Microeconomics (Monopoly, Ch 10)

Microeconomics (Monopoly, Ch 10)

Lecture 14

Feb 23, 2017

Microeconomics (Monopoly, Ch 10)
} Describe the goals and difficulties involved in regulating monopolists.

O n May 18, 1998, the U.S. Department of Justice, with the attorneys general
of 20 states and the District of Columbia, filed an antitrust suit against the
Microsoft Corporation, claiming it was a monopolist in the market for PC oper-
ating systems. For the next two and a half years, the case was front-page news in coun-
tries around the world. Was Microsoft really a monopolist? Had it used illegal tactics to
strengthen and extend its market position? Lawyers on
both sides of the case turned to economists to answer
these questions.
Why would government officials be concerned
about the existence of a monopoly? In this chapter we’ll
address this and other questions about monopoly mar-
kets. How, for example, does the market outcome under
monopoly differ from the market outcome under perfect
competition? How can the government tell if a group
of firms is colluding and acting just like a monopolist
U.S. Attorney General Janet Reno announcing the filing of an antitrust suit against instead of competing vigorously? What can govern-
Microsoft Corporation for monopolization ment do to improve on the outcomes of monopoly?
622
Microeconomics (Monopoly, Ch 10)
Microeconomics (Monopoly, Ch 10)
Microeconomics (Monopoly, Ch 10)

CHAPTER 10 OUTLINE

10.1 Monopoly
10.2 Monopoly Power
10.3 Sources of Monopoly Power
10.4 The Social Costs of Monopoly Power
10.5 Monopsony
10.6 Monopsony Power
10.7 Limiting Market Power: The Antitrust Laws
Microeconomics (Monopoly, Ch 10)

Market Power: Monopoly and Monopsony

● monopoly Market with only one seller.

● monopsony Market with only one buyer.

● market power Ability of a seller or buyer

to affect the price of a good.
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

Average Revenue and Marginal Revenue

● marginal revenue Change in revenue
resulting from a one-unit increase in output.

To see the relationship among total, average, and marginal revenue,

consider a firm facing the following demand curve:
P=6–Q
TABLE 10.1 Total, Marginal, and Average Revenue
Total Marginal Average
Price (P) Quantity (Q) Revenue (R) Revenue (MR) Revenue (AR)
$6 0 $0 --- ---
5 1 5 $5 $5
4 2 8 3 4
3 3 9 1 3
2 4 8 -1 2
1 5 5 -3 1
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

Average Revenue and Marginal Revenue

Figure 10.1
Average and Marginal
Revenue
Average and marginal
revenue are shown for
the demand curve
P = 6 − Q.
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

The Monopolist’s Output Decision

We can also see algebraically that Q* maximizes profit. Profit π is the

difference between revenue and cost, both of which depend on Q:

As Q is increased from zero, profit will increase until it reaches a

maximum and then begin to decrease. Thus the profit-maximizing
Q is such that the incremental profit resulting from a small increase
in Q is just zero (i.e., Δπ /ΔQ = 0). Then

But ΔR/ΔQ is marginal revenue and ΔC/ΔQ is marginal cost. Thus

the profit-maximizing condition is that

, or
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

An Example
Figure 10.3

Example of Profit Maximization

Part (a) shows total revenue R, total cost C,

and profit, the difference between the two.
Part (b) shows average and marginal
revenue and average and marginal cost.
Marginal revenue is the slope of the total
revenue curve, and marginal cost is the
slope of the total cost curve.
The profit-maximizing output is Q* = 10, the
point where marginal revenue equals
marginal cost.
At this output level, the slope of the profit
curve is zero, and the slopes of the total
revenue and total cost curves are equal.
The profit per unit is $15, the difference
between average revenue and average
cost. Because 10 units are produced, total
profit is $150.
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

A Rule of Thumb for Pricing

(Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity of demand,
1/Ed, measured at the profit-maximizing output, and

Now, because the firm’s objective is to maximize profit, we

can set marginal revenue equal to marginal cost:

which can be rearranged to give us

(10.1)

Equivalently, we can rearrange this equation to express

price directly as a markup over marginal cost:

(10.2)
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

In 1995, Prilosec, represented a new

generation of antiulcer medication. Prilosec
was based on a very different biochemical
mechanism and was much more effective
than earlier drugs.

By 1996, it had become the best-selling drug in the world and

faced no major competitor.
Astra-Merck was pricing Prilosec at about $3.50 per daily dose.
The marginal cost of producing and packaging Prilosec is only
about 30 to 40 cents per daily dose.
The price elasticity of demand, ED, should be in the range of
roughly −1.0 to −1.2.
Setting the price at a markup exceeding 400 percent over
marginal cost is consistent with our rule of thumb for pricing.
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

The Effect of a Tax

Suppose a specific tax of t dollars per unit is levied, so that the
monopolist must remit t dollars to the government for every unit it
sells. If MC was the firm’s original marginal cost, its optimal production
decision is now given by

Figure 10.5

Effect of Excise Tax on Monopolist

With a tax t per unit, the firm’s

effective marginal cost is
increased by the amount t to
MC + t.
In this example, the increase in
price ΔP is larger than the tax t.
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

*The Multiplant Firm

Suppose a firm has two plants. What should its total output be, and
how much of that output should each plant produce? We can find the
answer intuitively in two steps.

● Step 1. Whatever the total output, it should be divided between

the two plants so that marginal cost is the same in each plant.
Otherwise, the firm could reduce its costs and increase its profit
by reallocating production.

● Step 2. We know that total output must be such that marginal

revenue equals marginal cost. Otherwise, the firm could increase
its profit by raising or lowering total output.
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

*The Multiplant Firm

We can also derive this result algebraically. Let Q1 and C1 be the
output and cost of production for Plant 1, Q2 and C2 be the output and
cost of production for Plant 2, and QT = Q1 + Q2 be total output. Then
profit is

The firm should increase output from each plant until the incremental
profit from the last unit produced is zero. Start by setting incremental
profit from output at Plant 1 to zero:

Here Δ(PQT)/ΔQ1 is the revenue from producing and selling one more
unit—i.e., marginal revenue, MR, for all of the firm’s output.
Microeconomics (Monopoly, Ch 10)

10.1 MONOPOLY

*The Multiplant Firm

The next term, ΔC1/ΔQ1, is marginal cost at Plant 1, MC1. We thus

have MR − MC1 = 0, or

Similarly, we can set incremental profit from output at Plant 2 to zero,

Putting these relations together, we see that the firm should produce so
that

(10.3)
Microeconomics (Monopoly, Ch 10)

10.2 MONOPOLY POWER

Figure 10.7

The Demand for Toothbrushes

Part (a) shows the market

demand for toothbrushes.
Part (b) shows the demand
for toothbrushes as seen by
Firm A.
At a market price of $1.50,
elasticity of market demand
is −1.5.
Firm A, however, sees a
much more elastic demand
curve DA because of
competition from other firms.
At a price of $1.50, Firm A’s
demand elasticity is −6.
Still, Firm A has some
monopoly power: Its profit-
maximizing price is $1.50,
which exceeds marginal
cost.
Microeconomics (Monopoly, Ch 10)

10.2 MONOPOLY POWER

Measuring Monopoly Power

Remember the important distinction between a perfectly competitive

firm and a firm with monopoly power: For the competitive firm, price
equals marginal cost; for the firm with monopoly power, price exceeds
marginal cost.
● Lerner Index of Monopoly Power
Measure of monopoly power calculated as
excess of price over marginal cost as a
fraction of price.

Mathematically:

This index of monopoly power can also be expressed in terms of the elasticity
of demand facing the firm.

(10.4)
Microeconomics (Monopoly, Ch 10)

10.2 MONOPOLY POWER

The Rule of Thumb for Pricing

Figure 10.8

Elasticity of Demand and Price Markup

The markup (P − MC)/P is equal to minus the inverse of the elasticity of demand facing the firm.
If the firm’s demand is elastic, as in (a), the markup is small and the firm has little monopoly power.
The opposite is true if demand is relatively inelastic, as in (b).
Microeconomics (Monopoly, Ch 10)

10.2 MONOPOLY POWER

Although the elasticity of market demand for food

is small (about −1), no single supermarket can
raise its prices very much without losing
customers to other stores.
The elasticity of demand for any one supermarket
is often as large as −10.
We find P = MC/(1 − 0.1) = MC/(0.9) = (1.11)MC.
The manager of a typical supermarket should set prices about 11 percent
above marginal cost.
Small convenience stores typically charge higher prices because its customers
are generally less price sensitive.
Because the elasticity of demand for a convenience store is about −5, the
markup equation implies that its prices should be about 25 percent above
marginal cost.
With designer jeans, demand elasticities in the range of −2 to −3 are typical.
This means that price should be 50 to 100 percent higher than marginal cost.
Microeconomics (Monopoly, Ch 10)

10.3 SOURCES OF MONOPOLY POWER

The Elasticity of Market Demand

If there is only one firm—a pure monopolist—its demand curve is the

market demand curve.
Because the demand for oil is fairly inelastic (at least in the short run),
OPEC could raise oil prices far above marginal production cost during
the 1970s and early 1980s.
Because the demands for such commodities as coffee, cocoa, tin, and
copper are much more elastic, attempts by producers to cartelize
these markets and raise prices have largely failed.
In each case, the elasticity of market demand limits the potential
monopoly power of individual producers.
Microeconomics (Monopoly, Ch 10)

10.4 THE SOCIAL COSTS OF MONOPOLY POWER

Figure 10.10

Deadweight Loss from Monopoly Power

The shaded rectangle and triangles

show changes in consumer and
producer surplus when moving from
competitive price and quantity, Pc
and Qc,
to a monopolist’s price and quantity,
Pm and Qm.
Because of the higher price,
consumers lose A + B
and producer gains A − C. The
deadweight loss is B + C.
Microeconomics (Monopoly, Ch 10)

10.4 THE SOCIAL COSTS OF MONOPOLY POWER

Price Regulation
Figure 10.11

Price Regulation

If left alone, a monopolist

produces Qm and charges Pm.
When the government
imposes a price ceiling of P1
the firm’s average and
marginal revenue are constant
and equal to P1 for output
levels up to Q1.
For larger output levels, the
original average and marginal
revenue curves apply.
The new marginal revenue
curve is, therefore, the dark
purple line, which intersects
the marginal cost curve at Q1.
Microeconomics (Monopoly, Ch 10)

10.4 THE SOCIAL COSTS OF MONOPOLY POWER

Price Regulation
Figure 10.11

Price Regulation

When price is lowered to

Pc, at the point where
marginal cost intersects
average revenue, output
increases to its maximum
Qc. This is the output that
would be produced by a
competitive industry.
Lowering price further, to
P3 reduces output to Q3
and causes a shortage,
Q’3 − Q3.
Microeconomics (Monopoly, Ch 10)

10.7 LIMITING MARKET POWER: THE ANTITRUST LAWS

● antitrust laws Rules and regulations
prohibiting actions that restrain, or are
likely to restrain, competition.

There have been numerous instances of illegal combinations. For example:

● In 1996, Archer Daniels Midland Company (ADM) and two other major
producers of lysine (an animal feed additive) pleaded guilty to criminal
charges of price fixing.
● In 1999, four of the world’s largest drug and chemical companies—
Roche A.G. of Switzerland, BASF A.G. of Germany, Rhone-Poulenc of
France, and Takeda Chemical Industries of Japan—were charged by the
U.S. Department of Justice with taking part in a global conspiracy to fix
the prices of vitamins sold in the United States.
● In 2002, the U.S. Department of Justice began an investigation of price
fixing by DRAM (dynamic access random memory) producers. By 2006,
five manufacturers—Hynix, Infineon, Micron Technology, Samsung, and
Elpida—had pled guilty for participating in an international price-fixing
scheme.
Microeconomics (Monopoly, Ch 10)

10.7 LIMITING MARKET POWER: THE ANTITRUST LAWS

Antitrust in Europe

The responsibility for the enforcement of antitrust concerns that

involve two or more member states resides in a single entity, the
Competition Directorate.
Separate and distinct antitrust authorities within individual member
states are responsible for those issues whose effects are felt within
particular countries.
The antitrust laws of the European Union are quite similar to those of
the United States. Nevertheless, there remain a number of differences
between antitrust laws in Europe and the United States.
Merger evaluations typically are conducted more quickly in Europe.
It is easier in practice to prove that a European firm is dominant than it
is to show that a U.S. firm has monopoly power.
Microeconomics (Monopoly, Ch 10)

10.7 LIMITING MARKET POWER: THE ANTITRUST LAWS

Robert Crandall, president and CEO of American, made a phone call to

Howard Putnam, president and chief executive of Braniff. It went like
this:
Crandall: I think it’s dumb as hell for Christ’s sake, all right, to sit here
and pound the @!#$%&! out of each other and neither one of us making
a @!#$%&! dime.
Putnam: Well . . .
Crandall: I mean, you know, @!#$%&!, what the hell is the point of it?
Putnam: But if you’re going to overlay every route of American’s on top
of every route that Braniff has—I just can’t sit here and allow you to bury
us without giving our best effort.
Crandall: Oh sure, but Eastern and Delta do the same thing in Atlanta
and have for years.
Putnam: Do you have a suggestion for me?
Microeconomics (Monopoly, Ch 10)

10.7 LIMITING MARKET POWER: THE ANTITRUST LAWS

Crandall: Yes, I have a suggestion for you. Raise your @!#$%&! fares
20 percent. I’ll raise mine the next morning.
Putnam: Robert, we. . .
Crandall: You’ll make more money and I will, too.
Putnam: We can’t talk about pricing!
Crandall: Oh @!#$%&!, Howard. We can talk about any @!#$%&! thing
we want to talk about.
Crandall was wrong. Talking about prices and agreeing to fix them is a
clear violation of Section 1 of the Sherman Act.
However, proposing to fix prices is not enough to violate Section 1 of the
Sherman Act: For the law to be violated, the two parties must agree to
collude.
Therefore, because Putnam had rejected Crandall’s proposal, Section 1
was not violated.
Microeconomics (Monopoly, Ch 10)

10.7 LIMITING MARKET POWER: THE ANTITRUST LAWS

Did Microsoft engage in illegal practices?

The U.S. Government said yes; Microsoft disagreed.
Here is a brief road map of some of the U.S.
Department of Justice’s major claims and Microsoft’s
responses.
DOJ claim: Microsoft has a great deal of market power in the market for PC
operating systems—enough to meet the legal definition of monopoly power.
MS response: Microsoft does not meet the legal test for monopoly power
because it faces significant threats from potential competitors that offer or will
offer platforms to compete with Windows.
DOJ claim: Microsoft viewed Netscape’s Internet browser as a threat to its
monopoly over the PC operating system market. In violation of Section 1 of the
Sherman Act, Microsoft entered into exclusionary agreements with computer
manufacturers and Internet service providers with the objective of raising the
cost to Netscape of making its browser available to consumers.
MS response: The contracts were not unduly restrictive. In any case,
Microsoft unilaterally agreed to stop most of them.
Microeconomics (Monopoly, Ch 10)

10.7 LIMITING MARKET POWER: THE ANTITRUST LAWS

DOJ claim: In violation of Section 2 of the Sherman Act, Microsoft engaged in

practices designed to maintain its monopoly in the market for desktop PC
operating systems. It tied its browser to the Windows 98 operating system,
even though doing so was technically unnecessary. This action was predatory
because it made it difficult or impossible for Netscape and other firms to
successfully offer competing products.
MS response: There are benefits to incorporating the browser functionality into
the operating system. Not being allowed to integrate new functionality into an
operating system will discourage innovation. Offering consumers a choice
between separate or integrated browsers would cause confusion in the
marketplace.
DOJ claim: In violation of Section 2 of the Sherman Act, Microsoft attempted
to divide the browser business with Netscape and engaged in similar conduct
with both Apple Computer and Intel.
MS response: Microsoft’s meetings with Netscape, Apple, and Intel were for
valid business reasons. Indeed, it is useful for consumers and firms to agree on
common standards and protocols in developing computer software
Microeconomics (Monopoly, Ch 10)

Intellectual monopoly (is it desirable?)

Microeconomics (Monopoly, Ch 10)

Thank You