CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 311 Thus, for these two reasons, the long-run supply curve in a market may be up- ward sloping rather than horizontal, indicating that a higher price is necessary to induce a larger quantity supplied. Nonetheless, the basic lesson about entry and exit remains true. Because firms can enter and exit more easily in the long run than in the short run, the long-run supply curve is typically more elastic than the short-run supply curve. QUICK QUIZ: In the long run with free entry and exit, is the price in a market equal to marginal cost, average total cost, both, or neither? Explain with a diagram. CONCLUSION: BEHIND THE SUPPLY CURVE We have been discussing the behavior of competitive profit-maximizing firms. You may recall from Chapter 1 that one of the Ten Principles of Economics is that rational people think at the margin. This chapter has applied this idea to the competitive firm. Marginal analysis has given us a theory of the supply curve in a competitive market and, as a result, a deeper understanding of market outcomes. We have learned that when you buy a good from a firm in a competitive mar- ket, you can be assured that the price you pay is close to the cost of producing that good. In particular, if firms are competitive and profit-maximizing, the price of a good equals the marginal cost of making that good. In addition, if firms can freely enter and exit the market, the price also equals the lowest possible average total cost of production. Although we have assumed throughout this chapter that firms are price tak- ers, many of the tools developed here are also useful for studying firms in less competitive markets. In the next three chapters we will examine the behavior of firms with market power. Marginal analysis will again be useful in analyzing these firms, but it will have quite different implications. ◆ Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm’s average revenue and its marginal revenue. ◆ To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost. Thus, the firm’s marginal cost curve is its supply curve. ◆ In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost. ◆ In a market with free entry and exit, profits are driven to zero in the long run. In this long-run equilibrium, all firms produce at the efficient scale, price equals the minimum of average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price. ◆ Changes in demand have different effects over different time horizons. In the short run, an increase in demand raises prices and leads to profits, and a decrease in Summary 312 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY demand lowers prices and leads to losses. But if firms can freely enter and exit the market, then in the long run the number of firms adjusts to drive the market back to the zero-profit equilibrium. competitive market, p. 292 average revenue, p. 294 marginal revenue, p. 294 sunk cost, p. 298 Key Concepts 1. What is meant by a competitive firm? 2. Draw the cost curves for a typical firm. For a given price, explain how the firm chooses the level of output that maximizes profit. 3. Under what conditions will a firm shut down temporarily? Explain. 4. Under what conditions will a firm exit a market? Explain. 5. Does a firm’s price equal marginal cost in the short run, in the long run, or both? Explain. 6. Does a firm’s price equal the minimum of average total cost in the short run, in the long run, or both? Explain. 7. Are market supply curves typically more elastic in the short run or in the long run? Explain. Questions for Review 1. What are the characteristics of a competitive market? Which of the following drinks do you think is best described by these characteristics? Why aren’t the others? a. tap water b. bottled water c. cola d. beer 2. Your roommate’s long hours in Chem lab finally paid off—she discovered a secret formula that lets people do an hour’s worth of studying in 5 minutes. So far, she’s sold 200 doses, and faces the following average-total- cost schedule: Q AVERAGE TOTAL COST 199 $199 200 200 201 201 If a new customer offers to pay your roommate $300 for one dose, should she make one more? Explain. 3. The licorice industry is competitive. Each firm produces 2 million strings of licorice per year. The strings have an average total cost of $0.20 each, and they sell for $0.30. a. What is the marginal cost of a string? b. Is this industry in long-run equilibrium? Why or why not? 4. You go out to the best restaurant in town and order a lobster dinner for $40. After eating half of the lobster, you realize that you are quite full. Your date wants you to finish your dinner, because you can’t take it home and because “you’ve already paid for it.” What should you do? Relate your answer to the material in this chapter. 5. Bob’s lawn-mowing service is a profit-maximizing, competitive firm. Bob mows lawns for $27 each. His total cost each day is $280, of which $30 is a fixed cost. He mows 10 lawns a day. What can you say about Bob’s short-run decision regarding shut down and his long- run decision regarding exit? 6. Consider total cost and total revenue given in the table below: QUANTITY 01 2 3 4 5 6 7 Total cost $8 $9 $10 $11 $13 $19 $27 $37 Total revenue 0 8 16 24 32 40 48 56 a. Calculate profit for each quantity. How much should the firm produce to maximize profit? Problems and Applications CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 313 b. Calculate marginal revenue and marginal cost for each quantity. Graph them. (Hint: Put the points between whole numbers. For example, the marginal cost between 2 and 3 should be graphed at 2 1/2.) At what quantity do these curves cross? How does this relate to your answer to part (a)? c. Can you tell whether this firm is in a competitive industry? If so, can you tell whether the industry is in a long-run equilibrium? 7. From The Wall Street Journal (July 23, 1991): “Since peaking in 1976, per capita beef consumption in the United States has fallen by 28.6 percent . . . [and] the size of the U.S. cattle herd has shrunk to a 30-year low.” a. Using firm and industry diagrams, show the short- run effect of declining demand for beef. Label the diagram carefully and write out in words all of the changes you can identify. b. On a new diagram, show the long-run effect of declining demand for beef. Explain in words. 8. “High prices traditionally cause expansion in an industry, eventually bringing an end to high prices and manufacturers’ prosperity.” Explain, using appropriate diagrams. 9. Suppose the book-printing industry is competitive and begins in a long-run equilibrium. a. Draw a diagram describing the typical firm in the industry. b. Hi-Tech Printing Company invents a new process that sharply reduces the cost of printing books. What happens to Hi-Tech’s profits and the price of books in the short run when Hi-Tech’s patent prevents other firms from using the new technology? c. What happens in the long run when the patent expires and other firms are free to use the technology? 10. Many small boats are made of fiberglass, which is derived from crude oil. Suppose that the price of oil rises. a. Using diagrams, show what happens to the cost curves of an individual boat-making firm and to the market supply curve. b. What happens to the profits of boat makers in the short run? What happens to the number of boat makers in the long run? 11. Suppose that the U.S. textile industry is competitive, and there is no international trade in textiles. In long- run equilibrium, the price per unit of cloth is $30. a. Describe the equilibrium using graphs for the entire market and for an individual producer. Now suppose that textile producers in other countries are willing to sell large quantities of cloth in the United States for only $25 per unit. b. Assuming that U.S. textile producers have large fixed costs, what is the short-run effect of these imports on the quantity produced by an individual producer? What is the short-run effect on profits? Illustrate your answer with a graph. c. What is the long-run effect on the number of U.S. firms in the industry? 12. Suppose there are 1,000 hot pretzel stands operating in New York City. Each stand has the usual U-shaped average-total-cost curve. The market demand curve for pretzels slopes downward, and the market for pretzels is in long-run competitive equilibrium. a. Draw the current equilibrium, using graphs for the entire market and for an individual pretzel stand. b. Now the city decides to restrict the number of pretzel-stand licenses, reducing the number of stands to only 800. What effect will this action have on the market and on an individual stand that is still operating? Use graphs to illustrate your answer. c. Suppose that the city decides to charge a license fee for the 800 licenses. How will this affect the number of pretzels sold by an individual stand, and the stand’s profit? The city wants to raise as much revenue as possible and also wants to ensure that 800 pretzel stands remain in the city. By how much should the city increase the license fee? Show the answer on your graph. 13. Assume that the gold-mining industry is competitive. a. Illustrate a long-run equilibrium using diagrams for the gold market and for a representative gold mine. b. Suppose that an increase in jewelry demand induces a surge in the demand for gold. Using your diagrams, show what happens in the short run to the gold market and to each existing gold mine. c. If the demand for gold remains high, what would happen to the price over time? Specifically, would the new long-run equilibrium price be above, below, or equal to the short-run equilibrium price in part (b)? Is it possible for the new long-run equilibrium price to be above the original long-run equilibrium price? Explain. 14. (This problem is challenging.) The New York Times (July 1, 1994) reported on a Clinton administration proposal to lift the ban on exporting oil from the North Slope of Alaska. According to the article, the administration said that “the chief effect of the ban has 314 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY been to provide California refiners with crude oil cheaper than oil on the world market. . . . The ban created a subsidy for California refiners that had not been passed on to consumers.” Let’s use our analysis of firm behavior to analyze these claims. a. Draw the cost curves for a California refiner and for a refiner in another part of the world. Assume that the California refiners have access to inexpensive Alaskan crude oil and that other refiners must buy more expensive crude oil from the Middle East. b. All of the refiners produce gasoline for the world gasoline market, which has a single price. In the long-run equilibrium, will this price depend on the costs faced by California producers or the costs faced by other producers? Explain. (Hint: California cannot itself supply the entire world market.) Draw new graphs that illustrate the profits earned by a California refiner and another refiner. c. In this model, is there a subsidy to California refiners? Is it passed on to consumers? 315 IN THIS CHAPTER YOU WILL . . . See why monopolies try to charge different prices to different customers See how the monopoly’s decisions affect economic well-being Learn why some markets have only one seller Analyze how a monopoly determines the quantity to produce and the price to charge Consider the various public policies aimed at solving the problem of monopoly If you own a personal computer, it probably uses some version of Windows, the operating system sold by the Microsoft Corporation. When Microsoft first de- signed Windows many years ago, it applied for and received a copyright from the government. The copyright gives Microsoft the exclusive right to make and sell copies of the Windows operating system. So if a person wants to buy a copy of Windows, he or she has little choice but to give Microsoft the approximately $50 that the firm has decided to charge for its product. Microsoft is said to have a mo- nopoly in the market for Windows. Microsoft’s business decisions are not well described by the model of firm behavior we developed in Chapter 14. In that chapter, we analyzed competitive mar- kets, in which there are many firms offering essentially identical products, so each firm has little influence over the price it receives. By contrast, a monopoly such as Microsoft has no close competitors and, therefore, can influence the market price of its product. While a competitive firm is a price taker, a monopoly firm is a price maker. MONOPOLY 316 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY In this chapter we examine the implications of this market power. We will see that market power alters the relationship between a firm’s price and its costs. A competitive firm takes the price of its output as given by the market and then chooses the quantity it will supply so that price equals marginal cost. By contrast, the price charged by a monopoly exceeds marginal cost. This result is clearly true in the case of Microsoft’s Windows. The marginal cost of Windows—the extra cost that Microsoft would incur by printing one more copy of the program onto some floppy disks or a CD—is only a few dollars. The market price of Windows is many times marginal cost. It is perhaps not surprising that monopolies charge high prices for their prod- ucts. Customers of monopolies might seem to have little choice but to pay what- ever the monopoly charges. But, if so, why does a copy of Windows not cost $500? Or $5,000? The reason, of course, is that if Microsoft set the price that high, fewer people would buy the product. People would buy fewer computers, switch to other operating systems, or make illegal copies. Monopolies cannot achieve any level of profit they want, because high prices reduce the amount that their cus- tomers buy. Although monopolies can control the prices of their goods, their prof- its are not unlimited. As we examine the production and pricing decisions of monopolies, we also consider the implications of monopoly for society as a whole. Monopoly firms, like competitive firms, aim to maximize profit. But this goal has very different ramifi- cations for competitive and monopoly firms. As we first saw in Chapter 7, self- interested buyers and sellers in competitive markets are unwittingly led by an invisible hand to promote general economic well-being. By contrast, because monopoly firms are unchecked by competition, the outcome in a market with a monopoly is often not in the best interest of society. One of the Ten Principles of Economics in Chapter 1 is that governments can sometimes improve market outcomes. The analysis in this chapter will shed more light on this principle. As we examine the problems that monopolies raise for so- ciety, we will also discuss the various ways in which government policymakers might respond to these problems. The U.S. government, for example, keeps a close eye on Microsoft’s business decisions. In 1994, it prevented Microsoft from buying Intuit, a software firm that sells the leading program for personal finance, on the grounds that the combination of Microsoft and Intuit would concentrate too much market power in one firm. Similarly, in 1998, the U.S. Justice Department objected when Microsoft started integrating its Internet browser into its Windows operat- ing system, claiming that this would impede competition from other companies, such as Netscape. This concern led the Justice Department to file suit against Microsoft, the final resolution of which was still unsettled as this book was going to press. WHY MONOPOLIES ARISE A firm is a monopoly if it is the sole seller of its product and if its product does not have close substitutes. The fundamental cause of monopoly is barriers to entry: Amo- nopoly remains the only seller in its market because other firms cannot enter the market and compete with it. Barriers to entry, in turn, have three main sources: monopoly a firm that is the sole seller of a product without close substitutes CHAPTER 15 MONOPOLY 317 CASE STUDY THE DEBEERS DIAMOND MONOPOLY A classic example of a monopoly that arises from the ownership of a key re- source is DeBeers, the South African diamond company. DeBeers controls about 80 percent of the world’s production of diamonds. Although the firm’s share of the market is not 100 percent, it is large enough to exert substantial influence over the market price of diamonds. How much market power does DeBeers have? The answer depends in part on whether there are close substitutes for its product. If people view emeralds, rubies, and sapphires as good substitutes for diamonds, then DeBeers has rela- tively little market power. In this case, any attempt by DeBeers to raise the price of diamonds would cause people to switch to other gemstones. But if people view these other stones as very different from diamonds, then DeBeers can ex- ert substantial influence over the price of its product. DeBeers pays for large amounts of advertising. At first, this decision might seem surprising. If a monopoly is the sole seller of its product, why does it need to advertise? One goal of the DeBeers ads is to differentiate diamonds from other gems in the minds of consumers. When their slogan tells you that “a diamond is forever,” you are meant to think that the same is not true of emeralds, rubies, and sapphires. (And notice that the slogan is applied to all diamonds, not just DeBeers diamonds—a sign of DeBeers’s monopoly position.) If the ads are ◆ A key resource is owned by a single firm. ◆ The government gives a single firm the exclusive right to produce some good or service. ◆ The costs of production make a single producer more efficient than a large number of producers. Let’s briefly discuss each of these. MONOPOLY RESOURCES The simplest way for a monopoly to arise is for a single firm to own a key resource. For example, consider the market for water in a small town in the Old West. If dozens of town residents have working wells, the competitive model discussed in Chapter 14 describes the behavior of sellers. As a result, the price of a gallon of wa- ter is driven to equal the marginal cost of pumping an extra gallon. But if there is only one well in town and it is impossible to get water from anywhere else, then the owner of the well has a monopoly on water. Not surprisingly, the monopolist has much greater market power than any single firm in a competitive market. In the case of a necessity like water, the monopolist could command quite a high price, even if the marginal cost is low. Although exclusive ownership of a key resource is a potential cause of mo- nopoly, in practice monopolies rarely arise for this reason. Actual economies are large, and resources are owned by many people. Indeed, because many goods are traded internationally, the natural scope of their markets is often worldwide. There are, therefore, few examples of firms that own a resource for which there are no close substitutes. “Rather than a monopoly, we like to consider ourselves ‘the only game in town.’” 318 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY successful, consumers will view diamonds as unique, rather than as one among many gemstones, and this perception will give DeBeers greater market power. GOVERNMENT-CREATED MONOPOLIES In many cases, monopolies arise because the government has given one person or firm the exclusive right to sell some good or service. Sometimes the monopoly arises from the sheer political clout of the would-be monopolist. Kings, for exam- ple, once granted exclusive business licenses to their friends and allies. At other times, the government grants a monopoly because doing so is viewed to be in the public interest. For instance, the U.S. government has given a monopoly to a com- pany called Network Solutions, Inc., which maintains the database of all .com, .net, and .org Internet addresses, on the grounds that such data need to be central- ized and comprehensive. The patent and copyright laws are two important examples of how the gov- ernment creates a monopoly to serve the public interest. When a pharmaceutical company discovers a new drug, it can apply to the government for a patent. If the government deems the drug to be truly original, it approves the patent, which gives the company the exclusive right to manufacture and sell the drug for 20 years. Similarly, when a novelist finishes a book, she can copyright it. The copy- right is a government guarantee that no one can print and sell the work without the author’s permission. The copyright makes the novelist a monopolist in the sale of her novel. The effects of patent and copyright laws are easy to see. Because these laws give one producer a monopoly, they lead to higher prices than would occur under competition. But by allowing these monopoly producers to charge higher prices and earn higher profits, the laws also encourage some desirable behavior. Drug companies are allowed to be monopolists in the drugs they discover in order to en- courage pharmaceutical research. Authors are allowed to be monopolists in the sale of their books to encourage them to write more and better books. Thus, the laws governing patents and copyrights have benefits and costs. The benefits of the patent and copyright laws are the increased incentive for creative activity. These benefits are offset, to some extent, by the costs of monopoly pricing, which we examine fully later in this chapter. NATURAL MONOPOLIES An industry is a natural monopoly when a single firm can supply a good or ser- vice to an entire market at a smaller cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of out- put. Figure 15-1 shows the average total costs of a firm with economies of scale. In this case, a single firm can produce any amount of output at least cost. That is, for any given amount of output, a larger number of firms leads to less output per firm and higher average total cost. An example of a natural monopoly is the distribution of water. To provide wa- ter to residents of a town, a firm must build a network of pipes throughout the town. If two or more firms were to compete in the provision of this service, each firm would have to pay the fixed cost of building a network. Thus, the average to- tal cost of water is lowest if a single firm serves the entire market. natural monopoly a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms CHAPTER 15 MONOPOLY 319 We saw other examples of natural monopolies when we discussed public goods and common resources in Chapter 11. We noted in passing that some goods in the economy are excludable but not rival. An example is a bridge used so infre- quently that it is never congested. The bridge is excludable because a toll collector can prevent someone from using it. The bridge is not rival because use of the bridge by one person does not diminish the ability of others to use it. Because there is a fixed cost of building the bridge and a negligible marginal cost of additional users, the average total cost of a trip across the bridge (the total cost divided by the number of trips) falls as the number of trips rises. Hence, the bridge is a natural monopoly. When a firm is a natural monopoly, it is less concerned about new entrants eroding its monopoly power. Normally, a firm has trouble maintaining a monop- oly position without ownership of a key resource or protection from the govern- ment. The monopolist’s profit attracts entrants into the market, and these entrants make the market more competitive. By contrast, entering a market in which an- other firm has a natural monopoly is unattractive. Would-be entrants know that they cannot achieve the same low costs that the monopolist enjoys because, after entry, each firm would have a smaller piece of the market. In some cases, the size of the market is one determinant of whether an indus- try is a natural monopoly. Consider a bridge across a river. When the population is small, the bridge may be a natural monopoly. A single bridge can satisfy the entire demand for trips across the river at lowest cost. Yet as the population grows and the bridge becomes congested, satisfying the entire demand may require two or more bridges across the same river. Thus, as a market expands, a natural monop- oly can evolve into a competitive market. QUICK QUIZ: What are the three reasons that a market might have a monopoly? ◆ Give two examples of monopolies, and explain the reason for each. Quantity of Output Average total cost 0 Cost Figure 15-1 ECONOMIES OF SCALE AS A C AUSE OF MONOPOLY. When a firm’s average-total-cost curve continually declines, the firm has what is called a natural monopoly. In this case, when production is divided among more firms, each firm produces less, and average total cost rises. As a result, a single firm can produce any given amount at the smallest cost. 320 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY HOW MONOPOLIES MAKE PRODUCTION AND PRICING DECISIONS Now that we know how monopolies arise, we can consider how a monopoly firm decides how much of its product to make and what price to charge for it. The analysis of monopoly behavior in this section is the starting point for evaluating whether monopolies are desirable and what policies the government might pursue in monopoly markets. MONOPOLY VERSUS COMPETITION The key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output. A competitive firm is small relative to the market in which it operates and, therefore, takes the price of its output as given by market conditions. By contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market. One way to view this difference between a competitive firm and a monopoly is to consider the demand curve that each firm faces. When we analyzed profit maximization by competitive firms in Chapter 14, we drew the market price as a horizontal line. Because a competitive firm can sell as much or as little as it wants at this price, the competitive firm faces a horizontal demand curve, as in panel (a) of Figure 15-2. In effect, because the competitive firm sells a product with many Quantity of Output Demand (a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve 0 Price Quantity of Output0 Price Demand Figure 15-2 DEMAND CURVES FOR COMPETITIVE AND MONOPOLY FIRMS. Because competitive firms are price takers, they in effect face horizontal demand curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it faces the downward-sloping market demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it wants to sell more output. . discussing the behavior of competitive profit-maximizing firms. You may recall from Chapter 1 that one of the Ten Principles of Economics is that rational people. sharply reduces the cost of printing books. What happens to Hi-Tech’s profits and the price of books in the short run when Hi-Tech’s patent prevents other firms