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Chapter 8
Monopoly
CHECK STATION 4
Suppose that the demand curve facing OPEC is given by P ⴝ 120 ⴚ 2Q and that each member’s cost of producing oil is AC ⴝ MC ⴝ $20. Find the cartel’s profit-maximizing total output and price. If instead of keeping to this output, all members overproduced their quotas by 20 percent, what would be the effect on OPEC’s total profit?
Natural Monopolies A natural monopoly occurs when the average cost of production declines throughout the relevant range of product demand. Utilities—water, electric power, gas, and telephone—typically fall into this category. Figure 8.4 shows a natural monopoly (say, in the generation of electricity) that displays steeply declining average cost. Natural monopoly poses obvious difficulties for the maintenance of workable competition. First, it is costly and inefficient for multiple competing firms to share the market. A single firm can always produce a specified quantity of output—call this Q—at lower average cost than it could if the same total quantity were supplied by n firms, each producing Q/n. (Use Figure 8.4 to confirm this.) For six local firms to make the large capital investment to supply electricity is unnecessarily duplicative and costly. With a facility of suitable capacity, a single firm is better suited to be the sole source of supply. Second, even if the market, in principle, could support more than one firm, the inevitable result would be the emergence of a single dominant monopolist. This is simply to say that any firm that increases output can achieve lower unit costs and so price the competition out of the market. Thus, we would expect that the first firm to enter the market and expand its output will grow to control the industry. Government decision makers play an active and direct role in the regulation of natural monopoly. The principal regulatory aim is to target industry price and output at the efficient competitive level. Let’s use Figure 8.4 to display the natural-monopoly outcome, with and without price regulation. In the absence of any regulation (i.e., under a policy of laissez-faire), the firm acts as a pure monopolist. The resulting outcome is the price-quantity pair QM and PM, where the firm’s marginal revenue equals its marginal cost. Here the marginal benefit of the last unit consumed is equal to the monopoly price, which, of course, is well above the marginal cost of production. An increase in output from the monopoly level would improve welfare (since MB MC). The regulator can induce an increase in output by limiting the natural monopolist to a price that delivers a “fair” rate of return on the firm’s investment. This is accomplished by instituting average-cost pricing. The appropriate price and quantity are determined by the intersection of the demand and average cost curves in Figure 8.4. At price PR, the firm earns zero “economic” profit; that is, price exactly equals average cost, where AC includes a provision for a normal return on invested capital. Relative to the unregulated outcome,
