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Learning Objectives

By the end of this chapter, you will be able to:

• Define monopoly and calculate average revenue and marginal revenue, given data on price and output. Diagram average revenue, marginal revenue, marginal cost, and average cost curves for a monopolistic firm making an economic profit, a loss, and finally, a normal profit.

• 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.

Monopoly

10

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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10

Introduction

Consider this. . . Do you ever cut coupons out of the local Value Mailer? Maybe you have a membership tag on your key chain for your local grocery store. No doubt you’ve seen shoppers with their coupons organized into binders and fold- ers by product line so they can maximize the amount of money they save. Some retailers promote double and triple coupon days. There are countless websites devoted to cou- pons: manufacturers’ sites offer printable coupons for their products, social network sites enable shoppers to share current deals, and other sites teach shoppers how to save money on grocery shopping by being very organized in coupon gathering. The author of one such extreme couponing site, a self-described “stay at home mom of two gorgeous baby girls,” (“About Me,” para. 1) teaches couponing classes to local community groups. She estimates that she spends 90 minutes each week cutting, filing, and organizing her cou- pons to maximize her budget and estimates that she saves on average $300 a month. For her time and effort, that comes to an equivalent wage of about $50.00 per hour take-home pay. There aren’t many part-time jobs that pay that well!

The benefits to the coupon user are obvious. But why do stores issue coupons for a 50 cent discount rather than simply reduce the price of the product by 50 cents for all shoppers? And why doesn’t everybody use coupons? After you study the material in this chapter, you will be able to explain this behavior and analyze why stores and manufacturers use coupons as promotional tactics.

Monopoly is at the other end of the market continuum from perfect competition, in the sense that perfect competition involves many firms and monopoly involves just one. The word monopoly is derived from the Greek words mono for “one” and polein for “seller.” Monopoly is the market structure in which there is a single seller of a product that has no close substitutes.

Although there are no pure monopolies, there are many firms that have some degree of monopoly power. Monopoly power is the ability to exercise power over market price and output. As you learned in the last chapter, firms in perfect competition are price takers. In this chapter, you will see that, because it has some control over price, a monopoly is a price searcher. A price searcher is a firm that sets price in order to maximize profits. A price-searching firm has monopoly power. It searches for the price–quantity combination that will maximize its profit.

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

A perfectly competitive firm faces a perfectly elastic demand curve. 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 and is, therefore, the market. This distinction is very important because market demand curves have negative slopes. Since the monopolist’s demand curve has a negative slope, its mar- ginal revenue curve will lie below that curve. The commonsense explanation for why the marginal revenue curve lies below the demand curve is that the monopolist can’t simply

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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10

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 reduc- tion applies to all units of output that the monopolist sells, not 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.

Some data illustrating the relationship among average, total, and marginal revenue for a monopoly firm are presented in Table 10.1. When 3 units are sold, the total revenue is $186 (3 3 $62). In order to sell 4 units, the monopolist must reduce the price from $62 to $60. Total revenue will then increase by $60 because an additional unit is being sold for $60. At the same time, it will decrease by $6 because the other 3 units now sell for $2 less each (for $60 each rather than for $62). The net result is that the monopolist has added $54 ($60 2 $6) to total revenue by reducing the price from $62 to $60. Note that marginal revenue is $54 and price (average revenue) is $60 for 4 units. Marginal revenue has to be smaller than average revenue whenever units other than the marginal one suffer a price reduction.

Table 10.1: Average, total, and marginal revenue for a monopolist Units sold Price (Average revenue) Total revenue Marginal revenue

0 $65 0 0

1 64 $64 $64

2 63 126 62

3 62 186 60

4 60 240 54

5 58 290 50

6 56 336 46

7 54 378 42

8 52 416 38

9 50 450 34

10 48 480 30

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 negative. In Figure 10.1, a reduction in price below P1 will decrease total revenue because marginal revenue will be negative. This region corresponds to the inelastic portion of the demand curve. However, a reduction in price from P2 to P1 would increase total revenue because the demand curve is elastic in this range.

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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10

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 P1 and inelastic below P1.

Profit Maximization

Think back to the discussion of demand elasticity and Cournot’s analysis of the min- eral spring owner’s situation. In that problem, the monopoly owner of a mineral spring with no production costs maximized profits by setting price where the price elasticity of demand was unitary. We can now apply the profit maximization rule MR 5 MC to this case. If costs were zero, the MC curve would lie along the horizontal axis. In Figure 10.1, the monopolist would maximize profits by producing xl units (where MR 5 MC 5 0) and selling them at price P1. Since monopolists are profit maximizers, they produce the quan- tity where MR 5 MC and sell the product for the maximum price that the market will pay. The demand curve shows the limits of what price buyers are willing to pay for all levels of output. The mineral spring monopolist will increase sales of water as long as marginal revenue is positive, since it costs nothing more to produce another unit. You should note that this does not mean the mineral spring monopolist sells as much as possible. Rather, the monopolist sells the quantity that maximizes profit. The quantity at which profit is maximized is where marginal revenue equals marginal cost.

0

Price

Quantity/ Time Period

P1

P0

P2

E > 1d

E = 1d

E < 1d

x 1 x 0x 2 MR

D = AR

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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10

Price and Output Decisions Under Monopoly

In the more general case, where costs are positive, the monopolist finds the profit- maximizing level of output by equating marginal cost and marginal revenue. The per- fectly competitive firm is a price taker. The monopoly firm is a price searcher. A monopo- list searches for the profit-maximizing price, not the highest price. This process can be seen by looking at the cost relationships graphically.

In Figure 10.2, a monopolist is producing a certain good for which the market demand curve is D. The marginal revenue curve (MR), derived from D, and the average cost (AC) and marginal cost (MC) curves are also given. The monopolist will maximize profit by producing x1 units because at that level of output, MR 5 MC. If MR is greater than MC (that is, if output is less than x1), 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 x1,), the monopolist will reduce output because additions to output add more to total cost than to total revenue.

Figure 10.2: The profit-maximizing position of a monopolist

The profit-maximizing monopolist will produce x1 units of output, where MC 5 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

Quantity/ Time Period

P1

C1

x1 MR

D

MC

AC

B

A Economic

Profit

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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10

After choosing output level x1, the monopolist will search for the highest price it can charge and still sell that amount of output. In Figure 10.2, this price is P1. The monopolist can sell x1 units of output at price P1 because the demand curve in Figure 10.2 shows that P1 is the maximum that consumers will pay for that level of output.

At P1 and x1, the monopolist is making an economic profit. The average revenue (price) is P1, and average cost is C1. Since P1 is larger than C1, the monopolist is making a profit of P1 2 C1 on each unit for a total profit of (P1 2 C1) 3 x1. In Figure 10.2, total cost is represented by rectangle 0C1Bx1, and total revenue is represented by rectangle 0P1Ax1. Total revenue minus total cost equals economic profit, or rectangle C1P1AB. Since the cost curves include both explicit and implicit costs, the monopoly firm is making more than its opportunity cost. That is, the firm is earning more than is necessary to keep its resources employed in this industry—it is making an economic profit.

Table 10.2 shows the revenue and cost data for a monopolist. The monopolist would maxi- mize profits at an output level of 7 units, where MC 5 MR 5 $46. Price should be set at $52 because the demand curve (AR) indicates that 7 units will sell for $52 each. At a price of $52, total revenue is $364 (7 3 $52) and total cost is $322 ($46 3 7), which means that the monopo- list is making a profit of $42 ($364 2 $322). If you don’t believe this is maximum profit, cal- culate the profit at each level of output from 1 to 10 units. You will see profit is maximized at 7 units because at that level, MR 5 MC. Actually, in this numerical example, the firm would maximize profit at either 6 or 7 units. A unique point exists only when dealing with continu- ous functions that allow you to find a point somewhere between 6 and 7 units.

Table 10.2: Cost and revenue data for a monopolist Output and sales

Total cost (TC)

Average cost (AC)

Marginal cost (MC)

Average revenue (AR)

Total revenue (TR)

Marginal revenue (MR)

Economic profit

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

6 276 46 41 53 318 48 42

7 322 46 46 52 364 46 42

8 372 461/2 50 51 408 44 36

9 429 472/3 57 50 450 42 21

10 490 49 61 49 490 40 0

The Monopolist’s Supply Curve

A supply curve shows how much output will be offered for sale at various prices. In order to determine a supply curve, it is necessary to show that a firm will supply a unique quan- tity of output at any given price. This supply is, by definition, independent of demand.

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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly CHAPTER 10

A monopoly firm does not have a supply curve in this sense. 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 5 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.

To convince yourself that the monopolist does not have a supply curve, examine Figure 10.3. In part (a), two different prices, P1 and P2 are consistent with output x1, depending on where the market demand curve is located (D1 or D2). The marginal revenue curves that are derived from the demand curves D1 and D2 both intersect the monopolist’s marginal cost curve at the same level of output. In part (b), two different output levels, x1 and x2, can be produced at price P1, depending on whether market demand is represented by D1 or D2.

Figure 10.3: One output with two prices or one price for two outputs

It is possible to trace out a supply curve only if a unique price is associated with a certain output. In graph (a), there are at least two prices, P1 and P2, consistent with output x1. In graph (b), there are at least two outputs, x1 and x2, consistent with P1.

Figure 10.3 shows that, in the case of a monopolist, you cannot discuss supply indepen- dent of demand. There is no way to predict what the monopolist will do without knowing the demand curve. The predictive powers of economists are, therefore, more limited in an analysis of monopoly. In this case, economists cannot say that an increase in demand will cause price to rise, ceteris paribus.

0 Quantity/ Time Period

Quantity/ Time Period

Price, Cost

0

Price, Cost

(a) (b)

P1 P1

x1 x1 x2

MC

MC

P2 D1

D2

D1

MR1 MR1

MR2

MR2

D2

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Section 10.2 Profits and Barriers to Entry CHAPTER 10

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, monopoly cannot continue.

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 then do a search for the video "Monopoly Basics" to learn more about how it differs from perfect competition.

Natural Barriers

Economies of scale 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. If there are great economies of scale, one firm that is bigger than any of the others will be able to undersell the rest. In such a case, the bigger firm will cut its price below that of its rivals and capture their customers. Eventually the large firm will become the only 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 telephone companies, electric companies, and cable television companies fit this category. The government recognizes that these are natural monopo- lies and therefore charters them and then regulates their prices and output levels. Some economists argue that even public utilities are not really natural monopolies. Since the occurrence of a natural monopoly is rare, most of the monopoly power that exists in our economy is due to artificial barriers.

Artificial Barriers

An artificial barrier to entry is one that is contrived by the firm (or someone else) to keep others out. It doesn’t take much imagination to come up with a list of such barriers. The

Economics in Action: Viewing the Market Through Revenue and Cost Graphs The Khan Academy analyzes revenues and cost graphs to discuss topics such as marginal revenues, total revenue, marginal cost, and average total cost in a monopoly. Follow the link to the Khan Acad- emy (http://www.khanacademy.org), and then do a search for the video "Review of Revenue and Cost Graphs for a Monopoly."

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http://www.khanacademy.org/finance-economics/microeconomics/v/monopoly-basics
http://www.khanacademy.org/finance-economics/microeconomics/v/monopoly-basics
http://www.khanacademy.org/finance-economics/microeconomics/v/review-of-revenue-and-cost-graphs-for-a-monopoly_DUP_1
http://www.khanacademy.org/finance-economics/microeconomics/v/review-of-revenue-and-cost-graphs-for-a-monopoly_DUP_1
Section 10.2 Profits and Barriers to Entry CHAPTER 10

least sophisticated, but perhaps the most effective example, would be the use of violence. Suppose you want to have a monopoly on the illegal numbers racket in South Chicago. If new entrepreneurs move in to reap some of these profits, you simply “do away” with them and hence establish a monopoly—very effective! This sort of tactic may sound bar- baric, but business history contains many examples of the use of violence to keep out com- petitors. In the early history of oil exploration and drilling in the United States, private armies were often essential.

On a more civilized level, it may be possible to erect artificial barriers that are legal, or at least quasi-legal. If exclusive ownership of all the raw materials in an industry could be captured, entry could be controlled by refusing to sell to potential new entrants. The firm of Alcoa enjoyed a monopoly before World War II because it controlled almost all the known sources of bauxite, the essential ore for the production of aluminum.

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 enormous influence over price. In this case, there was still competition because all diamonds that had been produced in the past were potential com- petitors. If de Beers manipulated production to drive price “too high,” individuals might enter the market as suppliers, selling diamonds they presently owned.

Another way to create artificial barriers is to own the patent on a process or machine that is vital in production. Patent rights give sole authority to use the process or machine to the holder of the patent. The problems with a patent, however, are twofold: First, a patent provides only a finite period of protection. In the United States plant and util- ity 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. Second, to get a patent, detailed plans on how the item is produced must be provided, and these plans are available to potential competitors at the Library of Congress. So it appears a patent is not a very effective entry barrier to anyone who is willing to risk a lawsuit brought by the patent holder (and patent holders don’t always win their cases). A good alternative to pat- ents is secrecy. If a firm can keep its vital process or machine secret, it can keep new firms out of its industry. Now you know why there is barbed wire around some research and development offices, why you aren’t told the formula for Pepsi-Cola, and why corporate spying is big business.

BananaStock/Thinkstock

Alcoa used to have a monopoly over bauxite, which is essential in the production of aluminum.

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Section 10.2 Profits and Barriers to Entry CHAPTER 10

Governmental 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. Let’s look briefly at two industries where firms have significant market power: the steel industry and the taxicab industry.

Suppose firms in the U.S. steel industry are earning economic profits. Firms that are pro- ducing 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 taxicab industry. You probably consider this to be a competitive indus- try since in any large city there are cabs from many companies on the street every day. But, if you decide to start a cab business, you might be in for some trouble. Suppose you already own a car, so the entry costs are relatively small. All you need to do is to mark your car so that it can be recognized as a cab, and perhaps install a meter. However, you will need a permit, which in some cities will be very difficult and expensive to obtain. If you operate as an underground cab that avoids city regulations, you will make the exist- ing cab owners very unhappy. In many cities, cabs are a monopoly enterprise, and it is government that protects the monopoly.

In these examples, government supplied the artificial barriers to entry. Federal, state, and local governments all restrict entry and thereby ensure protected market positions. It should not be too surprising that many instances of corruption in government have centered on the granting of monopoly privileges. A government official or agency protects a monopoly by keeping competitors out. The monopolist is often willing to pay for this with campaign contributions, favors, or outright bribes, such as direct cash payments, free vacations, or jobs for relatives.

If monopoly power persists for a long period of time, there is very likely to be some explicit or implicit government role in creating barriers to entry. Monopoly profits are a very pow- erful and attractive force, and new entry is very difficult for the monopolist alone to block. As a result, monopolies usually try to enlist governmental support of one kind or another.

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 cities and countries by GDP and companies by gross sales. As you can see, ExxonMobil is larger than Colombia. Wal-Mart is larger than Denmark and Israel combined. In the top 100, there are 53 countries, 34 cities, and 13 corporations. This ranking is based on 2009 data, and there may now be even fewer countries and more companies on the list. In 2011, Wal-Mart sur- passed Norway and would rank as the world’s 25th biggest country in the world (Trivett, 2011). These multinationals have a large amount of monopoly power in small host countries. (continued)

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Section 10.2 Profits and Barriers to Entry CHAPTER 10

Global Outlook: Of Companies and Countries (continued)

Table 10.3: The world’s top 100 economies Country/City/ Company

GDP/ Revenues

Country/City/ Company

GDP/ Revenues

Country/City/ Company

GDP/ Revenues

1 United States 14,204 35 ExxonMobil 426 69 Chevron 255 2 China 7,903 36 Osaka/Kobe, Japan 417 70 Toronto, Canada 253 3 Japan 4,354 37 Wal-Mart Stores 406 71 Detroit, USA 253 4 India 3,388 38 Colombia 395 72 Peru 245 5 Germany 2,925 39 Mexico City, Mexico 390 73 Portugal 245 6 Russian Federation 2,288 40 Philadelphia, USA 388 74 Chile 242 7 United Kingdom 2,176 41 Sao Paulo, Brazil 388 75 Vietnam 240 8 France 2,112 42 Malaysia 383 76 Seattle, USA 235 9 Brazil 1,976 43 Washington, DC,

USA 375 77 Shanghai, China 233

10 Italy 1,840 44 Belgium 369 78 Madrid, Spain 230 11 Mexico 1,541 45 Boston, USA 363 79 Total 223 12 Tokyo, Japan 1,479 46 Buenos Aires,

Argentina 362 80 Singapore,

Singapore 215

13 Spain 1,456 47 BP 361 81 Sydney, Australia 213 14 New York, USA 1,406 48 Venezuela 357 82 Bangladesh 213 15 Korea, Republic of 1,358 49 Sweden 344 83 Mumbai, India 209 16 Canada 1,213 50 Dallas/Forth Worth,

USA 338 84 Rio de Janeiro,

Brazil 201

17 Turkey 1,028 51 Ukraine 336 85 Denmark 201 18 Indonesia 907 52 Greece 329 86 Israel 201

19 Iran, Islamic Rep 839 53 Switzerland 324 87 Ireland 197 20 Los Angeles, USA 792 54 Moscow, Russian

Federation 321 88 Hungary 194

21 Australia 762 55 Hong Kong, China 320 89 Finland 188 22 Taiwan 710 56 Austria 318 90 General Electric 183 23 Netherlands 671 57 Philippines 317 91 Kazakhstan 177 24 Poland 671 58 Nigeria 315 92 Volkswagen Group 158 25 Saudi Arabia 589 59 Atlanta, USA 304 93 ENI 158 26 Chicago, USA 574 60 Romania 302 94 AXA Group 157 27 Argentina 571 61 San Francisco/

Oakland, USA 301 95 Phoenix, USA 156

28 London, UK 565 62 Houston, USA 297 96 Minneapolis, USA 155 29 Paris, France 564 63 Miami, USA 292 97 Sinopec-China

Petroleum 154

30 Thailand 519 64 Seoul, South Korea 291 98 San Diego, USA 153

31 South Africa 492 65 Norway 277 99 HSBC Holdings 142

32 Royal Dutch Shell 458 66 Algeria 276 100 Barcelona, Spain 140

33 Egypt, Arab Rep 441 67 Toyota Motor 263 Country City Company GDP/Revenues in $ billions PPP, 200834 Pakistan 439 68 Czech Republic 257

Data sources: Country data: GDP–PPP from the Development Data Platform time series, World Bank; City data: PricewaterhouseCoopers (PwC). 2009. Which are the largest city economies in the world and how might this change by 2025? Economic Outlook; Companies; Data

retrieved from http://www.forbes.com/lists/2008/18/biz_2000global08_The-Global-2000_Rank.html (accessed November, 2009) Hoomweg, D., Bhada, P., Freire, M., Trejos Gomez, C.L., Dave, R. 2010. Cities and climate change: An urgent agenda. World Bank.

(continued)

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Section 10.3 Monopoly Power and Price Discrimination CHAPTER 10

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 govern- ment 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 dif- ferent 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 coun- tries force foreign firms to purchase a certain percent 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 uncom- mon 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.

10.3 Monopoly Power and Price Discrimination

In analyzing monopoly behavior, we have assumed that the monopolist charges the same price to all consumers 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 consumer different prices depending on the quantity purchased, the monopolist is practicing price discrimination. Price discrimination is a way to expand monopoly profits by extracting consumer surplus from consumers. In this sense, discrimi- nation 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.

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Section 10.3 Monopoly Power and Price Discrimination CHAPTER 10

To see how price discrimination works, you need to recall the discussion of consumer sur- plus in the chapter on demand and consumer choice. 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 purchased 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 10.4 illustrates this concept. At price Pl in Figure 10.4, the consumer was receiving a “bonus” in terms of utility. This extra utility is called consumer surplus, represented by the shaded area in Figure 10.4.

Figure 10.4: 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.

A monopoly producer might be able to deal separately with consumers depending on the number of units purchased. In terms of Figure 10.5, 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 10.5 to the

0

Price

D = AR

Consumer Surplus

Quantity/ Time Period

P1

Q1

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Section 10.3 Monopoly Power and Price Discrimination CHAPTER 10

shaded area in Figure 10.4. Both represent consumer surplus. In Figure 10.5, 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.

Figure 10.5: A price-discriminating monopolist

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

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 sepa- rate 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 discrimina- tion 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 $1.50 a cup; refills 50 cents” are examples of this type of price discrimination.