Chapter 5 Market Power Does It Help or Hurt the Economy? What's in This Chapter and Why

increase output.

2. If marginal revenue is less than marginal cost, the monopolist should decrease output.

D. Monopoly and Competition Compared

1. Unlike a competitive industry, a monopoly does not produce the efficient output. Monopolists charge a higher price and produce less output than a competitive industry.

a. Efficient output occurs where marginal social cost and marginal social benefit are equal.

b. Inefficiency occurs because of the divergence between marginal social benefit and marginal social cost.

1. At the output produced by the monopolist, marginal social benefit exceeds marginal social cost.

a. The value to consumers of an additional unit exceeds the value of the units of other goods given up to produce the additional unit - the opportunity cost.

III. MARKET POWER AND ECONOMIC EFFICIENCY

A. The Trend in Market Power

1. Some studies indicate that the U.S. economy is becoming more competitive.

a. Increased competition from imports in the manufacturing sector has decreased market power.

b. Government deregulation of the economy has decreased market power.

c. Federal government policies making mergers and price fixing more difficult have decreased market power.

d. The information revolution has increased competition in many industries, resulting in a decrease in market power.

B. Barriers to Entry

1. There are four major sources of market power in the United States.

a. Technical conditions can create entry barriers.

1. Technical conditions might be such that a technically efficient firm will supply all of a good that consumers wish to purchase at the going price.

a. Monopolies created by these technical conditions are sometimes referred to as natural monopolies.

b. Access to the supply of a product or an essential input for a product can create a barrier to entry.

c. Existing firms may develop and maintain market power through product differentiation.

d. Monopolies may be created by government regulations.

IV. OPEC: A FEW SELLERS ACTING LIKE A MONOPOLY

A. Cartel Formation

1. Three variables are important in determining the success of forming and maintaining a cartel.

a. The cartel must reach an agreement that all producers will abide by.

1. This agreement stipulates the total output to be produced by the cartel and the division of production among the members.

b. The cartel must continue to cooperate and come to new agreements as conditions change.

c. The agreement must be enforced.

1. Because it is very profitable for cartel members to cheat on the original agreement, there must be some method of enforcement.

B. The Determinants of Cartel Success

1. The fewer the number of firms and the more similar they are, the easier it is to form and operate a cartel.

a. As the number of firms increases, it becomes more difficult to include all the firms in the industry.

b. As the number of firms increases, it becomes more difficult to detect cheating on the agreement.

2. If firms are not similar, it becomes more difficult to determine the division of output and profits.

C. Problems of the OPEC Cartel

1. There are three factors accounting for the serious problems encountered by the OPEC cartel.

a. There are many members, as well as several nonmember petroleum producers.

1. The existence of large profits attracted entry to the industry and drove the price of petroleum down.

b. The members are dissimilar in that they have different and conflicting goals.

1. Countries with small reserves relative to population want higher prices now, while countries with relatively large reserves are more concerned with long‑run profits.

c. The demand for petroleum is more elastic in the long run.

1. Over time consumers have made adjustments to the higher OPEC price.

V. MARKET POWER AND ECONOMIC GROWTH

A. Basis of Economic Growth

1. Knowledge and the creation of new knowledge are the basis for much economic growth and for the growth of many firms.

2. Knowledge-based firms have several feature that lead to a monopoly or near-monopoly of their products.

a. The development of the product involves huge start-up costs.

b. There are large up-front costs involved in producing the product that has been developed.

3. Government grants monopolies of new products through copyrights and patents so that firms can cover the start-up and up-front costs of developing a product.

a. Microsoft’s first disk of Windows probably cost $50 million. Subsequent disks cost $3.

VI. GOVERNMENT AND MARKET POWER

A. Antitrust Laws

1. Antitrust laws prohibit price fixing and other types of explicit cartel or monopoly behavior.

2. Antitrust laws prohibit mergers in certain instances.

a. A merger is a combination of two or more firms into one firm.

3. Through the use of antitrust laws, government discourages market power.

4. Antitrust laws should not necessarily be used to restructure all firms with market power.

a. If the industry is a natural monopoly, monopoly profit may provide incentives for innovations that, over time, would reduce or eliminate market power.

b. The existence of monopoly profits provides an incentive for economic rent seeking.

c. The existence of profits encourages new firms to come into the industry causing prices to be lowered.

Efficient output occurs when the value of one more unit of a good equals its cost, where marginal social benefit equals marginal social cost. Observe the following graph, which represents the market for computers.

Suppose that the firm is considering producing an additional computer which will expand output to Q₁. At Q₁, the demand price is $2,000, while the supply price is only $800. If the computer is produced, consumers of computers will gain $2,000 in benefits. In order to produce the computer, society will have to sacrifice $800 worth of other goods and services. It would be possible for those who gain the $2,000 of benefits to reimburse those who lose the $800 of benefits and still be better off. This would result in a net gain of benefits equal to $1,200 ($2,000 ‑ $800).

Now suppose the firm is considering producing an additional computer which will expand output to Q₂. At Q₂, the supply price is $2,000, while the demand price is only $800. If an additional computer is produced there will be a net loss to society of $1,200. This loss implies that resources should be allocated away from computer production. By cutting back on computer output and increasing output in other industries, consumers of computers will lose $800 worth of benefits while others in society will gain $2,000 worth of benefits. Consumers of other goods could reimburse consumers of computers for their loss in benefits and still be better off. Net benefits, and hence efficiency, will increase. At any point where the supply price is greater than the demand price, net benefit can be increased by reallocating resources away from this industry. Such a point is inefficient.

Suppose output is at Q₃ where the demand price and supply price are equal. If production were increased, the supply price would exceed the demand price. There is no way to compensate consumers of other goods for the benefits they would forego as resources are allocated to the production of computers. Likewise if production were decreased, the demand price would exceed the supply price. There is no way to compensate consumers of computers for the benefits they would forego as resources are allocated to the production of other goods and services. In both cases, one group in society will benefit and another will be made worse off. Only at the point where the demand price and the supply price are equal will net benefits be maximized and efficiency obtained. Because the demand price equals marginal benefit and the supply price equals marginal cost, equality of the demand and supply prices implies that marginal benefit and marginal cost are equal.

In order to understand why a pure competitor's marginal revenue is equal to price and why a monopolist's marginal revenue is less than price, recall the following facts. A pure competitor is one of many producers of a homogenous good. She faces a horizontal demand curve. This means that she can sell all the output she wishes at the market price. She is a price taker. A monopolist, on the other hand, is the only producer of a good with no close substitutes. He, in effect, is the industry and faces a downward sloping demand curve. This means that in order to sell additional units of output he must lower the price of the product. The monopolist is a price searcher.

Why does this mean that the pure competitor's marginal revenue is the same as the market price while the monopolist's marginal revenue is less than the market price? Marginal revenue is the change in total revenue associated with a one unit change in output. For a pure competitor, each additional unit of output sold will increase total revenue by an amount equal to the market price. For example, Christie, a pure competitor, sells one hundred pieces of pizza for $2 per slice. Her total revenue is $200. If she sells one hundred one pieces of pizza her total revenue is $202. Marginal revenue is $202 less $200 or $2, and $2 is the market price of pizza. Because Christie does not have to lower price in order to sell more, marginal revenue will be equal to market price.

For a monopolist, each additional unit of output sold will increase total revenue by an amount less than the market price. For example, Dan, a monopolist, can sell one bottle of Dr. Goodbody's cure‑all for $5 per bottle. His total revenue will be $5. In order to induce customers to buy more than one bottle of the tonic, he must reduce the price. This lower price must be charged for all bottles sold. Thus, to sell two bottles of cure‑all he must lower the price to $4.00 per bottle. His total revenue will now be $8 ($4 x 2). His marginal revenue will be the change in total revenue, $8 less $5, or $3. Because Dan must lower price in order to induce customers to take a greater quantity, marginal revenue will be less than price.

a. The firm's total revenue is price times quantity sold or P x Q. Applying this formula, the total revenue associated with the first unit of output is found to be 1 x $50 or $50. Using this formula the total revenue associated with each unit of output sold can be derived. These results are exhibited in column (a) in the table below.

d. If the monopolist is producing 5 units, her marginal cost is $20 while her marginal revenue is $10. The revenue received from the sale of this unit is less than the cost of producing this unit. Production of this unit will cause profits to fall by $10 ($20 ‑ $10). In order to maximize profits, the firm should cut back on output. In this instance, as output falls, profits will rise.

The statement is false. While it is true that the monopolist is not a price taker and does exert control over the price of output, profit maximization means she cannot charge any price she desires. In the previous question, the monopolist maximized profit by selling 4 units at a price of $35 per unit. If she were to raise the price to $45 per unit and still sell 4 units, profit would go up by $40. But at the price of $45 she can only sell 2 units. Even though she charges a higher price, her profit goes down by $10 because she sells fewer units. The law of demand puts a constraint on the price charged by a monopolist.

The monopolist follows the marginal principle in maximizing profits. This principle states that the output which will maximize profits is the output at which marginal revenue and marginal cost are equal. If marginal revenue is greater than marginal cost, the monopolist should increase output. If marginal revenue is less than marginal cost, the monopolist should decrease output.

D represents the monopolist's demand, MR his marginal revenue, and MC his marginal cost. We have already discussed the fact that marginal revenue lies below the demand curve because that the monopolist must lower price in order to sell more output. Suppose the monopolist is currently producing output 0Q₁. At 0Q₁, marginal revenue is equal to OR₁ or distance AC, while marginal cost is equal to OC₁ or distance AB. If output is increased by one unit, profits will rise by an amount equal to OR₁ minus OC₁ or distance BC. Thus, anytime the monopolist is producing at a point where marginal revenue exceeds marginal cost, it is possible to increase profits by increasing output.

Likewise, if the monopolist is producing output 0Q₂, marginal revenue will be OR₂ or distance EF. Marginal cost will be OC₁ or distance EG. The firm is earning a loss of OR₂ minus OC₁ or FG on this unit of output. By decreasing output by one unit, profits will increase by FG. Thus, anytime the monopolist is producing at a point where marginal cost exceeds marginal revenue, it is possible to increase profits by decreasing output. Only where marginal cost and marginal revenue are equal (output Q₃) will profits be at a maximum.

6. Use graphical analysis to compare and contrast the economic outcome of monopoly with the economic outcome of pure competition.

The following graph can be used to compare the economic outcome of monopoly with the economic outcome of pure competition.

The supply curve for the competitive industry (S) is the marginal cost curve (MC) for the monopoly. D, the demand curve, is the same for both monopoly and pure competition. Equilibrium for pure competition occurs where demand and supply intersect at point A. Output is 0Q₁ and price is OB. Profits are zero (there is a normal rate of earnings).

The monopolist produces where marginal revenue and marginal cost are equal at point E. Output is 0Q₂ and price is OF. Monopoly profit is equal to area BFGE. So monopoly price is higher than the competitive price and monopoly output is lower. The monopolist may earn a profit. For the competitive industry, demand price (marginal benefit for society) equals the supply price (marginal cost to society). All potential gains from trade are realized. For the monopoly, marginal revenue (marginal benefits for the monopolist) equals the supply price. Because demand price is greater than marginal revenue, demand price is greater than supply price. Marginal benefit for society exceeds marginal cost, and there are unrealized gains from trade.

7. "Because a monopolist can extract a higher price than a firm that is a pure competitor, the monopolist will always earn a profit." Is this statement true or false? Defend your answer.

This statement is false. In order to maximize profits, the monopolist must produce the quantity at which marginal revenue and marginal cost are equal. This means that the monopolist is not free to charge whatever price she desires. Instead she must charge the price that consumers are willing to pay for this profit maximizing quantity. Depending upon the monopolist's costs relative to consumer demand, it is possible that no profit will be earned. The monopolist may even earn a loss.

There are four major sources of monopoly in the United States: technical conditions that require production to take place on a very large scale, control of the supply of a product or of essential production inputs, product differentiation, and government regulation. If technical conditions are such that a factory must produce an extremely large output in order to be technically efficient, it is possible that a single firm could provide the majority of output that consumers would want to buy. In this instance, a monopoly‑type structure would emerge. Cable television supplies an example of this situation.

Monopoly may also emerge if a single firm or a small group of firms control the only source of supply of a product or an essential input for a product. For example, the DeBeers Company controls most of the world's diamond production, and hence has a monopoly on the world diamond market.

Firms may also develop and maintain market power through product differentiation. If firms can convince consumers that their product is superior, they can raise price and make only a small sacrifice in terms of sales.

Finally, government regulations have been a source of monopoly. For example, regulations limiting the number of doctors that are able to enter the medical profession work to restrict supply and raise price. Tariffs and other types of regulation designed to limit the number of imports have the same effect on the price of the regulated goods. Thus, government actions may actually hinder competition and thereby impose a loss on society.

9. What is a cartel? What factors help to maintain a cartel? What factors encourage its dissolution?

A cartel is an organized group of producers who manage their output and pricing as if they were a monopoly. The purpose of the cartel is to restrict output and raise price above the competitive price. In order to be successful, the cartel must do two things: restrict output and restrict the entry of new firms. The major incentive holding the cartel together is the incentive to earn a profit. As long as the cartel succeeds, price will be above marginal cost and the firms may earn a monopoly profit.

While the desire for profit works to hold the cartel together, this same desire works to dissolve the cartel. As long as output is restricted, the price will be a monopoly price. Suppose a firm cheats by expanding output. It can now sell more output at the monopoly price and earn a profit even greater than the one possible under the cartel agreement. This same incentive works upon the other firms in the cartel. If all firms cheat, industry supply will increase and price will fall.

The larger the number of firms in the industry, the more difficult it will be to detect the cheater. For example, if there are only two firms in the cartel and price begins to fall, it is relatively easy to discover if the price decrease is due to a decrease in demand or due to an expansion of output by one of the firms. On the other hand, if there are fifteen firms in the cartel, it becomes much more difficult to identify the source of the price decline. With detection less easy, the cost the cheater would have to bear through cartel discipline falls and cheating becomes more prevalent.

In addition to increasing the probability of cheating, large numbers also make it difficult for firms to reach an agreement that will allow the cartel to organize. As the number of firms increases, it becomes more and more difficult to include all or at least most of the major firms in the industry. There are likely to problems of a "holdout," a firm that refuses to join the cartel, but reaps the benefits of increased profits if the cartel is formed.

Another problem with large numbers of firms is the fact that increases in numbers are generally accompanied by increases in heterogeneity. The less similar the firms, the more difficult it becomes to reach agreement. For example, suppose all firms in the group can be broken into two groups: low‑cost producers and high‑cost producers. In order to produce output at minimum cost the low‑cost producers will have to produce a greater share of industry output. These producers may feel that they deserve a greater share of industry profits. High‑cost producers, on the other hand, may argue that because they were forced to cut back on their production they should receive a share of profits greater than their output share. The possibility of these and other conflicts makes a cartel agreement very difficult to reach as the number of firms increases.

Government provides drug companies with this market power through the granting of patents. While it is true that drug companies do profit from their products, the role that this profit plays in the development of new drugs must be considered. The research undertaken by this companies is both expensive and risky. Thus, the profits that companies reap as a result of patents induces firms to bear this expense and risk. Goldberg argues that monopoly profits are necessary to get firms to undertake the research necessary to discover and develop new drugs. Without such activity, drugs to treat serious diseases would not be available. Nevertheless, as Friedman, a staunch advocate of the market, says, a situation may exist which requires government intervention to regulate an "essential" monopolized good. This is a judgement call.

It is true that an effort to eliminate monopoly profits either through regulations that would increase competition or through regulations that would eliminate monopoly profit may increase economic efficiency. It is equally true that policies to eliminate such profits may have some undesirable consequences. The possibility of obtaining monopoly profits encourages economic rent seeking. Economic rent seeking means that individuals attempt to gain an economic advantage by offering improved products or by producing products at a lower cost. Eliminating monopoly profits will decrease this incentive, thereby imposing some cost on society.

In addition to lowering incentives to engage in economic rent seeking, the elimination of profits inhibits the potential threat of entry into the monopoly industry. Monopoly profits signal other producers that resources should flow into the industry. The threat of entry encourages the monopolist to charge a price less than that which would be charged in the absence of the threat. Eliminating profits reduces the incentive for resources to flow into the industry and thereby lowers the threat of entry. As a result, a monopolist may be able to extend his or her power. These arguments show that although monopoly does cause inefficiency in society, any actions designed to eliminate the monopoly must be carefully evaluated.

12. According to the box, “The Battle between American and Japanese Automobile Firms,” why were the Japanese firms successful in the battle?

Japanese firms were successful in the battle because management in the U. S. automobile industry enjoyed the “quiet life.” In 1981, wages in the automobile industry were 50 percent greater than average wages in manufacturing. In addition, management allowed production methods to become obsolete and ignored quality problems. When the energy crisis occurred in the 1970s, it caught U. S. car manufacturers off guard. Demand for imports surged. These cars were cheaper and of a higher quality than their U. S. counterparts. Japanese managers adopted quality-control, inventory, and human relations policies that resulted in productivity that exceeded U. S. manufacturers. Just-in-time manufacturing, quality circles, and continuous improvement also contributed to the productivity of Japanese firms.

If the widespread belief that the Mac operating system is technically superior to the MS system is true, then we are now entrenched on an inefficient technological path that the market cannot reverse. The primary advantage of government choosing the industry standard for computer operating systems is that they would likely choose the system that is technically efficient. This, of course, assumes that there are government officials with the expertise to make this decision.

A disadvantage of allowing the government to set the standard for computer operating systems is that the government’s choice may not be the choice that maximizes the satisfaction of the most consumers. Despite technical inefficiencies, the public may place a greater value on MS systems.

Another disadvantage of allowing the government to choose our operating system is that this would likely stifle innovation on the part of potential competitors in this market. Microsoft achieved its dominance through economic rent-seeking. Had the government chosen the Mac as the standard for operating systems, MS would have had no economic incentive for innovation. In addition, Apple would have no incentive for innovation since they are already guaranteed dominance through the government’s protection.

Although some argue that the early Mac operating system was technically superior to DOS, the MS DOS systems were still chosen over the Mac. Authors Liebowitz and Margolis argue that the DOS systems were superior with respect to cost. First, DOS was cheaper because it took less computing power than the Mac’s graphical interface. Second, DOS was faster. Third, Mac’s had limited hard drive capacity; therefore, users had to change floppies in order to change programs.