Hubbard Obrien MacroEconomics 2nd edition chapter 09

Chapter 9

Monopoly andAntitrust PolicyTime Warner RulesManhattan

Today most people can hardly imag-ine life without cable television. Infact, almost 80 percent of U.S. homeshave cable television: a larger fractionthan have clothes dryers, dishwashers,air conditioning, or personal comput-ers. The first cable systems were estab-lished in the 1940s in cities that weretoo small to support broadcast sta-tions. Those systems consisted of largeantennas set up on hills to receivebroadcasts from television stationswithin range. The signals were thentransmitted by cable to individualhouses.

The cable industry grew slowlybecause the technology did not existto rebroadcast the signals of distantstations, so cable systems offered justa few channels. By 1970, only about 7percent of households had cable tele-vision. In addition, the Federal Com-munications Commission (FCC)—the U.S. government agency that regu-lates the television industry—placedrestrictions on both rebroadcastingthe signals of distant stations and thefees that could be charged for “pre-mium channels” that would showmovies or sporting events. In the

late 1970s, two key developmentsoccurred: First, satellite relay technol-ogy made it feasible for local cablesystems to receive signals relayedby satellite from distant broadcaststations. Second, Congress loosenedregulations on rebroadcasting distantstations and premium channels. Theresult of these developments was thegrowth of both “superstations,” whichare local broadcast stations in largecities—such as New York, Chicago,and Atlanta—whose programming issent by satellite to cable systemsaround the country, and premiumchannels, such as Home Box Office(HBO).

One of the most successful of thesuperstations was WTBS, started byAtlanta entrepreneur Robert Edward“Ted” Turner III. Turner went on tofound the Turner Broadcasting System(TBS), which included the Cable NewsNetwork (CNN), the first 24-hournews network. In 2001, Turner wasinvolved in the largest merger of enter-tainment companies in history, whenAOL Time Warner was formed. Thecompany—now known as TimeWarner—was made up of leadingfirms from four segments of the enter-tainment industry: Warner Brothers(movie making), Time (magazinepublishing), TBS (cable television),

and AOL (Internet). Today, TimeWarner operates cable systems in 22states through Time Warner Cable.

A firm needs a license from thecity government to enter a local cabletelevision market. If you live inManhattan and you want cable televi-sion, you have to purchase it fromTime Warner Cable. Other cable com-panies could ask the New York Citygovernment for licenses to competeagainst Time Warner Cable inManhattan, but none have. This is notan unusual situation for a cable televi-sion system: Of the nearly 9,000 mar-kets for cable television in the UnitedStates, fewer than 400 have competingcable systems.

As the only provider of cable TVin Manhattan, Time Warner has amonopoly. Few firms in the UnitedStates are monopolies because in amarket system, whenever a firm earnseconomic profits, other firms willenter its market. Therefore, it is verydifficult for a firm to remain the onlyprovider of a good or service. In thischapter, we will develop an economicmodel of monopoly that can help usanalyze how such firms affect the econ-omy. AN INSIDE LOOK AT POLICYon page xxx explores how legislationin California is lowering barriers toentry in the cable TV market.

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LEARNING ObjectivesAfter studying this chapter, youshould be able to:

9.1 Define monopoly, page xxx.

9.2 Explain the four main reasonsmonopolies arise, page xxx.

9.3 Explain how a monopoly choosesprice and output, page xxx.

9.4 Use a graph to illustrate how amonopoly affects economicefficiency, page xxx.

9.5 Discuss government policiestoward monopoly, page xxx.

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Economics in YOUR Life!

Why Can’t I Watch the NFL Network?Are you a fan of the National Football League? Would you like to see more NFL-related program-ming on television? If so, you’re not alone. The NFL felt there was so much demand for more foot-ball programming that it began its own football network, the NFL Network.

Unfortunately for many football fans, the NFL Network is not available to most households withcable television. Why are some of the largest cable TV systems unwilling to include the NFL Networkin their channel lineups? Why are some systems requiring customers who want the NFL Network toupgrade to more expensive channel packages or digital service? As you read this chapter, see if youcan answer these questions. You can check your answers against those we provide at the end of thechapter. >> Continued on page xxx


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Is Xbox 360 a Close Substitute for PlayStation 3?In the early 2000s, Microsoft’s Xbox and Sony’s PlayStation 2(PS2) were the best-selling video game consoles. When the two

companies began work on the next generation of consoles, they had important decisionsto make. In developing the Xbox, Microsoft had decided to include a hard disk and aversion of the Windows computer operating system. As a result, the cost of producing

276 PA R T 4 | Market Structure and Firm Strategy

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9.1 LEARNING OBJECTIVE

Monopoly A firm that is the onlyseller of a good or service that doesnot have a close substitute.

Although few firms are monopolies, the economic model of monopoly can still be

quite useful. As we saw in Chapter 8, even though perfectly competitive markets

are rare, this market model provides a benchmark for how a firm acts in the most

competitive situation possible: when it is in an industry with many firms that all

supply the same product. Monopoly provides a benchmark for the other extreme, where a

firm is the only one in its market and, therefore, faces no competition from other firms sup-

plying its product. The monopoly model is also useful in analyzing situations in which firms

agree to collude, or not compete, and act together as if they were a monopoly. As we will dis-

cuss in this chapter, collusion is illegal in the United States, but it occasionally happens.

Monopolies also pose a dilemma for the government. Should the government allow

monopolies to exist? Are there circumstances in which the government should actually pro-

mote the existence of monopolies? Should the government regulate the prices monopolies

charge? If so, will such price regulation increase economic efficiency? In this chapter, we will

explore these public policy issues.

9.1 | Define monopoly.

Is Any Firm Ever Really a Monopoly?A monopoly is a firm that is the only seller of a good or service that does not have a closesubstitute. Because substitutes of some kind exist for just about every product, can any firmreally be a monopoly? The answer is “yes,” provided that the substitutes are not “close” sub-stitutes. But how do we decide whether a substitute is a close substitute? A narrow definitionof monopoly that some economists use is that a firm has a monopoly if it can ignorethe actions of all other firms. In other words, other firms must not be producing closesubstitutes if the monopolist can ignore the other firms’ prices. For example, candles are asubstitute for electric lights, but your local electric company can ignore candle prices becausehowever low the price of candles falls, almost no customers will give up using electric lightsand switch to candles. Therefore, your local electric company is clearly a monopoly.

Many economists, however, use a broader definition of monopoly. For example, sup-pose Joe Santos owns the only pizza parlor in a small town. (We will consider later thequestion of why a market may have only a single firm.) Does Joe have a monopoly?Substitutes for pizzas certainly exist. If the price of pizza is too high, people will switch tohamburgers or fried chicken or some other food instead. People do not have to eat at Joe’sor starve. Joe is in competition with the local McDonald’s and Kentucky Fried Chicken,among other firms. So, Joe does not meet the narrow definition of a monopoly. But manyeconomists would still argue that it is useful to think of Joe as having a monopoly.

Although hamburgers and fried chicken are substitutes for pizza, competition fromfirms selling them is not enough to keep Joe from earning economic profits. We saw inChapter 8 that when firms earn economic profits, we can expect new firms to enter theindustry, and in the long run, the economic profits are competed away. Joe’s profits willnot be competed away as long as he is the only seller of pizza. Using the broader defini-tion, Joe has a monopoly because there are no other firms selling a substitute closeenough that his economic profits are competed away in the long run.


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C H A P T E R 9 | Monopoly and Antitrust Policy 277


the Xbox was much higher than the cost to Sony of producing thePlayStation 2. Microsoft was not concerned by the higher produc-tion cost because it believed it would be able to charge a higherprice for Xbox than Sony charged for PlayStation 2. Unfortunatelyfor Microsoft, consumers considered the Sony PS2 a close substi-tute for the Xbox. Microsoft was forced to charge the same pricefor the Xbox that Sony charged for the PS2. So, while Sony wasable to make a substantial profit at that price, Microsoft initiallylost money on the Xbox because of its higher costs.

In developing the next generation of video game consoles, bothcompanies hoped to produce devices that could serve as multipur-pose home-entertainment systems. To achieve this goal, the newsystems needed to play DVDs as well as games. Sony developed anew type of DVD called Blu-ray. Blu-ray DVDs can store five timesas much data as conventional DVDs and can play back high-definition (HD) video. Sony’s decision to give the new PlayStation 3(PS3) the capability to play Blu-ray DVDs was risky in two ways: First, it raised the cost ofproducing the consoles. Second, because there is a competing second-generation standardfor DVDs, called HD-DVD, the PlayStation 3 would not be capable of playing all availablesecond-generation DVDs, thereby reducing its appeal to some consumers. Microsoftdecided to sell its Xbox 360 with only the capability of playing older-format DVDs, whilemaking available an add-on component that would play HD-DVDs.

At first it appeared that Microsoft may have made the better decision. Consumersseemed to consider the PS3 and the Xbox to be close substitutes. In that case, the factthat the PS3’s price was $200 higher than the Xbox 360’s price was a significant problemfor Sony. By 2008, however, the PS3 received a boost when most film studios decided tostop producing HD-DVDs and release films only in the Blu-ray format.

Sources: Stephen H, Wildstrom, “PlayStation 3: It’s Got Game,” BusinessWeek, December 4, 2006; and “Sony: Playing a LongGame,” Economist, November 16, 2006.

YOUR TURN: Test your understanding by doing related problem 1.7 on page xxx at the end

of this chapter.

9.2 | Explain the four main reasons monopolies arise.

Where Do Monopolies Come From?Because monopolies do not face competition, every firm would like to have a monopoly.But to have a monopoly, barriers to entering the market must be so high that no otherfirms can enter. Barriers to entry may be high enough to keep out competing firms forfour main reasons:

1 Government blocks the entry of more than one firm into a market.

2 One firm has control of a key resource necessary to produce a good.

3 There are important network externalities in supplying the good or service.

4 Economies of scale are so large that one firm has a natural monopoly.

Entry Blocked by Government ActionAs we will discuss later in this chapter, governments ordinarily try to promote competi-tion in markets, but sometimes governments take action to block entry into a market. Inthe United States, government blocks entry in two main ways:

1 By granting a patent or copyright to an individual or firm, giving it the exclusiveright to produce a product.

2 By granting a firm a public franchise, making it the exclusive legal provider of a goodor service.

To many gamers, PlayStation 3 is a close substitute for Xbox.


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The End of the Christmas Plant MonopolyIn December, the poinsettia plant seems to be almost every-where, decorating stores, restaurants, and houses. Although it

may seem strange that anyone can have a monopoly on the production of a plant, formany years the Paul Ecke Ranch in Encinitas, California, had a monopoly on poinsettias.

The poinsettia is a wildflower native to Mexico. It was almost unknown in theUnited States before Albert Ecke, a German immigrant, began selling it in the early twen-tieth century at his flower stand in Hollywood, California. Unlike almost every otherflowering plant, the poinsettia blossoms in the winter. This timing, along with the plant’sstriking red and green colors, makes the Poinsettia ideal for Christmas decorating.

Albert Ecke’s son, Paul, discovered that by grafting together two varieties of poinset-tias, it was possible to have multiple branches grow from one stem. The result was a plantthat had more leaves and was much more colorful than conventional poinsettias. PaulEcke did not attempt to patent his new technique for growing poinsettias. But because theEcke family kept the technique secret for decades, it was able to maintain a monopoly onthe commercial production of the plants. Unfortunately for the Ecke family—but fortu-nately for consumers—a university researcher discovered the technique and published itin an academic journal.

New firms quickly entered the industry, and the price of poinsettias plummeted.Soon consumers could purchase them for as little as three for $10. At those prices, theEcke’s firm was unable to earn economic profits. Eventually, Paul Ecke III, the owner ofthe firm, decided to sell off more than half the firm’s land to fund new state-of-the-art


Patents and Copyrights The U.S. government grants patents to firms that develop newproducts or new ways of making existing products. A patent gives a firm the exclusive rightto a new product for a period of 20 years from the date the product is invented. BecauseMicrosoft has a patent on the Windows operating system, other firms cannot sell their ownversions of Windows. The government grants patents to encourage firms to spend moneyon the research and development necessary to create new products. If other firms couldhave freely copied Windows, Microsoft is unlikely to have spent the money necessary todevelop it. Sometimes firms are able to maintain a monopoly in the production of a goodwithout patent protection, provided that they can keep secret how the product is made.

Patent protection is of vital importance to pharmaceutical firms as they developnew prescription drugs. Pharmaceutical firms start research and development work on anew prescription drug an average of 12 years before the drug is available for sale. A firmapplies for a patent about 10 years before it begins to sell the product. The average 10-year delay between the government granting a patent and the firm actually selling thedrug is due to the federal Food and Drug Administration’s requirements that the firmdemonstrate that the drug is both safe and effective. Therefore, during the period beforethe drug can be sold, the firm will have substantial costs to develop and test the drug. Ifthe drug does not make it successfully to market, the firm will have a substantial loss.

Once a drug is available for sale, the profits the firm earns from the drug will increasethroughout the period of patent protection—which is usually about 10 years—as the drugbecomes more widely known to doctors and patients. After the patent has expired, otherfirms are free to legally produce chemically identical drugs called generic drugs. Gradually,competition from generic drugs will eliminate the profits the original firm had been earn-ing. For example, when patent protection expired for Glucophage, a diabetes drug manu-factured by Bristol-Myers Squibb, sales of the drug declined by more than $1.5 billion inthe first year due to competition from 12 generic versions of the drug produced by otherfirms. When the patent expired on Prozac, an antidepressant drug manufactured by EliLilly, sales dropped by more than 80 percent. Most economic profits from selling a pre-scription drug are eliminated 20 years after the drug is first offered for sale.

At one time, the Ecke family had amonopoly on growing poinsettias,but many new firms entered theindustry.

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Patent The exclusive right to aproduct for a period of 20 years fromthe date the product is invented.


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greenhouses and research into new varieties of plants that he hoped would earn the firmeconomic profits once again. One of the firm’s new products was a variety of white poin-settias that could be spray-painted in different colors and sold for $10 or more—doublethe price of plain poinsettias.

Sources: Bart Ziegler, “What Color Is Your Poinsettia?” Wall Street Journal, December 14, 2006; Cynthia Crossen, “Holiday’sUbiquitous Houseplant,” Wall Street Journal, December 19, 2000; and Mike Freeman and David E. Graham, “Ecke RanchPlans to Sell Most of Its Remaining Land,” San Diego Union-Tribune, December 11, 2003.


of this chapter.

Just as the government grants a new product patent protection, books, films, andsoftware receive copyright protection. U.S. law grants the creator of a book, film, orpiece of music the exclusive right to use the creation during the creator’s lifetime. Thecreator’s heirs retain this exclusive right for 70 years after the creator’s death. In effect,copyrights create monopolies for the copyrighted items. Without copyrights, individu-als and firms would be less likely to invest in creating new books, films, and software.

Public Franchises In some cases, the government grants a firm a public franchisethat allows it to be the only legal provider of a good or service. For example, state andlocal governments often designate one company as the sole provider of electricity, nat-ural gas, or water.

Occasionally, the government may decide to provide certain services directly to con-sumers through a public enterprise. This is much more common in Europe than in theUnited States. For example, the governments in most European countries own the rail-road systems. In the United States, many city governments provide water and sewageservice themselves rather than rely on private firms.

Control of a Key ResourceAnother way for a firm to become a monopoly is by controlling a key resource. Thishappens infrequently because most resources, including raw materials such as oil oriron ore, are widely available from a variety of suppliers. There are, however, a fewprominent examples of monopolies based on control of a key resource, such as theAluminum Company of America (Alcoa) and the International Nickel Company ofCanada.

For many years until the 1940s, Alcoa either owned or had long-term contracts tobuy nearly all of the available bauxite, the mineral needed to produce aluminum.Without access to bauxite, competing firms had to use recycled aluminum, which lim-ited the amount of aluminum they could produce. Similarly, the International NickelCompany of Canada controlled more than 90 percent of available nickel supplies.Competition in the nickel market increased when the Petsamo nickel fields in northernRussia were developed after World War II.

In the United States, a key resource for a professional sports team is a large stadium.The teams that make up the major professional sports leagues—Major League Baseball,the National Football League, and the National Basketball Association—usually havelong-term leases with the stadiums in major cities. Control of these stadiums is a majorbarrier to new professional baseball, football, or basketball leagues forming.

Copyright A government-grantedexclusive right to produce and sell acreation.

Public franchise A designation bythe government that a firm is the onlylegal provider of a good or service.

Are Diamond Profits Forever? The De Beers Diamond MonopolyThe most famous monopoly based on control of a raw materialis the De Beers diamond mining and marketing company of

South Africa. Before the 1860s, diamonds were extremely rare. Only a few pounds ofdiamonds were produced each year, primarily from Brazil and India. Then in 1870,

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De Beers promoted the sentimentalvalue of diamonds as a way tomaintain its position in thediamond market.

Network externalities The situationwhere the usefulness of a productincreases with the number ofconsumers who use it.

enormous deposits of diamonds were discovered along the Orange River in SouthAfrica. It became possible to produce thousands of pounds of diamonds per year, andthe owners of the new mines feared that the price of diamonds would plummet. Toavoid financial disaster, the mine owners decided in 1888 to merge and form De BeersConsolidated Mines, Ltd.

De Beers became one of the most profitable and longest-lived monopolies in his-tory. The company has carefully controlled the supply of diamonds to keep prices high.As new diamond deposits were discovered in Russia and Zaire, De Beers was able tomaintain prices by buying most of the new supplies.

Because diamonds are rarely destroyed, De Beers has always worried about compe-tition from the resale of stones. Heavily promoting diamond engagement and weddingrings with the slogan “A Diamond Is Forever” was a way around this problem. Becauseengagement and wedding rings have great sentimental value, they are seldom resold,even by the heirs of the original recipients. De Beers advertising has been successful evenin some countries, such as Japan, that have had no custom of giving diamond engage-ment rings. As the populations in De Beers’s key markets age, its advertising in recentyears has focused on middle-aged men presenting diamond rings to their wives as sym-bols of financial success and continuing love and on professional women buying “right-hand rings” for themselves.

In the past few years, competition has finally come to the diamond business. By2000, De Beers directly controlled only about 40 percent of world diamond produc-tion. The company became concerned about the amount it was spending to buy dia-monds from other sources to keep them off the market. It decided to adopt a strategy ofdifferentiating its diamonds by relying on its name recognition. Each De Beers dia-mond is now marked with a microscopic brand—a “Forevermark”—to reassure con-sumers of its high quality. Other firms, such as BHP Billiton, which owns mines innorthern Canada, have followed suit by branding their diamonds. Sellers of Canadiandiamonds stress that they are “mined under ethical, environmentally friendly condi-tions,” as opposed to “blood diamonds,” which are supposedly “mined under armedforce in war-torn African countries and exported to finance military campaigns.”Whether consumers will pay attention to brands on diamonds remains to be seen,although through 2007, the branding strategy had helped De Beers maintain its 40 per-cent share of the diamond market.

Sources: Edward Jay Epstein,“Have You Ever Tried to Sell a Diamond?”Atlantic Monthly, February 1982; Donna J. Bergenstock,Mary E. Deily, and Larry W. Taylor, “A Cartel’s Response to Cheating: An Empirical Investigation of the De Beers DiamondEmpire,” Southern Economic Journal, Vol. 73, No. 1, July 2006, pp. 173–189; Bernard Simon,“Adding Brand Names to NamelessStones,” New York Times, June 27, 2002; Blythe Yee, “Ads Remind Women They Have Two Hands,” Wall Street Journal, August14, 2003; quote in last paragraph from Joel Baglole,“Political Correctness by the Carat,” Wall Street Journal, April 17, 2003.


of this chapter.

Network ExternalitiesThere are network externalities in the consumption of a product if the usefulness of theproduct increases with the number of people who use it. If you owned the only cellphone in the world, for example, it would not be very valuable. The more cell phonesthere are in use, the more valuable they become to consumers.

Some economists argue that network externalities can serve as barriers to entry. Forexample, in the early 1980s, Microsoft gained an advantage over other software compa-nies by developing MS-DOS, the operating system for the first IBM personal computers.Because IBM sold more computers than any other company, software developers wrotemany application programs for MS-DOS. The more people who used MS-DOS–basedprograms, the greater the usefulness to a consumer of using an MS-DOS–based pro-gram. Today, Windows, the program Microsoft developed to succeed MS-DOS, has a 95percent share in the market for personal computer operating systems (although


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Natural monopoly A situation inwhich economies of scale are so largethat one firm can supply the entiremarket at a lower average total costthan can two or more firms.

Windows has a much lower share in the market for operating systems for servers). Ifanother firm introduced a competing operating system, some economists argue that rel-atively few people would use it initially, and few applications would run on it, whichwould limit the operating system’s value to other consumers.

eBay was the first Internet site to attract a significant number of people to its onlineauctions. Once a large number of people began to use eBay to buy and sell collectibles,antiques, and many other products, it became a more valuable place to buy and sell.Yahoo.com, Amazon.com, and other Internet sites eventually started online auctions,but they found it difficult to attract buyers and sellers. On eBay, a buyer expects to findmore sellers, and a seller expects to find more potential buyers than on Amazon or otherauction sites.

As these examples show, network externalities can set off a virtuous cycle : If a firmcan attract enough customers initially, it can attract additional customers because itsproduct’s value has been increased by more people using it, which attracts even morecustomers, and so on. With products such as computer operating systems and onlineauctions, it might be difficult for new firms to enter the market and compete away theprofits being earned by the first firm in the market.

Economists engage in considerable debate, however, about the extent to which net-work externalities are important barriers to entry in the business world. Some econo-mists argue that the dominant positions of Microsoft and eBay reflect the efficiency ofthose firms in offering products that satisfy consumer preferences more than the effectsof network externalities. In this view, the advantages existing firms gain from networkexternalities would not be enough to protect them from competing firms offering betterproducts. In other words, a firm entering the operating system market with a programbetter than Windows or a firm offering an Internet auction site better than eBay wouldbe successful despite the effects of network externalities. (We discussed this point inmore detail in Chapter 6.)

Natural MonopolyWe saw in Chapter 7 that economies of scale exist when a firm’s long-run average costsfall as it increases the quantity of output it produces. A natural monopoly occurs wheneconomies of scale are so large that one firm can supply the entire market at a loweraverage total cost than two or more firms. In that case, there is really “room” in the mar-ket for only one firm.

Figure 9-1 shows the average total cost curve for a firm producing electricity and thetotal demand for electricity in the firm’s market. Notice that the average total cost curve

$0.06

0.04

0

Priceand cost(dollars

perkilowatt-

hour)

Quantity(kilowatt-hours

per year)

30 billion

Demand

ATC

15 billion

B

A

Figure 9-1Average Total Cost Curve for a Natural Monopoly

With a natural monopoly, the average total costcurve is still falling when it crosses the demandcurve (point A). If only one firm is producingelectric power in the market and it produceswhere average cost intersects the demandcurve, average total cost will equal $0.04 perkilowatt-hour of electricity produced. If themarket is divided between two firms, each pro-ducing 15 billion kilowatt-hours, the averagecost of producing electricity rises to $0.06 perkilowatt-hour (point B). In this case, if onefirm expands production, it can move downthe average total cost curve, lower its price, anddrive the other firm out of business.


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is still falling when it crosses the demand curve at point A. If the firm is a monopoly andproduces 30 billion kilowatt-hours of electricity per year, its average total cost of pro-duction will be $0.04 per kilowatt-hour. Suppose instead that two firms are in the mar-ket, each producing half of the market output, or 15 billion kilowatt-hours per year.Assume that each firm has the same average total cost curve. The figure shows that pro-ducing 15 billion kilowatt-hours would move each firm back up its average cost curve sothat the average cost of producing electricity would rise to $0.06 per kilowatt-hour(point B). In this case, if one of the firms expands production, it will move down theaverage total cost curve. With lower average costs, it will be able to offer electricity at alower price than the other firm can. Eventually, the other firm will be driven out of busi-ness, and the remaining firm will have a monopoly. Because a monopoly would developautomatically—or naturally—in this market, it is a natural monopoly.

Natural monopolies are most likely to occur in markets where fixed costs are verylarge relative to variable costs. For example, a firm that produces electricity must make asubstantial investment in machinery and equipment necessary to generate the electricityand in wires and cables necessary to distribute it. Once the initial investment has beenmade, however, the marginal cost of producing another kilowatt-hour of electricity isrelatively small.

Solved Problem|9-2Is the “Proxy Business” a Natural Monopoly?

A corporation is owned by its shareholders, who elect mem-bers of the corporation’s board of directors and who alsovote on particularly important issues of corporate policy.The shareholders of large corporations are spread aroundthe country, and relatively few of them are present at theannual meetings at which elections take place. Before eachmeeting, corporations must provide shareholders withannual reports and forms that allow them to vote by mail.Voting by mail is referred to as “proxy voting.” People whowork on Wall Street refer to providing annual reports andballots to shareholders as the “proxy business.” Currently,one company, Broadridge, controls almost all of the proxybusiness.

According to the Wall Street Journal, Don Kittell of theSecurities Industry Association has explained Broadridge’svirtual monopoly by arguing that, “The economies of scale

and the efficiencies achieved by Broadridge handling all thebrokerage business—rather than multiple companies—resulted in savings to [corporations].”

a. Assuming that Kittell is correct, draw a graph showingthe market for handling proxy materials. Be sure thatthe graph contains the demand for proxy materials andBroadridge’s average total cost curve. Explain why costsavings result from having the proxy business handledby a single firm.

b. According to a spokesperson for Broadridge, the proxybusiness produces a profit rate of about 7 percent,which is lower than the profit rate the company receivesfrom any of its other businesses. Does this informationsupport or undermine Kittell’s analysis? Explain.

SOLVING THE PROBLEM:Step 1: Review the chapter material. This problem is about natural monopoly, so

you may want to review the section “Natural Monopoly,” which begins onpage xxx.

Step 2: Answer question (a) by drawing a natural monopoly graph and discussingthe potential cost savings in this industry. Kittell describes a situation ofnatural monopoly. Otherwise, the entry of another firm into the marketwould not raise average cost. Draw a natural monopoly graph, like the one inFigure 9-1:


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Make sure your average total cost curve is still declining when it crosses thedemand curve. If one firm can supply Q1 proxies at an average total cost ofATC1, then dividing the business equally between two firms each supplying Q2proxies would raise average total cost to ATC2.

Step 3: Answer question (b) by discussing the implications of Broadridge’s lowprofit rate in the proxy business. If Broadridge earns a low profit rate on itsinvestment in this business even though it has a monopoly, Kittell probably iscorrect that the proxy business is a natural monopoly.

EXTRA CREDIT: Keep in mind that competition is not good for its own sake. It isgood because it can lead to lower costs, lower prices, and better products. In certainmarkets, however, cost conditions are such that competition is likely to lead to highercosts and higher prices. These markets are natural monopolies that are best served byone firm.

Source: Phyllis Plitch, “Competition Remains Issue in Proxy-Mailing Costs,” Wall Street Journal, January 16, 2002.

YOUR TURN: For more practice, do related problem 2.11 on page xxx at the end of this chapter.

9.3 | Explain how a monopoly chooses price and output.

How Does a Monopoly Choose Price and Output?Like every other firm, a monopoly maximizes profit by producing where marginal rev-enue equals marginal cost. A monopoly differs from other firms in that a monopoly’sdemand curve is the same as the demand curve for the product. We emphasized in Chapter8 that the market demand curve for wheat was very different from the demand curve forthe wheat produced by any one farmer. If, however, one farmer had a monopoly onwheat production, the two demand curves would be exactly the same.

Marginal Revenue Once AgainRecall from Chapter 8 that firms in perfectly competitive markets—such as a farmer inthe wheat market—face horizontal demand curves. They are price takers. All other firms,including monopolies, are price makers. If price makers raise their prices, they will losesome, but not all, of their customers. Therefore, they face a downward-sloping demandcurve and a downward-sloping marginal revenue curve as well. Let’s review why a firm’smarginal revenue curve slopes downward if its demand curve slopes downward.

ATC2

ATC1

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Priceandcost

Quantity of proxiesQ1

Demand

ATC

Q2



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Remember that when a firm cuts the price of a product, one good thing happens,and one bad thing happens:

• The good thing. It sells more units of the product.

• The bad thing. It receives less revenue from each unit than it would have received atthe higher price.

For example, consider the table in Figure 9-2, which shows the demand curve for TimeWarner Cable’s basic cable package. For simplicity, we assume that the market has only 10potential subscribers instead of the millions it actually has. If Time Warner charges a price of$60 per month, it won’t have any subscribers. If it charges a price of $57, it sells 1 subscrip-tion. At $54, it sells 2, and so on. Time Warner’s total revenue is equal to the number of sub-scriptions sold per month multiplied by the price. The firm’s average revenue—or revenueper subscription sold—is equal to its total revenue divided by the quantity of subscriptionssold. Time Warner is particularly interested in marginal revenue because marginal revenuetells the firm how much revenue will increase if it cuts the price to sell one more subscription.

Notice that Time Warner’s marginal revenue is less than the price for every sub-scription sold after the first subscription. To see why, think about what happens if TimeWarner cuts the price of its basic cable package from $42 to $39, which increases its sub-scriptions sold from 6 to 7. Time Warner increases its revenue by the $39 it receives forthe seventh subscription. But it also loses revenue of $3 per subscription on the first 6subscriptions because it could have sold them at the old price of $42. So, its marginal

Priceand

revenue(dollars per

subscription)

Quantity(subscriptions

per month)

Demand =averagerevenue

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0 1 2 3 4 5 6 7 8 9 10

Figure 9-2Calculating a Monopoly’sRevenue

Time Warner Cable faces a downward-slopingdemand curve for subscriptions to basic cable.To sell more subscriptions, it must cut theprice. When this happens, it gains the revenuefrom selling more subscriptions but loses rev-enue from selling at a lower price the subscrip-tions that it could have sold at a higher price.The firm’s marginal revenue is the change inrevenue from selling another subscription. Wecan calculate marginal revenue by subtractingthe revenue lost as a result of a price cut fromthe revenue gained. The table shows that TimeWarner’s marginal revenue is less than theprice for every subscription sold after the firstsubscription. Therefore, Time Warner’s mar-ginal revenue curve will be below its demandcurve.


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revenue on the seventh subscription is $39 − $18 = $21, which is the value shown in thetable. The graph in Figure 9-2 plots Time Warner’s demand and marginal revenuecurves, based on the information given in the table.

Profit Maximization for a MonopolistFigure 9-3 shows how Time Warner combines the information on demand and marginalrevenue with information on average and marginal costs to decide how many subscriptionsto sell and what price to charge. We assume that the firm’s marginal cost and average totalcost curves have the usual U shapes we encountered in Chapters 7 and 8. In panel (a), we seehow Time Warner can calculate its profit-maximizing quantity and price. As long as themarginal cost of selling one more subscription is less than the marginal revenue, the firmshould sell additional subscriptions because it is adding to its profits. As Time Warner sellsmore cable subscriptions, rising marginal cost will eventually equal marginal revenue, andthe firm will be selling the profit-maximizing quantity of subscriptions. This happens withthe sixth subscription, which adds $27 to the firm’s costs and $27 to its revenues (point A inpanel (a) of Figure 9-3). The demand curve tells us that Time Warner can sell 6 subscrip-tions for a price of $42 per month. We can conclude that Time Warner’s profit-maximizingquantity of subscriptions is 6 and its profit-maximizing price is $42.

Panel (b) shows that the average total cost of 6 subscriptions is $30 and that TimeWarner can sell 6 subscriptions at a price of $42 per month (point B on the demand curve).Time Warner is making a profit of $12 per subscription—the price of $42 minus the averagecost of $30. Its total profit is $72 (6 subscriptions × $12 profit per subscription), which isshown by the area of the green-shaded rectangle in the figure. We could also have calculatedTime Warner’s total profit as the difference between its total revenue and its total cost. Its totalrevenue from selling 6 subscriptions is $252. Its total cost equals its average cost multiplied bythe number of subscriptions sold, or $30 × 6 = $180. So, its profit is $252 − $180 = $72.

It’s important to note that even though Time Warner is earning economic profits,new firms will not enter the market. Because Time Warner has a monopoly, it will not facecompetition from other cable operators. Therefore, if other factors remain unchanged,Time Warner will be able to continue to earn economic profits, even in the long run.

0

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subscription)


per month)

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price

Panel (a) shows that to maximize profit, Time Warner should sell subscriptions up tothe point that the marginal revenue from selling the last subscription equals its mar-ginal cost (point A). In this case, the marginal revenue from selling the sixth subscrip-tion and the marginal cost are both $27. Time Warner maximizes profit by selling 6

subscriptions per month and charging a price of $42 (point B). In panel (b), the greenbox represents Time Warner’s profits. The box has a height equal to $12, which is theprice of $42 minus the average total cost of $30, and a base equal to the quantity of 6cable subscriptions. Time Warner’s profit equals $12 × 6 = $72.

Figure 9-3 | Profit-Maximizing Price and Output for a Monopoly


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Solved Problem|9-3Finding the Profit-Maximizing Price and Output for a Monopolist

Suppose that Comcast has a cable monopoly in Philadelphia. The following table gives Comcast’s demand and costs per monthfor subscriptions to basic cable (for simplicity, we once again keep the number of subscribers artificially small).

MARGINALREVENUE MARGINAL COST

PRICE QUANTITY TOTAL REVENUE (MR = ΔTR/ΔQ) TOTAL COST (MC = ΔTC/ΔQ)

$17 3 $56

16 4 63

15 5 71

14 6 80

13 7 90

12 8 101

a. Fill in the missing values in the table.

b. If Comcast wants to maximize profits, what priceshould it charge and how many cable subscriptions permonth should it sell? How much profit will Comcastmake? Briefly explain.

SOLVING THE PROBLEM:Step 1: Review the chapter material. This problem is about finding the profit-

maximizing quantity and price for a monopolist, so you may want to reviewthe section “Profit Maximization for a Monopolist,” which begins on page xxx.

Step 2: Answer question (a) by filling in the missing values in the table. Rememberthat to calculate marginal revenue and marginal cost, you must divide thechange in total revenue or total cost by the change in quantity.

MARGINALREVENUE MARGINAL COST

PRICE QUANTITY TOTAL REVENUE (MR = ΔTR/ΔQ) TOTAL COST (MC = ΔTC/ΔQ)

$17 3 $51 — $56 —

16 4 64 $13 63 $7

15 5 75 11 71 8

14 6 84 9 80 9

13 7 91 7 90 10

12 8 96 5 101 11

We don’t have enough information from the table to fill in the values for mar-ginal revenue or marginal cost in the first row.

Step 3: Answer question (b) by determining the profit-maximizing quantity andprice. We know that Comcast will maximize profits by selling subscriptionsup to the point where marginal cost equals marginal revenue. In this case, thatmeans selling 6 subscriptions per month. From the information in the firsttwo columns, we know Comcast can sell 6 subscriptions at a price of $14 each.Comcast’s profits are equal to the difference between its total revenue and itstotal cost: Profit = $84 − $80 = $4 per month.

c. Suppose the local government imposes a $2.50 permonth tax on cable companies. Now what price shouldComcast charge, how many subscriptions should it sell,and what will its profits be?


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>> End Solved Problem 9-3


Don’t Let This Happen to YOU!Don’t Assume That Charging a Higher Price Is Always More Profitable for a Monopolist

In answering question (c) of Solved Problem 9-3, it’s tempt-ing to argue that Comcast should increase its price to makeup for the tax. After all, Comcast is a monopolist, so whycan’t it just pass along the tax to its customers? The reason itcan’t is that Comcast, like any other monopolist, must payattention to demand. Comcast is not interested in charginghigh prices for the sake of charging high prices; it is inter-ested in maximizing profits. Charging a price of $1,000 for abasic cable subscription sounds nice, but if no one will buyat that price, Comcast would hardly be maximizing profits.

To look at it another way, before the tax is imposed,Comcast has already determined $14 is the price that willmaximize its profits. After the tax is imposed, it must deter-mine whether $14 is still the profit-maximizing price.Because the tax has not affected Comcast’s marginal rev-enue or marginal cost (or had any effect on consumerdemand), $14 is still the profit-maximizing price, andComcast should continue to charge it. The tax reducesComcast’s profits but doesn’t cause it to increase the priceof cable subscriptions.

YOUR TURN: Test your understanding by doing related

problems 3.7 and 3.8 on page xxx at the end of this chapter.

Step 4: Answer question (c) by analyzing the impact of the tax. This tax is a fixedcost to Comcast because it is a flat $2.50, no matter how many subscriptions itsells. Because the tax has no impact on Comcast’s marginal revenue or mar-ginal cost, the profit-maximizing level of output has not changed. So, Comcastwill still sell 6 subscriptions per month at a price of $14, but its profits will fallby the amount of the tax from $4.00 per month to $1.50.

YOUR TURN: For more practice, do related problems 3.3 and 3.4 on page xxx at the end

of this chapter.

9.4 | Use a graph to illustrate how a monopoly affects economic efficiency.

Does Monopoly Reduce EconomicEfficiency?We saw in Chapter 8 that a perfectly competitive market is economically efficient. Howwould economic efficiency be affected if instead of being perfectly competitive, a marketwere a monopoly? In Chapter 4, we developed the idea of economic surplus. Economicsurplus provides a way of characterizing the economic efficiency of a perfectly competi-tive market: Equilibrium in a perfectly competitive market results in the greatest amount ofeconomic surplus, or total benefit to society, from the production of a good or service. Whathappens to economic surplus under monopoly? We can begin the analysis by consider-ing the hypothetical case of what would happen if the market for television sets begins asperfectly competitive and then becomes a monopoly. (In reality, the market for televi-sion sets is not perfectly competitive, but assuming that it is simplifies our analysis.)

Comparing Monopoly and Perfect CompetitionPanel (a) in Figure 9-4 illustrates the situation if the market for televisions is perfectlycompetitive. Price and quantity are determined by the intersection of the demand andsupply curves. Remember that none of the individual firms in a perfectly competitiveindustry has any control over price. Each firm must accept the price determined by themarket. Panel (b) shows what happens if the television industry becomes a monopoly.We know that the monopoly will maximize profits by producing where marginal rev-enue equals marginal cost. To do this, the monopoly reduces the quantity of televisions



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that would have been produced if the industry were perfectly competitive and increasesthe price. Panel (b) illustrates an important conclusion: A monopoly will produce less andcharge a higher price than would a perfectly competitive industry producing the same good.

Measuring the Efficiency Losses from MonopolyFigure 9-5 uses panel (b) from Figure 9-4 to illustrate how monopoly affects con-sumers, producers, and the efficiency of the economy. Recall from Chapter 4 thatconsumer surplus measures the net benefit received by consumers from purchasing agood or service. We measure consumer surplus as the area below the demand curve andabove the market price. The higher the price, the smaller the consumer surplus.Because a monopoly raises the market price, it reduces consumer surplus. In Figure 9-5,the loss of consumer surplus is equal to rectangle A plus triangle B. Remember thatproducer surplus measures the net benefit to producers from selling a good or service.We measure producer surplus as the area above the supply curve and below the marketprice. The increase in price due to monopoly increases producer surplus by an amountequal to rectangle A and reduces it by an amount equal to triangle C. Because rectangleA is larger than triangle C, we know that a monopoly increases producer surplus com-pared with perfect competition.

Economic surplus is equal to the sum of consumer surplus plus producer surplus.By increasing price and reducing the quantity produced, the monopolist has reducedeconomic surplus by an amount equal to the areas of triangles B and C. This reductionin economic surplus is called deadweight loss and represents the loss of economic effi-ciency due to monopoly.

The best way to understand how a monopoly causes a loss of economic efficiency is torecall that price is equal to marginal cost in a perfectly competitive market. As a result, aconsumer in a perfectly competitive market is always able to buy a good if she is willing topay a price equal to the marginal cost of producing it. As Figure 9-5 shows, the monopoliststops producing at a point where the price is well above marginal cost. Consumers areunable to buy some units of the good for which they would be willing to pay a price greater

PC

0

Price andcostperunit

Quantity

(a) Perfect competition (b) Monopoly

Demand

Supply

QC

PC

PM

0

Price andcostperunit

Quantity

DemandMR

MC

QCQM

1. If the industry becomes amonopoly, the supply curvebecomes the monopolist’smarginal cost curve.

If the industry is perfectlycompetitive, the intersection ofthe demand and supply curvesdetermines equilibrium priceand quantity.

2. The monopolist reducesoutput to the level at whichmarginal revenue equalsmarginal costs...

3. ...and chargesa higher price.

In panel (a), the market for television sets is perfectly competitive, and price andquantity are determined by the intersection of the demand and supply curves. Inpanel (b), the perfectly competitive television industry became a monopoly. As aresult, the equilibrium quantity falls, and the equilibrium price rises.

1. The industry supply curve becomes the monopolist’s marginal cost curve.2. The monopolist reduces output to where marginal revenue equals marginal

cost, QM.3. The monopolist raises the price from PC to PM.

Figure 9-4 | What Happens If a Perfectly Competitive Industry Becomes a Monopoly?


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MCM

PC

PM

0

Priceand cost

Quantity

Demand

MR

AB

C

MC

QCQM

Transfer ofconsumersurplus tomonopoly

Marginal costof the last unitproduced bythe monopoly

Deadweightloss frommonopoly(B + C)

Figure 9-5The Inefficiency of Monopoly

A monopoly charges a higher price, PM, andproduces a smaller quantity, QM, than a per-fectly competitive industry, which charges aprice of PC and produces at QC. The higherprice reduces consumer surplus by the areaequal to the rectangle A and the triangle B.Some of the reduction in consumer surplus iscaptured by the monopoly as producer sur-plus, and some becomes deadweight loss,which is the area equal to triangles B and C.

than the marginal cost of producing them. Why doesn’t the monopolist produce this addi-tional output? Because the monopolist’s profits are greater if it restricts output and forcesup the price. A monopoly produces the profit-maximizing level of output but fails to pro-duce the efficient level of output from the point of view of society.

We can summarize the effects of monopoly as follows:

1 Monopoly causes a reduction in consumer surplus.

2 Monopoly causes an increase in producer surplus.

3 Monopoly causes a deadweight loss, which represents a reduction in economicefficiency.

How Large Are the Efficiency Losses Due to Monopoly?We know that there are relatively few monopolies, so the loss of economic efficiency dueto monopoly must be small. Many firms, though, have market power, which is the abilityof a firm to charge a price greater than marginal cost. The analysis we just completedshows that some loss of economic efficiency will occur whenever a firm has market powerand can charge a price greater than marginal cost, even if the firm is not a monopoly. Theonly firms that do not have market power are firms in perfectly competitive markets, whomust charge a price equal to marginal cost. Because few markets are perfectly competi-tive, some loss of economic efficiency occurs in the market for nearly every good or service.

Is the total loss of economic efficiency due to market power large or small? It is pos-sible to put a dollar value on the loss of economic efficiency by estimating for everyindustry the size of the deadweight loss triangle, as in Figure 9-5. The first economist todo this was Arnold Harberger of the University of Chicago. His estimates—largely con-firmed by later researchers—indicated that the total loss of economic efficiency in theU.S. economy due to market power is small. According to his estimates, if every industryin the economy were perfectly competitive, so that price were equal to marginal cost inevery market, the gain in economic efficiency would equal less than 1 percent of thevalue of total production in the United States, or about $450 per person.

The loss of economic efficiency is this small primarily because true monopolies arevery rare. In most industries, competition keeps price much closer to marginal cost thanwould be the case in a monopoly. The closer price is to marginal cost, the smaller the sizeof the deadweight loss.

Market power The ability of a firm to charge a price greater thanmarginal cost.


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Market Power and Technological ChangeSome economists have raised the possibility that the economy may actually benefit fromfirms having market power. This argument is most closely identified with JosephSchumpeter, an Austrian economist who spent many years as a professor of economicsat Harvard. Schumpeter argued that economic progress depended on technologicalchange in the form of new products. For example, the replacement of horse-drawn car-riages by automobiles, the replacement of ice boxes by refrigerators, and the replacementof mechanical calculators by electronic computers all represent technological changesthat significantly raised living standards. In Schumpeter’s view, new products unleash a“gale of creative destruction” that drives older products—and, often, the firms that pro-duced them—out of the market. Schumpeter was unconcerned that firms with marketpower would charge higher prices than perfectly competitive firms:

It is not that kind of [price] competition which counts but the competition fromthe new commodity, the new technology, the new source of supply, the new typeof organization . . . competition which commands a decisive cost or qualityadvantage and which strikes not at the margins of the profits and outputs of theexisting firms but at their foundations and their very lives.

Economists who support Schumpeter’s view argue that the introduction of newproducts requires firms to spend funds on research and development. It is possible forfirms to raise this money by borrowing from investors or from banks. But investors andbanks are usually skeptical of ideas for new products that have not yet passed the test ofconsumer acceptance in the market. As a result, firms are often forced to rely on theirprofits to finance the research and development needed for new products. Because firmswith market power are more likely to earn economic profits than are perfectly competi-tive firms, they are also more likely to carry out research and development and introducenew products. In this view, the higher prices firms with market power charge are unim-portant compared with the benefits from the new products these firms introduce to themarket.

Some economists disagree with Schumpeter’s views. These economists point to thenumber of new products developed by smaller firms, including, for example, Steve Jobsand Steve Wozniak inventing the first Apple computer in Wozniak’s garage, and LarryPage and Sergey Brin inventing the Google search engine as graduate students atStanford. As we will see in the next section, government policymakers continue to strug-gle with the issue of whether, on balance, large firms with market power are good or badfor the economy.

9.5 | Discuss government policies toward monopoly.

Government Policy toward MonopolyBecause monopolies reduce consumer surplus and economic efficiency, most govern-ments have policies that regulate their behavior. Collusion refers to an agreementamong firms to charge the same price or otherwise not to compete. In the United States,government policies with respect to monopolies and collusion are embodied in theantitrust laws. These laws make illegal any attempts to form a monopoly or to collude.Governments also regulate firms that are natural monopolies, often by controlling theprices they charge.

Antitrust Laws and Antitrust EnforcementThe first important law regulating monopolies in the United States was the ShermanAct, which Congress passed in 1890 to promote competition and prevent the formationof monopolies. Section 1 of the Sherman Act outlaws “every contract, combination inthe form of trust or otherwise, or conspiracy in restraint of trade.” Section 2 states that“every person who shall monopolize, or attempt to monopolize, or combine or conspire

Collusion An agreement amongfirms to charge the same price orotherwise not to compete.


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with any other person or persons, to monopolize any part of the trade or commerce . . .shall be deemed guilty of a felony.”

The Sherman Act targeted firms in several industries that had combined togetherduring the 1870s and 1880s to form “trusts.” In a trust, the firms were operated indepen-dently but gave voting control to a board of trustees. The board enforced collusive agree-ments for the firms to charge the same price and not to compete for each other’s cus-tomers. The most notorious of the trusts was the Standard Oil Trust, organized by JohnD. Rockefeller. After the Sherman Act was passed, trusts disappeared, but the termantitrust laws has lived on to refer to the laws aimed at eliminating collusion and pro-moting competition among firms.

The Sherman Act prohibited trusts and collusive agreements, but it left several loop-holes. For example, it was not clear whether it would be legal for two or more firms tomerge to form a new, larger firm that would have substantial market power. A series ofSupreme Court decisions interpreted the Sherman Act narrowly, and the result was awave of mergers at the turn of the twentieth century. Included in these mergers was theU.S. Steel Corporation, which was formed from dozens of smaller companies. U.S. Steel,organized by J. P. Morgan, was the first billion-dollar corporation, and it controlled two-thirds of steel production in the United States. The Sherman Act also left unclearwhether any business practices short of outright collusion were illegal.

To address the loopholes in the Sherman Act, in 1914, Congress passed the ClaytonAct and the Federal Trade Commission Act. Under the Clayton Act, a merger was illegalif its effect was “substantially to lessen competition, or to tend to create a monopoly.”The Federal Trade Commission Act set up the Federal Trade Commission (FTC), whichwas given the power to police unfair business practices. The FTC has brought lawsuitsagainst firms employing a variety of business practices, including deceptive advertising.In setting up the FTC, however, Congress divided the authority to police mergers.Currently, both the Antitrust Division of the U.S. Department of Justice and the FTC areresponsible for merger policy. Table 9-1 lists the most important U.S. antitrust laws andthe purpose of each.

Mergers: The Trade-off between Market Power and EfficiencyThe federal government regulates business mergers because it knows that if firms gainmarket power by merging, they may use that market power to raise prices and reduceoutput. As a result, the government is most concerned with horizontal mergers, ormergers between firms in the same industry. Horizontal mergers are more likely toincrease market power than vertical mergers, which are mergers between firms at dif-ferent stages of the production of a good. An example of a vertical merger would be amerger between a company making personal computers and a company making com-puter hard drives.

Antitrust laws Laws aimed ateliminating collusion and promotingcompetition among firms.

TABLE 9-1Important U.S. Antitrust Laws

LAW DATE PURPOSE

Sherman Act 1890 Prohibited “restraint of trade,” including price fixing andcollusion. Also outlawed monopolization.

Clayton Act 1914 Prohibited firms from buying stock in competitors and fromhaving directors serve on the boards of competing firms.

Federal Trade 1914 Established the Federal Trade Commission (FTC) to helpCommission Act administer antitrust laws.

Robinson–Patman Act 1936 Prohibited charging buyers different prices if the resultwould reduce competition.

Cellar–Kefauver Act 1950 Toughened restrictions on mergers by prohibiting anymergers that would reduce competition.

Horizontal merger A mergerbetween firms in the same industry.

Vertical merger A merger betweenfirms at different stages of productionof a good.


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Regulating horizontal mergers can be complicated by two factors. First, the “mar-ket” that firms are in is not always clear. For example, if Hershey Foods wants to mergewith Mars, Inc., maker of M&Ms, Snickers, and other candies, what is the relevant mar-ket? If the government looks just at the candy market, the newly merged company wouldhave more than 70 percent of the market, a level at which the government would likelyoppose the merger. What if the government looks at the broader market for “snacks”? Inthis market, Hershey and Mars compete with makers of potato chips, pretzels, peanuts,and, perhaps, even producers of fresh fruit. Of course, if the government looked at thevery broad market for “food,” then both Hershey and Mars have very small marketshares, and there would be no reason to oppose their merger. In practice, the govern-ment defines the relevant market on the basis of whether there are close substitutes forthe products being made by the merging firms. In this case, potato chips and the othersnack foods mentioned are not close substitutes for candy. So, the government wouldconsider the candy market to be the relevant market and would oppose the merger onthe grounds that the new firm would have too much market power.

The second factor that complicates merger policy is the possibility that the newlymerged firm might be more efficient than the merging firms were individually. Forexample, one firm might have an excellent product but a poor distribution system forgetting the product into the hands of consumers. A competing firm might have built agreat distribution system but have an inferior product. Allowing these firms to mergemight be good for both the firms and consumers. Or, two competing firms might eachhave an extensive system of warehouses that are only half full, but if the firms merged,they could consolidate their warehouses and significantly reduce their costs.

An example of the government dealing with the issue of greater efficiency versusreduced competition occurred in early 2000, when Time Warner—which owns cablesystems with more than 20 million subscribers—and America Online (AOL)—whichwas the country’s largest Internet service provider (ISP), with more than 26 millionsubscribers—announced plans to merge. The firms argued that the merger would speedthe development of high-speed (or “broadband”) Internet access and would lead tomore rapid growth of services such as interactive television. Some competing firmscomplained that the new firm created by the merger would have excessive market power.In particular, other ISPs were worried that they would be denied access to the cable sys-tems owned by Time Warner. After more than a year of study, the FTC finally approvedthe merger, subject to certain conditions. One key condition was that Time Warner wasrequired to allow AOL’s competitors to offer their services over Time Warner’s high-speed cable lines before AOL would be permitted to offer its services over those lines.

Most of the mergers that come under scrutiny by the Department of Justice and theFTC are between large firms. For simplicity, let’s consider a case where all the firms in aperfectly competitive industry want to merge to form a monopoly. As we saw in Figure 9-5,as a result of this merger, prices will rise and output will fall, leading to a decline in con-sumer surplus and economic efficiency. But what if the larger, newly merged firm actuallyis more efficient than the smaller firms had been? Figure 9-6 shows a possible result.

If costs are unaffected by the merger, we get the same result as in Figure 9-5: Pricerises from PC to PM, quantity falls from QC to QM, consumer surplus is lower, and a lossof economic efficiency results. If the monopoly has lower costs than the competitivefirms, it is possible for price to decline and quantity to increase. In Figure 9-6, to find thenew profit-maximizing quantity, note where MR crosses MC after the merger. This newprofit-maximizing quantity is QMerge. The demand curve shows that the monopolist cansell this quantity at a price of PMerge. Therefore, the price declines after the merger fromPC to PMerge and quantity increases from QC to QMerge. We have the following seeminglyparadoxical result: Although the newly merged firm has a great deal of market power,because it is more efficient, consumers are better off and economic efficiency is improved. Ofcourse, sometimes a merged firm will be more efficient and have lower costs, and othertimes it won’t. Even if a merged firm is more efficient and has lower costs, that may notoffset the increased market power of the firm enough to increase consumer surplus andeconomic efficiency.


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As you might expect, whenever large firms propose a merger, they claim that thenewly merged firm will be more efficient and have lower costs. They realize that withoutthese claims, it is unlikely their merger will be approved. It is up to the Department ofJustice and the FTC, along with the court system, to evaluate the merits of these claims.

The Department of Justice and Federal TradeCommission Merger GuidelinesFor many years after the passage of the Sherman Antitrust Act in 1890, lawyers from theDepartment of Justice enforced the antitrust laws. They rarely considered economicarguments, such as the possibility that consumers might be made better off by a mergerif economic efficiency were significantly improved. This began to change in 1965, whenDonald Turner became the first Ph.D. economist to head the Antitrust Division of theDepartment of Justice. Under Turner and his successors, economic analysis shapedantitrust policy. In 1973, the Economics Section of the Antitrust Division was estab-lished and staffed with economists who evaluate the economic consequences of pro-posed mergers.

Economists played a major role in the development of merger guidelines by theDepartment of Justice and the FTC in 1982. The guidelines made it easier for firms con-sidering a merger to understand whether the government was likely to allow the mergeror to oppose it. The guidelines have three main parts:

1 Market definition

2 Measure of concentration

3 Merger standards

Market Definition A market consists of all firms making products that consumersview as close substitutes. We can identify close substitutes by looking at the effect of aprice increase. If our definition of a market is too narrow, a price increase will causefirms to experience a significant decline in sales—and profits—as consumers switch tobuying close substitutes.

PMerge

PC

PM

0

Price

Quantity

Demand

MR

MC afterthe merger

QC QMergeQM

MC beforethe merger

Merger withno efficiencygains

Merger withefficiencygains

Figure 9-6A Merger That MakesConsumers Better Off

This figure shows the result of all the firms in aperfectly competitive industry merging toform a monopoly. If costs are unaffected by themerger, the result is the same as in Figure 14-5on page 487: Price rises from PC to PM, quan-tity falls from QC to QM, consumer surplusdeclines, and a loss of economic efficiencyresults. If, however, the monopoly has lowercosts than the perfectly competitive firms, asshown by the marginal cost curve shifting toMC after the merger, it is possible that the pricewill actually decline from PC to PMerge and out-put will increase from QC to QMerge followingthe merger.


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Identifying the relevant market involved in a proposed merger begins with a narrowdefinition of the industry. For the hypothetical merger of Hershey Foods and Mars, Inc.,discussed previously in this chapter, we might start with the candy industry. If all firmsin the candy industry increased price by 5 percent, would their profits increase ordecrease? If profits would increase, the market is defined as being just these firms. Ifprofits would decrease, we would try a broader definition—say, by adding in potatochips and other snacks. Would a price increase of 5 percent by all firms in the broadermarket raise profits? If profits increase, the relevant market has been identified. If prof-its decrease, we consider a broader definition. We continue this procedure until a markethas been identified.

Measure of Concentration A market is concentrated if a relatively small number offirms have a large share of total sales in the market. A merger between firms in a marketthat is already highly concentrated is very likely to increase market power. A mergerbetween firms in an industry that has a very low concentration is unlikely to increasemarket power and can be ignored. The guidelines use the Herfindahl-Hirschman Index(HHI) of concentration, which squares the market shares of each firm in the industryand adds up the values of the squares. The following are some examples of calculating aHerfindahl-Hirschman Index:

• 1 firm, with 100% market share (a monopoly):

HHI = 1002 = 10,000

• 2 firms, each with a 50% market share:

HHI = 502 + 502 = 5,000

• 4 firms, with market shares of 30%, 30%, 20%, and 20%:

HHI = 302 + 302 + 202 + 202 = 2,600

• 10 firms, each with market shares of 10%:

HHI = 10 (102) = 1,000

Merger Standards The Department of Justice and the FTC use the HHI calculationfor a market to evaluate proposed horizontal mergers according to these standards:

• Post-merger HHI below 1,000. These markets are not concentrated, so mergers inthem are not challenged.

• Post-merger HHI between 1,000 and 1,800. These markets are moderately concen-trated. Mergers that raise the HHI by less than 100 probably will not be challenged.Mergers that raise the HHI by more than 100 may be challenged.

• Post-merger HHI above 1,800. These markets are highly concentrated. Mergers thatincrease the HHI by less than 50 points will not be challenged. Mergers that increasethe HHI by 50 to 100 points may be challenged. Mergers that increase the HHI bymore than 100 points will be challenged.

Increases in economic efficiency will be taken into account and can lead to approvalof a merger that otherwise would be opposed, but the burden of showing that the effi-ciencies exist lies with the merging firms:

The merging firms must substantiate efficiency claims so that the [Departmentof Justice and the FTC] can verify by reasonable means the likelihood and mag-nitude of each asserted efficiency. . . . Efficiency claims will not be considered ifthey are vague or speculative or otherwise cannot be verified by reasonablemeans.


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Should the Government PreventBanks from Becoming Too Big?For many years, state and federal regulations kept bankssmall. Until the 1990s, federal regulations required a bank to

operate in only a single state. This restriction on interstate banking meant that therewere no nationwide banks. As recently as the 1980s, some states—including Illinoisand Texas—did not allow banks to have branches. So, if a bank opened in Chicago, itcould not have branches in other cities in Illinois. Today, these regulations have beenrepealed, and banks are free to have as many branches as they choose and can operatenationwide. Many economists believe that the old regulations on banks reduced eco-nomic efficiency. If there are significant economies of scale in banking, then keepingbanks artificially small by not allowing them to operate in more than one state willdrive up their average cost of providing banking services. As a result, consumers willhave to pay higher interest rates on loans and will receive lower interest rates ondeposits.

The elimination of government regulations on nationwide banking and on branchbanking led to a sharp decline in the number of banks. In the early 1980s, there were14,500 banks in the United States; today there are fewer than 7,500. Smaller, less efficientbanks were acquired by larger banks or went out of business, and some large banksmerged with other large banks. There is, however, still one limit on the size of banks. In1994, when Congress removed restrictions on interstate banking, it wrote into the law arestriction that no bank mergers would be allowed if they resulted in one bank havingmore than 10 percent of all bank deposits. This provision was included because somesmaller, community-based banks were afraid that they would be unable to competeagainst large, nationwide banks.


|Making the

Connection

2006

Dometic deposits, in billions

Percentage of all U.S. deposits

1994

Dometic deposits, in billions

Percentage of all U.S. deposits

Bank of America $584.33 9.0% Bank of America $125.59 4.0%

J.P. Morgan Chase 447.30 6.9 NationsBank 87.44 2.8

Wachovia/Golden West Financial*

375.61 5.8 Chemical Banking

66.86 2.1

Wells Fargo 295.14 4.6 Banc One 64.74 2.1

Citigroup 226.26 3.5 First Union 52.54 1.7

Note: Deposit share information is based on FDIC quarterly reports. The Federal Reserve, which approves acquisitions, uses a slightly different definition of deposits. * Figures are combined to reflect merger which took place Oct. 1, 2006 Source: FDIC call reports

The Top-Five U.S. Banks by Domestic Deposits, Through Sept. 30 of Each Year

As the chart shows, at the time the government removed restrictions on interstatebanking, no bank was near the 10 percent limit. But by the end of 2006, Bank ofAmerica had 9 percent of all U.S. deposits and was considering mergers that wouldhave brought its share above 10 percent. Bank of America Chairman and ChiefExecutive Kenneth D. Lewis began to push for Congress to remove the 10 percentlimit. He argued that because other countries did not have limits on the size of banks,foreign banks were able to take advantage of economies of scale beyond what waspossible for U.S. banks. In a position paper, Bank of America argued, “In time, themega-foreign banks will be positioned to acquire the largest U.S. banks.” Many com-munity banks, though, remained opposed to lifting the 10 percent limit. Some con-sumer groups also argued that very large banks would have enough market power to


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raise interest rates on loans and lower interest rates on deposits because they wouldhave less competition. Members of Congress considering the possibility of changingthe law had to face the usual question raised by antitrust policy: Will a potentialincrease in monopoly power made possible by lifting the 10-percent limit be offset bygains in economic efficiency?

Source: Valerie Bauerlein and Damian Paletta, “Bank of America Quietly Targets Barrier to Growth,” Wall Street Journal,January 16, 2007, p. A1.


of this chapter.

Regulating Natural MonopoliesIf a firm is a natural monopoly, competition from other firms will not play its usual roleof forcing price down to the level where the company earns zero economic profit. As aresult, local or state regulatory commissions usually set the prices for natural monopolies,such as firms selling natural gas or electricity. What price should these commissions set?Recall from Chapter 8 that economic efficiency requires the last unit of a good or serviceproduced to provide an additional benefit to consumers equal to the additional cost ofproducing it. We can measure the additional benefit consumers receive from the lastunit by the price and the additional cost to the monopoly of producing the last unit bymarginal cost. Therefore, to achieve economic efficiency, regulators should require thatthe monopoly charge a price equal to its marginal cost. There is, however, an importantdrawback to doing so, which is illustrated in Figure 9-7. This figure shows the situationof a typical regulated natural monopoly.

Remember that with a natural monopoly, the average total cost curve is stillfalling when it crosses the demand curve. If unregulated, the monopoly will charge aprice equal to PM and produce QM. To achieve economic efficiency, regulators shouldrequire the monopoly to charge a price equal to PE. The monopoly will then produceQE. But here is the drawback: PE is less than average total cost, so the monopoly willbe suffering a loss, shown by the area of the red-shaded rectangle. In the long run, theowners of the monopoly will not continue in business if they are experiencing losses.Realizing this, most regulators will set the regulated price, PR, equal to the level ofaverage total cost at which the demand curve intersects the ATC curve. At that price,the owners of the monopoly are able to break even on their investment by producingthe quantity QR.

PM

PR

PE

0

Loss

Priceand

cost

QuantityQR QE

Demand

ATC

MC

MR QM

Monopolyprice

Regulatedprice

Efficientprice

Figure 9-7Regulating a Natural Monopoly

A natural monopoly that is not subject to gov-ernment regulation will charge a price equal toPM and produce QM. If government regulatorswant to achieve economic efficiency, they willset the regulated price equal to PE, and themonopoly will produce QE. Unfortunately, PE isbelow average cost, and the monopoly will suf-fer a loss, shown by the shaded rectangle.Because the monopoly will not continue toproduce in the long run if it suffers a loss, gov-ernment regulators set a price equal to averagecost, which is PR in the figure.


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>> Continued from page xxx

Economics in YOUR Life

At the beginning of the chapter, we asked why many cable systems won’t carry the NFLNetwork. You might think that the cable systems would want to televise one of themost popular sports in the nation. In most cities, a customer of a cable system can’tswitch to a competing cable system, so many areas cable systems can be the sole sourceof many programs. (Although some consumers have the option of switching to satellitetelevision.) As a result, a cable system can increase its profits by, for example, not offer-ing popular programming such as the NFL Network as part of its normal programmingpackage, requiring instead that consumers upgrade to digital programming at a higherprice.

ConclusionThe more intense the level of competition among firms, the better a market works. Inthis chapter, we have seen that with monopoly—where competition is entirely absent—price is higher, output is lower, and consumer surplus and economic efficiency declinecompared with perfect competition. Fortunately, true monopolies are rare. Even thoughmost firms resemble monopolies in being able to charge a price above marginal cost,most markets have enough competition to keep the efficiency losses from market powerquite low.

We’ve seen that barriers to entry are an important source of market power. Read AnInside Look at Policy on the next page for a discussion of how legislation in California islowering barriers to entry into the cable TV market.


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An Inside LOOK at Policy

298

WALL STREET JOURNAL, SEPTEMBER 28, 2006

As Barriers Fall, WillCable TV CompetitionRise?

b

a

Cable GuysIn an era of partisan nastiness andgridlock, the California legislature didsomething on Aug. 31 that was shock-ingly harmonious, reasonable andbeneficial to consumers. Both partiesvoted overwhelmingly to allow com-petition into a sector—cable televi-sion—where prices have been elevatedand service depressed by the mostpernicious monopoly in America.

When Gov. Arnold Schwarzeneg-ger signs the bill, as expected, compa-nies that want a statewide video fran-chise can go straight to the PublicUtility Commission and get approvalto operate within 44 days. In the past,in California, as in other states, cablecompanies had to make separate dealswith America’s 33,760 municipalunits—a process that can take years. . . .

The effect was to create cablemonopolies that often infuriated cap-tive customers. According to a 2004study by the Government Account-ability Office, “cable subscribers inabout 2% of all markets have theopportunity to choose between two ormore wire-based operators.” As cablerates rose in the 1980s, the federal gov-ernment tried to fix the market withmore regulation. That attempt, ofcourse, failed. For the five years endingJanuary 2004, the Federal Communi-cations Commission reports that aver-age cable rates increased 7.8% annu-ally, compared with a 2.1% increase inthe Consumer Price Index.

Very quietly, things are chang-ing. Seven states, comprising about

cone-third of the U.S. population, havenow passed video franchise laws,which will not only lower monthlysubscriber costs but also create newtechnology jobs—10,000 in Californiaalone, according to one estimate—asVerizon and AT&T, along with cableoverbuilders like RCN, jump in withboth feet. To bring high-quality videoto the home over a technology calledInternet protocol, the telcos will makemajor investments to drive the fiber—which carries the data—much moredeeply into their networks. Broadbandservice will improve; state and localgovernments will still get their fran-chise fees. All that will end is a monop-oly that drives consumers nuts. . . .

With a national election comingup, you would expect Congress to geton the bandwagon and embrace a ver-sion of the state bills, killing themonopoly and taking the credit.Instead, federal legislation is sloweddown by measures promoting “netneutrality”—the concept that telecomcompanies should be barred from ask-ing content providers, like Amazon, topay extra for higher-speed service thetelcos develop—the way that an airlineasks more for a first-class seat. . . .

How much will consumers save?A 2004 study by the GAO looked at sixmarkets with cable competition andfound that rates were 15% to 41%below similar markets with no com-petition. Annual savings for U.S.households through competition willtotal $8 billion, says the Phoenix Cen-ter for Advanced Legal and EconomicPublic Policy.

In Texas, where a statewide fran-chising law went into effect last year, astudy by the American Consumer Insti-tute surveyed consumers and foundthat 22% switched cable providers andsaved an average of $22.30 per month.Subscribers who stayed with incum-bent providers saved $26.83 per monthbecause of the downward pressure onprices. Verizon rolled out a service inKeller, Plano and Lewisville, charging$43.95 a month for 180 video andmusic channels. “Shortly thereafter,”writes the Heartland Institute’s StevenTitch, Charter, the erstwhile monopolycable provider,“began offering a bundleof 240 channels and fast Internet ser-vice for $50 a month, compared to$68.99 Charter had been charging forthe TV package alone.” Savings in Texasthis year alone will total $599 million,according to the Phoenix Center. YaleBraunstein, an economist at the Univer-sity of California at Berkeley, estimatesthat Californians will save between$692 million and $1 billion a year.

Yes, Americans can choose satel-lite TV, but, for reasons of conve-nience and service, many find it aninadequate substitute. There’s a rea-son that cable families far outnum-ber satellite families. “Overall cus-tomer satisfaction among satellitesubscribers has declined,” says SteveKirkeby, senior director of telecom-munication research for J.D. Powerand Associates. . . .

Source: James K. Glassman, “Cable Guys,” WallStreet Journal, September 28, 2006. Copyright © 2006 Dow Jones. Reprinted by permission ofDow Jones via Copyright Clearance Center.


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299

Key Points in the ArticleThis article discusses a change in regulatorypolicy toward cable television in California.The change should make it easier for newcable firms to enter the market. As a result,prices for cable TV should fall, and weshould see more firms offering cable TV inCalifornia cities. This article indicates thatan increase in quantity and a decrease inprice occurs as policy makes entry into thecable TV market easier.

Analyzing the NewsIn California, the state government’srequirement that a cable provider buy

a

a franchise in each jurisdictionwas a barrier to entry becauseof the high cost of franchises.By allowing firms a statewidelicense, California has made iteasier for them to enter thecable TV market in a given juris-

diction, making competition morelikely. In fact, the relative lack of competitionin many local cable television markets waspartly the result of technology—laying morethan one set of cables to an individual homewould be very expensive—and partly theresult of government regulations, whichoften allowed only one firm to be in themarket.

Entry, of course, will reduce the eco-nomic profit existing firms earn. The

figure illustrates what happens as entryoccurs and the market becomes competi-tive. For simplicity, we assume that the mar-ginal cost of providing cable services isconstant, so the marginal cost curve is ahorizontal line. Notice that output increasesfrom QM to QC, and price falls from PM to

b

PC. You can also see that consumer surplusincreases from areas A + E to areas A + E +B + C + D, and the deadweight loss in themarket (area D) disappears and becomesconsumer surplus. In this figure, what wereprofits to the monopoly (areas B + C) areredistributed to consumers as consumersurplus. Economic profits fall to zero.

One of the benefits of competition isthat firms compete not just by cutting

prices, but also by improving the servicesthey offer. Here, we see cable systemscompeting by providing more services andchannels to their customers.

Thinking Critically

About Policy1. What is the most a firm would be willing

to spend to remain the sole provider ofcable television in a market?

2. Even with a statewide franchise, whatmight prevent new cable TV firms fromentering local markets?

c

PC

PM

0

Price(dollars per

subscription)

Quantity(subscriptions per month)

D

MR

MC

QCQM

With one cable provider, theprice is PM and quantity is QM.

With competition, the pricefalls to PC and the quantityincreases to QC. This is the socially eifficient outputlevel.

A E

B

C

D

Competition lowers the price of cable TV and increases economic efficiency.


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>> End Learning Objective 9.1

Key TermsAntitrust laws, p. 291

Collusion, p. 290

Copyright, p. 279

Horizontal merger, p. 291

Market power, p. 289

Monopoly, p. 276

Natural monopoly, p. 281

Network externalities, p. 280

Patent, p. 278

Public franchise, p. 279

Vertical merger, p. 291

9.1 LEARNING OBJECTIVE 9.1 | Define monopoly, pages xxx–xxx.

Is Any Firm Ever Really a Monopoly?

Summary

A monopoly exists only in the rare situation in which a firmis producing a good or service for which there are no closesubstitutes. A narrow definition of monopoly that someeconomists use is that a firm has a monopoly if it can ignorethe actions of all other firms. Many economists favor abroader definition of monopoly. Under the broader defini-tion, a firm has a monopoly if no other firms are selling asubstitute close enough that the firm’s economic profits arecompeted away in the long run.

Visit www.myeconlab.com to complete these exercisesonline and get instant feedback.

Review Questions

1.1 What is a monopoly? Can a firm be a monopoly ifclose substitutes for its product exist?

1.2 If you own the only hardware store in a small town,do you have a monopoly?

Problems and Applications

1.3 Is “monopoly” a good name for the game Monopoly?What aspects of the game involve monopoly? Explainbriefly, using the definition of monopoly.

1.4 [Related to the Chapter Opener on pagexxx] Some observers say that changes in the past fewyears have eroded the monopoly power of local cableTV companies, even though no other cable firmshave entered their markets. What are these changes?Do these “monopoly” firms still have monopolypower?

1.5 Are there any products for which there are no sub-stitutes? Are these the only products for which itwould be possible to have a monopoly? Brieflyexplain.

1.6 An economist argues, “No firm can remain a monop-oly for long in the face of technological change.” Doyou agree?

1.7 [Related to the Making the Connection onpage xxx] Microsoft thought that the initial Xboxwas sufficiently different from PS2 that it couldcharge a significantly higher price for the Xbox thanSony could charge for PS2. As it turns out, Microsoftwas wrong. Draw the average total cost and marginalcost curves for Microsoft’s Xbox. Now draw thedemand curve Microsoft thought would exist forXbox and the demand curve that actually existed.Why were the two demand curves different? Show onyour graph the profits Microsoft would earn witheach demand curve.

9.2 LEARNING OBJECTIVE 9.2 | Explain the four main reasons monopolies arise, pages xxx–xxx.

Where Do Monopolies Come From?

Summary

To have a monopoly, barriers to entering the market must beso high that no other firms can enter. Barriers to entry maybe high enough to keep out competing firms for four mainreasons: (1) government blocks the entry of more than onefirm into a market by issuing a patent, which is the exclusiveright to a product for 20 years, or a copyright, which is the

exclusive right to produce and sell a creation, or giving afirm a public franchise, which is the right to be the onlylegal provider of a good or service (2) one firm has controlof a key raw material necessary to produce a good, (3) thereare important network externalities in supplying the good orservice, or (4) economies of scale are so large that one firmhas a natural monopoly. Network externalties refer to thesituation where the usefulness of a product increases with


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the number of consumers who use it. A natural monopolyis a situation in which economies of scale are so large thatone firm can supply the entire market at a lower average costthan two or more firms.


Review Questions

2.1 What are the four most important ways a firmbecomes a monopoly?

2.2 If patents reduce competition, why does the federalgovernment grant them?

2.3 What is a public franchise? Are all public franchisesnatural monopolies?

2.4 What is “natural” about a natural monopoly?


2.5 The U.S. Postal Service (USPS) is a monopolybecause the federal government has blocked entryinto the market for delivering first-class mail. Is italso a natural monopoly? How can we tell? Whatwould happen if the law preventing competition inthis market were removed?

2.6 Patents are granted for 20 years, but pharmaceuticalcompanies can’t use their patent-guaranteed monop-oly powers for anywhere near this long because ittakes several years to acquire FDA approval of drugs.Should the life of drug patents be extended to 20years after FDA approval? What would be the costsand benefits of this extension?

2.7 Just as a new product or a new method of making aproduct receives patent protection from the govern-ment, books, articles, and essays receive copyrightprotection. Under U.S. law, authors have the exclu-sive right to their writings during their lifetimes—unless they sell this right, as most authors do to their

publishers—and their heirs retain this exclusive rightfor 50 years after their death. The historian ThomasMacaulay once described the copyright law as “a taxon readers to give a bounty to authors.” In what sensedoes the existence of the copyright law impose a taxon readers? What “bounty” do copyright laws giveauthors? Discuss whether the government would bedoing readers a favor by abolishing the copyright law.

Source of quote: Thomas Mallon, Stolen Words: The Classic Book onPlagiarism, San Diego: Harcourt, 2001 (original ed. 1989), p. 59.

2.8 The German company Koenig & Bauer has 90 per-cent of the world market for presses that print cur-rency. Discuss the factors that would make it difficultfor new companies to enter this market.

2.9 [Related to the Making the Connection onpage xxx] Would the Ecke’s have been better off ifthey had patented their process for growing poinset-tias? Briefly explain.

2.10 [Related to the Making the Connection onpage xxx] Why was De Beers worried that peoplemight resell their old diamonds? How did De Beersattempt to convince consumers that used diamondswere not good substitutes for new diamonds? Howdid De Beers’ strategy affect the demand curve fornew diamonds? How were De Beers’ profits affected?

2.11 [Related to Solved Problem 9-2 on pagexxx] Suppose that the quantity demanded per dayfor a product is 90 when the price is $35. The follow-ing table shows costs for a firm with a monopoly inthis market:

QUANTITY(PER DAY) TOTAL COST

30 $1,200

40 1,400

50 2,250

60 3,000

Briefly explain whether this firm has a naturalmonopoly in this market.

9.3 LEARNING OBJECTIVE 9.3 | Explain how a monopoly chooses price and output, pages xxx–xxx.

How Does a Monopoly Choose Price and Output?

Summary

Monopolists face downward-sloping demand and marginalrevenue curves and, like all other firms, maximize profit byproducing where marginal revenue equals marginal cost.

Unlike a perfect competitor, a monopolist that earns eco-nomic profits does not face the entry of new firms into themarket. Therefore, a monopolist can earn economic profits,even in the long run.


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Review Questions

3.1 What is the relationship between a monopolist’sdemand curve and the market demand curve? Whatis the relationship between a monopolist’s demandcurve and its marginal revenue curve?

3.2 Draw a graph that shows a monopolist that is earninga profit. Be sure your graph includes the monopolist’sdemand, marginal revenue, average total cost, andmarginal cost curves. Be sure to indicate the profit-maximizing level of output and price.


3.3 [Related to Solved Problem 9-3 on pagexxx] Ed Scahill has acquired a monopoly on the pro-duction of baseballs (don’t ask how), and faces thedemand and cost situation given in the followingtable:

QUANTITY(PER TOTAL MARGINAL TOTAL MARGINAL

PRICE WEEK) REVENUE REVENUE COST COST

$20 15,000 $330,000

19 20,000 365,000

18 25,000 405,000

17 30,000 450,000

16 35,000 500,000

15 40,000 555,000

a. Fill in the remaining values in the table.b. If Ed wants to maximize profits, what price should

he charge and how many baseballs should he sell?How much profit will he make?

c. Suppose the government imposes a tax of $50,000per week on baseball production. Now what priceshould Ed charge, how many baseballs should hesell, and what will his profits be?

3.4 [Related to Solved Problem 9-3 on pagexxx] Use the information in Solved Problem 9-3 toanswer the following questions.a. What will Comcast do if the tax is $6.00 per

month instead of $2.50? (Hint: Will its decisionbe different in the long run than in the shortrun?)

b. Suppose that the flat per-month tax is replacedwith a tax on the firm of $0.50 per cable sub-scriber. Now how many subscriptions shouldComcast sell if it wants to maximize profit? What

price does it charge? What are its profits? (Assumethat Comcast will sell only the quantities listed inthe table.)

3.5 Before inexpensive pocket calculators were devel-oped, many science and engineering students usedslide rules to make numeric calculations. Slide rulesare no longer produced, which means nothing pre-vents you from establishing a monopoly in the sliderule market. Draw a graph showing the situation yourslide rule firm would be in. Be sure to include on yourgraph your demand, marginal revenue, average totalcost, and marginal cost curves. Indicate the price youwould charge and the quantity you would produce.Are you likely to make a profit or a loss? Show thisarea on your graph.

3.6 Does a monopolist have a supply curve? Brieflyexplain. (Hint: Look again at the definition of a sup-ply curve in Chapter 3 and consider whether thisapplies to a monopolist.)

3.7 [Related to the Don’t Let This Happen toYou! on page xxx] A student argues,“If a monop-olist finds a way of producing a good at lower cost, hewill not lower his price. Because he is a monopolist,he will keep the price and the quantity the same andjust increase his profit.” Do you agree? Use a graph toillustrate your answer.

3.8 [Related to the Don’t Let This Happen toYou! on page xxx] Discuss whether you agree ordisagree with the following statement: “A monopolistmaximizes profit by charging the highest price atwhich it can sell any of the good at all.”

3.9 When home builders construct a new housing devel-opment, they usually sell the rights to lay cable to asingle cable television company. As a result, anyonebuying a home in that development is not able tochoose between competing cable companies. Somecities have begun to ban such exclusive agreements.Williams Township, Pennsylvania, decided to allowany cable company to lay cable in the utility trenchesof new housing developments. The head of the town-ship board of supervisors argued, “What I would liketo see and do is give the consumers a choice. If there’sno choice, then the price [of cable] is at the whim ofthe provider.” In a situation in which the consumersin a housing development have only one cable com-pany available, is the price really at the whim of thecompany? Would a company in this situation belikely to charge, say, $500 per month for basic cableservices? Briefly explain why or why not.

Source: Sam Kennedy, “Williams Township May Ban Exclusive CableProvider Pacts,” (Allentown, Pennsylvania) Morning Call, November 5,2004, p. D1.

3.10 Will a monopoly that maximizes profit also be maxi-mizing revenue? Will it be maximizing production?Briefly explain.


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9.4 LEARNING OBJECTIVE 9.4 | Use a graph to illustrate how a monopoly affects economic efficiency,

pages xxx–xxx.

Does Monopoly Reduce Economic Efficiency?

Summary

Compared with a perfectly competitive industry, a monopolycharges a higher price and produces less, which reduces con-sumer surplus and economic efficiency. Some loss of eco-nomic efficiency will occur whenever firms have marketpower and can charge a price greater than marginal cost. Thetotal loss of economic efficiency in the U.S. economy due tomarket power is small, however, because true monopolies arevery rare. In most industries, competition will keep price muchcloser to marginal cost than would be the case in a monopoly.


Review Questions

4.1 Suppose that a perfectly competitive industry becomesa monopoly. Describe the effects of this change on con-sumer surplus, producer surplus, and deadweight loss.

4.2 Explain why market power leads to a deadweight loss.Is the total deadweight loss from market power forthe economy large or small?


4.3 Review Figure 9-5 on page xxx on the inefficiency ofmonopoly. Will the deadweight loss due to monopoly

be larger if the demand is elastic or if it is inelastic?Briefly explain.

4.4 Economist Harvey Leibenstein argued that the lossof economic efficiency in industries that are notperfectly competitive has been understated. Heargues that when competition is weak, firms areunder less pressure to adopt the best techniques orto hold down their costs. He refers to this effect as“x-inefficiency.” If x-inefficiency causes a firm’smarginal costs to rise, show that the deadweight lossin Figure 9-5 understates the true deadweight losscaused by a monopoly.

4.5 In most cities, the city owns the water system thatprovides water to homes and businesses. Somecities charge a flat monthly fee, while other citiescharge by the gallon. Which method of pricing ismore likely to result in economic efficiency in thewater market? Be sure to refer to the definition ofeconomic efficiency in your answer. Why do youthink the same method of pricing isn’t used by allcities?

4.6 Review the concept of externalities on page xxx inChapter 4. If a market is a monopoly, will a negativeexternality in production always lead to productionbeyond the level of economic efficiency? Use a graphto illustrate your answer.

9.5 LEARNING OBJECTIVE 9.5 | Discuss government policies toward monopoly, pages xxx–xxx.

Government Policy toward Monopoly

Summary

Because monopolies reduce consumer surplus and eco-nomic efficiency, most governments regulate monop-olies. Firms that are not monopolies have an incentive toavoid competition by colluding, or agreeing to charge the same price, or otherwise not to compete. In theUnited States, antitrust laws are aimed at deterringmonopoly, eliminating collusion, and promoting com-petition among firms. The Antitrust Division of the U.S. Department of Justice and the Federal TradeCommission share responsibility for enforcing theantitrust laws including regulating mergers betweenfirms. A horizontal merger is a merger between firms inthe same industry. A vertical merger is a merger betweenfirms at different stages of production of a good. Local

governments regulate the prices charged by naturalmonopolies.


Review Questions

5.1 What is the purpose of the antitrust laws? Who is incharge of enforcing them?

5.2 What is the difference between a horizontal merger anda vertical merger? Which type of merger is more likelyto increase the market power of a newly merged firm?

5.3 Why would it be economically efficient to require anatural monopoly to charge a price equal to marginalcost? Why do most regulatory agencies require natural


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monopolies to charge a price equal to average costinstead?


5.4 Use the following graph for a monopoly to answerthe questions.

a. What quantity will the monopoly produce, andwhat price will the monopoly charge?

b. Suppose the monopoly is regulated. If the regula-tory agency wants to achieve economic efficiency,what price should it require the monopoly tocharge? How much output will the monopolyproduce at this price? Will the monopoly make aprofit if it charges this price? Briefly explain.

5.5 Use the following graph for a monopoly to answerthe questions.

a. What quantity will the monopoly produce, andwhat price will the monopoly charge?

b. Suppose the government decides to regulate thismonopoly and imposes a price ceiling of $18 (inother words, the monopoly can charge less than$18 but can’t charge more). Now what quantitywill the monopoly produce, and what price willthe monopoly charge? Will every consumer who iswilling to pay this price be able to buy the prod-uct? Briefly explain.

5.6 The following is from an article in the New YorkTimes: “United Airlines and US Airways announcedtoday that they had called off their proposed mergerafter the Justice Department threatened to file a law-suit to block the $4.2 billion deal, calling it anticom-petitive.” Why would the Justice Department care iftwo airlines merge? What is “anticompetitive” abouttwo airlines merging?

Source: Kenneth N. Gilpin and Jack Lynch, “United and US Airways CallOff Merger after U.S. Opposes It,”New York Times, July 27, 2001.

5.7 A marketing textbook observes, “Pricing actions thatviolate laws can land executives in jail.” Why wouldexecutives be thrown in jail because of the prices theycharge? Which laws are they likely to have violated?

Source: David W. Cravens, Strategic Marketing, 5th ed., Boston: IrwinMcGraw-Hill, 1997, p. 343.

5.8 Draw a graph like Figure 9-6 on page xxx. On yourgraph, show producer surplus and consumer surplusbefore a merger and consumer surplus and producersurplus after a merger.

5.9 The following phone call took place in February 1982between Robert Crandall, the chief executive officer ofAmerican Airlines, and Howard Putnam, the chiefexecutive officer of Braniff Airways. Although Crandalldidn’t know it, Putnam was recording the call:

Crandall: I think it’s dumb . . . to sit here andpound the (obscenity) out of each other andneither one of us making a (obscenity) dime . . .

Putnam: Do you have a suggestion for me?

Crandall: Yes, I have a suggestion for you. Raiseyour . . . fares 20 percent. I’ll raise mine the nextmorning.

Putnam: Robert, we . . .

Crandall: You’ll make more money and I will, too.

Putnam: We can’t talk about pricing.

Crandall: Oh (obscenity), Howard. We can talkabout any . . . thing we want to talk about.

Who had a better understanding of antitrust law,Crandall or Putnam? Briefly explain.

Source: Mark Potts,“American Airlines Charged with Seeking a Monopoly,”Washington Post, February 24, 1983; “Blunt Talk on the Phone,” New YorkTimes, February 24,1983; and Thomas Petzinger Jr., Hard Landing: The EpicContest for Power and Profits that Plunged the Airline Industry into Chaos,New York: Random House, 1995, pp. 149–150.

$10

3

5

6

7

0

Priceand

costperunit

Quantity100908050

D

MR

ATC

MC

$30

21

18

8

0

Priceandcostperunit

Quantity40353320

D

MR

ATC

MC


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5.10 Look again at the section “The Department of Justiceand Federal Trade Commission Merger Guidelines,”which begins on page xxx. Evaluate the followingsituations.a. A market initially has 20 firms, each with a 5 per-

cent market share. Of the firms, 4 propose tomerge, leaving a total of 17 firms in the industry.Are the Department of Justice and the FederalTrade Commission likely to oppose the merger?Briefly explain.

b. A market initially has 5 firms, each with a 20 per-cent market share. Of the firms, 2 propose tomerge, leaving a total of 4 firms in the industry.Are the Department of Justice and the FederalTrade Commission likely to oppose the merger?Briefly explain.

5.11 In 2007, Sirius Satellite Radio and XM Satellite Radio,the only two satellite radio firms, announced thatthey would attempt to merge. Maurice McKenzie, ananalyst for Signal Hill investment bank, was quotedin the Wall Street Journal as arguing, “We believe thatgovernmental approval could hinge on the marketdefinition surrounding radio competition, which weexpect to be narrowly defined to include terrestrialand satellite radio operators. . . . ” What is a “terres-trial” radio operator? Why would governmentapproval depend on how it defines the relevant mar-ket? What other firms—apart from terrestrial radiooperators—might the government consider competi-tors to a newly merged Sirius-XM firm?

Source:“Analysts Like Sirius-XM Merger, but Note Regulatory Difficulties,”Wall Street Journal, February 20, 2007.

5.12 In a column in the Wall Street Journal, DavidHenderson, an economist at the Hoover Institution,argued that it was possible to judge whether the pro-posed merger between Sirius and XM would makeconsumers better or worse off by looking at howowners of “free,” or broadcast, radio stations reacted:

Look at what the “free” broadcasters aresaying about the XM-Sirius merger. Asthis newspaper recently reported, “Theradio industry has loudly opposed thedeal since it was announced, and broad-casters cite satellite-radio operators asmajor competitors in securities filings.”Traditional radio broadcasters under-stand that they are competing with satel-lite radio. And they oppose the merger.

Why would “free” radio broadcasters oppose themerger? If the newly merged Sirius-XM chargedhigher prices, wouldn’t that be good news to “free”radio broadcasters? Does the reaction of the “free”radio broadcasters indicate that consumers would bemade better or worse off by the Sirius-XM merger?

Source: David R. Henderson,“Sirius Business,”Wall Street Journal, February28, 2007.

5.13 Industrial gases are used in the electronics industry.For example, nitrogen trifluoride is used for cleaningsemiconductor wafers. The following table shows themarket shares for the companies in this industry.

COMPANY MARKET SHARE

Air Products 29%

Air Liquide 22

BOC Gases 21

Nippon Sanso 17

Praxzir 8

Other 3

In 2000, Air Products discussed a merger with BOCGases. Use the information in the section “TheDepartment of Justice and Federal Trade CommissionMerger Guidelines” that begins on page xxx to predictwhether the Department of Justice and the FederalTrade Commission opposed this merger. Assume that“Other” in the table consists of three firms, each ofwhich has a 1 percent share of the market.

Source for market share data: Dan Shope, “Air Products Turns a Corner,”(Allentown, Pennsylvania) Morning Call, July 29, 2001.

5.14 The following table gives the market shares of thecompanies in the U.S. carbonated soft drink industry.

COMPANY MARKET SHARE

Coca-Cola 37%

PepsiCo 35

Cadbury Schweppes 17

Other 11

Use the information in the section “The Departmentof Justice and Federal Trade Commission MergerGuidelines” that begins on page xxx to predictwhether the Department of Justice and the FederalTrade Commission would be likely to approve amerger between any two of the first three companieslisted. Does your answer depend on how many com-panies are included in the “Other” category? Brieflyexplain.

Source: Pepsico Annual Report, 2003.

5.15 According to a column in the New York Times byAustan Goolsbee of the University of Chicago, theFrench National Assembly approved a bill:

. . . that would require Apple Computerto crack open the software codes of itsiTunes music store and let the files workon players other than the iPod. . . . If theFrench gave away the codes, Apple wouldlose much of its rationale for improvingiTunes.


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a. Why would Apple no longer want to improveiTunes if its software codes were no longer secret?

b. Why would the French government believe it wasa good idea to require Apple to make the codespublic?

Source: Austan Goolsbee, “In iTunes War, France Has Met the Enemy.Perhaps It Is France,”New York Times, April 27, 2006.

5.16 [Related to the Making the Connection onpage xxx] Bank of America has attempted to con-vince Congress to eliminate the rule that banks maynot merge if the newly merged bank would havemore than a 10 percent share of U.S. deposits. In2007, Bank of America was expanding its bankingactivities by, among other things, offering checkingaccounts and credit cards to illegal immigrants andother people who lacked Social Security numbers. Anarticle in the Wall Street Journal observed:

Unorthodox initiatives like the new credit-card program may be crucial to Bank ofAmerica’s long-term success. In the past

the bank, which operates in 31 states andthe District of Columbia, grew mostly bybuying up other banks. Now, however, it isbumping up against a regulatory cap thatbars any U.S. bank from an acquisition thatwould give it more than 10% of thenation’s total bank deposits. That meansBank of America’s only way to growdomestically is to sell more products toexisting customers and to attract new ones.

Should the government take this information intoaccount in evaluating the policy of limiting mergersamong large banks? The Wall Street Journal articlealso notes,“Illegal immigrants have typically relied onloan sharks and neighborhood finance shops [whichcharge very high interest rates] for credit.” Should thegovernment consider this additional piece of infor-mation when formulating policy on bank mergers?

Source: Miriam Jordan and Valerie Bauerlein, “Bank of America CastsWider Net for Hispanics,”Wall Street Journal, February 13, 2007, p. A1.


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Hubbard Obrien MacroEconomics 2nd edition chapter 09

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