CHAPTER EIGHT
MONOPOLY
OBJECTIVES
1. To examine price and output decisions under pure monopoly.
(Pure Monopoly)
2. To explore how monopolies are maintained through barriers to entry.
(Barriers to Entry)
3. To contrast competitive and monopolistic outcomes. (Perfect
Competition versus Pure Monopoly)
4. To analyze cartel behavior. (Cartels)
5. To discuss natural monopoly and regulation. (Natural Monopolies)
6. To present a model of monopolistic competition. (Monopolistic
Competition)
TEACHING SUGGESTIONS
I. Introduction and Motivation
Market structure is studied in Chapters 7, 8, 9 and 10. The present chapter
focuses on monopoly and monopolistic competition – a natural contrast to
the analysis of perfect competition in Chapter 7. In turn, Chapter 9 considers
oligopoly.
Through the comparison of competition and monopoly, it should
become apparent that market structure is very important to decision making
and profitability. This is one reason that we see expensive and protracted
patent battles, why trademarks are so earnestly protected, and why so much
advertising money is spent to establish brand loyalty. Thus any managerial
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decision must consider current market structure and how market structure is
evolving or likely to evolve.
II. Teaching the “Nuts and Bolts”
We begin by discussing with the students their notions of competition and
monopoly. In particular, we discuss the consequences of raising price.
Students will often declare that “a monopolist can increase price as high as
he or she wants and the consumer has no choice.” Again, this can lead to a
nice discussion about demand and elasticity, substitute goods, etc. You may
want to refer back to the discussion of elasticity in Chapter 3.
In studying pure monopoly we like to begin by examining the
optimization process (again, it is identical to that studied in Chapter 2) and
also the determinants of profitability. Then we turn our attention to the many
types of barriers to entry. It is helpful to get students to discuss these barriers
and whether some may be socially useful (patents, scale economies, etc.)
and which may be socially harmful (strategic barriers, control of resources,
etc.) Note that there is a brief discussion of antitrust policy in Chapter 11. If
you are not assigning Chapter 11 later in the course you may want to assign
this short section now.
The comparison of perfect competition and monopoly focuses on
price and quantity effects. Again, social welfare implications are deferred to
Chapter 11. However, if Chapter 11 is not assigned in the course then you
might want to discuss the social welfare implications at this point. Cartels
offer dramatic examples of the difference between competitive behavior and
monopolistic behavior (achieved via cooperation). The regulation of natural
monopoly provides a second contrast between monopolistic behavior and
competitive behavior.
Finally, a discussion of monopolistic competition is provided. We
emphasize that this structure combines the monopolistic assumption of a
downward sloping demand curve, that is, differentiated products and some
product loyalty, with the competitive assumption of free exit and entry.
Mini-cases: Monopolies, Past and Present and Gasoline Price Gauging.
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Monopolies, Past and Present
For many managers, acquiring a monopoly position in a market is akin to
an all-consuming search for the Holy Grail. However, it is worth
remembering how few and far between monopolies are in the American
marketplace. The adage “Many are called, but few are chosen” certainly
applies to the monopoly quest. Here are three examples of “once, but not
necessarily future” monopolies.
The Xerox Corporation accounted for over 95 percent of photocopier
sales in the United States a classic monopoly until the late 1960s. In
the 1970s, Xerox’s U.S. market share fell sharply. New firms, such as
Canon, Sharp, Royal, and Savin successfully entered the copier market,
particularly in the low- and medium-price segments. Currently, these four
firms and Xerox make up this market with roughly comparable market
shares. In the high-price, high-volume, copier-duplicator segment, Xerox,
IBM, and Eastman Kodak divide the market (again roughly equally).
How did Xerox lose its monopoly position? During the 1970s, many of
the company’s original patents expired, making it much easier for firms to
market similar copiers. In 1975, Xerox was forced to sign a consent decree
with the Federal Trade Commission agreeing to license its copier patents to
other manufacturers. Perhaps more important, competitors were able to
innovate around Xerox’s patents and develop comparable or superior
copiers. In the early 1970s, Xerox stumbled by introducing a line of
medium-volume copiers that proved unreliable. Finally, when the market
moved from copier rental to copier purchase, new entry was facilitated
because far less financial muscle was needed to sell copiers than to
maintain a rental base.
Today, Xerox offers the widest product line and competes in more parts
of the world than any other copier manufacturer. However, copiers have
become much more of a “commodity” business, where numerous
companies produce comparable copiers and where efficient assembly is as
important as technological innovation. Instead of being a monopolist,
Xerox is merely one of a dozen major players in the world copier industry.
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The American Medical Association (AMA) has the responsibility for
overseeing the practice of medicine in the United States. Among its other
activities, the AMA establishes procedures for licensing physicians and
implementing guidelines for medical schools. In this latter role, the AMA
has exercised control over the number of medical schools and the number
of medical students in the United States. Prior to 1965, the AMA
influenced the number of doctors practicing in the United States by
limiting the number of medical students and imposing formidable
restrictions on the domestic practice of foreign-educated physicians. One
result of this limitation was elevated incomes for physicians. In the 1960s,
doctors’ earnings put them in the upper 20 percent of the income
distribution.
Since the 1980s, the AMA’s control of the number of medical students
has diminished and immigration laws for foreign doctors have been
loosened, resulting in a greater-than-40-percent increase in the supply of
doctors. By one estimate, this supply increase has “cost” the average
doctor 20 to 25 percent in annual income.2 In short, the erosion of the
AMA’s monopoly restrictions on the supply of physicians has meant a
reduction in the excess returns earned by the medical profession.
The National Collegiate Athletic Association (NCAA) establishes and
enforces the myriad rules governing intercollegiate athletics. Though
intercollegiate athletics are certainly a part of the college experience and
education, they are also “big business,” returning hundreds of thousands of
dollars to universities with the most successful programs. Some top college
coaches make seven-figure salaries. Athletic shoe companies pay top teams
to wear their products. By its authority, the NCAA has monopoly control
over this business. The organization determines the size and number of
scholarships in different sports and the number of games played. It
negotiates most of the lucrative radio and television agreements for major
collegiate sports, such as football and basketball. Most important, the
NCAA limits the “salaries” paid to athletes to the cost of tuition plus room
and board. Of course, the NCAA and university presidents argue
strenuously that student athletes should not be paid. Whether one agrees
with this view or not, a basic fact remains. The enormous profitability of
intercollegiate sports is a direct result of the NCAA’s “monopoly-like”
behavior in particular, output restrictions that keep revenues high and
scholarship rules that keep costs low.
Gasoline Price Gauging
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In 1981, a Boston-based gas station owner set the highest gasoline
prices in the nation.1 During that summer, he charged $1.69 per gallon
for unleaded gas during the daytime and $2.59 per gallon at night,
when other downtown gas stations were closed. (His all-time high
price was $3.99.) Even at these extreme prices, the station sold an
average of 3,000 gallons per week, half of this at night. Despite
catcalls, pickets, and even vandalism from angry motorists during the
gasoline crisis, the owner “stuck by his pumps”; he even charged $1
for air. As he put it, “People think of gas stations as public mammary
glands, but they’re wrong. This is a business and it’s important to
generate profits from every part of it. If I can use a resource, like air,
to pay for the electric bill, so much the better. If you allow capitalism
in its true form, it works beautifully.”
The station owner was an avowed profit maximizer, albeit not a
very attractive one. How did he profit by his dual-price policy? The
answer is price discrimination. Although his costs varied little day and
night, the elasticity of demand varied greatly. He maximized his profit
by charging a higher price at night, when demand is much more
inelastic than during the day. In fact, we could go so far as to say that
he operated under different market structures, day and night. At night,
he appeared to have a pure local monopoly. Motorists desperate for
gas had to drive miles to find another station open during those hours.
Thus, the owner sold gas even at gouging prices. (Of course, at those
prices the motorist may have preferred to buy five gallons rather than
a full tank.) During the day, he faced a number of competitors within
blocks and numerous stations in neighboring Cambridge. That is, the
market resembled monopolistic competition. There was some product
differentiation due to locational convenience and brand allegiance.
Nonetheless, in normal times excess profits are limited by relatively
free entry of new firms. (The gasoline crisis and accompanying supply
shortage afforded sellers short-run, excess profits.)
1 E. Keerdojan, “There’s No Oil Glut for a Price Glutton,” Newsweek (July 6, 1981), p.
14.
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Question
a. Suppose that, during the day, the station owner’s demand is given by
PD = 2.06 – .00025QD. The marginal cost of selling gasoline is $1.31
per gallon. At his current $1.69 price, he sells 1,500 gallons per
week. Is this price-output combination optimal? Explain.
b. The station owner sells an equal number of gallons at night, setting
PN = $2.59. Suppose elasticity of demand is EP = -3. According to
the optimal markup rule (in Chapter 3), is this price profit
maximizing?
c. The station owner is able to sell gasoline day and night at high
prices. Why aren’t there more gas stations in downtown locations in
major cities? Explain.
Answer
a. The combination, QD = 1,500 gallons and PD = $1.69, is profit
maximizing. This quantity satisfies MR = MC: 2.06 – (.0005)(1,500)
= 1.31.
b. The $2.59 price at night is not optimal. According to the markup rule,
the price should be: P = [-3/(1 – 3)]1.31 = $1.96 1/2.
c. Although his contribution margin is very high, this does not mean
that he is enjoying large profits. The high, fixed cost of downtown
real estate is the main factor limiting his profit. This factor explains
why one finds skyscrapers, not gas stations, in the downtown sections
of major cities.
ADDITIONAL MATERIALS
I. Short Readings
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N. Irwin, Uber’s Real Challenge: Leveraging the Network Effect,” The New
York Times, June 16, 2014, p. B8.
P. Krugman, “The Decline of E-Empires,” The New York Times, August 26,
2013, p. A14.
N. Bilton, “Disruptions: Ride-Sharing Upstarts Challenge Taxi Industry,”
The New York Times, July 22, 2013, p. B4.
S. Reed, “OPEC, Foreseeing no Glut, Keeps Oil Production Level Steady,”
The New York Times, December 5, 2013, p. B3.
A. Frangos and H. Tan, “Cartel Pushes up Price of Rubber,” The Wall Street
Journal, August 20, 2012, p. C4.
J. D. Rockoff, “Goodbye, Lipitor. Pfizer Bids a Farewell,” The Wall Street
Journal, May 10, 2012, pp. B1, B2.
D. Brooks, “The Creative Monopoly,” The New York Times, April 24, 2012,
p. A21.
P. Loftus, “Forget Generics, Pfizer Has Plenty of Lipitor for You,” The Wall
Street Journal, November 2, 2011, p. B1.
T. Wu,” In the Grip of the New Monopolists,” The Wall Street Journal,
November 19, 2010, p. A23.
J. B. Stewart, “Few Match Google; Does that Make it a Monopoly?” The
Wall Street Journal, May 6, 2009, p. D2.
R. L. Rundle, “Botox Faces Worry Lines in Smooth Skin Game,” The Wall
Street Journal, December 6, 2007, p. B1.
J. Carreyrou, “Inside Abbott’s Tactics to Protect AIDS Drug,” The Wall
Street Journal, January 3, 2007, pp. A1, A10.
“The Garbage Wars: Cracking the Cartel” The New York Times, July 30,
1996, p. 1.
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II. Longer Readings
L. M. Kahn, “Cartel Behavior and Amateurism in College Sports,” Journal of
Economic Perspectives, Vol. 21, Winter 2007, 209-226.
J. M. Perloff, “Cartels,” Journal of Industrial Organization Education, Vol. 1,
2006.
III. Cases
Forever: De Beers and U.S. Antitrust Law, Harvard Business School,
(9-700-082), 2000. Teaching Note (5-701-019)
IV. Quips and Quotes
Where does the monopolist gorilla sleep? Anywhere it wants.
United cartels stand, divided they fall.
There is no good solution for technical monopoly. There is only a choice
among three evils: private unregulated monopoly, private monopoly
regulated by the state, and government operation. (Milton Friedman)
The best of all monopoly profits is the quiet life. (J. R. Hicks)
Like many businessmen of genius he learned that free competition was
wasteful, monopoly efficient. (Mario Puzo, in The Godfather)
Monopoly . . . is a great enemy to good management. (Adam Smith)
= AC = $264.
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