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TABLE 14-1 Monopolist’s revenue
The price a monopolist chooses to charge affects the quantity demanded, and therefore total revenue.
(1)
(2)
(3)
(4)
(5)
Price
Quantity sold
Total revenue
Average revenue
($/diamond)
(Violet diamonds)
($)
Marginal
revenue
6,500
0
0
($)
($/diamond)
—
6,000
6,000
1
6,000
6,000
5,000
5,500
2
11,000
5,500
4,000
5,000
3
15,000
5,000
3,000
4,500
4
18,000
4,500
2,000
4,000
5
20,000
4,000
1,000
3,500
6
21,000
3,500
0
3,000
7
21,000
3,000
−1,000
2,500
8
20,000
2,500
−2,000
2,000
9
18,000
2,000
−3,000
1,500
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10
15,000
1,500
are willing to buy at a given price. Column 2 shows the quantity of diamonds demanded
at various prices. When price is high, consumers demand a small quantity of diamonds.
For example, if De Beers chose to charge $6,000 per diamond, only one person would
purchase a diamond. As price decreases, consumers demand higher and higher quantities. At a price of $1,500, consumers will purchase 10 violet diamonds. If we graphed the
price and corresponding quantity sold from the first two columns of the table, we would
have the market demand curve.
The total revenue that De Beers could earn at each price is simply price times quantity sold, which is the amount shown in column 3. As price increases and quantity sold
decreases, total revenue first rises, and then falls. Remember from Chapter 4 that total
revenue increases on sections of the demand curve where demand is price-elastic; it
decreases on sections of the curve where demand is price-inelastic.
Average revenue, shown in column 5, is the revenue De Beers receives per diamond
sold. It is calculated by dividing total revenue by quantity sold. This is simply a rearrangement of the equation that total revenue is quantity times price. Thus, just as in a
competitive market, average revenue is equal to price.
Unlike a firm in a competitive market, however, a monopolist’s marginal revenue is
not equal to price. Marginal revenue is the revenue generated by selling each additional
unit. We calculate marginal revenue by taking total revenue at a certain quantity and
subtracting the total revenue when quantity is one unit lower. For instance, based on
Table 14-1, total revenue from five diamonds is $20,000, and total revenue from four
diamonds is $18,000. So, the marginal revenue in the interval between four and five
diamonds is $20,000 − $18,000 = $2,000.
In a competitive market, a firm can sell as much as it wants without changing the
market price. The additional revenue brought in by one unit is always simply the price
of that unit. Thus, in a competitive market, marginal revenue is equal to price. In a market dominated by a monopoly, however, the monopoly’s choice to produce an additional
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unit drives down the market price. Because of this effect, producing an additional unit
of output has two separate effects on total revenue:
1.
2.
Quantity effect: First, total revenue increases due to the money brought in by the
sale of an additional unit.
Price effect: Second, total revenue decreases, because all units sold now bring in
a lower price than they did before.
Depending on which of these effects is larger, total revenue might increase or decrease
when De Beers increases the quantity of diamonds it sells. If there were no price effect
(as in a perfectly competitive market), then marginal revenue would be determined
solely by the quantity effect; it would be equal to price. But the price effect always works
in the opposite direction of the quantity effect—it decreases revenue. Thus, marginal
revenue in a monopoly market is always less than the price.
Figure 14-2 shows hypothetical values for De Beers’s total, average, and marginal
revenue at various prices in the U.S. market for violet diamonds. Average revenue is
equal to price at any quantity sold. In other words, the average revenue curve is the
same as the market demand curve. The marginal revenue curve lies below the average
revenue curve, because marginal revenue is always less than price.
Table 14-1 and Figure 14-2 show that marginal revenue can sometimes be negative. This occurs in our example at quantities above the quantity at which the marginal
FIGURE 14-2
Monopolist’s total, average, and marginal revenue
TR, AR, MR ($)
The MR curve intersects
the x-axis at the revenuemaximizing quantity.
25,000
20,000
1. A monopolist’s
total revenue first
increases…
2. …then decreases.
15,000
10,000
TR
5,000
AR
0
1
2
3
4
5
6
7
8
9
10
11
12
MR
25,000
Quantity of violet diamonds
As the monopolist increases the price, total revenue (TR) first increases
and then decreases. Total revenue is maximized when marginal revenue
(MR—the lightest green line) equals zero. Average revenue (AR, or price)
is always greater than marginal revenue, because each additional unit
sold brings less revenue than the last unit.
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revenue curve crosses the x-axis in Figure 14-2. What does it mean when marginal revenue drops below zero in Figure 14-2? Think back to the price effect. Negative marginal
revenue means that the price effect has become bigger than the quantity effect, and so
each additional unit of output decreases total revenue. Thus, the point at which the MR
curve crosses the x-axis represents the revenue-maximizing quantity. In our example,
total revenue is maximized in the interval between 6 and 7.
Revenue is important, but as we know, what firms really care about is maximizing
profit. So how do monopolists go about maximizing their profit?
Maximizing profits by picking price and quantity sold. De Beers exerted control
over the diamond market through the quantity of diamonds it released for sale at any
given time. The company held back stockpiles of diamonds worth billions of dollars for
years at a time to maintain this control.
The purpose of this stockpiling was to ensure that the quantity of diamonds for
sale was always the quantity that maximized De Beers’s profits. Sometimes, the profitmaximizing quantity was lower than the total quantity of diamonds available, and so
it was in De Beers’s interest to hold some back from the market. How can a monopolist
choose the price-quantity combination that maximizes its profits? Perhaps surprisingly,
it can approach this problem in exactly the same way that a firm in a competitive market
would.
Figure 14-3 shows hypothetical cost and revenue curves for De Beers. The general
appearance of these curves should be familiar from the “Perfect Competition” chapter.
The only relevant difference between the curves for a monopoly and the equivalent
FIGURE 14-3
Monopolist’s cost curves
MC, MR, ATC ($)
8,000
7,000
MC
2. Price is determined by the
point on the demand curve
that corresponds to the profitmaximizing quantity.
6,000
ATC
5,000
4,500
4,000
3,000
A
1. The profit-maximizing
quantity is found at the
intersection of the MC
and MR curves.
B
D
2,000
1,000
0
1
2
3
MR
4
5
6
7
Quantity of violet diamonds
8
9
10
A monopolist can choose both the quantity and the price at which to produce.
To maximize profit, the monopolist will always produce that quantity at which
marginal cost equals marginal revenue. It then sets the price based on the
demand for that quantity.
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ones for a firm in a competitive market is that marginal and average revenue slope
downward for the monopolist. (In a competitive market, those curves are horizontal at the market-price level.) Just as in a competitive market, the profit-maximizing
quantity of output for a monopoly is the point at which the marginal revenue curve
intersects the marginal cost curve. Why is this so?
Remember that the contribution of each additional unit of output to a firm’s profit is
the difference between marginal revenue and marginal cost. If the marginal revenue of
a unit of output is higher than its marginal cost, then the unit brings in more money in
sales than it costs the firm to produce it. Thus, it contributes to the firm’s profit. What
if, on the other hand, marginal revenue is lower than marginal cost? In that case, the
unit costs more to produce than it brings in, and the firm loses money by producing it.
The same marginal decision-making analysis we used in the “Perfect Competition”
chapter applies here:
• At any quantity of output below the intersection of the marginal revenue and
marginal cost curves, MR is higher than MC. At that point, De Beers could earn
more profits by offering an additional diamond for sale.
• At any quantity of output above the intersection, the company loses profits on
each additional diamond offered for sale. At that point, De Beers could earn more
profits by offering fewer diamonds for sale.
Therefore, De Beers should increase the quantity of output up to the point where it
can no longer earn more profits by increasing output. (That is where MR = MC, shown
at point B in Figure 14-3.) It should then stop producing output, before it starts losing
money.
There is an important difference between a firm in a competitive market that produces at the point where MR = MC and a monopoly that does the same thing. In a competitive market, marginal revenue is equal to price. For a monopolist, price is greater
than marginal revenue; therefore price is also greater than marginal cost at the optimal
production point. The profit-maximizing price is the price on the demand curve that
corresponds to the profit-maximizing quantity of output. This is shown as point A in
Figure 14-3.
This fact—that a monopoly’s profit-maximizing price is higher than its marginal
costs—is key to understanding how monopolies are able to earn positive economic profits in the long run. Remember that a firm in a competitive market produces at the point
where P = MC = ATC in the long run. If price is higher than MC, other firms will enter
the market, increasing supply and driving down the price, until profits are zero and
there is no longer an incentive for more firms to enter. In a monopoly market, however,
other firms can’t enter the market, due to the barriers to entry that allowed the firm to
become a monopolist in the first place. The result is that a monopolist is able to maintain
a price higher than average total cost.
Remember that the formula for calculating profit is:
To improve your
understanding of
how to calculate
profit-maximizing
price and quantity,
try the online
interactive
graphing tutorial.
Profit 5 (P 2 ATC) 3 Q
So, if price is greater than ATC, profits will be positive, even in the long run.
We can also observe this same fact graphically, as shown in Figure 14-4. De Beers’s profit
is equal to the area of the shaded box. The box’s length is equal to the profit-maximizing
quantity of output. The box’s height is the distance between the profit-maximizing price
and average total cost. We can also think of that amount ($1,500, the difference between
A and B in the figure) as the profit earned on the average diamond sold.
This analysis shows us why De Beers had such a strong incentive to maintain its
monopoly power. The fact that there were no other diamond producers to enter the
market and drive down the price of diamonds gave De Beers the ability to maintain a
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FIGURE 14-4
Monopoly profit
MC, MR, ATC ($)
8,000
MC
7,000
Monopoly profit
6,000
Profit per diamond
5,000
4,500
ATC
A
4,000
B
3,000
D
2,000
1,000
0
1
2
3
MR
4
5
6
7
Quantity of violet diamonds
8
9
10
The monopolist sets the price at point A on the demand curve, which corresponds
to the profit-maximizing quantity. The monopolist’s profit equals the difference
between the price and the average total cost (point B), multiplied by the quantity
sold. Put another way, Profit 5 (P 2 ATC) 3 Q, or the area of the shaded box.
price higher than its costs. This market power in turn allowed it to earn economic profits
in the long run.
✓CONCEPT CHECK
❒ Why can’t a monopoly choose to sell at any price-quantity combination it wants?
[LO 14.2]
❒ Why is marginal revenue lower than price for a monopoly? [LO 14.3]
❒ Why are monopolies able to earn positive economic profits in the long run?
[LO 14.3]
Problems with Monopoly and
Public Policy Solutions
Since 2000, De Beers’s grip on the diamond industry has lessened: Its market share has
dropped from more than 80 percent of the world diamond trade to near 40 percent.
This is partly due to large-scale mining of diamonds in Canada and Russia, outside of
De Beers’s range of control. It is also due in part to increased pressure from governments and diamond consumers to stop De Beers from exercising its monopoly power.
Following a series of lawsuits in the United States and Europe, De Beers was banned
from operating in certain countries, and forced to pay large fees or change its practices
in others. Until 2004, De Beers executives weren’t even allowed to travel to the United
States on business.
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Monopolies are great for the monopolist, and not so great for everyone else. Consumers get fewer diamonds, at a higher price. This market inefficiency reduces total surplus.
In this section, we’ll see how the existence of monopolies has welfare costs. We’ll also
look at the range of public policies governments use to try to discourage monopolies
and mitigate their effect on consumers. As we’ll see, these policy responses are imperfect, and often highly controversial. Before we weigh the costs and benefits of different
policy responses, let’s consider the welfare costs of monopoly power.
The welfare costs of monopoly
LO 14.4 Calculate the loss in total social welfare associated with a monopoly.
Why do policy-makers get riled up about monopolies? A monopoly’s ability to keep
quantity low and prices high hurts society in general and consumers in particular. Let’s
dig back into the monopolist’s production decision to show why this is so.
The equilibrium price and quantity in a competitive market maximize total surplus.
In other words, the market is efficient. Figure 14-5 shows the market demand curve for
diamonds, as well as hypothetical marginal revenue and marginal cost curves. What
is the efficient production level in this market? Remember from the “Perfect Competition” chapter that a competitive firm’s supply curve is equivalent to the section of the
marginal cost curve that lies above average total cost. The efficient quantity lies at the
FIGURE 14-5
Deadweight loss in a monopoly market
(A) Efficient market equilibrium
(B) Inefficient monopoly market
MC, MR ($)
MC, MR ($)
Consumer surplus
Consumer surplus
Producer surplus
Producer surplus
Deadweight loss
MC
MC
A
4,500
C
3,500
B
D
D
MR
MR
6
Quantity of violet diamonds
0
A competitive market produces the equilibrium price
and quantity (point C) where price equals marginal
cost. When the market is in equilibrium, total surplus
is maximized, and there is no deadweight loss.
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0
4
Quantity of violet diamonds
A monopoly market produces the quantity at which
marginal revenue equals marginal cost (point B).
Quantity is lower than the market equilibrium quantity,
and price is higher than the competitive price. As a
result, consumer surplus is smaller than in the
competitive case. Fewer trades take place, and society
suffers a deadweight loss.
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intersection of supply (marginal cost) and demand, at point C in panel A. At any higher
quantity, total surplus is reduced, because the increase in consumer surplus is less than
the decrease in producer surplus. At any lower quantity, total surplus is also reduced—
the decrease in consumer surplus is greater than the increase in producer surplus.
A monopoly, however, will produce the quantity found at point B in panel B of
Figure 14-5, where marginal revenue intersects marginal cost. This quantity is lower
than the efficient quantity that would prevail in a competitive market, which tells
us that total surplus is not maximized. It also tells us that producer surplus is higher
than the level in a competitive market, while consumer surplus is lower. Panel B represents the loss of total surplus as a deadweight loss (exactly as we did in the “Efficiency”
chapter when discussing the welfare cost of taxes).
It’s important to remember that this description of the costs of monopoly is a positive statement—a statement about how things are. That is different from a normative
judgment—a statement about how things should be. There can be cases in which people
believe that the advantages to maintaining a particular monopoly outweigh the total
welfare costs due to lost surplus. This is similar to the feeling many people have that it
is worth accepting some deadweight loss from taxes in order to achieve goals such as
providing benefits to the poor or supporting military or police forces. There is no principle that tells us that maximizing efficiency trumps other goals.
However, voters and policy-makers in many countries have made the normative
judgment that monopolies are usually a bad thing. This isn’t so surprising: Maximizing
total surplus means that society’s resources are being used efficiently, and few people
are excited to provide extra profits to monopolies. After all, voters are more likely to be
consumers than owners of monopolies.
This does not mean that monopolists are always wealthy, large-scale enterprises. For
an example of a monopolist toward whom we might feel more than usually sympathetic, check out the From Another Angle box “Poor monopolists.”
FROM ANOTHER ANGLE
Poor monopolists
When Muhammad Yunus won the Nobel Peace Prize in 2006, the Grameen Bank became
a household name around the world. The bank is credited with bringing access to financial services to millions of rural Bangladeshis. It is less widely known that Grameen was
also the first to bring access to phones within reach of the same population.
Grameen used an ingenious business model to accomplish this, in a country known for
its strained rural infrastructure and limited resources. The bank recruited long-standing
clients to act as local phone operators. It loaned them the $420 necessary to start a small
phone kiosk and trained them to operate it as a business. Grameen also sold the operators discounted telephone airtime on credit, which the operators in turn sold to villagers.
The demand for phone services in Bangladeshi villages was tremendous, and the
phone kiosks flourished. Farmers and traders used the phones to manage business
orders and keep track of prices in local markets. Families used the phones to stay in
touch with relatives who had left home to find work in the city.
Because Grameen’s operators were the first to bring phone services to rural villages,
they had no competitors. Grameen initially established a single phone-kiosk operator
in each village. By doing so, it inadvertently created a local monopoly in this previously missing market. This turned out to be a huge windfall for the operators; they
were able to earn profits often amounting to double or triple the average Bangladeshi
income. Needless to say, this new stream of income enabled the operators to pay off
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their loans in record time. Recognizing the demand for phone services, and perhaps
that the new rural telecom market would benefit from healthy competition, Grameen
began establishing multiple operators in each village.
When you hear the word “monopolist,” you might think of a massive corporation
getting rich by quashing the competition. The reality of Grameen phone operators
couldn’t be further from this stereotype. The phone operators were indeed monopolists, but they were also impoverished villagers, just trying to improve their families’ lives. Remember—there’s nothing inherently evil about monopoly. The important
thing is to weigh the social welfare benefits that accrue to monopolists against the
efficiency losses to the rest of society.
Source: http://www.grameentelecom.net.bd/about.html.
Public policy responses
LO 14.5 Describe the pros and cons of common public policy responses to monopoly.
Policy-makers have developed a range of policy responses to monopolies. These tools
aim to break up existing monopolies, prevent new ones from forming, and ease the
effect of monopoly power on consumers. Each comes with costs as well as benefits;
some economists argue that the best response is often to do nothing at all. As we discuss
each type of policy, keep a critical eye on its pros and its cons.
Antitrust laws. The regulation of monopolies has been a high-profile political issue in
America for quite a while. In the late nineteenth century, massive corporations called
“trusts” were beginning to dominate entire industries. To check their growing power,
Congress passed the Sherman Antitrust Act in 1890. The act requires the federal government to investigate and prosecute corporations that engage in anti-competitive practices.
This includes practices such as price fixing and bid rigging. The early twentieth century
was also a period of major antitrust activity in the United States. President Theodore
Roosevelt, in particular, became known as a “trustbuster.” Using the Sherman Act, he
vigorously prosecuted corporations that used monopolistic practices to stifle competition. Over the years, the government has used the Sherman Act to break up monopolies in
various industries, including railroads, oil, aluminum, tobacco, and telecommunications.
The Sherman Act still has an impact. As recently as the late 1990s, it was uncommon to use an Internet browser other than Microsoft’s Internet Explorer. In 1999, the
U.S. government sued Microsoft for anti-competitive behavior. The suit alleged that by
bundling Internet Explorer with Microsoft Windows, the company was unfairly pushing competing web browsers out of the market. (Microsoft eventually reached a settlement with the government, and agreed to stop certain business practices perceived to be
anti-competitive.) Today, there are lots of Internet browsers, including Chrome, Firefox,
Safari, and improved versions of Internet Explorer.
For another case concerning an area in which the antitrust law has not yet had much
impact, read the Real Life box “Rockers vs. Ticketmaster.”
REAL LIFE
Rockers vs.Ticketmaster
Anyone who has been to a major concert or show in the U.S. has probably experienced
the hefty pile of fees and charges that come with buying a ticket through Ticketmaster.
These fees can add up to between 20 and 40 percent of the face value of the tickets
themselves.
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Ticketmaster is the single dominant player in the lucrative U.S. ticket business.
For example, 27 of 30 NHL teams and 28 of 30 NBA teams sell tickets only through
Ticketmaster. Many of the nation’s leading concert and theater venues have similar
agreements. These exclusive agreements are a crucial element of Ticketmaster’s business strategy. Because of them, competitors have difficulty gaining a foothold in the
market. Many feel that Ticketmaster has thus become a de facto monopoly in the market for tickets.
This has infuriated many musicians who want to keep prices of tickets low for their
fans’ sake. Two groups have even pursued lawsuits against Ticketmaster. In 1994, Pearl
Jam complained to the U.S. Justice Department about Ticketmaster’s allegedly monopolistic practices and high markups. The group’s lawsuit was unsuccessful. In 2003,
jam band String Cheese Incident sued Ticketmaster. The suit alleged that the exclusive
agreements with venues were monopolistic and violated the Sherman Antitrust Act.
This case settled out of court, and the results were not publicly disclosed.
The power of Ticketmaster may not last long, though. A slew of new sites that sell
concert tickets online, including Etix and Ticketfly, are trying to compete against Ticketmaster. Since they can offer cheaper booking fees for bands and ticket prices for fans,
these competitors may prove to be a win for everyone—except, of course, Ticketmaster.
Sources: http://www.rollingstone.com/music/news/string-cheese-incident-eliminate-service-charges-for-summertour-20120302; http://latimesblogs.latimes.com/music_blog/2010/08/ticketmaster-a-new-era-of-transperancy-orsmoke-mirrors-.html.
The U.S. government has also used the Sherman Antitrust Act and its partner the
Clayton Antitrust Act of 1914 to prevent monopolies from forming in the first place.
The Justice Department can block two firms from merging if the merger would result
in a company with too much market power. Two examples include a proposed merger
between office-supply giants Office Depot and Staples, which the Justice Department
blocked in 1997, and a failed AT&T merger with T-Mobile in 2011.
In recent years, however, the government has only infrequently used the power to
block mergers. More often, the government investigates a potential merger and allows
it to go forward. For instance, in 2008, Delta Airlines merged with Northwest Airlines
to become the largest airline in the world. Then, in 2012, the merger of United and
Continental created a new global number one. These mergers occurred with the full
blessing of the Justice Department, which determined that there was sufficient pressure
from other airlines to maintain competition. Further, the mergers were seen as actually
generating benefits for customers due to cost savings in airport operations and the organization of plane fleets.
People sometimes criticize antitrust actions as being politically motivated or causing more inefficiency than they create. How could antitrust action cause inefficiency
in the market? It could accidentally break up a natural monopoly. Or, it could break a
large company into several firms that operate at a smaller-than-efficient scale. Different
regulators handle these decisions differently. For instance, Microsoft still faced antitrust
lawsuits in Europe long after it settled its case in the United States.
Public ownership. Natural monopolies pose a particular problem for policy-makers.
On the one hand, the monopolist is able to achieve lower costs of production than multiple competing producers would. On the other hand, even a natural monopoly chooses
to produce at a price that is higher than marginal cost, causing deadweight loss.
One possible solution for governments is to run natural monopolies as public agencies. Examples of public ownership of natural monopolies include the U.S. Postal Service to deliver mail and Amtrak to provide train services. The rationale behind public
ownership of natural monopolies is that governments are supposed to serve the public
interest rather than maximize profit. They could choose to provide broader service than
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FIGURE 14-6
Price regulation of a natural monopoly
(A) Price ceiling above MC but below
full monopoly pricing
(B) Price ceiling at efficient price
Price (cents per kilowatt-hour)
Price (cents per kilowatt-hour)
Monopoly loss at efficient price
Monopoly profit
Deadweight loss
Efficient price
(P = MC)
Ceiling
20
ATC
MC
ATC
MC
14
D
D
MR
5,600
0
Millions of kilowatt hours of electricity
When the price ceiling (20 cents) is set above the
natural monopoly’s average total cost, the firm will
produce at the point where the price intersects the
average revenue curve (which is identical to the
demand curve) to maximize its profit. Some
deadweight loss remains.
MR
0
6,350
Millions of kilowatt hours of electricity
In a competitive market, there is no deadweight
loss, and the efficient price occurs at the point
where P 5 MC. A publicly owned natural
monopoly producing at this point loses money.
a private monopolist might. For example, a government-supported monopoly might
deliver mail to any postal address in the country; a private monopolist might prefer not
to deliver to remote addresses that are more expensive to reach.
A publicly owned monopoly could also set prices lower than an unregulated monopolist would. Panel A of Figure 14-6 shows an example. In this case, the regulated price is
higher than average total cost, but is lower than the price that an unregulated monopoly
would set. Even though price is lower than it would be if the monopoly were unregulated, there is still some deadweight loss. Panel B shows how governments often regulate
prices for a natural monopoly in order to diminish deadweight loss. Recall that in a competitive market, where deadweight loss is zero, firms produce at the point where P = MC.
However, a natural monopoly is defined by the fact that ATC falls as quantity increases,
which means that MC must be below ATC at all possible quantities. As a result, a natural
monopolist that sets price equal to marginal cost will incur losses, as shown in panel B.
However, public ownership of a natural monopoly has its problems. Politicians may
feel pressure to lower prices even further, below the level they would be in a competitive
market. As we saw in the “Efficiency” chapter, doing so will create shortages and people
will demand more than it makes sense for the producer to supply at that price. Publicly
owned companies may also make business decisions—such as where to locate or what
types of products to offer—on the basis of political concerns. Perhaps most importantly,
the loss of the profit motive could reduce the publicly owned monopolist’s motivation
to improve efficiency and to provide better service or lower costs. After all, there is no
rule stating that all monopolies must make a profit. (Amtrak and the U.S. Postal Service
both lost money in 2013.) If an inefficient public monopoly cannot provide a service at a
price that sufficient numbers of people are willing to pay, it can remain in operation by
covering its losses with revenue from taxes.
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