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Chapter 12 Monopoly Power and Firm Pricing Decisions 13 consumer welfare that could be achieved by dissolving the monopoly and expanding production from Q m to Q C . This area helps explain consumers prefer Q C and producers prefer Q m . Figure 12.7(a) shows the additional benefits consumers would receive from Q c – Q m units, the area under the demand curve, Q m abQ c . The additional money consumers must pay producers for Q c – Q m units, shown by the area under the marginal revenue curve, is a much smaller amount: only Q m cdQ c . That is, the additional benefits of Q c – Q m units, exceed the cost to consumers by the shaded area abcd. Consumers obviously gain from an increase in production. FIGURE 12.7 The Costs and Benefits of Expanded Production If the monopolist expands production from Q m to Q c in part (a), consumers will receive additional benefits equal to the area bounded by Q m abQ c . They will pay an amount equal to the area Q m cdQ c for those benefits, leaving a net benefit equal to the vertically striped area abcd. To expand production, the monopoly must incur additional production costs equal to the area Q m cbQ c in part (b). It gains additional revenues equal to the area Q m cdQ c , leaving a net loss equal to the shaded area cbd. Thus expanded production helps the consumer but hurts the monopolist. Yet for virtually the same reason, the monopolistic firm is not interested in providing Q c – Q m units. It must incur an additional cost equal to the area Q m cdQ c (part (b)] , while it can expect to receive only Q m cdQ c in additional revenues. The extra cost incurred by expanding production from Q m to Q c exceeds the additional revenue acquired by the horizontally stripped area cbd. Thus an increase in production will reduce the monopolistic firm’s profits (or increase its losses). Notice that consumers would gain more from an increase in production than the monopolist would lose. The shaded area in part (a) is larger than the shaded area in part (b). The difference is the triangular area abc. Chapter 12 Monopoly Power and Firm Pricing Decisions 14 Price Discrimination A grocery store may advertise that it will sell one can of beans for $0.30, but two cans for $0.55. Is the store trying to give customers a break? Sometimes this kind of pricing may simply mean that the cost of producing additional cans decreases as more are sold. At other times it may indicate that customer’s demand curves for beans are downward sloping and that the store can make more profits by offering customers a volume discount than by selling beans at a constant price. In other words, the store may be exploiting its limited monopoly power. Consider Figure 12.8. Suppose the demand curve represents your demand for beans, and the supply curve represents the store’s marginal cost of producing and offering the beans for sale. If the store charges the same price for each can of beans, it will have to offer them at $0.25 each to induce you to buy two. Its total revenues will be $0.50. As the graph shows, however, you are actually willing to pay more for the first can $0.30—than for the second. If the store offers one can for $0.30 and two cans for $0.55, you will still buy two cans, but its revenues from the sale will be $0.55 instead of $0.50. 5 Similarly, to entice you to buy three cans, the store need only offer to sell one for $0.30, two for $0.55, and three for $0.75, and its profits will rise further. 6 The deal does not change the marginal cost of providing each can, which is below the selling price for the first two units and equal to the selling price for the third. The marginal cost of the first can is $0.09; the second, $0.14; and the third, $0.20. The total cost of the three cans to the store is $0.43, regardless of how the cans are priced. ___________________________________________ FIGURE 12.8 Price Discrimination By offering customers one can of beans for $0.30, two cans for $0.55, and three cans for $0.75, a grocery store collects more revenues than if it offers three cans for $0.20 each. In either case, the consumer buys three cans. But by making the special offer, the store earns $0.15 more in revenues per customer. 5 Notice that if the store had tried to sell all its beans at $0.30, you would have bought only one can, and the store would have forgone the opportunity to make a profit on the second can. Why? 6 Notice that if the cans had been priced at $0.25 apiece, you would have purchased only two cans. Can you explain the apparent contradiction? Chapter 12 Monopoly Power and Firm Pricing Decisions 15 A firm can discriminate in this way only as long as its customers do not resell what they buy for a higher price—and as long as other firms are unable to move into the market and challenge its monopoly power by lowering the price. In the case of canned beans, resale is not very practical. The person who buys three cans has little incentive to seek out someone who is willing to pay $0.25 instead of $0.20 for one can. The profit potential—five cents—is just not great enough to bother with. Suppose a car dealer has two identical automobiles carrying a book price of $5,000 each, however. If the dealer offers one car for $5,000 and two cars for $9,000, many people would be willing to buy both cars and spend the time needed to find a buyer for one of them at $4,500. The $500 gain they stand to make would compensate them for their time and effort in searching out a resale. Thus advertised price discrimination is much more frequently found in grocery stores than in car dealerships. Price discrimination is the practice of varying the price of a given good or service according to how much is bought and who buys it, supposing that marginal costs do not differ across buyers. Car dealers also discriminate with regard to price, however. The salesperson who in casual conversation asks a customer’s age, income, place of work, and so forth is actually trying to figure out the customer’s demand curve, so as to get as high a price as possible. Similarly, many doctors and lawyers quietly adjust their fees to fit their clients’ incomes, using information they obtain from client questionnaires. Whether price discrimination is unadvertised and based on income, as in the case of doctors and car dealers, or advertised and based on volume sold, as in the case of utilities and long-distance phone companies, the important point is that the products or services involved are typically difficult if not impossible to resell. Some monopolies’ products are not difficult to resell, and so they cannot engage in price discrimination. For example, copyright law gives the publishers of economics textbooks some monopoly power, but textbooks are easily resold, both through a network of used-book dealers and among students. Thus, although textbook publishers can alter their sales by changing the price, they rarely engage in price discrimination. Nor do they encourage college bookstores to price-discriminate in their sales to students. The discounts publishers give bookstores on large sales reflect cost differences in handling large and small orders, not students’ or professors’ downward-sloping demand curves for books. The same can be said about a host of other products protected by patents and copyrights. The monopolist whose production level was shown in Figure 12.6 could not discriminate among buyers or units bought by each buyer. A monopolist who has such power, however, can produce at a higher output level than Q m and earn greater profits. Just how much greater depends on how free, or “perfect,” the monopolist’s power to discriminate is. Perfect Price Discrimination The monopolist represented Figure 12.9 can charge a different price for each and every unit sold. Theoretically, this firm has the power of perfect price discrimination (“perfect” from the standpoint of the producer, not the consumer). Perfect price Chapter 12 Monopoly Power and Firm Pricing Decisions 16 discrimination is the practice of selling each unit of a given good or service for the maximum possible price. Under perfect price discrimination, the seller’s marginal revenue curve is identical to the seller’s demand curve. In Figure 12.10, for instance, the firm’s marginal revenue curve is not separate and distinct from its demand curve, as in Figure 12.7. Its demand curve is its marginal revenue curve. If the first unit can be sold for a price of, say, $20, the marginal revenue from that unit is equal to the price, $20. If the next unit can be sold for $19.95, the marginal revenue from that unit is again the same as the price; and so on. In short, the seller extracts the entire consumer surplus. ___________________________________________ FIGURE 12.9 Perfect Price Discrimination The perfect price-discriminating monopolist will produce where marginal cost and marginal revenue are equal (point a). Its output level, Q c is therefore the same as that achieved under perfect competition. But because the monopolist charges as much as the market will bear for each unit, its profits—the shaded area ATC 1 P 1 ab—are higher than the competitive firm’s. As in Figure 12.3, the perfectly price-discriminating monopolist equates marginal revenue with marginal cost. Equality occurs this time at point a, the intersection of the demand curve (also the marginal revenue curve) with the marginal cost curve (see Figure 12.9). Thus the perfectly price-discriminating monopolist achieves the same output level as does the perfectly competitive industry. In this sense the perfect price discriminating firm is an efficient producer. As before, profit is found by subtracting total cost from total revenue. Total revenue here is the area under the demand curve up to the monopolist’s output level, or the area bounded by 0P 1 aQ c . Total cost is the area bounded by 0ATC 1 bQ c (found, you may recall, by multiplying average total cost times quantity). Profit is therefore the shaded area above the average total cost line and below the demand curve, bounded by ATC 1 P 1 ab. Through price discrimination the monopolist increases profits (compare Figure 12.3). Consumers also get more of what they want, although not necessarily at the price they want. In the strict economic sense, perfect price discrimination increases the efficiency of a monopolized industry. Consumers would be still better off if they could pay one constant price, P c , for the quantity Q c , as they would under perfect competition. This, however, is a choice the price-discriminating monopolist does not allow. Chapter 12 Monopoly Power and Firm Pricing Decisions 17 Discrimination by Market Segment Charging a different price for each and every unit sold to each and every buyer is of course improbable, if not impossible. The best most producers can do is to engage in imperfect price discrimination—that is, to charge a few different prices, like the grocery store that sells beans at different rates. Imperfect price discrimination is the practice of charging a few different prices for different consumption levels or different market segments (based on location, age, income, or some other identifiable characteristic that is unrelated to cost differences). The practice is fairly common. Electric power and telephone companies engage in imperfect price discrimination when they charge different rates for different levels of use, measured in watts or minutes. Universities try to do the same when they charge more for the first course taken than for any additional course. Both practices are examples of multipart price discrimination. Drugstores price- discriminate when they give discounts to senior citizens and students, and theaters price discriminate by charging children less than adults. In those cases, discrimination is based on market segment—namely, age group. By treating different market segments as having distinctly different demand curves, the firm with monopoly power can charge different prices in each market. Figure 12.10 shows how discrimination by market segment works. Two submarkets, each with its own demand curve, are represented in parts (a) and (b). Each also has its own marginal revenue curve. To price its product, the firm must first decide on its output level. To do so it adds its two marginal revenue curves horizontally. The combined marginal revenue curve it obtains is shown in part (c) of the figure. The firm must then equate this aggregate marginal revenue curve with its marginal cost of production, which is accomplished at the output level Q m in part (c). FIGURE 12.10 Imperfect Price Discrimination The monopolist that cannot perfectly price-discriminate may elect to charge a few different prices by segmenting its market. To do so, it divides its market by income, location, or some other factor and finds the demand and marginal revenue curves in each (part (a) and (b)] . Then it adds those marginal revenue curves horizontally to obtain its combined marginal revenue curve for all market segments, MR m (part (c)] . By equating marginal revenue with marginal cost, it selects its output level, Q m . Then it divides that Chapter 12 Monopoly Power and Firm Pricing Decisions 18 quantity between the two market segments by equating the marginal cost of the last unit produced (part (c)] with marginal revenue in each market (Parts (a) and (b)] . It sells Q a in market A and Q b in market B, and charges different prices in each segment. Generally, the price will be higher in the market segment with the less elastic demand (part (b)] . Finally, the firm must divide the resulting output, Q m , between markets A and B. The division that maximizes the firm’s profits is found by equating the marginal revenue in each market (shown in parts (a) and (b)] with the marginal cost of the last unit produced (part c). That is, the firm equates the marginal cost of producing the last unit of Q m , (part (c)] with the marginal revenue from the last unit sold in each market segment (MC = MR a = MR b ). For maximum profits, then, output Q m , must be divided into Q a for market A and Q b for market B. Why does selling where MC = MR a = MR b result in maximum profit? Suppose MR a were greater than MR b . Then by selling one more unit in market A and one less unit in market B, the firm could increase its revenues. Thus the profit-maximizing firm can be expected to shift sales to market A from market B until the marginal revenue of the last unit sold in A exactly equals the marginal revenue of the last unit sold in B. Having established the output level for each market segment, the firm will charge whatever price each segment will bear. In market A, quantity Q a will bring a price of P a . In market B, quantity Q b will bring P b . (Note that the price-discriminating monopolist charges a higher price in a market with the less elastic demand—market B.) To find total profit, add the revenue collected in each market segment (parts (a) and (b)] and subtract the total variable cost of production (the area under the marginal cost curve in part (c)] and the fixed cost. Applications of Monopoly Theory Economics is a fascinating course of study because it often leads to counterintuitive conclusions. This is clearly the case with monopoly theory, as we can show with several policy issues relating to monopoly. Price Controls under Monopoly Market theory suggests that price controls can cause monopolistic firms to increase their output. Figure 12.11 shows the pricing and production of a monopolistic electric utility. Without price controls, a firm with monopoly power will produce Q m kilowatts and sell them at P m . If the government declares that price too high, it can force the firm to sell at a lower price—for example, P 1 . At that price the firm can sell as many as Q 1 kilowatts. With the price controlled at P 1 , the firm’s marginal revenue curve for Q 1 units becomes horizontal at P 1 a. Every time it sells an additional kilowatt, its total revenues will rise by P 1 . As we stressed in the last chapter, the firm’s ideal production level is the point at which marginal cost equals marginal revenue. If the firm cannot exactly equate marginal Chapter 12 Monopoly Power and Firm Pricing Decisions 19 cost and marginal revenue, it should strive to come as close as possible. With the maximum price controlled at P 1 , the firm can increase its revenues by selling up to Q 1 units, which is all demand will permit. At that point marginal revenue approaches but does not equal marginal cost (MC). (To equate marginal revenue with marginal cost, the firm would have to expand production past Q 1 , the limit consumers will buy.) Notice that Q 1 is greater than Q m , the amount the firm would produce under a free but monopolized market. In short, price controls can cause a firm with market power to expand production. (Some exceptions to this rule will be described later.) ___________________________________________ FIGURE12.11 The Effect of Price Controls on the Monopolistic Production Decision In a free market, a monopolistic utility will produce Q m kilowatts and will sell them for P m . If the firm’s price is controlled at P 1 , however, its marginal revenue curve will become horizontal at P 1 . The firm will produce Q 1 more than the amount it would normally produce. Taxing Monopoly Profits Some people claim that the economic profits of monopoly can be taxed with no loss in economic efficiency. By definition, economic profit represents a reward to the resources in a monopolized industry that is greater than necessary to keep those resources employed where they are. It also represents a transfer of income, from consumers to the owners of the monopoly. Therefore a tax extracted solely from the economic profits of monopoly should not affect the distribution of resources and should fall exclusively on monopoly owners—so the argument goes. Figure 12.12 shows the reasoning behind this position. This monopoly produces Qm 1 , charges Pm 1 , and makes an economic profit equal to the shaded area ATC 1 P m1 ab. Since marginal cost and marginal revenue are equal at Q m1 , the firm is earning its maximum possible profit. Expansion or contraction of production will not increase its profit. Even if the government were to take away 25, 50, or 90 percent of its economic profit, then the firm would not change its production plans or its price. Nor would it raise prices to pass the profits tax on to consumers. The monopolist price-quantity combination, Pm 1 and Qm 1 , leaves the monopolist with the largest after-tax profit—regardless of the tax rate. The economic profit shown on the graph is not the same as the firm’s book profit, however. Book profit tends to exceed economic profit by the sum of the owners’ opportunity cost and risk cost. For practical reasons, government must impose its tax on Chapter 12 Monopoly Power and Firm Pricing Decisions 20 book profit, not economic profit. As a result, the tax falls partly on the legitimate costs of doing business, shifting the firm’s marginal cost curve upward, from MC 1 to MC 2 in Figure 12.12 The monopolist, in turn, will reduce the quantity produced from Q m1 to Q m2 , and raise the price from P m1 to P m2 . Thus part of the government tax on profits is passed along to consumers as a price increase. Consumers are doubly penalized—first through the monopoly price, which exceeds the competitive price, and second through the surcharge added by the profits tax. _________________________________________ FIGURE 12.12 Taxing Monopoly Profits Theoretically, a tax on the economic profit of monopoly will not be passed on to the consumer— but taxes are levied on book profit, not economic profit. As a result, a tax shifts the firm’s marginal cost curve up, from MC 1 to MC 2 , raising the price to the consumer and lowering the production level. Monopolies in “Goods” and “Bads” Because monopolies restrict output, raise prices, and misallocate resources, students and policy-makers tend to view them as market failures that should be corrected by antitrust action. If a monopolized product or service represents an economic good—something that gives consumers positive utility—restricted sales will necessarily mean a loss in welfare. Some products and services, however, may be viewed as “bads” by large portions of the citizenry. Drugs, prostitution, contract murder, and pornography may be goods to their buyers, but they represent negative utility to others in the community. Thus monopolies in the production of such goods may be socially desirable. If a drug monopoly attempts to increase its profits by holding the supply of drugs below competitive levels, most citizens would probably consider themselves better off. The question is not quite that simple, however. A heroin monopoly may restrict the sale of heroin in a given market. Yet because the demand for heroin is highly inelastic (because of drug addiction), higher prices may only increase buyers’ expenditures, raising the number of crimes they must commit to support their habit. Paradoxically then, reducing heroin sales could lead to more burglaries, muggings, and bank hold-ups. Of course, drugs and other underground services are not normally subject to antitrust action; they are illegal. The analogy may be applied to legal goods and services, however, such as liquor. Given the negative consequences of drinking, as well as religious prohibitions, many people might consider alcoholic beverages an economic bad. Chapter 12 Monopoly Power and Firm Pricing Decisions 21 In that case a state-long-run liquor monopoly could provide a social service. By restricting liquor sales through monopoly pricing, it would reduce drunk driving, thus limiting the external costs associated with drinking. (The same objective—fewer liquor sales and less drunk driving—could also be accomplished through higher taxes.) The Total Cost of Monopoly High prices and restricted production are not the only costs of monopoly. The total social cost of monopoly power is actually greater than is shown by the supply and demand model in Figure 12.6. Many firms attempt to achieve the benefits of monopoly power by erecting barriers to entry in their markets. The resources invested in building barriers are diverted from the production of other goods, which could benefit consumers. The total social cost of monopoly should also include the time and effort that the antitrust Division of the Department of Justice, the Federal Trade Commission, state attorneys general, and various harmed private parties devote to thwarting such attempts to gain monopoly power and to breaking it up when it is acquired. Another, subtler social cost of monopoly is its redistributional effect. Because of monopoly power, consumers pay higher prices than under perfect competition (P m instead of P c in Figure 12.6). The real purchasing power of consumer incomes is thus decreased, while the incomes of monopoly owners go up. To the extent that monopoly increases the price of a good to consumers and the profits to the producer, then, it may redistribute income from lower-income consumers to higher-income entrepreneurs. Many consider this redistributional effect a socially undesirable one. In addition, when we measure the inefficiency of monopoly by the triangular area abc in Figure 12.6, we are assuming that demand for the monopolized product and all other goods is unaffected by the redistribution of income from consumers to monopoly owners. This may be a reasonable assumption when the monopolist is a maker of vegetable-slicing machines. It is less reasonable for other monopolies, such as the postal, local telephone, and electric power services. Those firms, which are quite large in relation to the entire economy, can shift the demand for a large number of products, causing further misallocation of resources. Finally, our analysis has assumed that a monopoly will seek to minimize its cost structure, just as perfect competitors do. That may not be a realistic assumption because the monopolist does not, by definition, face competitive pressure. If a monopoly relaxes its attentiveness to costs, the result can be the inefficient employment of resources. Why a Durable Goods Monopoly Must Charge the Competitive Price If prohibitive barriers to entry protect it, can a monopolist always charge the monopoly price indicated? University of Chicago Professor of Law and Economics and Noble Laureate Ronald Coase wrote a very famous article years ago in which he pointed out Chapter 12 Monopoly Power and Pricing Decisions that even a monopolistic producer of a durable good would charge a competitive price for its product. 7 Why? Because no sane person would buy all or any portion of the durable good at a price above the competitive level. He used the example of a monopoly owner of a plot of land. If the owner tried to sell the land all at once, he would have to lower the price on each parcel until all the land were bought – where the downward sloping demand for land crossed the fixed vertical supply of land which means the owner would have to charge the competitive price (where the demand for the land and the supply of the land came together). You might think that the sole/monopoly owner of land would be able to restrict sales and get more than the competitive price. However, buyers would reason that the monopoly owner would eventually want to sell the remaining land, but that land could only be sold at less than the price of land already sold. This means that the buyers would rationally wait to buy until the price came down. This means that the owner would sell nothing at the monopoly price, and would only be able to sell the land at the competitive price. This analysis works out this way only because the land is durable. Monopolies can charge monopoly prices for nondurable goods, and they can do that because they have control over production. This means that one way a monopoly can elevate its price above the competitive level is by somehow making its product less durable. This may explain why many software producers are constantly bringing out new, updated, and upgraded versions of their programs – to, in the minds of consumers, make their programs less than durable. Still, computer programs must remain, to some degree for some time, “durable,” which ultimately imposes a competitive check on dominant software producers, for example, Microsoft. The Justice Department seems to believe that Microsoft doesn’t have competitors. Well, and one of Microsoft’s biggest competitors is none other than Microsoft itself. Any new version of, say, windows, must compete head to head with the existing stock of old versions, which computer users can continue to use at zero price. That very low price on old versions of Windows imposes a check on the prices that Microsoft can charge on any new version. Monopolies in Network Goods The conditions under which monopoly might be expected to emerge and prosper have expanded in recent years with the development of the theory of networks, which we have already introduced. As noted in an earlier chapter, in 1998, the Justice Department filed an antitrust suit against Microsoft for, among other things, engaging in “predatory” pricing in the Internet browser market. The Justice Department argued that by giving away Internet Explorer, Microsoft was attempting to snuff out a serious market rival in 7 Ronald H. Coase, “Durability and Monopoly,” Journal of Law and Economics, vol. 15 (April 1972), pp. 143-149. . actually willing to pay more for the first can $0.30—than for the second. If the store offers one can for $0.30 and two cans for $0.55, you will still. can of beans for $0.30, two cans for $0.55, and three cans for $0.75, a grocery store collects more revenues than if it offers three cans for $0.20 each.

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