Krugwellsecps3e_micro_ch13.indd

chapter:
Monopoly
1. Each of the following firms possesses market power. Explain its source.
a. Merck, the producer of the patented cholesterol-lowering drug Zetia
b. WaterWorks, a provider of piped water
c. Chiquita, a supplier of bananas and owner of most banana plantations
d. The Walt Disney Company, the creators of Mickey Mouse
Solution
1. a. Merck has a patent for Zetia. This is an example of a government-created barrier
to entry, which gives Merck market power.
b. There are increasing returns to scale in the provision of piped water. There is a
large fixed cost associated with building a network of water pipes to each house-hold; the more water delivered, the lower its average total cost becomes. This gives WaterWorks a cost advantage over other companies, which gives WaterWorks market power.
c. Chiquita controls most banana plantations. Control over a scarce resource gives
d. The Walt Disney Company has the copyright on animations featuring Mickey
Mouse. This is another example of a government-created barrier to entry that gives the Walt Disney Company market power.
2. Skyscraper City has a subway system, for which a one-way fare is $1.50. There is pres-
sure on the mayor to reduce the fare by one-third, to $1.00. The mayor is dismayed, thinking that this will mean Skyscraper City is losing one-third of its revenue from sales of subway tickets. The mayor’s economic adviser reminds her that she is focusing only on the price effect and ignoring the quantity effect. Explain why the mayor’s estimate of a one-third loss of revenue is likely to be an overestimate. Illustrate with a diagram.
Solution
2. A reduction in fares from $1.50 to $1.00 will reduce the revenue on each ticket that
is currently sold by one-third; this is the price effect. But a reduction in price will lead to more tickets being sold at the lower price of $1.00, which creates additional revenue; this is the quantity effect. The accompanying diagram illustrates this.
Quantity of tickets
The price effect is the loss of revenue on all the currently sold tickets. The quantity effect is the increase in revenue from increased sales as a result of the lower price.
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3. Consider an industry with the demand curve (D) and marginal cost curve (MC)
shown in the accompanying diagram. There is no fixed cost. If the industry is a single-price monopoly, the monopolist’s marginal revenue curve would be MR. Answer the following questions by naming the appropriate points or areas.
Quantity
a. If the industry is perfectly competitive, what will be the total quantity produced?
b. Which area reflects consumer surplus under perfect competition?
c. If the industry is a single-price monopoly, what quantity will the monopolist pro-
d. Which area reflects the single-price monopolist’s profit?
e. Which area reflects consumer surplus under single-price monopoly?
f. Which area reflects the deadweight loss to society from single-price monopoly?
g. If the monopolist can price-discriminate perfectly, what quantity will the perfectly
Solution
3. a. In a perfectly competitive industry, each firm maximizes profit by producing the
quantity at which price equals marginal cost. That is, all firms together produce a quantity S, corresponding to point R, where the marginal cost curve crosses the demand curve. Price will be equal to marginal cost, E. b. Consumer surplus is the area under the demand curve and above price. In part a,
we saw that the perfectly competitive price is E. Consumer surplus in perfect com-petition is therefore the triangle ARE. c. A single-price monopolist produces the quantity at which marginal cost equals
marginal revenue, that is, quantity I. Accordingly, the monopolist charges price B, the highest price it can charge if it wants to sell quantity I. d. The single-price monopolist’s profit per unit is the difference between price and
the average total cost. Since there is no fixed cost and the marginal cost is con-stant (each unit costs the same to produce), the marginal cost is the same as the average total cost. That is, profit per unit is the distance BE. Since the monopolist sells I units, its profit is BE times I, or the rectangle BEHF. e. Consumer surplus is the area under the demand curve and above the price. In
part c, we saw that the monopoly price is B. Consumer surplus in monopoly is therefore the triangle AFB. f. Deadweight loss is the surplus that would have been available (either to consum-
ers or producers) under perfect competition but that is lost when there is a single-price monopolist. It is the triangle FRH. C H A P T E R 1 3
M O N O P O LY S-197
g. If a monopolist can price-discriminate perfectly, it will sell the first unit at price
A, the second unit at a slightly lower price, and so forth. That is, it will extract from each consumer just that consumer’s willingness to pay, as indicated by the demand curve. It will sell S units, because for the last unit, it can just make a con-sumer pay a price of E (equal to its marginal cost), and that just covers its mar-ginal cost of producing that last unit. For any further units, it could not make any consumer pay more than its marginal cost, and it therefore stops selling units at quantity S. 4. Bob, Bill, Ben, and Brad Baxter have just made a documentary movie about their bas-
ketball team. They are thinking about making the movie available for download on the Internet, and they can act as a single-price monopolist if they choose to. Each time the movie is downloaded, their Internet service provider charges them a fee of $4. The Baxter brothers are arguing about which price to charge customers per down-load. The accompanying table shows the demand schedule for their film.
Quantity of downloads
download
demanded
a. Calculate the total revenue and the marginal revenue per download.
b. Bob is proud of the film and wants as many people as possible to download it.
Which price would he choose? How many downloads would be sold? c. Bill wants as much total revenue as possible. Which price would he choose? How
d. Ben wants to maximize profit. Which price would he choose? How many down-
e. Brad wants to charge the efficient price. Which price would he choose? How
Solution
4. a. The accompanying table calculates total revenue (TR) and marginal revenue
(MR). Recall that marginal revenue is the additional revenue per unit of output, that is, ΔTR/ΔQ. Quantity
Price of download
downloads demanded
TR
MR
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b. Bob would charge $0. At that price, there would be 15 downloads, the largest
c. Bill would charge $4. At that price, total revenue is greatest ($24). At that price,
d. Ben would charge $6. At that price, there would be 3 downloads. For any more
downloads, marginal revenue would be below marginal cost, and so further down-loads would lose the Baxters’ money.
e. Brad would charge $4. A price equal to marginal cost is efficient. At that price,
5. Jimmy has a room that overlooks, from some distance, a major league baseball stadi-
um. He decides to rent a telescope for $50.00 a week and charge his friends and classmates to use it to peep at the game for 30 seconds. He can act as a single-price monopolist for renting out “peeps.” For each person who takes a 30-second peep, it costs Jimmy $0.20 to clean the eyepiece. The accompanying table shows the informa-tion Jimmy has gathered about the demand for the service in a given week.
Price of peep
Quantity of peeps demanded
a. For each price in the table, calculate the total revenue from selling peeps and the
b. At what quantity will Jimmy’s profit be maximized? What price will he charge?
c. Jimmy’s landlady complains about all the visitors coming into the building and
tells Jimmy to stop selling peeps. Jimmy discovers, however, that if he gives the landlady $0.20 for every peep he sells, she will stop complaining. What effect does the $0.20-per-peep bribe have on Jimmy’s marginal cost per peep? What is the new profit-maximizing quantity of peeps? What effect does the $0.20-per-peep bribe have on Jimmy’s total profit? C H A P T E R 1 3
M O N O P O LY S-199
Solution
5. a. Total revenue (TR) and marginal revenue (MR) are given in the accompanying
Quantity of peeps
Price of peep
demanded
TR
MR
b. Jimmy’s profit will be maximized when he sells 250 peeps, since for the first 250
peeps his marginal revenue exceeds his marginal cost of $0.20. He will charge $0.70 per peep. His total profit is (250 × $0.70) − (250 × $0.20) − $50.00 = $75.00.
c. When Jimmy pays the landlady $0.20 per peep, his marginal cost increases to
$0.40 per peep, so the profit-maximizing quantity decreases to 200 and the profit-maximizing price increases to $0.80. His total profit will now be (200 × $0.80) − (200 × $0.40) − $50.00 = $30.00.
6. Suppose that De Beers is a single-price monopolist in the market for diamonds.
De Beers has five potential customers: Raquel, Jackie, Joan, Mia, and Sophia. Each of these customers will buy at most one diamond—and only if the price is just equal to, or lower than, her willingness to pay. Raquel’s willingness to pay is $400; Jackie’s, $300; Joan’s, $200; Mia’s, $100; and Sophia’s, $0. De Beers’s marginal cost per dia-mond is $100. This leads to the demand schedule for diamonds shown in the accom-panying table.
Quantity of diamonds
demanded
a. Calculate De Beers’s total revenue and its marginal revenue. From your calcula-
tion, draw the demand curve and the marginal revenue curve.
b. Explain why De Beers faces a downward-sloping demand curve.
c. Explain why the marginal revenue from an additional diamond sale is less than
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d. Suppose De Beers currently charges $200 for its diamonds. If it lowers the price to
$100, how large is the price effect? How large is the quantity effect? e. Add the marginal cost curve to your diagram from part a and determine which
quantity maximizes De Beers’s profit and which price De Beers will charge.
Solution
6. a. Total revenue (TR) and marginal revenue (MR) are given in the accompanying
Quantity of diamonds
Price of diamond
demanded
TR
MR
The accompanying diagram illustrates De Beers’s demand curve and marginal rev-enue (MR) curve.
Quantity of diamonds
b. De Beers is the only producer of diamonds, so its demand curve is the market
demand curve. And the market demand curve slopes downward: the lower the price, the more customers will buy diamonds.
c. If De Beers lowers the price sufficiently to sell one more diamond, it earns extra
revenue equal to the price of that one extra diamond. This is the quantity effect of lowering the price. But there is also a price effect: lowering the price means that De Beers also has to lower the price on all other diamonds, and that lowers its revenue. So the marginal revenue of selling an additional diamond is less than the price at which the additional diamond can be sold.
d. If the price is $200, then De Beers sells to Raquel, Jackie, and Joan. If it lowers the
price to $100, it will also sell a diamond to Mia. The price effect is that De Beers loses $100 (the amount by which it lowered the price) each from selling to Raquel, Jackie, and Joan. So the price effect lowers De Beers’s revenue by 3 × $100 = $300. The quantity effect is that De Beers sells one more diamond (to Mia), at $100. So the quantity effect is to raise De Beers’s revenue by $100.
e. The marginal cost (MC) curve is constant at $100, as shown in the diagram.
Marginal revenue equals marginal cost at a quantity of 2 diamonds. So De Beers will sell 2 diamonds at a price of $300 each.
C H A P T E R 1 3
M O N O P O LY S-201
7. Use the demand schedule for diamonds given in Problem 6. The marginal cost of
producing diamonds is constant at $100. There is no fixed cost.
a. If De Beers charges the monopoly price, how large is the individual consumer sur-
plus that each buyer experiences? Calculate total consumer surplus by summing the individual consumer surpluses. How large is producer surplus? Suppose that upstart Russian and Asian producers enter the market and the market becomes perfectly competitive.
b. What is the perfectly competitive price? What quantity will be sold in this
c. At the competitive price and quantity, how large is the consumer surplus that each
buyer experiences? How large is total consumer surplus? How large is producer surplus? d. Compare your answer to part c to your answer to part a. How large is the dead-
weight loss associated with monopoly in this case? Solution
7. a. The monopoly price is $300. At that price Raquel and Jackie buy diamonds.
Raquel’s consumer surplus is $400 − $300 = $100; Jackie’s is $300 − $300 = $0. So total consumer surplus is $100 + $0 = $100. Producer surplus is $300 − $100 = $200 for each diamond sold; 2 × $200 = $400.
b. In a perfectly competitive market, P = MC. That is, the perfectly competitive price
is $100, and at that price 4 diamonds will be sold—to Raquel, Jackie, Joan, and Mia.
c. At the competitive price, Raquel’s consumer surplus is $400 − $100 = $300;
Jackie’s, $300 − $100 = $200; Joan’s, $200 − $100 = $100; and Mia’s, $100 − $100 = $0. So total consumer surplus is $300 + $200 + $100 + $0 = $600. Since the price is equal to marginal cost, there is no producer surplus.
d. Under perfect competition, the sum of consumer and producer surplus is $600 +
$0 = $600. Under monopoly, the sum of consumer and producer surplus is $100 + $400 = $500. So the loss of surplus to society from monopoly—the deadweight loss—is $600 − $500 = $100.
8. Use the demand schedule for diamonds given in Problem 6. De Beers is a monopo-
list, but it can now price-discriminate perfectly among all five of its potential cus-tomers. De Beers’s marginal cost is constant at $100. There is no fixed cost.
a. If De Beers can price-discriminate perfectly, to which customers will it sell dia-
b. How large is each individual consumer surplus? How large is total consumer sur-
plus? Calculate producer surplus by summing the producer surplus generated by each sale.
Solution
8. a. If De Beers can price-discriminate perfectly, it will charge each customer that cus-
tomer’s willingness to pay. That is, it will charge Raquel $400, Jackie $300, Joan $200, and Mia $100. De Beers does not want to sell to Sophia since she will only buy at a price of $0, and that would be below De Beers’s marginal cost.
b. Since each consumer is charged exactly her willingness to pay, there is no con-
sumer surplus. De Beers’s producer surplus is $400 − $100 = $300 from selling to Raquel; $300 − $100 = $200 from selling to Jackie; $200 − $100 = $100 from sell-ing to Joan; $100 − $100 = $0 from selling to Mia. So producer surplus is $300 + $200 + $100 + $0 = $600.
S-202 CHAPTER 13 MONOPOLY
9. Download Records decides to release an album by the group Mary and the Little
Lamb. It produces the album with no fixed cost, but the total cost of downloading an album to a CD and paying Mary her royalty is $6 per album. Download Records can act as a single-price monopolist. Its marketing division finds that the demand sched-ule for the album is as shown in the accompanying table.
Price of album
Quantity of albums demanded
a. Calculate the total revenue and the marginal revenue per album.
b. The marginal cost of producing each album is constant at $6. To maximize profit,
what level of output should Download Records choose, and which price should it charge for each album? c. Mary renegotiates her contract and now needs to be paid a higher royalty per
album. So the marginal cost rises to be constant at $14. To maximize profit, what level of output should Download Records now choose, and which price should it charge for each album? Solution
9. a. Total revenue (TR) and marginal revenue per album (MR) is shown in the accom-
Quantity of albums
Price of album
demanded
TR
MR
b. If the marginal cost of each album is $6, Download Records will maximize profit
by producing 4,000 albums, since for each album up to 4,000, marginal revenue is greater than marginal cost. For any further albums, marginal cost would exceed marginal revenue. Producing 4,000 albums, Download Records will charge $14 for each album.
c. If the marginal cost of each album is $14, Download Records will maximize profit
by producing 2,000 albums, and it will charge $18 per album.
C H A P T E R 1 3
M O N O P O LY S-203
10. The accompanying diagram illustrates your local electricity company’s natural
monopoly. The diagram shows the demand curve for kilowatt-hours (kWh) of elec-tricity, the company’s marginal revenue (MR) curve, its marginal cost (MC) curve, and its average total cost (ATC) curve. The government wants to regulate the monop-olist by imposing a price ceiling.
Quantity of kWh (thousands)
a. If the government does not regulate this monopolist, which price will it charge?
Illustrate the inefficiency this creates by shading the deadweight loss from monopoly.
b. If the government imposes a price ceiling equal to the marginal cost, $0.30, will
the monopolist make profits or lose money? Shade the area of profit (or loss) for the monopolist. If the government does impose this price ceiling, do you think the firm will continue to produce in the long run? c. If the government imposes a price ceiling of $0.50, will the monopolist make a
Solution
10. a. The monopolist would choose a price of $0.80. Deadweight loss is shaded and
Quantity of kWh (thousands)
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b. If the government imposes a price ceiling of $0.30, the quantity demanded is
10,000. The monopolist will incur a loss equal to the shaded rectangle in the accompanying figure. Since the firm is incurring a loss, in the long run it will exit the market.
Quantity of kWh (thousands)
c. If the government imposes a price ceiling of $0.50, the quantity demanded is
8,000. The price equals the monopolist’s average total cost, and so the firm will make zero profit.
11. The movie theater in Collegetown serves two kinds of customers: students and pro-
fessors. There are 900 students and 100 professors in Collegetown. Each student’s willingness to pay for a movie ticket is $5. Each professor’s willingness to pay for a movie ticket is $10. Each will buy at most one ticket. The movie theater’s marginal cost per ticket is constant at $3, and there is no fixed cost.
a. Suppose the movie theater cannot price-discriminate and needs to charge both
students and professors the same price per ticket. If the movie theater charges $5, who will buy tickets and what will the movie theater’s profit be? How large is con-sumer surplus? b. If the movie theater charges $10, who will buy movie tickets and what will the
movie theater’s profit be? How large is consumer surplus? c. Now suppose that, if it chooses to, the movie theater can price-discriminate
between students and professors by requiring students to show their student ID. If the movie theater charges students $5 and professors $10, how much profit will the movie theater make? How large is consumer surplus? Solution
11. a. If the movie theater charges $5 per ticket, both students and professors will buy
tickets. The movie theater will sell to 1,000 customers (students and professors), at a price of $5 each. Since the movie theater’s cost per ticket is $3, its profit is $2 per ticket for a total profit of 1,000 × $2 = $2,000. Students will experience no consumer surplus, but each of the 100 professors will experience consumer sur-plus of $10 − $5 = $5 for a total consumer surplus of 100 × $5 = $500.
b. If the movie theater charges $10 per ticket, only professors will buy tickets. The
movie theater will sell to 100 customers (professors) at a price of $10 each. Since the movie theater’s cost per ticket is $3, its profit is $7 per ticket for a total profit of 100 × $7 = $700. Students experience no consumer surplus since they do not buy any tickets. Each of the 100 professors experiences no consumer surplus since the price is equal to their willingness to pay. So consumer surplus is $0.
C H A P T E R 1 3
M O N O P O LY S-205
c. If the movie theater charges students a price of $5, it sells 900 tickets at a profit
of $5 − $3 = $2 each for a profit from selling to students of 900 × $2 = $1,800. Charging professors $10, it sells 100 tickets at a profit of $10 − $3 = $7 each for a profit from selling to professors of 100 × $7 = $700. So the theater’s total profit is $1,800 + $700 = $2,500. Since each customer is charged exactly his or her willing-ness to pay, there is no consumer surplus.
12. A monopolist knows that in order to expand the quantity of output it produces from
8 to 9 units it must lower the price of its output from $2 to $1. Calculate the quantity effect and the price effect. Use these results to calculate the monopolist’s marginal revenue of producing the 9th unit. The marginal cost of producing the 9th unit is positive. Is it a good idea for the monopolist to produce the 9th unit? Solution
12. The quantity effect is $1 (the increase in total revenue from selling the 9th unit at
$1). The price effect is 8 × (−$1) = −$8 (the decrease in total revenue from having to lower the price of 8 units by $1 each). So the marginal revenue of producing the 9th unit is $1 − $8 = −$7. Since marginal revenue is negative, producing the 9th unit is definitely not a good idea: it lowers revenue (since marginal revenue is negative) and increases the total cost (since marginal cost is positive). So it will definitely lower profit. Instead, the monopolist should produce less output.
13. In the United States, the Federal Trade Commission (FTC) is charged with promoting
competition and challenging mergers that would likely lead to higher prices. Several years ago, Staples and Office Depot, two of the largest office supply superstores, announced their agreement to merge.
a. Some critics of the merger argued that, in many parts of the country, a merger
between the two companies would create a monopoly in the office supply super-store market. Based on the FTC’s argument and its mission to challenge mergers that would likely lead to higher prices, do you think it allowed the merger? b. Staples and Office Depot argued that, while in some parts of the country they
might create a monopoly in the office supply superstore market, the FTC should consider the larger market for all office supplies, which includes many smaller stores that sell office supplies (such as grocery stores and other retailers). In that market, Staples and Office Depot would face competition from many other, small-er stores. If the market for all office supplies is the relevant market that the FTC should consider, would it make the FTC more or less likely to allow the merger? Solution
13. a. If Staples and Office Depot create a monopoly, they will be able to reduce the
quantity of output and raise prices, which would create inefficiency in the form of deadweight loss. Since the FTC is charged with challenging mergers that would like-ly lead to higher prices, you should think that the FTC would not allow this merger. And, in fact, in a court ruling in 1997, the FTC was able to prevent the merger.
b. If the relevant market is the market for all office supplies, the merger between
Staples and Office Depot would not create a monopoly, and the companies would not be able to raise prices to the same extent. If this were the relevant market, it would make the FTC more likely to allow the merger. This illustrates the impor-tance of what economists call “market definition”—deciding what the correct market is: in this example, the office supply superstore market or the market for all office supplies.
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14. Prior to the late 1990s, the same company that generated your electricity also
distributed it to you over high-voltage lines. Since then, 16 states and the District of Columbia have begun separating the generation from the distribution of electric-ity, allowing competition between electricity generators and between electricity distributors.
a. Assume that the market for electricity distribution was and remains a natural
monopoly. Use a graph to illustrate the market for electricity distribution if the government sets price equal to average total cost.
b. Assume that deregulation of electricity generation creates a perfectly competitive
market. Also assume that electricity generation does not exhibit the characteristics of a natural monopoly. Use a graph to illustrate the cost curves in the long-run equilibrium for an individual firm in this industry.
Solution
14. a. The market for electricity distribution is shown in panel (a) of the accompanying
diagram. Electricity distribution has the characteristics of a natural monopoly: the large fixed cost of building the electric grid, combined with the low marginal cost of routing electricity over the grid, give this industry increasing returns to scale over the relevant output range. If the government sets the price equal to average total cost, at P *, the natural monopolist will produce quantity Q *. In this case, the monopolist will make zero economic profit.
b. The cost curves of an individual electricity generator are shown in panel (b). Since
the market is perfectly competitive, in the long run, price, P , will be equal to minimum average total cost, and the individual generator will produce electricity at the quantity Q , where marginal cost is just equal to the market price.
(a) Regulated Natural Monopolist
(b) Perfectly Competitive Firm
Q* Quantity
Quantity
15. Explain the following situations.
a. In Europe, many cell phone service providers give away for free what would oth-
erwise be very expensive cell phones when a service contract is purchased. Why might a company want to do that? b. In the United Kingdom, the country’s antitrust authority banned the cell phone
service provider Vodaphone from offering a plan that gave customers free calls to other Vodaphone customers. Why might Vodaphone have wanted to offer these calls for free? Why might a government want to step in and ban this practice? Why might it not be a good idea for a government to interfere in this way? Solution
15. a. Cell phone service is a good characterized by network externalities: the more
people you can reach while they are away from their fixed-line phones, the greater C H A P T E R 1 3
M O N O P O LY S-207
your utility from having a phone that allows you to reach others when you are also away from your fixed-line phone. This is an industry that exhibits positive feedback: once the market reaches critical mass, the number of cell phones in use increases rapidly. So if a company gives away phones for free (or below cost), it can attract more customers and the market reaches critical mass more quickly.
b. By offering free calls to other Vodaphone subscribers, the company was attempt-
ing to tip the market and attract customers to its service. This can be seen as an anticompetitive practice that leads to monopolization, which is why a government might want to ban the practice. However, banning Vodaphone from creating and exploiting its monopoly position might stifle the company’s incentive to inno-vate and invent new services (such as text messaging, transmission of pictures by phone, and so on).

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