44 Review and Practice

 

Summary

This chapter has examined the profit-maximizing behavior of monopoly firms. Monopoly occurs if an industry consists of a single firm and entry into that industry is blocked.

Potential sources of monopoly power include the existence of economies of scale over the range of market demand, locational advantages, high sunk costs associated with entry, restricted ownership of raw materials and inputs, and government restrictions such as licenses or patents. Network effects for certain products further increase the market power that patents afford.

Because the demand curve faced by the monopolist is downward-sloping, the firm is a price setter. It will maximize profits by producing the quantity of output at which marginal cost equals marginal revenue. The profit-maximizing price is then found on the demand curve for that quantity.

Because a typical monopolist holds market price above marginal cost, the major impact of monopoly is a reduction in efficiency. Compared to a competitive market, the monopoly is characterized by more centralized power, potential higher profits, and less pressure to be responsive to consumer preferences. Public policy toward monopoly includes antitrust laws and, in the case of natural monopolies, regulation of price and other aspects of the firm’s behavior.

A firm that is the sole purchaser of a factor is a monopsony. The distinguishing feature of the application of the marginal decision rule to monopsony is that the MFC of the factor exceeds its price. Less of the factor is used than would be the case if the factor were demanded by many firms. The price paid by the monopsony firm is determined from the factor supply curve; it is less than the competitive price would be. The lower quantity and lower price that occur in a monopsony factor market arise from features of the market that are directly analogous to the higher product price and lower product quantity chosen in monopoly markets. A price floor (e.g., a minimum wage) can induce a monopsony to increase its use of a factor.

Sellers can also exercise power to set price. A factor can be sold by a monopoly firm, which is likely to behave in a way that corresponds to the monopoly model.

When there are a large number of sellers, they may band together in an organization that seeks to exert a degree of market power on their behalf. Workers (sellers of labor), for example, have organized unions to seek better wages and working conditions. This goal can be accomplished by restricting the available supply or by increasing the demand for labor. When a union represents all of a monopsony firm’s workers, a bilateral monopoly exists. A bilateral monopoly results in a kind of price-setters’ standoff, in which the firm seeks a low wage and the union a high one.

Professional associations may seek to improve the economic position of their members by supporting legislation that reduces supply or raises demand. Some agricultural producers join producers’ cooperatives to exert some power over price and output. Agricultural cooperatives must be authorized by Congress; otherwise, they would violate laws against collusion in the marketplace.

Concept Problems

  1. Consider the following firms. Would you regard any of them as a monopoly? Why or why not? Could you use the monopoly model in analyzing the choices of any of them? Explain.

    1. the best restaurant in town
    2. your barber or beautician
    3. your local telephone company
    4. your campus bookstore
    5. Microsoft
    6. Amtrak
    7. the United States Postal Service
  2. Explain the difference between the demand curve facing a monopoly firm and the demand curve facing a perfectly competitive firm.
  3. What are the necessary conditions for a monopoly position in the market to be established?
  4. A monopoly firm is free to charge any price it wishes. What constrains its choice of a price?
  5. Suppose the government were to impose an annual license fee on a monopolist that just happened to be equal to its economic profits for a particular year. How would such a fee affect price and output? Do you think that such a fee would be appropriate? Why or why not?
  6. Name one monopoly firm you deal with. What is the source of its monopoly power? Do you think it seeks to maximize its profits?
  7. “A monopolist will never produce so much output as to operate in the inelastic portion of the demand curve.” Explain.
  8. “A monopoly is not efficient, and its pricing behavior leads to losses to society.” What does this statement mean? Should society ban monopolies?
  9. A small town located 30 miles from the nearest town has only one service station. Is the service station a monopoly? Why or why not?
  10. Explain why under monopoly price is greater than marginal revenue, while under perfect competition price is equal to marginal revenue.
  11. In what sense can the monopoly equilibrium be considered inequitable?
  12. What is a natural monopoly? Should a natural monopoly be allowed to exist?
  13. Give some examples of industries in which you think natural monopoly conditions are likely to prevail. Why do you think so?
  14. People often blame the high prices for events such as professional football and basketball and baseball games on the high salaries of professional athletes. Assuming one of these teams is a monopoly, use the model to refute this argument.

  15. How do the following events affect a monopoly firm’s price and output? How will it affect the firm’s profits? Illustrate your answers graphically.

    1. an increase in labor costs in the market in which the firm operates
    2. a reduction in the price of gasoline
    3. the firm’s Chief Executive Officer persuades the Board to increase his or her annual salary
    4. demand for the firm’s product falls
    5. demand for the firm’s product rises
    6. the price of a substitute for the firm’s product rises
  16. Unions have generally advocated restrictions on goods and services imported from other countries. Why?
  17. There is a growing tendency in the United States for hospitals to merge, reducing competition in local markets. How are such mergers likely to affect the market for nurses?
  18. When a town has a single university, the university may have monopsony power in the hiring of part-time faculty. But what about the hiring of full-time faculty? (Hint: The market for full-time faculty is a national one.)
  19. David Letterman earns more than $10 million per year from CBS. Why do you suppose he earns so much? Is there any reason to believe he is underpaid?
  20. Suppose a union obtains a union shop agreement with firms in a particular industry. Is there any limit to the wages the union can achieve for its workers?
  21. It is illegal for firms in most industries to join together in a producers’ cooperative. Yet such arrangements are common in agriculture. Why?
  22. In proposing an increase in the minimum wage in 2005, the Democratic Party argued that in some markets, a higher minimum wage could actually increase employment for unskilled workers. How could this happen?
  23. Has increases in the minimum wage increased employment for unskilled workers?
  24. In 2005–06 the maximum salary of professional basketball players with up to three years of experience in the Women’s National Basketball Association (WNBA) stood at $42,000, while the maximum salary for a WNBA player in 2005 was $90,000 (the average was somewhere between $46,000 and $60,000 (depending on whether one’s source was the Players Union or the WNBA league itself). The minimum salary of a (male) rookie professional NBA basketball player in 2005–06 was $398,762 (WNBA rookies earned only slightly more than $30,000 that year). The average NBA salary in 2005–06 was $4,037,899. Why was there such a large discrepancy?
  25. The Case in Point on professional sports suggests that most professional athletes now receive salaries equal to their marginal revenue products. These are typically quite high. Are such high salaries fair? Why or why not?
  26. The Case in Point on the airline industry suggested that unions can enhance airline profitability and productivity. How is this possible?
  27. Large retail firms often advertise that their “buying power” allows them to obtain goods at lower prices and hence offer lower prices to their consumers. Explain the economic logic of this claim.

Numerical Problems

  1. A university football team estimates that it faces the demand schedule shown for tickets for each home game it plays. The team plays in a stadium that holds 60,000 fans. It estimates that its marginal cost of attendance, and thus for tickets sold, is zero.

    Price per ticket Tickets per game
    $100 0
    80 20,000
    60 40,000
    40 60,000
    20 80,000
    0 100,000
    1. Draw the demand and marginal revenue curves. Compute the team’s profit-maximizing price and the number of tickets it will sell at that price.
    2. Determine the price elasticity of demand at the price you determined in part (a).
    3. How much total revenue will the team earn?
    4. Now suppose the city in which the university is located imposes a $10,000 annual license fee on all suppliers of sporting events, including the University. How does this affect the price of tickets?
    5. Suppose the team increases its spending for scholarships for its athletes. How will this affect ticket prices, assuming that it continues to maximize profit?
    6. Now suppose that the city imposes a tax of $10 per ticket sold. How would this affect the price charged by the team?

  2. A monopoly firm faces a demand curve given by the following equation: P = $500 − 10Q, where Q equals quantity sold per day. Its marginal cost curve is MC = $100 per day. Assume that the firm faces no fixed cost.

    1. How much will the firm produce?
    2. How much will it charge?
    3. Can you determine its profit per day? (Hint: you can; state how much it is.)
    4. Suppose a tax of $1,000 per day is imposed on the firm. How will this affect its price?
    5. How would the $1,000 per day tax its output per day?
    6. How would the $1,000 per day tax affect its profit per day?
    7. Now suppose a tax of $100 per unit is imposed. How will this affect the firm’s price?
    8. How would a $100 per unit tax affect the firm’s profit maximizing output per day?
    9. How would the $100 per unit tax affect the firms profit per day?

30. Suppose a firm faces the following supply schedule for labor by unskilled workers:

Wage per day Number of workers
$0 0
8 1
16 2
24 3
32 4
40 5
48 6
56 7
64 8
72 9
80 10
      1. In terms of its supply of labor, what sort of firm is this? Explain. Add columns for total factor cost and marginal factor cost and fill them in.
      2. Plot the supply and marginal factor cost curves for this firm. Remember to plot marginal values at the midpoints of the intervals.
Number of workers Output per day
0 0
1 92
2 176
3 252
4 320
5 380
6 432
7 476
8 512
9 540
10 560

31. Suppose the firm faces the above total product schedule for labor.

  1. Compute the schedules for the firm’s marginal product and marginal revenue product curves, assuming the price of the good the firm produces is $1 and that the firm operates in a perfectly competitive product market
  2. Add the marginal revenue product curve from Problem 31 to your graph in Problem 30, and determine the number of workers the firm will employ and the wage it will pay.
  3. Now suppose the firm is required to pay a minimum wage of $48 per day. Show what will happen to the quantity of labor the firm will hire and the wage it will pay.

    32.  Suppose that the market for cranberries is perfectly competitive and that the price is $4 per pound. Suppose that an increase in demand for cranberries raises the price to $6 per pound in a matter of a few weeks.

            1. Illustrate the increase in demand in the market and in the case of a typical firm in the short run.
            2. Illustrate what happens in the long run in this industry. Assuming that the cost per unit of production remains unchanged throughout, what will the new price be?
            3. Now suppose that the industry is permitted to organize all firms into a producers’ cooperative that maximizes profits. Starting with the solution that you had in (b), illustrate the impact of this change on industry price and output.

    33. Again, consider the market for cranberries. The industry is perfectly competitive and the price of cranberries is $4 per pound. Suppose a reduction in the cost of obtaining water reduces the variable and average total cost by $1 per pound at all output levels.

              1. Illustrate graphically the impact of the change in the short run. Will the price fall by $1? Why or why not?
              2. Now show the impact of the $1 reduction in cost in the long run. Who benefits from the reduction in cost?
              3. Assume again that the producers in the industry are permitted to band together in a cooperative that maximizes profits. Now show the short run impact of the cost reduction on the price and output of cranberries.
              4. Now show the long run impact of the change. Who benefits from the reduction in cost?
              5. Compare your responses to parts (b) and (d), and explain the difference, if any.

    34. A single firm is the sole purchaser of labor in its market. It faces a supply curve given by q = (1/4)w + 1,000, where q is hours of work supplied per day, and w is the hourly wage.

              1. Draw a graph of the firm’s supply curve.
              2. Show the firm’s marginal factor cost curve on the same graph you used in (a).

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