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Chapter Monopoly CHAPTER IN PERSPECTIVE 14 In Chapter 14 we study how a monopoly chooses its price and quantity and discuss whether a monopoly is efficient or fair. ■ Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly. A monopoly is a market with a single supplier of a good or service that has no close substitutes and in which natural or legal barriers to entry prevent competition. A monopolist faces a tradeoff between price and the quantity sold. A single-price monopoly is a monopoly that must sell each unit of its output for the same price to all its customers. A price-discriminating monopoly is a monopoly that is able to sell different units of a good or service for different prices. ■ Explain how a single-price monopoly determines its output and price. The demand curve for a monopoly is the downward sloping market demand curve. For a single-price monopoly, marginal revenue is less than price, so the marginal revenue curve lies below the demand curve. A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost and finding the highest price at which it can sell this output on the demand curve. ■ Compare the performance of a single-price monopoly with that of perfect competition. Compared to perfect competition, a single-price monopoly produces a smaller output and charges a higher price. A monopoly is inefficient because it creates a deadweight loss. A monopoly redistributes consumer surplus so that the producer gains and the consumers lose. Rent seeking is the act of obtaining special treatment by the government to create an economic profit or divert consumer surplus or producer surplus away from others. Rent seeking restricts competition and can create a monopoly. ■ Explain how price discrimination increases profit. To be able to price discriminate, a firm must be able to identify and separate different types of buyers and sell a product that cannot be resold. Price discrimination converts consumer surplus into economic profit. Perfect price discrimination charges every consumer the maximum price the consumer is willing to pay. Perfect price discrimination leaves no consumer surplus but is efficient. ■ Explain how monopoly regulation influences output, price, economic profit, and efficiency. Monopolies exist and have a potential advantage over a competitive alternative because of economies of scale and incentives to innovate. Natural monopolies are regulated. Marginal cost pricing is a rule that sets price equal to marginal cost. The monopoly produces the efficient quantity but incurs an economic loss. Average cost pricing is a rule that sets price equal to average cost. The monopoly produces an inefficient quantity but earns a normal profit. 218 Part 5 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE EXPANDED CHAPTER CHECKLIST • When you have completed this chapter, you will be able to: • 1 Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly. • • • • how a single-price monopoly determines its output and price. • • • Calculate marginal revenue and explain why marginal revenue is less than price for a single-price monopoly. Explain the relationship between marginal revenue and elasticity. Use a total revenue curve and a total cost curve to find the profit-maximizing level of output for a single-price monopoly. Use a marginal revenue curve, a marginal cost curve, and a demand curve to find the profit-maximizing level of output and price for a single-price monopoly. 3 Compare the performance of a single-price monopoly with that of perfect competition. • • • Compare the output and price of perfect competition and single-price monopoly. Discuss the efficiency and fairness of monopoly. Define rent seeking and discuss its effects. 4 Explain how price discrimination increases profit. • 5 Explain how monopoly regulation influences output, price, economic profit, and efficiency. Define monopoly and state the two conditions under which monopoly arises. Define natural barrier and natural monopoly. Give examples of legal barriers that create legal monopoly. Describe how a price-discriminating monopoly differs from single-price monopoly. 2 Explain • • State the two conditions necessary for price discrimination. Explain how a firm profits from price discrimination. Define perfect price discrimination and explain how a perfectly price-discriminating monopoly chooses its level of output. Discuss the relationship between price discrimination and efficiency. • • List two potential advantages of monopoly over perfect competition. Define and illustrate a marginal cost pricing rule and average cost pricing rule. KEY TERMS • • • • • • • • • Barrier to entry (page 340) Natural monopoly (page 340) Legal monopoly (page 341) Single-price monopoly (page 342) Price-discriminating monopoly (page 342) Rent seeking (page 351) Perfect price discrimination (page 356) Marginal cost pricing rule (page 361) Average cost pricing rule (page 361) CHECKPOINT 14.1 ■ Explain how monopoly arises and distinguish between single-price monopoly and price-discriminating monopoly. Practice Problems 14.1 1. Monopoly arises in which of the following situations? a. Coca-Cola cuts its price below that of Pepsi-Cola in an attempt to increase its market share. b. A single firm, protected by a barrier to entry, produces a personal service that has no close substitutes. c. A barrier to entry exists, but some close substitutes for the good exist. Chapter 14 . Monopoly d. A firm offers discounts to students and seniors. e. A firm can sell any quantity it chooses at the going price. f. The government issues Tiger Woods, Inc. an exclusive license to produce golf balls. g. A firm experiences economies of scale even when it produces the quantity that meets the entire market demand. 2. Which of the cases a to f in Problem 1 are natural monopolies and which are legal monopolies? Which can price discriminate, which cannot, and why? Solution to Practice Problems 14.1 These Practice Problems focus on the definition of monopoly. Remember that a monopoly arises when there are no close substitutes for the good or service and there are barriers to entry. Quick Review • Barrier to entry A natural or legal constraint that protects a firm from competitors. 1. Monopoly arises in which of the following situations? 1a. Coca-Cola cuts its price below that of Pepsi-Cola in an attempt to increase its market share. A monopoly is a market with a single firm. There is no monopoly in part (a) because there is more than one firm. 1b. A single firm, protected by a barrier to entry, produces a personal service that has no close substitutes. A monopoly is a market with a single supplier of a good that has no close substitutes and in which natural or legal barriers to entry prevent competition. Part (b) describes a monopoly. 1c. A barrier to entry exists, but some close substitutes for the good exist. A monopoly does not arise because close substitutes for the good exist. 1d. A firm offers discounts to students and seniors. Firms other than a monopoly can price discriminate, so price discrimination by itself is not proof of a monopoly. 219 1e. A firm can sell any quantity it chooses at the going price. When a firm can sell any quantity it chooses at the going price, demand for the good that the firm produces is perfectly elastic. This situation occurs when the firm is in perfect competition. 1f. The government issues Tiger Woods, Inc. an exclusive license to produce golf balls. This government license creates a legal monopoly in golf balls because a single firm is protected from competition and is supplying a good without close substitutes. 1g. A firm experiences economies of scale even when it produces the quantity that meets the entire market demand. When a firm experiences economies of scale when it produces the quantity that meets the entire market demand, it produces that quantity at a lower price than two or more firms could. This firm is a natural monopoly. 2. Which of the cases a to f in Problem 1 are natural monopolies and which are legal monopolies? Which can price discriminate, which cannot, and why? A natural monopoly is a monopoly that arises because one firm can meet the entire market demand at a lower price than two or more firms. Part (g) describes a natural monopoly. Part (b) could be a natural monopoly, but the type of barrier to entry is not specified. A legal monopoly is a market in which competition and entry are restricted by the concentration of ownership of a natural resource or by the granting of a public franchise, government license, patent, or copyright. Part (f) describes a legal monopoly. Part (b) could be a legal monopoly, but the type of barrier to entry is not specified. Monopoly (b) can price discriminate because a personal service cannot be resold. Monopoly (f) cannot price discriminate because golf balls could be resold. There is not enough information given about the type of good in monopoly (g) to determine if monopoly (g) can price discriminate. 220 Part 5 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE Additional Practice Problem 14.1a What is the source of the monopoly for the U.S. Postal Service’s first class mail delivery and DeBeer’s diamond sales? Solution to Additional Practice Problem 14.1a The U.S. Post Service derives its monopoly status by a government franchise to deliver first class mail. Though it retains its franchise on first class mail delivery, it faces competition from the overnight services provided by FedEx, United Parcel Service, and others. DeBeers gained its monopoly power in diamond sales by buying up supplies of diamonds from sources throughout the world. 3. A natural monopoly is one that arises from a. patent law. b. copyright law. c. a firm buying up all of a natural resource. d. economies of scale. ■ Self Test 14.1 5. Pizza producers charge one price for a single pizza and almost give away a second one. This is an example of a. monopoly. b. a barrier to entry. c. behavior that is not profit-maximizing. d. price discrimination. Fill in the blanks One of the requirements for monopoly is that there ____ (are; are no) close substitutes for the good. A ____ (legal; natural) monopoly exists when one firm can meet the entire market demand at a lower price than two or more firms could. A monopoly that is able to sell different units of a good or service for different prices is a ____ (legal-price; natural-price; pricediscriminating) monopoly. True or false 1. A legal barrier creates a natural monopoly. 2. A firm experiences economies of scale along a downward-sloping long-run average total cost curve. 3. A monopoly always charges all customers the same price. Multiple choice 1. A monopoly market has a. a few firms. b. a single firm. c. two dominating firms in the market. d. only two firms in it. 2. There are two types of barriers to entry: a. legal and illegal. b. natural and legal. c. natural and illegal. d. natural and unnatural. 4. A legal barrier is created when a firm a. has economies of scale, which allow it to produce at a lower cost than two or more firms. b. is granted a public franchise, government license, patent, or copyright. c. produces a unique product or service. d. produces a standardized product or service. Short answer and numeric questions 1. What conditions define monopoly? 2. What are the two types of barriers to entry? 3. What are the two pricing strategies a monopoly can use? Why don’t perfectly competitive firms have these same strategies? CHECKPOINT 14.2 ■ Explain how a single-price monopoly determines its output and price. Practice Problem 14.2 1. Minnie’s Mineral Price Total Springs is a sin- (dollars Quantity cost gle-price moper (bottles (dollars nopoly. The first bottle) per hour) per hour) two columns of 10 0 1.0 9 1 1.5 the table show 8 2 2.5 the demand 7 3 5.5 schedule for 6 4 10.5 Minnie’s spring 5 5 17.5 water, and the Chapter 14 . Monopoly middle and third columns show the firm’s total cost schedule. a. Calculate Minnie’s total revenue schedule and marginal revenue schedule. b. Sketch Minnie’s demand curve and marginal revenue curve. c. Calculate Minnie’s profit-maximizing output, price, and economic profit. d. If the owner of the water source that Minnie uses increases the fee that Minnie pays by $15.50 an hour, what are Minnie’s new profit-maximizing output, price, and economic profit? e. If instead of increasing the fee that Minnie pays by $15.50 an hour, the owner of the water source increases the fee that Minnie pays by $4 a bottle, what are Minnie’s new profit-maximizing output, price, and economic profit? Solution to Practice Problem 14.2 Both a monopoly and a perfectly competitive firm maximize their profit by producing where marginal revenue equals marginal cost. Quick Review • Marginal revenue The change in total revenue resulting from a one-unit increase in the quantity sold. • Maximize profit A single-price monopoly maximizes its profit by producing where MR = MC and then using the demand curve to determine the price for this quantity of output. a. Calculate Minnie’s total revenue schedule and marginal revenue schedule. Total revenue Total Marginal equals price times Quantity revenue revenue quantity and is (bottles (dollars (dollars reported in the per hour) per hour) per hour) 0 0 middle column of 9 the table. Mar1 9 7 ginal revenue is 2 16 5 equal to the 3 21 change in total 3 revenue when 4 24 1 Minnie increases 5 25 her output by 1 221 bottle an hour and is reported in the third column in the table. b. Sketch Minnie’s demand curve and marginal revenue curve. The demand Price and marginal revenue (dollars per bottle) curve and the marginal revenue 10 curve are in the 8 figure to the right. 6 The marginal D revenue curve lies 4 below the demand 2 curve. MR 0 1 2 3 4 5 Quantity (bottles per hour) c. Calculate Minnie’s profit-maximizing output, price, and economic profit. Equate marginal revenue to marginal cost. The marginal revenue of 3 bottles is $4.00 (the average of the marginal revenue from 2 to 3 and from 3 to 4) and the marginal cost is $4.00, so the profit-maximizing output is 3 bottles an hour. The price is determined from the demand curve above 3 bottles and is $7.00 per bottle. Minnie’s economic profit is the total revenue minus the total cost or $21.00 − $5.50 = $15.50 an hour. d. If the owner of the water source that Minnie uses increases the fee that Minnie pays by $15.50 an hour, what are Minnie’s new profit-maximizing output, price, and economic profit? Minnie’s fixed cost increases when the fee increases but her marginal cost does not change. The profit-maximizing output and price remain the same. But the economic profit falls to $0. e. If instead of increasing the fee that Minnie pays by $15.50 an hour, the owner of the water source increases the fee that Minnie pays by $4 a bottle, what are Minnie’s new profit-maximizing output, price, and economic profit? Minnie’s marginal cost increases by $4 a bottle. Marginal revenue now equals marginal cost when Minnie produces 2 bottles. Minnie sells both at a price of $8, so her total revenue is $16 Part 5 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE 222 an hour. Total cost is $10.50 an hour. Minnie’s economic profit is $16.00 − $10.50, which is $5.50 an hour. Additional Practice Problem 14.2a 1. The table gives part of Minnie’s total cost schedule from Practice Problem 14.2. Average total cost (dollars per bottle) Quantity (bottles per hour) Total cost (dollars per hour) 0 1.0 1 1.50 ____ 2 2.50 ____ 3 5.50 ____ 4 10.50 ____ a. Complete the table. b. Using information in the table and in Practice Problem 14.2, plot Minnie’s demand, marginal revenue, average total cost, and marginal cost curves. Indicate the equilibrium quantity and price, and show Minnie’s economic profit. Marginal cost (dollars per bottle) ____ ____ ____ ____ Price and cost (dollars per bottle) 10 8 6 4 2 0 1 2 3 4 5 Quantity (bottles per hour) Solution to Additional Practice Problem 14.2a a. Complete the table. Average total cost (dollars per bottle) Quantity (bottles per hour) Total cost (dollars per hour) 0 1.00 1 1.50 1.50 2 2.50 1.25 3 5.50 1.83 4 10.50 2.63 Marginal cost (dollars per bottle) 0.50 1.00 3.00 5.00 The completed table is above. b. Using information in the table and in Practice Problem 14.2, plot Minnie’s de- mand, marginal revenue, average total cost, and marginal cost curves. Indicate the equilibrium quantity and price, and show Minnie’s economic profit. The completed figure is to the right. The Price and cost (dollars per bottle) equilibrium quantity is the quantity where 10 the MR and MC 8 curves intersect, which is 3 bottles an 6 D MC hour. The price is $7 a 4 ATC bottle, from the de2 mand curve. The MR economic profit is 0 1 2 3 4 5 equal to the area of Quantity (bottles per hour) the rectangle. ■ Self Test 14.2 Fill in the blanks For each level of output, marginal revenue for a single-price monopoly is ____ (greater than; equal to; less than) price. When demand is inelastic, marginal revenue is ____ (positive; negative). A single-price monopoly maximizes profit by producing the quantity at which marginal revenue ____ (is greater than; equals; is less than) marginal cost and then finds the highest price for which it can sell that output by using the ____ (demand; marginal revenue; average total cost) curve. True or false 1. For a single-price monopoly, marginal revenue exceeds price. 2. Marginal revenue is always positive for a monopoly. 3. A single-price monopoly maximizes profit by producing the quantity that makes marginal revenue equal to marginal cost. Multiple choice 1. For a single-price monopoly, price is ____ marginal revenue. a. greater than b. less than c. equal to d. unrelated to Chapter 14 . Monopoly 2. A single-price monopoly can sell 1 unit for $9.00. To sell 2 units, the price must be $8.50 per unit. The marginal revenue from selling the second unit is a. $17.50. b. $17.00. c. $8.50. d. $8.00. 3. When demand is elastic, marginal revenue is a. positive. b. negative. c. zero. d. increasing as output increases. 4. To maximize profit, a single-price monopoly produces where a. the difference between marginal revenue and marginal cost is as large as possible. b. marginal revenue is equal to marginal cost. c. average total cost is at its minimum. d. the marginal cost curve intersects the demand curve. 5. Once a monopolist has determined its output level, it will charge a price that a. is determined by the intersection of the marginal revenue and marginal cost curves. b. minimizes marginal cost. c. is determined by its demand curve. d. is independent of the amount produced. Complete the graph Quantity (hamburgers per hour) 1 Price (dollars) 8.00 2 7.00 3 6.00 4 5.00 5 4.00 Marginal revenue (dollars) ___ ___ ___ ___ 1. The table gives the demand schedule for a monopoly seller of hamburgers. Complete the table by calculating the marginal revenue and then draw the demand curve and marginal revenue curve in Figure 14.1. 223 FIGURE 14.1 Price and marginal revenue (dollars per hamburger) 10 9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 Quantity (hamburgers per hour) FIGURE 14.2 Price and cost (dollars per unit) 0 Quantity (units per year) 2. Figure 14.2 shows a monopoly. Label the curves. Identify the quantity produced by labeling it Q and the price charged by labeling it P. Is the monopoly earning an economic profit or incurring an economic loss? Darken the area that shows the economic profit or economic loss. Short answer and numeric questions 1. What is the relationship between the elasticity of demand and marginal revenue? 2. Both perfectly competitive and monopoly firms maximize their profit by producing where MR = MC. Why do both use the same rule? 3. Why can a monopoly earn an economic profit in the long run? 224 Part 5 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE CHECKPOINT 14.3 ■ Compare the performance of a single-price monopoly with that of perfect competition. Practice Problem 14.3 Township is a small isolated community served by one newspaper that can meet the market demand at a lower cost than two or more newspapers could. There is no local radio or TV station and no Internet access. The Township Gazette is the Price (cents per newspaper) only source of news. 100 The figure shows 80 MC the marginal cost of 60 printing the Township Gazette and the 40 demand for it. The 25 Township Gazette is a D profit-maximizing, 0 100 200 300 400 500 single-price moQuantity (newspapers per day) nopoly. a. How many copies of the Township Gazette are printed each day? b. What is the price of the Township Gazette? c. What is the efficient number of copies of the Township Gazette? d. What is the price at which the efficient number of copies could be sold? e. Is the number of copies printed the efficient quantity? Explain why or why not. f. On a graph, show the consumer surplus that is redistributed from consumers to the Township Gazette. g. On a graph, show the deadweight loss that results from the monopoly of the Township Gazette. Solution to Practice Problem 14.3 Single-price monopolies create a deadweight loss because a monopoly produces where MR = MC but efficiency requires production where MB = MC. Quick Review • Monopoly and competition compared Compared to perfect competition, a single- price monopoly produces a smaller output and charges a higher price. a. How many copies of the Township Gazette are printed each day? To maximize profit, the firm produces 150 papers because in the figure below, 150 papers a day is the quantity at which marginal revenue equals marginal cost. b. What is the price of the Township Gazette? Using the demand Price (cents per newspaper) curve, in the fig- 100 ure, the price that 80 MC corresponds to the 70 60 quantity of 150 50 newspapers a day 40 is 70¢ a newspa25 per. D MR 0 100 200 300 400 500 c. What is the Quantity (newspapers per day) efficient number of copies of the Township Gazette? The efficient quantity is the quantity where marginal benefit equals marginal cost. The demand curve is the marginal benefit curve, so the figure shows that the efficient quantity is 250 newspapers a day. d. What is the price at which the efficient number of copies could be sold? From the demand curve, 250 newspapers a day will be purchased at 50¢ each. e. Is the number of copies printed the efficient quantity? Explain why or why not. The Township Gazette is not printing the efficient quantity. The marginal benefit of the 150th newspaper exceeds the marginal cost. f. On a graph, show the consumer surplus that is redistributed from consumers to the Township Gazette. The redistributed consumer surplus is the light rectangle in the figure. g. On a graph, show the deadweight loss that results from the monopoly of the Township Gazette. The dark triangular area is the deadweight loss from the monopoly. Chapter 14 . Monopoly Additional Practice Problem 14.3a The Township Gazette is put up for sale. Suppose that looking at the entire future, the Township Gazette’s total economic profit is $2 million. If the bidding for the Township Gazette is a competitive process, what do you expect will be the price for which the newspaper is sold? What result are you illustrating? Solution to Additional Practice Problem 14.3a Bidders will be willing to pay up to $2 million for the Township Gazette because if they can buy it for any price less than $2 million, they will receive an economic profit. Because the bidding is competitive, the price the Township Gazette will be bid up to $2 million, so that the winning bidder will earn a normal profit. This result demonstrates rent-seeking equilibrium in which the rent-seeking costs exhaust the economic profit. ■ Self Test 14.3 Fill in the blanks Compared to perfect competition, a single-price monopoly produces a ____ (larger; smaller) output and charges a ____ (higher; lower) price. A single-price monopoly ____ (creates; does not create) a deadweight loss. The act of obtaining special treatment by the government to create an economic profit is called ____ (government surplus; rent seeking). Rent seeking ____ (decreases; increases) the amount of deadweight loss. True or false 1. A monopoly charges a higher price than a perfectly competitive industry would charge. 2. A monopoly redistributes consumer surplus so that the consumers gain and the producer loses. 3. The buyer of a monopoly always makes an economic profit. 225 Multiple choice 1. If a perfectly competitive industry is taken over by a single firm that operates as a singleprice monopoly, the price will ____ and the quantity will ____. a. fall, decrease b. fall, increase c. rise, decrease d. rise, increase 2. Comparing single-price monopoly to perfect competition, we see that a. monopoly increases the amount of consumer surplus. b. monopoly has the same amount of consumer surplus. c. perfect competition has no consumer surplus. d. monopoly decreases the amount of consumer surplus. 3. Is a single-price monopoly efficient? a. Yes, because it creates a deadweight loss. b. No, because it creates a deadweight loss. c. Yes, because consumers gain and producers lose some of their surpluses. d. Yes, because consumers lose and producers gain some of their surpluses. 4. Monopolies are a. always fair but not efficient. b. efficient but might or might not be fair. c. inefficient and might or might not be fair. d. both fair and efficient. 5. In equilibrium, rent seeking eliminates the a. deadweight loss. b. economic profit. c. consumer surplus. d. demand for the product. Part 5 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE 226 Complete the graph FIGURE 14.3 Price and costs (dollars per ostrich) 50 40 30 20 10 0 5 10 15 20 25 30 35 40 45 50 Quantity (thousands of ostriches per year) 1. Figure 14.3 shows the market for ostrich farming, an industry that is initially perfectly competitive. Then one farmer buys all the other farms and operates as a singleprice monopoly. In the figure, label the curves. What was the competitive price and quantity? What is the monopoly price and quantity? Darken the deadweight loss area. Short answer and numeric questions 1. How does the quantity produced and the price set by a single-price monopoly compare to those in a perfectly competitive market? 2. What happens to consumer surplus with a single-price monopoly? 3. What is rent seeking? How does rent seeking affect society? CHECKPOINT 14.4 ■ Explain how price discrimination increases profit. Practice Problem 14.4 Village, a small isolated town, has one doctor. For a 30-minute consultation, the doctor charges a rich person twice as much as a poor person. a. Does the doctor practice price discrimination? b. Does the doctor’s pricing system redistribute consumer surplus? If so, explain how. c. Is the doctor using resources efficiently? Explain your answer. d. If the doctor decided to charge everyone the maximum price that he or she would be willing to pay, what would be the consumer surplus? e. In part (d), is the market for medical service in Village efficient? Solution to Practice Problem 14.4 This Practice Problem helps you understand who truly gains from price discrimination. Remember that the key idea behind price discrimination is to convert consumer surplus into economic profit. Quick Review • Price discrimination Price discrimination is selling a good at a number of different prices. • Consumer surplus The consumer surplus of a good is its marginal benefit, which equals the maximum price the consumer is willing to pay, minus the price paid for it. a. Does the doctor practice price discrimination? Yes, charging different prices to rich people and poor people for the same service is price discrimination. b. Does the doctor’s pricing system redistribute consumer surplus? If so, explain how. Yes. Because the doctor is setting the price closer to the maximum the consumer is willing to pay, each consumer receives less consumer surplus. The doctor is converting consumer surplus into economic profit. c. Is the doctor using resources efficiently? Explain your answer. The doctor is not using resources efficiently. Price discrimination creates a deadweight loss Chapter 14 . Monopoly unless the producer can practice perfect price discrimination. d. If the doctor decided to charge everyone the maximum price that he or she would be willing to pay, what would be the consumer surplus? The doctor is practicing perfect price discrimination. All of the consumer surplus would be converted into economic profit and so consumer surplus would be zero. e. In part (d), is the market for medical service in Village efficient? Yes, because the demand curve becomes the marginal revenue curve in perfect price discrimination. The demand curve is also the marginal benefit curve. So the doctor will continue services until marginal revenue equals marginal cost, which is the quantity where marginal benefit equals marginal cost. And when marginal benefit equals marginal cost there is an efficient use of resources. Additional Practice Problem 14.4a Why is the price to attend a movie less on a weekday afternoon than on a weekend evening? Solution to Additional Practice Problem 14.4a When the price to attend a movie is less on a weekday afternoon than on a weekend evening, the movie theater is practicing price discrimination among two groups of buyers. Each group has a different average willingness to pay to see a movie. By having two different prices, the movie theater maximizes profit by converting consumer surplus into economic profit. ■ Self Test 14.4 Fill in the blanks It is ____ (sometimes; never) possible for a monopoly to charge different customers different prices. The key idea behind price discrimination is to convert ____ (consumer surplus; producer surplus) into economic profit. Price discrimination results in consumers with a higher willingness to pay paying a ____ (higher; lower) price than consumers with a lower willingness to pay. Perfect price discrimination results in ____ 227 (the maximum; zero) consumer surplus and ____ (creates; does not create) a deadweight loss. True or false 1. Price discrimination lowers a firm’s profit. 2. Price discrimination converts producer surplus into consumer surplus. 3. With perfect price discrimination, the demand curve becomes the marginal revenue curve. Multiple choice 1. Which of the following must a firm do to successfully price discriminate? a. divide buyers into different groups according to their willingness to pay b. prevent resale of the good or service c. identify into which group a buyer falls d. All of the above answers are correct. 2. Which of the following is NOT price discrimination? a. different prices based on differences in production cost b. charging business flyers a higher airfare than tourists c. charging consumers who buy a larger quantity a lower price d. pricing on the basis of some easily distinguishing characteristic of buyers that identifies some buyers as having higher willingness to pay 3. When a monopolist price discriminates, it a. increases the amount of consumer surplus. b. decreases the monopolist’s economic profit. c. converts consumer surplus into economic profit. d. converts economic profit into consumer surplus. Part 5 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE 228 4. If a monopolist is able to perfectly price discriminate, then consumer surplus is a. equal to zero. b. maximized. c. unchanged from what it is with a singleprice monopoly. d. unchanged from what it is in a perfectly competitive industry. 5. With perfect price discrimination, the quantity of output produced by the monopolist is ____ the quantity produced by a perfectly competitive industry. a. greater than b. less than c. equal to d. almost always greater than Complete the graph 1. Figure 14.4 shows the cost and demand curves for a dry-cleaner that has a monopoly in a small town. FIGURE 14.4 Price and cost (dollars per article of clothing) 10 9 8 7 6 5 4 3 2 1 0 MC MR 10 ATC D 20 30 40 50 Quantity (articles of clothing per day) a. In the figure, lightly darken the area of the economic profit for a single-price monopoly. What is the amount of economic profit this firm earns? b. Suppose the firm is able to perfectly price discriminate. More heavily darken the additional economic profit the firm now earns. What is the amount of the firm’s economic profit now? Short answer and numeric questions 1. Explain the effect of price discrimination on consumer surplus and economic profit. 2. When does a price discriminating monopoly produce the efficient quantity of output? CHECKPOINT 14.5 ■ Explain how monopoly regulation influences output, price, economic profit, and efficiency. Practice Problem 14.5 The local water Price and cost company is a natural monopoly. The 10 8 figure shows the demand for water 6 and the water com4 pany’s cost of proLRAC viding water. 2 MC D a. If the com0 pany is an un1 2 3 4 5 Quantity regulated (thousands of gallons per day) profitmaximizer: i. What is the price of water? ii. What quantity of water would be supplied? iii. What would be the deadweight loss? b. If the company is regulated to make normal profit: i. What is the price of water? ii. What quantity of water would be supplied? iii. What would be the deadweight loss? c. If the company is regulated to be efficient: i. What is the price of water? ii. What quantity of water would be supplied? iii. What would be the deadweight loss? Solution to Practice Problem 14.5 This Practice Problem studies the implications of monopoly regulations that affect all our lives through prices we pay. Chapter 14 . Monopoly Quick Review • Marginal cost pricing rule Set the price equal to the marginal cost. • Average cost pricing rule Set the price equal to the average total cost. a. If the company is an unregulated profitmaximizer: i. What is the price of water? ii. What quantity of water would be supplied? iii. What would be the deadweight loss? The firm produces where marginal Price and cost revenue equals 10 marginal cost. As 8 the figure shows, 6 the firm supplies 4 2,000 gallons of waLRAC ter and the price is 2 MC D $6. The deadweight MR loss is the large tri0 1 2 3 4 5 angular area made Quantity (thousands of gallons per day) up of the lightly shaded gray area plus the (small) darker grey triangle and equals $4,000 a day. b. If the company is regulated to make normal profit: i. What is the price of water? ii. What quantity of water would be supplied? iii. What would be the deadweight loss? If the company is regulated using an average cost pricing rule, it makes a normal profit. As the figure shows, the company will charge $4 and will supply 3,000 gallons. The deadweight loss is the area of the (small) darker grey triangle and is $1,000 a day. c. If the company is regulated to be efficient: i. What is the price of water? ii. What quantity of water would be supplied? iii. What would be the deadweight loss? If the company is regulated to be efficient, it is regulated using a marginal cost pricing rule. As the figure shows, the company charges $2 and supplies 4,000 gallons. Because the company is 229 producing the efficient quantity, there is no deadweight loss. Additional Practice Problem 14.5a Suppose you are the owner of the natural monopoly in the previous Practice Problem. Would you want to be regulated or unregulated? If you were regulated, would you prefer an average cost pricing rule or a marginal cost pricing rule? Solution to Additional Practice Problem 14.5a You would prefer not to be regulated. If you are not regulated, as in part (a) of the Practice Problem, price is greater than average total cost and you earn an economic profit. If you are regulated, you would prefer the average cost pricing rule. With this rule you earn a normal profit. If a marginal cost pricing rule is imposed, you will incur an economic loss. ■ Self Test 14.5 Fill in the blanks ____ (Economies of scale; Incentives to innovate) can lead to natural monopoly. Efficiency is attained if a natural monopoly is regulated using ____ (a marginal; an average) cost pricing rule. ____ (A marginal; An average) cost pricing rule allows a natural monopoly to earn a normal profit. True or false 1. Large firms with monopoly power innovate more than smaller competitive firms which lack monopoly power. 2. A natural monopoly regulated using a marginal cost pricing rule incurs an economic loss. 3. A natural monopoly that is regulated using an average cost pricing rule incurs an economic loss. 230 Part 5 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE Multiple choice 1. If a single firm can meet the entire market demand at a lower price than a larger number of smaller firms can, the single firm is a. price discriminating. b. a natural monopoly. c. a legal monopoly. d. efficient when profit maximizing. 2. What are the potential advantages of monopoly over competition for the economy? a. There are none. b. Monopolists earn more profit. c. Monopolies have a higher rate of productivity growth. d. Economies of scale and incentives to innovate are potential advantages. 3. When the government regulates a natural monopoly, the government a. can determine the price the monopoly charges. b. insures that there is enough competition because the government operates competing firms. c. almost always uses the marginal cost pricing rule. d. All of the above answers are correct. 4. With a marginal cost pricing rule, a natural monopoly produces an ____ amount of output and ____. a. efficient; earns an economic profit b. efficient; incurs an economic loss c. inefficient; earns an economic profit d. inefficient; incurs an economic loss 5. With an average cost pricing rule, a natural monopoly produces an ____ amount of output and ____. a. efficient; earns an economic profit b. efficient; incurs an economic loss c. inefficient; earns a normal profit d. inefficient; earns an economic profit Short answer and numeric questions 1. Why is creating competition in a market with a natural monopoly wasteful from society’s vantage? 2. Describe the slope of a natural monopoly’s long-run average cost curve at the point where it intersects the demand curve. 3. What are the two ways to regulate a natural monopoly? What are their advantages and disadvantages? Chapter 14 . Monopoly 231 SELF TEST ANSWERS ■ CHECKPOINT 14.1 Fill in the blanks One of the requirements for monopoly is that there are no close substitutes for the good. A natural monopoly exists when one firm can meet the entire market demand at a lower price than two or more firms could. A monopoly that is able to sell different units of a good or service for different prices is a price-discriminating monopoly. True or false 1. False; page 340 2. True; page 340 3. False; page 342 Multiple choice 1. b; page 340 2. b; page 340 3. d; page 340 4. b; page 341 5. d; page 342 Short answer and numeric questions 1. Monopoly occurs when there is a market with a single firm selling a good or service that has no close substitutes and in which the firm is protected by either a natural or a legal barrier to entry; page 340. 2. Barriers to entry are anything that protects a firm from the entry of new competitors. Barriers to entry are either natural barriers or legal barriers; page 340. 3. A monopoly can sell each unit of its output for the same price to all its customers or it can price discriminate by selling different units of its good or service at different prices. A perfectly competitive firm cannot affect the price so it must charge a single price determined by market demand and market supply; page 342. ■ CHECKPOINT 14.2 Fill in the blanks For each level of output, marginal revenue for a single-price monopoly is less than price. When demand is inelastic, marginal revenue is nega- tive. A single-price monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost and then finds the highest price for which it can sell that output by using the demand curve. True or false 1. False; page 344 2. False; page 345 3. True; page 346 Multiple choice 1. a; page 344 2. d; page 344 3. a; page 345 4. b; page 346 5. c; page 346 Complete the graph Quantity (hamburgers per hour) 1 Price (dollars) 8.00 2 7.00 3 6.00 4 5.00 5 4.00 Marginal revenue (dollars) 6.00 4.00 2.00 0.00 1. The completed table is above and Figure 14.5 plots the demand and marginal revenue curves; page 344. FIGURE 14.5 Price and marginal revenue (dollars per hamburger) 10 9 8 7 6 5 4 3 2 1 0 D MR 1 2 3 4 5 Quantity (hamburgers per hour) Part 5 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE 232 Rent seeking increases the amount of deadweight loss. FIGURE 14.6 Price and cost (dollars per unit) MC ATC P MR 0 Q D Quantity (units per year) 2. The curves, quantity, price, and economic profit are labeled and illustrated in Figure 14.6; page 347. Short answer and numeric questions 1. If demand is elastic, marginal revenue is positive; if demand is unit elastic, marginal revenue is zero; and if demand is inelastic, marginal revenue is negative; page 345. 2. Both competitive and monopoly firms maximize profit by producing where MR = MC because for any firm, a unit of output is produced if MR > MC and is not produced if MR < MC. As long as MR > MC, any firm continues to produce additional output until it reaches the point at which MR = MC; page 346. 3. A monopoly can earn an economic profit in the long run because it is protected by a barrier to entry. Other firms might want to enter the market in order to earn an economic profit, but they cannot do so; page 347. ■ CHECKPOINT 14.3 Fill in the blanks Compared to perfect competition, a single-price monopoly produces a smaller output and charges a higher price. A single-price monopoly creates a deadweight loss. The act of obtaining special treatment by the government to create an economic profit is called rent seeking. True or false 1. True; page 349 2. False; page 351 3. False; page 351 Multiple choice 1. c; page 349 2. d; page 350 3. b; page 350 4. c; page 351 5. b; page 352 Complete the graph 1. Figure 14.7 shows that the perfectly competitive price is $20 an ostrich and the quantity is 30,000 ostriches. The monopoly price is $30 an ostrich and the quantity is 20,000 ostriches a year. The deadweight loss is the dark triangular area; page 350. FIGURE 14.7 Price and cost (dollars per ostrich) 50 40 Deadweight loss S=MC 30 20 10 MR D=MB 0 5 10 15 20 25 30 35 40 45 50 Quantity (thousands of ostriches per year) Short answer and numeric questions 1. The price set by a monopoly firm exceeds the price in a competitive market and the quantity produced by a monopoly is less than the quantity produced in a competitive market; page 349. 2. Consumer surplus decreases with a singleprice monopoly. Consumer surplus decreases because the monopoly produces less Chapter 14 . Monopoly output and charges a higher price; page 350. 3. Rent seeking is the act of obtaining special treatment by the government to create economic profit or to divert consumer surplus or producer surplus away from others. Rent seeking harms society because in a competitive rent-seeking equilibrium, the amount of the deadweight loss increases; page 352. ■ CHECKPOINT 14.4 Fill in the blanks It is sometimes possible for a monopoly to charge different customers different prices. The key idea behind price discrimination is to convert consumer surplus into economic profit. Price discrimination results in consumers with a higher willingness to pay paying a higher price than consumers with a lower willingness to pay. Perfect price discrimination results in zero consumer surplus and does not create a deadweight loss. True or false 1. False; page 354 2. False; page 354 3. True; page 357 Multiple choice 1. d; page 354 2. a; page 354 3. c; page 354 4. a; pages 356-357 5. c; page 358 Complete the graph 1. a. The economic profit is the light blue rectangle in Figure 14.8. The economic profit equals the area of the rectangle, which is $60 a day; page 355. b. The economic profit is increased by the addition of the two darker blue areas. The economic profit is now the sum of the initial economic profit plus the additional economic profit, which is a total of $120 a day; page 357. 233 FIGURE 14.8 Price and cost (dollars per article of clothing) 10 9 8 7 6 5 4 3 2 1 0 MC MR 10 ATC D 20 30 40 50 Quantity (articles of clothing per day) Short answer and numeric questions 1. Price discrimination decreases consumer surplus and increases economic profit. Price discrimination allows the firm to charge a price closer to the maximum the consumer is willing to pay, which is the marginal benefit of the good. Consumer surplus is converted into economic profit; page 354. 2. With perfect price discrimination, the monopoly increases output to the point at which price equals marginal cost. This output is identical to that of perfect competition. Deadweight loss with perfect price discrimination is zero. So perfect price discrimination produces the efficient quantity; page 358. ■ CHECKPOINT 14.5 Fill in the blanks Economies of scale can lead to natural monopoly. Efficiency is attained if a natural monopoly is regulated using a marginal cost pricing rule. An average cost pricing rule allows a natural monopoly to earn a normal profit. True or false 1. False; page 360 2. True; page 361 3. False; page 361 234 Part 5 . PRICES, PROFITS, AND INDUSTRY PERFORMANCE Multiple choice 1. b; page 360 2. d; page 360 3. a; page 361 4. b; page 361 5. c; page 361 Short answer and numeric questions 1. A natural monopoly is a situation in which a single firm can produce at a lower average total cost than a larger number of smaller firms can. Where such significant economies of scale exist, it would be wasteful not to have a monopoly. So creating competition in a market that is a natural monopoly would be wasteful; page 360. 2. The average total cost curve is sloping downward at the point where it intersects the demand curve; page 361. 3. A natural monopoly can be regulated using a marginal cost pricing rule or an average cost pricing rule. The marginal cost pricing rule is a price rule for a natural monopoly that sets price equal to marginal cost. The advantage of this rule is that the firm produces the efficient quantity of output. The disadvantage is that the firm suffers an economic loss. An average cost pricing rule is a price rule for a natural monopoly that sets the price equal to average total cost and enables the firm to cover its costs and earn a normal profit. The advantage of this rule is that the firm earns a normal profit. The disadvantage is that the firm produces less than the efficient quantity of output and a deadweight loss is created; pages 360, 361.