Principles of Microeconomics Scarcity and Social Provisioning Chapter 12 Monopoly

CHAPTER 12 . MONOPOLY INTRODUCTION TO A MONOPOLY Figure . Political Power from a Cotton Monopoly . In the century , the United States , specifically the Southern states , had a near monopoly in the cotton supplied to Great Britain . These states attempted to leverage this economic power into political to sway Great Britain to formally recognize the Confederate States of America . Credit modification of work by Creative Commons ) THE REST IS HISTORY Many of the opening case studies have focused on current events . This one steps into the past to observe how monopoly , or near monopolies , have helped shape history . In the spring of 1773 , the East India Company , a firm that , in its time , was designated too big to fail , was continuing to experience financial difficulties . To help shore up the failing firm , the British Parliament authorized the Tea Act . The act continued the tax on teas and made the East India Company the sole legal plier of tea to the American colonies . By November , the citizens of Boston had had enough . They refused to permit the tea to be unloaded , citing their main complaint No taxation Without representation . Arriving ships were warned

PRINCIPLES or ECONOMICS 345 via several newspapers , including The Massachusetts Gazette , We are prepared , and shall not fail to pay them an unwelcome visit by The . Step forward in time to eve of the American Civil another near monopoly supplier of historical cancer the US . cotton industry . At that time , the Southern states provided the majority of the cotton Britain imported . The South , wanting to secede from the Union , hoped to leverage Britain high dependency on its cotton into formal diplomatic recognition of the Confederate States of America . This leads us to the topic of this chapter a firm that controls all ( or nearly all ) of the supply of a good or monopoly . How do monopoly firms behave in the marketplace ?

Do they have power ?

Does this power potentially have unintended consequences ?

We return to this case at the end of the chapter to see how the tea and cotton monopolies US . history . OB ( Introduction to a Monopoly In this chapter , you will learn about How Monopolies form Barriers to Entry How a Monopoly Chooses Output and Price here is a widespread belief that top executives at firms are the strongest supporters of market competition , but this belief is far from the truth . Think about it this way If you very much wanted to win an Olympic gold medal , would you rather be far better than everyone else , or locked in competition with many athletes just as good as you are ?

Similarly , if you would like to attain a very high level of profits , would you rather manage a business with little or no competition , or against many tough competitors who are trying to sell to your customers ?

By now , you might have read the chapter on Perfect Competition . In this chapter , we explore the opposite extreme monopoly . If perfect competition is a market where firms have no market power and they simply respond to the market price , monopoly is a market with no competition at all , and firms have complete market power . In the case of monopoly , one firm produces all of the output in a market . Since a monopoly faces no significant competition , it can charge any price it wishes . While a monopoly , by definition , refers to a single firm , in practice the term is often used to describe a market in which one firm merely has a very high market share . This tends to be the definition that the Department of justice uses . Even though there are very few true monopolies in existence , we do deal with some of those few every day , often without realizing it The . Postal Service , your electric and garbage collection companies are a few examples . Some new drugs are produced by only one pharmaceutical no close substitutes for that drug may exist . From the until 2004 , the Department ofjustice prosecuted the Corporation for including Internet Explorer as the default web browser with its operating system . The Justice argument was that , since possessed an extremely high market share in the industry for operating systems , the inclusion of a free web browser constituted unfair competition to other , such as Navigator . Since nearly everyone was using Windows , including Internet Explorer eliminated the incentive for consumers to explore other and made it

346 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER impossible for competitors to gain a foothold in the market . In 2013 , the Windows system ran on more than 90 of the most commonly sold personal computers . In 2015 , a federal court tossed out antitrust charges that Google had an agreement with mobile device makers to set Google as the default search engine . This chapter begins by describing how monopolies are protected from competition , including laws that prohibit competition , technological advantages , and certain configurations of demand and ply . It then discusses how a monopoly will choose its quantity to produce and What price to charge . While a monopoly must be concerned about whether consumers will purchase its products or spend their money on something altogether different , the monopolist need not worry about the actions of other competing firms producing its products . As a result , a monopoly is not a price taker like a perfectly competitive firm , but instead exercises some power to choose its market price .

HOW MONOPOLIES FORM BARRIERS TO ENTRY LEARNING OBJECTIVES By the end of this section , you will be able to Distinguish between a natural monopoly and a legal monopoly . Explain how economies of scale and the control of natural resources led to the necessary formation of legal monopolies Analyze the importance of trademarks and patents in promoting innovation Identify examples of predatory pricing ecause of the lack of competition , monopolies tend to earn significant economic profits . These profits should attract vigorous competition as described in Perfect Competition , and yet , because of one particular characteristic of monopoly , they do not . Barriers to entry are the legal , technological , or market forces that discourage or prevent potential competitors from entering a market . Barriers to entry can range from the simple and easily surmountable , such as the cost of renting retail space , to the extremely restrictive . For example , there are a finite number of radio available for broadcasting . Once the rights to all of them have been purchased , no new can enter the market . In some cases , barriers to entry may lead to monopoly . In other cases , they may limit competition to a few firms . Barriers may block entry even if the firm or firms currently in the market are earning profits . Thus , in markets with significant barriers to entry , it is not true that abnormally high profits will attract new firms , and that this entry of new firms will eventually cause the price to decline so that surviving firms earn only a normal level of profit in the long run . There are two types of monopoly , based on the types of barriers to entry they exploit . One is natural monopoly , where the barriers to entry are something other than legal prohibition . The other is legal monopoly , where laws prohibit ( or severely limit ) competition . NATURAL MONOPOLY Economies of scale can combine with the size of the market to limit competition . This theme was introduced in Cost and Industry Structure ) Figure presents a average cost curve for the airplane manufacturing industry . It shows economies of scale up to an output of planes per year and a price of , then constant returns to scale from to planes per year , and of scale at a quantity of production greater than planes per year .

343 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Now consider the market demand curve in the diagram , which intersects the average cost ( curve at an output level of planes per year and at a price , which is higher than . In this situation , the market has room for only one producer . If a second firm attempts to enter the market at a smaller size , say by producing a quantity of planes , then its average costs will be higher than the existing firm , and it will be unable to compete . If the second firm attempts to enter the market at a larger size , like planes per year , then it could produce at a lower average it could not sell all planes that it produced because of insufficient demand in the market . Cost or Price ( Demand . Output Figure . Economies of Scale and Natural Monopoly . In this market , the demand curve intersects the average cost ( curve at its part . A natural monopoly occurs when the quantity demanded is less than the minimum quantity it takes to be at the bottom of the average cost curve . This situation , when economies of scale are large relative to the quantity demanded in the market , is called a natural monopoly . Natural monopolies often arise in industries where the marginal cost of adding an additional customer is very low , once the fixed costs of the overall system are in place . Once the main water pipes are laid through a neighborhood , the marginal cost of providing water service to another home is fairly low . Once electricity lines are installed through a neighborhood , the cost of providing additional electrical service to one more home is very low . It would be costly and duplicative for a second water company to enter the market and invest in a whole second set of main water pipes , or for a second electricity company to enter the market and invest in a whole new set of electrical wires . These industries offer an example where , because of economies of scale , one producer can serve the entire market more efficiently than a number of smaller producers that would need to make duplicate physical capital investments . A natural monopoly can also arise in smaller local markets for products that are difficult to transport .

PRINCIPLES or ECONOMICS 349 For example , cement production exhibits economies of scale , and the quantity of cement demanded in a local area may not be much larger than what a single plant can produce . Moreover , the costs of transporting cement over land are high , and so a cement plant in an area without access to water transportation may be a natural monopoly . CONTROL OF A PHYSICAL RESOURCE Another type of natural monopoly occurs when a company has control of a scarce physical resource . In the economy , one historical example of this pattern occurred when Aluminum Company of most of the supply of bauxite , a key mineral used in making . Back in the , when controlled most of the bauxite , other firms were simply unable to produce enough aluminum to compete . As another example , the majority of global diamond production is controlled by , a national company that has mining and production operations in South Africa , and Canada . It also has exploration activities on four continents , while directing a worldwide network of rough cut diamonds . Though in recent years they have experienced growing petition , their impact on the rough diamond market is still considerable . LEGAL MONOPOLY For some products , the government erects barriers to entry by prohibiting or limiting competition . Under law , no organization but the . Postal Service is legally allowed to deliver mail . Many states or cities have laws or regulations that allow households a choice of only one electric company , one water company , and one company to pick up the garbage . Most legal monopolies are considered necessary for everyday are socially beneficial to have . As a consequence , the government allows producers to become regulated monopolies , to insure that an appropriate amount of these products is provided to consumers . Additionally , legal monopolies are often subject to economies of scale , so it makes sense to allow only one provider . PROMOTING INNOVATION Innovation takes time and resources to achieve . Suppose a company invests in research and ment and finds the cure for the common cold . In this world of near ubiquitous information , other companies could take the formula , produce the drug , and because they did not incur the costs of research and development ( undercut the price of the company that discovered the drug . Given this possibility , many firms would choose not to invest in research and development , and as a result , the world would have less innovation . To prevent this from happening , the Constitution of the United States specifies in Article , Section The Congress shall have Power . To Promote the Progress of Science and Useful Arts , by securing for limited Times to Authors and Inventors the Exclusive Right to their Writings and Congress used this power to create the Patent and Trademark Office , as well as the . Copyright Office . A patent gives the inventor the exclusive legal right to make , use , or sell the invention for a limited time in the United States , exclusive patent rights last for 20 years . The idea is to provide limited monopoly power so that innovative firms can recoup their investment in , but then to allow other firms to produce the product more cheaply once the patent expires . A trademark is an identifying symbol or name for a particular good , like Chiquita bananas , Chevrolet

350 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER cars , or the Nike swoosh that appears on shoes and athletic gear . Roughly million trademarks are registered with the government . A firm can renew a trademark over and over again , as long as it remains in active use . A copyright , according to the . Copyright Office , is a form of protection provided by the laws of the United States for original works of authorship including literary , dramatic , musical , cartographic , choreographic , pantomimic , pictorial , graphic , sculptural , and audiovisual No one can reproduce , display , or perform a copyrighted work without permission of the author . Copyright protection ordinarily lasts for the life of the author plus 70 years . Roughly speaking , patent law covers inventions and copyright protects books , songs , and art . But in certain areas , like the invention of new software , it has been unclear whether patent or copyright should apply . There is also a body of law known as trade secrets . Even if a company does not have a patent on an invention , competing firms are not allowed to steal their secrets . One famous trade secret is the formula for , which is not protected under copyright or patent law , but is simply kept secret by the company . Taken together , this combination of patents , trademarks , copyrights , and trade secret law is called intellectual property , because it implies ownership over an idea , concept , or image , not a physical piece of property like a house or a car . Countries around the world have enacted laws to protect intellectual property , although the time periods and exact provisions of such laws vary across tries . There are ongoing negotiations , both through the World Intellectual Property Organization ( and through international treaties , to bring greater harmony to the intellectual property laws of different countries to determine the extent to which patents and copyrights in one country will be respected in other countries . Government limitations on competition used to be even more common in the United States . For most of the twentieth century , only one phone legally allowed to provide local and long distance service . From the 19305 to the , one set of federal regulations limited which airlines could choose to to and what fares they could charge another set of regulations limited the interest rates that banks could pay to depositors yet another specified what trucking firms could charge customers . What products are considered utilities depends , in part , on the available technology . Fifty years ago , local and long distance telephone service was provided over wires . It did not make much sense to have multiple companies building multiple systems of wiring across towns and across the country . AT lost its monopoly on long distance service when the technology for providing phone service changed from wires to microwave and satellite transmission , so that multiple firms could use the same mission mechanism . The same thing happened to local service , especially in recent years , with the growth in cellular phone systems . The combination of improvements in production technologies and a general sense that the markets could provide services adequately led to a wave of deregulation , starting in the late and into the . This wave eliminated or reduced government restrictions on the firms that could enter , the prices that could be charged , and the quantities that could be produced in many industries , including telecommunications , airlines , trucking , banking , and electricity . Around the world , from Europe to Latin America to Africa and Asia , many governments continue to

PRINCIPLES or ECONOMICS 351 control and limit competition in what those governments perceive to be key industries , including lines , banks , steel companies , oil companies , and telephone companies . Visit this website for examples of some pretty bizarre patents . COLLEGE ' El INTIMIDATING POTENTIAL COMPETITION Businesses have developed a number of schemes for creating barriers to entry by deterring potential competitors from entering the market . One method is known as predatory pricing , in which a firm uses the threat of sharp price cuts to discourage competition . Predatory pricing is a violation of antitrust law , but it is difficult to prove . Consider a large airline that provides most of the between two particular cities . A new , small airline decides to offer service between these two cities . The large airline immediately slashes prices on this route to the bone , so that the new entrant can not make any money . After the new entrant has gone out of business , the incumbent firm can raise prices again . After this pattern is repeated once or twice , potential new entrants may decide that it is not wise to try to compete . Small airlines often accuse larger airlines of predatory pricing in the early , for example , accused Delta of predatory pricing , Frontier accused United , and Reno Air accused Northwest . In 2015 , the Justice Department ruled against American Express and Mastercard for imposing restrictions on retailers who encouraged customers to use lower swipe fees on credit actions . In some cases , large advertising budgets can also act as a way of discouraging the competition . If the only way to launch a successful new national cola drink is to spend more than the promotional gets of and Pepsi Cola , not too many companies will try . A firmly established brand name can be difficult to dislodge . SUMMING UP BARRIERS TO ENTRY Table lists the barriers to entry that have been discussed here . This list is not exhaustive , since firms have proved to be highly creative in inventing business practices that discourage competition . When barriers to entry exist , perfect competition is no longer a reasonable description of how an industry works . When barriers to entry are high enough , monopoly can result .

352 Barrier to Entry Natural monopoly Control of a physical resource Legal monopoly Patent , trademark , and copyright potential competitors ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Government Role ?

Example Government often responds with regulation ( or Water and electric Companies ownership ) No for diamonds Yes Post office , past regulation of airlines and trucking Yes , through protection of intellectual property New drugs or software Predatory pricing brand names Somewhat Table . Barriers to Entry KEY CONCEPTS AND SUMMARY Barriers to entry prevent or discourage competitors from entering the market . These barriers include economies of scale that lead to natural monopoly control of a physical resource legal restrictions on competition patent , trademark and copyright protection and practices to intimidate the like predatory pricing . Intellectual property refers to legally guaranteed ownership of an idea , rather than a physical item . The laws that protect intellectual property include patents , copyrights , trademarks , and trade secrets . A natural monopoly arises when economies of scale persist over a large enough range of output that if one firm supplies the entire market , no other firm can enter without facing a cost disadvantage . SELF ' QUESTIONS enforced , Classify the following as a barrier to entry , a barrier to entry that is not or a situation that does not involve a barrier to entry . A patented invention A popular but easily copied restaurant recipe An industry Where economies of scale are very small compared to the size of demand in the market A reputation for slashing prices in response to new entry A brand name that has been carefully built up over many years Classify the following as a barrier to entry , a barrier to entry that is not enforced , or a situation that does not involve a barrier to entry . A city passes a law on how many licenses it will issue for taxicabs A city passes a law that all taxicab drivers must pass a driving safety test and have insurance A trademark Owning a spring that offers very pure water An industry Where economies of scale are very large compared to the size of demand in the market . Suppose the local electrical utility , a legal monopoly based on economies of scale , was split into four firms of

353 PRINCIPLES OF ECONOMICS equal size , with the idea that eliminating the monopoly would promote competitive pricing of electricity . What do you anticipate would happen to prices ?

If Congress reduced the period of patent protection from 20 years to 10 years , What would likely happen to the amount of private research and development ?

REVIEW QUESTIONS ! How is monopoly different from perfect competition ?

What is a barrier to entry ?

Give some examples . What is a natural monopoly ?

What is a legal monopoly ?

What is predatory pricing ?

How is intellectual property different from other property ?

By what legal mechanisms is intellectual property protected ?

In what sense is a natural monopoly natural ?

CRITICAL THINKING QUESTIONS does not have the monopoly power it once had . How do you suppose their barriers to entry were weakened ?

Why are generic pharmaceuticals significantly cheaper than name brand ones ?

For many years , the justice Department has tried to break up large firms like IBM , and most recently Google , on the grounds that their large market share made them essentially monopolies . In a global market , where firms compete with firms from other countries , would this policy make the same sense as it might in a purely domestic context ?

Intellectual property laws are intended to promote innovation , but some economists , such as Milton , have argued that such laws are not desirable . In the United States , there is no intellectual property protection for food recipes or for fashion designs . Considering the state of these two industries , and bearing in mind the discussion of the inefficiency of monopolies , can you think of any reasons why intellectual property laws might hinder innovation in some cases ?

PROBLEMS Return to Figure . Suppose is 10 and is 11 . Suppose a new firm with the same curve as the incumbent tries to break into the market by selling units of output . Estimate from the graph what the new firm average cost of producing output would be . If the incumbent continues to produce units , how much output would be supplied to the market by the two firms ?

Estimate What would happen to the market price as a result of the supply of both the incumbent firm and the new entrant . Approximately how much profit would each firm earn ?

354 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER barriers to entry the legal , technological , or market forces that may discourage or prevent potential competitors from entering a market copyright a form of legal protection to prevent copying , for commercial purposes , original Works of authorship , including books and music deregulation removing government controls over setting prices and quantities in certain industries intellectual property the body of law including patents , trademarks , copyrights , and trade secret law that protect the right of inventors to produce and sell their inventions legal monopoly legal prohibitions against competition , such as regulated monopolies and intellectual property protection monopoly a situation in which one firm produces all of the output in a market natural monopoly economic conditions in the industry , for example , economies of scale or control of a critical resource , that limit effective competition patent a government rule that gives the inventor the exclusive legal right to make , use , or sell the invention for a limited time predatory pricing when an existing firm uses sharp but temporary price cuts to discourage new competition trade secrets methods of production kept secret by the producing firm trademark an identifying symbol or name for a particular good and can only be used by the firm that registered that trademark SOLUTIONS Answers to Questions a . A patent is a barrier to entry . This is not a barrier to entry . This is not a barrier to entry . This is a barrier to entry , but it is not . This is a barrier to entry , but it is not directly government enforced . a . This is a barrier to entry . This is an example of a government law , but perhaps it is not much of a barrier to entry if most people can pass the safety test and get insurance . Trademarks are enforced by government , and therefore are a barrier to entry . This is probably not a barrier to entry , since there are a number of different Ways of getting pure water . This is a barrier to entry , but it is not . Because of economies of scale , each firm would produce at a higher average cost than before . They would each have to build their own power lines . As a result , they would each have to raise prices to cover their higher costs . The policy would fail . Shorter patent protection would make innovation less lucrative , so the amount of research and development would likely decline .

HOW A MONOPOLY CHOOSES OUTPUT AND PRICE LEARNING By the end of this section , you will be able to Explain the perceived demand curve for a perfect competitor and a monopoly Analyze a demand curve for a monopoly and determine the output that maximizes profit and revenue Calculate marginal revenue and marginal cost Explain efficiency as it pertains to the efficiency of a monopoly a monopoly firm , comfortably surrounded by barriers to entry so that it need not fear competition from other producers . How will this monopoly choose its quantity of output , and what price will it charge ?

Profits for the monopolist , like any firm , will be equal to total revenues minus total costs . The pattern of costs for the monopoly can be analyzed within the same framework as the costs of a perfectly competitive is , by using total cost , fixed cost , variable cost , marginal cost , average cost , and average variable cost . However , because a monopoly faces no competition , its situation and its decision process will differ from that of a competitive firm . The Clear it Up feature discusses how hard it is sometimes to define market in a monopoly situation . DEMAND CURVES PERCEIVED BY A PERFECTLY COMPETITIVE FIRM AND BY A MONOPOLY A perfectly competitive firm acts as a price taker , so its calculation of total revenue is made by taking the given market price and multiplying it by the quantity of output that the firm chooses . The demand curve as it is perceived by a perfectly competitive firm appears in Figure ( a ) The perceived demand curve means that , from the viewpoint of the perfectly competitive firm , it could sell either a relatively low quantity like or a relatively high quantity like at the market price WHAT DEFINES THE MARKET ?

A monopoly is a firm that sells all or nearly all of the goods and services in a given market . But What defines the market ?

In a famous 1947 case , the federal government accused the DuPont company of having a monopoly in the cellophane ket , pointing out that DuPont produced 75 of the cellophane in the United States . DuPont countered that even though it had a 75 market share in cellophane , it had less than a 20 share of the packaging materials , which includes

356 Perceived demand Price ( 01 Oh Quantity ( a ) Perceived demand for a perfect competitor ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Price ( 13 I Perceived . I I demand I 01 Oh Quantity ( Perceived demand for a monopolist Figure . The Perceived Demand Curve for a Perfect Competitor and a Monopolist . a ) A perfectly competitive firm perceives the demand curve that it faces to be . The flat shape means that the firm can sell either a low quantity ( or a high quantity ( at exactly the same price ( A monopolist perceives the demand curve that it faces to be the same as the market demand curve , which for most goods is . Thus , if the monopolist chooses a high level of output ( it can charge only a relatively low price ( conversely , if the monopolist chooses a low level of output ( it can then charge a higher price ( The challenge for the monopolist is to choose the combination of price and quantity that maximizes profits . all other papers , films , and foils . In 1956 , after years of legal appeals , the US . Supreme Court held that the broader market definition was more appropriate , and the case against DuPont was dismissed . Questions over how to define the market continue today . True , in the had a dominant share of the Ware for computer operating systems , but in the total market for all computer software and services , including everything from games to scientific programs , the share was only about 14 in 2014 . The Greyhound bus company may have a on the market for intercity bus transportation , but it is only a small share of the market for intercity transportation if that market includes private cars , airplanes , and railroad service . has a monopoly in diamonds , but it is a much smaller share of the total market for precious gemstones and an even smaller share of the total market for jewelry . A small town in the country may have only one gas station is this gas station a monopoly , or does it compete with gas stations that might be five , 10 , or 50 miles away ?

In general , if a firm produces a product without close substitutes , then the firm can be considered a monopoly producer in a single market . But if buyers have a range of if not available from other firms , then the firm is not a monopoly . Still , arguments over Whether substitutes are close or not close can be controversial . While a monopolist can charge any price for its product , that price is nonetheless constrained by demand for the firms product . No monopolist , even one that is thoroughly protected by high barriers to entry , can require consumers to purchase its product . Because the monopolist is the only firm in the market , its demand curve is the same as the market demand curve , which is , unlike that for a competitive firm , Figure illustrates this situation . The monopolist can either choose a point like with a low price ( and high quantity ( or a point like with a high price ( and a low quantity ( or some intermediate point . Setting the price too high will result in a low quantity sold , and will not bring in

PRINCIPLES OF ECONOMICS 357 much revenue . Conversely , setting the price too low may result in a high quantity sold , but because of the low price , it will not bring in much revenue either . The challenge for the monopolist is to strike a balance between the price it charges and the quantity that it sells . But why the perfectly competitive firm demand curve also the market demand curve ?

See the following Clear it Up feature for the answer to this question . WHAT IS THE DIFFERENCE BETWEEN PERCEIVED DEMAND AND MARKET DEMAND ?

The demand curve as perceived by a perfectly competitive firm is not the overall market demand curve for that product . However , the firm demand curve as perceived by a monopoly is the same as the market demand curve . The reason for the difference is that each perfectly competitive firm perceives the demand for its products in a market that includes many other firms in effect , the demand curve perceived by a perfectly competitive firm is a tiny slice of the entire market demand curve . In contrast , a monopoly perceives demand for its product in a market where the monopoly is the only producer . TOTAL COST AND TOTAL REVENUE FORA MONOPOLIST Profits for a monopolist can be illustrated with a graph of total revenues and total costs , as shown with the example of the hypothetical firm in Figure . The total cost curve has its typical shape that is , total costs rise and the curve grows steeper as output increases . Total cost I I ' 3000 . Total revenue 2000 Total Revenue ( I I I I Quantity Figure . Total Revenue and Total Cost for the Monopoly . Total revenue for the monopoly firm called first rises , then falls . Low levels of output bring in relatively little total revenue , because the quantity is low . High levels of output bring in relatively less revenue , because the high quantity pushes down the market price . The total cost curve is . Profits will be highest at the quantity of output where total revenue is most above total cost . Of the choices in Table , the highest profits happen at an output of . The level of output is not the same as the level of output , which should make sense , because profits take costs into account and revenues do not .

353 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Quantity Total Cost Quantity Price Total Revenue Profit Total Revenue Total Cost 400 800 900 800 800 500 700 600 500 Table . Total Costs and Total Revenues of To calculate total revenue for a monopolist , start with the demand curve perceived by the monopolist . Table shows quantities along the demand curve and the price at each quantity demanded , and then calculates total revenue by multiplying price times quantity at each level of output . In this example , the output is given as , and so on , for the sake of simplicity . If you prefer a dash of greater ism , you can imagine that these output levels and the corresponding prices are measured per or pills . As the figure illustrates , total revenue for a monopolist rises , out , and then falls . In this example , total revenue is highest at a quantity of or . Clearly , the total revenue for a monopolist is not a straight line , in the way that total revenue was for a perfectly competitive firm . The different total revenue pattern for a monopolist occurs because the quantity that a monopolist chooses to produce affects the market price , which was not true for a perfectly competitive firm . If the monopolist charges a very high price , then quantity demanded drops , and so total revenue is very low . If the monopolist charges a very low price , then , even if quantity demanded is very high , total revenue will not add up to much . At some intermediate level , total revenue will be highest . However , the monopolist is not seeking to maximize revenue , but instead to earn the highest possible profit . Profits are calculated in the final row of the table . In the example in Figure , the highest profit will occur at the quantity where total revenue is the farthest above total cost . Of the choices given in the table , the highest profits occur at an output of , where profit is 800 . MARGINAL REVENUE AND MARGINAL COST FORA MONOPOLIST In the real world , a monopolist often does not have enough information to analyze its entire total revenues or total costs curves after all , the firm does not know exactly what would happen if it were to alter production dramatically . But a monopolist often has fairly reliable information about how changing output by small or moderate amounts will affect its marginal revenues and marginal costs , because it has had experience with such changes over time and because modest changes are easier to extrapolate from current experience . A monopolist can use information on marginal revenue and marginal cost to seek out the combination of quantity and price . The first four columns of Table use the numbers on total cost from the example in the previous exhibit and calculate marginal cost and average cost . This monopoly faces a typical sloping marginal cost curve , as shown in Figure . The second four columns of Table use the total revenue information from the previous exhibit and calculate marginal revenue .

PRINCIPLES OF ECONOMICS 359 Notice that marginal revenue is zero at a quantity of , and turns negative at quantities higher than . It may seem counterintuitive that marginal revenue could ever be zero or negative after all , does an increase in quantity sold not always mean more revenue ?

For a perfect competitor , each unit sold brought a positive marginal revenue , because marginal revenue was equal to the given market price . But a monopolist can sell a larger quantity and see a decline in total revenue . When a monopolist increases sales by one unit , it gains some marginal revenue from selling that extra unit , but also loses some marginal revenue because every other unit must now be sold at a lower price . As the quantity sold becomes higher , the drop in price affects a greater quantity of sales , eventually ing a situation where more sales cause marginal revenue to be negative . cost . revenue , 000 , I ' 800 I . 500 a 400 , 200 I I I I I Quantity Figure . Marginal Revenue and Marginal Cost for the Monopoly . For a monopoly like , marginal revenue decreases as additional units are sold . The marginal cost curve is . The choice for the monopoly will be to produce at the quantity where marginal revenue is equal to marginal cost that is , If the monopoly produces a lower quantity , then at those levels of output , and the firm can make higher profits by expanding output . If the firm produces at a greater quantity , then , and the firm can make higher profits by reducing its quantity of output .

360 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Cost Information Revenue Information Quantity Average Cost Quantity Price 300 900 400 733 800 600 700 900 600 700 700 800 400 700 700 700 200 800 600 925 500 Table . Costs and Revenues of A monopolist can determine its price and quantity by analyzing the marginal and marginal costs of producing an extra unit . If the marginal revenue exceeds the marginal cost , then the firm should produce the extra unit . For example , at an output of in Figure , marginal revenue is 800 and marginal cost is 400 , so this unit will clearly add to overall profits . At an output of , marginal revenue is 600 and cost is 600 , so producing this unit still means overall profits are unchanged . However , expanding output from to would involve a marginal revenue of 400 and a marginal cost of 700 , so that fifth unit would actually reduce profits . Thus , the monopoly can tell from the marginal revenue and cost that of the choices given in the table , the level of output is . Indeed , the monopoly could seek out the level of output by increasing quantity by a small amount , calculating marginal revenue and marginal cost , and then either increasing output as long as marginal revenue exceeds marginal cost or reducing output if marginal cost exceeds revenue . This process works without any need to calculate total revenue and total cost . Thus , a monopoly should follow the rule of producing up to the quantity where marginal revenue is equal to marginal is , MAXIMIZING PROFITS If you find it counterintuitive that producing where marginal revenue equals marginal cost will maximize profits , working through the numbers will help . Step . Remember that marginal cost is defined as the change in total cost from producing a small amount of additional output . change in total cost change in quantity produced Step . Note that in Table , as output increases from to units , total cost increases from 1500 to 1800 . As a result , the marginal cost of the second unit will be 1800 1500 300

PRINCIPLES or ECONOMICS 361 Step . Remember that , similarly , marginal revenue is the change in total revenue from selling a small amount of additional output . change in total revenue change sold Step . Note that in Table , as output increases from to units , total revenue increases from 1200 to 2200 . As a result , the marginal revenue of the second unit will be 22 12 00 00 1000 Quantity Marginal Revenue Marginal Cost Marginal Profit Total Profit 300 700 400 800 400 400 800 600 600 800 400 700 500 200 700 Table . Marginal Revenue , Marginal Cost , Marginal and Total Profit Table repeats the marginal cost and marginal revenue data from Table , and adds two more columns Marginal profit is the profitability of each additional unit sold . It is defined as marginal revenue minus marginal cost . Finally , total profit is the sum of marginal profits . As long as marginal profit is positive , producing more output will increase total profits . When marginal profit turns , producing more output will decrease total profits . Total profit is maximized where marginal revenue equals marginal cost . In this example , maximum profit occurs at units of output . A perfectly competitive firm will also find its level of output where . The key difference with a perfectly competitive firm is that in the case of perfect competition , marginal revenue is equal to price ( while for a monopolist , marginal revenue is not equal to the price , because changes in quantity of output affect the price . ILLUSTRATING MONOPOLY PROFITS It is straightforward to calculate profits of given numbers for total revenue and total cost . However , the size of monopoly profits can also be illustrated graphically with Figure , which takes the marginal cost and marginal revenue curves from the previous exhibit and adds an average cost curve and the perceived demand curve . Figure illustrates the process where a monopolist selects the quantity to produce decides what price to charge determines total revenue , total cost , and profit . Step The Monopolist Determines Its Level of Output

362 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER . 800 600 400 200 cost Total Average cost Demand revenue Marginal Reven ue I I I I Figure . Illustrating Profits at the Monopoly . This figure begins with the same marginal revenue and marginal cost curves from the monopoly presented in Figure . It then adds an average cost curve and the demand curve faced by the monopolist . The firm first chooses the quantity where in this example , the quantity is . The monopolist then decides what price to charge by looking at the demand curve it faces . The large box , with quantity on the horizontal axis and marginal revenue on the vertical axis , shows total revenue for the firm . Total costs for the firm are shown by the box , which is quantity on the horizontal axis and marginal cost of production on the vertical axis . The large total revenue box minus the smaller total cost box leaves the darkly shaded box that shows total profits . Since the price charged is above average cost , the firm is earning positive profits . The firm can use the points on the demand curve to calculate total revenue , and then , based on total revenue , calculate its marginal revenue curve . The quantity will occur where at the last possible point before marginal costs start exceeding marginal revenue . On ure , occurs at an output of . Step The Monopolist Decides What Price to Charge The monopolist will charge what the market is willing to pay . A dotted line drawn straight up from the quantity to the demand curve shows the price . This price is above the average cost curve , which shows that the firm is earning profits . Step Calculate Total Revenue , Total Cost , and Profit Total revenue is the overall shaded box , where the width of the box is the quantity being sold and the height is the price . In Figure , the bottom part of the shaded box , which is shaded more lightly , shows total costs that is , quantity on the horizontal axis multiplied by average cost on the vertical axis . The larger box of total revenues minus the smaller box of total costs will equal profits , which is shown by the darkly shaded box . In a perfectly competitive market , the forces of entry would erode this profit in the long run . But a monopolist is protected by barriers to entry . In fact , one telltale sign of a

PRINCIPLES OF ECONOMICS 363 monopoly is when a firm earns profits year after year , while doing more or less the same thing , without ever seeing those profits eroded by increased competition . Step Look at demand curve to see what prIce to charge cost Average , cost I ( I Demand I , Step revenue Quantity Figure . How a Monopoly Decides Price In Step , the monopoly chooses the level of output , by choosing the quantity where . In Step , the monopoly decides how much to charge for output level by drawing a line straight up from to point on its perceived demand curve . Thus , the monopoly will charge a price ( In Step , the monopoly identifies its profit . Total revenue will be multiplied by . Total cost will be multiplied by the average cost of producing , which is shown by point on the average cost curve to be . Profits will be the total revenue rectangle minus the total cost rectangle , shown by the shaded zone in the figure . WHY IS A MONOPOLIST MARGINAL REVENUE ALWAYS LESS THAN THE PRICE ?

The marginal revenue curve for a monopolist always lies beneath the market demand curve . To understand why , think about increasing the quantity along the demand curve by one unit , so that you take one step down the demand curve to a slightly higher quantity but a slightly lower price . A demand curve is not sequential It is not that first we sell at a higher price , and then we sell at a lower price . Rather , a demand curve is conditional If we charge the higher price , we would sell . If , instead , we charge a lower price ( on all the units that we sell ) we would sell . So when we think about increasing the quantity sold by one unit , marginal revenue is affected in two ways . First , we sell one additional unit at the new market price . Second , all the previous units , which could have been sold at the higher price , now sell for less . Because of the lower price on all units sold , the marginal revenue of selling a unit is less than the price of that the marginal revenue curve is below the demand curve . Tip For a demand curve , and demand have the same vertical intercept . As output increases , marginal revenue decreases twice as fast as demand , so that the horizontal intercept of is halfway to the horizontal intercept of demand . You can see this in the Figure .

364 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Demand Revenue Figure . The Monopolist Marginal Revenue Curve versus Demand Curve . Because the market demand curve is conditional , the marginal revenue curve for a monopolist lies beneath the demand curve . THE INEFFICIENCY OF MONOPOLY Most people criticize monopolies because they charge too high a price , but what economists object to is that monopolies do not supply enough output to be efficient . To understand why a monopoly is inefficient , it is useful to compare it with the benchmark model of perfect competition . efficiency is a social concept . It refers to producing the optimal quantity of some output , the quantity where the marginal benefit to society of one more unit just equals the marginal cost . The rule of profit maximization in a world of perfect competition was for each firm to produce the of output where , where the price ( is a measure of how much buyers value the good and the marginal cost ( is a measure of what marginal units cost society to produce . Following this rule assures efficiency . If , then the marginal benefit to society ( as measured by ) is greater than the marginal cost to society of producing additional units , and a greater quantity should be produced . But in the case of monopoly , price is always greater than marginal cost at the maximizing level of output , as can be seen by looking back at Figure . Thus , consumers will suffer from a monopoly because a lower quantity will be sold in the market , at a higher price , than would have been the case in a perfectly competitive market . The problem of inefficiency for monopolies often runs even deeper than these issues , and also involves incentives for efficiency over longer periods of time . There are incentives here . On one side , firms may strive for new inventions and new intellectual property because they want to become monopolies and earn high least for a few years until the competition catches up . In this way , monopolies may come to exist because of competitive pressures on firms . However , once a barrier to entry is in place , a monopoly that does not need to fear competition can just produce the same old products in the same old still ringing up a healthy rate of profit . john Hicks , who won the Nobel Prize for economics in 1972 , wrote in 1935 The best of all oly profits is a quiet He did not mean the comment in a complimentary way . He meant that monopolies may bank their profits and slack off on trying to please their customers .

PRINCIPLES or ECONOMICS 365 When AT provided all of the local and phone service in the United States , along with manufacturing most of the phone equipment , the payment plans and types of phones did not change much . The old joke was that you could have any color phone you wanted , as long as it was black . But in 1982 , AT was split up by government litigation into a number of local phone companies , a phone company , and a phone equipment manufacturer . An explosion of innovation lowed . Services like call waiting , caller ID , calling , voice mail though the phone company , mobile phones , and wireless connections to the Internet all became available . A wide range of ment plans was offered , as well . It was no longer true that all phones were black instead , phones came in a wide variety of shapes and colors . The end of the telephone monopoly brought lower prices , a greater quantity of services , and also a wave of innovation aimed at attracting and pleasing customers . THE REST IS HISTORY In the opening case , the East India Company and the Confederate States were presented as a monopoly or near monopoly provider of a good . Nearly every American schoolchild knows the result of the unwelcome visit the ' bestowed upon Boston Harbor Boston Tea Party . Regarding the cotton industry , we also know Great Britain remained neutral during the Civil War , taking neither side during the . Did the monopoly nature of these business have unintended and historical consequences ?

Might the American Revolution have been deterred , if the East India Company had sailed the ships back to England ?

Might the southern states have made different decisions had they not been so confident King Cotton would force diplomatic recognition of the Confederate States of America ?

Of course , it is not possible to definitively answer these questions after all we can not roll back the clock and try a different scenario . We can , however , consider the monopoly nature of these businesses and the roles they played and hypothesize about what might have occurred under different circumstances . Perhaps if there had been legal free tea trade , the colonists would have seen things differently there was smuggled Dutch tea in the colonial market . If the colonists had been able to freely purchase Dutch tea , they would have paid lower prices and avoided the tax . What about the cotton monopoly ?

With one in five jobs in Great Britain depending on Southern cotton and the ate States nearly the sole provider of that cotton , why did Great Britain remain neutral during the Civil War ?

At the ning of the war , Britain simply drew down massive stores of cotton . These stockpiles lasted until near the end of 1862 . Why did Britain not recognize the Confederacy at that point ?

Two reasons The Emancipation Proclamation and new sources of cotton . Having outlawed slavery throughout the United Kingdom in 1833 , it was politically impossible for Great Britain , empty cotton Warehouses or not , to recognize , diplomatically , the Confederate States . In addition , during the two years it took to draw down the stockpiles , Britain expanded cotton imports from India , Egypt , and Brazil . Monopoly sellers often see no threats to their superior marketplace position . In these examples did the power of the monopoly blind the decision makers to other possibilities ?

Perhaps . But , as they say , the rest is history . KEY CONCEPTS AND SUMMARY A monopolist is not a price taker , because when it decides what quantity to produce , it also determines the market price . For a monopolist , total revenue is relatively low at low quantities of output , because not much is being sold . Total revenue is also relatively low at very high quantities of output , because a very high quantity will sell only at a low price . Thus , total revenue for a monopolist will start low , rise , and then decline . The marginal revenue for a monopolist from selling additional units will decline . Each additional unit sold by a monopolist will push down the overall market price , and as more units are sold , this lower price applies to more and more units . The monopolist will select the level of output where , and then charge

366 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER the price for that quantity of output as determined by the market demand curve . If that price is above average cost , the monopolist earns positive profits . are not productively efficient , because they do not produce at the minimum of the age cost curve . are not efficient , because they do not produce at the quantity where . As a result , produce less , at a higher average cost , and charge a higher price than would a combination of firms in a perfectly competitive industry . also may lack incentives for innovation , because they need not fear entry . SELF CHECK QUESTIONS . Suppose demand for a monopoly product falls so that its price is below average variable cost . How much output should the firm supply ?

Hint Draw the graph . Imagine a monopolist could charge a different price to every customer based on how much he or she were Willing to pay . How would this affect monopoly profits ?

REVIEW QUESTIONS . How is the demand curve perceived by a perfectly competitive firm different from the demand curve perceived by a monopolist ?

How does the demand curve perceived by a monopolist compare with the market demand curve ?

Is a monopolist a price taker ?

Explain . What is the usual shape of a total revenue curve for a monopolist ?

Why ?

What is the usual shape of a marginal revenue curve for a monopolist ?

Why ?

How can a monopolist identify the level of output if it knows its total revenue and total cost curves ?

How can a monopolist identify the level of output if it knows its marginal revenue and marginal costs ?

When a monopolist identifies its quantity of output , how does it decide what price to charge ?

Is a monopolist efficient ?

Why or why not ?

How does the quantity produced and price charged by a monopolist compare to that of a perfectly competitive firm ?

CRITICAL THINKING QUESTIONS . Imagine that you are managing a small firm and thinking about entering the market of a monopolist . The monopolist is currently charging a high price , and you have calculated that you can make a nice profit charging 10 less than the monopolist . Before you go ahead and challenge the monopolist , what possibility should you consider for how the monopolist might react ?

PRINCIPLES OF ECONOMICS 367 . If a monopoly firm is earning profits , how much would you expect these profits to be diminished by entry in the long run ?

PROBLEMS . Draw the demand curve , marginal revenue , and marginal cost curves from Figure , and identify the quantity of output the monopoly wishes to supply and the price it will charge . Suppose demand for the monopoly product increases dramatically . Draw the new demand curve . What happens to the marginal revenue as a result of the increase in demand ?

What happens to the marginal cost curve ?

Identify the new quantity and price . Does the answer make sense to you ?

Draw a monopolist demand curve , marginal revenue , and marginal cost curves . Identify the output level . Now , think about a slightly higher level of output ( say ) According to the graph , is there any consumer willing to pay more than the marginal cost of that new level of output ?

If so , what does this mean ?

REFERENCES , Chapter 20 Girding for War The North and the South , Accessed July , British Parliament . 28 August 183 ) Slavery Abolition Act 18 33 Section . Cotton and the Civil Mississippi Historical Society . Accessed July . 2015 . Says Tablet Sales Continue to Be Slow in Accessed March 12 , David . 2015 . Finds Rule Violates Antitrust ican Booksellers Association . Accessed March 12 , 80 . Massachusetts Historical Society . The Coming of the American Revolution The Boston Tea Retrieved from . Massachusetts Historical Society . Whereas our The Massachusetts Gazette , Accessed July 2013 ?

William . 2015 . Judge Overrules Antitrust Case Against Google , Says Setting Default Search Engines Is Digital Trends . Accessed March 12 , 363 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER efficiency producing the optimal quantity of some output the quantity where the marginal benefit to society of one more unit just equals the marginal cost marginal profit of one more unit of output , computed as marginal revenue minus marginal cost SOLUTIONS Answers to Questions . If price falls below , the firm will not be able to earn enough revenues even to cover its variable costs . In such a case , it will suffer a smaller loss if it shuts down and produces no output . By contrast , if it stayed in operation and produced the level of output Where , it would lose all of its fixed costs plus some variable costs . If it shuts down , it only loses its fixed costs . This scenario is called perfect price discrimination . The result would be that the monopolist would produce more output , the same amount in fact as would be produced by a perfectly competitive industry . However , there would be no consumer surplus since each buyer is paying exactly what they think the product is worth . Therefore , the monopolist would be earning the maximum possible profits .