CHAPTER 12 Monopoly Power and Firm Pricing Decisions That competition is a virtue, at least as far as enterprises are concerned has been a basic article of faith in the American Tradition, and a vigorous antitrust policy has long been regarded as both beneficial and necessary, not only to extend competitive forces into new regions but also to preserve them where they may be flourishing at the moment. G. Warren Nutter Henry Alder Einhorn t the bottom of almost all arguments against the free market is a deep-seated concern about the distorting (some would say corrupting) influence of monopolies. People who are suspicious of the free market fear that too many producers are not controlled by the forces of competition, but instead hold considerable monopoly power. Unless government intervenes, these firms are likely to exploit their power for their own selfish benefit. This theme has been fundamental to the writings of John Kenneth Galbraith. The initiative in deciding what is produced comes not from the sovereign consumer who, through the market, issues instructions that bend the productive mechanism to his ultimate will. Rather it comes from the great producing organization which reaches forward to control the markets that it is presumed to serve and, beyond, to bend the customers to its needs. 1 Currently, the Department of Justice and nineteen state attorneys general are suing Microsoft because of the concern that one firm has too much “market power.” Furthermore, the company, as a consequence, is harming consumers as well as its potential market rivals and may be doing other damage to the economy, for example, impairing competition. This chapter is really a continuation of our earlier discussion of “market failures,” for monopoly is often seen as one of the gravest of all forms of failure in markets. Accordingly, we will examine the dynamics of monopoly power and attempt to place their consequences in proper perspective. We will also consider the usefulness of antitrust laws in controlling monopoly and promoting competition. This chapter will elucidate the government’s concerns with Microsoft’s market position. It will also help us understand Microsoft’s court defense. In the next chapter, we will apply the model of monopoly developed here to two forms of partial monopoly, monopolistic competition and oligopoly. 1 John Kenneth Galbraith, The New Industrial State (Boston: Houghton Mifflin, 1967), p. 6. A Chapter 12 Monopoly Power and Firm Pricing Decisions The Origins of Monopoly We have defined the competitive market as the process by which market rivals, each pursuing its own private interests, strive to outdo one another. This competitive market process has many benefits. It enables producers to obtain information about what consumers and other producers are willing to do. It promotes higher production levels, lower prices, and a greater variety of goods and services than would be achieved otherwise. Monopoly power is the conceptual opposite of competition. Monopoly power is the ability of a firm to raise profitably the market price of its good or service by reducing production. Whereas the demand curve of the competitive firm is horizontal (see the previous chapter), a firm with monopoly power faces a downward-sloping demand curve. By restricting production the monopoly can raise its market price. To maximize its profits (or minimize its losses), such a firm need only search through the various price- quantity combinations. In very general terms, then, a firm with monopoly power is a price searcher. It can control price because other firms are to some extent unable or unwilling to compete. As a result, a monopolized market produces fewer benefits than perfect competition. Businesses vary considerably in the extent of their monopoly power. The postal service and your local telephone company both have significant monopoly power. They confront few competitors, and entry into their markets is barred by law. IBM has far less monopoly power. Although it can affect the price it charges for its computers by expanding or contracting its sales, IBM is restrained by the possibility that other firms will enter its market. On a smaller scale, grocery stores face the same threat. They may have many competitors already, and they must be concerned about additional stores entering the market. Nevertheless, grocery stores still retain some power to restrict sales and raise their prices. The exact opposite of perfect competition is pure monopoly. Since, by definition, the pure monopolist is the only producer of a product that has no close substitutes, the demand it confronts is the market demand for the product. Unlike the perfect competitor, who has no power over price, the pure monopolist can raise the price of its product without fear that customers will go elsewhere. With no other producers offering the same product, or even a close substitute, the consumer has nowhere to turn. As we will see, production levels are generally lower and prices higher under pure monopoly than under competition. How does monopoly arise? To answer that question clearly, we must reflect once again on the basis for competition. Competition occurs because market rivals want to exploit profitable opportunities and can enter markets where such opportunities exist. In the extreme case of perfect competition, there are no barriers to entry, and competitors are numerous. Entrepreneurs are always on the lookout for any opportunity to enter such a market in pursuit of profit. Individual competitors cannot raise their price, for if they do, their rivals may move in, cut prices, and take away all their customers. If a wheat farmer asks more than the market price, for example, customers can move to others who will sell wheat at market price. For this reason perfect competitors are called price takers. They have no real control over the price they charge. Chapter 12 Monopoly Power and Firm Pricing Decisions The essential condition for competition is freedom of market entry. In perfect competition entry is assumed to be completely free. Conversely, the essential condition for monopoly is the presence of barriers to entry. Monopolists can manipulate price because such barriers protect them from being undercut by rivals. Barriers to entry can arise from several sources. • First, the monopolist may have sole ownership of a strategic resource, such as bauxite (from which aluminum is extracted). • Second, the monopolist may have a patent or copyright on the product, which prevents other producers from duplicating it. For years, Polaroid had a patent monopoly on the instant-photograph market. (Eastman Kodak developed an alternative process, but was forced to withdraw its camera from the market when a Federal court ruled that it infringed on Polaroid’s patent.) • Third, the monopolist may have an exclusive franchise to sell a given product in a specific geographical area. Consider the exclusive franchise enjoyed by your local telephone company, or was enjoyed, until very recently, your local electric utility. • Fourth, the monopolist may own the rights to a well-known brand name with a highly loyal group of customers. In that case, the barrier to entry is the costly process of trying to get customers to try a new product. • Finally, in a monopolized industry, production may be conducted on a very large scale, requiring huge plants and large amounts of equipment. The enormous financial resources needed to produce on such a scale can act as a barrier to entry, because a new entrant operating on a small scale would have costs too high to compete effectively with the dominant firm. All in all, these external barriers to entry can be thought of as costs that must be borne by potential competitors before they can complete. Such barriers may be “low,” which means that a sole producer’s monopoly power may be very limited, but such barriers could, theoretically, be prohibitively high. The Limits of Monopoly Power Unlike the competitive seller, the monopolist has the power to withhold supplies from the market and to charge more than the competitive market price. Even the pure monopolist’s market power is not completely unchecked, however. It is restricted in two important ways. First, without government assistance, the monopolist’s control over the market for a product is never complete. Even if a producer has a true monopoly of a good, the consumer can still choose a substitute good whose production is not monopolized. For instance, in most parts of the nation, only one firm is permitted to provide local telephone service. Yet people can communicate in other ways. They can talk directly with one another; they can write letters or send telegrams; they can use their children as messengers. In a more general sense, consumers can use their income to buy rugs or bicycles instead of private lines. To the extent that the individual has alternatives, Chapter 12 Monopoly Power and Firm Pricing Decisions his consumption of any good must be considered voluntary. As the Nobel Laureate Friedrich Hayek has written, If, for instance, I would very much like to be painted by a famous artist (one who has monopoly power) and if he refuses to paint monopoly efficient for less than a very high price, it would clearly be absurd for monopoly efficient to say that I am coerced. The same is true of any other commodity or service that I can do without. So long as the services of a particular person are not crucial to my existence or the preservation of what I most value, the conditions he exacts for rendering these services cannot be called “coercion.” 2 This is not to say that the effects of monopoly are all positive. If monopoly means that one firm is garnering the assets and markets of all other competitors, it can be viewed as a force that reduces consumer choice. Although the monopolist’s coercive power may not be complete, it nevertheless can restrict consumer freedom. Monopoly power can develop for other reasons. A firm may gain monopoly power because it has built a better mousetrap or developed a good that was previously unavailable. In other words, a firm may be the only producer because it is the first producer, and no one has been able to figure out how to duplicate its product. In this instance, although monopolized, a new product results in an expansion of consumer choice. Furthermore, the monopoly may be only temporary, for other competitors are likely to break into the market eventually. The monopolist is also restricted by market conditions—that is, by the cost of production and the downward-sloping demand curve for the good. If the monopolistic firm raises its price, it must be prepared to sell less. How much less depends on what substitutes are available. The monopolist must consider as well the costs of expanding production and of trying to prevent competitors from entering the market. The important point here is that there is a range of possible costs and prices at which the monopolistic firm can sell various quantities of a good. Its task is to search through the available price- quantity combinations for the one that maximizes profit. In a free and open market, monopoly power can be dissolved in the long run. With time, competitors can discover weakly protected avenues through which to invade the monopolist’s domain. The Reynolds International Pen Company had a patent monopoly on the first ballpoint pen that it introduced in 1945. Two years later other pen companies had found ways of circumventing the patent and producing a similar but not identical product. The price of ballpoint pens fell from an initial $12.50 to the low prices of today. Many other products that are freely produced today—calculators, video games, car telephones, and cellophane tape, to name a few—were first sold by companies that enjoyed short-run monopolies. Thus the imperfection of monopoly power is crucial. In the long run, excessively high prices, restricted supply, and high profits give potential competitors the incentive to find and exploit imperfections in the monopolist’s power. Like the proverbial hole in the dike, those imperfections can undermine even the strongest barrier. 2 F.A Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960). P. 136. Chapter 12 Monopoly Power and Firm Pricing Decisions One of the most effective ways for a monopoly to retain its market power is to enlist the coercive power of the state in protecting or extending it boundaries. This strategy has been used effectively for decades in the electric utilities industry and the cable television market. The insurance industry and the medical profession, both of which are protected from competition through licensing procedures, are also good examples. Even the power of the state may not be enough to shield an industry from competition forever. Consumer tastes and the technology of production and delivery can change dramatically over the very long run. The franchise-monopoly of electric power companies, for example, is slowly being weakened by the introduction of home solar power. The railroad industry’s market, which was protected from price competition by the state for almost a century, has been gradually eroded by the emergence of new competitors, principally airlines, buses, and trucks. Even the first-class mail monopoly of the U.S. Postal Service is being eroded by Federal Express and other overnight delivery firms. In the long run, government protection may be extended to the very competitors who arise to break a state-protected monopoly. (Such was the case, until recently, with the airline, bus, and tracking industries.) Should government attempt to break up all monopolies? Since without state protection monopoly may eventually dissipate, the relevant public policy questions are how long the monopoly power is likely to persist if left alone, and how costly it will be while it lasts, in terms of lost efficiency and unequal distribution of income. The machinery of government needed to dissolve monopoly power is costly in itself. Thus the decision whether to prosecute antitrust violations depends in part on the costs and benefits of such an action. Often the rise of a monopoly does warrant government action, but in some cases the benefits of action cannot justify the costs. As described in Chapter 3, the first seller of land calculators enjoyed a temporary monopoly of the U.S. market in 1969. Subsequently the industry developed very rapidly, however, and in retrospect it is clear that a long, drawn-out antitrust action would have been inappropriate. To give another example, in 1969 the Justice Department found that IBM enjoyed an unwarranted monopoly of the domestic computer market, which was dominated by large mainframe computers. It concluded that an antitrust suit against IBM was justified. Prosecution of the case, which the Justice Department dropped in January 1982, took more than a decade. The accumulated documentation from the proceedings filled a warehouse, and the Justice Department and IBM devoted an untold number of lawyer- hours to the case. In the meantime, IBM’s alleged monopoly was seriously eroded by new firms producing mini-and microcomputers, a trend that has continued (and accelerated) since 1982. Thus the net benefits to society from the antitrust action against IBM are at best debatable, and probably negative. That is, the costs most likely exceeded the benefits. Equating Marginal Cost with Marginal Revenue In deciding how many times a week to play tennis, an athlete weights the estimated benefits of each game against its costs. Producers of goods follow a similar procedure, although the benefits of production are measured in terms of revenue acquired rather than personal utility. A producer will produce another unit of a good if the additional (or Chapter 12 Monopoly Power and Firm Pricing Decisions marginal) revenue it brings is greater than the additional cost of its production—in other words, if it increases the firm’s profits. The firm will therefore expand production to the point where marginal cost equals marginal revenue (MC = MR). This is a fundamental rule that all profit-maximizing firms follow, and monopolies are no exception. Suppose you are in the yo-yo business. You have a patent on edible yo-yos, which come in three flavors—vanilla, chocolate, and strawberry. (We will assume there is a demand for these products.) The cost of producing the first yo-yo is $0.50, but you can sell it for $0.75. Your profit on that unit is therefore $0.25 ($0.75 - $0.50). If the second unit costs you $0.60 to make (assuming increasing marginal cost) and you can sell it for $0.75, your profit for two yo-yos is $0.40 ($0.25 profit on the first plus $0.15 profit on the second). If you intend to maximize your profits, you—like the perfect competitor—will continue to expand production until the gap between marginal revenue and marginal cost disappears. As a monopolist, however, you will find that your marginal revenue does not remain constant. Instead, it falls over the range of production. The monopolist’s marginal revenue declines as output rises because the price must be reduced to entice consumers to buy more. Consider the price schedule in Table 12.1. Price and quantity are inversely related, reflecting the assumption that a monopolist faces a downward-sloping demand curve. (Because the monopolist is the only producer of a product, its demand curve is the market demand curve.) As the price falls from $10 to $6 (column 2), the number sold rises from one to five (column 1). If the firm wishes to sell only one yo-yo, it can charge as much as $10. Total revenue at that level of production is then $10. To see more—say, two yo-yos—the monopolist must reduce the price for each to $9. Total revenue the rises to $18 (column 3). By multiplying columns 1 and 2, we can fill in the rest of column 3. As the price is lowered and the quantity sold rises, total revenue rises from $10 for one unit to $30 for five units. With each unit increase in quantity sold, however, total revenue does not rise by an equal amount. Instead, it rises in declining amounts—first by $10, then $8, $6, $4, and $2. These amounts are the marginal revenue from the sale of each unit (column 4), which the monopolist must compare with the marginal cost of each unit. At an output level of one yo-yo, marginal revenue equals price, but at every other output level marginal revenue is less than price. Because of the monopolist’s downward- sloping demand curve, the second yo-yo cannot be sold unless the price of both units 1 and 2 is reduced from $10 to $9. If we account for the $1 in revenue lost on the first yo- yo in order to sell the second, the net revenue from the second yo-yo is $8 (the selling price of $9 minus the $1 lost on the first yo-yo). For the third yo-yo to be sold, the price on the first two must be reduced by another dollar each. The loss in revenue on them is therefore $2. And the marginal revenue for the third yo-yo is its $8 selling price less the $2 loss on the first two units, or $6. Thus the monopolist’s marginal revenue curve (columns 1 and 4) is derived directly from the market demand curve (columns 1 and 2). Graphically, the marginal revenue curve lies below the demand curve, and its distance from the demand curve Chapter 12 Monopoly Power and Firm Pricing Decisions increases as the price falls (see Figure 12.1, above). 3 (More details on the derivation of the marginal revenue curve can be found in the appendix to this chapter.) TABLE 12.1 The Monopolist’s Declining Marginal Revenue Quantity Total Marginal of Yo-yos Price Revenue Revenue Sold of Yo-yos (col. 1 x col. 2) (change in col. 3) (1) (2) (3) (4) 0 $11 $ 0 $ 0 1 10 10 10 2 9 18 8 3 8 24 6 4 7 28 4 5 6 30 2 ______________________________ FIGURE 12.1 The Monopolist’s Demand and Marginal Revenue Curves The demand curve facing a monopolist slopes downward, for it is the same as market demand. The monopolist’s marginal revenue curve is constructed from the information contained in the demand curve (see Table 12.1). Figure 12.2 adds the monopolist’s marginal cost curve to the demand and marginal revenue curves from Figure 12.1. Because the profit-maximizing monopolist will produce to the point where marginal cost equals marginal revenue, our yo-yo maker will produce Q 2 units. At that quantity, the marginal cost and marginal revenue curves intersect. If the yo-yo maker produces fewer than Q 2 yo-yos -- say Q 1 -- profits are lost 3 Prove this to yourself by plotting the figures in columns 1 and 2 versus the figures in columns 1 and 4, on a sheet of graph paper. (Another simple way of drawing the marginal revenue curve is to extend the demand curve until it intersects both the vertical and horizontal axes. Then draw the marginal revenue curve starting from the demand curve’s point of intersection with the vertical axis to a point midway between the original and the intersection of the demand curve with the horizontal axis. This method can be used for any linear demand curve.) Chapter 12 Monopoly Power and Firm Pricing Decisions unnecessarily. The marginal revenue acquired from selling the last yo-yo up to Q 1 , MR 1 , is greater than the marginal cost of producing it, MC 1 . Furthermore, for all units between Q 1 and Q 2 , marginal revenue exceed marginal cost. In other words, by expanding production from Q 1 to Q 2 , the monopolist can add more to total revenue than to total cost. Up to an output level of Q 2 , the firm’s profits will rise. Why does the monopolist produce no more than Q 2 ? Because the marginal cost of all additional units beyond Q 2 is greater than the marginal revenue they bring. Beyond Q 2 units, profits will fall. If it produces Q 3 yo-yos, for instance, the firm may still make a profit, but not the greatest profit possible. The marginal cost of the last yo-yo up to Q 3 (MC 2 ) is greater than the marginal revenue received from its sale (MR 2 ). By producing Q 3 units, the monopolist adds more to cost than to revenues. The result is lower profits. Once the monopolistic firm selects the output at which to produce, the market price of the good is determined. In this illustration, the price that can be charged for Q 2 yo-yos is P 1. (Remember, the demand curve indicates the price that can be charged for any quantity.) Of all the possible price-quantity combinations on the demand curve, therefore, the monopolist will choose combination a. ______________________________________ FIGURE 12.2 Equating Marginal Cost with Marginal Revenue The monopolist will move toward production level Q 2 , the level at which marginal cost equals marginal revenue. At production levels below Q 2 , marginal revenue will exceed marginal cost; the monopolist will miss the chance to increase profits. At production levels greater than Q 2 , marginal cost will exceed marginal revenue; the monopolist will lose money on the extra units. . Short-Run Profits and Losses How much profit will a monopolist make by producing where marginal cost equals marginal revenue? The answer can be found by adding the average total cost curve developed in the last chapter to the monopolist’s demand and marginal revenue curves (see Figure 12.3). As we have seen, the monopolist will produce where the marginal cost and revenue curves intersect, at Q 1 , and will charge what the market will bear for the quantity, P 1 . We know also that profit equals total revenue minus total cost (Profit = TR – TC). Total revenue of P 1 times Q 1 , or the rectangular area bounded by 0P 1 aQ 1 . Total cost is the average total cost, ATC 1 , times quantity, Q 1, or the rectangular area bounded by 0ATC 1 bQ 1 . Subtracting total cost from total revenue, we find that the monopolist’s profit Chapter 12 Monopoly Power and Pricing Decisions 9 is equal to the shaded rectangular area ATC 1 P 1 ab. (Mathematically, the expression profit = P 1 Q 1 -ATC 1 Q 1 can be converted to the simpler form, profit = Q 1 (P 1 - ATC 1 ).) __________________________________________ FIGURE 12.3 The Monopolist’s Profits The profit-maximizing monopoly will produce at the level defined by the intersection of the marginal cost and marginal revenue curves: Q 1 . It will charge a price of P 1 -- as high as market demand will bear - -for that quantity. Since the average total cost of producing Q 1 units is ATC 1 , the firm’s profit is the shaded area ATC 1 P 1 ab. Like perfectly competitive firms, monopolies are not guaranteed a profit. If market demand does not allow them to charge a price that covers the cost of production, they will lose money. Figure 12.4 shows the situation of a monopoly that is losing money. Because losses are negative profits, the monopolist’s losses are obtained in the same way as profits, by subtracting total cost from total revenue. The maximum price the monopolist can charge for its profit-maximizing (or in this case, loss-minimizing) output level is P 1 , which yields total revenues of P 1 Q 1 or 0P 1 bQ 1 . Total cost is higher: ATC 1 Q 1 , or 0ATC 1 Q 1 . Thus the monopolist’s loss is equal to the shaded rectangular area bounded by P 1 ATC 1 ab. _________________________________________ FIGURE 12.4 The Monopolist’s Short-Run Losses Not all monopolists make a profit. With a demand curve that lies below its average total cost curve, this monopoly will minimize its short-run losses by continuing to produce where marginal cost equals marginal revenue (Q 1 units). It will charge P 1 , a price that covers its fixed costs, and will sustain short-run losses equal to the shaded area P 1 ATC 1 ab. Chapter 12 Monopoly Power and Firm Pricing Decisions 10 Why does the monopolist not shut down? Because it follows the same rule as the perfect competitor. Both will continue to produce as long as price exceeds average variable cost -- that is, as long as production will help to defray fixed costs. In Figure 12.4, average fixed cost is equal to the difference between average total cost, ATC 1 , and average variable cost, AVC 1 –or the vertical distance ac. Total fixed cost is therefore ac times Q 1 , or the area bounded by AVC 1 ATC 1 ac. Because the firm will suffer a greater loss if it shuts down (AVC 1 ATC 1 ac) than if it operates (P 1 .ATC 1 ab), it chooses to operate and minimize its losses. Of course, in the long run, when the monopoly firm is able to extricate itself from its fixed costs, it will shut down. Production Over the Long Run In the long run the monopolistic firm follows the same production rule as in the short run: it equates marginal revenue with long-run marginal cost. In Figure 12.5(a), for instance, the firm produces quantity Q a , and sells it for price P a ,. (As always, profits are found by comparing the price with the long-run average cost. As an exercise, shade in the profit areas on the figure.) Unlike the perfect competitor, the monopoly firm does not attempt to produce at the lowest point on the long-run average cost cure. With no competition, the monopolistic firm has no need to minimize average total cost. By restricting output, it can charge a higher price and earn greater profits than it can by taking advantage of economies of scale. Monopolists sometimes do produce at the low point of the long-run average cost curve. They do so only when the marginal revenue curve happens to intersect the long- run marginal and average cost curves at the exact same point [see Figure 12.5(b)] . In this case the monopolist produces quantity Q b , and sells it at a price of P b , earning substantial monopoly profits in the process. If the demand is great enough, the monopolist will actually produce in the range of diseconomies of scale [see Figure 12.5(c)]. How can the monopolist continue to exist when its price and costs of production are so high? Because barriers to entry protect it from competition. If barriers did not exist, other firms would certainly enter the market and force the monopolistic firm to lower its price. The net effect of competition would be to induce the monopolist to cut back on production, reducing average production costs in the process. Monopolists cannot exist without barriers to market entry. If other firms had access to the market, the monopolist’s profit would be its own undoing—for profit is what others want and will seek, if they can enter the market. The Comparative Inefficiency of Monopoly The last chapter concluded that in a perfectly competitive market, firms tend to produce at the intersection of the market supply and demand curves. That point (b in Figure 12.6) is the most efficient production level, in the sense that the marginal benefit to the . (Boston: Houghton Mifflin, 1967), p. 6. A Chapter 12 Monopoly Power and Firm Pricing Decisions The Origins of Monopoly We have defined the competitive market. Chicago Press, 1960). P. 136. Chapter 12 Monopoly Power and Firm Pricing Decisions One of the most effective ways for a monopoly to retain its market power