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Monopoly markets

Barriers to entry may exist for three reasons:


1. economies of scale,
2. actions by firms, and/or
3. actions by the government.
If economies of scale exist throughout the relevant range of output, large firms can produce
output at a lower cost than can smaller firms. The diagram below illustrates this possibility.
When an industry of this sort begins to develop, there may be many small firms. Suppose, for
example that all of the firms have the average total cost curve labeled "ATCo." If one of them
becomes larger than the others, though, it can produce output at a lower cost per unit (as
illustrated by the curve ATC'). This allows the larger firm to sell its output at a lower price (such
as P') at which smaller firms will experience economic losses. (Note that the smaller firms would
receive zero economic profit if the price were Po. At a price of P' the smaller firms would receive
economic losses and the larger firm would receive zero economic profits.)

In this situation, the smaller firms will eventually be forced to either leave the industry or merge
with other firms to become at least as large as the current largest firm. As firms keep growing
(either through internal expansion or by buying up smaller firms), their average costs continue to
decline. Smaller firms continue to disappear until eventually only one large firm remains. Such
an industry is referred to as a natural monopoly since the long-run outcome of the competitive
process is the creation of a monopoly industry.
The concept of "natural monopoly" in the U.S. was first used to explain the early development of
the telephone industry in the U.S. In the early years, most cities had several telephone companies
competing to offer telephone service. To call all of the other people who had phones in a given
city, people might have to subscribe to 3 or 4 telephone services (since they were not initially
interconnected). By virtue of its patents and head start, though, the Bell Company was larger
than most of its competitors. To see why this provided an advantage, note that once a company
pays for the right-of-way and places telephone poles and wires on a given street, the cost of
adding an additional customer (on that street) is fairly small. The company that acquires the most
customers faces lower average costs. This is why AT&T was able to offer lower prices then its

competitors. AT&T bought up these companies when they were no longer profitable. Since the
government recognized that it would be more costly to have many small telephone companies, it
chose to allow AT&T to operate as a regulated monopoly in which the government regulated the
prices that could be charged for telephone services. (The government chose to break up AT&T in
the latter part of the 20th century because the introduction of microwave and satellite
transmissions of telephone signals and digital switching networks were believe to have
eliminated some of the economies of scale that were present under the earlier technology.)
One way in which firms may acquire monopoly power is by acquiring exclusive ownership of a
raw material. As your text notes, a single family in New Mexico controls most of the known
supply of desiccant clay. Firms can also raise the sunk costs associated with entry into an
industry to help discourage entry by new firms. Sunk costs are costs that cannot be recovered
upon exit from an industry. These sunk costs include things like the advertising expenditures
needed to ensure brand-name recognition. If a firm spends a large amount of money on
advertising, new firms in the industry will have to spend a similar amount to counteract this
advertising spending. While investments in buildings can be (at least partly) recovered if a firm
leaves the industry, it cannot recover it's sunk costs. These costs represent a cost of exit that must
be taken into account by firms considering entry into an industry. If all costs were recoverable on
exit, firms would be quite willing to enter to receive even just temporary short-run profits. If they
know that they'd lose a large amount in the form of sunk costs, though, they'd be much more
cautious about entering an industry. Large sunk costs are also difficult to finance. (A problem
experienced by John DeLorean when he attempted to enter the automotive manufacturing
industry.... His method of financing the high sunk costs of this industry were not well received
by the legal authorities...)
Patents and licenses provide two types of barriers to entry that are created by the government.
While patent protection is necessary to ensure that there are sufficient incentives for firms to
engage in research and development expenditures, it also provides the patent holder with some
degree of monopoly power. This is how Polaroid has been able to maintain it's long-term
monopoly of the instant film business.
A local monopoly is a monopoly that exists in a specific geographical area. In many regions,
there is only a single company providing local newspapers (at least on a daily basis). In
Syracuse, for example, the Syracuse Newspapers company is the only local newspaper (note that
this company publishes both the Post-Standard, a morning newspaper, and the Herald American,
an afternoon paper).

Demand, AR, MR, TR, and elasticity


The demand curve facing a monopoly firm is the market demand curve (since the firm is the only
firm in the market). Since the market demand curve is a downward sloping curve, marginal
revenue will be less than the price of the good Marginal revenue is:
positive when demand is elastic,
equal to zero when demand is unit elastic, and

negative when demand is inelastic.

These relationships are illustrated in the diagram below. As this diagram illustrates, total revenue
is maximized at the level of output at which demand is unit elastic (and MR = 0). It might be
tempting to assume that this is the best output level for the firm to produce. This would be the
case, though, only if the firm's goal is to maximize it's revenue. A profit- maximizing firm must
take its costs as well as its revenue into account in determining how much output to produce.

As in all other market structures, average revenue (AR) is equal to the price of the good. (To see
this note that AR = TR/Q = (PxQ)/Q = P.) Thus, the price given by the demand curve is the
average revenue that the firm receives at each level of output.
As discussed in Chapter 9, any firm maximizes its profits by producing at the level of output at
which marginal revenue equals marginal cost (as long as P > AVC). For the monopoly firm
described by the diagram below, MR = MC at an output level of Qo. The price that this firm will
charge is Po (the price that the firm can charge for this level of output given by the demand
curve). Since the price (Po) exceeds average total cost (ATCo) at this level of output, the firm
receives economic profit. These monopoly profits, though, differ from those received by a
perfectly competitive firm in that these profits will persist in the long run (due to the barriers to
entry that characterize a monopoly industry).

Of course, it is possible that a monopoly firm may experience losses. The diagram below
illustrates this possibility. In this diagram, the firm receives economic losses equal to the shaded
area. Since price is above AVC, though, it will continue operations in the short run, but will leave
the industry in the long run. Note that the ownership of a monopoly does not guarantee the
existence of economic profits. It is quite possible to have a monopoly in the production of a good
that few people want....

A monopoly firm will shut down in the short run if the price falls below AVC. This possibility is
illustrated in the diagram below.

Those who have not studied economics often believe that a monopolist is able to choose any
price that it wishes and that it can always receive higher profits by raising its price. As in all
other market structures, though, the monopolist is constrained by the demand for its product. If a
monopoly firm wishes to maximizes its profit, it must select the level of output at which MR =
MC. This determines a unique price that will be charged in this industry. An increase in the price
above this level would reduce the profits received by the firm.

Price discrimination and dumping


Firms operating in markets other than those of perfect competition are able to increase their
profits by engaging in price discrimination, a practice in which higher prices are charged to
those customers who have the most inelastic demand for the product. Necessary conditions for
price discrimination include:
the firm cannot be a price taker,
the firm must be able to sort customers according the their elasticity of demand, and

resale of the product must not be feasible.

The diagram below illustrates how price discrimination may be used in the market for airline
travel. Those flying for vacation purposes are likely to have a more elastic demand than those
who fly for business purposes. As the diagram below indicates, the optimal price is higher in for
business travelers than for vacation travelers. Airlines engage in price discrimination by offering
low price "super saver" fares that require a weekend stay and that tickets be purchased 2-4 weeks
in advance. These conditions are much more likely to be satisfied by individuals traveling for
vacation purposes. This helps to ensure that the customers with the most elastic demand pay the
lowest price for this commodity.

Other examples of price discrimination includes daytime and evening telephone rates, child and
senior citizen discounts at restaurants and movie theaters, and cents-off coupon in Sunday
newspapers. (Be sure to understand why each of these is an example of price discrimination.)
When countries practice price discrimination by charging different prices in different countries,
they are often accused of dumping in the low-price countries. Predatory dumping occurs if a
country charges a low price initially in an attempt to drive out domestic competitors and then
raises the price once the domestic industry is destroyed. While it is often claimed that predatory
dumping occurs, the evidence on this is rather weak.

Comparison of perfect competition and monopoly


The left-hand side portion of the diagram below illustrates the consumer and producer surplus
that is received in a perfectly competitive market. The right-hand side portion of the diagram
illustrates the loss in consumer and producer surplus that results when a perfectly competitive
industry is replaced by a monopoly. As this diagram indicates, the introduction of a monopoly
firm causes the price to rise from P(pc) to P(m) while the quantity of output falls from Q(pc) to
Q(m). The higher price and reduced quantity in the monopoly industry causes consumer surplus
to fall by the trapezoidal area ACBP(pc). This does not all represent a cost to society, though,
since the rectangle P(m)CEP(pc) is transferred to the monopolist as additional producer surplus.
The net cost to society is equal to the blue shaded triangle CBF. This net cost of a monopoly is
called deadweight loss. It is a measure of the loss of consumer and producer surplus that results
from the lower level of production that occurs in a monopoly industry.

Some economists argue that the threat of potential competition may encourage monopoly firms
to produce more output at a lower price than the model presented above suggests. This argument
suggests that the deadweight loss from a monopoly is smaller when barriers to entry are less
effective. Fear of government intervention (in the form of price regulation or antitrust action)
may also keep prices lower in a monopoly industry than would otherwise be expected.
A related point is that it is unreasonable to compare outcomes in a perfectly competitive market
with outcomes in monopoly market that results from economies of scale. While competitive
firms may produce more output than a monopoly firm with the same cost curves, a large
monopoly firm produces output at a lower cost than could smaller firms when economies of
scale are present. This reduces the amount of deadweight loss that might be expected to occur as
a result of the existence of a monopoly.
On the other hand, deadweight loss may understate the cost of monopoly as a result of either Xinefficiency or rent-seeking behavior on the part of monopolies. X-inefficiency occurs if
monopolies have less incentive to produce output in a least-cost manner since they are not
threatened with competitive pressures. Rent-seeking behavior occurs when firms expend
resources to acquire monopoly power by hiring lawyers, lobbyists, etc. in an attempt to receive
governmentally granted monopoly power. These rent-seeking activities do not benefit society as
a whole and divert resources away from productive activity.

Regulation of natural monopoly


As noted above, a monopoly firm can produce at a lower cost per unit of output than could any
smaller firms in a natural monopoly industry. In this case, the government generally regulates the
price that a monopoly firm can charge. The diagram below illustrates alternative regulatory
strategies in such an industry. If the government leaves the monopolist alone, it will maximize its
profits by producing Q(m) units of output and charging a price of P(m). Suppose, instead,
though, that the government attempts to emulate a perfectly competitive market by setting the
price equal to marginal cost. This would occur at a price of P(mc) and a quantity of output of
Q(mc). Since this is a natural monopoly, though, the average cost curve declines over the
relevant range of output. If average costs are declining, marginal costs must be less than average
costs (this relationship between marginal and average costs was discussed in detail in Chapter 9).
Thus, if the price equals marginal costs, the price will be less than average total costs and the

monopoly firm will experience economic losses. This pricing strategy could only exist in the
long run if the government subsidized the production of this good.

An alternative pricing strategy is to ensure that the owners of the monopoly receive only a "fair
rate of return" on their investment rather than monopoly profits. This would occur if the price
were set at P(f). At this price, it would be optimal for the firm to produce Q(f) units of output. As
long as the owners receive a fair rate of return, there would be no incentive for this firm to leave
the industry. Roughly speaking, this is the pricing strategy that regulators use in establishing
prices for utilities, cable services, and the prices of other services produced in regulated
monopoly markets