Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

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Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

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All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

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Chapter 10: Monopoly

Figure 10.1: What do your cell phones have to do with monopolies? [1] ​

FTC Charges Qualcomm With Monopolizing Key Semiconductor Device Used in Cell Phones [1]

“Qualcomm is the world’s dominant supplier of baseband processors – devices that manage cellular communications in mobile products. The FTC alleges that Qualcomm has used its dominant position as a supplier of certain baseband processors to impose onerous and anticompetitive supply and licensing terms on cell phone manufacturers and to weaken competitors."

[...]

"By excluding competitors, Qualcomm impedes innovation that would offer significant consumer benefits, including those that foster the increased interconnectivity of consumer products, vehicles, buildings, and other items commonly referred to as the Internet of Things.”

               -Federal Trade Commission Press Release, January 17, 2017


How Warby Parker successfully disrupted the eyewear monopoly [2]

Figure 10.2: Despite the many brand names, the eyewear industry has been under monopoly control for many years. [2]​

“The company originated from Gilboa’s own personal struggle, after he lost his $700 pair of glasses while backpacking in Southeast Asia before he started grad school at the University of Pennsylvania’s Wharton School of Business. Replacing them would have been so expensive he ended up going through his entire first semester without them.

Gilboa and Blumenthal wanted to offer an alternative to the monopoly of the eyewear industry. Last month, Italy’s dominant optical firm Luxottica – which includes brands like RayBan and Oakley – and leading French lens maker, Essilor, agreed to a $49 billion merger deal to create the global eyewear giant, EssilorLuxottica."

                             -CBS News, February 8, 2017

10.1 Objectives

This chapter is similar to the chapter on competitive markets, with one significant exception. We now turn to markets dominated by a single firm selling a product. The demand in the market is the demand that the single individual firm faces. The amount produced is derived from our discussions of costs for a firm.

After reading this chapter, answering the questions in the text, and doing the exercises, you will be able to:

  • Explain the conditions that produce a monopoly
  • Describe the differences between a competitive firm (and market) and a monopoly and its market.
  • Determine the profit-maximizing level of output for a monopolist.
  • Compare the market results of a monopoly with a competitive industry.
  • Discuss the effects of monopoly on economic efficiency.
  • Compare a natural monopoly with a competitive market.
  • Recommend and evaluate price discrimination by a monopolist.

We have discussed the workings and the wonders of perfect competition and economic efficiency. Now we turn to a scenario where there might not be an efficient allocation of resources. First, we will look at what allows a single firm in a market to survive as the only producer. We then compare the decision-making process for a monopolist to the profit-maximizing behavior of a competitive firm. We will see that a monopolist can earn economic profits and that it will likely, but not always, charge a higher price and produce a lower quantity than a perfectly competitive market. We will then show that economic efficiency is not a characteristic of unregulated monopolies. As a result, governments might regulate monopolies (see Chapter 12: Regulation of Firms with Market Power)  to prevent the emergence of new monopolies. We will then turn to examples where monopolies are beneficial to consumers, in terms of lowering price and increasing innovation. The chapter will end by discussing ways monopolies price discriminate to increase revenue.

10.2   What Is a Monopoly?

Simply speaking, a monopoly is one firm in a market. Examples are difficult to find because monopolies are seldom permitted to exist. Markets and the temptations of profits often eliminate monopolies, but so does government regulation. We will consider why both happen. The model of a monopoly that we will develop in this chapter is most accurate if not only is there only one firm producing a product, but there are also no close substitutes and something prevents other firms from entering the market.

The best examples of monopolies are often local utilities, such as the water, electric, and phone companies. But even that is changing. Cellular phones are provided by a number of companies, each competing for customers. In other areas, electric companies are threatening to compete with one another.

Question 10.01

The Coca-Cola Company is the only producer of Coca-Cola. Is it considered a monopoly?

A

Yes, it is the only firm with the recipe for a real Coca-Cola.

B

Yes, because Coca-Cola has no close substitutes.

C

No, because Coca-Cola has many close substitutes.

10.3   Reasons for Monopolies' Survival

Monopolies exist for a number of reasons. Most often, monopolies arise through legal or economic barriers to entry. In other cases, a firm may own an important resource, giving the firm complete control of production or distribution. We will introduce each of these reasons below and then discuss some of them individually in more detail later in the chapter.

Figure 10.3.: The diamond industry was long controlled by a monopoly. [3]​

First, let’s discuss legal barriers to entry. In some cases, it is in our interest to have only a single firm. Do we really want two or three sets of wires strung around our city to allow two or three phone companies to compete or two or three cable television companies to offer service? In cases like these, cities and states have often granted rights to firms to be the only providers of water, electricity, natural gas, cable television, and telephone service, usually with price controls.

Sometimes legal protection is given to incentivize firms and individuals to create new products, as in the case of patents and copyrights – legal prohibitions on any other firm that might consider producing the product. The drug industry is perhaps the most obvious example of patents protecting the rights of a firm to be the only producer. Drug companies spend large sums of money on research and development. If they were not protected from someone replicating their drug, they would not receive any of the  benefits of their R&D costs.

Economic barriers also lead to monopoly power. If a single firm faces significant economies of scale (average costs of production decrease as they increase production), then that single firm may drive out smaller competitors. Smaller firms will not be able to compete because they will have significantly higher costs. Similarly, if the nature of the industry is such that a huge investment is required to enter the market, that huge investment may indeed be a barrier to potential competition.

It may also be that a firm establishes a monopoly through technical advances that no other firm has matched. Microsoft gained a near monopoly in computer operating systems software by creating better, more effective systems and distributing the results faster than anyone else. Alternatively, a firm may also gain monopoly power by deliberately erecting barriers to entry. Large amounts of advertising or tying products to other products will make it difficult for new firms to enter.

In other instances, a company may become a monopoly by being the only firm with access to a natural resource or a formula. Sometimes that access is a natural event, as in the case of the South Africa diamond monopoly, where De Beers had monopoly control of diamonds for over a hundred years. All of these reasons fall into two primary categories: barriers to entry or cost advantages over small firms. We will discuss many of these factors in more detail later in the chapter.

Question 10.02

What is a reason that monopolies exist?

A

A firm owns a resource that no one else has

B

A firm is given legal protection that prevents another firm from entering

C

A firm naturally drives out competitors through lower prices.

D

All of the above are reasons

10.4   Market Demand and Marginal Revenue

The monopolist faces the demand for the entire market, because, by definition, it is the only firm in the market. The primary analytical difference in the way we look at a monopolist and the manner in which we consider competitive firms originates from this characteristic. Competitive firms are so small that they are "price-takers.” They are given the market price and have no choice. They could raise their prices, but quantity demanded will fall to zero. They could lower their prices, but there is no motivation to do so because they can sell as much as they want at the going market price.

Unlike a perfectly competitive firm, a monopoly decides what price to set and all of the conditions that influence market demand determine the corresponding quantity demanded. A monopoly is then sometimes described as a "price-maker," in contrast with "price-taking" competitive firms. Thus, if the monopolist increases prices, the quantity demanded will fall, but not necessarily to zero. If the price is lowered, the quantity demanded will increase.

Even with this price-setting power, a monopolist will not charge any price, but rather will consider the additional revenue it gains for each level of output and compare it to the additional costs of production to determine the optimal price and quantity.

The effects on the monopolist's revenue from producing more goods are more complicated than they were in our discussions of competitive markets. To sell one more unit of a good, the monopolist must lower the price. The effect of the increased sales on revenues is the gain from the sale of one more good (the new price of the good times the quantity sold) minus the amount of revenue the monopoly loses because it now sells the rest of its production at a lower price. Thus, unlike for a perfectly competitive firm, the marginal revenue is not equal to price.

For example, in Figure 10.4, we can find the marginal revenue (the change in revenue from a change in quantity) by comparing the total revenue earned from selling eight oranges with the total revenue that can be earned from selling nine oranges. Total revenue from producing eight oranges is 8 x $1.01 or $8.08. To sell more, the monopolist must lower the price. So, total revenue when nine oranges are sold is 9 x $1.00 or $9.00. The marginal revenue of the ninth orange is the one dollar gained from selling the ninth orange minus the penny lost on the previous eight oranges sold. Because we subtract an amount from the price, the marginal revenue is always going to be less than the price. The marginal revenue of the ninth orange is the $1.00 gained minus the 8 cents lost = $.92, that is, the price of the new unit sold minus the amounts lost on the first eight units sold.

If the monopolist raises its price, the opposite happens. The new higher price will mean more revenue gained from the higher price – but it means less revenue from the fall in the number of goods sold.

Figure 10.4: Decreasing the price of oranges decreases the revenue by 8 cents for the first 8 oranges and increases the revenue by $1 for the 9th orange sold.​​
Question 10.03

Markets of perfectly competitive firms and monopolies both _________.

A

Have barriers to entry

B

Have downward sloping demand curves

C

Are easy to enter and exit


Question 10.04

If a monopoly is currently selling 20 goods at a price of $10 each and it wants to sell 30 units, it needs to ______________ (increase / decrease / hold constant) the price for all goods it sells.


Question 10.05

Assume that a market is operating in equilibrium. What would happen if the monopoly increased quantity produced but the price did not change?

A

A surplus

B

A shortage

C

People would stop buying from the monopoly altogether

D

None of the above


Question 10.06

Given the following table, calculate total revenue.

question description
Premise
Response
1

A

A

25

2

B

B

24

3

C

C

21

4

D

D

24

5

E

E

9

6

F

F

16

7

G

G

0


Question 10.07

Given the following table and your answers for total revenue in the previous question, calculate marginal revenue.

question description
Premise
Response
1

A

A

1

2

B

B

-1

3

C

C

7

4

D

D

3

5

E

E

9

6

F

F

5


Question 10.08

Given your answers to the previous question, the marginal revenue is ______________ (less than / greater than / equal to) the price at each quantity demanded?

Graphing Question 10.1

Question 10.10

Question 10.10

Explain, in your own words, why marginal revenue for a monopolist declines as output increases.

Hover here to see the hint for Question 10.10.
Click here to see the answer to Question 10.10.

Graphing Question 10.02

10.5 Profit Maximization for a Monopolist

The marginal analysis for monopolistic profit maximization is basically the same as the marginal analysis we used to discuss decision-making for perfectly competitive firms. However, given that the monopoly is facing the market demand curve, the monopoly also faces a marginal revenue curve that is derived from that demand curve.

Unlike for a perfectly competitive firm, there is no market supply curve for a monopolist. The monopolist decides the price to charge or how much to produce, constrained, of course, by the demand conditions and their costs. Alternatively, a competitive firm is given the price and decides how much to produce in response.

If the perfectly competitive firm’s marginal cost of producing one more unit is less than the marginal benefit from selling that unit (the marginal revenue), then the firm should expand production. For a monopolist, if the marginal cost is less than the marginal benefit, the firm should also expand its production. That is because when marginal revenue is greater than the marginal cost, the total revenue for the next unit of production would go up by more than the cost increases, so profits will increase.

Figure 10.5: The monopolist will choose to produce where marginal revenue is equal to marginal cost (quantity is equal to 3) and charge the price that corresponds to the demand curve ($7)​.​

Figure 10.5 shows a demand curve facing a monopoly and the related marginal revenue. We add to that market (and firm) demand curve the marginal cost curve faced by the firm. At an output level of one unit, the marginal revenue of producing one more unit of output is greater than the marginal cost. Economic profits will increase if the firm expands – but the firm should not expand past three. If the firm produces four units, for example, the marginal cost of that last unit of output is greater than the marginal revenue gained. In other words, the firm has lower profits than before by producing that much. The firm should contract back to three units.

This analysis is not any different from what we said about perfectly competitive firms – monopolists will also produce where marginal revenue is equal to marginal cost. There are, however, two distinguishing characteristics. First, the demand curve faced by a monopoly is not the same as its marginal revenue curve so price will not equal marginal revenue, and second, because of barriers to entry, new firms will not enter to drive price to equal the minimum average total cost and eliminate economic profits.

Once the firm decides to produce the profit-maximizing level of output (in this case three units), the firm determines the price to charge. It finds that by considering demand. The market price will be the maximum price the firm can charge while still selling three units. If the firm tried to charge a higher price, it would not be able to sell three units. If the firm charged less but only produced three units, there would be a shortage.

Profit is Total Revenue (price x quantity) minus Total Cost. Therefore, economic profit per unit produced is the difference between that price and average total cost. Total economic profit is that difference multiplied by the number produced (three in this case).

A monopoly will always be producing where marginal revenue is positive. Otherwise, it would mean that as the firm decreased the price, revenue would decrease. Meanwhile, an increase in output would also result in an increase in cost. Therefore, the firm’s profits would necessarily be falling as revenue is decreasing and costs are increasing. Additionally, if a firm is profit-maximizing, they will set marginal revenue equal to marginal cost and marginal cost has to be positive, so marginal revenue must be too.

Question 10.11

Question 10.11

"It has been said that a monopolist charges the highest price the market will bear." Is that true? Why or why not?

Hover here to see the hint for Question 10.11.
Click here to see the answer to Question 10.11.

Look at the table below. It shows a demand schedule and asks you to calculate marginal revenues. The table then shows total cost at each level of output. Calculate marginal revenue and then choose a profit-maximizing rate of output. Finally, calculate economic profits to prove that your choice is correct. Use this table to answer the following two questions.

Question 10.12

The level of output where marginal revenue is less than marginal cost is at any quantity greater than or equal to _______.

question description
A

0

B

1

C

2

D

3

E

4


Question 10.13

The firm should produce at what quantity so that marginal revenue is not less than marginal cost and profits are at their maximum point?

A

0

B

1

C

2

D

3

E

4


Question 10.14

Question 10.14

In your own words, explain why a firm should produce where marginal revenue is equal to marginal cost (or as close to equal as possible).

Hover here to see the hint for Question 10.14.
Click here to see the answer to Question 10.14.

Question 10.15

Think back to our discussions of changes in total revenue and price and how the concept of elasticity was used. When a firm decreases price and demand is elastic, the percentage change in quantity demanded will be A) ______________ (greater than / less than) the percentage change in price. Therefore, revenue will B) ______________ (increase / decrease). If the demand is inelastic, total revenue will C) ______________ (increase / decrease) when price decreases.

Premise
Response
1

A

A

Increase

2

B

B

Greater than

3

C

C

Less than

D

Increase

E

Decrease

F

Decrease


Question 10.16

A profit-maximizing monopolist produces where marginal cost is equal to ________.

A

Price

B

Marginal revenue

C

0

D

The minimum


Question 10.17

Marginal cost is always positive; therefore, marginal revenue at the profit-maximizing output will have to be ________.

A

Negative

B

Positive

C

Equal to 0


Question 10.18

Marginal revenue is only positive when demand is _______.

A

Elastic

B

Inelastic

C

Neither elastic nor inelastic


Question 10.19

Given your answers to the previous questions, a monopolist will produce on the portion of the demand curve that is _______.

A

Elastic

B

Inelastic

C

Perfectly elastic

D

Either elastic or inelastic

Question 10.20

Question 10.20

In your own words, why does a monopoly always produce where demand is elastic? Or is it inelastic? Explain which is correct and why.

Hover here to see the hint for Question 10.20.
Click here to see the answer to Question 10.20.

Graphing Question 10.03

Graphing Question 10.04


Graphing Question 10.05

10.6 Economic Profit for a Monopolist

At this point, you should ask yourself what would happen in a competitive market. Competitors would be attracted by the existence of economic profits. The entrance of firms would drive prices down until they equal average total cost and no more economic profits would be earned. Does that happen here?

No, it does not. Remember that this is a monopoly. There must be some type of barrier to entry. Firms cannot enter. Thus, a huge difference between firms in a competitive markets and monopolists is that the monopolist can continue to earn economic profits.

As we discussed, a monopoly will produce the quantity where marginal revenue equals marginal cost. Given that quantity, they will then charge the price people are willing to pay. See (Figure 10.6). At the quantity produced in the figure, the price is greater than the average total cost of producing that quantity. In other words, the revenue (price * quantity) is greater than the cost (average total cost * quantity), so the firm is making a profit (See Figure 10.6). However, unlike in the perfectly competitive market, other firms will not be able to enter – which would lead to a lowering of the price.

In the chapter on Regulation of Firms with Market Power, we will discuss government price controls which may limit monopolies such as utilities from making an economic profit.

Figure 10.6: In this figure, we see a monopoly that is making a positive profit because price is greater than average cost. ​


Question 10.21

Why do barriers to entry allow a monopolist to make positive economic profits?

A

It causes the monopoly to have lower costs.

B

Otherwise, firms would enter the market, resulting in a decrease in price and profits.

C

It allows the monopoly to be price-takers.

D

It does not need a barrier to entry because of the market demand.


Graphing Question 10.06

10.6.1 Economic Losses

While economic profits are maximized when marginal revenue equals marginal cost, there is no guarantee that they will be positive. In Figure 10.7, the firm has higher fixed costs than before. Relative to Figure 10.6, there is no change in marginal cost or demand (or, therefore, marginal revenue). In this instance, however, the average total cost curve lies completely above the demand curve, so no matter the quantity the firm produces; they will always be making a loss. Here, the firm is not able to make a positive economic profit, but they are minimizing their losses (doing the best they can in this industry) where marginal cost equals marginal revenue. In the long run, the firm will leave the industry if average costs or demand do not change, as they could do better in another market.

Figure 10.7: In this figure, we see a monopoly that is making a loss because price is less than average cost. This point of production is still their profit-maximizing point even though it is a loss.


Graphing Question 10.07


Question 10.22

In the long run, a monopolist facing the same cost curves as a perfectly competitive firm will charge a ______________ price than the competitive market and produce a ______________ output.

A

Lower; higher

B

Lower; lower

C

Higher; higher

D

Higher; lower


Question 10.23

Given the following data, what price will a monopolist most likely charge? Average cost and marginal cost are equal to $10 at all levels of output.

question description
A

Less than $8

B

$8

C

$10

D

$12

E

More than $12

10.7 Competitive Markets and Monopoly – How Do They Differ?

Remember that marginal revenue in a monopoly is always less than the price. Additionally, the profit-maximizing monopoly produces a level of output where marginal revenue equals marginal cost. Thus, the monopoly price must always be greater than the marginal cost.

If the marginal cost is the same for the monopolist and the competitive firm, the price in the monopoly must, therefore, be higher than the competitive price. If the market price is higher in the monopoly market, the quantity produced by the monopolist must be less than the quantity produced in the competitive market.

To see this, recall that in competitive markets firms will charge the market price and in the long-run that price will be at the lowest possible average cost (See the chapter on Competitive Markets). In a monopoly, however, there is no guarantee that the firm will produce where average cost is at a minimum. To illustrate this, look at Figure 10.8. If a monopoly owned all of the competitive firms, its marginal cost curve would be the same as the competitive industry's supply curve. Since the monopolist will produce the quantity where the marginal revenue equals the marginal cost and charge the price at which it can sell that amount, it will be at a point where price is higher than the perfectly competitive price.

Figure 10.8: The monopoly price will be greater than the perfectly competitive price in the long-run when costs are the same.​

Monopoly prices will thus be greater than marginal cost. That means that the value people place on the good (as measured by the price that they are willing to pay) is greater than the cost of producing one more unit of output (marginal cost). Society would, therefore, benefit if production were to be increased beyond what the monopolist would produce.

Question 10.24

In the long run, the monopolist's economic profits will be ______________ than the total of the competitive firms' profits.

A

Higher

B

Lower

C

The same


Question 10.25

In the long run, the monopolist ______________ (will/will not) produce a quantity where average cost is at a minimum, whereas the perfectly competitive firm ______________ (will/will not) produce that quantity.

A

Will; will

B

Will; will not

C

Will not; will

D

Will not; will not

10.8 Economic Efficiency

Economic efficiency in a market requires that the market be allocatively and technically efficient. The allocative efficiency requirement means that the right amount of a good or service is being produced – marginal utilities per dollar of resource used are all equal. That result means that prices are equal to marginal costs and consumers are maximizing their own satisfaction. We cannot be better off with different levels of production.

The following question will help you understand how a monopoly is not operating at an allocatively efficient level. Use the following information on a monopoly and perfectly competitive firms to answer the following six questions:

Consider the following monopoly where consumers are currently consuming where the marginal utility is 10 units of utility for the good. The price of the product is $5. The marginal cost of producing the good is $2.00.

Consider the following perfectly competitive firms where consumers are currently consuming where the marginal utility is 20 units of utility for the perfectly competitive product. The price of the product is $10. At current production levels, the marginal cost of producing the good is $10.00.

Question 10.26

Calculate the marginal utility per dollar spent by consumers in a monopolistic industry.

Graphing Question 10.08

Graphing Question 10.09


Question 10.27

Calculate the consumer marginal utility per dollar of marginal cost for the monopoly.


Question 10.28

Calculate the marginal utility per dollar spent by consumers in the perfectly competitive market.


Question 10.29

Is the marginal utility / marginal cost = marginal utility / price for the monopoly?

A

Yes

B

No


Question 10.30

Calculate the consumer marginal utility per dollar of marginal cost for the perfectly competitive firms.


Question 10.31

Is the marginal utility / marginal cost = marginal utility / price for the perfectly competitive firms?

A

Yes

B

No


Question 10.32

The monopoly and perfectly competitive firm are allocatively efficient.

A

True

B

False

Question 10.33

Question 10.33

With a monopoly, marginal cost is less than price. Does that mean too much or too little is produced by a monopoly for allocative efficiency? Why?

Hover here to see the hint for Question 10.33.
Click here to see the answer to Question 10.33.

Monopolies will not necessarily be technically efficient either. Nothing forces them to produce where average cost is a minimum. And, in fact, nothing truly forces a monopoly to hold costs to a minimum at whatever level of output it chooses to produce. If there are goals, other than profit maximization, that are important to the monopolist (such as a relaxed lifestyle or high executive salaries), those costs may not be minimized.

Question 10.34

If a monopoly is producing where price is greater than average cost (and thus making a profit), more firms will enter the market.

A

True

B

False


What we have learned so far:

  • A monopoly price is higher than the price would be in competitive markets, and the quantities produced are lower. (The one exception to this is when there are significant economies of scale – large enough to bring price down below the competitive market price. We will discuss this topic later in the chapter.)
  • Because the price (the marginal benefit to consumers) is greater than the marginal cost at a monopoly’s level of production, society will benefit if production is increased.
  • There are no guarantees that production under a monopoly will be at the lowest possible average cost.
  • In the long run, monopolies may earn economic profits while perfectly competitive firms earn normal profits (that is, zero economic profits).

10.9 When Is a Monopoly Natural?

Monopolies might occur naturally in some markets. If economies of scale are so significant that a single firm can produce output at a lower average cost than is possible for a number of smaller firms, we describe that firm as a natural monopolist. This does not mean that the monopolist has to be a huge company, but it means that it is large relative to the size of the market. A drug store, bank, or grocery store may be able to function as a monopolist in a small town. Two or three firms may not be able to lower costs as much as a single firm producing enough services to satisfy the demand for the entire town.

Figure 10.9 shows a firm's average cost curve that declines throughout relevant output ranges. Several small firms would face average costs of producing that are significantly higher than the average cost for a single firm producing a larger level of output. These lower costs allow the natural monopoly to set a price that would put smaller firms out of business. Thus, just as the name implies, it naturally becomes the only firm in the market.

Figure 10.9: A natural monopoly has economies of scale, meaning their average costs are falling. ​

Question 10.35

Question 10.35

Why does it make little sense to have many small firms when production is characterized by economies of scale?

Hover here to see the hint for Question 10.35.
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Question 10.36

Question 10.36

Suppose firms face increasing returns to scale throughout the range of possible firm sizes. Discuss the advantage and disadvantages, in terms of economic efficiency, of allowing a single firm to dominate the market.

Hover here to see the hint for Question 10.36.
Click here to see the answer to Question 10.36.

Question 10.37

A natural monopolist will face which of the following?

A

The same costs a competitive industry faces

B

Ownership of all of the sources of a natural resource

C

Economies of scale

D

Prices that are higher than average costs, while other monopolists will have average costs that are higher than prices


Question 10.38

Compared to a perfectly competitive market, a natural monopoly will have a.) ______________ (higher / lower / either higher or lower) average costs and may charge a b.)______________ (higher / lower / either higher or lower) price.

Premise
Response
1

A

A

Lower

2

B

B

Either higher or lower

C

Higher

D

Lower

E

Either higher or lower

F

Higher


Figure 10.10: Copyrights give musicians a legal monopoly over their music. [4]​

10.10   Creation of Legal Monopolies

Think of an inventor of a new handheld personal device, or the writer of a new piece of software, or the latest pop singer with a brand new album. What are their incentives to create? 

Question 10.39

Question 10.39

What are the incentives for people to create new inventions, new music, or new books?

Hover here to see the hint for Question 10.39.
Click here to see the answer to Question 10.39.

What if those individuals are creating, writing, and selling albums in a very competitive market? What will likely happen? Think of an initial monopoly – the only owner / producer of a new product. Then think about potential competitors who may not have the costs of developing the product, but only the copying and distribution costs.

The original producer has all of the costs of the invention: writing the software, the book, or the music, or creating the drug. In addition, once the item is produced, they have the costs related to production and distribution. The competitors who copy the product only have the production and distribution costs.

Once a product is produced, competitors can copy and produce the product without having to bear the creative, now fixed,  costs. Competitive pricing drives prices down below the initial levels to a level where the creator cannot make even a normal profit. The original creator may be driven out of the business. The incentives to create, write, and sing are significantly reduced, and the process is made much more difficult.

Question 10.40

Question 10.40

In your own words, what would happen to an inventor of a new product if there was no patent (if it was a competitive market)?

Hover here to see the hint for Question 10.40.
Click here to see the answer to Question 10.40.

Figure 10.11: In the United States, the Department of Commerce awards patents and copyrights. [5]​

10.10.1 Patents and Copyrights

 The solution? One solution is to create a monopoly for the initial developer. Legislation can be passed that prevents the competitors from stepping in and competing with much lower costs. The initial profits can be protected, and in so doing, provide incentives for the developers.

The U.S. Constitution recognized these challenges in a number of situations. The Constitution gave Congress the right to “promote the progress of science and useful arts, by securing for limited times for authors and inventors the exclusive right to their respective writings and discoveries.” In the case of copyrights, that limited time was initially defined as 14 years with the right to one renewal. Since then, the limited time has been significantly expanded – in the case of copyrights, to as much as 95 years from the publication of copyrighted material. For an individual’s copyrights, the time is life plus 70 years.

The most recent extension of time has been cynically labeled as the Mickey Mouse Protection Act – recognizing that the Mickey Mouse logo would have become public property in 2004. Now it will do so in 2024.

Patents fulfill the same role in protecting inventors. The time spans are less – now 20 years from the point of application.

The policy dilemma is how to balance the creation of incentives for initial design and development, the subsequent potential monopoly profits, and the ultimate distribution and use of the work to further stimulate creativity and invention. Policy makers currently face the same dilemma with the prescription drug industry. We want effective drugs to be available to large numbers of people, but at the same time, we grant monopolies to drug companies in order to create sufficient incentives for the creation of the drugs in the first place.

How Mylan, the Maker of EpiPen, Became a Virtual Monopoly [3]

"...A two-pack of the injectors, which release epinephrine to stop an allergic reaction, has risen from less than $100 in 2007 to $608 today."

"...Mylan benefited from factors including failed competitors, patent protections and laws requiring allergy medications in schools. Having a virtual monopoly has facilitated the rapid price hike."

         -Carolyn Y. Johnson and Catherine Ho for The Washington Post, August 25, 2016

10.11 Price Discrimination

Figure 10.12: Ever wondered why firms charge different prices to different consumers?​

Traditional print textbook firms charge different prices to students in different countries. They charge much higher prices to purchases from the United States versus those buying them in Europe. Firms offer coupons, which allows individuals with more time and desire to search through coupons to pay a lower price than those who are not as sensitive to price changes. Similarly, movie theaters (although not pure monopolies) lower ticket prices for senior citizens and children. Cable companies charge businesses more and individual consumers less.

A monopoly may charge different prices for its products to increase revenues. It does this by discriminating among units of output or discriminating between individual types of buyers and is called price discrimination .

Suppose that the monopoly has determined that the profit-maximizing rate of output is 1,000 units. However, it also knows that it has a group of consumers who have an elastic demand and another group that has an inelastic demand at that price. If the firm can, it will raise the price to the consumers with the inelastic demand. The result will be an increase in total revenue from those customers. If possible, the firm will also lower the price to the consumers who have a more elastic demand. Total revenue for this group will also increase. If the firm has adjusted prices for both groups so that total amount demanded has not changed, then costs have not changed, revenues have increased, and thus economic profits have gone up.

Your school uses price discrimination to determine tuition. A university may have a goal of attracting a wide variety of students from all income levels. In order to do so, the university may offer financial aid to ensure that all who are admitted based on abilities can attend. Given the accepted pool, revenues may be increased by raising tuition on those with inelastic demands (wealthier students) and lowering tuition on those with elastic demands. (Alternatively, if the goal is to maximize revenue and a university has a pool of qualified applicants willing to come that is larger than can possibly be accepted, and all have inelastic demands, then it would make sense for the university to raise tuition for all.)

Figure 10.13: Do Universities price discriminate? [6]​

Use the following information to answer the next three questions about price discrimination.

Suppose that a local cable company, the only provider of service, is maximizing profits at a price of $15 per month for local cable service. Assume that some of its customers have quite elastic demands and others have inelastic demands. A price change of $5 per month would cause a change in quantity demanded of 1,000 individual customers. There are 100,000 current individual customers. Businesses are more sensitive to price changes because they often have connections and can easily add or subtract a cable connection. An additional charge of $1 will mean a 100 fewer customers. There are 1,000 business connections in the town.

Question 10.41

In the above situation, is individual demand is elastic or inelastic?

A

Elastic

B

Inelastic


Question 10.42

In the above situation, is business demand is elastic or inelastic?

A

Elastic

B

Inelastic


Question 10.43

As a result of the answers to the previous two questions, the cable company should a.) (increase / decrease) prices for individual customers and b.) (increase / decrease) prices for businesses in order to increase revenues.

Premise
Response
1

A

A

Decrease

2

B

B

Increase


Question 10.44

A monopoly will engage in price discrimination, if it can, in order to increase profits by doing which of the following?

A

By selling more of its goods

B

By reducing costs for some of its products

C

By continuing to produce the same amount

D

By increasing prices for all consumers and producing less


Question 10.45

A monopolist deciding to engage in price discrimination wants to keep the quantity produced the same (or close to the same) because which of the following is true?

A

Revenue will automatically go down with price discrimination.

B

Marginal revenue will be greater than price at that point.

C

Costs will decrease with an increase in quantity.

D

Costs will increase with an increase in quantity.

10.12 Summary  

  • In this chapter, we discussed markets dominated by a single firm – a monopoly. 
  • We started by establishing the reasons monopolies exist: barriers to entry.
  • The demand in monopoly markets is the same demand competitive markets face. 
  • The supply decisions are based on costs for a firm and marginal revenue – a monopoly produces where marginal cost is equal to marginal revenue and then charges a price along the demand curve for that particular quantity. 
  • We discussed the point where firms are maximizing profit given the costs they face. Changes in costs and demand will affect production decisions.
  • Marginal utility per dollar of resources for a good produced by a monopoly will not equal the marginal utility per dollar of resources for goods produced in competitive industries, so monopolies are not allocatively efficient.
  • We compared the technical efficiency of a monopoly with the efficiency of a perfectly competitive market. 
  • Firms that have quite large economies of scale are natural monopolies; that is, they will be the resulting market structure if a competitive market is left alone.
  • Monopolies can, in some circumstances, charge lower prices and produce more than a competitive market will. However, the monopoly still will not be economically efficient. 
  • The government may grant a firm the legal right to have a monopoly to promote innovation.
  • Firms with sufficient market power may charge different prices for the same goods to different consumers with different price elasticities of demand, which is called price discrimination.

10.13 Key Concepts

Monopoly
Market demand and firm demand
Marginal revenue and price
Profit maximization
Elasticity and marginal revenue
Short run
Price and marginal revenue
Profit maximization
Positive economic profits
No supply curve
Comparison of perfect competition and monopoly
Long run
Entry barriers
Natural monopoly
Economic efficiency
Price > marginal cost
Production at other than minimum average cost
Price discrimination
Types

10.14 Key Term Glossary

Barrier to entry: Some factor that prevents firms from entering an industry when economic profits are being earned.

Monopoly: A single firm in an industry with barriers to entry and no close substitute goods.

Natural monopoly: A firm that can produce at a lower average cost per unit of output than a number of smaller firms producing a similar amount of total output.

Price discrimination: A producer charges different prices for different units of output of the same product for reasons other than differences in costs.





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Answer Keys

Answer to Question 10.10

An answer should include much of the following: A monopolist faces the market demand curve. It is the market. However, the law of demand tells us that to increase sales by one, the price must decrease. Thus, if the monopolist is to sell one more unit, it will gain the revenue from the additional unit, but lose revenues on all units sold up to the last one. If the monopolist continues to expand output, marginal revenue will decline. The additional revenue from selling one more unit will be less, and the reduction in price will be on larger numbers of units sold.

Click here to return to Question 10.10.










Answer to Question 10.11

The monopoly will charge the price at the height of the demand curve where it can sell the quantity produced when marginal cost equals marginal revenue. That will not be the highest price it can charge (this would be at the vertical intercept of the demand function); rather, it will be the price that maximizes profits.

Click here to return to Question 10.11.













Answer to Question 10.14

Your answer should discuss how if marginal revenue is greater than marginal cost, then profits increase as quantity increases. If marginal revenue is less than marginal cost, then profits are decreasing as quantity increases. The point where marginal revenue is equal to marginal cost occurs when profits are maximized.

Click here to return to Question 10.14.













Answer to Question 10.20

1. A profit-maximizing monopolist will produce where marginal cost is equal to marginal revenue. 

2. Marginal cost is always going to be positive (or at least never negative). 

3. Because marginal cost is equal to marginal revenue if the monopolist maximizes profits and marginal cost is always positive, marginal revenue has to be positive.

4. Marginal revenue is only positive where demand is elastic. 

The logic behind the fourth step is as follows. Marginal revenue is the change in revenue from producing one more unit of the good. If the price is lowered to sell one more unit and total revenue rises as a result, that is, marginal revenue is positive, the percentage increase in the quantity must be greater than the percentage decrease in the price. That is the definition of an elastic demand. So, while the monopolists face demand curves that are often relatively less responsive to price changes than other goods (due to the low number of substitutes), they will produce along the portion of the demand curve that is elastic.

Click here to return to Question 10.20.







Answer to Question 10.33

Given that marginal cost is less than price for a monopoly, the marginal utility / marginal cost ratio for the monopoly’s product will be greater than the marginal utility / marginal cost ratio for the rest of the economy, assuming that the rest of the economy is closer to being competitive. Thus, if the rest of the economy produces less and those resources are moved to the monopolistic industry, there will be a net gain in satisfaction. The monopolist, in other words, is producing too little for allocative efficiency.

Click here to return to Question 10.33.












Answer to Question 10.35

Small firms will have relatively high average costs, and larger firms will have relatively lower average costs. A group of small firms will not be able to compete with a single or a smaller number of larger firms because the larger firm or firms will have lower costs. If prices are lowered through competition, the prices may be below average cost for the small firms, but at or above average cost for the large firms.

Click here to return to Question 10.35.












Answer to Question 10.36

The answer should include the following issues. Fewer resources will be used to produce the product if a single firm produces the good or service. Economic efficiency will be enhanced. However, the single firm will not produce an amount that is economically efficient because of its market power. Thus, the outcome will be less than economically efficient. The dilemma is how to take advantage of the economies of scale and at the same time end up with an economically efficient amount of output.

Click here to return to Question 10.36.












Answer to Question 10.39

Opportunity to earn profits – to earn a living. In addition, they may to some extent create because of sheer enjoyment.

Click here to return to Question 10.39.














Answer to Question 10.40

Competitors would enter the market and produce their own similar or identical version of the new product. With new suppliers entering the industry, competition would drive the price down. The price might drop far enough that the original inventor (who still bears the research and development costs) will not even be able to make a normal profit, and he/she may be driven out of the market. These effects will further reduce the inventor’s incentive to invent other new products.

Click here to return to Question 10.40.











Image Credits

[1] Image courtesy of Unsplash in the Public Domain.

[2] Image courtesy of the Clker-Free-Vector-Images in the Public Domain.

[3] Image courtesy of Mario Sarto under CC BY-SA 3.0.

[4] Image courtesy of freestocks.org in the Public Domain.

[5] Image courtesy of the U.S. government in the Public Domain.

[6] Image courtesy of Dansan4444 under CC BY-SA 3.0.

A single firm in an industry with barriers to entry and no close substitute goods
See Chapters "Using Supply and Demand" and "Behind Demand".
See Section 10.4.
How does a monopoly choose what price to charge?
See Section 10.5.
See previous questions.
Some factor that prevents firms from entering an industry when economic profits are being earned.
Think about where allocative efficiency occurs.
A firm that can produce at lower average cost per unit of output than a number of smaller firms producing a similar amount of total output.
See Section 10.9
See Section 10.9.
Think about how someone benefits from inventions, new music, and new books.
See previous paragraph.
A producer charges different prices for different units of output of the same product for reasons other than differences in costs.