principles_of_economics_gregory_mankiw

probably be arrested for price-fixing if they ever held an official meeting in America.

Most cable TV companies have government-issued licenses that keep competitors out. Thus, this business supports the hypothesis (offered, I think, by George Stigler) that private monopolies are not sustainable for long unless they have the weight of government behind them.

The rapid escalation of prices and the limitations on services seem, however, to be getting customers and their congressional representatives progressively more annoyed. Thus, it would not be surprising if legislative action leads soon to a deterioration of the cable companies’ monopoly power. . . . This fear about the future diminishes the claim of this otherwise worthy contestant for the first annual prize.

Officials of Ivy League universities have been able to meet in semi-public forums to set rules that determine prices of admission (tuition less financial aid) as a function of applicant characteristics, especially financial resources. In some cases, the schools pooled information to agree in advance on the right price to charge a specific customer. Airlines and other industries that wish to price discriminate can only dream about this kind of setup.

Moreover, the universities have more or less successfully applied a high moral tone to the process: Rich appli- cants—especially smart rich applicants— are charged more than the competitive price for schooling in order to subsidize the smart poor, but it is unclear why this

subsidy should come from the smart rich rather than from taxpayers in general.

In any event, the universities’ enviable cartel position has been damaged by the unenlightened Justice Department, which argued that the price-setting meetings were a violation of antitrust laws. Since most of the universities involved have agreed to stop these practices, it may be that future prices for private higher education will come closer to being competitively determined. . . .

The final contestant, the NCAA, has been remarkably successful in holding down “salaries” paid to college athletes. It would be one thing merely to collude to determine price ceilings (for example, to restrict payments so that they not exceed tuition plus room and board and some minor additional amount), but the NCAA has also managed to monopolize all the moral arguments.

Consider a poor ghetto resident who can play basketball well, but not well enough to make it to the NBA. If there were no NCAA, this player might be able legitimately to accumulate a significant amount of cash during a four-year career. But the NCAA ensures that the player will remain poor after four years and, moreover, has convinced most observers that it would be morally wrong for the college to pay the player a competitively determined wage for his or her services.

For many economists, this interference with competition—in a setting that has no obvious reasons for market fail- ure—is itself morally repugnant. But the outrage is compounded here because the transfer is clearly from poor ghetto

residents to rich colleges. Compare the situation of contestant number 4, the Ivy League universities, in which the transfer from rich to poor students can readily be supported on Robin Hood grounds.

The NCAA has the much more difficult task of defending a policy that prevents many poor individuals from earning money. Incredibly, this defense has been so successful that it has even allowed the organization to maintain the moral high ground. When the NCAA maintains its cartel by punishing schools that violate the rules (by paying too much), almost no one doubts that the evil entities are the schools or people who paid the athletes, rather than the cartel enforcers who prevented the athletes from getting paid. Given this extraordinary balancing act, the decision of the panelists was straightforward and the NCAA is the clear and deserving winner of the first annual prize for best monopoly in America.

The panel of economists also considered briefly an award for the least efficient monopoly in America. This choice was, however, too easy. It goes to the American Economic Association, which has been a dismal failure at establishing licensing requirements or other restrictions on entry into the economics profession. It is a sad state of affairs when almost anyone can assume the title of economist.

SOURCE: The Wall Street Journal, August 27, 1991, p. A12.

A monopoly is a firm that is the sole seller in its market. A monopoly arises when a single firm owns a key resource, when the government gives a firm the exclusive right to produce a good, or when a single firm can supply the entire market at a smaller cost than many firms could.

Because a monopoly is the sole producer in its market, it faces a downward-sloping demand curve for its product. When a monopoly increases production by 1 unit, it causes the price of its good to fall, which reduces the amount of revenue earned on all units produced. As a result, a monopoly’s marginal revenue is always below the price of its good.

Like a competitive firm, a monopoly firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost. The monopoly then chooses the price at which that quantity is demanded. Unlike a competitive firm, a monopoly firm’s price exceeds its marginal revenue, so its price exceeds marginal cost.

A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus. That is, when the monopoly charges a price above marginal cost, some consumers who value the good more than its cost of production do not buy it. As a result, monopoly causes deadweight losses similar to the deadweight losses caused by taxes.

Policymakers can respond to the inefficiency of monopoly behavior in four ways. They can use the antitrust laws to try to make the industry more competitive. They can regulate the prices that the monopoly charges. They can turn the monopolist into a government-run enterprise. Or, if the market failure is deemed small compared to the inevitable imperfections of policies, they can do nothing at all.

Monopolists often can raise their profits by charging different prices for the same good based on a buyer’s willingness to pay. This practice of price discrimination can raise economic welfare by getting the good to some

consumers who otherwise would not buy it. In the extreme case of perfect price discrimination, the deadweight losses of monopoly are completely

eliminated. More generally, when price discrimination is imperfect, it can either raise or lower welfare compared to the outcome with a single monopoly price.

1.Give an example of a government creating this monopoly necessarily Explain.

2.Define natural monopoly. What market have to do with whether monopoly?

3.Why is a monopolist’s marginal price of its good? Can marginal negative? Explain.

4.Draw the demand, marginalcurves for a monopolist. Show level of output. Show the profit-

5.In your diagram from the previous level of output that maximizes

the monopoly. Explain your

government the power to regulate firms? From the standpoint of the give a good reason and a bad reason

want to merge.

problems that arise when regulators that it must set a price equal to

of price discrimination. In each case, monopolist chooses to follow this

e.If the author were paid $3 million instead of $2 million to write the book, how would this affect the publisher’s decision regarding the price to charge? Explain.

f.Suppose the publisher were not profit-maximizing but were concerned with maximizing economic efficiency. What price would it charge for the book? How much profit would it make at this price?

2.Suppose that a natural monopolist were required by law to charge average total cost. On a diagram, label the price charged and the deadweight loss to society relative to marginal-cost pricing.

3.Consider the delivery of mail. In general, what is the shape of the average-total-cost curve? How might the shape differ between isolated rural areas and densely populated urban areas? How might the shape have changed over time? Explain.

4.Suppose the Clean Springs Water Company has a monopoly on bottled water sales in California. If the price of tap water increases, what is the change in Clean Springs’ profit-maximizing levels of output, price, and profit? Explain in words and with a graph.

5.A small town is served by many competing supermarkets, which have constant marginal cost.

a.Using a diagram of the market for groceries, show the consumer surplus, producer surplus, and total surplus.

b.Now suppose that the independent supermarkets combine into one chain. Using a new diagram, show the new consumer surplus, producer surplus, and total surplus. Relative to the competitive market, what is the transfer from consumers to producers? What is the deadweight loss?

6.Johnny Rockabilly has just finished recording his latest CD. His record company’s marketing department determines that the demand for the CD is as follows:

The company can produce the CD with no fixed cost and a variable cost of $5 per CD.

a.Find total revenue for quantity equal to 10,000, 20,000, and so on. What is the marginal revenue for each 10,000 increase in the quantity sold?

b.What quantity of CDs would maximize profit? What would the price be? What would the profit be?

c.If you were Johnny’s agent, what recording fee would you advise Johnny to demand from the record company? Why?

7.In 1969 the government charged IBM with monopolizing the computer market. The government argued (correctly) that a large share of all mainframe computers sold in the United States were produced by IBM. IBM argued (correctly) that a much smaller share of the market for all types of computers consisted of IBM products. Based on these facts, do you think that the government should have brought suit against IBM for violating the antitrust laws? Explain.

8.A company is considering building a bridge across a river. The bridge would cost $2 million to build and nothing to maintain. The following table shows the company’s anticipated demand over the lifetime of the bridge:

a.If the company were to build the bridge, what would be its profit-maximizing price? Would that be the efficient level of output? Why or why not?

b.If the company is interested in maximizing profit, should it build the bridge? What would be its profit or loss?

c.If the government were to build the bridge, what price should it charge?

d.Should the government build the bridge? Explain.

9.The Placebo Drug Company holds a patent on one of its discoveries.

a.Assuming that the production of the drug involves rising marginal cost, draw a diagram to illustrate Placebo’s profit-maximizing price and quantity. Also show Placebo’s profits.

b.Now suppose that the government imposes a tax on each bottle of the drug produced. On a new diagram, illustrate Placebo’s new price and quantity. How does each compare to your answer in part (a)?

c.Although it is not easy to see in your diagrams, the tax reduces Placebo’s profit. Explain why this must be true.

d.Instead of the tax per bottle, suppose that the government imposes a tax on Placebo of $10,000 regardless of how many bottles are produced. How does this tax affect Placebo’s price, quantity, and profits? Explain.

10.Larry, Curly, and Moe run the only saloon in town. Larry wants to sell as many drinks as possible without losing money. Curly wants the saloon to bring in as much revenue as possible. Moe wants to make the largest possible profits. Using a single diagram of the saloon’s demand curve and its cost curves, show the price and quantity combinations favored by each of the three partners. Explain.

11.For many years AT&T was a regulated monopoly, providing both local and long-distance telephone service.

a.Explain why long-distance phone service was originally a natural monopoly.

b.Over the past two decades, many companies have launched communication satellites, each of which can transmit a limited number of calls. How did the growing role of satellites change the cost structure of long-distance phone service?

After a lengthy legal battle with the government, AT&T agreed to compete with other companies in the longdistance market. It also agreed to spin off its local phone service into the “Baby Bells,” which remain highly regulated.

c.Why might it be efficient to have competition in long-distance phone service and regulated monopolies in local phone service?

12.The Best Computer Company just developed a new computer chip, on which it immediately acquires a patent.

a.Draw a diagram that shows the consumer surplus, producer surplus, and total surplus in the market for this new chip.

b.What happens to these three measures of surplus if the firm can perfectly price discriminate? What is the change in deadweight loss? What transfers occur?

13.Explain why a monopolist will always produce a quantity at which the demand curve is elastic. (Hint: If demand is inelastic and the firm raises its price, what happens to total revenue and total costs?)

14.The “Big Three” American car companies are GM, Ford, and Chrysler. If these were the only car companies in the world, they would have much more monopoly power. What action could the U.S. government take to create monopoly power for these companies? (Hint: The government took such an action in the 1980s.)

15.Singer Whitney Houston has a monopoly over a scarce resource: herself. She is the only person who can produce a Whitney Houston concert. Does this fact imply that the government should regulate the prices of her concerts? Why or why not?

16.Many schemes for price discriminating involve some cost. For example, discount coupons take up time and resources from both the buyer and the seller. This question considers the implications of costly price discrimination. To keep things simple, let’s assume that our monopolist’s production costs are simply proportional to output, so that average total cost and marginal cost are constant and equal to each other.

a.Draw the cost, demand, and marginal-revenue curves for the monopolist. Show the price the monopolist would charge without price discrimination.

b.In your diagram, mark the area equal to the monopolist’s profit and call it X. Mark the area equal to consumer surplus and call it Y. Mark the area equal to the deadweight loss and call it Z.

c.Now suppose that the monopolist can perfectly price discriminate. What is the monopolist’s profit? (Give your answer in terms of X, Y, and Z.)

d.What is the change in the monopolist’s profit from price discrimination? What is the change in total surplus from price discrimination? Which change is larger? Explain. (Give your answer in terms of X, Y, and Z.)

e.Now suppose that there is some cost of price discrimination. To model this cost, let’s assume that the monopolist has to pay a fixed cost C in order to price discriminate. How would a monopolist make the decision whether to pay this fixed cost? (Give your answer in terms of X, Y, Z, and C.)

f.How would a benevolent social planner, who cares about total surplus, decide whether the monopolist should price discriminate? (Give your answer in terms of X, Y, Z, and C.)

g.Compare your answers to parts (e) and (f). How does the monopolist’s incentive to price

discriminate differ from the social planner’s? Is it possible that the monopolist will price discriminate even though it is not socially desirable?

O L I G O P O L Y

If you go to a store to buy tennis balls, it is likely that you will come home with one of four brands: Wilson, Penn, Dunlop, or Spalding. These four companies make almost all of the tennis balls sold in the United States. Together these firms determine the quantity of tennis balls produced and, given the market demand curve, the price at which tennis balls are sold.

How can we describe the market for tennis balls? The previous two chapters discussed two types of market structure. In a competitive market, each firm is so small compared to the market that it cannot influence the price of its product and, therefore, takes the price as given by market conditions. In a monopolized market, a single firm supplies the entire market for a good, and that firm can choose any price and quantity on the market demand curve.

The market for tennis balls fits neither the competitive nor the monopoly model. Competition and monopoly are extreme forms of market structure. Competition occurs when there are many firms in a market offering essentially identical products; monopoly occurs when there is only one firm in a market. It is

IN THIS CHAPTER YOU WILL . . .

See what market str uctur es lie between monopoly and competition

Examine what outcomes ar e possible when a market is an oligopoly

Learn about the prisoners’ dilemma and how it applies to oligopoly and other issues

Consider how the antitr ust laws tr y to foster competition in oligopolistic markets

oligopoly

a market structure in which only a few sellers offer similar or identical products

monopolistic competition a market structure in which many firms sell products that are similar but not identical

natural to start the study of industrial organization with these polar cases, for they are the easiest cases to understand. Yet many industries, including the tennis ball industry, fall somewhere between these two extremes. Firms in these industries have competitors but, at the same time, do not face so much competition that they are price takers. Economists call this situation imperfect competition.

In this chapter we discuss the types of imperfect competition and examine a particular type called oligopoly. The essence of an oligopolistic market is that there are only a few sellers. As a result, the actions of any one seller in the market can have a large impact on the profits of all the other sellers. That is, oligopolistic firms are interdependent in a way that competitive firms are not. Our goal in this chapter is to see how this interdependence shapes the firms’ behavior and what problems it raises for public policy.

BETWEEN MONOPOLY AND PERFECT COMPETITION

The previous two chapters analyzed markets with many competitive firms and markets with a single monopoly firm. In Chapter 14, we saw that the price in a perfectly competitive market always equals the marginal cost of production. We also saw that, in the long run, entry and exit drive economic profit to zero, so the price also equals average total cost. In Chapter 15, we saw how firms with market power can use that power to keep prices above marginal cost, leading to a positive economic profit for the firm and a deadweight loss for society.

The cases of perfect competition and monopoly illustrate some important ideas about how markets work. Most markets in the economy, however, include elements of both these cases and, therefore, are not completely described by either of them. The typical firm in the economy faces competition, but the competition is not so rigorous as to make the firm exactly described by the price-taking firm analyzed in Chapter 14. The typical firm also has some degree of market power, but its market power is not so great that the firm can be exactly described by the monopoly firm analyzed in Chapter 15. In other words, the typical firm in our economy is imperfectly competitive.

There are two types of imperfectly competitive markets. An oligopoly is a market with only a few sellers, each offering a product similar or identical to the others. One example is the market for tennis balls. Another is the world market for crude oil: A few countries in the Middle East control much of the world’s oil reserves. Monopolistic competition describes a market structure in which there are many firms selling products that are similar but not identical. Examples include the markets for novels, movies, CDs, and computer games. In a monopolistically competitive market, each firm has a monopoly over the product it makes, but many other firms make similar products that compete for the same customers.

Figure 16-1 summarizes the four types of market structure. The first question to ask about any market is how many firms there are. If there is only one firm, the market is a monopoly. If there are only a few firms, the market is an oligopoly. If there are many firms, we need to ask another question: Do the firms sell identical or differentiated products? If the many firms sell differentiated products, the market is monopolistically competitive. If the many firms sell identical products, the market is perfectly competitive.