Chapter 14.Monopoly1

/

Monopoly

/

Chapter

14
CHAPTER OUTLINE

I.Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly.

A.How Monopoly Arises

1.No Close Substitutes

2.A Barrier to Entry

a.Natural Barrier to Entry

b.Ownership Barrier to Entry

c.Legal Barrier to Entry

B.Monopoly Price-Setting Strategies

1.Single-Price

2.Price Discrimination

2.Explain how a single-price monopoly determines its output and price.

A.Price and Marginal Revenue

B.Marginal Revenue and Elasticity

C.Output and Price Decision

3.Compare the performance of single-price monopoly with that of perfect competition.

A.Output and Price

B.Is Monopoly Efficient?

C.Is Monopoly Fair?

D.Rent Seeking

1.Buy a Monopoly

2.Create a Monopoly by Rent Seeking

3.Rent-Seeking Equilibrium

4.Explain how price discrimination increases profit.

A.Price Discrimination and Consumer Surplus

1.Discriminating Among Groups of Buyers

2.Discriminating Among Units of a Good

B.Profiting by Price Discriminating

C.Perfect Price Discrimination

D.Price Discrimination and Efficiency

5.Explain why monopoly can sometimes achieve a better allocation of resources than competition can.

A.Benefits of Monopoly

1.Capturing Economies of Scale

2.Strengthening the Incentives to Innovate

B.U.S. Patent Law

What’s New in this Edition?

Checkpoint 14.5 has been rewritten. The material on regulating natural monopolies has been eliminated. In its place is a longer discussion of how monopoly can benefit society by capturing economies of scale and strengthening the incentive to innovate. The checkpoint concludes with a brief discussion of U.S. patent law.

Where We Are

In this chapter, we examine another market structure: monopoly. We discuss how monopoly arises and how a monopoly (single-price or price-discriminating) chooses its profit-maximizing output and price. Recognizing that monopoly creates a deadweight loss, we discuss whether monopoly is efficient and fair. The concept of rent seeking is examined and reveals that rent seeking is likely to extract all of the economic profit earned by a monopoly. Finally, benefits of monopoly is covered.

Where We’ve Been

The previous chapter studied perfectly competitive firms’ demand and marginal revenue curves. We combined them with the cost curve analysis in Chapter 12 to determine perfectly competitive firms’ profit-maximizing output and price decisions.

Where We’re Going

After this chapter we examine two more market structures: monopolistic competition, in Chapter 15, and oligopoly, in Chapter 16. Then, in Chapter 17, we move to a discussion of antitrust and regulation. All these chapters depend on the material presented in this chapter.

IN THE CLASSROOM

Class Time Needed

Because the students are familiar with firm behavior in perfect competition, this chapter is somewhat easier to present. You should spend between two to three class sessions on this material.

An estimate of the time per checkpoint is:

  • 14.1 Monopoly and How It Arises—15 minutes
  • 14.2 Single-Price Monopoly—25 to 45 minutes
  • 14.3 Monopoly and Competition Compared—30 to 40 minutes
  • 14.4 Price Discrimination—30 to 40 minutes
  • 14.5 Monopoly Policy Issues—10 to 15 minutes

CHAPTER LECTURE

14.1How Monopoly Arises

A monopoly has two key features:

  • No Close Substitutes: There are no close substitutes for the good or service.
  • Barriers to Entry: Legal or natural constraints that protect a firm from potential competition are called barriers to entry. Monopolies are protected by barriers to entry.
  • 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.
  • When one firm owns all (or most) of a natural resource, it creates an ownership barrier to entry. DeBeers owns about 80 percent of the world’s diamonds.
  • Legal barriers to entry create a legal monopoly, which is a market in which competition and entry are restricted by the granting of a public franchise (an exclusive right is granted to a firm to supply a good or service—the U.S. Postal Service has a public franchise to deliver first-class mail), a government license (when the government controls entry into particular occupations, professions and industries—a license is required to practice law), a patent (an exclusive right granted to the inventor of a product or service) or a copyright (exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work).

There are many examples of government licensing. Licensing can protect consumers from fraud and abuse, but they can also hurt consumers by preventing competition from producing an efficient allocation of resources. Have the students debate the merits of the following licensing arrangements: 1) Doctors can receive a medical license to practice medicine only by graduating from an AMA approved medical program; 2) Lawyers can practice law only after passing an extensive Bar Exam; 3) Cab drivers in New York City can operate a taxi only if they have purchased a medallion from the city, of which there are a finite number; 4) Beauticians in many states cannot operate a beauty parlor without a state certification that requires training in sanitary practices as well as other courses completely unrelated to their profession (such as civics and history courses).

Monopoly Price-Setting Strategies

  • 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.
  • A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers.

14.2A Single-Price Monopoly’s Output and Price Decisions

Price and Marginal Revenue

  • The demand curve facing a monopoly firm is the market demand curve. Total revenue (TR) is the price (P ) multiplied by the quantity sold (Q ). Marginal revenue (MR ) is the change in total revenue resulting from a one-unit increase in the quantity sold. The table shows the calculation of TR and MR.
  • A key feature of a single-price monopoly is that MRP at each quantity so, as illustrated in the figure below, the MR curve lies below the demand curve. MRP because a single–price monopoly must lower its price on all units sold to sell an additional unit of output.

Marginal Revenue and Elasticity

If demand is elastic, the MR is positive; if demand is unit elastic, the MR equals zero; and if demand is inelastic, MR is negative. A single-price monopoly never produces in the inelastic part of its demand because if it did, the firm could increase its total profit by decreasing its output, which would raise its total revenue and decrease itstotal cost.

Output and Price Decisions

  • To maximize its profit, a monopoly produces the level of output where MR=MC. The monopoly then uses its demand curve to set the price at the maximum possible price for which it will be able to sell the quantity it produces. In the figure, which uses the demand and MR schedules from the table above, the firm produces 200 units of output and sets a price of $160 per unit.
  • The firm earns an economic profit if P>ATC, which is the case for the firm in the figure. The monopoly can earn the economic profit even in the long run because the barriers to entry protect the firm from competition. However, a monopoly firm is not guaranteed an economic profit. In the short run and/or long run, it might earn a normal profit, (P=ATC ) or in the short run, it might incur an economic loss (PATC ).

14.3Single-Price Monopoly and Competition Compared

Output and Price

  • Perfect Competition: The market demand curve (D) in perfect competition is the same demand curve that the firm faces in monopoly. The market supply curve (S ) in perfect competition is the horizontal sum of the individual firm’s marginal cost curves. This supply curve also is the monopoly’s marginal cost curve, so in the figure above the supply curve is labeled MC. In a competitive market, equilibrium occurs where the quantity demanded equals the quantity supplied, which in the figure above is 250 units of output and a price of $140 per unit.
  • Monopoly: The monopoly produces where MR = MC and sets its price using its demand curve. In the figure, the monopoly produces 200 units of output and sets a price of $160 per unit.
  • Compared to a perfectly competitive industry, a single-price monopoly produces less output and sets a higher price.

Is Monopoly Efficient?

  • A perfectly competitive industry produces the efficient quantity of output. Because a single-price monopoly produces less output, it creates a deadweight loss.
  • Though the monopoly creates a deadweight loss, the monopoly benefits its owners because it earns an economic profit. A monopoly benefits the owner because it redistributes some of the consumer surplus away from the consumer and to the monopoly producer.

It is important for students to recognize that the source of the inefficiency of a monopoly firm’s output and pricing decision arises from the absence of competition in the market, rather than any change in the behavioral assumptions about the firm owners. So, “Mom and Pop,” the owners of a perfectly competitive firm, are maximizing their profit as surely as the owners of a monopoly.

Rent Seeking

  • The social cost of monopoly might exceed the deadweight loss it creates because of rent seeking, which is any attempt to capture consumer surplus, producer surplus, or economic profit. Rent seeking can occur when someone uses resources seeking the opportunity to buy a monopoly for a price less than the monopoly’s economic profit. Rent seeking also can occur when someone uses resources lobbying the government to restrict the competition faced by the lobbyist.
  • The resources used up in rent seeking are a cost to society that adds to the monopoly’s deadweight loss. Because there are no barriers to entry in the activity of rent seeking, the resources used up can equal the monopoly’s potential economic profit.

14.4Price Discrimination

Price discrimination is the practice of selling different units of a good or service for different prices. Price discrimination converts consumer surplus into economic profit. To be able to price discriminate, a firm must:

  • Identify and separate different buyer types.
  • Sell a product that cannot be resold

Price Discrimination and Consumer Surplus

  • Price discrimination occurs because of different willingnesses to pay for the good. A firm can charge the same buyer different prices for different units of a good or a firm can charge different prices to different groups of buyers.
  • Discriminating Among Groups of Buyers: A firm can charge different customers different prices for the product. Groups with a higher average willingness to pay are charged a higher price and groups with a lower average willingness to pay are charged a lower price. An example is airline travel, where business travelers who have a high average willingness to pay and often make last-minute reservations are charged a higher price than leisure travelers, who have a low average willingness to pay and often make advance reservations.
  • Discriminating Among Units of a Good: A firm can charge a higher price for the first units purchased and a lower price for later units purchased. An example is pizza delivery, where the second pizza is generally cheaper than the first.
  • 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. In this case, the price of each unit is the same as the unit’s marginal revenue, so the firm’s (downward sloping) demand curve becomes the same as its marginal revenue curve. Output increases to the point where the demand (= marginal revenue) curve intersects the marginal cost and the efficient quantity is produced. The deadweight loss is eliminated. The firm’s economic profit is the greatest possible. But consumer surplus equals zero because the firm captures the entire consumer surplus.

14.5Monopoly Policy Issues

Benefits from Monopoly

  • Economies of Scale: If a monopoly has economies of scale (so its ATC decreases as its output increases), it might be able to produce at lower cost than could several competing firms.
  • Incentives for Innovation: Granting the discoverer a monopoly to an innovation increases the incentives to innovate.
  • Patents give the innovator a monopoly on the invention for 20 years. So patents strengthen the incentive to innovate but at the cost of granting a monopoly with the resulting deadweight loss.

Consider the struggle for developing countries with populations dealing with world-wide epidemics such as AIDS. In the developed countries in which they operate, pharmaceutical companies are granted legal barriers (patents) on their drugs, granting them a legal monopoly and enabling them to earn a high economic profit once they bring a new and successful medicine to market. The anticipation of this profit provides the incentive for these firms to undertake the expensive (currently estimated at approximately $900 million per approved drug) and risky development of innovative cures for the terrible diseases afflicting mankind, such as AIDS. However, once the new medicines are made available, the absence of competition means the price is high, which decreases the use of these new medicines, especially among the population of the poorer, developing nations that have been hit the hardest by these diseases. So, once the drug is discovered, the monopoly creates a deadweight loss but without the economic profit the monopoly brings, the drug might not have been discovered. There is a tradeoff between current sufferers, who want a low price, and sufferers in the future, who want new and better medicines developed.

Lecture Launchers

1.Students love monopoly! 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 bottom line of which is the bottom line is miserable. Normal profit might be the best that many people can achieve but it is not very exciting. This chapter teaches the students how to make a 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.

2.After defining a monopoly, you can ask your students to discuss the economic factors which lead to the development of monopolies. To what extent are those conditions products of the free market? In which case, students can debate the role of government with regard to monopoly. If it is the result of natural coalescence in a free market, then is it equitable and/or efficient to intervene? Clearly there is no definitively correct answer to these questions, which is perhaps why they are so much fun to debate!

3.Explain that the monopoly model is a benchmark model. Similar to the case of perfect competition, 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 13 discussed the most competitive end.

4.Figure 14.5, the classic monopoly diagram, 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 and your students can learn more about Joan Robinson at . 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.

Land Mines

1.Marginal revenue can be a sticking point for many students. Students find it easier to see the difference between the monopoly’s demand and marginal revenue curves if you take two steps. First develop a total revenue schedule using price and quantity data. Then add another column showing marginal revenue. As the text shows, place the marginal revenue values between the quantity values. In the next step, draw the demand and marginal revenue curves. Again, emphasize that marginal revenue is plotted between two quantity levels. By explicitly graphing the data, you also have the framework for showing that the price of the good is always less than marginal revenue of a monopoly.

2.Students differ in their learning styles. It is always wise to accommodate as many of these styles as possible. To more clearly show the deadweight loss, start with a numeric approach. Draw a figure, labeling points on the axes with prices and quantities. Use these values to make your point and explicitly calculate the deadweight loss. Then, realizing that some students learn better from a geometric approach, shade the appropriate areas.

ANSWERS TO CHECKPOINT EXERCISES