Review Question Index

Answers to the Review Questions from Chapter 13 of Parkin's Microeconomics

1. The definition of monopoly is "an industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing entry of new firms." Essentially, a monopoly is the only firm in its industry. As examples, one could list regulated monopolies, such as the electric, gas, or water company, the cable television company, or perhaps the U.S. Postal Service.

2. Barriers to entry are obstacles that prevent new firms from entering an industry. Barriers to entry may be divided into two types: legal and natural. There are several types of legal barriers:

bulletPublic franchise. When the government grants one firm the legal right to be the only firm in a particular market. Many utilities have been granted public franchises.
bulletGovernment license. When a license is required to produce a good or service legally. Although they do not create pure monopolies, government license requirements apply to many professions (e.g., medical, legal, engineering, and accounting) and other occupations (e.g., morticians, contractors, and barbers).
bulletPatents. When the legal right to be the only producer of a good or service is granted to the inventor. An example is the role of patents in the pharmaceutical industry. Here, drug firms are granted legal monopolies over new drugs that they develop.

Natural barriers arise when one firm can supply the market at lower cost than two or more firms (which creates a "natural monopoly") and when one firm controls all of a vital resource needed to produce a good. DeBeers, which controls over 80 percent of the world’s rough diamond supply, is an example of this type of monopoly.

3. Legal barriers to entry create legal monopolies, and natural barriers to entry create natural monopolies. Examples of legal barriers include the government’s granting one company the sole legal right to produce a product, requiring a license or certificate to work in an occupation, and granting patents. Examples of legal monopolies include the U.S. Postal Service, any of the thousands of patented drugs, or any of the thousands of regulated utilities. Natural monopolies occur for basic "technological" reasons. One reason is economies of scale, whereby one firm can supply the market at a cost lower than two or more firms. Public utilities such as electric utilities or local phone companies often claim to be natural monopolies of this type. Another is when a firm, such as DeBeers, controls the market for a resource essential to making a product.

4. A monopoly controls the entire market. A monopoly sets the highest price possible that allows it to sell all the output it produces. If it wants to sell any additional output it must lower its price to get demanders to buy the extra output.

5. Marginal revenue is less than the price because the monopoly’s demand curve is the same as the industry’s and slopes downward. Thus to sell another unit of output, the monopoly must lower its price. The sale raises the firm’s revenue by the amount of the price. But the fact that the (now) lower price reduces the amount collected on the sale of the initial units produced lowers the total MR collected. This reduction implies that P > MR.

6. A single-price monopoly never operates on the inelastic part of its demand curve. The reason is simple: Operating on the inelastic portion of the demand curve is never profit maximizing. Recall that, if demand is inelastic, total revenue rises if the monopoly raises its price and sells one less unit of output. Further, by cutting its production the firm lowers its costs. Hence cutting production by a unit raises revenue and lowers costs. Both effects boost the monopoly’s profit. As long as the monopoly finds itself on the inelastic portion of its demand curve, it can raise its total profits by cutting production and thereby moving toward an elastic part of the demand curve.

7. A monopoly chooses its output and price so as to maximize its profit. As illustrated in Figure 13.4 (page 269), the monopoly produces the level of output so that MR = MC because it is the profit-maximizing level. For instance, once at this level of output (Q = 3 in the figure), if the monopoly produced more output, MR would fall short of MC and the monopoly would incur a loss on the extra units of output. For the (profit-maximizing) level of production, the monopoly selects the price to charge from the demand curve. The point on the demand curve above the level of output produced shows the maximum possible price that can be charged and still have demanders purchase all that is produced. This price (P in the figure) is the price the monopoly charges. If the monopoly charged a higher price, not all the output would be purchased; if it charged a lower price, it would sell all it produces but would unnecessarily forego revenue and hence lose profit.

8. A monopoly does not necessarily make an economic profit in the short run. For instance, if demand for its product decreased, a monopoly can incur an economic loss in the short run. In the short run, any result is possible: The firm can earn an economic profit, or a normal profit, or incur an economic loss.

9. A monopoly does not necessarily earn zero economic profit in the long run. It may, but this result would be coincidental. Generally, monopolies will earn an economic profit in the long run. They are able to do so indefinitely because of barriers to entry that keep competitors out of the market.

10. Not all monopolies can price discriminate. A monopoly must meet three requirements to be able to do so. First, at least one class of customers must have an elasticity of demand different from another class. Second, customers must not be able to resell the good to other customers. Third, the firm must be able to distinguish among the groups that have different elasticities of demand. If the monopoly cannot meet all of these requirements, it cannot price discriminate.

When considering price discrimination for the sale of various quantities of units to one customer — that is, charging lower prices for additional units of output — the ability to price discriminate again depends on the inability of customers to sell (low-priced) units of the good to other customers.

11. In technical terms, a perfectly competitive industry produces at the level where its supply curve crosses the demand curve (P = MC). The supply curve for a perfectly competitive industry is the summation of the individual firms’ marginal cost curves. If the industry becomes monopolized, the supply curve becomes the monopoly’s MC curve. The monopoly produces at the level where this MC curve crosses the MR curve. Because the MR curve lies below the demand curve, the MC and MR curves intersect at an output level less than the intersection of the MC (which is the perfectly competitive industry’s supply curve) and demand curves. In other words, a monopoly produces less than a perfectly competitive industry because the monopoly can capture all the gains from producing less and boosting the price of the product. If a perfectly competitive firm produces less, the ensuing (small) price rise benefits all the firms in the industry and the firm cutting back on its output captures only a trivial part of the gain. Unlike a monopoly, no perfectly competitive firm has the incentive to decrease its output.

12. In general, single-price monopolies are inefficient because their output restriction/price elevation creates a loss in consumer and producer surplus. A perfectly competitive industry produces the efficient amount of output and, relative to a perfectly competitive industry, a single-price monopoly produces less output. Therefore the monopoly cannot be producing the efficient level of output. Another way to demonstrate this result is by considering the relationship between the value that consumers place on an additional unit of output and the cost of producing this unit. The value is measured by the price of the product, whereas the cost of producing the unit equals the marginal cost. Because a monopoly produces at the level where P > MC, consumers clearly value an extra unit more than it costs to produce the unit, so the level of output is inefficient.

13. Consumer surplus is the difference between how much a consumer values a good and the price that the consumer must pay. In a diagram, it is the area below the demand curve and above the price. Producer surplus is the difference between the price that a firm receives for a good and the minimum price at which the firm would have supplied the good. In a diagram, producer surplus is the area below the price and above the supply curve (MC).

14. The deadweight loss from a perfectly competitive industry becoming a single-price monopoly is illustrated in Figure 13.9( page 276). Deadweight loss is the loss of consumer and producer surplus owing to the monopolization of a perfectly competitive industry and the resulting decrease in output fromtoand the rise in price fromto Or, as the text puts it, deadweight loss "measures inefficiency as the reduction in consumer and producer surplus resulting from a restriction of output below its efficient level."

15. This is a trick question! There is no deadweight loss under perfect price discrimination. What may lead to confusion is that, under perfect price discrimination, all the consumer surplus is collected by the monopoly. This situation is not illustrated in the text. However, we may use Figure 13.9( page 276). Under perfect price discrimination, the monopolist would produce , but charge prices varying from PC to PA. Some of you may mistakenly identified the lost consumer surplus as deadweight loss. This conclusion is not correct: The consumer surplus is collected by the monopoly and hence is not lost to society.

16. The deadweight loss from inefficiency is larger for a single-price monopoly than for a monopoly able to practice perfect price discrimination. Indeed, an exception to the general rule of inefficiency is a monopoly that can perfectly price discriminate. Such a monopoly produces the same level of output as does the competitive industry and therefore is efficient. Although a perfectly price-discriminating monopoly captures the entire amount of consumer surplus, it does produce the efficient level of output. Thus a perfectly price-discriminating monopoly generates no deadweight loss. Although a single-price monopoly cannot capture all the consumer surplus, it produces less than the efficient level of output. Hence, the single-price monopoly is less efficient than the perfectly price-discriminating monopoly.

17. Under perfect price discrimination, the monopoly charges each consumer the maximum that he or she is willing to pay for each unit of the product. Consumers have no consumer surplus. However, a single-price monopoly charges the same price for all units of the product. Thus consumers who value the good more highly than the price charged still retain some consumer surplus.

18. People engage in rent seeking because monopolies can earn an economic profit indefinitely. Rent seeking, the activity of "artificially" establishing a monopoly, can be highly profitable. As with any potentially profitable business venture, many people looking to further their own well-being engage in this activity.

19. Rent seeking uses resources that otherwise could be used in productive activities. Thus the total cost imposed on society by a monopoly equals the sum of the deadweight loss from the monopoly and the value of resources used in rent seeking. In the long run, rent seeking may absorb all of the economic profit.

20. Economies of scale occur if the firm’s ATC declines as it expands output; economies of scope take place if the firm’s ATC declines as the number of different goods produced increases. When monopolies arise because of economies of scale or scope, the monopoly may be more efficient than would be the case if the industry were perfectly competitive. In particular, the MC of the monopoly is lower than that for a competitive industry (comprising many small firms unable to capture the economies of scale or scope). If the monopoly’s MC is enough lower, the level of output produced by the monopoly may be more than (and the price less than) what a perfectly competitive industry would produce (and charge).

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