― Anna Lappe
Monopoly and Antitrust Policy (Part B)
by
Charles Lamson
Price and Output Decisions in Pure Monopoly Markets
To analyze monopoly behavior, we make two assumptions: (1) that entry to the market is blocked, and (2) that firms act to maximize profits. Initially, we also assume that our pure monopolist buys in competitive input markets. Even though the firm is the only one producing for its product market, it is only one among many firms buying factors of production in input markets. The local telephone company must hire labor like any other firm. To attract workers it must pay the market wage; to buy fiber optic cable, it must pay the going price. In these input markets the monopolistic firm is a price-taker (a company that must accept the prevailing prices in the market of its products, its own transactions being unable to affect the market price). On the cost side of the profit equation, a pure monopolist does not differ one bit from a perfect competitor (Perfect competition is theoretically the opposite of a monopolistic market). Both choose the technology that minimizes the cost of production. The cost curve of each represents the minimum cost of producing each level of output. The difference arises on the revenue, or demand, side of the equation, where we begin our analysis. Demand in Monopoly Markets A perfectly competitive firm, you will recall, faces a fixed, market demand price, and we assumed it can sell all it wants to sell at that price; it is constrained only by its current capacity in the short run. The demand curve facing such a firm is thus a horizontal line (Figure 2). Raising the price of its product means losing all demand, because perfect substitutes are available. The perfectly competitive firm has no incentive to change a lower price either.  Because a perfectly competitive firm can charge only one price, regardless of the output level chosen, its marginal revenue---the additional revenue that it earns by raising output by one unit---is simply the price of the output, or P* = $5 in Figure 2. Remember that marginal revenue is important because a profit-maximizing firm will increase output as long as marginal revenue exceeds marginal cost.  The most important distinction between perfect competition and monopoly is that with one firm in a monopoly market, there is no distinction between the firm and the industry. In a monopoly, the firm is the industry. The market demand curve is the demand curve facing the firm, and the total quantity supplied in the market is what the firm decides to produce. To proceed, we need a few more assumptions. First, we assume that a monopolistic firm cannot price discriminate. It sells its product to all demanders at the same price. (Price discrimination means selling to different consumers or groups of consumers at different prices.) We also assume that the monopoly faces a known demand curve. That is, we assume that the firm has enough information to predict how households will react to different prices. (Many firms use statistical methods to estimate the elasticity of demand for their products. Other firms may use less formal methods, including trial and error, sometimes called "price searching." All firms with market power must have some sense of how customers are likely to react to various prices.) By knowing the demand curve it faces, the firm must simultaneously choose both the quantity of output to supply and the price of that output. Once the firm chooses a price, the market determines how much will be sold. Stated somewhat differently, the monopoly chooses the point on the market demand curve where it wants to be. Marginal Revenue and Market Demand Just like a competitor, a profit-maximizing monopolist will continue to produce output as long as marginal revenue exceeds marginal cost. Because the market demand curve is the demand curve for a monopoly, a monopolistic firm faces a downward-sloping demand curve. Consider the hypothetical demand schedule in Table 1. Column 3 lists the total revenue that the monopoly would take in at different levels of output. If it were to produce one unit, that unit would sell for $10, and total revenue would be $10. Two units would sell for $9 each, in which case total revenue would be $18. As column 4 shows, marginal revenue from the second unit would be $8 ($18 - $10). Notice that the marginal revenue from increasing output from one unit to two units ($8) is less than the price of the second unit ($9).    Moving from 6 to 7 units of output actually reduces total revenue for the firm. At 7 units, marginal revenue is negative. Although it is true that the 7th unit will sell for a positive price ($4), the firm must sell all seven units for $4 each (for a total revenue of $28). If output had been restricted to six units, each would have sold for $5. Thus, offsetting the revenue gain of $4 is a revenue loss of $6---that is, $1 for each of the six units that the firm would have sold at the higher price. Increasing output from 6 to 7 units actually decreases revenue by $2. Figure 3 graphs the marginal revenue schedule derived in Table 1. Notice that at every level of output except one unit, marginal revenue is below price. Marginal revenue turns from positive to negative after 6 units of output. When the demand curve is a straight line, the marginal revenue curve bisects the quantity axis between the origin and the point where the demand curve hits the quantity axis Figure 4.  Look carefully at figure 4. What you can see in the diagram is that a monopoly's marginal revenue curve shows the change in total revenue that results as a firm moves along the segment of the demand curve that lies directly above it. Consider starting at an output of 0 units per period in the top panel of Figure 4. At zero units, of course, total revenue (shown in the bottom panel) is 0 because nothing is sold. To begin selling, the firm must lower the product price. Marginal revenue is positive. And total revenue begins to increase. To sell increasing quantities of the good, the firm must lower its price more and more. As output increases between 0 and Q* and the firm moves down its demand curve from point A to point B, marginal revenue remains positive and total revenue continues to increase. The quantity of output (Q) is rising, which tends to push total revenue (P * Q) up. At the same time, the price of output (P) is falling, which tends to push total revenue (P * Q) down. Up to point B, the effect of increasing Q dominates the effect of falling P, and total revenue rises: marginal revenue is positive (above the quantity axis).      A monopoly firm has no supply curve that is independent of the demand curve for its product. To see why, consider what a firm's supply curve means. A supply curve shows the quantity of output the firm is willing to supply at each price. If we ask a monopolist how much output she is willing to supply at a given price, the monopolist will say her supply behavior depends not just on marginal cost but also on the marginal revenue associated with the price. To know what that marginal revenue would be, the monopolist must know what her demand curve looks like.  In sum: in perfect competition, we can draw a firm's supply curve without knowing anything more than the firm's marginal cost curve. The situation for a monopolist is more complicated. A monopolist sets both price and quantity, and the amount of output that it supplies depends on both its marginal cost curve and the demand curve that it faces. Monopoly in the Long and Short Run In our analysis of perfectly competitive markets we distinguished between the long run and the short run. In the short run, all firms face some fixed factor of production, and no entry into or exit from the industry is possible. The assumption of a fixed factor of production is the primary reason that marginal cost increases with output in the short run. That is, the short run marginal cost curve of a typical competitive firm slopes upward and to the right because of the limitations imposed by the fixed factor. In the long run, however, firms can enter and exit the industry. Long-run equilibrium is established when the entry and exit of firms drives profits in the industry to zero. The distinction between the long and short runs is less important in monopoly markets. In the short run, monopolists are limited by a fixed factor of production, as competitive firms are. The cost curves in Figure 5 reflect the diminishing return to the monopoly's fixed factor of production---for example, plant size. What will happen to the monopoly in the long run? If the monopoly is earning positive profits (a rate of return above the normal rate of return to capital), nothing will happen. In competition, positive profits lead to expansion and entry, but in a monopoly, entry is blocked. In addition, because we assumed that the monopoly is a profit-maximizing firm, it will operate at the most efficient scale of production, and it will neither expand nor contract in the long run. Thus, Figure 5 will not change in the long run.    Similarly, in the long run, a firm that cannot generate enough revenue to cover total costs will go out of business, whether it is perfectly competitive or a monopoly. Because the demand curve in Figure 6 lies completely below the average total cost curve, the monopoly will go out of business in the long run, and its product will not be produced because it is simply not worth the cost of production to buyers.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 257-263* end |
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