chapter ELEVEN
Pure Monopoly
This chapter is divided into six basic sections: the characteristics of pure monopoly; the barriers to entry that create and protect monopolies; price and output determination under monopoly; the economic effects of monopoly; price discrimination under monopoly; and the regulation of monopolies.
The discussion of barriers to entry states at the outset that these barriers may occur to some extent in any form of imperfect competition, not just in a pure monopoly. The concept of a natural monopoly is addressed in this section.
Building on the analysis of the preceding chapter, the discussion of price‑output decision making by monopoly firms points out that the marginal-revenue—marginal-cost rule still applies. Emphasis here is on the major difference between the determination of marginal revenue in pure competition and in pure monopoly. The misconceptions about monopoly pricing behavior are presented as well as a comparison of efficiency in pure competition and pure monopoly. This section ends with a discussion of effects of monopoly power in the U.S. economy and some policy alternatives.
The case of price discrimination and its effects are discussed along with the conditions necessary for it to occur. At the end of the chapter, the basic issues involved in the regulation of public service monopolies are reviewed.
After completing this chapter, students should be able to
1. List the five characteristics of pure monopoly.
2. Explain the difference between a “pure” monopoly and a “near” monopoly.
3. List and give examples of the four barriers to entry.
4. Describe the demand curve facing a pure monopoly and how it differs from that facing a firm in a purely competitive market.
5. Compute marginal revenue when given a monopoly demand schedule.
6. Explain why the marginal revenue is equal to the price in pure competition but not in monopoly.
7. Determine the price and output level the monopoly will choose given demand and cost information in both table and graphic form.
8. Discuss the economic effects of pure monopoly on price, quantity of product produced, allocation of resources, distribution of income, and technological progress.
9. Give examples of how new technology has lessened monopoly power.
10. List three conditions necessary for price discrimination.
11. Explain why profits and output will be higher for a discriminating monopoly as compared to non-discriminating monopoly.
12. Identify two pricing strategies of monopoly regulation and explain the dilemma the regulators face in utilizing these strategies.
13. Define and identify terms and concepts listed at the end of the chapter.
I. Pure Monopoly: An Introduction
A. Definition: A pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes.
B. There are a number of products where the producers have a substantial amount of monopoly power and are called “near” monopolies.
C. There are several characteristics that distinguish pure monopoly.
1. There is a single seller so the firm and industry are synonymous.
2. There are no close substitutes for the firm’s product.
3. The firm is a “price maker,” that is, the firm has considerable control over the price because it can control the quantity supplied.
4. Entry into the industry by other firms is blocked.
5. A monopolist may or may not engage in nonprice competition. Depending on the nature of its product, a monopolist may advertise to increase demand.
C. Examples of pure monopolies and “near monopolies.”
1. Public utilities—gas, electric, water, cable TV, and local telephone service companies—are pure monopolies.
2. First Data Resources (Western Union), Wham-o (Frisbees) and the DeBeers diamond syndicate are examples of “near” monopolies. (See Last Word.)
3. Manufacturing monopolies are virtually nonexistent in nationwide U.S. manufacturing industries.
4. Professional sports leagues grant team monopolies to cities.
5. Monopolies may be geographic. A small town may have only one airline, bank, etc.
D. Analysis of monopolies yields insights concerning monopolistic competition and oligopoly, the more common types of market situations. (See Chapter 25.)
II. Barriers to Entry
Limiting Competition
A. Economies of scale constitute one major barrier. This occurs where the lowest unit costs and, therefore, lowest unit prices for consumers depend on the existence of a small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale. (See Figure 22-9b and Figure 24-1.)
1. Public utilities are known as natural monopolies because they have economies of scale in the extreme case where one firm is most efficient in satisfying existing demand.
2. Government usually gives one firm the right to operate a public utility industry in exchange for government regulation of its power.
3. The explanation of why more than one firm would be inefficient involves the description of the maze of pipes or wires that would result if there were competition among water companies, electric utility companies, etc.
B. Legal barriers to entry into a monopolistic industry also exist in the form of patents and licenses.
1. Patents grant the inventor the exclusive right to produce or license a product for seventeen years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits.
2. Licenses are another form of entry barrier. Radio and TV stations, and taxi companies are examples of government granting licenses where only one or a few firms are allowed to offer the service.
C. Ownership or control of essential resources is another barrier to entry.
1. International Nickel Co. of Canada (now called Inco) controlled about 90 percent of the world’s nickel reserves, and DeBeers of South Africa controls most of world’s diamond supplies (see Last Word).
2. Aluminum Co. of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication.
3. Professional sports leagues control player contracts and leases on major city stadiums.
D. Monopolists may use pricing or other strategic barriers such as selective price cutting and advertising.
1. Dentsply, manufacturer of false teeth, controlled about 70 percent of the market. In 1999 the U.S. Justice Department accused Dentsply of illegally preventing distributors from carrying competing brands.
2. Microsoft charged higher prices for its Windows operating system to computer manufacturers featuring Netscape Navigator instead of Microsoft’s Internet Explorer. U.S. courts ruled this action illegal.
III. Monopoly demand is the
industry (market) demand and is therefore downward sloping.
A. Our analysis of monopoly demand makes three assumptions.
1. The monopoly is secured by patents, economies of scale, or resource ownership.
2. The firm is not regulated by any unit of government.
3. The firm is a single‑price monopolist; it charges the same price for all units of output.
B. Price will exceed marginal revenue because the monopolist must lower the price to sell the additional unit. The added revenue will be the price of the last unit less the sum of the price cuts that must be taken on all prior units of output (Table 24‑1 and Figure 24‑2).
1. Figure 24‑3 shows the relationship between demand, marginal-revenue, and total‑revenue curves.
2. The marginal-revenue curve is below the demand curve, and when it becomes negative, the total-revenue curve turns downward as total revenue falls.
C. The monopolist is a price maker. The firm controls output and price but is not free of market forces, since the combination of output and price that can be sold depends on demand. For example, Table 24-1 shows that at $162 only 1 unit will be sold, at $152 only 2 units will be sold, etc.
D. Price elasticity also plays a role in monopoly price setting. The total revenue test shows that the monopolist will avoid the inelastic segment of its demand schedule. As long as demand is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true when demand becomes inelastic. At this point, total revenue falls as output expands, and since total costs rise with output, profits will decline as demand becomes inelastic. Therefore, the monopolist will expand output only in the elastic portion of its demand curve. (Key Question 4)
IV. Output and Price Determination
A. Cost data is based on hiring resources in competitive markets, so the cost data of Chapters 22 and 23 can be used in this chapter as well. The costs in Table 24-1 restate the data of Table 22-2.
B. The MR = MC rule will tell the monopolist where to find its profit‑maximizing output level. This can be seen in Table 24‑1 and Figure 24‑4. The same outcome can be determined by comparing total revenue and total costs incurred at each level of production. (Key Question 5)
C. The pure monopolist has no supply curve because there is no unique relationship between price and quantity supplied. The price and quantity supplied will always depend on the location of the demand curve.
D. There are several misconceptions about monopoly prices.
1. A monopolist cannot charge the highest price it can get, because it will maximize profits where total revenue minus total cost is greatest. This depends on quantity sold as well as on price and will never be the highest price possible.
2. Total, not unit, profits is the goal of the monopolist. Table 24‑1 has an example of this, in which unit profits are $32 at 4 units of output compared with $28 at the profit‑maximizing output of 5 units. Once again, quantity must be considered as well as unit profit.
3. Unlike the purely competitive firm, the pure monopolist can continue to receive economic profits in the long run. Although losses can occur in a pure monopoly in the short run (P > AVC), the less-than-profitable monopolist will shutdown in the long run (P > ATC). Figure 24‑5 shows a short‑run loss situation for a monopoly firm.
V. Evaluation of the
Economic Effects of a Monopoly
A. Price, output, and efficiency of resource allocation should be considered.
1. Monopolies will sell a smaller output and charge a higher price than would competitive producers selling in the same market, i.e., assuming similar costs.
2. Monopoly price will exceed marginal cost, because it exceeds marginal revenue and the monopolist produces where marginal revenue and marginal cost are equal. The monopolist charges the price that consumers will pay for that output level.
3. Allocative efficiency is not achieved because price (what a product is worth to consumers) is above marginal cost (opportunity cost of product). Ideally, output should expand to a level where price = marginal revenue = marginal cost, but this will occur only under pure competitive conditions where price = marginal revenue. (See Figure 24-6)
4. Productive efficiency is not achieved because the monopolist’s output is less than the output at which average total cost is minimum.
B. Income distribution is more unequal than it would be under a more competitive situation. The effect of the monopoly power is to transfer income from consumers to business owners. This will result in a redistribution of income in favor of higher-income business owners, unless the buyers of monopoly products are wealthier than the monopoly owners.
C. Cost complications may lead to other conclusions.
1. Economies of scale may result in one or two firms operating in an industry experiencing lower ATC than many competitive firms. These economies of scale may be the result of spreading large initial capital cost over a large number of units of output (natural monopoly) or, more recently, spreading product development costs over units of output, and a greater specialization of inputs.
2. X‑inefficiency may occur in monopoly since there is no competitive pressure to produce at the minimum possible costs.
3. Rent‑seeking behavior often occurs as monopolies seek to acquire or maintain government‑granted monopoly privileges. Such rent seeking may entail substantial costs (lobbying, legal fees, public relations advertising, etc.), which are inefficient.
D. Technological progress and dynamic efficiency may occur in some monopolistic industries but not in others. The evidence is mixed.
1. Some monopolies have shown little interest in technological progress.
2. On the other hand, research can lead to lower unit costs, which help monopolies as much as any other type of firm. Also, research can help the monopoly maintain its barriers to entry against new firms.
E. Assessment and policy options.
1. Although there are legitimate concerns about the effects of monopoly power on the economy, monopoly power is not widespread. While research and technology may strengthen monopoly power, over time it is likely to destroy a monopoly position.
2. When monopoly power is resulting in an adverse effect upon the economy, the government may choose to intervene on a case-by-case basis.
VI. Price discrimination
occurs when a given product is sold at more than one price and the price
differences are not based on cost differences.
A. Conditions needed for successful price discrimination.
1. Monopoly power is needed with the ability to control output and price.
2. The firm must have the ability to segregate the market, to divide buyers into separate classes that have a different willingness or ability to pay for the product (usually based on differing elasticities of demand).
3. Buyers must be unable to resell the original product or service.
B. Examples of price discrimination.
1. Airlines charge higher fares to executive travelers (inelastic demand) than to vacation travelers (elastic demand).
2. Electric utilities frequently segment their markets by end uses, such as lighting and heating. (Lack of substitutes for lighting makes this demand inelastic).
3. Long‑distance phone service has higher rates during the day, when businesses must make their calls (inelastic demand), and lower rates at night and on weekends, when less important calls are made.
4. Movie theaters and golf courses vary their charges on the basis of time and age.
5. Discount coupons are a form of price discrimination, allowing firms to offer a discount to price-sensitive customers.
6. International trade has examples of firms selling at different prices to customers in different countries.
7. CONSIDER THIS … Price Discrimination at the Ballpark
C. Outcomes of price discrimination.
1. More profits can be earned by the seller, since the price charged is what each buyer is willing to pay in perfect discrimination. The marginal revenue will be equal to price in the perfect discrimination case. (See Figure 24-8.)
2. More production will occur with discrimination because as output expands, the reduced price applies only to the additional unit sold and not to prior units. Marginal revenue can now be equated to marginal cost to find the profit‑maximizing level of output, and price of the last unit sold will equal that marginal revenue. End‑of‑chapter questions 5 and 6 allow comparison of the outcomes in nondiscriminating and discriminating cases.
VII. Regulated Monopoly
A. This occurs where a natural monopoly or economies of scale make having one firm desirable.
B. As a result of changes in technology and deregulation in the local telephone and the electricity-providers industry, some states are allowing new entrants to compete in previously regulated markets.
C. In those markets that are still regulated, a regulatory commission may attempt to establish the legal price for the monopolist that is equal to marginal cost at the quantity of output chosen. This is called the “socially optimal price.”
C. However, setting price equal to marginal cost may cause losses, because public utilities must invest in enough fixed plant to handle peak loads. Much of this fixed plant goes unused most of the time, and a price = marginal cost would be below average total cost. Regulators often choose a price equal to average cost rather than marginal cost, so that the monopoly firm can achieve a “fair return” and avoid losses. (Recall that average-total cost includes an allowance for a normal or “fair” profit.)
D. The dilemma for regulators is whether to choose a socially optimal price, where P = MC, or a fair‑return price, where P = AC. P = MC is most efficient but may result in losses for the monopoly firm, and government then would have to subsidize the firm for it to survive. P = AC does not achieve allocative efficiency, but does ensure a fair return (normal profit) for the firm. (Key Question 11)
VIII. LAST WORD: De Beers’ Diamonds: Are Monopolies Forever?
A. De Beers Consolidated Mines of South Africa has been one of the world’s strongest and most enduring monopolies. It produces about 50 percent of all rough-cut diamonds in the world and buys for resale many of the diamonds produced elsewhere, for a total of about 80 percent of the world’s diamonds.
B. Its behavior and results fit the monopoly model portrayed in Figure 24-4. It sells a limited quantity of diamonds that will yield an “appropriate” monopoly price.
C. The “appropriate” price is well over production costs and has earned substantial economic profits.
D. How has De Beers controlled the production of mines it doesn’t own?
1. It convinces producers that “single-channel” monopoly marketing is in their best interests.
2. Mines that don’t use De Beers may find the market flooded from De Beers stockpiles of the particular kind of diamond they produce, which causes price declines and loss of profits.
3. Finally, De Beers purchases and stockpiles diamonds produced by independents.
E. Threats and problems face De Beers’ monopoly power.
1. New diamond discoveries have resulted in more diamonds outside their control.
2. Russia, which has been a part of De Beers’ monopoly, has been allowed to sell a part of its stock directly into the world market.
F. In mid-2000, De Beers abandoned its attempt to control the supply of diamonds.
G. The company is transforming itself into one that sells “premium” diamonds and luxury goods under the De Beers label.
H. De Beers plans to reduce its stockpile of diamonds and increase the demand for diamonds through advertising.