
MC.
c)For all output levels at which MB > MC, a deadweight loss
is incurred. So, an increase in output would generate additional MB
for society that would exceed the additional MC to society.
C.Redistribution of Surpluses
Monopoly redistributes a portion of consumer surplus by changing
it to producer surplus.
D.Rent Seeking
1.The social cost of monopoly may exceed the deadweight loss
through an activity called rent seeking, which is any attempt to
capture a consumer surplus, a producer surplus, or an economic
profit. Rent seeking is not confined to a monopoly.
2.There are two forms of rent seeking:
a)Buy a monopoly—expend resources by seeking out the opportunity
to buy monopoly rights for a price below the value of the economic
profit earned by the monopoly. Example: The buying of taxi cab
medallions (a government license) in New York City.
b)Create a monopoly—expend resources seeking political
influence, such as lobbying legislators to provide preferential
market status by restricting domestic competition or enacting
tariffs on imports. Example: U.S. steel firms successfully seeking
large tariffs placed against imported steel from foreign firms.
E.Rent-Seeking Equilibrium
1.There are no barriers to entry in the activity of rent
seeking. This fact means that the resources used up in rent seeking
are costs which can exhaust the monopoly’s potential economic
profit and leave the monopoly owner with only a normal profit.
2.However, the outcome is still not efficient, because output
does not occur where MB = MC. Figure 12.7 shows the
normal profit outcome that results from rent seeking.
IV.Price Discrimination
A.Price discrimination is the selling of different units of a
good or service for different prices.
1.To be able to price discriminate, a firm must:
a)Identify and separate different buyer types
b)Sell a product that cannot be resold
2.Price discrimination occurs because of different consumer’s
willingness to pay for the good.
a)Price discrimination does not occur because of cost
differences between units produced.
b)Not all observed price differences are the result of price
discrimination.
B.Price Discrimination and Consumer Surplus
1.Price discrimination converts consumer surplus into economic
profit.
2.A monopoly firm can price discriminate in different ways:
a)Monopoly firms can charge the same buyer a different price for
each unit sold. Quantity discounts are an example. However,
quantity discounts that reflect lower costs at higher volumes are
not price discrimination.
b)Monopoly firms can charge different buyers different prices
for the same good or service. Giving a lower price on advance
purchase airline tickets is an example of this form of price
discrimination.
C.Profiting by Price Discriminating
Figure 12.8 and Figure 12.9 show the same market with a single
price monopoly firm and monopoly firm practicing price
discrimination, respectively. Comparing these two diagrams shows
how price discrimination converts consumer surplus into economic
profit for the firm.
D.Perfect Price Discrimination
1.Perfect price discrimination occurs if a firm is able to sell
each unit of output for the highest price anyone is willing to pay
for it. The outcome of perfect price discrimination is
characterized by:
a)Economic profit increases above that earned by a single-price
monopoly firm.
b)Output increases to the quantity at which
P = MC.
c)Deadweight loss is eliminated.
2.Figure 12.10 shows the outcome of perfect price
discrimination.
E.Efficiency and Rent Seeking with Price Discrimination
1.The more perfectly a monopoly can price discriminate, the
closer its output gets to the competitive output where P = MC and
the outcome is more efficient.
2.However, this outcome differs from the outcome of perfect
competition in two important ways:
a)The monopoly firm captures the entire consumer surplus.
b)The increase in economic profit attracts even more
rent-seeking activity that leads to an inefficient use of resources
for society.
V.Monopoly Policy Issues
A.Gains from Monopoly
1.Monopolies create inefficiency:
a)Both single-price and price-discriminating monopolies create
deadweight loss. And a price discriminating monopoly converts
consumer surplus into producer surplus and economic profit.
b)Both types of monopoly also encourage rent-seeking activity,
which wastes resources.
2.However, monopoly also brings benefits to society:
a)Patents and copyrights provide protection from competition,
which lets the monopoly enjoy the profits stemming from product
innovation for a longer period of time. This encourages more
expenditures on researching/developing new products.
b)When production technology exhibits potential for economies of
scale or economies of scope, a monopoly firm can produce goods at a
lower ATC than what a large number of competitive firms could
achieve. (However, because of the deadweight loss, this lower cost
of production cannot be fully experienced by society unless the
monopoly firm sells the good at a competitive market price.)
B.Regulating Natural Monopoly
1.Where demand and cost conditions create a natural monopoly, a
federal, state, or local government agency usually steps in to
regulate the price of the monopoly.
a.Figure 12.11 shows a the output decisions of a natural
monopoly firm and compares two types of outcomes with government
regulation with the outcome of no regulation.
b.Left alone, the natural monopoly will charge a price and
produce at a quantity where MR = MC. Under this outcome, P > MC
and the quantity produced is less than the efficient level of
output under perfect competition.
2.Regulating a natural monopoly in the public interest sets firm
output where MB = MC and P = MC. Setting price equal to marginal
cost is called the marginal cost pricing rule, and it results in an
efficient use of resources.
a)With output occurring where P = MC, the firm’s ATC > P and
the monopoly incurs an economic loss. If the monopoly receives a
subsidy from the government equal to its economic loss, then taxes
must be imposed on some other economic activity. This tax creates
deadweight loss in the allocation of resources in the taxed
market.
b)Where possible, a regulated natural monopoly might be
permitted to price discriminate to cover the loss from marginal
cost pricing.
3.Another alternative is to produce the quantity at which P =
ATC. Setting the price equal to the average total cost is called
the average cost pricing rule.
a)Output occurs where P > MC, which means that resources are
not allocated as efficiently as with a perfectly competitive
market.
b)However, the inefficiency is less than the unregulated market
outcome.
Reading Between the Lines
The market structure of two internet-based firms are compared to
see whether they fit the description of a natural monopoly. e-Bay
is a natural monopoly, exhibiting both economies of scale (high
fixed costs, low variable costs) and no close substitutes (due to
network externalities). Google also exhibits economies of scale for
the same reasons as e-Bay. However, Google faces high competition
from firms making close substitutes that will likely be developed
soon in the fast-paced development of search engine software
design.
New in the Seventh Edition
The Reading Between the Lines looks at the firms e-Bay and
Google to illustrate the characteristics of a natural monopoly.
Teaching Suggestions
1.Market Power: Students love a monopoly (if they are the
monopolist) Most of your students are taking an economics course
because they think it will help them either get a better job or run
a better business. Many of your students are aspiring
entrepreneurs. You’ve just had them slog through a heavy chapter on
perfect competition, the upshot of which is: The firm’s bottom line
is miserable. Normal profit maybe the best that many people can
achieve but it is not very exciting. This chapter teaches the
students how to make some serious entrepreneurial income. Innovate,
create a monopoly that produces something that people value much
more than the cost of producing it, and price-discriminate as much
as possible.
Use the monopoly model as a benchmark. Explain (like you did in
the case of perfect competition) that although no real-world
industry satisfies the full definition of a monopoly market, the
behavior of firms in many real world industries can be predicted by
using the monopoly model. Mention that this chapter examines the
least competitive end of the spectrum of markets, just like Chapter
11 discussed the most competitive end.
2.A Single-Price Monopoly’s Output and Price Decision
Marginal revenue curve. Students don’t find the concept of
marginal revenue too difficult, but they do need to be clear on the
intuition of the MR curve and the reason why MR < P at all
levels of quantity for a single-price monopoly. This fact is the
central source of the monopoly market outcomes.
The classic monopoly diagram. The classic monopoly diagram,
Figure 12.4b, provides a good opportunity to tell your students
about the contribution of one of the most brilliant economists of
the 20th century, Joan Robinson. This diagram first appeared in her
book, The Economics of Imperfect Competition, published in 1933
when she was just 30 years old. (You can learn more about Joan
Robinson at
http://cepa.newschool.edu/het/profiles/robinson.htm).
Women are still not attracted to economics on the scale that
they’re attracted to most other disciplines, so the opportunity to
talk about an outstanding female economist shouldn’t be lost. Joan
Robinson was a formidable debater and reveled in verbal battles, a
notable one of which was with Paul Samuelson on one of her visits
to MIT. Anxious to make and illustrate a point, Samuelson asked
Robinson for the chalk. Monopolizing the chalk and the blackboard,
the unyielding Robinson snapped, “Say it in words young man.”
Samuelson meekly obeyed.
This story illustrates Joan Robinson’s approach to economics:
work out the answers to economic problems using the appropriate
techniques of math and logic, but then “say it in words.” Don’t be
satisfied with formal argument if you don’t understand it. Your
students will benefit from this story if you can work it into your
class time.
3.Single-Price Monopoly and Competition Compared: Monopoly is
always inefficient. The inefficiency of monopoly is one of the key
propositions in this chapter.
· When a monopoly firm operates where MR = MC, it chooses an
output level where P > MR and P > MC. A single-price monopoly
under-produces and creates a deadweight loss.
· Rent seeking uses further resources, so potentially the social
cost of monopoly is the sum of the deadweight loss and the economic
profit that a monopoly might earn.
· Price Discrimination by a monopoly firm is relatively less
inefficient, but it is still not as efficient as perfect
competition.
· Adam Smith described the situation thus: “People in the same
trade seldom meet together, even for merriment and diversion, but
the conversation ends in some contrivance to raise prices.
4.Monopoly Policy Issues
A quick introduction. The treatment of monopoly policy here is
designed for the instructor who wants to cover the topic briefly
and at this point in the course. Chapter 14 provides a more
extensive treatment of regulation and antitrust law. You can cover
that chapter, in whole or part, right now if you want to do more on
the topic.
The Big Picture
Where we have been
Chapter 11 on perfect competition and Chapter 12 on monopoly
have shown the student the two opposite ends of the market spectrum
(relevant to market power) and contrasted the performance of these
ideal market types. The chapters have also deepened the student’s
understanding of the efficiency of competitive markets and the
source of inefficiency of monopoly.
Where we are going
Chapter 13 describes firms and industries in monopolistic
competition and oligopoly and fills in the middle of the spectrum.
Chapter 14 expands on the final section of the present chapter by
reviewing regulation and antitrust law.
Overhead Transparencies
Transparency
Text figure
Transparency title
73
Figure 12.2
Demand and Marginal Revenue
74
Figure 12.3
Marginal Revenue and Elasticity
75
Figure 12.4
A Monopoly’s Output and Price
76
Figure 12.5
Monopoly’s Smaller Output and Higher Price
77
Figure 12.6
Inefficiency of Monopoly
78
Figure 12.9
Price Discrimination
79
Figure 12.10
Perfect Price Discrimination
80
Figure 12.11
Regulating a Natural Monopoly
81
Table 12.1
A Monopoly’s Output and Price Decision
Electronic Supplements
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PowerPoint Lecture Notes
PowerPoint Electronic Lecture Notes with speaking notes are
available and offer a full summary of the chapter.
PowerPoint Electronic Lecture Notes for students are available
in MyEconLab.
Instructor CD-ROM with Computerized Test Banks
This CD-ROM contains Computerized Test Bank Files, Test Bank,
and Instructor’s Manual files in Microsoft Word, and PowerPoint
files. All test banks are available in Test Generator Software.
Additional Discussion Questions
1.The double-edged sword of a natural monopoly. Emphasize how
economic analysis reveals the social benefits and costs of an
industry characterized by a downward sloping, long run ATC curve.
Ask the student the following questions:
What is the characteristic of the monopoly market that allows a
natural monopoly to potentially produce output at the lowest
possible ATC? The student should see that a lack of competition
allows the firm to potentially serve the entire market at a lower
unit cost than if it had to share the market with any other number
of firms. A multi-firm market would be forced to produce at a
higher ATC.
What is the characteristic of a monopoly market that allows a
natural monopoly to potentially charge consumers a price premium
above long-run ATC? If the natural monopoly has the freedom to set
its own price, the student should identify the lack of competition
that prevents the consumer from benefiting from production actually
occurring at the lowest ATC. On the one hand, the lack of
competition is the only way to allow society to enjoy a
(potentially) more efficient allocation of resources, yet it also
allows the firm to extract consumer surplus while generating an
inefficient resource allocation—a “double-edged sword.”
2.Troubles with price discrimination: The ethics of scalping.
Get the students to address the realities of arbitrage in secondary
markets that arise when the primary seller of a good refuses to
price discriminate.
Is it in society’s best interest (economically efficient) to
allow the scalping of tickets? The students should see that ticket
scalping is just a form of price discrimination, which is a
business practice shown in the text to increase the level of
efficiency in resource allocation within a monopoly market
context.
Why do the original ticket sellers refuse to price discriminate
like the scalpers? There are many possible reasons:
· The original seller of the tickets (usually the music group
giving the concert or the ticket sellers that are under direct
contract for them) may want to avoid the reputation of charging
different prices to different people, or different prices at
different time intervals before the concert.
· The original seller may not have the ability to distinguish
between high and low demand customers, like those who sell the
tickets standing outside the doors on the day of the concert
· The original sellers may be very risk averse and prefer to
sell every ticket well in advance of the concert date, based on the
expectations of sales potential made with the best available
information at the time. However, information about the actual
demand for a concert becomes clearer as the concert date draws
nearer and the equilibrium price for a ticket may change
significantly. Scalpers must gamble that ticket prices will
increase when it eventually becomes clear that demand for the event
is relatively inelastic. They bear the risk that the original
ticket seller would not bear: that the ticket prices may also
decrease if it is revealed that demand for the event is relatively
elastic.
Is it “fair” to allow scalping of concert tickets? Remind the
students that the practice of price discrimination can increase
monopoly profits for the resellers while simultaneously increasing
efficiency for society. Remind them of the principle of opportunity
cost and ask them to consider how much efficiency they are willing
to give up in the name of “fairness.”
If it is unfair to scalp tickets because of the way price
discrimination transfers consumer surplus to producer surplus, then
what about other forms of price discrimination? Ask the students to
consider the following scenarios. They should understand that in
each case, there is an identifiable group of consumers who have a
different willingness to pay for the product or service
mentioned.
· If the costs of projecting a movie are the same at all times
of day, why are matinee movie prices lower than evening movie
prices for the exact same movie in the exact same theater? Why do
movie theaters often give students discounts?
· If the cost of publication is the same for all potential
subscribers, then why do magazines and newspapers offer students
discounts on subscription prices?
· If the cost of serving beverages and supplying entertainment
(live bands) is the same for both men and women, then why do bars
and clubs offer “Ladies Night” where women get free drinks or pay
no cover charge?
· If the cost of serving food and beverages is the same for all
diners, then why do seniors get a price break from restaurants for
the exact same meals?
3.Why is a monopoly firm motivated to operate at the socially
inefficient level of output and steal away consumer surplus? The
lack of competition from barriers to entry gives the monopoly firm
the ability to exercise market power and set price. Market power
drives a wedge between the price the monopoly firm receives for
selling an additional unit and the marginal revenue received from
selling that additional unit. Selling fewer units creates a
deadweight loss, some of which is borne by the monopoly firm.
However, it more than makes up for its share of lost producer
surplus by extracting a larger amount of consumer surplus.
4.How would you measure the inefficiency of a monopoly? The
students should see that the lost potential for consumer and
producer surplus could be calculated as deadweight loss, but that
is only part of the total loss of benefits. Ask the students:
Is there more to the inefficiency of a monopoly than meets the
eye? If you are rather brave, you may want to ask the students to
play the following game: Show the class a fresh, real five-dollar
bill. Announce that it is a monopoly profit that anyone in class
can receive simply by submitting the highest, non-zero price bid
for it. Mention that even if the highest bid is only one penny,
then that person will receive the five-dollar bill. However,
everyone else that submits a bid must also pay you the value of
that bid, regardless of whether they are successful. In the case of
a tie for highest bid, a run-off bidding contest among the tied
high bidders will occur, but their first bid still stands as a debt
to you, the holder of the monopoly profit.
How much would YOU bid for this monopoly profit? Ask the
students to write down on a small piece of paper their name and the
price he or she is willing to bid for the five-dollar bill. They
may write a bid of zero cents, but they will not get a chance to
win. Announce that you will collect the money from them later (you
will have their name and their bid). After collecting the bids,
roughly tally them up and announce the winning bid, as well as the
total sum of the bids to be collected. There are two possible
scenarios to the outcome of this auction:
There is one high bidder, and this bid is usually very close to
the monopoly profit offered for sale—there are usually one or two
students who want to signal their “devil-may-care” attitude or
signal their status as a relatively wealthy student who can afford
to play extravagant games.
There is a tie between two or more students. The resulting
run-off bidding is usually very high, because each of the remaining
students hasn’t yet fully appreciated the economic notion of sunk
costs. In this latter case, do not be surprised if the winning bid
is more than five dollars, as the “winner” wants desperately not to
lose the full amount of his or her initial bid.
What is the total opportunity cost of the resources used to
pursue monopoly profits? Point out that the bids represent the
resources people use (usually through lobbying efforts) to pursue a
monopoly market position by convincing government to restrict
competition. Ultimately, only one person wins, but all contenders
expend resources in the pursuit. That is why all losing bidders had
to pay their bid price.
Can we compare the value of lost output in other markets that
could have been produced against the value of those goods and
services produced specifically for pursuing a monopoly? Emphasize
that the goods and services that were used to pursue a monopoly
would not have been chosen for production if the monopoly profit
hadn’t been offered up for sale in the first place. That is how we
can know that rent seeking is inefficient—there was a decline in
net benefits for society from forgone production of higher-valued
goods. After the discussion is over, give the highest bidder the
five-dollar bill in exchange for the bid he or she pledged. (You
were warned about having to be brave!) If the highest bid is over
five dollars, just state that you will forgive the student his or
her debt and call it a wash. Then announce that the other bidders
are also off the hook, as you were just trying to make the scenario
as realistic as possible. Many sighs of relief will be heard.
Answers to the Review Quizzes
Page 267
1.A single-price monopoly firm chooses to maximize profits by
producing at an output level where marginal cost equals marginal
revenue (MR = MC).
2.The market demand curve is the monopolist firm’s demand curve.
The demand curve reveals that the profit-maximizing level of output
is associated with a maximum price that the monopolist firm can
charge and sell that level of output.
3.The MR < P at every level of output. When the
profit-maximizing monopoly firm chooses output where MR = MC, MC
must be below price: (MR = MC) < P.
4.Barriers to entry prevent the monopoly firm from enduring the
pressure of competition, and allow it to choose the quantity of
output that is associated with the profit-maximizing market price.
This allows a monopoly firm to potentially enjoy positive economics
profits, even in the long run.
Page 271
1.The market supply curve for a competitive industry is the
horizontal summation of the individual firm’s marginal cost curves.
Equilibrium output level is determined where market supply curve
intersects the market demand curve, and market price equals
marginal cost. Equilibrium output for a single-price monopoly is
determined by the intersection of its marginal cost curve and the
marginal revenue curve. Marginal revenue is always less than price,
which means that MR = MC at a lower level of output than P=MC, and
market price exceeds the marginal cost. Compared to a perfectly
competitive firm, a monopoly restricts its output and charges a
higher price.
2.The monopoly raises price by lowering quantity offered for
sale. This raises the price consumers must pay for the good
compared to the competitive market price. This difference in price
multiplied by the quantity the monopolist sells represents the
amount of consumer surplus that is transferred to producer
surplus.
3.In a competitive market, the supply curve represents marginal
cost to society, and the demand curve represents the marginal
benefits to society. The perfectly competitive market is efficient
because production occurs where supply equaled demand (MB = MC).
The monopolist is inefficient because price exceeds marginal cost
at all levels of output. When the monopoly equates MC = MR to
choose the profit-maximizing level of output, it charges a price
from the demand curve that is greater than marginal cost, which
means MB > MC. Consumer and producer surplus are not maximized
and society suffers a dead weight loss.
4.Rent seeking is any attempt to capture consumer surplus,
producer surplus, or economic profit. There are two forms of rent
seeking activity to pursue a monopoly status: i) Buying a monopoly,
where a person expends resources seeking to purchase monopoly
rights for a price slightly less than the monopoly profits, or ii)
Creating a monopoly, where a person expends resources seeking
political influence, such as lobbying legislators to provide
preferential market status by restricting domestic competition or
enacting tariffs on imports. The resources expended in rent seeking
can be equal to (or even greater than) the economic profit that a
monopoly status would create for the owner.
Page 274
1.Price discrimination is the practice of selling different
units of a good or service for different prices. In order for a
monopoly to practice price discrimination, a monopoly must be able
to: i) identify and separate different buyer types, and ii) sell a
product that cannot be resold. The key idea to price discrimination
is to charge different consumers different prices, according to
their willingness to pay for the good. This transfers potential
consumer surplus under a single-price scenario into producer
surplus, raising monopoly profits.
2.When a monopoly price discriminates, it charges different
prices to different consumers and transfers the consumer surplus
that would appear under a single-price scenario into producer
surplus, increasing monopoly profits.
3.Perfect price discrimination is when a monopoly charges each
consumer the maximum price he or she is willing to pay. This
transfers the entire potential consumer surplus to producer
surplus. The monopoly increases its profits compared to charging a
single-price to all customers and produces at a higher level of
output, where price equals marginal cost. This outcome achieves
efficiency by eliminating the deadweight loss relative to a
single-price monopoly outcome.
4.A consumer’s elasticity of demand for airline tickets tends to
increases with the amount of advance time they are willing to
endure for purchasing them. The airline companies make airline
tickets non-transferable, preventing consumers with high elasticity
of demand form reselling their less expensive tickets to those
consumers with inelastic demand. This allows the airlines to charge
different prices to different groups of consumers, according to
their willingness to pay.
Page 277
1.First, monopolies might encourage product innovation. Patents
and copyrights provide protection from competition and let the
monopoly enjoy the profits stemming from innovation for a longer
period of time. Second, monopolies can take advantage of economies
of scale and scope. A monopoly’s access to different technology
stemming from larger production runs can generate marginal costs
that are lower than a supply curve of a competitive industry over
the larger range of output. This means the monopoly can produce
more output and charge a lower price than would a firm in a
perfectly competitive industry.
2.Economies of scale occur if the firm’s ATC declines as it
expands output. Examples given in the text are public utilities
such as water and natural gas, although the economies of scale may
occur only in distribution and not production. Economies of scope
take place if the firm’s ATC declines as the number of different
goods produced increases. Examples given in the text are burger and
fry production at fast food restaurants, the manufacture of
household appliances and the refining of petroleum.
3.Monopoly markets may encourage greater product innovation than
under perfect competition. Patents and copyrights provide
protection from competition and let the monopoly enjoy the profits
from innovation for a longer period of time.
4.Regulating the actions of a natural monopoly in the public
interest implies setting the level of output where the MB = MC, and
the monopoly must set its price equal to marginal cost. This is
type of regulation is called the marginal cost pricing rule,
resulting in a maximum of total consumer and producer surplus in
the market. However, when the monopoly price equals marginal cost,
the ATC exceeds the price and the monopoly suffers an economic
loss. The monopoly will exit the market unless it receives a
subsidy to return it to zero economic profit. Yet this subsidy must
be raised through imposing taxes on other economic activity, which
creates deadweight loss and prevents efficient resource allocation
in the markets affected by the tax.
5.For a natural monopoly, marginal cost is less than average
cost at all levels of output in the market. The marginal cost
pricing rule will generate greater consumer surplus and less
producer surplus because P = MC at a higher level of output than
when P = ATC. However, when P = MC, ATC exceeds price and the
monopoly suffers an economic loss (negative producer surplus). The
monopoly will only stay in business if it receives a subsidy to
make up for the economic loss, returning it to a zero producer
surplus (normal profit) condition. Yet this subsidy must be
provided through taxing other markets, causing inefficient resource
allocations in those markets. While the monopoly market will be
efficient (MB = MC) and not experience a deadweight loss, the other
markets affected by the tax will experience an increase in dead
weight loss. The average cost pricing rule generate the same
producer surplus as a subsidized monopoly under a marginal cost
pricing rule, but the consumer surplus will be lower because P =
ATC at a lower level of output than P = MC. Deadweight loss will
occur in this monopoly market because MB no longer equals MC. This
result occurs because the monopoly produces where P = ATC and ATC
exceeds MC at this level of output.
Answers to the Problems
1.a.Minnie’s total revenue schedule lists the total revenue at
each quantity sold. For example, Minnie’s can sell 1 bottle for $8
a bottle, which is $8 of total revenue at the quantity 1
bottle.
b.Minnie’s marginal revenue schedule lists the marginal revenue
that results from increasing the quantity sold by 1 bottle. For
example, Minnie’s can sell 1 bottle for a total revenue of $8.
Minnie’s can sell 2 bottles for $6 each, which is $12 of total
revenue at the quantity 2 bottles. So by increasing the quantity
sold from 1 bottle to 2 bottles, marginal revenue is $4 a bottle
($12 minus $8).
2.a.Burma’s total revenue schedule lists the total revenue at
each quantity sold. For example, Burma’s can sell 2 rubies for $700
each, which gives it a total revenue of $1,400 at the quantity 2
rubies.
b.Burma’s marginal revenue schedule lists the marginal revenue
that results from increasing the quantity sold by 1 ruby. For
example, Burma’s can sell 1 ruby for $900, which is total revenue
of $900 at the quantity of 1 ruby. Burma’s can sell 2 rubies for
$700 each, which is $1,4000 of total revenue at the quantity 2
rubies. So by increasing the quantity sold from 1 to 2 rubies,
marginal revenue is $500 per ruby ($1,400 minus $900).
3.a.Marginal cost is the increase in total cost that results
from increasing output by 1 unit. When Minnie’s increases output
from 1 bottle to 2 bottles, total cost increases by $4, so the
marginal cost is $4 a bottle.
b.Minnie’s profit-maximizing output is 1.5 bottles.
The marginal cost of increasing the quantity from 1 bottle to 2
bottles is $4 a bottle ($7 minus $3). That is, the marginal cost of
the 1.5 bottles is $4 a bottle. The marginal revenue of increasing
the quantity sold from 1 bottle to 2 bottles is $4 ($12 minus $8).
So the marginal revenue from 1.5 bottles is $4 a bottle. Profit is
maximized when the quantity produced makes the marginal cost equal
to marginal revenue. The profit-maximizing output is 1.5
bottles.
c.Minnie’s profit-maximizing price is $7 a bottle.
The profit-maximizing price is the highest price that Minnie’s
can sell the profit-maximizing output of 1.5 bottles. Minnie’s can
sell 1 bottle for $8 and 2 bottles for $6, so it can sell 1.5
bottles for $7 a bottle.
d.Minnie’s economic profit is $5.50.
Economic profit equals total revenue minus total cost. Total
revenue equals price ($7 a bottle) multiplied by quantity (1.5
bottles), which is $10.50. Total cost of producing 1 bottle is $3
and the total cost of producing 2 bottles is $7, so the total cost
of producing 1.5 bottles is $5. Profit equals $10.50 minus $5,
which is $5.50.
e.Minnie’s is inefficient. Minnie’s charges a price of $7 a
bottle, so consumers get a marginal benefit of $7 a bottle.
Minnie’s marginal cost is $4 a bottle. That is, the marginal
benefit of $7 a bottle exceeds Minnie’s marginal cost.
4.a.Burma’s marginal cost when output is increased from 1 ruby
to 2 rubies a day is $80. The total cost of producing 1 ruby is
$1,220 and the total cost of producing 2 rubies is $1,300, so the
marginal cost of an additional ruby is $80.
b.Burma’s profit-maximizing output is 2.5 rubies a day.
The marginal cost of increasing the quantity from 2 rubies to 3
rubies is $100 ($1,300 minus $1,400). That is, the marginal cost of
producing the 2.5th ruby is $100. The marginal revenue of
increasing the quantity sold from 2 to 3 rubies is $100 ($1,400
minus $1,500). So the marginal revenue from selling the 2.5th ruby
is $100. Profit is maximized when the quantity produced makes the
marginal cost equal to marginal revenue. The profit-maximizing
output is 2.5 rubies per day.
c.Burma’s profit-maximizing price is $600 a ruby.
The profit-maximizing price is the highest price that Burma’s
can sell the profit-maximizing output of 2.5 rubies a day. Burma’s
can sell 2 rubies for $700 each and 3 rubies for $500 each, so it
can sell 2.5 rubies for $600 each.
d.Burma’s economic profit is $150.
Economic profit equals total revenue minus total cost. Total
revenue equals price ($600 a ruby) multiplied by quantity (2.5
rubies), which is $1,500. Total cost of producing 2 rubies is
$1,300 and the total cost of producing 3 rubies is $1,400, so the
total cost of producing 2.5 rubies is $1,350. Profit equals $1,500
minus $1,350, which is $150.
f.Burma’s is inefficient. Burma’s charges a price of $600 a
ruby, so consumers get a marginal benefit of $600 a ruby. Burma’s
marginal cost is $100 a ruby. That is, consumers’ marginal benefit
exceeds Burma’s marginal cost.
5.a.The profit-maximizing quantity is 150 newspapers a day and
price is 70 cents a paper.
Profit is maximized when the firm produces the output at which
marginal cost equals marginal revenue. Draw in the marginal revenue
curve. It runs from 100 on the y-axis to 250 on the x-axis. The
marginal revenue curve cuts the marginal cost curve at the quantity
150 newspapers a day.
The highest price that the publisher can sell 150 newspapers a
day is read from the demand curve.
b.The daily total revenue is $105 (150 papers at 70 cents
each).
c.Demand is elastic.
Along a straight-line demand curve, demand is elastic at all
prices above the midpoint of the demand curve. The price at the
midpoint is 50 cents. So at 70 cents a paper, demand is
elastic.
d.The consumer surplus is $22.50 a day and the deadweight loss
is $15 a day.
Consumer surplus is the area under the demand curve above the
price. The price is 70 cents, so consumer surplus equals (100 cents
minus 70 cents) multiplied by 150/2 papers a day, which is $22.50 a
day.
Deadweight loss arises because the publisher does not produce
the efficient quantity. Output is restricted to 150, and the price
is increased to 70 cents. The deadweight loss equals (70 cents
minus 40 cents) multiplied by 100/2.
e.The newspaper will not want to price discriminate unless it
can find a way to prevent sharing and resale of the newspaper from
those who are charged a lower price to those who are charged a
higher price.
6.a.The profit-maximizing quantity is 2 cups an hour. The price
is $3 a cup.
Profit is maximized when the firm produces the output at which
marginal cost equals marginal revenue. Draw in the marginal revenue
curve. It runs from 4 on the y-axis to 4 on the x-axis. The
marginal revenue curve cuts the marginal cost curve at the quantity
2 cups an hour.
The highest price at which the coffee shop can sell 2 cups an
hour is read from the demand curve.
b.Economic profit per cup is $1 ($3 minus $2). The quantity
produced and sold is 2 cups. So economic profit is $2 a day.
c.The consumer surplus is $1.00 a day and the deadweight loss is
$0.50 a day.
d.The efficient quantity is 3 cups an hour. The quantity at
which marginal cost equals marginal benefit (the intersection of
the marginal cost curve and the demand curve, which show marginal
benefit).
Consumer surplus is the area under the demand curve above the
price. The price is $3, so consumer surplus equals ($4 minus $3)
multiplied by 2/2cups a day, which is $1.00 a day.
Deadweight loss arises because the coffee shop does not produce
the efficient quantity. Output is restricted to 2 cups an hour, and
the price is increased to $3 a cup. The deadweight loss equals ($3
minus $2) multiplied by 1/2, which is $0.50.
e.The coffee shop will want to price discriminate. The cup of
coffee is not really an item that can be resold, so the coffee shop
might offer 1 coffee a day for $3.00 and a second cup for $2.50 and
stamp the back of the hand of each customer who buy 1 coffee a day.
Or it might offer coffee to students at $2.50 and senior citizens
at $2.00.
7.a.The firm will produce 2 cubic feet a day and sell it for 6
cents a cubic foot. Deadweight loss will be 4 cents a day.
Draw in the marginal revenue curve. It runs from 10 on the
y-axis to 2.5 on the x-axis. The profit-maximizing output is 2
cubic feet at which marginal revenue equals marginal cost. The
price charged is the highest that people will pay for 2 cubic feet
a day, which is 6 cents a cubic foot. The efficient output is 4
cubic feet, at which marginal cost equals price (marginal benefit).
So the deadweight loss is (4 minus 2 cubic feet) multiplied by (6
minus 2 cents)/2.
b.The firm will produce 3 cubic feet a day and charge 4 cents a
cubic foot. Deadweight loss is 1 cent a day.
If the firm is regulated to earn only normal profit, it produces
the output at which price equals average total cost—at the
intersection of the demand curve and the ATC curve.
c.The firm will produce 4 cubic feet a day and charge 2 cents a
cubic foot. There is no deadweight loss.
If the firm is regulated to be efficient, it will produce the
quantity at which price (marginal benefit) equals marginal cost—at
the intersection of the demand curve and the marginal cost
curve.
8.a.The firm will produce 1.5 cubic feet a day and sell it for 7
cents a cubic foot. Deadweight loss will be 2.25 cents a day.
Draw in the marginal revenue curve. It runs from 10 on the
y-axis to 2.5 on the x-axis. The marginal cost doubles to 4 cents
and the marginal cost curve shifts up to cut the y-axis at 4 cents.
The profit- maximizing output is 1.5 cubic feet at which marginal
revenue equals marginal cost. The price charged is the highest that
people will pay for 1.5 cubic feet a day, which is 7 cents a cubic
foot. The efficient output is 3 cubic feet, at which marginal cost
equals price (marginal benefit). So the deadweight loss is (3 minus
1.5 cubic feet) multiplied by (7 cents minus 4 cents)/2.
b.The firm will produce 2 cubic feet a day and charge 6 cents a
cubic foot. Deadweight loss is 1 cent a day.
If the firm is regulated to earn only normal profit, it produces
the output at which price equals average total cost—at the
intersection of the demand curve and the ATC curve.
c.The firm will produce 3 cubic feet a day and charge 4 cents a
cubic foot. There is no deadweight loss.
If the firm is regulated to be efficient, it will produce the
quantity at which price (marginal benefit) equals marginal cost—at
the intersection of the demand curve and the marginal cost
curve.
Additional Problems
1. Dolly’s Diamond Mines, a single-price monopoly, faces the
following demand schedule for industrial diamonds:
PriceQuantity
(dollarsdemanded
per pound)(pounds per day)
2,2005
2,0006
1,8007
1,6008
1,4009
1,20010
a.Calculate Dolly’s total revenue schedule.
b.Calculate its marginal revenue schedule.
2. Dolly’s Diamond Mines in problem 1 has the following total
cost:
QuantityTotal
producedcost
(pounds per day)(dollars)
58,000
69,000
710,200
811,600
913,200
1015,000
Calculate the profit-maximizing levels of
a.Marginal cost
b.Marginal revenue
c.Output
d.Price
e.Economic profit
f.Does Dolly’s Mines use resources efficiently? Explain your
answer.
3.The figure illustrates the situation facing the publisher of
the only newspaper containing local news in an isolated community.
The publisher’s marginal cost for the new plant is constant at 20
cents per copy printed.
a.What quantity of newspapers will maximize the publisher’s
profit?
b.What price will the publisher charge for a daily
newspaper?
c.What is the publisher’s daily total revenue?
d.At the price charged for a newspaper, is the demand for
newspapers elastic or inelastic? Why?
4. In the monopoly newspaper market described in problem 3,
a.What is the efficient quantity of newspapers to print each
day? Explain your answer.
b.What is the consumer surplus of the readers of the
newspaper?
c.What is the deadweight loss created by the monopoly newspaper
publisher?
5. What is the maximum value of resources that will be used in
rent seeking to acquire Dolly’s monopoly in problem 1? Considering
this loss, what is the total social cost of Dolly’s monopoly?
Solutions to Additional Problems
1.a.Dolly’s total revenue schedule lists the total revenue at
each quantity sold. For example, Dolly’s can sell 10 pounds for
$1,200 a pound, which gives it a total revenue of $12,000 at the
quantity 10 pounds.
b.Dolly’s marginal revenue schedule lists the marginal revenue
that results from increasing the quantity sold by 1 pound. For
example, Dolly’s can sell 5 pounds for $2,200 each, which is total
revenue of $11,000 at the quantity of 5 pounds. Dolly’s can sell 6
pounds for $2,000 each, which is $12,000 of total revenue at the
quantity 6 pounds. So by increasing the quantity sold from 5 pounds
to 6 pounds, marginal revenue is $1,000 a pound ($12,000 minus
$11,000).
2.a.Dolly’s marginal cost is $1,000 a pound.
The marginal cost of increasing the quantity from 5 pounds to 6
pounds is $1,000 a pound ($9,000 minus $8,000). That is, the
marginal cost of the 5.5 pounds is $1,000 a pound.
b.Dolly’s marginal revenue is $1,000 a pound.
The marginal revenue of increasing the quantity sold from 5
pounds to 6 pounds is $1,000 ($12,000 minus $11,000). So the
marginal revenue from 5.5 pounds is $1,000 a pound.
c.Dolly’s profit-maximizing output is 5.5 pounds.
The marginal cost of increasing the quantity from 5 pounds to 6
pounds is $1,000 a pound ($9,000 minus $8,000). That is, the
marginal cost of the 5.5 pounds is $1,000 a pound. The marginal
revenue of increasing the quantity sold from 5 pounds to 6 pounds
is $1,000 ($12,000 minus $11,000). So the marginal revenue from 5.5
pounds is $1,000 a pound. Profit is maximized when the quantity
produced makes the marginal cost equal to marginal revenue. The
profit-maximizing output is 5.5 pounds.
d.Dolly’s profit-maximizing price is $2,100 a pound.
The profit-maximizing price is the highest price that Dolly’s
can sell the profit-maximizing output of 5.5 pounds. Dolly’s can
sell 5 pounds for $2,200 and 6 pounds for $2,000, so it can sell
5.5 pounds for $2,100 a pound.
e.Dolly’s economic profit is $3,050.
Economic profit equals total revenue minus total cost. Total
revenue equals price ($2,100 a pound) multiplied by quantity (5.5
pounds), which is $11,550. Total cost of producing 5 pounds is
$8,000 and the total cost of producing 6 pounds is $9,000, so the
total cost of producing 5.5 pounds is $8,500. Profit equals $11,550
minus $8,500, which is $3,050.
f.Dolly’s is inefficient. Dolly’s charges a price of $2,100 a
pound, so consumers get a marginal benefit of $2,100 a pound.
Dolly’s marginal cost is $1,000 a pound. That is, the marginal
benefit of $2,100 a pound exceeds Dolly’s marginal cost.
3.a.The profit-maximizing output is 200 newspapers a day.
Profit is maximized when the firm produces the output at which
marginal cost equals marginal revenue. Draw in the marginal revenue
curve. It runs from 100 on the y-axis to 250 on the x-axis. The
marginal revenue curve cuts the marginal cost curve at the quantity
200 newspapers a day.
b.The price charged is 60 cents a paper.
The highest price that the publisher can sell 200 newspapers a
day is read from the demand curve.
c.The daily total revenue is $120 (200 papers at 60 cents
each).
d.Demand is elastic.
Along a straight-line demand curve, demand is elastic at all
prices above the midpoint of the demand curve. The price at the
midpoint is 50 cents. So at 60 cents a paper, demand is
elastic.
4.a.The efficient quantity is 400 newspapers—the quantity that
makes marginal benefit (price) equal to marginal cost. With 400
newspapers available, people are willing to pay 20 cents for a
paper. To produce 400 newspapers, the publisher incurs a marginal
cost of 20 cents a paper.
b.The consumer surplus is $40 a day.
Consumer surplus is the area under the demand curve above the
price. The price is 60 cents, so consumer surplus equals (100 cents
minus 60 cents) multiplied by 200/2 papers a day, which is $40 a
day.
c.The deadweight loss is $40 a day.
Deadweight loss arises because the publisher does not produce
the efficient quantity. Output is restricted to 200, and the price
is increased to 60 cents. The deadweight loss equals (60 cents
minus 20 cents) multiplied by 200/2.
5.The maximum that will be spent on rent seeking is $3,050 a
day—an amount equal to Dolly’s economic profit. The total social
cost equals the deadweight loss plus the amount spent on rent
seeking. To calculate the deadweight loss, first calculate the
efficient output—the intersection point of the demand curve
(marginal benefit curve) and the marginal cost curve. Do this by
finding the equations to the two curves and solving them. The
efficient output is 8.25 pounds. The deadweight loss equals
$1,512.50. The loss to society is $4,562.50 ($3,050 plus
$1,512.50).