Capítulo 4: Monopólios, Monopsônias e Firmas Dominantes

112 c h a p t e r 4 Monopolies Monopsonies and Dominant Firms Aeroflot Airlines You Have Made the Right Choice Ad campaign for the only airline in the then Soviet Union A firm is a monopoly if it is the only supplier of a product for which there is no close substitute A monopoly sets its price without fear that it will be undercut by a rival firm A monopoly faces a downwardsloping demand curve and sets a price above marginal cost As a result less is sold than if the market were com petitive where price equals marginal cost and society suffers a deadweight loss This chapter analyzes a monopolys behavior and the consequences of that be havior It also discusses how a monopoly is maintained and asks whether mo nopoly is always bad The effects of externalities in a monopolized market are discussed next The chapter then turns to two related topics It examines monopsony which is a monopoly on the buying side of the market Then it dis cusses what happens to a monopoly if highercost competitive firms enter its market The six key questions we answer in this chapter are 1 How does monopoly compare to competition in terms of prices and welfare 2 How are monopolies created and maintained 3 Are there markets in which there are benefits to monopoly 4 Are all firms that earn profits monopolies do all monopolies earn profits and can monopolies earn profits in the long run 5 How does a monopsony exercise its market power 6 What happens to a monopoly if smaller pricetaking firms enter its market 3641AWLCARLCh04pp112145qxp 12715 1248 PM Page 112 Monopoly Behavior 113 Monopoly Behavior Because a monopoly faces a downwardsloping market demand curve it can raise its ptice above marginal cost To maximize its profit it has an incentive to produce its output efficiently A firms behavior and government regulations influence the firms ability to become and remain a monopoly Profit Maximization Price n Value plus a reasonable sum for the wear and tear of conscience in demanding it Ambrose Bierce Like a competitive firm a monopoly sets its level of output to maximize its profits Be cause the market demand curve is downward sloping the more the monopoly sells the lower the price it receives The market demand curve constrains the monopoly In its quest to maximize profit it can set only price or only quantitynot both If the monopoly sets quantity the market price is determined by the market demand curve If it sets price the quan tity is determined by the market demand curve Given the demand curve in Figure 41 if the monopoly wants to sell Q units of its product it charges price fp If it wishes to sell one more unit it has to lower its price to pj If the monopoly lowers its price to p its revenues may rise or fall The monopoly gains revenue on the extra unit it sells at price p Area B in Figure 41 To sell that ex tra unit however it must cut its price from pp to p on the original Q units resulting in a loss of revenues of py p Qo Area A in Figure 41 When discussing a competitive firms behavior in Chapter 3 we did not have to consider this loss of revenue due to lower price Because a competitive pricetaking firm faces a horizontal demand curve the price it receives does not fall if it expands its quantity If Area Bis larger than Area A in Figure 41 then selling the extra unit causes rev enues to rise The extra revenues pQy 1 poQp that a firm receives when it produces one more unit of the product is called the marginal revenue Hence the marginal revenue equals area B minus Area A If the monopoly did not have to lower its price to sell the additional unit then the increment to revenues from selling an additional unit would simply be the initial price py But because the demand curve Marginal revenue MR is the change in revenue from selling an additional unit Total revenue is pQQ where pQ is the inverse demand curve p is a decreasing function of Q Marginal revenue is equal to p QApAQ where ApAQ is the decline in price necessary to sell the additional unit Using calculus apQQ ap MR pQ aQ aQ 114 Chapter 4 Monopolies Monopsonies and Dominant Firms FIGURE 41 Demand Curve Facing a Monopoly Decrease in revenues on sales of 0 from lowering price PyP1Qo Dolrrrtrrt ttt fhrresees Increase in revenues from A i increasing output by 1 unit P Py nn esse 1B Demand Oy Qt Output O is downward sloping the monopoly must lower its price to sell more units There fore the marginal revenue is always less than the price for a monopoly as Figure 42a illustrates For a firm in a perfectly competitive market marginal revenue equals Price Marginal revenue and total revenue are closely related When marginal revenue is positive total revenue increases as output expands but when marginal revenue is neg ative total revenue falls as output expands As a result total revenues are maximized Figure 42b when marginal revenue equals zero Figure 42a3 A monopoly maximizes its profit rather than its revenue just as a competitive firm does Profit is maximized at a smaller quantity than is revenue as Figure 42b illustrates 2If a straightline demand curve as in Figure 42a hits a horizontal line at Q the corresponding mar ginal revenue curve is also a straight line and hits the horizontal line at Q2 To prove this result let the straightline demand curve be p a bQ Total revenue is R pQ aQ bQ The marginal revenue curve is obtained by differentiating R with respect to Q MR a 2bQ The demand curve hits the horizontal axis p 0 at Q ab The marginal revenue curve hits the horizontal axis MR 0 at Q al2b 31f the monopoly wants to maximize revenues through its choice of Q max R pQQ Q it sets its marginal revenues equal to zero firstorder condition dp MR pQ0 P aq Monopoly Behavior 115 FIGURE 42 Monopoly Profit Maximization a o Pm 8 oS Deadweight S 2 loss DWL Pe Me Om Q Output Q b Lt 7 Revenue On Output O A monopoly maximizes its profit when the extra revenue from selling one more unit just equals the extra cost of producing that last unit of output That is profit is maximized where marginal revenue equals marginal cost MR MC 41 4If the monopoly wants to maximize profits through its choice of Q nen pQao cQ it sets its marginal profits equal to zero firstorder condition ot mr c p Ba o continues 116 Chapter 4 Monopolies Monopsonies and Dominant Firms Figure 42a illustrates this profitmaximizing relationship The profitmaximizing monopoly output Q is smaller than the competitive output Q determined by the intersection of the demand curve with the marginal cost curve which we assume would be the supply curve if the market were competitive at price p The monopoly does not have a supply curve that can be specified solely as a function of price because the monopolys output depends on marginal revenue which depends on the slope of the demand curve and marginal cost The properties of the demand curve determine the monopoly overcharge the amount by which the monopoly price p exceeds the marginal cost or competitive price p in Figure 42a A relationship exists between the monopoly overcharge and the price elasticity of demand The elasticity of demand is a characteristic of the demand curve and is defined as the percentage change in quantity that results from a 1 percent change in price If the elasticity of demand is very high a large negative number then the curve is said to be elastic With a very elastic demand a small price change induces a very large change in the quantity demanded If the elasticity is low a number between 1 and 0 the de mand curve is inelastic and a price change of 1 percent has relatively little effect on the quantity demanded Marginal revenue can be written as 1 MR AC 42 where is the elasticity of demand Thus marginal revenue is positive if the demand curve is elastic 1 It is negative if the demand curve is inelastic 1 0 The elasticity of demand in general depends on not only the particular demand curve but also the point the price and quantity pair on the demand curve For example the elasticity of demand could decrease as price becomes lower By substituting Equation 42 for MRin Equation 41 we can write the profitmax imizing condition for the monopoly as p Mc I 43 p Thus it sets MR MC Another condition for profit maximization is that the marginal revenue curve cut the marginal cost curve from above as in Figure 42a That is the secondorder condition must hold a dMR dMC aQ7 ao aQ A monopoly uses the same shutdown condition as does a competitive firm In the short run if price is below average variable cost the monopoly stops producing Differentiating revenue R pQQ with respect to Q we find that the marginal revenue is mRpPQpi2 p14 where é is defined as dQdp pQ Monopoly Behavior 117 The lefthand side of Equation 43 is the pricecost margin the difference between price and marginal cost as a fraction of price p MCp As the equation shows the prticecost margin depends on only the elasticity of demand the monopoly faces The pricecost margin is also called the Lerner Index of market power Lerner 1934 Equation 43 shows that the monopolys price is close to MMC when the demand is very elastic and the price increasingly exceeds MC as the demand becomes less elastic For ex ample if the elasticity of demand is 2 price is twice marginal cost If the elasticity is 100 very elastic price equals 101MC The higher the elasticity of demand the closer is the monopoly price to the competitive price Therefore the key element in an investi gation of market power is the price elasticity of demand Where the elasticity of demand is relatively inelastic a monopoly markup may be substantial as Example 41 illustrates Market and Monopoly Power In contrast to a pricetaking competitive firm a monopoly knows that it can set its own price and that the price chosen affects the quantity it sells A monopoly can set its price above its marginal cost but does not necessarily make a supracompetitive profit For example if a monopoly incurs a fixed cost its profit may be zero the competitive level even if its price exceeds its marginal cost It is common practice to say that whenever a firm can profitably set its price above its marginal cost without making a loss it has monopoly power or market power One might usefully distinguish between the terms by using monopoly power to describe a firm that makes a profit if it sets its price optimally above its marginal cost and market power to describe a firm that earns only the competitive profit when it sets its price op timally above its marginal cost However people do not always make this distinction and generally use the two terms interchangeably sometimes creating confusion Ess Monopoly Newspaper Ad Prices When the Houston Post shut down in April 1995 the managing editor of the sole surviving paper the Houston Chronicle received dozens of calls from concerned Post readers worried about one thing Would the Chronicle pick up the Posts comics Lo cal advertisers also were very concerned What would happen to newspaper advertis ing prices Ad rates skyrocketed by nearly 62 percent from January 1995 before the Post folded to December 1996 The rate for a onecolumn inch ad in a daily paper rose from 25264 to 40900 per day and Sunday rates jumped from 29484 to 47728 These rates increased by much more than readership which rose 32 percent on weekdays and 23 percent on Sunday Thus a loss of competition resulted in a substantial increase in price Source Iver Peterson New Realities of Life in a OnePaper Town New York Times December 30 1996C5 118 Chapter 4 Monopolies Monopsonies and Dominant Firms The Incentive for Efficient Operation Organized crime in America takes in over forty billion dollars a year and spends very little on office supplies Woody Allen The consequences of inefficient behavior are different for monopolies and competitive firms An inefficient competitive firm may not be able to remain in business because it is unprofitable but an inefficient monopoly can profitably remain in business This observation has led some to conclude that the monopoly strives less hard to be effi cient called xinefficiency by Leibenstein 1966 than does a competitive firm This argument is rejected by many economists who believe that monopolies like other firms prefer more to less Monopolies want to maximize profits and the only way a firm can do so is to minimize its costs at its chosen output level Therefore to postulate that monopolies want to maximize profits is to assume implicitly that they also minimize their costs No firmmonopolistic or competitivewants to throw money away If improving the efficiency of operations increases profits the firm should do it whether it is a monopoly or a competitor A monopoly however may not have the same ability to produce as efficiently as a competitive firm A firm in a market with many other firms can observe what other firms are doing It can observe for example whether its own costs of production are above or below the market price Because the market price reflects the efficiency of the other firms in the market a competitive firm knows that it can improve its production efficiency if its costs of production are high relative to the market price In contrast a monopoly has no other firms to look at and may have no other standard by which to judge how efficiently it is operating Therefore a competitive firm may operate more efficiently than does a monopoly because it is more difficult for a monopoly to moni tor internal efficiency than it is for a competitive firm Monopoly Behavior over Time If demand is inelastic 1 0 it is not possible to satisfy the profitmaximiza tion condition of Equation 43 Thus a monopoly never operates on the inelastic por tion of its demand curve If a monopoly were operating in the inelastic portion of its demand curve it could increase its profits by raising its prices until it was operating in the elastic portion of its demand curve In the inelastic portion of the demand curve a 1 percent increase in the monopolys price causes the quantity sold to fall by less than 1 percent so that revenues increase With reduced output however the monopolys costs must fall so that total profits must rise Thus if the monopoly is operating in the inelastic portion of the demand curve it should keep increasing its price obtaining ever more profits until it is in the elastic portion of the demand curve What if there were no elastic portion of the demand curve The monopoly would produce just a small amount of output charge an infinite price and make infinite profits That this story is implausi ble underscores the empirical irrelevance of a monopolys demand curve that is everywhere inelastic The Costs and Benefits of Monopoly 119 This observation however applies only in the context of a simple timeless model In actual markets demand curves shift over time As a result a rational monopoly changes its price over time Consumers may have a more inelastic demand curve in the short run than in the long run In the short run there are limitations on how fast consumers can substitute away from a product in the face of a price increase Therefore if a monopoly takes ad vantage of an inelastic portion of its shortrun demand curve and raises its price its consumers are more likely to substitute away from its product in subsequent periods Thus a monopoly may operate in the inelastic portion of its shortrun demand curve to avoid longrun substitution The oil market provides an excellent example of the time it takes to substitute away from a product When the Organization of Petroleum Exporting Countries OPEC raised the price of oil in the early 1970s total consumption of energy changed very lit tle in the first year However the quantity of oil demanded fell sharply over the next several years as consumers adjusted to the increased price and began to take energy saving measures The Costs and Benefits of Monopoly A monopoly is socially reprehensible in the hands of others If a monopoly restricts its output and raises its price above marginal cost society suf fers a deadweight loss We first examine why such behavior leads to a deadweight loss Then we use our understanding of how monopolies arise to show that in certain cir cumstances there are benefits associated with monopolies Indeed in certain situa tions monopoly may be preferable to competition The Deadweight Loss of Monopoly In order to maximize its profit a monopoly sets its output where its marginal revenue curve intersects its marginal cost curve as Figure 42a shows The gap between the monopolys price and marginal cost represents the difference between the value price that buyers place on the product and the marginal cost of producing it This gap is similar to the one caused by a tax on a competitive market Chapter 3 In both cases price and output differ from their competitive levels and there is a deviation between the demand price as given by the demand curve and the supply price as given by the marginal cost curve If consumers must pay a monopoly price pm that is above the competitive price pc they lose consumer surplus equal to the sum of the monopoly profits and the dead weight loss in Figure 42a The monopoly profit is less than the consumer surplus loss Thus society suffers a deadweight loss the DWL triangle in Figure 42a that equals the consumers loss less the monopolys gain This DWL triangle is the area below the demand curve above the marginal cost curve and to the right of the equilibrium mo nopoly quantity Thus both monopoly and an inefficient tax cause a deadweight loss However who keeps the transfer from consumers differs Tax revenues go to the government whereas 3641AWLCARLCh04pp112145qxp 12715 1248 PM Page 119 120 Chapter 4 Monopolies Monopsonies and Dominant Firms 7Stigler 1956 and Cowling and Mueller 1978 criticize Harbergers methodology on technical grounds 8See however Masson and Shaanan 1984 for a critique of this last result 9Whether the firm would dissipate the entire monopoly profit depends on the institutional details as to how the monopoly can be acquired Fisher 1985 the monopoly keeps the monopoly profit Even fairly small deadweight losses may be associated with a large redistribution of wealth as the monopoly profit box in Figure 42a illustrates Many researchers have estimated the deadweight loss that monopoly imposes on the US economy In a pioneering paper Harberger 1954 calculated that the dead weight loss is small less than 01 percent of the gross national product GNP a mea sure of the value of all goods and services in our economy7 Later researchers repeated these calculations based on different assumptions Worcester 1973 for example also finds that the DWL is small 04 to 07 percent Kamerschen 1966 estimates the DWL at 6 percent and Cowling and Mueller 1978 estimate that it is between 4 and 13 percent8 Jenny and Weber 1983 find that the DWL in France is as high as 74 percent RentSeeking Behavior The gods help those that help themselves Aesop Some researchers contend that the efficiency loss to society is much larger than the DWL triangle They argue that an amount equal to some or all of the monopoly prof its is also an efficiency loss Monopoly profits can be regarded as a transfer from consumers to the monopoly just as tax revenues are a transfer of income from consumers to the government By it self a transfer of income does not affect efficiency Only if the monopoly restricts out put below competitive levels is there an efficiency effect However Posner 1975 argues that the monopoly profits may also represent a loss to society to the extent that it creates incentives for a firm to use real resources to be come a monopoly For example suppose that a firm can become a monopoly by per suading the government to pass a law that restricts entry into the market The use of a firms resources to hire lobbyists lawyers and economists to argue its case before legis lators is a cost to society because these resources could have been productively em ployed elsewhere If there is a positive monopoly profit as in Figure 42a a firm would be willing to spend an amount up to these profits in order to become a monopoly Of course the firm would like to spend as little as possible but the opportunity to earn monopoly profit could create the incentive to use valuable resources up to the amount of monop oly profits in order to secure the monopoly9 Because firms compete to earn the rent 3641AWLCARLCh04pp112145qxp 12715 1248 PM Page 120 The Costs and Benefits of Monopoly 121 monopoly profits from the monopoly the expenditure of resources to attain govern mentcreated monopoly profits is called rent seeking If rent seeking occurs the calculation of the deadweight loss from monopoly must include that part of the transfer that is dissipated by the firms seeking to become the monopoly Thus the cost of monopoly is greater than the DWL triangle that Harberger calculated The loss equals the DWZ triangle plus at least part of the monopoly profits Posner recalculates the deadweight loss from regulated and unregulated monopoly on the extreme assumption that the entire amount of monopoly profit is dissipated in rentseeking activities His estimates of deadweight loss as a percent of revenues exceed previous estimates For example Posner found deadweight losses of up to 30 percent of revenues for some of the industries he examined such as motor carriers physician services and oil His insight was that a great part of the loss to the economy from mo nopoly or more generally noncompetitive pricing is directly traceable to the exis tence of government institutions that insulate some firms from competition If hes correct the recent rescinding of many government regulations see Chapter 20 will provide sizable benefits to society Monopoly Profits and Deadweight Loss Vary with the Elasticity of Demand Monopoly profits and the DWZ triangle depend on the shape of the demand curve We illustrate how monopoly profits and deadweight loss vary with the elasticity of de mand with a linear demand curve pa 2 The light demand curve in Figure 43 is for a 60 and 6 05 Given a constant marginal and average cost MC AC 10 the monopoly sells Q 50 units at Pm 35 where the elasticity of demand is 14 The monopolys profit is Area A 1250 and the deadweight loss is area D 625 We now rotate the demand curve so as to vary the elasticity of demand The de mand curve is rotated around the point where it crosses the MC line at 100 units That is for all the demand curves examined if price were set efficiently at WC 10 consumers would buy 100 units Because the demand curve is linear the marginal rev enue curve is also linear and crosses the horizontal Cline at half the distance that the demand curve does Thus the profitmaximizing monopoly equilibrium quantity of 50 units is unchanged as we rotate the demand curve T0Let t Py Pelp be the monopoly markup above the competitive price For small the mo nopoly DWL triangle can be approximated as 12tRe where R would be the revenues if the product were sold at the competitive price pQ and is the elasticity of demand DWL does not necessarily rise as the absolute value of increases because t is inversely related to e and as t changes so does R Holding R constant DWL falls as the absolute value of increases 122 Chapter 4 Monopolies Monopsonies and Dominant Firms FIGURE 43 Monopoly Profits and Deadweight Loss Vary with the Elasticity of Demand 90 Rotated demand 60 Rotated MR Demand Co 35 P MC LN OS 0 50 100 Quantity O The thick blue demand curve in Figure 43 shows a demand curve that has been ro tated so that its intercept with the price axis a is 90 which is higher than the origi nal 60 intercept The thick blue demand curve intercepts the price axis at 90 The monopoly sells the same quantity as before Q 50 but at a higher price p 50 so that the demand elasticity falls in absolute value from 140 to 125 be comes less elastic as Table 41 illustrates The monopoly profit rises to A B 2000 and the deadweight loss increases to area C D 1000 Se Monopoly Profits and Deadweight Loss Vary with the Price Elasticity of Demand Intercept of Demand Curve Elasticity of Monopoly Deadweight Monopoly with Price Axis Demand at Q 50 Price Loss Profit 30 200 20 250 500 60 140 35 625 1250 90 125 50 1000 2000 120 118 65 1375 2750 150 114 80 1750 3500 Creating and Maintaining a Monopoly 123 As the demand curve becomes less elastic at the monopoly equilibrium people are less willing to do without this good An increase in price causes the quantity they pur chase to fall by less than if demand were more elastic The monopoly realizing this op portunity exists increases its equilibrium price and earns a larger monopoly profit As the demand curve becomes steeper at a given quantity demand is more inelastic the deadweight loss increases The Benefits of Monopoly The welfare harms from monopoly may be offset by several benefits These benefits are ignored in the static analysis above where we calculated deadweight losses For exam ple the prospect of receiving monopoly profits may motivate firms to develop new products improve products or find lowercost methods of manufacturing Were it not for the quest to obtain monopoly profits firms might innovate less The benefit of monopoly is most clearly recognized in research and development see Chapter 16 If a firm succeeds in developing a new product it can obtain a patent that prohibits other firms from using the patented technology for a fixed num ber of yearscurrently 20 years in the United States Were it not for the patent the innovative firm might discover that within a matter of weeks other firms had copied the new product The innovative firm would then receive no more than the competi tive level of profits and would not recover its expenditures on research and develop ment The firms that copied the product would have no research and development expenditure to recover The ability of other firms to copy a new product removes the innovating firms incentive to invest in research and development The patent system attempts to deal with this problem by granting the innovating firm the sole property right to commercially exploit its innovation Naturally if monopoly had no offsetting benefits competition would be preferable For example if all firms in a competitive market decide to merge and if the merger does not lead to a more efficient market then the only result is the creation of a mo nopoly As long as new entry takes time the firms could price above their marginal cost Because there is no benefit from this action such behavior should be discour aged One responsibility of the Department of Justice and the Federal Trade Commis sion is to scrutinize each merger carefully to make sure that its effect is not simply to raise prices to consumers Creating and Maintaining a Monopoly There are several ways in which a firm may become and remain a monopoly One possibility is that all the firms merge combine into a single firm or act in concert as a monopoly would We address these possibilities in detail in Chapter 5 and in Ex ample 42 Another possibility is that the firm takes strategic actions that prevent entry by other firms as we discuss in Chapter 11 and in Example 43 Here we ex amine three other reasons why a firm is able to create and maintain a monopoly 3641AWLCARLCh04pp112145qxp 12715 1248 PM Page 123 124 Chapter 4 Monopolies Monopsonies and Dominant Firms Monopolizing by Merging United States In 2001 the Federal Trade Commission FTC accused the Hearst Corporation of il legally acquiring a monopoly over medical drug databases that are used by pharma cies and hospitals Hearst bought MediSpan which was the only major competitor for Hearsts database company First DataBank according to the FTC The FTC went on to contend that Hearst withheld information necessary for its premerger an titrust review After Hearst acquired MediSpan it raised prices doubling some and tripling others according to the FTC and Express Scripts a pharmacybenefit man agement company In its settlement with the FTC Hearst agreed to return 19 mil lion to customers Later Hearst paid more than 26 million to Express Scripts and other classaction plaintiffs in a private antitrust suit in 2002 South Africa South African Breweries controls 98 percent of South Africas beer sales with its 14 brands including Castle Lion Heineken Guinness Amstel and Carling Black La bel It was formed by a merger of two major competitors in 1979 because South Africa had virtually no antitrust laws A company spokesman claims that the firm has little market power because the market is fully contestable with no legal barriers to entry The firms control of distribution channels may be responsible for its ability to maintain its high market share Sources FTC Accuses Hearst of Creating Monopoly San Francisco Chronicle April 15 2001D2 Hearst Settles Dispute with FTC Milwaukee Journal Sentinel December 15 2001D1 Peter Shinkle Express Scripts Drops Antitrust Suit vs Hearst Maryland Heights Company with Share in FTC Settlement St Louis PostDispatch May 23 2002C11 Donald G McNeil Jr In South African Beer Forget Market Share New York Times August 27 1997C1 C4 Bernard Simon Private Sector An Old School Brewer for Miller New York Times February 2 200332 Example 42 The firm may have special knowledge the government may protect it from entry or the market may only be large enough for a single firm to produce profitably Knowledge Advantage A firm may be a monopoly because only it knows how to produce a certain product or it can produce the product at lower cost than other firms A firm may have special knowledge that enables it to produce a new or better product that others cannot imi tate The firm may try to keep secret its special knowledge so as to prevent rivals from imitating it see Example 44 A firm with an important secret faces a downwardslop ing demand curve for its product and does not fear the entry of rival firms or the in troduction of products that are close substitutes 3641AWLCARLCh04pp112145qxp 12715 1248 PM Page 124 Creating and Maintaining a Monopoly 125 Controlling a Key Ingredient In 2000 the attorneys general of 33 states and the Federal Trade Commission settled a lawsuit with Mylan Labs and its suppliers for 100 million The suit contended that Mylan Labs cornered the market on the active ingredients for two drugs used to treat Alzheimer patients and then raised the price of the drug Clorazepate more than 3000 percent from about 2 a tablet to over 75 and increased the price of the drug Lorazepam more than 2000 percent from about 1 a tablet to over 37 Source wwwstateiausgovernmentagmylanhtm Example 43 Similarly a firm may have special knowledge about production techniques that enable it to produce the same product at lower cost than other firms which may be unable to discover the production technique of the efficient firm We illustrate this possibility in Figure 44 Initially all the firms in a competitive market have a con stant marginal cost m1 so the equilibrium price p1 equals m1 and the equilibrium quantity is Q1 One firm discovers a new production technique that it can keep se cret and that lowers its marginal costs from m1 to m0 It faces a residual demand curve the unmet demand after all other firms sell as much as they want at a given price that is horizontal at p1 equal to m1 up to Q1 because many firms can pro duce and sell at price m1 Beyond Q1 prices less than p1 the residual demand curve coincides with the market demand curve because below p1 no other firm can profitably produce If m0 is close to m1 the firm may maximize its profit by selling at a price equal to p1 However in Figure 44 m0 is enough less than m1 that the profitmaximizing mo nopoly price is less than m1 but above m0 Because the residual demand curve has a kink in it at Q1 the corresponding marginal revenue curve is discontinuous at the output Q 1 The marginal revenue curve is horizontal where the residual demand curve is horizontal and slopes down where the residual demand curve is downward Preventing ImitationCat Got Your Tongue Why are violin strings called catgut when they are really made of sheep intestines An old Roman named Erasmo c 130 AD started making strings for musical instru ments out of sheep intestine The demand grew Because it was considered extremely bad luck to kill a cat Erasmo identified his product as catgut so nobody would imi tate it and ruin his monopoly Source L Boyd Grab Bag San Francisco Chronicle October 27 198435 Example 44 3641AWLCARLCh04pp112145qxp 12715 1248 PM Page 125 126 Chapter 4 Monopolies Monopsonies and Dominant Firms acu toe o Monopolization Through Efficiency Demand Py my Po Residual demand aN QO OD Output O sloping To maximize its profit the firm with the secret process produces Qp units of output where its marginal revenue curve equals its marginal cost curve The firm sets its price at Py which is less than p my so no other firm remains in the market GovernmentCreated Monopolies A firm may be a monopoly because the government protects it from entry by other firms For example suppose a firm invents a new product and realizes that imitation 7s possible technically In most countries the original innovating firm can obtain legal protection to prevent entry for some period of time The law on intellectual property in particular the patent law grants a legal monopoly to a firm that has discovered a new product or tech nique A firm can obtain a patent see Chapter 16 on a new product that prevents any other firm from copying its product and competing with it for a fixed period of years Aside from the patent laws other types of government or government sanctioned restrictions on entry can serve to create and maintain monopolies Generally govern ment restrictions on entry allow at least a few firms to produce but they prevent the normal competitive forces from driving price and profits down to competitive levels see Example 45 For example in many cities one must purchase medallions of which only a fixed number are sold by local authorities to operate a taxicab The United States by grant ing exclusive monopoly rights to portions of the electromagnetic spectrum gave broadcast television stations at least 40 billion in presentvalue terms for the first 30 years of television Isé and Perloff 1997 Creating and Maintaining a Monopoly 127 Protecting a Monopoly An 1872 law established the US Postal Service USPS monopoly on mail delivery In 1971 the USPS started an express mail service A 1979 amendment to the 1872 law broke the agencys monopoly on urgent mail establishing as the definition of ur gent mail that must arrive by noon the next day or lose its value However the USPS has the right to decide what is urgent and what is not How serious was the Postal Services competition on express mail By 1994 the USPSs share of the express mail market had fallen to just under 15 percent Worse to the horror of postal officials the federal government contracted with Federal Ex press for nextday delivery of government parcels at a price of 375 well below the Postal Services overnight Express Mail rate of 995 The USPS fought back From 1990 through 1993 the Postal Service fined 21 companies for violating the USPSs legal monopoly on mail delivery collecting more than 542000 in fines from these companies that sent nonurgent mail by private couriers such as Federal Express UPS and DHL For example an Atlantabased creditreporting company Equifax Inc was as sessed a 30000 penalty making up the loss to the Postal Service for routine busi ness mail it sent by express services Postal officials say they recovered 4 in lost revenue for every 1 spent on enforcement In 1994 the USPS issued a postal inspectors audit that found that five federal agenciesthe General Services Administration GSA and the departments of Agri culture Health and Human Services Treasury and Energyroutinely infringed on the USPSs monopoly on firstclass mail by using Federal Express to ship materials that were not time sensitive The report warned that the agencies which accounted for onethird of the 43 million government packages moved by Federal Express in the first two years of the contract are incurring a substantial liability for postagethe revenue that would have otherwise gone to the Postal Service The USPS did not demand any payments for the postage but postal officials pressured the GSA to train federal mailroom per sonnel as to what kind of materials they can legally send by Federal Express Armed with news reports of USPS fines on private firms and pressure on federal agencies outraged private companies went to Congress for legislation ending the Postal Services practices Smarting from bad publicity and congressional pressure the USPS announced that it would cease its practice of raiding businesses to check up on their use of commercial overnight delivery services and stopped complaining about federal agencies Nice try though Sources Michael A Goldstein Can the US Postal Service Market Itself to Success Los Angeles Times Magazine December 22 199614 Bloomberg News UPS Aims to Curb Postal Service Mo nopoly The Dallas Morning News April 14 19989D Bill McAllister Must It Get There Overnight Agencies Improperly Bypassing Postal Service Inspectors Report Washington Post January 12 1994A17 Private Couriers and Postal Service Slug It Out New York Times February 14 1994D2 Example 45 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 127 128 Chapter 4 Monopolies Monopsonies and Dominant Firms Until recently US states required someone wishing to build an inpatient medical facility to obtain a certificate of need by demonstrating that a new facility was needed Using these laws an early entrant could make entry by potential competitors difficult In part because of these laws Community Psychiatric Centers a chain of psychiatric hospitals in the United States and Britain had annual earnings growth of 15 to 30 per cent between 1969 when it went public and 1985 Similarly trade barriers can be used to prevent entry For example in 1992 the Ontario government agency that monopolizes the sale of beer in that province the Liquor Control Board of Ontario announced a ban on American beer imports Simi larly China places a 230 percent tariff tax on foreign products on foreign cigarettes to protect the China National Tobacco Corporation which sells 175 trillion of the 5 trillion cigarettes sold throughout the world and accounts for 12 percent of the rev enue of the Chinese government 2 Natural Monopoly In some markets it is efficient for only one firm to produce all of the output When total production costs would rise if two or more firms produced instead of one the single firm in a market is called a natural monopoly A firm is a natural monopoly if it can produce the market quantity Q at lower cost than can two or more firms Let g 4 be the output of the 2 firms in a market that produce an identical product so that total market output equals the sum of the firms output Q q q If each firm has a cost function Cq and one firm can produce Qat lower cost than the sum of the firms CQ Clq Cqy CG then the least expensive most efficient way to produce is to have one firm produce all Q units A cost function is said to be subadditive at Q if this inequality holds so sub additivity is a necessary condition for the existence of a natural monopoly Sharkey 1982 Baumol Panzar and Willig 1982 A natural monopoly often has falling average costs and constant or falling marginal costs in the region in which it operates A strictly decreasing average cost curve implies subadditivity though the opposite does not necessarily follow Suppose that the average cost curve of a natural monopoly is downward sloping and that the firm can produce 100 units at an average cost of 10 per unit The firms total cost of producing that many units is 1000 Now suppose that a second firm with identical costs enters the market If each of these two firms produces 50 units their average cost of production is higher than before because the average cost curve is downward sloping If their average cost is 15 per unit for example their combined See wwwawbccomcarltonperloff Model of Insanity 2Glenn Collins US Tobacco Industry Looks Longingly at Chinese Market but in Vain New York Times November 20 1998A10 Profits and Monopoly 129 13The empirical literature however leaves some doubt as to whether many utilities exhibit increas ing returns to scale which implies downwardsloping marginal and average cost curves Moreover showing that there are scale economies in one range of output is not sufficient to demonstrate that a firm is a natural monopoly that is the cost function is subadditive See for example Fuss and Wa verman 1981 and Evans and Heckman 1982a 1982b Shin and Ying 1992 argue that local tele phone exchange carriers were not natural monopolies prior to deregulation Friedlaender 1992 finds evidence of substantial returns to scale for railroads 14In Chapter 20 we examine how governments regulate natural monopolies and the conditions un der which other firms will try to enter a market with a natural monopoly total cost of producing 100 units is 1500 Thus a single firm can produce 100 units at lower cost than can two firms It is often argued but may not be true that electrical gas telephone and cable television are natural monopolies There is a relatively high fixed cost for running an electric power line or a phone line to a home or firm but constant or falling marginal costs of supplying the service As a result marginal cost is constant or falls and average cost falls as output increases13 If production is characterized by economies of scale everywhere then average cost de clines as output increases and it is always less costly for one firm to produce any given output than for several firms to produce that output Therefore when average cost falls with output there is a natural monopoly A natural monopoly can occur even if average cost is not declining everywhere with output For example if a Ushaped average cost curve reaches a minimum at an output of 100 it may be most efficient for only one firm to produce an output of 101 even though average cost is rising at that output Therefore economies of scale are a sufficient but not a necessary condition for natural monopoly14 Profits and Monopoly Many people associate high profits with monopoly or too little competition normal profits with competition and losses with excessive competition Although each of these beliefs has some element of truth none is correct We now show why these be liefs do not hold in general by answering three questions 1 Is anyone who earns pos itive profits a monopoly 2 Does a monopoly always earn positive profits 3 Should the government allow mergers that create monopoly in a market that was suffering shortrun losses Is Any Firm That Earns a Positive Profit a Monopoly Although a monopoly may earn positive profits it does not follow that any firm that earns a positive profit is a monopoly The previous chapter discusses the possibility that certain scarce resources such as land can earn rents For example a wheat farmer who owns particularly productive land earns a large profit This profit is attributable to the land that is owned and should properly be called a rent The farmer behaves com petitively taking price as given and operating where price equals marginal cost This 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 129 130 Chapter 4 Monopolies Monopsonies and Dominant Firms EU Allows Merger to Eliminate Losses In 2003 the European Union allowed Rupert Murdochs News Corporation to merge Telepiu which had twothirds of all payTV subscribers in Italy with its own Italian payTV firm Stream to create a new firm called Sky EU Competition Com missioner Mario Monti conceded that his decision will create a quasimonopoly on the Italian market He justified his actions by saying that a weak business environ ment allowed room for only one firm to survive in this market as both Stream and Telepiu had been losing money Source Raf Casert EU Commission Allows Murdochs News Corp to Forge QuasiMonopoly in Italian Pay TV Associated Press April 2 2003 Example 46 farm is a competitive firm rents on factors of production do not indicate a monopoly As long as output is not restricted so that price equals marginal cost there is no market power Scarce resources can command very high prices and those who own those re sources benefit For example star athletes earn high salaries rents even though they are not monopolies that restrict output Does a Monopoly Always Earn a Positive Profit Although a monopoly earns a larger profit than a competitive firm would it is not true that a monopoly always earns a positive profit In the short run a monopoly can make losses just as a competitive firm can A monopoly that faces a sudden decline in demand may continue to operate even though it makes a negative shortrun profit its price is less than its average cost if its price is above its average variable cost Losses in a market do not imply that it is competitive In the long run when there are no sunk costs no firm continues to operate if there are only losses in the market As in competition the length of time that losses will be earned by a monopoly de pends on how long the short run lastshow long it takes for the plant and equipment to wear out forcing a decision on whether to replace them In some markets the short run may be very long For example railroad tracks can last for years or possibly decades Therefore one might expect that a monopoly railroad could earn a negative profit on its investments for a long time before deciding to exit the market Briefly in the long run a competitive firm makes zero economic profit whereas a monopoly makes a zero or positive profit In the short run both competitive firms and monopolies may make losses or profits Are Monopoly Mergers to Eliminate ShortRun Losses Desirable A merger of firms into a monopoly can eliminate competition and allow the merged firm to exercise market power and raise price so that the losses are eliminated Firms in a market where all firms are losing money often argue for a merger for this reason see Example 46 This motivation for merger appears to have a certain logical appealif 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 130 Monopsony 131 the merger eliminates the losses perhaps it is efficient for the merger to occur How ever such a merger harms society If a merger enables firms to set a price in the short run that is greater than the level at which they would have priced had they remained competitive then the merger im poses a deadweight loss on society The existence of sunk costs in the short run that cause shortrun losses cannot be eliminated by merging firms The merger only changes the amount of competition that firms face Because the merger does not eliminate sunk costs it is inefficient to allow firms to form a monopoly and thus allow the price to rise Monopsony A single buyer in a market is called a monopsony A monopsonys decision on how much to buy affects the price it must pay just as a monopolys choice of output affects the price it receives The monopsony decides how much to purchase by choosing a pricequantity pair on the market supply curve Monopsony is the flip side of monopoly Both a monopoly and a monopsony recognize that their actions affect the market price A monopsony determines how much to buy in much the same way that a monop oly determines how much to produce A monopsony buys more of the good as long as the value of the extra consumption as given by its demand curve equals or exceeds its marginal cost of consuming one more unit If there is a competitive labor market each firm takes the wage rate as given and the marginal cost of hiring one more worker is simply the wage rate Now suppose there is only one local employer buyer of labor services a monopsony In Figure 45 Workers L Marginal outlay schedule MO Supply of labor wm wc Lm Lc DWL D Wage FIGURE 45 Deadweight Loss from Monopsony 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 131 132 Chapter 4 Monopolies Monopsonies and Dominant Firms it faces an upwardsloping supply curve for labor In order to hire an extra worker the monopsony must not only pay that worker a slightly higher wage rate but also pay all its other workers a slightly higher wage rate because only by raising the wage can extra labor be induced into the marketplace If the monopsony must raise its wage from say 5 to 6 to induce that last indi vidual to work for the firm the monopsonys extra cost of hiring the additional worker is not just 6 it is 6 plus the 1 increase in wages that must be passed along to each of its original workers If it originally had 100 workers its total wage bill rises from 500 to 606 an increase of 106 The monopsony recognizes that its marginal cost of hiring the additional worker is 106 rather than 6 and takes that into account in deciding whether to hire the additional worker The monopsony hires an extra worker only if the marginal benefit as given by its labor demand curve exceeds its marginal cost of hiring an additional worker The marginal cost to a monopsony of buying additional units hiring additional workers is described by a marginal outlay schedule which is analogous to a marginal revenue curve As Figure 45 illustrates the marginal outlay schedule lies above the up wardsloping supply curve because the monopsony must raise the wage for all its workers to hire an extra worker A profitmaximizing monopsony hires Lm workers where its marginal benefit as given by its demand curve equals its marginal outlay Because the marginal outlay curve lies above the supply curve the monopsony hires fewer workers Lm than would a competitive market which hires Lc workers deter mined by the intersection of the demand curve and the supply curve In other words a monopsony restricts output just as a monopoly does The monopsony wage rate wm is below the competitive wage rate wc Using a de finition analogous to the one for market power we can define monopsony power as the ability to profitably set wages or other input prices below competitive levels At the monopsony solution Lm wm in Figure 45 there is a gap between the demand curve and the supply curve A gap between the demand curve which represents the marginal benefit to society of consumption and the supply curve which represents the marginal cost to society reflects a loss in efficiency The monopsony deadweight loss triangle Figure 45 is analogous to the deadweight loss that results from monop oly Figure 42a Most labor economists believe there are few monopsonized labor markets in the United States Example 47 identifies one such market The most frequent examples given of monopsony in the labor market concern singlecompany towns local em ployment markets and sports leagues For example a major league baseball player can work in the United States only if he plays for a team that belongs to either the Ameri can or National Leagues Collectively these teams are the sole buyer in the United States for the services of a major league baseball player To the degree that the teams agree not to compete for players they gain monopsony power To offset such monop sony power baseball players can form a union to obtain monopoly power in selling their labor services Monopsony is most likely in markets where resources are specialized to a few uses Moreover even if resources are initially specialized to one use as with a piece of cus tomdesigned machinery or a plant in a specific location serving a single buyer 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 132 Monopsony 133 Priest Monopsony Newspapers repeatedly report a shortage of Catholic priests citing sources both in side and outside the church hierarchy Between 1960 and 2000 the number of priests declined 13 percent even as 55 percent more Catholics had joined their local parishes Strikingly other religious denominations are not suffering from a shortage of clergy Why the difference between churches Is it due to changing tastes among poten tial priests or some other factor Daniel Condon 2002 attributes the difference to the fact that the Catholic Church exercises monopsony power whereas other churches and synagogues permit an active competitive labor market for clergy Indi vidual Catholic parishes do not compete for clergy who are instead assigned by the central church authority diocese Wages vary little across parishes although priests in wealthy parishes may receive larger fees for performing wedding and funeral services Condon estimates that Catholic priests earn 41 percent less than nonCatholic of ficiants controlling for education experience location and whether they are pro vided rentfree housing He concludes p 918 that the true differential is more pronounced when one considers that Catholic clergy have a condition of employ ment celibacy that would require additional monetary compensation for most Academics at a Catholic university may face an even greater problem For them its publish or parish Example 47 monopsony may not persist in the long run The reason is that no one will make new customdesigned machinery or new investments in a plant for a specific buyer if they earn a depressed return compared to what they can earn from making other machines or building a plant elsewhere In other words few resources are special ized in the long run and therefore it is unlikely that monopsony can persist in the long run Another way to explain the preceding point is as follows If resources are not spe cialized to a particular market in the long run then the longrun supply curve tends to be flat highly elastic As Chapter 3 explained a flat longrun supply curve is most likely to occur when the market in question uses only a relatively small fraction of the total consumption of its inputs Longrun monopsony power is impossible if the long run supply curve is flat because price cannot be lowered below the competitive price If the longrun supply curve is flat there may not be any monopsony power even in the short run Suppose that before a firm enters a market it has many alternative uses for the resources it owns After it enters the market it specializes its machines so that it has very few alternative uses for its assets Suppose that it will only enter a particular market if it receives 10 per unit of output which is the longrun average cost The sole buyer the monopsony agrees to pay 10 After the firm enters it is committed at 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 133 134 Chapter 4 Monopolies Monopsonies and Dominant Firms 15A firms share of sales in an industry depends crucially on how the industry is defined and hence is often controversial especially in court proceedings least for some time in the sense that its machines are specialized to this particular mar ket If the monopsony lowers its price to 9 it may not pay for the firm to exit imme diately But the firm will not replace the specialized machines when they wear out and the monopsony may eventually have no one willing to supply the product Even if the buyer again promises 10 per unit to induce a supplier to enter no firm would believe the buyer in light of its previous behavior So for a buyer that is concerned about a longrun source of supply it may not pay to exercise shortrun monopsony power Dominant Firm with a Competitive Fringe Where does the gorilla sleep Anywhere the gorilla wants to sleep What happens to a monopoly if other highercost firms enter its market Or similarly what happens if a lowercost firm enters a market with many pricetaking highercost firms After entry the lowercost firm has a relatively large share of the market If one firm is a price setter and faces smaller pricetaking firms it is called a dominant firm It typically has a large market share The smaller pricetaking firms called fringe firms each have a very small share of the market though collectively they may have a substantial share of the market There are several industries in which one firm has a large share of the industry sales For example Kodaks share of the photographic film business has been esti mated at 65 percent15 HewlettPackard is estimated to have 59 percent of laser printer sales We begin by discussing what makes a firm dominant We then analyze how entry limits a dominant firms market power We examine two extreme cases In the first en try by other firms is impossible In the second entry by competing fringe firms can oc cur instantaneously The analysis shows that a dominant firms pricesetting behavior depends on the ease of entry by fringe firms We draw two main conclusions First it is generally not in a profitmaximizing dominant firms best interest to set its price so low that it drives all competitivefringe firms out of the market Second the presence of competitivefringe firms or the threat of entry by additional firms may force a dominant firm to set a price lower than the price a monopoly would set see Example 48 If a sufficiently large number of pricetaking firms can enter the market a domi nant firm cannot continue to charge a price higher than the minimum average cost of these new firms Indeed if potential entrants costs are as low as the dominant firms the dominant firm eventually has no more market power than any other firm 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 134 Dominant Firm with a Competitive Fringe 135 Price Umbrella It is often asserted that a dominant firm provides a pricing umbrella for smaller firms As long as competing firms price at or below the level of the dominant firm they will be able to find buyers If their products are inferior say because they are risky to use for legal reasons the fringe firms have to set their prices substantially below the dominant firms In many countries phone monopolies charge rates that are more than twice those in the United States where competition has kept rates relatively low This price dif ference causes problems for the monopolies Callback services offer some customers a way to evade paying high monopoly prices A callback service provides a trigger number connected to a computer in the United States The customer calls that number using the monopoly service and hangs up before the phone is answered paying nothing for the incomplete call The computer calls the customers back and offers an American dial tone which can be used to place a call anywhere in the world for rates well below the monopoly price In some cases the callback rates are less than the price of a local call Hundreds of American companies provide these services and the rate of use has grown exponen tially over time Ghanas monopoly is reported to lose 1 million each week to call back and Internet services To protect local monopolies governments in many countriesincluding Ar gentina Canadas Northwest Territories China Malaysia Saudi Arabia South Ko rea and Ugandatry to stop these services The US operators believe they are beyond the reach of local laws For example when Uganda blocked all calls to the Seattle Washington area code where one service Kallback is based the company routed the calls through a different area When other countries tried to identify and block the services by picking up the touchtone beeps used to complete calls Kall back added a voicerecognition system As a firm spokesman said Its a cat and mouse game Its kind of fun Source Dont Call US The Economist 3387947 January 6 199655 wwwkallbackcom Telecom Loses 1m a Week Communications Experts Say Ghanaian Chronicle February 7 2003 Example 48 Why Some Firms Are Dominant All animals are equal but some animals are more equal than others George Orwell Why do some firms gain substantial market power while others do not At least three possible reasons are sufficient to create a dominant firmcompetitive fringe market structure 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 135 136 Chapter 4 Monopolies Monopsonies and Dominant Firms The first reason is that dominant firms may have lower costs than fringe firms There are at least four major causes of lower costs A firm may be more efficient than its rivals For example it may have better management or better technology that allows it to produce at lower costs Such a technological advantage may be protected by a patent An early entrant to a market may have lower costs from having learned by experience how to produce more efficiently An early entrant may have had time to grow large optimally in the presence of adjustment costs so as to benefit from economies of scale By spreading fixed costs over more units of output it may have lower average costs of production than a new entrant could instantaneously achieve The government may favor the original firm The US Postal Service does not pay taxes or highway user fees which reduces its cost relative to that of competing package delivery services A second important reason is that a dominant firm may have a superior product in a market where each firm produces a differentiated product This superiority may be due to a reputation achieved through advertising or through goodwill generated by its having been in the market longer A third reason is that a group of firms may collectively act as a dominant firm As Chapter 5 shows groups of firms in a market have an incentive to coordinate their ac tivities to increase their profits A group of firms that explicitly acts collectively to pro mote its best interests is called a cartel If all the firms in a market coordinate their activities then the cartel is effectively a monopoly if only some of them do so then the group acts as a dominant firm facing a competitive fringe of noncooperating firms One example of a dominant firm is the cartel consisting of Philippine coconutoil producing firms that act in concert but face a fringe of firms in other countries that act as price takers With nearly fourfifths of the worlds export market the Philippine car tel has dominantfirm market power with a Lerner Index of 089 Buschena and Perloff 1991 Whether a dominant firm can exercise market power in the long run depends cru cially on the number of firms that can enter the market how their production costs compare to those of the dominant firm and how fast they can enter We now examine the dominant firmcompetitive fringe model under two alternative extreme assump tions about the ease of entry The NoEntry Model Consider a market with a dominant firm and a competitive fringe in which no addi tional fringe firms can enter Two key results emerge from an analysis of this model 1 It is more profitable to be the gorilla of a market than a mere fringe firm 2 The existence of the fringe limits the dominant firms market powerthat is it is more profitable to be the only firm in a market a monopoly than merely a dominant firm Assumptions Five crucial assumptions underlie this noentry model 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 136 Dominant Firm with a Competitive Fringe 137 1 There is one firm that is much larger than any other firm because of its lower pro duction costs Although a market may be characterized by a small group of rela tively large firms rather than a single dominant firm we concentrate on the case of the single dominant firm for simplicity 2 All firms except the dominant firm are price takers determining their output levels by setting marginal cost equal to the market price p 3 The number of firms n in the competitive fringe is fixed No new entry can occur That is the dominant firm knows that it can raise the markets price without causing new firms to enter the market or existing firms to build additional plants 4 The dominant firm knows the markets demand curve Dp Each firm produces a homogeneous product so that there is a single price in this market 5 The dominant firm can predict how much output the competitive fringe will produce at any given price that is it knows the competitive fringes supply curve Sp The first three assumptions determine that this market has a dominant firm facing a competitive fringe with no more than n firms The last two assumptions ensure that the dominant firm knows enough to be able to set its output level optimally The Dominant Firms Reasoning Suppose you ran the dominant firm How would you choose your output level Given your firms large size you could drive up the mar kets price by restricting your output Unfortunately for you as your dominant firm low ers its output and price rises the competitive fringe output increases because the fringe supply curve Sp is increasing in p As a result market output falls less than you would like and the market price does not rise as high as it would if your firm had a monopoly Thus your dominant firms problem is much more complex than that of a monop oly which merely needs to consider the market demand curve with its corresponding marginal revenue curve and its marginal cost curve to determine its profitmaximiz ing output Your dominant firm in contrast must consider not only those factors but also how the competitive fringe responds to your actions To maximize your profits you must take the competitive fringes actions into ac count when setting your policy A convenient way to calculate your optimal price level is to do the following thought experiment For lack of an ability to stop them let the fringe firms sell as much as they want at the market price the price you set Except at the very highest prices the competitive fringe does not produce enough to meet all of the markets demand Your dominant firm then is in a monopoly position with re spect to this residual demand Thus you can determine your optimal output by a two step procedure First determine your firms residual demand curve then act like a monopoly with respect to the residual demand This twostep procedure can be illus trated with the use of graphs A Graphic Analysis of DominantFirm Behavior The first step is to determine the longrun residual demand curve facing the dominant firm Figure 46 shows two graphs a one for a representative competitivefringe firm and for the entire competi tive fringe and b one for the dominant firm 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 137 138 Chapter 4 Monopolies Monopsonies and Dominant Firms acti toe The Dominant Firm and the Competitive Fringe a b MC AC Sp Dp MC AC p Xt Di Jem Meek Dw EN Do DO 1 ved 2 2 IMRa Doo I Doo dp O Fringe firm and total supply g O QO Q o Market quantity O dS Or The graph on the left Figure 46a shows the market demand curve Dp and the supply curve of a typical pricetaking competitivefringe firm The fringe firms sup ply curve is its marginal cost curve above the minimum of its average cost curve p That is the fringe firms shutdown price is p Above p each fringe firm makes positive economic profits At p each fringe firm makes zero profits and is indifferent between operating and shutting down Below 7 each firm shuts down and the dominant firm is a monopoly The competitive fringes supply curve Sp is the horizontal summation of the in dividual fringe firms supply curves as Figure 46 shows That is Sp ngp where nis the number of firms and q is the output of a typical fringe firm T6As drawn each fringe firm produces essentially no output at p If the firms had the usual Ushaped average cost curves however they would produce a positive amount of output at that price Dominant Firm with a Competitive Fringe 139 The dominant firms residual demand curve is the horizontal difference between the market demand curve and the competitive fringes supply curve Dp Dp Sp In Figure 46b the market demand curve thin blue line is above the residual demand curve heavy blue line at prices above p and equal to it at prices below p That is the fringe firms meet some or all of the market demand if price is above p but they drop out of the market and leave all of the demand to the dominant firm if price falls below p At p the quantity that the fringe supplies equals the quantity that the market de mands so the dominant firm has no residual demand The dominant firm maximizes its profits by picking a price or equivalent an out put level so that its marginal cost equals its marginal revenue The dominant firms marginal revenue curve MR 4 is derived from its residual demand curve and has two distinct sections If the competitive fringe produces positive levels of output the dom inant firms residual demand curve lies below and is flatter than the market demand curve The dominant firms marginal revenue curve MR in this region is flatter than the marginal revenue curve in the region where the dominant firms residual demand curve and the market demand curve are coincident There is a discrete jump between the two sections of the marginal revenue curve at the point where the residual demand curve and the market demand curve meet The dominant firm behaves as a monopoly would with respect to the residual de mand it sets its price or output so that its marginal cost equals marginal revenue Be cause the marginal revenue curve has two sections there are two possible types of equilibria which one occurs depends on the dominant firms cost curves We now consider two types of markets 1 The dominant firm charges a high price so that it makes economic profits and the fringe firms also make profits or break even 2 The dominant firm sets a price so low that the fringe firms shut down to avoid making losses The dominant firm is now a monopoly The Dominant FirmCompetitive Fringe Equilibrium The first type of equilibrium occurs if the dominant firms costs are not substantially less than those of the fringe firms7 The dominant firms marginal cost curve MC crosses the first downwardsloping segment of the marginal revenue curve MR in Figure 46b The dominant firm chooses to produce Q level of output at price p the height of the residual demand curve at the output level Q At the price level p the difference between the market demand Q and the dominant firms output Q is the competi tive fringes supply Qr which is shown in Figures 46a and 46b If the dominant 17A mathematical analysis of this case is presented at wwwawbccomcarltonperloff Dominant Firm and Competitive Fringe Model 140 Chapter 4 Monopolies Monopsonies and Dominant Firms firms costs are this high it does not drive the competitive fringe out of business Its own profits are maximized at a price so high that the fringe firms make positive profits In most markets positive economic profits would attract new entrants In this mar ket however no new firms can enter by assumption so both the dominant firm and the competitive fringe firms can make positive profits forever In Figure 46b the dom inant firms profits are labeled ag The profits of a typical fringe firm are positive as well because p p and a typical fringe firms profits are shown as 7r in Figure 46a Because the dominant firms average cost is lower than that of the fringe firms mini mum AC p the dominant firm makes more profits per unit average profits and it also sells more units than an individual fringe firm so it must make more total prof its as well Thus the dominant firm maximizes its profits by charging a price so high that it loses some of its market share to the competitive fringe It does not make sense for the dominant firm to set its price so low that it drives the fringe out of business even though that would increase the number of units of output the dominant firm could sell After all few good business people accept the argument I lose a little on every sale but make up for it in volume The dominant firm makes lower profits than it would if it were a monopoly and the fringe did not exist The fringe can only hurt the dominant firm and benefit con sumers For example in 1993 NEC Corporation which then controlled half of all personal computer sales in Japan had to cut its prices roughly in half due to increased competition from US fringe firms The Dominant Firm as Monopoly Now suppose that the dominant firm has ex tremely low costs compared to the fringe firms so that its marginal cost curve is MC in Figure 46b Notice that MC crosses MR in the lower part of its two downwardsloping sections The dominant firm chooses to produce Q level of output at price p the height of the residual demandcurve at output level Q Because p is below the fringe firms shutdown point their minimum average cost the fringe firms produce nothing Q 0 As a result market output Q equals the dominant firms output Qy The dominant firm sets a monopoly price and no competitivefringe firm enters The dominant firm meets all the demand of the market unchecked by the fringe and is thus a monopoly The reason it has a monopoly is that MC intersects MR along the segment of MR that is the same as the marginal revenue curve associated with the market demand curve That is the monopoly price is below p so no fringe firm wants to produce A Model with Free Instantaneous Entry If unlimited entry is possible a dominant firm cannot set as high a price as it can if en try is limited or prevented This section retains all the assumptions made in the pre ceding section except that now an unlimited number of competitivefringe firms may enter the market Firms enter if they can make positive profits In this situation fringe firms cannot make profits in the long run they either break even or are driven out of business If identical fringe firms produce at all the market Dominant Firm with a Competitive Fringe 141 China Tobacco Monopoly to Become a Dominant Firm Established in 1982 the Chinese governments tobacco monopoly the China Na tional Tobacco Corporation has been the most profitable corporation in the world accounting for 12 of the Chinese governments revenues It sells to Chinas 310 million smokers a quarter of the worlds smoking population who consume 1700 billion cigarettes a yearabout 30 of global consumption By imposing a 230 tax rate on foreign cigarettes and by imposing import quo tas and restrictions such as designating only a few sales outlets for imported ciga rettes the government limited legal foreign cigarette sales to less than 2 of total Chinese sales in the late 1990s By 2003 their share was only 10 To appease the World Trade Organization WTO China has agreed to lift re strictions on the retail sale of imported cigarettes by January 2004 to reduce the tar iff on cigarettes from the current 65 to 24 and to phase out the tariff over the next two years Thus the states monopoly will be turned into a dominant firm Government of ficials expect that the price of imported cigarettes will drop in half and that they will gain a major share of the market Sources Glenn Collins US Tobacco Industry Looks Longingly at the Chinese Market but in Vain New York Times November 20 1998A10 China to Lift Restrictions on Retail Sales of Im ported Cigarettes Next Year AFX European Focus February 11 2003 Remove of Foreign Tobac cos Retailing Licenses to Cut Prices by Half sic China News February 14 20031 Chinese Tobacco Industry Facing Mergers and Recapitalizations China BusinessTimes February 17 20031 Example 49 18According to its chief executive officer Lawrence Herkimer in Peter Applebome The Worlds Oldest and Fattest Cheerleader San Francisco Chronicle January 12 198424 price ultimately can go no higher than a fringe firms minimum average cost so that fringe firms always just break even After all if they made positive profits more firms would flood into the market and drive price down to the level where each earns zero economic profits Because the dominant firm has lower costs than fringe firms it makes positive profits but its profits are lower than if entry did not occur Even with unlimited entry the dominant firm can gain and hold indefinitely a large share of the market if it has some cost or other advantage see Example 49 Another example is the Cheerleader Supply Co which accounts for 60 percent of cheerleading uniforms and equipment sold in this country18 This is an industry with easy entry and yet one firm has the lions share of the market presumably because it has superior products a superior sales force lower costs or has generated goodwill with buyers The competitivefringe firms cost curves are the same as before As more and more firms enter n rises the slope of the competitivefringe supply curve becomes flatter 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 141 142 Chapter 4 Monopolies Monopsonies and Dominant Firms Quantity Q a b Qd Q Qd MCd Quantity Q S p MCd MRd MRd D p Dd p Dd p D p p p p Qf FIGURE 47 Dominant Firm with Free Instantaneous Entry by Fringe Firms and flatter it is n times the slope of a typical firms supply or MC curve As the num ber of firms grows large the fringes supply curve becomes essentially horizontal as shown in Figure 47a That is as long as price is at least the competitive fringe is ca pable of and is willing to supply any quantity that the market demands As shown in Figure 47b the residual demand curve facing the dominant firm is horizontal at so the corresponding marginal revenue curve is also flat remember that in a competitive market a firm faces a horizontal demand curve and hence its marginal revenue curve is identical to its demand curve at the market price Below the residual demand curve is the market demand which slopes downward so that the corresponding marginal revenue curve also slopes downward Again the marginal rev enue curve corresponding to the residual demand curve jumps at the quantity where the kink in the residual demand curve occurs There are two possible equilibria First if the dominant firms marginal cost is rela tively high MCd in Figure 47b so that it intersects the horizontal portion of the p p p 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 142 Summary 143 MR curve the price is p and the competitive fringe meets some of the markets de mand At this price each fringe firm makes zero economic profits because its average cost equals p and is indifferent between staying in business and leaving the market How much is produced by the competitive fringe depends on the dominant firms cost structure that is where MC intersects the horizontal marginal revenue curve which determines the dominant firms output Qj Collectively the fringe firms produce an output level Qe Q Qy as Figure 47b shows It is possible that Qr 0 even though the presence of the fringe constrains price to equal p Thus if fringe firms flood into a market whenever positive profits can be made the dominant firm cannot charge a price above the minimum average cost of a fringe firm Although a dominant firm can make positive profits competitivefringe firms just break even If the dominant firms price would be above p in the absence of entry con sumers are better off if entry is possible because it results in lower prices The second type of equilibrium occurs if the dominant firms marginal cost is lower MC in Figure 47b so that it hits the marginal revenue curve in the downward sloping portion Here the price is so low that no fringe firm stays in the market when the dominant firms costs are lower than the fringe firms costs This equilibrium Q p is the same as discussed previously in the second noentry equilibrium and is shown in Figures 46b and 47b The dominant firm is a monopoly and the potential supply of fringe firms is irrelevant SUMMARY Monopoly or market power is the ability to price profitably above marginal cost A sin gle seller of a product a monopoly faces a downwardsloping demand curve and sets its price above marginal cost As a result less is purchased than if the market were per fectly competitive and society suffers a deadweight loss In some markets however there are benefits to monopoly For example the promise of future monopoly profits can spur a firm to develop new products or more efficient production techniques Not all firms that earn profits are monopolies and not all monopolies earn profits Just like a competitive firm a monopoly can make either profits or losses in the short run However unlike a competitive firm a monopoly can earn positive profits in the long run A natural monopoly exists when it is efficient to have only one firm produce the markets output 19Why dont fringe firms meet the entire demand at p instead of splitting it with the dominant firm The answer is that the dominant firm has lower costs and can force some of the fringe firms out of the industry Suppose that the dominant firm is producing its desired output of Qy and n fringe firms are producing Q Q Qg Now if additional fringe firms enter this market output exceeds market de mand at p For the market to clear the price must fall Since the dominant firm is making positive profits it stays in the industry The fringe firms however start making losses because they just break even at p Thus some of the fringe firms must drop out of the industry until the price again rises to p Alternately stated the dominant firm can always charge slightly below p to sell as much as it wants 144 Chapter 4 Monopolies Monopsonies and Dominant Firms Monopsony is monopoly on the buying side A firm with monopsony power sets lower prices and employs fewer resources than would prevail under competition Like monopoly monopsony imposes an efficiency cost on society Monopsony power can persist only when resources are specialized in the long run A lowcost dominant firm has market power even though it competes with other firms A profitmaximizing dominant firm does not attempt to drive out fringe firms at all costs Its behavior depends on how great its cost advantage over fringe firms is and on how easily other firms can enter If a large number of pricetaking firms can en ter the market whenever a profit opportunity occurs and if they can produce at costs not much above those of the dominant firm the dominant firm is unable to charge prices substantially above the competitive price Even if fringe firms do not enter a market the threat of their entry may cause a monopoly in the sense that it is the only firm in the market to set a lower price than it would in the absence of the fringe PROBLEMS 1 Does a monopolys profit differ if it chooses price a the market price b the number of fringe or quantity assuming it chooses them optimally firms c total output and d the dominant firms Why cant a monopoly choose both price and share of the market Hint What does an increase quantity in fixed costs do to the average cost curve of a 2 After a shift in the demand curve show that a mo fringe firm nopolys price may remain constant but its output 7 By showing the behavior of both a monopoly and may rise a dominant firm in the same graph show that mo 3 If the demand curve is Q 5p what is the nopoly profits are greater than the profit of a dom elasticity of demand What is total revenue when inant firm in the noentry equilibrium MC p 1 and when p 30 If production costs 1 Show how much consumers benefit from buying per unit and the smallest production level is 1 from a dominant firmcomp eritive fringe rather unit how much should the monopoly produce than from a monop oly Hint A firms variable costs are the area under its marginal cost curve up 4 If the demand curve is Qp p what is the to the relevant output 5 clesticig chat ake proce alaine price and 8 How would the noentry model diagrams Figure 46 change if fringe firms had the usual Ushaped 5 Suppose the demand curve for corn is Qp average and marginal cost curves Assume that be 10 p Suppose that one firm owns all five units cause of a barrier to entry there are only 7 fringe of corn in the world and has zero marginal cost firms Describe the types of possible equilibria Does a monopoly sell less output than would be Lo sold in a competitive market in which 100 firms 9 Would a p rofitmaximizing dominant firm ever each own 005 units produce more than if it were a monopoly Hint Show the behavior of both a monopoly and a 6 Suppose the Environmental Protection Agency dominant firm in the noentry model on the sets new requirements that raise the fixed costs of same graph and note where the marginal revenue reporting compliance with pollution control rules curves cross Pashigian 1984 How would this change affect Suggested Readings 145 10 What effect does a binding minimum wage have on a monopsony labor market Answers to oddnumbered problems are given at the back of the book SUGGESTED READINGS Stigler 1965 provides a good nontechnical introduc tion to the dominant firmcompetitive fringe model Fisher McGowan and Greenwood 1983 is a very readable controversial discussion of the important IBM antitrust case 3641AWLCARLCh04pp112145qxp 12715 1249 PM Page 145