1.1 Module 28: Monopoly in Practice

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In this module we turn to monopoly, the market structure at the opposite end of the spectrum from perfect competition. A monopolist’s profit-maximizing decision is subtly different from that of a price-taking producer, yet it has large implications for the output produced and the welfare created. We will see the crucial role that market demand plays in leading a monopolist to behave differently from a firm in a perfectly competitive industry.

The Monopolist’s Demand Curve and Marginal Revenue

Recall 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 the last unit of output. That is, MR = MC at the profit-maximizing quantity of output.

Although the optimal output rule holds for all firms, decisions about price and the quantity of output differ between monopolies and perfectly competitive industries due to differences in the demand curves faced by monopolists and perfectly competitive firms.

We have learned that even though the market demand curve always slopes downward, each of the firms that make up a perfectly competitive industry faces a horizontal, perfectly elastic demand curve, like D_C in panel (a) of Figure 28-1. Any attempt by an individual firm in a perfectly competitive industry to charge more than the going market price will cause the firm to lose all its sales. It can, however, sell as much as it likes at the market price.

Because an individual perfectly competitive producer cannot affect the market price of the good, it faces a horizontal demand curve D_C, as shown in panel (a). A monopolist, on the other hand, can affect the price. Because it is the sole supplier in the industry, its demand curve is the market demand curve D_M, as shown in panel (b). To sell more output, it must lower the price; by reducing output, it can raise the price.

We saw that the marginal revenue of a perfectly competitive firm 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.

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 D_M in panel (b) of Figure 28-1. This downward slope creates a “wedge” between the price of the good and the marginal revenue of the good.

Table 28-1 shows how this wedge develops. The first two columns of Table 28-1 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 28-2.

Panel (a) shows the monopolist’s demand and marginal revenue curves for diamonds from Table 28-1. 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. When the quantity effect dominates the price effect, total revenue rises. When the price effect dominates the quantity effect, total revenue falls.

The third column of Table 28-1 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 shows marginal revenue, the change in total revenue from producing and selling another diamond.

Clearly, after the first 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.

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

1. A quantity effect. One more unit is sold, increasing total revenue by the price at which the unit is sold (in this case, +$500).
2. A price effect. In order to sell that last unit, the monopolist must cut the market price on all units sold. This decreases total revenue (in this case, by 9 × (−$50) = −$450).

The quantity effect and the price effect are illustrated by the two shaded areas in panel (a) of Figure 28-2. 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. So, 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 28-2 and taken from the last column of Table 28-1. 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, which means that a monopolist’s marginal revenue from selling an additional unit is always less than the price the monopolist receives for that 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. 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 output for a firm with market power that charges every customer the same price. So for such a firm, the marginal revenue curve always lies below the demand curve.

Take a moment to compare the monopolist’s marginal revenue curve with the marginal revenue curve for a perfectly competitive firm, which has no 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 28-2. 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 (due to the price per diamond falling by $50). As a result, the marginal revenue of the 12th diamond is −$150.

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 28-3.

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 economic 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:

The monopolist’s optimal point is shown in Figure 28-3. 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, Q_M. The price at which consumers demand 8 diamonds is $600, so the monopolist’s price, P_M, 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

In the 1880s, when Cecil Rhodes consolidated many independent diamond producers into the company he founded, 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.

Let’s look again at Figure 28-3 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:

In Figure 28-3, this would correspond to producing at C, where the price per diamond, P_C, is $200, equal to the marginal cost of production. So the profit-maximizing output of an industry under perfect competition, Q_C, is 16 diamonds.

But does the perfectly competitive industry earn any profit at C? No: the price of $200 is equal to the average total cost per diamond. So there is no economic profit 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 marginal revenue is influenced by the price effect, so that marginal revenue is less than the price. That is,

Compared with competitive firms, monopolies produce less, charge more, and earn a profit.

Apttone/Dreamstime.com

As shown in Figure 28-3, 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, we can see that compared with a competitive industry, a monopolist does the following:

• produces a smaller quantity: Q_M < Q_C
• charges a higher price: P_M > P_C
• earns a profit

Monopoly: The General Picture

Figure 28-3 involved specific numbers and assumed that marginal cost was constant, there was no fixed cost, and therefore, that the average total cost curve was a horizontal line. Figure 28-4 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.

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 Q_M. It finds its monopoly price, P_M, from the point on the demand curve directly above point A, point B here. The average total cost of Q_M 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, identified as the quantity at which marginal revenue and marginal cost intersect (see point A), is Q_M. The monopolist charges the highest price possible for this quantity, P_M, found at the height of the demand curve at Q_M (see point B). At the profit-maximizing level of output, the monopolist’s average total cost is ATC_M (see point C).

Profit is equal to the difference between total revenue and total cost. So we have

Profit is equal to the area of the shaded rectangle in Figure 28-4, with a height of P_M − ATC_M and a width of Q_M.

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, while a monopoly can earn a profit or a loss in the short run, barriers to entry make it possible for a monopolist to make positive profits in the long run.

!world_eia!SHOCKED BY THE HIGH PRICE OF ELECTRICITY

Historically, electric utilities were recognized as natural monopolies. As you’ll recall, these are monopolies that are created and sustained by economies of scale. A utility serviced a defined geographical area, owning the plants that generated electricity as well as the transmission lines that delivered it to retail customers. The rates charged customers were regulated by the government, set at a level to cover the utility’s cost of operation plus a modest return on capital to its shareholders.

In the late 1990s, however, there was a move toward deregulation, based on the belief that competition would result in lower retail electricity prices. Competition was introduced at two junctures in the channel from power generation to retail customers: (1) distributors would compete to sell electricity to retail customers, and (2) power generators would compete to supply power to the distributors.

That was the theory, at least. According to one detailed report, 92% of households in states claiming to have retail choice actually cannot choose an alternative supplier of electricity because their wholesale market is still dominated by one power generator.

What proponents of deregulation failed to realize is that the bulk of power generation still entails large up-front fixed costs. Although many small, gas-fired power generators have been built in the last decade, massive, coal-fired plants are still the cheapest and most plentiful form of electricity generation.

In addition, deregulation and the lack of genuine competition enabled power generators to engage in market manipulation—intentionally reducing the amount of power they supplied to distributors in order to drive up prices.

Although electric utilities were deregulated in the 1990s, there’s been a trend toward reregulating them.

Brand X Pictures

The most shocking case occurred during the California energy crisis of 2000–2001 that brought blackouts and billions of dollars in electricity surcharges to homes and businesses. On audiotapes later acquired by regulators, workers could be heard discussing plans to shut down power plants during times of peak energy demand, joking about how they were “stealing” more than $1 million a day from California.

According to a Michigan State University study, from 2002 to 2006, average retail electricity prices rose 21% in regulated states versus 36% in fully deregulated states. Another study found that from 1999 to 2007, the difference between prices charged to industrial retail customers in deregulated states and regulated states tripled. And data through 2011 indicate that customers in deregulated states continue to pay more for electricity than those in regulated states.

Angry customers have prompted several states to change the way they regulate their industries, slow down the process of deregulation, or move to reregulate their industries. California has gone so far as to mandate that its electricity distributors re-acquire their generation plants (and has plans to reregulate the industry). In addition, regulators continue to be on the lookout for price manipulation in energy markets.

Module 28 Review

Check Your Understanding

Refer to the graph provided for questions 1–4.

Question

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Question

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Question

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Question

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Question

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PITFALLS: IS THERE A MONOPOLY SUPPLY CURVE?

IS THERE A MONOPOLY SUPPLY CURVE?

Given that a monopolist applies its optimal output rule in the same way as a perfectly competitive industry, can we then conclude that a monopolist’s supply curve can be calculated in the same way as the supply curve for the industry in perfect competition?

No, because 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.

To learn more, see pages 302–306.