Business

DECISION SNAPSHOT

Profit-Maximizing Range of Prices for Tires

Amount of Profit In Chapter 5, you learned that a perfectly competitive firm makes an economic profit if P 7 ATC, makes a competitive return if P = ATC, and incurs an economic loss if P 6 ATC. Thankfully, you do not need to memorize yet another rule because the same set of results holds true for monopoly firms. In fact, these relationships apply to any firm.

Figure 6.5 includes the average total cost curve (ATC) for your firm’s drug, assum- ing that it makes an economic profit. In the figure, the price ($60,000 per treatment) exceeds the average total cost ($40,000), which shows that your company is making an economic profit. The area of the green rectangle in Figure 6.5 is 1P – ATC2 * Q. As you learned in Chapter 5, this area equals the amount of the firm’s economic profit because it is the economic profit per unit 1P – ATC2 multiplied by the quantity sold (Q). In Figure 6.5, the economic profit is 1$60,000 – $40,0002 * 150,000 treat- ments, which comes out to $3 billion.

Figure 6.5 shows the monopoly is making an economic profit, so it would be easy to suppose that all monopolies make an economic profit. However, the fact that there is only one firm in the industry is no guarantee that a monopoly will make an economic profit, much less an exorbitant one. If production costs are high relative to demand, profits will be low, and economic losses may even occur. For instance, take the classic online failure, Pets.com. This pet-food delivery company was founded in 1998 and used a sock puppet dog in its advertising. Pets.com faced no competition in the market for home delivery of pet supplies, so it was effectively a monopoly. The company had both high costs—it offered free shipping for heavy products, such as dog food and cat litter, which were expensive to ship—and low demand—consumers tend to buy pet food and litter when they run out and therefore did not want to wait for delivery from Pets.com. Observers suggested that P 6 ATC for each item Pets.com shipped; that is, each bag of dog food and cat litter shipped increased Pets.com’s loss. Pets.com incurred a large economic loss and survived for approximately two years before it declared bankruptcy. What happened to the sock puppet dog remains a mystery.

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238 CHAPTER 6 Monopoly and Monopolistic Competition

Shut-Down Rule for a Monopoly Pets.com ultimately closed. In Chapter 5, you learned the shut-down rule for a firm in a perfectly competitive market: The firm closes if total revenue is less than total variable cost and remains open if total revenue is greater than total variable cost. Equivalently, the firm closes if price is less than average variable cost 1P 6 AVC2 and remains open if price is greater than average variable cost 1P 7 AVC2. When does a monopoly close? It turns out that the same shut-down rule applies. If any firm cannot make enough revenue to cover its variable costs, which means P 6 AVC, the firm minimizes its loss by closing.

Long-Run Profit Maximization for a Monopoly Because there is only one firm in a monopoly market, when the firm is in long-run equilibrium, the market is also in long-run equilibrium. Recall from Chapter 5 that when firms in a perfectly competitive market are making an economic profit, entry occurs, and in the long run, the entry drives the firms’ economic profit to zero. In a monopoly, however, the presence of insurmountable barriers to entry prevents entry by new firms, so the firm can continue to make an economic profit. Even so, the managers may still need to adjust the scale of production to minimize the firm’s long-run average cost and increase its economic profit even more.

Figure 6.6 shows the long-run outcome for your pharmaceutical firm after you have changed the scale of production of your firm’s drug by adjusting the firm’s inputs. The managers are maximizing long-run profit by producing so that marginal revenue equals long-run marginal cost, or MR = LMC. In the figure, the firm maxi- mizes its long-run profit by producing 175,000 treatments and setting a price of $55,000 per treatment. The company is producing its profit-maximizing quantity, 175,000, at the lowest possible average cost, $15,000, and is making the largest possi- ble economic profit, $7 billion. As long as no other firm can enter the market, the economic profit can persist.

D

MR

MC ATC

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Quantity (thousands of treatments per year)

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35030025020015010050

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Economic profit, $3 billion

Figure 6.5 Economic Profit for a Monopoly

Your firm is making an economic profit because its price, $60,000 per treatment, exceeds its average total cost, $40,000 per treatment. The amount of the economic profit equals the area of the green rectangle.

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6.2 Monopoly Profit Maximization 239

Comparing Perfect Competition and Monopoly You have learned that the profit-maximization rule and the shut-down rule apply to both monopoly firms and firms in perfectly competitive markets. How does the equilib- rium in a perfectly competitive market compare to the equilibrium in a monopoly market? Understanding the differences is essential for the formulation of public policy, such as antitrust policy (presented in Chapter 9).

Comparing a Perfectly Competitive Market and a Monopoly Market Although the goal of managers of both monopolies and firms in perfectly competi- tive markets is to maximize profit, their impact on society differs dramatically. As you learned in Section 2.4, perfectly competitive markets maximize society’s total surplus of benefit over cost. Figure 6.7(a) illustrates the maple syrup market first presented in Chapter 5. In a perfectly competitive market for maple syrup, the equi- librium quantity is 12 million gallons, and the price is $30 per gallon. In this perfectly competitive market, the total surplus of benefit over cost to society is equal to the area of the green triangle.6 The area equals the largest possible amount of total sur- plus, which is why economists generally favor perfectly competitive markets.

Suppose that one firm becomes a monopoly by buying all of the others and somehow manages to create a barrier to entry that keeps any other firm from enter- ing the market. Instead of having many separate firms under independent owner- ship and control, there is now a single firm with many separate plants or production

D

MR

LMC LAC

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Quantity (thousands of treatments per year)

$90

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35030025020015010050

$30

$40

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Economic profit, $7 billion

Figure 6.6 Long-Run Profit Maximization

Your firm is maximizing its long-run economic profit because its marginal revenue equals its long- run marginal cost, MR = LMC . You are producing the profit- maximizing quantity, 175,000 treatments, at the lowest average cost for this quantity, $15,000 per treatment. The price is $55,000 per treatment so the economic profit equals the area of the green rectangle, $7 billion.

6 Applied to the maple syrup market, Chapter 2 explained that for any gallon of maple syrup, the maxi- mum price a consumer is willing to pay, measured by the demand curve, is the marginal benefit from that gallon. The supply curve measures the marginal cost of any gallon. So the difference between the demand curve and the supply curve equals society’s surplus of marginal benefit over marginal cost for each gallon of syrup. The total surplus is the sum of the surpluses of all gallons produced, 12 million gallons in Figure 6.7(a).

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240 CHAPTER 6 Monopoly and Monopolistic Competition

facilities. Figure 6.7(b) shows this situation in the monopoly market. The market demand curve (D) is the monopoly firm’s demand curve. Associated with this demand curve is the monopoly’s marginal revenue curve (MR). This marginal reve- nue curve was present when the market was competitive, but because it was irrele- vant, it was omitted from Figure 6.7(a). Now, however, the MR curve matters. Because the monopolist’s managers equate marginal revenue and marginal cost to determine the profit-maximizing output, you also need the marginal cost curve. As you learned in Chapter 5, the competitive supply curve is the sum of the individual competitive firms’ supply curves, and each individual firm’s supply curve is that firm’s marginal cost curve. Once these firms are brought under single ownership as a monopoly, the sum of the individual firms’ marginal cost curves becomes the monopoly’s marginal cost curve, MC in Figure 6.7(b). The monopoly’s managers now use marginal analysis to maximize their profit by producing 8 million gallons and setting a price of $40 per gallon.

You can see that, when compared to a perfectly competitive market, the monopoly sets a higher price—$40 per gallon versus $30—and produces a smaller quantity— 8 million gallons versus 12 million. The higher price means that the firm’s owners are better off at the expense of the consumers. Economists have traditionally had lit- tle to say about such reallocations between groups because both producers and con- sumers are members of society and everyone counts. Rather, economists’ main objection to monopoly stems from the resulting misallocation of resources, which can be seen by considering the total surplus to society. In Figure 6.7(b), all of the 8 million gallons of syrup the monopoly produces have a surplus to society because

Price (dollars per gallon of maple syrup)

Quantity (millions of gallons of maple syrup per year)

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20 2412 164 8

$20

$30

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SEquilibrium price

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20 2412 164 8

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D

MC

MR

Profit-maximizing price

Profit-maximizing quantity

Total surplus Deadweight

loss

Figure 6.7 Comparing the Total Surplus to Society in a Competitive Market and a Monopoly Market

(a) Total Surplus in a Competitive Market (b) Total Surplus in a Monopoly Market The equilibrium quantity is 12 million gallons, and the equilibrium price is $30 per gallon. Society’s total surplus of benefit over cost is equal to the area between the demand and supply curves (the area of the green triangle). This is the maximum possible amount of surplus.

The managers of the monopoly maximize profit by producing the quantity that sets MR equal to MC, 8 million gallons, and setting a price of $40 per gallon. With this price and quantity, society’s total surplus equals the area of the green trapezoid. This surplus is less than that shown in Figure 6.7(a) for a competitive market because of the deadweight loss, which is equal to the area of the red triangle.

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6.2 Monopoly Profit Maximization 241

their marginal benefit exceeds their marginal cost. The total surplus for these 8 million gallons is the sum of all the individual surpluses, which equals the area of the green trapezoid in Figure 6.7(b).

Comparing the green triangle in Figure 6.7(a) to the green trapezoid in Figure 6.7(b), you can see that society’s total surplus is less with the monopoly. The difference in total surplus to society is the deadweight loss. The deadweight loss is society’s loss of total surplus from producing less than or more than the efficient quantity, 12 million gallons. In Figure 6.7(b), where the monopoly produces less than the efficient quantity, the deadweight loss from the monopoly is equal to the area of the red triangle, $40 million per year. The deadweight loss is the funda- mental economic social harm created by monopoly. The damage a monopoly causes is the production of too little output and the decrease in the number of employees and other resources involved in producing the product. Neither the economic profit nor the high monopoly price is the social problem. Instead, these are symp- toms of the real problem, which from the social perspective is the misallocation of resources and the resulting deadweight loss. The deadweight loss from monopoly is the basis for the nation’s antitrust laws, but aside from this rationale, it has no direct relevance to managers.

Comparing a Perfectly Competitive Firm and a Monopoly Firm You know that managers of both perfectly competitive firms and monopoly firms follow the same profit-maximization rule: Produce the quantity that sets marginal revenue equal to marginal cost 1MR = MC2, and charge the highest price possible that still allows the firm to sell the quantity produced. This similarity, however, masks the differ- ences between monopolies and perfectly competitive firms summarized in Table 6.2.

Barriers to entry are significant to a firm and its managers because they enable a monopoly to make a long-run economic profit. Let’s turn to a more detailed exam- ination of this important concept.

Barriers to Entry As you learned in Chapter 5, a barrier to entry is any factor that makes it difficult for new firms to enter a market. Examples include legal barriers (such as patents, trade secrets, copyrights, and trademarks), control of an essential raw material, the exis- tence of overwhelming economies of scale, government control of entry, sunk costs, and—possibly—advertising.

Deadweight loss The loss in total surplus from producing less than or more than the efficient quantity.

Table 6.2 Comparing a Perfectly Competitive Firm to a Monopoly

Perfectly Competitive Firm Monopoly

Amount of markup? Zero; the price equals marginal cost

Positive; the amount of the markup of the price over marginal cost depends on the price elasticity of demand

Can make a short-run economic profit? Yes Yes

Can make a long-run economic profit? No

Yes; some type of barrier to entry protects the economic profit from entry by new firms

Always produces at the minimum average total cost in the long run? Yes

No; the firm might produce at the minimum average total cost but does not necessarily do so

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242 CHAPTER 6 Monopoly and Monopolistic Competition

Patents, Trade Secrets, Copyrights, and Trademarks Chapter 15 presents a more complete discussion of patents, trade secrets, copyrights, and trademarks. This chapter focuses on how they serve as legal barriers to entry, how they provide their owners some legal protection from infringement, and the different types of products they protect.

• Patents. Patents protect products or specific production processes by giving the owner the exclusive right to produce a certain commodity or to use a spe- cific production process for a 20-year period that begins at the time the pat- ent application is filed. Granting a patent ensures that no competitor can legally copy the inventor’s creation during the life of the patent. Although it affords legal protection against blatant copying, a patent does not provide absolute protection. The market power from a patent is limited because pat- ents are often narrowly defined, which may allow other firms to approximate closely the process or product without infringing. For example, Merck pat- ented the first statin (a cholesterol-lowering drug), Mevacor, and began mar- keting it in the United States in 1987. Ultimately, however, other companies began selling six other, closely related statins. After Mevacor enjoyed a U.S. market share of 100 percent for the first three years, other companies started selling their statins, and its market share fell to less than 15 percent within seven years.

• Trade secrets. The fact that patents are often narrowly defined may leave man- agers concerned that a patent on a product or production process will not pre- vent competitors from selling or using a closely related product. For this reason, some managers opt to keep their production process a trade secret. KFC’s “secret recipe of eleven herbs and spices” is a trade secret. Less tasty examples include Google’s search algorithms and the ingredients of the WD-40 Company’s name- sake product, WD-40.

• Copyrights. Copyright law gives legal protection to works of authorship, such as movies, songs, and books. This book is copyrighted, as is the film Avatar, which to date has grossed $2.7 billion. The length of copyright protec- tion varies. For works produced after January 1, 1978, the copyright protec- tion lasts for the life of the creator plus an additional 70 years, but the copyright for a work-for-hire (such as a pamphlet) is typically 95 years from the first publication.

• Trademarks. Trademarks protect brand names, symbols, or designs that iden- tify the source of the product. For example, The Walt Disney Company has trademarked Mickey Mouse, and Nike, Inc., has trademarked its “Swoosh” logo. No one else can use Mickey Mouse or the “Swoosh” design without per- mission from Disney or Nike, respectively. In the United States, trademark owners are protected for 10 years, but they can renew their trademarks indefinitely.

The economic value of patent, trade secret, copyright, or trademark protection depends on the value of the protected item in the marketplace. For example, a patent on a solar-powered mousetrap would not be worth much because few people want to buy them. Similarly, copyright protection on a film about famous economists that no one wants to see is worthless. In contrast, a patent on a cure for cancer would be worth a fortune. Patents, trade secrets, copyrights, and trademarks offer legal pro- tection to a monopoly and protect its economic profit by preventing the entry of copycat producers into the market.

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6.2 Monopoly Profit Maximization 243

Control of an Essential Raw Material It should be obvious that if one firm controls the supply of an essential input, other firms will be unable to compete. The classic example of this situation is the alleged control of bauxite reserves in the 1930s and 1940s by the Aluminum Company of America (Alcoa). Through purchases and long-term contracts, Alcoa was purported to have preempted control of the available supplies of bauxite ore, the ore used to produce aluminum. Through that control, Alcoa allegedly prevented the entry of other firms into the U.S. aluminum market. More recently, in 1987, De Beers had approximately a 90 percent share of the gem diamond market because it controlled virtually all of the world’s raw gem diamonds.

In some cases, it may be possible to restrict the availability of the raw material. For example, New York’s ban on hydraulic fracturing (fracking) has limited the sup- ply of natural gas from the Marcellus Shale. Although this ban does not create a monopoly producer of natural gas, it does protect natural gas firms from entry by competitors located in New York.

Ultimately, it is difficult for managers to preserve their grasp on an essential raw material. For example, Alcoa lost its alleged death grip on bauxite after the U.S. gov- ernment financed a vast expansion of U.S. aluminum capacity during World War II and then sold its interests to competing firms after the war. De Beers also failed to protect its positions and fell prey to competition from new sources of raw diamonds that were not under the firm’s control: Today, De Beers’ market share is under 40 percent.

Economies of Scale Sometimes new firms do not enter the industry because they would be at a sub- stantial cost disadvantage to the larger established firm. Natural monopolies, such as water, sewage, electricity, and natural gas utilities, are extreme examples. Natural monopolies have massive economies of scale, so that as their produc- tion increases, their long-run average cost constantly falls throughout the range of demand. Recall from Chapter 4 that economies of scale refers to the region of the long-run average cost curve where the long-run average cost falls as produc- tion increases; it is the downward-sloping segment of the curve. A natural monopoly’s economies of scale are so extensive that the firm’s minimum efficient scale—the quantity at which the long-run average cost first reaches its mini- mum—exceeds the quantity customers demand. Figure 6.8 illustrates this situa- tion. Suppose that a firm like Georgia Power, an electric utility operating out of Atlanta, reaches its minimum efficient scale of 60 billion kilowatt hours per year at a cost of 6¢, while at the price of 6¢, customers demand only 47 billion kilowatt hours per year.

The interaction between the demand for the product and the technological conditions that require large scale for efficient, low-cost production limits the number of firms in the market. For example, Figure 6.8 shows that this electric utility company’s managers maximize profit by producing 20 billion kilowatt hours per year—the quantity that sets the marginal revenue (MR) equal to the long-run marginal cost (LMC)—and setting a price of 14¢ per kilowatt hour—the highest price consumers will pay for 20 billion kilowatt hours per year. The firm’s average cost of producing 20 billion kilowatts is 10¢ per kilowatt hour. If another firm enters the market, it will be unable to immediately attain the economies of scale that this firm enjoys. Suppose that the new firm has the same long-run aver- age cost as this one but produces only one-half of the output, or 10 billion kilowatt hours. Even though the new firm’s scale of production is remarkably large, the

Natural monopoly A firm with economies of scale so large that as its production increases, its long-run average cost constantly falls throughout the range of demand.

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244 CHAPTER 6 Monopoly and Monopolistic Competition

new entrant still has higher costs. The new firm’s lowest possible average cost of producing 10 billion kilowatt hours is 15¢ per kilowatt hour, much higher than the existing firm’s average cost of 10¢ per kilowatt hour. Indeed, the 15¢-per-kilowatt- hour cost is above the existing firm’s monopoly price of 14¢ per kilowatt hour. If the new firm tried to match this price, it would incur a significant economic loss. The prospect of such an economic loss will deter many—likely all—other firms from entering the market. The profound economies of scale operate as a barrier to entry and create a natural monopoly.

As Figure 6.8 shows, because the minimum efficient scale is larger than the quantity demanded, the long-run average cost curve (LAC) continues to decrease even after it crosses the demand curve (D). This result poses a problem for society because it means that one firm can produce the quantity demanded in the market at a lower total cost than could two or more firms. For example, with one firm in the market, the electric utility can produce 20 billion kilowatt hours at an average cost of 10¢ per kilowatt hour, for a total cost of 10¢ * 20 billion or $2.0 billion. If two equal-sized firms produced the 20 billion kilowatt hours, each would produce 10 billion kilowatt hours at an average cost of 15¢ per kilowatt hour. Each firm’s total cost would be 15¢ * 10 billion = $1.5 billion. The total cost of producing 20 billion kilowatt hours in a market with two firms is $3.0 billion 1$1.5 billion + $1.5 billion2, higher than the total cost of the single firm. Why is the total cost lower with only one firm? With only one firm distributing electricity in a city, only one set of poles and wires must be erected, but if two (or more) companies distribute power, two (or more) sets of poles and wires are necessary which drastically increases the total cost of distributing power.

The lower total cost with one firm makes it socially desirable to have a single firm supply the entire market. As a monopoly, however, the firm produces less than a competitive market would, thereby creating a deadweight loss. Because of this

D MR

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