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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213

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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http://www.khanacademy.org

http://www.khanacademy.org

215

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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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.