A monopoly misallocates resources when it

10 Monopoly

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Learning Outcomes

After reading this chapter, you should be able to

• Define monopoly and calculate marginal revenue, given data on price and output.

• Describe the economic role of natural and artificial barriers to entry into an industry.

• Explain why firms practice price discrimination.

• Discuss how a monopolist misallocates resources in terms of price and costs.

• Describe the costs associated with monopoly.

• Explain facts and fallacies of monopoly organization.

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210

Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

Introduction In 1956 the drug methotrexate was used to cure metastatic cancer (American Cancer Society, 2018). Since then, biopharmaceutical companies have been in a race to develop newer and better treatments for a wide range of cancers. In October 2017 the U.S. Food and Drug Admin- istration approved a new drug, abemaciclib (Verzenio), to treat advanced breast cancer. The manufacturer of the drug, pharmaceutical giant Eli Lilly, was projected to earn $1.8 billion in revenue by 2022. How could a company generate such high rates of return in such a short period of time? One reason is that demand for the drug would be incredibly high; an esti- mated 252,710 cases of invasive breast cancer were diagnosed in the United States in 2017. The drug would also be a necessity, demand would be very inelastic, and individuals would be willing to pay high prices.

With billions of dollars in profits to be made, why wouldn’t another firm step in and start selling the same product? In pharmaceuticals, like in technology and other industries that produce new products for the market, the creator of a new good can obtain a patent. Patent rights give sole authority to use the process or machine to the holder of the patent. In this case the owner of the patent has a legal monopoly. However, patents provide only a finite period of protection. In the United States plant and utility patents expire after 20 years, while design patents are good for only 14 years. After that, the patent expires, and everyone is entitled to use the idea. In pharmaceuticals, this means that other companies can develop generic ver- sions of the drug. Until 2029 Eli Lilly will have the sole right to produce and sell Verzenio.

Monopolies can arise in several different ways, such as the granting of patents in the above example, or by natural or illegal means as discussed later in this chapter. Monopoly is at the other end of the market continuum from perfect competition, in the sense that perfect com- petition involves many firms and monopoly involves just one. Monopoly is the market struc- ture in which there is a single seller of a product that has no close substitutes.

Although pure monopolies are relatively rare, since even the sole producer of a new can- cer drug may face competition from new radiation treatments, there are many firms that have some degree of monopoly power. Monopoly power is the ability to exercise power over market price and output. Without the fear of competition, monopolies can choose the price– quantity combination that maximizes profit.

10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

A perfectly competitive firm faces a perfectly elastic demand curve. What this means is that a firm operating under perfectly competitive conditions can sell any amount it wants at the price that is currently prevailing. As a result, price (or average revenue) and marginal revenue are equal. However, a monopolistic firm faces the market demand curve because the firm is the single seller. This distinction is very important because market demand curves have nega- tive slopes. Thus, the monopolist can’t simply choose any price at which to sell its products. A monopolist still has to follow the law of demand and must lower price in order to sell more units of output. The price reduction applies to all units of output that the monopolist sells, not

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211

Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

just the last, or marginal, unit. Each additional unit sold adds to total revenue by the amount it sells for (its price) but takes away from total revenue by the reduction in price on each unit sold. Thus, the change in revenue (the marginal revenue) must be less than the change in price.

Imagine that a new start-up company, EatGluten, has patented a miracle drug that allows peo- ple with celiac disease to consume foods containing gluten without becoming ill. The drug, labeled Glutenme, must be consumed in pill form immediately before a meal and only works for 1 hour. The economists at EatGluten have generated an estimate of the market demand for the pills. Data illustrating the relationship among average, total, and marginal revenue for Glutenme are presented in Table 10.1. When 3 million pills are sold, the total revenue is $168 (3 × $56). In order to sell 4 million pills, EatGluten must reduce the price from $56 to $55. Total revenue will then increase by $55 because an additional unit is being sold for $55. At the same time, it will decrease by $3 because the other 3 million pills now sell for $1 less each ($55 each, rather than $56). The net result is that EatGluten has added $52 ($55 – $3) to total revenue by reducing the price from $56 to $55. Note that marginal revenue is $52, and price (average revenue) is $55 for 4 million pills.

Table 10.1: Average, total, and marginal revenue for the monopolist EatGluten

Pills sold (in millions)

Price (average revenue)

Total revenue (in millions)

Marginal revenue (in millions)

0 $65 $0 —

1 58 58 58

2 57 114 56

3 56 168 54

4 55 220 52

5 54 270 50

6 53 318 48

7 52 364 46

8 51 408 44

9 50 450 42

10 49 490 40

The relationship between marginal revenue and demand is graphed in Figure 10.1. When demand is inelastic, decreases in price will cause total revenue to decline. If total revenue is declining, additions to total revenue must be negative. That is, marginal revenue is nega- tive. In Figure 10.1 a reduction in price below $34 will decrease total revenue because for the amount of pills demanded at $34, marginal revenue is negative. This region corresponds to the inelastic portion of the demand curve. However, a reduction in price from $40 to $34 would increase total revenue because the demand curve is elastic in this range.

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212

Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

Price and Output Decisions Under Monopoly Where costs are positive, the monopolist finds the profit-maximizing level of output by equat- ing marginal cost and marginal revenue. A monopoly firm does not have a supply curve in the sense that a market typically does. A monopolist sets the price at the profit-maximizing level of output, so it doesn’t make sense to ask how much will be supplied at various prices. For a monopoly, the profit-maximizing output, where MC = MR, will depend on the location and shape of the demand curve. A monopoly firm therefore doesn’t have a supply curve that is independent of demand.

Table 10.2 shows the revenue and cost data for the fictional monopolist EatGluten. With this information, EatGluten would maximize profits at an output level of 7 million pills, where MC = MR = $46. Price should be set at $52 because the demand curve indicates that 7 million pills will sell for $52 each. At a price of $52, total revenue is $364 million (7 × $52) and total cost is $322 ($46 × 7), which means that the monopolist is making a profit of $42 million ($364 – $322).

Figure 10.3 adds the cost information to Figure 10.2. A monopolist, like EatGluten, will maxi- mize profit by producing 7 million pills because at that level of output, MR = MC. If MR is greater than MC (that is, if output is less than 7 million), the monopolist can increase profits by expanding output. Additions to output will cause total revenue to increase by more than the increase in total cost. On the other hand, if MR is less than MC (that is, if output is greater than 7 million), the monopolist will reduce output because additions to output add more to total cost than to total revenue. The firm is earning more than is necessary to keep its resources employed in this industry—it is making an economic profit.

Figure 10.1: Demand and marginal revenue

The marginal revenue curve lies below the average revenue curve when there is a negatively sloped demand curve. For a linear demand curve, the marginal revenue curve will intersect the x-axis exactly halfway between the origin and the point where the average revenue curve interests the x-axis. Demand is elastic above $34 and inelastic below $34.

0 -10

Price

Millions of pills/year

24

34

> 1Ed

= 1Ed

Ed < 1

MR

D = AR

40

17.5

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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

Table 10.2: Cost and revenue data for producing Glutenme (in millions)

Output and sales (millions)

Total cost (TC)

Average cost (AC)

Marginal cost (MC)

Average revenue

(AR)

Total revenue

(TR)

Marginal revenue

(MR)

Economic profit

(millions)

0 $60 $— $— $0 $0 $0 $60

1 100 100 40 58 58 58 –42

2 136 68 36 57 114 56 –22

3 168 56 32 56 168 54 0

4 200 50 32 55 220 52 20

5 235 47 35 54 270 50 35

6 277 46 42 53 318 48 41

7 322 46 46 52 364 46 42

8 372 46.5 50 51 408 44 36

9 429 47.67 57 50 450 42 21

10 490 49 61 49 490 40 0

Figure 10.2: The profit-maximizing position of a monopolist

The profit-maximizing monopolist will produce x1 units of output, where MC = MR. Since average cost (C1) is less than average revenue (P1) for output level x1, this monopolist is making an economic profit.

0

Price, cost

Millions of pills/ year

53

46

7

MC

MR

D

AC

B

A

Economic profit

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214

Section 10.2 Profits and Barriers to Entry

10.2 Profits and Barriers to Entry If a monopolist is earning profits, other entrepreneurs will want some of those profits. As a result, there will be pressure from new firms entering the industry. But wait! A monopoly is a single seller producing a product that has no close substitutes. If there is new entry, there is no longer a monopoly. If a monopoly is to persist, there must be some forces at work to keep new firms from entering. Barriers to entry are natural or artificial obstacles that keep new firms from entering an industry. Without such barriers, a monopoly cannot keep competitors out of the market.

Economics in Action: Viewing the Market Through Revenue and Cost Graphs

The Khan Academy reviews marginal revenue, total revenue, marginal cost, and average total cost in a monopoly through analyzing revenue and cost graphs. Follow the link to The Khan Academy (http://www.khanacademy.org) and search for the video “Review of Revenue and Cost Graphs for a Monopoly.”

Economics in Action: And Then There Was One

What if the government wanted only one major player to take care of one product? Welcome to the monopoly system. Follow the link to The Khan Academy (http://www.khanacademy.org) and search for the video “Monopoly Basics” to discover how it differs from perfect competition.

Natural Barriers Economies of scale can provide a natural barrier to entry. If the long-run cost curves are such that the optimal-size firm is very large relative to the size of the market, there may be room for only one cost-efficient firm in the industry. When just one firm emerges in this way, the firm is called a natural monopoly. Natural monopolies exist in very few industries.

Public utilities such as electric and water companies fit this category. Consider the case of two competing water companies. The fixed cost to install a second set of pipelines to each home and business would not be worth the decrease in price that comes with competition. The government recognizes that a single water-producing utility is more efficient for this reason and thus allows the company to exist as a natural monopoly, but the government regulates its prices and output.

Local monopolies are another form of natural monopoly. A local monopoly is a firm that has monopoly power in a geographic region. Even though close substitutes for the firm’s product exist, the distance to other sources of supply creates a virtual monopoly. If you grew up in a small, remote town, there may have been only one movie theater or perhaps only one grocery store. A firm in such a situation is a local monopoly because the substitutes are costly in the sense that you must travel to reach them.

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Section 10.2 Profits and Barriers to Entry

Artificial Barriers An artificial barrier to entry is one that is contrived by the firm (or someone else) to keep oth- ers out. It doesn’t take much imagination to come up with a list of such barriers. A firm could choose to underprice its competitors to force them out of the market, as in the case of retail giant Walmart. Or a company could simply purchase its competition, as in the case of Face- book buying Instagram or Anheuser-Busch and InBev (AB InBev) buying SABMiller. In the case of AB InBev, the purchase led to market dominance of about 46% of global beer profits in 2017 (Feroldi, 2017).

Another method would be to obtain exclusive ownership of all the raw materials in a given industry. Once the scarce resources are under a company’s ownership, entry could be con- trolled by refusing to sell to potential new entrants.

A recent example of the use of artificial barriers could be found in the market for diamonds. Through most of the 20th century, the De Beers Company of South Africa controlled most of the world’s diamond supply. This firm effectively controlled the mining and marketing of new diamonds and wielded enor- mous influence over price. In this case there was still competition because all diamonds that had been produced in the past were potential competitors. If De Beers manipulated production to drive price “too high,” individuals might enter the market as suppli- ers, selling diamonds they currently owned.

Legal Barriers to Entry It is very difficult to be a monopolist, because it is very hard to keep new entrants out of an industry—unless you can get the government to help you. One of the primary legal barriers to entry are patents, discussed earlier. Other legal barriers can come in the form of tariffs (taxes on foreign imports) or quotas (quantity limits).

Suppose firms in the U.S. steel industry are earning economic profits. Firms that are produc- ing steel in other countries see profits being earned and gear up to export steel to the United States to earn some of these profits. In effect, the foreign steel firms are entering the U.S. market. The domestic firms then appeal to Congress and/or the president to keep the foreign firms out (to block their entry). Tariffs or quotas may be put into effect. These tariffs or quotas serve as artificial barriers to entry for foreign firms by raising the price of foreign goods or prohibiting their sale in the United States.

Next, consider the legal industry. To practice as an attorney, one must be admitted to the bar in the United States (commonly referred to as passing the bar exam). Each U.S. state has its own court system that sets the rules for admission to the bar. However, a lawyer who is admit- ted to the bar in one state is not automatically allowed to practice law in any state. Thus, each state has its own legal barrier to entry to practice law.

Marcio Jose Sanchez/ASSOCIATED PRESS Facebook paid $1 billion to acquire Instagram, formerly a competitor, in 2012.

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216

Section 10.2 Profits and Barriers to Entry

Global Outlook: Of Companies and Countries

Many multinational corporations are very large relative to the countries in which they operate. Some companies may have worldwide net sales that are larger than the GDP of the country in which they are operating. Table 10.3 ranks the top 25 countries by GDP and companies by gross sales. As you can see, Walmart is almost as large as Sweden and India combined. Corporations hold 9 spots in the top 25. These multinationals have a large amount of monopoly power.

Table 10.3: The world’s top 25 economies Rank Type Name Revenue (in millions)

1 Government United States 3,251

2 Government China 2,426

3 Government Germany 1,515

4 Government Japan 1,439

5 Government France 1,253

6 Government United Kingdom 1,101

7 Government Italy 876

8 Government Brazil 631

9 Government Canada 585

10 Corporation Walmart 482

11 Government Spain 474

12 Government Australia 426

13 Government Netherlands 337

14 Corporation State Grid 330

15 Corporation China National Petroleum 299

16 Corporation Sinopec Group 294

17 Government South Korea 291

18 Corporation Royal Dutch Shell 272

19 Government Mexico 260

20 Government Sweden 251

21 Corporation ExxonMobil 246

22 Corporation Volkswagen 237

23 Corporation Toyota Motor 237

24 Government India 236

25 Corporation Apple 234

From “Corporations vs governments revenues: 2015 data,” by Global Justice Now, n.d., Retrieved from http://www .globaljustice.org.uk/sites/default/files/files/resources/corporations_vs_governments_final.pdf

(continued)

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Section 10.3 Monopoly Power and Price Discrimination

10.3 Monopoly Power and Price Discrimination Up to this point we have assumed that the monopolist charges the same price to all con- sumers and the same price for all units sold to a specific consumer. If, on the other hand, the monopolist is able to charge different consumers different prices or charge a given con- sumer different prices depending on the quantity purchased, the monopolist is practicing price discrimination. Price discrimination is a way to expand monopoly profits by extract- ing consumer surplus from consumers. In this sense, discrimination does not have a negative connotation; it simply means that the sellers are able to differentiate between different types of consumers in order to maximize profits. Have you ever used a student ID card to pay a lower price to enter a museum or see a movie? Many businesses choose to offer lower prices to students, senior citizens, and other groups of people who have been identified as a lower demand group, typically because of a lower ability to pay. If a business can differentiate across different types of consumers, it can offer different prices in order to maximize profits.

Global Outlook: Of Companies and Countries (continued)

The political and economic dilemmas faced by multinational corporations and host governments have even come to the United States. For decades U.S. policy makers were confronted with only one side of the problem, that of U.S. corporations in foreign countries. Recently, however, the United States has become a host country for foreign investment.

Small, developing countries face a political dilemma in bargaining with large multinational companies. At the onset, such a country may have very little bargaining power with the multinational because the company can “shop around” for hospitable governments. If the country’s policy makers want to pursue economic growth, they may have to agree initially to the multinational’s terms.

As time passes and the company invests more fixed capital assets in the country, the host government can increase taxes and capture more of the monopoly profits. However, a delicate balance must be maintained. Taxes and government controls diminish the profitability of investment and future investment for the multinational. Other multinationals may be driven away by changes in a host country’s business climate.

Host country controls on multinationals can take several forms. Some countries impose foreign exchange regulations that require the foreign firm to convert earnings at exchange rates that are different from market exchange rates. Another control is a rule requiring the foreign firms to use their earnings to buy local products and export them to countries with freely exchangeable currencies. Some countries (such as India) require foreign companies to divest their assets over time by selling them to native investors. This policy is a form of expropriation with compensation. Still other countries force foreign firms to purchase a certain percentage of the components in a manufacturing process from domestic sources. Finally, although it may be illegal (or if not illegal, at least hushed), politicians in some countries may require bribes as a condition for doing business. This practice is not uncommon in countries with dictators.

In a small country, multinational companies not only exert monopoly power but also must confront monopoly power exerted by the host government. In this situation, with one monopoly confronting another, it is not always clear who wins.

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218

Section 10.3 Monopoly Power and Price Discrimination

To see how price discrimination works, you need to recall the discussion of consumer surplus in Chapter 5. Consumer surplus is the extra utility gained by consumers who end up paying less for an item than they would be willing to pay for it. Consumers purchase an item until the marginal utility of the last dollar spent on the item is equal to the marginal utility of spending the dollar on any other good or of holding the dollar. The marginal utility of previously pur- chased units was greater than the price paid for those units because they were all purchased at the price of the last unit. The consumer would have been willing to pay higher prices for those units. Figure 10.3 illustrates this concept. At price Pl in Figure 10.3, the consumer was receiving a “bonus” in terms of utility. This extra utility is called consumer surplus, repre- sented by the shaded area in Figure 10.3.

Figure 10.3: Consumer surplus

Consumer surplus is the difference between the total utility received from the purchase of a product and the total revenue generated by the product. It exists because the marginal utility of each previous unit purchased was greater than price P1.

0

Price

D = AR

Consumer surplus

Quantity/ time period

P1

Q1

A monopoly producer might be able to deal separately with consumers, depending on the number of units purchased. In terms of Figure 10.4, the monopolist could say, “You may buy up to Q1 units for P1, from Q1 to Q2 units for P2, from Q2 to Q3 units for P3, and from Q3 to Q4 units for P4.” By doing this, the monopolist extracts most of the consumer surplus and converts it into revenue for the firm. Compare the shaded areas in Figure 10.4 to the shaded area in Figure 10.3. Both represent consumer surplus. In Figure 10.4, by charging different prices for different amounts of consumption, the monopolist has expropriated much of the consumer surplus. It is theoretically possible for the monopolist to capture all the consumer surplus by charging a different price for each unit.

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219

Section 10.3 Monopoly Power and Price Discrimination

The second type of price discrimination occurs when a monopolist can separate markets and charge different prices to different groups of consumers. If the monopolist can separate the markets and prevent resale, it can price discriminate by adjusting output for the different demand elasticities in the two markets.

Price Discrimination in Practice In practice, the first type of price discrimination is common. It requires that the seller have the power to separate sales on a unit-by-unit basis. This form of price discrimination is what is being practiced when multiples of a product can be purchased for a total that is less than the per-unit price times the number purchased. “Artichokes: $2.50 each or two for $4.00” and “Coffee $2.50 a cup; refills $1” are examples of this type of price discrimination.

The second type of price discrimination requires that the seller be able to separate markets according to different elasticities of demand. Movies offer cheaper tickets for children and those in the military. University athletic departments offer lower priced tickets to sports events to students and faculty. Senior citizens get discounts on all kinds of items, from hotels to restaurants and more. In each of these cases, the market with the greater elasticity gets lower prices. Let’s see why.

Figure 10.4: A price-discriminating monopolist

A price-discriminating monopolist can capture most of the consumer surplus by charging different prices for different amounts of consumption.

0

Price

D

Quantity/ time period

P1

P2

P3

P4

Q1 Q2 Q3 Q4

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220

Section 10.3 Monopoly Power and Price Discrimination

Consider plane tickets. If you fly to Europe and stay for more than 14 days, the fare is cheaper than if you stay for less than 14 days. If you stay a month or longer, flights are even cheaper. Why? Which class of consumers of air transportation have the most inelastic demand? Busi- ness travelers, of course, who tend to travel on tight schedules and have bosses who don’t want them sightseeing in France for 14 days! Major carriers have developed sophisticated techniques to set and change fares instantaneously. Their objective is to juggle fares to match the bargain offerings of low-cost rivals while protecting their full-fare business.

Two conditions are necessary in order to practice price discrimination. First, it must be pos- sible to separate consumers into groups that have different demand elasticities. These groups need to be economically identifiable. If it costs too much to identify the groups, discrimi- nation might not pay. When economists talk about price discrimination, they’re not talking about discriminating on the basis of race, sex, or national origin, unless different races, sexes, or nationalities have different demand elasticities for certain products. Many times, age is used to identify groups with different demand elasticities. Senior citizens and students have more elastic demand curves because they typically have a tighter budget and more time to shop around than middle-aged people do. In the case of airfares, the classes of consumers are separated by length of stay. Businesspeople seldom want to stay at a destination for more than a few days.

Time-of-day price discrimination includes matinee performances of cultural events and mov- ies, bowling alley use, and lunch and dinner menus. In these cases demand is more inelastic at night because some consumers are limited to night consumption. Magazine publishers charge higher prices for magazines purchased at newsstands than for subscriptions. Sometimes subscription prices are only a fraction of the newsstand prices. Newsstand demand is more inelastic because it is typically a spur-of-the-moment, unplanned purchase. Book publishers charge much higher prices for hardcover novels than for softcover versions of the same novel. They separate the markets by publishing the softcover version after the hardcover demand has been satiated. Some colleges charge in-state and out-of-state tuition because it is very easy to separate these two markets. Has your car ever broken down when you were out of town? Your demand is very inelastic in such a situation. You have little information about services available, and you are easy to identify as a one-time customer (you may have an out- of-state license plate). What do you think happens? You’re right! You pay much more than a local person with car trouble would pay.