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Fernando & Yvonn Quijano

Prepared by:

Market Power:Monopoly and

Monopsony

10

CHA

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Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

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2 of 50Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

CHAPTER 10 OUTLINE

10.1 Monopoly

10.2 Monopoly Power

10.3 Sources of Monopoly Power

10.4 The Social Costs of Monopoly Power10.5 Monopsony

10.6 Monopsony Power

10.7 Limiting Market Power: The Antitrust Laws

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monopoly Market with only one seller.

monopsony Market with only one buyer.

market power Ability of a seller or buyerto affect the price of a good.

Market Power: Monopoly and Monopsony

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MONOPOLY10.1

Average Revenue and Marginal Revenue

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

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

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MONOPOLY10.1

Average Revenue and Marginal Revenue

Average and marginalrevenue are shown forthe demand curveP= 6 Q.

Average and Marginal

Revenue

Figure 10.1

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MONOPOLY10.1

The Monopolists Output Decision

Q* is the output level at whichMR = MC.

If the firm produces a smaller

outputsay, Q1it sacrificessome profit because the extrarevenue that could be earnedfrom producing and selling theunits between Q1and Q*exceeds the cost of producingthem.

Similarly, expanding output fromQ* to Q2would reduce profitbecause the additional costwould exceed the additionalrevenue.

Profit Is Maximized When Marginal

Revenue Equals Marginal Cost

Figure 10.2

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MONOPOLY10.1

The Monopolists Output Decision

We can also see algebraically that Q* maximizes profit. Profit is thedifference between revenue and cost, both of which depend on Q:

As Qis increased from zero, profit will increase until it reaches amaximum and then begin to decrease. Thus the profit-maximizingQis such that the incremental profit resulting from a small increasein Qis just zero (i.e., /Q= 0). Then

But R/Qis marginal revenue and C/Qis marginal cost. Thusthe profit-maximizing condition is that

, or

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MONOPOLY10.1

An Example

Part (a)shows total revenue R, total cost C,and profit, the difference between the two.

Part (b)shows average and marginalrevenue and average and marginal cost.

Marginal revenue is the slope of the totalrevenue curve, and marginal cost is theslope of the total cost curve.

The profit-maximizing output is Q* = 10, thepoint where marginal revenue equalsmarginal cost.

At this output level, the slope of the profit

curve is zero, and the slopes of the totalrevenue and total cost curves are equal.

The profit per unit is $15, the differencebetween average revenue and averagecost.

Because 10 units are produced, total profitis $150.

Example of Profit Maximization

Figure 10.3

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MONOPOLY10.1

A Rule of Thumb for Pricing

We want to translate the condition that marginal revenue shouldequal marginal cost into a rule of thumb that can be more easilyapplied in practice.

To do this, we first write the expression for marginal revenue:

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MONOPOLY10.1


Note that the extra revenue from an incremental unit of quantity,(PQ)/Q, has two components:

1.Producing one extra unit and selling it at price Pbrings inrevenue (1)(P) = P.

2.But because the firm faces a downward-sloping demandcurve, producing and selling this extra unit also results ina small drop in price P/Q, which reduces the revenuefrom all units sold (i.e., a change in revenue Q[P/Q]).

Thus,

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MONOPOLY10.1


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

Now, because the firms 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 expressprice directly as a markup over marginal cost:

(10.2)

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In 1995, Prilosec, represented a newgeneration of antiulcer medication. Prilosecwas based on a very different biochemicalmechanism and was much more effectivethan earlier drugs.

By 1996, it had become the best-selling drug in the world andfaced no major competitor.

Astra-Merck was pricing Prilosec at about $3.50 per daily dose.

The marginal cost of producing and packaging Prilosec is onlyabout 30 to 40 cents per daily dose.

The price elasticity of demand, ED, should be in the range ofroughly 1.0 to 1.2.

Setting the price at a markup exceeding 400 percent over marginalcost is consistent with our rule of thumb for pricing.

MONOPOLY10.1

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MONOPOLY10.1

Shifts in Demand

A monopolistic market has no supply curve.

The reason is that the monopolists output decision depends not only

on marginal cost but also on the shape of the demand curve.

Shifts in demand can lead to changes in price with no change inoutput, changes in output with no change in price, or changes in both

price and output.

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MONOPOLY10.1

Shifts in Demand

Shifting the demand curve showsthat a monopolistic market has nosupply curvei.e., there is noone-to-one relationship betweenprice and quantity produced.

In (a), the demand curve D1shiftsto new demand curve D2.

But the new marginal revenuecurve MR2intersects marginalcost at the same point as the oldmarginal revenue curve MR1.

The profit-maximizing outputtherefore remains the same,although price falls from P1to P2.

In (b), the new marginal revenuecurve MR2intersects marginalcost at a higher output level Q2.

But because demand is now more

elastic, price remains the same.

Shifts in Demand

Figure 10.4

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MONOPOLY10.1

The Effect of a Tax

With a tax tper unit, the firmseffective marginal cost isincreased by the amount ttoMC + t.

In this example, the increase inprice Pis larger than the tax t.

Effect of Excise Tax on Monopolist

Figure 10.5

Suppose a specific tax of tdollars per unit is levied, so that the monopolistmust remit tdollars to the government for every unit it sells. If MC was thefirms original marginal cost, its optimal production decision is now given by

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MONOPOLY10.1

*The Multiplant Firm

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

Step 1. Whatever the total output, it should be divided betweenthe two plants so that marginal cost is the same in each plant.Otherwise, the firm could reduce its costs and increase its profitby reallocating production.

Step 2. We know that total output must be such that marginalrevenue equals marginal cost. Otherwise, the firm could increaseits profit by raising or lowering total output.

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MONOPOLY10.1


We can also derive this result algebraically. Let Q1and C1be the outputand cost of production for Plant 1, Q2and C2be the output and cost ofproduction for Plant 2, and QT= Q1+ Q2be total output. Then profit is

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

Here (PQT)/Q1is the revenue from producing and selling one more uniti.e., marginal revenue, MR, for all of the firms output.

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MONOPOLY10.1


The next term, C1/Q1, is marginal costat Plant 1, MC1. We thus haveMR 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)

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MONOPOLY10.1


A firm with two plantsmaximizes profits bychoosing output levels Q1and Q2so that marginalrevenue MR (which

depends on totaloutput)equals marginal costs foreach plant, MC1and MC2.

Production with Two Plants

Figure 10.6

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MONOPOLY POWER10.2

Part (a)shows the marketdemand for toothbrushes.

Part (b)shows the demandfor toothbrushes as seen byFirmA.

At a market price of $1.50,elasticity of market demandis 1.5.

FirmA, however, sees amuch more elastic demandcurve DAbecause ofcompetition from other firms.

At a price of $1.50, FirmAsdemand elasticity is 6.

Still, FirmAhas somemonopoly power: Its profit-maximizing price is $1.50,which exceeds marginalcost.

The Demand for Toothbrushes

Figure 10.7

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MONOPOLY POWER10.2

Remember the important distinction between a perfectly competitive firmand a firm with monopoly power: For the competitive firm, price equalsmarginal cost; for the firm with monopoly power, price exceeds marginal

cost.

Measuring Monopoly Power

Lerner Index of Monopoly PowerMeasure of monopoly power calculated asexcess of price over marginal cost as afraction of price.

Mathematically:

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

(10.4)

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MONOPOLY POWER10.2

The Rule of Thumb for Pricing

The markup (P MC)/Pis equal to minus the inverse of the elasticity of demand facing the firm.

If the firms 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).

Elasticity of Demand and Price Markup

Figure 10.8

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MONOPOLY POWER10.2

Although the elasticity of market demand for foodis small (about 1), no single supermarket can

raise its prices very much without losingcustomers 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 percentabove 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 abovemarginal 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.

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MONOPOLY POWER10.2

TABLE 10.2 Retail Prices of VHS and DVDs

2007

Title Retail Price DVD

Purple Rain $29.88

Raiders of the Lost Ark $24.95

Jane Fonda Workout $59.95

The Empire Strikes Back $79.98

An Officer and a Gentleman $24.95

Star Trek: The Motion Picture $24.95

Star Wars $39.98

1985

Title Retail Price VHS

Pirates of the Caribbean $19.99

The Da Vinci Code $19.99

Mission: Impossible III $17.99

King Kong $19.98

Harry Potter and the Goblet of Fire $17.49

Ice Age $19.99

The Devil Wears Prada $17.99

Source(2007): Based on http://www.amazon.com. Suggested retail price.

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MONOPOLY POWER10.2

Between 1990 and 1998, lowerprices induced consumers to buymany more videos.

By 2001, sales of DVDs overtooksales of VHS videocassettes.

High-definition DVDs wereintroduced in 2006, and areexpected to displace sales ofconventional DVDs.

Video Sales

Figure 10.9

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SOURCES OF MONOPOLY POWER10.3

If there is only one firma pure monopolistits demand curve is the marketdemand curve.

Because the demand for oil is fairly inelastic (at least in the short run), OPECcould raise oil prices far above marginal production cost during the 1970s andearly 1980s.

Because the demands for such commodities as coffee, cocoa, tin, and copperare much more elastic, attempts by producers to cartelize these markets andraise prices have largely failed.

In each case, the elasticity of market demand limits the potential monopolypower of individual producers.

The Elasticity of Market Demand

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When only a few firms account for most of the sales in a market, we say thatthe market is highly concentrated.

The Number of Firms

barrier to entry Condition thatimpedes entry by new competitors.

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Firms might compete aggressively, undercutting one anothers prices tocapture more market share.

This could drive prices down to nearly competitive levels.

Firms might even collude (in violation of the antitrust laws), agreeing to limitoutput and raise prices.

Because raising prices in concert rather than individually is more likely to beprofitable, collusion can generate substantial monopoly power.

The Interaction Among Firms

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THE SOCIAL COSTS OF MONOPOLY POWER10.4

The shaded rectangle and trianglesshow changes in consumer andproducer surplus when moving fromcompetitive price and quantity, Pcand Qc,

to a monopolists price and quantity,

Pmand Qm.

Because of the higher price,consumers loseA+ B

and producer gainsA C. Thedeadweight loss is B+ C.

Deadweight Loss from Monopoly Power

Figure 10.10

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Rent Seeking

rent seeking Spending money insocially unproductive efforts to acquire,maintain, or exercise monopoly.

In 1996, the Archer Daniels Midland Company (ADM) successfully lobbied theClinton administration for regulations requiring that the ethanol (ethyl alcohol)

used in motor vehicle fuel be produced from corn.

Why? Because ADM had a near monopoly on corn-based ethanol production,so the regulation would increase its gains from monopoly power.

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Price Regulation

If left alone, a monopolistproduces Qmand chargesPm.

When the governmentimposes a price ceiling of

P1the firms average andmarginal revenue areconstant and equal to P1for output levels up to Q1.

For larger output levels, theoriginal average andmarginal revenue curves

apply.

The new marginal revenuecurve is, therefore, the darkpurple line, which intersectsthe marginal cost curve atQ1.

Price Regulation

Figure 10.11

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Price Regulation

When price is lowered toPc, at the point wheremarginal cost intersectsaverage revenue, outputincreases to its maximum

Qc. This is the output thatwould be produced by acompetitive industry.

Lowering price further, toP3reduces output to Q3and causes a shortage,Q3 Q3.

Price Regulation

Figure 10.11

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Natural Monopoly

A firm is a natural monopolybecause it has economies ofscale (declining average andmarginal costs) over its entireoutput range.

If price were regulated to be Pcthe firm would lose money andgo out of business.

Setting the price at Pryields thelargest possible output consistentwith the firms remaining in

business; excess profit is zero.

natural monopoly Firm that can producethe entire output of the market at a costlower than what it would be if there wereseveral firms.

Regulating the Price of a NaturalMonopoly

Figure 10.12

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Regulation in Practice

rate-of-return regulation Maximum priceallowed by a regulatory agency is based on the(expected) rate of return that a firm will earn.

The difficulty of agreeing on a set of numbers to be used in rate-of-return

calculations often leads to delays in the regulatory response to changes incost and other market conditions.

The net result is regulatory lagthe delays of a year or more usually entailedin changing regulated prices.

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MONOPSONY10.5

oligopsony Market with only a few buyers. monopsony power Buyers ability to affect

the price of a good.

marginal value Additional benefit derivedfrom purchasing one more unit of a good.

marginal expenditure Additional cost ofbuying one more unit of a good.

average expenditure Price paid per unit of agood.

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MONOPSONY10.5

In (a), the competitive buyer takes market price P* as given. Therefore, marginal expenditure andaverage expenditure are constant and equal;

quantity purchased is found by equating price to marginal value (demand).

In (b), the competitive seller also takes price as given. Marginal revenue and average revenue areconstant and equal;

quantity sold is found by equating price to marginal cost.

Competitive Buyer Compared to Competitive Seller

Figure 10.13

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MONOPSONY10.5

The market supply curve ismonopsonists average expenditure

curve AE.

Because average expenditure isrising, marginal expenditure liesabove it.

The monopsonist purchases quantityQ*m, where marginal expenditure andmarginal value (demand) intersect.

The price paid per unit P*mis thenfound from the average expenditure(supply) curve.

In a competitive market, price andquantity, Pcand Qc, are both higher.

They are found at the point whereaverage expenditure (supply) andmarginal value (demand) intersect.

Monopsonist Buyer

Figure 10.14

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MONOPSONY10.5

These diagrams show the close analogy between monopoly and monopsony.

(a)The monopolist produces where marginal revenue intersects marginal cost.

Average revenue exceeds marginal revenue, so that price exceeds marginal cost.

(b)The monopsonist purchases up to the point where marginal expenditure intersects marginal value.

Marginal expenditure exceeds average expenditure, so that marginal value exceeds price.

Monopoly and Monopsony

Figure 10.15

Monopsony and Monopoly Compared

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MONOPSONY POWER10.6

Monopsony power depends on the elasticity of supply.

When supply is elastic, as in (a), marginal expenditure and average expenditure do not differ bymuch, so price is close to what it would be in a competitive market.

The opposite is true when supply is inelastic, as in (b).

Monopsony Power: Elastic versus Inelastic Supply

Figure 10.16

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MONOPSONY POWER10.6

Sources of Monopsony Power

Elasticity of Market SupplyIf only one buyer is in the marketa pure monopsonistits monopsonypower is completely determined by the elasticity of market supply. Ifsupply is highly elastic, monopsony power is small and there is little gainin being the only buyer.

Number of Buyers

When the number of buyers is very large, no single buyer can have muchinfluence over price. Thus each buyer faces an extremely elastic supplycurve, so that the market is almost completely competitive.

Interaction Among Buyers

If four buyers in a market compete aggressively, they will bid up the priceclose to their marginal value of the product, and will thus have littlemonopsony power. On the other hand, if those buyers compete lessaggressively, or even collude, prices will not be bid up very much, andthe buyers degree of monopsony power might be nearly as high as if

there were only one buyer.

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MONOPSONY POWER10.6

The Social Costs of Monopsony Power

The shaded rectangle andtriangles show changes inbuyer and seller surpluswhen moving from

competitive price andquantity, Pcand Qc,

to the monopsonists price

and quantity, Pmand Qm.

Because both price andquantity are lower, there isan increase in buyer

(consumer) surplus givenbyA B.

Producer surplus falls byA + C, so there is adeadweight loss given bytriangles Band C.

Deadweight Loss from

Monopsony Power

Figure 10.17

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MONOPSONY POWER10.6

Bilateral Monopoly

bilateral monopoly Market with onlyone seller and one buyer.

Monopsony power and monopoly power will tend to counteract each other.

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MONOPSONY POWER10.6

The role of monopsony power wasinvestigated to determine the extent to whichvariations in price-cost margins could beattributed to variations in monopsony power.

The study found that buyers monopsony

power had an important effect on the price-cost margins of sellers.

In industries where only four or five buyers account for all or nearly all sales,the price-cost margins of sellers would on average be as much as 10percentage points lower than in comparable industries with hundreds of buyersaccounting for sales.

Each major car producer in the United States typically buys an individual partfrom at least three, and often as many as a dozen, suppliers.

For a specialized part, a single auto company may be the onlybuyer.

As a result, the automobile companies have considerable monopsony power.

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LIMITING MARKET POWER: THE ANTITRUST LAWS10.7

antitrust laws Rules and regulationsprohibiting actions that restrain, or arelikely to restrain, competition.

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

In 1996, Archer Daniels Midland Company (ADM) and two other majorproducers of lysine (an animal feed additive) pleaded guilty to criminal

charges of price fixing.

In 1999, four of the worlds largest drug and chemical companiesRocheA.G. of Switzerland, BASF A.G. of Germany, Rhone-Poulenc of France,and Takeda Chemical Industries of Japanwere 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 pricefixing by DRAM (dynamic access random memory) producers. By 2006,five manufacturersHynix, Infineon, Micron Technology, Samsung, andElpidahad pled guilty for participating in an international price-fixing

scheme.

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parallel conduct Form of implicitcollusion in which one firm consistentlyfollows actions of another.

predatory pricing Practice ofpricing to drive current competitors outof business and to discourage newentrants in a market so that a firm canenjoy higher future profits.

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The antitrust laws are enforced in three ways:

1. Through the Antitrust Division of the Department of Justice.

2. Through the administrative procedures of the Federal Trade Commission.

3. Through private proceedings.

Enforcement of the Antitrust Laws

Antitrust in Europe

The responsibility for the enforcement of antitrust concerns that involve two ormore member states resides in a single entity, the Competition Directorate.

Separate and distinct antitrust authorities within individual member states areresponsible for those issues whose effects are felt within particular countries.

The antitrust laws of the European Union are quite similar to those of the UnitedStates. Nevertheless, there remain a number of differences between antitrustlaws 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.

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Robert Crandall, president and CEO of American, made a phone call toHoward Putnam, president and chief executive of Braniff. It went like this:

Crandall:I think its dumb as hell for Christs sake, all right, to sit here andpound 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 youre going to overlay every route of Americans on top of

every route that Braniff hasI just cant 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 andhave for years.

Putnam: Do you have a suggestion for me?

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Crandall: Yes, I have a suggestion for you. Raise your @!#$%&! fares 20percent. Ill raise mine the next morning.

Putnam: Robert, we. . .

Crandall:Youll make more money and I will, too.

Putnam: We cant talk about pricing!

Crandall: Oh @!#$%&!, Howard. We can talk about any @!#$%&! thing wewant to talk about.

Crandall was wrong. Talking about prices and agreeing to fix them is a clearviolation of Section 1 of the Sherman Act.

However,proposingto fix prices is not enough to violate Section 1 of theSherman Act: For the law to be violated, the two parties must agreetocollude.

Therefore, because Putnam had rejected Crandalls proposal, Section 1 was

not violated.

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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. Departmentof Justices major claims and Microsofts responses.

DOJ claim: Microsoft has a great deal of market power in the market for PC

operating systemsenough to meet the legal definition of monopoly power.MS response:Microsoft does not meet the legal test for monopoly powerbecause it faces significant threats from potential competitors that offer or willoffer platforms to compete with Windows.

DOJ claim: Microsoft viewed Netscapes Internet browser as a threat to its

monopoly over the PC operating system market. In violation of Section 1 of theSherman Act, Microsoft entered into exclusionary agreements with computermanufacturers and Internet service providers with the objective of raising thecost 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.

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DOJ claim: In violation of Section 2 of the Sherman Act, Microsoft engaged inpractices designed to maintain its monopoly in the market for desktop PCoperating systems. It tied its browser to the Windows 98 operating system,even though doing so was technically unnecessary. This action was predatorybecause it made it difficult or impossible for Netscape and other firms tosuccessfully offer competing products.

MS response:There are benefits to incorporating the browser functionalityinto the operating system. Not being allowed to integrate new functionality intoan operating system will discourage innovation. Offering consumers a choicebetween separate or integrated browsers would cause confusion in themarketplace.

DOJ claim: In violation of Section 2 of the Sherman Act, Microsoft attemptedto divide the browser business with Netscape and engaged in similar conductwith both Apple Computer and Intel.

MS response: Microsofts meetings with Netscape, Apple, and Intel were for

valid business reasons. Indeed, it is useful for consumers and firms to agree

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