CHAPTER 10

Market Power:
Monopoly and Monopsony
eletly competitive mket, e age nunber of s
buyers ot a tood ensures that o ningle seller or buyer
an atfet its pree The maket foces of supply and dem
letermine prico, lndividual ims Lake the market prie
Chapter Outline yiVen in decidiug how much to | produce and sell, and con
SUmerN take it aNa yiven in decidiny, ow muc hto buy
Monopoly 328 0opoly and moopsony, the subecth, of thi hapter, ore he
ar oPPOsites of pertect competition, Amonopoly i ma
Monopoly Power 339 hT hat lhas only one seller but many buyern, A monospony
Sourcesof Monopoly |ST h opposile: a market with many ellers but only ont
Power 345 buyer, Monopoly and monopsony are closely related, whien
why we cover them n the same
The Social Costs of
First we discuss the behavior chapter.
Monopoly Power 347 of a monopolist. Becaus
monopolist is the sole producer of a product, the demand
05 Monopsony 352 Curve (hat it faces is the market demand curve. This market
Monopsony Power 355 demand curve relates the price that the monopolist receives l
10.7 Lìmiting Market Power: the quantity it offers for sale. We willsee how a monopolist
can take advantage of its control over price and how the pro
The Antitrust Lawws 359 maximizing price and quantity differ from what would prevail
in acompetitive market.
List of Examples In
general, the monopolist's quantity will be lower and its
Astra-Merck Prices price higher than the compctitive quantity and price. This
Prilosec 334 mposes a cost on society because fewer consumers buy the
produc:, and those who do pay more for it. This is why
Markup Pricing:
10.2 Supermarkets to Designer antitrust laws exist which forbid firms from monopolizing
most markets. When economies of scale make monopoly
Jeans 342
desirable-for example, with local electric power companies
103 The Pricing of
Prerecorded
we will see how the government can then increase efficiency
bv regulating the monopolist's price.
Videocassettes 343 Pure monopoly is rare, but in many markets only a few firms
compete with each other. The interactions of firms in such
14 Monopsony Power in U,S.
Manufacturing 358 markets can be complicated and often involve aspects of
Phone CallAbout
A
strategic gaming, a topic covered in Chapters 12 and 13. In any
105. case, the firms may be able to affect price and may find it prof
Prices 362
itable to charge a price higher than marginal cost. These firms
The United States veros have momopoly power. We will discuss the determinants of
Microsoft 363 monopoly power, its measurement, and its implications for
pricing.
 328 Part 3 s Market Structure and
Competitive Strategy
monopoly
one seller. Market with only Next we will turn to monopsony. Unlike acompetitive buyer,,a

monopsony Market with

pays a price that depends on the quantity that it purchases. The
problem is to cho0se the quantity that maximizes its net benefit from
monopons
monopyt
he
only one buyer. chase-the value derived from the good less the money paid for it. pur
By
how the choice is made, we will demonstrate the close parallel
sony and monopoly.
Although pure monopsony is also unusual, many markets have
between showi
mongp-g
buyers who can purchase the good for less than they would Pay in a only afew
market. These buyers have monopsony power. Typically, this
markets for inputs to production. For example, General Motors, the situationcomnpet
in o0CCuritisve
car manufacturer, has monopsony power in the markets for tires, car US largest
market power Ability of a
and other parts. We will discuss the determinants of
surement, and its implications for pricing. monopsony power, its rmee- baatteries,
seller or buyer to affect the Monopoly and monopsony ppower are two forms of market power: the
price of a good. ity--of either a seller or abuyer-to affect the price of a good. abil.
buyers have at least some market pOwer (in most real-world 'Because
sellers or
to understand how market
power works and how it affectsmarkets), we need
Consumers. producers and

10.1 Monopoly
As the sole producer of a product, a
monopolist decides to raise the pricemonopolist is in a unique
of the product, it need notposition. Ií the
competitors who, by charging lower prices, would capture a larger worry about
market at the monopolist'
pletely controls the amountsofexpense. The monopolist is the marketshare and
of the
com
But this does not mean that output offered for sale.
least not if its objective is to the monopolist can charge any price it wants-at
maximize profit. This textbook is a case in point.
Prentice Hall, Inc., owns the copyright
this book. Then why doesn't it and is, therefore, a
would buy it, and Prentice Hall sell the book monopoly producer ot
for $500 a copy?
would earn a much lower profit. Because few people
To maximize profit, the
monopolist must first determine its costs and the
acharacteristics
of market demand.
firm's economic decision making.Knowledge of demand and cost is crucial or
then decide how much to Given this knowledge,
the monopolist must
list receives then follows produce and sell. The price per unit that the monop
the directly from the
market demand curve.
Jowsmonopolist can
from the marketdetermine price,and the quantity it will sell at Equivalent
demand curve. that price

Average
The
Revenue and MarginalRevenue
ciselymonopolise'
the markets average revenue--the price it receives per unit sold-is pre
marginal revenue Change in
revenue resulting from a one
unit increase in output. the demand curve. To choose its
monopolist alsO needs to know its level.
marginal profit-maxithemizchange
revenue: ing output
in revenue
I The courts use the
sufficient to term "monopoly power" to
gogic reasonswarrant
we use particular scrutiny under the mean significant and sustainable market peda
POwer
whether substantial or"monopoly
not. power" differently,antitrust
to meanlaws. In this book, however, forsellers
market power on the part of
 Monopoiy and Monocsory 329
Chapter 10 Market Power

TABLE10.1 Total, Marginal, and Average Revenue

TOTAL MARGINAL AVERAGE
PICEP) QUANTITY (Q) REVENUE (R) REVENUE (MB) REVENUE (AR)

1 $5 $5
2 3

3
3 1 3

2 -1 2
5 -3 1

that mar
In 382 we explain
esults from a unit change in output. To see the relationship among total Znal retenue is a
of
measure
* and marginal revenue, consider a firm facing the following demand how much revenue
increases

une
when output increases bv one
uut
P=6-Q
Table 10.1 shows the behavior of total, average, and marginal revenue for this
mnd cure. Note that revenue is zero when the price is $6: At that price,
hing is sold. At a price of S5, however, one unit is sold, so total (and marginal)
ue is $5. An increase in quantitv sold from 1 to 2 increases revenue from $5
from 2 to 3, mar
58 marginal revenue is thus $3.As quantity sold increases
-nal revenue falls to S1, and when it increases from 3 to 4, marginal revenue
is increasing
haomes negative. When marginal revenue is positive, revenue
revenue is decreasing
with quanti ty, but when marginal revenue is negative, is
IWhen the demand curve is downward sloping, the price (average revenue) price. If
same
ereater than marginal revenue because all units are sold at the sold, not
that case, all units
sales are to increase bv 1 unit, the price must fall. In
ust the additional unit, will earn less revenue. Note, for example, what happens
2 units and price is reduced to
in Table 10.1 when output is increased from 1 to
sale of the additional unit of
4 Marginal revenue is $3: $4 (the revenue from the
unit for $4 instead of $5).
outrut) less $1 (the loss of revenue from selling the first
(S4).
Thus, marginal revenue (53) is less than price in Table 10.1. Our
the data
Figure 10.1plots average and marginal revenue formarginal revenue curve has
demand curve is a straight line, and in this case, the
intercept).
twice the slope of the demand curve (and the same

The Monopolist'sOutput Decision

What quantity should the monopolist produce? In Chapter 8, we saw that to
revenue is equal to
maximize profit, a firm must set output so that marginal In $72, we explain that mar
marginal cost. This is the solution to the monopolist's problem. In Figure 10.2, ginal cost is the change in
revenue curve. It speci
the market demand curve D is the mnonopolist's average varnable cost associated with
a function of its output
ties the price per unit that the monopolist receives as and the
aone-unit increase in output.
level. Also shown are the corresponding marginal revenue curve MR
is
a function of quantity, P=a- bQ, total revenue
i the demand curve is witten so that pnce is is d(PQViQ =a- 2bQ. In this exam
Q- Q. Marginal revernue (using calculus)
ven by PQ = = 6 - 2Q.(Tris holds oniy for small changes
p demand is P = 6 - O and marginal revenuedatais MR
in Table 10.1.)
and therefore does not exactiv match the
 Dollars per
Unit of
Output

Average Revenue (Demand)

3

2
Marginal
Revenue

1 2 3 4 5 6 7

Output
FIGURE 10.1 Average and Marginal Revenue
Average arnd marginal revenue are shown for the demand curve P =6-0.

Price

MC

P.

Lost profit from producing

too little (Q) and selling at D= AR
too high a price (P;)

Lost profit from producing

too much (Q) and selling at
too low a price (P2)

MR

Q* Quantity
FIGURE 10.2 Profit Is Maximized When Marginal Revenue Equals Marginal Cost
is the output level at which MR = MC. If the firm produces a smaller output-say, O,-it sacrifices some
because the extra revenue that could be earned from producing and selling the units between O, and O* exceedsproft
the
cost of producing them. Similarly, expanding output from Q" to Q, would reduce profit because the additional cost
would exceed the additional revenue.
 331
Chapter 10 Market Power: Monopoly and Monopsony

averagearnd marginal cost curves, AC and MC. Marginal revenue and marginal
tare equal at quantity Q". Then from the demand curve, we find the price P*
this quantity Q.
t corresponds to
can we be sure that Q* is the profit-maximizing quantity? Suppose the
monopolist produces asmaller quantity Q, and receives the corresponding
higher priceP..As Figure 10.2 shows, marginal revenue wouldthen exceed mar-
alcost. In that case, if the monopolist produced a little more than Q,, it would
ve extra profit (MR - MC) and thereby increase its total profit. In fact, the
onopolist could keep increasing output, adding more to its total profit until
nnut Q",at which point the incremental profitearned from producing one
te unit is zero. So the smaller quantity Q, is not profit maximizing, even
hough it allows the monopolist to charge ahigher price. If the monopolist pro
auced O, instead of Q", its total profit would be smaller by an amount equal to
he shaded area below the MR curve and above the MC curve, between Q, and *.
In Figure 10.2, the larger quantity Qis likewise not profit maximizing. At this
ouantity, marginal cost exceeds marginal revenue. Therefore, if the monopolist
produced a little less than Q, it would increase its total profit (by MC - MR). It
could increase its protit even more by reducing output all the way to Q*. The
increased profit achieved by producing Q* instead of Q, is given by the area
helow the MC curve and above the MR curve, between * and Q2.
We can also see algebraically that Q* maximizes profit. Profit is the differ
ence between revenue and cost, both of which depend on Q:
m()= R(Q) C(Q)
it reaches a maximum and
As Ois increased from zero, profit will increase until
that the incremen
then begin to decrease. Thus the profit-maximizing Qis such Am/AQ= 0). Then
zero (i.e.,
tal profit resulting from a small increase in is just
An/AQ = AR/AQ AC/AQ = 0
marginal cost. Thus the profit
But AR/AQ is marginal revenue and AC/AQ0, oris MR = MC.
maximizing condition is that MR - MC =

An Example
an example. Suppose the cost of
lograsp this result more clearly, let's look at
production is
C(Q) = 50 + Q²
and variable cost is . Suppose
In other words. there is a fixed cost of $50,
demand is given by
PQ) = 40 - Q

cost, you can verify that profit is

ySetting marginal revenue equal to marginal price of $30.
maximized when Q = 10, an output level that corresponds to a

Revenue is
3
average cost is C(Q)/Q = 50/Q +Q and marginal cost is SC/AQ = 2Q.marginal rev
Riothat
=P(RQ = 400 - , so marginal revenue is MR = AR/AQ= 40- 2Q. Setting
40 - 2Q= 22, or Q= 10.
equal to marginal cost gives
32 Part Martet Sructura snd (ompefis Susig!

$/0

redit
2)

15

FIGURE 10.3 Example of Profit Maximization

Part (a) shows total rervenue P, trtal crst C, and profit, the differerce betiee e
two. P'art (b) shows average and marziral revee and average ard narz s
Marginal revenue is the slope of the total reveue Curve, and marzinal ost s e
slope of the total cost curve. The profit-masirnizing output is = 10, e pe
where maryjnal reverue equals rrarginal crs At thás output level, the sope
profitcurve is zero, and the slopes of the total revenue and total cst urves
equal. The profit per unitis $15, the difererce between average reverse ard zverg
cost. Because 10 units are produced,total profit is $150.
 Monopsony 333
Chapter 10 Market Power: Monopoly and
dcc' are parallel.) Ihe slope of the revenue curve is AR/AQ, or marginal
evenue, and the slope of the cost curve is AC/AQ, or marginal cost. Because
ee maximized when marginal revenue equals marginal cost, the slopes are
equal.
Figure 10.3(b) shows both the corresponding average and marginal revenue
os and average and marginal cost curves. Marginal revenue and marginal
cOst intersect at Q* = 10. At this quantity, average cost is $15 per unit and price
a0 ner unit. Thus average profit is $30 - $15 = $15 per unit. Because 10 units
cnid. profit is (10)($15) = $150, the area of the shaded rectangle.

Rule of Thumb for Pricing

A
We know that price and output should be chosen so that marginal revenue
als marginal cost, but how can the manager of a firm find the correct price
and output level in practice? Most managers have only limited knowledge of the
average and marginal revenue curves that their firms face. Similarly, they might
know the firm's marginal cost only over a limited output range. We therefore
want to translate the condition that marginal revenue should equal marginal
ost into arule of thumb that can be more easily applied in practice.
To do this, we first rewrite the expression for marginal revenue:
AR A(PO)
MR =
AQ

Note that the extra revenue from an incremental unit of quantity, A(PQ)/AQ, has
two components:
revenue
1. Producing one extra unit and selling it at price P brings in
(1)(P) = P.
2. But because the firm faces a downward-sloping demand curve, producing
in price AP/AQ,
and selling this extra unit also results in a small dropchange
which reduces the revenue from all units sold (i.e., a in revenue
QlAP/AQ).
Thus,
MR = P + Q= P+

ODtained the expression on the right bythetaking the term Q(AP/AQ) and multi
of demand is defined as
Png and dividing it by P. Recall that elasticity elasticity of
=(P/Q4O/AP), Thus (O/P(AP/AQ) is the reciprocal of the and
demand, 1/E4 measured at the profit-maximizing output,
MR = P+ P(1/E,)

Now, because the firm's objective is to maximize profit, we can set marginal rev-
enue equal to marginal cost:
P+ P(1/E) = M
 334 Part 3 Market Structure and Competitive Strategy

which can be rearranged to give us

P- MC 1

(10.1)
This relationship provides a rule of thumb for pricing. The
(P - MC/P, is the nmarkup over marginal cost as a
percentage off price.
tionship says that this markup should equal minus the inverse The rela-
left-hand side,
demand. (This figure will be a positive number because ofthethe
demand is negative.) Equivalently, we can rearrange this equation
to of
ch elelaasstiticciittyy
price directly as a markup over marginal cost:
expresS
MC
P=
1+ (1/E) (10.2)
For example, if the elasticity of demand is -4 and marginal cost is $9 per
price should be $9/(1 - 1/4) = $9/.75 $12 per unit. iuni
How does the price set by a monopolist compare with the
tition? In Chapter 8, we saw that in a perfectly price under compe
In $8.2, we explain that a per competitive market,
marginal cost. A monopolist charges a price that exceeds marginal price equals
fectly competitive firm will an amount that depends inversely on the elasticity of demand. As the cost, but by
equation (10.1) shows, if demand is extremely elastic, E is a large negativemarkun
choose its output so that mar
ginal cost equals price. num:
ber, and price will be very close to marginal cost. In that case, a
market will look much like a competitive one. In fact, when demandmonopolized
is very elas
tic, there is little benefit to being a monopolist.

EXAMPLE 10.1 Astra-Merck Prices Prilosec

n 1995,a new drug developed by Astra-Merck became available for the long
Lterm treatment of ulcers. The drug, Prilosec, representedanew generation ot
antiulcer medication, Other drugs to treat ulcer conditions were already on the
market: Tagamet had been introduced in 1977, Zantac in 1983, Pepcid in 1986,
and Axid in 1988. As we explained in Example 1.1, these four drugs worked in
much the same way to reduce the stomach's secretion of acid. Prilosec, how
ever, was based on a very different biochemical mechanism and was much
more effective than these earlier drugs. By 1996, it had become the best-selling
drug in the world arnd faced no major competitor.

Remember that this markup equation applies at the point of aprofit maximum. If both the elaste
ity of demand and marginal cost vary considerably over the range of outputs under considerd
you may have to know the entire demand and marginal cost curves to determine the optimun
put level. On the other hand, you can use this equation to check whether a particular output leer
and price are optimal.
Prilosec, developed
introduced in 1989, butthrough
only forathe
jointtreatment
venture ofofthe Sw edish firm Astra
gastroesophageal refluxanddisease,
the U.S.
andfirmwasMerck, d
approved
1995
for short-term ulcer treatment in 1991. It was the approval for long-tterm ulcer treatment in
however, that created a very large market for the drug. In 1998, Astra bought Merck's share of the
rights to Prilosec. In 1999, Astra acquired the firm Zeneca and is now called AstraZeneca.
 Cheptor 10 Markot 'ower Munnpoly and Monopsony 335

thin wg salent ith te natku loula (02) the naginal

his ln argul t inien that the ie claatiily ot denand. t,.
the raget igl 00 aed onlalintcalatule ot
demakb ths in leed aieanalle timate o the demal

Shifts in Demand
2eitive matket hew is a lear velatitahip belween pie and the
lhat elatimship in the supplv uve, wich, ax we nav in

latiash1p eteen pr andthe quantity podwed The waum is that tlhe

NNs soutut de inndepends nof uly m naignal eoxt but alu on the
haiy af the demand ne A aieult, nhitt in deand do ot rave out lhe

lxead shuts un denan can lead to hanges i prewith to hange in output

hanges n utput ivth nohatge n prr or hangeN in both.
Ihis prniple is illustratedin igur 0. a) and (lb), ln both parts ot the lig
uN the demadcune is inital ?}, te oeoming marginal rvewe urve
s104a)
MR, and the monoolist 'x initial prie and quantity ae P and Q, n Figur
the demand u e N shittad lwn ad otatod. The teu demanl and
nangnal evenue uIves an shownas ,ad MR, Note that MR, intersects the
mangnal stcune at the saMe pont that MR, does. As a result, the quantity
pnxnd stavs the sme lic however, (alls to ..
In hgu l) (b), the demad cunve is shitle u and notated. The new mar
gnal venue(une MR, ntersvtn the margnal st urve al a larger quantity,
instud ot ut the shittin the demand euve is suh that the priee chargvd
se\tlh the ne
shits indemand usuall cause changes inboth prie and quntity, But the
sral cases shown in igur 04illustrate an important distinetion between
Nnlr and ometitive supp1 Aonnpetitive industry suplies a specitic
uantitv at everv prie No such elationship eists tor a monopolist, which,
dependng om how ademand shits, might supply sveral ditternt quantities at
the same prie or the same quantitv at ditteent pries,

The Effect of a Tax

Atax m outpyutcan als have a dternt ettet on a monopolist than on a com
ehtive industry In (haptr we saw that whena speitic (ie, per unit) tax is
ln $9.6 we eplain that a sp
mpsd on acvmetitive industrv the market prie rises by an amount that is
ls than the tax and that the bunten ot the tax is shard by produeers and con amont ot moneY e nt
Sumers Under monopoly, however prir can sometimes rise by mor than the sold.and we show how the
amount ot the tal tax attets pre and quantiy
336 Part 3 Market Structure and Competitive Strategy

MO $/0

M
P.
PP
D,
P:
M?
D,
D D.

MR2
MR, MR,

Quantity Quantity
(a) (b)

FIGURE 10.4 Shifts in Demand

Shifting the demand curve shows that a monopolistic market has no supply curve ie., there is no one-to-one rela.
tionship between price and quantity produced. In (a), the demand curve D, shifts to new demand curve D,. But fhe
new marginal revenue curve MR, intersects marginal cost at the same point that the old marginal revenue curve MR.
did. The profit-maximizing output therefore remains the same, although price falls from P, to P,. In (b), the new mat:
ginal revenue curve MR, intersects marginal cost at a higher output level 2. But because demand is now more elas.
tic, price remains the same.

Analyzing the effect of a tax on a monopolist is straightforward. Suppose a

specific tax of t dollars per unit is levied, so that the monopolist must remit tdol
lars to the government for every unit it sells. Therefore, the firm's marginal (and
average) cost is increased by the amount of the tax t. If MC was the firm's orig
nal marginal cost, its optimal production decision is now given by
MR = MC + t

Graphically, we shift the marginalcost curve upward by an amount t, and

In $8.2, we explain that a firm find the new intersection with marginal revenue. Figure 10.5 shows this. Here Q:
maximizes its profit by choos
ing the output at which mar
and Po are the quantity and price before the tax is imposed, and Q,and P, are the
ginal revenue is equal to mar quantity and price after the tax.
ginal cost. Shifting the marginal cost curve upward results in a smaller quantity and
higher price. Sometimes price increases by less than the tax, but not always-in
Figure 10.5,price increases by more than the tax. This would be impossible ni
competitive market, but it can happen with a monopolist because the relato
ship between price and marginal cost depends on the elasticity of dema
Suppose, for example, that a monopolist faces a constant elasticity dema
curve, with elasticity -2, and has constant marginalcost MC. Equation (
then tells us that price will equal twice marginal cost. With a tax t, margna
increases to MC + t, so price increases to 2(MC + t) = 2MC + 2t; that is, it ris
nonetheless
by twice the amount of the tax. (However, the monopolise's profit
falls with the tax.)
 337
Monopsony
Chapter 10 Market Power Monopolyand

MC +t

D= AR
MC

MR

Quantity

FIGURE10.5 Effect of Excise Tax on Monopolist

cost is increased by the amount t to
h atax t per unit, the firm's effective marginal
larger than the tax t.
VC - t. In this example, the increase in price AP is

The Multiplant Firm

he have seen that a firm maximizes profitmany by setting output at a level where marin
For firms, production takes place
znal revenueequals marginal cost.operating costs can differ. However, the logic
00T more different plants whose similar to that for the single-plant firm.
sed in choosing output levels is very
firm has two plants. What should its total output be,and how
Suppose a answer intu
plant produce? We can find the
much of that output should each
tvely in two steps.
total output, it should be divided between the two plarnts
IStep 1.Whatever the reduce its
thatmarginal cost is the same in each plant. Otherwise, the firm couldif marginal
50 reallocating production. For example,
cOsts and increase its profit by Plant 2, the firm could produce the same out
at
COst at Plant 1 were higher than
producing less at Plant 1 and more at Plant
2.
put at a lower total cost by equals
know that total output must be such that marginal revenue
Step 2. We increase its profit by raising or lowering
Targnal cost. Otherwise, the firm could marginal costs were the samefirm at each plant,
For example, suppose would do
Dloutput. marginal cost. In that case, the
narginal revenue exceeded because the revenue earned same
from the
more at both piants
ter by producing exceed the cost. Since marginal costs must be the
Oitional units would cost, we see that
and marginal revenue must equalmarginal plant.
each plant,
maximized when marginal revenue equals marginal cost at each
Pront is output and
also derive this result algebraically. Let i and Cbe theproductionfor
ne can output andcost of
production for Plant 1, O, and C, be the profit is
nt 2, and O = , + , be total output. Then
C{Q:)
m= PQ, - C(Q) -
Part 3 Market Structure and Compettve Stratezr

The firm should increase output from each plant until the
frorn the last unut produced is zero Start by setting incrernental
put at Plant 1to ZeTO

PO
=0

Here s(PO)/0, is the revenue from producing arnd selling

marginal revenue, MR, ior all of the fims output The One more
next
Tnarginal cost at Plant 1, MC,.We thus have MR - MC = 0. ortem, 1C
MR = MC.
Similariy, wecan set incremental proit irom output at Plart2 o en
MR = MC;
Putting these relations together, we see that the firm
should produce so tha
MR = MC, = MC,
(10.3)
Figure 10.6 illustrates this principle for a
are themarginal cost curves for the two plants.fim with two plants. MC, and MC.
marginal costs than Plant 2.) Also shown is a (Note that Plant 1 has highe
firm's total rmarginal cost and is curve labeled MC-. This is he
obtained horizontallv summing MC- nc
bv

$/Q

MC,
MC

MR'
D = AR

MR

Quantitv
FIGURE 10.6 Productionwith Two
Afirm with two Plants
plants
that marginal revenue MRmaximizes profits bv choosing output levels Q, and Q. s
each plant, MC, and MC,. (which depends on total output) equals marginal osts r
 Chapter 10 Market Power: Monopoly and Monopsony 339
Now we can find the
the
profit-maximizing
inntersection of MC- with MR;
that
output
point levelsQ,.Q,
and Q,. First,
n drau a horizontal
line determines total
marginal revenueoutput
t from that point on the Q1:
ertica/axis; point MR*
determines the firm's marginal curve to
the marginal revenue line with MC, and revenue. The inter-
MC, give the outputs Q
irthetwo plants, as in equation (10.3). and
Notethat Q-
total output determines the firm's marginal
spice.P). Q, and O,, however,
determine revenue (and hence
marginal costs at each of the two
ants. Because MC, was found by horizontally
inOwthat
+ Q, = Qr. Thus these output summing MC, and MC, we
levels satisfy the condition that
MC,= MC,.
R=

02 Monopoly Power
Pure monopoly is rare. Markets in which several firms compete with one
nther are much more common. We say more about the forms this competition
n take in Chapters 12 and 13. But we should explain here why each firm in a
rketwith several firms is likely to face a downward-sloping demand curve,
ni as aresult, produce so that price exceeds marginal cost.
Suppose, for example, that four firms produce toothbrushes, which have
he market demand curve shown in Figure 10.7(a). Let's assume that these

200 - 2.00

Market Demand $/Q

Demand Faced by Firm A

MCA
1.60

1.50
150
1.40

DA

MRA
1.00
3,000 5,000 7,000
30,000 Quantity
10,000 20,000
(b)
(a)

HGURE 10,7 The Demand for Toothbrushes

(b)shows the demand for toothbrushes as seen by Firm A.
TaT la) shows the market demand for toothbrushes. Part 1.5. Firm A, however, sees a much more elastic demand
is -
amarket price of $1.50, elasticity of market demandaprice Fim A
of competition from other firms. At of $1.50, Firm A's demand elasticity is -6. Still,
eD,because $1.50, which exceeds marginal cost.
haSsome monopoly power: Its profit-maximizing price is

industry'ssupply curvein Chapter 8 by

Note the similarity to the wav we obtained a competitive
individual firms.
Tonzontal y summing the marginal cost curves of the
 Suategy
40 Par Mata Strveture and Competivs
an aggregate of 2000
lour inn are producing thern at $150 each. Note that matre
selling
Per day each) and
relatively inelasti, you carn verify that at this $19 price, the
demand ia 5
deciding whether to
Now supose that firm A isneeds to know how its
sales make
loin this decision, it
change its price. In other words, it needs sorne idea dernas
curve, A reanable
taces, as opposed to the market dernand
curve D, is much
in igure 10.7(b), where the firn's dernand
the market demand curve (At the $1.) price the elasticity
to $120, its sales will
might predictthat by raising price frorn $1.0
from S000 units to 000 as Consurmers buy rmore tothbrushes irn
(ll all tims raised their prices to $160), sales for firm A waild
But for several reasons, sales won't drop to zero as they wuid it sserar
competitive market First, if Firm A's toothbrushes are a little ,fletomt k
cOmpetitors, somne consumers will pay a bit rnore for thern
mightalso raise their prices Similarly, firrm Amight arntic ipate tat ytw
its price from$50 to $L40, it can sell rmore, perhaps 700 toti brushen e
of a000 But it will not capture the entire narket. Sorne corsuners might
prefer the competitors' toothbrushes, and the corrnpetitors trizt als. lowar he
prices.
Thus Frm A's demandcurve depends both on howrnuch its prrduct ifor
from its competitors products and on how the four firrns competo oith
aother We will discuss product differentiation and interfirrn competon :
Chapters 12 and 13, But one important point should be clear. Firm Ais ite
fuce ademnand curve which is mnore elastic than the market demand curoe, but whst
ot infinitely elastic like the demand curvefacing a perfectly competitroefirm
Givenknowledge of its demand curve, how much should Firrn Aprodue
The same principle applies: The profit-maximizing quantity equates marzna
revenue and marginalcost. In Figure 10.7(b), that quantity is 5000 units The co
responding price is $1.50, which exceeds marginal cost. Thus although Fitm s
not apure monopolist, it does have monopoly power-it can profitabiy charze
price greater than marginal cost. Ofcourse, its monopoly power is less than
would be if it had driven away the competition and mornopolized the marke
but it might stillbe substantial.
This raises two questions,
1. How can we measure monopoly power in order to compare one fhrm wi
another? (So tar we have been talking about monopoly power only in j
tative terms )
2. Whatare the sources of monopoly power, and why do sorme firms have mor
monopoly power than others?

Waddress both these questions below, although amore complete answer o

NrOndquestion will be provided in Chapters 12 and 13.

Measuring Monopoly Power

and
Remember theimportant distinction between aperfectly competitivefirmCOst
tr
tirm with marg1nal
monopoly power: For the competitive firm, price equals
the firm with monooly power, price exceeds marginal cost. Therefore, a naturalw3
to measure monopoly power is to examine the extent to which the profit-ma
 Chapter 10 Market Power Monopoly and Monopsony 341
mizing price exceeds marginal cost. In particular, we can use the markup ratio of
price minus marginal cost to price that we introduced earlier as part
thumb for pricing. This measure of monopoly power, introduced byofa rule of
Abba Lerner in 1934, is called the Lerner Indexof Monopoly P'ower. Iteconomist
is the dif Lerner Index of Monopoly
ference between price and marginal cost, divided by price. Mathematically: Power Meanure of monopoy
power calulated as exean of
price oer marginal cot as a
L= (P - MC)/P fraction of price
The Lerner index always has a value between zero and one.
For a perfectly
competitive firm, P= MC, so that L =0. The larger L, the greater the degree of
monopoly power.
This index of monopoly power can also be expressed in terms of the
of demand facing the firm. Using equation (10.1), we know that elasticity

L= (P - MC)/P =-1/E, (10.4)

Remember, however, that E,is now the elasticity of the firm's demand curve, not
the market demand curve. In the toothbrush example discussed above, the clas
ticity of demand for Firm Ais -6.0, and the degree of monopoly power is
1/6 = 0.167."
Note that considerable monopoly power does not necessarily imply high
profits. Profit depends on average cost relative to price. Firm Amight have more
monopoly power than Firm Bbut earn alower profit because of higher average
Costs.

The Rule of Thumb for Pricing

In the previous section, we used equation (10.2) to compute price as a simple
markup over marginal cost:
MC
P=
1+ (1/E)

This relationship provides a rule of thumb for any firm with monopoly power.
We must remember, however, that Eis the elasticity of demand for the firm, not
the elasticity of market demand.
It is harder to determine the elasticity of demand for the firm than for the
market because the firm must consider how its competitors will react to price
changes. Essentially, the manager must estimate the percentage change in the
firm'sunit sales that is likely to result from a l-percent change in the firm's price.
This estimate might be based on a formal model or on the manager's intuition
and experience.
Given an estimate of the firm's elasticity of demand, the manager can calcu
late the proper markup. If the firm's elasticity of demand is large, this markup

There are three problems with applying the Lerner index to the analysis of public policy towand
firms. First, because marginal cost is difficult to measure, average variable cost is often used in
Lerner index calculations. Second, if the firm prices below its optimal price (possibly to avoid legal
Scrutiny), its potential monopoly power will not be noted by the index. Third, the index ignores
dynamic aspects of pricing such as effects of the learning curve and shifts in demand. See Robert S.
Pindyck, "The Measurement of Monopoly Power in Dynamic Markets," Jounal of law and Economics
28(April 1985): 193-222.
342 Part 3 Market Structure and Competitive Strategy

$/Q

p
p*- MC MC MC

p-MC
AR

MR

AR

MR

Quantity Quantity
(a) (b)

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
dermand is elastic as in (a), the markup is small and the firm has little monopoly power. The opposite is tre i
dermand ís relatively inelastic, as in (b).

will be small (and we can say that the firm has very little monopoly power) i
the firm's elasticity of demand is small, this markup will be large (and the firm
will have considerable monopoly power). Figures 10.8(a) and 10.8(b) illustrate
these two extremes.

EXAMPLE 10.2 Markup Pricing: Supermarkets

to Designer Jeans
rhree examples should help clarify the use of markup pricing. Consider:
T retail supermarket chain. Although the elasticity of market demand o
food is small(about -1), several supermarkets usually serve most areds, s
single supermarket can raise its prices very much without losing måny
tomers toother stores. As a result, the elasticity of demand for any one s
market is often as large as -10. Substituting this number for E, in Words,
eq the
(10.2), we find P = MC/1 - 0.1) = MC/(0.9) = (1.11)MC. In other
percentabove
manager of atypical supermarket should set prices about 11(over whichthe
marginal cost. For a reasonably wide range of output levels margin
size of the store and the number of its employees wili remain fixed), ofster
the costs
cost includes the cost of purchasing the food at wholesale, plus
Supermarkets,th
ing the food, arranging it on the shelves, etc. For most
markup is indeed about 10 or 11 percent. andev
Small convenience stores, which are often open 7 days a week
Supermarkets. Wh
24 hours a day, typically charge higher than customers
prices Its
Because a converience store faces a less elastic demand curve. loafofbr
generally less price sensitive. They might need aquarttof milk or a
 Chapter 10 Market Power: Monopoly and Monopsony 343
late at night, or may find it inconvenient to drive to the supermarket. The elas
ticity of demand or a convenience store is about-5, so the markup
implies that its prices should be about 25 percent above marginal equation
cost, as
indeedthey typically are.
The Lemer index, (P MO/P, tells us that the convenience store has more
monopoly power, but does it make larger profits? No. Because its volume is far
smaller and its average fixed costs are larger, it usually earns a much
profit than a large supermarket, despite its higher markup. smaller
Finally, consider a producer of designer jeans.
jeans, but some consumers will pay much more for Many companies produce
jeans with adesigner label.
Just how much more they will pay or more exactly, how
much sales willdrop
in response to higher prices--is aquestion that the producer
consider because it is critical indetermining the price at which themust carefully
clothing will
be sold (at wholesale to retail stores, which then
mark up
With designer jeans, demand elasticities in the range of -3 to the price further).
-4
the major labels. This means that price should be 33 to 50 percent are typical for
higher
marginal cost. Marginal cost is typically $12 to $18per pair, and the wholesale than
price is in the $18 to $27 range.

EXAMPLE 10.3 The Pricing of Prerecorded Videocassettes

uring the mid-1980s, the number of households owning videocassette

recorders (VCRs) grew rapidly, as did the markets for rentals and sales of
prerecorded cassettes. Although many more videocassettes are rented through
small retail outlets than are sold outright, the market for sales is large and
growing. Producers, however, found it difficult to decide what price to charge
for cassettes. As a result, in 1985 popular movies were selling for vastly different
prices,as the data for that year show in Table 10.2.
Note that while The Empire Strikes Back was selling for nearly $80, Star Trek,
afilm that appealed to the same audience and was about as popular, sold
for only about $25. These price differences reflected uncertainty and a wide

TABLE 10,2 Prices of Videos in 1985 and 1999

1985 1999
TITLE RETAIL PRICE (S) TITLE RETAIL PRICE (S)
Purple Rain $29.98 Austin Powers $10.49
Raiders of the Lost Ark 24.95 ABug's Life 17.99
Jane Fonda Workout 59.95 There's Something about Mary 13.99
The Empire Strikes Back 79.98 Tae-Bo Workout 24.47
AnOfficer and a Gentleman 24.95 Lethal Weapon 4 16.99
Star Trek: The Motion Picture 24.95 Men in Black 12.99
Star Wars 39.98
Armageddon 15.86
nd Competitve Strategy

Video entals Video sales

$10billom

1990 1991 1992 1993 1994 1995 1996 1997

FIGURE 10.9 Video Rentals and Sales
Between 1990 and 1997, lower prices induced consumers to buy many more videos.
While revenues from sales more than doubled, rental revenues were flat.

divergence of yiews on pricing by producers. The issue was whether lower

prices would induce consumers to buy videocassettes rather than rent them.
Because producers do not share in the retailers' revenues from rentals, thev
should charge a low price for cassettes only if that will induce enough con
sumers to buy them. Because the market was young, producers had no good
estimates of the elasticity of demand, so they based prices on hunches or trial
and error8
As the market matured, however, sales data and market research
studies put
pricing decisions on firmer ground. They strongly indicated that demand was
elastic arnd that the profit-maximizing price was in the range of $15 to
one industry analyst said, "People are becoming collectors. .. . As you$30. AS
the price you attract households that would not have considered buyinglower at a
higher price point." By the 1990s, most producers had lowered prices across
the board. As Table 10.2 shows, in 1999 prices of top-selling
videos were consid
erably lower than in 1985. As a result of these price declines, sales of videos
increased steadily during the 1990s, as did profits from these sales. As Figure
10.9 shows, revenues from video sales more than doubled from 1990to 1997,
while revenues from rentals remained fairly flat.

"Video Producers Debate the Value of Price Cuts," New York Times,
February 19, 1985.
"Studios Now Stressing Video Sales Over Rentals," New York Times,
letailed study of videocassette pricing, see Carl E. Enomoto and Soumendra October 17, 1989. For a
he Home-Video Market" (working paper, New N. Ghosh, "Pricing n
Mexico State University, 1992).
 Chapter 10 Market Pn Mnnpty snd tntysrg 45
3 Sources of Monopoly Powe
dosome firms have
Why
none?
Remember considerable
that nmonopolymonopoly power while other
tleor
arginalCost and that the power is the ability to wt pir msabove
have
amount
by which price
deendsinversely
shows,the less
on the elasticity
clastic its
ofdemand faing the eNCCds
fim As
narginal tst
eqahon (10 )
demand curve, the more monopoly
Thee
ultimate determinant of
monopoly power is therefore the powera fin has
demand. Thus we should rephrase our
supermarket chain) face demand curves that
fmn'selashoty
question: Why do some fns (e g,, a
of
are more clastic than those faced by
thers (e g-, a producer of designer clothing)?
Three factors determine a firm's elasticity of
demand:
, The clasticity of nnarket demand. Because the firm's own
least as elastic as market demand, the elasticity of market demand will be at
demand limits the
potential for monopoly power.
, The number of firnms in the market. If there are many
firms, it is unlikely that
any one firm will be able to affect price significantly.
The interaction among firms. Even if only two or three firms are in the market,
pach firm will be unable to profitably raise price very much if the rivalry
among them is aggressive, with each firm trying to capture as much of the
market as it can. Let's examine each of these three determinants of monop
oly power.
The Elasticity of Market Demand
If there is only one firm-a pure monopolist--its demand curve is the market
demand curve. In this case, the firm'sdegree of monopoly power depends com
pletely on the elasticity of market demand. More often, however, several firms
compete with one another; then the elasticity of market demand sets a lower
limit on the magnitude of the elasticity of demand for each firm. Recall our
example of the toothbrush producers illustrated in Figure 10.7. The market
demand for toothbrushes might not be very elastic, but each firm's demand will
be more elastic. (In Figure 10.7, the elasticity of market demand is - 1.5, and the
depends
elasticity of demand for each firm is - 6.) A particular firm's elasticity compete,
another. But no matter how they
On how the firms compete with one
the elasticity of demand for each firm could never become smaller in magnitude
than - 1.5.
short run), OPEC
Because the demand for oil is fairly inelastic (at least in the
Could raise oil prices far above marginal production cost during the 1970s and
commodities as coffee, cocoa, tin, and
cariy 1980Os. Because the demands for such
to cartelize these markets
OPper are much more elastic, attempts by producerselasticity of market demand
raise prices have largely failed. In each case, the
limits the potential monopoly power of individual producers.

The Number of Firms

demand curve--and thus of its monopoly
eCond determinant of afirm's Other things being equal, the
of firms in its market.
power-is the number firm number of firms increases. As more
will fall as the
monopoly firms
and more
power of each
compete, each firm will
find it harderto raise prices and avoid
losing sales to other firms.
346 Part 3 Market Structure and Competve Strategy thettal
ranter Afirna, tr
rot just
matters, of ours,
is
sigrúfhicart tmarkn share
What players"irms with a l in a narke,
of "majotfirms accountfor perCeritf the two latyp frtta
fwolarge
the remaininz 10 percet, hrns aAMIrA bn
accounting for a fencmentrated
monopoly power. When ondy huzly
erable the market is eaten le
market, we say that (not always ykiny)tat te Bit we
said rA Atru
Itis sometirnes Thattay of may nart,thnt
Competition.
business 1S are inn a
only afew firns f fistns
expect that when An increas in the furt
enter. p
that no new firmns incurmbert firrm Ar
iprat
monopoly power of each
in Chaptet 12)
barrier to entry Condition strategy (discussed in detail entry by nen Inpeitns
that impedes entry by new entry-conditions that deter natfpe, ne
barriers to ertry Fr
competitors. Sometines there are natural partiular
technology needed to produe z
a patent on the unitil the ptt
impossible for other firrms to enter the market, at a t p y t an i e
in the sane way
Other legally created rights workoitware che
pryat 2 Si1e IMpaty,
of abook, music, or acormputer
prevent ngn iffis trI enteinZ he
need for a government license can intetate
broadcastin
for telephone service, television mIe than afen firms to wy
In §7.4, we explain that a firm economies of scalermay make it toocostiy for laye trt itis e
ale may be
enjoys economies of scale entire mnarket. In sorme cases, econornies of re tite mat o
when it can double its output
with less than a doubling of efficient for a single firrm-a natural mmpoly-0 suppy dail shoriy
ATe
COst. willdiscuss scale economies and natural rnonply in

The InteractionAmong Firms

The ways in which competing firms interact is also an irniponart-znd me
times the most important-determinant of rnonopoly power suppse thes
four firms in a market. They míght cornpete agzresively, undercutting me
another's prices to capture more market share This cuid drive prices down
nearly competitive levels. Each firrn will fear that if it raises its price it wile
undercut and lose market share. As a result, it willhave litie maphy ps
On the other hand, the firms might not cornpete rnuch They ugt eie h
lude (in violation of the antitrust laws), agreeing to lirnit output arnd raise prica
Raising prices in concert rather than individually is more likely to te prrfitatie
socollusion can generate substantial rnonopoly power.
We willdiscuss the interaction arnong firrns in detail in Chapters 12 and 13
Now we simply want to point out that other things being equal, moapog
power is smaller when firms compete aggressively and is larzer wher the
COoperate.
Rernermber that a firn's monopoly power often changes over time,as its oper
ating conditions (rmarket demand and cost), its behavior, and the behavor of s
competitors change. Monopoly power must therefore be thought of in a
dynamic context.For example, the market dernard curve might be veryinelastk
in the short run but much more elastic in the long run. (Pecauss this is the a
with oil, the OPEC cartelenjoyed considerable short-run but rmuch less lor t
monopoly power.) Furtherrnore, real or potential rnonopoly powet in tre s
1A statistic called the conentrat on ratio, wh reaurs the fracti d
es Ned t y
the four laryest firrns, is often used t describe the commtration od a mare Conotrat
but not the ondy, determirart of rmarket power
 Chepter 10 Market Power: MonopoÛy and Monogsny 347
run can make an industry more competitive in the long run.
Large short-run
profits can induce new firms to enter an industry, thereby reducing
power over the longer term. monopoly

10.4 The Social Costs of Monopoly Power

In a competitive market, price equals marginal cost.
Monopoly powe, on the
other hand, implies that price exceeds marginal cost. Because
monopoly power
results in higher prices and lower quantities produced, we would
make consumers worse off and the firm better off. But expect it to
suppose we value the
welfare of consumers the same as that of producers. In the
aggregate, does
monopoly power make consumers and producers better or worse off?
We can answer this question by comparing the consumer and producer
sur
plus that results when a competitive industry produces a good with the surplus
that results when a monopolist supplies the entire market." (We assume that the In 9.1, we explain that con
competitive market and the monopolist have the same cost curves.) Figure 10.10 Surmer surplus is the total
shows the average and marginal revenue curves and marginal cost curve for the benefit or value that con
monopolist. To maximize profit, the firm produces at the point where marginal sumers receive bevond what
they pay for 2zood: producer
revenue equals marginal cost, so that the price and quantity are P, and . In a surplus is the analogous ea
competitive market, price must equal marginal cost, so the competitive price sure for producers
and quantity, P. and Qo are foundat the intersection of the average revenue

$/Q
Lost Consumer Surplus

Deadweight Loss
MC
Pm
A
B
P.

AR

MR

Qm Quantity
FIGURE 10.10 Deadweight Loss from Monopoly Power
The shaded rectangle and triangles show changes in consumer and producer sur
plus when moving from competitive price and quantity, , and Q, to a monopolist's
price and quantity, P, and Qm. Because of the higher price, consumers lose A + B
and producer gains A - C. The deadweight loss is-B- C.

If there were two or more firms, each with some monopoly power, the analysis would be more
Complex. However, the basic results would be the same.
 348 Part 3 Market Structure and Competitive Strategy
the marginal cost curve. Now let's enarnine
(demand) curve and price and quantity, P
the competitive
changes if we move from l, and m
monopoly price andquantity, higher and consurmers buy less
the price is
Under monopoly, consumers
those who buy the good lose surplus of
higher price, consumers who do not buy the good at
rectangle A. Those
given by an arnourt zver
who will buy at price Palso losesurplus-namely,
total loss of consumer surplus istherefore A + B. The producer,
B. The
gains rectangle A by selling at the higher price but loses triangie Cthe
tional profit it would have earned by selling Q. - Qm at price P The ttz t
producer surplus is therefore A - C. Subtracting the loss of corsurner
from the gaain in producer surplus, we see a net loss,of surplus gven by B-
This is the deadweight loss from monopoly power. Even if the rnonopoiisrs
were taxed away and redistributed to the consumers of its producs r
would be an inefficiency because output would be lower than under CorCtos
ineffcien
of competition. The deadweight loss is the social cost of this

Rent Seeking
In practice, the social cost of monopoly power is likely to exceed the deadweg
loss in triangles B and C of Figure 10.10. The reason is that the firm
rent seeking Spending in rent seeking: spending large amounts of money in SOCialiy unprocc:
money in socially unproduc efforts to acquire, maintain, or exercise its monopoly power. Rernt seeKing ig
tive eftorts to acquire, main
tain, or exercise monopoly involve lobbying activities (and perhaps campaign contributions) to cotaur
power. ernment regulations that make entry by potential competitors more diht
Rent-seeking activity could also involve advertising and legal efforts o zvog
antitrust scrutiny. It might also mean installing but not utilizing extra oduc
tion capacity to convince potential competitors that they cannot sell encug
make entry worthwhile. We would expect the economic incentive to incr
seeking costs to bear a direct relation to the gains fromn monopolv cower
rectangle A minus triangle C). Therefore, the larger the transfer frOm cursume
to the firm (rectangle A), the larger the social cost of monopolv
Here's an example. In 1996, the Archer Daniels Midland Companv 4DM
successfully lobbied the Clinton administration for regulations requirg t
the ethanol (ethyl alcohol) used in motor vehicle fuel be produced rom n.
(The government had already planned to add ethanol to gasoline in ote T
reduce the country's dependence on imported oil.) Ethanol is checaTe
same whether it is produced from corn, potatoes, grain, or anvthing ese
why require that it be produced only from corn? Because ADM hat i e
monopoly on corn-based ethanol production, so the regulation wouid r
its gains from monopoly power.

Price Regulation
Because of its social cost, antitrust laws prevent irms from
accumulatne
sive amounts of monopoly power. We will say more about such laws at e
of the chapter. Here, we examine
another means by which gov ermment
monopoly power-price regulation.

12The concept of rent

seeking was first
see Gordon Tullock, Rent S developed by Gordon Tullock For more
 Chepter 10 Market Power Monopoly and Monagsony 349

MK
M

Maryinal revense
Curve when price
in regulated to be
no higher than P,

AC

AR

Quantity
FIGURE 10.11 Prico Regulation
If left alone, a monopolist produces Q, and charges P. When the
imposes a price ceiling of P, the firm's average and marginal revenue government
are constant
and equal to P, for output levels up to Q,. For larger output levels, the original aver
age and marginal revenue curves apply. The new marginal revenue curve is, there
fore, the dark purple line, which intersects the marginalcost curve at Q,. When price
is lowered to P, at the point where marginalcost intersects average revenue,output
increases to its maximum Q. This is the output that would be produced by a com
petitive industry. Lowering price further, to Py reduces output to Q, and causes a
shortage, (Q- Q

We saw in Chapter 9 that in aompetitive market, price regulation always

results in a deadweight loss. This need not be the case, however, when a firm has
monopoly power. On the contrary, price regulation can eliminate the dead
weight loss that results from monopoly power.
Figure 10.11illustrates price regulation. I, and Q, are the price and quantity
that result without regulation. Nowsuppose the price is regulated to be no
higher than P. Because the firm can charge no more than , foroutput levels up
to Q, itsnew average revenue curve is a horizontal line at P. For output levels
greater than Q, the new average revenuecurve is identicalto the old average
revenue curve: Atthese output levels, the firm will charge less than P and s0
willbe unaffected by the regulation.
The firm's new marginal revenue curve corresponds to its new average rev
enue curve and isshown by the dark purple line in Figure 10.10. For output lev
els up to Q, marginal revenue equals average revenue. For output levels greater
than Q, the new marginal revenue curve is identical to the original curve. The
lim willproduce quantity Q, because that is the point at which its marginal rev
enue curve intersects its marginal cost curve. You can verity that at price P and
quantity Q, the deadweight loss from monopoly power is reduced.
350 rt $
I the ty s kwwnt trther the quantity peuced continues.
ANt the tevttneght ixtot e Atpie , where average evenue
eltt ttteet the quantity ducdhas itvasel to the. and ma
the teatwsht Ntom monopoy wer has been eliminated ompeitive
yumalvnt tu m%Nts
in quantity This
t eelng on a competitive industry A
Reduiredutnog
it atutition to the deadveight los tron
swenirther t equantity potuBcontinues to tall and the th
As gulationshotag
ns all tt the pie ts lowennl below , the inim
shotag
avetage cos!

Natural Monopoly
t r gulatton is tust otteu uset tor ntural monopoltes, such as local utlt
wes Anatural monopoly is a tinthat can produce tlhe cnbte
tihe tarket at a wst that is lower than what it would be itthee t output
were several
tirns It a tirtt is a ttatural wpoly, it is mor vtticient to letit serve the ent
arket rather than have sveral tirms compete.
Anetural ttonlv usually arises when thee are strong conomies of scale
as tllustratri in gur 0 ltthe tirmrvpreented by the tigure was broken up
inte wmeing tirms, ch suplyng, halt the mnarket, the average cost for
atwuli le higher than the st incurrvd by the origunal monopoly.
Noe in Figure 0. 2that beause average cost is declininy everywhere, mar
sual st is alwavs below average Ost. I the firm were unregulated,it would
praiued sell at the pric , ldeally, tthe gulatory agency would like to

AC

MC

AR

MR

Quantity
FIGURE 10.12 Regulating the Price of a Natural
Afm is a natural monopoly because it has evonomies of Monopoly
scale (declining average
and marinal costs) over its entire output range. lt price were rgulatedto be P, the
firm would lose money and go out of business. Setting the price aat Pyieldsthe
largest possible output rofit
 Chapter 10 Market Power Monopolyand Monopsoy 3
price down to the
the tirm s competitive level P. A level, however,
average cost and the hrm would gothat
Oer
out of business The
aleatrleis theretoe to set the prie at P.
untret In that case, the tirnm earns no
where average cost and average
without dnving the firm out ofmonopolv
business.
profit, and output is

Regulation in Practice
the vmetitive prie (Pin Figure 10.11) is found at the point at which
cOst anmd average revenue (demand) curves intersect.
natural monovl: The minimum feasible price (P in Figure 10.12)
i at the; n t at which average cost and demand intersect Unfortunately,
iithcult tto determine these pries accuratelv in practice because the
oa and ostcuves mav shift as market conditions evolve.
Rzte-ot-Return Regulation As a result,the regulation of a monopoly is
the rate ot return that it earns on its capital. The regulatory
ietermines an alowed price, sothat this rate of return is in some sense
rate-of-return regulation
or iair. This practice is called rate-of-return regulation: The The maximum price allowed
allowed is basedonthe (expected) rate of return that the firm by a regulatory agency is
based on the (expected) rate of
ahortunatel ditticult problems arise when implementing rate-of-return return that a firm will earn.
firm's rate of
n Fist. althoughit is akev element in determining the "fair" rate of
a
m2irm's capital strk is diffricult to value. Second, while depends in
must be based on the firm's actual cost of capital, that cost
perceptions of
onthe behavior of the regulatory agency (and on investors'
uue llowei rates of return willbe),
to be used in rate-of-return cal
hedimultt of ageeing on a set of numbers
response to changes in cost and
atonsoten leads to delavs in the regulatory
and expensive regulatory hear
her market conditions (not to mention long lavers, accountants, and, occasion
NThe major beneficiaries are usually regulatory lag--the delavs of a year
LT eonomicconsultants. The net result is
regulated prices.
rmoe usuallv entailed in changing regulatory
in the 1950s and 1960s, lag worked to the advantage of
ricallv as a
costs were typically falling (usually
zted firms. During those decades,firms allowed
grew). Thus regulatory lag
S0t scale economies achieved as actual rates of returngreater than those
hrms,at least for a while, to enjov
regulatory proceedings. Beginning in the
atelv deemed "fair" at the end of and regulatory lag worked to the detri
Showever, the situation changed,when oil prices rose sharply, electric utili
ot regulated firms. For example, caused many ofthem to earn
s teeded to raise their prices. Regulatory lag been earning earlier.
had
sof retum well below the fair" rates theythe United States hadchanged dra-
envionment in
rthe 1900s,the regulatorytelecommunications industry had been deregulated,
aaly Manv parts of the states. Because Scale economies had been largely
sad electric utlities in many argument thatthesefirms were natural monop-
sted, Was nolonger an by newfirms relatively easy.
s h there technological change made entry
addition,
tormula like the tollowingto determune prie
agencies tvpicallv use a
+ TsÅ)/Q
P= AVC + (D
"fair" rate of retum, Dis deprcia-
Ois output, s is the allowed
Cis variable cost.
tzres tvand
erageKis the firm's stock.
urrent capital