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Chapter 5
Market Power: Does It Help or Hurt the Economy?
What's in This Chapter and Why
This chapter continues the development of the function of competitive markets by showing that a
competitive market results in economic efficiency. Thus, the analysis of the price system and the
analysis of demand and supply in previous chapters, along with the efficiency analysis contained in
Chapter 3 and this chapter provide an introduction to the workings of a competitive market
economy.
Chapter 6 and Chapters 7 through 9 are used to consider market failure. The monopoly and
market power analysis of this chapter shows one way that markets can result in inefficiency.
The issue raised in the chapter is market power in the U.S. economy. How important is it? It
is shown that if market power exists in the U.S. economy, it exists mostly in oligopolies. How do
oligopolies achieve monopoly-like results? They may do so, if they can act as if they are in a cartel.
The OPEC cartel is discussed because of its intrinsic interest and because it shows conditions
necessary for a cartel to be successful.
If government is antagonistic to cartels or collusion--as it is in the United States—it is
concluded that competitive pressures will be intense in a large economy.
Instructional Objectives
After completing this chapter, your students should know:
1. The basic monopoly analysis, including a comparison of monopoly equilibrium with
competitive equilibrium.
2. Elementary conclusions about competition and economic efficiency.
3. The sources and extent of monopoly in the U.S. economy.
4. The conditions under which a cartel might succeed and be able to discuss OPEC's history in
light of cartel analysis.
5. The relationship between market power and economic growth.
Key Terms
These terms are introduced in this chapter:
Market power
Monopoly
Oligopoly
Cartel
Marginal revenue
Marginal principle
Efficient output
Barrier to entry
Natural monopoly
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64  Chapter 5/Market Power: Does It Help or Hurt the Economy?
Suggestions for Teaching
The approach taken to demand and supply analysis in Chapter 2 makes the discussion of efficiency
easier for students. Depending upon your objectives for the course, you can either emphasize the
formal monopoly analysis or you can use intuition to argue that a monopoly will charge a higher
price and restrict output. Students are intrigued by the discussion of oligopoly and cartel behavior.
The incentives to cooperate and the incentives to cheat can be developed in ways that students
relate to. For instance, do students have incentives to "hold back" in classes in which grades are
determined on a curve? If so, do students in fact "hold back"?
Students and automobiles are often strong complements. Both the text and boxed discussions
of the automobile industry should interest and motivate students.
It is interesting to discuss with students the rationale for and the effect of the licensing of taxis,
barbers, and the like. Then, the question of the licensing of physicians or child care centers might
be raised.
Additional References
In addition to the references in the text, instructors may wish to read or assign one or more of the
following:
1. "A Survey of the Car Industry," The Economist (October 17, 1992).
2. Walter Adams, "Public Policy in a Free Enterprise Economy," Chapter 13 in Walter Adams,
ed., The Structure of American Industry, 8th ed. (New York: Macmillan, 1990), pp. 349-376.
3. John Kenneth Galbraith, American Capitalism: The Concept of Countervailing Power (Boston:
Houghton Mifflin, 1952).
4. Steven Martin, "The Petroleum Industry," Chapter 2 in Walter Adams, ed., The Structure of
American Industry, 9th ed. (New York: Macmillan, 1994).
5. F. M. Scherer and David Ross, Industrial Market Structure and Economic Performance, 3rd
ed. (Boston: Houghton Mifflin, 1990).
6. "The Fall of Big Business" and "Japanese Cars at Day," The Economist (April 17, 1993), pp.
13-14 and 61-62.
7. Mine K. Yucel and Carol Dahl, "Reducing U.S. Oil-Import Dependence: A Tariff, Subsidy, or
Gasoline Tax?" Federal Reserve Bank of Dallas Economic Review (May 1990), pp. 17-25.
Outline
I. GENERAL COMMENTS AND DEFINITIONS
A. Market Power
1. Firms have market power when the following conditions exist.
a. Firms can influence price in attempts to increase profits.
b. The existence of profits does not attract new firms into the industry.
2. The following conditions are required for market power.
a. A few firms control the product.
b. There are limitations on the entry of new firms.
B. Monopoly
1. A monopoly is a single seller of a product with no close substitutes.
Instructor's Manual  65
C. Oligopoly
1. An oligopoly is a market with a few producers or sellers of a good.
D. Cartel
1. A cartel is an organized group of firms who manage output and pricing as if they were
a monopoly.
II. MONOPOLY ANALYSIS
A. Demand
1. Because the monopolist is a single seller, it faces the market demand curve for the
product produced.
a. This demand curve is negatively sloped and shows that the monopolist can sell
more output only by lowering the price of the product.
1. This means that the output the monopolist chooses to sell affects price.
B. Marginal Revenue
1. Marginal revenue is the change in total revenue associated with selling one more unit
of output.
a. It is the private benefit to the monopolist of selling one more unit.
2. For a monopolist, marginal revenue is less than price.
a. Because the monopolist must lower the price on all units in order to sell additional
units, marginal revenue is less than price.
b. Because marginal revenue is less than price, the marginal revenue curve will lie
below the demand curve.
1. Because demand represents marginal social benefit and marginal revenue
represents marginal private benefit, marginal social benefit is greater than
industry marginal private benefit in monopoly.
C. The Marginal Principle
1. In choosing the output to produce, the monopolist follows the marginal principle.
a. This principle states the profit maximizing output is that output where marginal
revenue equals marginal cost.
1. If marginal revenue is greater than marginal cost, the monopolist should
increase output.
2. If marginal revenue is less than marginal cost, the monopolist should
decrease output.
D. Monopoly and Competition Compared
1. Unlike a competitive industry, a monopoly does not produce the efficient output.
Monopolists charge a higher price and produce less output than a competitive industry.
a. Efficient output occurs where marginal social cost and marginal social benefit are
equal.
b. Inefficiency occurs because of the divergence between marginal social benefit and
marginal social cost.
1. At the output produced by the monopolist, marginal social benefit exceeds
marginal social cost.
66  Chapter 5/Market Power: Does It Help or Hurt the Economy?
a. The value to consumers of an additional unit exceeds the value of the units
of other goods given up to produce the additional unit - the opportunity
cost.
III. MARKET POWER AND ECONOMIC EFFICIENCY
A. The Trend in Market Power
1. Some studies indicate that the U.S. economy is becoming more competitive.
a. Increased competition from imports in the manufacturing sector has decreased
market power.
b. Government deregulation of the economy has decreased market power.
c. Federal government policies making mergers and price fixing more difficult have
decreased market power.
d. The information revolution has increased competition in many industries, resulting
in a decrease in market power.
B. Barriers to Entry
1. There are four major sources of market power in the United States.
a. Technical conditions can create entry barriers.
1. Technical conditions might be such that a technically efficient firm will supply
all of a good that consumers wish to purchase at the going price.
a. Monopolies created by these technical conditions are sometimes referred
to as natural monopolies.
b. Access to the supply of a product or an essential input for a product can create a
barrier to entry.
c. Existing firms may develop and maintain market power through product
differentiation.
d. Monopolies may be created by government regulations.
IV. OPEC: A FEW SELLERS ACTING LIKE A MONOPOLY
A. Cartel Formation
1. Three variables are important in determining the success of forming and maintaining a
cartel.
a. The cartel must reach an agreement that all producers will abide by.
1. This agreement stipulates the total output to be produced by the cartel and the
division of production among the members.
b. The cartel must continue to cooperate and come to new agreements as conditions
change.
c. The agreement must be enforced.
1. Because it is very profitable for cartel members to cheat on the original
agreement, there must be some method of enforcement.
B. The Determinants of Cartel Success
1. The fewer the number of firms and the more similar they are, the easier it is to form
and operate a cartel.
a. As the number of firms increases, it becomes more difficult to include all the firms
in the industry.
Instructor's Manual  67
b. As the number of firms increases, it becomes more difficult to detect cheating on
the agreement.
2. If firms are not similar, it becomes more difficult to determine the division of output
and profits.
C. Problems of the OPEC Cartel
1. There are three factors accounting for the serious problems encountered by the OPEC
cartel.
a. There are many members, as well as several nonmember petroleum producers.
1. The existence of large profits attracted entry to the industry and drove the price
of petroleum down.
b. The members are dissimilar in that they have different and conflicting goals.
1. Countries with small reserves relative to population want higher prices now,
while countries with relatively large reserves are more concerned with
long-run profits.
c. The demand for petroleum is more elastic in the long run.
1. Over time consumers have made adjustments to the higher OPEC price.
V. MARKET POWER AND ECONOMIC GROWTH
A. Basis of Economic Growth
1. Knowledge and the creation of new knowledge are the basis for much economic
growth and for the growth of many firms.
2. Knowledge-based firms have several feature that lead to a monopoly or near-monopoly
of their products.
a. The development of the product involves huge start-up costs.
b. There are large up-front costs involved in producing the product that has been
developed.
3. Government grants monopolies of new products through copyrights and patents so that
firms can cover the start-up and up-front costs of developing a product.
a. Microsoft’s first disk of Windows probably cost $50 million. Subsequent disks
cost $3.
VI. GOVERNMENT AND MARKET POWER
A. Antitrust Laws
1. Antitrust laws prohibit price fixing and other types of explicit cartel or monopoly
behavior.
2. Antitrust laws prohibit mergers in certain instances.
a. A merger is a combination of two or more firms into one firm.
3. Through the use of antitrust laws, government discourages market power.
4. Antitrust laws should not necessarily be used to restructure all firms with market
power.
a. If the industry is a natural monopoly, monopoly profit may provide incentives for
innovations that, over time, would reduce or eliminate market power.
b. The existence of monopoly profits provides an incentive for economic rent
seeking.
68  Chapter 5/Market Power: Does It Help or Hurt the Economy?
c. The existence of profits encourages new firms to come into the industry causing
prices to be lowered.
Answers to Review Questions
1. Why does the efficient output occur where marginal benefit equals marginal cost?
Analyze in detail.
Efficient output occurs when the value of one more unit of a good equals its cost, where
marginal social benefit equals marginal social cost. Observe the following graph, which
represents the market for computers.
Price per Unit (Dollars)
S
2,000
1,500
800
D
Q
1
Q
3
Q
2
Quantity per Year
Suppose that the firm is considering producing an additional computer which will expand
output to Q1. At Q1, the demand price is $2,000, while the supply price is only $800. If the
computer is produced, consumers of computers will gain $2,000 in benefits. In order to
produce the computer, society will have to sacrifice $800 worth of other goods and services. It
would be possible for those who gain the $2,000 of benefits to reimburse those who lose the
$800 of benefits and still be better off. This would result in a net gain of benefits equal to
$1,200 ($2,000 - $800).
Now suppose the firm is considering producing an additional computer which will expand
output to Q2. At Q2, the supply price is $2,000, while the demand price is only $800. If an
additional computer is produced there will be a net loss to society of $1,200. This loss implies
that resources should be allocated away from computer production. By cutting back on
computer output and increasing output in other industries, consumers of computers will lose
$800 worth of benefits while others in society will gain $2,000 worth of benefits. Consumers
Instructor's Manual  69
of other goods could reimburse consumers of computers for their loss in benefits and still be
better off. Net benefits, and hence efficiency, will increase. At any point where the supply
price is greater than the demand price, net benefit can be increased by reallocating resources
away from this industry. Such a point is inefficient.
Suppose output is at Q3 where the demand price and supply price are equal. If production were
increased, the supply price would exceed the demand price. There is no way to compensate
consumers of other goods for the benefits they would forego as resources are allocated to the
production of computers. Likewise if production were decreased, the demand price would
exceed the supply price. There is no way to compensate consumers of computers for the
benefits they would forego as resources are allocated to the production of other goods and
services. In both cases, one group in society will benefit and another will be made worse off.
Only at the point where the demand price and the supply price are equal will net benefits be
maximized and efficiency obtained. Because the demand price equals marginal benefit and the
supply price equals marginal cost, equality of the demand and supply prices implies that
marginal benefit and marginal cost are equal.
2. If a firm is a pure competitor, marginal revenue and price will be equal. If the firm is a
monopoly, marginal revenue will be less than price. Explain these statements.
In order to understand why a pure competitor's marginal revenue is equal to price and why a
monopolist's marginal revenue is less than price, recall the following facts. A pure competitor
is one of many producers of a homogenous good. She faces a horizontal demand curve. This
means that she can sell all the output she wishes at the market price. She is a price taker. A
monopolist, on the other hand, is the only producer of a good with no close substitutes. He, in
effect, is the industry and faces a downward sloping demand curve. This means that in order to
sell additional units of output he must lower the price of the product. The monopolist is a price
searcher.
Why does this mean that the pure competitor's marginal revenue is the same as the market price
while the monopolist's marginal revenue is less than the market price? Marginal revenue is the
change in total revenue associated with a one unit change in output. For a pure competitor,
each additional unit of output sold will increase total revenue by an amount equal to the market
price. For example, Christie, a pure competitor, sells one hundred pieces of pizza for $2 per
slice. Her total revenue is $200. If she sells one hundred one pieces of pizza her total revenue
is $202. Marginal revenue is $202 less $200 or $2, and $2 is the market price of pizza.
Because Christie does not have to lower price in order to sell more, marginal revenue will be
equal to market price.
For a monopolist, each additional unit of output sold will increase total revenue by an amount
less than the market price. For example, Dan, a monopolist, can sell one bottle of Dr.
Goodbody's cure-all for $5 per bottle. His total revenue will be $5. In order to induce
customers to buy more than one bottle of the tonic, he must reduce the price. This lower price
must be charged for all bottles sold. Thus, to sell two bottles of cure-all he must lower the
price to $4.00 per bottle. His total revenue will now be $8 ($4 x 2). His marginal revenue will
be the change in total revenue, $8 less $5, or $3. Because Dan must lower price in order to
induce customers to take a greater quantity, marginal revenue will be less than price.
70  Chapter 5/Market Power: Does It Help or Hurt the Economy?
3. Suppose you are given the information about a monopoly that appears in the table.
Quantity
1
2
3
4
5
6
7
8
9
10
Price
50
45
40
35
30
25
20
15
10
5
Marginal Cost
20
20
20
20
20
20
20
20
20
20
a.
b.
c.
d.
What is the firm's total revenue for each quantity?
What is the firm's marginal revenue for each quantity?
What quantity and price should the firm choose to maximize its profits?
Suppose the monopolist is currently producing five units of the good. What actions
should it undertake and why?
e. Use the information above to plot the demand curve faced by the monopolist, the
monopolist's marginal revenue and marginal cost curves, the profit-maximizing level
of output, and the profits earned by the firm.
a. The firm's total revenue is price times quantity sold or P x Q. Applying this formula, the
total revenue associated with the first unit of output is found to be 1 x $50 or $50. Using
this formula the total revenue associated with each unit of output sold can be derived.
These results are exhibited in column (a) in the table below.
b. The firm's marginal revenue shows the change in total revenue that is brought about by a
one unit change in output. It is (TR1 - TR0)/(Q1 - Q0). The marginal revenue associated
with increasing production from one to two units of output would be (90 - 50)/(2 - 1), or
$40. Applying this formula to the various levels of output results in column (b) in the table
below.
Q
1
2
3
4
5
6
7
8
9
10
P
$50
45
40
35
30
25
20
15
10
5
MC
$20
20
20
20
20
20
20
20
20
20
(a)
TR
$50
90
120
140
150
150
140
120
90
50
(b)
MR
$40
30
20
10
0
-10
-20
-30
-40
c. In order to maximize profit, the firm should produce where its marginal revenue and
marginal cost are equal. The firm's marginal cost of production is $20 for each unit. When
the firm produces 4 units, its marginal revenue is $20. Thus, the firm should produce 4
Instructor's Manual  71
units of output. When it produces four units, the previous table indicates that people will
be willing to pay $35 per unit. Thus output of 4 and price of $35 are the profit maximizing
output and price.
d. If the monopolist is producing 5 units, her marginal cost is $20 while her marginal revenue
is $10. The revenue received from the sale of this unit is less than the cost of producing
this unit. Production of this unit will cause profits to fall by $10 ($20 - $10). In order to
maximize profits, the firm should cut back on output. In this instance, as output falls,
profits will rise.
e. In order to draw the monopolist's demand curve, simply plot the price and quantity
combinations given in the above table. This is done in the diagram below. The marginal
revenue curve is drawn by plotting the marginal revenue and quantity combinations in the
table. Plotting the marginal cost and quantity combinations will give the marginal cost
curve. The profit maximizing output, Q*, is found by equating marginal revenue and
marginal cost at point A. Q* is found by reading down from point A to the horizontal axis.
Reading up from point A to the demand curve and then across to the vertical axis gives the
price the monopolist will charge, P*. Profit is equal to total revenue minus total cost. Total
revenue is equal to price times quantity, or area OP*BQ*. Total cost is equal to the sum of
the marginal costs. It is the area under the marginal cost curve up to Q*. Thus, total cost is
given by the area OC*AQ*. Total profit, total revenue minus total cost, is given by area
OP*BQ* minus area OC*AQ*, or area C*P*A.
Price per Unit (Dollars)
50
40
P*
C
*
30
20
10
.
.
. . B
.
.
.
.
A
.
.
.
.
.
MR
0
2
4
6
8
MC
.
10
D
Quantity per Month
Q*
4. "A monopolist can charge whatever price it desires for its output." Is this statement true
or false? Defend your answer.
The statement is false. While it is true that the monopolist is not a price taker and does exert
control over the price of output, profit maximization means she cannot charge any price she
desires. In the previous question, the monopolist maximized profit by selling 4 units at a price
of $35 per unit. If she were to raise the price to $45 per unit and still sell 4 units, profit would
go up by $40. But at the price of $45 she can only sell 2 units. Even though she charges a
72  Chapter 5/Market Power: Does It Help or Hurt the Economy?
higher price, her profit goes down by $10 because she sells fewer units. The law of demand
puts a constraint on the price charged by a monopolist.
5. State and explain the general principle to be followed in maximizing profits.
The monopolist follows the marginal principle in maximizing profits. This principle states that
the output which will maximize profits is the output at which marginal revenue and marginal
cost are equal. If marginal revenue is greater than marginal cost, the monopolist should
increase output. If marginal revenue is less than marginal cost, the monopolist should decrease
output.
This principle is quite easy to understand. For example, suppose marginal revenue is $10 while
marginal cost is $7. If the monopolist produces this unit of output, profits will increase by $3
($10 - $7). Likewise, if marginal revenue is $10 and marginal cost is $15, production of this
unit of output will cause profits to fall by $5 ($10 - $15). Since profits will increase whenever
marginal revenue exceeds marginal cost, and profits will fall whenever marginal cost exceeds
marginal revenue, they must be at a maximum when marginal revenue and marginal cost are
equal. This same idea is depicted in the graph below.
Price per Unit (Dollars)
C
R1
G
C
1
B
MC
F
R2
D
MR
A
0
Q
E
1
Q
3
Q
2
Quantity per Month
D represents the monopolist's demand, MR his marginal revenue, and MC his marginal cost.
We have already discussed the fact that marginal revenue lies below the demand curve because
that the monopolist must lower price in order to sell more output. Suppose the monopolist is
currently producing output 0Q1. At 0Q1, marginal revenue is equal to OR1 or distance AC,
while marginal cost is equal to OC1 or distance AB. If output is increased by one unit, profits
will rise by an amount equal to OR1 minus OC1 or distance BC. Thus, anytime the monopolist
is producing at a point where marginal revenue exceeds marginal cost, it is possible to increase
profits by increasing output.
Likewise, if the monopolist is producing output 0Q2, marginal revenue will be OR2 or distance
EF. Marginal cost will be OC1 or distance EG. The firm is earning a loss of OR2 minus OC1
Instructor's Manual  73
or FG on this unit of output. By decreasing output by one unit, profits will increase by FG.
Thus, anytime the monopolist is producing at a point where marginal cost exceeds marginal
revenue, it is possible to increase profits by decreasing output. Only where marginal cost and
marginal revenue are equal (output Q3) will profits be at a maximum.
6. Use graphical analysis to compare and contrast the economic outcome of monopoly with
the economic outcome of pure competition.
The following graph can be used to compare the economic outcome of monopoly with the
economic outcome of pure competition.
Price per Unit (Dollars)
C
G
F
B
A
E
D
MR
0
Q2
MC (S)
Q1
Quantity
The supply curve for the competitive industry (S) is the marginal cost curve (MC) for the
monopoly. D, the demand curve, is the same for both monopoly and pure competition.
Equilibrium for pure competition occurs where demand and supply intersect at point A.
Output is 0Q1 and price is OB. Profits are zero (there is a normal rate of earnings).
The monopolist produces where marginal revenue and marginal cost are equal at point E.
Output is 0Q2 and price is OF. Monopoly profit is equal to area BFGE. So monopoly price is
higher than the competitive price and monopoly output is lower. The monopolist may earn a
profit. For the competitive industry, demand price (marginal benefit for society) equals the
supply price (marginal cost to society). All potential gains from trade are realized. For the
monopoly, marginal revenue (marginal benefits for the monopolist) equals the supply price.
Because demand price is greater than marginal revenue, demand price is greater than supply
price. Marginal benefit for society exceeds marginal cost, and there are unrealized gains from
trade.
7. "Because a monopolist can extract a higher price than a firm that is a pure competitor,
the monopolist will always earn a profit." Is this statement true or false? Defend your
answer.
This statement is false. In order to maximize profits, the monopolist must produce the quantity
at which marginal revenue and marginal cost are equal. This means that the monopolist is not
free to charge whatever price she desires. Instead she must charge the price that consumers are
willing to pay for this profit maximizing quantity. Depending upon the monopolist's costs
74  Chapter 5/Market Power: Does It Help or Hurt the Economy?
relative to consumer demand, it is possible that no profit will be earned. The monopolist may
even earn a loss.
8. List and briefly discuss the major sources of monopoly in the United States.
There are four major sources of monopoly in the United States: technical conditions that
require production to take place on a very large scale, control of the supply of a product or of
essential production inputs, product differentiation, and government regulation. If technical
conditions are such that a factory must produce an extremely large output in order to be
technically efficient, it is possible that a single firm could provide the majority of output that
consumers would want to buy. In this instance, a monopoly-type structure would emerge.
Cable television supplies an example of this situation.
Monopoly may also emerge if a single firm or a small group of firms control the only source of
supply of a product or an essential input for a product. For example, the DeBeers Company
controls most of the world's diamond production, and hence has a monopoly on the world
diamond market.
Firms may also develop and maintain market power through product differentiation. If firms
can convince consumers that their product is superior, they can raise price and make only a
small sacrifice in terms of sales.
Finally, government regulations have been a source of monopoly. For example, regulations
limiting the number of doctors that are able to enter the medical profession work to restrict
supply and raise price. Tariffs and other types of regulation designed to limit the number of
imports have the same effect on the price of the regulated goods. Thus, government actions
may actually hinder competition and thereby impose a loss on society.
9. What is a cartel? What factors help to maintain a cartel? What factors encourage its
dissolution?
A cartel is an organized group of producers who manage their output and pricing as if they
were a monopoly. The purpose of the cartel is to restrict output and raise price above the
competitive price. In order to be successful, the cartel must do two things: restrict output and
restrict the entry of new firms. The major incentive holding the cartel together is the incentive
to earn a profit. As long as the cartel succeeds, price will be above marginal cost and the firms
may earn a monopoly profit.
While the desire for profit works to hold the cartel together, this same desire works to dissolve
the cartel. As long as output is restricted, the price will be a monopoly price. Suppose a firm
cheats by expanding output. It can now sell more output at the monopoly price and earn a
profit even greater than the one possible under the cartel agreement. This same incentive
works upon the other firms in the cartel. If all firms cheat, industry supply will increase and
price will fall.
The larger the number of firms in the industry, the more difficult it will be to detect the cheater.
For example, if there are only two firms in the cartel and price begins to fall, it is relatively
easy to discover if the price decrease is due to a decrease in demand or due to an expansion of
output by one of the firms. On the other hand, if there are fifteen firms in the cartel, it becomes
much more difficult to identify the source of the price decline. With detection less easy, the
Instructor's Manual  75
cost the cheater would have to bear through cartel discipline falls and cheating becomes more
prevalent.
In addition to increasing the probability of cheating, large numbers also make it difficult for
firms to reach an agreement that will allow the cartel to organize. As the number of firms
increases, it becomes more and more difficult to include all or at least most of the major firms
in the industry. There are likely to problems of a "holdout," a firm that refuses to join the
cartel, but reaps the benefits of increased profits if the cartel is formed.
Another problem with large numbers of firms is the fact that increases in numbers are generally
accompanied by increases in heterogeneity. The less similar the firms, the more difficult it
becomes to reach agreement. For example, suppose all firms in the group can be broken into
two groups: low-cost producers and high-cost producers. In order to produce output at
minimum cost the low-cost producers will have to produce a greater share of industry output.
These producers may feel that they deserve a greater share of industry profits. High-cost
producers, on the other hand, may argue that because they were forced to cut back on their
production they should receive a share of profits greater than their output share. The
possibility of these and other conflicts makes a cartel agreement very difficult to reach as the
number of firms increases.
10. "Profits on drugs are too high. Drug companies should not be allowed to profit
excessively from drugs necessary to treat serious diseases." Discuss this statement.
Government provides drug companies with this market power through the granting of patents.
While it is true that drug companies do profit from their products, the role that this profit plays
in the development of new drugs must be considered. The research undertaken by this
companies is both expensive and risky. Thus, the profits that companies reap as a result of
patents induces firms to bear this expense and risk. Goldberg argues that monopoly profits are
necessary to get firms to undertake the research necessary to discover and develop new drugs.
Without such activity, drugs to treat serious diseases would not be available. Nevertheless, as
Friedman, a staunch advocate of the market, says, a situation may exist which requires
government intervention to regulate an "essential" monopolized good. This is a judgement
call.
11. Evaluate the following statement. "Because monopoly results in economic inefficiency
and in large profits for a few powerful corporations, we should enforce regulations to
break up these firms or eliminate their profits."
It is true that an effort to eliminate monopoly profits either through regulations that would
increase competition or through regulations that would eliminate monopoly profit may increase
economic efficiency. It is equally true that policies to eliminate such profits may have some
undesirable consequences. The possibility of obtaining monopoly profits encourages economic
rent seeking. Economic rent seeking means that individuals attempt to gain an economic
advantage by offering improved products or by producing products at a lower cost.
Eliminating monopoly profits will decrease this incentive, thereby imposing some cost on
society.
In addition to lowering incentives to engage in economic rent seeking, the elimination of
profits inhibits the potential threat of entry into the monopoly industry. Monopoly profits
signal other producers that resources should flow into the industry. The threat of entry
encourages the monopolist to charge a price less than that which would be charged in the
76  Chapter 5/Market Power: Does It Help or Hurt the Economy?
absence of the threat. Eliminating profits reduces the incentive for resources to flow into the
industry and thereby lowers the threat of entry. As a result, a monopolist may be able to extend
his or her power. These arguments show that although monopoly does cause inefficiency in
society, any actions designed to eliminate the monopoly must be carefully evaluated.
12. According to the box, “The Battle between American and Japanese Automobile Firms,”
why were the Japanese firms successful in the battle?
Japanese firms were successful in the battle because management in the U. S. automobile
industry enjoyed the “quiet life.” In 1981, wages in the automobile industry were 50 percent
greater than average wages in manufacturing. In addition, management allowed production
methods to become obsolete and ignored quality problems. When the energy crisis occurred in
the 1970s, it caught U. S. car manufacturers off guard. Demand for imports surged. These cars
were cheaper and of a higher quality than their U. S. counterparts. Japanese managers adopted
quality-control, inventory, and human relations policies that resulted in productivity that
exceeded U. S. manufacturers. Just-in-time manufacturing, quality circles, and continuous
improvement also contributed to the productivity of Japanese firms.
13. What are the advantages and disadvantages of government choosing the industry
standard for computer operating systems?
If the widespread belief that the Mac operating system is technically superior to the MS system
is true, then we are now entrenched on an inefficient technological path that the market cannot
reverse. The primary advantage of government choosing the industry standard for computer
operating systems is that they would likely choose the system that is technically efficient.
This, of course, assumes that there are government officials with the expertise to make this
decision.
A disadvantage of allowing the government to set the standard for computer operating systems
is that the government’s choice may not be the choice that maximizes the satisfaction of the
most consumers. Despite technical inefficiencies, the public may place a greater value on MS
systems.
Another disadvantage of allowing the government to choose our operating system is that this
would likely stifle innovation on the part of potential competitors in this market. Microsoft
achieved its dominance through economic rent-seeking. Had the government chosen the Mac
as the standard for operating systems, MS would have had no economic incentive for
innovation. In addition, Apple would have no incentive for innovation since they are already
guaranteed dominance through the government’s protection.
14. For the sake of the question, assume that Apple’s operating systems were and are
superior to the MS systems. Explain why DOS dominated the early Mac systems and
why only Windows dominated later Mac systems. Given Windows’ dominant position,
how could a new operating system replace Windows?
Although some argue that the early Mac operating system was technically superior to DOS,
the MS DOS systems were still chosen over the Mac. Authors Liebowitz and Margolis argue
that the DOS systems were superior with respect to cost. First, DOS was cheaper because it
took less computing power than the Mac’s graphical interface. Second, DOS was faster.
Third, Mac’s had limited hard drive capacity; therefore, users had to change floppies in order
to change programs.
Instructor's Manual  77
Even though DOS dominated this early market, users were not locked into the operating
system. Users were ready to switch over to Windows when it first entered the market. Again,
many argue that the Mac system was technically superior to the early Windows system, but
consumers still chose Windows for economical reasons. First, Window could run DOS
programs, and second, Windows maintained backward compatibility, so that upgrading was
less costly. Microsoft had the better product in terms of consumer preferences and cost
considerations.
15. Go to http://www.swcollege.com/bef/econ_news.html and click on monopoly under the
microeconomics section. Choose an article of interest, read the full summary and answer
the questions. (Some of these questions may go beyond the materials in this course. If you
run into such questions you may want to try to answer anyway, go to a different article,
or just answer the ones that seem appropriate.)
Choices of articles and answers will vary.