Monopoly

Objectives You may wish to call stu-dents’ attention to the objectives inthe Section Preview. The objectives arereflected in the main headings of thesection.

Bellringer Ask students if they haveever played the game Monopoly®.Ask them to explain the reason for itsname. Explain to students that in thissection they will learn about the char-acteristics of monopoly markets.

Vocabulary Builder Have studentsfind the definitions of each key termlisted in the Section Preview. Thenhave students create fill-in-the-blanksentences for each term. Ask studentsto read their sentences aloud, lettingtheir classmates identify the correctterms.

Competition To build understanding of the conceptof competition, have students use a web graphic or-ganizer like the one below to explain the variousconditions that lead to monopolies. Remind stu-dents that a web shows a main idea and its sup-porting details.

Section Reading Support Transparencies A tem-plate and the answers for this graphic organizercan be found in Chapter 7, Section 2 of the SectionReading Support Transparency System.

Graphing the Main IdeaB U I L D I NGB U I L D I NG

K E Y CONCE PTSK E Y CONCE PTS

ChaptChapter er 77 •• Section Section 22

Guided Reading and ReviewUnit 2 folder, p. 37 asks students toidentify the main ideas of the sectionand to define or identify key terms.

YYou’ve gone to the emergency room witha high fever and a sharp pain in your

leg. The doctor diagnoses a rare infectionand writes a prescription for ten pills of anew medication that the governmentapproved just last year. The doctor tells youthat without this medication, your recoverywill be slow.

At the pharmacy, you find that themedicine costs $97.35, or nearly ten dollarsa pill! The pharmacist tells you that onlyone company has the right to produce themedicine, and it charges a high pricebecause its scientists worked for years to

develop the medication. You feelthat you have no choice, so you

hand over the cash.

The market for prescription medicines isone of many markets in which monopoliescan develop. In this section you will readabout different types of monopolies andhow they form.

Describing MonopolyA monopoly forms when barriers preventfirms from entering a market that has asingle supplier. While a perfectly competi-tive market has many buyers and sellers,monopoly markets have only one seller, butany number of buyers. In fact, barriers toentry are the principal condition thatallows monopolies to exist.

While you can probably think of severalcompanies that look and act like monopo-lies, economists use a strict set of require-ments to define a monopoly. If we definethe good or service provided by a companybroadly enough, we can usually find substi-tute goods from a different source. Forexample, you might think that a conve-nience store on a highway in the middle ofthe desert has a monopoly. However, youcould have carried more water in the car,or, if you had enough money, you mighthave flown across the desert instead ofpaying high prices for food and waterduring the car trip.

monopoly a marketdominated by a singleseller

Monopoly

Section FocusA firm has a monopoly when itcontrols an entire market. Because amonopolist controls the price of itsproduct, a monopoly produces lessand charges higher prices than woulda perfectly competitive firm.

ObjectivesAfter studying this section you will be able to:1. Describe characteristics and give

examples of monopoly.2. Describe how monopolies are formed,

including government monopolies.3. Explain how a firm with a monopoly sets

output and price, and why companiespractice price discrimination.

Key Termsmonopolyeconomies of scalenatural monopolygovernment monopolypatentfranchiselicenseprice discriminationmarket power

Preview

� One company,DeBeers of SouthAfrica, has almosttotal control over theworld’s diamondsupply.

Lesson PlanTeaching the Main Concepts

1. Focus A major characteristic of amonopoly is that it is made up of a singleseller. Ask students to give examples offirms that they think are monopolies andto identify any elements they have incommon.2. Instruct Begin by making sure thatstudents understand what a monopolyis. Then discuss how monopolies areformed, including government monopo-lies. Be sure that students understandthat a monopolist maximizes profits by producing at a level of output atwhich marginal cost equals marginalrevenue.3. Close/Reteach Ask small groups ofstudents to create scenarios similar tothe Leland/BreatheDeep example on p.159. Suggest that they illustrate theirwork. Have them present their sce-narios to the class along with anygraphics they have created.

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(Enrichment) To help students understand how economists define amonopoly, have them work in smallgroups to find out about monopoliesduring specific periods of history.Students might, for example, chooseguilds as a focus. Ask them to research the characteristics of guildsthat resulted in their functioning asmonopolies. Have each group pre-sent its findings as an illustratedposter.

To help students transfer informa-tion from one medium to another(data to graph), display the followingaluminum production data in tableform. (Create two columns: “Quan-tity Produced” and “Average Cost.”)0.5 million pounds of aluminumproduced/$2.80 per pound; 1 millionpounds/$2.10 per pound; 1.5 millionpounds/$1.80 per pound; 2 millionpounds/$1.60 per pound; 2.5 millionpounds/$1.53 per pound. Ask stu-dents to plot a graph that showsthese data. If available, have studentsuse a computer graphing software inthis activity. Display the graphs anddiscuss what they show abouteconomies of scale.

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ChaptChapter er 77 •• Section Section 22

Markets and Prices One of the key concepts in thissection is that output affects marginal revenue. To-tal revenue is the money a firm gets by selling itsproduct—the price multiplied by the quantity sold.A firm’s marginal revenue is the change in total rev-enue that results from selling two different quanti-ties of output.

To help students understand how marginal rev-enue is determined, refer them to the table on p. 161.Explain to students that to compute the marginal

revenue that results from selling 10,000 dosesrather than 9,000 doses, they should first find thedifference between the total revenues for the twooutputs. ($1,000) Then have them divide that fig-ure by the difference in the quantities (1,000). Themarginal revenue at a price of $10 per unit is $1.

Econ 101: Key Concepts Made EasyEcon 101: Key Concepts Made Easy$Answer to . . .Building Key Concepts Wheneconomies of scale do not exist, in-creasing production beyond a cer-tain point becomes costly. Otherfirms may enter the industry andproduce additional units profitably.

The problem with monopolies is thatthey can take advantage of their marketpower and charge high prices. Given thelaw of demand, this means that thequantity of goods sold is lower than in amarket with more than one seller. For thisreason, the United States has outlawedsome monopolistic practices, as you willread in Section 4.

Forming a MonopolyAll monopolies have one trait in common:a single seller in a market. However,different market conditions can createdifferent types of monopolies.

Economies of ScaleIf a firm’s start-up costs are high, and itsaverage costs fall for each additional unit itproduces, then it enjoys what economistscall economies of scale. Economies of scaleare characteristics that cause a producer’saverage cost to drop as production rises.

The graph on the left in Figure 7.3 aboveshows an average total cost curve for a firmwithout economies of scale. Follow thecurve from left to right. As output increasesfrom zero, the average cost of each gooddrops, and the curve initially slopes

downward. This is because large, initial,fixed costs, like the cost of the factory andmachinery, can be spread out among moreand more goods as production rises. If thefactory cost $1,000 to build and each unitof output costs $10 to make, producingone unit will cost $1,010, but producingtwo units will cost $1,020, or only $510each. However, if the industry has limitedeconomies of scale, output will eventuallyrise to a level at which the limited scaleeconomies are exhausted, and the cost ofmaking each unit will rise. The average costof producing each good increases as outputincreases, and the curve slopes upward tomatch the rising cost per unit.

A factory in an industry with economiesof scale never reaches this second stage ofrising costs per unit. As productionincreases, the firm becomes more efficient,even at a level of output high enough tosupply the entire market. The graph on theright in Figure 7.3 above shows how costand output are related in economies ofscale. Follow the curve from left to right.As output increases, the cost per unit falls,and continues to fall.

A good example is a hydroelectric plant,which generates electricity from a dam on ariver. A large dam is expensive to build.

economies of scalefactors that cause aproducer’s averagecost per unit to fall asoutput rises

Average Total Cost CurveWithout Economies of Scale

Average Total Cost CurveWith Economies of Scale

Figure 7.3 Effect of Economies of ScaleFigure 7.3 Effect of Economies of Scale

Cos

t

Average Total Cost

Output

Average Total Cost

Output

Cos

t

With economies of scale, the average cost of production falls when the firm produces more.

The average cost rises when output exceeds a certain level.

With economies of scale, production costs continue to fall as output increases. Markets and Prices Describe the cost curve for a firm without economies of scale.

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Consider these suggestions to take advantage ofextended class time:

� Refer students to the map on p. 160. Point outthat the cost of an expansion football team hasskyrocketed. Have students research the cost ofbuying an NFL franchise over the last 25 yearsand graph their findings. Hold a discussion aboutthese costs and the monopolistic management ofthe league.

� Have students work in pairs to complete thefirst activity on p. 163. Then have the pairs createsimilar examples and present them to the class asproblems to be solved.

� Organize students into groups of three or four.Assign each group a different industry, and askgroup members to gather production and costdata about that industry. Then have groups graphtheir data.

Block Scheduling StrategiesBlock Scheduling Strategies

This section contains an extended dis-cussion of how one monopoly, publicwater, is formed. Ask students to con-sider another monopoly that occurs intheir own community. (Students maysuggest public sewers, public electricity,freight railroads, or mass transit.) Thenask them to write a paragraph explain-ing why a monopoly occurs in this sec-tor of the marketplace.

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Answer to . . .Building Key Concepts Competitionin the area of public water wouldcreate inefficiency.

BackgroundInterdisciplinaryInterdisciplinarySometimes the government is able toprevent monopolies from occurringthrough changes in technology. Forexample, in late 1999, telephone com-panies such as AT&T were buyinglarge cable networks to gain accessto the growing high-speed Internetaccess, or broadband, market. Thistactic could have given those tele-phone companies a natural monopolyover broadband by forcing con-sumers to choose the owners of thecable networks as their Internet ser-vice providers (ISPs). Although thefederal government was wary of forc-ing cable companies to share theirnetworks, many major cities—suchas Portland, Oregon—have declaredthat the cable companies must sharetheir networks with other ISPs, suchas America Online, Inc.

natural monopoly amarket that runs mostefficiently when onelarge firm supplies allof the output

� Before cellular phones becamepopular, telephone service was anatural monopoly because no onewanted to build more than onenetwork of wires.

However, once the dam is built, the plantcan produce energy at a very low addi-tional cost simply by letting water flowthrough the dam. The average cost of thefirst unit of electricity produced is very highbecause the cost of the dam is so high. Asoutput increases, the fixed costs of the damcan be spread over more units of electricity,so the average cost drops. In a market witheconomies of scale, bigger is better. Anindustry that enjoys economies of scale caneasily become a natural monopoly.

Natural MonopoliesA natural monopoly is a market that runsmost efficiently when one large firmprovides all of the output. If a second firmenters the market, competition will drivedown the market price charged tocustomers and decrease the quantity eachfirm can sell. One or both of the firms willnot be able to cover their costs and will goout of business.

Public water provides a good example ofa natural monopoly. In a competitivemarket, different water companies woulddig reservoirs and set up overlappingnetworks of pipes and pumping stations todeliver water to the same town. Companieswould use more land and water than neces-sary. Each company would have to pay forall of the unneeded pipes and would servecustomers no better than a single network.

In cases like this, the government oftensteps in to allow just one firm in eachgeographic area to provide these necessaryservices. The government action ensuresthat we don’t waste resources building addi-tional plants when only one is needed. Inreturn for monopoly status, a firm with anatural monopoly agrees to let governmentcontrol the prices it can charge and whatservices it must provide.

Technology and ChangeSometimes the development of a new tech-nology can destroy a natural monopoly. Anew innovation can cut fixed costs andmake small companies as efficient as onelarge firm.

Number of firms:One

Barriers to entry:Complete Control over prices:

Complete

Variety of goods:None

Figure 7.4 MonopolyFigure 7.4 Monopoly

In a monopoly, one company controls the market.Markets and Prices Why is public water a monopoly?

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(Reteaching) Have students workwith partners to read the informa-tion under the heading “Govern-ment Monopolies.” After they haveread the material, ask partners toexplain to each other the way inwhich these monopolies are formed.Then have students show theirunderstanding of the material by cre-ating a captioned poster or a graphicthat illustrates the ways in which thegovernment extends market power.

Have students divide a piece of paperinto two columns. Ask them to describe a natural monopoly in onecolumn. In the other column, havethem describe the different kinds ofgovernment monopolies. Then havethem write a sentence or two summa-rizing the differences between the two.ELL

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ChaptChapter er 77 •• Section Section 22

BackgroundEconomics in HistoryEconomics in HistoryThe word franchise comes from theOld French word franc, which meant“free.” During the Middle Ages, afranchise was a right or a privilege.The lord who owned a piece of landwould grant private individuals cer-tain rights. These might include theright to hold markets or fairs, to oper-ate ferries, or to conduct other com-mercial activities.

In the United States during the lat-ter part of the 1800s, franchises weregranted for the provision of such ser-vices as electricity and water. Even-tually public utility commissions tookover these tasks, and by the 1950sfranchises were becoming a popularform of private business organization.Restaurants, convenience stores,printing shops, and dry-cleaningshops are popular types of fran-chises today.Have students read the section titled “Government Monopolies” and then answer the

question below.According to the text, which of the following might the government use to encouragefirms to research and develop new products?

A licenses to control specific resources

B patents for a specific length of time

C franchises to sell goods

D restrictions on the number of firms

Preparing for Standardized TestsPreparing for Standardized Tests�

When telephone calls werecarried by thick copper wires,local telephone service wasconsidered a natural monopoly.No one wanted to build morethan one network of wires toconnect thousands of homesand businesses. In the 1980sand 1990s, consumers beganusing cellular phones, whichwere portable and could carryphone calls via radio wavesrather than through wires.Cellular technology reducedthe barriers to entry in the localtelephone market. Now that cellular phonecompanies can link to thousands or millionsof customers with a few, well-placedtowers, they don’t need to invest in anexpensive infrastructure of cables and tele-phone poles. Cellular phone companies arebecoming as efficient as traditional wire-based phone services.

Government MonopoliesIn the case of a natural monopoly, thegovernment allows the monopoly to formand then regulates it. In other cases,however, government actions themselvescan create barriers to entry in markets andthereby create monopolies. A governmentmonopoly is a monopoly created by thegovernment.

Technological MonopoliesOne way that the government can give acompany monopoly power is by issuing apatent. A patent gives a company exclusiverights to sell a new good or service for aspecific period of time. Suppose that LelandPharmaceuticals developed a new asthmamedication called BreatheDeep that helpedpeople with asthma develop stronger lungs.If Leland’s researchers could prove to thegovernment that they had inventedBreatheDeep, the Food and DrugAdministration would grant Leland apatent. This patent would give Leland theexclusive right to sell BreatheDeep fortwenty years.

Why would the government want to givea company monopoly power? Patents guar-antee that companies can profit from theirown research without competition. For thisreason, patents encourage firms to researchand develop new products that benefitsociety as a whole, even though the researchand development costs may be very high.The market power that comes with thepatent allows firms to set prices thatmaximize their opportunity to make a profit.

Franchises and LicensesA franchise is a contract issued by a localauthority that gives a single firm the right tosell its goods within an exclusive market.For example, the National Park Servicepicks a single firm to sell food and othergoods at national parks, such asYellowstone, Yosemite, and the Everglades.Your school may have contracted with onesoft-drink company to install and stockvending machines. The franchise mayinclude a condition that noother soft drinks will be soldin the building. Governments,parks, and schools use fran-chises to keep small marketsunder control.

On a larger scale, govern-ments can issue a licensegranting firms the right tooperate a business. Examplesof scarce resources that requirelicensing include radio and tele-vision broadcast frequencies

government monopolya monopoly created bythe government

patent a license thatgives the inventor of anew product theexclusive right to sell itfor a certain period oftime

franchise the right tosell a good or servicewithin an exclusivemarket

license a government-issued right to operatea business

Many villages in India and Bangladesh have never had phone service, even though most of the population lives in the countryside. Stretching a cable to every village was too expensive and inefficient, even for a natural monopoly. Using a cellular network, Grameen Telecom now plans to bring pay phones to 68,000 villages in Bangladesh and serve 100 million new customers.

FAST FACT

� A national parkcan give onecompany a franchisefor, or monopoly over,food service withinthe park.

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Have students study the map on thispage. Ask them to use the informationin the map along with their ownknowledge to explain how a monopo-listic organization, in this case the Na-tional Football League, may controloutput or price in an industry.

You may wish to have students addthe following to their portfolios. Havethem use the information in the sectionas well as other resources to find moreinformation about monopolies. Thenhave them write a position paper onthe following question: Are monopo-lies harmful to consumers? Students’papers should include examples tosupport their positions. GT

Economics Assessment RubricEconomics Assessment Rubrics folder,pp. 22–23 provides sample evaluationmaterials for a position paper.

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Answer to. . .Building Key Concepts Havingfewer teams in the National Foot-ball League allows each team tohave less competition in its regionand, therefore, more fans.

Thomas Alva Edison Thomas Alva Edison obtained1,093 patents from the United States govern-ment—the greatest number of patents issued to asingle person. In the early 1900s Edison attemptedto control the U.S. motion picture industry bypooling his patents with those of other movie inventors. Together they formed the Motion Pic-ture Patents Company, which controlled the pro-duction, distribution, and exhibition of motion

pictures. However, in 1917 the Supreme Court ofthe United States ruled that the company was anillegal monopoly, dissolving Edison’s control overthe industry.

Making the Connection Have students researchpatents that Edison received for inventions outsidethe movie industry. Ask them to report how theseinventions continue to affect life today.

Interdisciplinary Connections: HistoryInterdisciplinary Connections: History

and land. The Federal CommunicationsCommission issues licenses for individualradio and television stations. Some citiesselect a single firm to own and manage all oftheir public parking lots.

Industrial OrganizationsIn rare cases, the government allows thecompanies in an industry to restrict thenumber of firms in a market. For example,the United States government lets MajorLeague Baseball and other sports leaguesrestrict the number and location of theirteams. The government allows teamowners of the major professional sportsleagues to choose new cities for their teamsand does not charge them with violatingthe laws that prevent competitors fromworking together.

Major League Baseball has an exemptionfrom these laws, which are known asantitrust laws, because they were originallypassed to break up an illegal form of

monopoly known as a trust. Other sportsleagues do not have an official exemption,but the government treats them as it treatsbaseball. The restrictions that the leaguesimpose help keep team play orderly andstable by preventing other cities fromstarting their own major league teams andcrowding the schedule.

The problem with this type of monopolyis that team owners may charge high pricesfor tickets. In addition, if you’re a sports fanin a city without a major league team,you’re out of luck.

Output DecisionsIf you had severe asthma, which can befatal, what would BreatheDeep be worth toyou? You would probably want themedicine no matter how much it cost. SoLeland, the company that invented andpatented the drug, could charge a very highprice for its new medication. In fact, they

BaltimoreIn 1984, Baltimore lost the Colts to Indianapolis. With no help from the NFL in sight, the city lured the Browns from Cleveland via a 30-year, zero-rent lease on a new stadium. Renamed the Ravens, the team won the Super Bowl for Baltimore in 2000 by a score of 34–7.

ClevelandThe owner of the Cleveland Browns took his team to Baltimore in 1995. After Cleveland built a new stadium with help from NFL loans, the NFL approved a new team for Cleveland in 1999.

HoustonThe fourth-largest city in the U.S. lost the Oilers to Tennessee in 1996. An underdog, Houston beat out L.A. for a new team in October 1999 when it promised to build a $310 million stadium and pay the NFL a $700 million fee.

Los AngelesThe second-largest city in the U.S. lost teams to Oakland and St. Louis in 1995. The NFL's 30 team owners voted to give L.A. a new team in March 1999, but withdrew the offer when L.A. could not meet their demands for a new stadium.

Figure 7.5 Monopoly Decisions in the National Football LeagueFigure 7.5 Monopoly Decisions in the National Football League

The owners of professional football teams have a monopoly overmembership in the National Football League. Cities have to apply tothe NFL for a new team or pay top dollar for an existing team.Supply and Demand Why do team owners limit the number of teams?

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(Reteaching) To help students understand the example of Lelandand BreatheDeep, form groups offour to five students. Explain to themembers of each group that they areto create a simple illustration—atable or chart—that will display theeffects of changing prices as de-scribed in “The Monopolist’sDilemma.” Have groups work forabout 15 minutes on their illustra-tions. Then have a representativefrom each group present the graphicto the class. This illustration willprepare them to understand thegraph on the next page.

Transparency Resource PackageEconomics Concepts, 7D:

Monopoly Setting OutputEconomics Concepts, 7E: MonopolySetting Price

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ChaptChapter er 77 •• Section Section 22

Answer to. . .Building Key Concepts Althoughmore units are being sold, all of theunits are sold at a lower price thanbefore production expanded.Therefore, the marginal revenue is anegative number.

could charge enough to earn well abovewhat it cost to research and manufacturethe drug. The resulting profits would givethe company a reason, or incentive, forinventing the new medication in the firstplace. But could Leland sell as muchmedication as it wanted to at whateverprice it chose?

Even a monopolist faces a limitedchoice—it can choose either output orprice, but not both. The monopolist looksat the big picture and tries to maximizeprofits. This usually means that, comparedto a perfectly competitive market for thesame good, the monopolist produces fewergoods at a higher price.

The Monopolist’s DilemmaThe law of demand states that buyers willdemand more of a good at lower prices andless at higher prices. Figure 7.6 shows apossible demand curve for BreatheDeep,with prices in dollars on the vertical axisand doses on the horizontal axis. Manypeople with life-threatening asthma will paywhatever the medicine costs. But somepeople with milder asthma will choose acheaper, weaker medicine if the price risestoo high.

Trace the demand curve from left toright. At $12 per dose, consumers mightdemand 8,000 doses of BreatheDeep each

week. But at $9 per dose, as many as11,000 doses will sell. The law of demandmeans that when the monopolist increasesthe price, it will sell less, and when itlowers the price, it will sell more. Anotherway to interpret this graph is that if amonopolist produces more, the price of thegood will fall, and if it produces less, theprice will rise.

Falling Marginal RevenueRemember from Chapter 5 that tomaximize profits, a seller should set itsmarginal revenue, or the amount it earnsfrom the last unit sold, equal to itsmarginal cost, or the extra cost fromproducing that unit. This same rule appliesto a firm with a monopoly. The key differ-ence is that in a perfectly competitivemarket, marginal revenue is always thesame as price, and each firm receives thesame price no matter how much itproduces. Neither assumption is true in amonopoly.

To understand how this happens,consider the demand schedule forBreatheDeep in Figure 7.6. WhenBreatheDeep is sold at $12 a dose,consumers buy 8,000 doses, providing$96,000 in revenue. If Leland lowers theprice to $11 a dose, 9,000 doses will bebought for a total revenue of $99,000. The

Figure 7.6 Demand Schedule for BreatheDeepFigure 7.6 Demand Schedule for BreatheDeep

Price WeeklyDemand

Change in Revenue

Total Revenue

MarginalRevenue

(per dose)

$10 10,000 $100,000 $1,000 $1

$12 8,000 $96,000 — —

$11 9,000 $99,000 $3,000 $3

11,000 $99,000 –$1,000 –$1 $9

12,000 $96,000 –$3,000 –$3 $8

12

11

10

9

8

080 9 10 11 12

Output (in thousands of doses)

Pri

ce (i

n do

llar

s)

When 8,000 doses are made, the market price is $12.

DemandAs production rises to 11,000 doses, the price falls to $9.

By increasing output, a monopolist lowers the price of the good.Above a certain level of output, revenue also begins to decrease. Markets and Prices Why does revenue fall when productionincreases from 10,000 doses to 11,000 doses?

Background NoteMonopoly and PatentsThe patent system is often tested intimes of crisis. As a result of the anthraxpoisonings of 2001, the U.S. govern-ment decided to stockpile millions ofdoses of drugs that provide resistanceand treatment for anthrax infection.Bayer, the German multinational com-pany that holds the patent for Cipro,agreed to sell 100 million tablets to thegovernment at 95 cents per tablet, halfthe normal price. The company agreedto sell the second hundred million at 85cents each, and the third 100 million at75 cents each.

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Ask students to create a captioned ver-sion of the graph on this page. Suggestthat they redraw the graph on a largerpiece of paper and then use materialfrom the textbook to write paragraphsthat explain the significance of theaxes, curves, and points on the graph.

Simulations and Data Graphing CD-ROM offers data graphing

tools so that students can practice cre-ating and interpreting line graphs.

Math Practice ActivityMath Practice folder, p. 6, “Maximiz-ing Profit,” gives students additionalpractice in calculating total revenueand marginal revenue to maximizeprofits.

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Answer to. . .Building Key Concepts A monop-olist’s marginal revenue is lowerthan the market price, so outputmust be set at the point wheremarginal cost equals marginalrevenue. In a perfectly competitivemarket, marginal revenue remainsthe same as price. Under monop-oly, output will be lower and pricehigher than they would be underperfect competition.

Have students study Figure 7.7 and then answer the question below.Which of the following would be an accurate description of Point a on this graph?

A the point at which marginal revenue exceeds marginal cost

B the point at which demand exceeds supply

C the point at which marginal revenue equals marginal cost

D the point at which supply exceeds demand

Preparing for Standardized TestsPreparing for Standardized Tests��

sale of 1,000 more doses brought Leland$3,000 in new revenue.

In Chapter 5, you read that marginalrevenue in most markets is equal to price. Inthis monopoly, the marginal revenue at amarket price of $11 is roughly $3 a dose,far below the price. This is because thelower market price affects both the 1,000new doses sold and the 8,000 doses peoplebuy for $11 each instead of $12.

Now suppose that Leland lowers theprice of BreatheDeep from $11 to $10 adose. 10,000 doses will be bought, giving atotal revenue of $100,000. This time, thesale of 1,000 more doses brought only$1,000 in additional revenue. $10,000 inrevenue from 1,000 new sales barelyexceeds the $9,000 fall in revenue from the9,000 doses which are sold for $10, not$11. The market price is $10 a dose, but themarginal revenue has fallen to a mere $1 foreach dose of BreatheDeep sold.

As you’ve seen, when a firm has somecontrol over price—and can cut the price tosell more—marginal revenue is less thanprice. In contrast, in a perfectly competitivemarket, the price would not drop at all asoutput increased, so marginal revenuewould remain the same as price. The firm’stotal revenue would increase at a steadyrate with production.

The table in Figure 7.6 lists marginalrevenues for several different prices. Notethat marginal revenue actually becomes

negative when the quantity demanded isgreater than 10,000 doses a week.

Setting a PriceLeland will choose a level of output thatyields the highest profits. As you read inChapter 6, this is the point at whichmarginal revenue is equal to marginal cost.

In Figure 7.6 we have plotted the demandfor BreatheDeep at market prices of $8, $9,$10, $11, and $12 a dose. According toFigure 7.6, output at these prices will be12,000, 11,000, 10,000, 9,000, and 8,000doses, respectively. These points form themarket demand curve for BreatheDeepshown in purple.

Then, based on this data, we plottedLeland’s marginal revenue at these levels ofoutput. These points form the marginalrevenue curve shown in blue in Figure 7.7.The marginal revenue curve is at thebottom of the graph because a monopo-list’s marginal revenue is lower than themarket price.

Marginal cost equals marginal revenue atpoint a in Figure 7.7. This is the most prof-itable level of output. The monopolistproduces 9,000 units, the quantity at whichmarginal revenue and marginal cost areboth $3. According to the market demandcurve, the market price is $11 when 9,000units are sold (point b). Therefore, themonopolist will set the price of each dose at$11 or set production at 9,000 units.

Figure 7.7 also shows how price andoutput would be different if dozens of firmssold BreatheDeep and the market wereperfectly competitive. In a perfectly compet-itive market, marginal revenue is alwaysequal to market price, so the marginalrevenue curve would be the same as thepurple demand curve. Firms will set outputwhere marginal revenue is equal tomarginal cost, shown at point c. As you cansee, a perfectly competitive market forBreatheDeep would have more units soldand a lower market price than a monopoly.

ProfitsHow much profit does a monopolist earn?The cost of producing 9,000 doses is $3 per

9,000

Pri

ce

Output(in doses)

b

c

a$3

$11

Figure 7.7 Setting a Price in a MonopolyFigure 7.7 Setting a Price in a Monopoly

Marginal Cost

Market Price

Demand

MarginalRevenue

A monopolist setsoutput at a point (a)where marginalrevenue is equal tomarginal cost.Markets and PricesHow does this affectoutput and pricecompared to aperfectly competitivemarket?

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Provide students with the followingscenarios:• Students receive discounts on

movie theater tickets when theyshow their student identification.

• Consumers pay much more forfruit early in the harvest seasonthan they do in the middle of theharvest season.Ask students if these situations

are examples of price discrimination.Have them provide reasons for theiranswers. (The first is an example ofprice discrimination; the second isnot, because the price reflects theforces of supply and demand in aperfectly competitive market.) GT

(Enrichment) Ask students to com-pare how supply, demand, and priceoperate in perfectly competitive mar-kets and in monopolies. Have themcreate graphs or tables to display theircomparisons.

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ChaptChapter er 77 •• Section Section 22

BackgroundGlobal ConnectionsGlobal ConnectionsPrice discrimination on an interna-tional scale is known as dumping.When this occurs, a firm charges alower price in a foreign market thanit does in its home country. Some-times the price is even lower thanthe actual production cost.

Why would a firm engage indumping? Usually the firm has amonopoly in its own home marketbut faces competition in a foreignmarket. The firm is using its marketpower at home to discriminateagainst consumers. Sometimesdumping is an attempt to drive rivalfirms out of business in the foreignmarket. For this reason dumping isillegal under international tradeagreements.

Have students read the section titled “Targeted Discounts” and then answer the questionbelow.According to the text, why do companies offer targeted discounts?

A They offer discounts to appeal to all of their customers.

B They offer discounts to allow all people to enjoy luxuries.

C They offer discounts to get people to buy products they don’t need.

D They offer discounts to entice people who might not normally purchase theirgoods or services.

Preparing for Standardized TestsPreparing for Standardized Tests��

dose. Each dose is sold for $11. Themonopolist will earn $8 of profit per dose.Total profit is $72,000, or $8 per dose for9,000 doses.

Price DiscriminationThe previous example assumed that themonopolist must charge the same price toall consumers. But in some cases, themonopolist may be able to divideconsumers into two or more groups andcharge a different price to each group. Thispractice is known as price discrimination.

Price discrimination is based on the ideathat each customer has his or her ownmaximum price he or she will pay for agood. If a monopolist sets the good’s priceat the highest maximum price of all thebuyers in the market, the monopolist willonly sell to the one customer willing to paythat much. If the monopolist sets a lowprice, the monopolist will gain a lot ofcustomers, but the monopolist will lose theprofits it could have made from thecustomers who bought at the low price butwere willing to pay more.

Although price discrimination is a featureof monopoly, it can be practiced by anycompany with market power. Market poweris the ability to control prices and totalmarket output. As you will read in the nextsection, many companies have some marketpower without having a true monopoly.Market power and price discrimination

may be found in any market structureexcept for perfect competition.

Targeted DiscountsIn the monopolist’s ideal world, the firmcould charge each customer the maximumthat he or she is willing to pay, and no less.However, this is impractical, so companiesdivide consumers into large groups anddesign pricing policies for each group.One common form of price discriminationidentifies some customers who are notwilling to pay the regular price and offersthose customers a discount. Price discrim-ination can also mean that a companyfinds the customers who need the good themost, and charges them more for thatgood. Here are some examples of pricediscrimination.

1. Discounted airline fares Airlines offerdiscounts to travelers who buy ticketsseveral weeks in advance or are willingto spend a Saturday night at their desti-nations. Business travelers would prefernot to stay over on a Saturday night, butthese tickets are appealing to vaca-tioners who wouldn’t otherwise pay tofly and don’t mind the restrictions.

2. Manufacturers’ rebate offers At times,manufacturers of refrigerators, cars,televisions, and other items will refund asmall part of the purchase price tobuyers who fill out a form and mail itback. People who take the time to fulfillthe rebate requirements are likely more

price discriminationdivision of customersinto groups based onhow much they will payfor a good

market power theability of a company tochange prices andoutput like a monopolist

� Pricediscrimination cantake the form ofdiscounts for seniorcitizens, children,and students.

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Guide to the EssentialsChapter 7, Section 2, p. 29 providessupport for students who need addi-tional review of the section content.Spanish support is available in theSpanish edition of the guide on p. 29.

Quiz Unit 2 folder, p. 38 includesquestions to check students’ under-standing of Section 2 content.

Presentation Pro CD-ROMQuiz provides multiple-choice

questions to check students’ under-standing of Section 2 content.

Answers to . . .

Section 2 AssessmentSection 2 Assessment1. A company with market power can

control prices and output.2. Natural monopolies operate at a

lower cost to both consumers and pro-ducers, so they are generally allowedbecause they are the most efficientsource of that good or service.

3. Students should list three of the fol-lowing: discounted airline fares, man-ufacturer’s rebate offers, seniorcitizen or student discounts, and kidsfly or stay free promotions.

4. Sample answer: When economies ofscale exist, a firm’s start-up costs arehigh, but its average costs fall foreach unit it produces, even at a levelof output high enough to supply theentire market.

5. Answers will vary but should show anunderstanding of price discrimination.Students may list any of the typeslisted in the text on pp. 163–164 orothers, such as kids eat free offers inrestaurants.

6. As a supporting reason, students maysay that this would allow the govern-ment to exercise close control of themarket for meats in the town. As areason not to grant the request, stu-dents may say that competitionamong several butcher shops wouldprovide greater choice and higherquality.

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ChaptChapter er 77 •• Section Section 22

164

7. Student responses should demonstrate an under-standing of the concept of natural monopoly. Moststudents will probably say that public education is anatural monopoly because state boards determinewhat will be offered. Students who disagree maypoint to the school choice movement and the way itaffects the natural monopoly.

Section 2 Assessment

Key Terms and Main Ideas1. What can a firm with market power do?2. Why does government usually approve of natural

monopolies?3. What are three different forms of price discrimination?4. Define the term economies of scale in your own words.

Applying Economic Concepts5. Try This Look through a recent newspaper for adver-

tisements and coupons. List five examples of pricediscrimination.

6. Decision Making Suppose that you are the mayor ofyour town, and a local butcher asks you to franchise his

shop as the only approved butcher shop in town. List areason for and a reason against granting his request.

7. Critical Thinking Do you believe that public educationis a natural monopoly? Why or why not?

price-conscious than those who don't,and may be unwilling to pay full price.

3. Senior citizen or student discountsMany senior citizens or students havelower incomes than people who work fulltime. Zoos, theaters, and restaurantsoften offer discounts to senior citizensand students because they are unlikely tobe able to pay full price for what someconsider luxuries.

4. Children fly or stay free promotionsFamilies with young children spend moreof their income on food, clothing, andschool expenses. As a result, they haveless to spend on vacations. Once again,firms would rather have their businessand earn lower profits than earn noprofits at all, so they offer discounts forfamilies with children.

Limits of Price DiscriminationFor price discrimination to work, a marketmust meet three conditions. Firms that useprice discrimination must have somemarket power, customers must be dividedinto distinct groups, and buyers must not bein a position in which they can easily resellthe good or service.

1. Some market power Price-discrimi-nating firms must have some controlover prices. For this reason, price

discrimination is rare in highly competi-tive markets.

2. Distinct customer groups The price-discriminating firm must be able todivide customers into distinct groupsbased on their sensitivity to price. Inother words, monopolists must be ableto guess the demand curves of differentgroups, one of which is more elastic, orprice-sensitive, than the others.

3. Difficult resale If one set of customerscould buy the product at the lower priceand then resell the product for a profit,the firm could not enforce its pricediscrimination. Because consumer goodslike shoes, groceries, and clothes areeasily resold, price discrimination worksbest in marketing services that areconsumed on the spot. Examples includetheme park admissions and restaurantmeals. Airlines can offer seniordiscounts because the company can askfor identification and proof of age beforeletting the customer board.

Although most forms of price discrimina-tion are perfectly legal, sometimes firms useprice discrimination to drive other firms outof business. This illegal form of the practiceis called predatory pricing, and you willread more about it in Section 4.

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