Natural Monopolies

CHECK STATION 4

Suppose that the demand curve facing OPEC is given by P 120 2Q and that each member’s cost of producing oil is AC MC $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?

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,

the lower average-cost-based price spurs a significant increase in output and, therefore, in welfare.

However, average-cost pricing does not exhaust the opportunities for welfare gains. At output QR 8, the demand curve still lies above marginal cost; that is, MB MC. Output should be expanded and price lowered. In fact, optimal price and output can be determined by the intersection of the demand and marginal cost curves. This outcome is referred to as marginal-cost pricing because it fulfills the efficiency condition P MB MC. Consumers are encouraged to purchase more output as long as their value exceeds the (low) marginal cost of production.

If marginal-cost pricing is efficient, why isn’t it universally used? The practical difficulty with this pricing scheme should be evident. Price falls short of the firm’s declining average cost P MC AC—so the firm makes persistent losses. One way to maintain P MC while making good this loss is to have

Dollars per Unit of Output $12

11

10 Declining average cost

9

8

7

PM = 6

5

4

PR = 3

2

MC = 1 Electricity demand

Monopoly outcome: PM = $6, QM = 5

Marginal revenue Average-cost pricing under regulation

MC

0 1 2 3 4 5 6 7 8 9 10 11 Q

12

Electricity (Kilowatt-Hours)

FIGURE 8.4

A Natural Monopoly

Regulators seek to implement averagecost pricing where the demand curve intersects the AC curve.

A “Natural” Telecommunications Monopoly?

the government subsidize the decreasing-cost producer. (Government-owned utilities often follow this route, financing deficits from general tax revenues.) An alternative method is for the utility to institute so-called two-part pricing. Here each customer pays a flat fee (per month) for access to output and then pays an additional fee, equal to marginal cost, according to actual usage. Thus, customers are encouraged to consume output at marginal cost. At the same time, the flat-fee charge allows the firm to cover average cost; that is, it covers the firm’s large fixed costs. Though beneficial, two-part pricing is not a perfect remedy for the pricing problems associated with declining average cost. The problem is that the fixed fee may deter some potential customers from purchasing the service altogether, even though their marginal benefit exceeds marginal cost.

Average-cost pricing is the most common regulatory response, and it goes a long way toward implementing the virtues of competitive pricing in the natural-monopoly setting. However, it is far from perfect. First, the regulator/rate setter faces the problem of estimating the monopolist’s true costs over the relevant range of potential output. At regulatory rate hearings, the natural monopolist has a strong incentive to exaggerate its average cost to justify a higher price. Imperfect or biased cost estimates lead to incorrect regulated price and output. Second, the regulated monopolist has a reduced incentive to minimize its cost of production. Indeed, if the regulatory agency were able to maintain PR AC at all times, any cost change would be immediately reflected in a price increase. The firm would have no economic incentive (although it might have a political one) to hold costs down. Interestingly, the presence of “regulatory lag”—the fact that prices are reset periodically, sometimes after long delay—bolsters the firm’s cost-cutting incentives. In the typical case of escalating costs, the monopolist profits from cost-cutting measures during the period over which the regulated price is fixed.

Finally, critics of price regulation point out that over time government intervention has spread into many areas that are a far cry from natural monopolies—trucking, airlines, and banking, for example. Furthermore, they point out that, by intention or not, regulation frequently reduces true competition: Regulated rates can hold prices up as well as down. In this sense, regulators are “captured” by the firms over which they are supposed to exercise control, in effect maintaining a status quo protected from new competition. For instance, until the emergence of airline deregulation, the express purpose of the Civil Aeronautics Board (the governing regulator) was to fix prices and limit entry into the airline market. In the late 1970s, the CAB, under economist Alfred Kahn, changed course dramatically, freeing fares and allowing the entry of nofrills airlines. The result was the present era of significantly lower airfares.

Before 1996, most communities in the United States received local telephone service and cable television services by single, separate companies. Created by the breakup of AT&T in the 1980s, the “Baby Bells” provided local telephone

services across the geographic regions of the country. Customarily, local authorities granted a legally protected monopoly to a single cable company. Regulators argued for a single provider on the grounds of natural monopoly. By building a single network to serve all households, the cable monopolist would enjoy significant economies of scale, allowing it to deliver low-cost services to subscribers. During this time, many cable companies were largely unregulated and were shielded from competition. Not surprisingly, they tended, over time, to raise monthly fees for basic services.

Economic analysis is useful in exploring the alternatives of regulation and competition in the ever-expanding domain of telecommunications. If one believes that telecommunications has the economic features of a natural monopoly, then granting one firm a regulated monopoly to provide services over a single network is the appropriate response. Alternatively, if one believes competition to be viable in telecommunications, regulatory effort should be aimed at removing all entry barriers. Telecommunication companies, cable firms, satellite operators, telecom-cable merged companies, and other firms should all be allowed to offer competing services. Competition might mean the creation of multiple networks in each service area. Or, if economies of scale are important, it might mean a single broadband network, with the controlling firm obligated to allow access to any multimedia company.

Over the last decade, the advent of deregulation and the development of advanced telecommunications services have reduced monopoly barriers and greatly increased competition.7 Today, local telephone services are provided by the Baby Bells, long-distance companies, Internet companies, and cable companies. The same companies plus independent firms offer long-distance services. Network broadcasters, cable companies, and satellite operators provide television services. Cable, DSL, and dial-up services offer Internet connectivity. Telecommunication companies of all stripes provide cellular and wireless communications. (However, cellular firms must acquire the necessary spectrum licenses to provide these services.) In short, a host of firms (coming from different original markets) are competing to offer the most attractive bundled services to consumers—Internet services, hundreds of television channels, movies on demand, and so on.

There is much evidence supporting the viability of competition. For instance, in jurisdictions where multiple cable firms compete, economic studies have found that subscribers on average pay two to three dollars less per month than in jurisdictions with a monopoly provider of comparable services. (Indeed, some studies indicate that the degree of competition is more important than firm costs in explaining cable prices.) The availability of competing substitutes, such as satellite providers, also induces lower cable prices. (In the same way,

7For a history and economic analysis of telecommunications markets, see N. Economides, “Telecommunications Regulation: An Introduction,” in R. R. Nelson (Ed.), The Limits and Complexity of Organizations (New York: Russell Sage Foundation Press, 2005).

rural areas unable to receive multiple network broadcasts face higher cable prices.) Evidence from the long-distance telephone market, where Verizon, Sprint, the Baby Bells, and independent companies compete successfully with AT&T, also underscores the price-lowering benefits of increased competition. Likewise, in the cellular market, intense competition by the same players and others has lowered prices dramatically. (Since 2003, allowing number portability when switching providers has had an additional price-lowering effect.) By comparison, local telephone competition has been somewhat disappointing. Prices to consumers have fallen, mainly due to regulations requiring the local network owner to provide access to competitor firms at low fees. Thus, lower retail prices have stemmed from lower regulated retail prices rather than from new network capacity.

In short, many economists advocate a “hands-off” regulatory approach to allow the process of free entry and competition to uncover the most efficient ways of providing telecommunications services.

MONOPOLISTIC COMPETITION

In perfect competition, all firms supply an identical standardized product. In monopoly, a single firm sells a unique product (albeit one that may have indirect substitutes). As the term suggests, monopolistic competition represents a mixture of these two cases. The main feature of monopolistic competition is product differentiation: Firms compete by selling products that differ slightly from one another. Product differentiation occurs to a greater or lesser degree in most consumer markets. Firms sell goods with different attributes (claimed to be superior to those of competitors). They also deliver varying levels of support and service to customers. Advertising and marketing, aimed at creating product or brand-name allegiance, reinforce (real or perceived) product differences.

Product differentiation means that competing firms have some control over price. Because competing products are close substitutes, demand is relatively elastic, but not perfectly elastic as in perfect competition. The firm has some discretion in raising price without losing its entire market to competitors. Conversely, lowering price will induce additional (but not unlimited) sales. In analyzing monopolistic competition, one often speaks of product groups. These are collections of similar products produced by competing firms. For instance, “designer dresses” would be a typical product group, within which there are significant perceived differences among competitors.

The determination of appropriate product groups always should be made on the basis of substitutability and relative price effects. Many, if not most, retail stores operate under monopolistic competition. Consider competition among supermarkets. Besides differences in store size, types of products stocked, and service, these stores are distinguished by locational convenience—arguably the most important factor. Owing to locational convenience and other service

differences, a spectrum of different prices can persist across supermarkets without inducing enormous sales swings toward lower-priced stores.

Monopolistic competition is characterized by three features. First, firms sell differentiated products. Although these products are close substitutes, each firm has some control over its own price; demand is not perfectly elastic. Second, the product group contains a large number of firms. This number (be it 20 or 100) must be large enough so that each individual firm’s actions have negligible effects on the market’s average price and total output. In addition, firms act independently; that is, there is no collusion. Third, there is free entry into the market. One observes that the last two conditions are elements drawn from perfect competition. Nonetheless, by virtue of product differentiation (condition 1), the typical firm retains some degree of monopoly power. Let’s consider the output and price implications of these conditions.

Figure 8.5a shows a short-run equilibrium of a typical firm under monopolistic competition. Because of product differentiation, the firm faces a slightly downward-sloping demand curve. (If it raises price slightly, it loses some, but not all, customers to competitors.) Given this demand curve, the firm maximizes profit by setting its marginal revenue equal to its marginal cost in the usual way. In the figure, the resulting output and price are Q and P, respectively. Because price exceeds average cost, this typical firm is earning positive economic profits.

In a long-run equilibrium, the free entry (or exit) of firms ensures that all industry participants earn zero economic profits. Thus, in the long run, the outcome in Figure 8.5a is not sustainable. Attracted by positive economic profits, new firms will enter the market. Because it must share the market with a greater number of competitors, the typical firm will find that demand for its product will be reduced; that is, its demand curve will shift to the left.

Figure 8.5b shows the firm’s new long-run demand curve. As in part (a), the firm is profit maximizing. The firm’s optimal output is QE, where marginal revenue equals marginal cost. However, even as a profit maximizer, the firm is earning zero economic profit. At this output, its price, PE, exactly equals its average cost. In fact, the firm’s demand curve is tangent to (and otherwise lies below) its average cost curve. Any output other than QE, greater or smaller, implies an economic loss for the firm.

A comparison of Figures 7.3 and 8.5 shows the close correspondence between the graphical depictions of monopolistic competition and perfect competition. The essential difference centers on the individual firm’s demand curve—either downward sloping (reflecting differentiated products) or infinitely elastic (indicating standardized products that are perfect substitutes). In both cases, the long-run equilibrium is marked by the tangency of the demand line with the average cost curve. Under perfect competition, this occurs at the point of minimum average cost. In contrast, the typical firm in monopolistic competition (by virtue of its differentiated product) charges a higher price (one above minimum average cost) and supplies a smaller output than its counterpart in a competitive market.

FIGURE 8.5

Monopolistic Competition

In part (a), the firm produces output Q (where MR MC) and makes a positive economic profit. In part (b) the entry of new firms has reduced the firm’s demand curve to the point where only a zero economic profit is available. Dollars per Unit of Output

P

AC

Q MRF

DF

(a) The Firm Earns Excess Profit

Dollars per Unit of Output MC AC

Output

MC AC

PE

MRF

DF

QE

Output (b) Long-Run Equilibrium—The Firm Earns Zero Economic Profit

Over the last 70 years, New York City’s taxi commission has kept the number of medallions (legally required to drive a taxi) nearly fixed. Currently, there are 12,487 cabs to serve a population of some 8 million. Cabs are never around when New Yorkers want them. Yet the market price of medallions (bought and sold weekly) is over $250,000. It would seem there is significant unfilled demand for taxi service and a substantial profit to be had from supplying it.

The New York taxi market is a classic case of a monopoly restriction on output— sanctioned and maintained by government regulation. Although there are economic grounds for government regulation in many aspects of this service (fare rates, safety and maintenance of cabs, conduct of drivers), an absolute restriction on entry does not appear to be one of them. Consider the following hypothetical, but plausible, illustration. Weekly demand for trips is

Q 7 .5P,

where Q denotes the number of trips in millions and P is the average price of a trip in dollars. The taxi meter rates currently established by the commission (after a 25 percent hike in 2004) imply an average fare of P $10 per trip. The current number of licensed taxis is 12,487, and a taxi, if fully utilized, can make a maximum of 140 trips per week. The typical taxi’s cost of carrying q weekly trips is

C 910 1.5q.

This cost includes wages paid to the driver, a normal rate of return on the investment in the taxi, depreciation, and gasoline.

These facts allow us to prepare an economic analysis of the taxi market that addresses a number of policy questions. Is there an insufficient supply of cabs? The answer is yes. If fully utilized, the current number of taxis can supply (12,487)(140) 1,748,180 trips per week. But demand is Q 7 .5(10) 2 million trips. (The supply shortfall is 13 percent of total demand.) Are medallion holders (fleet owners and individual taxi owners) earning excess profits? The answer is yes. The cost per week is 910 (1.5)(140) $1,120 for a fully utilized cab. The average cost is $1,120/140 $8 per trip. Cab owners enjoy an excess profit of ($10 8)(140) $280 per week, or $14,560 per year. A medallion entitles the owner to this excess profit each and every year. Thus, it is not surprising that the market value of a medallion is $250,000 or more. (At a price of $250,000, the medallion earns an annual real return of 14,560/250,000 5.8 percent; this is in line with real returns for other assets of comparable riskiness.)

Are consumer interests being served? Surely not. At the very least, the commission should increase the number of medallions by 13 percent so that trip supply can match trip demand at the $10 fare. Current medallion holders would continue to earn $280 excess profit per week (along with new holders), so they would feel no adverse effects. A more dramatic policy change would be to do away with the medallion system and allow free entry into the taxi market by anyone who wishes to drive a cab. What would be the likely

New York City’s Taxicabs Revisited

outcome of this deregulation? Attracted by excess profits, new taxis would enter the market. If fare regulations remained unchanged (P $10), the influx of taxis would mean fewer trips per taxi and zero economic profits for all taxis in equilibrium. Alternatively, the commission could set lower fares (say, P $9.50) in conjunction with free entry, allowing price to decline with the influx of supply. A third option is to allow free entry and, at the same time, deregulate fares. In the past, a number of cities (e.g., San Diego and Seattle) have tried to introduce free competition into taxi markets. Drivers are free to discount fares below the standard meter rates (with these discounts being posted on the cabs’ doors). Supply (augmented by free entry) and demand would then determine prevailing taxi fares—presumably at levels well below those set by regulation.

Finally, our economic analysis provides a ready explanation for the reluctance of commissions in major cities like New York to increase the number of medallions. A large increase in medallions would reduce the profit associated with holding a medallion and, therefore, decrease the value of the medallion itself. (Allowing perfectly free entry would eliminate these profits altogether and reduce the value of a medallion to zero.) Fierce lobbying by taxi drivers and taxi companies has persuaded city governments to retain the current medallion system.

SUMMARY

Decision-Making Principles

1.Whatever the market environment, the firm maximizes profit by establishing a level of output such that marginal revenue equals marginal cost. 2.A monopolist sets MR MC, where MR is determined by the industry demand curve. The magnitude of monopoly profit depends on demand (the size and elasticity of market demand) and on the monopolist’s average cost. 3.In monopolistic competition, the firm’s long-run equilibrium is described by the conditions MR MC and P AC.

Nuts and Bolts

1.Under pure monopoly, a single producer is shielded from market entrants by some form of barrier to entry. To maximize profit, the monopolist restricts output (relative to the competitive outcome) and raises price above the competitive level. 2.A cartel is a group of producers that enter into a collusive agreement aimed at controlling price and output in a market. The cartel restricts output and raises price to maximize the total profits of its members. The incentive for individual members to sell extra output (at discounted prices) is the main source of cartel instability.

3.A natural monopoly occurs when the average cost of production declines throughout the relevant range of product demand. Regulation via average-cost pricing is the most common response to natural monopoly. 4.In monopolistic competition, a large number of firms sell differentiated products, and there are no barriers to entry by new suppliers. Because each firm faces a slightly downward-sloping demand curve, price exceeds minimum average cost.

Questions and Problems

1.In 1989, the Detroit Free Press and Detroit Daily News (the only daily newspapers in the city) obtained permission to merge under a special exemption from the antitrust laws. The merged firm continued to publish the two newspapers but was operated as a single entity. a.Before the merger, each of the separate newspapers was losing about $10 million per year. What forecast would you make for the merged firms’ profits? Explain. b.Before the merger, each newspaper cut advertising rates substantially.

What explanation might there be for such a strategy? After the merger, what prediction would you make about advertising rates? 2.A pharmaceutical company has a monopoly on a new medicine.

Under pressure by regulators and consumers, the company is considering lowering the price of the medicine by 10 percent. The company has hired you to analyze the effect of such a cut on its profits.

How would you carry out the analysis? What information would you need? 3.The ready-to-eat breakfast cereal industry is dominated by General Mills,

Kellogg, Kraft Foods, and Quaker Oats that together account for 90 percent of sales. Each firm produces a bewildering proliferation of different brands (General Mills alone has over 75 cereal offerings), appealing to every conceivable market niche. Yet, the lowest brands on each company’s long pecking list generate meager or no profits for the corporate bottom line. What strategic reasons might the dominant companies have for pursuing extreme brand proliferation? Explain. 4.Formerly, the market for air travel within Europe was highly regulated.

Entry of new airlines was severely restricted, and air fares were set by regulation. Partly as a result, European air fares were higher than U.S. fares for routes of comparable distance. Suppose that, for a given

European air route (say, London to Rome), annual air travel demand is estimated to be Q 1,500 3P (or, equivalently, P 500 Q/3), where Q is the number of trips in thousands and P is the one-way fare in dollars. (For example, 600 thousand annual trips are taken when the

fare is $300.) In addition, the long-run average (one-way) cost per passenger along this route is estimated to be $200. a.Some economists have suggested that during the 1980s and 1990s there was an implicit cartel among European air carriers whereby the airlines charged monopoly fares under the shield of regulation. Given the preceding facts, find the profit-maximizing fare and the annual number of passenger trips. b.In the last 10 years, deregulation has been the norm in the European market, and this has spurred new entry and competition from discount air carriers such as Ryan Air and EasyJet. Find the price and quantity for the European air route if perfect competition becomes the norm. 5.Consider a natural monopoly with declining average costs summarized by the equation AC 16/Q 1, where AC is in dollars and Q is in millions of units. (The total cost function is C 16 Q.) Demand for the natural monopolist’s service is given by the inverse demand equation

P 11 Q. a.Determine the price and output of the unregulated natural monopolist. b.Suppose a regulator institutes average-cost pricing. What is the appropriate price and quantity? c.Answer part (b) assuming the regulator institutes marginal-cost pricing. What is the enterprise’s deficit per unit of output? How might this deficit be made up? 6.Firm S is the only producer of a particular type of foam fire retardant and insulation used in the construction of commercial buildings. The inverse demand equation for the product is

P 1,500 .1Q,

where Q is the annual sales quantity in tons and P is the price per ton. The firm’s total cost function (in dollars) is

C 1,400,000 300Q .05Q2 .

a.To maximize profit, how much foam insulation should firm S plan to produce and sell? What price should it charge? b.Compute the firm’s total profit. 7.Suppose that, over the short run (say, the next five years), demand for

OPEC oil is given by Q 57.5 .5P or, equivalently, P 115 2Q. (Here Q is measured in millions of barrels per day.) OPEC’s marginal cost per barrel is $15. a.What is OPEC’s optimal level of production? What is the prevailing price of oil at this level?

b.Many experts contend that maximizing short-run profit is counterproductive for OPEC in the long run because high prices induce buyers to conserve energy and seek supplies elsewhere.

Suppose the demand curve just described will remain unchanged only if oil prices stabilize at $50 per barrel or below. If oil price exceeds this threshold, long-run demand (over a second five-year period) will be curtailed to Q 42 .4P (or P 105 2.5Q).

OPEC seeks to maximize its total profit over the next decade. What is its optimal output and price policy? (Assume all values are present values.) 8.Consider once again the microchip market described in Problem 9 of

Chapter 7. Demand for microprocessors is given by P 35 5Q, where

Q is the quantity of microchips (in millions). The typical firm’s total cost of producing a chip is Ci 5qi, where qi is the output of firm i. a.Suppose that one company acquires all the suppliers in the industry and thereby creates a monopoly. What are the monopolist’s profitmaximizing price and total output? b.Compute the monopolist’s profit and the total consumer surplus of purchasers. 9.Consider again the New York taxi market, where demand is given by Q 7 .5P, each taxi’s cost is C 910 1.5q, and ACmin $8 at 140 trips per week. a.Suppose that, instead of limiting medallions, the commission charges a license fee to anyone wishing to drive a cab. With an average price of P $10, what is the maximum fee the commission could charge?

How many taxis would serve the market? b.Suppose the commission seeks to set the average price P to maximize total profit in the taxi industry. (It plans to set a license fee to tax all this profit away for itself.) Find the profit-maximizing price, number of trips, and number of taxis. How much profit does the industry earn? (Hint: Solve by applying MR MC. In finding MC, think about the extra cost of adding fully occupied taxis and express this on a costper-trip basis.) c.Now the city attempts to introduce competition into the taxi market.

Instead of being regulated, fares will be determined by market conditions. The city will allow completely free entry into the taxi market. In a perfectly competitive taxi market, what price will prevail?

How many trips will be delivered by how many taxis? d.Why might monopolistic competition provide a more realistic description of the free market in part (c)? Explain why average price might fall to, say, only $9.00. At P $9.00, how many trips would a typical taxi make per week? (Are taxis underutilized?) How many taxis would operate?

10.Firms A and B make up a cartel that monopolizes the market for a scarce natural resource. The firms’ marginal costs are MCA 6 2QA and

MCB 18 QB, respectively. The firms seek to maximize the cartel’s total profit. a.The firms have decided to limit their total output to Q 18. What outputs should the firms produce to achieve this level of output at minimum total cost? What is each firm’s marginal cost? b.The market demand curve is P 86 Q, where Q is the total output of the cartel. Show that the cartel can increase its profit by expanding its total output. (Hint: Compare MR to MC at Q 18.) c.Find the cartel’s optimal outputs and optimal price. (Hint: At the optimum, MR MCA MCB.) 11.A single buyer who wields monopoly power in its purchase of an item is called a monopsonist. Suppose that a large firm is the sole buyer of parts from 10 small suppliers. The cost of a typical supplier is given by C 20 4Q Q2 . a.Suppose that the large firm sets the market price at some level P. Each supplier acts competitively (i.e., sets output to maximize profit, given P). What is the supply curve of the typical supplier? Of the industry? b.The monopsonist values the part at $10. This is the firm’s break-even price, but it intends to offer a price much less than this and purchase all parts offered. If it sets price P, its profit is simply:

where Qs is the industry supply curve found in part (a). (Of course, Qs is a function of P.) Write down the profit expression and maximize profit with respect to P. Find the firm’s optimal price. Give a brief explanation for this price. 12.a.When a best-selling book was first released in paperback, the Hercules Bookstore chain seized a profit opportunity by setting a selling price of $9 per book (well above Hercules’ $5 average cost per book). With paperback demand given by P 15 .5Q, the chain enjoyed sales of Q 12 thousand books per week. (Note: Q is measured in thousands of books.) Draw the demand curve and compute the bookstore’s profit and the total consumer surplus. b.For the first time, Hercules has begun selling books online—in response to competition from other online sellers and in its quest for new profit sources. The average cost per book sold online is only $4. As part of its online selling strategy, it sends weekly e-mails to

(10 P)Qs,

*Starred problems are more challenging.

preferred customers announcing which books are new in paperback. For this segment, it sets an average price (including shipping) of $12. According to the demand curve in part (a), only the highest value consumers (whose willingness to pay is $12 or more) purchase at this price. Check that these are the first 6 thousand book buyers on the demand curve. In turn, because of increased competition, Hercules has reduced its store price to $7 per book. At P $7, how many books are bought in Hercules’ stores? (Make sure to exclude online buyers from your demand curve calculation.) Compute Hercules’ total profit. Then compute the sum of consumer surplus from online and in-store sales. Relative to part (a), has the emergence of online commerce improved the welfare of book buyers as a whole? Explain. 13.Firm 1 is a member of a monopolistically competitive market. Its total cost function is C 900 60Q1 9Q1 2. The demand curve for the firm’s differentiated product is given by P 660 16Q1. a.Determine the firm’s profit-maximizing output, price, and profit. b.Attracted by potential profits, new firms enter the market. A typical firm’s demand curve (say, firm 1) is given by P [1,224 16(Q2 Q3 . . . Qn) 16Q1], where n is the total number of firms. (If competitors’ outputs or numbers increase, firm 1’s demand curve shifts inward.) The long-run equilibrium under monopolistic competition is claimed to consist of 10 firms, each producing 6 units at a price of $264. Is this claim correct? (Hint: For the typical firm, check the conditions MR MC and P AC.) c.Based on the cost function given, what would be the outcome if the market were perfectly competitive? (Presume market demand is P 1,224 16Q, where Q is total output.) Compare this outcome to the outcome in part (b). 14.Consider a regulated natural monopoly. Over a 10-year period, the net present value of all the investment projects it has undertaken has been nearly zero. Does this mean the natural monopoly is inefficient? Does it mean the regulatory process has been effective? Explain.

Discussion Question Pharmaceutical companies can expect to earn large profits from blockbuster drugs (for high blood pressure, depression, ulcers, allergies, sexual dysfunction) while under patent protection. What is the source of these profits? Upon patent expiration, numerous rival drug companies offer generic versions of the drug to consumers. (The original developer continues to market the drug under its trade name and usually offers a second generic version of the drug as well.) Discuss the effect of patent expiration on market structure, pricing, and profitability for the drug.

Spreadsheet Problems

S1.Imagine that the perfectly competitive market described in Chapter 7,

Problem S1, were transformed into a pure monopoly. (What were formerly independent small firms are now production units owned by the monopolist.) The cost structure of the typical unit continues to be given by C 25 Q2 4Q, and industry demand is Q 400 20P or, equivalently, P 20 .05Q. Currently, the monopolist has 30 production facilities in place. a.Create a spreadsheet similar to the example shown. Enter numerical values for cells B14 and C8; all other cells should be linked by formulas to these two cells. b.In the short run, the monopolist can change output level QF but cannot vary the number of production facilities. Use the spreadsheet optimizer to maximize the firm’s short-run profit. c.In the long run, the monopolist can change output levels QF and the number of production facilities. Use the spreadsheet optimizer to maximize the firm’s long-run profit.

1 2 3 A B C D E F G

Monopolist Controls the Market

4

5 The Industry 6 Output Plants Price MR Tot Profit

7

8 180 30 11 2 870

9 10

11 The Typical Production Unit 12 QF MC Cost AC

13

14 6 8 37 6.17

15

16 Short Run: Maximize total profit: Adjust: QF 17 Long Run: Maximize total profit: Adjust Q F & # firms

18

S2.Suppose a monopolist controls the industry described in Problem S2 of

Chapter 7. The industry demand curve remains P 160 2Q. In addition, total production costs are unchanged: C 800 40Q .5Q2 .

Create the requisite spreadsheet and use the spreadsheet’s optimizer to determine the monopolist’s profit-maximizing output.

Suggested References

Carlton, D. W., and J. M. Perloff. Modern Industrial Organization. Chapters 4, 5, and 7. Reading, MA: Addison-Wesley, 2004. Joskow, P. L. “Restructuring, Competition, and Regulatory Reform in the U.S. Electricity Sector.” Journal of Economic Perspectives (Summer 1997): 119–138. Joskow notes that natural monopoly elements are more important in electricity transmission than in generation and discusses opportunities for competition and deregulation. Levenstein, M. C. “What Determines Cartel Success?” Journal of Economic Literature (March 2006): 43–95. Tirole, J. The Theory of Industrial Organization. Chapter 1. Cambridge, MA: MIT Press, 1989. Tirole’s opening chapters provide a theoretical overview of pure monopoly. OPEC’s official Web site is www.opec.org.

1. Note that the Lerner index is just the monopolist’s optimal markup.

According to the markup rule in Chapter 3, (P MC)/P 1/Ep. In short, if the monopolist is profit maximizing, the Lerner index should be equal to the inverse of the industry’s price elasticity of demand. This index indicates the degree to which the monopolist can elevate price above marginal cost. However, it does not measure the magnitude of monopoly profit (since no account is made for the firm’s total quantity of output or its fixed costs). 2. Intel’s entry barriers stemmed from (1) pure quality and cost advantages (Intel’s chips were cheaper and faster than anyone else’s), (2) patents (which the company vigorously defended), (3) product differentiation (the Intel Inside campaign), and possibly (4) economies of scale. Besides items (2) and (3), Intel impeded entry by cutting prices on its chips and expanding factory capacity for producing chips. Indeed, when Intel announced the development of its Pentium chip, it exaggerated its features, thereby deterring its major customers (computer manufacturers) from experimenting with rival chips. 3. In a competitive market, the increase in demand would generate an equal long-run increase in supply. There is no increase in price. Under monopoly, the demand shift causes a rightward shift in the MR curve. As a result, the monopolist increases output as well as price. What if there is a cost increase instead? In the competitive market, price increases dollar

CHECK STATION ANSWERS

for dollar with cost. (Firms’ economic profits remain zero.) The monopolist’s optimal response is to cut output (MR MC occurs at lower Q) and pass on only part of the cost increase in the form of a higher price. (For linear demand and cost, the price increase is one-half the cost increase.) 4. OPEC maximizes its profit by setting MR MC. Thus, we have 120 4Q 20, implying Q 25 million barrels per day. In turn, P 120 50 $70 per barrel and (70 20)(25) $1,250 million per day. If the cartel overproduces by 20 percent, the new quantity is 30, the new price is $60, and OPEC’s profit falls to (60 20)(30) $1,200 million, a 4 percent drop.