Monopoly and Monopolistic Competition

Monopoly and Monopolistic Competition

 

After reading this chapter, you should be able to:

LO14-1. Summarize how and why the decisions facing a monopolist differ from the collective decisions of competing firms.

LO14-2. Determine a monopolist’s price, output, and profit graphically and numerically.

LO14-3. Show graphically the welfare loss from monopoly.

LO14-4. Explain why there would be no monopoly without barriers to entry.

LO14-5. Explain how monopolistic competition differs from monopoly and perfect competition.

“Monopoly is business at the end of its journey.”

Henry Demarest Lloyd

In the last chapter we considered perfect competition. We now move to the other end of the spectrum: monopoly. Monopoly isa market structure in which one firm makes up the entire market. It is the polar opposite to competition. It is a market structure in which the firm faces no competitive pressure from other firms.

Monopolies exist because of barriers to entry into a market that prevent competition. These can be legal barriers (as in the case where a firm has a patent that prevents other firms from entering); sociological barriers, where entry is prevented by custom or tradition; natural barriers, where the firm has a unique ability to produce what other firms can’t duplicate; or technological barriers, where the size of the market can support only one firm.

The Key Difference between a Monopolist and a Perfect Competitor

A key question we want to answer in this chapter is: How does a monopolist’s decision differ from the collective decision of competing firms (i.e., from the competitive solution)? Answering that question brings out a key difference between a competitive firm and a monopoly. Since a competitive firm is too small to affect the price, it does not take into account the effect of its output decision on the price it receives. A competitive firm’s marginal revenue (the additional revenue it receives from selling an additional unit of output) is the given market price. A monopolistic firm takes into account that its output decision can affect price; its marginal revenue is not its price. A monopolistic firm will reason: “If I increase production, the price I can get for each unit sold will fall, so I had better be careful about how much I increase production.”

Let’s consider an example. Say your drawings in the margins of this book are seen by a traveling art critic who decides you’re the greatest thing since Rembrandt, or at least since Andy Warhol. Carefully he tears each page out of the book, mounts them on special paper, and numbers them: Doodle Number 1 (Doodle While Contemplating Demand), Doodle Number 2 (Doodle While Contemplating Production), and so on.

All told, he has 100. He figures, with the right advertising and if you’re a hit on the art circuit, he’ll have a monopoly in your doodles. He plans to sell them for $20,000 each: He gets 50 percent, you get 50 percent. That’s $1 million for you. You tell him, “Hey, man! I can doodle my way through the entire book. I’ll get you 500 doodles. Then I get $5 million and you get $5 million.”

The art critic has a pained look on his face. He says, “You’ve been doodling when you should have been studying. Your doodles are worth $20,000 each only if they’re rare. If there are 500, they’re worth $1,000 each. And if it becomes known that you can turn them out that fast, they’ll be worth nothing. I won’t be able to limit quantity at all, and my monopoly will be lost. So obviously we must figure out some way that you won’t doodle anymore—and study instead. Oh, by the way, did you know that the price of an artist’s work goes up significantly when he or she dies? Hmm?” At that point you decide to forget doodling and to start studying, and to remember always that increasing production doesn’t necessarily make suppliers better off.

As we saw in the last chapter, competitive firms do not take advantage of that insight. Each individual competitive firm, responding to its self-interest, is not doing what is in the interest of the firms collectively. In competitive markets, as one supplier is pitted against another, consumers benefit. In monopolistic markets, the firm faces no competitors and does what is in its best interest. Monopolists can see to it that the monopolists, not the consumers, benefit; perfectly competitive firms cannot.

Doodle Number 27: Contemplating Costs

Q‑1Why should you study rather than doodle?

 

A Model of Monopoly

How much should the monopolistic firm choose to produce if it wants to maximize profit? To answer that we have to consider more carefully the effect that changing output has on the total profit of the monopolist. That’s what we do in this section. First, we consider a numerical example; then we consider that same example graphically. The relevant information for our example is presented in Table 14-1.

Table 14-1 Monopolistic Profit Maximization

12345678
QuantityPriceTotal RevenueMarginal RevenueTotal CostMarginal CostAverage Total CostProfit
0$36$ 0$33$ 47$ 1$48.00$–47
133332748225.00–15
230602150418.0010
327811562815.5027
424969781615.6034
52110531022417.0027
618108–31424020.296
715105–91985624.75–37
81296–151988030.89–102
998127830.89–197

Monopolists see to it that monopolists, not consumers, benefit.

Determining the Monopolist’s Price and Output Numerically

Table 14-1 shows the price, total revenue, marginal revenue, total cost, marginal cost, average total cost, and profit at various levels of production. It’s similar to the table in the last chapter where we determined a competitive firm’s output. The big difference is that marginal revenue changes as output changes and is not equal to the price. Why?

First, let’s remember the definition of marginal revenue: Marginal revenue is the change in total revenue associated with a change in quantity. In this example, if a monopolist increases output from 4 to 5, the price it can charge falls from $24 to $21 and its revenue increases from $96 to $105, so marginal revenue is $9. Marginal revenue of increasing output from 4 to 5 for the monopolist reflects two changes: a $21 gain in revenue from selling the 5th unit and a $12 decline in revenue because the monopolist must lower the price on the previous 4 units it produces by $3 a unit, from $24 to $21. This highlights the key characteristic of a monopolist—its output decision affects its price. Because an increase in output lowers the price on all previous units, a monopolist’s marginal revenue is always below its price. Comparing columns 2 and 4, you can confirm that this is true.

A monopolist’s marginal revenue is always below its price.

Now let’s see if the monopolist will increase production from 4 to 5 units. The marginal revenue of increasing output from 4 to 5 is $9, and the marginal cost of doing so is $16. Since marginal cost exceeds marginal revenue, increasing production from 4 to 5 will reduce total profit and the monopolist will not increase production. If it decreases output from 4 to 3, where MC < MR,the revenue it loses ($15) exceeds the reduction in costs ($8). It will not reduce output from 4 to 3. Since it cannot increase total profit by increasing output to 5 or decreasing output to 3, it is maximizing profit at 4 units.

As you can tell from the table, profits are highest ($34) at 4 units of output and a price of $24. At 3 units of output and a price of $27, the firm has total revenue of $81 and total cost of $54, yielding a profit of $27. At 5 units of output and a price of $21, the firm has a total revenue of $105 and a total cost of $78, also for a profit of $27. The highest profit it can make is $34, which the firm earns when it produces 4 units. This is its profit-maximizing level.

Q‑2In Table 14-1, explain why 4 is the profit-maximizing output.

Determining Price and Output Graphically

The monopolist’s output decision also can be seen graphically. Figure 14-1 graphs the table’s information into a demand curve, a marginal revenue curve, and a marginal cost curve. The marginal cost curve is a graph of the change in the firm’s total cost as it changes output. It’s the same curve as we saw in our discussion of perfect competition. The marginal revenue curve tells us the change in total revenue when quantity changes. It is graphed by plotting and connecting the points given by quantity and marginal revenue in Table 14-1.

Figure 14-1 Determining the Monopolist’s Price and Output Graphically

The profit-maximizing output is determined where the MC curve intersects the MR curve. To determine the price (at which MC = MR) that would be charged if this industry were a monopolist with the same cost structure as that of firms in a competitive market, we first find that output and then extend a line to the demand curve, in this case finding a price of $24. This price is higher than the competitive price, $20.50, and the quantity, 4, is lower than the competitor’s quantity, 5.17.

Added Dimension: A Trick in Graphing the Marginal Revenue Curve

Here’s a trick to help you graph the marginal revenue curve. The MR line starts at the same point on the price axis as does a linear demand curve, but it intersects the quantity axis at a point half the distance from where the demand curve intersects the quantity axis. (If the demand curve isn’t linear, you can use the same trick if you use lines tangent to the curved demand curve.) So you can extend the demand curve to the two axes and measure halfway on the quantity axis (3 in the graph on the right). Then draw a line from where the demand curve intersects the price axis to that halfway mark. That line is the marginal revenue curve.

The marginal revenue curve for a monopolist is new, so let’s consider it a bit more carefully. It tells us the additional revenue the firm will get by expanding output. It is a downward-sloping curve that begins at the same point as the demand curve but has a steeper slope. In this example, marginal revenue is positive up until the firm produces 6 units. Then marginal revenue is negative; after 6 units the firm’s total revenue decreases when it increases output.

Notice specifically the relationship between the demand curve (which is the average revenue curve) and the marginal revenue curve. Since the demand curve is downward-sloping, the marginal revenue curve is below the average revenue curve. (Remember, if the average curve is falling, the marginal curve must be below it.)

Having plotted these curves, let’s ask the same questions as we did before: What output should the monopolist produce, and what price can it charge? In answering those questions, the key curves to look at are the marginal cost curve and the marginal revenue curve.

MR = MC Determines the Profit-Maximizing Output 

 

The monopolist uses the general rule that any firm must follow to maximize profit: Produce the quantity at which MC = MR. If you think about it, it makes sense that the point where marginal revenue equals marginal cost determines the profit-maximizing output. If the marginal revenue is below the marginal cost, it makes sense to reduce production. Doing so decreases marginal cost and increases marginal revenue. When MR < MC, reducing output increases total profit. If marginal cost is below marginal revenue, you should increase production because total profit will rise. If the marginal revenue is equal to marginal cost, it does not make sense to increase or reduce production. So the monopolist should produce at the output level where MC = MR. As you can see, the output the monopolist chooses is 4 units, the same output that we determined numerically.1 This leads to the following insights:

1This could not be seen precisely in Table 14-1 since the table is for discrete jumps and does not tell us the marginal cost and marginal revenue exactly at 4; it only tells us the marginal cost and marginal revenue ($8 and $15, respectively) of moving from 3 to 4 and the marginal cost and marginal revenue ($16 and $9, respectively) of moving from 4 to 5. If small adjustments (1/100 of a unit or so) were possible, the marginal cost and marginal revenue precisely at 4 would be $12.

Q‑3In the graph below, indicate the monopolist’s profit-maximizing level of output and the price it would charge.

MR and Profit Maximization in Monopoly

  • If MR > MC, the monopolist gains profit by increasing output.
  • If MR < MC, the monopolist gains profit by decreasing output.
  • If MC = MR, the monopolist is maximizing profit.

Thus, MR = MC is the profit-maximizing rule for a monopolist.

The general rule that any firm must follow to maximize profit is: Produce at an output level at which MC = MR.

The Price a Monopolist Will Charge

The MR = MC condition determines the quantity a monopolist produces; in turn, that quantity determines the price the firm will charge. A monopolist will charge the maximum price consumers are willing to pay for that quantity. Since the demand curve tells us what consumers will pay for a given quantity, to find the price a monopolist will charge, you must extend the quantity line up to the demand curve. We do so in Figure 14-1 and see that the profit-maximizing output level of 4 allows a monopolist to charge a price of $24.

Q‑4Why does a monopolist produce less output than would perfectly competitive firms in the same industry?

Comparing Monopoly and Perfect Competition

For a competitive industry, the horizontal summation of firms’ marginal cost curves is the market supply curve.2 Output for a perfectly competitive industry would be 5.17, and price would be $20.50, as Figure 14-1 shows. The monopolist’s output was 4 and its price was $24. So, if a competitive market is made into a monopoly, you can see that output would be lower and price would be higher. The reason is that the monopolist takes into account the effect that restricting output has on price.

2The above statement has some qualifications best left to intermediate classes.

Equilibrium output for the monopolist, like equilibrium output for the competitor, is determined by the MC = MR condition, but because the monopolist’s marginal revenue is below its price, its equilibrium output is different from a competitive market.

An Example of Finding Output and Price

We’ve covered a lot of material quickly, so it’s probably helpful to go through an example slowly and carefully review the reasoning process. Here’s the problem:

Say that a monopolist with marginal cost curve MC faces a demand curve D in Figure 14-2(a). Determine the price and output the monopolist would choose.

Figure 14-2 (A, B, C, AND D) Finding the Monopolist’s Price and Output

Determining a monopolist’s price and output can be tricky. The text discusses the steps shown in this figure. To make sure you understand, try to go through the steps on your own, and then check your work with the text.

The first step is to draw the marginal revenue curve, since we know that a monopolist’s profit-maximizing output level is determined where MC = MR. We do that in Figure 14-2(b), remembering the trick in the box on page 291 of extending our demand curve back to the vertical and horizontal axes and then bisecting the horizontal axis (half the distance from where the demand curve intersects the x-axis).

The second step is to determine where MC = MR. Having found that point, we extend a line up to the demand curve and down to the quantity axis to determine the output the monopolist chooses, QM. We do this in Figure 14-2(c). Finally we see where the quantity line intersects the demand curve. Then we extend a horizontal line from that point to the price axis, as inFigure 14-2(d). This determines the price the monopolist will charge, PM.

Profits and Monopoly

The monopolist’s profit can be determined only by comparing average total cost to price. So before we can determine profit, we need to add another curve: the average total cost curve. As we saw with a perfect competitor, it’s important to follow the correct sequence when finding profit:

  • First, draw the firm’s marginal revenue curve.
  • Second, determine the output the monopolist will produce by the intersection of the marginal cost and marginal revenue curves.
  • Third, determine the price the monopolist will charge for that output. (Remember, the price it will charge depends on the demand curve.)
  • Fourth, determine the monopolist’s profit (loss) by subtracting average total cost from average revenue (P) at that level of output and multiplying by the chosen output.

If price exceeds average total cost at the output it chooses, the monopolist will make a profit. If price equals average total cost, the monopolist will make no profit (but it will make a normal return). If price is less than average cost, the monopolist will incur a loss: Total cost exceeds total revenue.

A Monopolist Making a Profit

I consider the case of a monopolist making a profit in Figure 14-3, going through the steps slowly. The monopolist’s demand, marginal cost, and average total cost curves are presented in Figure 14-3(a). Our first step is to draw the marginal revenue curve, which has been added in Figure 14-3(b). The second step is to find the output level at which marginal cost equals marginal revenue. From that point, draw a vertical line to the horizontal (quantity) axis. That intersection tells us the monopolist’s output, QM in Figure 14-3(b). The third step is to find what price the monopolist will charge at that output. We do so by extending the vertical line to the demand curve (point A) and then extending a horizontal line over to the price axis. Doing so gives price,PM. Our fourth step is to determine the average total cost at that quantity. We do so by seeing where our vertical line at the chosen output intersects the average total cost curve (point B). That tells us the monopolist’s average cost at its chosen output.

Figure 14-3 (A, B, AND C) Determining Profit for a Monopolist

Q‑5Indicate the profit that the monopolist shown in the graph below earns.

A Reminder: Finding a Monopolist’s Output, Price, and Profit

To find a monopolist’s level of output, price, and profit, follow these four steps:

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  1. Draw the marginal revenue curve.
  2. Determine the output the monopolist will produce: The profit-maximizing level of output is where the MRandMC curves intersect.
  3. Determine the price the monopolist will charge: Extend a line from where MRMC up to the demand curve. Where this line intersects the demand curve is the monopolist’s price.
  4. Determine the profit the monopolist will earn: Subtract the ATCfrom price at the profit-maximizing level of output to get profit per unit. Multiply profit per unit by quantity of output to get total profit.

To determine profit, we extend lines from where the quantity line intersects the demand curve (point A) and the average total cost curve (point B) to the price axis in Figure 14-3(c). The resulting shaded rectangle in Figure 14-3(c) represents the monopolist’s profit.

A Monopolist Breaking Even and Making a Loss

A monopolist doesn’t always make a profit. In Figure 14-4 we consider two other average total cost curves to show you that a monopolist may make a loss or no profit as well as an economic profit. In Figure 14-4(a) the monopolist is making zero profit; inFigure 14-4(b) it’s making a loss. Whether a firm is making a profit, zero profit, or a loss depends on average total costs relative to price. So clearly, in the short run, a monopolist can be making either a profit or a loss, or it can be breaking even.

Figure 14-4 (A AND B) Other Monopoly Cases

(a) Zero Profit

(b) Loss

Depending on where the ATC curve falls, a monopolist can make a profit, break even (as in (a)), or make a loss (as in (b)) in the short run. In the long run, a monopolist who is making a loss will go out of business.

Most of you, if you’ve been paying attention, will say, “Sure, in the model monopolists might not make a profit, but in the real world monopolists are making a killing.” And it is true that numerous monopolists make a killing. But many more monopolists just break even or lose money. Each year the U.S. Patent Office issues about 400,000 patents. A patent is legal protection of a technical innovation that gives the person holding it sole right to use that innovation—in other words, it gives the holder a monopoly to produce a good. Most patented goods make a loss; in fact, the cost of getting the patent often exceeds the revenues from selling the product.

Let’s consider an example—the self-stirring pot, a pot with a battery-operated stirrer attached to its lid. The stirrer was designed to prevent the bottom of the pot from burning. The inventor tried to get the Home Shopping Network to sell it. Unfortunately for the inventor, HSN considered the cost (even after economies of scale were taken into account) far more than what people would be willing to pay and therefore decided not to include the pot in its offerings. The inventor had a monopoly on the production and sale of the self-stirring pot, but only a loss to show for it. Examples like this can be multiplied by the thousands. The reality for many monopolies is that their costs exceed their revenues, so they make a loss.

Welfare Loss from Monopoly

As we saw above, monopolists aren’t guaranteed a profit. Thus, profits can’t be the primary reason that the economic model we’re using sees monopoly as bad. If not because of profits, then what standard is the economic model using to conclude that monopoly is undesirable? One reason can be seen by looking at consumer and producer surplus for the normal monopolist equilibrium and perfectly competitive equilibrium.

The welfare loss from monopoly is a triangle, as in the graph below. It is not the loss that most people consider. They are often interested in normative losses that the graph does not capture.

The Normal Monopolist

Producer and consumer surplus for both monopoly and perfect competition is shown in Figure 14-5. In a competitive equilibrium, the total consumer and producer surplus is the area below the demand curve and above the marginal cost curve up to market equilibrium quantity QC. The monopolist reduces output to QM and raises price to PM. The benefit lost to society from reducing output from QC to QM is measured by the area under the demand curve between output levels QC and QM. That area is represented by the shaded areas labeled A, B, and D. Area A, however, is regained by society. Society gains the opportunity cost of the resources that are freed up from reducing production—the value of the resources in their next-best use indicated by the shaded area A. So the net cost to society of decreasing output from QC to QM is represented by areas B and D. (Area Csimply represents a transfer of surplus from consumers to the monopolist. It is neither a gain nor a loss to society. Since both monopolist and consumer are members of society, the gain and loss net out.) The triangular areas B and D are the net cost to society from the existence of monopoly.

Figure 14-5 The Welfare Loss from Monopoly

The welfare loss from a monopoly is represented by the triangles B and D. The rectangle C is a transfer from consumer surplus to the monopolist. The area A represents the opportunity cost of diverted resources. This is not a loss to society since the resources will be used in producing other goods.

As discussed in an earlier chapter, the area designated by B and D is often called the deadweight loss or welfare loss triangle. That welfare cost of monopoly is one of the reasons economists oppose monopoly. That cost can be summarized as follows: Because monopolies charge a price that is higher than marginal cost, people’s decisions don’t reflect the true cost to society. Price exceeds marginal cost. Because price exceeds marginal cost, people’s choices are distorted; they choose to consume less of the monopolist’s output and more of some other output than they would if markets were competitive. That distinction means that the marginal cost of increasing output is lower than the marginal benefit of increasing output, so there’s a welfare loss.

Q‑6Why is area C in Figure 14-5 not considered a loss to society from monopoly?

When a monopolist pricediscriminates, it charges individuals high up on the demand curve higher prices and those low on the demand curve lower prices.

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Web Note 14.1 Divide and Conquer

The Price-Discriminating Monopolist

So far we’ve considered monopolists that charge the same price to all consumers. Let’s consider what would happen if our monopolist suddenly gained the ability to price-discriminateto charge different prices to different individuals or groups of individuals (for example, students as compared to businesspeople). If a monopolist can identify groups of customers who have different elasticities of demand, separate them in some way, and limit their ability to resell its product between groups, it can charge each group a different price. Specifically, it could charge consumers with less elastic demands a higher price and individuals with more elastic demands a lower price. By doing so, it will increase total profit. Suppose, for instance, Megamovie knew that at $10 it would sell 1,000 movie tickets and at $5 a ticket it would sell 1,500 tickets. Assuming Mega-movie could show the film without cost, it would maximize profits by charging $10 to 1,000 moviegoers, earning a total profit of $10,000. If, however, it could somehow attract the additional 500 viewers at $5 a ticket without reducing the price to the first 1,000 moviegoers, it could raise its profit by $2,500, to $12,500. As you can see, the ability to price-discriminate allows a monopolist to increase its profit.

We see many examples of price discrimination in the real world:

Automobiles are seldom sold at list price.

© Vincent Hobbs/SuperStock

  1. Movie theaters give discounts to senior citizens and children.Movie theaters charge senior citizens and children a lower price because they have a more elastic demand for movies.
  2. Airlines charge more to fly on Fridays and Sundays.Businesspeople who work far from home fly out on Sunday and back on Friday. Their demand is inelastic. Tourists and leisure travelers are far more flexible in their travel plans and can fly any day of the week. Tuesday, Wednesday, and Saturday flights are the cheapest.
  3. Tracking consumer information and pricing accordingly.Two people buying something on the Internet are not necessarily presented with the same price. Firms collect data about individuals with tracking devices called cookies, which are deposited on buyers’ computer hard drives, and offer prices according to their estimated elasticity of demand. Thus, when you are searching the Internet for something to buy, you might be presented with a different price than someone else visiting the same site.

It might seem unfair for a monopolist to charge different people different prices, but doing so eliminates welfare loss from monopoly. The reason is that for a price-discriminating monopolist, the marginal revenue curve is the demand curve. So it will produce where MC = MR = D; in other words, it will produce the same output as would be produced in a perfectly competitive market. You can see this in Figure 14-6. The monopolist chooses to produce QPM. Since the supply curve in a perfectly competitive market is the sum of all marginal cost curves and equilibrium is where the supply and demand curves intersect, output in a competitive market will also be QPM. Both are producing where quantity supplied equals quantity demanded and there is no welfare loss.

Figure 14-6

A price-discriminating monopolist produces the same output as the combination of all firms in a competitive market. Total surplus is maximized in both cases. The differences is that the price-discriminating monopolist captures all of the surplus represented by areas A and B while all firms in the perfectly competitive market capture only area B.

What could be seen as unfair is what happens to consumer and producer surplus. In a perfectly competitive market, consumers pay and producers receive one price, PC. Consumer surplus is the area above market price (area A) and producer surplus is the area below market price above the marginal cost curve (area B). For a price-discriminating monopolist, because it can charge what consumers are willing to pay, all consumer surplus is captured by the monopolist. Producer surplus for a price-discriminating monopolist is areas A and B.

Q‑7Why does a price-discriminating monopolist make a higher profit than a normal monopolist?

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Web Note 14.2 Diamonds Are Forever

If there were no barriers to entry, profit-maximizing firms would always compete away monopoly profits.

Barriers to Entry and Monopoly

The standard model of monopoly just presented is simple, but, like many simple things, it hides some issues. One issue the standard model of monopoly hides is in this question: What prevents other firms from entering the monopolist’s market? You should be able to answer that question relatively quickly. If a monopolist exists, it must exist due to some type of barrier to entry (a social, political, or economic impediment that prevents firms from entering the market). Three important barriers to entry are natural ability, economies of scale, and government restrictions. In the absence of barriers to entry, the monopoly would face competition from other firms, which would erode its monopoly. Studying how these barriers to entry are established enriches the standard model and lets us distinguish different types of monopoly.

Added Dimension: Can Price Controls Increase Output and Lower Market Price?

In an earlier chapter, you learned how effective price ceilings increase market price, reduce output, and reduce the welfare of society. With any type of price control in a competitive market, some trades that individuals would like to have made are prevented. Thus, with competitive markets, price controls of any type are seen as generally bad (though they might have some desirable income distribution effects).

When there is monopoly, the argument is not so simple. The monopoly price is higher than the marginal cost and society loses out; monopolies create their own deadweight loss. In the monopoly case, price controls can actually lower price, increase output, and reduce deadweight loss. Going through the reasoning why provides a good review of the tools.

The figure below shows you the argument.

The monopoly sets its quantity where MR = MC. Output is QM and price is PM; the welfare loss is the blue shaded triangle A. Now say that the government comes in and places a price ceiling on the monopolist at the competitive price, PC. Since the monopolist is compelled by law to charge price PC, it no longer has an incentive to restrict output. Put another way, the price ceiling—the dashed line PC—becomes the monopolist’s demand curve and marginal revenue curve. (Remember, when the demand curve is horizontal, the marginal revenue curve is identical to the demand curve.) Given the law, the monopolist’s best option still is to produce where MC = MR, but that means charging price PC and increasing output to QC. As you can see from the figure, the price ceiling causes output to rise and price to fall.

If, when there is monopoly, price controls can increase efficiency, why don’t economists advocate price controls more than they do? Let’s review four reasons why.

  1. For price controls to increase output and lower price, the price has to be set within the right price range— below the monopolist’s price and above the price where the monopolist’s marginal cost and marginal revenue curves intersect. It is unclear politically that such a price will be chosen. Even if regulators could pick the right price initially, markets may change. Demand may increase or decrease, putting the controlled price outside the desired range.
  2. All markets are dynamic. The very existence of monopoly profits will encourage other firms in other industries to try to break into that market, keeping the existing monopolist on its toes. Because of this dynamic element, in some sense no market is ever a pure textbook monopoly.
  3. Price controls create their own deadweight loss in the form of rent seeking. Price controls do not eliminate monopoly pressures. The monopolist has a big incentive to regain its ability to set its own price and will lobby hard to remove price controls. Economists see resources spent to regain their monopoly price as socially wasteful.
  4. Economists distrust government. Governments have their own political agendas—there is no general belief among economists that governments will try to set the price at the competitive level. Once one opens up the price control gates in cases of monopoly, it will be difficult to stop government from using price controls in competitive markets.

The arguments are, of course, more complicated, and will be discussed in more detail in later chapters, but this should give you a good preview of some of the policy arguments that occur in real life.

Natural Ability

A barrier to entry that might exist is that a firm is better at producing a good than anyone else. It has unique abilities that make it more efficient than all other firms. The barrier to entry in such a case is the firm’s natural ability. The defense attorneys in the Microsoft antitrust case argued that it was Microsoft’s superior products that led to its capture of 90 percent of the market.

Monopolies based on ability usually don’t provoke the public’s ire. Often in the public’s mind such monopolies are “just monopolies.” The standard economic model doesn’t distinguish between a “just” and an “unjust” monopoly. The just/unjust distinction raises the question of whether a firm has acquired a monopoly based on its ability or on certain unfair tactics such as initially pricing low to force competitive companies out of business but then pricing high. Many public debates over monopoly focus on such normative issues, about which the economists’ standard model has nothing to say.

Natural Monopolies

An alternative reason why a barrier to entry might exist is that there are significant economies of scale. If sufficiently large economies of scale exist, it would be inefficient to have two producers since if each produced half of the output, neither could take advantage of the economies of scale. Such industries are called natural monopolies. A natural monopoly is an industry in which a single firm can produce at a lower cost than can two or more firms. A natural monopoly will occur when the technology is such that indivisible setup costs are so large that average total costs fall within the range of possible outputs. I demonstrate that case in Figure 14-7(a).

Figure 14-7 (A AND B) A Natural Monopolist

(a) Average Cost for Natural Monopolist

(b) Profit of Natural Monopolist

The graph in (a) shows the average cost curve for a natural monopoly. One firm producing Q1 would have a lower average cost than a combination of firms would have. For example, if three firms each produced Q1/3, the average cost for each would be C3.

The graph in (b) shows that a natural monopolist would produce QM and charge a price PM. It will earn a profit shown by the orange shaded box. If the monopolist were required to charge a price equal to marginal cost, PC, it would incur a loss shown by the blue shaded box.

If one firm produces Q1, its cost per unit is C1. If two firms each produces half that amount, Q1/2;, so that their total production is Q1, the cost per unit will be C2, which is significantly higher than C1. In cases of natural monopoly, as the number of firms in the industry increases, the average total cost of producing a fixed number of units increases. For example, if each of three firms in an industry had a third of the market, each firm would have an average cost of C3.

In a natural monopoly, a single firm can produce at a lower cost than can two or more firms.

Until the 1990s local telephone service was a real-world example of such a natural monopoly. It made little sense to have two sets of telephone lines going into people’s houses. I say “until recently” because technology changes and now, with wireless communications and cable connections, the technical conditions that made local telephone service a natural monopoly are changing. Such change is typical; natural monopolies are only natural given a technology.

Real-World Application: Monopolizing Monopoly

Have you ever played Monopoly? Probably you have. And in the process, you have made money for Parker Brothers, the firm that has the monopoly on Monopoly. How they got it is an interesting story of actual events following games and vice versa. The beginnings of the Monopoly game go back to a Quaker woman named Lizzie Magie, who was part of the one-tax movement of populist economist Henry George. That movement, which was a central populist idea in the late 1800s, wanted to put a tax on all land rent to finance government. George argued that there would be no need for an income tax; the tax on the land monopoly would finance it all. Lizzie Magie created a game, called the Landlord’s Game, as a way of teaching George’s ideas, and showing how monopoly caused problems. She patented the game in 1904.

Despite the patent, people copied the game with her approval, since her desire was to spread George’s ideas. As the game spread, it kept changing form and rules, and eventually acquired the property names associated with Atlantic City, which the game now uses, and came to be called Monopoly. A number of variations of the game developed.

Used with permission from Ralph Anspach and University Games

In the 1930s Charles Darrow was taught the game and had some friends write up the rules, which they copyrighted. (They couldn’t patent the game because they didn’t invent it.) In 1935 Darrow made an agreement with Parker Brothers, a firm that sold games, that gave them the right to produce this monopoly game in exchange for royalties. As Parker Brothers discovered the history of the monopoly game and of the particular games that preceded it, Parker Brothers bought the right to the previous games so that they would secure their full rights to Monopoly. It paid the various people between $500 and $10,000 for those rights. In 1974, an economics professor, Ralph Anspach, created an “Anti-Monopoly” game that pitted monopolists against competitors. That game led to suits and countersuits between Anspach and General Mills Fun Group, which had bought Parker Brothers in the interim, as they attempted to protect their monopoly.

A natural monopoly also can occur when a single industry standard is more efficient than multiple standards, even when that standard is owned by one firm. An example is the operating system for computers. A single standard is much more efficient than multiple standards because the communication among computer users is easier.

From a welfare standpoint, natural monopolies are different from other types of monopolies. In the case of a natural monopoly, even if a single firm makes some monopoly profit, the price it charges may still be lower than the price two firms making normal profit would charge because its average total costs will be lower. In the case of a natural monopoly, not only is there no welfare loss from monopoly, but there can actually be a welfare gain since a single firm producing is so much more efficient than many firms producing. Such natural monopolies are often organized as public utilities. For example, most towns have a single water department supplying water to residents.

Figure 14-7(b) shows the profit-maximizing level of output and price that a natural monopolist would choose. To show the profit-maximizing level of output, I’ve added a marginal cost curve that is below the average total cost curve. (If you don’t know why this must be the case, a review of costs is in order.) A natural monopolist uses the same MC = MR rule that a monopolist uses to determine output. The natural monopolist will produce QM and charge a price PM. Average total costs are CM and the natural monopolist earns a profit shown by the orange shaded box.

Added Dimension: Normative Views of Monopoly

Many laypeople’s views of government-created monopoly reflect the same normative judgments that Classical economists made. Classical economists considered, and much of the lay public considers, such monopolies unfair and inconsistent with liberty. Monopolies prevent people from being free to enter whatever business they want and are undesirable on normative grounds. In this view, government-created monopolies are simply wrong.

This normative argument against government-created monopoly doesn’t extend to all types of government-created monopolies. The public accepts certain types of government-created monopoly that it believes have overriding social value. An example is patents. To encourage research and development of new products, government gives out patents for a wide variety of innovations, such as genetic engineering, Xerox machines, and cans that can be opened without a can opener.

A second normative argument against monopoly is that the public doesn’t like the income distributional effects of monopoly. Although, as we saw in our discussion of monopoly, monopolists do not always earn an economic profit, they often do, which means that the monopoly might transfer income in a way that the public (whose normative views help determine society’s policy toward monopoly) doesn’t like. This distributional effect of monopoly based on normative views of who deserves income is another reason many laypeople oppose monopoly: They believe it transfers income from “deserving” consumers to “undeserving” monopolists.

A third normative reason people oppose government-created monopoly that isn’t captured by the standard model of monopoly is that the possibility of government-created monopoly encourages people to spend a lot of their time in political pursuits trying to get the government to favor them with a monopoly, and less time doing “productive” things. It causes rent-seeking activities in which people spend resources to gain monopolies for themselves.

Each of these arguments probably plays a role in the public’s dislike of monopoly. As you can see, these real-world arguments blend normative judgments with objective analysis, making it difficult to arrive at definite conclusions. Most real-world problems require this blending, making applied economic analysis difficult. The economist must interpret the normative judgments about what people want to achieve and explain how public policy can be designed to achieve those desired ends.

Where a natural monopoly exists, the perfectly competitive solution is impossible, since average total costs are not covered where MC = P. A monopolist required by government to charge the competitive price PC, where P = MC, will incur a loss shown by the blue shaded box because marginal cost is always below average total cost. Either a government subsidy or some output restriction is necessary in order for production to be feasible. In such cases, monopolies are often preferred by the public as long as they are regulated by government. I will discuss the issues of regulating natural monopolies in the chapter on real-world competition.

Q‑8Why is the competitive price impossible for an industry that exhibits strong economies of scale?

Government-Created Monopolies 

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Web Note 14.3 The Best Monopoly in America

Possible economic profits from monopoly lead potential monopolists to spend money to get government to give them a monopoly.

A final reason monopolies can exist is that they’re created by government. The support of laissez-faire by Classical economists such as Adam Smith and their opposition to monopoly arose in large part in reaction to those government-created monopolies, not in reaction to any formal analysis of welfare loss from monopoly.

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