10.4 Review and Practice
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.
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.
- the best restaurant in town
- your barber or beautician
- your local telephone company
- your campus bookstore
- the United States Postal Service
- Explain the difference between the demand curve facing a monopoly firm and the demand curve facing a perfectly competitive firm.
- What are the necessary conditions for a monopoly position in the market to be established?
- A monopoly firm is free to charge any price it wishes. What constrains its choice of a price?
- 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?
- Name one monopoly firm you deal with. What is the source of its monopoly power? Do you think it seeks to maximize its profits?
- “A monopolist will never produce so much output as to operate in the inelastic portion of the demand curve.” Explain.
- “A monopoly is not efficient, and its pricing behavior leads to losses to society.” What does this statement mean? Should society ban monopolies?
- 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?
- Explain why under monopoly price is greater than marginal revenue, while under perfect competition price is equal to marginal revenue.
- In what sense can the monopoly equilibrium be considered inequitable?
- What is a natural monopoly? Should a natural monopoly be allowed to exist?
- Give some examples of industries in which you think natural monopoly conditions are likely to prevail. Why do you think so?
- 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.
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.
- an increase in labor costs in the market in which the firm operates
- a reduction in the price of gasoline
- the firm’s Chief Executive Officer persuades the Board to increase his or her annual salary
- demand for the firm’s product falls
- demand for the firm’s product rises
- the price of a substitute for the firm’s product rises
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
- 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.
- Determine the price elasticity of demand at the price you determined in part (a).
- How much total revenue will the team earn?
- 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?
- Suppose the team increases its spending for scholarships for its athletes. How will this affect ticket prices, assuming that it continues to maximize profit?
- Now suppose that the city imposes a tax of $10 per ticket sold. How would this affect the price charged by the team?
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.
- How much will the firm produce?
- How much will it charge?
- Can you determine its profit per day? (Hint: you can; state how much it is.)
- Suppose a tax of $1,000 per day is imposed on the firm. How will this affect its price?
- How would the $1,000 per day tax its output per day?
- How would the $1,000 per day tax affect its profit per day?
- Now suppose a tax of $100 per unit is imposed. How will this affect the firm’s price?
- How would a $100 per unit tax affect the firm’s profit maximizing output per day?
- How would the $100 per unit tax affect the firms profit per day?