The Meaning of Monopoly

A monopolist is a firm that is the only producer of a good that has no close substitutes. An industry controlled by a monopolist is known as a monopoly.

The De Beers monopoly of South Africa was created in the 1880s by Cecil Rhodes, a British businessman. By 1880 mines in South Africa already dominated the world’s supply of diamonds. There were, however, many mining companies, all competing with each other. During the 1880s Rhodes bought the great majority of those mines and consolidated them into a single company, De Beers. By 1889 De Beers controlled almost all of the world’s diamond production.

De Beers, in other words, became a monopolist. A producer is a monopolist if it is the sole supplier of a good that has no close substitutes. When a firm is a monopolist, the industry is a monopoly.

Monopoly: Our First Departure from Perfect Competition

As we saw in the Chapter 7 section “Defining Perfect Competition,” the supply and demand model of a market is not universally valid. Instead, it’s a model of perfect competition, which is only one of several different types of market structure. Back in Chapter 7 we learned that a market will be perfectly competitive only if there are many producers, all of whom produce the same good. Monopoly is the most extreme departure from perfect competition.

In practice, true monopolies are hard to find in the modern American economy, partly because of legal obstacles. A contemporary entrepreneur who tried to consolidate all the firms in an industry the way that Rhodes did would soon find himself in court, accused of breaking antitrust laws, which are intended to prevent monopolies from emerging. Oligopoly, a market structure in which there is a small number of large producers, is much more common. In fact, most of the goods you buy, from autos to airline tickets, are supplied by oligopolies.

Monopolies do, however, play an important role in some sectors of the economy, such as pharmaceuticals. Furthermore, our analysis of monopoly will provide a foundation for our analysis of other departures from perfect competition, such as oligopoly and monopolistic competition.

What Monopolists Do

Why did Rhodes want to consolidate South African diamond producers into a single company? What difference did it make to the world diamond market?

Figure 8-2 offers a preliminary view of the effects of monopoly. It shows an industry in which the supply curve under perfect competition intersects the demand curve at C, leading to the price PC and the output QC.

What a Monopolist Does Under perfect competition, the price and quantity are determined by supply and demand. Here, the competitive equilibrium is at C, where the price is PC and the quantity is QC. A monopolist reduces the quantity supplied to QM and moves up the demand curve from C to M, raising the price to PM.

Suppose that this industry is consolidated into a monopoly. The monopolist moves up the demand curve by reducing quantity supplied to a point like M, at which the quantity produced, QM, is lower and the price, PM, is higher than under perfect competition.

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Market power is the ability of a firm to raise prices.

The ability of a monopolist to raise its price above the competitive level by reducing output is known as market power. And market power is what monopoly is all about. A wheat farmer who is one of 100,000 wheat farmers has no market power: he or she must sell wheat at the going market price. Your local water utility company, though, does have market power: it can raise prices and still keep many (though not all) of its customers, because they have nowhere else to go. In short, it’s a monopolist.

The reason a monopolist reduces output and raises price compared to the perfectly competitive industry levels is to increase profit. Cecil Rhodes consolidated the diamond producers into De Beers because he realized that the whole would be worth more than the sum of its parts—the monopoly would generate more profit than the sum of the profits of the individual competitive firms. As we saw in Chapter 7, under perfect competition economic profits normally vanish in the long run as competitors enter the market. Under monopoly the profits don’t go away—a monopolist is able to continue earning economic profits in the long run.

In fact, monopolists are not the only types of firms that possess market power. Later in this chapter we will study oligopolists, firms that can have market power as well. Under certain conditions, oligopolists can earn positive economic profits in the long run by restricting output like monopolists do.

But why don’t profits get competed away? What allows monopolists to be monopolists?

Why Do Monopolies Exist?

To earn economic profits, a monopolist must be protected by a barrier to entry—something that prevents other firms from entering the industry.

A monopolist making profits will not go unnoticed by others. (Recall that this is “economic profit,” revenue over and above the opportunity costs of the firm’s resources.) But won’t other firms crash the party, grab a piece of the action, and drive down prices and profits in the long run? For a profitable monopoly to persist, something must keep others from going into the same business; that “something” is known as a barrier to entry. There are five principal types of barriers to entry: control of a scarce resource or input, increasing returns to scale, technological superiority, a network externality, and a government-created barrier to entry.

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1. Control of a Scarce Resource or Input A monopolist that controls a resource or input crucial to an industry can prevent other firms from entering its market. Cecil Rhodes created the De Beers monopoly by establishing control over the mines that produced the great bulk of the world’s diamonds.

2. Increasing Returns to Scale Many Americans have natural gas piped into their homes, for cooking and heating. Invariably, the local gas company is a monopolist. But why don’t rival companies compete to provide gas?

In the early nineteenth century, when the gas industry was just starting up, companies did compete for local customers. But this competition didn’t last long; soon local gas supply became a monopoly in almost every town because of the large fixed costs involved in providing a town with gas lines. The cost of laying gas lines didn’t depend on how much gas a company sold, so a firm with a larger volume of sales had a cost advantage: because it was able to spread the fixed costs over a larger volume, it had lower average total costs than smaller firms.

Local gas supply is an industry in which average total cost falls as output increases. As we learned in Chapter 6, this phenomenon is called increasing returns to scale. There we learned that when average total cost falls as output increases, firms tend to grow larger. In an industry characterized by increasing returns to scale, larger companies are more profitable and drive out smaller ones. For the same reason, established companies have a cost advantage over any potential entrant—a potent barrier to entry. So increasing returns to scale can both give rise to and sustain monopoly.

A natural monopoly exists when increasing returns to scale provide a large cost advantage to a single firm that produces all of an industry’s output.

A monopoly created and sustained by increasing returns to scale is called a natural monopoly. The defining characteristic of a natural monopoly is that it possesses increasing returns to scale over the range of output that is relevant for the industry. This is illustrated in Figure 8-3, showing the firm’s average total cost curve and the market demand curve, D. Here we can see that the natural monopolist’s ATC curve declines over the output levels at which price is greater than or equal to average total cost. So the natural monopolist has increasing returns to scale over the entire range of output for which any firm would want to remain in the industry—the range of output at which the firm would at least break even in the long run. The source of this condition is large fixed costs: when large fixed costs are required to operate, a given quantity of output is produced at lower average total cost by one large firm than by two or more smaller firms.

Increasing Returns to Scale Create Natural Monopoly A natural monopoly can arise when fixed costs required to operate are very high. When this occurs, the firm’s ATC curve declines over the range of output at which price is greater than or equal to average total cost. This gives the firm increasing returns to scale over the entire range of output at which the firm would at least break even in the long run. As a result, a given quantity of output is produced more cheaply by one large firm than by two or more smaller firms.

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The most visible natural monopolies in the modern economy are local utilities—water, gas, and sometimes electricity. As we’ll see later in this chapter, natural monopolies pose a special challenge to public policy.

3. Technological Superiority A firm that maintains a consistent technological advantage over potential competitors can establish itself as a monopolist. For example, from the 1970s through the 1990s the chip manufacturer Intel was able to maintain a consistent advantage over potential competitors in both the design and production of microprocessors, the chips that run computers. But technological superiority is typically not a barrier to entry over the longer term: over time competitors will invest in upgrading their technology to match that of the technology leader. In fact, in the last few years Intel found its technological superiority eroded by a competitor, Advanced Micro Devices (also known as AMD), which now produces chips approximately as fast and as powerful as Intel chips.

We should note, however, that in certain high-tech industries, technological superiority is not a guarantee of success against competitors because of network externalities.

4. Network Externality If you were the only person in the world with an Internet connection, what would that connection be worth to you? The answer, of course, is nothing. Your Internet connection is valuable only because other people are also connected. And, in general, the more people who are connected, the more valuable your connection is. As we learned in Chapter 6, this phenomenon, whereby the value of a good or service to an individual is greater when many others use the same good or service, is called a network externality—its value derives from enabling its users to participate in a network of other users.

The earliest form of network externalities arose in transportation, where the value of a road or airport increased as the number of people who had access to it rose. But network externalities are especially prevalent in the technology and communications sectors of the economy.

When a network externality exists, the firm with the largest network of customers using its product has an advantage in attracting new customers, one that may allow it to become a monopolist. At a minimum, the dominant firm can charge a higher price and so earn higher profits than competitors. Moreover, a network externality gives an advantage to the firm with the “deepest pockets.” Companies with the most money on hand can sell the most goods at a loss with the expectation that doing so will give them the largest customer base.

5. Government-Created Barrier In 1998 the pharmaceutical company Merck introduced Propecia, a drug effective against baldness. Despite the fact that Propecia was very profitable and other drug companies had the know-how to produce it, no other firms challenged Merck’s monopoly. That’s because the U.S. government had given Merck the sole legal right to produce the drug in the United States. Propecia is an example of a monopoly protected by government-created barriers.

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A patent gives an inventor a temporary monopoly in the use or sale of an invention.

The most important legally created monopolies today arise from patents and copyrights. A patent gives an inventor the sole right to make, use, or sell that invention for a period that in most countries lasts between 16 and 20 years. Patents are given to the creators of new products, such as drugs or devices. Similarly, a copyright gives the creator of a literary or artistic work the sole rights to profit from that work, usually for a period equal to the creator’s lifetime plus 70 years.

A copyright gives the creator of a literary or artistic work sole rights to profit from that work.

The justification for patents and copyrights is a matter of incentives. If inventors are not protected by patents, they would gain little reward from their efforts: as soon as a valuable invention was made public, others would copy it and sell products based on it. And if inventors could not expect to profit from their inventions, then there would be no incentive to incur the costs of invention in the first place. Likewise for the creators of literary or artistic works. So the law gives a temporary monopoly that encourages invention and creation by imposing temporary property rights.

Patents and copyrights are temporary because the law strikes a compromise. The higher price for the good that holds while the legal protection is in effect compensates inventors for the cost of invention; conversely, the lower price that results once the legal protection lapses and competition emerges benefits consumers and increases economic efficiency.

Because the length of the temporary monopoly cannot be tailored to specific cases, this system is imperfect and leads to some missed opportunities. In some cases there can be significant welfare issues. For example, the violation of American drug patents by pharmaceutical companies in poor countries has been a major source of controversy, pitting the needs of poor patients who cannot afford retail drug prices against the interests of drug manufacturers that have incurred high research costs to discover these drugs. To solve this problem, some American drug companies and poor countries have negotiated deals in which the patents are honored but the American companies sell their drugs at deeply discounted prices.

How a Monopolist Maximizes Profit

As we’ve suggested, once Cecil Rhodes consolidated the competing diamond producers of South Africa into a single company, the industry’s behavior changed: the quantity supplied fell and the market price rose. In this section, we will learn how a monopolist increases its profit by reducing output. And we will see the crucial role that market demand plays in leading a monopolist to behave differently from a perfectly competitive industry. (Remember that profit here is economic profit, not accounting profit.)

The Monopolist’s Demand Curve and Marginal Revenue In Chapter 7 we derived the firm’s optimal output rule: a profit-maximizing firm produces the quantity of output at which the marginal cost of producing the last unit of output equals marginal revenue—the change in total revenue generated by that last unit of output. That is, MR = MC at the profit-maximizing quantity of output. Although the optimal output rule holds for all firms, we will see shortly that its application leads to different profit-maximizing output levels for a monopolist compared to a firm in a perfectly competitive industry—that is, a price-taking firm. The source of that difference lies in the comparison of the demand curve faced by a monopolist to the demand curve faced by an individual perfectly competitive firm.

In addition to the optimal output rule, we also learned in Chapter 7 that even though the market demand curve always slopes downward, each of the firms that make up a perfectly competitive industry faces a perfectly elastic demand curve that is horizontal at the market price, like DC in panel (a) of Figure 8-4. Any attempt by an individual firm in a perfectly competitive industry to charge more than the going market price will cause it to lose all its sales. It can, however, sell as much as it likes at the market price. As we saw in Chapter 7, the marginal revenue of a perfectly competitive producer is simply the market price. As a result, the price-taking firm’s optimal output rule is to produce the output level at which the marginal cost of the last unit produced is equal to the market price.

Comparing the Demand Curves of a Perfectly Competitive Producer and a Monopolist Because an individual perfectly competitive producer cannot affect the market price of a good, it faces the horizontal demand curve DC, as shown in panel (a), allowing it to sell as much as it wants at the market price. A monopolist, though, can affect the price. Because it is the sole supplier in the industry, it faces the market demand curve DM, as shown in panel (b). To sell more output, it must lower the price; by reducing output, it raises the price.

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A monopolist, in contrast, is the sole supplier of its good. So its demand curve is simply the market demand curve, which slopes downward, like DM in panel (b) of Figure 8-4. This downward slope creates a “wedge” between the price of the good and the marginal revenue of the good—the change in revenue generated by producing one more unit.

Table 8-1 shows this wedge between price and marginal revenue for a monopolist, by calculating the monopolist’s total revenue and marginal revenue schedules from its demand schedule.

Table : TABLE 8-1 Demand, Total Revenue, and Marginal Revenue for the De Beers Monopoly

The first two columns of Table 8-1 show a hypothetical demand schedule for De Beers diamonds. For the sake of simplicity, we assume that all diamonds are exactly alike. And to make the arithmetic easy, we suppose that the number of diamonds sold is far smaller than is actually the case. For instance, at a price of $500 per diamond, we assume that only 10 diamonds are sold. The demand curve implied by this schedule is shown in panel (a) of Figure 8-5.

A Monopolist’s Demand, Total Revenue, and Marginal Revenue Curves Panel (a) shows the monopolist’s demand and marginal revenue curves for diamonds from Table 8-1. The marginal revenue curve lies below the demand curve. To see why, consider point A on the demand curve, where 9 diamonds are sold at $550 each, generating total revenue of $4,950. To sell a 10th diamond, the price on all 10 diamonds must be cut to $500, as shown by point B. As a result, total revenue increases by the green area (the quantity effect: +$500) but decreases by the orange area (the price effect: −$450). So the marginal revenue from the 10th diamond is $50 (the difference between the green and orange areas), which is much lower than its price, $500. Panel (b) shows the monopolist’s total revenue curve for diamonds. As output goes from 0 to 10 diamonds, total revenue increases. It reaches its maximum at 10 diamonds—the level at which marginal revenue is equal to 0—and declines thereafter. The quantity effect dominates the price effect when total revenue is rising; the price effect dominates the quantity effect when total revenue is falling.

The third column of Table 8-1 shows De Beers’s total revenue from selling each quantity of diamonds—the price per diamond multiplied by the number of diamonds sold. The last column calculates marginal revenue, the change in total revenue from producing and selling another diamond.

Clearly, after the 1st diamond, the marginal revenue a monopolist receives from selling one more unit is less than the price at which that unit is sold. For example, if De Beers sells 10 diamonds, the price at which the 10th diamond is sold is $500. But the marginal revenue—the change in total revenue in going from 9 to 10 diamonds—is only $50.

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Why is the marginal revenue from that 10th diamond less than the price? It is less than the price because an increase in production by a monopolist has two opposing effects on revenue:

The quantity effect and the price effect when the monopolist goes from selling 9 diamonds to 10 diamonds are illustrated by the two shaded areas in panel (a) of Figure 8-5. Increasing diamond sales from 9 to 10 means moving down the demand curve from A to B, reducing the price per diamond from $550 to $500. The green-shaded area represents the quantity effect: De Beers sells the 10th diamond at a price of $500. This is offset, however, by the price effect, represented by the orange-shaded area. In order to sell that 10th diamond, De Beers must reduce the price on all its diamonds from $550 to $500. So it loses 9 × $50 = $450 in revenue, the orange-shaded area. As point C indicates, the total effect on revenue of selling one more diamond—the marginal revenue—derived from an increase in diamond sales from 9 to 10 is only $50.

Point C lies on the monopolist’s marginal revenue curve, labeled MR in panel (a) of Figure 8-5 and taken from the last column of Table 8-1. The crucial point about the monopolist’s marginal revenue curve is that it is always below the demand curve. That’s because of the price effect: a monopolist’s marginal revenue from selling an additional unit is always less than the price the monopolist receives for the previous unit. It is the price effect that creates the wedge between the monopolist’s marginal revenue curve and the demand curve: in order to sell an additional diamond, De Beers must cut the market price on all units sold.

In fact, this wedge exists for any firm that possesses market power, such as an oligopolist as well as a monopolist. Having market power means that the firm faces a downward-sloping demand curve. As a result, there will always be a price effect from an increase in its output. So for a firm with market power, the marginal revenue curve always lies below its demand curve.

Take a moment to compare the monopolist’s marginal revenue curve with the marginal revenue curve for a perfectly competitive firm, one without market power. For such a firm there is no price effect from an increase in output: its marginal revenue curve is simply its horizontal demand curve. So for a perfectly competitive firm, market price and marginal revenue are always equal.

To emphasize how the quantity and price effects offset each other for a firm with market power, De Beers’s total revenue curve is shown in panel (b) of Figure 8-5. Notice that it is hill-shaped: as output rises from 0 to 10 diamonds, total revenue increases. This reflects the fact that at low levels of output, the quantity effect is stronger than the price effect: as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small. As output rises beyond 10 diamonds, total revenue actually falls. This reflects the fact that at high levels of output, the price effect is stronger than the quantity effect: as the monopolist sells more, it now has to lower the price on many units of output, making the price effect very large. Correspondingly, the marginal revenue curve lies below zero at output levels above 10 diamonds. For example, an increase in diamond production from 11 to 12 yields only $400 for the 12th diamond, simultaneously reducing the revenue from diamonds 1 through 11 by $550. As a result, the marginal revenue of the 12th diamond is −$150.

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The Monopolist’s Profit-Maximizing Output and Price To complete the story of how a monopolist maximizes profit, we now bring in the monopolist’s marginal cost. Let’s assume that there is no fixed cost of production; we’ll also assume that the marginal cost of producing an additional diamond is constant at $200, no matter how many diamonds De Beers produces. Then marginal cost will always equal average total cost, and the marginal cost curve (and the average total cost curve) is a horizontal line at $200, as shown in Figure 8-6.

The Monopolist’s Profit-Maximizing Output and Price This figure shows the demand, marginal revenue, and marginal cost curves. Marginal cost per diamond is constant at $200, so the marginal cost curve is horizontal at $200. According to the optimal output rule, the profit--maximizing quantity of output for the monopolist is at MR = MC, shown by point A, where the marginal cost and marginal revenue curves cross at an output of 8 diamonds. The price De Beers can charge per diamond is found by going to the point on the demand curve directly above point A, which is point B here—a price of $600 per diamond. It makes a profit of $400 × 8 = $3,200. A perfectly competitive industry produces the output level at which P = MC, given by point C, where the demand curve and marginal cost curves cross. So a competitive industry produces 16 diamonds, sells at a price of $200, and makes zero profit.

To maximize profit, the monopolist compares marginal cost with marginal revenue. If marginal revenue exceeds marginal cost, De Beers increases profit by producing more; if marginal revenue is less than marginal cost, De Beers increases profit by producing less. So the monopolist maximizes its profit by using the optimal output rule:

(8-1) MR = MC at the monopolist’s profit-maximizing quantity of output

The monopolist’s optimal point is shown in Figure 8-6. At A, the marginal cost curve, MC, crosses the marginal revenue curve, MR. The corresponding output level, 8 diamonds, is the monopolist’s profit-maximizing quantity of output, QM. The price at which consumers demand 8 diamonds is $600, so the monopolist’s price, PM, is $600—corresponding to point B. The average total cost of producing each diamond is $200, so the monopolist earns a profit of $600 − $200 = $400 per diamond, and total profit is 8 × $400 = $3,200, as indicated by the shaded area.

Monopoly versus Perfect Competition When Cecil Rhodes consolidated many independent diamond producers into De Beers, he converted a perfectly competitive industry into a monopoly. We can now use our analysis to see the effects of such a consolidation.

Finding the Monopoly Price

In order to find the profit-maximizing quantity of output for a monopolist, you look for the point where the marginal revenue curve crosses the marginal cost curve. Point A in Figure 8-6 is an example.

However, it’s important not to fall into a common error: imagining that point A also shows the price at which the monopolist sells its output. It doesn’t: it shows the marginal revenue received by the monopolist, which we know is less than the price.

To find the monopoly price, you have to go up vertically from A to the demand curve. There you find the price at which consumers demand the profit-maximizing quantity. So the profit-maximizing price–quantity combination is always a point on the demand curve, like B in Figure 8-6.

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Is There a Monopoly Supply Curve?

Given how a monopolist applies its optimal output rule, you might be tempted to ask what this implies for the supply curve of a monopolist. But this is a meaningless question: monopolists don’t have supply curves.

Remember that a supply curve shows the quantity that producers are willing to supply for any given market price. A monopolist, however, does not take the price as given; it chooses a profit-maximizing quantity, taking into account its own ability to influence the price.

Let’s look again at Figure 8-6 and ask how this same market would work if, instead of being a monopoly, the industry were perfectly competitive. We will continue to assume that there is no fixed cost and that marginal cost is constant, so average total cost and marginal cost are equal.

If the diamond industry consists of many perfectly competitive firms, each of those producers takes the market price as given. That is, each producer acts as if its marginal revenue is equal to the market price. So each firm within the industry uses the price-taking firm’s optimal output rule:

(8-2) P = MC at the perfectly competitive firm’s profit-maximizing quantity of output

In Figure 8-6, this would correspond to producing at C, where the price per diamond, PC, is $200, equal to the marginal cost of production. So the profit-maximizing output of an industry under perfect competition, QC, is 16 diamonds.

But does the perfectly competitive industry earn any profits at C? No: the price of $200 is equal to the average total cost per diamond. So there are no economic profits for this industry when it produces at the perfectly competitive output level.

We’ve already seen that once the industry is consolidated into a monopoly, the result is very different. The monopolist’s calculation of marginal revenue takes the price effect into account, so that marginal revenue is less than the price. That is,

(8-3) P > MR = MC at the monopolist’s profit-maximizing quantity of output

As we’ve already seen, the monopolist produces less than the competitive industry—8 diamonds rather than 16. The price under monopoly is $600, compared with only $200 under perfect competition. The monopolist earns a positive profit, but the competitive industry does not.

So, just as we suggested earlier, we see that compared with a competitive industry, a monopolist does the following:

Monopoly: The General Picture Figure 8-6 involved specific numbers and assumed that marginal cost was constant, that there was no fixed cost, and, therefore, that the average total cost curve was a horizontal line. Figure 8-7 shows a more general picture of monopoly in action: D is the market demand curve; MR, the marginal revenue curve; MC, the marginal cost curve; and ATC, the average total cost curve. Here we return to the usual assumption that the marginal cost curve has a “swoosh” shape and the average total cost curve is U-shaped.

The Monopolist’s Profit In this case, the marginal cost curve has a “swoosh” shape and the average total cost curve is U-shaped. The monopolist maximizes profit by producing the level of output at which MR = MC, given by point A, generating quantity QM. It finds its monopoly price, PM, from the point on the demand curve directly above point A, point B here. The average total cost of QM is shown by point C. Profit is given by the area of the shaded rectangle.

Applying the optimal output rule, we see that the profit-maximizing level of output is the output at which marginal revenue equals marginal cost, indicated by point A. The profit-maximizing quantity of output is QM, and the price charged by the monopolist is PM. At the profit-maximizing level of output, the monopolist’s average total cost is ATCM, shown by point C.

Recalling how we calculated profit in Equation 7-5, profit is equal to the difference between total revenue and total cost. So we have:

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Profit is equal to the area of the shaded rectangle in Figure 8-7, with a height of PMATCM and a width of QM.

In Chapter 7 we learned that a perfectly competitive industry can have profits in the short run but not in the long run. In the short run, price can exceed average total cost, allowing a perfectly competitive firm to make a profit. But we also know that this cannot persist. In the long run, any profit in a perfectly competitive industry will be competed away as new firms enter the market. In contrast, barriers to entry allow a monopolist to make profits in both the short run and the long run.

Newly Emerging Markets: A Diamond Monopolist’S Best Friend

An increase in demand for diamonds in emerging markets has led to increased depletion of the world’s diamond mines and higher prices.
L. Lartigue/USAID

When Cecil Rhodes created the De Beers monopoly, it was a particularly opportune moment. The new diamond mines in South Africa dwarfed all previous sources, so almost all of the world’s diamond production was concentrated in a few square miles.

Until recently, De Beers was able to extend its control of resources even as new mines opened. De Beers either bought out new producers or entered into agreements with local governments that controlled some of the new mines, effectively making them part of the De Beers monopoly. The most remarkable of these was an agreement with the former Soviet Union, which ensured that Russian diamonds would be marketed through De Beers, preserving its ability to control retail prices. De Beers also went so far as to stockpile a year’s supply of diamonds in its London vaults so that when demand dropped, newly mined stones would be stored rather than sold, restricting retail supply until demand and prices recovered.

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However, over the past few years the De Beers monopoly has been under assault. Government regulators have forced De Beers to loosen its control of the market. For the first time, De Beers has competition: a number of independent companies have begun mining for diamonds in other African countries. In addition, high-quality, inexpensive synthetic diamonds have become an alternative to real gems, eating into De Beers’s profits. So does this mean an end to high diamond prices and De Beers’s high profits?

Not really. Although today’s De Beers is more of a “near-monopolist” than a true monopolist, it still mines more of the world’s supply of diamonds than any other single producer. And it has been benefiting from newly emerging markets. Consumer demand for diamonds has soared in countries like China and India, leading to price increases.

Nevertheless, the economic crisis of 2009 put a serious dent in worldwide demand for diamonds. DeBeers responded by cutting 2011 production by 20% (compared to 2008). But affluent Chinese continue to be heavy buyers of diamonds, and DeBeers anticipates that Asian demand will accelerate the depletion of the world’s existing diamond mines. As a result, diamond analysts predict rough diamond prices to rise by at least 5% per year for the next five years.

In the end, although a diamond monopoly may not be forever, a near-monopoly with rising demand in newly emerging markets may be just as profitable.

Quick Review

  • In a monopoly, a single firm uses its market power to charge higher prices and produce less output than a competitive industry, generating profits in the short and long run.
  • Profits will not persist in the long run unless there is a barrier to entry. A natural monopoly arises when average total cost is declining over the output range relevant for the industry. This creates a barrier to entry because an established monopolist has lower average total cost than an entrant.
  • Patents and copyrights, government-created barriers, are a source of temporary monopoly.
  • The crucial difference between a firm with market power, such as a monopolist, and a firm in a perfectly competitive industry is that perfectly competitive firms are price--takers that face horizontal demand curves, but a firm with market power faces a downward-sloping demand curve.
  • Due to the price effect of an increase in output, the marginal revenue curve of a firm with market power always lies below its demand curve. So a profit-maximizing monopolist chooses the output level at which marginal cost is equal to marginal revenue—not to price.
  • As a result, the monopolist produces less and sells its output at a higher price than a perfectly competitive industry would. It earns profits in the short run and the long run.

Check Your Understanding 8-1

    1. Question

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      This does not support the conclusion. Texas Tea has a limited amount of oil, and the price has risen in order to equalize supply and demand.
    2. Question

      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
      This supports the conclusion because the market for home heating oil has become monopolized, and a monopolist will reduce the quantity supplied and raise price to generate profit.
    3. Question

      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
      This does not support the conclusion. Texas Tea has raised its price to consumers because the price of its input, home heating oil, has increased.
    4. Question

      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
      This supports the conclusion. The fact that other firms have begun to supply heating oil at a lower price implies that Texas Tea must have earned profits profits that attracted the other firms to Frigid.
    5. Question

      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
      This supports the conclusion. It indicates that Texas Tea enjoys a barrier to entry because it controls access to the only Alaskan heating oil pipeline.
    1. Question

      rSSkhTogSVckZm3/XUY6J/+t7PHRL5qj+9GcotDdeNz/wGHPz7QG9LOXmRnPwBmcNghCHFFBYmye9SxT/jf3Rc+I4Kb6MBie3oLCYwVGhhFwsp1mqHTWYNzzQy4BuGX5MoRuF4vX7q0XWYh4sdsZ5a35qYi2c1zkqC5kXDcNANE7sfFIINIBBr5KjCtgdjmhfTM8KNU9xUMiRaFUNJfqWOc7tvvC8Sk88WRKgbi/H/ralD0sZJdK/lO9IYoXkLUh1N9Fb+mpBnQmZbQiMWRDyheQ3sI1TmY8X6DmS0GKYrf3Cwsg54d8I3chhkkWxhvnbUj3hTOZM/S6XfNQCrq3vl1nTXZjnPwak1+F9InWsZEpQqh1ZFx1+GIVF4byld10Rvyupur0eFkt2DRMrHZF2wQmeT+AfjUv/tU9JLEj8Ih8Mr951WWUkNlScLuWAleIdKmo2b75Fa0=
      The price at each output level is found by dividing the total revenue by the number of emeralds produced. The price at the various output levels is then used to construct the demand schedule in the accompanying table.
    2. Question

      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
      The marginal revenue schedule is found by calculating the change in total revenue as output increases by one unit. For example, the marginal revenue generated by increasing output from 3 to 4 emeralds is ($280 - $252) = $28.
    3. Question

      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
      The quantity effect component of marginal revenue is the additional revenue generated by selling one more unit of the good at the market price. For example, as shown in the accompanying table, at 4 emeralds, the market price is $70; so, when going from 3 to 4 emeralds the quantity effect is equal to $70.
    4. Question

      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
      For example, as shown in the table, when only 3 emeralds are sold, each emerald sells at a price of $84. However, when Emerald, Inc. sells an additional emerald, the price must fall by $14 to $70. So the price effect component in going from 3 to 4 emeralds is (-$14) × 3 = -$42. That’s because 3 emeralds can only be sold at a price of $70 when 4 emeralds in total are sold, although they could have been sold at a price of $84 when only 3 in total were sold.
  1. Question

    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
    As the accompanying diagram shows, the marginal cost curve shifts upward to $400. The profit-maximizing price rises and quantity falls. Profit falls from $3,200 to $300 × 6 = $1,800. Competitive industry profits, though, are unchanged at zero.

Solutions appear at back of book.

253