Download What is Economics? 1 Chapter 12 monopoly 1 What is Economics

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MONOPOLY
Chapter Key Ideas
The Only Game in Town
A. Most buyers use e-Bay for auctions because most sellers use e-Bay for auctions. Most
companies and organizations list their websites on Google because most internet browsing
customers use Google to search the web.
1. These firms clearly have little competition and enjoy significant market power (ability to
influence market price), so these firms can’t be operating in a perfectly competitive market.
2. Is there anything different about how firms with market power operate? Do industries
with a singularly dominant firm behave differently than competitive ones?
B. Students get lots of price breaks—at the movies. Seniors get price breaks at restaurants.
Business travelers tend to pay higher prices for tickets on the airlines.
1.
How do firms get different people to pay different prices?
2.
How can it be profit maximizing to offer lower prices to some customers but higher
prices to others?
Outline
I.
Market Power
A. Market power and competition are the two forces that influence the market structure of most
markets.
1.
Market power is the ability to influence the market, and in particular the market price,
by influencing the total quantity offered for sale.
2.
A monopoly is a firm that produces a good or service for which no close substitute
exists and which is protected by a barrier that prevents other firms from selling that good
or service.
B. How a Monopoly Arises
1.
A monopoly market has two key features:
a) No close substitutes. The absence of any firms making close substitute goods or
services allows the monopolist to avoid competition in the market.
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b) Barriers to entry. Legal or natural constraints that protect a firm from potential
competitors are called barriers to entry.
2.
There are two types of barriers to entry:
a)
Legal barriers to entry create a legal monopoly—a market in which competition
and entry are restricted by the granting of a public franchise, a government license, a
patent, or a copyright.
i)
A public franchise exists when an exclusive right is granted to a firm to
supply a good or service. For example, the U.S. Postal Service has a public
franchise to deliver first-class mail.
ii) A government license exists when the government controls entry into
particular occupations, professions and industries. For example, a license is
required to practice law. Licensing doesn’t always create a monopoly, but
it does restrict competition.
iii) A patent is an exclusive right granted to the inventor of a product or
service, and a copyright is an exclusive right granted to the author or
composer of a literary, musical, dramatic, or artistic work. Patents and
copyrights don’t always create a monopoly, but because these rights can be
sold, they do restrict competition.
b) Natural barriers to entry create a
natural monopoly, which is an
industry in which one firm can
supply the entire market at a lower
price than two or more firms can.
Figure 12.1 shows the LRAC curve
for an electrical power company that
is a natural monopoly.
C. Monopoly Price-Setting Strategies
1.
Monopolies face a tradeoff between the
price it charges and the quantity it can
sell. For a monopoly firm to determine
the quantity it sells, it uses its market
power to choose the appropriate price.
2.
There are two types of monopoly pricesetting strategies:
a) Price discrimination is the practice of selling different units of a good or service
for different prices. Many firms price discriminate, but not all of them are monopoly
firms.
b) A single-price monopoly is a firm that must sell each unit of its output for the
same price to all its customers.
3.
Although the practice of price discrimination appears to be for the benefit some
consumers, it is really an attempt by the firm to receive the maximize price for each unit
sold to maximize its economic profit.
II. A Single-Price Monopoly’s Output and Price Decision
A. Price and Marginal Revenue
1.
The demand curve facing a monopoly firm is the entire market demand curve.
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2.
This demand curve relates the market price at which the monopoly firm can sell the
corresponding quantity of output.
a) Total revenue, TR, is the
price, P, multiplied by the
quantity sold, Q.
b) Marginal revenue, MR, is the
change in total revenue
resulting from a one-unit
increase in the quantity sold.
The key feature of a singleprice monopoly is that at
each level of output,
marginal revenue is less than
the price, that is, MR < P.
c) MR < P at every level of
output because the single–
price monopoly firm must
lower its price on all units
sold to sell an additional unit
of output. This fact means
that the extra revenue
received equals the price of
the additional unit sold
minus the decrease in price
for each of the previous units
it would have sold at the
higher price. As a result, the
net increase to firm’s
revenue, that is, its MR, is
less than the price of the last
unit sold.
d) Figure 12.2 uses a demand
curve to show how these
offsetting influences on total
revenues.
B. Marginal Revenue and Elasticity
1.
A single-price monopoly’s MR is related to the elasticity of demand for its good.
a) If demand is elastic, a fall in price brings an increase in total revenue. The rise in
revenue from the increase in quantity sold outweighs the fall in revenue from the
lower price per unit, and so the MR is positive.
b) If demand is inelastic, a fall in price brings a decrease in total revenue. The rise in
revenue from the increase in quantity sold is outweighed by the fall in revenue from
the lower price per unit, and so the MR is negative.
c) If demand is unit elastic, a fall in price does not change the firm’s total revenues.
The rise in revenue from the increase in quantity sold equals the fall in revenue from
the lower price per unit, and so the MR is zero.
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2. Figure 12.3 shows the
relationship between elasticity of
demand and total revenues for all
three cases.
3. A single-price monopoly will
never produce at an output for
which demand is inelastic. If it
did so, the firm could decrease
output, increase total revenue
while decreasing total cost, and
thereby enjoy higher economic
profits. So a single price
monopoly will always maximize
its economic profit by producing
in the elastic range of its demand.
C. Price and Output Decisions
1.
The monopoly faces the same
types of technology and cost
constraints as does a competitive
firm, so its costs behave the same
as the costs of a perfectly
competitive firm. But the
monopoly faces a different type of
market constraint.
a) The monopoly selects the
profit-maximizing level of
output in the same manner as
a competitive firm, choosing
the level of output where:
MR = MC.
b) The monopoly sets its price
at the highest level at which it
can sell the profitmaximizing quantity. Table 12.1 uses a numerical example to illustrate the
monopoly firm’s output and price decision.
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2.
The monopoly might earn an
economic profit—even in the long
run—because the barriers to entry
protect the firm from market entry
by competitor firms.
a) Figure 12.4 illustrates the
profit-maximizing choices of a
single-price monopolist.
b) A monopoly is not guaranteed
an economic profit. An
economic profit is received
only when P > ATC.
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III. Single-Price Monopoly and Competition Compared
A. Comparing the same industry under perfect competition and monopoly reveals the significant
differences in these two types of markets.
B. Comparing Output and Price
1. Figure 12.5 shows the market
outcomes under perfect competition
and under monopoly.
2. The market demand curve, D, in
perfect competition is the same
demand curve that the firm faces in
monopoly.
3. The market supply curve, S, in
perfect competition is the horizontal
sum of the individual firm’s marginal
cost curves (S = sum of MC for each
firm). This supply curve is also the
monopoly’s marginal cost curve.
4.
Equilibrium in perfect competition
occurs where the quantity demanded
equals the quantity supplied at quantity QC and market price PC.
5.
The profit-maximizing equilibrium output for a monopoly QM occurs where MR = MC.
Equilibrium price for the monopoly, PM, is obtained from the demand curve, at the profitmaximizing quantity.
6.
The monopoly firm produces less output and charges a higher price than a perfectly
competitive market.
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B. Efficiency and Comparison
1.
The monopoly output decision is
inefficient. Figure 12.6 shows why this
result is so.
a) The demand curve, D, is the
marginal benefit curve for society,
MB, and the competitive market
supply curve, S, is the marginal
cost curve for society, MC. So
competitive equilibrium is efficient
because output is produced where
MB = MC.
b) Monopoly is inefficient because
output occurs where MB > MC.
c)
For all output levels at which MB >
MC, a deadweight loss is incurred.
So, an increase in output would
generate additional MB for society
that would exceed the additional
MC to society.
C. Redistribution of Surpluses
Monopoly redistributes a portion of
consumer surplus by changing it to producer
surplus.
D. Rent Seeking
1.
The social cost of monopoly may
exceed the deadweight loss through an
activity called rent seeking, which is
any attempt to capture a consumer
surplus, a producer surplus, or an
economic profit. Rent seeking is not
confined to a monopoly.
2.
There are two forms of rent seeking:
a) Buy a monopoly—expend resources by seeking out the opportunity to buy monopoly
rights for a price below the value of the economic profit earned by the monopoly.
Example: The buying of taxi cab medallions (a government license) in New York
City.
b) Create a monopoly—expend resources seeking political influence, such as lobbying
legislators to provide preferential market status by restricting domestic competition
or enacting tariffs on imports. Example: U.S. steel firms successfully seeking large
tariffs placed against imported steel from foreign firms.
E. Rent-Seeking Equilibrium
1. There are no barriers to entry in the activity of rent seeking. This fact means that the
resources used up in rent seeking are costs which can exhaust the monopoly’s potential
economic profit and leave the monopoly owner with only a normal profit.
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2.
However, the outcome is still not
efficient, because output does not
occur where MB = MC. Figure 12.7
shows the normal profit outcome that
results from rent seeking.
IV. Price Discrimination
A. Price discrimination is the selling of
different units of a good or service for
different prices.
1.
To be able to price discriminate, a firm
must:
a) Identify and separate different
buyer types
b) Sell a product that cannot be resold
2.
Price discrimination occurs because of different consumer’s willingness to pay for the
good.
a)
Price discrimination does not occur because of cost differences between units
produced.
b) Not all observed price differences are the result of price discrimination.
B. Price Discrimination and Consumer Surplus
1.
Price discrimination converts consumer surplus into economic profit.
2.
A monopoly firm can price discriminate in different ways:
a)
Monopoly firms can charge the same buyer a different price for each unit sold.
Quantity discounts are an example. However, quantity discounts that reflect lower
costs at higher volumes are not price discrimination.
b) Monopoly firms can charge different buyers different prices for the same good or
service. Giving a lower price on advance purchase airline tickets is an example of
this form of price discrimination.
C. Profiting by Price Discriminating
Figure 12.8 and Figure 12.9 show the same market with a single price monopoly firm and
monopoly firm practicing price discrimination, respectively. Comparing these two diagrams
shows how price discrimination converts consumer surplus into economic profit for the firm.
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D. Perfect Price Discrimination
1.
Perfect price discrimination
occurs if a firm is able to sell each
unit of output for the highest price
anyone is willing to pay for it. The
outcome of perfect price
discrimination is characterized by:
a) Economic profit increases above
that earned by a single-price
monopoly firm.
b) Output increases to the quantity
at which P = MC.
c) Deadweight loss is eliminated.
2. Figure 12.10 shows the outcome of
perfect price discrimination.
E. Efficiency and Rent Seeking with Price
Discrimination
1.
The more perfectly a monopoly can price discriminate, the closer its output gets to the
competitive output where P = MC and the outcome is more efficient.
2.
However, this outcome differs from the outcome of perfect competition in two important
ways:
a) The monopoly firm captures the entire consumer surplus.
b) The increase in economic profit attracts even more rent-seeking activity that leads to
an inefficient use of resources for society.
V. Monopoly Policy Issues
A. Gains from Monopoly
1.
Monopolies create inefficiency:
a)
Both single-price and price-discriminating monopolies create deadweight loss. And
a price discriminating monopoly converts consumer surplus into producer surplus
and economic profit.
b) Both types of monopoly also encourage rent-seeking activity, which wastes
resources.
2.
However, monopoly also brings benefits to society:
a) Patents and copyrights provide protection from competition, which lets the
monopoly enjoy the profits stemming from product innovation for a longer period of
time. This encourages more expenditures on researching/developing new products.
b) When production technology exhibits potential for economies of scale or economies
of scope, a monopoly firm can produce goods at a lower ATC than what a large
number of competitive firms could achieve. (However, because of the deadweight
loss, this lower cost of production cannot be fully experienced by society unless the
monopoly firm sells the good at a competitive market price.)
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B. Regulating Natural Monopoly
1.
Where demand and cost conditions
create a natural monopoly, a federal,
state, or local government agency
usually steps in to regulate the price of
the monopoly.
a. Figure 12.11 shows a the output
decisions of a natural monopoly
firm and compares two types of
outcomes with government
regulation with the outcome of no
regulation.
b. Left alone, the natural monopoly
will charge a price and produce at
a quantity where MR = MC. Under
this outcome, P > MC and the
quantity produced is less than the
efficient level of output under
perfect competition.
2. Regulating a natural monopoly in the public interest sets firm output where MB = MC
and P = MC. Setting price equal to marginal cost is called the marginal cost pricing
rule, and it results in an efficient use of resources.
a) With output occurring where P = MC, the firm’s ATC > P and the monopoly incurs
an economic loss. If the monopoly receives a subsidy from the government equal to
its economic loss, then taxes must be imposed on some other economic activity. This
tax creates deadweight loss in the allocation of resources in the taxed market.
b) Where possible, a regulated natural monopoly might be permitted to price
discriminate to cover the loss from marginal cost pricing.
3. Another alternative is to produce the quantity at which P = ATC. Setting the price equal
to the average total cost is called the average cost pricing rule.
a)
Output occurs where P > MC, which means that resources are not allocated as
efficiently as with a perfectly competitive market.
b) However, the inefficiency is less than the unregulated market outcome.
Reading Between the Lines
The market structure of two internet-based firms are compared to see whether they fit the description
of a natural monopoly. e-Bay is a natural monopoly, exhibiting both economies of scale (high fixed
costs, low variable costs) and no close substitutes (due to network externalities). Google also exhibits
economies of scale for the same reasons as e-Bay. However, Google faces high competition from firms
making close substitutes that will likely be developed soon in the fast-paced development of search
engine software design.
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New in the Seventh Edition
The Reading Between the Lines looks at the firms e-Bay and Google to illustrate the characteristics of
a natural monopoly.
Te a c h i n g S u g g e s t i o n s
1.
2.
3.
Market Power: Students love a monopoly (if they are the monopolist) Most of your students are
taking an economics course because they think it will help them either get a better job or run a
better business. Many of your students are aspiring entrepreneurs. You’ve just had them slog
through a heavy chapter on perfect competition, the upshot of which is: The firm’s bottom line is
miserable. Normal profit maybe the best that many people can achieve but it is not very exciting.
This chapter teaches the students how to make some serious entrepreneurial income. Innovate,
create a monopoly that produces something that people value much more than the cost of
producing it, and price-discriminate as much as possible.
Use the monopoly model as a benchmark. Explain (like you did in the case of perfect
competition) that although no real-world industry satisfies the full definition of a monopoly
market, the behavior of firms in many real world industries can be predicted by using the
monopoly model. Mention that this chapter examines the least competitive end of the spectrum of
markets, just like Chapter 11 discussed the most competitive end.
A Single-Price Monopoly’s Output and Price Decision
Marginal revenue curve. Students don’t find the concept of marginal revenue too difficult, but
they do need to be clear on the intuition of the MR curve and the reason why MR < P at all levels
of quantity for a single-price monopoly. This fact is the central source of the monopoly market
outcomes.
The classic monopoly diagram. The classic monopoly diagram, Figure 12.4b, provides a good
opportunity to tell your students about the contribution of one of the most brilliant economists of
the 20th century, Joan Robinson. This diagram first appeared in her book, The Economics of
Imperfect Competition, published in 1933 when she was just 30 years old. (You can learn more
about Joan Robinson at http://cepa.newschool.edu/het/profiles/robinson.htm).
Women are still not attracted to economics on the scale that they’re attracted to most other
disciplines, so the opportunity to talk about an outstanding female economist shouldn’t be lost.
Joan Robinson was a formidable debater and reveled in verbal battles, a notable one of which was
with Paul Samuelson on one of her visits to MIT. Anxious to make and illustrate a point,
Samuelson asked Robinson for the chalk. Monopolizing the chalk and the blackboard, the
unyielding Robinson snapped, “Say it in words young man.” Samuelson meekly obeyed.
This story illustrates Joan Robinson’s approach to economics: work out the answers to
economic problems using the appropriate techniques of math and logic, but then “say it in words.”
Don’t be satisfied with formal argument if you don’t understand it. Your students will benefit
from this story if you can work it into your class time.
Single-Price Monopoly and Competition Compared: Monopoly is always inefficient. The
inefficiency of monopoly is one of the key propositions in this chapter.
 When a monopoly firm operates where MR = MC, it chooses an output level where P > MR
and P > MC. A single-price monopoly under-produces and creates a deadweight loss.

Rent seeking uses further resources, so potentially the social cost of monopoly is the sum of
the deadweight loss and the economic profit that a monopoly might earn.

Price Discrimination by a monopoly firm is relatively less inefficient, but it is still not as
efficient as perfect competition.
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
4.
Adam Smith described the situation thus: “People in the same trade seldom meet together,
even for merriment and diversion, but the conversation ends in some contrivance to raise
prices.
Monopoly Policy Issues
A quick introduction. The treatment of monopoly policy here is designed for the instructor who
wants to cover the topic briefly and at this point in the course. Chapter 14 provides a more
extensive treatment of regulation and antitrust law. You can cover that chapter, in whole or part,
right now if you want to do more on the topic.
The Big Picture
Where we have been
Chapter 11 on perfect competition and Chapter 12 on monopoly have shown the student the two
opposite ends of the market spectrum (relevant to market power) and contrasted the performance
of these ideal market types. The chapters have also deepened the student’s understanding of the
efficiency of competitive markets and the source of inefficiency of monopoly.
Where we are going
Chapter 13 describes firms and industries in monopolistic competition and oligopoly and fills in
the middle of the spectrum. Chapter 14 expands on the final section of the present chapter by
reviewing regulation and antitrust law.
O ve r h e a d Tr a n s pa r e n c i e s
Transparency
73
Text figure
Figure 12.2
Transparency title
Demand and Marginal Revenue
74
Figure 12.3
Marginal Revenue and Elasticity
75
Figure 12.4
A Monopoly’s Output and Price
76
Figure 12.5
Monopoly’s Smaller Output and Higher Price
77
Figure 12.6
Inefficiency of Monopoly
78
Figure 12.9
Price Discrimination
79
Figure 12.10
Perfect Price Discrimination
80
Figure 12.11
Regulating a Natural Monopoly
81
Table 12.1
A Monopoly’s Output and Price Decision
Electronic Supplements
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incorporate graphing questions. Questions are automatically graded and results are tracked
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PowerPoint Lecture Notes
PowerPoint Electronic Lecture Notes with speaking notes are available and offer a full
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PowerPoint Electronic Lecture Notes for students are available in MyEconLab.
Instructor CD-ROM with Computerized Test Banks
This CD-ROM contains Computerized Test Bank Files, Test Bank, and Instructor’s Manual
files in Microsoft Word, and PowerPoint files. All test banks are available in Test Generator
Software.
Additional Discussion Questions
1.
2.
The double-edged sword of a natural monopoly. Emphasize how economic analysis reveals the
social benefits and costs of an industry characterized by a downward sloping, long run ATC curve.
Ask the student the following questions:
What is the characteristic of the monopoly market that allows a natural monopoly to
potentially produce output at the lowest possible ATC? The student should see that a lack of
competition allows the firm to potentially serve the entire market at a lower unit cost than if it had
to share the market with any other number of firms. A multi-firm market would be forced to
produce at a higher ATC.
What is the characteristic of a monopoly market that allows a natural monopoly to potentially
charge consumers a price premium above long-run ATC? If the natural monopoly has the
freedom to set its own price, the student should identify the lack of competition that prevents the
consumer from benefiting from production actually occurring at the lowest ATC. On the one hand,
the lack of competition is the only way to allow society to enjoy a (potentially) more efficient
allocation of resources, yet it also allows the firm to extract consumer surplus while generating an
inefficient resource allocation—a “double-edged sword.”
Troubles with price discrimination: The ethics of scalping. Get the students to address the
realities of arbitrage in secondary markets that arise when the primary seller of a good refuses to
price discriminate.
Is it in society’s best interest (economically efficient) to allow the scalping of tickets? The
students should see that ticket scalping is just a form of price discrimination, which is a business
practice shown in the text to increase the level of efficiency in resource allocation within a
monopoly market context.
Why do the original ticket sellers refuse to price discriminate like the scalpers? There are many
possible reasons:
 The original seller of the tickets (usually the music group giving the concert or the ticket
sellers that are under direct contract for them) may want to avoid the reputation of charging
different prices to different people, or different prices at different time intervals before the
concert.
 The original seller may not have the ability to distinguish between high and low demand
customers, like those who sell the tickets standing outside the doors on the day of the concert
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
The original sellers may be very risk averse and prefer to sell every ticket well in advance of
the concert date, based on the expectations of sales potential made with the best available
information at the time. However, information about the actual demand for a concert becomes
clearer as the concert date draws nearer and the equilibrium price for a ticket may change
significantly. Scalpers must gamble that ticket prices will increase when it eventually
becomes clear that demand for the event is relatively inelastic. They bear the risk that the
original ticket seller would not bear: that the ticket prices may also decrease if it is revealed
that demand for the event is relatively elastic.
Is it “fair” to allow scalping of concert tickets? Remind the students that the practice of price
discrimination can increase monopoly profits for the resellers while simultaneously increasing
efficiency for society. Remind them of the principle of opportunity cost and ask them to consider
how much efficiency they are willing to give up in the name of “fairness.”
If it is unfair to scalp tickets because of the way price discrimination transfers consumer
surplus to producer surplus, then what about other forms of price discrimination? Ask the
students to consider the following scenarios. They should understand that in each case, there is an
identifiable group of consumers who have a different willingness to pay for the product or service
mentioned.


3.
4.
If the costs of projecting a movie are the same at all times of day, why are matinee movie
prices lower than evening movie prices for the exact same movie in the exact same theater?
Why do movie theaters often give students discounts?
If the cost of publication is the same for all potential subscribers, then why do magazines and
newspapers offer students discounts on subscription prices?

If the cost of serving beverages and supplying entertainment (live bands) is the same for both
men and women, then why do bars and clubs offer “Ladies Night” where women get free
drinks or pay no cover charge?

If the cost of serving food and beverages is the same for all diners, then why do seniors get a
price break from restaurants for the exact same meals?
Why is a monopoly firm motivated to operate at the socially inefficient level of output and steal
away consumer surplus? The lack of competition from barriers to entry gives the monopoly firm
the ability to exercise market power and set price. Market power drives a wedge between the price
the monopoly firm receives for selling an additional unit and the marginal revenue received from
selling that additional unit. Selling fewer units creates a deadweight loss, some of which is borne
by the monopoly firm. However, it more than makes up for its share of lost producer surplus by
extracting a larger amount of consumer surplus.
How would you measure the inefficiency of a monopoly? The students should see that the lost
potential for consumer and producer surplus could be calculated as deadweight loss, but that is
only part of the total loss of benefits. Ask the students:
Is there more to the inefficiency of a monopoly than meets the eye? If you are rather brave, you
may want to ask the students to play the following game: Show the class a fresh, real five-dollar
bill. Announce that it is a monopoly profit that anyone in class can receive simply by submitting
the highest, non-zero price bid for it. Mention that even if the highest bid is only one penny, then
that person will receive the five-dollar bill. However, everyone else that submits a bid must also
pay you the value of that bid, regardless of whether they are successful. In the case of a tie for
highest bid, a run-off bidding contest among the tied high bidders will occur, but their first bid
still stands as a debt to you, the holder of the monopoly profit.
How much would YOU bid for this monopoly profit? Ask the students to write down on a small
piece of paper their name and the price he or she is willing to bid for the five-dollar bill. They
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may write a bid of zero cents, but they will not get a chance to win. Announce that you will collect
the money from them later (you will have their name and their bid). After collecting the bids,
roughly tally them up and announce the winning bid, as well as the total sum of the bids to be
collected. There are two possible scenarios to the outcome of this auction:
 There is one high bidder, and this bid is usually very close to the monopoly profit offered for
sale—there are usually one or two students who want to signal their “devil-may-care” attitude
or signal their status as a relatively wealthy student who can afford to play extravagant games.

There is a tie between two or more students. The resulting run-off bidding is usually very
high, because each of the remaining students hasn’t yet fully appreciated the economic notion
of sunk costs. In this latter case, do not be surprised if the winning bid is more than five
dollars, as the “winner” wants desperately not to lose the full amount of his or her initial bid.
What is the total opportunity cost of the resources used to pursue monopoly profits? Point out
that the bids represent the resources people use (usually through lobbying efforts) to pursue a
monopoly market position by convincing government to restrict competition. Ultimately, only one
person wins, but all contenders expend resources in the pursuit. That is why all losing bidders had
to pay their bid price.
Can we compare the value of lost output in other markets that could have been produced
against the value of those goods and services produced specifically for pursuing a monopoly?
Emphasize that the goods and services that were used to pursue a monopoly would not have been
chosen for production if the monopoly profit hadn’t been offered up for sale in the first place.
That is how we can know that rent seeking is inefficient—there was a decline in net benefits for
society from forgone production of higher-valued goods. After the discussion is over, give the
highest bidder the five-dollar bill in exchange for the bid he or she pledged. (You were warned
about having to be brave!) If the highest bid is over five dollars, just state that you will forgive the
student his or her debt and call it a wash. Then announce that the other bidders are also off the
hook, as you were just trying to make the scenario as realistic as possible. Many sighs of relief
will be heard.
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Answ ers to the Review Quizzes
Page 267
1.
A single-price monopoly firm chooses to maximize profits by producing at an output level
where marginal cost equals marginal revenue (MR = MC).
2.
The market demand curve is the monopolist firm’s demand curve. The demand curve reveals
that the profit-maximizing level of output is associated with a maximum price that the
monopolist firm can charge and sell that level of output.
3.
The MR < P at every level of output. When the profit-maximizing monopoly firm chooses
output where MR = MC, MC must be below price: (MR = MC) < P.
4.
Barriers to entry prevent the monopoly firm from enduring the pressure of competition, and
allow it to choose the quantity of output that is associated with the profit-maximizing market
price. This allows a monopoly firm to potentially enjoy positive economics profits, even in the
long run.
1.
The market supply curve for a competitive industry is the horizontal summation of the
individual firm’s marginal cost curves. Equilibrium output level is determined where market
supply curve intersects the market demand curve, and market price equals marginal cost.
Equilibrium output for a single-price monopoly is determined by the intersection of its marginal
cost curve and the marginal revenue curve. Marginal revenue is always less than price, which
means that MR = MC at a lower level of output than P=MC, and market price exceeds the
marginal cost. Compared to a perfectly competitive firm, a monopoly restricts its output and
charges a higher price.
2.
The monopoly raises price by lowering quantity offered for sale. This raises the price
consumers must pay for the good compared to the competitive market price. This difference in
price multiplied by the quantity the monopolist sells represents the amount of consumer surplus
that is transferred to producer surplus.
3.
In a competitive market, the supply curve represents marginal cost to society, and the demand
curve represents the marginal benefits to society. The perfectly competitive market is efficient
because production occurs where supply equaled demand (MB = MC). The monopolist is
inefficient because price exceeds marginal cost at all levels of output. When the monopoly
equates MC = MR to choose the profit-maximizing level of output, it charges a price from the
demand curve that is greater than marginal cost, which means MB > MC. Consumer and
producer surplus are not maximized and society suffers a dead weight loss.
4.
Rent seeking is any attempt to capture consumer surplus, producer surplus, or economic profit.
There are two forms of rent seeking activity to pursue a monopoly status: i) Buying a
monopoly, where a person expends resources seeking to purchase monopoly rights for a price
slightly less than the monopoly profits, or ii) Creating a monopoly, where a person expends
resources seeking political influence, such as lobbying legislators to provide preferential
market status by restricting domestic competition or enacting tariffs on imports. The resources
expended in rent seeking can be equal to (or even greater than) the economic profit that a
monopoly status would create for the owner.
1.
Price discrimination is the practice of selling different units of a good or service for different
prices. In order for a monopoly to practice price discrimination, a monopoly must be able to: i)
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identify and separate different buyer types, and ii) sell a product that cannot be resold. The key
idea to price discrimination is to charge different consumers different prices, according to their
willingness to pay for the good. This transfers potential consumer surplus under a single-price
scenario into producer surplus, raising monopoly profits.
2.
When a monopoly price discriminates, it charges different prices to different consumers and
transfers the consumer surplus that would appear under a single-price scenario into producer
surplus, increasing monopoly profits.
3.
Perfect price discrimination is when a monopoly charges each consumer the maximum price he
or she is willing to pay. This transfers the entire potential consumer surplus to producer
surplus. The monopoly increases its profits compared to charging a single-price to all
customers and produces at a higher level of output, where price equals marginal cost. This
outcome achieves efficiency by eliminating the deadweight loss relative to a single-price
monopoly outcome.
4.
A consumer’s elasticity of demand for airline tickets tends to increases with the amount of
advance time they are willing to endure for purchasing them. The airline companies make
airline tickets non-transferable, preventing consumers with high elasticity of demand form
reselling their less expensive tickets to those consumers with inelastic demand. This allows the
airlines to charge different prices to different groups of consumers, according to their
willingness to pay.
1.
First, monopolies might encourage product innovation. Patents and copyrights provide
protection from competition and let the monopoly enjoy the profits stemming from innovation
for a longer period of time. Second, monopolies can take advantage of economies of scale and
scope. A monopoly’s access to different technology stemming from larger production runs can
generate marginal costs that are lower than a supply curve of a competitive industry over the
larger range of output. This means the monopoly can produce more output and charge a lower
price than would a firm in a perfectly competitive industry.
2.
Economies of scale occur if the firm’s ATC declines as it expands output. Examples given in
the text are public utilities such as water and natural gas, although the economies of scale may
occur only in distribution and not production. Economies of scope take place if the firm’s ATC
declines as the number of different goods produced increases. Examples given in the text are
burger and fry production at fast food restaurants, the manufacture of household appliances and
the refining of petroleum.
3.
Monopoly markets may encourage greater product innovation than under perfect competition.
Patents and copyrights provide protection from competition and let the monopoly enjoy the
profits from innovation for a longer period of time.
4.
Regulating the actions of a natural monopoly in the public interest implies setting the level of
output where the MB = MC, and the monopoly must set its price equal to marginal cost. This is
type of regulation is called the marginal cost pricing rule, resulting in a maximum of total
consumer and producer surplus in the market. However, when the monopoly price equals
marginal cost, the ATC exceeds the price and the monopoly suffers an economic loss. The
monopoly will exit the market unless it receives a subsidy to return it to zero economic profit.
Yet this subsidy must be raised through imposing taxes on other economic activity, which
creates deadweight loss and prevents efficient resource allocation in the markets affected by the
tax.
5.
For a natural monopoly, marginal cost is less than average cost at all levels of output in the
market. The marginal cost pricing rule will generate greater consumer surplus and less
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MONOPOLY
299
producer surplus because P = MC at a higher level of output than when P = ATC. However,
when P = MC, ATC exceeds price and the monopoly suffers an economic loss (negative
producer surplus). The monopoly will only stay in business if it receives a subsidy to make up
for the economic loss, returning it to a zero producer surplus (normal profit) condition. Yet this
subsidy must be provided through taxing other markets, causing inefficient resource allocations
in those markets. While the monopoly market will be efficient (MB = MC) and not experience a
deadweight loss, the other markets affected by the tax will experience an increase in dead
weight loss. The average cost pricing rule generate the same producer surplus as a subsidized
monopoly under a marginal cost pricing rule, but the consumer surplus will be lower because P
= ATC at a lower level of output than P = MC. Deadweight loss will occur in this monopoly
market because MB no longer equals MC. This result occurs because the monopoly produces
where P = ATC and ATC exceeds MC at this level of output.
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Answ ers to the Problems
1.
a.
b.
2.
a.
b.
3.
a.
b.
c.
d.
e.
4.
a.
b.
Minnie’s total revenue schedule lists the total revenue at each quantity sold. For example,
Minnie’s can sell 1 bottle for $8 a bottle, which is $8 of total revenue at the quantity 1 bottle.
Minnie’s marginal revenue schedule lists the marginal revenue that results from increasing
the quantity sold by 1 bottle. For example, Minnie’s can sell 1 bottle for a total revenue of $8.
Minnie’s can sell 2 bottles for $6 each, which is $12 of total revenue at the quantity 2 bottles.
So by increasing the quantity sold from 1 bottle to 2 bottles, marginal revenue is $4 a bottle
($12 minus $8).
Burma’s total revenue schedule lists the total revenue at each quantity sold. For example,
Burma’s can sell 2 rubies for $700 each, which gives it a total revenue of $1,400 at the
quantity 2 rubies.
Burma’s marginal revenue schedule lists the marginal revenue that results from increasing the
quantity sold by 1 ruby. For example, Burma’s can sell 1 ruby for $900, which is total
revenue of $900 at the quantity of 1 ruby. Burma’s can sell 2 rubies for $700 each, which is
$1,4000 of total revenue at the quantity 2 rubies. So by increasing the quantity sold from 1 to
2 rubies, marginal revenue is $500 per ruby ($1,400 minus $900).
Marginal cost is the increase in total cost that results from increasing output by 1 unit. When
Minnie’s increases output from 1 bottle to 2 bottles, total cost increases by $4, so the
marginal cost is $4 a bottle.
Minnie’s profit-maximizing output is 1.5 bottles.
The marginal cost of increasing the quantity from 1 bottle to 2 bottles is $4 a bottle ($7 minus
$3). That is, the marginal cost of the 1.5 bottles is $4 a bottle. The marginal revenue of
increasing the quantity sold from 1 bottle to 2 bottles is $4 ($12 minus $8). So the marginal
revenue from 1.5 bottles is $4 a bottle. Profit is maximized when the quantity produced
makes the marginal cost equal to marginal revenue. The profit-maximizing output is 1.5
bottles.
Minnie’s profit-maximizing price is $7 a bottle.
The profit-maximizing price is the highest price that Minnie’s can sell the profit-maximizing
output of 1.5 bottles. Minnie’s can sell 1 bottle for $8 and 2 bottles for $6, so it can sell 1.5
bottles for $7 a bottle.
Minnie’s economic profit is $5.50.
Economic profit equals total revenue minus total cost. Total revenue equals price ($7 a
bottle) multiplied by quantity (1.5 bottles), which is $10.50. Total cost of producing 1 bottle
is $3 and the total cost of producing 2 bottles is $7, so the total cost of producing 1.5 bottles
is $5. Profit equals $10.50 minus $5, which is $5.50.
Minnie’s is inefficient. Minnie’s charges a price of $7 a bottle, so consumers get a marginal
benefit of $7 a bottle. Minnie’s marginal cost is $4 a bottle. That is, the marginal benefit of
$7 a bottle exceeds Minnie’s marginal cost.
Burma’s marginal cost when output is increased from 1 ruby to 2 rubies a day is $80. The
total cost of producing 1 ruby is $1,220 and the total cost of producing 2 rubies is $1,300, so
the marginal cost of an additional ruby is $80.
Burma’s profit-maximizing output is 2.5 rubies a day.
The marginal cost of increasing the quantity from 2 rubies to 3 rubies is $100 ($1,300 minus
$1,400). That is, the marginal cost of producing the 2.5th ruby is $100. The marginal revenue
of increasing the quantity sold from 2 to 3 rubies is $100 ($1,400 minus $1,500). So the
marginal revenue from selling the 2.5th ruby is $100. Profit is maximized when the quantity
produced makes the marginal cost equal to marginal revenue. The profit-maximizing output
is 2.5 rubies per day.
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301
c.
d.
f.
5.
a.
b.
c.
d.
e.
6.
a.
b.
c.
d.
Burma’s profit-maximizing price is $600 a ruby.
The profit-maximizing price is the highest price that Burma’s can sell the profit-maximizing
output of 2.5 rubies a day. Burma’s can sell 2 rubies for $700 each and 3 rubies for $500
each, so it can sell 2.5 rubies for $600 each.
Burma’s economic profit is $150.
Economic profit equals total revenue minus total cost. Total revenue equals price ($600 a
ruby) multiplied by quantity (2.5 rubies), which is $1,500. Total cost of producing 2 rubies is
$1,300 and the total cost of producing 3 rubies is $1,400, so the total cost of producing 2.5
rubies is $1,350. Profit equals $1,500 minus $1,350, which is $150.
Burma’s is inefficient. Burma’s charges a price of $600 a ruby, so consumers get a marginal
benefit of $600 a ruby. Burma’s marginal cost is $100 a ruby. That is, consumers’ marginal
benefit exceeds Burma’s marginal cost.
The profit-maximizing quantity is 150 newspapers a day and price is 70 cents a paper.
Profit is maximized when the firm produces the output at which marginal cost equals
marginal revenue. Draw in the marginal revenue curve. It runs from 100 on the y-axis to 250
on the x-axis. The marginal revenue curve cuts the marginal cost curve at the quantity 150
newspapers a day.
The highest price that the publisher can sell 150 newspapers a day is read from the demand
curve.
The daily total revenue is $105 (150 papers at 70 cents each).
Demand is elastic.
Along a straight-line demand curve, demand is elastic at all prices above the midpoint of the
demand curve. The price at the midpoint is 50 cents. So at 70 cents a paper, demand is
elastic.
The consumer surplus is $22.50 a day and the deadweight loss is $15 a day.
Consumer surplus is the area under the demand curve above the price. The price is 70 cents,
so consumer surplus equals (100 cents minus 70 cents) multiplied by 150/2 papers a day,
which is $22.50 a day.
Deadweight loss arises because the publisher does not produce the efficient quantity. Output
is restricted to 150, and the price is increased to 70 cents. The deadweight loss equals (70
cents minus 40 cents) multiplied by 100/2.
The newspaper will not want to price discriminate unless it can find a way to prevent sharing
and resale of the newspaper from those who are charged a lower price to those who are
charged a higher price.
The profit-maximizing quantity is 2 cups an hour. The price is $3 a cup.
Profit is maximized when the firm produces the output at which marginal cost equals
marginal revenue. Draw in the marginal revenue curve. It runs from 4 on the y-axis to 4 on
the x-axis. The marginal revenue curve cuts the marginal cost curve at the quantity 2 cups an
hour.
The highest price at which the coffee shop can sell 2 cups an hour is read from the demand
curve.
Economic profit per cup is $1 ($3 minus $2). The quantity produced and sold is 2 cups. So
economic profit is $2 a day.
The consumer surplus is $1.00 a day and the deadweight loss is $0.50 a day.
The efficient quantity is 3 cups an hour. The quantity at which marginal cost equals marginal
benefit (the intersection of the marginal cost curve and the demand curve, which show
marginal benefit).
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e.
7.
a.
b.
c.
8.
a.
b.
c.
Consumer surplus is the area under the demand curve above the price. The price is $3, so
consumer surplus equals ($4 minus $3) multiplied by 2/2cups a day, which is $1.00 a day.
Deadweight loss arises because the coffee shop does not produce the efficient quantity.
Output is restricted to 2 cups an hour, and the price is increased to $3 a cup. The deadweight
loss equals ($3 minus $2) multiplied by 1/2, which is $0.50.
The coffee shop will want to price discriminate. The cup of coffee is not really an item that
can be resold, so the coffee shop might offer 1 coffee a day for $3.00 and a second cup for
$2.50 and stamp the back of the hand of each customer who buy 1 coffee a day. Or it might
offer coffee to students at $2.50 and senior citizens at $2.00.
The firm will produce 2 cubic feet a day and sell it for 6 cents a cubic foot. Deadweight loss
will be 4 cents a day.
Draw in the marginal revenue curve. It runs from 10 on the y-axis to 2.5 on the x-axis. The
profit-maximizing output is 2 cubic feet at which marginal revenue equals marginal cost. The
price charged is the highest that people will pay for 2 cubic feet a day, which is 6 cents a
cubic foot. The efficient output is 4 cubic feet, at which marginal cost equals price (marginal
benefit). So the deadweight loss is (4 minus 2 cubic feet) multiplied by (6 minus 2 cents)/2.
The firm will produce 3 cubic feet a day and charge 4 cents a cubic foot. Deadweight loss is 1
cent a day.
If the firm is regulated to earn only normal profit, it produces the output at which price equals
average total cost—at the intersection of the demand curve and the ATC curve.
The firm will produce 4 cubic feet a day and charge 2 cents a cubic foot. There is no
deadweight loss.
If the firm is regulated to be efficient, it will produce the quantity at which price (marginal
benefit) equals marginal cost—at the intersection of the demand curve and the marginal cost
curve.
The firm will produce 1.5 cubic feet a day and sell it for 7 cents a cubic foot. Deadweight loss
will be 2.25 cents a day.
Draw in the marginal revenue curve. It runs from 10 on the y-axis to 2.5 on the x-axis. The
marginal cost doubles to 4 cents and the marginal cost curve shifts up to cut the y-axis at 4
cents. The profit- maximizing output is 1.5 cubic feet at which marginal revenue equals
marginal cost. The price charged is the highest that people will pay for 1.5 cubic feet a day,
which is 7 cents a cubic foot. The efficient output is 3 cubic feet, at which marginal cost
equals price (marginal benefit). So the deadweight loss is (3 minus 1.5 cubic feet) multiplied
by (7 cents minus 4 cents)/2.
The firm will produce 2 cubic feet a day and charge 6 cents a cubic foot. Deadweight loss is 1
cent a day.
If the firm is regulated to earn only normal profit, it produces the output at which price equals
average total cost—at the intersection of the demand curve and the ATC curve.
The firm will produce 3 cubic feet a day and charge 4 cents a cubic foot. There is no
deadweight loss.
If the firm is regulated to be efficient, it will produce the quantity at which price (marginal
benefit) equals marginal cost—at the intersection of the demand curve and the marginal cost
curve.
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303
Additional Problems
1.
Dolly’s Diamond Mines, a single-price monopoly, faces the following demand schedule for
industrial diamonds:
Price
Quantity
(dollars
demanded
per pound)
2.
(pounds per day)
a.
2,200
5
2,000
6
1,800
7
1,600
8
1,400
9
1,200
10
Calculate Dolly’s total revenue schedule.
b.
Calculate its marginal revenue schedule.
Dolly’s Diamond Mines in problem 1 has the following total cost:
Quantity
Total
produced
cost
(pounds per day)
(dollars)
5
8,000
6
9,000
7
10,200
8
11,600
9
13,200
10
15,000
Calculate the profit-maximizing levels of
a. Marginal cost
3.
b.
Marginal revenue
c.
Output
d.
Price
e.
Economic profit
f.
Does Dolly’s Mines use resources efficiently? Explain your answer.
The figure illustrates the situation facing the publisher of the only newspaper containing local
news in an isolated community. The
publisher’s marginal cost for the new plant
is constant at 20 cents per copy printed.
a. What quantity of newspapers will
maximize the publisher’s profit?
b.
What price will the publisher charge for
a daily newspaper?
c.
What is the publisher’s daily total
revenue?
d.
At the price charged for a newspaper, is
the demand for newspapers elastic or
inelastic? Why?
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4.
5.
In the monopoly newspaper market described in problem 3,
a. What is the efficient quantity of newspapers to print each day? Explain your answer.
b.
What is the consumer surplus of the readers of the newspaper?
c.
What is the deadweight loss created by the monopoly newspaper publisher?
What is the maximum value of resources that will be used in rent seeking to acquire Dolly’s
monopoly in problem 1? Considering this loss, what is the total social cost of Dolly’s monopoly?
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305
Solutions to Additional Problems
1.
a.
b.
2.
a.
b.
c.
d.
e.
f.
3.
a.
b.
c.
d.
Dolly’s total revenue schedule lists the total revenue at each quantity sold. For example,
Dolly’s can sell 10 pounds for $1,200 a pound, which gives it a total revenue of $12,000 at
the quantity 10 pounds.
Dolly’s marginal revenue schedule lists the marginal revenue that results from increasing the
quantity sold by 1 pound. For example, Dolly’s can sell 5 pounds for $2,200 each, which is
total revenue of $11,000 at the quantity of 5 pounds. Dolly’s can sell 6 pounds for $2,000
each, which is $12,000 of total revenue at the quantity 6 pounds. So by increasing the
quantity sold from 5 pounds to 6 pounds, marginal revenue is $1,000 a pound ($12,000
minus $11,000).
Dolly’s marginal cost is $1,000 a pound.
The marginal cost of increasing the quantity from 5 pounds to 6 pounds is $1,000 a pound
($9,000 minus $8,000). That is, the marginal cost of the 5.5 pounds is $1,000 a pound.
Dolly’s marginal revenue is $1,000 a pound.
The marginal revenue of increasing the quantity sold from 5 pounds to 6 pounds is $1,000
($12,000 minus $11,000). So the marginal revenue from 5.5 pounds is $1,000 a pound.
Dolly’s profit-maximizing output is 5.5 pounds.
The marginal cost of increasing the quantity from 5 pounds to 6 pounds is $1,000 a pound
($9,000 minus $8,000). That is, the marginal cost of the 5.5 pounds is $1,000 a pound. The
marginal revenue of increasing the quantity sold from 5 pounds to 6 pounds is $1,000
($12,000 minus $11,000). So the marginal revenue from 5.5 pounds is $1,000 a pound. Profit
is maximized when the quantity produced makes the marginal cost equal to marginal revenue.
The profit-maximizing output is 5.5 pounds.
Dolly’s profit-maximizing price is $2,100 a pound.
The profit-maximizing price is the highest price that Dolly’s can sell the profit-maximizing
output of 5.5 pounds. Dolly’s can sell 5 pounds for $2,200 and 6 pounds for $2,000, so it can
sell 5.5 pounds for $2,100 a pound.
Dolly’s economic profit is $3,050.
Economic profit equals total revenue minus total cost. Total revenue equals price ($2,100 a
pound) multiplied by quantity (5.5 pounds), which is $11,550. Total cost of producing 5
pounds is $8,000 and the total cost of producing 6 pounds is $9,000, so the total cost of
producing 5.5 pounds is $8,500. Profit equals $11,550 minus $8,500, which is $3,050.
Dolly’s is inefficient. Dolly’s charges a price of $2,100 a pound, so consumers get a marginal
benefit of $2,100 a pound. Dolly’s marginal cost is $1,000 a pound. That is, the marginal
benefit of $2,100 a pound exceeds Dolly’s marginal cost.
The profit-maximizing output is 200 newspapers a day.
Profit is maximized when the firm produces the output at which marginal cost equals
marginal revenue. Draw in the marginal revenue curve. It runs from 100 on the y-axis to 250
on the x-axis. The marginal revenue curve cuts the marginal cost curve at the quantity 200
newspapers a day.
The price charged is 60 cents a paper.
The highest price that the publisher can sell 200 newspapers a day is read from the demand
curve.
The daily total revenue is $120 (200 papers at 60 cents each).
Demand is elastic.
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Along a straight-line demand curve, demand is elastic at all prices above the midpoint of the
demand curve. The price at the midpoint is 50 cents. So at 60 cents a paper, demand is
elastic.
4.
a.
b.
c.
5.
The efficient quantity is 400 newspapers—the quantity that makes marginal benefit (price)
equal to marginal cost. With 400 newspapers available, people are willing to pay 20 cents for
a paper. To produce 400 newspapers, the publisher incurs a marginal cost of 20 cents a paper.
The consumer surplus is $40 a day.
Consumer surplus is the area under the demand curve above the price. The price is 60 cents,
so consumer surplus equals (100 cents minus 60 cents) multiplied by 200/2 papers a day,
which is $40 a day.
The deadweight loss is $40 a day.
Deadweight loss arises because the publisher does not produce the efficient quantity. Output
is restricted to 200, and the price is increased to 60 cents. The deadweight loss equals (60
cents minus 20 cents) multiplied by 200/2.
The maximum that will be spent on rent seeking is $3,050 a day—an amount equal to Dolly’s
economic profit. The total social cost equals the deadweight loss plus the amount spent on rent
seeking. To calculate the deadweight loss, first calculate the efficient output—the intersection
point of the demand curve (marginal benefit curve) and the marginal cost curve. Do this by
finding the equations to the two curves and solving them. The efficient output is 8.25 pounds. The
deadweight loss equals $1,512.50. The loss to society is $4,562.50 ($3,050 plus $1,512.50).
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307