Chapter 18
Price and Output: Monopoly
Chapter Summary
- Pure monopoly is the form of market organization in which there is a single seller of a commodity for which there are no close substitutes.
- The monopoly faces the negatively sloped industry demand curve, and so its marginal revenue curve lies below the demand curve.
- The best level of output for the monopolist is the one at which marginal revenue equals marginal cost. The monopolist can earn profits, break even, or incur losses in the short run.
- A monopolist can increase its total profits by practicing price discrimination. This involves charging different prices for different quantities purchased, to different classes of consumers, or in different markets.
- Since price exceeds marginal revenue, the monopolist produces less and charges a higher price than the perfect competition Thus, pure monopoly leads to a misallocation of resources.
- Natural monopolies are often allowed to operate subject to government regulation so as to earn only a normal rate of return on investment.
Important Terms
Natural monopoly. A firm that experiences increasing returns to scale (i.e., falling long-run average cost) and is able to supply the entire market at a lower per-unit cost than two or more firms could.
Price discrimination.The practice of charging different prices for a commodity (1) for different quantities purchased (2) to different classes of consumers, or (3) in different markets.
Pure monopoly. The form of market organization in which there is a single seller of a commodity for which there are noclose substitutes.
Outline of Chapter 18: Price and Output: Monopoly
18.1 Pure Monopoly Defined
18.2 Demand and Marginal Revenue
18.3 Profit Maximization
18.4 Price Discrimination
18.5 Efficiency Considerations
18.6 Regulation of Monopoly
18.1 PURE MONOPOLY DEFINED
Pure monopoly is the form of market organization in which there is a single seller of a commodity for which there are no close substitutes. Thus, it is at the opposite extreme from perfect competition. Pure monopoly may be the result of (1) increasing returns to scale, (2) control over the supply of raw materials, (3) patents, or (4) government franchise.
EXAMPLE 18.1. Electrical companies, telephone companies, and other “public utilities” usually have increasing returns to scale (i.e., falling long-run average costs) over a sufficient range of outputs as to enable a single firm to satisfy the entire market at a lower per-unit cost than two or more firms could. These natural monopolies usually operate under a government franchise and are subject to government regulation. Before World War II, Alcoa (the Aluminum Corporation of America) had a virtual monopoly over the production of aluminum in the United States by controlling the entire supply of bauxite (the raw material required to produce aluminum). A monopoly may also arise because a firm may own a patent which precludes other firms from producing the same commodity.
18.2DEMAND AND MARGINAL REVENUE
Under pure monopoly, the firm is the industry and Lees the negatively sloped industry demand curve for the commodity. As a result, if the monopolist wants to sell more of the commodity, it must lower its price. Thus, for a monopolist, MR is less than P, and its MR curve lies below its D curve.
EXAMPLE 18.2. In Table 18-1, columns 1 and 2 give the demand schedule faced by a monopolist. The TR values of column 3 are obtained by multiplying each value of column I by the corresponding value in column 2. The MR values of column 4 are the differences between successive TR values and are recorded between successive levels of TR and sales. The MR of $3 recorded at the sales level of 2.5 units; is the change in TR resulting from the increase in sales from 2 to 3 units (this will be needed later to find the equilibrium level of output for the monopolist). P and MR are graphed in Fig. 18-1. Note that the MR values are plotted between successive levels of sales.
18.3PROFIT MAXIMIZATION
The profit-maximizing or best level of output for the monopolist is given at the output at which MR = MC. Price is then read off the demand curve. Depending on the level of AC at this output, the monopolist can have profits (see Example 18.3), break even, or minimize the short-run total losses.
EXAMPLE 18.3. In Table 18-2, the values in columns 1 through 4 come from Table 18-1. Columns 2 and 5 give a typical TC schedule. The other values in this table are derived from the values given in columns 1, 2, 3, and 5. The monopolist maximizes total profits at $3.75 when it produces and sells 2.5 units of output at the price of $5.50. At this output, MR = MC = $3. As long as MR exceeds MC, the monopolist will expand output and sales because doing so adds more to TR than to TC (and profits rise). The opposite is true when MR is less than MC (see Table 18-2). Thus total profits are maximized where MR=MC. The same conclusion can be reached with the “total-revenue-total-cost approach”.
Table 18-2
(1)P($) / (2)
Q / (3)
TR ($) / (4)
MR ($) / (5)
TC ($) / (6)
MC ($) / (7)
AC ($) / (8)
Profit/Unit ($) / (9)
Total Profit ($)
8.00
7.00
6.00
5.50
5.00
4.00
3.00 / 0
1
2
2.5
3
4
5 / 0
7.00
12.00
13.75
15.00
16.00
15.00 / 7
5
3
1
–1 / 6
8
9
10
12
20
35 / 2
1
3
8
15 / ...
8.00
4.50
4.00
4.00
5.00
7.00 / ...
–1.00
+1.50
+1.50
+1.00
–1.00
–4.00 / –6.00
–1.00
+3.00
+3.75
+3.00
–4.00
–20.00
EXAMPLE 18.4. The profit-maximizing or best level of output for this monopolist can also be seen in Fig. 18-2 (obtained by plotting the value of columns 1, 2, 4, 6, and 7 of Table 18-2). In Fig. 18-2, the best level of output is at the point where MR = (rising) MC. At this best output level of 2.5 units, the monopolist makes a profit of $1.50 per unit vertical distance between D and AC at 2.5 units of output) and $3.75 in total (2.5 units of output times the $1.50 fit per unit). Note that since P exceeds MR where MR = MC, the rising portion of the MC above the AVC does represent the monopolist supply curve. In the long run, the monopolist can adjust the scale of at, and profits may persist because of blocked or restricted entry.
18.4PRICE DISCRIMINATION
A monopolist can increase TR and profits at a given level of output and TC by practicing price discrimination. This involves charging different prices for the commodity (1) for different quantities purchased, to different classes of consumers, or (3) in different markets.
EXAMPLE 18.5. A telephone company may charge individuals 15 cents for each of the first 50 telephone calls made during each month, 10 cents for each of the next 100 calls, and so on. Electrical companies usually charge less kilowatt-hour to industrial users than to households because industrial users have more substitutes available (such generating their own electricity) and thus have a more elastic demand curve than households. The markets are kept separate or segmented by meters whereby industrial users are unable to buy more electricity than they need and undersell the monopolists to households. The monopolist reaps the maximum benefit from price discrimination when MR of the last unit sold to different buyers or markets is the same.
18.5 EFFICIENCY CONSIDERATIONS
Since the monopolist produces the output at which MR = MC and P exceeds MR, the monopolist produces less and charges a higher price than a perfect competitor with the same cost curves. For example, if Fig. 18-2 referred to a perfectly competitive industry, output would be 3 units and price $5 (given where P = MC), rather than
Q = 2.5 and P = $5.50 for the monopolist. Thus, monopoly leads to a misallocation of resources. Monopoly profits may also persist in the long run because of blocked or restricted entry. Since corporate stocks are owned mostly by high-income groups, monopoly profits lead to greater income inequality. Finally, the monopolist may feel secure and have no great incentive to make technological advances.
18.6 REGULATION OF MONOPOLY
For efficiency considerations, a government (federal, state, or local) often allows natural monopolies (such as public utilities) to operate but subjects them to regulation. This usually takes the form of setting a price which allows the monopolist only the “normal or fair” return of about 8% to 10% on its investment. However, such regulation only partially corrects the more serious problem of misallocation of resources.
EXAMPLE 18.6. In Fig. 18-3, the unregulated monopolist would produce 400 units (shown by the point where = MC), sell them at P = $12 (on D), and receive a profit of $1 per unit (P – AC at Q = 400) and $400 in total. The government could set P = $9 (where P= AC) so that the monopolist would break even and earn only a normal Air return at Q = 600 units. However, at this point, Pstill exceeds MC and there still remains some misallocation of resources. At P= MC (where D crosses MC), Pexceeds AC. In this case, this monopolist would incur a loss and would not produce in the long run without a government subsidy.
Solved Problems
PURE MONOPOLY DEFINED
18.1.Define pure monopoly. What is the relationship between pure monopoly and perfect competition?
Pure monopoly occurs when (1) there is a single firm selling the commodity, (2) there are no close substitute for the commodity, and (3) entry into the industry is very difficult or impossible(see problem 18.2). Pure monopoly is at the opposite extreme from perfect competition. (See Chapter 17.) Instead of an industry composed of numerous firms, in pure monopoly there is only a single firm. Instead of many firms producing homogeneous, identical. or perfectly standardized product, there are no close substitutes or similar commodities. for the monopolist’s product. Instead of firms being easily able to enter or leave the industry in the long run entry under pure monopoly is blocked or very difficult (otherwise the monopolist would not remain a monopolist in the long run).
18.2.What conditions might give rise to monopoly?
(1)Increasing returns to scale may operate over a sufficiently large range of outputs as to leave only one firm to produce the industry output. These are called “natural monopolies” and are fairly common in industries such as public utilities and transportation. What the government usually does in these cases is to allow the monopolist to operate but subjects it to government control. For example, electricity rates in New York City are set so as to leave Con Edison with only a “normal rate of return” of, say, 8% to 10% on its investment.
(2)A firm may control the entire supply of raw materials required to produce the commodity. For example, up to World War II. Alcoa owned or controlled almost every source of bauxite (the raw material necessary to produce aluminum) in the United States and had a complete monopoly over the production of aluminum in the United States.
(3)A firm may own a patent which precludes other firms from producing the same commodity. For example. when cellophane was first introduced. do Pont had monopoly power based on its patents.
(4)A monopoly may be established by a government franchise. In that case, the firm is set up to be the sole producer and distributor of a good or service but is subjected to governmental control in certain aspects of its operation. For efficiency considerations, this is fairly common in public utilities [see (1), above].
18.3.(a)Are cases of pure monopoly common in the United States today?
(b)What forces limit the pure monopolist’s market power?
(a)Aside from regulated monopolies, cases of pure monopoly have been rare in the past and are prohibited today by antitrust laws. Even so, the pure monopoly model is often useful in explaining observed business behavior in cases approximating pure monopoly, and also gives us insights into the operation of the other types of imperfectly competitive markets discussed in Chapter 19.
(b)A pure monopolist does not have unlimited market power. It faces indirect competition for the consumer’s dollar from all other commodities. Even though there are no close substitutes for the commodity sold by the monopolist. substitutes may nevertheless exist: for example. plastic for aluminum, aluminum for steel, etc. Fear of government prosecution and the threat of potential competition also act as a check on the monopolist’s market power.
DEMAND AND MARGINAL REVENUE
18.4.(a)What type of demand curve does the monopolist face? Why? How does this differ from perfect competition? Why?
(b)Why is MR less than P for the monopolist? How does this differ from perfect competition? Why?
(a)Since the monopolist is the only seller of a commodity for which there are no good substitutes, it is the industry and faces the negatively sloped industry demand curve for the commodity. The market demand curve facing a perfectly competitive industry is also negatively sloped. However, in a perfectly competitive industry there are a very large number of firms, each supplying only a very small fraction of the total market. As a result. each competitive firm, being so small in relation to the market, does not affect market price and faces a horizontal or infinitely elastic demand curve at the prevailing market price.
(b)Since the monopolist faces the negatively sloped industry demand curve, it must lower its price if it wants to sell more. Because it must also lower its price on all units sold, the MR (i.e., the change in TR from selling one more unit) is less than P. For example, when the monopolist of Table
18-1 sells 3 units at P = $5, its TR = $15. To sell 4 units, it must lower its price on all units to $4 each. Thus, TR = $16 and MR $1, while P = $4. A perfectly competitive firm, on the other hand, can sell any quantity at the prevailing market price: thus the change in TR in selling one more unit (i.e., its MR) is constant and equals P.
18.5.For the monopolist demand schedule of Table 18-3,
(a)find TR and MR, and
(b)graph D and MR.
Table 18-3
P ($) / 12 / 11 / 10 / 9 / 8 / 7 / 6 / 5 / 4 / 3 / 2 / 1 / 0Q / 0 / 1 / 2 / 3 / 4 / 5 / 6 / 7 / 8 / 9 / 10 / 11 / 12
(a)Note that in Table 18-4 MR is obtained by subtracting successive TR and is recorded between various levels of sales.
(b)In Fig. 18-4, MR is plotted between various levels of sales and lies below D.
Table 18-4
P ($) / 12 / 11 / 10 / 9 / 8 / 7 / 6 / 5 / 4 / 3 / 2 / 1 / 0Q / 0 / 1 / 2 / 3 / 4 / 5 / 6 / 7 / 8 / 9 / 10 / 11 / 12
TR ($) / 0 / 11 / 20 / 27 / 32 / 35 / 36 / 35 / 32 / 27 / 20 / 11 / 0
MR ($) / 1197531–1–3–5–7–9–11
18.6.(a)From the relationship between P and TR in Table 18-4, determine if and when the D of Fig. 18-4 is elastic, inelastic. and unitary elastic.
(b)What can you say in general about the relationship among ED, TR, and MR? Why?
(a)In Section 14.3, we saw that when P falls, D is elastic if TR rises, unitary elastic if TR remains unchanged, and inelastic if TR falls. The D of Table 18-4 is elastic up to P = $6. inelastic at P lower than $6, and unitary elastic at P = $6.
(b)From Table 18-4 and Fig. 18-4. we see that as long as ED > 1, a fall in P increases TR, and MR is positive. When ED < 1, a fall in P reduces TR, so MR is negative. When ED = 1, TR does not change (and is maximum), and MR = 0.
PROFIT MAXIMIZATION
18.7.(a)What is the basic difference between the pure monopolist and the perfectly competitive firm, if the monopolist does not affect factor prices?
(b)What basic assumption do we make in order to determine the pure monopolist’s best level of output?
(a)If the monopolist does not affect factor prices (i.e., if it is a perfect competitor in the factor markets), then its cost curves are similar to those developed in Chapter 16 and need not be different from those used in Chapter 17 for the analysis of perfect competition. Thus, the basic difference between the perfectly competitive firm and the monopolist lies on the selling or demand side rather than on the production or cost side.
(b)In order to determine the pure monopolist’s best level of output, we assume (as in the case of perfect competition) that the monopolist wants to maximize total profits. We can look at this either from the total-revenue-total-cost approach or from the marginal-revenue-marginal-cost approach.
18.8.Referring to Table 18-5,
(a)find the profit-maximizing or best level of output for this monopolist by using the TR and TC approach, and
(b)graph the results.
(a)Table 18-6 shows that the best level of output for this monopolist is three units per time period. At this output, the monopolist charges a price of $9 and has the maximum total profit of $6 per time period.
Table 18-5
P ($) / 12 / 11 / 10 / 9 / 8 / 7Q / 0 / 1 / 2 / 3 / 4 / 5
TC / 10 / 17 / 18 / 21 / 30 / 48
(b)Note that the monopolist’s TR curve in Fig. 18-5 is not a (positively sloped) straight line through the origin as it was in the case of perfect competition. Total profits are maximized at Q = 3, where TR exceeds TC by the greatest amount ($27 – $21).
Table 18-6
P ($) / Q / TC ($) / TC ($) / Total Profits ($)12 / 0 / 0 / 10 / –10
11 / 1 / 11 / 17 / – 6
10 / 2 / 20 / 18 / + 2
*9 / 3 / 27 / 21 / + 6
8 / 4 / 32 / 30 / + 2
7 / 5 / 35 / 48 / –13
18.9.In terms of the marginal-revenue-marginal-cost approach,
(a)state and explain the condition for profit maximization.
(b)At what price does the monopolist sell? How does this differ from perfect competition?
(c)Can the monopolist incur short-run losses?
(a)The profit-maximizing or best level of output for the monopolist is the output at which MR = MC. The reason for this is that as long as MR exceeds MC, the monopolist expands output, adding more to total revenue than to total cost, and so total profits rise. On the other hand, it does not pay for the monopolist to produce where MR is smaller than MC because it would be adding more to TC than to TR and the total profits would fall. This leaves the output at which MR = MC as the profit-maximizing or best level of output for the monopolist.
(b)The price charged is read firm the demand curve facing the monopolist at the sales level at which MR MC. Because the demand curve is negatively sloped, P exceeds MR. This differs from the perfectly competitive case where (because the demand curve facing each firm is horizontal or infinitely elastic) P = MR. Note that the monopolist neither charges the highest possible price ($12 in Table 18-5 at which the monopolist would incur a loss of $10), nor sells the output at which TR is maximum ($36 at Q = 6 in Table 18-4).
(c)The monopolist can incur losses, break even. or make a profit in the short run. If P = AC, it breaks even. If P is lower than AC (as long as P exceeds AVC), the monopolist minimizes total losses by staying in business in the short run.
18.10.(a)Using Table 18-5, find this monopolist’s MR, MC, and AC.
(b)Show graphically the profit-maximizing level of output. How much profit per unit and in total does the monopolist make?
(a)See Table 18-7.
Table 18-7